The Bee Hive

Pundits will continue to predict economic recovery or decline. But the only certainty is that economic conditions will change in the future (for better or worse). How manufacturers react to such changes can have a significant impact on the service levels provided to their customers and the amount of working capital they have tied up in finished goods inventories (FGI). Periodic and practical reviews of FGI levels, based on item performance can yield significant benefits to manufacturers and their customers. Given the impact this can have on customer service levels and a company's balance sheet, it goes beyond being simply an operational best practice and deserves the attention of senior management.

Most inventory textbooks provide a thorough and statistically sound treatment of the relationship between FGI levels and customer service levels. Unfortunately, few organizations put such guidance into practice. Those that do often find that the theoretical results promised by the textbooks are rarely realized. The outcome for most organizations is an inventory position that is far from optimal, achieving neither the service levels hoped for nor the financial performance required.

However, by segmenting FGI based on recent demonstrated sales behavior, or product movement, companies can manage inventory levels to better support overall business objectives. But this can only be achieved through a thorough understanding of two key attributes of product movement: sales velocity and sales consistency.

Sales Velocity

Sales velocity is a measure of sales volume by stock-keeping unit (SKU). Many manufacturers employ some form of ABC analysis to help manage their FGI. Sometimes the outcome of this analysis is further adjusted by factors such as relative cost. For simplicity, I propose focusing strictly on volume per unit of time (with a focus on the preceding 6 to 12 months) and grouping products into one of two categories - fastest half and slowest half. The fastest half designates that 50 percent of cumulative product volume of which the most was sold during a given period. Slowest half designates the balance of products for the period being studied.

Most companies find this classification relatively easy to apply and maintain. The only adjustment companies generally find necessary to this approach are related to forgone sales and specific sales promotions. Forgone sales reflect an inability to satisfy demand during the specific time period, which would otherwise have been satisfied had the product been available. If this number is critical, "phantom sales" may need to be estimated and added to the sales history in order to reflect true product demand during a given period.

Adjusting for the effect of sales promotions can be a bit more challenging. Sales promotions refer to new product introductions and incentive schemes that stimulate demand during the time period under consideration. New product sales estimates are often biased toward the high end, initially resulting in unusually heavy inventory being carried. Some judgement is required to appropriately account for the impact of sales promotions when assigning products to the fastest half and the slowest half categories. Other factors that can affect product categorization, although to a lesser degree, include returns, product obsolesence, and product line cannibalization.

Sales Consistency

Sales consistency is a measure of how smooth the demand is for products during a given time period. Consistent movers are those that are sold steadily during the period being studied. Less consistent movers are those that are sold sporadically and may exhibit lumpy demand during that same period. A simple measure of sales consistency is the ratio of average daily sales divided by the standard deviation of daily sales during that same timeframe.

Note that other units of time can be used in this calculation as long as the unit of time used in the numerator of the equation is the same as the unit of time used in the denominator e.g. average monthly sales divided by the standard deviation of monthly sales.

If the resulting ratio is greater than or equal to 1.0, the product should be considered a consistent mover. If the ratio is less than 1.0, the product should be considered an inconsistent mover.

Quadrant Analysis

While each of the measures just cited is useful in its own right, when considered together on a product-specific basis they provide a practical managerial tool to help optimize the performance of FGIs. All finished goods can be categorized into one of four categories by analyzing them and applying the previously mentioned thresholds associated with each dimension of product movement:

• fast-moving and consistent
• fast-moving and inconsistent
• slow-moving and consistent
• slow-moving and inconsistent

Fast-moving products that sell consistently

For most organizations, the upper left quadrant of the matrix constitutes the major focus of the business. These are implications that need to be understood when managing this category of FGI. First, the products will likely be stocked items, due to the consistent demand for them. These products will often be forecasted separately, which generally consumes little effort given the overall predictability of this category. In some manufacturing environments, production capacity for items in this category can be permanently allocated or locked in, thus simplifying the management of residual capacity. The overriding objectve to keep in mind is to simplify the management and ensure the availability of products fitting this description.

Fast-moving products that sell inconsistently

For products in the lower left quadrant, there are alternative strategies. First, the order profiles or customer base associated with these products may need to be examined. Sporadic ordering patterns may be smoothed out through discussions with key customers or the application of a tiered incentive structure.

Where the demand remains inconsistent, greater forecasting sophistication is required along with higher invetory levels to accomodate the greater unpredictability. Generally speaking, this group consumes a disproportionate amount of management time given the cumulative volume it represents and the difficulty involved in forecasting the overall timing of demand.

Slow-moving products that sell consistently

Products that fall into the upper right quadrant of the matrix have lower demand but exhibit relatively consistent sales patterns. In other words, predictability is relatively high, but demand is relatively low. Depending on the dollar value of the product in question and the characteristics of the manufacturing environment, this can be managed in different ways.

If the product has a relatively low dollar value, it may be more economical to periodically produce batches of it, as manufacturing capacity allows, and inventory it to fulfill the demand forecasted over a given period of time (e.g. 3 months). This approach will ensure product availability and customer service levels, not tie up excessive amounts of working capital in FGI, and enable a company to balance capacity utilization in its factory. If the product has a relatively high dollar value, and the manufacturing environment allows, it can be made to order to satisfy customer demand. If this practice would be disruptive to the manufacturing environment, refer to the strategies suggested in the next quadrant.

Slow-moving products that sell inconsistently

The bottom right quadrant represents a particular challenge. These products exhibit relatively low volume and unpredictable demand. There are several approaches to managing this category. First, determine how much working capital your company typically has tied up in such products and whether it is absolutely necessary to include them in your overall product line. Many companies find that substantially equivalent products often exist in more desirable (i.e. consistent) quadrants that can accomodate customer needs, thus simplifying the product portfolio.

If the remaining products are expensive, low margin, not essential to maintaining customer service levels, and/or disruptive to manufacturing environment,consider discontinuing them. However, if such products are essential to maintaining customer service levels, consider changing them from make to stock to make to order. If this decision is made, there will likely need to be related changes to the pricing of these products and their standard availability schedules.

By applying a few relatively basic and easy-to-use analytics to your FGI, you can gain some fairly powerful insights into the effect such inventory may be having on your company's financial performance and service levels to customers. These same analytics also provide the basis for managment decision making to help improve company performance along both dimensions.