Evaluating the Level of Inventory

The level of inventory that should be kept depends from one company to another. For
instance manufacturers and retailers should have a higher level of inventory, whereas
software makers or advertising companies require lower levels of inventories. When one
evaluates the inventory levels of a company one should compare its inventories to that of its
rivals. Try to make the comparison in terms of percentages. Another thing you should check
is the increase in inventories. If it is rapid you should study the reasons for this.

One should study inventories in comparison with the company's sales. This should be done,
because the inventory levels of a company may have increased just because it has more
orders and sales to meet. However, one should be cautious if the company increases its
inventory levels without the corresponding increase in sales and orders.

Inventory Turnover Ratio

The inventory-turnover ratio gives a general view on the inventories of a company. In order
to calculate it you should divide the annual sales of the company by its inventory.

Inventory Turnover = Sales / Inventory

The result represents the turnover or inventory or how many times inventory was used and
then again replaced. This number is representative for a one year time period. If the value of
the inventory-turnover ratio is low, then it indicates that the management team doesn't do its
job properly in managing inventories.

For example, company ABC has $10 million in sales for the previous year. Its inventory for
the same year is $50 million. So, its inventory turnover ratio is 0.2, which is significantly low
and means that the company will need five years to deplete the existing inventory.

One should compare the turnover ratios of companies in order to determine their efficiency of
inventory management. Between companies with different inventory turnover ratios you
should select the one with higher turnover, because it indicates higher inventory efficiency.

Application in Business

A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product
line or marketing effort. However, in some instances a low rate may be appropriate, such as
where higher inventory levels occur in anticipation of rapidly rising prices or shortages. A
high turnover rate may indicate inadequate inventory levels, which may lead to a loss in
business.

Cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for
purposes of comparative analysis. Cost of sales is considered to be more realistic because of
the difference in which sales and the cost of sales are recorded. Sales are generally recorded
at market value, i.e. the value at which the marketplace paid for the good or service provided
by the firm. In the event that the firm had an exceptional year and the market paid a premium
for the firm's goods and services then the numerator may be an inaccurate measure. However,
cost of sales is recorded by the firm at what the firm actually paid for the materials available
for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle
inventory. In this article, the terms "cost of sales" and "cost of goods sold" are synonymous.

Stock turnover also indicates the briskness of the business. The purpose of increasing
inventory turns is to reduce inventory for three reasons.

 Increasing inventory turns reduces holding cost. The organization spends less money
on rent, utilities, insurance, theft and other costs of maintaining a stock of good to be
sold.

 Reducing holding cost increase net income and profitability as long as the revenue
from selling the item remains constant.

 Items that turn over more quickly increase responsiveness to changes in customer
requirements while allowing the replacement of obsolete items. This is a major
concern in fashion industries.

However high turns may indicate that the inventory is too low. This often can result in stock
shortages.

 When making comparison between firms, it's important to take note of the industry, or
the comparison will be distorted. Making comparison between a supermarket and a
car dealer, will not be appropriate, as supermarket sells fast moving goods such as
 sweets, chocolates, soft drinks so the stock turnover will be higher. However, a car
dealer such as Honda will have a low turnover due to the item being a slow moving
item. As such only intra-industry comparison will be appropriate.

Reorder point

The reorder point ("ROP") is the level of inventory when an order should be made with
suppliers to bring the inventory up by the Economic order quantity ("EOQ").

The reorder point for replenishment of stock occurs when the level of inventory drops down
to zero. In view of instantaneous replenishment of stock the level of inventory jumps to the
original level from zero level.

In real life situations one never encounters a zero lead time. There is always a time lag from
the date of placing an order for material and the date on which materials are received. As a
result the reorder point is always higher than zero, and if the firm places the order when the
inventory reaches the reorder point, the new goods will arrive before the firm runs out of
goods to sell. The decision on how much stock to hold is generally referred to as the order
point problem, that is, how low should the inventory be depleted before it is reordered.

The two factors that determine the appropriate order point are:

1. Delivery time stock which is the Inventory needed during the lead time (i.e., the difference
between the order date and the receipt of the inventory ordered)

2. The safety stock which is the minimum level of inventory that is held as a protection
against shortages due to fluctuations in demand.

Therefore:

Reorder Point = Normal consumption during lead-time + Safety Stock.

Several factors determine how much delivery time stock and safety stock should be held. The
efficiency of a replenishment system affects how much delivery time is needed. Since the
delivery time stock is the expected inventory usage between ordering and receiving
inventory, efficient replenishment of inventory would reduce the need for delivery time stock.
And the determination of level of safety stock involves a basic trade-off between the risk of
stock out, resulting in possible customer dissatisfaction and lost sales, and the increased costs
associated with carrying additional inventory.

Another method of calculating reorder level involves the calculation of usage rate per day,
lead time which is the amount of time between placing an order and receiving the goods and
the safety stock level expressed in terms of several days' sales.

Reorder level = Average daily usage rate x lead-time in days.

From the above formula it can be easily deduced that an order for replenishment of materials
be made when the level of inventory is just adequate to meet the needs of production during
lead-time.

Example

If the average daily usage rate of a material is 50 units and the lead-time is seven days, then:

Reorder level = Average daily usage rate x Lead time in days = 50 units x 7 days = 350 units

When the inventory level reaches 350 units an order should be placed for material. By the
time the inventory level reaches zero towards the end of the seventh day from placing the
order materials will reach and there is no cause for concern.

Reorder point = S x L + J (S x R x L) Where

 S = Usage in units per day

 L = Lead time in days
 R = Average number of units per order
 J = Stock out acceptance factor
 The stock-out acceptance factor, `F', depends on the stock-out percentage rate
specified and the probability distribution of usage (which is assumed to follow a
Poisson distribution)

Determination of Safety Stocks: Safety stock is a buffer to meet some

unanticipated increase in usage. The usage of inventory cannot be perfectly
forecasted. It fluctuates over a period of time. The demand for materials may fluctuate
and delivery of inventory may also be delayed and in such a situation the firm can
face a problem of stock-out. The stock-out can prove costly by affecting the smooth
working of the concern. In order to protect against the stock out arising out of usage
fluctuations, firms usually maintain some margin of safety or safety stocks. The basic
problem is to determine the level of quantity of safety stocks. Two costs are involved
in the determination of this stock i.e. opportunity cost of stock-outs and the carrying
costs. The stock outs of raw materials cause production disruption resulting into
higher cost of production. Similarly, the stock-out of finished goods result into the
failure of the firm in competition as the firm cannot provide customer service. If a
firm maintain low level of safety frequent stock-outs will occur resulting into the
large opportunity costs. On the other hand, the larger quantity of safety stocks
involves higher carrying costs.