Inventory management involves balancing the tradeoff of stock-outs – a Voice of the Customer performance measure versus inventory control – a Voice of the Business cost-control performance measure. Effective inventory management improves visibility, resilience to supply chain disruption, and overall profitability. Inventory optimization is one of the most controllable and important aspects of supply chain management.
Inventory Optimization uses computer-based mathematical modeling, advanced analytics, and software that allows for the swift evaluation of trillions of choices for inventory levels. These findings help decision-makers make informed decisions about the most profitable inventory level for every item (known as a stock keeping unit – SKU) that you stock and sell.
The process includes proven inventory management techniques and mathematical optimization algorithms to maximize your profit-return-on-inventory-investment for real-time results.
These methods build on the popular ABC inventory control method and use the latest mathematical and computer technology to achieve optimal results, enabling lean inventory, improved inventory accuracy, and reducing inventory without sacrificing service.
Our Inventory Management Consulting Process
Led by experienced management consultants, our structured process aligns your inventory management system with your business goals and inventory needs while addressing real-world inventory challenges.
Demand Forecasting
Any company that carries inventory is forecasting, whether they think so or not. Many companies claim that they don’t forecast, but if you are stocking raw materials, work-in-process, or finished goods in anticipation of fulfilling demand, you are forecasting.
At Supply Velocity, we run multiple, proven forecast algorithms and analytics to determine if each SKU is trending up or down, and/or if there is a seasonality factor. These algorithms are optimized to maximize forecast accuracy, align supply and demand, and ensure you can meet customer orders with proper inventory levels.
ABC Inventory Classification, Safety Stock, and Service Levels
ABC Analysis or SKU Classification is an important first step in inventory planning. To differentiate SKUs and the customer service level (or expected fill rate) applied to safety stocks, we utilize multi-criteria inventory classification (MCIC).
This model, plus inventory classification, allows the organization to determine what criteria define a high-performing SKU for their business and improves visibility across their inventory management system.
Often, we see organizations choose either profit, sales, or volume, but these criteria may not provide a holistic picture. Using multiple criteria specific to your organization, the MCIC model determines high and low-performing SKUs for your business so you can make informed decisions that improve customer service and profitability.
The lowest performing SKUs will not be stocked and will only be produced or replenished on demand. The remaining SKUs will be stocked based on their ABC Classification, with greater service levels and safety stock for A SKUs and less for C or D SKUs. This approach supports lean inventory, proper inventory positioning, and reduces the risk of lost sales and dissatisfied customers.
Demand Forecasting is an important component of inventory management because it “looks” forward to anticipated customer demand and eventual customer satisfaction.
Another aspect is safety stock, which protects against stockouts due to variation and supply chain disruption. Safety stock looks backward at how well the forecasting algorithms were able to anticipate demand. Highly accurate forecasts need very little safety stock, while SKUs with high forecast error need more safety stock.
Supply Velocity’s solutions use forecast error, the item lead time, SKU classification, and service level goals to set each SKU’s optimal inventory level. Our method and model maximize the overall profit-return-on-inventory-investment and support improved inventory decisions that boost profitability.
Inventory Holding Cost
An important input to the optimization algorithm is the inventory holding cost. This is different for every company and is based on three criteria that influence cash flow and company profits:
- The cost of borrowing, or the cost of money. Since the year 2000, this has been very low, with most companies being able to borrow at 5% or less. However, since the pandemic and associated inflation pressure, borrowing costs have gone up and are likely to stay elevated.
- Obsolescence – often caused by holding excess inventory that becomes obsolete. For example, in food companies such as cheese producers and the perishable food supply chain, this cost is very high because of the product lifecycle. For hard-goods companies such as machine tools and OEM supply chains, this cost is very low because their parts only slowly go “out of date” or deteriorate.
- Storage. If your products are very small and don’t require temperature control, this cost is very low. Our team of consultants at Supply Velocity has calculated that the inventory carrying costs in supply chains can vary between 10% and 45% of revenue.
Understanding these costs helps you make informed decisions that improve profitability and ensure proper inventory levels across your management system.
Target Service Levels
The next step in inventory optimization is determining your target service levels. This will allow you to choose the tradeoff between inventory costs (impacting working capital) and your inventory targets or service levels. The higher you set your service levels, the more inventory you will hold, and the more demand you can fulfill from stock.
However, your inventory costs will increase. Another consideration is the cost of a stock-out. In hospital supply chains, the cost of a stock-out may be critical, including the loss of life.
