Aztec Connect

In a previous post we discussed a metric called the customer service level. The customer service level measures the percentage of line items ordered by customers that can be shipped complete, in one shipment, by the date the customer expected the material. The customer service level is a great measurement but it is dependent on two factors that are sometimes hard to control:

• Salespeople will accurately record the promise date for each line item on a customer order
• All customer requests for products will be accurately recorded

One of our clients had salespeople who continually defaulted the promise date on every customer order to the current date even though the firm delivered most orders the next day. Because most orders were delivered after the recorded promise date, their computer system considered nearly every line item late and reported a very low customer service level even though deliveries generally met customers’ expectations. At another company customer requests for products that were completely out of stock were not recorded. For example if a customer ordered 10 pieces of a product and one piece was shipped in the initial shipment, the transaction negatively affected the customer service level. But if the item was completely out of stock and no order was entered when a customer requested 10 pieces there was no effect on the customer service level.

To avoid these problems some companies measure stockouts as an alternative to the customer service level. A stockout occurs when the available quantity of a product (on-hand quantity minus quantity committed on current orders) falls to or below zero. When this situation occurs:

• The number of stockouts for the product is incremented by one
• The date of the stockout is recorded

When a stock receipt for the product is entered into the computer system and the available quantity rises above zero, the date of the end of the stockout is noted and a “days out of stock” for the current month is incremented by the length of the stockout.

It is imperative that both the number of stockouts and days out of stock are recorded each month for each stocked item because they tend to identify two very different problems:

Number of Stockouts: If a popular “A” ranked product experiences many stockouts (e.g., more than two in a four month period) it probably means that its normal reorder quantity is too small. All or most of each replenishment shipment is used to fill orders backorders that have accumulated during the lead time. The standard reorder quantity of the product needs to be increased to satisfy customer demand between the receipts of replenishment shipments.

Days Out of Stock: A situation where the number of stockouts is low but an item has been out of stock for a significant number of days within the past several months (e.g., 14 days within a four month period). This usually is the result of an inconsistent lead time or other vendor problem.

Some companies consider an item to be out of stock when the available quantity drops below the average or typical order quantity. For example, if customers normally order a dozen of a fastener at a time, having only one or two pieces on the shelf may be the equivalent of having none.

The first part of the goal of effective inventory management is to meet or exceed your customers’ expectations of product availability. Accurately tracking stock outs will help you achieve this goal.

We received a request from a reader to list some of the “best practices” receiving material that are utilized by the most successful distributors, manufacturers and retailers. Here are some policies and procedures we suggest you implement to ensure that your receiving department is an active participant in your goal of achieving effective inventory management:

Assign your most technically competent people to receiving and stocking. These people know your products. They can easily differentiate between similar looking items and tell if each product received meets your quality standards. They also know where material is stored in the warehouse and can stock it in such a way as to minimize the cost of filling orders. How often have you had to conduct a “treasure hunt” looking for needed stock that was inadvertently placed in the wrong location by an inexperienced new employee? New employees should be assigned the task of filling orders under careful supervision. It is easy to find and correct their mistakes as they learn your products.

Check material in against your purchase order not the packing list supplied by the vendor. The material in the shipment may agree with the vendor’s paperwork but it may not be what you ordered.

Cross dock backordered and special order items. When entering a stock receipt into the system the receiving clerk should be notified by the system of the quantities of each item that are needed to fill outstanding customer orders. Racking and/or shelves in the receiving area should be reserved to temporarily store this “cross docked” material. After posting the stock receipt the receiving clerk should be able to print pick tickets or be notified of shipping instructions for these products.

There are situations where the quantity received is not adequate to completely fill all outstanding customer orders. In these situations the appropriate buyer should be notified (by email or daily report/inquiry) and he or she should specify which customers should receive material by releasing those outstanding orders to the receiving department.

Have standard policies and procedures for all situations. There should be two ways to handle any situation: your company’s approved way and the wrong way. Every person in the receiving department should understand how to handle all situations including:

• Who needs to approve keeping shipments from vendors that arrive without a valid purchase order number?

