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The Inventory Historical Puzzle: How to Balance Service and Inventory Levels

  Chaouki M. Eid | Deputy Managing Director

  28th January, 2015

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Effective inventory management is aimed at finding the optimum between the high availability of inventory items (driven by customer service objectives) and the tied capital in order to reduce expenses (a financial objective); definitely two conflicting objectives. As a result, “Supply Chain” professionals are under constant pressure to reduce inventory and there are many reasons why. We have all heard of dead, slow moving, duplicate and overly stocked items sitting in warehouses where the cash could have been utilized somewhere else in the company to deliver profit instead of incurring carrying cost. While I must say a lot of progress has been made on this, keep in mind though that if at any point in the process the maintenance or production departments are unable to meet their schedules due to lack of operational/maintenance parts or production material then all hell breaks loose. As such, “Supply Chain” professionals and more specifically “Inventory Control” in-charge are faced with this constant puzzle/dilemma: “How to maintain effective Customer Service with the lowest Inventory Levels possible”; easier said than done. Hence what can be done?

Before looking at solutions, we need to examine the following issues prior to taking any decision regarding when and how much to order:

  1. Limitation and availability of available storage space?
  2. Knowledge of the annual demand and in what pattern/cycle and is there an upward or downward trend?
  3. Is the inventory demand based on BOQ (Bill of Quantities) or a forecast? If a forecast, is it qualitative, quantitative or a mix? Moreover, are the employees in your company who are responsible for the forecast, accountable for their decisions? In many companies the answer is no.
  4. How accurate is the forecast and is the forecast accuracy being measured on a regular basis and shared with all the parties concerned?
  5. Is there a price discount breakdown (i.e. a discount based on volume brackets)? Many times purchasers accept larger volumes because of the discount only to keep that extra stock idle in the warehouse; a complete waste of our cash resources.
  6. What will the storage cost be while the material is in the warehouse? Different material will require different storage conditions. Also is the warehouse a company owned one, a rented one or are we using 3PL (3rd Party Logistics) and have we completed a financial evaluation to check which is the most suited for our company. None of the above options offer an ideal solution for the entire company inventory.  
  7. What is the purchasing cost incurred by each PO (Purchase Order)? Is this cost properly calculated or estimated?
  8. What is the LT (Lead Time) for the product? How accurate this Lead Time is and what mechanisms do we have in place to control the Lead Time for each SKU (Stock Keeping Unit).
  9. Where is the location of the supplier and how easy is it to ship from that location?
  10. What is the shelf-life for the product and what options do we have, if any, for expired items?
  11. How frequently can deliveries be made and are there quantity constraints (e.g.: minimum order quantity or packaging constraints).
  12. What demand and supply flexibilities do we have internally and are the deviations calculated scientifically or guessed?
  13. Are there potential threats that can disrupt our supply (e.g.: winter storms, fire or breakdown of production at the supplier’s location, transportation or customer clearance issues, etc) and how much risk can we accommodate? Is senior management in agreement with those risk factors?
  14. Last is the tricky question that no one can answer with 100% accuracy: what will be the future cost of the inventory item and will having more stock deliver financial gains due to increase of price of that specific item? Many times the answer to the above is based on a perception related to market trends.

Once we have had clear answers to the above, we need to scientifically calculate the ROP (Re-Order Point) for each Stock Keeping Unit (SKU) and strategize how to order. The ROP inventory replenishment technique considers forecasted demand over the replenishment lead time period, plus an allowance for safety stock. The ROP can be scientifically calculated depending on the situation. There are four distinct situations for calculating and setting the ROP, as follows:

  1. Constant Demand Rate, Constant Lead Time. 
  2. Variable Demand Rate, Constant Lead Time.
  3. Constant Demand Rate, Variable Lead Time.
  4. Variable Demand Rate, Variable Lead Time (the worst case scenario).
    Demand
Lead Time   Constant Variable
Constant (1) (2)
Variable (3) (4)

When the inventory level of an item goes down to a pre-specified minimum level (ROP), an “Economic Order Quantity” (EOQ) is ordered to replenish the system. This EOQ is intended to be a balanced quantity that optimizes both the purchasing cost and the carrying cost for the inventory hence keeping the total inventory cost to a minimum.

  • Smaller economic order quantities keep the inventory down, but generate higher shipping and purchasing stocking costs. 
  • Larger economic order quantities keep shipping and ordering stocking costs down, but increase cost of keeping items in stock known as carrying or holding.

The EOQ model finds the optimal order quantity keeping the above two constraints in mind. However, the EOQ model is not the best solution for all items. For very expensive items, the strategy could be to order the exact amount needed, while for cheap consumable items, buying in bulk makes more sense. On the other hand companies that employ a JIT (Just-In-Time) approach consider the EOQ as a waste since the purchased quantities ordered should only be the ones required for the next immediate schedule. Then you also have the blanket agreement option.

Each of the above strategies has its own pros and cons depending on the situation and unfortunately there is no one single solution that fits all scenarios. As such, it becomes imperative that the right strategy be used for the corresponding situation. Last but not least, the inventory specialists should be accountable for the two most important and conflicting inventory KPIs (Key Performance Indicators) which are:

  1. Customer satisfaction level
  2. Holding or carrying cost

Chaouki Eid, Deputy Managing Director, Meirc Training & Consulting. Chaouki is a subject matter expert on strategy, supply chain management, project management, maintenance planning and management.