Tuesday, June 5, 2012

Level Of Inventory

All too often inventory is treated by 'rules of thumb' that do not provide sufficient justification for inventory levels, do not ensure working capital is minimized, and don't have a clear correlation between inventory level and customer service. Many businesses talk of 'days' or 'weeks' supply - but what does that really mean in a supply chain where demand quantities, supply quantities and supply lead times all vary day to day or week to week?

Do we really need inventory?

Inventory ties up working capital, costs money to store, costs money to handle, and can become damaged or obsolete. With the exception of work in progress, in an ideal world there would be no inventory in a business. Material would flow through the supply chain with no stops or bottlenecks, and the inbound supply rates would be synchronous with the outbound supply rates. A perfect world, but not the one many businesses operate within.

The reality is that for most businesses to remain in business, they need to protect their supply. If they can't supply when the customer wants, in the quantity they require, then the customer will go elsewhere. So, how do you protect your supply? You could follow the Japanese and adopt the Kaizen approach - simplifying and synchronising each step in your supply chain. That's great for an internal production process, but in a real world supply chain it is unlikely your suppliers and customers will be inclined to synchronize their processes to fit with yours. Consequently the answer is that to protect supply, you need to hold inventory.

Where should inventory be held?

Now we've established that inventory is a necessary, and indeed a critical element in many supply chains, the question becomes where should inventory be held? To determine the location of inventory in a business, you firstly need to establish the points in your supply chain where continuity of supply needs to be protected. There are various events in a supply chain that require inventory in order to protect supply - often referred to as 'decoupling points'. A decoupling point is where the inbound and outbound rates do not match. These are most likely to occur between raw material supply and manufacturing process, and between manufacturing process and finished goods supply. There are increasingly few businesses that have the luxury of customers requesting finished goods at exactly the same rate as the raw materials are supplied and processed.

How much inventory should be held?

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 down. Inventory levels are often driven through the sub-optimization of other processes (i.e. optimal production batch quantities) or driven by rules of thumb (i.e. '4 weeks supply'). The consequence of this is often lots of stock, but it's just the wrong type and in the wrong quantity. Consequently you continue to get customer service failures, the stock you do have doesn't get used, and can ultimately become obsolete.

There are two types of inventory that protect supply - cycle stock and safety stock. Of course, there are other types of inventory like goods in transit, work in progress, obsolete etc, but these are all a consequence of an activity and not specifically held to protect supply.

Cycle stock is the level of inventory held to ensure that the mean average customer demand can be met during the replenishment lead time. So, if it takes 5 days to receive a replenishment, then you must ensure there is sufficient inventory to cover 5 days of average customer demand. Providing a business has accurate historical or forecast data for each product, then this element of inventory is relatively easy to calculate.

Safety stock is conceptually more difficult. Safety stock is in addition to the cycle stock, but the safety stock level is designed to cover the potential for customer demand peaking above average. For example, if it took 5 days to replenish your inventory, and your expected customer demand in units over that 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 day 6 the customer orders 7 items? The answer is that you will incur a stock-out, and fail to supply the customer. This is what safety stock protects against.

Balancing inventory levels with customer service targets

Safety stock is based on a calculation that assesses the probability of the customer ordering more than the average. Using normal, or Gaussian distribution, the inventory manager can assess the safety stock requirement based on the service level a business wants to achieve. So, if the business wants to achieve a 99% service level, then the inventory manager builds a calculation that captures 99% of eventualities outside of the mean average demand. If the business targets a 95% service level, then the inventory manager can build 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 the customer service requirements.

Balancing inventory levels with working capital targets

By making these calculations, the inventory manager will have successfully bridged the inventory level with the customer service requirements. However, it is not just the supply that has to be protected, but also the cash constraints of the business. It is of no value to calculate inventory levels that perfectly meet the demands of the customer, if the business does not have the working capital available to invest in that inventory. This is where the inventory manager needs to bridge the best possible service with the constraints of working capital availability.

To give an example of the relationship between working capital and inventory, consider a business that sells EUR 10m worth of a product (at cost) each year. The total revenue received from sales of that product is EUR 15m. If the business buys all EUR 10m worth of the product at the start of the year, by the end of the year it would have made a EUR 5m gross profit on an investment of EUR 10m. However, if the business buys 50% (EUR 5m) of the product at the start of the year, sells it and then buys the next 50% (EUR 5m) with the sales revenue, then the profit will remain the same, but only EUR 5m is required as a total investment.

This is what the inventory manager has to consider - how to meet customer requirements, but minimize the amount of investment required in inventory. This can be a difficult task which is often further complicated by standard measurements that businesses use. Accountants often dictate the maximum levels of inventory that can be held in 'stock-turns'; this is an accounting term that provides no indication to the type and location of physical inventory required. It is the task of the inventory manager to bridge the calculated inventory requirements with working capital constraints, as well as the customer service targets.

Balancing inventory levels with working capital constraints and customer service targets is a science, not an art. The inventory manager needs to deal with hard facts and hard data. There are no magic methods of protecting supply - if you have decoupling points in your supply chain, but insufficient capital to invest in inventory then you will fail to service your customer. The business needs to calculate accurately what service it can afford.

To do this the inventory manager needs to ascertain the cost of the inventory calculated. This will include the purchase price of the inventory (or manufacturing cost), plus the inventory holding costs i.e. warehousing, equipment, IT, staff, 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 simple sensitivity analysis all stake-holders can be shown how, if customer service want x% service, then it will cost EUR y in working capital. Or conversely, if finance want EUR y working capital, then customer service will have to be x%.

By undertaking this approach the inventory manager will be presenting the business with facts on which to make decisions, not 'rules of thumb'. They will have successfully balanced inventory levels with working capital constraints, and customer service targets. They will have achieved the inventory balancing act.

Gideon Hillman FCILT FCMI has over 20 years European Supply Chain, Logistics and Materials Handling industry experience, having been employed at a Senior Management Level throughout Europe with both manufacturers and Global 3rd Party Logistics Providers for over 12 years, prior to establishing Gideon Hillman Consulting in 2004.

His areas of expertise and experience are in Logistics Outsourcing and Tender Management, Logistics Network Development, Commercial and Business Development, Operational and Commercial due diligence, Supply Chain Solution Design, Improvement and Implementation throughout Europe for major manufacturers and household brand names in the Automotive, Aerospace, Food Production and Processing, Grocery and Non-Grocery Retail, Home Delivery Networks, Utilities and General Industrial and Manufacturing sectors.

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