Aztec Connect

There is a common philosophy that states, “The definition of insanity is repeatedly doing the same procedure, the same way, expecting different results”.  Are there re-occurring problems in your stores and warehouses?  Do you have a way for your employees to record these errors for analysis?  For example, is there an easy way to record damaged material or stock inventory that for some reason cannot be used?  This material includes:

• Damaged material found in the warehouse
• Unintentional scrap created when a mistake was made in filling an order
• “Drops” or quantities of a product that are too small to be sold or used

In many organizations, damaged or unusable inventory is hidden.  Maybe it is thrown in a scrap pile or discarded.  But the best run organizations encourage or better yet insist that employees record these “unquality events”.  Recorded events are analyzed to determine if polices or procedures can be changed to prevent the same mistakes from occurring again in the future.  For example:

Damaged material found in the warehouse:

• Was the material damaged because it was not stored in its stocking location?
• Was the material damaged in its designated stocking location?  Is there a better way to store the product?
• Was the material damaged when it was received from the supplier?  Do we need to ask the vendor to improve packaging or use alternative shipping methods?
• Is a particular employee careless in the way he handles material?

Unintentional scrap created when a mistake was made in filling an order:

• Are the proper tools not available for filling an order?  For example, it is difficult to measure a long length of pipe with a short ruler just as it is nearly impossible to create a precise, clean cut with a dull saw.
• Is an employee not paying proper attention to what he or she is doing?
• Are there environmental problems?  For example are products melting because they are not stored in a cool location?  Should lighting be improved?  Is there adequate space to properly deal with the amount of material that you have to keep in inventory?

“Drops” or leftover quantities of a product that are too small to be sold or used

• Should a customer be forced to purchase a whole unit so no drops are created?
• Should the price the customer pays include the cost of any leftover “drops” so that this unusable material has been paid for?
• Can a more appropriate quantity of the product be ordered from the supplier?

Correcting material handling problems allow you to reduce your operating costs and increase profitability.  In these challenging economic times you’ve got to take advantage of every opportunity to improve your operations!

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In order to receive all of the benefits from a good inventory management system, stock balances must be at least 97% accurate, every day of the year.  This means that the actual available quantity of every item in the warehouse is no more than 3% greater or less than the available quantity displayed on your computer inquiry screens.  If the computer says there are 100 pieces of an item on the shelf, there should be no less than 97, nor more than 103.  Note that this standard works for most companies.  Your company’s actual tolerance for error may be higher or lower.

Many companies are in the midst of conducting their annual physical inventory; every item is counted and, if necessary, the balance in the computer is adjusted to reflect the actual quantity on the shelf.  Even if you assume that the physical inventory results in an accurate count of each stocked product (a big assumption for many firms), how long do the counts remain accurate:  One month?  Two months?  Six months?

Our research shows that the more often a product is received or shipped, the less accurate the computer stock balance is.  This makes sense.  Every time someone goes to the bin, it is an opportunity for a mistake (or to coin the new term, “unquality event”) to occur.  For example, material can be put away in the wrong bin, or the wrong product can be taken to fill an order.  So, why not focus counting efforts on those items with the highest risk of error?

To change counting strategy to focus on these items, we must:

1.  Identify them by ranking by cost of goods sold (COGS) or hits.  A ranked-based method directs you to count the items with a large number of dollars flowing through inventory (i.e. with the highest annual cost of goods sold) or count the products with the largest number of transactions (hits) more often than slower moving products.

Ranking theory is based on “Pareto’s Law” (named for the 19^th century  Italian economist Vilfredo Pareto) which basically states that, in general,  80% of the results of any process is produced by 20% of the contributing factors.  Applied to inventory, this means that approximately 20% of your inventory items are responsible for 80% of your stock sales.  In fact, we have often found that only 10% – 13% of inventory items usually will account for 80% of sales and no more than 50% of stocked products will account for 95% of sales.  If your computer system doesn’t have the capability to rank products, don’t worry.  Ranking can be performed utilizing Excel or another spreadsheet software package.  For a guide to utilizing spreadsheets to rank your products, please send an email to us at info@effectiveinventory.com.

