Monday, July 26, 2021

Holistic Inventory Optimization

The following was first published by me as a LinkedIn article.

Tens of millions or hundreds of millions of dollars or more, in addition to stock prices or market valuation, are at stake depending on the company’s inventory sizes. C-level executives want answers to the following critical questions which are both sides of the same coin.

  • How to spend a fixed budget on safety stocks so that the average demand satisfaction for the whole inventory is the highest?
  • How to achieve the desired average demand satisfaction for the whole inventory with the lowest budget of total safety stocks?
To illustrate the point, consider the following simple inventory with 10 stock items. Factors determining the total value of safety stocks including lead time, unit price, demand standard deviation, and demand satisfaction (DS). Among these factors, DS for the individual stock items is the only one that we can adjust readily.

Figure 1. Common Approach - Setting the Same DS to Each Item

A common approach is to simply set the DS for all parts to a single number. Some managers adopt ABC analysis to divide stock items into several groups based on their values and assign the DS to each group. When we set DS to 91% for all items as shown in Figure 1, the average DS is 91% and the total value of safety stock is $129,985.

However, we can do much better. By setting the DS for each item more intelligently, we can keep the average DS of 91% and reduce the total safety stock by about 16% (Figure 2). Or by assigning a different set of DSs, we can maintain the same total safety stock budget and increase the average DS from 91% to 93% (Figure 3).

Figure 2. How to Keep the Average DS of 91% and Reduce the Total Safety Stock by About 16%?

Figure 3. How to Keep the Same Total Safety Stock Budget and Increase the Average DS From 91% to 93%?

Interested readers may do an exercise. Here is a downloadable spreadsheet file that embeds the formula to calculate DS. One simply fills in whatever DS she/he desires for each item. The average DS and total safety stock will be calculated for you.

If you can produce the results as shown in Figures 2 and 3 or better, congratulations! If not, I would invite you to attend my webinar "Holistic Safety Stock Optimization - Putting the Horse Before the Cart" on Thursday, August 12, 2021

Even if you are able to solve the 10-item problem by trial-and-error, in the real world many businesses have far more stock items than 10, I would still encourage you to attend the event.

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