Inventory is usually the biggest cash investment a business makes every year and if you do not have an inventory policy, then that cash investment has no approval process.
If you are overstocked, have high levels of slow moving stock or obsolete stock, then you have invested cash without approval and you do not have an effective inventory policy. You wouldn’t let any other significant expenditure be made without a detailed approval process, so why inventory?
Here are a few points on how to manage your inventory effectively.
Make to Order (MTO) vs. Make to Stock (MTS)
If you are a manufacturing business then you should be carefully analysing the MTO and MTS. You should assess the frequency, value and volume of each product and then overlay this information with the commercial strategy. If a product is sold infrequently, generates low returns, and does not form part of a wider commercial offering, then it should not be MTS. In fact, it should probably be delisted altogether.
It doesn’t make sense to invest your cash in all products equally. Isn’t it better to have more stock, and consequently a better service level, for those products that generate the most sales and the most revenue? This is the purpose of an ABC classification. An ABC classification, sometimes called ‘runners, repeaters, strangers’, is an opportunity to focus cash, and improved service levels, at the products that are critically important to your business.
Broadly speaking your inventory targets should be comprised of two components, cycle stock and safety stock. Cycle stock is straightforward – it is the mean expected demand during the replenishment lead time. Safety stock is more complex, and often overlooked. Safety stock is a probability assessment of demand exceeding the mean during the replenishment lead time, combined with the probability of delays in the replenishment lead time. This should be properly calculated – rules of thumb do not work and will leave you with too little or too much stock.
Devising an inventory policy is not a one-off exercise. As your business profile changes, new products will come in, old products will go out and sales will increase and decrease. These factors will impact your inventory targets and consequently you should be making revisions to your MTO/MTS, portfolio classification and inventory targets periodically. If you do not have inventory management software then simple models can be developed in MS Excel to achieve this.
Developing an inventory policy is not just about the known numbers; it is not purely an analytical exercise. You need to ensure that the analysis is overlaid with the expectations of the product life cycle, market promotions, sales strategies and commercial forecasts. It is important that there is cross-functional consensus from the commercial, finance and operations teams on the levels of inventory being targeted.
Once you have an inventory policy established and a process for periodic review, then you should be looking at levers on how you can work to reduce stock. There are a number of methods you can use, but typically businesses should focus on:
- Modifying service levels (reducing service against ‘B’ & ‘C’ class items);
- Increasing MTO;
- Introducing minimum order quantities (MOQs) for customers;
- Negotiating higher frequency, lower volume deliveries with suppliers;
- Rationalising the portfolio;
- Improving forecasting and considering implementing Sales and Operations Planning (S&OP).