A core competency of any inventory planning system is inventory optimization and strategy. Despite inventory optimization being the primary influence to your return on investment of the system, most planners do not proactively manage their inventory strategies. Consider that your inventory planning software is a complex mathematical engine designed to manage the errors throughout your supply chain, managing your inventory optimization and strategy is essential to understanding what that error is costing you, in both dollars and service. Nevertheless, inventory planning is still overlooked as a value added task and process which planners should add to their workflow schedule.
What is Inventory Optimization and Strategy
Everyone knows how important inventory is to distributors and retailers – no inventory, no sales. Inventory optimization and strategy is a set of rules you apply to your items that will minimize the amount of inventory you need to provide the customer service you want and can afford.
Every company would like to fulfill all customer orders all the time but the cost to do so is too high based on the inventory investment required, especially for low volume, highly volatile items. Inventory optimization balances the cost of inventory against desired service levels to maximize your profit. Your inventory plan and strategy addresses how you apply and manage that balance across your stocked items. The two most important drivers of your inventory optimization and strategy is your cycle stock optimization and your safety stock optimization.
What is Cycle Stock Optimization
Cycle stock optimization is how you set your item-level ordering quantities based on the costs of holding your forecasted inventory versus the transaction costs of ordering and receiving it. The economic ordering quantity formula is a well-known model of cycle stock strategy that considers some of these cost trade-offs. Your cycle stock represents half of your ordering quantity. Cycle stock, however, is often driven by minimums and multiples like case pack quantities. Cycle stock optimization considers forecast, numerous carrying and ordering costs and any line-item ordering constraints. Generally, your cycle stock strategy makes up most of the inventory you have stocked which is why it is important to manage in your inventory optimization and strategy policies. By planning and optimizing your cycle stock, you can achieve significant service levels without holding any safety stock.
Safety Stock Optimization
Where cycle cost optimization is mostly cost driven, safety stock optimization is service driven. Optimizing your safety stock strategy is generally perceived as inventory optimization despite it being the smaller aspect of the two key components. Key factors considered in safety stock optimization are your service level targets, your forecast, how wrong your forecast might be, your lead time and how wrong your lead time might be. Lastly, a key consideration in safety stock optimization is the amount of service your cycle stock will provide with no safety stock.
Traditional safety stock methods such as a fixed safety stock, days of supply or forecast, or even simpler service-level methods do not consider all these factors. Safety stock strategies should, however, vary across all your items as there is never one answer for all items. Stratifying your safety stock policies by ABC classification is a great way to approach your inventory optimization and strategy.
Every stocked item will be subject to your inventory optimization and strategy such that you can map your “sawtooth” diagram to understand your past, current, and future investment. By applying cycle stock optimization and safety stock optimization you will optimize your inventory investment while achieving desired services levels. After all, your inventory investment for a single item or for all items is simply your safety stock plus your cycle stock – an easy way to forecast your future inventory investment.
YES!!! Lead time might be one of the most important and influential inputs to your planning software. It still amazes me how often companies will use stated lead times and not validate or calculate the true/actual lead time. Poor lead times will impact and degrade your forecasting, safety and cycle stock calculation, and order plan.
How does lead time impact your forecasting? Perhaps the most overlooked consequence, best of breed software solutions will calculate and use lead-time forecast error. The lead-time forecast error will influence which forecast model is selected in traditional statistical forecasting engines. If your lead time is not accurate, your forecast engine may not be selecting the best forecast model in its simulation or tournament of best fit since the forecast error over lead time may be unreliable. After all, planners should be most concerned with the lead-time forecast when reviewing monthly or weekly forecasts.
How does lead time impact your safety and cycle stock calculation? There are numerous ways to calculate safety and/or cycle stock. When optimizing your safety stock based on a service level objective, not only is the forecast and forecast error considered, but so is lead time and lead-time error. The longer the lead time and the larger the lead time variance, the more safety stock you need, and vice versa. If you are trying to minimize your total annual costs by using the economic order quantity (EOQ) to define your cycle stock (1/2 EOQ), the EOQ is directly proportional to the forecast, which as described above, could be unreliable as the forecast selection is dependent upon the forecast error over lead time.
How does lead time impact your order plan? This may be the most obvious system calculation impacted by poor lead times. And, generally it is the order plan that planners will focus on when validating the accuracy of the supplier stated lead time . Having inaccurate lead times could either generate orders too earlier or not early enough resulting in over stock and under stock situations, respectively.
Having a system calculate and manage (1.) lead time along with (2.) an estimate of how wrong your lead time may be is critical to optimizing all functions of your planning software.
This will be the first of several blog postings of InventorySux - a theme many planners are familiar with. If you have too much, you are over ordering. If you have too little, you are not ordering enough. In other words, "you're damned if you do and damned if you don't".
There is very little room for a planner to make mistakes. A real simple rule of thumb to help planners is to break their items into one of the three inventory states: overstocked, under stocked, or balanced. Planners should try to maintain 60-80% of their inventory in the balanced state, whilst the balance should contribute toward the under stocked and overstocked state.
Maintaining and reporting inventory in these states is a great first step to creating an actionable, drill-down dashboard. Workflow and focus should be on those items contributing most to the overstock and under stock states, thereby improving your productivity and balancing the inventory for the items you manage.
Unfortunately for planners, management typically looks and tracks inventory at the level of responsibility a planner is responsible for, which is then compared to corporate-wide top-down financials. And, by the law of large numbers the overstocked items end up balancing the under stocked when looking at the inventory from a top-down perspective. The true breakdown of inventory by state is lost, along with your true performance. However, by proactively breaking your items into their respective states and working the outliers, the overall result on inventory will still reflect upon you positively.
In our next segment of InventorySux, we will discuss correct inventory reporting.