One of the biggest costs in a business and often the largest commitment of cash is inventory. In Lean thinking all inventory is also waste. So what is the right level of inventory for your business?

A common mistake by businesses is to treat inventory as a driver of business performance. The theory goes, reduced inventory leads to reduced working capital, which leads to improved return on capital. Unfortunately what usually happens is that reduced inventory leads to reduced customer service levels and increased firefighting in the supply chain, which then leads to lost business, increased costs and reduced profits! The problem with attacking inventory in isolation is that inventory levels are an outcome of how you run your business, not a driver!

Good and bad inventory

Of course all businesses have inventory they would rather not have. This “bad inventory” is made up of excess and obsolete inventory. Obsolete inventory is stock of products that you no longer make, while excess inventory is stock in excess of that required to maintain your target level of customer service (more about that later). Your business needs a process to manage excess and obsolete stock. The best approach is to prevent it by careful management of product run-outs and setting of target stock levels. Management of excess and obsolete stock is an ongoing process, not a one-off event.

The reality is that unless your customer demand is constant every day of the year or you have a supply chain with infinite capacity, you will need to keep some inventory somewhere in the chain. The question is, how much?

In an ideal world your average inventory will be equal to your safety stock plus half of your replenishment quantity. The replenishment quantity is the average amount of the product that your business consumes between deliveries. For example if you receive deliveries every week, then your replenishment quantity will be equal to one weeks average consumption. Safety stock on the other hand is a function of how variable the supply and demand of the product is and what level of customer service you are targeting. The more variable the usage or demand, or the higher the level of stock availability you require, the greater the level of safety stock you will need.

So how do you reduce inventory?

Many things drive your stock levels — the level of customer service you need, the level of variability in supply and demand, the replenishment frequency, and the lead time to replenish. Also, in distribution networks, the number of stock points has a large impact on stock.

Frequently the first target is to attack suppliers to improve their level of service and beat up on sales-people to give better forecasts. While these activities are generally satisfying for the frustrated supply chain manager, they are usually not the biggest drivers of inventory.

The biggest driver is replenishment frequency. Switching from monthly to weekly or daily replenishment will reduce the amount of replenishment stock and the need for safety stock by an order of magnitude. Look at ways to consolidate freight through regular “milk runs” to reduce the impact on freight costs.

Shorter supplier lead times also have a significant impact. By increasing the frequency of replenishment you can also review the number of locations where you stock the product. You may have to slaughter some parochial “sacred cows” to achieve this, but if you can offer more frequent and more reliable replenishment the argument becomes a lot easier.