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If a company does these five things, it will satisfy its customers and become extremely
profitable. Although this inventory objective sounds simple, hard and often painful
experience tells us that it is not. A forecast of the customer’s demands is based on past
history, but if a customer places an item on promotion the supplier may not have the
right quantity. Most of the required product is in the Texas warehouse, and suddenly
the demand is heavy in Boston. A company stocks up on a new product that Marketing
knows will be a hit, and it turns out to be a dud. Or worse, a new product is suspected
of being a dud so very little is stocked, and it turns out to be a hit, leaving Marketing and
the customers mad.
The days are long gone when customers would accept shipments from suppliers that
were 70 percent complete on a routine basis. Many companies will cease doing
business with a supplier that cannot maintain a service level of at least 98 percent. Of
course, a supplier without customers will quickly go out of business. Therefore, if a
company experiences fulfillment problems, the solution demanded by the Sales
Department and the corner office is usually “bring in more inventory and get rid of these
stock outs or else!”
By simply adding safety stock in hopes of ensuring enough inventory the next time, the
core problem is not addressed. After all, according to the computer records, there was
enough stock to complete the order. The real problem in this situation is that the
inventory on the shelf did not match the inventory figures in the computer. Will
increasing safety stock solve this problem? No, quite often it is aggravated because
now there is more inventory to track.
Overall inventory accuracy depends upon conducting each process flawlessly, including
Receiving, Putaway, Picking, Shipping, and Invoicing. Some things that help improve
inventory accuracy are:
However, there is another way to look at inventory that is doing nothing more than
taking up space. First of all, it is taking up valuable space! As discussed earlier,
inventory carrying costs are not free, they average 20—36 percent per year. If the
company has a 36 percent carrying cost, in three years the inventory will have been
paid for twice — once when purchased with cold, hard cash, and a second time through
the costs associated with carrying inventory.
If we decide to get rid of the inventory, we can get some benefit from it. Many closeout
companies will pay between $0.10 and $0.40 on the dollar for the inventory. This may
not sound like much, but it is better than nothing. In addition, any inventory that is
disposed of for less than cost can be written off against the company’s taxes.
A manager who has ample time to monitor each SKU daily, strategize the optimal
ordering and stocking of each of those SKUs is a rare breed in an ideal situation. Those
who manage inventory in the real world have to decide what to do—and what not to do.
One of the most powerful—yet simple—decision-making tools in the arsenal of the
inventory manager is the use of ABC stratification in setting priorities regarding
inventory ordering and stocking decisions.
The concept behind ABC stratification is that some items are more important than
others, and therefore deserve more managerial attention. If one is in charge of office
products, and the range of products extends from computers to paperclips, does it make
sense to pay as much attention to how many computers are in stock as it does
paperclips? Common sense says, “of course not, computers are so expensive, they
demand more attention.” Does this mean a department can afford to run out of
paperclips on a routine basis? No, that also is not one of the options. So how does one
set these priorities?
This is where ABC stratification emerges as an important option. There are a couple of
steps that must be taken in order to prepare for using ABC stratification. First, an ABC
analysis spreadsheet is needed. To do this the cost of each item is multiplied by its
annual unit sales to get an annualized cost of sales, and then each item is ranked in
descending order by this amount. In most companies, the top 20 percent of items are
Once sorted into the appropriate ABC classifications, it is time to apply the principle of
prioritization. In many companies, the same relative amount of inventory is maintained
for all items. For example, a company will set the inventory level for all items to equal
two-month’s sales. A company switching to the ABC approach sets inventory levels
differently. Realizing that the fast moving “A” items make up a much larger portion of
sales and are probably always on order, the company tries to maintain relatively less
inventory. Instead of eight-weeks of inventory, the company maintains a four-week
level. The company compensates for the lowered inventory level by paying more
attention to the “A” items to make sure they do not run out. Although the relative
amount of inventory is lower, the absolute value of the “A” inventory is higher than either
“B” or “C” items, because the sales level of “A” items is so much higher. The “B” items
would maintain the inventory level of eight weeks. In order to concentrate our attention
on the fast moving “A” items, we increase the inventory level of our “C” items to double
its previous level. Because this represents so many items—50 percent of our total—it
frees up a lot of review and monitoring time. However, because the sales volume these
items are based on—only 5 percent of sales—doubling the amount while cutting the
amount of “A” items in half will still allow for a significant inventory reduction.
As you can see from the example above, a company implementing the ABC strategy
will carry 33 percent less inventory than a company that maintains the same inventory
level for all items. That is not only a significant inventory reduction, but also normally
leads to an increase in customer service level.
Both have sales of 600 units over a six-month period for an average of 100 per month.
All similarity stops there. Item A-45 has a very steady sales pattern, varying from its
average of 100 monthly units by five or less during any month. Keeping one months
worth of safety stock, or one hundred extra units on hand for this item is surely a waste
of inventory. However, the same safety stock level for item B-14 would not be enough
to cover the two peak months of March and May.
