INVENTORY

Basic Inventory Concepts

CLOSE

Introduction

Course Overview

A major metropolitan hospital, in partnership with one of its biggest suppliers, launches a stockless, just-in-time inventory management system. It features automated supply management…online order processing…24/7 systems coverage…and more frequent, convenient delivery schedules.
You would expect the cost of inventory to go down. It did.
Would you expect revenue to go up?
That freed-up storage space means room for more beds, or a clinic, or whatever revenue-generating activity they can think of.
Would you expect services to improve?
Instead of dropping off supplies at the hospital's loading dock, the supplier delivers them directly to where they are needed—for example right to the maternity ward.
And, with less invested in inventory, the hospital has more capital to work with. Given that hospitals spend about 35 percent of their annual budgets on inventory costs, it looks like this hospital has the right idea.

The Total Cost View

In our example, the hospital did not take the narrow view: to cut costs, cut inventory. They looked at the total view: working in partnership with a supplier, not simply demanding price cuts…investing in a system to track inventory…balancing inventory reductions against their patients' and employees' needs.
When the goal is to cut costs, inventory is an easy target. Or an afterthought. Instead, keep this concept in mind:  tweaking inventory levels has ripple effects all through the supply chain. You need to look at total costs, not just quick-fix savings. Click on the figure for more on this concept.
To manage inventory well, you must accept this basic premise: inventory can not be managed in isolation. It is a process that requires collaboration, both inside and outside the supply chain.
Inventory rises sharply, and so do inventory carrying costs, because Procurement gets a great volume discount.
Manufacturing requires more frequent, expensive changeovers on the production line because inventory requirements were reduced.
Transportation costs rise because inventory ships in less-than-truckload quantities.
Consolidating warehouses is a good idea, until transportation costs rise (more miles to travel) and customers have to wait longer for their orders.
More stock-outs, so customers look somewhere else. Revenue falls.

Course Objectives

The purpose of this course is to explore the many facets of effective inventory management. It is a broad overview of related concepts, definitions, tools, and techniques.
Throughout the course, you are the one responsible for inventory decisions. Your job is to manage inventory levels. You collaborate with colleagues in your own company and up and down the supply chain. At the end of the course, you will be able to:

• Describe inventory management's place within the overall supply chain, and within fulfillment.
• Discuss the profit impact of inventory.
• Explain what drives up inventory costs.
• Describe key activities: forecasting, ABC analysis, and cycle counting.
• Discuss inventory performance metrics and how to apply them.
• Summarize how information—coupled with technology—enables accuracy, visibility, and speed in the supply chain.

Defining Inventory

Overview

What is inventory? Why is it so important? Here is a simple definition:

"A quantity of goods, finished or unfinished, held in storage."

But, inventory is so much more than that. How much inventory is held in storage affects almost every aspect of the supply chain. Bottom line: you want enough inventory in stock to satisfy your customers. In today’s competitive world, if you are out of stock, you are often out of luck—and losing customers. But, if you store too much inventory—to ensure that no stock-outs ever occur—that can backfire, too. Why? It ties up funds that could be used in other, more profitable ways.
This topic looks at these aspects of inventory:

• The importance of managing inventory
   
• Inventory management: a balancing act
   
• Inventory as revenue generator, cost, and asset
   
• Inventory's effect on profit

Why We Manage Inventory

Inventory is the second-biggest fulfillment expense next to transportation. That includes operating expenses like taxes, insurance, obsolescence, labor, storage space, and the cost of money. What if a company could cut inventories and still meet its objectives? That money could be invested in almost anything else—to develop new products, improve processes, modernize, add more salespeople, expand, acquire, or reduce debt.
Efficient inventory management succeeds on two levels:

• Reduces yearly operating expenses.
• Frees up working capital for use in other, higher-return opportunities.

The cost of inventory is only one side of this equation. The other side is the effect that inventory management has on customer service. You might need large inventories to fulfill customer demand. The added investment and the higher operating costs might be worth it:

• Increased customer satisfaction
• Expanded sales volumes due to higher fill rates on orders

Next, you get to help a company decide: to cut—or not to cut—inventory?

Check Your Understanding

Carl's Transmissions sells automobile transmissions and transmission parts to auto dealers and auto repair shops. They operate out of one location in the industrial area of a big city. Carl's inventories have grown over the past five years. Carl's wants customers to get what they want, when they want it. Management, on the other hand, is concerned that if the trend continues, it may start to erode profitability. The company's average inventory increased about 5 percent in each of the last five years. The number of items in inventory has remained constant in this same period, while the number of customers has grown.
What actions would you recommend that the management of Carl's Transmissions take to correct its inventory problem?

Inventory Management: A Balancing Act

Inventory can not be managed in isolation. The goal is an optimal supply chain, not an optimal inventory level.
Consider transportation. To reduce transportation costs, it can make sense to increase inventory levels. Larger loads could mean fewer loads. Enough fewer loads could reduce transportation costs by more than the added inventory costs. You have to find the balance.
Another cost-cutting approach is "forward buying." This is buying in volume to take advantage of big discounts. It works only if the savings on the discount offset the added costs to carry the inventory. The problem is the Fulfillment and Procurement functions need to talk to each other to make this price analysis possible, which rarely happens. In fact, Procurement personnel are often rewarded for purchasing product at the lowest landed cost. This is a danger if it becomes an incentive to buy large volumes without looking at the cost of carrying additional inventory.
The best approach to managing inventories is to take a total cost view when making decisions about inventory levels. If you can reduce inventory costs, do it. But first, look at how much you propose to save against all related supply chain costs and the effects on service to customers.

