The Basics of Inventory Management Explained

In this article we look at the basic requirements of an effective inventory management policy, applicable to many situations within both retail and manufacturing. We guide you through why inventory is needed, how to use inventory to protect against unknown supply chain factors, how much inventory to hold and how to reduce inventory costs.

Firstly, let’s start with why inventory is needed. There should be no such thing as holding inventory ‘just in case’, and every point in the supply chain where inventory is held should be understood and the inventory level justified…

Why is Inventory Needed?

Primarily, inventory is required in the supply chain to protect against ‘decoupling’ points. A decoupling point is where the input rate (supply) and output rate (demand) differ. The difference could be in volume and/or time.

For example, if you retail a product to customers in units of 5, with a 1-day lead time, but your supplier provides the product in units of 1,000 against a 1-week lead time, then that is a decoupling point in both volume and time. You have no alternative but to hold inventory to ensure you can service your customer.

Despite advances in supply chain collaboration over recent years, and many companies making consistent efforts to synchronise material flow through their upstream supply chains, decoupling points with variation in the input and output rates remain the norm in most supply chains. Consequently, the need to hold inventory remains a key factor of supply chain management.

Protecting Against the Unknown

As previously stated, the primary reason to hold inventory is to protect against decoupling points with varying input and output rates. However, this is only one aspect of the role of inventory. A decoupling point is usually a known factor that can be managed, but there are many events within a supply chain that can’t be predicted quite so easily.

For example, delays in supply, non-forecasted demand and defective items are all potential supply chain issues that are not easily predicted and, if you are to maintain customer service levels, are all areas that will need to be protected by inventory.

What Level of Inventory Should Be Held?

To determine the level of inventory required, the first step is to ascertain all of the decoupling points in your supply chain and any likely supply chain issues that may be experienced at those decoupling points. Normally, there will be two elements to the inventory held at decoupling points; they are Cycle Stock and Safety Stock.

– Cycle Stock

The basic inventory required to protect a decoupling point is often referred to as ‘Cycle Stock’. Cycle Stock is relatively easy to calculate and it is simply the mean expected demand during the replenishment lead time.

– Safety Stock

Safety Stock is a result of considering the supply chain issues that may impact the decoupling point, and what additional level of inventory protection may be required over and above the Cycle Stock.

In order to calculate Safety Stock the supply and demand history, along with the forecast, need to be assessed in detail. For example, have there been any delays in supplying the product? Were there any defective items on receipt? How has demand historically fluctuated and what level of demand forecast error has there been?

Using the assessment of these issues, combined with probability analysis, the required safety stock level can be calculated. The best way to do this is to calculate the distribution profile of the historical data for each potential issue and then make an appropriate calculation to ensure a level of Safety Stock that will provide you with optimal coverage.

A Safety Stock calculation is most often completed by identifying the service level you want to achieve, calculating where that service level would fall on the distribution profile i.e. x standard deviations from the mean, and then multiplying it by the square root of the lead time.

It should be noted that most often, especially with high throughput products, the distribution profile will fit what’s called the Normal Distribution or Gaussian Distribution. Many inventory approaches use this distribution but it is important not to assume this distribution type. Supply and demand issues can follow any number of distribution models and it’s important to make the assessment based on the demand and supply characteristics of the specific product.

When Should Inventory Be Ordered and How Much Should Be Purchased?

At each decoupling point the inventory should be re-ordered whenever the level reaches what’s known as the Reorder Point (ROP), which is the Cycle Stock + Safety Stock. As the ROP will equate to the amount of inventory you are likely to sell during the replenishment lead time, then the level of inventory you should order must equal the ROP as a minimum.

The reality is that most companies order more than the ROP. This may be due to having calculated and pre-determined Economic Order Quantities (EOQs), or, quite often, due to Minimum Order Quantities (MOQs) stipulated by the supplier which are in excess of the ROP.

How Can Inventory Be Reduced?

There are several levers that can help you to reduce inventory, including reducing replenishment lead times and negotiating MOQs with suppliers to synchronise with your ROP. One of the main levers however, is through portfolio prioritisation.

– Portfolio Prioritisation

In most companies, not every product can be considered of equal importance in terms of revenue, margin or strategic value. In fact, product portfolios often follow the Pareto Rule in that 80% of the revenue is generated by only 20% of the products. Consequently, inventory holding, and in turn service performance, should be focused at the products achieving, or with the potential to achieve, the greatest value for the company.

In practice inventory holding can be favoured towards the more important products by undertaking an ‘ABC’ classification of the product portfolio, sometimes referred to as ‘runners, repeaters, strangers’, and assigning varying service levels according to the products importance.

In this classification, products that generate proportionally high revenues and margins may be classified as ‘A’ products, with other products being classified as ‘B’ or ‘C’ in descending order of their revenue and margin. With this information a higher service level can be targeted for ‘A’ products and that service level can be built into the Safety Stock calculation.

The service level indicates the products availability from stock. Typically, a retail business may apply a service level of 99% for ‘A’ products, 95% for ‘B’ products and 90% for ‘C’ products. By reducing the service level for ‘B’ and ‘C’ within the Safety Stock calculations total inventory will be reduced, and consequently the cost of holding inventory will also be reduced.

Further Support from Paul Trudgian

Inventory is a major investment for any business and having the wrong levels of inventory can have a huge impact on the bottom line and service levels. Inventory approaches that do not take a systematic and scientific approach to stock levels run the risk of both failing to service customers and eroding profit.

There are many different approaches to inventory, and the one described in this article focuses on the Reorder Level system which is a common approach in both the retail and manufacturing sectors. If you would like to discuss alternative approaches, or if you need consultancy support in any aspect of inventory management, please contact one of our supply chain consultants today.

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Tamsin Giles, Client Service Coordinator, contact photo

Hello! I’m Tamsin, Client Services Coordinator at Paul Trudgian. Please get in touch by phone, email or the contact form and I’ll make sure your enquiry is dealt with promptly and passed to the right member of the consulting team. We look forward to hearing from you!