Inventory Management in Supply Chains: Reducing Safety Stock with Planning Solutions
Introduction: Planning Inventory Is Needed
Inventory is a generic term describing the quantity of goods in stock. Inventory can describe raw materials, WIP (an acronym for Work In Progress), and finished goods.
Managing inventory is important across all phases of supply chain management, but is especially important in the planning phase. On one hand, holding too much inventory can tie up space and incur significant costs. On the other hand, running out of inventory can lead to catastrophic slowdowns across the supply chain, affecting many other downstream companies. (This was a major problem after the Japan earthquake.)
Thus, inventory must be held in proper quantities to satisfy the ever important law of supply and demand. Because the future is inherently uncertain (can’t know for sure how much customers need, or how much suppliers will be able to supply at any given point in time), inventory must be held to accomplish the following goals:
- Balance supply and demand
- Anticipation of demand (for hot items like the iPhone 5)
- Protect against uncertainty
- Reduce costs
- Stabilize manufacturing (reduce spikes)
- Protect against quality problems and defects
Types of Inventory Held
There are various types of inventory, and distinguishing between them is important because each serves a special purpose.
Cycle (replenishment) Stock Inventory
Cycle stock is the periodically replenished stock that keeps the supply chain moving. Milk is a great example of cycle stock – a small to medium sized grocery store will have a few hundred one-gallon containers of milk delivered on a regular basis, say twice a week.
An important calculation regarding cycle stock is known as the “average stock holding calculation.” The amount of stock will vary with time – it will obviously be highest right after the cyclical inventory is delivered, and lowest right before the next delivery. The formula for calculating the average stockholding is:
AS = Q/2 (AS = average stockholding, Q = order quantity)
Calculating the average stockholding is important for other calculations: for example, the average cycle stock investment. Since cycle stock must be replenished frequently, it is important for supply chain managers to know how much of the company’s business capital is tied up in these rolling inventory purchases. The average cycle investment is quite easy to calculate:
ACSI = AS x unit price
In the example of gallons of milk, if the AS (average stockholding) was 500 gallons, and the cost of a gallon of milk was $1.50, then the average cycle investment would be $750.
For small businesses especially, large average cycle investments might be difficult. Imagine a furniture warehouse that sells sofas and obtains these sofas at a cost of $500. They expect to sell through 3,000 sofas in the year. If their “cycle” is once per year, their ACSI would be 3,000 x 500 = $150,000 – a large amount for a small business! It might be better to order once per month, or once per quarter, so less capital is tied up in inventory.
Safety Stock Inventory
Cycle stock accounts for regular inventory turnover, but it doesn’t cover late deliveries or other such mishaps. It’s good practice to keep a little extra inventory on hand, to prevent loss of business or sales in the event of adverse circumstances.
Safety stock comprises two components: safety stock supply, to protect against unforeseeable delays on the supplier side, and safety stock demand, to fulfill unforeseeable changes in demand.
Calculating the first component is straightforward. The safety stock supply is obtained by multiplying the average demand by the supplier uncertainty. So if 100 gallons of milk are sold by a grocery store in a day, and the supplier may be up to three days late, the safety stock supply would be 300 gallons.
The second component (demand) is more difficult to calculate. We must take into account the service level (the percentage of customer requests we want to be able to satisfy) and convert it to a service level factor. We must also calculate the forecast error by calculating the standard deviation of the product demand function. Luckily, statisticians have created tables based on the normal distribution, so you can refer to a table instead of doing the complex calculation for the service level factor every time.
The formula for calculating safety stock demand is then as follows:
Forecast error X service level factor X (the square root of (lead time + supplier uncertainty))
The result derived from this equation is then added to the necessary inventory for safety stock supply to calculate the total safety stock.
In Transit Stock Inventory
The last few types of inventory are relatively straightforward and, for the purpose of this discussion, don’t have any associated mathematical equations.
In transit stock is defined as the inventory that is currently being transported (for example, on a truck or train).
Seasonal Stock Inventory
Seasonal stock refers to stock built up to meet seasonal demand (for example, ice cream in summer).
Speculative Stock Inventory
Speculative stock is held for special circumstances like price increases and catastrophes (like the Japan earthquake).
Promotional Stock Inventory
Promotional stock is special inventory used for marketing efforts.
Obsolete Stock Inventory
Obsolete inventory is made up of products that are obsolete – that is, they cannot be sold or they are broken.
Reducing Inventory: Planning and Other Methods
For many reasons, a reduction of inventory may be beneficial for a business. There are two primary stocks to target: cycle stock and safety stock.
As discussed previously, cycle stock can be decreased by placing smaller, more frequent orders. Safety stock can be reduced by targeting any one of the four areas in the equation: lead time, supplier uncertainty, service level, or forecast error.
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