Using Residual Inventory Analysis in Fine Tuning Your Safety Stock Quantities
Over the last several months we have been discussing various ways of calculating safety stock quantities. If safety stock quantities are too low, they will not provide adequate insurance to prevent stockouts in case of unusually high demand or delays in receiving a replenishment shipment. 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 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 day’s 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 day’s supply (three or four days is a typical number) the forecast plus safety stock quantity was not adequate to meet actual usage and it is highly probable that a stock out occurred. You should consider increasing the safety stock quantity. Why not base this analysis on zero day’s supply? Because you might have experienced some lost sales because the on hand quantity was not adequate to meet a customer need (e.g., they wanted 5 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. That is the months with actual sales or usage 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” day (typical value is 21 days) supply, consider reducing the safety stock quantity for this item and invest the money saved it 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. Determining what items you should stock based on the number customer orders for the product and fine tuning safety stock quantities with residual inventory analysis are valuable tools in this effort.