Editor’s note: A version of this article appeared on the Baxter Planning Blog and is adapted here with permission.
In part 1 of this series devoted to Total Cost Optimization, we discussed the operational costs of not having a part in the right place, and how these costs need to be considered in the service parts planning optimization process.
As we continue our exploration of cost optimization, we consider two additional costs that must be balanced in the optimization process: inventory costs and instability costs.
Everyone knows that inventory costs money. Look at the financials of any publicly traded company, and you’ll see inventory right there in their financial statement.
Parts planning is often viewed as strictly a balancing act of inventory versus service level. This is often viewed in terms of an exchange curve graph, which shows that as service level approaches 100%, the inventory investment to achieve incremental service level improvement grows exponentially.
While it is important to understand that key planning concept – that service gains become smaller and smaller as you approach 100% – it’s also important to understand how those inventory investments impact your company and, in the case of total cost optimization, how much other operational expenses are reduced as inventory is added.
There are multiple categories of inventory costs that should be considered in a total cost optimization approach for service parts. This is not a full list, but represents some key categories of the cost of on-the-shelf inventory:
- Carrying cost: This is sometimes described as “opportunity cost” or “the cost of money.” If your company has invested in inventory, then that investment is sitting on a shelf, depreciating rather than growing. If too much is invested in inventory, then that money is unavailable for other parts of your business, such as investing in R&D, or buying back company stock. Excessive inventory investment is a lost opportunity for that cash to do more valuable things.
- Risk of obsolescence or excess: Any investment in inventory needs to consider the risk that the inventory will eventually become obsolete. This is a worst-case scenario, not only does your organization risk needing to scrap a valued asset, but there are also finance and write-off cost implications. There is also the cost of the scrap exercise itself, as environmentally sound disposal may be expensive depending on the type of asset.
- Warehousing costs: More inventory means more warehouse space. In an environment where a third-party logistics (3PL) company is providing warehousing, paying for inventory space by the square foot is common. Inventory that’s on the shelf needs to be periodically counted, and that takes warehousing personnel time investment as well.
Understanding the costs of holding inventory is key to creating a stocking plan that balances inventory costs and the stockout costs discussed in the first post of this total cost optimization series.
Plan Instability Costs
Another key cost, related to inventory costs, is the cost of plan instability.
No inventory plan for service parts can be completely static, as business situations the plan is supporting change over time. New customers are added, new products are introduced, and products go out of support. Your network may need to change over time to support changing business needs. If you have technicians that hold inventory, technician turn over will also contribute to plan instability.
However, changes to a plan cost money. Each time a stocking plan changes, there are transportation expenses moving parts in your network to adjust to the new plan. If you use a third-party logistics operator, in addition to the transportation expense of moving a part, there are inbound and outbound charges as parts are moved from one stocking location to another.
Technicians that hold inventory are particularly sensitive to plan instability. If you send a technician a part for their van stock, and request that part be returned as excess, only to send it back again a short time later, technicians notice. Their time is wasted. Each change to their stock means they need to do some level of re-organization of their inventory.
A cost optimized inventory plan will consider these operational expenses of changing a target stock level. Each stocking level change must provide more sufficient cost benefit, in either reduced stockout cost risk or reduced inventory holding costs, to justify the operational costs driven by changing the stock level.
In this article, we have discussed that there are organizational costs of holding inventory and operational costs to changing stock targets. In the final part of this series introducing total cost optimization, we’ll discuss how when these inventory and instability costs are properly balanced with stockout costs, you will have achieved true optimization of your service parts inventory plan: the lowest possible operational costs of providing excellent service to your customers.