I have recently received a lot of inquiries regarding average inventory levels so I thought I would devote and article regarding how to find them. The first half of this article covers how to find what inventory levels should be, and the second half covers what they have been in the past.
Part I: How to Optimize Average Inventory Levels
This section is mainly here to provide a brief description
for how optimal inventory levels for materials are kept assuming the company is
a textbook example with no strange variables. Essentially, this section can serve as a starting point for inventory
First thing you need to determine the ideal inventory levels is a material's Economic Order Quantity (EOQ). This is the amount you should be ordering when you place orders.
Next you need to determine your Safety Stock (SS). This is the amount that you should have
remaining when the EOQ arrives.
Basically, safety stock is the average bare minimum you will
have at any give time, and EOQ+SS is the average maximum amount you will have
at any given point in time. This should
be intuitive because safety is what you have when your shipment arrives and
when the order arrives (EOQ) it gets added to the safety stock.
I say average minimum and maximum because you might not
receive the EOQ exactly when you planned to and therefore may have more or
less. On average you should have the SS amount when you receive shipments. Between these two average minimum and maximum
values lies your long-term average inventory.
The formula for this is:
Optimal Average Inventory=(EOQ+SS+SS)/2
This is for materials. For finished goods, you should aim to keep an inventory level designed
to prevent a stock out. This level would
be a safety stock of finished goods, thus making the ideal average inventory
for finished the safety stock value based on your company's service level.
Part II: How to Assess Inventory Levels
Simplistic Method - Historical Inventory Levels
Most methods of accounting take the beginning inventory of a
period, add it to the ending inventory of a period, and divide by 2. This essentially provides the mathematical
average for a given month.
For example, if your inventory level for a good is 2000 on
July 1st, you produce 3000 units and sell 1000 units by July 31st. This leaves you with 4000 units. The formula is:
Avg. Inventory = (Beginning Inventory+(Beginning
Inventory+Units Produced-Units Sold))/2
Avg. Inventory = (2000+(2000+3000-1000))/2 = 3000
Or more simply:
Avg. Inventory = (Beginning Inventory+Ending Inventory)/2
So this covers historical looks using an accounting
approach. A lot of firms use this method
to evaluate their average inventory levels. Personally, I have a problem with this method which I believe the
following example will help to illustrate:
Daily Weighted Average Inventory Approach
Suppose you start with 10,000 units on May 1st. Also suppose you produce 10,000 units in that
month spread out across 21 business days. Now (and this is the important part) suppose you sold 20,000 units in
May. This brings the ending inventory to
0. Using accounting methods, the formula
gives us 10,000 as the average inventory.
So why is this so bad? In short, because the average inventory is not 10,000 units. In fact, there were only two days in which
10,000 units or less were held and these days were May 1st (10,000 units) and
May 31st (0 Units). Assuming that
production was level through the 21 day working month, this means that 500
units were produced daily, thus raising inventory by 500 units a day until
inventory was dropped by 20,000 on the 31st. Here is what the inventory levels look like in the month of May (each
record represents the end of 1 working day in a 21 day work month).
Clearly, this method of average inventory provides much different average inventory values than accounting procedures. It gives each day of the month an equal weight as opposed to giving the first and the last day of the month 50% weight each which I believe to provide more accurate results.
My example may seem a bit extreme, but consider a company who produces large runs of goods for another company and agrees to hold onto their inventory delivering once a month. In this case the supplier could start and end with 0 units each month end ship it all off, ending with 0 units each month making the average finished goods inventory 0. Their average inventory sure as hell isn't 0. They are higher, and they may be much higher. For this reason, it is very important to carefully choose how you assess your average inventory levels.
Why are inventory levels so important?
To put it simply, average inventory levels are important because they allow you to determine how much money you have tied up in inventory and how much value your inventory assets hold. Helping to determine what they should be can help cut back on unneeded inventory, and knowing what they are can help you determine average warehouse usage, inventory risk, percentage of assets that are made up inventory, holding costs, etc. To review information regarding high and low inventory levels, refer to my previous article, The Pros and Cons of Inventory.
Did you enjoy this post?
Any idea what if any software programs can track this "average inventory" metric?
You could go further and wonder: what if I shipped out all my finished goods by the end of the day while producting linearly over the course of a day (perhaps a bakery).
Perhaps inventory should be measured in some cases on an hourly basis !
Posted by: Norman | Oct 3, 2007 5:03:30 PM
in my current company, the order that we make to our supplier starts arriving 8-9 months after the date of order (each SKU has a different arriving month) and usually the order should be good for 6 months (becase there is no reorder in the middle of the season). how do you suggest we forecast/manage the optimal level of inventory?
Posted by: moiky | Dec 12, 2007 11:34:15 PM
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