Oct 112010

As with most things in life if you don’t measure it you don’t know where you are or if you need to improve.  While this can be bothersome in your personal life with measurements such as how much you weigh or your waistline it’s a necessity in business.  So we’re going to talk about several of the most common measurements regarding inventory and supply chain and their definitions.  While some are optional some are vital to understanding your inventory position.  There are also some that provide the same basic measurement just from different perspectives.

 The first one that comes to mind and one that everyone wants to know is inventory turns.  Everyone from operations to finance wants to know the inventory turns, usually from very different perspectives.  The definition is obvious, it’s how many times you have “turned” or sold through your inventory within a given time frame.  The formula is the cost of goods sold for the time period divided by the average inventory value for the same period.  So, if the CoGS was $1,000,000 and your average inventory was $250,000 the calculation would be 1,000,000 divided by 250,000 which equals 4.  The inventory turns in this example is 4.  There is only 2 ways to increase your turns; increase sales (without increasing inventory) or decrease inventory.  There is another way to view this measurement as days of inventory.  If the above example was for a four week period instead of saying you have 4 inventory turns you have 1 weeks worth of inventory.  You can calculate turns using retail value, cost value or units as long as the unit of measure is constant.

 Another common measurement is quantity on hand.  This can be broken down to raw materials, WIP, components, replacement parts and finished goods.  This could also include available to promise which is the uncommitted portion of your inventory or the inventory that isn’t needed for current customer orders. 

 The next measurement is inventory value.  We’ve discussed this in past episodes but it fits in here as well.  You can measure the inventory value either at cost or retail value.  Some companies like to value inventory at cost to represent their investment while others like to value inventory using the retail cost to capture the total value of the inventory including their profit.  Because value changes over time a valuation method will need to be employed to capture this change or to standardize it such as FIFO, LIFO and standard costing.

 Inventory accuracy is measured by performing cycle counts and is reported in 3 different ways.  The first is overall accuracy; this is the number of locations counted without discrepancies divided by total number of locations counted.  As an example, if you count 50 locations and 49 of them are without discrepancies (the counted item matches the perpetual inventory) your inventory accuracy is 98%.  The other two ways are by number of units and by cost.  Both of these measurements should be measured using absolute numbers.  In other words, no negative counts.  Whether you’re short 3 units or over 3 units the variance is 3.  If you take into account if a variance is positive or negative opposing variances will cancel each other out.  It reminds me of the old joke of the 3 accountants that go bow hunting together; the 1st accountant sees a buck in the distance, he draws his bow and fires missing to the left of the buck.  The 2nd accountant draws his bow and fires missing to the right.  The 3rd accountant exclaims, “You got him!”

 There are other measurements but we can cover them later.  If you have questions about what we’ve discussed here today or if there is another measurement you would like to know about please send us a message at www.cashflowabc.com.

Jul 252010

This week’s episode is an open forum discussion regaring the pros and cons of physical inventories and cycle count programs.  We discuss why physical inventories need to be performed, the benefits of cycle count programs and what must be accomplished before physical inventories can be replaced with a cycle count program which will save you money and improve your CashFlow.  So, listen to the episode and turn your cash flow into a cash flood.  Or at least stop the leaks.

Thanks for listening,

John & Dave

Dec 272009

Whether you operate a warehouse, retail sales, service or manufacturing business you have some form of inventory.  In the past we have discussed some of the methods for maintaining the proper levels of inventory now we will discuss where to put these items within your facility.  You will have items that you use frequently and those you use infrequently.  You will have items that you use in large quantity and those that you use sparingly.  Where you place or profile this product is just as important to your efficiencies and costing as controlling the amount.


The overall amount you use or sell during a specific timeframe is called the volume.  The number of times you need the product or to be more specific the number of times an employee needs to visit the location holding the product is called the visits or hits.  The difference between the two is you can have an item that uses or sells 50 units within let’s say a week but only have 2 visits or hits.  This could be because the item is used in 25 unit increments or perhaps, if sold, a customer purchased 30 on Tuesday and on Wednesday another customer purchased 20.  Either way if this is the average usage then the volume would be 50 per week while the visits or hits are 2.


