Vendor-Managed Inventory

Many firms are trying to concentrate on the "core competences." They want to outsource minor tasks and activities when it is cost effective to do so. For a distributor, an example of one of these tasks is the replenishment of less-expensive products. For a manufacturer, it may be the procurement of MRO (maintenance, repairs, and operations) inventory. A popular way to outsource these procurement activities is a vendor-managed inventory (VMI) agreement. Under a VMI agreement, a supplier takes full responsibility for maintaining stock of its products at a customer's facility. VMI agreements differ from traditional consignment agreements in that the customer is billed for material when it is delivered, not when it is consumed or issued. When establishing a VMI agreement, the supplier and customer must agree on:
* The specific products that will be covered under the VMI agreement.* "Acceptable availability" of these products at the customer's site and the corresponding investment required by the customer. Usually the supplier and customer will agree on a "service level," which is the percentage of orders for a product that can be completely filled out of the VMI stock inventory. The higher the agreed-upon service level, the more the customer will have to invest in the supplier's products.
* How often the stock of these products will be replenished.
* The automatic return of material that is no longer needed by the customer.
Potential advantages for a customer participating in a VMI program include:
* Eliminating the cost of managing replenishment parameters and issuing purchase orders.
* Establishing an extremely reliable source of supply for products that are very important to its operations but represent a relatively small investment.
Advantages to the supplier include:
* Securing all of a customer's business for the types of products it supplies.
* The ability to better plan its own inventory replenishment needs because the supplier's buyers can monitor the actual sales or use of its products at the customer's site.

Goal of Effective Inventory Management

The goal of effective inventory management – that is, to meet or exceed customers' expectations of product availability while maximizing the organization's net profits or minimizing its inventory related costs.One of our primary areas of concentration has been the improvement of future predictions of product sales or usage, otherwise known as "demand forecasts." the accuracy of any demand forecast is dependent on the "goodness" of your sales or usage history. Does this data truly reflect what would have been sold or used under "normal" circumstances?
Many software packages identify possible unusual usage at the end of each week, month, or other inventory period. The simplest of these systems compare usage in the month just completed to the total usage recorded over the previous "x" months, or inform you if you were out of stock for more than "y" days. More advanced systems bring to the attention of a buyer significant differences between the demand forecast and actual sales or usage recorded during the inventory period just completed. A common feature of both methods is a belief that usage history has been recorded correctly.

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

Inventory ranking

Distributors, manufacturers, and retailers often stock thousands of products. Properly managing the physical inventory and replenishment of these items is a challenging task. While most buyers and salespeople realize that not all items are equally important to customers or their company, it often difficult to identify those products that demand the most attention.
* 80% of your sales are generated by 20% of your salespeople.
* 80% of your sales come from 20% of your customers.
* 80% of your stock sales involve 20% of your inventory items.
But this rule is not always true. In fact for many companies, 80% of sales are generated by only 10% to 13% of stocked inventory items!
Rank or classify your products based on their contribution to total sales. The products that account for 80% of your sales are typically referred to as "A" ranked items. This may be 5%, 10%, or 20% of your products.
While this type of ranking is important to identify those products that have the most potential for inventory turnover (i.e., opportunities to earn a profit), it is not as valuable in answering other inventory-related questions, such as:

* What products should be maintained in stock?
* Where should a specific inventory item be located in your warehouse?
A special-order item is not maintained in stock inventory, but is ordered and received to fulfill a specific customer requirement.
Reorder quantities of a product with a high cost of goods sold ranking should be carefully determined to achieve a high level of inventory turnover. At the same time you might consider maintaining additional safety stock for products with a high hit rank to minimize the chance of stock-outs. You also might want to include a third type of ranking in your classification analysis, one based on profitability.Ranking products based only on annual cost of goods sold provides an incomplete picture of inventory performance. Three-way ranking provides valuable information concerning each stocked product's contribution to the overall profitability of your organization, information that is vital in your quest to achieve Effective Inventory Management.

