Predictions of the State of Inventories for 2012

This morning I heard a report that the “misery index” continues to rise. The misery index, introduced during the Carter presidency, is the sum of the unemployment and inflation rates. A high misery index results in low consumer and business confidence.

Consumers see inflation increasing the price of necessities leaving less disposable income available for discretionary spending. Salaries usually don’t rise when unemployment rates are high and there is a lot of uncertainty about finding a new job if your current employer decides to cut back.

The uncertainty among consumers is felt all of the way up the supply chain through retailers, distributors, manufacturers; all of the way back to the raw-material providers. In this environment, businesses are unwilling to invest in large speculative purchases.

My recommendations to clients in this uncertain economic climate include:

Examine Slow-Moving Products & Dead Stock

As economic activity slows, the amount of slow-moving inventory and dead stock in a distributor’s warehouse tends to increase. Consider liquidating material that won’t be sold or used over the next six months. This will free up space in your facility. Selling this material will generate cash that can be invested in more of the products that will sell or be used for other purposes.

Ensure That Your On-Hand Quantities are Accurate

Utilize any spare labor you have to implement a comprehensive cycle-counting program. Cycle counting involves verifying the accuracy of the on-hand quantities of some stocked items every day. Concentrate on your faster-moving items. If you know what is in your warehouse, you can stock less material while meeting or exceeding your product-availability goals.

Monitor the Accuracy of Your Demand Forecasts

A demand forecast is a prediction of the quantity of a stocked item that will be sold or otherwise used in the future. Accurate forecasting is the key to the effective replenishment of inventory. That is buying the right quantity, of the right item, in the right location, at the right time. Notify salespeople and buyers if the actual sales or usage of specific stocked items (particularly “A”-ranked products) differ significantly from the demand forecast.

For example, one of our clients notifies the appropriate buyer if sales are less than 50% or more than 300% of the demand forecast in the previous week. Sales management can consider offering promotions or discounts to increase sales. If this is not an option, buyers can reduce replenishment quantities of these products already on order with the supplier.

Evaluate Your Safety Stock Quantities

Safety stock (also known as safety allowance) is reserve stock you maintain to protect against stockouts due to unusual demand or delays in receiving a replenishment shipment. Like any other type of insurance, safety stock is an expense, not an investment. You do not want to maintain more safety stock for an item than you need to achieve your desired level of customer service.

As with demand forecasts, many distributors use one common formula for maintaining safety stock (often 50% of lead time usage). They do not realize that individual items might need more or less safety stock.

Calculating your Residual Inventory

To help determine if your safety stock quantities are appropriate, try performing what we call residual inventory analysis. For each of the previous three months, perform the following calculation for each item:

Forecast + Current Safety Stock – Actual Usage = Residual Inventory

The forecast is what you estimated you would sell during this week or month. The safety stock is the reserve inventory maintained for the item. The total of the forecast and safety stock equals the quantity of each product you are planning on selling or using. Actual usage is what’s actually left in your warehouse. The balance is residual inventory.

If the residual inventory (in terms of days of supply) for a product is continually high – greater than a 21-day supply – consider lowering the safety-stock quantity. If the residual inventory is low – less than a 4 to 7-day day supply – consider increasing the safety-stock quantity.

Accounting for Variations

Note that this simple formula to calculate residual inventory does not consider variations in the lead time. We have found it is best practice to set the anticipated lead time for each item equal to the longest normally-anticipated lead time for the product. For example, if the lead time for an item ranges from 2-4 weeks, set the lead time in your system equal to 4 weeks.

By determining appropriate safety stock levels based on a single criteria (i.e., the difference between the forecast and actual usage) we can fine-tune these quantities and maintain just enough safety stock to maintain our desired level of customer service.

A Plan to Weather the Storm

For hundreds of years businesses have faced economic challenges. Those who have understood the challenges they face and implemented a comprehensive plan to deal with the situation have successfully weathered the storm and prospered when economic conditions improved. In my next article, I will discuss more ideas for “misery-proofing” your inventory.

In the meantime get started! As Bette Davis said in All About Eve, “Fasten your seat belts, it’s going to be a bumpy night”.

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