What is Inventory Policy?

Inventory Policies

Understanding the Fundamentals:

Do you think inventory policy is just safety stock? You can be sure it's not — in fact, taking good care of your inventory in times of high interest rates, when carrying inventory is more expensive than ever, should be a priority for any industry. So what are these so-called inventory policies?

Inventory policies play a crucial role in the efficient management of an industrial company. They involve defining guidelines and procedures for acquiring, storing and managing materials and products — from raw materials to semi-finished and finished goods. The main purpose of these policies is to ensure the company has the right amount of inventory at the right time, minimizing costs and avoiding both excess and shortage of products. There are some possible fronts to work with such policies:

1. Replenishment Strategy — Review Types

First, you must decide how the replenishment of important items will be performed. The options are:

1. Continuous Replenishment or Review: Inventory is monitored continuously and an order is triggered as soon as the inventory level hits a predefined reorder point. The order size is usually fixed (such as an economic lot) or a multiple of that lot.

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

Periodic Review is useful for essential and critical raw materials, usually with high demand and shorter lead times, as well as low purchasing cost due to the volume normally acquired (often already tied to a contract). Continuous Review is ideal when purchasing cost is higher, or item demand behavior isn't very linear and/or the item itself is costly and a periodic review could cause excess.

We can also define a different strategy for an item — replenishment against Order. This is used for items where it isn't interesting to maintain constant inventory, but to replenish only when an order is placed. It's not traditionally cited as a replenishment type in make-to-stock (MTS) scenarios, since it represents a make-to-order (MTO) orientation. However, since the decision to produce or buy for stock or to order is up to the company, it's important to know you can always redefine whether an item should be MTO or MTS, especially if demand is dynamic in the medium/long term.

2. Inventory Level Management

If every company could replenish its inventory instantly, no planning would be needed — it would just be responding to immediate demand. But reality isn't anywhere close to that. So we need to think about how much inventory we want to hold and when we'll replenish. Understanding future demand and the replenishment time makes this possible. What are the levels or volumes to be defined?

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

Minimum Stock: minimum stock can be the safety stock itself, or a bit above — the lowest point inventory will reach when replenishment finally arrives. It's the lower extreme of the “sawtooth chart.”  

Reorder or Order Point: this is the point at which an order is placed (purchase or production) under the continuous-review strategy.

Cycle Stock: basically the inventory between the position at order time and the minimum stock. It's the volume that's always turning over.

Maximum Stock: the volume reached when inventory is replenished with a newly planned lot. It's the highest peak of the “sawtooth chart.”

3. Lots

Lot sizes are usually empirical rules in industry, but can also be calculated for use in more mature production chains. They are:

1. Economic Order Quantity (EOQ): the lot size with the lowest cost to the company. It considers annual demand, cost per order and annual inventory carrying cost. Since these 3 parameters can vary a lot in some cases, or be defined based on very subjective costing assumptions, you should always evaluate EOQ use carefully.

2. Minimum Production or Purchase Lot: the smallest lot at which it makes sense to produce or buy an item. For production, it's usually defined by the industrial area, and it's a parameter to watch since it was often defined many years ago and never reassessed or challenged. In Purchasing, it's usually imposed by the supplier.

3. Production or Purchase Lot Multiple: the multiple in which you must produce or buy — often equivalent to the minimum lot (but not always). When it's not equal to one unit, it's usually defined by some batch process or a transport unit (a box, pallet, coil), which makes this lot break obvious.

4. Maximum Production Lot: limit for a production lot. Usually defined by management for material traceability (very large lots are harder to trace) or for regulatory reasons (as in pharma, for example).

4. Segmentation (the curves)

Here come the famous curves. The most famous is certainly the ABC curve. But there are others, such as XYZ, 123, PQR, among others. If you'd like to know more about each, check our dedicated post on the topic here.
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5. Specific Methods and Analyses

There are also more specific methodologies to manage inventories, such as Just-In-Time (JIT), which seeks to minimize inventories as much as possible by ordering only what's needed for short-term production with agile replenishment, and Just-In-Case, which does the opposite by “rounding up” purchase lots to meet future demand and save on unit purchase cost.

Beyond these, inventory policies imply a series of analyses aimed at improving health, such as inventory turnover, sales frequency, stockouts, average replenishment lead times and their standard deviations, carrying and storage costs, obsolescence index and even demand planning and purchasing-area information such as the Supplier Scorecard. In other words, information that can be critically useful for deciding how much to keep in stock and how much to order to buy or produce is relevant to such policies.

In summary, inventory policies are essential to the effective operation of an industrial company. They help ensure necessary materials are available when needed, while controlling costs and optimizing processes. A well-planned inventory management can lead to better customer satisfaction, less waste and higher profitability.

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