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A core competency of any inventory planning system is inventory optimization and strategy. In my last blog "What is the difference between Inventory Management, Planning and Optimization", I only touched on some basics. Here, I plan to provide more insight and detail with the focus being at the item by location level, or the bottoms-up level of inventory optimization.
Inventory optimization can be a key influencer to your return on investment of any software, however, most planners do not proactively manage their inventory strategies. Consider that your inventory planning software is a complex mathematical engine designed to manage the errors throughout your supply chain, managing your inventory optimization and strategy is essential to understanding what that error is costing you, in both dollars and service. Nevertheless, inventory planning is still overlooked as a value added task and process which planners should add to their workflow schedule.
What is Inventory Optimization and Strategy?
Everyone knows how important inventory is to distributors and retailers – no inventory, no sales. Inventory optimization and strategy is a set of rules you apply to your items that will minimize the amount of inventory you need to provide the customer service you want and can afford.
Every company would like to fulfill all customer orders all the time but the cost to do so is too high based on the inventory investment required, especially for low volume, highly volatile items. Inventory optimization balances the cost of inventory against desired service levels to maximize your profit. Your inventory plan and strategy addresses how you apply and manage that balance across your stocked items. The two most important drivers of your inventory optimization and strategy is your cycle stock optimization and your safety stock optimization.
What is Cycle Stock Optimization?
Cycle stock optimization is how you set your item-level ordering quantities based on the costs of holding your forecasted inventory versus the transaction costs of ordering and receiving it. The economic ordering quantity formula is a well-known model of cycle stock strategy that considers some of these cost trade-offs. Your cycle stock represents half of your ordering quantity. Cycle stock, however, is often driven by minimums and multiples like case pack quantities. Cycle stock optimization considers forecast, numerous carrying and ordering costs and any line-item ordering constraints. Generally, your cycle stock strategy makes up most of the inventory you have stocked which is why it is important to manage in your inventory optimization and strategy policies. By planning and optimizing your cycle stock, you can achieve significant service levels without holding any safety stock.
What is Safety Stock Optimization?
Where cycle cost optimization is mostly cost driven, safety stock optimization is service driven. Optimizing your safety stock strategy is generally perceived as inventory optimization despite it being the smaller aspect of the two key components. Key factors considered in safety stock optimization are your service level targets, your forecast, how wrong your forecast might be, your lead time and how wrong your lead time might be. Lastly, a key consideration in safety stock optimization is the amount of service your cycle stock will provide with no safety stock.
Traditional safety stock methods such as a fixed safety stock, days of supply or forecast, or even simpler service-level methods do not consider all these factors. Safety stock strategies should, however, vary across all your items as there is never one answer for all items. Stratifying your safety stock policies by ABC classification is a simple and great way to approach your inventory optimization and strategy.
What should be your takeaway?
Every stocked item will be subject to your inventory optimization and strategy such that you can map your “sawtooth” diagram to understand your past, current, and future investment. By applying cycle stock optimization and safety stock optimization you will optimize your inventory investment while achieving desired services levels. After all, your inventory investment for a single item or for all items is simply your safety stock plus your cycle stock – an easy way to forecast your future inventory investment.
I often get asked what the difference is between inventory management, planning and optimization. It is an important question and one that needs to be answered and understood, especially when you are looking to purchase software to help you with your inventory. There is, of course, some cross over, between the three (picture a Venn diagram), so I will provide some examples to best describe and highlight how they are each unique in their own way.
What is Inventory Management?
Inventory Management is often misused to describe inventory planning and inventory optimization. Although, it does and should include some inventory planning, like a min/max type of inventory policy, it almost never includes inventory optimization.
Think of Inventory Management as the tracking and trace-ability of inventory through out the supply chain. A good example would be RFID tracking. Using bar coding to track and know where your inventory is in your network at any given time is the simplest and most unique way to differentiate that which Inventory Management does, but inventory planning and optimization do not.
What is Inventory Planning?
Inventory Planning is what most companies look for to understand their inventory position and to control their inventory levels and investment. Inventory Planning in its simplest form is included with Inventory Management. And, an optimal inventory plan will and should include Inventory Optimization. So, they are intertwined and Inventory Planning sits in the middle.
Back to what exactly is Inventory Planning. From a bottoms-up perspective (i.e., item by location), it is a proactive inventory policy that defines what your cycle stock and safety stock should be. The policies are such that they can be forward looking to help you understand where your inventory investment will be. A typical example is calculating policies by the number of days of forecast you should order and stock, respectively (e.g., days of supply).
From a top-down perspective, Inventory Planning is the forward looking investment in inventory spend. This is generally performed at a product category level and deemed to be your open-to-buy budget and extremely popular among retailers where working at the item by location level can be cumbersome (especially in fashion).
What is Inventory Optimization?
Inventory Optimization can be viewed as a sophisticated inventory plan. It takes on two forms, a bottoms-up inventory plan and a top-down inventory plan.
The top-down inventory plan, if optimized, can be referred to as network optimization. It is the optimal inventory investment for all stocking locations and all items within a distribution network. The bottoms-up plan if optimized is referred to as multi-echelon inventory optimization. This is the item by location inventory plan for each item at every stocking location. To be optimized at this level, safety stock is driven by a service level target and the cycle stock is derived by the trade-off in carrying and ordering costs.
Reconciling both the bottoms-up and top-down plan is the key to optimizing the inventory investment. The end result being a forward-looking, time-phased replenishment plan that takes into consideration how wrong the forecast is, the variability in lead-time, your service level objectives, the costs of inventory, and the budget and investment constraints of your business.
What make the most sense for you?
Each business has its unique needs and issues. If you are looking for Inventory Management, a warehouse management software will generally have the functionality you are looking for. But, if you are looking to manage and control your inventory spend and investment so your inventory does not get out of control, I recommend starting with the simplest approach - a top-down software like open-to-buy planning. Start with managing your sales objectives, your purchase orders, your profit and margin targets, and from there back into an inventory budget that you are comfortable with. Translate that budget into a prioritized list of orders, hence balancing your financial goals with your assortment.