When a hurricane starts to form off the eastern seaboard, Walmart sends extra inventory of strawberry Pop-Tarts and beer to the stores where the storm is predicted to hit. Through their massive data collection efforts, they found Pop-Tarts sales increase 7x ahead of a hurricane and the top-selling item is beer. Thanks to their data inventory analysis, Walmart is able to optimize their inventory in stores across the country, keeping up with customer demand, while increasing sales and controlling costs.
If the biggest retailers in the world are investing billions in inventory analysis, it’s clear how important it is to their bottom line. Inventory analysis may not be the sexiest part about running a business of any size, but it’s essential to ensure the survival of most companies.
That’s because inventory analysis can smooth out the biggest challenge for most growing businesses — cash flow. A study by U.S. Bank found 82% of business failures are due to cash flow issues. For manufacturing and retail businesses, the vast majority of their cash is represented by their inventory every month. Without effective inventory analysis methods, operating a business can feel like riding a roller coast that is about to run off the rails.
Fortunately, you don’t need a big data infrastructure like Walmart’s to conduct inventory analysis. It just requires understanding inventory analysis formulas, and a grasp of the inventory analysis mindset. Managing inventory is all about efficiency — you don’t want too much or not enough of any item. Either outcome is a nightmare for business owners, increasing costs or costing them sales every passing day. Before we dive into how we conduct inventory analysis, let’s take a step back and better define it:
What Is An Inventory Analysis?
It’s hard not to be reactive running a growing business. There are endless fires to put out and many hats to wear. Inventory analysis empowers you to work on your business instead of being stuck inside it, allowing your company to be proactive with its most valuable assets. As we mentioned earlier, the purpose of analyzing your inventory is to run an efficient business, so you’re not losing money on wasted items or missing out on sales due to stockouts.
In some services businesses, like contracting for example, inventory analysis can tell you if your company has the materials to take on a new project. It allows you to identify trends and acquire the right mix of products based on customer demand. The benefits of doing regular inventory analyses might not be obvious, but when you dig deeper, it’s clear how essential they are to the continued growth of your business:
Reduce stockouts and project delays
Some companies take on projects that require hundreds, sometimes thousands, of items. Stockouts can mean project delays, which upsets the client and cuts into profits. For retail companies, stockouts mean lost sales and unhappy customers who will go to a competitor to get a similar product.
Improved cash flow
Maintaining positive cash flow is a high-wire balancing act for most businesses, but with efficient inventory management, it doesn’t have to be. Low on cash and run out of an in-demand SKU? Finding short-term financing is a pain and cuts into your margins. Capital all tied up in inventory that is sitting rotting in storage? It’s incredibly painful to write it off as a loss. Inventory analysis can show you when the lean times in your business are and when the rush is, so you can prepare with safety stock or stop buying inventory you’re not selling.
Jeff Bezos wrote in his 1997 annual letter to Amazon shareholders that his goal was to make Amazon the earth’s most customer-centric company. Well, their inventory analysis (rivaled only by Walmart) allows Amazon to offer Prime members free two-day shipping on millions of products. Inventory analysis enables faster response times and efficiently filled orders, giving you the ability to earn loyal customers.
Less wasted inventory
Writing off inventory as a loss is akin to lighting cash on fire. Doing a proper inventory analysis can help prevent you from making the same mistakes, so you never again have to see those boxes that have been sitting in the back of your warehouse for the past year. The same applies to lost inventory, theft, and leakage, which reduces costs and enables you to introduce costs controls.
Better pricing from suppliers and vendors
When you know what items produce the most profit for your company, you’ll be more likely to confidently negotiate better terms with suppliers, improving your bottom line. Operating a business can drag you in a million directions, often pulling you away from the actions that actually make money. By analyzing the inventory that keeps your company profitable, you can prioritize it, making the supply chain for that inventory as efficient as possible.
How To Measure Inventory Efficiency
ABC analysis is the most popular inventory analysis method and is based on the Pareto Principle, which states that, for many events, roughly 80% of the effects come from 20% of the causes. ABC stands for “Always Better Control.”
For most businesses, especially retail, it’s uncanny how often 80% of their profits come from 20% of their total inventory. The way the Pareto Principle factors into ABC analysis is how it is used to prioritize and sort certain inventory over others. ABC analysis brings simplicity to inventory analysis by putting all of your inventory into three buckets, which enables you to make more strategic decisions. The buckets are:
- A-Inventory. This is inventory that has the highest value, most often the highest profit margins or sales revenue. It should be your highest priority and rarely, if ever, stockout.
- B-Inventory. Inventory that sells regularly but doesn’t have as much value as A inventory. Often inventory that costs more to hold than A inventory.
- C-Inventory.: This is the rest of your inventory that doesn’t sell much and generates the least revenue and makes up the bulk of your inventory cost.
In the chart below, you can see a typical inventory curve, where items in the A bucket makeup 70% of total sales and then drops off dramatically with buckets B and C.
ABC Analysis allows you to separate your most important inventory from the rest so you can give it more time and focus, boost your profits and control your costs.
This enables you to reduce obsolete inventory, optimize inventory turnover rate, increase prices and forecast demand.
