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Cost of Over and Under Stocking

In either a manufacturing or retail environment, having too much inventory of products your customers don't want and/or too little inventory on hand of what products your customers do want can cost you money.  This Recipe shows you why it costs and how to reduce the damage.

Recipes are business techniques likely to be applied in many menus in Smorgasbord. You learn how to follow the recipe here then repeat at will.

Recipe

Just like a real recipe, it assumes that you have read the background information on the recipe and are now ready to get cooking.  

  1. Check your software system or ask your staff if you have any lines that are regularly out of stock and which you could sell if you had more of them.  These are your fast moving lines and probably your best sellers.  If so, try to estimate the cost of these shortages using the maths below.
  2. Repeat the process by inspecting the surplus stock that you have and place a cost on that surplus stock using the method below.
  3. If either, or both of these, are significant numbers in your mind:
    1. Design the outline of a project to improve the availability of these products.
    2. Rank the profit impact of this project against others your are, or planning to, work on (see The Amazing 80/20 Rule) to see what projects are more important to work through before this one.
    3. If you decide this is a priority project, consider the human and other resources necessary to work on this project and plan to start the project when those resources finish doing what they are now. (thus avoiding inefficient Multitasking)
  4. If there was significant profit / value loss in your inventory system, give thought to how to prevent it happening again in the future.
    1. Consider a new or better inventory software system.  
    2. Introduce or tweak useful metrics to warn you when it reoccurs.

Background

Having too much or too little stock on hand for your customers if you're a manufacturer or a retailer can cost a significant amount of money.

The Understocked Problem

If you're a manufacturer and you run out of a stock item it's quite likely the lines that you run out of are your best selling ones.  Because they are your best selling lines, they move most rapidly and you have trouble keeping up the supply through your production system or your wholesaler.  
Try this simple exercise to see the cost of shortages:

  • assume your profit margin on a particular item is $10
  • assume that you have 50 items in your product line and that at any point in time 5 of them are out of stock
  • assume that of the five out of stock, you could sell 100 units a week for each of them and
  • assume that you are out of stock for 15 weeks of the year in your prime selling season.

The cost to you of being out of stock is:

$10 times 5 understocked items times 100 missed sales a week times 15 weeks of the year = $75,000

Did you think that the cost would be as great as it was?  When you look at the individual numbers involved they seem quite small but they can add up to a significant sum.

If you are a retailer, you face the opposite side of the same problem.

The customer enters your store with a view to buying a particular item and you don't have it in stock.  It's quite likely to be a sale that you miss because they may not buy an alternative product from your store. Even worse, they may go to another shop to buy that item and then continue to shop in the other shop in future. Therefore, not only have you not sold the original item that they came in for, but you may have lost the customer entirely!

You can use the same mathematics as above to estimate the cost of understocked items to you as a retailer.

Solutions to Understocking

A first step to finding a remedy for under stocked lines is to be aware that you have a problem at all!

Many manufacturers and retailers don't have the sort of record keeping that will tell them when they run out of a product on a regular basis.  One of your early steps should be to set up some method of flagging your attention when a product is regularly out of stock. (see Kanban Recipe)

Very often, your best intentions for maintaining good inventory control will rapidly fall apart because it's very difficult to estimate what products will be in fashion or demand at any particular point in time.

Any production system that produces all products on a best guess basis of what the customers will want will very quickly find shortages in the fast running lines and surpluses in slow running lines.  This best guess approach can be thought of as a “push” model of inventory management; you are pushing the inventory that you think will sell out to the customer.

Alternatively, you can adopt a “pull” inventory model. This means that you stock your inventory according to what your customers are buying at any point in time.  If they buy 10 units of a product then you replace it with 10 units. That way, you should be tracking customer demand fairly well. This is often known as “small batches”.

To manufacturers, this may seem very inefficient.  It means that small quantities are required to be manufactured when the conventional wisdom is that you need large production batches to get  “economies of scale”.  On the face of it this is probably quite true for manufacturing as it's widely known but, there's also a great deal of business knowledge on how to convert your production line to small batches and therefore make it much more responsive to customer demand and therefore improve your income from having more fast selling lines in stock to sell.

For a retailer,  buying from a wholesaler in small batches and having the overhead cost of shipping those batches to you may seem very expensive.  However, there is the lost income cost of being out of a fast running product and the risk of losing a customer for life to offset the additional cost. With modern day courier systems, the cost may not be as bad as you expect.

You might need to convince your wholesaler of the benefit of this because it may make more handling work for them.  For this reason, they may have a policy of minimum lot sizes.  However, they face the same ‘feast and famine’ inventory problem that you do and you might find that they also find shipping small batches allows them to balance out their inventory as well; a “win win” situation.  

