To a chief financial officer, inventory is often a line item on the balance sheet that measures inventory turns against the income statement (cost of goods sold). This COGS analysis provides an overall view of how much inventory is held across the company's supply chain. What it doesn't provide, however, are the reasons why the inventory is there in the first place or whether the return on each inventory dollar is sufficient. Is there too much inventory at the store? Is there too little at the warehouses? Answers to these questions begin with understanding what drives inventory levels.
What's Driving Inventory Levels?
Are you losing sales and margins because your products are not in the right place at the right time and in the right amounts? Does settling on the exact quantities needed to fill demand seem uncomfortably like guesswork? To minimize errors, retailers usually count on their business managers to manage inventory levels. Business managers are, or should be, pretty good at analyzing sales figures, reviewing customer data, forecasting demand, and using their well-honed retail skills and judgment to align inventory levels with consumer demand.
Yet for every business manager who correctly manages inventory levels, there are many more who do not. That's because it is an enormously complex job. Some retailers must track hundreds of thousands of stock keeping units (SKUs) from thousands of suppliers, and distribute them to hundreds or even thousands of stores and distribution centers (DCs). And they must differentiate the products based on consumer demand in local, regional, national and global markets. Internal processes and systems such as warehouse management and automated ordering, although designed to improve efficiency, often add to the complexity.
Retailers could manage their inventory better if they had a clear understanding of what drives inventory levels, and metrics to track the key drivers. Although the accounting drivers of inventory are well documented and understood, the true business drivers of inventory are often lost in a maze of misinformation.
Determining Inventory Levels
Inventory decisions in a complex retail environment are determined by five key business drivers: consumer demand, lead time variability, pack mix, merchandising presentation requirements and visibility. Yet for each driver there is a margin of error, which means determining inventory levels based solely on these drivers can lead to severe miscalculations and a subsequent loss of sales and increased costs (see Figure 1). That's why leading retailers set up processes and metrics to fine-tune their decision-making and correct for error. Let's examine the solutions for each business driver in turn.
Figure 1: Inventory Drivers Can Push the Inventory Far Above Ideal Levels
- Forecasting consumer demand
The slightest error in demand forecasting can have a detrimental effect, either increasing the inventory unnecessarily (and raising costs) or reducing it below demand and losing sales. For example, a retailer may forecast demand for Russell T-shirts to be at seven and eight units for the two weeks beginning a month from today. The supply chain group places an order for 27 units (after factoring in lead time, lead time variability and package size constraints). If, instead, the retailer sells nine units total (+67 percent error) during the two weeks, the system is left with 18 extra units. On the other hand, if the demand turns out to be 35 units instead of 27 (-30 percent error), the retailer could have sold eight more units than it had in stock. Indeed, any inaccuracy in the forecast will cascade down through the supply chain.