The Economic Benefits of Inventory Optimization

By Scott Fenwick,
The Economic Benefits of Inventory Optimization

A retailer’s inventory represents its largest liquid asset and is a vital investment. From a financial perspective it makes sense to take advantage of any resource that can lower that investment in inventory while still allowing a company to maintain and ultimately improve service levels.

For retail and wholesale CFOs, a main objective is to make inventory investments as productive as possible, and to do this it’s important to be aware of the volume of inventory on hand. Ensuring the balance between “not enough” and “too much” inventory can be tricky, but inventory optimization technology can help retailers effectively manage that balance and ensure that what they have on hand makes sense from an economic perspective.

Let’s take a look at three common excuses for having “too much” product on hand and examine how a sophisticated inventory optimization system can help.

Excuse #1: “I was told to never be out of stock on XYZ product”

This is a common challenge – every company has key items that they must have in stock at all times. But when the edict “never be out of stock” is issued, your replenishment system should be able to tell you what it will cost to achieve this goal, as well as the impact of relaxing the requirement slightly to say a 99 or 98 percent fill rate. A best in class inventory optimization solution enables execs to simulate multiple service investment strategies to determine how much inventory investment is needed to achieve a given service level before committing it to production. Additionally, an effective inventory optimization solution tracks every unit of inventory purchased regardless of reason, providing multiple discrete layers that are updated in real time so an exec can instantly view how much inventory the company owns and why. 

Excuse #2: “The vendor’s minimum is too high”

This is another common problem, and a retailer’s ability to address it usually depends on how much leverage it has with the vendor. But regardless of a company’s size in the market, its replenishment system should provide the ability to analyze inventory and suggest the most profitable order cycle. This means the ability to handle the analysis of ordering patterns, whether orders happen every day or once per year. It also means taking into account annual dollars spent for a given vendor line, which includes order generation costs, transportation costs, inventory carrying costs, safety stock carrying costs, and order brackets based on different order sizes and discounts. The result of this is determining the most profitable order cycle to implement. If a retailer is able to demonstrate how its minimums affect profitability, it could serve as a powerful negotiation tool with vendors. Worse case, if negotiations fail, the inventory optimization solutions inventory layering will enable the retailer to measure how much incremental inventory was purchased just to meet vendor minimums.

Excuse #3: “The season didn’t drive sales like we thought it would”

Properly identifying SKUs with seasonal demand, creating seasonal profiles and assigning them is perhaps the most critical, but often poorly executed, component of demand forecasting. The correct identification of seasonality is absolutely critical to forecast accuracy; the wrong seasonal profile is worse than no profile at all. Seasonality identification affects every other component of an inventory investment. For large retailers, the problem is exacerbated by the sheer volume of item/store combinations. Another common issue is intermittent demand, which further complicates building seasonal profiles and assigning them correctly.

The traditional method to handling seasonality was to aggregate demand for a logical family grouping like a sub-category or class of SKUs, build a seasonal profile based on that aggregation and assign it to all SKUs in the group. This approach can result in high error rates, however, because not all SKUs selling patterns match the aggregate seasonal curve, and recognizing seasonality in intermittent demand SKUs at the item-store level is impossible using traditional methods. A sophisticated inventory management tool is able to assign the right seasonal profile to store-item SKUs, thereby improving forecast accuracy simply by providing a better seasonal profile.

Gaining Value from Inventory Optimization

Effectively managing inventory in a complex retail environment requires an inventory optimization system designed to accommodate all of these variables, while maintaining usability. Ultimately inventory profitability lies in optimum safety stock management and replenishment buying practices, which defend against uncertainty in supply and demand. By optimizing their inventory investment, retailers can yield a significantly improved return for their inventory dollar by maximizing sales and customer service levels with the absolute minimal network wide inventory investment.

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