Inventory Control for Farm Supply Cooperatives

Phil Kenkel Bill Fitzwater Endowed Cooperative Chair

Inventory investment represents over The inventory management index is 50% of current assets and 25% of total calculated as assets for the typical farm supply cooperative. Many managers fail to IMI =Turns x Earns appreciate fully the true costs of carrying inventory, which include not only direct The rule of thumb is that the IMI for a costs of storage, insurance and taxes, but category or product should equal or also the cost of money tied up in exceed 1.0. inventory. These cost total 10-30% of the inventory value for the typical farm The “Turns” term in the equation relates supply cooperative. Typical to inventory turnover which is calculated contributions to holding costs are as: illustrated below. Inventory Turnover = Costs of Goods Sold/Average Inventory

The typical benchmark for inventory turnover for the entire farm supply department is 7-10 times per year. However inventory turnover varies across product categories. Typical guidelines for turnover are shown below

Category Acceptable Turnover This fine line between keeping too much (times per year) inventory and not enough is at the heart Petroleum 15-18 of inventory management. The goals of Propane 20-40 inventory management are to: Oil 6-8 Tires 4-7  Maintain the proper mix of Batteries 6-8 inventory Bulk fertilizer 1-3  Maintain the efficient level of Feed 12-25 inventory  Order efficiently The “earns” part of the IMI equation is  Track inventory performance and the gross margin percentage which is make adjustments defined as: Gross margin = Inventory Management Index The inventory management index relates sales price-cost of goods sold the turnover of inventory and the gross Cost of goods sold margin return it creates. Typical guidelines for gross margins are Where lead time is equal to the time it shown below. takes to receive an item after ordering and the safety stock is the amount the Category Acceptable Gross Margin manager wants on hand in case actual Petroleum 14-18% demand is higher than average or Propane 7-12% delivery is slower than anticipated. Oil 10-20% Many managers use a rule of thumb for Tires 10-20% safety stock such as 50% of the lead time Batteries 12-20% amount. Bulk fertilizer 5-10% Feed 4-8% As an example, consider the re-order point for fence posts when the average Following these guidelines typically usage is 2 bundles per day and the generates a “Turns” x “Earns” index of average delivery time is 5 days. In this over 1.0 Some bulk items such as example the re-order point would be 15 fertilizer can be profitable managed with bundles (10 bundles for the lead time an IMI lower than 1.0 while some usage and a 50% safety stock) and the categories with higher labor or manager would re-order when the obsolescence such as animal health may inventory on-hand reached 15 bundles. require an IMI of over 1.0 The Re-order Quantity The IMI value provides an indication as The second component of the purchasing to whether you have the appropriate plan is the re-order quantity, which is the level of inventory. If the IMI is over 1.0 amount that is ordered. The optimum the inventory investment is paying its order quantity is a balance between way. When the IMI for a category, a ordering costs and holding costs. The product, or the farm supply department more often you order an item in small as a whole is less than 1.0 inventory quantities, the more costly it is in terms levels should be reduced unless margins time spent purchasing and receiving and can be improved. freight fees. But if you order an item less frequently in larger quantities the The Purchasing Plan inventory carrying costs escalate. The purchasing plan encompasses two critical decisions: when to purchase at There are formulas to calculate the item and how much to order. One of the optimum order quantity based on the goals of inventory management is to ordering costs and holding costs. Most have items in stock at the moment they farm supply managers find these are needed. The “re-order point” is the techniques too complex and develop rule inventory level at which the stock should of thumb through experience. For most be replenished. The re-order point is products (bulk petroleum might be an generally determined as exception) it doesn’t make sense to order more frequently than once a week. For Re-order point = almost all items it doesn’t make sense to have more than a 90 day supply on hand. (average daily usage x lead time) + safety stock Between these two endpoints (ordering a Items in the “C” category have low 7 day supply and a 90 day supply) the turnover and low importance. This may minimum amount required for favorable include seasonal or specialty items or freight or delivery charges should be items that the purchasing manager (or considered. A good rule of thumb is to perhaps the previous manager) erroneous order the smallest amount that will result thought would perform in the A or B in favorable freight charges but never categories. Strategies such as order so little that you will have to order consignment sales or requiring a in less than a week or so much that you customer to purchase a full case of will have a 2-3 month supply. These special order products can reduce this guideline can then be tweaked with category. Some “C” items should information from the IMI equation. For simply be eliminated. example, if the item has a profit margin of 15% you need 7.1 turns a year to Managing Seasonal Items reach an IM I of 1.0 which implies Another 80-20 rule is that seasonal items ordering and keeping less than a 2 month make up less than 20% of inventory but supply. create 80% of the headaches. The first step in managing seasonal inventories is A-B-C Analysis identifying the seasonal items. Sales Selective inventory control, also called from previous seasons should be ABC analysis provides a mechanism for examined. If 80% of the sales occurred identifying items that will have a in a 6 month period of time the item significant impact on inventory costs. should be handled as seasonal inventory. The system recognizes the fact that a small portion of inventory accounts for a Demand for seasonal items should be high portion of turnover and revenue. based on monthly usage in previous years. The purchasing manager should The most common version of the ABC develop a stocking plan for seasonal system classifies high turnover items inventory. The plan should reflect the such as dog food, salt or feed in the “A” lead time is needed to build seasonal category. These items typically stock, when seasonal inventories should represent less than 15% of your total peak, and the re-stocking cutoff date. A inventory but more than 80% of your key to managing seasonal items is retail farm supply sales. The purchasing realizing that it is acceptable, and plan should always keep these items in usually desirable to run out of these stock during season. items prior to the end of the season.