Determining the hits and volume is easy.  I recommend exponential smoothing over a 13 week period.

The hits determine the proximity to the usage point while the volume and size of the product determines the size of the location.  That may sound simple but that’s it, but as with all business practices what is easy on paper may not be easy in application.  You may lack space in close proximity to the usage point or you lack the space to have the locations large enough to cover demand.  Generally, depending on your business, you will have a variety of location sizes near the usage point.  In warehousing these are usually pallet, carton and bin locations.  In manufacturing you could also add barrels, drums, spools and a variety of other location types.

To summarize; to properly profile your items:

  • Understand the average volume per the time period you choose.
  • Understand the average number of times the item is ordered or how often it is needed.
  • Rate your items from highest hits to lowest hits (or visits).
  • Arrange the highest hitting items nearest to the point of usage in a location that is appropriately sized to handle the volume.

Profiling can be implemented with any 5S projects or it can be a project unto itself.

Proper profiling of your facility will lead to higher efficiencies and lower costs.

Sep 242009

There is a lot of talk regarding Lean improvements for business.  Removing waste, improving efficiencies and increasing profitability has become the battle cry of businesses around the country and the world.  But this is untested ground.  Where does one take the first step?  How does a company begin to head down this road to continual improvement?  Some will say Value Stream Mapping is the first thing you should do, but in order to properly create a current state VSM you need to bring your house in order.  I have seen VSMs rendered inaccurate only because the physical layout wasn’t maintained resulting in a changing process with changing process times and material queues.  The first step down the Lean highway is implementing 5S.  5S is nothing more than an organization and maintenance of your facility.  Some will consider it a bit anal in its approach but 5S is a proven method of organization and visual controls that will improve your company’s productivity and efficiencies by itself.

In the podcast I gave as an example of 5S the Batcave from the old Batman TV series starring Adam West.  Here are some photos to show you what I meant.  Notice the signs depicting each gadgets function:

5S stands for Sort, Set in order, Shine, Standardize and Sustain.  If you take a current look around your facility I think you’ll find that you’re already using 5S, but it’s a different form of 5S.  You’re probably using Sponge, Steal, Store, Scramble and Seek.  This means that currently if an employee is looking for something like a tool or another process necessary item they will sponge it off another employee leaving that employee to wait for its return, steal it from another work station or employee, store or hide items at their work station so others won’t be able to inconvenience them, scramble around wasting time and using that as a plausible cause for low productivity and endlessly seek for what they need sometimes getting others to join in the search.  All of these S’s are unproductive and frustrating for management and employee alike.  The 5S’s you need to use are:

  1. Sort – This is the first S to work on.  Sorting means going through the materials and tools of a work area and removing the unneeded and leaving the needed.  By properly communicating what is needed at each work station employees become more productive and quality improves through the use of the proper tools and materials.
  2. Set in order – This S means to organize the tools and materials of a work station so they are easily accessible to everyone who works at that particular station.  It also makes it obvious what tool belongs where.
  3. Shine – This S means just what it sounds like… clean!  This means more than clean it once it means to clean it and maintain that cleanliness.  Shine means putting in place processes and procedures that maintain a clean work area.
  4. Standardize – This S means to incorporate 5S into your daily processes or adding them to your SOPs.  This could involve using shadow boards, painted lines outlining functional areas or tools and labeling.
  5. Sustain – This is the guard dog of the S’s.  This S will take discipline.  If you don’t put in place the safeguards to maintain your efforts they will be in vain.  You will need empower and hold accountable your employees to maintain and improve the first 4 S’s.

If properly and attentively implemented 5S can not only set you on the right road to Lean it can show you the benefits of Lean even before you begin the more detailed aspects of Lean.  Your productivity and efficiencies will improve and you’ll be excited to continue.  Now you can start your Value Stream Mapping.

