How to calculate an adequate inventory and proper order quantity

How to Calculate an Adequate Inventory and Proper Order Quantity

This article introduces the type of ordering method and how to calculate the adequate inventory quantity of the regular timing & unfixed-quantity ordering method and how to calculate the proper ordering quantity from them and explain why it’s a right method with simulation.

(Duration: 8:04)

DOWNLOAD  ← Click this to download the “Proper Order Qty” Excel sample file.

 

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What’s Adequate Inventory Quantity?

 

Hi, this is Mike Negami, Lean Sigma, Black Belt.

 

The previous video was about ‘First In, First Out’. In that video, I said that “It’s important to maintain an adequate inventory amount.”

 

 

I’ve talked about inventory in many of my videos before, but here I’ll summarize the cons of excessive inventory.

 

Excessive inventory:

  1. Is a useless expense. You cannot make any profit if you’re just holding onto the inventory.
  2. Increases additional inventory management expenses such as labor, electricity and storage fees, etc.
  3. Increases the risk of inventory loss due to obsolescence and quality deterioration.
  4. Obstructs your visual management and prevents early problem detection.
  5. Interferes with organizing storage and may cause mis-ordering.

 

There is almost no good thing about excess inventory, except it does help to decrease the risk of sales loss from out-of-stock items. Taking all these points into consideration, the proper inventory quantity is the minimum amount that avoids being out-of-stock. This is the basic concept.

 

The Types of Ordering Methods

 

Next, I’ll show you how to calculate an adequate inventory quantity. Do you know that it depends on your ordering method?  The ordering method roughly depends on whether the time to place an order is regular or irregular, and whether the quantity to order is fixed or unfixed.

 

Type of Ordering Methods

 

No company always has the same amount of sales, so they never use regular timing & fixed-quantity ordering. On the contrary, some companies use irregular timing & unfixed-quantity ordering. In many cases with this method, they may end up that way due to a lack of planning. This method is not efficient when considering company optimization.  I recommend that you move to one of the other two ordering methods.

 

Irregular timing & fixed-quantity ordering places fixed-quantity orders when the current inventory quantity reaches a certain level. Since it’s very simple, many companies are using this method.
However, it’s difficult to accommodate sudden sales and usage changes, and it’s necessary to regularly check the proper fixed-order quantity. This method is good for products with inexpensive prices and little degradation of quality and value.

 

If that’s not the case, I recommend moving to the regular timing & unfixed-quantity ordering. Since you’ll be regularly placing orders like on a weekly or monthly basis, they will arrive regularly, so it becomes easy for both you and other departments to make work schedules. Please select the most advantageous order frequency for all related departments. Deciding the order quantity requires you to record inventories and received amounts and do calculations.

 

The Four Essential Factors to Calculate Adequate Inventory Quantity

 

Next, I’ll talk about how to calculate proper inventory for the regular timing & unfixed-quantity ordering method. For that, we need the following four factors:

 

  • Order Frequency,
  • Lead Time,
  • Safety Inventory,
  • Estimated Inventory Usage per period

 

The more frequent your Order Frequency is, the lower the required inventory quantity can be, but the more your labor and cost requirement are. It’s also influenced by your supplier’s schedule. Consider all these factors and decide the best Order Frequency.

 

Lead Time is the number of days for your order to arrive when ordering today.

 

Safety Inventory is extra days of inventory. Nobody can predict the future. There are times that you’ll sell more than expected or your order arrival has been delayed. This inventory quantity can prevent becoming out of stock.

 

The longer the Order Frequency and the Lead Time, the more Safety Stock is needed. You could calculate Safety Inventory statistically, but you should decide it by having plenty of safety inventory at the beginning, then gradually reducing it.

 

The unit measures of Order Frequency, Lead Time and Safety Inventory are all period.

 

Proper Ordering Simulation

 

In the chart below, the vertical axis represents the inventory quantity by day and the horizontal axis represents time. For example, let’s say that Order Frequency is 14 days, Lead Time is 7 days, and Safety Inventory is 14 days. Then, the total days, which is 35 days in this example, is the proper inventory. If you want to convert it to quantity or currency amount, just multiple it by the daily usage quantity or that price.

 

How to calculate adequate inventory quantity

 

Now, why does the total of this Order Frequency, Lead Time and Safety Inventory become the proper inventory quantity? You may have thought it’s low. Let’s do a simulation.

 

For example, today is the ordering day, which is Day 0. If the current inventory is over 35 days, which is more than the proper inventory, you do not need to place an order at this time.

 

The inventory will be decreasing until the next ordering day, which is Day 14. The proper order quantity is also easily calculated by subtracting the current inventory quantity from the proper inventory quantity. You may have thought it’s too low. Let’s continue.

 

How to calculate proper ordering quantity

 

Suppose we sold more than usual in the following week. Because of the safety inventory, we could avoid running out of stock. Then, the order quantity arrived and inventory was increased. A week later, we’ll place another order for the quantity of the proper inventory minus the current inventory. As we continue this, every product will fall within its proper inventory quantities.

 

How to calculate proper ordering quantity 2

 

I made a sample file so that you can check how the calculation is formulated. Here are explanations for that.  You can download this sample file. Please check how it formulates the calculations.

 

DOWNLOAD  ← Click this to download the “Proper Order Qty” Excel sample file.

 

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