The Overstocked Problem  

If you are overstocked, you face a number of other costly issues.  Stock on hand surplus to requirements has a number of associated expenses including the following:

  • The investment made in the production of a product which is equivalent to the variable costs of components of the product plus the labour, energy and other resources that are necessary to produce it.
  • If you are a retailer and purchase product for resale, you have to pay the wholesaler's invoice, which can often be in advance of receiving the income from selling a product if it's a slow moving line. You might need a loan or overdraft to fund the invoice payment incurring interest.
  • Losses from life expiry with products, like foodstuffs that have a short life and are then valueless, and have to be written off at a loss.
  • Obsolescence where the product has to be written off or sharply discounted in order to move it e.g. women's fashions.
  • Storage costs either in a warehouse or a shop. In both instances the excess stock needs either more shelf space or displaces stock that might sell. In a retail environment with finite shelf space, any space taken up with slow moving lines displaces space that could be used for fast moving lines reducing the amount of them presented and therefore sold.
  • The economic cost of excess inventory is both the direct cash tied up in the production and holding of the inventory and any interest on loan or overdraft funds borrowed to cover the inventory.  Economists call this the “opportunity cost”  of the money  tied up as it represents the cost of using it for some other opportunity that is more profitable.

Therefore any reduction that you can make in inventory is likely to reduce this cost of funding the surplus inventory.

Ironically, excess inventory sits on the company balance sheet as an asset of the company giving the somewhat misleading impression that it is contributing in some way.  Cash in your bank account also sits as an asset on the balance sheet and, given that cash increases in value through compound interest, it is better than excess inventory which diminishes in value over time and costs money to hold.

You could estimate the amount of money unnecessarily tied up in your inventory in the following example;

  • 20 slow moving inventory lines out of a total of 100
  • Each with 100 units in stock
  • At a wholesale purchase price (retailers) or a production cost (for manufacturers) of $50 each
  • Taking 100 days to clear the inventory and
  • Paying 5% per annum in interest

The maths is 20 * 100 * $50 * 100 * 5%/12 months = $41,600

Solutions to Overstocking

If we convert to the concept of “pull”  inventory management, then we need a system for predicting are cooling either production or purchases from a wholesaler through the system. A technique that has developed to permit this is known as a Kanban.  Because this tool is a large subject, it has a recipe of its own.


You can explore faster destocking by garage sales, heavy discounts and similar actions to move the slow stock more rapidly and get it down to manageable levels.  Be Careful if you sell this stock to your normal customers because they may slow down their purchases of your other products while they clear the discounted stock purchase meaning you get a double hit; a discount on excess stocks and a reduction in "normal” sales.  

Metrics

In keeping with the concept of good Metrics Recipe, we need a way to measure the speed your inventory is moving so you can see a positive or negative trend.

One metric is:

Inventory Dollar Days (IDD)


This is simply the acquisition cost of the product from the wholesaler, or from your production, times the number of days to date it has been held in inventory.  
The IDD will go up if more expensive inventory items enter the inventory system and/or if the length of time taken to clear the items out goes up. Either reason is one for concern.

Practical Inventory management systems

Given the attention paid to the costs of over and understocking, it is apparent that you can benefit from a good inventory management system.
Some small business accounting software has inventory modules that might be worth exploring.

A spreadsheet might also work. Search “spreadsheet inventory management” in Google.

A checklist, when you are looking for such a system, needs to be able to:

  1. Identify fast moving items and
  2. Calculate the lead time for replenishment from production (if you're a manufacturer) or resupply from a wholesaler (if you are a retailer) so that you don't run out.
  3. Identify slow moving items.
  4. Calculate the amount of "safety” stock required to avoid running out of an item (also known as a “buffer” (Buffer Management).
  5. Take into account any life expiry issues.
  6. Calculate the lost income from stock outs and the increased expense from overstocks and discarded products.
  7. Provide useful metrics to monitor the state of the inventory.


In a small business, this ‘software’ can largely be covered by the owners and staff ‘gut feel’ for what is moving or not.  The trick is to be alert to these costs and to take steps to reduce them.

Quiz

A short set of questions and exercises to test your understanding.

  1. Can you see how to calculate the cost of over and under stocked items?

Resources

Links to other resources for more learning:

Wikipedia: Inventory information from definitions through examples, terminology, accounting, management, rotation and analysis - link

YouTube: Inventory Management - An Introduction by Rob O'Byrne - link

Books:

EIM - Effective Inventory Management - EIM allows an organization to meet or exceed customers’ expectations of product availability while maximizing net profits. A website with links to resources, seminars and articles - link

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