Accurate Forecasts Key to Inventory Control

Every manufacturer, distributor and retailer has inventory and lists it on the balance sheet as an asset. But, from an operations management perspective, is inventory really a good thing? Too much inventory ties up precious resources (money, space) but too little can cause lost sales. So, how much inventory is enough?

The real question is not “how much inventory” but rather “what inventory” to have — you want the right quantity of the right items at the right place and time. In order to determine what that is, you first have to look at why you have inventory in the first place.

For a retailer or a manufacturer whose customers expect immediate delivery, you will need enough of the right inventory to meet the demand. The implication is that you know what that demand will be — meaning you need a good forecast. Forecasting is difficult and seldom accurate, so you are still at risk of not having the inventory you need, and probably will have too much of what you don’t need. Running out of something is likely to result in lost sales, so companies decide to “pad” the inventory of popular items, assuming the extra investment is worthwhile to avoid losing business opportunities. As long as this is a conscious decision, properly justified, then so be it.

But inventory tends to get out of hand. Maybe the item is not as popular as it once was. Businesses seldom revisit these inventory decisions and what was once a reasonable investment to improve customer service becomes an unnecessary drag on company funds, space and resources.

The same dynamic applies to goods that are not needed for immediate delivery. Whenever the acceptable lead time to the customer is shorter than the actual lead time to make or procure the product, it takes inventory either on hand or in the pipeline to be able to meet that customer expectation. In this case, the amount of inventory needed is equal to the expected demand (usage) during the time it takes to get more — known as the resupply lead time. Then, of course, there should be some additional inventory (safety stock) to accommodate variations like higher-than-expected demand during the resupply period or perhaps a late delivery from the supplier.

Enterprise computer systems often include inventory management and forecasting applications that can measure demand variation (forecast accuracy) and manage the amount of buffer inventory needed to meet your customer service objectives. But the real secret to success is to work at improving forecast accuracy because that will let you reduce inventory without harming service level. Accurate inventory information is also critical — the system can’t manage inventory if it doesn’t know what you have.

Note that another source of inventory is related to how it is procured — volume price breaks, shipping costs, minimum purchase quantities, economic lot sizes and the like will increase the initial quantity on-hand but these extras should be used up in the normal course of business and are not usually the source of an inventory build-up.

Inventory can be viewed as a necessary evil — a significant cost in most companies that is justified by the role it plays in reducing lead time and covering for the unexpected (forecast errors, late deliveries, damage or scrap, etc.). The secret to making the most of your inventory investment is in knowing just how much you need — the right amount of the right products or parts at the right time. And that comes down to good forecasts and intelligent buffers. It’s not magic. It’s just good operations management.

Reprint:  June 14, 2010 2:00 AM.  Portsmouth Herald; Seacoast Media Group, a subsidiary of Dow Jones Local Media Group.