In an ideal world, a product would arrive into stock from the supplier just at the same time as the last unit from the previous batch was being despatched to a customer. Taking into consideration the overheads associated with ordering and delivery, the number of units being received would have the lowest possible net cost.
When demand is predictable, it is possible for the Purchasing Manager to plan in this way. Consider the following graph:
There is a cost associated with Placing Orders. (Order Cost Line). This cost is high if the company orders small quantities, more frequently. This is because: a) suppliers generally offer incentives (lower pricing / promotions) to encourage larger orders and b) there is an overhead cost for each Order and each Delivery, so more frequent orders and deliveries will increase the cost. As a result, we see that the ‘Order Cost’ decreases as the Order Quantity increases.
The counter this, there are costs that can be associated with holding stock in a warehouse. Stock that is sitting on a shelf:
- Is tying up working capital
- Is likely to deteriorate
- Can get damaged
- May become obsolete
- Consumes valuable warehouse space that could be used for faster moving products.
Based on a products history and product attributes, it is possible to calculate a stock-holding cost for each unit of a product. The storage costs for each potential size can then be plotted.
The end result is that it is easy to calculate the most economical order quantity (EOQ) for each product. This is the point in the graph where the total cost of ordering is at a minimum.
Again, in an ideal world it should be possible to predict the lead time from the supplier. Armed with a known sales demand and a known lead time, it is easy to calculate the day when an order should be placed. This can be done by calculating the daily demand and multiplying this by the number of lead time days. This will give the Re-Order Level (ROL). When the stock level become less than or equal to the Reorder, a new order should be raised.
However, we don’t live in an ideal world and not everything can be correctly predicted. There will also be variations in demand and variations in lead time. Generally companies provide for this by holding some Safety Stock. The safety stock figure can be calculated by applying the logic described in the previous section to calculation the variation in demand and (if necessary) the variation in Lead Times.
Stock Turn is a measure of the number of times the stock value is replaced in a given period. It is often referred to as Stock Turnover Ratio of Inventory Turnover Ratio. It measures the velocity of conversion of stock into sales. Usually a high Stock Turn indicates efficient management of inventory because stock is being sold and replenished frequently. It is a simple concept. If €10 is invested in a unit of stock at the beginning of a year and €10 is still invested in the stock of the item at the end of the year (albeit through constant replenishment), then business is better if the item was sold 20 times instead of once!!. 20 times the profit for the same investment.
A low Stock Turn Ratio indicates inefficient management of inventory. It implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. The ratio is also an index of profitability, where a high ratio signifies more profit, a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied by high profits. It may be due to under-investment in inventories.
It is a measure of the effectiveness of the stock management function. The calculation of Stock Turn is Cost of Goods Sold in the Period divided by the Average Stock Value in the same period.
Generally the Average Stock Value is calculated as the average of the Opening Stock Value in the Period + the Closing Stock Value. So the calculation of the Stock Turn is:
Cost of Goods Sold in the Period
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(Opening Stock Value + Closing Stock Value) ÷ 2
Monitoring of the Stock Turn is an important management function and it should be regarded as a Key Performance Indicator.
Sometimes, a Maximum Stock Level is set in order to promote a good stock turn. The Maximum prevents orders from being approved if the forecasted stock-holding is likely to exceed the maximum. This allows company to protect against obsolescence and it reduces the risk of warehouse damage.
A Minimum Stock Level is often used as a warning signal to Purchasing Manager. There are various calculations for this but typically it is the Reorder Level minus (Average Demand X Average Lead Time). When the stock level falls below the minimum level, the Purchasing Manager needs to review the expected delivery dates on existing Purchase Orders.
