VED Analysis
VED Analysis is based on inventory value and how critical it is for an item to be in stock. This method is useful for manufacturing companies that stock many components and parts. It’s different from ABC analysis in that it only takes into account how necessary an item is to the continuing operation of the business.
- Vital: Inventory that must be in stock
- Essential: A minimum amount of these items is enough
- Desirable: These are optional items
HML Analysis
HML analysis is measured according to an item’s unit price. It’s different from ABC analysis because it only considers cost and doesn’t include the sales value of items. HML analysis is useful for controlling costs and staying on budget.
- High Cost: High unit value item
- Medium Cost: Medium unit value item
- Low Cost: Low unit value item
SDE Analysis
This inventory analysis method is based on the scarcity of items in the market or how soon you can acquire them. It’s usually used in businesses that deal with raw materials or items with long lead times to acquire.
- Scarce: Scarce or imported items that have long lead times
- Difficult: Inventory that has lead times anywhere from weeks to 6 months lead time
- Easily available: Items that are easily acquired
Safety stock analysis
Safety stockis inventory that a business holds to mitigate the risk of shortages or stockouts. Think of it as a type of insurance for when demand spikes or there’s a material shortage. Businesses can use a safety stock formula to make data-driven decisions about managing inventory levels to maximize profits.
The formula for safety stock is the difference between your maximum daily usage and lead time and your average daily usage and lead time:
(Maximum Daily Usage x Maximum Lead Time) – (Average Daily Usage x Average Lead Time)
As you can tell, there are different ways to analyze your inventory depending on the type of business you’re running, but the underlying principle remains the same. By simplifying your inventory analysis method, you can easily prioritize where to place your time and focus, increasing your operations’ efficiency.
Next, let’s look at some key metrics you can use to drill down and see how healthy your business is.
What are key metrics you can use to measure inventory efficiency?
Inventory analysis doesn’t just end with the Pareto Principle. You can use key inventory metrics to measure different segments of your business, which uncover ways to optimize your operations and increase profits.
The following inventory formulas can all be used to find ways to increase your bottom line:
Gross margin return on invested inventory (GMROI)
GMROIis an inventory formula used by retail businesses to measure a certain element of their profitability. It measures the gross profit that a retailer makes every year for each dollar of inventory they purchased. The formula is:
Gross profit margin ÷ average on-hand inventory cost
After doing this calculation, the number should at least be higher than one. If it’s below one, it means you are losing money on your inventory and aren’t a profitable business. A GMROI of 1.50 means you are making a profit on your inventory at 150% of your cost.
There’s no specific benchmark for GMROI. It depends on your industry. Industry-specific retail associations are good resources for benchmarks like this, as is theRetail Owners Institute.
Available to promise
Available to promise(ATP) is an inventory formula used for analyzing order fulfillment. It helps analyze customer demand and adjust operations to meet it. For example, every time you order takeout from a food delivery app, the app goes through the available to promise formula to calculate how long it will take for your food to arrive.
Here’s the formula:
ATP = Quantity On Hand + Supply (Planned Orders) – Demand (Sales Orders)
The ideal promise time depends on customer expectations and varies by industry.
Inventory turnover rate
Your inventory turnover rate shows you how effectively you’re managing inventory. It measures how many times your average inventory is sold during a certain period.
This inventory formula is calculated by dividing the cost of goods sold by the average inventory for a certain period. So if your average inventory the past year was $1,000 and your cost of goods sold was $10,000, your inventory turnover rate would be 10, meaning you sold your inventory ten times over. Ideally, you want this rate as high as possible because it shows how quickly you can sell your products and proves you’re not overbuying inventory and wasting capital.
Carrying costs
Carrying costs(also called holding costs) are costs incurred in storing and maintaining inventory. This may include insurances, warehouse space, equipment, security, and labor costs.
An example of a holding cost could be a forklift truck required to move stock in the warehouse. Holding costs are represented by the cumulative dollar value of these various costs. They can be accounted for separately or grouped together.
Average days to sell inventory
This metric indicates how long it takes a company to buy or create inventory and sell it. Average days to sell inventory is calculated as follows:
(Inventorycost of sales) x number of days in the year
The average days to sell inventory ratio alerts the business owner how long, on average, it takes to sell each item of inventory.
Stockout rate
The stockout rate is the ratio of a company’s total stockout losses to total orders, expressed as a percentage. This metric measures how effective a business is at managing inventory.
Let’s say you are a clothing retailer and want to figure out your stockout rate. One way to calculate your rate would be to divide your total sales back-ordered by your total sales.
So if you did $100,000 in sales, but $10,000 of those sales were for items that were on backorder, your stockout rate would be 10%, which is high. You’d want to look at why and make sure you had enough inventory on hand the next quarter to reduce that rate.
For your most in-demand and profitable inventory, you want your stockout rate to be as close to zero as possible. A high stockout rate can also hurt customer satisfaction, which we’ll talk about next.
Customer service level (CSL)
CSL is the expected probability of not having a stockout for a given period or the probability of not losing sales. Ideally, your CSL should be as close to 100% as possible, especially if it’s A-inventory based on ABC analysis. There are few ways to calculate customer service level, but an easy inventory calculation is to divide the number of products delivered on time divided by the number of products sold.
