Inventory analysis, a pivotal component of inventory control systems, serves as a strategic tool, enabling businesses to meet customer demands efficiently while minimizing inventory-related expenses. In our guide, we offer valuable insights, practical formulas, and crucial metrics to facilitate a comprehensive evaluation of your company’s inventory dynamics.
What Exactly is Inventory Analysis?
Inventory analysis is a strategic tool that enables businesses to accurately gauge the optimal quantity of stock needed to meet customer demand, without incurring excessive inventory storage costs.
Inventory, listed as an asset on a company’s balance sheet, signifies the products that a business intends to sell to its customers in due course. It encompasses not only the finished goods but also the raw materials required for the production of these goods, and work-in-progress items (for instance, a washing machine that is currently under assembly).
Understanding the Objectives of Inventory Analysis
The primary objectives of inventory analysis include cost reduction, theft mitigation, effective cash flow management, and ensuring a consistent supply of products that cater to customer demand.
Here’s an in-depth look at some of the main objectives of inventory analysis:
Enhancing Profitability:
By maintaining an ideal level of inventory, it is possible to stimulate sales and minimize costs, thereby boosting profits.
Cutting Down Storage and Related Costs:
By avoiding excessive stockpiling, one can significantly reduce the associated storage and handling costs. (For more on this, refer to our Essential Guide to Inventory Control.)
Reducing Capital Expenses:
By steering clear of overstocking, you can preserve more liquid cash and capital for alternative investments.
Optimizing Cash Flow:
Ensuring a steady availability of products that customers wish to purchase can positively impact cash flow.
Identifying Opportunities for Improvement:
Consistent inventory monitoring allows you to spot items that are either high in demand or underperforming. This understanding can lead to optimized shelf allocation and enhanced supplier relationships.
Avoiding Stockouts and Backorders:
Inability to deliver a product a customer wants to purchase can result in customer dissatisfaction, possibly leading them to wait on a backorder or seek the product from a competitor.
Preventing Project Delays:
For projects that involve product assembly, an inventory analysis can track necessary stock. Utilizing this data ensures sufficient lead time for restocking, thereby avoiding material shortages and potential project delays.
Reducing Wasted Inventory:
Excessive stock can lead to losses due to obsolescence, degradation, or other forms of value reduction. Regular inventory analysis can preemptively mitigate these losses.
Inventory Classification: An Overview
The inventory within a business typically falls into four primary categories: raw materials, work-in-progress goods, finished goods, and Maintenance, Repair, and Operating supplies (MRO).
Decoding the Process of Inventory Analysis
Businesses employ sales and stock data to conduct inventory analysis. Additionally, experts leverage specific ratios and metrics, often referred to as key performance indicators (KPIs), to evaluate the efficiency of an organization’s inventory management practices.
Exploring Inventory Analysis Techniques
Various techniques exist for inventory analysis, each best suited to specific industries and types of inventory. Here are some commonly employed methods:
ABC Analysis: Favoured particularly in retail, ABC Analysis categorises inventory based on revenue and profit margins, from highest to lowest, into three groups: A, B, and C.
VED Analysis: Primarily used in manufacturing, this method assesses inventory items based on their necessity: Vital (must always be in sufficient stock), Essential (should be minimally stocked), and Desirable (not critical to maintain consistent stock).
HML Analysis: Common in manufacturing, this approach evaluates inventory based on cost: High, Medium, and Low.
LIFO, FIFO, and FEFO: Accounting methods impact inventory costs. LIFO (Last In, First Out) firms sell the most recently acquired inventory first. FIFO (First In, First Out) businesses sell the earliest purchased inventory first. In FEFO (First Expire, First Out), stock expiration dates dictate the sales sequence. For a deeper understanding of these and other cost accounting methods, refer to our article, “The Key to Using Inventory Cost Accounting Methods in Your Business.”
SDE Analysis: This technique, often applied to manufacturing components, evaluates inventory based on item scarcity and acquisition ease: Scarce (hard-to-get items), Difficult (less scarce but may take weeks to arrive), and Easily Available (easy to acquire).
Material Requirements Planning (MRP): Employed by manufacturers, this method orders inventory based on sales forecasts and company-wide stock data.
Economic Order Quantity (EOQ): EOQ estimates the sales rate, ordering costs, and storage costs of an item to determine the frequency and quantity of orders, aiming to maintain low costs while fulfilling all customer orders. Learn more about EOQ in our inventory forecasting guide.
Fast, Slow, and Non-moving (FSN): In this approach, inventory is classified into Fast-moving, Slow-moving, and Non-moving categories, influencing new stock purchases.
Custom Par Levels: This technique establishes a threshold inventory level at which the company must reorder each item, which requires more effort initially but helps prevent stockouts.
Choosing the Right Inventory Analysis Technique: The ideal inventory analysis technique depends on your industry and business type. For instance, some methods work best for retail, while others are more suited to manufacturing.
It’s crucial to evaluate the effectiveness of your chosen technique over time. Is your business experiencing fewer stockouts? Have storage costs decreased due to improved inventory analysis and management? Your observations will guide future inventory strategy decisions.
