Inventory Management - Gaining Control of Inventory With Cycle Counting
By Steve Novak

If you make or sell physical products, controlling your inventory is an essential element for success. You certainly don’t want to lose anything by having it grow legs and walk out the door. You don’t want things to get damaged, pass their expiration date, or become obsolete while sitting around waiting to be sold. You don’t want to have too many or too few items on-hand. So you actively manage your inventory, put policies, procedures and physical controls in place to ensure that your inventory management system supports your organizational goals.

One aspect of inventory management that organizations often struggle with is ensuring the accuracy of the reported inventory by their inventory management system.  Inventory accuracy means that the quantity and location of inventory items reported by the inventory management system matches the actual physical quantity and location of the items.  If your system reports that you have 100 units in stock, but you actually have 90 or 120 units when you physically count them, your inventory records are not accurate.  If your system reports 100 units in location A, but they’re physically found in location B, again, your inventory records are not accurate.

Why is inventory record accuracy so important, and why should you spend the time and money to ensure accurate records?  There are three primary, and very good reasons.

1) It will cost less to keep your records accurate than it does to operate under your current conditions.

2) Your customer service will improve.

3) You’ll increase revenues through your improved customer service.

It will cost you less is to keep accurate records.  The record accuracy program, cycle counting, becomes a part of the job.  Just as processing orders, picking and packing, and shipping are part of the job, cycle counting becomes part of the job.  It’s not a separate or additional expense, though the initial ramp up and training will require a small investment.

Your customer service will improve.  When you tell a customer that you have the units in stock and can ship them right away, you can be sure that you do have the units in stock and can ship them right away.  No more failed promises, frustration, or mad scrambles due to inventory record errors.  Your employee satisfaction will grow too, because of this.

You’ll increase revenues through improved customer service.  Keeping promises is a key element of top-notch customer service.  When you keep promises because you know what you have and where it is, customers will notice.  They’ll choose you over the competition who can’t make and keep those promises.

You also make many decisions based on reported inventory balances.  You make daily ordering decisions for different items, including raw materials, purchased components, and resale merchandise.  You make production planning and scheduling decisions and shipping and delivery decisions depending on your type of business.  And you make long-range strategic decisions based on inventory balances and trends.  Do you want to trust these decisions to inventory records that you can’t depend on and don’t trust?  I didn’t think so.

So what is Cycle Counting, and how do you get started?  The first, and most important thing, to remember is that the purpose of cycle counting is to discover the sources and reasons for inventory errors, then eliminate or fix these causes so they don’t recur.  Cycle counting is not, as some people seem to think, just counting items more often and updating the records with whatever you’ve counted.  That’s just extra work that accomplishes nothing.  Find the causes of errors, and eliminate those causes, that’s what it’s all about.  The primary steps in the cycle counting process are:

1) Find the causes of errors in the inventory records.

2) Correct or eliminate the causes of errors so they don’t happen again.

3) Adjust the inventory records.

Steps 1 & 2 include more detailed process steps, of course, but remember these three, and their proper order, and you’ll be well ahead of your competition.

One of the basic concepts of cycle counting, and inventory management in general, is that not all inventory items are of equal importance and they don’t all need the same level of control.  So what we do is classify all of the different inventory items as either A, B, or C items.  A-class items are the most important or need the most controls in place.  C-class items are the least important, at least on an individual unit basis, and need the least amount of control.  B-class items fall somewhere in the middle.  If that sounds a little nebulous, it is, but don’t lose any sleep over it, and you’ll see why.  A-class items are items that are high-cost, have long procurement lead-times, or are difficult to obtain.  C-class items are low-cost and easy to get.  If you’re building houses, A items might be the chandeliers for the dining room, and C items might be the nails that you use to put the frame of the house together.  If you lose an expensive chandelier or two, that’s a big deal.  If you lose a few hundred nails, nobody will even notice.

To get started classifying all our items as A, B, or C, we usually start with classification by value.  This is because it is often found that a large percentage of the total inventory value comes from just a few inventory items.  You might know this as the 80/20 rule, or Pareto’s Law.  We use this as an initial basis for classifying our items.

20% of inventory items  =  80% of inventory value  =  A classification

30% of inventory items  =  15% of inventory value  =  B classification

50% of inventory items  =    5% of inventory value  =  C classification

Or, if we have 10 different inventory items with a total inventory value of $10,000, two of the items will have a value of $8,000.  Then three of the items will have a value of $1,500 and the other five items will only have a value of $500.  You can see from this example that those two items probably justify a greater level of control than the five items with only $500 of total value.  Just to be clear, we’re talking about different inventory items, not the number of units of each item.  The number of units of each different item will be used in the actual calculations used to classify the items, but here we’re just trying to get across the concept of how we classify items by value.  So if you’ve got that concept down, let’s jump into the calculations of how we determine the classification of our inventory items.