Inventory problems solving

Many companies suffer from several, apparently conflicting, inventory problems:

* Frequent stockouts of critical products.
* Large quantities (and value) of excess inventory and dead stock.
* Inaccurate product availability information in the computer system.
The underlying cause of these problems are the strategy companies hope would enhance their ability to effectively serve customers. Let's look at some of the reasons why their branch replenishment policies were doing more harm than good:
1. Any available stock could be transferred out of any other branch at any time if it was needed to fulfill an immediate customer need. On the surface this policy may make sense. Why keep four units of a product on the shelf in one location if it can be sold by another branch? Isn't that what inventory turnover and customer service is all about?
2. Salespeople buy because they know what customers really need.
3. Branches may overbuy in order to place vendor "target" purchase orders on a regular basis. A target order meets a vendor's requirements that enable a company to receive the discounts or terms that allow them to competitively sell the vendor's products. If each branch has to meet the vendor's target requirement when placing a replenishment order, they may have to purchase more of a popular item than they would if they could split shipments with other branches. They also might have to buy full package quantities of slow-moving products as opposed to "sharing" a package with other company locations.
At these companies, these problems and others could be solved by putting specific buyers in charge of replenishing inventory of specific product lines in all customer locations. These individuals had both customer service and inventory turnover goals they were expected to meet or exceed. This could be done through:
* Ensured that replenishment orders were issued as soon as the replenishment position of a product fell below its order point (lead time usage + safety stock or reserve inventory)
* Split replenishment orders between branches and centrally-warehoused slower-moving items.
* Possible unusual usage is identified and analyzed.
* Buyers approve all inter-branch transfers. After all, they are responsible for maximizing both customer service (i.e., minimizing stockouts) and inventory turnover.

All buyers were not necessarily physically located in the same office, but each was responsible for specific product lines throughout their company. As a result we achieved the results that every company desires: a maximization of both customer service and corporate profitability through effective inventory management.

Effective inventory management again

Lean manufacturing is helping producers throughout the world reduce inventories, lower labor costs, and increase their overall efficiencies. The same concepts embraced by lean manufacturing practitioners can help distributors achieve the goal of effective inventory management:
"Effective inventory management allows an organization to meet or exceed customers' expectations of product availability with the amount of each item that will maximize net profits or minimize costs."
There is a common philosophy that states, "The definition of insanity is repeatedly doing the same procedure, the same way, expecting different results." Are there re-occurring problems in your warehouse? Is there an easy to record damaged or stock inventory that for some reason cannot be used? This material includes:

* Damaged material found in the warehouse.
* Unintentional scrap created when a mistake was made in filling an order.
* "Drops" or quantities of a product that are too small to be sold or used.

In many organizations, damaged or unusable inventory is hidden. Maybe it is thrown in a scrap pile or discarded. But the best-run organizations encourage or (better yet) insist that employees record these "unquality events." Recorded events are analyzed to determine if polices or procedures can be changed to prevent the same mistakes from occurring again in the future.

Out-of-stock reports

Most computer systems provide buyers with out-of-stock reports. These are listings of stocked products with no available inventory. Because the stock-out sales orders cannot be filled, salespeople cannot provide the service their customers expect. Buyers scramble to obtain inventory to prevent the "crisis" of the out-of-stock situation from becoming the "catastrophe" of losing those valuable customers.

Out-of-stock reports are, in fact, "gotcha" reports: They inform a buyer of a problem that already exists. Wouldn't it be better if a computer system warned a buyer of an impending crisis? That is the goal of an "early warning system."