There is another method of calculating safety stock, based on the variation in demand.
This method assumes that an item exhibits “normal” demand characteristics, including
consistent demand. In order to employ this method of setting safety stock, we must first
determine the Mean Absolute Deviation (MAD). 2 To determine this, we must find the
total absolute deviation from the mean and divide it by the number of months. Let us
determine the MAD for each item above.
Total Total
Absolute Absolute
MAD= Deviation = 16 = 2.67 MAD= Deviation = 646 = 107
Number of 6 Number of 6
Periods Periods
After deciding on a target service level, we use the Table of Safety Factors to determine
the appropriate safety factor. 3
Even though both items averaged 100 units per month, the safety stock for A-45 is only
5 units, while for B-14 it is 177 units. This is proof that due to the variation of demand,
one size does not fit all.
One way to solve this problem is to switch suppliers in the hope that the new one will
have better performance. However, before taking this drastic step, ask one question.
Could your company be a major part of the problem? Is your company’s order pattern
extremely erratic, making it difficult for a supplier to anticipate its needs? Does it
provide its suppliers with its anticipated needs? It was stated earlier that a customer
and supplier should communicate their scheduling information in order to anticipate
each other’s needs. Has your company provided the same information to its suppliers?
Or does your company send them a purchase order and expect them to respond to its
ever-changing needs?
Partnering with suppliers, supplying them with anticipated needs so they can be
prepared for them, is often the quickest and most effective way to improve a supplier’s
delivery performance. Grouping your purchases by supplier in the computer system
and sending your key suppliers a copy of the portion of the purchasing report that
relates to them will allow them to prepare to meet your needs. 5 Will it always work?
Unfortunately no, some suppliers just do not understand the importance of on-time
delivery. Replacing such suppliers is often the only way to get better performance.
However, providing most suppliers with their customers’ anticipated needs will turn poor
performers into on-time deliverers!
In order to counter these problems, companies should reduce the amount of space
between operations where inventory can be stored. As space is decreased, it will force
underlying problems (machine breakdowns, long setups, poor quality) to the surface
where they will be visible for all to see. As an underlying problem surfaces, companies
should direct all efforts to solving the problem. Once the problem(s) is solved and the
operation is functioning smoothly with less space, reduce the WIP space some more to
uncover even more “opportunities” for improvement!
In order to change the mindset of employees who are used to individual incentives, the
wise company will move in two directions. First, instead of individual incentives, the
company will move to a group incentive involving everyone in the department or plant.
This will encourage employees to work with the team, instead of just pushing out more
of a given item, regardless of whether it is needed. Secondly, instead of basing the
incentives on production only, the new group incentives should be based on other
important goals such as quality, inventory reduction, and safety in addition to
production. This will focus employees on the myriad of elements needed to make
manufacturers successful.
Most companies can reduce their inventory while improving their service level by
making a concerted effort to train their employees in proper inventory management
techniques. These employees are not just those in inventory management or
purchasing positions (although they are definitely included), but the “rank and file”
employees who do the work in the organization. If a receiving clerk routinely enters the
wrong data into the system, if a stocking clerk often places goods in the wrong place, if
a picker does not bother to accurately count the product being picked or if the shipping
clerk puts the wrong label on boxes, the inventory won’t ever be accurate. In these
instances, a company will never have the ability to safely reduce inventory without
hurting its service level. Only by training the employees in the importance of doing their
jobs correctly and giving them the tools necessary, will you be able to create the best
kind of inventory reduction team—your entire workforce!
Conclusion
Companies exist to service customers. However, if a company attempts to service its
customers by maintaining an extremely high level of inventory, it may find itself with a
If a company aspires to maintain a high service level while minimizing inventory, it will
take hard work, dedication, and teamwork. Ensuring an accurate inventory of items that
supplier and customer agree must be in stock is a good starting place. This requires
precise recording and counting processes, along with an understanding of ABC
inventory methods and a commitment to clear, timely, confidential communications
regarding needs and expectations. Within either company, steps should be taken to
educate all people responsible for inventory accuracy in proper procedures for reducing
inventory and the space allotted to WIP storage. Team goals and incentives should be
established to bring about these ends, thus phasing out counterproductive individual
incentives. Improving communications and processes, increasing accuracy, and raising
the awareness and commitment of workers at all levels to inventory reduction will
ultimately enhance any company’s bottom line. There are no magic bullets, but if a
company employs the tools and techniques found in both this article and in the APICS
body of knowledge, it will be on the right path towards achieving these dual goals.
1
Ross, David Frederick, Distribution Planning and Control, Chapman & Hall, 1996
2
Arnold, J.R. Tony, Introduction to Materials Management, Prentice Hall, 1998.
3
Arnold.
4
Williams, Mark K., “Critical Tools of the Supply Chain,” APICS 42nd International
Conference Proceedings, 1999.
5
Williams, Mark K., “Information and Teamwork—Keys to Supply Chain Success,”
APICS 43rd International Conference Proceedings, 2000.