Proper inventory management practices are the crux of efficient warehouse operations and cost savings. Obviously, a company wants its inventory levels to match consumer demand exactly, but in the real world, this is never the case. Over stocking items means less cash flow, more expenses, and held up goods, while selling all of a company’s inventory can lead to stockouts, lost customers, and bad customer service.
There are essentially three ways that business try to control and monitor their inventory levels:
- Per-Item Management
- Flow Management
- No Inventory Management (unfortunately, the most popular “method”)
Per-item management involves tracking inventory levels by each product or unit. It is an inventory management practice that is characterized by a concern over the actual inventory levels. Flow management is a control method that is more concerned about production and flow management of inventory. Lastly, and most unfortunately, many businesses do not track inventory at all. Their end-of-year annual reports are generated for purely legal purposes and give a quick snapshot view of total dollar costs and earnings throughout the year. What most businesses don’t realize is that understanding proper inventory management practices can help you to lower costs and get rid of stale inventory.
Understanding Demand: Independent Demand vs. Dependent Demand
Proper inventory management practices are dependent upon the demand system a company runs on. Demand for production and manufacturing can come in two primary forms: independent demand, and dependent (or derived) demand. Independent demand is focused on the end product while dependent demand is focused on the materials or components of the product. For example, a laptop is the end product. The keys, screen, motherboard, hard drive, USB ports, etc. are all materials used to manufacture the laptop. So the independent demand serves as a “parent” to the dependent demand. Here’s a little bit more about how independent demand works:
Independent demand is a form of demand-forecasting that focuses on the finished product. In this approach, the actual demand of a product is rather uncertain. Let’s use the example of a laptop. If a laptop manufacturer expects to sell 500 laptops, their independent demand would be 500. Even though they may expect to sell 500 laptops, they may actually sell only 300 – or conversely, 700 laptops. Therefore, the independent demand is rather uncertain.
Dependent demand on the other hand is focused on the materials or components used in the production of an end product. This type of demand outlook provides significantly more insight and certainty into forecasted demand. Let’s use the example of the laptop one more time. While the independent demand may be uncertain (since it is not understood whether or not they will sell all the laptops), the dependent demand is certain. If the laptop assembler has a forecasted independent demand of 500 laptops, they will order 500 screens, 500 keyboards, 1500 USB ports, etc. Thus, manufacturers that operate on a dependent demand system have more security of demand. Regardless of how many laptops actually sell, they are guaranteed a project to build 500 laptops-worth of components.
Proper Inventory Management Practices: The Effect on Customer Service
Manufacturers and sellers often have inventory issues that cause them to encounter customer service problems. These issues may arise due to a variety of issues: damaged goods, expired shelf life, inaccurate demand forecasts, wrong materials being sent by the supplier, and so many other possibilities. Thus, manufacturers often use an Item Fill Rate (IFR) to measure how often a certain product is available. This way, a company can try to only fill 95% of all customer orders to reduce inventory holding costs.
However, as stated before, complications and inaccurate forecasts arise. In these situations, companies will often carry extra units in stock that remain untouched unless needed. These are referred to as safety stock. It’s important that safety stock is not used on a regular basis. If a company grows accustomed to tapping into their safety stock of items, they may not realize the purpose behind their constant need for more products. Is it inaccurate demand forecasts? Is the supplier frequently late on shipments? There is a great tradeoff between inventory related costs and customer service. The higher the level of customer service provided, the costlier logistics-related expenses can get. Also, holding excessive amounts of inventory on hand can lead to inventory turnover and issues tracking operational costs.
Inventory Forecasting: The Product Lifecycle Method
Independent demand, as stated before, is almost always subject to the product lifecycle. The product lifecycle is a timeline that lays out the course of popularity, growth, and product sales that will occur over a given “lifecycle.” The 4 chronological categories of a product lifecycle are: 1) introduction, 2) growth, 3) maturity, and 4) decline.
Take the example of how a new smartphone release is affected by the product lifecycle.
In the introduction phase, logistics-related costs must be factored in regarding the product launch. Aligning transportation to distribute the product from the manufacturing facility to various retailers/store locations/etc. must all be taken care of before consumer demand begins.
