John Schreibfeder: The 13 step program for achieving effective inventory management

Ryan Barradas, founder and managing partner of WealthPoint, LLC in Phoenix, Ariz., is STAFDA’s designated wealth management consultant.

The goal of effective inventory management (EIM) is to “meet or exceed customers’ expectations of product availability with the amount of each stocked item that will maximize an organization’s net profits.” Every week I get at least one phone call or e-mail in which a company president asks:

  • That goal sounds great, but how do we get started?  
  • What are the steps necessary to achieve the goal?
  • What are our inventory turnover and gross margin return on investment (GMROI) potentials?

While we develop customized programs to achieve EIM for each of our clients, most follow our basic “13-step plan.” The good news is that achieving EIM is not rocket science. It is just like achieving any other personal goal. Superior intellect is not necessary. The key factors to achieving EIM are organization, perseverance and an open mind to change the way things have always been done in your organization. Let’s review these 13 steps
to effective inventory management success:

1. Make sure that all material movement is properly recorded. Effective replenishment is impossible if the
on-hand quantity of each item in your computer system does not agree with what is physically on the shelves in your warehouse.

To uncover problems in your material handling procedures, we suggest you implement a comprehensive cycle counting program. Count a select number of products every day. Count your fastest moving products (those that sold in all 12 months within the past year) one time, and then count them again a week or two later. If you see significant discrepancies during the second count, examine transactions involving these products. You’ll probably discover some sloppy material-handling procedures that can be easily corrected.

2. Develop an approved stock list for each of your warehouses or branches. Separate the material that you want to stock from the stock that needs to be liquidated. Start by examining items that were sold or used in less than three of the past 12 months. How many of these items can be discontinued, ordered as needed to fill specific customer orders or maintained in a central warehouse? This process will free up both space and money that can be utilized to stock the products your customers expect you to have on the shelf available for immediate delivery.

3. Verify that the lead times for all items to be stocked. Achieving your customer service level goals is dependent on reordering products when your net available quantity (On Hand – Committed + On Replenishment Order) is no less than what you will sell during the anticipated lead time.

The best practice is to implement an unusual lead time notification report or inquiry. If a shipment arrives from a supplier more than a week early or late the appropriate buyer should be alerted. He or she should contact the vendor to determine if the lead time associated with this stock receipt was an exception or what can be expected for future shipments.

4. Separate products to be stocked into items with sporadic usage and those with recurring usage. The forecast for a stocked product is the quantity you anticipate selling in an upcoming week or month. Most computer systems calculate forecasts based on some average of past usage. But this doesn’t work well if a product does not sell in most months. For example, if you sell six units of an item three times a year (total of 18 pieces), do you really want to base your stocking decisions on selling an average of 1.5 pieces per month?

For most distributors, non-seasonal sporadic items have had usage activity in less than eight of the past 12 months. Seasonal sporadic items do not have consistent usage in the same months each year. Note that for the average distributor, more than 70 percent of stocked products experience sporadic usage.

5. Determine the average sales or usage quantity for each item with sporadic usage. This is the normal quantity sold or used in one transaction. Most often,
we find it to be the greatest of the Mean Hit Average (12 months usage ÷ # of orders in past 12 months); the Median Average (when all requested quantities of an item are sorted from the highest to lowest quantity, this is the middle value); and the Mode Average (this is the most common sales quantity).

6. Set minimum and maximum stock quantities for items with sporadic usage based on a multiple of the normal quantity sold or used in one transaction. You probably want to set the maximum quantity to a higher multiple of the normal sales quantity if it has a longer lead time, is used more frequently (i.e., it almost has recurring usage) or is a very inexpensive product.

The minimum is usually set to one less normal sale or usage quantity than the maximum quantity. However, if the maximum quantity is only one normal usage quantity, the minimum will be one piece less than the maximum quantity.

7. Determine the best forecast method for each item with recurring usage. Different stocked items have different patterns or usage. A good forecasting system will test each item against several forecasting formulas and choose the method that results in the lowest forecast error for each product. The forecast error measures the difference between the forecast and actual usage over the past several months.

8. Set safety stock quantities for each item to ensure that your company achieves the desired level of customer service. Customer service measures what percentage of orders can be filled completely in one shipment out of current stock inventory. Safety stock is “insurance inventory” protecting against stock outs due to unanticipated demand or delays in receiving a replenishment shipment.

Many companies take a “paint roller” approach to calculating safety stock quantities. That is, they apply the same rules to all items. Apply safety stock with a fine tipped artist’s brush. Dab it precisely where it is needed. Give more safety stock to “critical” items and those with erratic demand or lead times. Less important items, as well as those with very consistent usage and deliveries, do not need as much safety stock.

9. Be sure your order/review cycles are correctly set. The order/review cycle measures how often you can place a target order with a vendor. This is the vendor’s requirement that allows you to achieve the terms or discounts enabling you to competitively sell the vendor’s products.

10. Analyze possible unusual usage at the end of each month. Adjust usage history as necessary to correct for activity that probably will not reoccur.

11. Calculate replenishment parameters for each item every month after examining possible unusual usage. Your buyers should be very familiar with how your system determines when to order products and how much to order. They should be able to update software settings so that your system consistently produces the results you want.

12. Determine turnover and profitability goals. Every company has a potential inventory turnover. This is measured by dividing your annual cost of goods sold by your “ideal” inventory investment. (Contact us for an article on how to calculate the amount of inventory you should have to achieve your desired level of customer service.)

Profitability is normally measured by the Turn/Earn Index (average gross margin % times actual Iinventory turnover) or Gross Margin Return on Investment or GMROI (annual gross profit $ ÷ average inventory investment). While profitability goals vary by company, most of our clients strive to achieve a minimum Turn/Earn Index of 1.20 (four turns at a 30% margin) or a GMROI of 1.50 — (earning $1.50 for every dollar of your average inventory investment.)

13. Measure progress each month in achieving predetermined goals. You will never meet your customer service level, turnover and profitability goals unless you track your progress. You won’t achieve success overnight. Look for continual progress toward achieving the goal of effective inventory management.

What better time than the start of a new year to get started on achieving effective inventory management?  Get started right now. We are here to help you develop and implement your customized EIM program. CS

Jon Schreibfeder, president of Effective Inventory Management, Inc., is STAFDA’s inventory management consultant. Reach him at (972) 304-3325; e-mail: