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Inventory Obsolescence: It Can Get Complicated

By Jeff Bodenstab1 Sep 2015

It’s hard to get around inventory obsolescence. Derived from the Latin verb obsolesere—to grow old—most products in the marketplace grow “long in the tooth” at some juncture in their life cycle. Shorter innovation cycles, multi-channel complexity, and long-tail stock-keeping units (SKUs) accelerate the inevitable decline in value.

The knack in today’s innovation economy is to understand how the value of a particular SKU deteriorates or its costs increase so that profit erosion can be factored into inventory optimization calculations.

According to Nucleus Research, in its July 2015 Research Note, companies can optimize inventory using the right algorithms. The report says, “A business can optimize stock holdings in tighter alignment with marketplace demand, avoiding profit erosion while reaping costs savings from inventory optimization and reduced product obsolescence.”

But correctly modeling inventory obsolescence is important. Sometimes the algorithm is straightforward—a constant deterioration or a simple cutoff date will do.

But applying simple uniform logic to obsolescence won’t always work if an item doesn’t lose value at a constant rate. The value of perishable items like pharmaceuticals or fresh foods can deteriorate more rapidly as they approach their “use by” date. A long-tail item—say, a specialized electronic component—may lose value in a manner specifically impacted by newer versions planned for release.

Tricolor Auto Group is an example of a company with unique obsolescence patterns and a need to understand how to model inventory obsolescence in order to minimize obsolescence costs. The firm operates 17 automobile dealerships across Texas and Oklahoma with a mission that includes providing better financial terms than its competitors

Automobiles depreciate in value over time, and a combination of debt and equity financing means that Tricolor’s interest rates and costs grow the longer cars are held in inventory. Also, while a used car is reconditioned according to the needs of the make and model, the interest rate on the reconditioning cost does not accelerate at the same rate as the original cost of the car.

These variables make it tough for Tricolor to establish the optimum inventory levels that enable cars to be resold for its maximum value—while still holding enough inventory of the right cars to satisfy customer demand. Tricolor used obsolescence models and algorithms in its supply chain planning software to model these uniquely accelerating curves, and to calculate the interest on the reconditioning cost for each vehicle.

“These algorithms for calculating non-standard obsolescence provide companies with a sophisticated way to maximize profits on life cycle products,” Nucleus reports. “By using the non-standard obsolescence algorithms, Tricolor was able to improve forecast accuracy and optimize its car inventory to maintain service levels while avoiding both the cost of obsolescence and lost sales.”

Tricolor reduced inventory and obsolescence cost by 20 percent within just three months of implementing their new approach to modeling modeling obsolescence. According to Rebecca Roberts, vice president of operations, “We are really encouraged by the 20 percent inventory savings we’ve made already, and we fully expect to gain further benefits over time.”

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