Inventory Optimization

In my opinion, optimization means maximising the return at a given risk level or risk is minimised for a given expected return.  The two key elements that dominate the meaning of optimisation are the risk and ROI.  Now Inventory Optimisation means maintaining a certain level of inventory that would eliminate the out-of-stock situation and at the same time the cost of carrying inventory is not detrimental to the bottom line (ROI).  In simple inventory optimisation means balancing demand and supply.

Inventory is the largest single asset that most companies have. Unfortunately, it consumes space, gets damaged, and sometimes becomes obsolete and carrying surplus inventory costs the organisation.  Despite well-documented studies that have proven a 77% correlation between overall manufacturing profitability and inventory turns, manufacturers and traders by and large have acted with ignorance and carried excess inventory to please customers.  Today’s customer thinking is totally different and they suffer from the problem of plenty and the gratification is instant.  They do not have the patience to wait for the product, they don’t mind considering other brands with the same product features and most of the time they may buy the product if they are convinced that the product would meet their expectations.

What level of additional inventory is optimal?

How do you know if you have too much, too little, or just the right amount of merchandise inventory? One way is to compare the value of your current inventory to an “ideal inventory investment.”  The optimal safety and cycle inventory is determined by two factors, supply lead time and predictable demand for a specific time period. In fact, the third factor that could play a critical role is the demand deviation percentage.  Whereas the cycle inventory is expected to cover the demand during supply lead time, the safety stock is expected to cover the deviation in predictable demand and uncertainties in supply lead time.  If we are able to understand and master the technique of identifying these three factors, the inventory balancing is a piece of cake.  But unfortunately, no one is able to crack the code so far.

Safety stock is basically carried to protect against the out-of-stock situation.  Out-of-stock level measurement is industry and segment specific according to Bruce Tompkins.  In the case of manufacturers, the out-of-stock level is assessed at the distribution centre or product level whereas in the case of retailers at the store level or individual buyer level as shown in the below given graphic.

Source: “The Supply Chain Consortium’s report Supply Chain Planning, a True Balancing Act.”

According to Bruce Tompkins, average safety stock varies between 10% and 30% of monthly sales by industry and segment. Cycle stock ranges from 85% to more than 190%. This is based on the report, “The Supply Chain Consortium’s report Supply Chain Planning, a True Balancing Act.”  Industry wise the cycle inventory and safety stock levels are shown in the below given graphic:

How Top 25 Supply Chains behave?

When we compare the basic activities of the supply chain (plan, source and supply) of 2009 top 25 supply chains and others we may not notice any significant difference in efficiency levels as shown in the below-given chart.

Source: Kevin O’Marah (APICS) 2009

The critical difference between the top 25 supply chains and the rest of the pack is the leadership traits. As you can see from the above chart, only sourcing efficiencies are better compared to others.  This factor negates inefficiency caused due to deviation in predictable demand to some extent.

How they are different from the rest of the pack?

The leaders in 2009 top 25 supply chains clearly proved to the world how they are different from the rest by demonstrating leadership in the following areas:

1. Strategy and Change Management;
2. Customer Management;
3. New Product design and launch;
4. Post-Sales Support.

Top Five Techniques to achieve inventory optimisation:

Let us identify top 5 inventory management techniques and compare how the top 25 supply chains have embraced it.

1. Reduce replenishment cycle time:  This is one of the critical factors in deciding the safety stock.   Shorter lead time for inventory replenishment would lessen the complexity of supply chain.  However, due to global sourcing, this is becoming a great challenge.  Lead time consists of three factors, time taken to place the order, manufacturing time (includes sourcing time) and transit time.  What is critical in establishing the efficient cycle time is the accuracy or certainty?  There is no point having a shorter lead time with huge uncertainty.  It would be easier to plan for longer lead time with minimal uncertainty.
2. Rank the Inventory: It is necessary to know which part or SKU hurts more if you carry excess inventory.  The best way to rank the inventory is ABC classification. High dollar volume (A), moderate dollar volume (B) and low dollar volume (C). “A” Parts should comprise the top 80% of dollar volume, “B” Parts about 15%, and C Parts about 5%.  The ranking should be based on dollar volume.  The ABC classification system is a tool that will help you employ your inventory control efforts efficiently.
3. Eliminate Obsolete Stock: Ideal way to identify the obsolete stock is to run FSN analysis periodically.  FSN stands for fast, slow and non-moving items.  The criteria to decide fast, slow and non-moving is specific to industry and product.  In an IT industry if we have a finished product has not shown movement from 21 to 30 days, it is considered as a dead inventory.  Explore the possibility to liquidate non-moving items, review the slow moving items and identify the reasons for sluggish movement and take necessary action.  The red dot/tag sale organised by many organisations is the result of identifying dead inventory.
4. Understand your customer: Carrying surplus safety inventory is mainly due to lack of understanding about the customer buying patterns.  It is very important to understand the customer and their needs to adjust your supply accordingly and it is fundamental to the inventory management success.
5. Optimise your SKUs: Product proliferation is one of the reasons for dismal forecasting performance.  The proliferation of SKU numbers is the unfortunate consequence.  One more factor that is contributing to inefficiency is the inefficient management of product lifecycle.  The launch of the new product should be the end of the old product in most cases.  However, customers would prefer to order old products in spite new product with additional features.  This would lead to confusion and inefficiency in planning.

Now compare the five suggestions with the findings of AMR 2009 research and it is a close match.  Strategy and change management is critical to managing your supply chain efficiently.  Supply chain efficiency to a large extent depends upon inventory efficiency.  Understanding the customer and their needs is very critical in positioning your product in the market.  There is no point trying to sell a product that is not an immediate need of the customer.  It is like trying to sell laptops in an economically back word country where customer priorities are different.  Timing is very critical for new product design and launch and at the same time, product life cycle management is also equally important to improve forecasting efficiencies.

I asked myself whether Inventory Management is the key to the business success. I strongly believe that it is certainly a bigger factor in influencing the business success.  However, the results of 2010 AMR Research 2010 findings were not aligned to my thought process. The biggest average revenue growth registered company did not fare well with regard to their inventory management. However, the most comforting factor is that the leader, Apple Computers showed all-around success. Using the data provided by the AMR Research, I have sorted the data based on inventory turns which are the point of discussion for now and the results are quite interesting:

While analysing and understanding the above table one should consider the industry-specific characteristics.  Inventory carrying patterns differ from industry to industry.  Further, one should not draw conclusions based on the above table because two of the factors in the above-given table are based on 3-year average and whereas inventory turns shown in the table is for the period of assessment.  However, if we go by the average revenue growth factor all growing companies managed reasonable inventory turns specific to their industry.  I have again sorted the data based on 5% and above average growth registered companies and the efficient inventory management is a contributor to the success as shown below:

Let us not forget that the purpose of carrying safety stock is to protect customer service from volatile demand variation during the lead time or delays in receiving a replenishment shipment. Hence, it would be ideal to maintain safety stock considering the variation in demand and lead time.  The greater the variation in demand and/or lead time, the more safety stock will be maintained for the item. This method is known as the “average deviation method.”