The five common reasons to hold inventory

Do you have insight into your projected stock for the coming months? And do you know how specific inventory drivers influence your stock level? If you can answer yes to both these questions, you are one of the lucky few. In our estimation, less than 5% of all organizations can point out specific reasons for their inventory fluctuations – which is really surprising when one considers that organizations can only get a real grip on their inventory if they have a deep understanding of the inventory drivers first.

Five different stock types

As a starting point, we’ve defined five different stock types. While these are the five basic categories, individual organizations should define which drivers are meaningful for their business – without getting carried away in creating subdivisions.

1. Cycle stock is linked to the production frequency or order frequency and stems from the need to produce or order in batches. The Economic Order Quantity (EOQ) principle learns us that it is more economical to produce or source in bigger quantities in order to reduce the changeover costs and to receive price advantages. If we produce once a month, the average cycle stock will be two weeks. If we produce once a week, the average cycle stock will be half a week. Admittedly the lean philosophy aims for a one-piece flow, but until organizations reach that optimum they will have to take the EOQ principle into account.
   
   
2. Safety stock is a buffer against uncertainty in supply and demand. All products have a lead time in terms of procurement or production and it is rarely constant – e.g. a supplier may have delivered less than expected because of quality issues. Those uncertainties are typically covered by safety stock, which ensures that you can provide a good service to the next step in the supply chain. When calculating the safety stock, you will typically look at the forecast error, the average lead time and the variance on that lead time. More advanced variants will also take factors such as yield or quality loss into account.
   
   
3. Anticipation stock is the inventory that is held to absorb foreseen imbalances between supply and demand. If you know that a certain event – such as a tender or a shutdown – will result in a demand peak, you could decide to start producing upfront and to build up inventory in anticipation of that event.
   
   
4. Work-in-progress or transit stock is inventory which is ‘on the way’. Transit stock is unavoidable in long-distance trading. For example, products sourced in China will have a transit time. Improving the transport routes can reduce the transit stock, while optimizing the production flow can lead to less work-in-progress stock.
   
   
5. Strategic stock is carried to manage potential risks or to seize certain opportunities. For example, you may decide to build up extra inventory because you expect a market shortage of a key raw material. Alternatively, if you expect to close a big deal, you can start building inventory beforehand to be able to supply to the new, important customer immediately. In the case of strategic stock there is an element of uncertainty about whether the event will really happen, but you are willing to take the bet.

Monitoring is key

You can decide to fine-tune the above five key drivers, such as by opting for a category of ‘leveling stock’ for example. In this case, even if demand is low you decide to continue running at full capacity to keep your efficiency up and the costs down, based on the assumption that you will sell the resulting inventory later on. Alternatively, you could allocate this inventory as ‘cycle stock’. Irrespective of what you call them, the most important thing is to identify various different stock types and use the same terminology within your company.

The only way to truly explain increases or decreases in inventory is to monitor the underlying drivers throughout your inventory planning cycle. Typically, cycle and safety stocks are inventory parameters used as the input for your planning system. Inventory software tools, such as Arkieva, allow you to calculate those parameters. Meanwhile, anticipation stock is determined by the supply planning. Lean manufacturing projects are aimed at reducing the transit or work-in-process inventory. Furthermore, in our opinion, holding strategic stock should be a S&OP (Sales & Operations Planning) decision.

Stepping stone to integrated business planning

The importance of understanding the different types of inventory should not be underestimated, especially against the economic backdrop of an increasing need for visibility and ever-greater pressure on capital. “For one customer, we’d been working on the S&OP process for five years. But Finance only became interested in it when we made the different stock types visible. Finance plays a major role in most organizations so when the CFO endorses the S&OP solution it marks a tipping point in its adoption. Moreover, the involvement of Finance can transform the S&OP process into an integrated business planning process, whereby Production, Supply Chain and Finance make a joint forecast,” is how prof.dr. Bram Desmet, CEO of Solventure, sums up the importance of making a distinction between the different types of inventory.