Inventory stratification

by F. Barry Lawrence, Ph.D., Texas A&M University

Distribution firms have faced increasing pressure to reduce costs in their supply chain while simultaneously increasing inventory availability. These requirements are at odds for most traditional distribution firms. The result has been a reduction in distributor margins over the past 20 years supported only by increased demand for distribution services (increased sales). Many firms have tried to reduce the bottom-line impact by reducing inventory. This process has been resisted by customers, however, leaving many distributors in a quandary. Recently, material shortages (allocation) have helped distributors to support higher prices but the solution is likely to be a short-term one.

Another solution is to examine the distributor’s inventory and seek to reduce slow-moving inventory in favor of faster moving items or increasing product selection. It sounds simple enough but most find the process very difficult. A few of the difficulties include slow-move products that are necessary to retain important customers, critical spares that can have a devastating effect if not available, and competition that seems ready to carry everything to capture greater market share. Salespeople live in fear of inventory control programs and will defeat any process they perceive as being at odds with customer service.

How much inventory is enough?
If current inventories are too big or otherwise not profitable, what can the distributor do? Inventory stratification determines what inventory should be carried, in what amount, to meet specified customer service levels. The stratification system should be based on multiple criteria, not just velocity measures like sales or hits. Unit sales or usage is by far the most common measure. Unit sales, however, overlooks many important criteria like profitability, stockout cost, and logistics challenges. The result is that profitability is lost when the sales force and customers demand that slow-move inventory be introduced due to high stockout costs and logistics failures.

The second velocity measure, hits, covers a few more issues. A ranking based on the number of times an item is picked off the shelf can differ from one based on usage. An item that sells one unit at a time can rank lower than another that sells in large amounts each time it is sold. A usage-based (unit sales) measure can eliminate items that customers often access. For the most part, however, hits and usage tend to be redundant. Most systems support usage and quite a few do hits. These two measures alone, however, are not sufficient. Plus, a further problem arises when you try to connect the process to setting reorder minimums and purchasing decisions.

More measures needed
To properly stratify inventory, the firm needs some more measures. Gross Margin Return on Investment (GMROI), aka “Turn and Earn,” has gained tremendous popularity as an inventory stratification tool. GMROI divides the total gross margin a product generates in a year by its average inventory. GMROI protects profitability but still does not quite cover everything. What about slow-move products that are difficult to access and yet critical to the customer? If an item is critical, the customer will be forced to find it elsewhere, which potentially could cost the distributor the customer’s business. Further, the trend in customer expectations is for the distributor’s offering to grow, not be reduced.

There are two other forms of stratification designed to protect the firm from lost customers. The first is to base the stratification on stockout costs. This metric requires the firm to actually capture the cost of a stockout to a customer or to predict the customer’s response and its impact on the firm. Determining the cost of a stockout goes beyond what we can discuss here but in essence it means assessing the value lost from the customer’s viewpoint.

Some firms have also experimented with logistical complexity. If an item is difficult to pull through the supply chain, it runs a greater risk of stockout occurring. When stockout costs and logistics complexity are considered together, the firm will seek differing supply chain solutions for items that are logistically complex and carry a high stockout cost.

Once the proper stratification schemes are in place, the firm needs to weight them so that a final measure can be determined. A common one we use is 40 percent GMROI, 20 percent usage, 30 percent stockouts, and 10 percent hits. The weighting depends on the firm’s goals and customer expectations.

Once the inventory is stratified, the next step is to connect it to setting reorder points (minimums). “A” items should carry a very high fill rate (customer service level) for a couple of reasons. First, a stockout on “A” items is likely to be more distressing to the customer. Second, once the inventory hits zero, the number of stockouts that will occur during the time the firm is out of inventory will be very high. “A” items typically turn a minimum of 10 times as opposed to “C” items that turn less than once. When the inventory level hits zero, the “A” items will be hitting many customers whereas a “C” item may not experience any demand during the time it is out of stock.

Once the stratification is in place, “A” should be set to achieve a very high fill rate and “B” should be considerably lower. That may seem obvious but many firms tend to set fill rates on “A” and “B” items equally, with “C” not much lower. “C” items should either be dropped or only supported by a “Min Stock Policy.” A Min Stock Policy does not use a safety stock and only buys in supplier minimums. The policy will allow the distributor to list many items in inventory with minimal inventory and low risk of stockout.

Focus on fast movers
This inventory stratification policy linked to purchasing processes can decrease inventory while improving service levels by focusing on fast movers. An important byproduct is the reduction in “D” inventory. “D” items are obsolete and have to be liquidated at a cost. Many distributors have a much as 20 percent of their inventory in the D category. The automatic purchasing policy described above will reduce inventory as an “A” item falls to “B” status and carries only minimal inventory at “C” status. “D” items will only rarely occur since the “C” items will be liquidated before they become obsolete.

The key to any successful inventory program is the active support of the sales force. Most inventory programs are not well thought through or explained to the sales force. Any inventory program only acquiesced to by the sales force will have limited success. An inventory program resisted by the sales force will fail. The sales force needs to explain the program to the customer positively and help the customer to plan further in advance for “C” items.

Customer expectations are going to continue increasing. The only way to profitably meet these requirements is to manage assets to near perfection and increase sales through stronger services like a broader product selection. The tighter links provided by better service should ease customer pressure on pricing, leading to more profitable distributors in the future.

Dr. F. Barry Lawrence is the program coordinator for the Industrial Distribution Program, Director of the Thomas and Joan Read Center for Distribution Research and Education, and Director of the Supply Chain Systems Laboratory at Texas A&M. Reach him at lawrence@entc.tamu.edu.

This article originally appeared in the November/December 2006 issue of Progressive Distributor. Copyright 2006.

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