Three Ways a Good Inventory Formula Helps You Reduce Inventory
You need safety stock, but you also need to avoid overstocks. So, how can you get the math right when you’re not even sure what figures to put in?
Using a good inventory formula can help you reduce inventory in three ways.
First, a good formula will give you scientifically better safety stock levels than a bad formula or a rule of thumb.
This seems obvious, but the explanation gives some insight. A typical rule-of-thumb can be a blanket “days of supply” across all or groups of products.
Whenever you have a blanket policy across many products, a good inventory formula will quickly show you three things: products with too much inventory, those with too little, and those that work with the blanket policy.
If you have a blanket policy and want to keep your job, it is best to err on a blanket policy with extra inventory. If you don’t err on the side of excess inventory, a third of your products will be at risk of being out of stock (and not selling).
There is an easy test to see if this is the case: If the majority or vast majority of your products never come even close to stocking out, you probably have too much inventory.
So, a good inventory formula will set a policy tuned for each product’s characteristics. This does require more work as you have to collect data on each product. But, once you do that, good formulas are easy to implement.
Second, using a good formula systematically allows you to automatically reap the benefits of improving your business.
The second way is more subtle, and I only realized it after my friend and the founder and CEO of Lyric, Ganesh Ramakrishna, said it to me…
"If you work hard to reduce lead times and have a rule-of-thumb policy, there is no automatic way to reduce inventory. You have to debate whether the days of supply should go from 20 to 15. If you have a good formula in place, the formula’s output will give you less inventory as the lead time decreases.
In any business, things will continue to get better (hopefully). With a good formula in place, these changes will automatically show up in new inventory policies. Your inventory policy is on autopilot.”
This is a great insight. Your inventory adjusts appropriately by systematically collecting data and using a good formula.
Remember, though, that the reverse is also true. If things worsen, the formulas suggest more inventory. This is a feature, not a bug. You want the formulas to give you more inventory to protect against stockouts.
As a side point, these same formulas can be used to help prioritize improvements in the business. That is, you can determine the relative value of improving forecasts, reducing lead time and variability, or cutting batch sizes.
The third thing to remember? Using a good formula helps reduce inventory.
That’s it.
I’m convinced that just the act of using a good formula helps. There will always be uncertainty. So, setting the right inventory policies is a statistical exercise. You’ll do better with using data and a good formula. This is the same idea behind the book (and movie) Moneyball.
I intentionally used the word “good” and not “perfect” or “great.” I think there will always be so much noise in the data and so much uncertainty that a good model will get you almost all the benefits.
Of course, for all three of these things to work, you need to actually order or make products based on the results of the formula.
In practice, this fails when you don’t trust the results and override the recommendations. Usually, this happens if you need to fix the data, tune the formula, or educate everyone more to understand the results.
In the next post, we’ll discuss a good formula and an easy way to tune it.
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