What is Inventory Optimization?

July 2015

To a large extent, ERP is focused on inventory. The Material Planning function at the core of ERP calculates when parts and materials are needed and plans for their acquisition in time to avoid shortages while limiting the amount of inventory as much as possible. Inventory level and inventory turns are primary measurements that most companies watch as indicators of their success in managing the business and this very costly part of operations.

Reducing inventory while maintaining or improving service level (availability or lack of shortages) is the proverbial “win-win” accomplishment for manufacturers and distributors.

Any company that has additional warehouses or storage locations outside the plant will want to manage those inventories as well. And that’s where “inventory optimization” comes into play. Generally defined as consisting of supply chain planning, forecasting, and replenishment processes, inventory optimization is aimed at reducing inventory costs in the supply chain while improving availability (service), increasing profitability, and providing a competitive advantage in the marketplace.

To optimize means to seek the best or most effective result. Obviously, a lower level of inventory reduces cost but too little inventory leads to shortages and higher costs for expediting, premium freight, customer dissatisfaction and lost sales. So optimization goes beyond just minimizing inventory – it is looking for the best and most effective amount of inventory to yield minimum overall cost.

The planned amount of inventory in the supply chain is the difference between forecasted demand and planned replenishment. That’s why inventory optimization focuses on better forecasting and improving the replenishment planning process. Collaboration with supply chain partners in developing those plans and forecasts is usually a key part of improving supply chain inventory performance. Additional focus is on bringing the forecasting and demand planning process more fully into the overall plan through a formalized Sales & Operations Planning (S&OP) process.

Overall costs are reduced by making the best use of resources including transportation and warehousing. Reduced inventory means less warehouse space required but can also mean more shipments in smaller quantities in and out of the warehouses and that increases labor and handling costs as well as transportation costs. Minimizing inventory will not necessarily result in the lowest overall cost. That’s where the optimization aspect comes in. By watching how the various costs interact, the system can develop the lowest overall cost plan with the right (optimum) amount of inventory.