For manufacturing operations, managing inventory is no less important to the production process than material selection or machine set-up. It’s critical to understand the principles of inventorying — the P’s and Q’s, price and quantity. Having dealt with the price of inventory, we now turn to the Quantity factor.
This is the second of three parts addressing "Periodic vs. Perpetual Inventory Methods".
Manufacturers often ask if they should use a periodic or perpetual method of inventory management. In general, perpetual inventorying is highly preferred, and unless your inventory is not significant to your business operations — which raises the question, “Why have it?” — it is hard to rationalize a good reason not to have a perpetual inventory.
When used “correctly,” perpetual inventorying provides the backbone for ‘Materials Requirement Planning’ and also ‘Available to Sell’ inventory (on-hand, fewer future commitments, etc.)
From a planning perspective, you should have the basics, i.e., inventory items that are “planned” and the purchase orders (POs) generated. When the POs are received they should create additional on-hand quantity, reduce purchase commitments, and create AP (on the General Ledger.) This is very useful not only for inventory planning, but also for cash-requirements planning.
Planned ‘Quantity-on-Hand’ levels are dependent upon your inventory levels and “unplanned” demand. If you keep the levels low and demand is unpredictable, you may sell or commit to sell something you don’t have. If lead-time is short, it may not be not a crisis but it’s still a potential fire drill.
My preference always is for perpetual inventorying with frequent, even real-time updates, depending on transaction velocity. In addition to the typical cycle counting, counting items that have a low quantity-on-hand suggests that the “most important” item in inventory is generally the one that you think you have right up until you go to find it, and discover it is not there.
This can turn a very minor-cost part into nothing short of an emergency, depending upon your industry. Consider aviation: A simple bolt you don’t have can put a $300 million plane out of service. Even a one-day delay makes that the most expensive bolt in the world.
Read the final installment of this series, “Tools for Inventory Problem Solving”
Scott Palka is a partner and consulting CFO for Pro Back Office, a provider of skilled operational accounting, finance and strategic consulting talent, experience and expertise. He holds an MBA from the University of Denver’s Daniels School of Business and a B.S. with honors, from the University of Illinois. Contact him at LinkedIn.