Inventory Management: The 7 Key Points to Master

Welcome to this chapter on inventory management!

Among the tasks of the entrepreneur within the business unit is inventory management. It must be carried out efficiently in order to offer customers a wide variety of products available immediately.

Good inventory management also helps to cope with possible large demands. Thus, in this chapter we will see the following 7 points:

• How to monitor and track inventory?
• How to practice the CMUP method?
• How to use the FIFO method in inventory management?
• What are the consequences of physical inventory?
• How to set up an inventory?
• What are the inventory management indicators?
• Monitoring inventory management indicators
• Conclusion

 

How to monitor and track inventory?

What is the point of inventory tracking?

The main interest of monitoring stocks is to avoid stock shortages. Thanks to regular monitoring, the business unit avoids product shortages and can cope with sudden and significant demand.

Among the products offered by the business unit, some are more in demand than others and sell very well. The manager will therefore focus his attention on these products since they are the ones that contribute the most to the creation of turnover.

It is difficult for business units to track all of their products.

 

Monitor inventory with the 20/80 method

Principle of the 20/80 method in inventory management

The 20/80 method or Pareto law (or 20/80 law), consists of classifying products into two subcategories. The application of this method is based on the hypothesis that customers always buy the same products.

This method was put forward in the 1900s by Vilfredo Pareto, an Italian economist.

Here is what the 20/80 method says:

• 20% of articles represent 80% of turnover
• 80% of articles represent 20% of turnover

The company will therefore have more rigorous management and will pay more attention to the items that represent 20% of the total.

There is a second method to monitor inventory.

Application of the 20/80 method in inventory management

To illustrate this method I will take an example from the Excel spreadsheet so that everything is clearer for you.

 

Step #1: Gather the relevant products or references

 

 

 

Step 2: Enter the quantities and unit sales prices of the products

 

Step #3: Sort the products in descending order of turnover (from highest to lowest)

 

Step #4: Add a percentage column in quantity

 

Step #5: Insert a cumulative percentage column in quantity

 

Step #6: Add a percentage value (CA) column

 

Step #7: Insert a cumulative percentage value column

 

Step #8: The last step is to look at the percentage accumulation columns to see the two product subcategories.

You must read on the same line a percentage close to 20% in the cumulative quantity column et a percentage close to 80% in the cumulative turnover column.

To interpret our table and the results found, we can state that the first three products represent 20% of the total stock quantities and 80% of the turnover of the business unit.

Conversely, the last four products represent 80% of the total quantities of merchandise stock and 20% of the company's turnover.

Products in the first category will be monitored rigorously and very frequently. Products in the second category will be monitored less precisely.

Monitoring inventory with the ABC method

The ABC method also recommends a categorization of products but with a different distribution and into 3 subcategories.

Here is what the ABC method says:

• Category A: 10 to 20% of items represent approximately 70 to 80% of turnover
• Category B: 30% of items represent approximately 15 to 25% of turnover
• Category C: 50% of the items represent approximately 5% of the turnover

The 7 steps that we have just seen in the 20/80 method are identical for the application of the ABC method. The last step is different since it is necessary to distinguish 3 subcategories while respecting the percentages indicated in the question of the statement.

How to value stocks?

To value stocks, several methods are possible. But it is not so simple because the stock includes different items purchased on different dates and of course at different prices as well.

The manager indicates all the elements such as entries, exits, date to name but a few on a very specific document. Indeed, the business unit uses a document called a stock card.

What is a stock card?

The business unit is free to design its own stock sheet because its presentation is free.

A stock card groups together the following elements:

• the date of the operation
• the type of movement (entry or exit)
• the quantities entered
• the quantities released
• the unit price of entry
• the unit price of the output
• the amount of the entrance fee
• the amount of the exit
• the remaining quantity in volume
• the amount of the remaining quantity
• the unit price of the product remaining in stock

The stock sheet will allow you to value stock exits. In fact, the entry prices of the stock correspond to the purchase costs of the products.