Essential Metrics for Inventory Analysis
Often referred to as KPIs (Key Performance Indicators), these metrics provide crucial insights into your company’s inventory management effectiveness. Key metrics often include the turnover rate, Available to Promise (ATP), stockout rate, and sell-through rate.
Gross Margin Return on Investment in Inventory (GMROI):
Used primarily by retail businesses, this metric measures the profitability of inventory.
Formula:
GMROI = Gross profit margin / average cost of inventory on hand
(A desirable result should exceed 1.0.)
Available to Promise (ATP):
This metric informs about the product quantity available or expected for fulfilling customer orders, enabling accurate delivery date estimations.
Formula:
ATP = On-hand product quantity + Supply (or planned orders) – Demand (or sales orders)
Inventory Turnover Rate:
This metric calculates how frequently a company sells its average inventory within a certain period, indicating the effectiveness of inventory management and product demand.
Formula:
ITR = Cost of Goods Sold (COGS) during the specified period / Average inventory during the period
Stockout Rate:
Expressed as a percentage, this KPI indicates how often a customer’s ordered item is unavailable. Aim for a figure below 10%, ideally close to zero, especially for high-demand items.
Formula:
SR = (Stockout orders / Total customer orders) x 100
Customer Service Level (CSL):
Used to measure the likelihood of avoiding a stockout, and consequently, a lost sale within a given period. The result is expressed as a percentage.
Formula:
CSL = (Products delivered on time / Total products sold) x 100
Average Days to Sell Inventory, Days Sale of Inventory (DSI), or Days on Hand:
This KPI denotes the average time taken to sell an item, indicating how quickly inventory converts into sales revenue. Lower numbers signify more efficient operations.
Formulas:
ADS or DSI = (Average inventory value in a year / Cost of Goods Sold in the year) x 365
OR
ADS or DSI = 365 x Inventory turnover ratio
Sell-Through Rate:
This metric, critical in the retail industry, compares the quantity of an item sold during a period to the received inventory quantity. The result is expressed as a percentage.
Formula:
STR = (Total sales during period / Inventory received during the period) x 100
Back Order Rate:
Expressed as a percentage, this KPI measures the proportion of customer orders for items currently on backorder, indicating a delay in delivery.
Formula:
Back Order Rate = (Total back orders / Total orders) x 100
Qualitative Aspects of Inventory Analysis
Beyond numeric KPIs, businesses should incorporate qualitative practices that significantly influence effective inventory management. These include:
Just-in-Time (JIT) Ordering:
The JIT ordering strategy maintains only enough inventory to meet customer demand, significantly saving on storage costs. However, this approach necessitates meticulous planning to ensure on-time delivery of materials and products.
Fulfilment Strategy:
To ensure swift order fulfilment for high-demand products, a business may choose to stock a substantial quantity of these items.
Inventory Obsolescence:
For industries like fashion and cosmetics, products have a relatively short lifespan of relevance. Such businesses should control their inventory to avoid stock obsolescence, leading to unsellable goods.
Cash Availability:
For companies with limited cash reserves or restricted access to financing, the available cash might limit their inventory investments.
Leveraging Inventory Management Systems for Inventory Analysis
Inventory management systems offer a robust solution to maintain optimal stock levels, ensuring customer satisfaction while minimizing inventory costs. They can trace a product from the point of procurement until it reaches the end customer, providing insightful data along the way.
Choosing the Right Software for Inventory Analysis
The information derived from inventory analysis directly influences pivotal business decisions, affecting everything from stock management to profitability. Thus, it’s crucial to have an automated tool that delivers real-time insights.
NetSuite’s suite of features provides robust support for inventory management. Our system enables you to track inventory across various locations, define re-order points, and ensures that the right stock is in the right place at the right time. Utilizing this tool allows for informed decision-making and optimized business operations.
Inventory Analysis: Frequently Asked Questions
In this section, we delve into additional queries concerning inventory analysis, beyond methodologies and KPIs.
Who is an Inventory Analyst?
Often referred to as purchasing managers, inventory analysts are responsible for evaluating and managing a company’s inventory. They are skilled in understanding their company’s sales patterns, costs, and industry trends. Their primary role is to facilitate inventory management in a way that conserves financial resources.
What Does an Inventory Write-Off Mean?
An inventory write-off signifies the portion of the stock that a business deems as having lost its value. This could be due to spoilage, damage, or obsolescence. The write-off is an accounting figure that represents this loss.
What Comprises Holding Costs?
Holding costs refer to the expenses incurred by a company to store inventory. These costs encompass storage charges, insurance, equipment costs, and labour expenses related to inventory management.
How is Average Inventory Defined?
The average inventory represents the quantity of stock a company maintains over a specific period. To calculate average inventory, add the inventory amounts at the beginning and end of the period, then divide by two.
How Should an Inventory Analysis be Presented?
An inventory analysis should incorporate data on stock quantity from one period to the next. The analysis should also present key metrics illustrating the effectiveness of your company’s inventory management.