The B category would include items Shrinkage with lower sales and turnover such as oil Inventory shrinkage is the difference filters or lick tubs. These items may between the amounts that were represent 65% of your inventory but purchased and available for sale and the only 5-10% of sales. These items should amount actually sold or still held in be monitored closely and the tradeoffs inventory. The average shrinkage for between carrying costs and the shortages the U.S. retail industry is around 1.5% of can be weighed. sales. Shrinkage increases the effective cost of goods sold and reduces the gross sales and accounting for inter-company profit margin. transfer between branches.

Caused of shrinkage include damage, In addition to providing continuous broken packaging, obsolescence, theft, information on inventory levels, POS and paper work or computer entry errors. systems provide the mechanism to In the case of bulk products shrinkage monitor IMI ratios at the category and also results from inaccurate product level. Information on turnover measurement, moisture loss, and and profit by item can be used to adjust handling loss. Feed and fertilizer stored purchase decisions or pricing points. in three sided warehouses can also POS systems can also provide experience shrinkage from wind loss and information on seasonal sales trends. from rain and snow entering the storage. Auditing procedures require physical In the case of retail products shrinkage inventories prior to the annual audit. can be reduced by rotating stock, dating More frequent periodic physical products and eliminating slow moving or inventory checks can provide a more obsolete inventory. Customer and accurate indication of year to date cost employee theft can be addressed through of goods sold and margin. Physical a portfolio of strategies including inventory checks also serve as a security, monitoring, code of ethics deterrent to employee theft. Two policies, whistle blowing mechanisms common procedures for periodic and more frequent physical counts. inventories are visual inventory control and ticker control. Good warehouse management can help reduce shrinkage in bulk commodities. As the name implies, visual control This includes maintaining good involves the manager or other assigned warehouse condition including pest individual to examining the inventory control and sanitation. Broken bags visually to determine if additional should be repaired or re-bagged inventory is required. This simple immediately as research shows that method can be a good check and balance warehouse personnel are less careful in a with the continuous inventory level warehouse with one or more broken indicated by the POS system. bags. Lift truck training can reduce product loss and also enhance safety. Ticker control involves the manager or staff physically counting a small portion Controlling Inventory of the inventory each day so that each Most farm supply cooperatives maintain segment of the inventory is counted perpetual inventories using point of sales every so many days on a regular basis. (POS) systems. These systems have In a warehouse, a grid system can be facilitated more accurate and timely used with some section of the warehouse information on inventory levels and inventoried every day or every week. turnover. The most common problems with the POS system relate to employee After these physical counts, the error in recording purchases, coding inventory values in the accounting records can be reconciled to reflect the actual physical count. This more performance at the department level. generates a more accurate estimate of The goal of the research was to examine cost of goods sold and year-to-date purchasing decisions, inventory turnover profits. and profit at the category and item level. The research examined $35M of farm Dealing with Dead Inventory supply sales representing 300,000 At times, inventory items or sub- transactions, 5,000 items and 30 categories, stop moving and become branches over a 24 month period. dead inventory. For these items the IMI guideline are meaningless. The amount The results indicated that IMI paid for the item is a sunk cost and is performance varied substantially across also not important. The best strategy is categories. Petroleum, fertilizer, feed to liquidate the dead inventory and and crop protectants categories had the reinvest the proceeds in inventory that highest performance while animal will turn at adequate margins. health, seed and hardware were the lowest performing. The more important Consider an example of an item result was the variation in performance purchased for $300 but is clearly not within the categories. In all of the moving. One alternative would be to categories the IMI performance could be wait two years to sell the item for the improved above industry averages by desired $500 sales price. If inventory eliminating 5% or less of the total items. carrying costs, which include interest, insurance, labor, utilities, are 30% which The research also examined the is typical for hardware items, the profit purchasing strategies. Overall, the is $200 less $180 carrying costs actual purchasing strategies (re-order ($90/year) for a total of $20. points and re-order amounts) closely corresponded to the optimal least cost Alternatively, assume the item could be strategies. The cooperative purchased sold immediately for $250 and the slightly too frequently and held slightly proceeds invested in inventory that turns too high inventory levels. However, the over 5 times a year at a 20% margin. potential benefits from improved The profit in two years would be a $50 purchasing were not as great as those of loss on the dead item + $50 margin for eliminating non-performing items. each time the new item turned over (10 times) less the carrying cost of $75/year. Summary The total profit would be $150. Taking a Inventory is a necessary but costly $50 loss netted $130 more over the two aspect of a farm supply operation. The year period. goal of inventory management is to ensure that inventory items are OSU Research on Farm Supply generating sufficient margins to justify Inventory Management the carrying costs. The IMI provides a Research conducted by Oklahoma State measure of inventory management. University examined the inventory Tools for improving MI include the management practices of a local farm purchasing plan, selective inventory supply cooperative. The case study management, shrinkage control and cooperative had acceptable inventory periodic physical inventories.