EOQ: How much inventory to buy? – to stock or not to stock that inventory

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Retail Managers are responsible to ensure stock availability to customers by replenishing stocks regularly. At the same time, they are also responsible for profitability of their category or division, leading to questions on – whether we should carry that product and how much inventory should we carry on hand? This is where it gets interesting. Because if you want to cater to all customer demand, then theoretically you must carry infinite inventory so that you cater to all customers who may or may not come. And, carrying infinite inventory is a loss-making proposition, leading to unhealthy inventory and write-offs. Let us understand this through an example below.

Let’s say the product you are going to sell costs $6 and you will sell it at $10, making a profit of $4. However, if you cannot sell that product then you will incur a loss of $6 (product cost).

Therefore, the tradeoff here is between:

a). the profit that you’d earn if the customer walks in and you have it in your inventory

b). the loss that you’d incur if you stock and the customer doesn’t turn up

To make the right decision of whether to hold that extra unit of inventory or not, you need to understand the probability of selling that inventory (say one unit) denoted as Px.

  • If the probability of selling that extra unit is 100% (P100), then you should surely stock it and make a profit of $4.
  • If the probability of selling that extra unit is 25% (P25), then the payoff is

25%*$4 + 75%*(-$6) = -$3.5 (negative payoff). Since this is going to make a negative payoff, you shouldn’t stock that unit of inventory.

  • If the probability of selling that extra unit is 80%(P80), then the payoff is

80%*$4 + 20%*(-$6) = $2 (positive payoff)

  • If the probability of selling that extra unit is 60%(P60), then the payoff is

60%*$4 + 40%*(-$6) = $0 (critical point). So, as long as the probability of selling that extra unit is 40% or above, you should keep stocking inventory. Most auto-buying systems are designed in this way to stock inventory until the probability of selling that unit of inventory goes below the critical point.

Also, the probability of selling that unit is within what time period? It is within the planning cycle (order cycle time plus lead time from PO to delivery). Your days on hand should always be as lean as possible and close to the planning cycle. Credit period is the maximum limit of the planning cycle, but ideally shorter the planning cycle the better the benefit is for the business

The one mistake that we did in the above calculation is we wrongly assumed that profit that we will make out of the sale is only from that particular unit. We should also include the profit that we could’ve made by that particular customer in all future purchases at our store – customer lifetime value (CLV). So, the tradeoff has to be between the customer lifetime value of the customer vs. the loss you’d incur if the customer doesn’t turn up at all. Also, the above calculation should take ‘time’ into account in the form of cost of capital (inventory holding costs) because many times the loss is not the entire cost of the product.

In conclusion, the value of having that inventory in stock changes basis a lot of parameters such as CLV, importance of that category or brand to the image of the retail store, brand equity of the store, type of store and many other business parameters.

The one question that we are yet to answer is: how do we determine the probability of sale?

Intuitively you know that the probability of selling that first unit of a TV is 100%, the 100th unit is say 80%, 500th unit is 40% and 1000th unit is 10%. Probability changes by quantity.

To get the probability you should simulate a demand distribution basis past historical sales data. Demand in retail scenarios are usually normal distributions. So, we will need the average and standard deviation. It is what we learnt in our MBAs – you will calculate the probability for the random variable (sellout of a TV model) to take the value 500 units and that is P (X=500). One of the ways is for you to calculate the Z value =  (500 – average)/SD and then lookup for that Z value in the Z table to get the probability. This is if the distribution is gaussian or normal distribution. There are other ways too to get this estimate basis various distribution fits such as chi-square, t distribution (for small sample size of 30-100), gamma distribution, beta distribution, pareto distribution and others. Each of these distributions has a method to calculate the probability like the way we have for normal distribution as mentioned above. Typically, in the pre-computer era, because it was so difficult to calculate the area under the curve manually statisticians used to categorize the data they have into one of the 20-30 templatized distributions and use one of the methods to calculate the probability. In the computing era of today, we can actually plot the data and calculate the actual area under the curve with the help of a computer quickly. Therefore, if you don’t know which distribution the plot is looking like it is better to just calculate the area under the curve manually and get the probability. This method is called the ’empirical method’ or ’empirical distribution’. So, if you don’t know which distribution is your data looking like, you can opt for empirical probabilities.

Thank you.

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Sell-in, Sell-out and Sell-through

Sell-in: how many units of a product is a manufacturer selling into the retailer

Sell-out: how many units of a product is selling out to the customer (from the retailer)

Sell-through is the same as sell out. They just invented it to confuse you.

Service Output Demands and Sales Channel Design

Channel design is a crucial element in any product’s marketing plan. It is sometimes the most crucial factor for success. A channel designed properly will bring in customers and increases your market share. Most of the times a channel is designed by the marketing teams and the structure and the maintenance is done by the operations teams.

A channel delivers service output demands. Some of the examples of service output demands are: bulk breaking, spatial convenience, waiting time, delivery time, payment options such as credit,  assortment/variety and customer service and information provision.