• How large of an over shipment can they accept without management approval?

• What is the maximum allowable amount of time after stock receipt to have a shipment of products available for sale or use? This is typically referred to as “dock to stock” time.

• How should damaged or mis-shipped material be quarantined until the appropriate buyer decides how to deal with it?

• What is necessary to issue a customer a credit for returned material?

You can have the best forecasting and replenishment system available but if your receiving department loses material, double handles receipts, or is inconsistent in their material handles procedures your company will not be able to achieve the goal of effective inventory management.

Occasionally a supplier will provide you with an “incentive” for paying an invoice before its due date. These are often referred to as “terms discounts”. A common terms discount is “2% 10 Days Net 30 Days”. This means that while the vendor expects to be paid within 30 days of the invoice date, he or she will allow the customer an additional 2% discount if the invoice is paid within 10 days of the invoice date. This month a reader sent an email asking why we almost always recommend taking advantage of these discounts.

For example, the vendor is offering a 2% discount off of the cost of the material on an invoice if you pay for the material 20 days earlier than you normally would. That is pay for it in 10 days rather than 30 days. If you earn a 2% return every 20 days, you will earn more than a 36% return on your investment every year. Where did I come up with this fantastic return?

There are 365 days in a year or about eighteen 20 days periods (18 * 20 days = 360 days). If I can earn 2% eighteen times during the year the result is about a 36% annual return (2% * 18 times = 36%)! Even if I have to borrow money at a 6% annual interest rate, it makes sense to take advantage of this terms discount of “2% 10 Days Net 30 Days”. Even a terms discount of “1% 10 Days Net 30 Days” provides you with about an 18% annual return (1% * 18 times = 18%). Even borrowing money at 6% seems worth it to get an annual return of 18% or 36%.

Keep in mind that another vendor offer of “extended terms” does not provide nearly the same return on your investment. When a vendor offers extended terms he or she is giving you more time to pay an invoice. Common extended terms include paying an invoice in “60 Days Rather Than 30 Days” or “90 Days Rather Than 30 Days”. What this means is that the vendor is giving you free use of money for either 30 days in the case of “60 Days Rather Than 30 Days”(60 Days – Normal Pay Period of 30 Days = 30 Days) or 60 days in the case of “90 Days Rather Than 30 Days” ”(90 Days – Normal Pay Period of 30 Days = 60 Days). Your savings are the cost of money for either the 30 day or 60 day period. If you could borrow money for 6% per year or ½% per month:

- Extended terms of “60 Days Rather Than 30 Days” gives you an additional one-half percent discount on your order (1 month * ½% per month = ½%).
- Extended terms of “90 Days Rather Than 30 Days” the result is an additional 1% discount on your order (2 months * ½% per month = 1%).

I strongly believe one must stay disciplined to check the math on these offers. It has been my experience that it is almost always a good idea to take advantage of terms discounts. However, even though it may sound advantageous to take advantage of extended terms, they usually don’t provide a discount worth pursuing.

A customer recently asked me the difference between products with sporadic usage and those with erratic usage. Though both of these types of products cause headaches for many distributors they have different characteristics and require very different methods of replenishment.

Sporadic usage products are not sold or used on a regular basis. You don’t have transactions for these items every week or every month. But if you want to maintain these products in stock you’d better have enough on the shelf to fill a “typical customer order”. This is often known as the “typical order quantity”. Future demand of sporadic items cannot be forecast. Afterall, It is nearly impossible to determine when someone will ask for some. Therefore we suggest these products be maintained with minimum and maximum quantities. The maximum is a multiple of the “typical order quantity”. For example if the typical order quantity is five pieces and you want to keep two typical orders in stock, the maximum would be 10 pieces. The minimum quantity is the maximum quantity less one normal usage quantity. In the example above the minimum would be five pieces. We will usually base the multiple of the typical order quantity on factors such as:

• The cost of the typcial order quantity (we’ll stock more of lower cost items)
• The lead time (we’ll stock less if we can replenish our stock in a day or two)
• The number of times the product experienced usage in the past 12 months (if an item only sold once last year we probably shouldn’t keep five normal use quantiies on the shelf)

Erratic usage items are sold or used on a regular basis, but the usage quantities vary significantly from month to month, or even week to week. For example you might sell five pieces of a widget this week and 5,000 pieces of the same product next week. Forecasts for erratic usage items are rarely accurate. And, as with any item with recurring usage the greater the forecast error, the more safety stock (i.e., reserve inventory) you must maintain to cover customer demand in the months or weeks with high usage. This increased inventory investment will have a negative effect on the profitability of erratic usage items. They had better be very profitble on their own, or lead to other profitable sales.

Both sproadic and erratic usage stock items present challenges for buyers. They require special handling in order for you to achieve your desired level of customer service.

I received an email this week asking how often products should be cycle counted.  Cycle counting is the process of counting several items every day to ensure that the inventory on-hand quantities in your computer system agree with what is actually on the shelf in your warehouse.  We have found that cycle counting is usually better than taking an annual full physical inventory for several reasons:

1)      A full physical inventory causes you to have to interrupt your normal business operations.  There is a time constraint that may prevent you from obtaining the most accurate counts possible.

2)      Even if your counts are accurate after the completion of your physical inventory they may not remain accurate as soon as material starts moving again.

3)      It is difficult to determine the reason behind discrepancies found during the physical inventory.  If you do not correct the material handling policies and procedures that create these discrepancies you are destined to repeat them.

While cycle counting is a good business practice it is also a cost of doing business.  You want to minimize this cost.  That is you want to count as little as possible to maintain accurate on-hand quantities.  For this reason we suggest you concentrate on items with the most transactions.  These are your “A” items based on “hits”.  A hit is a sale of an item regardless of the quantity requested by the customer.   After all every time someone goes to the bin to fill an order for a product there is another opportunity for a mistake to happen.  We suggest you start with the following schedule:

• Count your “A” items based on hits (i.e., those responsible for 80% of total annual hits in a warehouse) six times a year
• Count your “B” items based on hits (those responsible for the next 15% of total annual hits) twice a year
• Count all other products once a year

Measure your count accuracy with the following formula:

Absolute Value of (Count – Current Computer On-Hand) divided by the Current Computer On-Hand

If you find that your cycle counts are more than 97% accurate, you can count products less often.  If your accuracy is below 90% you probably will want to count items more often until you discover the reasons behind your inventory discrepancies.

When placing a replenishment order, how do your buyer’s decide how much of each item to order? Often reorder quantities are based on “habit” (i.e., “this is the way we’ve always done it”) rather than logic. Most computer systems allow you to reorder using an economic order quantity (EOQ). This is the quantity that will minimize the total cost of inventory for each piece of each product with recurring usage that you buy. The EOQ balances four factors:

• The current forecast demand for the product
• The cost of carrying inventory (also known as the “K” cost)
• The cost of issuing a replenishment order (also known as the “R” cost)
• The replacement or landed cost per piece of the item

By utilizing an accurate EOQ you will ensure that you are buying the quantity that will maximize your corporate profitability. But is it is always a good idea to maximize profitability? That is buying a larger quantity at a lower total unit cost to maximize profit dollars. Probably, if you have the cash to do so.

However in today’s economy we see many companies emphasizing “cash flow management” over profitability. That is they are willing to sacrifice some profit dollars in order to invest smaller amounts in inventory. If you find yourself in this situation, closely examine the EOQ quantities calculated by your computer system in terms of the day’s supply of inventory. Compare the results to the value of the product sold or used during the order cycle for each supplier. The order cycle (also known as the review cycle) is the typical length of time between replenishment shipments being received from the vendor. For example you may receive shipments from the primary vendor of a particular product line every 10 days. If you include this item on each order you can order a ten day supply and have enough inventory on hand to meet your customers’ expectations of product availability.