Jul 032009

The purpose of safety stock is to protect against fluctuations in demand or supply or any uncertainty.  Safety stock is based and dependent on:


  • Frequency of ordering
  • Variability of demand (compared to the forecast)
  • Desired service level


We’ll address these one at a time:


Frequency of ordering – How often you order or manufacture your products will affect your safety stock.  The more frequent your ordering the less your demand during lead time therefore the amount of replenishment is smaller than less frequent ordering.  However, due to the smaller quantities your risk of a shortage increases but exists for a shorter period of time.  Less frequent ordering decreases the risk of a shortage but stock outs last longer.  It’s been my experience that it’s better to have more frequent stock outs for shorter periods of time than to have less frequent stock outs for longer periods of time.  Customers may understand or have safety stock of their own that will be lower if any stock outs are for only a short period of time


Variability of demand – No matter how accurate your forecasting is you will experience variability in your demand.  Safety stock is primarily to absorb this variability.  To set the proper levels of safety stock you will need to understand the absolute error between your forecast and your demand.  Then you will need to determine the standard deviation of that variance.  This was discussed in episode 4 of CashFlowABC.  Please review that episode for more details and examples.


Desired service level – The amount of safety stock you carry will be directly affected by your desired service level.  For those dreamers or naïve individuals in your company a 100% service level is unrealistic.  It serves as a goal but realistically cannot be attained.  If you do have a 100% order fill rate I guarantee you have too much available stock or your forecast was overstated.  Additionally, if your product is extremely low in cost and stock outs are unacceptable to your customers then it may necessary to carry enough inventory to eliminate stock outs.  But if your product isn’t next to free then you should choose a realistic service level and put waste reduction processes in place to continually reduce your inventory levels while increasing your service level.  For those realistic individuals APICS has come up with safety factor multipliers to help set safety stock levels based on desired service levels.  The higher the service levels the higher the multiplier and safety stock.  As an example, if your standard deviation is 100 and your desired service level is 95% your safety stock would be 100 x 1.65 or a safety stock level of 165 units.  If your desired service level is 99% your safety stock multiplier is 2.33 or a safety stock level of 233.  This means for a 4% higher service level you will need to carry twice the safety stock.  This is why removing waste from your processes and lowering your inventory will save you cash.  Also, reducing your forecast error will reduce the variation and your safety stock.  Below are the service level multipliers for both the standard deviation and the MAD:


Desired Service Level %



Standard Deviation





































You can apply these tools to other variables other than demand variation.  You can apply this to variation in supply.  If you have a production process that provides variable amounts compared to the ordered amounts this can be applied to account for that variability.  Or if you have a supplier that is unreliable but provides other services that increase their value you can apply this method to that supplier to create safety stock to absorb that availability.


To quickly recap:


  • Frequency of ordering will affect safety stock in relation to the frequency and duration of the stock out
  • Variability of demand must be known so you can determine the standard variation or MAD.
  • You must decide on a service level and that level will affect your safety stock profoundly.
May 152009

EOQ is a method for setting a consistent order quantities that both minimize ordering and inventory carrying costs.  EOQ can be used hand in hand with reorder point systems as they function under similar assumptions:

  • That demand is relatively constant and known.
  • The order quantity is usually the same.  (The EOQ will remain constant until the review period or if changes in the supply chain warrant a reformulation of the EOQ.)

EOQ has some additional requirements and assumptions:

  • The product is purchased or produced in batches or lots.
  • Order preparation costs are known.
  • Inventory carrying costs are known.
  • Annual usage is known.
  • Replenishment occurs all at once.

