Rachel Sellers
May 03, 2018
Inventory Policy: Focus on your core and trim the fat
For many out there this is the ‘January’ of the working world. A new financial year, new plans, strategies, hopes and dreams….
My Supply Chain Resolutions are as important now as ever. In this blog, I’m going to look deeper into my second Supply Chain resolution “Focus on Your Core and Trim the Fat”. It’s all about inventory policy and Core product identification. Getting this right will improve a whole host of things throughout your entire supply chain; warehousing and logistics costs, procurement saving opportunities, write down savings and availability improvements, ultimately leading to increased sales revenue and a healthier bottom line. “The holy grail of having the right stock of the right product is ever elusive…you’ll never get it right 100% of the time – but you can get close if you stage agile, adapt and review your inventory policies. “ Step One: Defining your Core Before we can do anything, we have to define our Core. Whatever your business, industry or market – defining your core will give focus to your business. Defining your Core product can be done in various ways. This could be determined by sales volume, overall revenue, profit, key customers, strategy…it’s really up to you. Step Two: How to determine your Core As a general guide, best practice is to use a Pareto classification method. Remember, reviewing your core on regular basis is advisable (annually is most common). This approach is popular because:
- It’s based on rules and logic that everyone can understand
- It’s easy to ‘tweak’ the boundaries and rules for modelling
- It focusses attention on the part of your business that delivers the most revenue – focus where it matters!
- Regular reviews and reclassification of products with revised Pareto Core identification reduces the risk of outdated stocking policies, overstock and stock outs
Explaining the Pareto Principle The Pareto principle (also known as the 80/20 rule, the law of the vital few, or the principle of factor sparsity) states that, for many events, roughly 80% of the effects come from 20% of the causes. The principle was first suggested by management consultant Joseph M. Juran. Richard Koch authored the book, The 80/20 Principle, which illustrated some practical applications of the Pareto principle in business management and life - "80% of sales come from 20% of clients". Mathematically, the 80/20 rule is roughly followed by a power law distribution (also known as a Pareto distribution) for a particular set of parameters, and many natural phenomena have been shown empirically to exhibit such a distribution. Popular Pareto Classifications A basic Pareto class groups products into 3 categories – A, B and C. The Best practice method assigns the top 80% to category A, the next 15% to category B and the final 5% to category C.
If we consider this graphically in the below example we can see the boundaries of our categories:
This basic Pareto classification will give you a solid starting point. Once you’ve assigned your categories, you can begin managing the groups with different rules and urgency. Step Three: Inventory Management Identifying your core is merely a tool. Management of the different categories is crucial to get the benefits you desire. Below are my guidelines for inventory management of the three ABC categories. Category A – These are your key revenue generators. They are typically consistent, high volume, low variation sellers. Service should be high, stock should be turned frequently, availability is key here. You should not go out of stock of these products. Forecasts should have a high accuracy. Good service from your suppliers is vital here. If managed correctly, orders should be frequent and at fairly regular volumes so physical stock holding can be managed as lean as possible. Many may think that these products should have a tonne of stock – they’re crucial after all. In reality – this is your most consistent, easy to plan and most predictable product area. You should be aiming for the minimal stock cover that gives you protection for expected variability. Dependant on your supply chain, you could be ordering this product on a daily basis – using a Just-In-Time approach. Category C – These products are your tail – the hardest and most costly to manage. Sales are erratic, sporadic and vary enormously in quantity. Efforts here should be focused on managing your way AWAY from stocking and selling these products at all!! A ‘bin-level’ stocking policy is a great strategy for these items. Maintaining maximum and minimum inventory levels allows you to determine the level of stock you want to hold (and the cost of that) whilst minimising the amount of time that you need to spend managing these products. Time spent here does not yield a return. These products should be passed to category managers, marketing and R&D to search for ways to relaunch, phase out, or transfer sales on these items to your category A and B products. If possible, you should seek to outsource the supply of these products and act simply as a vendor to your customers. Category B – These are typically where you will spend most of your time. This is where the importance of a flexible supply chain is key. These items sell fairly regularly, in perhaps a ‘spike-y’ fashion. They could be seasonal items that sell only in certain periods of the year. They could be low volume sellers. You should plan to stock the most cover on these items. They contribute significantly to your revenue, but it’s not possible to have these available at all times without extremely high levels of stock holding (which would be financially crippling). Consignment stocks, vendor owned inventory and a good stock return policy with your suppliers can alleviate some of the challenges with category B items. It’s also important to watch the fringes of category B – which items could become category A’s or category C’s in future? Step Four: Digging Deeper Once you’ve got to grips with the ABC classification, you can add another dimension to give a wider range of categories. This should be defined in line with your business strategy – giving you information to make changes towards your goal. A common advanced Pareto classification is ABC (based on Sales Volume), XYZ (based on cost of stock – unit price). This dual approach gives us 9 different classification groups: AX – biggest sales volume, lowest cost, through to CZ - lowest sales volume, highest cost AX are your lowest risk products – high volume, stable sales with low cost of product. These are the products you should aim to always have available. CZ are your highest risk products – low volumes, often volatile of sporadic sales patterns, with a high cost of stock. These items could be managed with vendor owned inventory if you purchase your goods for sale, or with consignment stocks and minimum order quantities if you manufacture your goods. Looking at ways to reduce your liability on these items should be a priority. Tailor your strategy for each category Remember – the classification is simply an indication of how the group of products should be managed. Your inventory policy, rules and strategy from a supply chain point of view should be tailored to the specific demands of each category to deliver the best possible results. I hope this has given some useful insight into the different approaches for managing your own product range. I promise it’s easy once you get started. Just be clear on your strategy, and strict on your policies… The benefits won’t be realised overnight, but with a sound inventory policy they will come in time. About the Author: Rachel Sellers is an experienced global commercial planner, and also an Associate Lecturer at the University of Manchester Business School.
