Have you ever taken the time to graph your company’s inventory levels relative to your customers’ demand patterns? If you haven’t, don’t worry. Most companies don’t and even fewer know why it's such an essential aspect of proper supply chain management. So what is the benefit of tracking inventory levels relative to customer demand? Well, for one, it helps to identify those periods when inventory doesn’t match customer order patterns. More importantly, it exposes what the costs are when a company’s inventory levels are low with high customer demand, versus when inventory levels are high with low customer demand.
A company’s inventory is often its biggest asset and also, its most costly. Companies need inventory to sell product, capture opportunistic sales, grow revenue and capture market share. Unfortunately, it’s also a necessary evil that often means higher holding costs when sales grind to a halt. However, as I’ve written about many times in the past, the biggest mistake companies make with respect to managing their supply chain, is to run an inventory management approach that doesn’t match their business model, market or customer order frequency.
The Bell Curve of Inventory & Customer Demand
If you were to graph your inventory levels relative to your customers’ demand and order patterns, you’d likely see something that represents two continuous bell curves. One would represent your company’s inventory levels and the other would represent your customers’ order frequency. In fact, consider both of these as frequency graphs that are combined in order to determine those periods where inventory doesn’t match customer demand.
I use this example with a number of my customers in order to expose the dangers of running an inventory management approach that doesn’t match their business model, their market and their customers’ needs. Consider the following graph below.
The Blue Line represents the customers’ demand patterns
The Green Line represents the company’s inventory levels
Point #1: High Inventory Holding Costs:
Company has high inventory levels and therefore high inventory holding costs. It sees this as a constant reminder of the cost of money and capital. At this point, its high inventory is more costly because customer demand is low.
Point #2: Lost Sales Cost of Inventory
Company has low inventory levels with high customer demand. It loses sales as a result. Now, most companies don’t track lost sales as a cost of inventory but they should. It is a direct cost of inventory – no inventory with high customer demand means no sales!
- High inventory/low demand = High inventory holding costs
- High customer demand/low inventory = Lost sales cost of inventory
Constantly Chasing Your Tail!
This is something I see all the time when working with my customers. Companies have an innate fear of having too much inventory and that’s perfectly understandable. This often happens when they’ve not properly anticipated customer demand and have been left with inventory levels that are simply unattainable.
Because these customers lack the proper visibility on customer demand, they try to spur that demand by reducing their product’s pricing. This makes perfect sense and is a valid solution to high inventory levels. However, it’s the solution the company should ONLY adopt if it knows its customer demand patterns won’t suddenly spike upwards. It’s a solution when the company has a thorough understanding of its market and when its customers will need parts.
I am not advocating holding inventory indefinitely. However, what I am advocating is that companies can’t constantly chase their tails on low inventory/high customer demand and high inventory/low customer demand. How does this happen? More importantly, when do I see this type of discrepancy as depicted by these graphs? When companies run the wrong inventory approach! The most common culprit is when companies try running Just in Time and can't. Companies that run this supply chain strategy when they shouldn't, are constantly in a continuous chase to match their inventory to their customers' order frequency because they lack the ability to make JIT work properly.
Company Reduces Costs By Liquidating Inventory
Company Doesn't Track Customer Demand Patterns
Company Encounters Lost Sales Cost of Inventory
The above video is from Lost Sales Cost of Inventory: Lose Gross Profit, Lose a Customer and Then Lose Market Share
Match Inventory to Business Model:
If you’ve read some of my prior articles, you’ll know that I strongly advocate companies matching their inventory approach to their business model and customer demand patterns. This means that companies that have cyclical, seasonal and infrequent demand patterns should stick to Min/Max inventory. Consequently, companies that have consistent and linear demand, and who have strong purchasing power and economies of scale, should run Just in Time. However, JIT only works when your company is your vendors' number one priority. Small companies have no place trying to make JIT work because it requires the company have the purchasing power, economies of scale and clout to dictate their vendors’ delivery requirements.
When I review my customers’ inventory management practices, this problem constantly comes up. In some cases, companies have contractual agreements on supply and still don’t have the inventory ready! When customers place an order and inventory isn’t available, the company pays high expedite fees and high freight costs to rush parts in and ship out to customers again. It’s a double freight "whammy" as they pay high freight costs to get those parts and high freight costs to rush their late shipments to their customers. In some cases, customers cancel their orders because they’re tired of waiting for inventory to become available. In this case, the company exceeds its lead times, and is ultimately left with extra inventory and an upset customer.
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