What is an Inventory Management Policy?

Inventory Policies

Understanding the Fundamentals:

Do you think inventory policies are just about safety stock? Rest assured, they're not. In fact, managing your inventory well, especially during periods of high interest rates when they're more expensive than ever, should be a priority for any industry. But then, what exactly are these infamous inventory policies?

Inventory policies play a crucial role in the efficient management of an industrial company . They involve defining guidelines and procedures for the acquisition, storage, and management of materials and products, from raw materials to semi-finished and finished goods. The main purpose of these policies is to ensure that the company has the right amount of inventory at the right time, minimizing costs and avoiding excess or shortage of products. There are several possible areas for working with such policies:

1. Replenishment Strategy – Types of Review

First, it's necessary to decide how the replenishment of items important to the company will be carried out. There are the following methods:

1. Replenishment or Continuous Review: Inventory is monitored continuously, and an order is triggered as soon as the stock level reaches a predefined reorder point. The order size is usually fixed (like an economic order quantity ) or a multiple of this quantity.

2. Periodic Replenishment or Review: Inventory is reviewed at fixed time intervals (e.g., weekly or monthly). The order size is determined based on the quantity needed to bring the inventory to a predetermined level.

Periodic Review is useful for essential and critical raw materials, typically with high demand and shorter leadmes , as well as a low purchase cost due to the volume usually acquired (usually already tied to a contract). Continuous Review, on the other hand, is ideal when the purchase cost is higher, or the demand for the item is not so linear, and/or the cost of the material itself is high, and a periodic review could lead to excess.

We can also define a different strategy for an item, which is replenishment against order. This is used for items where it is not advantageous to maintain constant stock, but rather to replenish it mes when an order is placed. It is not traditionally cited as a type of replenishment when considering make-to-stock (MTS) scenarios, as it represents a make-to-order (MTO) orientation. However, since the decision to produce or buy to stock or against order rests with the company , it is important to know that it is always possible to redefine whether an item should be MTO or MTS, especially if demand is dynamic in the medium/long term.

2. Inventory Level Management

If all company could replenish their inventory instantly, there would be no need for planning, as it would simply be a matter of responding to immediate demand. But reality is far from that. Therefore, we need to think about how much stock we want to have and when we will replenish it. Understanding your future demand and inventory replenishment time makes it possible to do so. What are these levels ormes to be defined?

Safety Stock: Safety stock is your protection against fluctuations in supply and demand. In theory, it should never be consumed. It is kept for extreme events.

Minimum Stock Level: The minimum stock level can be the safety stock itself, or it can be slightly above it, being the lowest point it will reach when its replenishment finally arrives. It is the lower extreme of the "sawtooth graph".  

Reorder Point: This is the point at which an order (whether for purchases or production) is placed within the continuous review strategy.

Cycle Stock: This is basically the stock between the order quantity and the minimum stock level. It's the volume that is constantly turning over.

Maximum Stock: This is the volume that will be reached when the stock is replenished with a new planned batch. It is the highest peak of the "sawtooth graph".

3. Lots

Batch sizes are typically based on empirical rules in industries, but they can also be calculated for use in more mature production chains. These include:

1. Economic Order Quantity (EOQ): This is the lowest cost order quantity for the company . It takes into account parameters such as annual demand, cost per order, and annual carrying cost. Since these three parameters can vary significantly in some cases, or be defined based on highly subjective cost allocation assumptions, it's always good to carefully evaluate the use of EOQ.

2. Minimum Production or Purchase Lot Size: This is the minimum lot size in which it makes sense to produce or purchase an item. For production, it is usually defined by the industrial area, and it is a parameter to be careful with, given that it was often defined many years ago and has never been re-evaluated or reviewed. In purchasing, it is usually imposed by the supplier

3. Multiple Production or Purchase Lot: a multiple for producing or buying, often equivalent to the minimum lot size (but not always). When it is not equal to one unit, it is usually defined based on some process that occurs in batches or by transport unit (a box, pallet, reel), which makes this batch breakdown evident.

4. Maximum Production Batch: limit for a production batch. Usually defined by management to improve the traceability of materials (very large batches are more difficult to trace) or for regulatory reasons (such as in the pharmaceutical industry, for example).

4. Segmentation (the curves)

Here we see the famous curves. The most famous is certainly ABC. However, there are others, such as XYZ, 123, PQR, among others. If you want to know more about each of them, check out the exclusive post on the subject here .

5. Specific Methods and Analyses

There are also more specific methodologies for managing inventory, such as Just-In-Time (JIT), which seeks to minimize inventory as much as possible by ordering only what is necessary for short-term production, with agile replenishment, and Just-In-Case, which does the opposite by "rounding up" purchase lots to meet future demands and thus save on the unit cost of the purchase.

In addition to these, inventory policies involve a series of analyses aimed at improving inventory health, such as inventory turnover, sales frequency, stockouts, average replenishment leadmes and their standard deviations, maintenance and storage costs, obsolescence rate, and even demand planning and purchasing information, such as the Supplier Scorecard. In other words, information that can be critically useful for making decisions about how much to keep in stock and how much to order or produce is relevant to such policies.

In short, inventory policies are essential for the effective operation of an industrial company . They help ensure that necessary materials are available when needed, mesalso controlling costs and optimizing processes. Well-planned inventory management can lead to improved customer satisfaction, reduced waste, and increased profitability.

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