Inventory Management | The Role for Inventory Management – balancing supply | demand | service
Inventory Management | The Role for Inventory Management
Inventory is absolutely one of the most useful tools for balancing supply and demand. Managed well, inventory helps you provide better service to your customers, but managed poorly, it can drain profits out of your business. So let’s look at the two different roles for inventory.
The first kind of inventory is cycle stock. Cycle stock helps you balance your expected supply with your expected demand. You could say it allows you to decouple supply and demand so that they can occur at different times and in different quantities.
For example, you can receive a big shipment on Monday and then, fill small orders on Tuesday and Wednesday and Thursday, or you can receive small shipments on Monday through Thursday so that you can fill a big order on Friday. That’s cycle stock inventory. But there’s another way to use inventory. You can treat it like an insurance policy against unexpected spikes in demand or to protect you from delays in inbound shipments. This is called safety stock inventory. You need to define rules for ordering inventory and these are called inventory policies, and you need to have different policies for different kinds of products.
A common method for setting different policies is called ABC inventory analysis. Basically, the items in category A sell fast. The ones in category B are slower, and so on. For each category, your cycle stock inventory policy will affect your average inventory level, If you receive shipments more often, you can order smaller amounts each time and that keeps your inventory levels low. But there’s a trade-off because having more frequent shipments could increase your ordering and transportation costs.
So placing fewer orders for larger quantities will increase your cycle stock inventory but it could save you money on replenishment cost. You can calculate an economic order quantity or EOQ to balance these costs.
Now, let’s talk about safety stock policies. The amount of safety stock you need depends on how predictable both your supply and your demand are. There are lots of different ways to calculate safety stock targets but most of them start by forcing you to set a customer service goal. Do you want to have enough inventory on hand to fill customer orders 90% of the time? How about 95%? You might think, “I want to make sure “I can fill orders 100% of the time”, but in order to do that, you’d actually need to have an infinite amount of inventory. That’s just not realistic.
So instead, you figure out what percentage of customer demand you need to meet with inventory and then have a backup plan for what you’ll do if you run out. Maybe you give your customers a rain check or expedited shipment or even substitute a different product. Both cycle stock and safety stock inventory are investments. We can estimate just how expensive our inventory is by calculating an inventory holding cost.
A good place to start is to base the stock holding cost on the interest rate your company is paying to borrow money. This is sometimes called the hurdle rate or the internal rate of return. The holding cost might also factor in a loss of value or depreciation that occurs as inventory ages. Other things can happen too. Inventory can get damaged, lost, or stolen. This is called shrinkage and inventory can expire or become obsolete. At which point, it loses all of its value. So all of these risks can factor in to your inventory holding cost. In reality, effective inventory management can make or break a business.
So whether you’re running a retail store, a distributor, a manufacturing plant, you need to make sure that you have just enough products on hand and no more than you need. That way, you’ll be able to use inventory to meet the needs of your customers, keep your supply chain moving, and generate a positive return for your shareholders.