Too much inventory in your distribution network? Inventory costs too high? Are profits too low? Stock-outs, availability issues, and SLOBs impacting service performance?
These are all pervasive issues for supply chain operators worldwide—and are classic symptoms of suboptimal inventory performance. The good news is that they are all problems with solutions, and that every supply chain can be improved through inventory optimisation.
But what exactly does inventory optimisation mean, and what obstacles must first be broken down to achieve it? Those are the precise questions we’ve set out to answer in this article.
Inventory Optimisation: A Clarification
Before we look at the barriers to optimal inventory and the possible ways to eliminate or overcome them, let’s be clear on what inventory optimisation means—because misconceptions do abound.
No inventory optimisation solution comes without tradeoffs. For example, you can optimise for cost, profit, or service, but not for all of them.
Instead, your company’s optimal inventory performance will be such that you can meet the service levels you aspire to (or to which your customer agreements commit you) with the barest minimum negative impact on profit and working capital.
Alternatively, you can focus on profit and accept tradeoffs in service and costs or concentrate on the cost and accept service and profit tradeoffs. But ultimately, it comes down to what you assess as optimal inventory performance for your organisation.
The Nine Factors Impacting Inventory
Having decided upon your primary goals, you can start working to achieve optimal inventory performance for your company and its supply chain. Nevertheless, there will inevitably be some barriers to overcome, circumvent, or break down.
The consultants here at Logistics Bureau are here to help you with that. Better still, through our inventory diagnostics service, we can do so 100% remotely, with minimal disruption to your business.
However, right now, perhaps you merely want some ideas about where your inventory performance might be suffering and what barriers prevent you from optimal performance. In that case, please read on, as the rest of this article is dedicated to explaining the nine fundamental factors typically contributing to suboptimal inventory levels.
1: Service Levels
Inventory management experts’ opinions vary about which factors have the most significant impact on inventory levels. However, ask the majority, and you will probably hear service level cited frequently as the most influential element.
Indeed, the higher the level of service your company aspires to, particularly regarding product availability, the more inventory you will likely hold. And availability is undoubtedly one of the most vital aspects of service in the eyes of the customer.
Perhaps you’re confident that you carry a range of products superior to your competitors’ offerings. But, despite that, if your customers don’t feel satisfied that they can get everything they need from you when they need it, they might be prepared to compromise on the product for the sake of availability. That’s why, for most companies with products to sell, high service levels are a critical goal.
So, your customers want high service levels, meaning you need to hold enough inventory to ensure availability is not compromised. That’s what makes service a barrier to inventory optimisation.
How Does Service Impact Inventory?
The quantity of inventory you hold in your warehouse(s) tends to increase proportionately to the service levels you promise your customers or the standards you aspire to uphold in the absence of formal service agreements.
Higher service requires increased inventory because product availability strongly influences customers’ perception of service.
Therefore, to avoid falling short of your service standards, you need to hold enough stock to ensure you can fulfill every sale or order, even in the face of supply chain shocks and demand spikes. The higher you set the bar for service, the more stock you must keep to ensure availability.
Service as a Barrier to Optimal Inventory
At this point, perhaps you’re wondering if we’re suggesting you reduce your service levels to lower the amount of inventory you hold. Indeed, in some cases, that might be a realistic solution, but more on that in a moment.
Suffice it to say that, generally, it’s wise to hold service as the non-negotiable element of inventory optimisation, thereby seeking to keep the right amount of stock to meet required service levels while minimising the inventory costs as much as possible. However, there are perhaps two exceptions to this general rule.
The first exception is when you can offer distinct tiers of service, perhaps based on contractual agreements with your customers. In that case, some customers will be incentivised to accept some slightly increased risk of products on backorder, maybe enabling you to reduce the inventory levels of those products.
The second is when you implement segmentation of the SKUs in your portfolio based on Pareto analysis. In this scenario, you might reduce control and inventory levels of your B and C-class products while ensuring sufficient A-class product cycle, buffer, and safety stock to maintain high availability.