Let’s look at EOQ’s requirements and assumptions one at a time:

  • The assumption that the product is purchased or produced in batches or lots is due to the consistent nature of the EOQ and the demand that determines it.  In other words, you won’t be ordering 7 now, 3 tomorrow and 12 next week.  The EOQ is formulated and is set until the next review period.  However, if the EOQ calculates to a number not divisible ty the batch or lot size you will need to round the EOQ up to a quantity divisible by the batch or lot quantity.
  • You will need to know your order preparation costs.  This holds true for both purchased and manufactured items.  You’ll need to know:
       – The number of orders placed annually.  This is determined by the annual demand / the standard order
         quantity.  If there is no standard order quantity use the average order quantity understanding you will need
         to review the EOQ sooner than anticipated.
      – How long it takes to process an order and the overhead costs associated with that process such as employee 
         salaries and the costs of purchase orders.
  • The inventory carrying costs in the EOQ are expressed as a percentage of the average annual inventory.  The inventory carrying costs fall into 3 main categories with the following sub-categories:
      – Capital
         – Inventory capital
         – Insurance
         – Taxes
      – Storage
         – Handling
         – Security
         – Storage
         – Record keeping
         – Space
      – Risk
         – Deterioration
         – Theft
         – Obsolescence
  • You will need to know your annual usage.  If that isn’t known you can extrapolate the data but you will need to review the EOQ sooner than anticipated.
  • Replenishment arrives and is ready for use all at once.  No partial shipments or a portion of the order quantity held in a QC queue for example.

 The calculation for the EOQ is: the square root of 2 x the annual demand x ordering costs / annual carrying costs x the unit costs.  As an example:

Annual usage = 1,000,000

Ordering costs = $5

Inventory carrying costs (as a percentage) = 0.20 (20%)

Unit costs = $2

Square root of:

2 x 1,000,000 x 5 / 0.20 x 2  or…

Square root of:

10,000,000 / 0.40  or…

Square root of:


EOQ = 5,000

If you wish to lower your EOQ you must take into account the following:

  • As your annual demand increases so does your EOQ to satisfy the increased need.
  • If your inventory carrying costs decrease your EOQ will increase as it is now more cost efficient to carry more inventory compared to unchanging unit costs and ordering costs.
  • If the unit costs decrease your EOQ will increase as it is now more cost efficient to purchase more inventory compared to unchanging carrying costs and ordering costs.
  • If you decrease your ordering costs your EOQ will decrease as it is more cost efficient to place more frequent orders compared to unchanging carrying and unit costs.

So, to lower your EOQ batch size you must lower your ordering costs.  This can be achieved through applying lean principles or mapping the process, identifying the waste and then removing the waste from the process.

If the EOQ assumptions and requirements are not valid for your company there are many other methods for ordering replenishment but you should always use a method that will keep your carrying costs and ordering cost to a minimum.

Apr 282009

A reorder point is a calculated stock level that, when reached, generates replenishment either through procurment or manufacturing while leaving enough inventory to satisfy demand during the replenishment process.

Reorder points work better in situations where demand is more or less constant and predictable or with slight variation.

All reorder points contain safety stock to absorb variations in demand. The purpose of safety stock is to reduce or eliminate stock outs due to variablility in either demand or replenishment. Safety stock levels are determined by various issues such as lapses in inventory integrity, receiving delays, supplier issues, scrap, damage and demand variability. Safety stock is also dependent on order frequency, desired service levels and forecast accuracy. We’ll cover safety stock levels at a later date.

Reorder points are based on demand history and therefore reactive. Regular periodic review is necessary to maintain the proper reorder point.

When using reorder points it’s very important to maintain communication with your suppliers as reorder points have a degree of “surprise”.  This surprise is due to the order being generated by a stocking level rather than set ordering schedule as with periodic ordering. Reorder points usually use consistant order quantities which is usually beneficial for suppliers.  The surprise can be deminished through open communication of the demand and changes in the demand, safety stock and any changes in the supply chain parameters that would affect the safety stock.

As with so many issues discussed here you will need to know and understand your demand.  You will also need to know your replenishment lead time.  Your replenishment lead time must be from the moment your reorder point is reached to the time the replenishment is ready for your use. This means you will need to take into account:

  • Purchasing or manufacturing planning lead time.
  • Supplier or manufacturing response or production lead time.
  • Transit lead time including any possible transit delays such as harbor inspections.
  • Receiving process lead time.
  • Any inspection or QC leadtime.

