Inventory versus customer service

Inventory costs money because it ties up working capital, consumes labor and real

estate, and depreciates quickly. Many supply chain professionals and business

analysts will even tell you that inventory is the enemy. You may wonder why ever-

yone doesn’t eliminate all inventory. Wouldn’t supply chain management be a

whole lot easier if you didn’t have to deal with warehouses, distribution centers,

and stock rooms?

That approach has one major problem: Companies make money by selling prod-

ucts to their customers, and if they have no product to sell, they earn no revenue.

When you think about what customers value — what they’re willing to pay for —

the product itself is only part of the equation. You have to consider, for example,

whether customers would be willing to pay the same amount for your product if

they had to pick it up 100 miles away or had to wait for it for a year. In other

words, the placement and availability of a product have a big effect on its value to

your customers and on your revenue. Inventory acts as a buffer against uncer-

tainty about who’s going to buy your product, how much they’re going to buy,

when they’re going to buy it, and where they’re going to want it.

Whether your customers buy your product in a store or through a website, your

ability to provide them all the products they want when they order them is called

your service level. Customers tend to buy more from suppliers that meet their needs

quickly, so high service levels can increase revenue and grow market share. But to

maintain a 100 percent service level, you’d need to have an infinite amount of

inventory, which is unrealistic, so you need to find ways to manage the tension

between reducing inventories to lower costs and increasing inventories to main-

tain acceptable service levels.

Inventory optimization is a process of reducing inventories to the minimum level

necessary to maintain the desired service level. Inventory optimization starts with

forecasting, the process in which you try to guess how much product you’re going

to sell and when you’re going to sell it. Companies have many ways to generate

forecasts, ranging from rules of thumb to sophisticated statistical modeling. No

matter what forecasting method you use, your forecast is still just a guess about

what will happen in the future.

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