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Principles of Good Inventory Management

It is easy to reduce investment in inventory if you don’t mind a deterioration in customer service. Likewise, it is easy to provide good customer service if you don’t mind having a large investment in inventory. Good inventory management is concerned with having a low investment in inventory in relation to the customer service provided (or providing good service in relation to the investment in inventory) and achieving this at a low cost. It should, however, be realised that the customers’ perception of the service provided is usually more important than the actual service level.

In order to reduce investment in inventory and improve the service level, there are a number of things which need to be looked at. Initially, it is better to tackle all of the important ones to some extent than to just concentrate on a few of them. More work can then be done in those areas which will lead to further cost-effective improvement. Things which will result in improvement include the following:

  1. Ensure that the data used for inventory management purposes is accurate and up to date.
  2. Ensure that the computer provides adequate and appropriate exception reporting.
  3. Ensure that any problems are identified and dealt with when they occur.
  4. Reduce the average effective lead time.
  5. Reduce the amount of variation in lead times.
  6. Improve the forecasting of lead times.
  7. Use the supplier as the stockist when appropriate.
  8. Improve the forecasting of demands.
  9. Do not aim at providing the same service level for all items. Instead, for each item, take into account
    1. the effects of shortages,
    2. the effects and likelihood of losing sales,
    3. the cost of providing a high service level for the item concerned,
    4. whether or not customers normally need the item urgently,
    5. whether or not the item can be obtained quickly in an emergency,
    6. whether or not there is an alternative item.
  10. When setting safety stocks, take into account
    1. the feasibility and costs of obtaining additional supplies quickly when necessary for the purpose of preventing shortages,
    2. the effect of the order quantity on the service level and
    3. the risks of obsolescence and deterioration.
  11. When setting order quantities, take into account the risks of obsolescence and deterioration.
  12. When considering cost saving measures such as quantity discounts and consolidation of orders, take into account the effects on the investment in inventory.

I will now elaborate on several of the above.

1. Ensure that the data used for inventory management purposes is accurate and up to date.

The reasons for this are obvious. However, achieving this objective in a cost-effective manner is far from being simple. See the article entitled “Data Accuracy“.

2. Ensure that the computer provides adequate and appropriate exception reporting.

Whenever, for any reason, action needs to be taken, that fact should be brought to someone’s attention promptly, thereby facilitating prompt appropriate action. However, too many false alarms can greatly reduce the benefits of exception reports.

3. Ensure that any problems are identified and dealt with when they occur.

This can be greatly facilitated by good exception reporting (See “2” above). The exception reporting needs to be prompt and acted upon promptly. Adequate monitoring of indicators of overall inventory system performance should also be carried out. Such indicators include total inventory value, total value of orders on suppliers and customer service level. The reasons for any unexpected changes in any of these should be investigated thoroughly.

4 Reduce the average effective lead time.

The lead time is the time taken to obtain replenishment supplies. It effectively starts when the item should be ordered. It effectively ends when the replenishment supplies are available for issue. The greater the lead time, the greater are the errors in forecasts of lead time demands and, consequently, the required amount of safety stock. The risks of being left with obsolete stock and of deterioration are also affected. See the articles entitled “Reducing Lead Times“, “Reducing Reorder Review Periods” and “Reducing Ordering Delays“.

5. Reduce the amount of variation in lead times.

Uncertainty in future lead times contributes to the uncertainty in the lead time demand and, consequently, to the required safety stock.

6. Improve the forecasting of lead times.

Part of each reorder point is the forecast lead time demand. In order to forecast that, one of the requirements is a forecast of the lead time. Averaging recent lead times is helpful in this regard. However, if for any reason, future lead times are likely to differ from those in the past, this needs to be taken into account. If there have been few purchases of the item from the supplier then the past lead times are likely to be of little use. For that reason, the historical lead times of all items obtained from the same supplier might provide useful information. As in any forecasting, it is better to forecast the distribution of future lead times rather than producing a forecast as a single number. For example, if, on average, the lead time for an item is 15 days but it is longer than 40 days on 10% of occasions, that information is useful. Unfortunately, what can be done in this regard is probably limited by data availability.

7. Use the supplier as the stockist when appropriate.

This benefit of this in terms of your investment in inventory is obvious.

8. Improve the forecasting of demands.

If the demands are, to some extent, predictable then you should be able to achieve a very high turnover ratio (i.e. a small amount of inventory in relation to sales). If the demands are unpredictable, as is usually the case, then they should be forecast as accurately as possible given the information available. Demand history, market knowledge and market indicators should all be used as appropriate. Good results can, as a general rule, only be achieved by choosing a forecasting technique on the basis of the peculiarities of your own company. Use of whatever forecasting technique is supplied with your inventory software will not usually produce good results, even if it is an adaptive technique (such as focus forecasting). As with lead time forecasting (See “6” above), it is helpful to produce each forecast as a distribution rather than a single number. In relation to forecasting of demands, see the articles entitled “Evaluating Forecasting Algorithms” and “Demand Rate Estimation“.

9. Do not aim at providing the same service level for all items.

This is usually a major source of potential improvement. The cost of providing good service is not the same for all items. Also, the effects of shortages are more serious for some items than for others.

10. Setting of safety stocks

Safety stock is the stock which is held in case of higher than expected demand and/or a longer than expected lead time. Appropriate setting of safety stocks is the main, but not the only, means by which the service levels are controlled. Improving the manner in which they are set is usually a major source of potential improvement.

11. When setting order quantities, take into account the risks of obsolescence and deterioration.

For some types of items, this is particularly important. Large order quantities can result in stock being on the shelves for a long time. This can be a problem for perishable items. Also, if an item becomes obsolete, there could be a substantial amount of “dead” stock as a result. One of the shortcomings of the classical “economic order quantity” formula is that it does not take these problems into account.

12. When considering cost saving measures such as quantity discounts and consolidation of orders, take into account the effects on the investment in inventory.

Such cost saving measures are often very tempting. They should only be used after a realistic analysis of both the short and long term effects on your inventory levels.

No mention has been made so far in this article about distribution through multiple stores. Achieving near optimal inventory management under these circumstances is far more complex than in a single store operation. However, the principles mentioned above can be extended to multiple store operations. In a multiple store operation, several of them are often even more relevant. For example, if a store normally obtains an item directly from the supplier, then the most appropriate method of obtaining the item in an emergency might be to obtain it from another store.

Inventory management improvement should be tackled on many fronts. That will usually produce much better results than concentrating on just a few improvements. An exception is if those improvements have been identified as the ones which will have the greatest effects.

It should now be apparent that good inventory management is far from being simple and that there are many inter-related things to be considered.

 

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