Inventory planning means forecasting the appropriate amount of inventory a business needs to satisfy current and future customer needs and services. Finding the right amount of inventory to have at any time is a big challenge, that when solved, increases a company’s profitability. A common problem is when there is too much inventory sitting around in a warehouse for a long period of time. Business owners need to convert that inventory into products to be sole for income. On the flip side, when companies have to little inventory that it cannot keep up with demand also creates problems for business owners. When a company cannot keep up with demand, it is losing out on sales. The solution to these challenges is finding the right amount of inventory to have at the right time.
Three types of inventory include
- Production– Inventory such as raw or direct materials which are used to make a finished product. ( wood needed to make tables at a factory would be an example of this type of inventory).
- Customer Service– Inventory including items that are already assembled, along with item(s) to maintain or compliment that assembled item. (for example wholesale T.V’s along with their remote controllers)
- MRO (maintenance, repair and other activities) – These items are not a part of a product but are used to make a product. (for example the blades needed on an electric saw to cut the wood needed to make tables.
The most important aspect to inventory planning is cycle inventory. The second most important aspect to inventory is safety stock.
Safety Stock– An extra supply of inventory used to ensure that a company doesn’t run out of goods needed to keep working. When demand suddenly increases business owners at times don’t have sufficient inventory to meet demand. Having a good safety stock helps companies keep working in times of demand.
Here is the Safety Stock Formula:
Safety Factor x Standard Deviation x √(Lead Time)
Multiplying these will give you the amount of safety stock you should carry for a particular product.
To calculate the safety stock for a particular item you would need to know 3 things.
- Safety Factor– this is also known as a z score. You can calculate different z scores depending upon what percentage of accuracy you want, in order to be sure you never run out of safety stock. The most common z score used to calculate safety inventory is 1.96 which gives a 95% chance that you will never run out of inventory.
- Standard Deviation– this refers to the variation in different data points. To calculate the standard deviation for an item that you want to calculate the safety stock for, you need history data points. For example, you might need to know how much of that product was demanded each day for the past 12 days. Daily demand in the past could be used as the data points to calculate the standard deviation for that item. Excel can calculate standard deviation through the stdev function.
- Lead Time- This is the amount of time it takes to have the product delivered to you from a supplier. (note: all units of time for standard deviation and lead time need to be calculated with the same measure of time. In our example we used days, so everything needs to be calculated in days. If we were doing weeks, everything would need to be calculated in weeks and so on.)
Having these three variables described above would provide a safety stock amount to have on a monthly basis.
Cycle Inventory– Means the amount of inventory that will be needed from one supply to the next. This is the most important aspect to inventory planning because it involves the replenishment process of inventory that was used to make and sell a product. For example a truck load of wood that is used up this week will need to be replenished by a new truck load of wood coming in at the end of this week.
ABC Classification and Cycle method
ABC Classification is method of ranking inventory of most importance first. The criteria of importance is classified by a dollar amount. This method is based on Pareto’s Law (80-20 rule). The inventory that constitutes the highest dollar amount is classified as “A” category, which represents 10-20% of items and 50-70% of the dollar volume of inventory. The Inventory that is in the middle range of importance is classified in the “B” category which represents around 20% of the items as well as 20% dollar volume of inventory. The inventory that is considered the lease important is classified in the C category, which contains 60-70% of the items and 10-30% of the volume.
Let’s take a look at an example of how the ABC classification and Cycling method could be applied.
Here are the steps:
- Calculate the annual dollar volume for each item of inventory (column J in spread sheet below) by multiplying the annual unit volume (column H) by the unit cost (column I) for each item.
- Place the items in order of decent under column J (annual dollar volume)
- Calculate each of the % of annual dollar volume (column K) by dividing each of the annual dollar volume cells (cells in column J)c by the sum of annual dollar volumes (cell J14)
- Then according to percentage size manually assign the classifications according to level of importance as shown in column L.
Performing an ABC classification and cycle method allow you so prioritize your inventory, and allow you to know which inventory is most important.