Inventory and Total Costs: An Example

Let's look at an example. Durand Manufacturing Co. buys sockets from a supplier in quantities of 10,000 units. They place four orders per year. They pay $5 or €4 per socket.
The socket supplier wants to reduce the number of orders they handle. So, they offer Durand a 10 percent discount per socket to double the order quantity to 20,000 units. That sounds like a good deal. Is it?

The table shows Durand's current annual costs to buy sockets 10,000 units at a time.
Click on each row of the table to review the annual costs.

The discount savings total 10 percent annually: $0.50 or €0.40 per socket times 40,000 sockets a year. By ordering in larger quantities, they can ship in larger quantities. That lowers transportation costs. And, fewer orders lowers order processing costs.

But, you are doubling your average inventory. Durand figures that carrying costs would double, too. Also, they would need more storage space, so warehouse costs would go up. Look at what this "savings" does to the total cost.

What did Durand decide to do about the 10 percent discount?
Taking the discount is not a good idea. That 10 percent "savings" would in fact increase total costs by about 9 percent. Costs do go down per socket, and for transportation and order processing. But the big jump in inventory and warehousing costs offsets any gains. Durand opts to continue ordering 10,000 sockets at a time.
As you can see, the cost of inventory has wide-ranging effects. All of those effects must be considered to see the real "total cost view."

Inventory Management Based on Product Type

Not all products are alike when it comes to managing their inventories. A factor to help you make balanced decisions is value per unit. In general, it makes sense to have larger inventories for items of low value: like cement blocks, or plastic pellets. And in general, with high-value items—like diamonds—you want lower inventories. The problem with generalities is, not every product follows this logic.
The figure shows a continuum with three dimensions: amount of inventory (blue); cost of inventory (orange); and the value per unit or per unit of weight (along the top). Click on each product to learn more about managing inventory based on value.

Three Facets of Inventory

To understand inventory, think of it as having three distinct yet related aspects.
Inventory as Revenue GeneratorInventory is a strategic tool because it can generate revenue. Inventory is often a company's most important asset. Retailing and wholesaling are good examples. Without adequate inventories of products, wholesalers and retailers could not survive. Having a large and varied inventory that provides a range of choice to the consumer is critical to the success of most retail and wholesale businesses. If products are frequently out of stock or the selection is poor, customers drift away. They may run away…to get what they want when they want it.
Inventory is also essential to manufacturers. They need to be able to meet the requirements of their customers for product variety and high fill rates on orders. If a product is always out of stock, customers will look for other suppliers who can fulfill their entire order and do it consistently. It may not be possible to ship product via express modes of transportation (due to the high cost), so the only other way to provide high levels of service is to ensure the product is available in inventory when the customer orders it.
Inventory as CostThe more inventory you have on hand, the better your chances of meeting all customer demand. But inventory is not free. It costs money for capital, insurance, taxes, labor, space, and protection. No one can afford to build huge inventories in an attempt to provide 100 percent perfect service. An exception is highly inelastic demand. In this case, 100 percent stock availability is required, or you lose that business. So, for items like medical supplies or some spare parts, big inventories are good business.
Businesses are always looking for ways to cut costs. Inventories are a favorite target. And rightly so: inventories can be used as a crutch to make up for poor planning. When inventory levels are not justified by customer demand, they simply add layer upon layer of cost to the supply chain. Since inventory is often the second largest expense in the fulfillment function, business looks for systems and approaches to cut those costs. Improved forecasting systems, faster transportation, and much faster communication systems allow companies to slash inventories and still meet customer needs.
Inventory as AssetInventories are just like any other capital-using asset—you need to earn a return on the investment. Companies make choices about where they invest their capital. To see whether inventory is a good choice, you can evaluate inventory productivity based on return on investment, or ROI. Use this formula, where Revenue minus Cost equals Profit:

Profit ÷ Asset investment = ROI (return on investment)

By looking at inventories based on ROI, we capture in one calculation all three facets of inventory: revenue, cost, and asset. It is difficult to accurately determine the revenue associated with a specific level of inventory. Even so, using the ROI metric persuades management to pay attention to inventory and to balance the facets so as to maximize the ROI.

Return on Investment – An Example

How does increasing inventories affect return on inventory? Let's look at an example.
A manager, deciding that service needs to improve, increases inventory levels. Costs will rise because inventory is larger. The investment will increase. So, revenue will have to increase enough to offset both the increase in cost and the larger investment. The table shows how inventory ROI is computed, before and after the increase.

As the numbers show, inventories had to grow significantly—in this case, 60 percent—to generate a 5 percent increase in revenues ($2 million or €1.6 million). Costs also rose because of the added carrying cost of the larger inventory. Overall, the ROI dropped. What does this suggest? Either the increased service level does not justify the larger investment in inventories. Or, the ROI is lower now in the short term, but the higher service levels might still lead to much higher sales in the future.

The Profit Impact of Inventory

Inventory management can have a big impact on profitability because it affects both revenues and costs. Too much inventory inflates costs. Too little inventory causes lost revenues and, possibly, lost customers.
On the other hand, "too much" inventory could actually be the level that makes it possible to reduce other costs in the supply chain. Or, to take advantage of big discounts. Both could increase profitability, even with inflated inventory costs.
Finding a balance is the challenge: a single change to inventory levels has obvious and subtle effects that ripple through the supply chain. Do not let this deter you. You can enhance profitability through shrewd, smart inventory planning.

