Inventory Management Theory

Companies used to measure their muscle by the size of theirinventory. Bigger was better. Vast warehouses filled to capacityensured efficient assembly lines and guaranteed that, come hell orhigh water, production would never stop. Who cared about carryingcosts? They would be erased by increased sales. But now thatequation has changed.

Lowering inventories is one of the quickest ways to decreaseworking capital needs. Performance measurements, such as the oldstandby ROA (return on assets) and the newer EVA (economic valueadded), as well as other measures that gauge how efficientlycapital is used, have become more common organizational drivers. Infact, many times an executive's bonus depends, at least in part, onhow efficiently capital is used. Couple the drive for efficientcapital use with the need to respond more quickly to changes incustomer demand, with shorter and shorter order-to-delivery cycletimes, and you have a problem that is challenging manyorganizations.

Leaner and Meaner

In the big picture, American business has succeeded in its quest torun lean. But almost all these gains in inventory reductionhappened from 1981 to 1991, and the past 10 years have not seenmuch improvement. Inventory as a percent of GDP held steady at 3.8percent from 1992 to 2000. Rather than being eliminated, inventoryhas been pushed down into the lower reaches of the supply chain,from manufacturers to top-tier suppliers to lower-tier suppliers.GM, for example, improved inventory turns, a common metric thatmeasures total cost of goods sold divided by average inventory, andserves as a valuable indication of how often a company sells outits inventory (the higher the better) - 55.2 percent between 1996and 2001. However, the company that supplies its tires, Goodyear,saw its inventory turns decline 21 percent during that same time.In other words, lower-tier suppliers are left holding the bag forthe big boys like GM and Wal-Mart.

Inventory Management Theory

Inventory and the management thereof belong to everyone in thecompany but nobody wants to own it.  Inventory Management istruly interdisciplinary and spans from financial and managerialaccounting, to operations research, material handling to logistics.The following is a quick overview of Inventory Control/Managementterminology and theory.

Reasons for Holding Inventory:

• Inventory balances supply and demand
• Inventory acts as a buffer between critical Supply Chaininterfaces
  • supplier – procurement
  • procurement – production
  • production – marketing
  • marketing – distribution
  • distribution – intermediary
  • intermediary – user
• Inventory allows for economies of scale in
  • Purchasing
  • Transportation
  • manufacturing

There are various reasons for holding inventory. Inventory acts asa buffer between supply and demand fluctuations and irons outsupply chain system failures.  The smoother your supply chainoperates and the better you are able to forecast the less inventoryyou have to hold, unless you gain some economies of scale inpurchasing, transportation and ormanufacturing.  

Categories of Inventory

• Raw Material Inventory
• Work-in-progress Inventory
• Finished Goods Inventory

There are three categories of inventory; too much in either may bea bad thing unless you have reasons for it such as seasonality,production runs, and prevention of stockouts or improvement ofcustomer satisfaction levels.

Types of Inventory/Stock

• Cycle stock
• In-transit stock
• Safety or buffer stock
• Speculative stock
• Seasonal stock
• Dead stock

If demand and lead time is constant, only cycle stock isnecessary. In transit inventory is usually accounted for on theplace of shipment as it is not available at the destination.In-transit stock can be reduced through faster modes oftransportation. Safety or buffer stock is a result ofuncertainty of demand and lead time. Speculative stock isinventory held for reasons other than satisfying current demand,often acquired to reach economies of scale or to generateseasonal stock. Dead stock includes items for whichno demand has been registered and may becomeobsolete. 

Inventory Management Conditions

• Certainty
• Uncertainty

In a perfect world as described in business school text books andcase studies one manages in a world of certainty. And the bestordering policy can be determined by minimizing the total ofinventory carrying costs and ordering costs using the EconomicOrder Quantity (EOQ) model.

EOQ =        2PD              √ CV

P = ordering cost   ($/order)

D = annual demand  (number of units)

C = annual inventory carrying cost  (% of productcost)

V = average cost of one unit ofinventory  ($/unit)

This formula can be adjusted for volume discounts and incrementalreplenishment, as well as other conditions.

Most of us don’t work in a place called perfect, and are facinguncertainties. Life ends up throwing monkey wrenches into theproduction of widgets. For those of you who love math look at theoperations management literature and you will find ways tocalculate fill rates, safety stock, and standard deviation ofreplenishment cycles.

Symptoms of Poor Inventory Management

• Increasing number of backorders
• Increasing cancelled orders
• Increasing numbers of returns
• High customer turnover rate
• Large number of obsolete items
• Periodic lack of storage space

You know you have a problem if your backorders continue to increaseand at the same time you are faced with increasing cancelledorders. Reverse logistics may be tasking as well as your number ofreturns increase, and you end up loosing customers, whileaccumulating obsolete items which among other things may lead tolack of storage space. You may face these inventory symptoms, butthe causes may be part of the bigger picture.

Ways to Reduce Inventory Levels

• Lead-time analysis
• Delivery-time analysis
• Eliminate low turnover items
• Eliminate obsolete items
• Analysis of package size
• Analysis of discount structure
• Examine returned goods procedures
• Measurement of fill rate by stock-keeping unit(SKU)
• Analysis of customer demand
• Improve forecasting
• Improve Electronic data interchange withvendors/suppliers

The above mentioned ways to reduce inventory levels should be partof a system approach to improving InventoryManagement

Inventory Management Systems/Analysis

• ABC Analysis
• Forecasting
• Advanced Order Processing Systems
• Enterprise Resource Planning (ERP
• Electronic Data Interchange (EDI)
• Knowledge Management (KM) Systems
• Vendor-Managed inventory (VMI)

ABC analysis is a tool to classify items according to theirrelative importance/profitability (Category A items are moreimportant than category B items, and so on). A distribution byvalue report usually forms the basis of an ABC analysis. Bettersales forecasting and advanced order processing systems as part ofa larger marketing plan will reduce inventory. And EnterpriseResource Planning (ERP) system such as SAP will eliminate stovepipes and information silos and contribute to information sharingalong with a company knowledge management (KM) system. Topmanagement may see Vendor-Managed Inventory (VMI) as a way toout-source the inventory problem. But one has to be careful as itrequires a high degree of transparency and integration between thepartners. Such a marriage may bring a lot of benefits during thehoneymoon period but also may have a costly divorce lurking in thebackground.

Inventory is a poorinvestment alternative for cash, but imperative to achieve requiredservice levels. Maintaining the appropriate levels and types ofinventory is essential to providing quality, timely service andproducts to your customers. Preventing stock-outs withoutoverstocking products requires a disciplined process andinformation system that can dynamically manage this balance. Two ofthe keys to optimizing inventories are to improve reliability andreduce variability in the supply chain to meet your customer'sdemand while being cost effective. To order just in time and justenough.

References

Arnold, T. and Chapman, S. (2004). Introduction to MaterialsManagement 5^th Ed.

Prentice Hall, Upper Saddle River, NY

Narasimhan, S., Mcleavy, D. and Billington, P. (1995).Production Planning and    Inventory Control2^nd ed. Prentice Hall, Upper Saddle River,NY

Plossl, G (1985). Production and Inventory Control: Principlesand Techniques   2^nd ed. PrenticeHall,  Upper Saddle River, NY

Stock, J. and Lambert, D. (2001). Strategic Logistics Management4^th ed. McGraw-Hill, NewYork,NY.

Tersine, R. (1994). Principles of Inventory and MaterialsManagement 4ed. Prentice Hall, Upper Saddle River,NY