Step 1: Segment the consumer/customer segments based on service output demands (SODs)

Step 2: Identify some of the consumer/custoemr segments

Step 3: Design a zero base optimal channel such that the SODs are satisfied. The channel can have multiple routes through which the SODs are satisfied

Step 4: Gap Analysis

If an existing channel is present, then compare the zero base channel with the existing channel and come up with the gaps. Evaluate whether these gaps are caused due to demand or supply.

The attached word document contains one such exercise for HUL. HUL_ChannelAudit

Wholesale market in India

Wholesellers are none but middlemen who buy products from distributors (wholesale/retail) and sell them to retailers. In most cases, the retailers come to the wholesellers to buy products to replenish their stock. However, wholesellers may also sell to end consumers, but such sales are minimal.

In the Indian FMCG market, we have broadly two types of wholesellers:

1. Modern Wholesale stores such as Metro, Wal-Mart BestPrice, etc.

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2.  The neighbourhood wholesellers around the streets in India

wholesale

Wholesale distributors buy in bulk (high volumes) bargaining low prices from manufacturers. Wholesellers in turn buy products in demand (what retailers ask for?) at low prices from wholesale distributors. Because of this reason that wholesale distributors are bulk buyers, it is generally seen that wholesale is cheaper than retail. But, it also depends on how many middlemen it passes through, as each middleman adds his margin to the selling price.

What’s in it for the retailer?

Few reasons why retailers buy from the wholesellers:

  • No direct distribution of a brand to their stores
  • Low margins by distributors
  • Direct distributors dictating terms
  • Better deals at wholesale
  • To be aware of the high selling products and brands

Retailers also face some disadvantages in buying from wholesellers:

  • Buying goods on immediate cash
  • Transportation costs of the goods
  • Wholesellers may not take back the unsold inventory/stock

What’s in it for the manufacturer?

The wholesale channel helps the manufacturers achieve sales from markets where they are not directly able to handle retail sales and their shipments. In a country like India, where 95% of the retail environment is unorganized, and spanning across millions  of small stores, it is impossible to reach all the stores directly through your distributors.

Most companies will have strong direct distribution in cities like Mumbai, but as you go deep into India, the dependence on wholesale indirect channels increases. Most top selling brands and categories have a good amount of wholesale component. For example, a brand which is selling in Pan-India (across the regions in India) may have a wholesale component ranging from 20% to as high as 50-70% depending on the category/brand’s dependence on Rural India. It is obvious that most of the sales in Rural India happen through wholesellers. In Rural India, you will have strong wholesellers for every group of villages or in the nearby town, where retailers go and replenish their stocks.

Manufacturers would always like to have a higher contribution of retail sales to their overall shipments, as this helps them directly to control the nuts and bolts in the operations such as trade promotions and schemes, in-store visibility, relationship with retailers, pushing and increasing their assortment within the stores, maximising profitability, increased visibility of their sales, etc. The top FMCG companies are driving their direct distribution in Rural India as they mine the Gold at the Bottom of the Pyramid.

Strategic Channel Management

A sales channel is about where you’re going to sell and how you’re going to sell. In fact, it is about where you’re consumer is willing to purchase your product, where the consumer expects the product to be available, what is the consumer decision making process regarding your category and product, and what is your positioning in the market. All the channel decisions should go hand in hand with Segmentation, Positioning, Pricing and other elements of the Mix.

For example, let us consider the purchase process of Toothbrush. Most consumers even today don’t know exactly which variant of the toothbrush they use, and many of them don’t really bother about the product much. The consumer may know that he uses an Oral-B (mother brand), but may not recollect the brand of the toothbrush.  A consumer generally doesn’t remember a brand and ask for that particular brand at the retail store. Mostly the retailer displays or the consumer browses through the toothbrushes available and the consumer may recollect the brand, or the advertisement, or like the in-store promotions and product design for those toothbrushes and one of these elements of advertisement recall, product design, etc. may make the consumer consider and choose a particular toothbrush. So, in such categories, there is a lot of dependence on you’re presence in the store as the consumer remembers you only when you’re present in the store.  There are lot of categories ranging from deodorants and refrigerators to laptops and anti-viruses. It depends a lot on your availability in the stores and consumers choose among what is available. So, channel becomes a crucial part of marketing strategy which is where to sell and how to sell. The channel and distribution management comprise the Place element in the Marketing Mix.

Under channel management, the company deals with external organizations(channel members or partners) to achieve its desired marketing goals and profitability. There are different types of channel partners like C&F Agents, Distributors, Retailers, OEMs, Value-Added Re-sellers (VARs), Brokers, etc. Each of the channel members business goals will differ in their expectations of profitability, sales, ROI, long-term prospects,etc. The right channel strategy will help bring coherence and build value to the customer, channel members and the company. So, a strong channel network has become a key component in corporate strategy.

As discussed, there are many factors that influence channel management, but following are the broad factors that influence a channel design or strategy:

1. Understanding of the Target Group, Target Segments, the consumer needs and the consumer behaviour

2. Understanding of the Marketing Mix and the product features, brand persona, positioning, pricing, etc.

3. Understanding of the retailers needs and behaviour

4. Channel goals and the functions to be performed by the channel

5. Legal Issues

6. Reach required

Refer IBM Route to Market Strategy for an understanding of how effective channel management helped IBM.