Here is a presentation of a stock sheet that you can copy in your homework.

with:

• Qty corresponding to Quantity
• PU corresponding to the unit price

The weighted average unit cost (WAUC) method

The weighted average unit cost method or weighted average unit cost (both are called) is a method of inventory valuation.

We can even talk about the weighted average cost method. So don't be confused if you hear one of these names in class and see another in a book.

This method is recommended for valuing stocks of non-perishable products. It consists of calculating an average unit price to evaluate stock withdrawals. This is weighted by quantities.

You can calculate the CMUP at the end of the period or after each entry. There is no best method, you will simply have to follow the instructions in the statement.

To illustrate this CMUP method, I will take an example of use after each entry to make it clearer for you.

First, you need to indicate the initial stock as below:

You will notice that it is positioned in the Stock column and in the Input column.

Then there can be a purchase or an entry (it's the same). This movement is to be entered in the Entry column:

I would like to point out that for the moment no calculation has been made since we have simply copied the elements of the statement!

You must then note the final stock of the day, that is to say after the purchase movement. In my example, there are 265 items at a unit price of €54,50 for a total amount of €14.

Of course I will explain the results to you.

First of all, note that we are in the Stock column. Here are the calculations:

• 265 = 55 items (previous stock) + 210 items (purchase)
• 14 = €445 (previous stock in value) + €2 (purchase amount)
• €54,50 (this is the weighted average unit cost) = 14 / 445

The weighted average unit cost is therefore equal to the following formula:

CMUP = Stock in value / Quantity in stock

You may also encounter the case of an output like in the screenshot below:

Here is the explanation of the product release. You will notice that this time it is the Release column that is used.

• 90 is the quantity to be output because it is the statement that imposes it on us.
• €54,50 corresponds to the CMUP calculated just above in the Stock column.
• 4 is the product of 905 by 90 (Qty x PU)

There is still one situation left: that of the final stock after a release. This is what we will see now:

explanations:

175 = 265 (final stock in quantity from the previous day) – 90 (quantity issued)

9 = 540 (closing stock in previous day's value) – 14 (exit amount)

54,51 (next CMUP to use on a next outing) = 9 / 540

There you have it, now you know how to fill out an inventory sheet using the weighted average unit cost method after each entry.

 

The First In, First Out (FIFO) method

The PEPS method is recommended for perishable products. Thus, the first products entered into stock will be the first to be released.

Therefore, the manager will prioritize the items from the oldest batches and at the unit price of the time.

Here is a complete video of a corrected exercise on inventory management to illustrate this first in first out method.

What are the consequences of physical inventory?

What is physical inventory?

The company has an obligation to take inventory at least once a year to prepare financial statements (balance sheet, income statement). This therefore involves counting the products: this is the physical inventory.

Sometimes there are differences between the actual (visible) stock and the theoretical stock (stock calculated using a spreadsheet or other inventory management program). This is called "markdown".

What are the types of physical inventories?

When the business unit does not have a real-time inventory management system in place, it is forced to perform a complete physical inventory.

The rotating physical inventory, on the other hand, consists of comparing the items listed on the stock cards with the actual quantities. This inventory is carried out during the year on certain products. This method makes it possible to avoid closing the business unit.

On the other hand, the cost of this type of inventory is quite high when compared to the quantity of references concerned.

The markdown

Markdown is the difference between theoretical stock and actual stock (inventory difference).

The theoretical stock corresponds to the following formula: initial stock + entries – exits

We distinguish between known shrinkage and unknown shrinkage.

They are talking about Known markdown in the following cases: breakage, deterioration, damaged products, products on display, tasting, sales, promotions, use by the company.

La Unknown markdown is mentioned in the following cases: theft, consumption on site, administrative errors.

La Overmark is observed when the actual quantity is greater than theoretical quantity : input or delivery error in favor of the business unit.

How to set up an inventory?

The business unit must establish an inventory procedure that must be communicated within the various departments so that it is applied by everyone.

