Learn the 6 types of inventory risk

Inventory is a substantial investment for manufacturers, distributors and retailers, as it ties up working capital. Corporate leadership teams must take action to mitigate inventory risk.

Many members of the C-suite could be affected by inventory risk. COOs and CSCOs could be impacted by the negative consequences of poor inventory management, as it can affect service levels and customer loyalty. CFOs could be affected by the financial consequences of bad inventory management, with the results potentially including carrying costs, write-downs and volatile cash flow.

Here are the six primary categories of inventory risk.

1. Inaccurate demand forecasting

Planners’ demand forecasting will be inaccurate if their forecasting uses incomplete historical data, fragmented input from multiple departments or information that fails to account for anomalies such as promotions.

Over-forecasting leads to excess inventory, tying up of cash, an increase in carrying costs and an increase in the likelihood of write-downs because of product obsolescence. Meanwhile, under-forecasting leads to stockouts, lost sales, expediting costs and potential customer dissatisfaction. COOs and CSCOs will find it harder to deliver on-time-in-full, while CFOs will face unpredictable fluctuations in working capital.

To mitigate this risk, COOs should consider implementing AI-enabled demand-sensing platforms, which ingest structured and unstructured data such as internal inputs, consumer sentiment indicators and macro-economic trends. The technology will give leaders more insight into demand. Meanwhile, CSCOs must enforce disciplined planning and carry out regular reviews of forecasts to ensure they’re accurate.

2. Supply chain disruption

Even perfect internal forecasting isn’t enough if suppliers miss delivery windows or the flow of goods is disrupted by geopolitical events or natural disasters. Relying on a single source for goods dramatically increases risk.

Supplier failures and general supply chain disruptions usually have a cascading impact, halting production lines and potentially leading to unfulfilled customer orders. Those effects can lead to unexpected expediting costs and damage customer loyalty. CSCOs bear primary responsibility, but COOs and CFOs must deal with fallout from the problem as well.

Prevention begins with awareness and supplier diversification. CSCOs should implement supplier evaluation processes that examine on-time delivery, quality and financial health and consider multi-sourcing critical components and materials. Long-term partnership agreements with shared risk and reward clauses as well as collaborative forecasting should considerably reduce volatility.

COOs can help prevent supply chain disruption by ensuring that internal systems provide suppliers with accurate demand signals.

3. Excess inventory and obsolescence

Excess inventory takes up warehouse space and can negatively affect picking efficiency. It may be caused by over-forecasting, product line changes or unexpected buyer preference shifts. Some categories of goods, such as perishables or technology products, lose value especially quickly.

Mitigation of this risk requires aggressive inventory management. COOs should implement regular ABC segmentation reviews and aging inventory reports and establish clear protocols for disposal of excess or obsolete goods. Meanwhile, CSCOs should align introduction of new products with phase-out plans for predecessor SKUs.

4. Shrinkage

Inventory can disappear or lose value because of theft, damage, spoilage or supplier fraud. Shrinkage not only leads to direct financial loss but reduces the accuracy of inventory records, making planning even more difficult. Repeated shrinkage also indicates insufficient control over inventory, which could undermine confidence in the company from investors and regulators.

COOs should implement cycle-counting programs, access controls, video surveillance and any other needed countermeasures, such as sensor-driven alerts for high-value items. Meanwhile, CSCOs should stay alert for supplier fraud.

5. Price volatility

Rapid shifts in commodity values, currencies or competitive pricing can affect existing inventory value and the economics involved with holding inventory. This risk is especially acute for organizations that have long lead times or often possess significant quantities of raw materials.

COOs and CSCOs must decide whether to hedge, build strategic buffers or pass costs on to customers. CSCOs can negotiate price-adjustment clauses and index-based contracts with key suppliers, while COOs can implement postponement strategies. CFOs can invest in hedging instruments that can potentially reduce the effects of fluctuations.

6. Quality defects and compliance risk

Defective, counterfeit and non-compliant inventory can lead to costly recalls, reputational damage and regulatory penalties. Stakes are especially high for companies in industries like pharmaceuticals, medical devices and food and beverage. Depending on their area of operations, some companies must adhere to extended producer responsibility laws and similar regulations or face compliance risk.

C-suite mitigation should focus on prevention and product traceability. CSCOs oversee supplier quality management, while COOs must ensure controls are in place for incoming products and work-in-process.

Many types of inventory risk are interrelated. Carrying out the proper demand forecasting will help reduce excess and obsolescence, while ensuring reliability of suppliers and quality programs will help reduce shrinkage and disruption. COOs and CSCOs should treat inventory risk as a cross-functional problem.

James Kofalt spent 16 years at SAP working with SME business applications and was a product manager for integration technology at Microsoft's Business Solutions division. He is currently the president of DX4 Research, a technology advisory practice specializing in ERP and digital transformation.