The purpose of inventory and effective inventory management is to protect supply. Inventory should be positioned to protect supply and service when the source of supply is not synchronised with a product’s demand. For most businesses, supply and demand are not synchronised and are never likely to be.
It is, in fact, the exploitation of unsynchronised supply and demand that creates the market for many businesses. If you think of the retail sector, its very existence is dependent upon the end consumer not being able to buy direct from the product manufacturer.
The customer may want to buy one item today, but the manufacturer wants to only sell in large volumes against longer lead times. It is the wholesalers and retailers who bridge this gap between source and consumer.
If you have a business that sits in between the source and consumer, and the source outputs at a different rate than the consumer demands, then it is not only important for you to hold inventory, but it is the cornerstone of your market offering. It is critical.
There are 3 main factors to consider with effective inventory management; they are (1) Demand, (2) Cost and (3) Service.
How much of a product do you believe you will sell and when? This is the fundamental question that is the foundation stone of your inventory policy. Some products will, of course, have a stable demand and can be easily predicted using history. However, new products, seasonal products, and low volume products may have very erratic demand patterns.
Forecasting demand is part science, in the form of statistical assessment, and part art, in the shape of market intelligence. All businesses should operate a comprehensive S&OP process so that they have a consistent and cross-functional agreement on the demand plan. It will never be 100% correct, nobody can perfectly predict the future, but what’s important is that there is a defined plan and it’s agreed by everybody in the business.
Your inventory level, and consequently inventory cost, will be determined by your forecast demand. However, this assumes that sufficient cash and resources are readily available to purchase and store the levels of inventory required to meet your demand.
In order to balance cost and the need to meet demand, it is important to manage your portfolio. Most product portfolios will adhere to the Pareto rule i.e. 80% of demand is for 20% of products. With this in mind, it makes more sense to focus inventory levels, and consequently cash, on the 20% of products that account for 80% of demand.
This isn’t to say that no inventory should be held for the other products, but rather you should position your inventory policy so that failure on the important few products is less likely than failure on the many.
Okay, so you want a 100% service level for all of your products i.e. every product is ‘on the shelf’ every time a customer wants it. In reality, this is not something you can plan to achieve. As stated before, nobody can predict the future 100% and, consequently, nobody can guarantee stock availability when working with forecast demand.
However, by using intelligent inventory calculations, you can determine target inventory levels by product that will give the best likelihood of product being available. Using statistics, you can target specific service levels, up to 99.99% if you so wish, which is far more effective in terms of service and cost than using ‘rules of thumb’ and guesswork.
With these inventory calculations, it is important to remember that the higher the service level you target, then the higher the inventory holding and cash investment will be. Consequently, you should once again consider your portfolio and target the highest service levels at the top 20% of products. The service level target should then be reduced for the remaining products until you’ve achieved a cost versus service balance.
Effective inventory management should never be about guesswork. Too many businesses apply ‘rules of thumb’, or just hold ‘x’ weeks’ supply and a bit extra ‘to be on the safe side’. It is this guesswork and roughly right types of assessment that lead to high levels of slow-moving and obsolete stock, reduced cash-flow, lower margins, and poorer customer service.