With the advent of online sales digging into retailers’ pockets, it is more important than ever for independent retailers to eliminate lost sales that occur as a result of stockouts. According to a study in May, 2018 by retail research organization IHL Group, customers of department stores and specialty retail shops experience a stockout 1 in 4 shopping trips. They estimate that stockouts are costing North American retailers more than $47B a year in sales! And where are these sales going? To Amazon; where else? IHL states that nearly 24% of Amazon’s North American retail revenue can be attributed to consumers who first tried to buy the product at a local store but couldn’t find it on the shelves.
Another study by Stitch Labs estimates that the Worldwide retail industry loses over $634B each year to stock-outs; even though the average retailer overstocks their shelves by 50%! This emphasizes what is arguably the most significant “Catch 22” for retailers that want to expand; that is, you need inventory to ensure business growth but if your cash is tied up in keeping inventory on hand, it can’t be used to grow your business.
In a perfect world, you would sell out of every product in your store just as you’re replenishing your shelves with new stock. That way you would get the highest return from your inventory investment and you wouldn’t have excess stock. Unfortunately, that’s just not realistic. What I have observed after working with hundreds of specialty retailers over 25 years is that most retailers follow one of two strategies:
- They worry so much about losing a sale from a stockout that they over-stock every popular product, thus tying up significant amounts of capital that could be better used elsewhere.
- They use rigid purchasing budgets (or have limited funds available) so they don’t buy enough merchandise and frequently stock out of popular items.
In many cases, these retailers have adequate computer systems in place; they just aren’t using them – or they don’t know how to use them to get the most bang for their inventory buck. According to Harvard Business Review, 72% of stock-outs are due to faulty in-store ordering and replenishing practices: ordering too little or too late, generating inaccurate demand forecasts, or otherwise mismanaging inventory. Only 28% of stock-outs can be attributed to replenishment and planning problems in the supply chain, which are out of the retailer’s control.
So how do you walk that fine line between eliminating stockouts but not having too much inventory? Well, it all starts with having dependable inventory information and then using that information to replenish stock in a timely fashion. The objective is to understand what your optimal on hand inventory quantities are and then issue purchase orders with enough products to ensure you don’t run out before the next shipment arrives – but don’t order too much either. The process of analyzing your requirements and determining when to place supplier orders and for how much is called “Inventory Planning’. In its most basic form, Inventory Planning leverages two key calculations for each product you order: Reorder Point and Economic Order Quantity. Having accurate Reorder Points for each inventory item will help eliminate stockouts; Economic Order Quantities will further optimize inventory levels by minimizing over-stock situations. By calculating these values and incorporating them into your replenishment procedures and systems, you stand the best chance of walking the thin line between having enough merchandise to meet demand and tying up too much money in unnecessary stock. For the purpose of today’s Blog post, let’s focus on Reorder Points. We’ll handle Economic Order Quantity in a future post.
You’ll go a long way to maximizing the impact from every dollar invested in inventory if you have realistic Reorder Points for each product you sell. Here’s how to calculate them to ensure you always have enough (but not too much extra) available stock. First you need to multiply the average daily usage of an inventory item (in unit sales) by the lead time (in days) to replenish it. However, it’s entirely possible that a spike in demand could occur, causing a stockout situation before the product is replenished. This is why you should also add a component for Safety Stock. The longer the lead time to get a product from your supplier, the more important it is to have adequate Safety Stock values. Safety Stock is the difference of a product’s maximum daily sales multiplied by the maximum lead time in days, minus the average daily sales multiplied by average lead time. The calculation takes into consideration the worse-case scenario and adjusts it so that it provides a more reasonable number. Make sure you also rely on your own industry knowledge and market insight; and adjust your Safety Stock requirements to reflect realistic values.
So let’s review the formulas:
Reorder Point = (Average Daily Usage X Lead Time) + Safety Stock
Safety Stock = (Maximum Daily Sales X Maximum Lead Time) – (Average Daily Sales X Average Lead Time)
If you have never calculated Reorder Points before, it might seem like an insurmountable job. So start by focusing on your most popular products with the longest lead times and then work your way through your Product list as you accumulate the required data for each item. You should be able to get sales and order history from your POS system; and if you don’t already know your lead times, you can easily get them from your suppliers or by reviewing purchase orders and invoices. Once you enter the data into a spreadsheet, it will do the hard work of actually calculating Reorder Points for all your products. Make sure you use at least 10 – 12 weeks of sales history – more is better. If you’re using MyPOS Connect, it’s easy to export product sales and order history to Excel, then import the calculated Reorder Points back into MyPOS Connect’s Product File. If your POS system doesn’t have this capability, then it will take longer to manually enter the raw data into your spreadsheet and the calculated Reorder Points back into your purchasing system; but it’s still worthwhile and you’ll still save a ton of money as a result of your efforts.
A couple of additional points to consider. Begin by focusing on products that take more than a week or two to get in. If you can place orders for a product and take delivery within a couple of days, you can ignore calculating Safety Stock; just set a reasonable Reorder Point for that item. Also, since there are so many factors that affect your customers’ buying behavior, you should consider revisiting your Reorder Point and Safety Stock values at least Quarterly. This will enable you to adjust your requirements for seasonal fluctuations or for one-off events that you didn’t previously take into consideration.