Sep 1, 2015
The impact of inventory risk on your business
As the owner/manager of a business you would have experienced the difficulties in getting the balance right between providing customers with a high level of service while targeting a specific inventory value or stock turn.
So why is it so difficult?
The main purpose of carrying inventory is to provide customers with an expected level of product availability. In other words, you need the right products in stock at the right time.
That would be simple if:
- You knew exactly how many of each product your customers will be asking for in the next cycle (this requires an accurate forecast)
- Your supplier lead time information is accurate
- You know when it is time to order and how much to order
- You trust your suppliers to deliver on time
What are the issues?
Losing a sale due to one or two stock-outs may seem relatively trivial; losing a customer has huge consequences as you may never get that customer back and you have strengthened your competitor’s position.
So stock-outs pose the biggest risk and typically result in over-ordering and over-stocking as inventory levels are increased for all items when only a few have been stocking out.
So a product that was not stocking out has its inventory levels increased, tying up additional working capital with no improvement in service on that product.
Pressure is now put on the value of the inventory and buyers/planners are instructed to reduce inventory. By reducing ordering across the board, cracks start to appear and you start experiencing an unacceptable level of stock-outs.
And so the cycle repeats.
Without the ability to compute the appropriate level of inventory to hold for each item in each location based on its inventory risks, you will continually oscillate between too much inventory and poor service.
What are the inventory risks?
There are inventory risks on both sides of your business – on both the supply side and the demand side.
Supply side inventory risks
There are three components to the supply side inventory risks – the reliability of the suppliers delivery to their agreed lead time, their adherence to the quantity ordered and the spread of the deliveries in terms of days early and days late.
- Delivery – if your supplier continually delivers early, you have more chance of generating excess inventory; if your supplier continually delivers late, you have more chance of stocking out.
- Quantity – if your supplier continually delivers more than you ordered, you have more chance of generating excess inventory; if your supplier continually delivers less than you ordered, you have more chance of stocking out.
- Reliability – if your supplier agrees a lead time of 12 days but sometimes delivers in 18 days and sometimes in 8 days, you swing from having too much to stocking out. The wider the gap between early and late deliveries, the bigger the level of uncertainty and risk.
You may now be inspired to start focusing on suppliers. How do you know which suppliers are problematic and where to start? The likelihood is that nothing will be done. This increases the risk further.
Demand side inventory risks
Demand side inventory risks relate to how well you are able to forecast demand in your business. While computing forecast accuracy is important, it is even more important to understand the impact of the direction of any error.
- Inaccurate forecasting – while you may not think you are actually forecasting in your business, whatever you use to determine what to order is in essence your forecast. How well you do has a significant impact on your ability to minimise stock-outs and reduce inventory simultaneously.
- The importance of the direction of any error – if you over-forecast demand (you believe you will sell more than you actually end up selling), then by buying to that forecast you are more likely to generate excess inventory. If you under-forecast demand (you end up selling more than you thought), you will run a much bigger risk of running out of stock.
Forecasting is a critical component of ensuring that you have the right stock in the right place at the right time, but it is time consuming, difficult to get right and needs to be constantly monitored. Factors to consider for effective forecasting include:
- Using a computer to generate forecasts for every item, resulting in great forecasts for the bulk of your items
- Identifying the small percentage of items that require manual intervention
- Manually forecasting new items for a few months, as they have no sales history
- Modifying forecasts for items where we have gained or lost customers
- Monitoring how sales are tracking the forecast during the month
The risks in data quality
Accurate inventory data such as stock on hand quantities or outstanding purchase orders are as important as getting a handle on the supply and demand risks in the business. Without accuracy in your data, any inventory planning will be an approximation at best.
Taking weeks to prepare the data for ordering purposes and then placing orders with information that is out of date also creates risk for your business.
Exceptions and alerts
A lack of metrics to identify existing inventory risks as well as risks not yet obvious further compounds the situation.
- A Potential stock-out alert that warns of potential stock-outs before they occur is priceless
- Knowing how to identify the excess stock that can be disposed without compromising customer service levels addresses a problem already existing in your warehouse
- A Surplus order alert warning that the quantity on order from a supplier will create additional excess stock allows for proactive resolution before it becomes a problem
So, what do you do about all of this?
Fortunately there are many solutions that make it possible to manage a large number of items effectively and achieve those elusive inventory targets.
It is a matter of finding the best tool for your business at a cost that you can afford and that does not require a huge team to do the job.
A requirement of the toolset is the setting of an additional buffer or safety stock level to protect against the risks. This is in itself a complex subject that we may well discuss at another time.