Inventory Management - the 3 Way Relationship

Inventory management boils down to a powerful relationship between two key principles:

• Selling inventory and
• Holding inventory

This might seem obvious.

However, the error is in taking it for granted.

So, let me ask a question.

Are you Holding What You are Selling?

Let me clarify why I am asking that question.

The main purpose of inventory management is:

• You Hold Inventories that You are Selling
• You DO NOT Sell Inventories that You are Holding.

Inventory is the Effect NOT the Cause.

The Cause is Sales or Consumption.

This brings us to the classic Inventory Triangle:

• Sales (or Revenue)
• Consumption and
• Inventories

See the image below:

Your Sales Mix and Pricing strategies are central driving forces in your journey to food and beverage, restaurant profit.

In that journey, inventories are not far behind.

The obvious fact is that you cannot sell what you do not have.

However, inventories allow you to gauge the extent of effectiveness of your:

• sales mix and
• pricing strategies.

We will shortly see how that can be done.

Let is come back to the Inventories Triangle visual.

Managing inventories is a delicate balancing act of:

• cost,
• effort and
• risk.

There is a Cause Effect Relationship principle in operation

The Cost - Inventory Relationship

The Food & Beverage department has much higher Direct expenses compared to the Rooms department.

This is the reason why its profitability is also lower than that of the Rooms department.

For example:

• when a menu item is served as a dish in the restaurant within the hotel
• simultaneously, a direct expense called the Food Cost is incurred.

This Food Cost is not only a Direct expense but also a Variable Expense.

The Beverage Cost is another Direct Variable Expense representing beverage that is served along with the food menu item.

Look at the Food & Beverage statement for Taste Buds Restaurant in Paradise Hotel below:

Notice the line above the Food Cost line - it says Cost of Goods Sold.

This is a unique representation of the Food Cost expenses.

It is applicable to the Beverage Cost as well.

It is important to understand this for effective inventory management.

Let us revisit a concept we learned earlier.

The Food Costs and Beverage Costs are two items for which the hotel holds inventories.

It means that ingredients that form part of the food cost are:

• first purchased and
• held as inventories in the hotel storage facilities.

They are then issued to the kitchen and used in preparing menu items in the restaurant.

So, what is different?

There are three stages involved here.

Those ingredients:

• are purchased to begin with,
• they then form part of inventories held in storage facilities of the hotel and
• finally are issued to the kitchen for preparation of menu items.

Here is the important thing to know.

This involves the way expenses for inventory items are accounted for.

How Inventory Based Expenses are Calculated

Food Cost and Beverage Cost become expenses only after:

• an inventory taking exercise is carried out each month and
• opening and closing inventories are calculated
• before actual Food or Beverage Cost can be determined.

In simple words, the formula is [applicable to Beverage Cost also]:

Opening Stock of Food Items in the month + [Add]

Purchases of Food Items during the month = [Equal to]

Cost of Consumption for the month (-) [Deduct]

Closing Stock of Food Items in the month = [Equal to]

Cost of Goods Sold (Food Items) for the month

The Cost of Goods Sold is also known as the Food Cost.

It is this Food Cost figure that is shown in the Taste Buds Restaurant statement above as an expense.

This clearly shows that:

• for expenses like Food Cost and Beverage Cost,
• actual cost of the expenses that will feature in the Food & Beverage Departmental Statement
• will depend on what purchases were made during the month and
• what were the levels of opening and closing stock for that month.

In other words, inventory management is involved in the case of these items.

Let us now visit an inventory concept which we learned about earlier but is part and parcel of your decision making.

Inventory Management Decisions

There is one area of the hotel operation where decisions may need to be taken possibly every day.

That area is hotel inventories.

Inventories are broadly of two categories:

• Inventories of items that will result in revenue
• Inventories of items that will result in expenses

Inventories of items that will result in revenue are items that will be sold.

For example:

• food and beverage items or
• ingredients that finally form a menu item
• that will be sold in the restaurant.

Inventories of items that will result in expenses are: 

• items that will be consumed internally 
• for the purposes of earning revenue.

For example:

• cleaning supplies,
• printing and stationery,
• menu and beverage lists

are all items of consumption in various departments of the hotel.

One of the most common but critical decisions that hotel managers need to take is how to manage hotel inventories.

Inventory management is a decision closely tied in with how purchases or sales are made.

Refer to the Inventory Triangle shown above.

Inventory Turnover Ratio

How would you know if your inventory management is efficient?

After all, you would want to know that would you not?

Let us use a KPI which is one of the most powerful for a restaurant operation.

This is irrespective of whether that restaurant is :

• a standalone one or
• is housed inside a hotel.

This is something that most hotel managers might be looking at.

Let us see what this ratio is all about.

The Inventory Turnover Ratio literally tells you how many times your inventories turned over.

That means, how many times sold or consumed in the operation.

