Inventory Management – More Than a System

Inventory Management is a critical functionality in many enterprise-level software systems. For any business holding parts for manufacturing, repairs, shipping, or other technical services, understanding the dimensions of your Inventory is critical to discerning the best system to use to manage it, and will help in setting requirements and expectations for configuration.  Even if you are using QuickBooks and spreadsheets to manage your inventory, these business decisions are relevant.

Inventory Management is a balance between holding inventory in stock while incurring the up-front costs of that inventory and ensuring that you do not stock out of critical inventory and hold up service/sales to your customers.  The costs of holding inventory are four-fold:

  1. The up-front cost of the inventory itself (not yet paid for by a customer in a sale)
  2. The cost of maintaining sufficient physical space to hold the inventory
  3. The opportunity cost of peoples’ time to manage the inventory
  4. Insurance costs for inventory loss coverage and/or physical space

As your volume of inventory on hand increases, many of these costs increase proportionally.  This has been one major driver in the popularity of “just-in-time” inventory management – receiving goods very close to when they will be used in the manufacturing and/or shipping workflow, reducing the costs of holding excess inventory as described above. 

However, what about that supplier (or those suppliers) who have long lead times, are critical to your quality and/or process, and/or for whatever reason simply do not consistently perform to their stated lead times?

Before assuming that an Inventory Management System will “solve” all these concerns, take a step back and make some business decisions about your inventory.

Inventory and Supplier Evaluation

Parse your inventory into A, B, C Categories, and consider the suppliers for each. 

Category A = critical for quality and/or compliance, high-value, typically long lead items, and often challenging to find multiple suppliers who can provide the same exact product.

Category  B = moderate value and lead time, not compliance or quality critical, typically able to find multiple vendors who can provide the same product.

Category C = “consumables” components that you can basically get “off the shelf” with no lead time which are not compliance critical at all (i.e., you can get them from “anyone at any time.”)

The riskiest components are the “A” items – things that are high value and are critical for compliance.  These items need to be managed more carefully than others.  You will always need counts on these and will evaluate the risk profile of vendors.  If you are single sourced in these parts, you may need to carry more inventory on hand to prevent stockout.

B items have a moderate level of management – you should be able to pull orders within lead times to never experience stockouts.  Since you have multiple vendors who can deliver, you should not need to carry as much inventory on hand to prevent stockout.

C items should be always on hand with “volume” based reorder points and no need for detailed inventory counting. 

Ideally you will minimize the use of “unique” suppliers where possible – i.e., suppliers that provide only one component.  Your leverage with them is much lower than with suppliers that provide multiple components.  However, in a compliance-driven industry, you may have unique suppliers which are critical to you.  Relationships with these vendors should be treated with special care, though you should continue to develop risk-based alternative contingencies should anything happen to them.

Question: Do you have a Supplier Approval Process to evaluate new suppliers in a risk-based fashion to ensure they meet your standards, based on the type of components/parts/materials they are providing?

Calculate Inventory On-Hand and Reorder Points

This is a “one-time” baseline exercise, that can be updated as you add parts/components and suppliers. Calculate your run rate for use of all components on a weekly basis and develop a forecast projection based on your growth trends and/or business data from the Leadership Team (i.e., consider a buffer if you anticipate growth faster than expected).

For all components, determine the quantities you need to maintain on hand based on lead times and establish a “Kanban” for all.” Kanban* in this case is where you set a minimum inventory on-hand quantity and once you go below that, you pull more to the work location. The Kanban amount is your “Safety Stock,” with quantities on hand such that you’ll never run out during the lead time, and you can set a “Service Level” for fluctuations.  For example, if you want to rest assured that you will not run out with 95% confidence, your Service Level is 95% and you use a specific formula to calculate the “Safety Stock”. 

*Kanban safety stock is not to be confused with the “Lean Kanban Method of Agile”

Here is the formula and constants: Safety Stock (SS)  = kσL

Where k = a safety stock constant (see below), and σL is the standard deviation quantity of components used during any given period (typically a week or month).

This was Figure 19 in my MIT LGO thesis

Here is an example:

A, B, C Part Inventory Calculations

Physical Inventory Management Plan

Now your maintenance of this inventory is relatively straightforward.

Every week (ideally) – go through and count inventory.  For “A” and “B” items, you may want to count exact quantities, though for “C” items, you should be able to aggregate to bundles (i.e., boxes of paperclips, pallets of boxes, etc.)

Procedure:

  1. Count inventory
  2. Record Actuals in System of Record
  3. Determine if below the Reorder Point
    1. If you are above the Reorder Point, you do not need to make a new order now
  4. If below the Reorder Point, order the correct quantity to get to the Reorder Up To point
    1. For Example – if you have 4300 of Test Kit 1 from the chart above, you will order 4098 of Test Kit 1 that day (see added 2 columns below):
    1. Note that in this case, we added 1 week of buffer to our Reorder Point just in case the supplier’s stated 6-week lead time is off by 1 week, and we are also at a 95% confidence rate.  These are all business decisions to be made based on risk and how much money you want tied up in inventory.
“A” Part Actual Qty and Reorder Amount Example

You can do things in your physical space that will make counting easier for your teams.  Some ideas are to use lights, colors, or markers on shelves that are visible when inventory gets below a certain point.  Or you can use scales/weight to sense when you are running low on supplies.  You could physically move small quantities of inventory into workspaces, and when you go back and retrieve the last quantities (or with a small amount left) from the storage location, that is when you know the Reorder Point has been reached. 

Automation

As you standardize your business decisions resulting in specific formulas for ABC inventory, as well as your physical processes to count and re-order components, you may discover the opportunity to automate some of this work.  For example, the calculation of re-order points based on dynamic use of parts for a trailing period to forecast growth or based on last year if your business experiences seasonality.  You may even be able to implement a system that includes automatically placing orders with suppliers or uses an API (Application Programming Interface) to allow interaction between systems to do so.

For physical product counting, an inventory management system may allow your team to scan barcodes to count inventory, confirming you do not re-enter the same products multiple times, and thereby reduce the risk of human error due to miscounts. If you have a sophisticated system, you could even put RFID chips on critical items that are “always” counted into your system – and once the Reorder Point is reached, it will automatically place orders with your suppliers.

Take Away

The key take-away is that creating a robust, yet dynamic, Inventory Management System relies on establishing, and continuously revisiting, many business decisions.  Whether these decisions are around growth forecasts, safety stock levels, how you will handle A, B, C parts differently, and how many Suppliers you will qualify, they are the underlying factors which will allow you to successfully use Inventory Management to continue to improve delivery and service to your end customers.