It is unbelievable that the report writers available in almost every system have the ability to create "early warning" stock-out reports, but few organizations utilize them. Check with your IT department or software company to see if the following reports or inquiries can be created for your top-selling "A"-ranked items as well as for other products that are crucial to maintaining a high level of customer service:

The available quantity (on-hand – current committed) is below the safety stock level. Safety stock is "insurance" inventory designed to fill unusual customer demand during the lead time or to compensate for delays in receiving replenishment shipments. Buyers should be informed if reserve inventory is being used to fill orders so they can expedite existing incoming shipments or obtain the product from an alternate source. At the very least, if a stock-out does occur, the buyers will not be caught off guard; they will have information in hand as to when the out-of-stock product will be available.

The actual usage by the 7th day of the current month is greater than 50% of the forecast demand for the month. Often, a buyer will be unaware of a surge in sales of a particular product until it is out of stock. If buyers know that sales of a product have suddenly "taken off," they can bring more of the product into inventory before a stock-out occurs.

The actual usage by the 14th day of the current month is greater than 75% of the forecast demand for the month. This is another check to identify products that suddenly have an unexpected dramatic increase in sales or usage activity.

The actual lead time for the just-received stock receipt is more than 50% over the anticipated lead time. The buyers can contact the vendors to determine if the delivery of the latest stock receipt is reflective of future lead times for the item. If so, the buyers can issue replenishment orders for the item earlier than they have done in the past to avoid a future stock-out.

The available quantity of the item at the time of stock receipt is less than an "x"-day supply. You didn't quite run out of the product during this replenishment cycle, but what is the possibility of a future stock-out? Does the forecast, lead time, safety stock quantity, or some other replenishment parameter for the item need to be adjusted?

Restricting the early warning system to fast-moving items and products that are critical to your corporate image will ensure that your buyers aren't buried in data. They won't receive a multitude of alerts, but every one they do get will require their attention. When we propose early warning reporting to our customers, their buyers, inventory planners, and purchasing agents often ask, "Why haven't we had this type of notification all along?" Some buyers prefer alerts in a daily end-of-day report, others as an inquiry, and still others as an email as soon as the situation is identified. The format doesn't matter as much as getting the information. Tell your software people that you want to immediately implement this critical reporting. Countries need an early warning system to prevent attack from foreign powers; you need one to protect something that is crucial to the survival and success of your firm: your customer service!!!

How much to stock?

How do you know if you have too much, too little, or just the right amount of stock inventory? One way is to compare the value of your current inventory to an "ideal inventory investment." In this article we will discuss how to calculate the value of this "right" amount of inventory. As with many of our other inventory analysis tools, calculating the ideal inventory investment requires that we first separate those inventory items with recurring demand from those items with sporadic usage.

Recurring Usage Items
Recurring usage products are sold or used on a regular basis. Typically these items:
* Have had usage in at least eight of the last twelve months.
* Have had usage in at least four continuous months in the last twelve months (this second condition identifies seasonal items that are only sold during certain times of the year).

Replenishment of these items is normally based on safety stock quantities, order points, line points, and standard order quantities:
* Safety Stock Quantity: The "insurance" inventory maintained in stock to protect you from stock outs resulting from unexpected customer demand or vendor shipment delays.
* Order Point: The Safety Stock Quantity plus predicted demand during the anticipated lead time.
* Line Point: The Order Point plus predicted demand during the supplier review or order cycle; the normal length of time between typical replenishment orders with the supplier.

Sporadic Usage Items

In many organizations more than 50% of stocked products have sporadic usage – that is, they are not sold or used on a regular, predictable basis. In other words you have no idea when they will be sold or used. In previous articles we have suggested that you base the inventory of sporadic usage products on a multiple of the normal or typical order quantity. For example, if you normally sell or use two of the items in a transaction, you would set the "target" stock level equal to two pieces (if you wanted to maintain one transaction in stock) or four pieces (if you wanted to maintain two transactions in stock).