It is the productivity measure for inventory management.

See below:

Believe me, you do not want a low inventory turnover ratio.

It requires more storage, is susceptible to loss or pilferage.

And it locks up precious cash flow.

The Minibar Model Magic 

We have now understood that keeping Inventory moving and related to sales is critical.

This brings us to a part of the hotel operation that practices this perfectly.

With amazing results.

Ever had the experience of wanting to munch on something in a hotel guest room?

Or have a chocolate bar?

You would have reached for that gem of a service.

The Miraculous Mini Bar.

Why miraculous?

Because it can satisfy a craving immediately.

Just pull something out from right inside the room.

The mini bar came to your rescue often.

However, there is a powerful principle behind the success of the mini bar service.

And related to inventory management.

Remember two statements we visited earlier in this post.

Let me reproduce them here.

You Hold Inventories that You are Selling

You DO NOT Sell Inventories that You are Holding.

Well, the mini bar executes the above perfectly.

Notice something else when you were using the mini bar in the hotel?

If you pulled out a Mars bar, the next day the bar was replenished.

Is that not magic?

That magic happens because the hotel realizes that mars bars are popular.

They analyze mini bar sales daily.

And only place items that sell regularly.

They often replace an item that does not sell with a new one.

All based on the simple premise: you hold inventories that sell.

Inventory Turnover Ratio for the mini bar will be extremely high based on this technique.

That is also the reason you find popular, fast moving items in the mini bar.

Your inventory management must harness this magical principle.

How?

Based on 3 simple steps:

1. Analyze sales for popular items
2. Hold inventories for those popular items
3. Replace non-selling items with ones that sell

Of course, this requires the above process to be adopted regularly.

Chef's Take 

Hotel Inventories are normally the responsibility of the Finance department.

This is particularly because the Purchasing function reports to the Financial Controller.

There are two reasons for this:

• First, Purchasing has to be a function independent from the departments that place purchase requisitions
• This is a cardinal principle of internal control
• Second, the hotel stores is also under the supervision of the Finance department
• Such an arrangement makes calculation of inventory turnover and other KPIs easier

I have had the experience of running a big hotel (more than 600 rooms) with a large store and well manned Purchasing department.

My major takeaways that you can consider in your own hotel are:

• Ensure you have an effective system of Par Stock calculation for each inventory item in the store
• Par Stocks are simply actual consumption levels for each month of the year
  • Par Stocks take into account the peak and lean months which affect order quantities
  • Par Stocks are the most powerful tools to manage inventories effectively.
• Always analyze your sales and related consumption of items in your inventory management system
• Use the Mini Bar Model to Hold Inventories you Sell and not the other way round
• Regularly purge the inventory items to locate items not needed any more
• Keep an eye on your Inventory Turnover Rate regularly and make adjustments - you will save tons of expenses.
• When I was the Financial Controller of the 628 room hotel:
  • I collaborated with my General Manager on a powerful concept called Just In Time Inventory Management.
  • It meant to avoid keeping inventories in the first place
  • It was very successful to a good extent (requires a lot of ground work)
  • If you would like to read more about this tool, read this Just In Time Inventory Management
• Read an alternative to inventory management below with its positive and negative points.

The Direct Consumption Challenge

Should You Order Your Perishables Directly?

What if we made purchases accordingly to what we need on a daily basis?

What will that achieve you ask?

All in good time.

The strategy for a Daily Purchases Order particularly for perishables is commonly done in most hotels.

What it will achieve is that you eliminate inventories.

Whatever you purchased that day goes directly into consumption or what you may call Direct Consumption.

It will reflect in your Profit and Loss Statement as Cost of Goods Sold.

However, remember, that eliminating inventories is a strategic decision.

It needs a lot of thought and research about the local market availability situation.

In major metropolitan cities availability of fresh items or what are known as perishables is excellent.

In such situations, it is easier to implement direct consumption.

Many hotel are also forced to follow this strategy because they do not have storage facilities for inventories.

Remember inventories also involve cash flow since they have to be paid for on purchases.

Any deterioration while being stored will also be the hotel's cost.

Whatever be the reason to eliminate inventories, the decision needs to be taken carefully.

Say, demand is not estimated well for a daily purchase.

Then, it may result in quite a bit of that remaining in the kitchens unprepared and with no sales revenue.

That is not a situation you would like your hotel to get into.

Most hotels do have reasonable storage in the form of Deep Freezers or Walk In Coolers.

So there you are, effective inventory management at its best.

How you manage inventories at your hotel or restaurant?

Are you holding what you sell?

Comment below, I am keen on knowing your thoughts.

Next Recipe

The next recipe in the Ultimate Hotel Finance Training Cookbook is about Yield Vs Revenue Management.

See you in the next recipe.

If you missed the Cookbook or recipe 1, click below.

Related Ultimate Hotel Finance Training Cookbook Recipes

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