2,  After ranking your items, develop a cycle counting schedule.  We suggest:

• “A” rank items (responsible for the top 80% of activity) are counted six times per year
• “B” rank items (responsible for the next 15% of activity) are counted two times per year
• All other products are counted once per year

Frequently counting your “A” items will allow you to uncover the reasons for inventory discrepancies.  As you correct your policies and procedures your computer on hand quantities will consistently be more accurate.  When you have confidence in the accuracy of your inventory, you can reduce the frequency of your cycle counts.  You may be able to assume that your slowest moving products have accurate counts and skip counting these products!  An occasional audit of the quantity of selected fast moving products will ensure that quantities in your computer will continue to agree with what is on the shelf.

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Several articles published this week discussed the new “alternative profitability measurements” that are being introduced by many companies.  These metrics such as “profitability before sales expense” and “income before operating expenses” may sound impressive.  They also can  provide results management can brag about.  But they may be hiding problems that can result in the organization’s demise.

We strongly recommend that you rely on time-tested and widely excepted metrics to gage your company’s financial performance.  This week we will discuss two of these meaningful metrics:  The turn-earn index and gross margin return on investment (GMROI).

If a company enjoys high gross margins, it can be successful with lower inventory turns.  Many surplus houses justify keeping items in their warehouse for years because they bought the material for pennies on the dollar and will eventually sell some of it for a premium.  The Turn/Earn Index will help you balance turnover and profits.  It is calculated by multiplying inventory turns by the gross margin percentage.  It highlights situations where high margins can compensate for low inventory turns.

Say, for example, you turn over inventory of an item four times a year and earn an average 30% gross margin on each sale of the product.  That’s a T/E Index of 120.  We get the same return on investment value if we turn the inventory of an item only twice but make an average gross margin of 60% on every sale:

2 turns * 60% average margin = 120

On the other hand, the stock of a product with an average margin of 20% has to turnover six times in order to achieve the same 120 T/E Index.  Your T/E target should normally be at least 120 (e.g. a vendor line turning six times annually and earning an average 20% margin).   But the higher the T/E Index, the better!

A similar measurement to the Turn/Earn Index is Gross Margin Return on Investment (GMROI).  It also measures the profitability of your investment in inventory.  GMROI is calculated by dividing gross profit dollars from sales in the past 12 months by the average inventory investment over the same time period:

Gross Profit Dollars from Past 12 Months ÷ Average Inventory Value

For example, if you earned $20,000 in gross profits from an average inventory investment of $10,000, your GMROI would be 200 ($20,000 ÷ $10,000 = 2.00).  In other words you are earning $2.00 for every dollar invested in inventory.

Please note that while the Turn/Earn Index and GMROI both measure profitability, they do so based on two different scales (sort of like Fahrenheit and Centigrade temperatures).  Compare the calculated T/E Index and GMROI using the following data:

T/E Index = 2.4 * 25% = 60

GMROI = 2,000 ÷ $2,500 = 80

Because they utilize different scales the GMROI will always be greater than the corresponding T/E Index.  It doesn’t matter whether you calculate a T/E Index or GMROI.  Either is a wonderful gauge of the profitability performance of your investment in stock inventory.

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A customer asks you to stock a product for them.  Because of the unique characteristics of the product you know that few if any other customers will be interested in this item.  How do you know whether or not to comply with this request and stock this “customer specific” inventory?

First you must consider if the item itself will generate an adequate profit to cover the cost of carrying the product in stock.  To do this we calculate an adjusted gross margin for the item with the formula:

[Annual Gross Profit $ - (Annual Carrying Cost % * Average Inventory Investment $)] ÷ Annual Sales $

Let’s look at an example.  Suppose the item the customer wants us to stock has these characteristics:

Projected Annual Sales Dollars                   =   $4,285

Projected Cost of Goods Sold                     =   $3,000

Projected Gross Profit Dollars                    =   $1,285

Value of Purchase Qty (from vendor)         =  $1,000

Value of Safety Stock                                 = $   250

Annual Carrying Cost %                                 = 18%

We calculate the Average Inventory Investment with the formula:

(Value of Purchase Quantity ÷ 2) + Value of Safety Stock

During the time it takes to sell the entire $1,000 worth of material we must buy from the vendor half the time we will have more than half of $1,000 (i.e., $500) and half of the time we will have less than $500.  In addition whenever we receive a replenishment shipment of this item we should have the safety stock quantity (i.e., reserve inventory) on the shelf.  Therefore our projected average inventory value for this item is $750:

($1000 ÷ 2) + $250

We are using a typical inventory carrying cost of 18% in this example.  We will help you (at no cost) calculate the carrying cost for your company.  Please see the “Carry Cost” section of our web site, www.EffectiveInventory.com.  As a result the projected adjusted margin for this item is 26.8%:

[$1,285 – (.18*750)] ÷ $4,285 = 26.8%

The adjusted margin must be greater than your overhead expense for you to be making money.  Many companies have a minimum adjusted margin goal of 7% – 9%.  The projected sales of this item exceed this requirement.  However if the gross margin on the product were lower, we had to purchase more at one time from the vendor, or there  was a requirement to carry more safety stock we might find ourselves experiencing losses in carrying this item.

