CONSULTANTS TO THE AFTERMARKET

Bill Wade

 

Suppliers and Distributors Can Take Advantage:
The ‘Natural Laws’ of Inventory

It’s Time to Renew Inventory Reduction Efforts

By Bill Wade

According to well trodden academic ground, fully supported by math and industry practice, the number of stocking points and overall inventory costs are related, but not linearly. The "square root rule" captures the nonlinear relationship between inventory and the number of stocking points:

The Square Root Rule

This rule states that the total inventory in a system is proportional to the square root of the number of locations at which a product is stocked (n = number of stocking points). This ‘law’ has been discussed as far back as 1962 and was proven mathematically in1975 in the International Journal of Physical Distribution. I read it - you don’t have to!

The significance of this apparent law of nature is that a firm (or industry) currently operating out of five warehouses which centralizes to one warehouse can theoretically reduce inventory carried in stock by 55 percent.

 
New Number of Stocking Points

Existing
Number
of
Stocking
Points

 
1
2
3
4
5
10
15
1
*
(29)
(42)
(50)
(55)
(68)
(74)
2
29
*
(18)
(29)
(37)
(55)
(63)
3
42
18
*
(13)
(23)
(45)
(55)
4
50
29
13
*
(11)
(37)
(48)
5
55
37
23
11
*
29)
(42)
10
68
55
45
37
29
*
(18)
15
74
63
55
48
42
18
*
20
78
68
61
55
50
29
13

This will of course result in large inventory carrying cost savings, which will be slightly offset by more rapid transport to meet current delivery service levels.

As one can see from the above chart, there are huge potential benefits to reducing the number of locations within an entire supply chain... and on the flip side, also significant inventory increase penalties to adding to the number of stocking locations.

If recent sales levels and general business activity are a real hint of the shape of the ‘new normal’, it would seem prudent for all participants in the chain to dust off their old inventory textbooks and get serious once again about significant inventory reduction.

Anticipated rapid increases in inflation point in the same direction. Look at viewing the entire channel as a closed system and imagine the enormous benefit everyone would derive (and share) if ‘our’ inventory was readily available to all of the ‘thems’ in our channel.

Other ‘Rules’ that Help Lowering Inventory Industry Wide.

The key to sustainable reductions is to focus on the input variables. However, any attempt to reduce inventory should be in harmony with the goal of maximizing long-term profits for distributor and supplier. First, try some of the obvious targets:

Pareto the Inventory - Gather sales and inventory in dollars by item. Construct two Pareto charts.

For the first chart, classify your items into A, B, C, and D (80%, 15%, 5%, 0%) based on sales. Then calculate your inventory for each group. Do A items represent 50% of inventory? If not, there may not be enough inventory for these items. A significant amount of inventory on low demand items may indicate problems with managing obsolete inventory.

For the second chart, classify your items based on inventory. Then calculate the sales for each group. Again, do A inventory items represent at least 50% of sales? If not, inventory may be out of balance.

Eliminate Obsolete Stock - Is obsolete stock kept on hand because no one wants to own up to it? Or is it because the company can't "afford" an expense hit this quarter to write-off the obsolete stock? Ridding the warehouses of obsolete inventory will result in good long-term financial results. Here, accounting rules can drive poor operating rules.

Revise Order Cycles - Smaller and more frequent order quantities translate into less inventory. Determining order frequencies is one of the key variables of the supply chain. A thorough understanding of metrics within supply chain costs is essential before embarking on this strategy.

Caution: while the goal is reducing inventory, the opposite may be true. Balance any loss of transportation efficiencies by moving to smaller batches. What does this mean to the labor workload at the distribution centers, at branches and with the delivery fleet?

Lower Service Levels - Heresy? Not any more. Understand your customers. What kind of service, in terms of lead time and availability, do your customers really require, and how do you know? Just assuming nothing has changed is not the right answer.

Reduce SKU Counts - How many customer-specific SKU's are in stock, and are those customers still active? Are identical products packaged and stored differently? Is there substantial part/SKU proliferation? How about kits? Are the 2-count, 4-count, 6-count and 8-count packs all in stock?

Working with sales and customers, you may be able gain agreement that eliminating some of the inventoried items will not affect real service levels at all. Any part reduction will help to free up space in warehouse, ease purchase planning and reduce inventory investment.

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