The calculation for determining a reorder point is:

(demand x replenishment lead time) + safety stock

Below is a graphic example of the reorder point with simulated usage:


As stated above the order quantity used is usually fixed but should be large enough to ensure you’re not at or below your reorder point when the replenishment is available for use.

For a reorder point system to work you will need a reorder point signal.  This can be done using several different methods such as:

  • Visual reorder points – This is the infamous crack in the wall method and can be very effective providing you can move the crack when the reorder point changes.  Any visual que can work such as: an empty bin, shelving or other indicator.  At the company John and I worked together we used a rolling sign on the floor next to the product as a visual reorder point.
  • Automated reorder points – These are calculated using a computer and sometimes using MRP.  When the item in question reaches the reorder point it is placed on an replenishment exception report or a planned PO or work order is created.  Then the planner or procurement specialist reviews the planned orders and releases them as they see fit.
  • Kanban – This system is usually used with a card.  When the reorder point is reached a card is retrieved and taken to the person assigned to replenish that item.

Reorder points are powerful tools that you can use to ensure material availability without maintaining excessive amounts of material.  They do, however, require that you review them at regular intervals to ensure they’re accurate.

Apr 162009

A forecast is an estimate of future demand based on market indicators and/or past performance plus market indicators.   We forecast to reduce the amount of uncertainty in order to prepare for demand.

Who is impacted by a forecast?

  • Finance
    • Investment capital
    • AP forecasting
    • Operational budgets
  • Inventory planning – for make to or order to stock environments.
  • Capacity planning – to ensure forecast does not exceed the ability of the company.
  • Procurement – to obtain the raw materials or products to support the forecasted sales. The finished goods forecast is broken down further into the materials planning requirements through the bills of materials.
  • Operations
  • Investors

Issues you need to consider

  • Data
    • Quantitative
      • Seasonality
      • Sales history
        • Record “actual” demand not sales history.
    • Qualitative
      • Expert opinion
      • Customer groups
      • Market estimates
  • Supply availability
    • Supplier or production issues.
  • Capacity
  • Available Capital
  • Current market conditions
  • Frequency of the forecast
  • Your planning horizon
    • Your longest lead time item will determine your planning horizon.
    • Aggregate forecasts are more accurate.
      Determine detail through product families and planning bills.  Below is an example of a product family planning bill:
    • Planning bills use individual item and family demand history to breakdown an aggregate forecast into individual item requirements.

Measure your forecast performance.




  • Rate of forecast consumption.
    • Divide your forecast into smaller periods to track the consumption.  As an example, divide a weekly forecast into daily checks.  If the forecast was 100 for the week you should sell 20 per day if your demand is flat.  Take into consideration any increases or decreases based on your historical demand or known forecast indicators.
    • If possible adjust the forecast to match the new rate of consumption.
  • Compare forecast to actual demand.
    • Track forecast accuracy by period.
    • APE (Absolute Percentage of Error) – The absolute of ((actual demand – forecasted demand) / actual demand) x 100.
      • Does not consider the direction of the variance.  Used to calculate the absolute variance for a single period.
    • MAPE (Mean Absolute Percentage of Error) – The average of the APE across a range of periods.
    • MAPE (Mean Absolute Percentage of Error) – The average of the APE across a range of periods.
      Does not consider the direction of the error.  Used to calculate the absolute variance across a range of periods. Below is an example of the APE and MAPE.
    • MAD (Mean Absolute Deviation) – The absolute of (actual demand – forecasted demand) / # of periods.
      • Does not consider the direction of the error.  Used to calculate the absolute variance across a range of periods.
      • Also is approximately the standard deviation / 1.25.
    • Standard Deviation – The square root of the absolute of the actual demand – the forecasted demand squared / the number of periods.
      • Does not consider the direction of the error.  Used to calculate the absolute variance across a range of periods.
        Also is approximately the MAD x 1.25.  Below is an example of the standard deviation equation:
    • Bias – Forecast bias is a consistent variation from the average (mean) in one direction.  The goal is a bias of zero.  This demonstrates that any variance is due to normal fluctuation and is not attributable to the method or data.  In the example above the variance total is 700.  That divided by the number of periods is +54.  This is a positive bias and you need to determine why the forecast is higher than the actual demand so you will understand the reasons for lowering your forecast or why demand has fallen short of forecast. 