In the growth phase, most transportation costs concern the growing need for quickly expanding distribution. Depending on the success of the product, the new smartphone may see wide-spread adoption of the technology, or may underperform the competition and experience a low growth rate.
The focus of logistics costs at the maturity point of the product lifecycle switches to being cost-driven. Keeping costs low while satisfying high consumer demand can be a tricky balance, but it is absolutely necessary. Maintaining similar logistical costs associated with the introduction and growth phases of the product lifecycle would prove detrimental to profits in the maturity phase. By this point in time, the initial import/export/long-haul and distribution of goods to stores has been finished and the focus changes to cheap, fast solutions to satisfy consumer demand.
Hopefully by the decline stage, most inventory has been sold. This is often when the safety stock comes into play. Although a company may have endured the most product-heavy demand season, it’s important to not forget of the importance of having extra inventory available. Sales may continue through the decline stage for prolonged periods of time depending on the product type and lifecycle.
Ultimately, the goal is to match product demand to inventory levels 100%. But manufacturers and distributers have to deal with great amounts of uncertainty in the product lifecycle. Product life cycles used to be much more predictable in the past, as the maturity phase lasted longer. But more recently, product life cycles are shorter, and next generation products are continually pushed into the market.
Managing Inventory Costs: Inventory Control Systems
Depending on the type of product a company is selling, each business will have different types of inventory costs. There are different inventory costs associated with products that have long or short lifecycles. These costs will fall into any of 3 primary categories:
- Carrying Costs: Regular and Safety Stock
- Setup and Ordering Costs
- Stockout Costs
In order for a company to fulfill customer demand and product orders, all items need to be properly inventoried. Inventory control systems help to balance carrying costs against ordering or shortfall costs to find the best savings and customer service.
In other words, carrying costs are the costs associated with holding onto a product. This includes capital, storage, risk, and service costs associated with holding inventory. This type of inventory can be thought of as “held up” money, since liquidating the inventory could create financial room for extra purchases or debt payments.
A company should determine how much of its insurance and tax expenses are associated with the held inventory. Keep in mind, there are plenty of states that have inventory tax, so make sure to look up your place of business to see if you are affected. The business should also decide how much money will be spent on space, since inventory is often held in spaces that are leased. It is easy to forget about what costs a company incurs simply by letting inventory sit and take up space. Next, risk is not so easily measurable, as it is the cost risk of products being stolen, damaged, or perished before sale.
To calculate your carrying costs, you need to know how much inventory you have, your inventory carrying cost as a percentage of product cost, and the average cost per unit of inventory.
Ordering costs can be broken into 4 overarching costs:
- Transmitting the order
- Placing the product into storage
- Inbound transportation
- Processing the invoice
Luckily, technological advancements in shipping have cut invoice processing costs down significantly (almost 6x lower). In the case of a manufacturer, production setup costs would be used instead of ordering costs.
Stockout costs occur when sales are lost due to items being out of stock. These hit companies negatively in two ways – sales are missed because of depleted inventory levels, and the company reputation is harmed due to poor customer service from out-of-stock products. These costs can be avoided through proper analytics of seasonal and market demands for the product. Most companies that do not have an in-house or outsourced analytics teams run into issues here. The key is to be adaptable. Stockout costs are hard to track since a large majority of it can be considered an “opportunity cost.”
Most of the ability to accurately forecast demand and inventory needs boils down to an understanding of your product, market, and industry, as well as analytics behind consumer purchasing behaviors. Obviously products that have higher demand and quicker life cycles are more difficult to track, so every company will need to take a slightly different inventory management approach. Always remember that good customer service is what will drive product sales, and having proper inventory management practices will directly influence the public’s perception of your company’s customer service. Make sure to understand and recognize how much your firm spends on stockout costs, carrying costs, and ordering costs per year, and when these costs come in to play during the product life cycle. These variables will all benefit your company in creating more streamlined, cost-effective, and proper inventory management practices.
Give us a call at Interlog USA if you’d like to learn more about proper inventory management practices. Don’t let your customer service levels drop due to poor organization habits!