Use Inventory to Attain Supply Chain Goals

Inventories are often thought of as wasteful—something to be eliminated. They are wasteful if they result from bad management practices, or are used to compensate for flaws in supply chain planning. When inventories are maintained for valid reasons, you can attain the following goals:

Provide High Levels of ServiceInventory can help you meet key customers' service needs. In fact, having inventory on hand may be more cost-effective than using an express delivery service.
One approach is to position inventories in key markets so that customers have a full range of products available to them within a 24-hour delivery period. Many industrial components and spare parts fall into this category—customers cannot afford to shut down because a part is not available. Retailers maintain inventory at levels that assure customers that what they want will be in stock when they want it.
Manage Supply/Demand Imbalances Some products are either consumed or produced seasonally. There are ways to avoid imbalances:

• Consumed seasonally: One answer is to produce all through the year and build inventory that can be sold off as the season approaches. A manufacturer of snowmobiles might produce year-round. It would be costly to leave the plant idle for several months. Plus, it would be difficult to have a stable and productive labor force if they worked only part of the year.
• Produced seasonally: For example, huge inventories of pickles are created when cucumbers are harvested in the summer. The entire year's supply is produced within just two months.

Counteract Unpredictable Demand and Inconsistent TransportationWhen demand is difficult to predict or is random by nature (like impulse items sold at checkout stands), you need higher levels of inventories. This way, demand can be satisfied as it materializes. The more unpredictable the demand, the greater the safety stock to protect against stock-outs. If the items are high margin, having extra inventory is justified by the profits that might be lost if the product was out of stock.
Plus, products are not always delivered on time. Weather, equipment problems, unloading inefficiencies, mistakes by drivers, traffic congestion—any of these could make a shipment late. Companies use safety stock as a buffer against late shipments so that sales or production can go on without stopping.
Create Transportation EconomiesIn many cases, the cost of transport far exceeds the cost of inventory. Cutting inventory may actually cause transport costs to rise. You might find that larger inventories are the best way to economize on transport.
This is the case with many bulky, low-value products where transport costs are a large portion of the product's value. It may be prudent to ship in large lots, and to have large inventories. The savings from shipping in large quantities more than offset the extra cost of inventory (which is not even that high for low-value products).
Take Advantage of Production EconomiesIt can take time to "change over" a production line—to stop it and set it up to run a different product. Certain types of paper are made in huge quantities because of the long and expensive changeover process. Many companies have gone to lean manufacturing, dramatically reducing changeover times. For many products, though, this will not work—large machinery, aircraft, and automobiles are good examples. The answer is balance: an increase in inventories to reduce changeover costs.
Take Advantage of DiscountsIt can be economical to buy in large quantities to take advantage of big discounts. The issue is balance: the savings from the discount against the cost of carrying a larger than normal inventory. Before large purchases are made based on a big discount, the Fulfillment and Purchasing teams should assess the net difference between the discount savings and the extra inventory carrying costs.

In this topic, we emphasized balance and the total cost view. In the next topic, we turn our attention to the real costs of inventory, and to how those costs should be computed.

Topic Summary

Key points to remember from this topic:
Click each bullet point to view more.

• Effective inventory management has two primary effects on the supply chain:
  1. Reduces yearly operating expenses.
  2. Frees up working capital for use in other, higher-return opportunities.
      
• Inventory levels and other costs must be carefully balanced.The goal is an optimal supply chain, not an optimal inventory level. It can make sense to have higher levels of inventory—to reduce transport costs, or to increase service levels. It can make sense to have lower levels—to reduce carrying costs, warehousing costs, and so on. Taking a total cost view helps set the right levels in each situation.
   
• Inventory is a revenue generator, a cost, and an asset. Inventory affects profitability. The right level of inventory can help to reduce total supply chain costs, and increase overall profitability. Too much inventory inflates costs. Too little inventory results in lost revenues and, maybe, lost customers. Trying to improve customer service—no stock-outs, so more inventory and higher costs—might spark new sales and increase profits.

Management Considerations

Overview

The process of managing inventory is complex: achieving a balance between the cost of inventory and the cost of customer service is not easy. This topic examines how companies develop overall management strategies for controlling inventory. It focuses on what companies look at to plan their strategies:

• Costs to carry inventory – capital costs, inventory service costs, storage space costs, and inventory risk costs
   
• Methods of calculating total annual inventory costs
   
• Drivers of inventory size and costs:
   
  • Size of product line
     
  • Number of stocking locations
     
  • Transportation costs
     
  • Customer service philosophy
     
  • Where in the supply chain inventory is held
     
  • Use of forward buying to get discounts

The Cost of Inventory

Inventory costs are difficult to compute. They are not easy-to-find line items on a ledger. Plus, the largest single expense is the cost of capital, and people still debate how that cost should be calculated.
Inventory costs are often called carrying costs. (The total amount of inventory in the supply chain is the amount "carried.") The carrying costs are totaled and divided by the value of an item in the inventory to produce a percentage that is referred to as the "carrying charge." Think of it as the cost to maintain $1 or €1's worth of inventory: if the carrying charge is 42 percent, it costs 42 cents to maintain $1 or €1's worth of inventory for one year.