Here’s the steps we’re going to take with the calculations:

1) Determine the annual usage for each item

2) Determine the annual usage in dollars for each item

3) Rank the items in descending order of value

4) Calculate the cumulative value, cumulative % of value, and cumulative % of items

5) Classify the items as A, B, or C

The annual usage for each item should be the annual quantity needed.  You might determine that quantity from actual sales, demand (the quantity that customers wanted, not what you actually gave them), or the quantity used in the manufacture or assembly of other items.  Depending on the systems you have in place, this may or may not be an easy number to determine.  The annual usage in dollars is simply the annual usage, that was just calculated, multiplied by the unit cost of the item.

Inventory item #1:

annual usage = 500 units

unit cost = $1.00 per unit

annual dollar usage = 500 x $1.00 = $500

To rank the items in descending order of value, list the items from top to bottom from highest annual usage in dollars to lowest annual usage in dollars.  The next step is a little trickier, but not too much.  The cumulative value of all inventory is the total annual dollar usage of all the inventory items on the list.  The cumulative value of each item is the value of that item plus all the other items listed above it.  So the first item’s cumulative value is just the annual dollar usage of that item.  The cumulative value of the second item on the list is the value of the first item plus the value of the second item.

Inventory item 8, Annual Usage in $’s  =  $10,500

Inventory item 23, Annual Usage in $’s  =  $  8,700

Inventory item 17, Annual Usage in $’s  =  $  6,200
and so on, to

Inventory item 1, Annual Usage in $’s  =  $     500

After you rank all your inventory items by value, take the top 20% of the items or top 80% of the total value, and make them the A items.  Take the next 30% of the items or 15% of the value, and make those the B items.  The rest will be C items.  This is just your starting point, or an easy guide to get you started.  You can move items into a different classification than is indicated by this calculation.  Hard to obtain items are probably A items, even if their annual dollar value doesn’t put them there.  Or if a particular item has a very high unit cost but low usage, you probably want to place more control over that item.

This is all well and good, you’re saying to yourself, but what do we do with it?  Now that we’ve got all our items classified as A, B, or C, what do we do?  One thing is to set the levels of physical and procedural control over the items.  Maybe you want to place all A items into a location with more physical controls (i.e. locks), or require different paperwork to be filled out for A and B items.  With C items, you often need very few physical controls, and little paper trail requirements.  Remember those nails?  Just give out as many boxes of nails as the crew needs for the day and be done with it.

The other thing that the A, B, C classifications does is determine the count frequency of each item, or how often each item will be counted.  It’s called cycle counting because you count different items in a recurring pattern based on the A, B, C classification.  You have to count each inventory item and compare the physical count with the  reported record count to find out if there is any error.  If there is no error, you move on to the next item.  If there is an error, you research the cause, put policies and procedures in place to eliminate the cause so it doesn’t happen again, then fix the reported records to reflect the physical count.

The usual pattern, or frequency, for counting items is:

A Items - 12 times per year (once a month)

B Items - 4 times per year (once a quarter)

C Items - 1 time per year

Depending on how many different inventory items you have, this could be a lot of work.  But, it’s less work, less disruptive, and provides better results than an annual complete physical inventory.

The frequency shows A items being counted once a month, B items once every three months, and C items once a year.  But here’s the thing, that doesn’t mean that you set aside one day a month to count all the A items.  The idea is that you count a few items every day.  Yes, that’s take a physical inventory count of a few different inventory items every day.  There are several ways you can go about that, but one way to start is to set up a schedule.  Of course, if you only have 10 different items, as in the first example, it’s pretty easy.  But most companies have many more than ten different items.  You might have hundreds, thousands, tens of thousands, or more.

Say you’ve got 1,000 different items.  If they fall neatly in line with the 80/20 rule, you’ll have 200 A items, 300 B items, and 500 C items.  If you’re going to count your A items once a month, or 12 times a year, that’s 200 items x 12 = 2,400 counts.  That means that over the course of the year, you have to perform 2,400 separate counts of your A-class items.  Say you work 240 days a year, that means you have to count 10 different A-class items every single day.  Then you’ve got all the B and C items, and you can see that you’ve got your work cut out for you.  But again, this is better than not doing it this way.

And you always have to remember, the point is not just to count items and update the records with what you’ve counted.  The whole point is to discover any causes of any errors, and fix them so they don’t happen again.  If you fix all the causes of errors, you won’t have any errors.  Then when you count the inventory, the records will match the count, and you’ll be done.  Then you can rely on those records, trust them, and reap the benefits of having accurate records.  So get started!

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