How to Manage Stock Out Risk

When I review inventory holding levels with people and I ask ‘why is the maximum setting so high?’, almost invariably the reply is, ‘because that item is critical to our operation’.  However, this response, while well meaning, highlights one of the major problems (in my opinion) of spare parts inventory management:  the misconception that setting a high maximum holding level for an inventory item is a risk minimization strategy.  This idea is just plain wrong because stock out risk is a function of the minimum holding level and setting a high max level does not reduce your stock out risk. 

The implication of this misconception is that companies can leave themselves exposed to a higher risk of a stock outs than they realize.  However, by taking a more correct approach to setting holding levels companies can put themselves in a position where they can minimize the likelihood of a stock out and the costs associated with a stock out event.

So, when you conduct a review of max-min holding levels, here are three things to consider when setting min value:

1. Can you predict the requirement for the item- i.e. is the item used as part of a planned activity or can it’s need be determined with condition monitoring?  In this case you can minimize your risk with improved coordination of planning and parts purchasing.
2. What is the ‘probable peak one-time’ usage that you might require- that is, what is the maximum number that you might need for a single demand event?  To minimize your stock out risk you need to set your minimum value based on this probable peak usage value, rather than an average.  Note that I am saying probable, not possible.
3. How many demands can be expected during the resupply time?

There are many misconceptions relating to materials and spare parts inventory holdings.  Some are relatively harmless; some can have significant impact on the amount of working capital that the inventory ties up.  The idea that setting a high maximum holding level is a risk minimization strategy can easily inflate your inventory holdings to unreasonable levels. 
 

For members of SparePartsKnowHow.com click here for an extended version of this article (also available in the Inventory Management and Optimization section at SparePartsKnowHow.com).  The extended version includes a couple of examples and goes on to show how using this approach to setting your min levels can also help save big bucks in better setting your max holding values.