How Inventory Accuracy Directly Impacts Profit

Authored By: Bridget Lazlo, CEO, Guardian Business Solutions

For every dollar of error in your inventory, there is a dollar of direct impact on your profitability.

It’s hard to believe, but it’s true.

Photo of Bridget Lazlo, CEO, Guardian Business Solutions
Bridget Lazlo, CEO, Guardian Business Solutions

To better understand, calculate profit by taking your total sales less the cost to produce, manage, and sell your product. When you value your inventory (known as book value) and count your inventory (known as count value), every dollar you write up or down to match these two values directly affects your profitability. For instance, if your book value is $250,000 and your count value is $225,000, that inventory error costs you $25,000 in profit.

Inventory accuracy is any inconsistency between your recorded and actual inventory, including its quantity, location, and value. Many sources claim that 97% inventory accuracy is a good benchmark for most companies. Depending on how much inventory your company carries, each percentage of improved accuracy also improves profitability; conversely, each percentage decrease in inventory accuracy can, when not managed effectively, subtracts from the bottom line. We all know inventory accuracy is vital for many reasons that indirectly affect profit. What many don’t often consider is how the accuracy of inventory affects profit directly. Let’s drill into this further to uncover why inventory accuracy is critical to any manufacturing business.

How to Calculate Inventory Accuracy

To calculate inventory, you first count the number of items. If the count equals the on-hand value in the system, it is a hit. If it does not equal the on-hand value, it is a miss. Divide the total number of items counted by the number of hits, and you get your record accuracy. This pure number does not account for inventory value or categorization techniques like the ABC analysis (with A items having very tight inventory control, B items less tightly controlled, and C items with the simplest inventory control).

Consider inventory accuracy from a value perspective as well. To calculate this, take the inventory value in your business system and compare it to the value of the counted inventory. If the value is a low number, it can be more misleading than the record-accuracy measurement described previously. One of the reasons it can be misleading is that your errors are occurring on items of similar value, or the count for low-value items is off but might have little impact on your inventory’s overall value. Many accounting people will be satisfied if the value of the inventory is highly accurate even when the count is not.

If the number is high, you need to spend time researching the parts with the bad counts. Is it the system or process you use? Look for the root cause. Accountants will insist that high-value differences need reconciling.

Why Manage Inventory?

Inventory is typically the largest asset manufacturers have and is expensive to carry and maintain. Carrying too much makes the out-of-pocket investment associated with that inventory too high. Carrying too little can lead to poor customer experiences with long-lasting, even irreversible, effects.

Inventory management affects cash flow. The more inventory turns you have, the more cash and related inventory-control expenses you free. Say your annual cost of sales is $2 million, and your average inventory level is $500,000. Divide average inventory into annual cost of sales, and you have four turns. You get five turns if you reduce your average inventory level to $400,000. One extra turn frees up $100,000 cash and eliminates the related expenses associated with that inventory. Typically, those related expenses are 25% or, in this example, another $25,000.

Some costs associated with carrying inventory are obvious, others less so. You have the cost of inventory, of course, along with the indirect labor that goes into managing it, including material handling, computer data entry, and scanning. Then you have the storage space, property taxes, electricity, heating, and cooling costs. You might incur the freight costs of moving inventory between plants or warehouses too.

There’s the risk of damage and pilferage and the increased insurance costs that go with both. When you have more inventory, you also increase the chance of inventory errors like inventory shrinking when your actual inventory is lower than your recorded inventory. You also increase the risk of obsolescence.

Perhaps the least obvious and most overlooked cost has to do with lost opportunities — the opportunity cost of inventory. If you can’t sell or use your inventory, you lose the opportunity to use the money elsewhere.

Ways to Minimize Your Inventory Investment

Cycle counting is an excellent way to increase accuracy and reduce inventory investment. It can help you promptly correct inventory errors. Catching errors early helps you pinpoint what caused them in the first place. Frequent cycle counting is much more effective than a full-blown physical inventory count. You can do a root cause analysis and correct mistakes immediately. Frequent counts help you find record errors and correct your statement of assets immediately instead of taking a big hit at year-end.

Be sure to educate the whole company on why inventory is so important. Many might need help to understand their role or impact on the process. Set cycle counts at a specific time of day. Everyone should know when they occur and how to process transactions around them. Better yet, don’t count during production hours, if possible. Count when few or (ideally) no transactions take place.

Also, don’t forget the purchasing department. How do you incentivize them? If you incentivize based on material cost reductions, are they buying more than you need to get the lowest cost per pound? They may feel they are getting a good deal on that metal when the cost to keep the inventory in stock is much higher than they realize. The cost of metal is always in a state of flux. Buying in larger quantities than needed is not a best practice.

Finally, look at the production side of inventory control. What metrics have you given production? Production metrics generally include efficiency, yield, and productivity—but know that these can work against your efforts to reduce inventory costs.

Are they nesting more parts than you need to get a better yield? Are they running more parts to fill a sheet and keep the machine running? If they are, they’re using valuable resources that would be better spent producing items your customers need and will use now — not later. Making them ahead will undoubtedly cost more in the long run. Hold excess finished goods, and you increase the risk of damaging them. Moreover, customers might send revisions that make those parts obsolete. These are all good reasons not to run extra parts just to increase your material yields.

Making material yield a metric can give you valuable improvement insights. But working to improve the yield metric without considering using other valuable resources (the laser, shear, inventory, people) can worsen matters.

Remember that each dollar of inventory error is a dollar of lost profit. Evaluate your turns. If your turns are low and you hold more inventory than you need, either because you bought or made too much, educate your employees on best practices. Implement policies that allow workers to be idle and machines not to be scheduled to 100% capacity. In the end, you will be more productive, more agile, less reactive, and more profitable.

Other Benefits of Accurate Inventory

Increased profitability isn’t the only benefit of inventory accuracy, of course.
Let’s explore other impacts of inventory accuracy.

  • Improve customer service. Customers might call and request certain parts; you think you have them and promise to ship them. However, the inventory is not there when you try to ship the parts, leaving disappointed customers in the lurch. Accurate inventory improves customer service, allowing you to make and deliver on promises confidently. Manufacturers work in competitive markets where maintaining customer satisfaction is crucial.
  • Reallocate money previously tied up in extra inventory. If you are confident that you have what your records indicate, you do not need excess inventory. Other purposes, such as employee education and benefits, research and development, and market acquisitions, can now be funded by eliminating the extra expense.
  • Improve your return on investment (ROI). Companies count on ROI to stay in business. A good ROI benefits the whole company and keeps people employed.
  • Eliminate the expense of doing a physical inventory. Physically counting an entire inventory introduces more errors than it fixes. Moreover, doing a physical inventory can be extremely expensive. You often have to pay people overtime and might even need to halt production.
  • Increase productivity. Not only are you saving time by eliminating time wasted on physical counts, but you are decreasing downtime spent searching for inventory to run the order(s) received. There is no goose chase on the shop floor, and customer service, in the end, doesn’t have to take the brunt of a disappointed customer due to altered lead times.

Overall, poor inventory accuracy has the potential to consume many resources that can impact employee and customer satisfaction and operations.

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