What is inventory optimization?
Inventory optimization is the practice of having the right inventory to meet your target service levels, while tying up a minimum amount of capital in inventory. To achieve this, you need to account for both supply and demand volatility.
Don’t confuse inventory optimization with basic inventory management. Inventory optimization is the next level of inventory management. Inventory management involves ordering, managing, storing and moving inventory. Whilst inventory optimization focuses on ordering the right products, in the right quantities to meet demand – as cost-effectively as possible.
Key elements of inventory optimization
In order to achieve inventory optimization, companies need to understand the three primary elements.
- Demand forecasting
- Inventory policy
Let’s take a closer look at each of these:
There are several ways to forecast demand including looking at last year’s or last period’s demand or request forecasts from your sales force. This can work for items with steady, predictable demand, but it can be entirely inadequate when demand gets more uncertain. Here’s why:
Every product has a unique life cycle. For example, when a product is first introduced to the market it will have no historical demand at all. Then it will likely move into to a positive trend as demand constantly grows, until it becomes a stable and fast moving good. From there, demand might get more irregular and then move into a negative trend before becoming a dying and then obsolete product.
Demand forecasting also needs to consider seasonality. Identifying seasonal demand is key for forecasting accuracy. For example, there’s no point forecasting demand for a product that only sells in the summer (e.g. sunscreen) based on the previous quarter’s sales.
Next, businesses need to set their inventory policy, meaning they must determine each product line’s optimal stock level. Many companies use the ABC analysis method, also known as the Pareto Rule, where management categorizes inventory into A, B, and C groups based on their usage. You can read all about ABC analysis in our blog post.
By categorizing inventory using the ABC method, businesses can determine which products should be stored on-hand and which can be ordered on demand. Then, management must calculate how much safety stock to keep in case of unexpected demand increases, supply chain disruptions, and vendor complications.
Finally, for businesses with multiple warehouses, inventory optimization is about distributing inventory across warehouses, in the right quantities at the right times. Items must be moved from regions where demand is low, to those where it’s higher. As in that way items are then available to ship to local customers as quickly and cost effectively as possible.
Last but certainly not least is stock replenishment. Once companies determine the optimal stock levels for each product, they must calculate reorder points to actively maintain a healthy inventory count. A reorder point (ROP) is the minimum amount of stock a business can hold before placing another order.
To optimize stock replenishment, businesses need to focus on:
Supplier lead times have a big effect on stock availability and service levels. So, businesses must have a clear idea of their vendor’s production cycles and operating hours. This is especially important for companies that have foreign suppliers. For example, manufacturers overseas may close for a national holiday that the United States does not recognize. These instances can delay lead times, stalling sequential processes, such as order fulfilment.
Goods in Transit
It is not enough to have an accurate count of on-hand inventory when replenishing stock, companies must also account for what goods are in transit. Otherwise, management can accidentally double inventory orders, driving storage, and stock expenses.
Why is inventory optimization important?
There are many reasons why inventory optimization is critical for businesses in today’s world.
First, inventory optimization dramatically improves the financial performance of an inventory because buying and stocking are more in-line with expected customer demand. It helps to reduce and almost eliminate the future build-up of excess inventory and dead stock.
Second, the costs for most items are steadily increasing; real estate costs and taxes are up. Inventory optimization provides a great balanced inventory to meet expected demand, while reducing costs and better controlling spend for additional stock purchases. Planning in a timelier manner reduces the need for expediting orders in from vendors, which in-turn reduces the need for expediting shipments to customers.
Third, there are too many known and unknown variables that can affect your inventory and subsequent customer service levels to manage properly. Just forecasting and planning your inventory leaves you wide-open to problems in meeting both your financial goals and customer expectations.
Demand forecasting, inventory policies and replenishment activities are the core inventory optimization techniques. Each aspect is crucial to guaranteeing you have the right stock in the right places at the right time.