The inventory in your warehouse or factory is both an asset and a liability. In either case, if it just sits there, it is worse than worthless - it's of negative value. Whether it's pens in the stationary cupboard or multi-million dollar machine tools in the dockside warehouse, inventory must be stored and cleared in as cost-effective and efficient a way as possible.

Inventory optimisation is about managing what is in the warehouse and how those contents flow into and out of the warehouse. It is the area where most ERP software implementations normally get the highest and fastest return on investment. It is therefore surprising that many companies that have implemented ERP have not yet added a dedicated inventory optimisation module, as it offers a huge potential for companies to maximise the value of their IT investment for a relatively small incremental cost.

It is a fundamental requirement for almost every company to be able to meet customers' requested service levels with a minimum amount of inventory. This means having just the right products in stock in the right amounts and virtually nothing else. Excess stock is excess capital outlay, which has a massive impact on bottom line profitability. However, this has to be balanced against the potential damage of inadequate stock leading to lost sales, lost customers and a negative impact on bottom line profitability.

If you could precisely predict exactly what your customers will buy in the future, inventory optimisation would be very simple. But, in reality, it is rather tricky. Deciding on the correct inventory level is a major issue, and the answers will vary from industry to industry, and from organisation to organisation.

The danger lies in either overstocking or understocking.

Overstocking results in a range of negative impacts:

• Organisations become inflexible, and difficult to manage

• There is an increased amount of funds tied-up in non-productive goods

• Consequently, there is an increased number and value of write-offs

• More goods become obsolete or expired

• Storage needs increase exponentially as less stock is removed than is brought in

• Overheads increase due to all of the above.

On the other side of the coin, understocking also has negative impacts:

• Service levels are low because of inability to meet demand

• Customers are disappointed, to say the least

• Organisations are subject to rush charges and express delivery fees to ensure the availability of inputs

• Business opportunities are lost.

To make the picture even more complicated, getting accurate forecast figures becomes equally problematic as the supply chain becomes more complex.

In the days following the Second World War, demand was larger than production. Companies were focused on making purchasing and manufacturing more efficient, as you could always sell what you produced or purchased. Today it's the other way around. Production is greater than demand and customers have become more and more demanding.

That's why an agile supply chain is vital, one that can react when customers suddenly demand a new version of an item, and that can deliver with shorter lead-times.

Inventory challenges facing organisations therefore include:

• Complex global supply chains, with potential outsourcing of manufacturing to low cost countries which increases freight costs

• Supply chain integration/visibility is limited, especially if dealing with low cost countries that do not have advanced IT systems

• Customers driving demand which can be broad and unclear

• Complex products, with broad and detailed configuring

• Subsequent stock-keeping requirements, potentially for a wide range of components required for configuration

• Shorter product life cycles

• Uncertain future market directions and trends.

To make it even more complex, different industries have different challenges that need to be addressed, which is why agile solutions that meet business-specific needs are required.

For instance, one example of a vertical industry dealing with inventory issues is paper merchants and distributors. Here, customers handle very large and heavy goods, and because of weight and volume it is essential to have direct delivery from the supplier to the customer. Delivery needs to be just-in-time, as a printing business cannot store a lot of paper. Paper stocks could be held at any one of a number of locations, including the mill, external warehouses owned by the mill or the merchant, the merchant's central or regional warehouses and even at the printer. This stock holding and the subsequent distribution requirement incurs costs for every member of the supply chain and should be reduced wherever possible, particularly where there is unnecessary duplication. Quite simply, whichever party can distribute stock in the most cost-effective manner to the required service level should be encouraged to do so. Implementing best practice at this stage requires mills, merchants and printers working together to establish the optimum distribution. This will eliminate the costs of empty warehouses and unnecessary journeys.

The pharmaceuticals and healthcare industry is another area for inventory optimisation. Distributors need to move and manage large volumes of items with speed and accuracy. This means that the reception, storage and picking of thousands of sales order lines has to be streamlined. Radio frequency identification and barcode support can give real-time inventory control and minimise paperwork. Pharmaceuticals warehousing must also meet strict regulations for narcotics and hazardous goods. In other words, the pharmaceuticals industry needs a system that supports large volumes of items. Most of the purchasing and planning activities need to be automated as much as possible to react and deliver on constantly changing demand.

Finally, when talking about stock keeping units, electrical component distributors are among the hardest hit. Some of them have more than 100,000 stock keeping units. It is essential that the information in the item file is correct and easy to maintain. They need to collaborate with suppliers, which means that they need a system that can easily import new prices. They also have to be able to handle extensive and complex agreements in order to purchase items at the right cost and at the right time. They need a solution that supports cross-referencing so that they can define alternative and replacement products; inventory segmentation so that product lines can be defined as high-turnover, low-margin, high-value, slow-moving, etc; and dynamic demand forecasting, replenishment suggestions, cross-docking, over-the-counter sales, and seasonal fluctuations. Warehousing requires real-time control to assure timely deliveries, without overstocking.

The fact is, more and more industries and verticals are facing the same problem as the electronics industry, as companies continue to collaborate and consolidate. This means that the supply chain runs at ever-faster rates and with greater volumes. Information requirements and ways to connect systems and use information become more critical for processes, while reporting, analysis and planning are becoming increasingly important for everyone.

At the same time as there are complexities in the supply chain, there are also internal challenges – even differing priorities – within the organisation. CEOs want to improve customer service, sales want more products to sell, and CFOs want to reduce inventory.

The best and truly the only way to adequately handle this conflict of interest and complexities of systems is the old slogan: Order the right product, at the right quantity and quality at the right time. The objective of any solid inventory management system is to provide the best possible customer service within the restraint of the lowest practical inventory costs.

Optimising inventory is a constant balancing act. Once you've made your initial decision to undertake an optimisation program, there are four different steps you will need to follow:

• Analyse the current situation, what items are selling and how is delivery performance, etc

• Classify items into different categories that can be handled with ease and define strategy per product segment

• Calculate as good a forecast as possible, adopting different policies on different segments

• Control costs by optimising replenishment, adopting different replenishment policies on different item segments; and replenish with the best possible collaboration with suppliers.

Then … you do it again. Inventory optimisation is a constant process of fine-tuning inventory and analysing performance: are there other item segments that can be improved, how effectively can they be improved and at what cost?

It's simple, when you know how.

It is just important that you follow a formal structure that gives you accurate and timely information, and that allows you to make tactical and strategic decisions about your inventory flow. The next step in this process is to determine how you stand at the moment – analysing your performance.