May 17, 2017
Lesson 6: Exception-Based Inventory Management
At this stage in the course, we have already covered the most essential steps in Inventory Management:
- Classify products to focus on the most important ones first and to set appropriate inventory policy
- Forecast products so that you can plan today for what you’re going to sell in the future
- Set proper safety stock levels to guard you against the risk of bad forecasts and unreliable suppliers
- Define an appropriate stocking policy that aligns with your goals of customer service levels and investment in inventory
- Place effective purchase orders that will implement your stocking policy
Inevitably, there will be items that are not performing well and you’ll have to fix problems with those items. These problems generally fall into one of two categories:
- They affect your stocking levels – you’re spending too much money keeping them in the warehouse
- They affect your customer service levels – you cannot supply your customers when they order the items
It’s interesting that those two categories of problems are the same categories that you use to set a stocking policy. If we can fix these items, we will get closer to our ideal stocking policy.
Here’s a list of the kinds of problem items that will need attention on a daily basis.
These are items where the current stock-on-hand is greater than the maximum level that you calculated when defining your stocking policy. The number of units of excess is simply stock-on-hand – maximum-level. Excess inventory is bad for your bottom line because:
- You have to warehouse it, costing you money
- You have to insure it, costing you money
- Its value depreciates over time, costing you money
- It breaks, expires, or gets stolen, costing you money
- You have to keep counting the same stock over-and-over, costing you money
- A large chunk of working capital is tied up in dead stock, costing you money
To fix it you have to get rid of the excess items. This may mean that you have to sell them at a steep discount or even write down the inventory.
These are items where you’ve placed purchase orders surplus to forecast demand. So when those items arrive in your warehouse, they will be in excess. The way to calculate if you have surplus orders is to look at an item as if no purchase order has been placed, then work out what you would ideally order today. If your existing outstanding purchase orders are more than what you would order today, you’ve ordered too much. The difference between the purchase orders and the ideal order is your surplus order units.
Surplus orders are bad because they are taking perfectly good working capital, turning it into inventory, and then storing it in the warehouse for a very long time.
To fix it you will have to either cancel the orders, delay the orders, or split the orders into multiple drops that are more in line with what we require when we require it. Do anything you can to prevent those items from landing in your warehouse.
These are items where you have zero net stock (on-hand less any allocated stock and back orders) and have demand for those items (customer orders or forecast demand). The number of lost sales units for the item is the forecast demand until the first purchase order arrives. Or, if you don’t have any purchase orders, the forecast demand over the lead time for this item.
Stocked-out items are bad because:
- You lose the sale of the product
- The customer may decide to buy their whole basket of products from your competitor
- Your competitor may give your customer great service and now you’ve lost a customer for life
To fix it you will have to bring an existing purchase order forward or place an emergency order. This may involve not using your preferred supplier or using air freight instead of sea freight. It may even involve you purchasing from your competitor. It may cost you more to purchase emergency supplies but it may be worth the expense to prevent losing the sale (or the customer).
Potential stock-out items
These are items where you do have stock on hand but before the next order arrives in your warehouse, you will run out of stock. The way to predict these items is to project how long your current stock on hand will last (based on your forecast). If that date is before the first purchase order arrives, or a purchase order you place today will arrive, you have a problem. The number of forecast sales in that time frame is the potential number of sales you will lose.
Potential stock-out items are bad for the same reasons as stocked out items. At least now you have a little bit of time to do something about it before you actually run out of stock.
To fix it you will also have to place an order or bring an existing order forward. Depending on how soon the stock will run out, you may have to place an emergency order. You may also be able to move inventory from one warehouse to another as a short-term fix.
That wraps up our 6 Day Inventory Management Crash Course.
I’ll be in touch in the coming weeks as we discover and develop insights into the world of inventory management and optimization. And as always, please let me know if you have any questions by replying to this email.