During our time spent with clients, we have found that properly forecasting how much inventory to carry is one of the greatest challenges our business owners face. Some common questions we hear:
- How much inventory is the right amount of inventory?
- What is it costing me when I order the wrong amount of inventory?
- How frequently should I re-order inventory?
Given these recurring questions, one of our advisers on our Client Advisory Committee, Steve Weiss, has graciously offered up his expertise in the following exercise.
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Inventory management is a significant element of a company's competitive strategy. By holding more inventory a firm may increase its responsiveness to customer demand, while holding less inventory supports a strategy of being a more efficient low cost supplier. Carrying inventory also entails costs, both operational and financial. Operationally, holding a large inventory can mean discounting overstock if consumer demand changes and new products are introduced. Too little inventory can result in stock-outs and reduced profit. The financial cost or inventory holding cost covers both the physical out-of-pocket holding cost, (i.e. insurance, security,warehouse changes, etc.), and the opportunity cost or foregone return on the funds invested in the inventory rather than other products. Understanding these costs and how they come into play is key in the marketplace.
In the Skateboard King exercise below, we will help a retailer determine its optimal economies of scale by calculating the annual holding cost for average inventory held, the optimal order size, (Economic Order Quantity) and how frequently to place an order. In addition we will also determine the annual costs involved in ordering, holding and purchasing inventory. This exercise will not take into consideration uncertainty in skateboard demand, which would include forecasting and determining the expected costs of ordering too little, such as lost revenue and expected profit.
Skateboard King, a company created solely for purposes of this exercise, sells skateboards, sport clothing and accessories. It owns one retail store. The main product line is skateboards. The skateboards are made of state-of-the-art materials and are equipped with the newest design of wheels and hardware. They sell at an average retail price of $195.00, which represents a markup of 50% over what Skateboard King pays the manufacturer or $130, which we will call the Unit Cost. Annual skateboard revenues at Skateboard King are roughly $1,000,000.
The agreement Skateboard King has with its manufacturer specifies that an order of 500 skateboards or more will be delivered two weeks after the order. Orders of 500 up to 1000 skateboards, which is a full truckload, are charged a flat fee of $1500, which we will call the Inventory Order Cost. Believing it is taking advantage of economies of scale by ordering truckload quantities, the company orders 600 skateboards every month, which has been resulting in overstock and inventory build-up. Skateboard King's cost of capital is 15%, which means that each dollar's worth of inventory carries an opportunity cost of $.15 per year in terms of the potential alternatives for use of the funds.
Below is a table of last year's skateboard sales:
| Month | Skateboards Sold |
| January | 600 |
| February | 550 |
| March | 200 |
| April | 500 |
| May | 450 |
| June | 500 |
| July | 450 |
| August | 350 |
| September | 500 |
| October | 250 |
| November | 550 |
| December | 500 |
Here are some common formulas used to assist small business owners with determining how much inventory to carry:
Annual Holding Cost Per Unit: Cost of Capital x Unit Cost
Annual Number of Units Sold: Revenues ÷ Sale Price
Economic Order Quantity (EOQ): √ ((2 x Inventory Order Cost x # of Units Sold) ÷ Unit Holding Cost))
Frequency to Place Order: Annual Number of Units Sold ÷ EOQ
Average Inventory: EOQ ÷ 2
Annual Average Inventory Holding Cost: Average Inventory ÷ Annual Unit Holding Cost
Annual Order Cost: (Annual Number of Units Sold ÷ EOQ) x Inventory Order Cost
Annual Material Purchase Cost: Unit Cost x Annual Number of Units Sold
Total Annual Order Cost: Annual Average Inventory Holding Cost + Annual Order Cost + Annual Material Purchase Cost
Questions:
- What was Skateboard King's annual revenue last year?
- How many skateboards moved through inventory?
- What is the annual cost to hold one unit?
- What is the Economic Order Quantity for Skateboard King?
- How frequently should Skateboard King place an order?
- What is the average inventory?
- What is the annual cost to hold the average inventory in stock?
- What is the annual order cost?
- What is the annual material cost to purchase?
- What is the total order cost?
- Using Skateboard King's policy of ordering 600 skateboards each month, what excess costs did it incur?
Answers:
- $1,053,000
- 5400
- $19.50
- 911 Skateboards - The total cost (annual order cost, inventory holding cost and purchase cost) decreases when the order size increases. In addition the holding cost increases when the order size increases. The Economic Order Quantity minimizes the total annual cost.
- 6 orders per year, one every 2 months
- 455 skateboards
- $8,882
- $8,891
- $702,000
- $719,773
- 1800 skateboards overstock at the end of the year. Product cost of excess = $234,000. Inventory Order Cost for excess = $4,500. Inventory holding cost for the excess (if held for one year) = $35,000
