Inventory Planning Strategies

Supply chain management (SCM) is the management of the flow of goods.1

The goal of Supply chain management is to make sure you have the right goods in the right place at the right time. Too few goods, goods in the wrong place or goods at the wrong time and customers become unhappy ex-customers. Too many goods strangle the business with cash flows problems.

Obviously then, an important part of the supply chain management process is working out what goods are needed when, which is the purpose of forecasting. However forecasting itself is merely a means to an end and just one part of the puzzle. For forecasting to be of any use, the results need to be used for Inventory Planning – to plan production and/or purchasing.

Inventory planning is the art and science of determining optimal inventory levels and planning replenishment to make it so. Essentially it consists of combining sales demand forecasts and supply constraints (such as delivery lead times) and using these to calculate what stock to buy when.

Safety stock

Since both sales demand and supplier lead times are variable, in addition to planning enough stock to meet forecasted demand between reorders, it’s industry practice to hold a certain amount of safety stock (against the possibility that demand is greater than expected or a delivery is late).

Service levels

From a mathematical point of view, it’s impossible to guarantee enough stock to cover all possibilities – that would require infinite stock. However, if we know the statistical variance of our demand forecast and that of our supplier lead times then it is possible to work out how much stock is needed to cover 70% of demand or 99% of demand or whatever service level you consider acceptable/practical for your company.

Once the service level has been decided, a little bit of fairly elementary statistics can be used to work backwards from the demand forecasts to calculate how much stock you need on hand at any one time.

Inventory replenishment strategies

Having decided upon a service level, there is still one more decision that has to be made. We want to use our inventory planning process to decide both when to buy goods and how often. Clearly, if we’re buying goods more frequently then we don’t have to buy as many. If we buy goods less frequently then we’ll need to purchase in larger quantities.

Thus, if we want to calculate when to order stock then we first need to fix the quantity that we’ll be ordering. Conversely, if we want to calculate how much stock to buy then we first need to fix how often we’ll place orders.

Fixed quantities

Using this strategy, the primary goal of inventory planning to decide when they need to place orders. The actual quantity of goods to be ordered will be the same for each order and is calculated according to the Economic Order Quantity (EOC) formula.

Fixing reorder quantities is fairly typical for larger companies with fairly stable product lines. However, unless you want to pick completely arbitrary order quantities (not recommended) it requires you to be able to estimate the holding costs of each SKU that you carry as well as the cost of placing orders.

Fixed intervals

Smaller companies or companies with more changeable product lines or seasonal products might choose instead to simply reorder stock once per week or once every couple of weeks. Implicitly then, they fix the regularity with which they place reorders.

For these companies, the primary question that they are trying to answer with their inventory planning process is how much stock to order.

Which strategy is best for my company?

The advantage of the fixed intervals strategy is that if avoids the need to calculate the Economic Order Quantity for each of the products you sell. The disadvantage is that it may not result in the most efficient reordering process since the decision as to how often orders should be placed is somewhat arbitrary.

If your company is spending a lot of time and money placing orders with suppliers then it may be worth calculating the EOC for each of your products and switching to a fixed quantities model. Otherwise, your best bet is probably the fixed intervals strategy, since it will be the easiest to implement and maintain.

References

  1. http://en.wikipedia.org/wiki/Supply_chain_management