Inventory Management term

A question for supply chains professionals is “How much finished goods inventory should be held”? But should the answer be provided as a financial value or as physical quantities? And is the answer readily available?

As with other aspects of supply chains, a discussion of inventory must commence with an assurance that definitions agreed at the organisation level are used. The term Inventory Management incorporates three linked aspects of interest for supply chain professionals and others:

• Inventory Policy: the decision about how much money an organisation is prepared to invest in inventory, rather than other aspects of the business. It is measured at the aggregate (or cumulative) level
• Inventory Planning: the inventory planned to be held at each location, by time period. It is measured at the product or family group level, based on the parameters provided by the Inventory Policy
• Inventory Control: the process of accurate record keeping to identify the actual amount held in inventory and to ascertain reasons for discrepancies against the Inventory Plan. It is measured at the SKU level

So, the question of “How Much” is answered at the Inventory Policy stage, where Directors and senior managers should consider the direction of performance and degrees of increase or decrease; not absolute numbers.

Inventory Turnover and Velocity measures

Commentators inform us that the measure of performance for inventory is the Inventory Turnover (or turns) Rate (ITR), which indicates the speed at which a business sells its finished goods inventory. The higher the ITR, the more effectively the inventory is being used. The ITR for finished goods is measured as: Cost of Goods Sold (COGS) for a selected period of time and annualised/Inventory investment at the end of the selected period of time. A variation on ITR is ‘Weeks Cover’, which calculates the period (expressed in weeks) that the expected sales are covered by available inventory. But ITR is a financial based measure, with COGS figures not readily available outside Finance.

Supply Chain professionals require a metric that provides a similar measure to ITR, and which is generated within the Supply Chains group. Inventory Velocity (IV) is a physical measure of items and time that equates to Inventory Turns. The IV measure enables a comparison of ‘stock-on-hand’ to consumption that identifies actions required by members of the Supply Chains group. For example, the ‘velocity’ of SKUs through the supply chains slows with excess inventory, enabling bottlenecks in capacity, labour, and storage space; increased cycle times and affected gross margins.

The IV calculation is: Average inventory level (AIL) for a period of time/Average monthly consumption (AMC). Where AIL = OS + ((CS-OS)/2). OS = opening stock and CS = closing stock. AMC = past 12 month consumption /12. The IV is calculated for each SKU in the sales catalogue, based on 12 months of past data and the answer is expressed in ‘weeks (or days) of cover’.

There are two challenges concerning the AMC calculation:

• month-end inventory balance may not be representative of the average inventory balance on a daily basis. This can be caused if a business has ‘end of month’ campaigns to meet sales forecasts. This can artificially reduce the month-end inventory levels and increase the next month’s week one inventory, due to restocking
• seasonal sales cause low inventory balance at the end of the selling season. Also there is a stock build period prior to the start of the selling season

Coefficient of Variability approach

The Coefficient of Variability (CoV) analysis of inventory addresses these challenges, because each Group/Class reflects the pattern of demand, rather than absolute demand. A description of the CoV technique is provided in the eBook Essential Information for Planning Supply Chains and in a previous blogpost.

As the SKUs are identified within their Group/Class, the range of inventory volumes to hold can be identified. Tom Rafferty at STOgroup has provided an inventory holding range for each Class. It is not definitive and can be modified to reflect your organisation’s business.

• Class a: Steady: <4 weeks of cover
• Class b: Variable: >4 weeks and <8 weeks of cover
• Class c: Erratic: >8 weeks and <26 weeks of cover
• Class d: Irregular: >26 weeks and <52 weeks of cover
• Class e: Lumpy: >52 weeks of cover
• Class f: Dead: items in the Sales catalogue that are not stocked and, mostly, not sold

For each SKU, the question “How much inventory should be held” can be answered by identifying a ‘weeks cover’ within the range for that Class. Using the conversion rate for families of SKUs in Sales & Operations Planning (S&OP), the various ‘weeks cover’ volumes are converted to the standard volume measure (e.g. tonnes, litres, standard shipper etc.) of your business.

In addition to the measurement of inventory, increasing the Velocity of SKUs is a good endeavour. But the energy expended to increase Velocity is likely to have only a small impact on the performance of all inventories. The ‘elimination’ approach (“if not for what can this be eliminated?”) is better for improving the performance of inventories, such as the following examples indicate:

• 24 percent of usable warehouse space to hold items that provide four percent of sales. A common situation that the CoVM approach will address
• an audit team sings ‘happy birthday’ to an inventory stack they counted the previous year. Write a proposal for Finance to write-off the value of inventory that should be in Class f – Dead
• building an automated high-rise warehouse for finished goods inventory that holds three times the inventory slots currently required. Indicates plans for additions to the ‘long tail’ of low selling Class d Irregular and Class e Lumpy SKUs. Increases in sales should be aimed at Class a, b, c SKUs
• excess inventory of imported items held in inventory. Require a ‘total cost of ownership’ (TCO) evaluation of airfreight vs sea freight for imported items

In articles and presentations, the use of ‘Inventory Turnover’ and ‘Inventory Velocity’ terms have become interchangeable but with a similar meaning. This is due to a lack of understanding concerning the terms. While the CoV and IV techniques are not ‘perfect’, they can be defended. But this can only be achieved if the definitions and approach is consistent within the Supply Chains group. It is a leadership task to get all in the group up to speed.