The Inventory Balance Law
Do we really need inventory, and if so, how much? How do we satisfy accountants that the level of inventory held is efficient and, at the same time, satisfy sales teams that the level of inventory held will meet customer service goals? […]
Do we really need inventory, and if so, how much? How do we satisfy accountants that the level of inventory held is efficient and, at the same time, satisfy sales teams that the level of inventory held will meet customer service goals? What levers will allow us to reduce inventory, but still meet customer service goals and working capital constraints?
These are questions that all businesses must answer. Too often inventory is dealt with “rules of thumb” that do not provide sufficient justification for inventory levels, do not guarantee that working capital is minimized, and do not have a clear correlation between inventory level and customer service. . Many companies talk about ‘days’ or ‘weeks’ supply, but what does that really mean in a supply chain where demand quantities, supply quantities and lead times vary from day to day or from day to day? week to week?
Do we really need inventory?
Inventory immobilizes working capital, costs money to store, costs money to manage, and can become damaged or obsolete. With the exception of work in progress, in an ideal world there would be no inventory in a company. Material would flow through the supply chain without stops or bottlenecks, and inbound supply rates would be synchronous with outbound supply rates. A perfect world, but not one in which many companies operate.
The reality is that for most businesses to keep running, they need to protect their supply. If they cannot supply when the customer wants, in the quantity he needs, the customer will go elsewhere. So how do you protect your supply? You can follow Japanese and take the Kaizen approach, simplifying and synchronizing every step in your supply chain. That’s great for an in-house production process, but in a real-world supply chain your suppliers and customers are unlikely to be inclined to sync their processes to fit yours. Consequently, the answer is that to protect supply, it is necessary to maintain an inventory.
Where should inventory be kept?
Now that we have established that inventory is a necessary and indeed critical item in many supply chains, the question is where should inventory be kept? To determine the location of inventory in a business, you must first establish the points in your supply chain where continuity of supply must be protected. There are several events in a supply chain that require inventory to protect supply, often referred to as “decoupling points.” A decoupling point is where the entry and exit rates do not match. They are more likely to occur between the supply of raw materials and the manufacturing process, and between the manufacturing process and the supply of finished products. Increasingly few companies can afford to have customers order finished products at exactly the same rate as raw materials are supplied and processed.
How much inventory should be kept?
Once you understand where inventory is required to protect supply, the next step is to understand how much inventory is required. This is where many companies fall. Inventory levels are often managed through suboptimization of other processes (ie optimal production batch quantities) or controlled by general rules (ie “4 week supply”). The consequence of this is often a lot of stock, but it is the wrong type and in the wrong quantity. Consequently, you continue to have customer service failures, the stock you have is not used, and can ultimately become obsolete.
There are two types of inventory that protect the supply cycle stock and the safety stock. Of course, there are other types of inventory such as goods in transit, work in progress, obsolete, etc., but all are the result of an activity and are not specifically maintained to protect supply.
Cycle stock is the level of inventory that is maintained to ensure that average customer demand can be met during the replenishment time. So if it takes 5 days to receive a restock, you need to make sure there is enough inventory to cover 5 days of average customer demand. As long as a business has accurate forecast or historical data for each product, this inventory item is relatively easy to calculate.
The safety stock is conceptually more difficult. The safety stock is in addition to the cycle stock, but the safety stock level is designed to cover the potential for customer demand to exceed the average. For example, if it took 5 days to replenish your inventory and the expected customer demand in units during those 5 days was as follows: (Day 1) = 5, (Day 2) = 3, (Day 3) = 5, (Day 4) = 4, (Day 5) = 6. The average demand in those 5 days would be 5 items. Multiplying those 5 items by 5 days will give you a cycle stock of 25 items. However, what happens if on the 6th the customer orders 7 items? The answer is that you will incur a stockout and will not be able to supply the customer. This is what the safety stock protects against.
Balance inventory levels with customer service goals
The safety stock is based on a calculation that assesses the probability that the customer will order more than the average. Using the normal or Gaussian distribution, the inventory manager can evaluate safety stock requirements based on the level of service a company wants to achieve. So if the business wants to achieve a 99% service level, the inventory manager creates a calculation that captures 99% of the eventualities outside of the average average demand. If the company is targeting a 95% service level, then the inventory manager can incorporate 95% into the calculation and consequently the safety stock will be lower. Of course, this now provides the total inventory level (cycle stock + safety stock) that is required to meet customer service requirements.
Balancing inventory levels with working capital targets
By performing these calculations, the inventory manager will have succeeded in matching the inventory level with the customer service requirements. However, it is not just the supply that needs to be protected, but also the cash constraints of the business. It is useless to calculate inventory levels that perfectly meet customer demands, if the company does not have the working capital available to invest in that inventory. This is where the inventory manager needs to match the best possible service with the limitations of working capital availability.
To give an example of the relationship between working capital and inventory, consider a company that sells a product worth 10 million euros (at cost) each year. The total income received from the sales of this product amounts to 15 million euros. If the company bought the product worth 10 million euros at the beginning of the year, by the end of the year it would have obtained a gross profit of 5 million euros with an investment of 10 million euros. However, if the company buys 50% (EUR 5 million) of the product at the beginning of the year, sells it and then buys the next 50% (EUR 5 million) with the sales revenue, then the profit will remain the same, but only 5 million euros are required as a total investment.
This is what the inventory manager should consider: how to meet customer requirements, but minimize the amount of investment required in inventory. This can be a difficult task that is often further complicated by the standard measurements that companies use. Accountants often dictate the maximum inventory levels that can be held on “stock rotations”; This is an accounting term that does not provide any indication of the type and location of the required physical inventory. The inventory manager’s task is to match calculated inventory requirements with working capital constraints as well as customer service goals.
Balancing inventory levels with working capital limitations and customer service goals is a science, not an art. The inventory manager must deal with hard facts and hard data. There are no magic ways to protect your supply: If you have decoupling points in your supply chain, but insufficient capital to invest in inventory, you will not be able to serve your customer. The business needs to calculate precisely what service it can afford.
To do this, the inventory manager needs to determine the calculated inventory cost. This will include the purchase price of the inventory (or manufacturing cost), plus the costs of maintaining the inventory, i.e., warehousing, equipment, IT, personnel, deterioration, insurance, etc. With this complete, the inventory manager now has the tools to clearly present to the business the balance between inventory levels, customer service, and costs. With a simple sensitivity analysis, all stakeholders can be shown how, if customer service wants x% service, then it will cost EUR y in working capital. Or conversely, if finance wants EUR and working capital, then customer service will have to be x%.
By taking this approach, the inventory manager will present the company with facts to make decisions about, not “rules of thumb.” They will have successfully balanced inventory levels with working capital limitations and customer service goals. They will have achieved the balancing act of inventory.