It is often said that sales and marketing are the lifeline for any business – and I’m not going to argue with that. If no one knows or buys your product – you probably aren’t going to last very long. However, no matter how well you execute your sales and marketing strategy, not properly managing your inventory can be detrimental to your organization. Inventory is quite a general term – including raw materials, WIP or work in process materials, and finished goods which are ready to sell to customers. If you have too much inventory – you are going to run into problems with storage, product expirations, and the associated high costs. However, if you stock-out and a customer can’t get their hands on one of your products, you not only will lose that potential revenue, but also might ruin the relationship with the customer, wasting the marketing dollars you put in to acquiring the customer and all the future revenue they might bring. Even further, ordering the right quantities is important as you might get discounts for ordering in bulk. In an environment where supply chain issues are becoming the new normal, having a strong inventory management system and strategy becomes even more essential. With all these factors to consider, how can you successfully manage and optimize your inventory and ordering? Two systems organizations are turning to are the Q and P inventory management systems. This blog will go into an explanation of what each of these systems are, and some of the pros and cons of both.
The Fixed Order Quantity or Q system
The fixed order quantity, or Q system, operates through ordering a fixed quantity of materials when the stock on hand reaches a pre-determine reorder point. For illustrative purposes, let’s assume this inventory has constant demand and lead times:
In this illustration, you can see that based on the historical demand and lead time for that product, you order a certain amount of inventory, or what is better known as the economic order quantity (EOQ), at a specific point of inventory, or known as the reorder point (ROP). The question becomes, how do you properly determine what the EOQ and ROP are?
Economic order quantity (EOQ)
The economic order quantity is the optimal amount of inventory your business should order to keep costs as low as possible. The two main costs that it looks to optimize for are the holding costs of inventory (cost of storing inventory, inventory expiring, etc.) and the total cost of ordering. Naturally, the higher quantity of inventory you order the more expensive the holding cost of the inventory will be, however, the lower the cost of ordering will be (per widget). Therefore, the EOQ is the point that minimizes the total annual costs, as illustrated below:
Reorder Point (ROP)
The ROP is much simpler to calculate, as you only need to know the demand rate and lead time of the inventory. Once you know this, all you must do is multiply these two factors. However, demand and lead times (especially in this turbulent environment) are rarely constant, and you don’t want to get to exactly zero inventory. Therefore, you must include safety stock (SS). This ensures that you won’t stock out and will help adjust for varying demands and lead times.
Pros
Each material you need is ordered at the most economical quantity
Limits reorder mistakes
Conserves space – makes sure you’re never ordering to much
Helps keep working capital low as expenditure is decreased compared to the P system
Cons
As orders are placed at irregular time periods it may be in convenient for your suppliers, straining relationships and decreasing the chances of discounts.
Continuous management and overview of inventory takes a lot of time and organization.
Fixed Order Period, or P system
The fixed order period, or P system, operates where you order a varying amount of inventory at fixed time internals. For example, whereas in the Q system you always order a fixed amount of inventory (EoQ) at variable times depending on when your reorder point is hit, the P system will be ordering at fixed time intervals (say every quarter), with a new EoQ calculated each time up to the max holding quantity.
Pros
Better supplier relationships as they get guaranteed, recurring sales. More likely to offer discounts.
Only need to look during review periods not continuous review system like the Q system.
Great for products which have high seasonality as you know recurring times when to order
Cons
Makes a lot of work for your organization during the review periods
System demands inflexible order quantities in favour of administrative efficiencies.
Which system should I use?
Unfortunately, there are no right answers here – as it depends on your current business processes, strategy, etc. Luckily, there are experts like us to help you decide which system is best for you, or check out this great chart from The MBA Knowledge Base which summarizes the differences of the two systems:
How to Implement
If you are looking to implement one (or both) of these systems into your organization, there are a few requirements you must get in order first. For one, you must look at your current processes – and determine how (if possible) to integrate the timing and new system into your existing people and technology infrastructure. Next, you must make sure you have these main data points available: ordering and holding costs for each product, demand and inventory data (recurring), lead times, supplier bundles and discounts. After you collect this data and do the proper analysis, you can determine which system you want to use and get started. To get full buy in for the team, make sure you prioritize education so they understand the new system and the reasons you are using it!
Conclusion
Implementing an inventory management system is a difficult and time-consuming process for any organization. However, the benefits are clear, and as more data becomes available to every organization and supply chain disruptions continue, it is becoming a key success factor for many organizations. If you are looking for help to get started, reach out to one of our experts for a free consultation today!