Inventory Management

Posted: Jan. 27, 2004, 9:00 a.m., EST

by John Steidl
Thomas Group Consultant

AKRON,OH -- As this column unfolds over the coming months, there will be several major themes, each with a number of articles. In this first series, we’ll address operational effectiveness. We’ve chosen the inventory dilemma as the first topic, though additional installments will include the related issues of inventory management methods, performance measures, information technology and others.

Inventory management is a classic business problem, because it represents a fundamental trade-off. On the one hand, inventory allows us to serve our customers. But at the same time, cash invested in inventory cannot be used for other things, and businesses that manage to turn their assets faster usually generate both higher margins and higher equity valuations. So what do we mean when we talk about improving inventory management performance?

I’m going to make two radical suggestions:

1. Although the “inventory problem” is clearly a trade-off exercise, most companies do not manage it that way. The automotive aftermarket tends to focus almost entirely on the service level side of the equation. Rather than asking, “What is the right trade-off between service level and cash tied up?” we tend to ask, “How much inventory do we need so we can always have our entire product line in stock?” This second question implies that, if it is possible to improve service level, it is always worth doing so. This is not true.
2. If we do talk about a trade-off, we tend to assume that the only way to increase service levels is through higher inventories. And conversely, that lower inventories always mean lower service levels. This is also wrong.

Let me take my second comment first. Economists use a concept called the "efficient frontier" to describe this kind of trade-off. Applied to inventory management it means that, for a given level of efficiency, service levels will vary directly with the level of inventory. What we tend to forget is that our level of efficiency is not fixed. If we were able to improve our inventory management practices, we could decrease inventory levels and increase service levels at the same time. Wal-Mart is a classic example in retailing. By combining improved POS information with more frequent replenishment and enhanced logistics practices, Wal-Mart is able to both turn its inventory faster, and offer its customers better service levels.

Now imagine for a moment that we have moved our efficient frontier to a new level through operational improvement. We’re still faced with the trade-off problem. Why is it not always worth improving service level if we can? It’s because service level does not improve linearly with increasing inventory. Once you’re already at fairly high service levels, it can take dramatically higher inventories to improve your service just another percentage point or two. What this suggests is that we need to categorize our SKUs and set service levels based on critical attributes:

* How fast do they move and how stable is the demand?
* What is the customer expectation? Standard, high volume items should be in stock at all times, but so customers will expect or be willing to wait for unusual or specialty products. How many fall into this category?
* What are the lead times for the items, and how reliable is the supplier?

The trade-off needs to be approached differently for different types of items. One service level does not fit all SKUs. We need to recognize that inventory management is a complex trade-off, and must be managed as such.

What are some specific opportunities for operational improvement in inventory management? Or to put it another way, how do we move our efficient frontier to a new level? We’ll look at this question in a future article.

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