Current economic conditions have caused many distributors to experience a decrease in sales and lower profit margins. There is less money available to invest in inventory. But in order to remain competitive, distributors must maintain a high level of customer service. In times like these it is critical that every dollar invested in inventory is working to achieve the goal of effective inventory management:

“Effective Inventory Management allows a distributor to meet or exceed customers’ expectations of product availability with the amount of each item that will maximize net profits.”

When forced to reduce inventory many distributors first look to get rid of dead stock and remove slow-moving inventory from warehouses. But this course of action presents several challenges:

  • It is often difficult to liquidate dead stock. After all, if your customers don’t want this material it probably will take a lot of effort to find someone who does want it.
  • Your customers may depend on you to have some of your slow-moving products always on the shelf just in case they need them. The availability of these products contributes to your reputation as a “reliable supplier” and helps to differentiate you from your competitors.

We have found that a more effective way to trim your inventory is to “micro-manage” your fast-moving products that also have a high cost of goods sold value. These products not only sell frequently but also represent a lot of dollars moving through your inventory. Reducing the stock of these products in most cases will substantially reduce your inventory investment while increasing turnover (i.e., your opportunities for earning a profit). The challenge is to ensure that any stock reduction does not negatively affect customer service. Here are two ideas to help you achieve this goal.

  1. Determine the Accuracy of Your Current Demand Forecast.

Demand forecasts are predictions of the quantity of each stocked item you will sell or use in the future. It is a very critical element in maintaining the best possible inventory. After all, if you have a good idea of what your customers will need in the future, you can stock less and still fulfill their requirements.

Unfortunately many distributors use a single formula to calculate demand forecasts. Different items in inventory (even products within the same product line) have very different patterns of usage and therefore require different forecasting methods or formulas to calculate accurate predictions of future usage. The results of bad forecasting are often hidden because most computer systems do not report the forecast error of each item – that is, the average difference between the forecast and actual usage over the past several months.

You can calculate the average forecast error for each item with the following formula:

[Absolute Value of (Forecast – Actual Usage)] ÷ The Smaller of the Forecast or Actual Usage

If your average forecast error exceeds 30% or 35%, you probably can lower your inventory (while maintaining a high level of customer service) by implementing a more comprehensive forecasting system. Talk to your software provider for available options for your system. You can also ask us for assistance in finding appropriate forecasting tools for your business.

  1. Make Sure You are Not Maintaining Too Much Safety Stock.

Safety stock (also known as “safety allowance”) is reserve stock that you maintain to protect against stock outs due to unusual demand or delays in receiving a replenishment shipment. Like any other type of insurance, safety stock is an expense… not an investment. You do not want to maintain more safety stock for an item than necessary to achieve your desired level of customer service. As with demand forecasts, many distributors use one common formula for maintaining safety stock (often 50% of lead-time usage). They do not realize that individual items might need more or less safety stock.

To help determine if your safety stock quantities are appropriate, try performing a residual inventory analysis. For each of the previous three months, perform the following calculation for each item:

(Forecast + Current Safety Stock) – Actual Usage = Residual Inventory

The forecast is what you estimated you would sell or use during the month. The safety stock is the reserve inventory you are maintaining for the item. The total of the forecast and safety stock equals the quantity of each product you planned to sell or use. Actual usage is what actually left your warehouse. The balance is residual inventory.

If the residual inventory (in terms of days’ supply) for a product is continually high (maybe greater than 21-day supply) consider lowering the safety stock quantity. If the residual inventory is low (maybe less than a four- or seven-day supply) consider increasing the safety stock quantity.

Note that this simple formula to calculate residual inventory does not consider variations in the lead time. We have found it is best practice to set the anticipated lead time for each item equal to the longest normally anticipated lead time for the product. For example, if the lead time for an item ranges from two to four weeks, set the lead time in your system equal to four weeks. By determining appropriate safety stock levels based on a single criteria (i.e., the difference between the forecast and actual usage) we can fine-tune these quantities and maintain just enough safety stock to maintain our desired level of customer service.

During an economic downturn you may find that things aren’t as busy as they are when sales are booming. Use this time to carefully examine your inventory. Take the “fat” (i.e., excess stock of fast-moving products) out of your inventory and keep the muscle (i.e., inventory that helps meet the goal of effective inventory management). Not only will this help you survive the bad times, it will help you prepare for the next upturn in the economy!