Capital CostsCapital costs—the cost to have money tied up in inventory. Capital costs are computed in different ways:

• The rate to borrow money times the cost of inventory
• The internal rate of return times the cost of inventory (if capital projects typically earn a 25 percent return, that is the internal rate of return)
• An average of the rate to borrow money, the internal rate of return, and opportunity cost times the cost of inventory

The cost of capital can be 80 percent or more of the total carrying cost. That is why there should be lively internal debate on this topic—the capital cost of inventory has a huge impact on inventory management. For example, if you use the highest of the rates to compute the cost of capital, the result will be lower inventories—because it costs more to maintain them. If the cost of capital is low, larger inventories can be held.
Inventory Service CostsInventory service costs include any taxes assessed on the inventory and the insurance associated with inventory liabilities. Many governments have eliminated inventory taxes, so this cost element is not always critical. Usually, inventory service costs are less than 2 percent of the value of the items in the inventory.
Storage Space CostsInventories must be kept somewhere--usually in a plant, warehouse, or the back room of a retail store. Generally, the larger the inventory, the more space will be required. For some products like coal, gravel, and bricks, the space cost is minimal. The product can be stored outdoors and requires little in the way of protection. Frozen food and expensive jewelry, on the other hand, require expensive space due to the value or nature of the product, so space may be costly. Some prefer to treat space costs as a separate line item and track it apart from their inventory carrying costs. This is fine from an accounting standpoint, but when making inventory decisions, it it important to recognize the space costs associated with storing inventories.
Inventory Risk CostsInventory risk costs are expenses incurred because of loss, or to protect from loss. The exception is transshipment costs, which are incurred to transfer an item laterally (e.g., factory to factory, not distribution center to factory).
Calculating inventory risk costs may involve a judgment. For example, at what point does a product become obsolete? And what is the cost?

Inventory Carrying Costs – An Example

The table shows how six different companies calculate their inventory carrying costs (Lambert 1976). Note the wide range: One company pays almost 43 cents to maintain $1 or €1's worth of inventory for a year, while another pays only 14 cents. Click on "A" and "D" for more on why this might be true.
For all six companies, note how the capital cost dominates the total carrying costs. Company A's capital costs are 93 percent of their total carrying charge.

Company A's carrying costs are so high because of their high capital cost. They may earn a high rate of return on investment, or it may cost them a lot to borrow money. They would tend to maintain lower inventories because of the high cost to carry the inventory.
Company D estimates its capital costs to be only 8 percent. They may assume that 8 percent is all they would have to pay to borrow money. Or, they may earn an extremely low rate of return on investment. They could maintain higher inventories because it costs less to carry.

Calculating Total Annual Inventory Costs

The annual inventory cost equation has three variables:

The carrying chargeThe carrying charge represents the annual cost, as a percent of an item's value, to carry an item in inventory for one year. If the carrying charge is 18 percent, it costs 18 cents to carry $1 or €1's worth of inventory for one year.
The number of units in the average inventoryThere are many ways to determine average annual inventory. It is so crucial to get this right: this calculation determines the accuracy of the inventory carrying cost.

• One way is to review computer records daily to find how many units are in a warehouse each day. The average annual inventory simply becomes the average of all the daily calculations.
• Another way is to take inventory at the start of a period (such as a week, month, or quarter) and again at the end of the period, adding them together and dividing by two to calculate the average annual inventory.

Generally, the more often you measure, the more accurate the average annual inventory will be.
The value of an item in the inventoryWe also need to know how much each item in the inventory is worth. That determines how much capital is tied up in the inventory.

• If a product resides in a warehouse just after production, then its value is the cost of the material, labor, and machinery to produce it.
• If that same product is kept in the back room of a retail store, its value is quite different. Its value also includes the margin charged by the manufacturer plus the transportation cost to move the product to the retail store.

So, inventories that are maintained at the retail level are going to cost more than do those maintained earlier in the supply chain.

With all three numbers, the annual inventory cost can be calculated:

Carrying charge times Average annual inventory times Value of an item = Annual inventory cost

Let's compute annual inventory costs when the carrying charge is 25 percent, the average annual inventory is 10,000 items, and the item is valued at $80 or €65:

0.25 x 10,000 x $80 = $200,000

0.25 x 10,000 x €65 = €162,500

Check Your Understanding

Simon Grant manages inventories for Gorgon Industries, manufacturers of hot air balloons. GI buys valves for the balloons from several manufacturers. They use the following discount schedule:
Up to 500 units at a time $50 or €40 per unit
501 to 1,000 units $48 or €38 per unit
Over 1,000 units $46 or €36 per unit
GI can borrow money on its line of credit for 12 percent. Their internal rate of return on invested capital is 20 percent. There are no inventory taxes in this location, and they estimate that inventory shrinkage is about 2 percent of the inventory. GI uses 400 units of valves per week to make the balloons they need. They usually order a two-week supply of valves when they buy from their suppliers. There are no warehousing costs because the valves can be stored outside in the company's back lot.
Determine GI's total annual inventory carrying costs. Remember the equation:

Carrying charge x Average annual inventory x Value of an item = Annual inventory cost

What Drives Inventory Costs

Decisions made throughout the supply chain affect the cost of inventory. To truly manage inventory, all involved functions have to be coordinated—including Fulfillment, Manufacturing, Marketing, and Procurement. No function can act in isolation. They all must connect with each other and look at the total cost view.
The size of the inventory drives inventory cost. Sound simple? Understanding that concept is the key to controlling inventory costs. As a company buys (or produces or ships) in larger quantities, the average inventory tends to grow. As inventory grows, carrying costs increase in almost direct proportion. So, management needs to be aware of what is most likely to drive up inventory levels—because that is what drives up costs. Let's look at some of the forces that drive cost.

