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How to set your Safety Stock Policies?

Every distribution warehouse in supply chain network holds inventory and has some safety stock maintained. How much safety stock or inventory should be kept at each warehouse is the topic I am going to address in this blog. In fact my focus will be on one common mistake that is made in the process of setting inventory and safety stock norms.

Products stored in the warehouse are categorized using some logic and inventory / safety stock policies are based on this categorization. Multiplicity of factors are considered before arriving at product categorization. Some of the commonly considered factors are mentioned below.

1) Average Sales per month - Referred as Fast / Medium / Slow moving categorization

2) Business Importance / Profit Margin - Refered as A, B, C categorization

3) Product Life Cycle - New / Emerging / Mature / Phase Out product

4) Sales Pattern - Seasonal / Non Seasonal

Above list can be increased using lots of situational factors suitable for a particular business scenario but ultimate theme will always revolve around above factors. After product categorization is complete demand and supply uncertainty is assesed before arriving at inventory and safety stock norms. Some of the commonly occuring demand side uncertainty factors are as follows - Forecast Accuracy, Lumpy demand flow because of lot size and truckload considerations, uncertain time and quantum of seasonality etc. Some of the supply side uncertainty factors are as follows - Uncertain inbound logistics leading to lead time variations, breakdown in factory, unreliable suppliers and so on. To counter both demand and supply side uncertainty a safety stock or buffer inevntory is maintained at warehouse under consideration. How much safety stock inventory is maintained and for which category of product is called Inventory Policy.

In this blog I am not going to elaborate on each and every factor mentioned above for product categorization or uncertainty and how each of them should be mapped to arrive at an Inventory Policy, rather I want to focus my attention on one commonly made mistake regarding one of the factor mentioned above namely Average Monthly Sales. It is very common for the company to say that we always maintain safety stock worth 3 times avergae monthly sales. Fundamental assumption in such policy is that average monthly sales is a constant number. Some companies adjust rules to accommodate for seasonality by norms like safety stock equals 3 times average monthly sales during the peak season and 2 times average monthly sales during off season. Still fundamental assumption of sales being constant is same. Also average sales number is calculated based on long term average of 3 or 5 years sales. My conetntion is as follows. Lot many things would have happened in these 3 to 5 years. Product could even have changed its life cycle phase. There could be few big one time sales order vitiated the average monthly sales picture. How fair is to calculate avergae sales number based on these long term trends and use it to decide Inventory Policy for future?

I think all of you will agree with above premise but then obvious next question will be regarding alternative number to be used. Average sales number is easy to calculate, maintain, understand and interprete. In fact this is the reason it is used so predominantly in deciding inventory policy. I propose following approach. Answer below questions for each of your product before deciding Inventory Policy.

  • Does this Product feature amongst top 20% products based on its Monthly Sales number in all of the last 12 months?
  • Does this Product feature amongst top 20% products based on its Monthly Sales number in at least 3 to 6 of the last 12 months?

Please read above statements very carefully. Answer will be "Yes" for first question if the product's monthly sales in month of January will put it in top 20% products in January, monthly sales in February will put it in in top 20% in February and so on. We are not using cumlative average sales here instead we are using individual monthly sales numbers and then ranking the products. I have following terminology based on answers to above questions.

If answer to first question is "Yes" then I call it a "Regular" product. If the answer is "No" to first question but "Yes" to second one then it is a "Repeater" product and if answer is "No" to both the above questions then I call it a "Rarity" product. Let us call this categorization as 3R categorization. My proposal is as follows.

It is safe to use conventional Average Monthly Sales based Inventory Policy for "Regulars" but would be a disaster if we use them for "Repeaters" or "Rarity" products. "Repeater" and "Rarity" should be better produced in campaigns rather than making them available as regular of the shelf. It is better to set customer expectation for delay in delivery rather than holding tons of inventory for them. If possible "Rarity" products should be phased out or they should be produced only against confirmed orders. No point in holding any safety stock inventory for them as whatever logic you will use to arrive at their inventory norms will essentially turn out to be wrong.

My another proposal is to invest heavily in supply chains for "Repeaters" to make their supply chains flexible. These products have potential to become "Regulars" if nurtured properly. Concepts like "Just in Time" should be applied to them to make logistics fast. Manufaturing flexibility concepts like SMED should be applied to them to make their manufacturing nimble and on-demand. Clear roadmap should be put in place for their supply chains.

However I have seen companies doing exactly opposite of this. They focus all their attentions and initiatives on "Regulars" as their sales number make them center of all attractions and justify any initiative for them. Supply chains for "Regulars" can be managed very easily by just holding some inventory. Invensting in their inventory is not at all risky. On the contrary "Repeaters" and "Rarirty" need more support with initiatives to make their supply chains flexible. This is because holding inventory for them is very risky.

Just a thought you should apply before taking your next supply chain initiative.



Excellent artciles,
Will you please talk further how to deal with "Product Life Cycle" and "? How to identify where the product is at in these stage?

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