With the rise of digital tools, the business unit should not neglect the use of tools such as a portable inventory terminal, or sticking electronic chips that will be read by barcode scanners.

 

What are the inventory management indicators?

What is the impact of high inventory on profitability?

There are advantages and disadvantages to having a large inventory for a business unit.

Here are some benefits of owning a high inventory:

• The business unit does not place a large number of orders. Therefore, it does not manage logistics that are sometimes very heavy and therefore very costly.
• Placing orders with a large number of items allows you to obtain very attractive prices from suppliers for the business unit.
• By purchasing large quantities of products, the business unit avoids stock shortages and a negative impact on turnover and the company's results.

But a high stock also has some disadvantages:

• The business unit spends large amounts to manage the large inventory: storage room rental, labor to be paid, storage equipment, insurance premiums.
• The trend of customer choices may change and the stock acquired by the company may turn into a significant quantity of unsold items.
• The business may also run out of storage space due to a sudden change in customer tastes or needs.
• A large stock within a company is a sum of immobilized agent.

Inventory management indicators

You need to know these three main indicators: average inventory, inventory turnover ratio and average storage duration.

The average stock

Average inventory is the average quantity stored by the business unit at all times over a defined period.

A management formula allows you to calculate the average stock:

average stock = (initial stock + ending stock) / 2

Here is an example to illustrate the average stock formula.

The Miladra company informs you of the following:

• the stock as of 01/01/N amounts to 3 items
• the stock as of 31/12/N is 1 items

Applying the formula we obtain the following calculation: (3 + 200) / 1 = 200 items

The interpretation of the result is as follows: the business unit permanently stocks an average of 2 items over a 200-month period.

The inventory turnover ratio

The inventory turnover ratio measures the average speed at which inventory is renewed.

A management formula allows this ratio to be calculated:

Inventory turnover ratio = cost of goods sold / average inventory (in value)

or Inventory turnover ratio = quantity sold during the period / average inventory (in quantity) during the period

Here is an example to illustrate the formula for the inventory turnover ratio in value.

Miladra Company (yes, it is the same business unit) states that its cost of purchasing goods sold is €39. The average stock in value is €600.

Applying the formula we obtain the following calculation: 39 / 600 = 6

The interpretation of the result is as follows: The Miladra company renews its stock 6 times during year N.

Now here is an example to illustrate the formula for the inventory turnover ratio in quantity.

The Miladra business unit sold 13 items during the year.

Applying the formula we obtain the following calculation: 13 / 200 = 2

The interpretation of the result is as follows: The Miladra company renews its stock 6 times during year N.

Average storage duration

Average inventory life measures how long goods remain in stock before being sold.

The formula for average storage time is:

Average storage duration = period duration / inventory turnover ratio

or Average storage duration = (average stock / quantity sold) x duration of the period

I will take an example to illustrate these two formulas.

Miladra company sold 13 items during the year N.

Applying the first formula we obtain the following calculation: 360 / 6 = 60

Applying the second formula we obtain the following calculation: 2 / 200 x 13 = 200

The interpretation of the result is as follows: The Miladra company stores its goods for two months before being sold.

Monitoring inventory management indicators

The business unit must absolutely monitor inventory management indicators in order to see the impact on profitability.

Impact of average stock on profitability :

Storage is a cost for the company. The lower the average stock, the lower the costs will be, which will generate a greater profit. It also means less money tied up.

Impact on inventory turnover ratio :

A high turnover ratio helps to cope with sudden customer changes and adapt to new trends.

Impact on average storage duration :

A low average storage duration allows the business unit to reinvest its funds more quickly.

 

Conclusion

To go further, you should keep in mind that management indicators can also be used to understand customer behavior. Thus, a high inventory turnover ratio shows a certain interest on the part of customers for the item in question.

There you have it, now you have mastered the chapter on inventory management. You no longer have any excuses for getting an excellent grade on the Operational Management test!