Driver: Size of the Product Line

Adding product lines is how you keep customers interested. Each time you add a product line, you need a separate inventory of the new item, along with safety stock. The net impact is to increase the size of the average inventory.
Over a decade ago, the grocery industry launched a process called Efficient Consumer Response, or ECR. Their goal was to reduce the number of stock-keeping units (SKUs) without affecting customer selection. Successful supermarkets reduced inventory by up to 10 percent at the store level. They focused on things like inventory turns and customer preferences based on purchase data. They got higher sales with fewer SKUs and the same number of product lines.

Driver: Number of Inventory Stocking Locations

Generally, the more places that inventories are maintained, the larger the average inventory. This conclusion is based on the "square root law." The square root law says that the amount of safety stock grows (or shrinks) in proportion to the square root of the number of locations at which the inventory is kept. This is the formula:

Total safety stock at N locations = Safety stock at 1 location x the Square root of N

So, let's assume we have one warehouse and a total of 1,000 units of safety stock. Then, we add three new warehouses to improve customer service. How much safety stock do we need?

Total safety stock at 4 locations = 1,000 units x √4 = 2,000 units

In this example, the total amount of safety stock doubled. As the formula implies, as new locations are added, total inventories will increase, but at a decreasing rate.
If your goal is to control inventories, assess whether it makes sense to decrease the number of places where inventories are held. Although reducing that number may reduce inventories, it may have an adverse effect on customer service. And it might increase transportation costs. (Product travels longer to reach customers as the warehouse base shrinks.))

Driver: Transportation Costs

Lower-value items—sand, plastic components, sugar, and the like—usually have big inventories. It is more cost-effective to ship large quantities. These items usually ship in truckload or railcar-load quantities. They do not have enough value or time-sensitivity to merit expensive modes of transportation, such as air freight. Plus, customers would not be willing to absorb the higher transportation costs. The result is that inventories are big because of the big quantities shipped.
However, since the products are relatively low in value, the tradeoff of lower transportation cost for higher inventory cost is usually a good "total cost view" strategy for reducing total supply chain costs.

Driver: Customer Service Philosophy

A company's approach to customer service drives inventory levels. Companies can have extremely different views on how important it is to always be in stock, and to consistently achieve perfect order status for their customers. As most companies realize, a high level of service comes at a price. It’s up to each company to decide what price they will pay.
Some products require either fast delivery or 100 percent in-stock availability. These products have larger inventories and higher carrying costs to meet their customers' requirements for service. Examples include lifesaving medicine, a repair part that will prevent a production line from shutting down, or a key computer component.
A company's market situation—small market share in a competitive market, or special customers requiring just-in-time delivery—can also drive up the cost of inventory. Fast delivery service and lots of safety stock cost money.

Driver: Where Inventory Is Held

The value of an item in inventory plays a big part in determining inventory carrying cost. That is why it can cost less to hold inventory where it has the lowest value. The more cost-efficiently items are stored, the smaller your capital outlay.

The most cost-efficient approach would be if manufacturers held the bulk of inventory for the entire supply chain. An item's value is lower here than it would be at the retail level. Carrying costs are lower (capital costs, storage, risk, and so on). Transportation costs are lower, too (no intermediate shipping or handling before you ship to the customer).
The cost at this stage is higher than it would be at the manufacturing stage, but lower than it would be at the retail stage. Here, though, you are closer to the customer. Higher levels of customer service balance out any added cost.
The value of the product at the retail level is what the retailer pays for it plus any associated handling and transportation expenses. Thus, a given quantity of product held at the retail level requires a larger capital outlay and generates higher carrying costs.

Driver: Forward Buying & Discounts

Big discounts and forward buying can make it economically feasible to expand inventories. True, much of the focus on supply chain in the last 15 years has been on reducing inventory through rapid, frequent replenishment. However, it can be wise to expand inventories if the savings in the landed price of the product more than offset the extra cost associated with carrying a larger inventory.
Any discount must be evaluated not solely on cost, but also on the total cost view. So, a 25 percent savings may justify the larger inventory that results if the additional inventory costs are less than 25 percent.

Topic Summary

Companies focus on these points when managing inventories:

• It costs money to store, or carry, a product in inventory for a set period. This "carrying cost" has four elements: capital costs, inventory service costs, storage space costs, and inventory risk costs.
   
• It is important to know the annual costs of inventory:

Carrying charge times Average annual inventory times Value of an item

• Inventory size is directly related to its cost: the bigger the inventory, the higher the cost. Understanding how and why inventories get bigger helps to control costs.
   
  • Size of product line
     
  • Number of stocking locations
     
  • Transportation costs
     
  • Customer service philosophy
     
  • Where in the supply chain inventory is held
     
  • Use of forward buying to get discounts

Key Activities

Overview

Once you know your company's inventory strategy—its approach to customer service, its stance on forward buying, and so on—you are better equipped to handle the daily process of managing inventory.
Based on the strategy, estimates are made: of how much inventory is needed, and how much product will be sold during given time periods. The effectiveness of the estimates is measured, too. This topic focuses on these and other key activities involved in inventory management:

• Forecasting
   
• ABC inventory management
   
• Cycle counting processes
   
• Measuring inventory performance:
  • Inventory turnover/days of supply
  • Inventory carrying costs
  • Stock-Outs

Forecasting

Forecasts help you manage inventory. Good forecasts help control inventory costs. Each time the accuracy of a forecast is improved, inventory levels can be reduced. Why? Because there is greater certainty about how much will be sold. If you knew exactly what was going to be sold today, this week, or this month, inventories could be drastically slashed. Sadly, this perfect state almost never exists. Let's look at two situations: one is perfect, and one is not.
Click on the Continue button to begin.

