Published February 16, 2017
Everybody is searching for ways to reduce expenses, which drain valuable cash flow from the business. The challenge is how you do this while maintaining a high level of service and revenue optimization. Cutting out inventory seems like an easy thing to do, but you do not want to upset the sales team.
Inventory optimization is a journey, not a task. In setting out on this path, you should start out at a very high level and work your way into the details. If you dig into the details and all of the techniques available, you will quickly become overwhelmed and lose sight of the mission. In this discussion, we will start at a high level and work into the mechanics.
If you can firmly grasp the fundamentals, the details will become very easy. Most people skip over the grounding process, and as a result become quickly discouraged. Do not fall into this trap, or rely on a packaged solution to solve your problems. By understanding the principles, one can understand the unique components of the business and how to apply them appropriately for that business.
High Level Perspective
At its core, warehouse inventory is a strategic capital use of funds to ensure a business can meet the needs of its customers and the orders they place. Businesses are willing to make this investment to cover the demand until the next order is received. Understanding the fundamental components of how the level should be computed will help define what products to invest in and what your customer’s value.
Very simply, the inventory (DC or Store) is computed:
Inventory Level = Average Daily Demand * Average Product Lead Time
In this simplest form of the calculation you are using the averages of demand and lead time. By the nature of its definition, you are planning to miss the demand for half of your customers. Further, you are planning to allow product gaps for half of your supply orders.
While this would provide a relative value for planning purposes, it fails to recognize the real life variations in performance that your sales lead or CEO will hold over you for not planning enough inventory to protect sales opportunities. Using this approach will leave to excessive expediting costs and a tough culture between the supply chain and the sales team around customer complaints and loss of business to your competitors.
“The devil is in the details.”
Gustave Flaubert
The old adage is the devil is in the details, for inventory planning this could not be truer. Because life can impact us in so many places related to customer demand, delays in transportation reaching its destination, and manufacturing downtime and/or delays; spending some time understanding the predictiveness of each component will go a long way, ensuring you are prepared to deal with whatever life brings you.
Part I will discuss the demand side of this conversation. We will help you understand the processes to define what you need to predict and the factors you will need to consider. Part II will address the vendor/supply side of this computation.
Demand Impacts
In our simplified equation, we defined demand as a key component. Let’s take a moment to dive into this to understand the complexities. As before, we will start this discussion at a very high level and work our way into the details. The impacts of demand (e.g. orders, sales, etc.) are the easiest to get your head around.
- Historical Sales/Orders
As a firm base for our journey, most folks will pull their historical orders/sales and define the average daily consumption. This seems like a great place to start because I know what I have actually experienced. If you really want to make this base level analysis complete, however, one should look at several years of history to ensure they have a true view of their business.
By looking at multiple years, you begin to normalize for yearly unique occurrences (e.g. weather anomalies, unexplained demand blips, etc.) to get a firm understanding of the true appetite. This analysis is working to understand the average daily consumption that will be so critical in being applied to the lead time. Do not simply rush past this stage, because it provides valuable information about a products “normal” business behavior.
At what level (e.g. Total Company, Business Segment, Product Category, Item, etc.) should you plan? Unfortunately, you will glean insight at each of these levels. Let’s take a minute to briefly discuss the value of planning at each level:
- Planning Levels
- Company
This will help understand competitive pressures and overall company trends. It sets that stage for a strategic conversation around business line priorities and strategic focus. This will be critical for inventory planning because it will help you adjust your inventory investment in profit drivers and/or strategic requirements.
- Business Segment
As we begin to peel the business layers back, the next natural place to look is at the various business segments you support and their value to the overall business strategy. This cascaded view will ensure your inventory policy aligns with the business priorities and the sales focus.
- Product Category
Once the segment review is complete, the sales team will begin to review the competitive landscape and start to define the specific products and the collective categories that will help position them uniquely in the marketplace. This will be driven by a strategic review of the current products offered, the margin they deliver, and an assessment of the products the business should carry to optimize the opportunity.
This is the time for the inventory planning team to weigh in and provide insight into vendor performance and current issues. The supply chain may be called in at this time to help find products that can deliver the required margin, given the strategic business positioning guidelines. The inventory team will support this by helping to find vendors that can deliver with short lead times and predictable performance. Both of these factors will reduce the overall inventory investment.
- Item
Inventory is bought and sold at the item level. As a result, detailed plans will be constructed that look at individual part demand requirements and any business imposed minimums and maximums that may impact how goods are consumed. It is important to understand the individualized inventory plans that will roll-up to a topside view of need.
As you can see, the analysis of demand which started out as a simple conversation quickly ballooned to a rather complex process.
As you work through the above process, there are techniques that you will need to apply to ferret out influences that may not be transparent to the native eye. Statistical modeling is introduced to help in this process. Do not glaze over; we will break this down quickly.
When talking with someone on the topic I use the words “Statistical Methodology”. I quickly see the conversation turn and interest is lost. The discussion of these topics and approaches can be simple.
- Company
- Planning Levels
- Factors Impacting Demand
If you keep the discussion at a very high level, there are a handful of concepts that impact a forecast. In this discussion, we help you get your head around those factors and understand how they impact inventory planning. This should help you understand the routines that your forecasting “black box” is doing when generating a forecast.
- Seasonality
Everybody loves time off of work to celebrate. Each year we stop our hectic work lives to celebrate New Year’s, Independence Day, Thanksgiving, and many other generally celebrated occasions. As we do these things, businesses react in recognizing that plants will shut down, trucks will stop moving, and the general course of “normal” business will be altered.
This “altering” of normalcy ripples through the order flow and quantities are altered. This normal behavior which occurs every year will become the new norm for a business. During the quest to understand the seasonality, we deploy mathematics to help clearly define trends. The different statistical algorithms approach understands this underlying behavior using different principles.
Why this is so important is because it helps you adjust your view of average demand during each week to its appropriate level to define the true need.
- Trend
This is best understood as a subtle movement of the business. Because it is slow in materializing, many processes fail to find trends early enough so they can respond appropriately. If you are always chasing stock-outs no matter how much inventory you are buying, this is usually caused by a trend that you have not recognized.
Often, you can recognize this if you step back from the day to day business and look at a time series of performance. Simply draw a straight line through your data points which provides for equal occurrences above and below the line. This will be your trend line.
- Variability
Everyone seems to know of this term, but they seem to misapply it. The Webster’s New World Dictionary defines it as, “The extent to which data points in a statistical distribution or data set diverge from the average, or mean, value as well as the extent to which these data points differ from each other”. Simply stated, it is a mathematical way of determining how closely the average actually defines the true performance.
As a metric what does it mean? Very simply, the higher the variability, the less accurate the average (mean) is at defining the actual behavior. This is important because most people complete their analysis based on an average. By doing so, they are unknowingly planning to miss half of the real world performance.
- Service Level
This is probably the hardest concept for most people to understand. It is probably easiest to explain using a customer complaint application. If you have 100 customers you will sell to this holiday, how many of these customers do you want to come back to your store with a compliant?
I think it is easy to say you do not want half of them. Using the average demand plans for half of them to come back. If you only want one, you will be planning for a 99% service level. This is an important definition because it has a high impact on the level of inventory you are planning.
Most analysis starts with 0% complaints, and works its way back to a realistic number that they are comfortable investing in. Understanding where you will land will be a business journey. You will begin to educate the business on the impact of reducing complaints and the cost (in inventory) to accomplish this.
You will quickly recognize that you cannot afford to treat each item equally.
- Inventory Prioritization
Many times, the business will reduce this into a strategy that is exemplified as ABC analysis. Using this principle, you will establish the “always in-stock items” (“A” Stock) that the business will invest in. These are a critical investment that the business will do whatever it takes to keep in-stock.
“B” Stock items are typically “A” item compliments and needed to ensure we are in business. Customer may accept a greater level of out of stock of these parts and/or transition to another part as a replacement if the actual part requested is out-of-stock. They are critical for the business in demonstrating to the customer that you are in the business, but are not as critical as the “B” items.
“C” items are slow movers and/or the customer accepts you may need to order these. You will most likely order these less frequently and manage them with a lower level of precision. Most times, because these are lower demand goods the inventory buy is based on a minimum buy amount.
- Inventory Prioritization
What are the formalized processes to use these factors? Statistical techniques consume this information and have developed repeatable processes to assess their ability to predict behavior. They put all of these together into a single number that you can use when planning inventory.
We will not go into the detailed statistical methods because you will really glaze over. Suffice it to say that there are data analysis approaches that take into account sporadic demand, timed demand, and variable demand. Smarter minds than ours have reduced the science to routines we can run today to ferret out the true behavior and predict it.
- Seasonality
- What to Forecast?
Sounds like a simple question and I am sure you will have a simple answer. But you need to take a breath and really think about this question. While the initial response may be sales, the question you have to ask yourself is where are you in the supply chain and what is it you are trying to plan?
- Store
At the store level, you are on the front line of responding to customer demands. At this place in the supply chain, you care about daily demand and the variability realized. Your lead time may be 3-5 days from a vendor/warehouse. As a result, you should look at the demand in a period that is close to your lead time.
You will need to marry up true demand to a replenishment plan that may be placed on the warehouse. Many times, stores have a shelf minimum and maximum that may mute the true demand into another ordered amount. As a result, a business should look at the store requirements and model the impact of raising/lowering these levels on the inventory required.
I have seen many times in my career where inventory has been driven by a required store replenishment, whichis not supported by the demand. By adding value in your ability to predict demand, you will add value in the store planning processes. Do not fear working your way downstream and helping the business understand the impact of their requirements on the inventory required.
- Warehouse/DC
The warehouse is a bulk deconsolidation point for store/customer orders. As a result, you are the interface to the factory or supplier on the flow of parts. The vendor/factory/plant may require minimums based on carton quantities and/or efficient production line requirements. You may need to take your demand and apply these “rules” to understand the order levels that may be placed and their impact on capacity/space.
The concept of Economic Order Quantity (EOQ) could be introduced here to balance the cost at various increments of ordering and the reduction in costs to create and manage orders. It is a business process way of balancing costs.
- Factory
A factory has a lot of expense in adjusting production lines to accommodate different manufacturing processes. Their goal is to set up a production run and then produce all they need to for a period of time. They lose money by having a lot of line changes, which is down time to them without any revenue to offset.
Understanding your vendor costs will help you partner with them to order inventory to optimize both parties costs.
- Store
Conclusion
In this first discussion, we covered the impacts of understanding demand on the calculation of inventory planning. What started out as a simple question, quickly deployed into math and science to determine what we really needed. It led us to question what we need to put the science against based on where we were in the supply chain.
In the end, inventory planning quickly reduces itself into a review of the corporate strategy and those items/products that are most important to the business. It is not a process that can occur in isolation. If done properly, you will raise a lot of piercing questions that will require the business to think about their investments not only in inventory, but also in the business. You will cause the business to have clarity on their strategic positioning and require they have a vision of where they are going.
“You may not be interested in strategy, but strategy is interested in you.”
Leon Trotsky
Do not allow the approach to be relegated to the backroom. Be the initiator of these strategic discussions. As with most processes, supply chain is the visualization of the corporate strategy. Do you have one?
