Master Inventory Management by Going Back to Basics
By Nicholas Seiersen
Do you have a love-hate relationship with inventory? You love that inventory makes it possible to satisfy your customers and help your company prosper. But you hate that not having enough inventory creates dissatisfied customers and lost business; or too much of the wrong kind of inventory clutters your warehouse and hogs your cashflow.
The problem is not that the forecast is wrong; the forecast is always wrong. The real issue is understanding how to plan inventory replenishment to accommodate uncertainty. This involves creating an effective inventory strategy, working with an adequate estimate, and understanding the parameters that affect availability and inventory levels. Following are five steps to help you get there.
Step one: Demand
Many factors affect demand, and understanding them will help you forecast with some degree of enlightenment.
Business base. This represents the basic demand of permanent items at the level at which they will sell without promotional goosing or seasonal surges and ebbs. Think of it as the business-as-usual level. Pareto’s law tells us that 20% of inventory items typically constitute 80% of inventory value. Considering product life cycles, we would expect a product to surge when introduced; grow quickly as it becomes popular and is distributed widely; stabilize; and, finally, decline as it is replaced by something else. This can take months or centuries.
Seasonal. Product consumption generally follows a natural seasonal pattern from year to year, enabling this effect to be easily modelled. Keep in mind, however, that seasonal sales are influenced by the weather, which is notoriously unpredictable, so seasonal erraticism can be a significant source of volatility.
New/temporary. Forecasting demand for new or temporary items is difficult because they have no history. Selecting a similar item for the demand profile can be effective, but it may lead to poor results if the demand dynamics are mismatched. Another strategy is keeping enough inventory to meet all potential sales, but this risks obsolescence issues if the sales do not materialize. As an alternative, fast-replenishment models can be effective. Postponement strategies are also worth considering.
Long-tail. Companies sell few long-tail items individually, but these products do build out a full range of products and represent an opportunity to enjoy higher margins. Long-tail items typically make up only 5% of sales, but they are the special flavor or atypical application that is attractive to a small set of customers who will pay a premium. This is where specialty stores can shine over generalists. Inventory management challenges include volatile demand, slow-moving inventory, large minimum-replenishment orders relative to sales volumes, unattractive manufacturing dynamics and high risk of obsolescence.
Promotional. When companies use discounts to increase sales, it is generally fairly easy to estimate the resulting sales boost. However, it can be confounded by pantry-loading (a retailer or consumer buying more than their immediate requirements), thereby borrowing from tomorrow’s sales. The good news is that this phenomenon is understood and the after-promotion sales dip well documented.
Maintenance, repair and overhaul (MRO)/spares. Equipment MRO and spare items present special inventory management challenges. While a simple average consumption is ineffective, linking them to a rigorous preventive-maintenance schedule can help you project demand accurately — as long as failure rates and equipment usage are close to the plan. Break/fix parts are far more difficult, as they must be available in the exact quantity required. Further, knowing when they will be required is extremely tricky. Most companies arrange for these parts to be available, just in case, at all times. This leads to slow-moving inventory and high risk of obsolescence. End of life. Parts for end-of-life equipment and discontinued items are similarly complex, as the last replenishment must cover all future demand. Have too little, and expensive equipment may be idled; too much poses a future obsolete disposal and write-down problem.
Returns. The growth of e-commerce and consumer-direct models has taken what was once an inconvenience (processing, disposing of or reinserting returned items into inventory) to a big problem. Additionally, returns can represent a significant product volume that can even exceed one-third of items sold. Understanding what drives returns can help you better integrate flows into your inventory strategies.
Finally, when dealing with such varying demand categories — each with different dynamics and requiring different approaches — fresher assumptions and more accurate data will enhance your chances of at least being close.
Step two: Safety stock
The most likely time for a stockout is when inventory has been depleted and the next delivery is expected but not yet arrived. In order to cover the service level risk, companies use safety stock. How much safety stock your own organization holds depends on the level of uncertainty from which you wish to protect yourself. Such computations are tedious and complex, so they have been programmed into computer systems, mainly enterprise resources planning (ERP) tools. But in order for ERP systems to function properly, it is essential to understand how the computations work. That way, you know when to revise your assumptions because something has changed.
Standard deviation often is used to measure variability around a reference, which can be the forecast or the average (mean). This assumes that a variance that occurred, say, two years ago, is as relevant as last month’s variance. Exponential smoothing is a weighted, moving-average forecasting technique that can address this issue. The exponentially smoothed variance becomes a proxy for forecast accuracy, supply lead time and inbound fill rates.