ABC Inventory Management

One of the most important aspects of inventory management is "selectivity." That means products are not equal when it comes to managing their inventories. Products that are crucial to customers, items that have high profit margins, or items in competitive markets—their inventories should be managed differently than products that are not as crucial or profitable.
Many use the ABC approach to inventory management to reflect this fact. With the ABC approach, you classify products into three categories. The criteria for classification vary, and inventory is managed differently for each class:

• A items
  • The top 10 percent of the product line based on importance or profitability.
  • Kept in all locations with higher levels of safety stock.
     
• B items
  • The next 15-20 percent or so of items, based on profits.
  • Kept at all regional warehouses, but with lower levels of safety stock.
     
• C items
  • Those that sell infrequently or are low margin.
  • Kept at one central location, as safety stock.

This approach recognizes that higher inventories may be needed for high profit/crucial items, while less important items do not need high levels of inventory. This way, inventory is managed based on the profitability of the items or on their importance to the customer.

Cycle Counting

One of the costs associated with maintaining inventories is the cost of assuring that inventory records are accurate—matching actual levels of inventory to the levels recorded on the books. To make sure that inventories are accurate, some take physical inventories on a periodic basis—quarterly, semiannually, or even annually. This process is long, tedious, and expensive. Operations may shut down for a few days, or employees do the physical count on a weekend (which does not excite them).
There is another approach called cycle counting. Rather than physically count the entire inventory periodically, high-value items are counted frequently. Slow moving or lower-value items are counted, but less frequently.
So, rather than counting every item in the warehouse every time you count, you count a number of "A" items, "B" items, and so on, during a cycle. The "A" items would be counted again in the next cycle. The "B" items might skip a cycle or two. The "C" items might be counted again only once or twice a the year. During each cycle, inventory levels would be compared to the book records.
Over the course of a year, every item is counted. The task is easier because you count only a few items per cycle. The results are better because you focus the effort on your most profitable items.

Measuring Inventory Performance

Inventory performance is difficult to isolate from the performance of the rest of the supply chain. If inventories are managed properly, then total costs will hit the targets set by management; and customers will be satisfied with the service they get. It is not useful to focus too much attention on inventory separate from all other activities in the supply chain. When this happens, inventories become the focus of cost-cutting, causing out-of-balance outcomes—higher transportation costs, many more stock-outs, and so on.
We are now going to explore several measures of inventory performance. These metrics are useful only if they cause no compromise elsewhere in the supply chain. Remember: always look for balance—total cost view and level of customer service.

Metrics: Turnover & Days of Supply

The most frequently used measure of inventory management is how often the average inventory is "turned over" or sold. Turnover keeps inventory fresh and visible, and decreases risks like obsolescence. The table shows how turnover is computed: annual sales divided by average inventory equals turnover.

Inventory turnover varies by industry or type of product. In the grocery industry, net margins are small (1–2 percent). Profits depend on being able to turn inventory rapidly. For some grocery products, turnover is measured in days. At the other end of the spectrum, furniture might turn over just once or twice year. Net margins approach 100 percent, so furniture does not have to turn as often for a company to be profitable.
Turnover should also be measured against a benchmark. If an industry standard does not exist, set your own.
What do we mean by "days of supply"?Some use "days of supply" to measure inventory performance. A 30-day supply of inventory means that inventory is sold about 12 times per year (365 ÷ 30). With a 10-day supply of inventory, inventory is sold 36.5 times per year (365 ÷ 10).

Metrics: Carrying Costs

Inventory carrying costs are often thought of in relation to turnover: turn inventory faster, lower its carrying costs. But carrying cost is a useful metric on its own. It can be a better measure than turnover where normal turnover is low, or the normal carrying cost is high.
For example, in the jewelry industry, carrying costs can be as high as 40 percent. A jeweler might turn product only 12 times a year. But it is not likely that the jeweler would try to increase turnover to lower those high carrying costs. Instead, a jeweler would keep a close eye on carrying costs. If they went up, the jeweler might have a problem:

• Higher than normal losses?
• Unexpected cost increase…in insurance, or storage?
• Higher cost of money?

It is also a good idea to benchmark your carrying costs. If your carrying charge is a nice low 5 percent, but you are not aware that the industry standard is 4 percent, you are at a competitive disadvantage. Industry groups and government agencies publish data to help you set the right mark.

Turnover & Carrying Costs – An Example

Increasing turnover is not always the most cost-effective way to lower carrying costs. For example, improving turnover from 2 times to 3 times a year is a giant improvement. Inventory levels fell; sales soared; or both.
Now, how would improving turnover by 1 affect an annual turnover of 42? Going from 42 to 43 has little effect. Neither the size of the average inventory nor the carrying cost changes much. This concept is illustrated in the figure, which shows the relationship between turns and carrying cost (Lambert and Quinn 1981).
Note the dramatic plunge in carrying costs when turns improve from once a year to twice a year. (This greatly reduces the size of the average inventory, frees up capital, and so on.) However, when turns are 8 and improve to 9, the reduction in carrying cost is slight. Think of it this way: When turnover improves from once to twice a year, it is, figuratively, 100 percent better. From 8 to 9, it is only 13 percent better.