You might think that like recurring items, the average or ideal value of sporadic inventory items should be some average of the normal quantity on hand, perhaps the target stock level divided by two. But because sporadic usage items are not consumed or sold on a predictable basis, it is very difficult to calculate an "average" investment for these items. After all, you might have the two or four pieces of a sporadic usage item in stock for a week, a month, or for more than a year! Therefore we have to consider the "ideal" value of sporadic inventory items to be equal to the target stock level quantity times the average cost. It's true that because we will occasionally use some of the stock of some sporadic items, the value of the target inventory will overstate the average value of some items. But this is the most accurate method we know of determining the ideal value of sporadic inventory items.
Unfortunately the value of the inventory of a sporadic inventory item will often exceed the value of the target stock level. Why? Because you may have to order a vendor package quantity of a product when replenishing stock. And the vendor package quantity may not have any relationship to the normal customer order quantity. For example, say that the normal customer order quantity of a product is three pieces and we want to maintain two normal order quantities in stock. The target stock level is six pieces (2 orders x 3 pieces per order). Whenever the replenishment position of the item falls below six pieces, a replenishment order is issued. If we must order a vendor package of 10 pieces, the product's stock level after we receive the replenishment shipment will probably be greater than the target stock level of six pieces.Because sporadic inventory is not sold on a recurring basis, we must carefully monitor the value of any amount of sporadic inventory in excess of the target stock level, particularly for those items with a high unit cost. We can define "planned excess" of sporadic inventory items as a quantity equal to:

(Target Stock Level - Normal Order Quantity) + Vendor Package Quantity

One of our goals should be to minimize the value of this planned excess. If a sporadic inventory item has a high planned excess value consider:
* Ordering an amount of the product close to the normal order quantity, even if you have to pay a higher price per unit.
* Discontinuing the product from stock inventory and ordering it only as necessary to fill specific requirements.
* Sharing one vendor package quantity among several stocking locations.
* Substituting a slightly more expensive item without passing the additional cost to the customer. Saving the carrying cost of excess inventory of one sporadic inventory item may more than compensate from the reduced profit on the resulting sale.

One of the best inventory metrics involves comparing the value of your current inventory to the sum of the values of the ideal stock level for each product. If the values are not close to one another, your buyers or inventory planners are probably not following the replenishment recommendations generated by your computer system. Are the system recommendations inadequate to provide your desired level of customer service and inventory turnover? Or do your buyers need more training in using your system to help your company maximize the return you receive from your investment in inventory? Either way, comparing your actual inventory to the "ideal" will lead you to action that can lead to improved profitability.

In our next article we will explore what you can do if your calculated ideal stock level is too high and needs to be reduced in order to achieve your organization's inventory turnover and profitability goals.

Cycle counting

Cycle counting is the process of verifying the on-hand quantity of a specific number of stock products every day. In previous articles, I have described how to set up and maintain an effective cycle counting program and why this process is usually better than a full physical inventory for maintaining an accurate perpetual inventory in your computer system. But verifying on-hand quantities is only one of the advantages of cycle counting. The other benefit of a cycle counting program is to improve your business processes, including:
* Making sure that all material movement is properly recorded.
* Ensuring that stock receipts are put away in the proper location.
* Verifying that the right quantity of the right item is shipped on outgoing orders or is pulled from stock for an assembly.
* Preventing shrinkage from theft and the mishandling of stocked items.
Absolute Value of (Quantity Counted – Current Stock Level)] ÷ Current Stock Level
Process improvement results from carefully analyzing significant stock discrepancies.
Including the "absolute value" of "Quantity Counted – Current Stock Level" in this equation signifies that a discrepancy should be analyzed if significantly more or less inventory is found during the cycle counting process.
It is impossible to achieve effective inventory management without accurate stock levels in your computer system. A comprehensive cycle counting program is a valuable tool for ensuring that the quantities in your computer system agree with what is physically in the warehouse. But to be certain that stock levels remain accurate over time, you must investigate significant stock discrepancies and take corrective action to prevent similar problems from reoccurring in the future – that is, you must utilize cycle counting to improve the way you run your business!