INVENTORY PLANNING & OPTIMIZATION
Have You Figured ALL the
Costs of Inventory?
Inventory working capital
reduction is a wonderful con-
cept; however, it is important
to understand all of the poten-
tial financial impacts before
—Ralph Cox, principal, Tompkins
s senior management focuses more on reducing inventory
working capital, it is helpful to understand how profit and
free cash flow will be impacted by these decisions. Regardless of how the reduction is managed, any inventory can be
viewed as having two components—safety stock and cycle stock—each
driven by very different factors.
When cycle stock inventory working capital is decreased by minimizing
forecast error, the balance sheet and profit and loss (P&L) are improved
through reduced period inventory holding costs. However, when cycle stock
inventory working capital is reduced through reduced purchase or transfer
order quantities (i.e., increased mean time between orders), the balance sheet
is improved but the P&L can be negatively impacted by increased purchasing
and expediting labor cost; higher receiving labor cost due to the number of
receipts; growing warehousing labor costs due to dock congestion;and missed
shipments due to receiving delays.
When safety stock is decreased through reduced forecast error, shorter lead
times or improved supply reliability (receipt order fill rate) while maintaining
the level of customer service provided (order fill rate or SKU in-stock percentage), then the balance sheet and the P&L are improved through the reduction
of period holding costs. Revenue remains unchanged.
For most businesses, when safety stock is reduced through a reduction of
customer service, period revenue and margin can be reduced. This is a far
riskier approach to reducing inventory working capital. The balance sheet may
be slightly improved, but the P&L is almost always negatively impacted. Technically, the period inventory holding costs are decreased, but the drop in gross
margin usually more than offsets any gain forming a net reduction.
To get the best cycle stock financial performance, reduce forecast error at
the SKU-location level and determine order quantities so as to minimize total
variable cost. To get the best safety stock financial performance and the eco-nomically-optimum level of customer service, reduce forecast error at the SKU-location level and balance safety stock investment with gross margin.
In order to achieve the best possible inventory performance, improve competi-
tive advantage and maximize profit perform the actions below:
• Educate personnel and collaborate;
• Apply enabling technology, such as inexpensive third-party modules;
• Refine business processes; and
• Measure inventory performance on a continuing basis.