| Converting your inventory into cash is as critical a | | | | A company's use of best practice purchasing |
| process for the health of your company's cash flow, | | | | methods in order to optimize price savings, to insure |
| as the process of converting Accounts Receivable | | | | quality products and to develop strong vendor |
| into cash. The effective conversion of inventory | | | | relationships cannot be overstated. Unfortunately, |
| into cash requires a methodical system that | | | | many purchasing decisions in small businesses are not |
| efficiently moves products from order to delivery. | | | | based on best practices. Wise purchasing decisions |
| Without a well-defined inventory management | | | | should not be made solely on volume discounts which |
| system in place, inventory stock levels may become | | | | generally produce lower unit prices. Under certain |
| too low or too high, resulting in lost sales and | | | | circumstances, this volume discount approach has its |
| increased costs. The longer an item(s) remains as | | | | benefits. However, one should not be lured by the |
| inventory, the greater the chance for the item(s) to | | | | myth that this approach works optimally all of the |
| become either damaged or obsolete and this | | | | time! In fact, this volume discount approach can be a |
| eventually results in an inventory write-down. | | | | major contributor to elevated inventory levels. |
| Slow-moving inventory adds to a slower cash flow | | | | A more pertinent approach to purchasing is the |
| and consequently creates greater carrying costs that | | | | Economic Order Quantity (EOQ) method. The EOQ |
| must finance the inventory. The degree of success, | | | | is an inventory model that indicates the quantity to |
| in converting inventory into cash, is directly related to | | | | be ordered which reflects customer demand and |
| the how well the inventory cycle is monitored and | | | | minimizes total ordering and holding costs. EOQ |
| controlled. | | | | inventory model employs the use of sales forecasts, |
| The inventory cycle, from order to delivery, involves | | | | historical customer sales volume reports, and the |
| the flow of both information and material. | | | | ongoing monitoring of current customers' sales |
| Information is initially generated from your sales | | | | activity. |
| forecast. As the inventory cycle advances, | | | | The Procurement Management Process involves the |
| information is generated from the receipt of sales | | | | following steps: |
| orders and the placement of purchase orders to your | | | | 1) Review Open Sales Report and Inventory Min |
| suppliers. Material flow is the movement of raw | | | | Max Report: Periodic analysis of these reports is |
| materials into your company that are processed into | | | | mandatory in order to determine the quantity that |
| finished goods. The material flow cycle ends with | | | | should be ordered to replenish standard in-stock |
| the movement of finished goods to your end-user. | | | | product inventory levels or non-stock items. |
| If you are a manufacturer, your inventory consists | | | | 2) Issue Purchase Orders: A formal purchase |
| of three basic types of inventories: raw materials, | | | | order (PO) must be issued to each supplier. The PO |
| work in progress, and finished inventory. Each of | | | | should include pertinent information: product |
| these types represents the various stages of | | | | description, quantity, quoted price, and time frame |
| completion of your product as it works its way | | | | for delivery. |
| through the manufacturing and assembly processes. | | | | 3) Purchase Order Procedures: Procedures that |
| If you are a retailer or wholesaler, you deal only with | | | | are recommended: |
| finished goods inventory. | | | | (a) Receive/Review Items: Once the items have |
| Ratio Analysis: | | | | been received, inspect them to determine whether |
| The periodic use of ratio analysis to monitor the | | | | or not they meet the description and quantity as |
| performance of your inventory is a highly | | | | stated in the Purchase Order and to determine any |
| recommended practice. The two main ratios for | | | | existing damages. |
| evaluating how well you manage your inventory are | | | | (b) Resolve Issues: Any discrepancies between |
| the Inventory Turnover Ratio and the Average | | | | "what was ordered" and "what was received" or any |
| Number of Days of Inventory: | | | | product damages must be noted on the shipping |
| • Inventory Turnover Ratio (ITR): The ITA | | | | documents and the supplier must be immediately |
| measures the number of times your business "turns | | | | notified. |
| over" its inventory in a year. It is a measure of the | | | | (c) Accept Items: After resolving any delivery, |
| operating efficiency of your business. The more | | | | damages, or discrepancy issues, the Shipping |
| frequent the inventory turnover, the greater the | | | | Receiving Supervisor accepts the items on behalf of |
| ratio. A higher ratio is preferable. | | | | the company. |
| To calculate inventory turnover, divide Cost of | | | | (d) Approve Payment: After the supplier issues an |
| Goods Sold (COGS) by Average Inventory. Use | | | | invoice for payment, the invoice must be approved |
| only finished inventory to simplify the calculation. A | | | | before scheduling and issuing payment. |
| low turnover rate may point to overstocking, | | | | Following above three steps ensures better supplier |
| obsolescence, or deficiencies in the product line | | | | relationships which, in turn, create greater customer |
| or marketing effort. However, in | | | | satisfaction. |
| some instances, a low rate may be appropriate; that | | | | Inventory Control System: |
| is, when higher inventory levels have occurred in | | | | Inventory control is difficult to embrace. Inventory |