Metrics: Stock-Outs

The other side of managing inventory costs effectively is the customer, and being able to satisfy customer demand. With inventories, it can be an art—finding that balance between too much or not enough. Thus, a measure of inventory management effectiveness is to evaluate how often you are able to fill a customer's order completely.
The most common terms for this metric are fill rate and stock-out percentage. Each measures basically the same thing: how often was the company able to provide what the customer wanted when they wanted it?

• Fill rate: the percent of orders that are filled completely when the customer wanted them.
• Stock-out percentage is just the reverse: percent of orders or products that were not available when desired.

What is acceptable varies by product and industry. Nonessential items whose consumption can be postponed have lower fill rates (or more stock-outs). For example, a good fill rate on spare computer parts can be as high as 99.5 percent. A good fill rate on dry grocery products could be as low as 85 percent. You can often find benchmarks through industry groups or associations.

Topic Summary

Remember these points about the key activities of inventory management:

• Good forecasting is crucial to effective inventory management. Whenever the accuracy of a forecast improves, inventory levels can be reduced.
• ABC analysis is a good way to manage inventory. You classify products based on their importance—are they crucial to customers, high margin, or in competitive markets?
• Cycle counting is a less tedious, less costly way to physically count inventory.
• Overall inventory effectiveness is best measured by balancing supply chain costs and the costs of customer service. Specific metrics include:
  • Inventory turnover/days of supply – the higher the turnover, the better.
  • Inventory carrying costs – lower carrying costs reduce the cost of inventory; sudden increases can be a sign of problems.
  • Stock-out percentage and fill rates – measures of how often customer orders are filled completely.

Importance of Information

Overview

You need lots of good information—fast—to stay ahead of demand. You want inventory in the right places. Not too much, and not too little. An investment that pays off in increased sales and happy customers. Information makes all this feasible.
Technology makes information useful and usable. Thanks to technology, information can be accurate and timely. Techniques include point-of-sale scanning, RFID (Radio Frequency Identification), and wireless networks. And, thanks to technology, complex processes are possible. These include Collaborative Planning, Forecasting, and Replenishment (CPFR) and Vendor Managed Inventory (VMI).

Old Model vs. New ModelIn the old model, items were made in huge quantities, and shipped to the retailers so they had a complete line of product and a deep inventory position within each product line…
The model today is completely changed: the customer walks into a retail store—or logs on to a computer—and buys something that has not yet been made. The order is sent electronically to the nearest factory and is made the next day. It is shipped the day after that. Sometimes the whole process takes hours. Neither the retailer nor the manufacturer is stuck with inventory that might not sell. The customer gets exactly what he/she wants in just a few days.
What makes the new model work?

• Accuracy – a real-time transfer of information does not work without pinpoint accuracy.
• Visibility – the partnership between the manufacturer and the retailer works if they both know how much inventory is available and where.
• Speed – the manufacturer can produce quickly and economically in small quantities.

Let's look at the importance of accuracy, visibility, and speed to inventory management today.

Accuracy

Information that is consistently accurate helps to reduce inventory levels.
Sales Forecasts Greater forecast accuracy—"knowing" which products will be selling over a given period—means supply chains can operate with much less inventory. That means lower inventory levels in the retail store, in the warehouse, or coming off the production line. Costs go down, freeing up working capital. Fill rates improve. Customer service improves.
Order Cycle Time Estimates Accurate estimates of how long it will take to receive product can help reduce inventory costs. If you are sure it will take five days to receive an order once it has been placed—whether that is just shipping time, or the time to produce and ship— then you know exactly when to place the order. If the order cycle time is five days, and you expect to sell 100 units per day, then you can place the order when there are 500 units on hand.
Accuracy in ActionModels for managing inventories keep getting better. And as they do, more industries and companies will use them to rein in their inventory levels.
Hau Lee, a professor at Stanford University's Graduate School of Business and a thought leader in supply chain management, developed a forecasting model using over 150 variables to estimate demand. This model has cut millions of dollars from inventories.

Visibility

For the supply chain to operate at peak efficiency, everyone must be able to "see" inventory, wherever it is. Once everyone—from suppliers to manufacturers, to wholesalers, to retailers—has this visibility, each can make better decisions. They know what to order and what inventory to keep on hand, and can adjust their plans accordingly.
Visibility demands collaboration. More and more, supply chains demand collaboration—they are becoming too complex for any one party to control. Here are some of the processes and techniques that enable collaboration (click on each):

Collaborative Planning, Forecasting, and Replenishment (CPFR)A process aimed at improving inventory forecasting. It involves sharing information on expected demand and planned promotions between manufacturers and retailers. All parties provide information on their plans and share their knowledge of demand. All involved benefit through a reduction of inventories system-wide.
Vendor Managed Inventory (VMI)An inventory planning and fulfillment technique in which a supplier is responsible for monitoring and restocking customer inventory at the right time to maintain predefined levels. The supplier is given access to current inventory, forecast, and sales information and initiates replenishment as required.
Warehouse Management Systems (WMS)Coordinates and directs almost all aspects of facility operations, including receiving, product putaway, location of storage areas, order picking, bill of lading preparation, electronic data interchange with trading partners, and inventory tracking. Data is accessible through a website. Customers, suppliers, retailers, and manufacturers can log in and instantly see how much inventory there is in the supply chain, and where it is.

Visibility in Action A U.S. hardware cooperative uses supplier integration and collaboration, with impressive results:

• Improved customer service by 10 percent.
• Reduced inventory by 20 percent.
• Shortened delivery time from the warehouse from five days to 24 hours.
• Reduced logistics costs by 25 percent.