Step three: Replenishment
Now you know how much inventory you need, and you have set the parameters that tell you when to replenish. But how much should you order?
The workhorse of inventory management is economic order quantity (EOQ ), which is a model that determines the amount of an item to purchase or manufacture at one time. Its intent is to minimize the combined costs of acquiring and carrying inventory. According to the APICS Dictionary, the basic formula is: Q = √(2AS/iC), where Q is quantity in units, A is annual usage in units, S is the ordering cost in dollars, i is the annual inventory carrying cost rate as a decimal and C is the unit cost.
How you define each of these costs, particularly inventory carrying cost, can have a significant effect on inventory levels and replenishment expenses. Be sure to align your definitions with your objectives. This will allow you to optimize cost with the desired outcomes.
Step four: Strategic objectives
Inventory management can be used to reach many goals. Make sure you are clear about what you want to achieve and proceed accordingly:
Inventory reduction: Take into consideration only the carrying costs that will actually be eliminated if you reduce your inventory. Unless you would be able to free up space for other uses, or completely close a facility, including certain occupancy and equipment costs may be inappropriate.
Staff allocation optimization: Compute the fully loaded cost of inventory replenishment using fully loaded labor rates, fully costed freight and import expenses. This will drive up inventory by reducing the number of replenishments and making them larger. This strategy is appropriate if the freed-up resources can be deployed easily and quickly elsewhere within the organization.
Service-level improvement: Define inventory carrying costs that reflect your marginal incremental costs. Again, unless you believe you will have to dedicate extra space or equipment, leave out these expenses.
Strategic capital allocation: If your business is capital-intensive and competition for funding is important, a hurdle-rate — also known as minimum acceptable rate of return — approach may make sense for the cost of capital.
Rightsizing: To make inventory fit into your current capacity, adopt an additional cost that reflects the cost of incremental storage. The cost of overflow storage facilities can be included in the normal inventory expenses. When these have been surrendered, a new inventory carrying cost can be used.
Finally, if and when your perspective changes, review EOQ parameters to make sure they reflect current goals.
Step five: People
Inventory management is a complex issue. Far too often, parameters are established once, at a summary level, based on a set of assumptions by a facilitator who does not appreciate the complexities of the business and who is unavailable after the initial setup. Worse, most ERP implementations are driven by aggressive timelines, and the people involved have insufficient backgrounds in inventory management theory, ERP or how to configure the system to your business requirements — or all three.
Staff members responsible for inventory management should be trained and certified in both forecasting and inventory management, as well as the way these tasks are handled by your company’s ERP system. Your organization also must have in place appropriate governance disciplines that ensure data is clean and complete, parameters are current and updated as required, and trade-offs are made with full understanding of the service and inventory risks. Many businesses use sales and operations planning to engage senior management in these initiatives. This is vital, as these decision-makers must have a solid grounding in inventory management fundamentals to be effective in their roles as arbiters of the key trade-offs.
Love your inventory
Understanding how to master the many elements of inventory management is essential to instituting an effective plan. Explore and tap into these fundamentals, and it won’t be long before your relationship with inventory blossoms into something truly beautiful.
An inventive approach to inventory management at Peugeot
French automotive manufacturer Peugeot produces to a final and formal sales commitment from its dealers. Every year, the dealers commit to a monthly number of vehicles, specifying only enough information needed to create the master schedule and set supplier capacity levels — model, type of engine, number of doors and the like. Several months out, the dealers refine their orders — gearbox type, engine size and interior fabric color — so long-lead-time items can be planned. Finally, one month out, the exact model with factory-mounted accessories is confirmed. When a customer comes in, the dealer is able to look up the production schedule and sell a car “off the production line.” They have the ability to change any parameters not yet frozen.
The parts required for these finishes are not built-to-order but ordered-to-inventory based on insightful analysis. Peugeot found that consumption variability grew as volumes fell, so the company entered into agreements with suppliers to specify an average annual volume commitment and set monthly maxima. Suppliers must be able to supply within these order lead times — typically days. For high-volume parts, they hold a small amount of safety stock in case of demand surges; for low-volume parts, the safety is a lot higher, but the supplier’s risk was mitigated by the annual volume commitment.
Nicholas Seiersen has more than 40 years of supply chain management experience, including inventory management and deployment, strategic sourcing, logistics, network design, and durably removing costs out of the total supply chain. He is author or co-author of nearly 50 publications and a highly active professional speaker. Seiersen may be contacted at email@example.com.