ABC inventory analysis is widely misapplied as a tool for setting service levels. As a result, many companies have significant inventory imbalances. This increases capital costs and lost revenue. The solution is Economic Stock Optimization.
As a consultant, I often encounter a slightly religious attitude about service levels for different categories of inventory. For example, a manager may say that a 99% service level should be associated with A-category products, with lower levels for B and C products. Whether these service levels lead to the lowest possible costs is not analyzed; the percentages are accepted as correct.
The weakness of the ABC analysis is that it provides no answers regarding how service levels impact costs
Consider a few critical questions that the ABC analysis can’t answer:
- What is the total cost of maintaining the current service level for a specific product?
- How will changing service levels from 95% to 97% affect all our logistics costs?
- Is there a benefit to changing service levels for any of our A-category products?
To help determine what the optimal service level is for each product, you need a tool that calculates all the costs linked to changes in inventory.
Economic Stock Optimization is a simulation method that finds the service level that leads to the lowest inventory holding costs. ESO creates full transparency regarding how inventory adjustments impact all logistics costs.
Based on advanced simulation, the ESO method splits the overall cost into specific expenditures, such as the cost of working capital, warehousing, lost sales, and costs associated with obsolete products.
ESO answers questions like:
- Within the range of 95% to 99%, what is the service level that will lead to the lowest possible cost for all items?
- What is the total potential for savings associated with optimizing current inventory?
- Which items are associated with the biggest potential for cost savings?
- How will savings be distributed among expenditures such as capital cost, warehousing, and obsolescence cost?
As a manager armed with this information, you can decide exactly how much safety stock to carry and when you need to reorder to maintain the service level that best serves your bottom line.
The conversation shifts from “How do we reach a 99% service level?” to “What is the best service level for this product?”
The ESO approach is a way of starting a conversation that will benefit the bottom line. Like all tools, there are situations to which it is not suited.
For example, medications for life-threatening diseases must be provided at close to a 100% service level, despite the high costs. Likewise, customers are unlikely to return to a supermarket that runs out of bread, so a high service level is a practical necessity no matter the optimal service level calculated by ESO.
In rarer cases, a company may benefit from stock-outs, either in terms of prestige or publicity. For example, whether intentional or not, Nintendo kept the Wii in short supply outside of Japan after its release, which boosted sales by exploiting fear of continued scarcity. The ESO method would need to be supplemented by market analysis in this situation.
Even in these special cases, however, fully understanding the trade-off between working capital and gross margin for each product provides valuable decision-making information. In all cases, our experienced consultants will work with you to ensure that our ESO analysis meets your company’s needs.