The goal of effective inventory management is to help distributors meet or exceed customers' expectations regarding product availability while stocking the amount of each item that will maximize net profits.
This article focuses on two measurements that will help you analyze your success in achieving the first part of this goal: measuring how well you are meeting or exceeding customers' expectations of product availability. The next article will explore profitability measurements.
Customer service level
The customer service level measures how often you have the items you've committed to stock when your customers want them. If you don't have what your customers want, they must look for it elsewhere. Your competitors won't have to make sales calls, because your customers will seek them out. Customer service level is calculated with this formula:
Customer service level = Number of line items for stocked products shipped complete by the promise date / Total number of line items for stocked products ordered
Notice that we measure line items “shipped complete,” meaning the entire quantity ordered is delivered in one shipment, on or before the promise date listed on the order. If the customer orders 10 items and we ship 10 items, we get credit toward the customer service level. But, if the customer orders 25 items and we only ship 24 items before the promise date, we get no credit. This is truly a pass-fail test.
Why no partial credit for shipping 24 items out of 25 items? Well, if customers want 24 items, they'll order 24 items. They want 25 items. The customer must find that last one somewhere else — probably at your competitor's warehouse down the street. Why no credit if we deliver the quantity in more than one shipment? Your customer must process multiple stock receipts and your firm has to process multiple shipments. Both parties incur additional costs.
When calculating your customer service level, we only include sales of stocked items filled using warehouse inventory. We don't include sales of other kinds of products such as special-order items. These are either products you do not keep on hand and are specially ordered to fill specific customer orders, or direct or drop shipments sent directly from a vendor to your customer.
Shipments of these items do not reflect how well you're using warehouse inventory to meet your customers' immediate needs. Companies that include special order items and direct shipments when calculating a customer service level tend to overstate how well they serve their customers from warehouse inventory.
Customer service level should be measured each month for each product, product rank, vendor line and warehouse. You should strive to achieve an overall customer service level of about 95 percent. That is, 95 times out of 100, you can deliver the total quantity of the stock item the customer orders. Why not 100 percent? Because there will usually be about 5 percent of customer requests you can't fill from inventory because they are unusual requests or exceptions. Perhaps you sell on average 500 pieces of a product each month and a customer requests 2,500 pieces. Should you have enough stock on hand to completely fill this order? Usually not. You probably couldn't afford to maintain a five-month supply of every inventory item. However you may want to maintain an unusually large stock quantity of a few specific items your customers always expect you to have in stock. These are what my mentor, the late Alan “Buddy” Silver, referred to as “painful backorder items.”
Recording out-of-stock situations
The customer service level is a great measurement, but it depends on two assumptions that are hard to control:
Salespeople will accurately record the promise date for each line item on a customer order.
All customer requests for products will be accurately recorded.
One of our clients had salespeople who always recorded the promise date on every customer order as the current date. Even though the firm delivered most orders the next day, they were delivered after the recorded promise date, so their system considered nearly every line item late and reported a very low customer service level.
At another distributor, requests for products that were completely out of stock were not recorded. If a customer ordered 10 pieces and one piece was shipped in the initial shipment, the transaction negatively affected the customer service level. But if the item was completely out of stock and no order was entered, the customer service level wasn't affected.
To avoid these problems, some distributors measure stockouts as an alternative to measuring the customer service level. A stockout occurs when the available quantity of a product (on-hand quantity minus quantity committed on current orders) falls to or below zero. When this situation occurs:
The number of stockouts for the product is increased by one.
The date of the stockout is recorded.
When a stock receipt for the product is entered into the computer system and the available quantity rises above zero, the date of the end of the stockout is noted and a “days out of stock” for the current month is increased by the length of the stockout.
Both the number of stockouts and days out of stock must be recorded each month, because they identify two different problems.
Number of stockouts
If a popular “A” product has many stockouts (more than two in a four-month period) it probably means that its normal reorder quantity is too small. All or most of each replenishment shipment is used to fill backorders that have accumulated during the lead time. The standard reorder quantity of the product needs to be increased to satisfy customer demand between replenishment shipments.
Days out of stock
Where the number of stockouts is low but an item has been out of stock many days within the past several months (14 days within a four-month period), look for inconsistent lead times or other vendor problem.
Some distributors consider an item out-of-stock when the available quantity drops below the average or typical order quantity. If customers normally order a dozen of a lamp at a time, having only one or two units on the shelf may be the same as having none.
Analyzing the Customer Service Level and Stockouts
Best practice is to analyze either customer service level or stock out analysis each month using several criteria including rank of product, vendor and buyer.
“A” ranked products usually make up 80 percent of either product requests or cost of goods sold. These are the products that customers request most often and provide the greatest opportunity for profit and inventory turnover and your sales staff is embarrassed if they are not readily available. As a result they should almost always be in stock. Even though your overall service level goal may be 95 percent, the standard for “A” ranked products should probably be higher. Best practice is to carefully examine the replenishment parameters of any “A” ranked product that has a service level of less than 98 percent or has had more than one stockout within the past 60 days. Lower ranked “C” products (typically responsible for the last 5 percent of activity) might have a service level goal of about 90 percent to result in an overall customer service level of 95 percent.
Is your customer service level for specific vendors' products unacceptably low? Or are many of their products out of stock for prolonged periods of time? Can you work with these vendors to provide more consistent deliveries and improved product availability?
Some buyers are more talented than others. The customer service level and stockout analysis are good objective measurements of a buyer's performance.
An analysis of customer service level and stockout allow you to determine how well you are achieving the first part of our goal of inventory management: to meet or exceed customers' expectations of product availability. My next article will explore some measurements that gauge your success in meeting the second part of our goal for effective inventory management: determining the amount of inventory that will maximize your company's net profits.
With more than 36 years of experience, Jon Schreibfeder is president of Effective Inventory Management Inc., Coppell, Texas, a consulting firm dedicated to helping distributors maximize the productivity and profitability of their investment in stock inventory. Schreibfeder is author of the recently published “Achieving Effective Inventory Management — 3rd Edition.” Contact Schreibfeder at (972) 304-3325 or via e-mail at firstname.lastname@example.org.