Safety Stock and Inventory Management

Computer systems maintain the stock of inventory items with parameters such as minimum and maximum quantities. Some of these parameters are objective – that is, there is one right or optimum answer. For example, an economic order quantity balances the actual cost of a product, inventory carrying costs, and costs of purchasing to determine the specific replenishment amount that results in the lowest total cost of each piece of the product.

Other inventory parameters are subjective in nature. There is no one best answer. Safety stock (also known as safety allowance) is one of these. Safety stock provides protection against stock-outs due to unexpected demand for a product or delays in receiving a replenishment shipment from a supplier. It is insurance. Like many other types of insurance there is no "right" or optimum amount. If you talk to three different life insurance agents, they will probably suggest you buy three different amounts of insurance. When you are determining safety stock quantities you have to ask yourself, "how much do I want to invest in preventing stock-outs?"
The answer will probably be different for various products you stock. In determining the safety stock amount, you have to ask:

* What is the likelihood that this product will experience a stock-out?
* How disappointed will customers be if this product is not stock?

Products are more likely to be out of stock if they experience:
* Inconsistent supplier lead times. If vendor shipments are often several weeks late, you may want to keep some extra stock to "cover" customer demand during these unexpected delays in receiving a replenishment shipment.
* Large fluctuations in sales or usage. You might sell 10 pieces or 1,000 pieces of a product in a month without much advance notice of when usage will significantly increase.
In deciding how much safety stock you want to maintain, perform this analysis for all of the items in your inventory to see how many total potential stock-outs you will experience with the various levels of safety stock. Also note when all of the resulting ending balances for a product represent a very high level of inventory. These products probably have fairly predictable usage and consistent lead times.
With this information the customer began to fine-tune their investment in inventory. They examined the stock-outs of painful backorder items and selectively increased the safety stock until there were no out-of-stock situations.
Your investment in safety stock is subjective. There is no "right" answer. But with some simple tools and analysis you can make an informed decision that will ensure that the funds you make available for safety stock are invested as wisely as possible

New Stock Items

It is common for new stock items to have a spike in sales or usage volume soon after they are introduced. This temporary high volume may be due to:
* Promotions for the new item or salespeople featuring the new item in sales calls.
* Customers wanting to try the new product.
* Customers establishing a normal stock quantity of the product in their inventory.
As in our other examples, if we were to stock based on monthly usage (i.e., four or five pieces per day), we would not be adequately stocked for the scheduled plant shutdown weeks. Accurate forecasting for these seasonal events again requires examining weekly usage – that is, the quantity sold or used in the same week last year, adjusted for increasing or decreasing trends in business.

An accurate demand forecast allows use to meet or exceed customer expectations of product availability with the least amount of inventory. While few demand forecasts are 100% accurate, we must continue to strive to reduce the forecast error (i.e., the difference between the forecast and actual usage) to better predict future demand of products. After all, no major league baseball player has ever achieved a batting average of 1,000 – but this fact does not stop them from trying to improve and play better baseball. Shouldn't you also continually do your utmost to improve the profitability and productivity of your investment in inventory? One of the ways to do this is to apply forecasts based on weekly usage whenever it is appropriate.

Effective inventory management and inventory investment

Many companies try to capture all unfulfilled customer requests and add them to the actual usage recorded for a specific inventory period. They believe that by including these lost sales in usage history, future demand forecasts will be adequate to cover the unfulfilled sales or usage experienced during the current inventory period.As part of a comprehensive customer relationship management (CRM) program, it is important to capture lost sales in order to see what customers are not being adequately served. Indeed, your sales manager probably wants to know if your most important customer requested an out-of-stock product five days in a row. But as we've seen, adding lost sale quantities to actual usage may not truly reflect the quantities of a product actually needed. The adjusted figures may distort future demand forecasts and result in either additional lost sales or excess inventory.

We've found that there is a better way to adjust actual usage for lost sales. This method does not require sales people to accurately record customer requests and protects you from capturing phantom demand. As with other aspects of our inventory management philosophy, we have different recommendations for items with recurring activity (i.e. those that are sold or used on a regular basis) and those with sporadic usage.

Recurring Items are sold on a regular basis. As these are the products customers request most often, it is important to correct for out-of-stock situations in order to ensure a high level of customer service.
1. Specify whether each of these inventory items will or will not accumulate backorders. If an item will accumulate backorders, customers will wait for you to receive the product. As a result, these items tend not to experience lost sales. If the product will not accumulate backorders, customers will go elsewhere to obtain the item. These are the items that will probably experience lost sales.
2. At the end of each inventory period (i.e. week, month, four-week period, etc.), record the number of days each product was out of stock.
3. For items that will not accumulate backorders, multiply the days out-of-stock by the forecast demand/day and adjust monthly usage by this quantity.

Sporadic Items are not sold on a regular basis and whose replenishment parameters are based on the normal quantity sold or used in one transaction as opposed to the forecast demand for an upcoming inventory period.
1. Record the number of times a product is out of stock (or its available quantity drops below the normal or average sales quantity).
2. If the product is out of stock more than one or two times in a six month period, automatically increase the minimum quantity for the product by the normal quantity sold or used in one transaction.
Note that to avoid an unrealistically large inventory investment, most organizations will tolerate a certain number of stock-outs of non-critical sporadic-usage items. That is why we normally will wait for several stock-outs to occur over a certain period before making the adjustment. However, this rule is not "cast in stone," and should be adapted to each company's specific situation and needs.A good forecast is the foundation of an effective inventory management program. The better the prediction of future demand of a product, the easier it will be to provide a superior level of customer service while minimizing your overall inventory investment. Correcting actual usage for lost sales opportunities is an essential part of the forecasting process. But to be effective, these corrections must predict, as accurately as possible, what would have been sold or used had the item continuously been in stock.

Costs

To determine the specific carrying cost for a product, we first have to determine what factors of the carrying cost will not vary by item. These are the factors that are solely dependent on cost or value of the average on-hand quantity:

* Insurance and taxes
* Opportunity cost of the money invested in inventory

If you take the total amount of these two elements and divide it by the average inventory value, the result is the cost of these elements per dollar of your average inventory investment. We will call it the ITO (Insurance, Taxes, and Opportunity Cost) factor.

Slow-moving inventory

You want to stock the products that your customers request most often in your warehouse(s). But what about products with sporadic sales, or no sales at all?
Even though a product is infrequently taken from stock (or may have never been taken off the shelf), the item must be available for immediate delivery if it is ever needed.

Every business needs to create its list of critical repair products. But as you add each item to this list, consider:
Is the item "critical" or merely "important"? A critical part not only shuts down a machine, it shuts down an entire process or vital service. For example, one of our customers is a food processor. They have one large mixer that is used to combine the ingredients necessary to make any of 25 different products. If the mixer is out of service, none of the 25 products can be produced. The company keeps on-hand in their inventory a spare piece of every component of the mixer. On the other hand, the company has 10 identical wrapping machines. If one wrapping machine breaks down, its workload can be reassigned to the other machines. Production might be delayed for a couple of hours, but the process would not be shut down. The spare parts for the mixer are critical inventory. Those for the wrapping machine are merely important and can be ordered as needed for next-day delivery. Keep in mind that a critical item has the potential, on its own, to shut down a process. When creating your critical item list be sure to note the process that is dependent on each product.
Maintaining critical item in inventory is considerably less expensive than buying one or two pieces whenever they are needed from an alternate source of supply. Keeping several years' supply of selected inexpensive products on the shelf will not have a great effect on your company's overall profitability. And by putting a significant amount of these items in inventory, you won't waste your buyers' time forcing them to continually deal with these "nuisance" items. Concentrate on ensuring you have the optimal quantities of those items that have the most dollars flowing through your warehouse.High-profit, slow-moving items may also represent a good inventory investment. The gross profit that results from each sale may be so large that it offsets the cost of carrying the inventory for a prolonged period of time.
Most companies have to maintain slow-moving products in inventory. However, you must be sure that each of these items improves your overall customer service and/or your company's net profitability.

Target Inventory Investment

Budgets are good management tools. Unfortunately, few distributors maintain budgets and projections for what is probably their largest asset, inventory. It is critical to the success of your inventory management system, and your business in general, to develop a budget for the value of stocked inventory maintained in each warehouse. This budget is referred to as the "target inventory investment."
Target Inventory Turnover: Most hard-goods distributors earning gross margins between 20% and 30% would like to receive five to six inventory turns in a main warehouse, and ten to twelve turns in a branch location. But these optimal goals cannot be achieved overnight. A realistic "incremental" goal is to increase your current turnover rate by 1/10th turn per month. And as we will see, it will probably take three months, after you begin an effective inventory management program, to start to see results.

So, if the inventory of stocked products in your warehouse is currently turning three times annually, and your company initiated an effective inventory management program three months ago, you should try to achieve 3.1 turns next month, 3.2 turns the month after, etc. This gradual increase in inventory turns is usually the result of an aggressive, but achievable, program to reduce the quantity of unneeded material in your warehouse.
you've developed a target inventory investment. Now you have to decide what products will comprise this investment. Let's start by dividing your inventory into three categories:

Dead Inventory: Inventory with no sales or recurring transfers during the past 12 months.

Slow-Moving Inventory: Inventory that has had some movement, but less than one and a half turns a year. That is, you've sold the normal shelf quantity less than 1-1/2 times in the past 12 months.

Other Items: Items whose stocked inventory will turn more than one and a half times per year. That is, your "good" inventory.

Please note that depending on your specific market, "good" inventory might have to turn more than 1-1/2 times a year. For some companies, "good" inventory must turn 12 times a year. If you have questions about what your particular situation, please contact us.

If you need to reduce your overall inventory investment to meet your turnover goals, a good place to start is to look at the dead stock and slow-moving items that are stocked in your warehouse. Of course, there are some valid reasons to maintain an inventory of items that don't currently sell on a regular basis. But, you must realize that if an item doesn't sell, it doesn't directly contribute to generating the profits necessary for you to remain in business. It is an expense. And, like a new truck, a computer system, new shelving, your payroll, or any other expense, non-moving inventory must indirectly contribute to the current or future profitability of your company. How can it do this?

• It might be a repair part or other item that you must have on hand to handle customer emergencies. That is, it contributes to your reputation as a reliable supplier.
• It may be an item that you're fairly certain will sell in the future. You've invested in the product today, to receive profits in the future.
  

As with any other expense, you must control the amount of dead stock and slow-moving inventory you maintain in your warehouse. You can only afford so much of it. In the following discussion, we'll guide you in establishing a budget for the amount of this inventory that you can reasonably maintain.

Just one more note before we go on. You must separately categorize dead stock and slow-moving inventory for each company warehouse or location. An item might have a lot of activity in one branch, but be as "dead as the market for eight-track tapes" in another location.

GOALS OF MATERIALS MANAGEMENT

Major goals
· Minimise inventory investment
· Maximise customer service
· Assure efficient plant operation
Common Subgoals
· Low unit cost
· High inventory turnover
· Consistency of quality
· Favourable supplier relation
· Continuity of supply
Inventory turnover
· A performance measure for inventory control
· It is the velocity with which materials move through the organisation
· It is the ratio of the annual cost of goods sold (from income statement) to the
average or current inventory investment (from balance sheet)
· This ratio computes