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Inventory Management 101


By Tony Donofrio, Stephen Francis and Jim Shepherd

Imagine a water tank with two valves: one lets water out at the bottom, the other refills the tank from the top. If we let too much water in, the tank overflows; if we don’t keep up with the rate of consumption, we end up with too little (or none). Many organizations manage inventory by manually draining and refilling their “tank’” at will.

The problem with this is that they can only hope to hit the optimal level of inventory by accident. The result is stock-outs – the water in the tank goes to zero – or cash that is tied up in excess inventory. Like water in a tank becoming stagnant, inventory ages. Given enough time, the inventory becomes obsolete and that cash has gone down the drain.

What we really need is an automated method for refilling each item as it reaches a critical threshold, much like the float valve in a water heater. Any good warehouse management system (WMS) has this capability built in, but the math is pretty basic and can be done in a spreadsheet, if that’s all you have.

First, we need to find out the average turnover of each item — how long we held it in stock. Of course, there were times we turned the item more frequently, so the average alone is not terrifically useful; we want to capture those deviations from the norm — in fact, we use two “standard deviations.”

For those of you who break into a sweat when you hear statistical terms, “standard deviations” are just bands on either side of the average that capture a certain percentage of fluctuations. If the average is the middle lane on a highway, the standard deviations would be like the lanes on either side. You don’t always stay in the middle lane; sometimes you go into the fast lane, sometimes the slow.

The more standard deviations you consider, the more variation you capture. Working with two standard deviations is more comparable to the shoulders on a highway — it’s rare to veer off into them, but not entirely unknown.

Two standard deviations will capture roughly 70 percent of fluctuations — it’s really just a way of saying that we hope to have the right level of stock about 70 percent of the time.

There is one important caveat to bear in mind when using this method: it will sometimes tell you that you don’t need to keep certain items in stock. This is fine if the item is obsolete, slow-moving and of low importance — but if it is critical to your core business, you may want to have at least one unit on hand at all times.

The easiest way for this is to take a careful look at any items with an optimal level below “one unit on hand.” Consult with a cross-functional team if necessary, to reassure yourself that you can indeed soldier on without a single one of those items in the warehouse. The supplier’s lead times should also be considered here — if it takes them six months to get you a replacement and you need one every three months, you’d be better off keeping a couple on hand.

Of course, no method works for everybody in every situation. That being the case, we’re also going to discuss the “ABC” technique.

The “ABC” Technique

The first step in this method is to gather data about your total spend on inventory. You’ll usually find that 80 percent of your sales is going to a surprisingly small number of items — somewhere between 10 percent to 20 percent of the SKU’s is typical. These form your “A” list. Just like in Hollywood, your “A” list items are the fast movers — you’ll probably want to keep them close to point of use.

The next category is the “B” list. These items take up roughly the next 10 percent of your sales. Unexpectedly, though you’re spending less money, there will typically be more items in the “B” category than in “A”. This is also where you can start to save serious money, given that you’ll often have reorder points that are set too high, and probably the wrong mix of vendors to boot.

The final category is “C” — the last 10 percent of your sales. If you put all of your inventory items on a chart ranked by spend, this would be the “long tail” of low-volume, slow-moving items stretching out. As long as you give careful thought to how long it takes for your supplier to get the item to you, and whether its lack would cause a major problem, you can often get rid of these items entirely. Simply put: they’re likely obsolete, or easily replaced as and when the need arises. Why would you want to tie your cash up in stuff you don’t need yet?

Tony Donofrio, head of Argo Consulting’s supply chain practice, has more than 30 years of supply chain experience. He has a reputation for taking on tough challenges, creating growth opportunities and outperforming the competition. Stephen Francis, senior consultant, co-created the Argo Integrated Management System (AIMS). He develops and implements tools that drive deep and rapid change for Argo’s clients. Jim Shepherd is a Director with Argo Consulting. Jim has led teams that launched satellites, returned manufacturers to profitability, and consistently delivered multi-million dollar savings for clients.

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