Service levels and safety stock levels in these supply chains are very high. In retail sector, the cost is possibly the loss of that sale or maybe the loss of the customer forever.
Exploring supply chain and inventory strategies, stock out costs, and creating an efficient inventory will inform how your company establishes safety stock service levels to avoid lost sales, reduce dissatisfied customers, and improve customer service.
Reorder Points, Reorder Quantities, and your ERP System
The final step is connecting the demand forecast with your SKU classification, lead time, and target service levels.
These results will determine your SKU-level inventory targets. In your ERP or inventory management system, this can be managed through MIN / MAX levels, Reorder Point / Reorder Quantity, or Safety Stock, and an order-up-to policy using MRP. Min/Max or ROP/ROQ work best for distributors that sell to end-users.
Safety stock and MRP work best for manufacturers that sell to other manufacturers or distributors. Configured correctly, your management system enhances visibility and smooths inventory flow from suppliers through fulfillment.
Monthly Updating of Inventory Levels
To support your supply chain and ensure robust inventory management, the forecasting process and calculations of reorder points and order quantities should be updated monthly.
This will ensure your inventory strategy is based on the most up-to-date customer demand and that your inventory levels support your supply chain strategy.
Inventory optimization also supports a supply chain planning process. To keep your supply chain operating efficiently, it is important to have the right inventory and also to achieve high inventory turns.
Your replenishment team will trust their inventory levels and can promptly react to changes, such as shortages, variability, and overstock.
With current inventory data, analytics, and disciplined reviews, you’ll enable effective inventory management, maintain lean inventory, focus on reducing inventory where appropriate, maintain healthy inventory flow, and consistently meet customer demand.
Multi-Echelon Inventory Optimization (MEIO)
Best-in-class inventory management includes optimizing inventory across all echelons of the supply chain. This includes working with suppliers to optimize inventory across their WIP and finished goods that you purchase, your purchased materials and components, WIP and finished goods, and those carried by your distributors and customers.
If the entire chain uses multi-echelon optimization, everyone wins, including the ultimate customer of the. MEIO increases end-to-end visibility, balances supply and demand across nodes, improves inventory flow, and builds resilience to disruption.
Taking Emotion out of Inventory Management
We often find that inventory-related decisions become very personal within companies. Planners, Buyers, and Analysts think they have special insight that is required to decide when to buy or produce more, and how much to buy or produce.
Consequently, we often see companies with people making inventory decisions for thousands of items. People in the business often have special insights, but this is only needed for a very small subset of items.
We believe the inventory optimization / inventory planning modeling and automation should set target inventory levels and decide how much to buy or produce for the majority of your inventory items.
However, new items, or products that are difficult to forecast due to intermittent demand, can be moved to an Analysts or Planner’s queue for manual evaluation.
This takes advantage of the speed of computer modeling with the intelligence of people working in the business. Our management consultants help teams make informed decisions, overcome inventory challenges, and embed practices that result in improved inventory performance and proper inventory control.
As a trusted partner, we guarantee measurable results for every engagement using proven methodologies. Your return is guaranteed!
Frequently Asked Questions
What is inventory optimization, and how does it differ from inventory management?
Inventory management focuses on day-to-day control of stock levels, while optimization uses advanced mathematical algorithms and analytics to determine the ideal inventory level for every SKU. It maximizes profit-return-on-inventory-investment by balancing service levels against carrying costs.
What ROI can I expect from inventory consulting?
Most clients see 15-30% reduction in inventory investment while maintaining or improving service levels. Typical payback periods range from 3-9 months, depending on current performance and implementation scope.
How does MEIO differ from single-echelon optimization?
Single-echelon optimization focuses on one location or stage in your supply chain. MEIO considers the entire network: suppliers, manufacturing, distribution, and customers. It delivers globally optimal solutions rather than local improvements that may create problems elsewhere.
Will inventory optimization integrate with our existing ERP system?
Yes. Our solutions are designed to work with major ERP platforms including SAP, Oracle, Microsoft Dynamics, and others. We configure outputs to match your system’s parameters, whether MIN/MAX, reorder points, or MRP-based planning.
How long does an inventory consulting engagement take?
Initial assessments typically require 2-3 weeks. Full implementation, including system integration and team training, ranges from 3-6 months depending on complexity and scope.
Our founder, Mitch Millstein, Ph.D., is a widely recognized researcher and teacher in the area of Supply Chain Optimization, Analysis, and Decisions. His research includes e-commerce and omnichannel supply chains, network design, performance measurement, inventory management and optimization, with a strong emphasis on data-driven analytical methods.
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