2: Forecast Accuracy
While your company can always make wilful decisions about service levels and, therefore, about the levels of inventory required to secure them, another critical barrier to optimal inventory, poor forecasting, is less straightforward to address.
After all, the need to create forecasts that are as accurate as possible is inarguable, but many companies struggle with generating precise demand forecasts.
And the less accurate your forecasts, the further your inventory levels will be from the optimum. That’s bad news for your supply chain costs, customer service, profitability, and, thus, your reputation.
For example, inaccurate forecasts typically lead to:
- Overstocking— a problem that ties up working capital and can lead to inventory obsolescence.
- Understocking, resulting in stock-outs and backorders
- Lost sales as a result of poor availability
- Upset customers and negative publicity for your brand
- Wasted time spent resolving stock-out situations
- Inadequate liquidity
- Erosion of profits
In summary, forecast accuracy directly impacts your ability to optimise inventory, whether your optimisation focus is on service, cost, or profit. Therefore, the more accurately you forecast demand, the more effective your inventory optimisation efforts will become.
How to Improve Forecast Accuracy for Optimal Inventory
While 100% forecast accuracy might be as elusive as the Holy Grail, hidden opportunities exist in most enterprises to improve forecasting and close the gap between projected and actual demand.
Inaccurate forecasts typically arise from mistakes, which, once identified, can be eliminated, such as:
- Failure to understand seasonality and other trends affecting demand volumes
- Neglecting to monitor external market factors that can affect demand
- Applying a single forecasting model to all products in the inventory portfolio
- Ignoring the presence of forecast biases which skew replenishment patterns
- Persisting with spreadsheet-based forecasting instead of investing in advanced forecasting software
3: Supplier Lead Time
Even if you could achieve 100% forecast accuracy, it would not signal the end of your potential inventory optimisation challenges. If you could always know the rate of demand for your products, you still would not be able to ensure a balanced supply without holding some level of buffer, or safety, inventory—as you have to keep stock for cover in case of supply delays.
No goods supply is 100% reliable because, as highlighted by the recent pandemic, many things can go wrong in the supply chain, some of which are not in your control or that of your suppliers.
However, even supply chain elements over which you and your suppliers do have control often conspire to affect inventory levels, supplier lead time being a prime example.
How Does Lead Time Affect Inventory?
Let’s explore a quick example of the relationship between supplier lead times and inventory levels. Let’s assume that yours is a retail organisation that sells products from several manufacturers.
One of your best-selling products comes from a manufacturer in your region, perhaps no more than 100 kilometres away. The products are dispatched straight from the factory and typically arrive within 48 hours of raising a purchase order. Another product comes from an overseas manufacturer, with a lead time of several weeks.
You will naturally need to hold more cycle stock of the product from the overseas manufacturer than the locally manufactured product. You will probably want to keep more safety stock of that product, too, since the risk of a shipping delay is much higher.
Reduce Lead Time to Aid Inventory Optimisation
Since holding inventory is essential to cover every day of lead time, the benefit of reducing lead time is self-evident. But how can you do it? Here are a few ideas:
- Secure relationships with local/domestic suppliers wherever possible
- Improve the accuracy of demand forecasting and share your forecasts with suppliers
- Collaborate with your strategic suppliers on initiatives to reduce lead time
- Explore options for faster transportation from overseas suppliers (switch from ocean to air freight, for example)
While some measures to reduce lead time will inevitably cost money to implement and maintain, they will enable you to reduce working capital tied up in inventory, and may even bring other cost benefits. For example, switching from overseas to domestic supply might eliminate the need to pay import fees and duties.
4: Your Inventory Management Approach
So far, we’ve looked at three potential barriers to inventory optimisation, all of which relate to responsibilities shared to some degree between your business and its partners, suppliers, and customers.
However, if there is one element that’s entirely under internal control, it’s the approach you take to managing your inventory.
We’re not necessarily talking about poor standards of management or process inefficiencies here. You might have excellent processes and exemplary management protocols. At the same time, like many companies, you could be mistakenly applying a single, standard inventory policy to every SKU in your product range.