This order cycle reorder quantity is usually less than the EOQ quantity. Note that the order cycle reorder quantity does not affect either anticipated lead time usage or safety stock quantity. These are elements of the minimum or “order point” quantity which will ensure that you reorder the product at the “right” time in order to avoid a stockout. Replacing the EOQ with the order cycle quantity for many items can substantially reduce the amount of money you have to invest in inventory. Though you will not be buying to achieve the lowest total cost for each piece of the product and maximize your profitability, buying just enough to last during the order cycle will reduce necessary cash outlays and increase your inventory turnover (i.e., your opportunities to earn a profit from every dollar of your average inventory investment). This may be just the remedy for a company having cash flow challenges.

In “challenging” economic times (i.e., today’s business environment) the amount of slow moving inventory and dead stock in an organization’s warehouses and stores tends to increase.  You need to clean out this unneeded stock to free up needed funds and space for those products that are needed by your customers.  We suggest you review established products (i.e., those that have been stocked for more than six months) that have not had sales in more than three of the past 12 months. Sort these products in descending order based on the current value of inventory.    Examine each of these products:

• Should it remain a stocked item in this location? 
• Can this product be centrally warehoused and transferred to this branch as needed? 
• Do you stock a similar item in another brand?  Remember you have plenty of competition.  You don’t want to unnecessarily encourage additional competition within the four walls of your building.  That is two similar items on the shelf in your warehouse competing to fill the same customer order.

Your best option is probably to move unneeded material to another store or warehouse where it can be sold or used.  If it isn’t needed anywhere in your organization liquidate it through other means.  Consider these options:

• Return Material to the Vendor.  The actual desirability of this option varies with each vendor.  Some vendors are very good about accepting returns.  Others assess so many charges and conditions that returning material is not a feasible option.  Remember that the best time to negotiate the terms for the return of material with a vendor is before you agree to take on a new product line or place a very large purchase order.
• Reduce the price to “move” the excess inventory.  Department stores do it, why can’t you?  This works especially well when the customer has some discretion as to which of several items she will purchase.  For example a customer might purchase a discontinued sink if the price is substantially lower than a similar item from normal stock.
• Offer your salespeople a monetary incentive to sell the product.  This works especially well when a customer can choose between several products that will meet his or her needs.  Sometimes it is almost miraculous how fast inventory can move when salespeople are provided with the proper incentive.
• Advertise the availability of this material to other suppliers.  Some companies place ads in industry publications listing the products they are planning to liquidate.  There are also Internet World Wide Web sites that maintain lists of available surplus stock.  Search for sites that feature surplus material using the words “surplus,” “inventory,” and the name of one of your major products lines. 
• Substitute the product for a less expensive item.  Suppose you sell water heaters.  Your manufacturer replaced his model A345 with the model A365 that offers easier access to the heating element.  You have three pieces of this discontinued 40-gallon heater in stock.  Naturally, contractors ordering a 40-gallon heater want the new model.  But, when a customer orders a 20-gallon heater, why not offer him one of the discontinued 40-gallon heaters at the price of a 20-gallon unit?  Remember, inventory isn’t worth what you paid for it.  It is worth what someone is willing to pay you for it.
• Donate the Material to a Non-Profit Organization.  Can a school, church, or charity use some of your dead or slow moving inventory?  This alternative is especially attractive for sub-chapter “C” corporations in the United States.  As of the date I am writing this chapter, these companies can take a deduction of up to twice the cost of the inventory.  Talk to your accountant or tax advisor for details and restrictions concerning material donations.  A good source for finding organizations that can use what you have to offer is the National Association for the Exchange of Industrial Resources, 560 McClure St., Galesburg, IL  61401 (800-562-0955 or http://www.naeir.org).
• Throw it away.  This is the least agreeable alternative.  But, at least you are freeing up some shelf space in your store or warehouse, getting rid of an eyesore, and getting some benefit by being able to write off the cost of the material.

Moving unneeded inventory will free up space in your facility.  With the proceeds of the sale of this material you will generate cash that can be invested in more of the products that will sell or be used for other purposes.