Five Key Metrics to Consider When Inventory Planning
Inventory planning is part art, part science, and can require some structural thinking. Our VP of Finance, Harley Pasternak lays out five must-know metrics that you can incorporate to help plan your inventory position.
Most consumer brands will invest the majority of their funding into three primary use cases: building & storing inventory, shipping products, and marketing to prospective customers. In this piece, we’ll focus on building and storing inventory and share five metrics you may want to consider when inventory planning.
Inventory planning is critical to get right. Produce too little, and you may not be able to fulfill all of your sales. Produce too much, and you risk throwing out excess product and taking a loss. So how much inventory is the right amount?
You’ll want to start by estimating how many sales you expect to make over the next production cycle. In an ideal scenario, you will produce the exact amount of product you will sell without any slippage or returns, but in manufacturing, you must prepare for the unexpected. It is important to account for a margin of error to avoid potential product shortages wherein you are winning sales you cannot fulfill, potentially damaging your brand with the dreaded “out of stock” label.
When deciding how much additional inventory you want to produce, there are a few important questions to consider: (1) What is my inventory turnover ratio? (2) What are my Days of Sales? (3) How long is my shelf-life? (4) Is my product seasonal? (5) What are my product margins?
Inventory Turnover Ratio
Your inventory turnover ratio will tell you how many times you sell through your inventory each year. This is calculated as:
Inventory Turnover Ratio = Cost of Goods Sold (COGs) ÷ Inventory Value
Most demand planning experts view six to twelve months as a desirable ratio, however, this changes dramatically by industry. Low-margin products should target higher inventory turnover ratios, while high-margin products have more wiggle room to achieve success at lower turnover rates. Intuit recommends using the following formula to determine effective inventory management.
Inventory Turnover Ratio x Gross Profit Margin (%) < 100%
Days of Sales Inventory (DSI)
DSI is an important metric to help you understand when you should expect to restock your inventory. It is calculated as:
DSI = days in the year (365) ÷ inventory turnover ratio
Brands typically want to target the lowest DSI possible while keeping a sufficient flow of product running through their supply chain. Similar to the Inventory Turnover Ratio, this will vary by industry and margin profile, where higher-margin products have more leniency. A lower DSI will improve the efficiency of your storage costs, a frequently overlooked expense that can stretch your dollar further if spent effectively.
Shelf life is an important factor to consider when planning inventory and determining your DSI, especially in the Food & Beverage industry.The Food & Drug Administration (FDA) has strict regulations on how long products can be stored and the conditions at which you must store them. As such, you may have a lower cap on your DSI before your product needs to be turned over or disposed of.
If your product is perishable or has a short shelf-life, batch production runs may be a great way to avoid excess waste. Batch production runs are smaller, so you will pay a little more for each product on a unit basis, but you will avoid having an oversupply of expired inventory, saving you money down the road by lowering your supply chain losses and storage costs.
Another helpful strategy for perishable products in the food and beverage business is partnering with a local agricultural or farming outpost that will pay for your expired product to be used as animal feed or compost. You may not recoup the full cost of your expired product, but 10% of something is better than 100% of nothing.
With seasonal products, any unsold inventory will likely be disposed of or sold at a deep discount at the end of the season. Good examples of this are Halloween candy or high-end fashion. If you have a seasonal product, excessive overproduction can be risky, since the likelihood of needing to sell your product at a discount or loss after the season ends is high.
Forming a relationship with a charity where you can donate your excess inventory to those in need and obtain a tax write-off is a good way to contribute to your community and simultaneously boost your bottom line.
Although it may not seem obvious at first, your product margins are an essential piece of inventory planning. The higher your product margins, the more cushion you will have to overproduce and absorb additional costs. To demonstrate, let’s walk through an example of both a high-margin and a low-margin product.
You sell a high-margin powdered beverage product with 70% gross margins and have extremely high supply chain losses of 50%. In this scenario you will make $20,000 of profit.
Now, let’s cut both your margins and supply chain losses. Here, you sell a low-margin refrigerated food product with 30% gross margins, but only have 20% supply chain losses. In this scenario you will only make $10,000 of profit, even though you have reduced your waste by more than half!
As you scale your business into a multi-product company, a mixture of high and low-margin products can be a helpful strategy to provide yourself with more financial flexibility. High-margin products can be used to offset and improve the margins on your total portfolio of products.
- It is important to plan inventory in line with sales forecasts. Producing too much inventory can result in supply chain losses, and producing too little leaves demand on the table.
- Target an Inventory Turnover Ratio, such that: Inventory Turnover Ratio x Gross Profit Margin (%) < 100%.
- Try to maintain a low DSI; this will keep your storage costs low and prevent product loss due to expiration.
- Keep your product type in mind when planning your inventory build. Seasonal products and perishables are at higher risk for supply chain losses than non-seasonal and shelf-stable products. If you cannot move your inventory, it may be worthwhile to pay more for batch production to avoid heavy losses or excess storage costs.
- High-margin products will provide you with more cushion on supply chain losses. Using high-margin products to improve the overall margin profile of your business can be a helpful strategy as you scale.