Inventory Optimization: Have Your Cake and Eat it Too
By: David Altemir
Tags: Inventory, Distribution, Manufacturing, Inventory Management, Retail

Can you reduce inventory while simultaneously reducing shortages? Yes.

For manufacturers, distributors, and retailers, the goal for inventory is to not have too much or too little. As with every goal, you need a plan … and preferably, a good one.

Unfortunately, inventory planning is an area where there are common misconceptions as to how to appropriately decide what to stock and, once you decide what to stock, how to optimally design target inventory levels accordingly. Additionally, there is also often a fundamental misunderstanding of how best to provide buyers and manufacturers with the signals necessary to effectively execute.

This often leads to two outcomes that can occur at the same time, sometimes in dramatic fashion:

Material shortages for items with high demand; and Overstock of the items with low demand

In some cases, we have observed overall inventory levels as much as three to seven times more than what is optimal to maintain fulfillment rates greater than 95%. This opens up the very real possibility that overall inventory can be reduced while at the same time reducing the incidence of shortages and stockouts.

The implications for reduced fulfillment lead times and better on-time performance are clear.

Let’s walk through two aspects of the basic inventory planning process associated with resolving these issues:

Selecting What to Stock

There are a variety of considerations when deciding what to stock. However, as a practical matter, we can differentiate which considerations are primary and which are secondary, not because they differ in importance but because they should be considered sequentially in two phases.

Primary inventory stocking considerations may include:

· Contributions by item to sales revenue

· Contributions by item to gross profit

Once an initial targeted inventory stock list is developed, the following secondary considerations may be applied to further refine the list:

· Sales forecasts and market outlook

· Strategic product changes

· Average frequency of demand

· Available shelf space

· Replenishment lead time

At some point, you will very likely have to prioritize the list and decide where to draw the line. Any items above this line comprise the final targeted list of standard stock items.

For manufacturers, items below the line will not normally be stocked and will instead be made to order. For distributors and retailers, the items below the line will either be special ordered or discontinued altogether.

Maintaining Appropriate Inventory Levels

There are a variety of technicalities to consider when performing inventory optimization using an inventory management system (e.g., MRP), none of which can be ignored or minimized. Far too often, the system is set up and/or managed incorrectly so that purchasing or manufacturing signals are not only incorrect and non-optimal, but are also significantly counter-productive to meeting operating and financial objectives.

One of the parameters that is needed to appropriately maintain inventory is safety stock. The purpose of safety stock is to absorb variation in demand (a.k.a., “spikes”). Many practitioners may think that spikes, are unavoidable and cannot be adequately anticipated and planned for. This is generally not true. If you have a history of sustained demand (at least six to 12 months), then safety stock levels can be optimally set using statistical methods that focus on measuring the spikes rather than average demand. In many cases, overall fill rates will increase while total inventory decreases, sometimes as much as 80%. This has a tangible impact on warehouse footprint, fulfillment costs, lead times, and on-time performance.