  • Understand the inaccuracy.
    • Reasons for forecast inaccuracy
      • Lack of participation
      • Inaccurate data
        • Qualitative
          • No hedging or “sandbagging”.
        • Quantitative
      • Incorrect method
      • Inappropriate data
      • Insufficient data
      • Lack of monitoring
      • Oops
  • Apply what you have learned.



Forecasts are nothing more than educated guesses.  And, as human beings, we do best what we do most often.  So that being said the more often you follow proper forecasting processes, understand that it won’t be “perfect”, understand your variances and apply what you have learned to your next forecast your forecast will only get easier and more accurate.  This will help you service your customers and keep costs down.

– David

Apr 022009

Materials management is the sumo arena the company’s other departments wrestle in.  Each of these departments; sales & marketing, production and finance will have different ideas on how the company is to prosper and make a profit.  Sales and marketing want a seemingly endless supply of finished goods and replacement parts to maintain sales without a single stock out, production wants an endless supply of raw materials and WIP so they can meet all the production requirements of sales and marketing and finance want to keep just enough material on hand to satisfy customer orders without any material left over.  Materials management must balance these often conflicting objectives while maintaining high levels of customer service.

You must remember that every dollar not spent is a dollar of profit.

To maintain the proper level of inventory you need to understand the demand for your products.  You’ll need to understand your company’s:

·     Sales trends

·     Any sales seasonality

·     Demand for replacement parts

·     Any variations in your demand whether they are random or cyclical. (Random is any fluctuation that doesn’t follow a pattern while cyclical fluctuations follow a pattern.)

When you do encounter fluctuations in the demand you will need to record the reason for the fluctuations.  This understanding will help provide more accurate inventory levels and forecasts. (More on that later…)

The focus this week is on finding some “low lying fruit” or those items that obviously have excessive levels of inventory.  You’ll need to begin by tracking your usage or demand.  The time frame will depend on your business needs and model but the most widely used is weekly average demand.  You can use daily average demand but that will require a larger commitment as you will need to track demand more frequently.

Then determine the “Mean Absolute Deviation” of the data you’ve collected.  The “MAD” is the average of the absolute value of the difference between the demand and the weekly average of the data being collected.  As an example, if the data for a fore week period is 5, 15, 15 and 5 your weekly average would be 10.  The absolute value of the difference between each data point and that average is 5.  Add the MAD to the weekly average to arrive at the proper inventory level.  In this case 10 + 5 or 15.  Below is an example:


Period 1 2 3 4 Avg. Inventory 
Demand 5 15 15 5 10 Level
Weekly Avg. 10 10 10 10 MAD 15
Absolute Difference 5 5 5 5 5

If you’re a manufacturer you will need to blow this down through your bill of materials to ensure there is sufficient stock of your subassemblies and raw materials.


Now track your average on hand inventory.  To keep this simple just take the beginning inventory level and the ending inventory level for the period being tracked and use the average of the two.  Make sure you didn’t have a last minute receipt or reduction in inventory that would give a false average.

Also review your demand to make sure there isn’t a recurring spike in demand that isn’t captured within the MAD plus average.  That would be an example of cyclical variation.  You don’t want to reduce your inventory so this demand is backordered or otherwise unfilled.  Depending on the type and frequency of the high demand and your material lead times it is possible to lower your inventory while meeting this demand.  But, for now, let’s stay focused on the low lying fruit.  Below is an example:


You’ll need to inform and work with your suppliers and production team as they may need to reduce the flow of product to make the reduction a reality.

This all sounds overly simplistic and it is.  As I mentioned earlier we are looking for the low lying fruit.  There are more complicated methods for inventory tracking and reduction but every company I have ever worked for was able to track demand for a short time, measure the inventory levels, make immediate reductions and save cash.  I wanted to provide you with the means to achieve a quick win so you can reap early benefits and see the value of these methods.