One Size Rarely Fits All
In our work with clients, we invariably find that those using some form of product segmentation and perhaps also segmenting their customers enjoy better inventory cost performance than those who apply standard inventory and replenishment rules to all their SKUs.
That’s because, for most sales organisations, a small percentage of products is responsible for a large portion of sales. It’s the old Pareto rule in action.
Ignore this rule at your peril because if you do, and therefore apply one approach to managing all your SKUs, inventory performance can suffer. For instance, your risk of suffering stock-outs of your most popular products and obsolescence or spoilage in your slow-moving products is higher under a one-size-fits-all inventory policy.
Segmentation Before Optimisation
If you plan to optimise your inventory, segment it first. Indeed, it’s fair to say that inventory segmentation is, in itself, an element of optimisation. It’s critical because, once you know which of your SKUs moves fastest, you can focus on setting stock levels and reorder points that ensure availability.
At the same time, since you will know which SKUs move more slowly, you’ll likely find that you’re keeping far more of those items in stock than you need to and can release some working capital by reducing the amount you hold and the frequency at which you reorder.
You can choose from several methods to segment your inventory, but even the most straightforward Pareto analysis, segmenting your products into A, B, and C categories based on sales volume, is better than having no segmentation.
5: Slow-Moving, Obsolete, and Excess Stock
Poor inventory management is the nemesis of inventory optimisation, because poor inventory management leads to issues such as obsolete and excess stock, usually among the SKUs that see the lowest volume of sales.
Of course, some of your company’s products will inevitably sell at a slower rate than others, so slow-movers are not a problem per se—and you can always decide whether to continue selling those items or discontinue them.
The problems start to arise when slow movers are not adequately managed, and for larger organisations with extensive product ranges, it’s easy to neglect them, albeit inadvertently.
Inventory managers are more likely to avoid such mistakes when they are mindful of the need for product segmentation and therefore implement ABC or a similar classification regimen. Those steps make it easier to control inventory and reduce the risk of overstocking and SKU obsolescence.
6: Ordering Frequency
The frequency at which you place orders to replenish each SKU is another factor that impacts inventory levels. For example, perhaps your suppliers incentivise your company to place large orders with generous discounts.
While taking advantage of such incentives may seem prudent, you should ensure that attractive pricing is not distracting you from the total cost of ordering infrequently and in large quantities. In general, the opposite approach, ordering in small amounts and frequently, is more conducive to inventory optimisation.
If you believe you could benefit from smaller, more frequent orders but are not 100% sure, a practical first step would be to ascertain the economic order quantity (EOQ) for each SKU in your range.
In basic terms, EOQ is the optimal order quantity for minimization of ordering and holding costs, so it’s an excellent yardstick and a basis for negotiating smaller order quantities with your suppliers, if necessary.
How to Calculate Economic Order Quantity
To calculate the EOQ of an SKU, you first need the following items of data to hand:
- The carrying cost per unit for the SKU
- The cost of ordering (per order) that particular SKU
- The annual throughput of the SKU (in units per year)
Once you have the above data, you can apply the following formula to calculate the EOQ:
EOQ = square root of: (2OU)/C.
EOQ: An Example
Let’s do an example EOQ calculation to clarify the process. We’ll assume that you have an SKU in your range with a carrying cost of $10, an ordering cost of $1.45, and a throughput of around 19,000 units per year. Thus:
(20U)/C = (2) (19,000) (2.90)/ (10) = 11,020.
The square root of 11,020 = 104.97, meaning that the EOQ for that SKU is 105 units. Hence if you order in quantities of 105 units, you will enjoy optimal ordering and carrying costs.
So, if, for example, you were previously ordering the SKU in quantities of 500 units, roughly every six months, you would need to increase the order frequency to around once every five weeks, in those smaller quantities of 105 units, to reap the benefits of an economic order quantity.
From MOQ to EOQ: The Transition Will Make a Difference
Of course, applying the EOQ principle might be easier said than done, since suppliers often impose minimum order quantities for purchases of their products. So you might need to try and negotiate with your vendor to reduce the MOQ if it’s greater than your EOQ, even if that means paying a slightly higher purchase price. Or you may prefer to look for another vendor who will agree to supply according to your EOQ.