| anticipation of rapidly rising prices or shortages. A high | | | | control is a system of maintaining inventories in order |
| turnover rate may indicate inadequate inventory | | | | to prevent stock outage, to control overage and |
| levels, which may lead to a loss in | | | | shortage, to reduce carrying charges (interest, |
| business. | | | | storage, and insurance), and fend off theft. |
| • Average Number of Days of Inventory | | | | Documenting policies and procedures that provide the |
| (ANDI): ANDI measures the number of days it | | | | guidelines for effective and efficient inventory control |
| takes, on average, to sell your finished goods | | | | is a must. |
| inventory. This ratio is simply the inverse of the | | | | Examples of Inventory Control requirements are: |
| Inventory Turnover Ratio. To calculate the ANDI, | | | | • Inventory accuracy: Inventory records must |
| divide the number of days in a year | | | | be consistently accurate in order to control costs and |
| (365) by the ITR. The fewer the number of days | | | | to fulfill sales order requirements. |
| that finished goods sit on the shelves, the better. | | | | • Reduce internal lead times: Overall lead time |
| Monitoring your Inventory Turnover Ratio and | | | | of raw material, sub-assemblies, and finished goods |
| Average Number of Days of Inventory helps you to | | | | must be reviewed in order to discover if any |
| improve inventory management and to avert | | | | inefficiencies exist. |
| write-offs associated with stale inventory. | | | | • Speed up the time to replenish raw material: |
| Sales Forecasting Process: | | | | Replenishing raw materials in a timely manner, so that |
| Believe it or not, most small businesses do not invest | | | | adequate inventory levels can meet customer |
| the time in forecasting future sales--- even though | | | | demand, is critical. Knowing suppliers' lead times is |
| cash flow projections demand it! Accurate | | | | the key to accurately replenishing raw materials. |
| forecasting of future sales not only impacts your | | | | • Review order quantities: As mention earlier, |
| cash flow projections, but it also becomes the | | | | ordering large quantities, in order to get a "volume |
| foundation for establishing adequate and realistic | | | | discount," is not always the best method for reducing |
| inventory levels. Without a solid projection of future | | | | cost. The Economic Order Quantity (EOQ) method |
| sales, managing your company's inventory and cash | | | | of purchasing works well in lowering overall cost. |
| flow would be difficult at best. Sales forecasting is a | | | | • Clean out old inventory: Identifying obsolete |
| critical activity for reducing risk and avoiding the high | | | | or slow moving inventory items, and then, developing |
| costs of either under-stocking or over-stocking of | | | | channels in which to sell and/or dispose of those |
| material. | | | | items, not only frees up storage space, but also |
| Sales forecast are not without its set of problems. | | | | generates immediate cash. |
| If sales forecasts are projected too optimistically, | | | | • Hold your suppliers accountable: Holding |
| then cash is often tied up in slow-moving inventory | | | | suppliers accountable for on-time deliveries, as well |
| and profit margins are reduced due to wasted | | | | as, for consistent quality control of their product is |
| overhead. On the other hand, if sales forecasts are | | | | important. Late deliveries can mean loss of sales |
| projected too pessimistically, then the result is poor | | | | due to inadequate inventory levels. Products of |
| delivery performance, dissatisfied customers and | | | | poor quality increases product returns |
| revenue shortfalls due to limited product availability. | | | | from customers, and if done repeatedly, could |
| The benefits of sales forecasting far out way any of | | | | ultimately result in loss of sales. |
| its pitfalls: increased revenue, increased customer | | | | • Inventory Reports: Creating a Min/Max |
| retention, increased operational efficiency, and overall | | | | Inventory Report, which defines the minimum and |
| decreased costs. | | | | maximum inventory count levels for each line item |
| Since your company's sales forecast is based on | | | | that is in stock, is imperative. The difference in |
| previous sales, it is necessary to obtain accurate | | | | count, between the minimum and maximum level, will |
| totals of dollar sales and unit volume for the past | | | | vary from product to product since it |
| several years. Your sales forecast should include, | | | | is based on a projected daily sales volume for that |
| both internal and external elements, since both can | | | | product. Lead time from the supplier also plays an |
| affect future sales. Internal elements include the | | | | important role in determining min/max levels. |
| use of accounting records, financial statements, and | | | | Following a pre-established set of processes and |
| sales/customer service reports that will be scrutinized | | | | procedures - as defined above – helps to more |
| and analyzed in the preparation of your sales | | | | consistently shorten the inventory cycle time. By |
| forecast. External elements include data on market | | | | shortening the inventory cycle time, the process of |
| conditions, economic climate, and competitive | | | | converting your inventory into cash becomes more |
| influences. The forecast's internal and external data | | | | efficient and effective. Improving the rate, at which |
| should be collected and analyzed on a consistent | | | | inventory is converted into cash, ultimately generates |
| basis. | | | | a healthier cash flow. |
| Procurement Management Process: | | | | Copyright © 2008 Terry H. |