Describe your inventory investment.
‘Better’ planning for your business starts with sales and operations plan (S&OP). However, for the plan to really make a difference, operations must be structured to enable response to demand in an acceptable time period.
Responding to demand means providing availability of items. This requires either making or assembling the items as required, or delivering finished items from inventory. But do you know enough about the behaviour patterns of your inventory to know how much to hold and where? This is the basis of logistics; designing the inventory management structure and processes, supported by your analysis of inventory usage and profitability.
To describe inventory behaviour patterns requires two calculations for each SKU:
- Coefficient of Variation (CoV)
- Gross Margin on Inventory Investment (GMOII)
My previous three blogs discussed the calculation and use of CoV through the Coefficient of Variation Management (CoVM), a structure developed by Tom Rafferty, which makes the CoV calculation useful.
Having structured the SKUs in a matrix based on their pattern of sales variation, you also need to know what financial return is earned from holding each SKU in inventory.
Margin analysis of your inventory
To measure the financial return, calculate the Gross Margin on Inventory Investment (GMOII); that is:
Gross margin x Inventory turns / 1 – gross margin
For example: an SKU placed in the LUMPY category has a gross margin of 56 per cent and inventory turns of 1.7 times per year. The calculation shows this SKU provides a gross margin of $2.16 per dollar of inventory investment. Considering the costs associated with holding inventory, an enterprise should aim to earn about $3 for each dollar invested in its newly effective inventory, following the CoVM process.
If an SKU is not achieving the required margin on its inventory investment, you must propose an increase in the sell price or decrease in the buy price, to obtain a higher gross margin. The alternative is to achieve higher stock turns through selling more at the current price and achieving more frequent stock replenishment.
The final decision concerning sell price and sales volume for each SKU belongs to marketing and sales. But no matter what decisions are taken, there will now be a continuing record of the financial return on inventory investment for all SKUs, together with their CoVM category.