Trim Your Inventory with Residual Inventory Analysis
By Matt and Jon Schreibfeder
Over the last several months, we have been discussing various ways of reducing inventory without affecting customer service. This month, we are going to explore how to determine if your safety stock quantities are too high. Safety stock is the reserve inventory you maintain to prevent stockouts due to unusually high demand for a product or delays in receiving a replenishment shipment.
If safety stock quantities are too low, they will not provide adequate insurance to prevent stockouts. If safety stock quantities are too high, part of your inventory investment will be tied up in non-productive stock. This excess inventory will not contribute to your efforts in achieving the goal of effective inventory management.
There is a simple, best practice analysis that will help ensure that the safety stock quantity you maintain for each item is “just right”. To perform this residual inventory analysis, you need to record, for each item, the forecast quantity, actual usage and the safety stock quantity for each of the previous three months. For each product in each month, add the safety stock quantity to the forecast:
Forecast + Safety Stock = Planned Total Available Stock for the Month
The result is the planned total available stock for the month. This is the quantity you are intending to sell or use, plus your insurance stock to cover unanticipated demand or delays in receiving replenishment shipments. Subtract from this quantity the actual usage quantity for the month. The result is called “residual inventory”.
Planned Total Available Stock for the Month – Actual Usage = Residual Inventory
To convert the residual inventory quantity into a number of days’ supply, divide this quantity by daily demand (e.g., your monthly forecast divided by 30):
Residual Inventory ÷ (Forecast ÷ 30) = Residual Inventory Day’s Supply
In a specific month, if the residual inventory is less than a minimum number of days’ supply (three or four days is a typical number), the forecast plus safety stock quantity was not adequate to meet actual usage, It is highly probable that a stock out might occur. We refer to this as a potential stockout. You should consider increasing the safety stock quantity. Why not base this analysis on zero days’ supply? Because you might have experienced some lost sales due to the on-hand quantity not being adequate to meet a customer’s need (e.g., they wanted five pieces but you only had one piece of the item in stock), and the customer didn’t place an order.
Calculate how many potential stockouts occurred during the three-month period and divide this quantity by the number of possible stockouts. Possible stockouts are equal to the months with actual sales or usage of an item during the previous three months. For example:
12,000 instances of usage for products in 3 months = 12,000 opportunities for a stock out
600 residual inventory values less than a three-day supply
Potential Stockout percentage = 600 ÷ 12,000 = 5%
An estimated customer service level is the inverse of the stockout percentage or 95%. This means that 95% of the time you should have adequate stock to meet customers’ expectations of product availability.
If residual inventory analysis shows that a product consistently has a residual inventory quantity representing more than an “x” days’ (typical value is 21 days) supply, consider reducing the safety stock quantity for this item and invest the money saved in additional safety stock for a critical product that has recently experienced one or more stockouts.
In today’s competitive environment it is critical to make sure that every dollar invested in inventory is contributing to achieving the goal of effective inventory management. Fine-tuning safety stock quantities with residual inventory analysis is a valuable tool in this effort.