Inventory Management 101

Because of the current economic conditions, many distributors are suffering from decreased sales and lower profit margins. While there is less money available to invest in inventory, to remain competitive distributors must maintain a high level of customer service. In this economic climate, it's critical that every dollar invested in inventory is working to achieve the goal of effective inventory management.

When forced to reduce inventory many distributors first look to get rid of dead stock and remove slow-moving inventory from warehouse. But this course of action presents several challenges:

• It's often difficult to liquidate dead stock. After all, if your customers don't want this material it probably will take a lot of effort to find someone who does want it.

• Your customers may depend on you having some slow-moving products always on the shelf just in case they need them. The availability of these products contributes to your reputation as a reliable supplier and helps differentiate you from your competitors.

I have found that a more effective way to trim your inventory is to micro-manage your fast-moving products that also have a high cost-of-goods-sold value. These products not only sell frequently, but also represent a lot of dollars moving through your inventory. Reducing the stock of these products in most cases will substantially reduce your inventory investment while increasing turnover (your opportunities for earning a profit). The challenge is to ensure that any stock reduction does not negatively affect customer service. Here are a few ideas to help you achieve this goal:

Identify the products with the highest potential to effectively reduce your inventory

Most distribution software will rank products based on cost of goods sold. For example:

• “A” ranked items produce the top 80 percent of sales.

• “B” ranked items contribute to the next 15 percent of sales.

• “C” ranked items are responsible for the last 5 percent of sales.

• “X” ranked items have no sales. This represents your dead stock.

Those “A” ranked items that have had sales in 10 or more of the past 12 months are your high cost of goods sold items that have frequent sales or usage. These products represent your best opportunity for inventory improvement.

Determine the accuracy of your current demand forecast

Demand forecasts are predictions of the quantity of each stocked item you will sell or use in the future. It's a very critical element in maintaining the best possible inventory. After all, if you have a good idea of what your customers will need in the future, you can stock less and still fulfill their requirements.

Unfortunately, many distributors use a single formula to calculate demand forecasts. They do not realize different items in inventory — and even products within the same product line — have very different patterns of usage and therefore require different forecasting methods or formulas to calculate accurate predictions of future usage. The results of bad forecasting are often hidden because most computer systems do not report the forecast error of each item (the average difference between the forecast and actual usage over the past several months). You can calculate the average forecast error for each item with the following formula:

[Absolute value of (forecast — actual usage)] ÷ the smaller of the forecast or actual usage

If your average forecast error exceeds 30 percent or 35 percent, you probably can lower your inventory while maintaining a high level of customer service by implementing a more comprehensive forecasting system. Talk to your software provider for available options for your system.

Make sure you are not maintaining too much insurance stock

Safety stock (also known as safety allowance) is reserve stock you maintain to protect against stock-outs due to unusual demand or delays in receiving a replenishment shipment. Like any other type of insurance, safety stock is an expense, not an investment. You do not want to maintain more safety stock for an item than you need to achieve your desired level of customer service. As with demand forecasts, many distributors use one common formula for maintaining safety stock (often 50 percent of lead time usage). They do not realize that individual items might need more or less safety stock. To help determine if your safety stock quantities are appropriate, try performing a residual inventory analysis. For each of the previous three months, perform the following calculation for each item:

Forecast + current safety sock — actual usage = Residual inventory

The forecast is what you estimated you would sell or use during the month. The safety stock is the reserve inventory you maintain for the item. The total of the forecast and safety stock equals the quantity of each product you plan to sell or use. Actual usage is what actually left the warehouse; the balance is residual inventory.

If the residual inventory (in terms of days' supply) for a product is continually high (maybe greater than a 21-day supply) consider lowering the safety stock quantity. If the residual inventory is low (maybe less than a four- or seven-day supply) consider increasing the safety stock quantity.

Note that this simple formula to calculate residual inventory does not consider variations in the lead time. I have found it's most effective to set the anticipated lead time for each item equal to the longest normally anticipated lead time for the product. For example, if the lead time for an item ranges from two to four weeks, set the lead time in your system equal to four weeks. By determining appropriate safety stock levels based on a single criteria (the difference between the forecast and actual usage) you can fine tune these quantities and maintain just enough safety stock to maintain our desired level of customer service.

During an economic downturn things aren't as busy was when sales are booming. Use this time to carefully examine your inventory. Take out the “fat” (excess stock of fast-moving products) from your inventory and keep the muscle (inventory that helps meet the goal of effective inventory management). Not only will this help you survive the bad times, but it will help you prepare for the next upturn in the economy.

To be continued next month.

Jon Schreibfeder is president of Effective Inventory Management, Inc., Denton, Texas, a firm dedicated to helping distributors and manufacturers get the most out of their investment in stock inventory. Over the past 28 years, he has helped over two thousand firms improve their productivity and profitability through better inventory management. He is the author of numerous articles and a series of books on effective inventory management, including the recently published Achieving Effective Inventory Management — Fourth Edition and the National Association of Wholesaler-Distributor's Guess Right — Best Practices in Demand Forecasting for Distributors. A featured speaker at seminars and conventions throughout North America, Latin America, Europe, Asia, and the Pacific Rim, he has been awarded the title “Subject Matter Expert” in inventory management by the American Productivity and Quality Center and is an advisor to Purdue University's Industrial Distribution Program. To learn more about inventory management contact Jon at (972) 304-3325 or e-mail him at [email protected].