In addition to calculating the adjusted gross margin you must be sure that the customer actually purchases the $4,285 worth of the product each year.  Best practice is to monitor purchases of customer-specific inventory each month and contact of the customer if none of the product has been purchased for 60 days.

Remember that the goal of effective inventory management does not only involve meeting or exceeding your customers’ expectations of product availability.  You must also be sure that every item you stock is either profitable, or leads to other profitable sales.

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Safety stock provides protection against stock outs due to unexpected demand for a product or delays in receiving a replenishment shipment from a supplier.  It is insurance.  Like many other types of insurance there is no “right” or optimum amount.  If you talk to three different life insurance agents they will probably suggest you buy three different amounts of insurance.  When you are determining safety stock quantities you have to ask yourself, “how much do we want to invest in preventing stock outs of this product?”

The answer will probably be different for various products you stock.  In determining the safety stock amount for a particular product you have to ask:

• What is the likelihood that this product will experience a stock out?
• How disappointed will customers be if this product is not stock?

Products are more likely to be out of stock if they experience:

• Inconsistent supplier lead times – If vendor shipments are often several weeks late, you may want to keep some extra stock to “cover” customer demand during these unexpected delays in receiving a replenishment shipment.
• Large fluctuations in sales or usage – You might sell 10 pieces or 1,000 pieces of a product in a month without much advance notice of when usage will significantly increase.

Though it is evident that some items need more safety stock than others, many companies maintain safety stock quantities with some general rules that apply to all stocked products.  Typical safety stock policies include:

• We will maintain safety stock for all products equal to a certain percentage of lead time usage
• We will keep a certain number of days on hand as safety stock for all items

The result is that some products have too much safety stock (unnecessarily tying up funds, suppressing turnover and taking up too much warehouse space) while other items have too little safety stock (resulting in additional stock outs and disappointed customers).  Rather than applying safety stock across your entire inventory with a paint roller, we would like you to take a fine tipped artists brush and “dab” specific amounts of safety stock exactly where it is needed.

To determine what products need more safety stock analyze the forecast, safety stock quantity and actual sales or usage for each product over the previous three months to calculate the “residual inventory value”:

Forecast + Safety Stock – Usage = Residual Inventory Value

If the residual inventory value is less than or equal to zero actual sales or usage was equal to or exceeded the sum of the forecast (what you predicted you would sell) + safety stock (your reserve inventory).  You might have experienced a stock out on the item in that month.  You probably can’t afford enough inventory to avoid stock outs on all stocked items.  However you might consider increasing the safety stock on “critical” products that have a negative residual inventory value in one or more of the previous three months.

Your investment in safety stock is subjective.  There is no “right’ answer.  But with some simple tools and analysis you can make an informed decision that will ensure that the funds you make available for safety stock are invested as wisely as possible.

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We are seeing a battle emerging between two Goliaths:  Walmart and Amazon.com. In selected markets  Amazon offers same day delivery for orders placed on line.  Walmart has also begun offering this service calling it “Walmart to Go”.  But Amazon has a tremendous advantage.  They will be filling these orders from its distribution centers while Walmart will be filling orders from local stores.

It is true that Walmart’s numerous stores allow it to fill the orders closer to where the customer is located.  This results in a lower delivery cost and less time necessary to actually transport the goods to the customer.  But this delivery advantage doesn’t come close to covering Walmart’s higher cost of filling orders.

State of the art distribution centers (like Amazon’s) are organized to do two things:

1)      Protect the inventory stored in the warehouse from breakage, spoilage and loss

2)      Minimize the cost of filling orders

Minimizing the cost of filling orders involves techniques including storing faster moving products in the most accessible locations regardless of the product line to which they belong.  Amazon might store a bestselling book next to a very popular DVD or electronic gadget.   This is known as storing products by product rank.  Picking documents, bar code scanners or voice-to-pick equipment direct an order picker to specific locations where needed products are located within the distribution center.