A computer manufacturer is a leader in configure-to-order. They do not own logistics, either inbound or outbound. They insist that their suppliers use VMI, so they do not own the inventory. So far, the result has been increased working capital turns, up to about 90. And customers love being able to build their own PCs.
The next success stories will be about retailers and wholesalers sharing real-time point-of-sale information with their suppliers.

Speed

Without the ability to make and move product quickly, you are doomed—to being saddled with big inventories. Speed makes the whole supply chain better:

• Wireless networks – transmit transactions instantly from anywhere in the store; transmit from hand-held devices.
• Internet-based capabilities speed information to and from the customer.
• Re-planning production quickly (in one case, every two hours) enables configure-to-order.
• Faster transport: today, products often ship within hours of order receipt.
• Strategic use of warehouses to complete final assembly closer to the customer shortens delivery times.
• Collaboration streamlines time-to-market.

Speed in Action A retailer of fashion merchandise in Europe compressed their design-to-replenishment cycle to two weeks. This is three to five times better than any of their competitors. Store managers send information directly to designers, merchandisers, and supply chain planners on what is moving…on customers' reactions…and on what's hot. They can get rapid replenishment of those items within season. (Competitors cannot.) They are also able to discount earlier. For retailers, this is a key to profitability.
A manufacturer uses technology to work virtually with their suppliers. They collaborate on design, testing, production, and manufacturing. This shortened the design cycle and improved the design of products—a big cost advantage.

Topic Summary

Here are the key points to remember from this topic:

• Accurate information reduces inventory levels. For example, each time the accuracy of the sales forecast is improved, inventory levels can be reduced. Why? Because there is greater certainty about how much will be sold.
• Visibility enables everyone in the supply chain to see inventory levels: how much there is, where it is, and what is planned. This reduces panic buying.
• Speed has two dimensions:
  • Instantly accessible information helps you act quickly.
  • Technology enables faster processes, like configure-to-order or collaborative design.

Conclusion

Course Summary

Success today requires highly effective inventory management. You need common processes, and people working together— and technology to enable both. Most of all, you need a strategy to guide decision making. That strategy has to come from the top.
A strategy can bring all the right parties together, and direct them toward a common goal.

For example, a common goal might be "to expand market share." Marketing suggests a new product line. Manufacturing works with a supplier on design issues. Purchasing works with Fulfillment to balance inventory levels against the costs of inventory. Warehousing plots out storage locations that balance cost and service. Manufacturing and retailers share plans about promotions. Fulfillment arranges for a supplier to handle replenishment.

This strategy will drive up inventories—and revenues. So, inventory is not just a cost, or an asset, but a revenue generator. What else can smart inventory management help you do?

• Reduce yearly operating expenses
• Free up working capital—to be invested in the next, best opportunity

The most basic concept of inventory management is simply this: inventory decisions made in isolation are bad decisions. Collaborate, connect, communicate.

Course Digest: Concepts & Techniques

Inventory Cost Drivers

• Size of product line
• Number of inventory stocking locations
• Transportation costs
• Customer service philosophy
• Where in the supply chain inventory is held
• Forward buying to get discounts

car•ry•ing chargethe cost to maintain $1 or €1's worth of inventory for one year
in•ven•to•rya quantity of goods, finished or unfinished, held in storage
Inventory Performance Metrics

• Turnover/Days of Supply
• Carrying Charge
• Stock-Outs

Course Digest: More Concepts & Techniques

Equations

Average inventory = (Beginning inventory + Ending inventory) ÷ 2

Carrying costs = Capital costs + Inventory service costs + Storage space costs + Inventory risk costs

Carrying charge (%) = Carrying costs ÷ Value of an item

Annual inventory cost = Carrying charge x Average annual inventory x Value of an item

ROI (return on investment) = Profit ÷ Asset investment

Square root law:

Total safety stock at N locations = Safety stock at 1 location x √N Turnover = Annual sales ÷ Average inventory

ABC Inventory Management

A items	B items	C items
Top 10% of items Stored in all locations High levels of safety stock	Next 15–20% or so of items Stored in regional locations Lower levels of safety stock	Slow moving or low margin Stored at a central location Low levels of safety stock

Resources

Professional organizations – tools, research, opportunities for networking (click each organization name for details):

APICS – The Association for Operations Management
http://www.apics.org/
Customer Support: 800-444-2742
E-mail service@apicshq.org
Council of Supply Chain Management Professionals
www.cscmp.org/
Main Number: 630-574-0985 (not toll-free)
E-mail cscmpadmin@cscmp.org
ISM – Institute for Supply Management
www.ism.ws/
Customer Service: 800-888-6276
E-mail customer service
WERC – Warehousing Education & Research Council
http://www.werc.org/
Membership: 888-333-1759
E-mail wercoffice@werc.org

Publications – some of the trade journals that cover inventory management (click each title for details):

"Supply Chain Management Review"
http://www.scmr.com/
Customer Support: 888-343-5567 Intl: 515-247-2984
"APICS Magazine"
http://www.apics.org/Magazine
Customer Support: 800-444-2742
E-mail service@apicshq.org
"Modern Materials Handling"
http://www.mmh.com/
Customer Service: 800-446-6551
E-mail subsmail@reedbusiness.com
"Traffic World"
http://www.trafficworld.com/
Customer Service: 888-215-6084
E-mail customer service

References

Lambert, Douglas M. 1976. The development of inventory costing methodology: A study of the costs associated with holding inventory. Chicago: National Council of Physical Distribution Management.
Lambert, