Slow-Moving Inventory: All Dressed Up and Nowhere to Go

With economic slowdown a global reality, companies are stepping up their efforts to find operating efficiencies and reduce capital requirements. The name of the game is no longer grow at any cost. Now, the cost of generating sales—return on assets (ROA) and return on investment (ROI)—carry significant weight.

As part of an overall effort to become more efficient and compete in a tough economic environment, organizations need to review their approach to inventory management. Concentrating in this area will produce significant and short-term results.

For most major international companies inventory management focus has only really applied to fast-moving stock items because of their revenue-generating ability. Many global companies have done fairly well managing inventory for fast movers.

But think of the stock that companies must carry that doesn’t turn over so quickly—the slow moving inventory (SMI). The management of SMI has not been quite stellar. Companies can have hundreds or thousands of SKUs sitting in the warehouse, sometimes costing millions of dollars each year, just sitting on a shelf until they are needed.

One issue that has hindered the progression of thinking in this area is the approach most companies have taken to SMI. In many instances, organizational policies, competing priorities, system support, and staff training (or the lack thereof) has resulted in companies holding inappropriate quantities of slow-moving items.

For the majority of companies, holding SMI levels of up to 15 to 20 percent is well in excess. Companies that address SMI yield one-time returns of more than 200 percent, and ongoing returns from reduced carrying charges of more than 25 percent.

Computing system constraints and a sales-based approach to business contribute to the emphasis on fast-moving items. At the time when most systems were built and organizations were implementing systems, computer power was expensive so companies focused on developing programs for the items “that mattered”—the fast-moving ones. Even then, companies took short cuts. Consequently, systems for the control of slow-moving items were rudimentary or non-existent.

Despite these limitations, which in some instances extend back to the 1970s, many organizations have not addressed the situation. Rather, time has been allowed to entrench existing thought processes in relation to SMI. Computer power, for instance, is no longer a constraint, as algorithms are readily available to more accurately determine a company’s inventory requirements. This, in addition to the fact that it is easy to deploy change to a company’s policies and procedures in this area, is helping organizations make informed decisions about the inventory holding requirements of its slow-moving items.

Slow Going

What constitutes “slow moving” varies from organization to organization. From a requirements determination perspective, however, slow-moving items may be classified as items that have less than six months of demand in the preceding 12 months. As a result, the slow-moving items within a consumer goods inventory—such as groceries—may not be classified as slow moving within other categories.

At the other extreme, in some organizations, such as those in a maintenance, repair and operations (MRO) environment, most stock items, such as spare parts, may be considered slow. This broad criterion is based on the ability to apply time series-based forecasting techniques. In essence, slow-moving items are items that cannot be forecasted in the normal way.

The key question when seeking to reduce SMI depends on the nature of the inventory items. In some instances, the most appropriate policy is to remove slow-moving items altogether. Within the fast moving consumer goods (FMCG) environment, an item that “does not move” is out. For companies where it is impractical to remove such items from the inventory, appropriate management methods need to be devised and applied.

Generally, organizations with relatively old inventory management systems in place and a large number of slow-moving items would benefit most from reviewing their SMI management practices.

SMI: One Solution

A leading Australian truck retailer realized actual benefits by reviewing its SMI management practices. This retailer sells a popular light-to-medium range of trucks; more than 50,000 operate on Australian roads. To support this number of vehicles, an inventory of approximately 20,500 different parts was required. Through analysis, the company determined that nearly 85 percent of these parts were slow moving.

Approximately 13,000 parts had a value of less than $100 and had been in the inventory for a sufficient period. An addition 1,300 items were understocked and could impact customer service levels. More than 5,300 items were appropriately stocked and more than 6,300 items were considered to be overstocked. More importantly, about 3,000 of the overstocked parts were considered obsolete. Instead of 20,500 different stock items, the retailer actually needed only 17,500.

To rectify the situation, the company invested approximately $75,000 to address the understocked items. The overstocked component represented approximately $470,000. Existing practices were borrowed from those applied to fast-moving items, and were insufficient to meet SMI requirements.

The truck retailer responded with new policies, practices, and algorithms. This response included:

• Segmenting the inventory and determining appropriate service levels for each segment.
• Documenting procedures for the introduction of new items into the inventory, which included order quantity calculation variables.
• Calculating more appropriate replenishment variables (re-order point and re-order quantity) for the slow moving.

It took about 12 weeks for the truck retailer to complete this exercise, and provided significant cost savings.

Think It’s Fixed? Break it Anyway

Generally, organizations have developed strong forecasting and inventory management procedures that led to consistent availability for the inventory that “mattered” (typically fast-moving items) and not for slow-moving items. The resulting mistakes of this approach tend to be costly because low levels of demand make it difficult to rectify the problem quickly. Inventory management practices need to take slow-moving items into account.

Four areas of regular concern:

1. Use of Economic Order Quantity (EOQ) model

The Economic Order Quantity (EOQ) model is orientated around minimizing the costs associated with introducing (or ordering) an item into inventory vs. holding an item within the inventory. Taking ordering, handling, and carrying costs into account, the model finds the optimal order quantity that potentially provides the best long-term value.

While the EOQ model is simple and often does the job, it has limitations.

Some companies take a shortcut—using broadly acceptable variables such as order handling costs, carrying costs and transport costs. Lambert and Stock (1993) highlight the folly of using representative industry values. They analyzed the Air Force’s parts inventory, revealing that using more representative variables in the EOQ equation offered a one-off savings of approximately $20 million.

Another belief is that the results of EOQ provide the best long-term value. While EOQ definitely offers benefits, the impact of obsolescence is sometimes ignored. With SMI, this cost is often ignored when products are ordered.

Generally, a suggested policy is to limit the order quantity, say to the equivalent of 12 months usage, until a demand profile can be established. Only when the demand profile—which tends to be a function of the item’s life cycle—has stabilized will demand information allow a company to determine the optimal quantity. Limiting the EOQ will help identify the various demand profiles. More importantly, the iterative step to order quantity determination will assist with minimizing obsolescence.

2. Emphasis on Stock Turns

Stock turns are regularly used as a measure of inventory performance. Generally, the higher the stock turn ratio, the better the performance. While the axiom of stock turns holds true, the level of acceptable performance often ignores other inventory optimization techniques, in particular, determining the order quantity.

Different order quantities impact inventory turns. As item cost decreases, order quantity increases. As a result, inventory turns are reduced. For those overemphasizing stock turns as a primary key performance indicator (KPI), it’s tempting to ignore the EOQ functionality and arbitrarily reduce order quantity, which will likely increase total costs beyond optimal levels. In the slow-moving environment, it is unrealistic to expect high inventory turns for those items that are relatively inexpensive.

Several opportunities present themselves. First, stock turns should not be used as a KPI for slow movers. Second, staff and management should be educated in stock turns and how they relate to slow-moving items, in particular the implications of EOQ.

3. Tools and Skills Development

With the focus on ensuring that fast-moving items are well managed, companies have spent millions on improving systems, processes, and skill development. For instance, ensuring that the Y2K bug did not bite resulted in significant upgrades to enterprise resource planning (ERP) systems.

At about the same rate that logistics professionals climbed the learning curve on fast movers, they have fallen behind in the systems, processes, and skills required to manage slow movers. Few system upgrades deal with SMI with any power or sophistication. Fewer logistics professionals understand how to use or improve on appropriate algorithms.

As a result, a large proportion of staff involved in determining what and how much inventory to introduce work with minimal guidance. Management only interrupts when there is insufficient stock to satisfy a demand. A conservative response is triggered: avoid stock-outs. Allowed to continue, the dominating culture becomes one of avoiding stock-outs at all costs.

Probability suggests that a 100-percent service level is impossible to obtain. While this is so, few companies understand the cost and service implications of reduced service levels—for instance, the difference between a 95-percent and a 99-percent service level.

Management and staff involved in inventory management typically do not recognize the cost implications of service level decisions. Developing and using appropriate policies and procedures can help overcome this problem.

A commitment to developing policy and procedure constitutes a critical step in determining the most appropriate service level. Along with that commitment, companies need the appropriate tools and techniques for calculating the most appropriate service level. These tools should answer questions about the implications and costs of various service levels.

Tools are not only required to measure service levels, they also are required to determine the company’s ongoing requirements. There needs to be some way of running inventory control models to produce stock replenishment values. In some instances, it may be appropriate to incorporate some or all of these techniques into the organization’s inventory management system. Alternatively, the values may be calculated externally and used to update the inventory management system’s replenishment values (reorder point and reorder quantity).

The need for policy, procedures, skills training, and system support is critical for slow-moving items. A lack of demand means that overstocking can take years to resolve—if indeed ever. When inventory managers have the tools, policies, and procedures, supported by appropriate training, the prospect of optimal inventory is greatly enhanced.

4. Insurance stock

Insurance stock regularly comprises a portion of the SMI. What constitutes an insurance item and the role that insurance items play will vary significantly. What seems to be constant, however, is an extremely conservative approach to the quantity of insurance items held.

Insurance items are typically those items that are not available because they are no longer in production or the timeframe for delivery does not align with customer requirements. For example, a special production run needs to be set up and run, or the item is supplied from an overseas vendor, either of which would result in an excessively long supply time frame.

Insurance items also may be referred to as life-of-type (LOT) and all-time-buy (ATB) items. Insurance items sometimes constitute the higher assemblies. For instance, a gearbox may be held instead of lower-level items.

Experience suggests that whenever insurance requirements are calculated, worst case anecdotal evidence prevails. “I remember when we needed one of them” and “Do you recall the problem caused when we could not supply…” are typical comments heard and used when determining insurance item quantities. In response, the quantity deemed to be needed is usually conservative.

While the need to rely upon professional judgement always exists, the default for insurance items should be calculated rather than guessed. It may mean using demand data for a similar item. Or it may require that probability/risk analysis needs to be performed to determine requirements.

The Hollow Log

Insurance items tend to represent the “hollow log” of inventory management. Items get “hidden” in the insurance category because the need (and quantity) is rarely questioned. Lack of policy, procedures, and tools in relation to SMI only fosters this approach.

SMI requires focused and constant management effort. Not only is care required during the introduction phase, but ongoing effort is needed. The fact that life cycle changes mean that some fast-moving items become slow-moving items only complicates the situation.

Consider the experience a European vehicle importer had when releasing a new model. Part of the marketing and promotion for this new vehicle was “excellent support.” In response, inventory managers were encouraged to ensure that local inventory could meet “all” demands for parts.

Without the necessary guidance and tools, the inventory managers did their best. In hindsight, however, analysis reveals that they introduced more than 1,600 lines that were never needed. These items had a cost value of more than $635,000, which ultimately had to be written off. While it is improbable that you’ll be able to get it right every time, you most likely could do better.

This example highlights the need for tools and policies. Collectively, the right tools and policies could have helped this vehicle importer determine more accurately which items to introduce and how many.

All is not lost. The information associated with “unusable” items constitutes a valuable resource. It tells the organization what not to order next time. On this basis, the information shouldn’t be thrown away when the parts are written off. Instead, it should be used a reference for new introductions.

Introducing a product is one thing, ongoing inventory management is another. In some instances, demand can go away as customers find alternative sources of supply. In response, prices may also need to be reviewed. Where demand is reduced, it may be possible to return some items to the supplier rather than allow the items to stagnate in inventory until they can no longer be used. Again, tools and policies will help.

Ongoing management can provide real value, particularly in the review of slow-moving items. Then the obsolete inventory write-off is likely to be higher than needed.

Tackling Slow Movers

Given the peculiarities in demand patterns and the lack of data to support time-series forecasting, SMI needs to be tackled in a different way. Different policies, procedures, systems and skills need to be formulated and deployed for companies to grab any opportunities available within their own operations. Opportunities for cost savings within operating and inventory are there to be realized.

A structured approach, developed by Dawson Consulting, helps organizations quickly achieve this prize. It involves three simple steps—segmentation, guidance and deployment.

Segmentation

Inventory composition and purpose influence inventory management techniques. What is slow-moving inventory for one organization may not be so for another. Similarly, the need to hold SMI varies from one organization to another. Accordingly, the initial step involves determining the amount of SMI. Details such as how the SMI should be segmented—for instance, what is critical and non-critical and where critical items need to be available immediately (service level).

In general terms, slow-moving items are those with less than six months of demand in the previous 12 months. This criteria stems from forecasting functionality. Essentially, different forecasting techniques are required for determining the service level and replenishment requirements for slow- moving items.

Once the “optimal” slow-moving item requirements have been determined, the real issue becomes what to do. Within some organizations—for example, retail—it may be appropriate to achieve quick wins, such as immediately removing any SMI from the inventory. The revenue that these items generate compared to the expense of holding and managing them does not warrant maintaining them.

For some organizations, slow-moving items represent a considerable portion of the inventory and it is inappropriate to consider purging these items altogether.

Guidance

Where SMI is necessary, it needs to be supported with policy and procedures. Specific policy requirements include:

Segmentation. Grouping inventory into logical lots. Included with each segment are details on the segment, why it exists, and how it should be managed.

Service level. Details on the service levels that are to be applied to various slow-moving segments. For instance, 95 percent for critical items and 85 percent to non-critical items.

Introduction. Guidelines for the introduction of new items into the inventory. What order quantities are to be used or how the order quantity parameters need to be configured.

Review. Guidelines on the need for and purpose of inventory reviews. Review of activities may include the need to investigate price, segmentation, and service level.

Performance. What indicators are to be used to measure inventory performance? What benchmarks are to be used in determining acceptable performance?

Significant obsolescence occurs when inventory managers don’t have guidance. Guessing or using the quantity of stock on hand for a similar item may not provide an appropriate solution. Determine the demand of a similar item, and calculate requirements through the use of an inventory management model and algorithms, with associated policy guidance. Use the results of this analysis as the basis for stocking recommendations.

The procedures also need to contain the associated reasoning—for example, how service levels are calculated and why a particular approach is pursued. Unless this supporting information is available, inventory managers may not be able to convince themselves that the procedures will align with policy requirements. They may end up doing their own thing.

Deployment

Policy and procedures will definitely help optimize inventory performance. However, system support is required, too. Determining the number of slow- moving items, especially when the demand quantity fluctuates significantly, can present difficulties. Unless the inventory manager has system support, an overly conservative response usually results. This, in turn, fosters excessively overstocked SMI.

The sophistication of the slow-moving forecasting support will vary from organization to organization. Again, the amount of slow-moving inventory will influence the response. Multi-million-dollar slow-moving inventories may warrant the implementation or upgrade of distribution resource planning (DRP) functionality.

Alternatively, a spreadsheet or database system incorporating an appropriate technique, which back-loads replenishment information into the organization’s inventory management system, may be appropriate.

The “glue” in sustaining strong SMI management is developing and maintaining skills. Without working in harmony and at par with policy and tools, your staff at all levels will soon resort to old habits.

Logistics professionals need to understand the use of algorithms, including key variables to consider, and how to get peak performance out of their systems. Staff directly involved with ordering need to understand the appropriate performance measures for slow-movers, and be trained in tactical procedures influencing order and inventory carrying costs. There’s a need for at least 20 to 30 hours of training annually per staff member. Hardly a large investment to keep SMI at the lowest possible levels.

Next Steps

SMI typically attracts less attention than other classes of inventory except when it comes to cost analysis. “Why is there so much SMI?” “Why are stock turns so low?” are common questions.

Without the requisite policy, procedures, and functionality, inventory managers operate in an uncertain environment. Therefore the conservative response typically prevails. Essentially, inventory accumulates wherever uncertainty exists.

Taking the right action offers significant benefits. Not only will you carry less SMI, you’ll also boost customer service levels.

ABOUT THE AUTHORS:

Wayne Patch, OAM, is a senior consultant and Fred Wintle is a managing partner for Dawson Consulting. The authors have agreed to field your questions about managing your company’s slow-moving inventory. Contact them at [email protected]