There are a number of other types of inventory analysis methods that are similar to ABC analysis, but their mileage depends on the type of business you run. Some businesses use ABC in addition to one of the below analyses to get a more robust view of their inventory management. The below analyses don’t typically pattern after the Pareto Principle because they aren’t based on consumption value. Here are a few examples:
VED Analysis is based on how critical it is for an item to be in stock. It useful for manufacturing companies that stock many components and parts. It’s different from ABC analysis in that it only takes into account how necessary an item is to the continuing operation of the business.
- Vital. Inventory that must be in stock.
- Essential. A minimum amount of these items is enough.
- Desirable. These are optional items.
HML analysis is measured according to an item’s unit price. It’s different from ABC analysis because it only takes into account cost, the value sales value of items aren’t taken into account. HML analysis is useful for controlling costs and staying on budget.
- High Cost. High unit value item.
- Medium Cost. Medium unit value item.
- Low Cost. Low unit value item.
This inventory analysis method is based on the scarcity of items in the market or how soon you can acquire them. It’s usually used in businesses that deal with raw materials or items that can have long lead times to acquire.
- Scarce. Scarce or imported items that have long lead times.
- Difficult. Inventory that has lead times anywhere from weeks to 6 months lead time.
- Easily available. Items that are easily acquired.
As you can tell, there are different ways to sort your inventory depending on the type of business you’re running, but the underlying 80/20 Pareto Principle remains the same. By not overcomplicating your inventory analysis method, you can easily prioritize where to place your time and focus, increasing the efficiency of your operations. ABC analysis can tell you the items that are essential for the growth of your business, but there is also a number of key metrics you can use to drill down and see how healthy your business is.
Key Inventory Metrics
Inventory analysis doesn’t just end with the Pareto Principle. There are key inventory metrics you can use to measure different segments of your business, which uncovers ways to optimize your operations and increase profits. The following inventory formulas can all be used to find ways to increase your bottom line:
Gross Margin Return On Invested Inventory (GMROI)
GMROI is an inventory formula used by retail businesses to measure the profitability of a certain element of their business. It measures the amount of gross profit that a retailer makes every year for each dollar of inventory they purchased. The formula is your company’s gross profit margin divided by your average on-hand inventory cost.
After doing this calculation, the number should at least be higher than one. If it’s below one, it means you are losing money on your inventory and aren’t a profitable business. A GMROI of 1.50 means you are making a profit on your inventory at 150% of your cost. There’s no specific benchmark for GMROI, it depends on your industry. Industry-specific retail associations are good resources for benchmarks like this as is the Retail Owners Institute.
Available to Promise
Available to promise is an inventory formula is used for analyzing order fulfillment. It helps analyze customer demand and adjust operations to meet it. For example, every time you order takeout from a food delivery app, the app goes through the available to promise formula to calculate how long it will take for your food to arrive.
The formula is:
ATP = Quantity On Hand + Supply (Planned Orders) – Demand (Sales Orders)
The ideal promise time depends on customer expectations and varies by industry. For example, Amazon is conditioning its Prime customers to expect to receive their product just a couple of days after receiving it, whereas Instacart users expect to receive their groceries within hours.
Inventory Turnover Rate
Your inventory turnover rate shows you how effectively you’re managing inventory. It measures how many times your average inventory is sold during a certain period.
This inventory formula is calculated by dividing the cost of goods sold by the average inventory for a certain period of time. So if your average inventory the past year was $1,000 and your cost of goods sold was $10,000, your inventory turnover rate would be 10, meaning you sold your inventory 10 times over. Ideally, you want this rate as high as possible, because it shows how quickly you are able to sell your products and proves you’re not overbuying inventory and wasting capital.
The stockout rate is the ratio of a company’s total stockout losses to total orders, expressed as a percentage. This metric measures how effective a business is at managing inventory. Harvard Business Review has cited average stockout rates worldwide at 8%
Let’s say you were are clothing retailer and wanted to figure out your stockout rate. One way to calculate your rate would be to divide your total sales that were back ordered by your total sales. So if you did $100,000 in sales, but $10,000 of those sales were for items that were on backorder, your stockout rate would be 10%, which is high. You’d want to look at why and make sure you had enough inventory on hand the next quarter to reduce that rate. For your most in-demand and profitable inventory, you want your stockout rate to be as close to zero as possible. High stockout rate can also hurt customer satisfaction, which we’ll talk about next.
Customer Service Level (CSL)
CSL is the expected probability of not having a stock out for a given period or the probability of not losing sales. Ideally, your CSL should be as close to 100% as possible, especially if it’s A inventory based on ABC analysis. There are few ways to calculate customer service level, but an easy inventory formula would be to divide the number of products delivered on time divided by the number of products sold.
In today’s on-demand world, customers expect their orders delivered quickly and correctly. Effective inventory analysis allows you to keep up with them and do it without getting overwhelmed. This means better cash flow, greater profits, and fewer sleepless nights. With QuickBooks Desktop Enterprise, you’ll have everything you need to efficiently manage your inventory, with automatic data tracking and customized reports. With no more inventory fires to put out, you’ll be able to work on the reason you started your business in the first place — doing what you love.