Top 3 methods to lose millions optimizing inventories

5 minutes to read

Table of Contents:

• Introduction
• 1. Use Min/Max inventory ordering system
• 2. Use Fixed period reordering system
• 3. Use dynamic reorder points and safety stock based on forecasting models
• Try out a system that does inventory optimization right

Introduction

The author of this article interviewed over 500 businesses complaining regarding inventory shortages and excessive inventories at the same time. In their case, classic inventory replenishment strategies failed without a feasible reason. This is the first time we share our notes on what went wrong with classic inventory optimization approaches and we really hope you’ll find them boring because you never make these mistakes.

To make sure we are on the same page, please note that the article is directed to executive positions in supply chain planning or operations. The article explains how inventory planners apply classic strategies to manage inventories and fail to reduce shortages or excessive inventories without an obvious reason. Please don’t extend any faults onto your inventory planning and purchasing team prior to a detailed audit of the whole purchasing process.

Businesses managing thousands of products or components always struggle with a trade-off of inventory levels and service levels. You decrease inventory levels to reduce carrying costs but that pulls down product availability, and vice versa.

Inventory levels seem under control while a company has a guru of inventory replenishment with 30+ years in the company who foresees sales numbers and items that will be trending well and successfully uses the rule of thumb to produce order quantities. But sooner or later an external audit uncovers that inventory turnover and fill rate is so poor compared to other companies in the industry. So the company decides to implement a shiny new automated inventory replenishment system that uses a bunch of classic approaches proven to be industry standard.

And what a surprise would expect a good 60% of the businesses after they evaluate their inventories in 3-6 months from implementing the inventory replenishment and optimization system. They end up where they started in terms of inventory distortions, and the only good thing is that the system allows the planning team to chill out most of the time, but that’s not in every implementation case as well.

So, what should you do in a regular industry standard way to inevitably repeat that frustrating experience? Here’s a list of top 3 approaches:

1. Use Min/Max inventory ordering system

This is one of the basic inventory planning systems and it often is built in into your ERP out of the box. There’s a lot of information on how this strategy works – you can easily find many handbooks and articles explaining how to fine-tune the Min and Max levels.

Just one question left, when a replenishment alert arises for a product or material, would you execute the purchase the same day, or wait a couple of weeks to sync this product with all other products of this supplier in order to minimize transportation costs and meet the supplier’s minimum purchase requirements?

If you got the question, think about it for a while. But it’s a catch – neither works. Literally, you are choosing between a 2-week stockout and capital freezing for an unknown period. Practically, planners do that in all possible combinations – some purchase immediately increasing the transportation costs and creating an overstock, and others ignore the potential shortage while the next big order needs to be placed. In the latter case, the planner creates periodic shortages of different products in every PO to every supplier.

Some businesses understand the issue of Min/Max from start, and therefore, prefer to lose money in a more sophisticated way with approach #2.

2. Use Fixed period reordering system

Shortly, here we’ll have the 2-week stockout option from case #1 preselected.

Let me explain. The fixed period system triggers POs once per period such as a week or a month. And that seems especially reasonable for ordering overseas. But guess what happens to items that are selling faster than we expected. They are ignored until the next cycle, that’s unfortunate.

Oh, wait, there’s probably a solution to shortages. Some companies create safety stock worth 90 days of sales to make sure shortages never happen again. No matter that annual carrying costs will jump up by a few million dollars. Then this is an inventory deoptimization, or what would be a good definition for this?

3. Use dynamic reorder points and safety stock based on forecasting models

Just like traditional assumptions based on average sales, the forecast with all possible parameters accounted for doesn’t bring you closer than a 50-60% accuracy. That means 40-50% of the time you’ll rely on safety stock that again is a trade-off – when you decrease safety-stock, you get lost revenues, when you increase it, you get increased carrying costs and frozen capital. Same issue again – a company optimizes inventories and continues to lose millions a year.

Try out a system that does inventory optimization right

You probably wonder what can be done differently at all? Below is a spoiler.

Yes, there’s a method to do inventory optimization right, though you’ll need to spend a while to understand it. The method starts with considering variable purchase cycle times and variable purchasing quantities. The system with the method should be prepared to issue an order that meets purchasing constraints at any day if actual demand numbers suddenly make large gap from the plan. If the system works stable and doesn’t have any issues, you can operate with much lower inventory levels than your competitors, offer higher service levels to your customers, and grow much faster than your competitors.

Learn about a better method to stop losses in your supply chain.

Alex Koshulko, Ph.D.

Co-founder at GMDH Streamline,

leading supply chain planning expert with more than ten years of experience in demand forecasting, inventory planning, and optimization.

Connect with Alex on LinkedIn

Further Reading:

• How to deal with supply chain processes during the Coronavirus outbreak
• Why switch from Excel to inventory planning software
• Must-read: Smart Supply Chain Management solutions for business processes optimization
• Cross-Functional Alignment in Supply Chain Planning: A Case Study of Sales and Operations Planning [PDF]
• Demand & Supply Management: Collaborative Planning, Forecasting & Replenishment