Storing merchandise by product rank does not work in a retail environment like a Walmart store.  Customers fill their own orders.  They expect to have similar products located in the same area.  This means that all items in a product line, whether fast moving, moderate moving or slow moving, will be stored in the same area.  This forces Walmart to stock some very fast moving items in the back of the store.

Is this a problem for Walmart?  No in fact it works to their advantage when customers are shopping in their store.  Retailers often try to arrange products to extend the amount of time it takes to fill an order; after all the customer is providing the labor to fill the order.  And the more time a customer spends in a store the more they are likely to buy.  Ever notice that milk is always stocked in the back of a supermarket and you have to pass by all of the store’s other inventory in order to find it?

This product layout will work to Walmart’s detriment as its own employees fill orders for delivery in retail stores (not Walmart distribution centers).  Employees will often have to take a grand tour of the building when filling a single order.  The additional cost of filling orders must be passed on to consumers or significantly reduce Walmart’s profits.  As price competition requires the chain to meet Amazon’s advertised prices the latter result is far more likely.

Wouldn’t Walmart ( or any other “bricks and mortar” retailer) be better off enhancing the in store experience for customers?  Providing experiences and services that cannot be duplicated over the world wide web?

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As I write this I am frustrated.  A new software company asked me to check the accuracy of their forecasting.  I sent them one of our sample databases (i.e., not with actual customer names or part numbers) withholding the most recent month.  I then compared the forecasting results they produced to the actual usage in the most recent month using our standard forecast error formula:

Absolute Value of (Forecast – Usage) ÷ Smaller of the Forecast or Actual Usage

For example if the forecast 100 pieces would be sold in October and they actually sold 50, the forecast error would be 100% [Absolute Value of (100 – 50) ÷ 50].  We would get the same error if the numbers were reversed, that is we forecast 50 pieces in October and actually sold 100 [Absolute Value of (50 – 100) ÷ 50].  This calculation reflects our strong belief that it is as bad to be overstocked as it is to be under stocked.

The results were not good.  But instead of looking to see why there were significant variances between the forecast and actual usage the software company attacked our methodology stating that it is “odd and numerically unstable”.  I find it strange they could not say why.  They claimed that the proper way to measure forecast accuracy would be:

Absolute Value of (Forecast – Usage) ÷ Forecast

This would mean that when the usage was less than the actual forecast the results would be twice as good (i.e., a forecast error of 50% rather than 100%).  To me this “statistically valid” method does not make sense.

Rather than trying to improve their results they attacked the test.  I believe that whenever you look for a tool to improve your business you should compare their results to what actually happens in your business; whether or not the software company feels that it is “statistically valid”.

I am very glad that reputable firms like Aztec Systems consider all feedback in an effort to improve their products and service to their customers.   Wouldn’t it be nice if more companies felt the same way?

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Some companies place ads in industry publications listing the products they are planning to liquidate.  There are also Internet 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.

The internet provides four advantages over print ads in the sale of excess inventory:

1. Maintaining a web site or utilizing a web site that specializes in liquidating stock is often less expensive than taking out print advertising.

2.  You usually have to submit the text for an ad several weeks before the publication is distributed.  After you have submitted the ad you might find other products you’d like to list, or you might sell some of the items that appear in the ad.  You can update a web site as often as you like.

3.  With an ad you are betting a reader will need something you are advertising as she is reading the magazine.  If she throws the issue out and then needs something in your ad three days later, you are both out of luck.  With the Internet, potential customers access your advertisement when they need something you have to offer.

4.  With the Internet, you are not restricted to the circulation of the magazine.  You are advertising to a worldwide audience.

You must realize that not all excess material can be sold over the Internet.  You have to consider the product’s potential market:

Excellent – Generic products (or products whose quality is assumed by buyers) that have a large number of potential customers and a large number of possible applications or uses.

Good - Generic products (or products whose quality is assumed by buyers) that have a large number of potential customers but a small number of possible applications or uses.

Fair – Products with a large number of uses but a low number of potential customers.  You will probably get better results if you directly approach these customers.

Poor – Products with a small number of uses and potential customers.

Keep in mind that generic products and items that are assumed to be of acceptable quality sell well over the Internet.  Those products that a customer must “touch and feel” before buying generally don’t sell well in an e-commerce environment unless the customer is very familiar and comfortable with the supplier.

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