January 2007 | Commentary | IT Matters

8 Common-Sense Rules for Inventory Management

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Inventory management is a hot topic. Books about the subject abound and there are many detailed techniques and practices, which vary by industry.

When looking at the big picture, however, you can reduce much of the philosophizing about inventory management to the following eight common-sense principles.

1. If you don' t know where you are going, no road will take you there. Enterprise resource management systems are designed to tell you about today' s inventory. With some work, you can also access information about past inventory. To manage inventory proactively, however, you must know projected inventory levels for the future.

Projecting inventory levels means combining anticipated and open orders with planned shipments, production, and bills of materials to determine projected supply and demand. You also need to calculate appropriate safety- stock levels for each location and each product based on forecast error, supply variability, restock lead times, quantity increments, and a number of other less tangible variables.

The ability to take these factors into account when planning your target inventories is critical to effective inventory management.

2. Make what you can sell. An integrated Sales and Operations Plan will naturally take into account expected demand in its production plan. Inventory is not an independent variable - it is the direct result of demand and supply. The less accurate the forecast, the more inventory you'll have on hand which is not "working" capital but "non-working" capital - costing you money but not contributing to the bottom line. Careful attention to improving the forecast and to ensuring that production follows the S&OP plan are critical to ensuring that the right inventory is on-hand in the right place at the right time.

3. Sell what you can make. Too often, a disconnect exists between sales and marketing desires and the reality of production capabilities.

What if, for example, the sales team promotes—and successfully creates demand for—a product with such stringent production specifications that your plant can successfully produce it less than 50 percent of the time?

The result is an enormous amount of off-spec, probably worthless material as well as wasted production time. It is imperative that new products are not developed in a vacuum, but rather through a collaborative effort between sales and production employees. This is all part of a well-run S&OP process.

4. If you can' t sell it, stop making it. If demand for your product does not materialize, you need to identify that gap quickly to avoid a buildup of non-moving inventory. Numerous mechanisms can be put in place to identify such trends.

An effective S&OP process must include the ability to identify these deviations and allow for re-planning, before you build with a bulldozer an inventory mountain you will have to dismantle with a teaspoon.

5. If you can' t stop making it, get out there and sell it. Another category of "can' t sell" inventory exists in the transition material or unavoidable by-products and co-products of goods that you do need. Properly managing this inventory is a tougher nut to crack.

Technical teams must continually strive to reduce such material. At the same time, the sales department should try to develop a market for it. Successfully finding an outlet for unavoidable materials can make a big difference to your bottom line and your level of "non-working" capital.

6. Safety stock is not a paperweight.Business leaders sometimes ask, "What level of inventory should we never fall below?" The answer is zero. Safety stocks are only useful if they are used. The whole point of safety stock is to protect against expected variations in demand and supply. If you never use your safety stock, you have too much.

On average, you should be below the safety-stock level half the time when replenishment is available, and above it the other half. If this is not the case, you need to re-examine what products you keep in each location to get the most from your inventory dollar.

7. Worthless inventory does not improve with age. Why do businesses retain inventory they know won't sell? Often, they have an unrealistic hope that they can find a way to sell off-spec material. As a result, these products become "just-in-case" inventory.

More often, companies hold on to worthless inventory for financial reasons: until inventory is written off, it is carried on the books as an asset. Downgrading the material results in a hit to earnings, which those responsible for earnings wish to postpone as long as possible.

Executives responsible for inventory, however, recognize that disposing of non-saleable material promptly leaves more warehouse space and working capital for inventory you need and can sell. Once again, you should make these decisions at the S&OP level for the good of the whole company, not individual departments.

8. You can' t improve what you can' t measure. Metrics are essential to a well-run supply chain. Metrics for their own sake, however, are worthless. The purpose of a metric is to drive change when the variable you are measuring trends in the wrong direction.

A number of different metrics are useful for inventory management. Days supply by product and location based upon forecast is an excellent metric at the SKU level.

When analyzing roll-up numbers for a product line, warehouse, or any other higher level, however, days supply is misleading because the lows cancel the highs and hide imbalances. At the higher level, inventory velocity is a much better measure of inventory health.

No metric is useful, however, unless it is acted upon. Constant vigilance and early response to imbalances are the keys to ensuring best-practice inventory management.

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