7: Your Suppliers’ Minimum Order Quantities
Your company’s suppliers, if they are at all inventory savvy, will be no less keen than you to pursue inventory optimisation, regardless of whether they are wholesale vendors or manufacturers. One way they can do this is to impose a minimum order quantity (MOQ) for each product.
The idea of MOQs is to enable the vendor to maximise profit margins and minimise shipping costs. But, unfortunately, the MOQs are not designed to be optimal for you, the customer.
That’s why suppliers’ MOQs are a barrier to inventory optimisation for your company. They will typically leave you with the need to hold more inventory than is optimal for your business. Therefore, you will need to try and address MOQs if you want to optimise your inventory levels fully.
How to Reduce Minimum Order Quantities
Bringing your suppliers’ minimum order quantities down can be quite a challenge. However, here are some practical options you might consider trying:
1) To negotiate with a supplier to try and find a way that a lower minimum can work for mutual benefit.
2) To seek alternative suppliers that will work with lower minimum orders.
3) To consolidate some of your inbound goods or materials through a large supplier who can comfortably meet manufacturers’ minimum order quantities and then resell the products to you in smaller quantities when you need replenishment.
8: The Size of Your SKU Range
The fewer SKUs you need to hold, the easier it will be to manage your inventory effectively—that’s a fact! So if yours is one of those companies that can thrive with a small product range, more power to you because inventory optimisation will be relatively straightforward.
On the other hand, if you have hundreds or thousands of SKUs in your range, you’ll need all the help you can get by employing inventory management experts and using services like Logistics Bureau’s inventory diagnostics.
In addition to that human support, you might also consider investing in sophisticated technology to analyse and model optimal stock levels and automate the execution of multiple inventory policies.
Of course, you can consider some obvious remedies, such as removing SKUs that don’t generate much profit or bring other tangible benefits to your business. Remember, too, that optimisation isn’t just about the whole SKU range, but also about which SKUs you keep in each one of your DCs or warehouses.
9: The Size of Your Distribution Network
Speaking of DCs and warehouses, what about their impact on your inventory? While the number of locations won’t necessarily affect your cycle stock levels (although it may if, for example, lead times vary for shipping to and from each warehouse), each warehouse will require some safety stock. Therefore, the more extensive your network, the more stock you will need to hold.
It might not be possible to reduce the number of warehouses in your network. Still, as mentioned in the previous section of this article, you should carefully consider which SKUs you keep in which location and implement specific inventory policies for each warehouse.
With all that being said, it’s common enough, upon completing an inventory optimisation project with extensive scenario modelling, for a company to conclude that adding, removing, or relocating warehouses within the network will improve overall inventory performance sufficiently to justify the investment in such a restructure.
Get Started in Just Two Weeks with Our Inventory Diagnostics
So now that we’ve shared the nine critical barriers to optimal inventory, you might be wondering how and where to start breaking them down. At Logistics Bureau, we offer the perfect solution, with guaranteed results (if you’re not delighted, we’ll give you a full refund).
Before you can optimise your inventory, you need to know the current strengths and weaknesses in your current IM setup. That’s what you’ll discover after undergoing our inventory diagnostic, but that’s not all.
With nothing more than access to your inventory and master data, along with your sales history, we’ll provide you with the following information and insights within just TWO WEEKS:
- An ABC Pareto analysis of your inventory by COGs and demand frequency
- An assessment of your product availability
- Calculations relating to your inventory ageing
- Suggested stocking strategies and policies
- Recommended levels of cycle and safety stock
- Suggested optimal inventory based on target service levels and replenishment methods
- Guidance on the steps you will need to take to unlock the benefits of optimal inventory
Your diagnostic will be completed 100% remotely, with no disruption to your business, by Melanie Genford, our IM consultant and specialist, using our proprietary, purpose-designed analytics software.
Sounds great, doesn’t it? We’re ready and waiting to help you break down those inventory optimisation barriers, so why not find out a little more by visiting our inventory diagnostic service page right now?