All too often, inventory is treated by ‘rules of thumb’ that do not provide sufficient justification for inventory levels and do not have a clear correlation between inventory level and customer service.
There are proven methodologies and formulae that can optimise the level of inventory against all of the service, working capital and equipment utilisation criteria.
A few questions professionals usually ask are:
Do you need inventory?
Inventory ties up working capital, costs money to store, costs money to handle and can become damaged or obsolete. The reality is that for most companies to remain in business they need to protect their supply. If they can’t supply when the customer wants, in the quantity they require, then the customer will go elsewhere.
So, how do you protect your supply?
Consequently, the answer is that to protect supply, you need to hold inventory. To determine the location of inventory in a business, you firstly need to establish the points in your supply chain where continuity of supply needs to be protected. There are various events in a supply chain that require inventory to protect supply – often referred to as decoupling points.
A decoupling point is where the inbound and outbound rates do not match. These are most likely to occur between raw material supply and manufacturing process, and between manufacturing process and finished goods supply. There are increasingly few companies that have the luxury of customers requesting finished goods at the same rate as the raw materials are supplied and processed.
How much inventory should be held?
Once you understand where inventory is required to protect supply, the next step is to understand how much inventory is required. This is where many companies fail.
Inventory levels are often driven through the sub-optimisation of other processes (i.e. optimal production batch quantities) or driven by rules of thumb (i.e. ‘4 weeks supply’).
The consequence of this is often lots of stock, but it’s just the wrong type and in the wrong quantity. Consequently, this can lead to customer service failures and unused remaining stock. Cycle stock and safety stock are the most efficient types of inventory that can protect supply.
Cycle stock is the level of inventory held to ensure that the average customer demand can be met during the replenishment lead time. So, if it takes five days to receive a replenishment, then you must ensure there is sufficient inventory to cover five days of average customer demand.
Safety stock is conceptually more difficult. Safety stock is in addition to the cycle stock, but the safety stock level is designed to cover the potential for customer demand peaking above average. For example, if it takes five days to replenish your inventory and your expected customer demand in units over that five days is as follows: (Day 1) = 5, (Day 2) = 3, (Day 3) = 5, (Day 4) = 4, (Day 5) = 6. The average demand in those five days would be five items. Multiplying those five items by five days will give you a cycle stock of 25 items. However, what happens if on Day 6 the customer orders seven items? The answer is that you will incur a stock-out and fail to supply the customer. This is what safety stock protects against.
How to balance inventory levels with customer service targets
Safety stock is based on a calculation that assesses the probability of the customer ordering more than the average. Using normal, or Gaussian Distribution, the inventory manager can assess the safety stock requirement, based on the service level a company wants to achieve. So, if the business wants to achieve a 99% service level, then the inventory manager builds a calculation that captures 99% of eventualities outside of the average demand.
Balancing inventory levels with working capital targets
By making these calculations, the inventory manager will have successfully bridged the inventory level with the customer service requirements. However, it is not just the supply that has to be protected, but also the cash constraints of the business.
Our inventory management consulting team is highly skilled in inventory policy development. The Supply Chain Consulting Group has considerable knowledge and experience in defining policies, formulae and calculations that can ensure inventory levels are fully optimised, justified and balanced with all the functional needs.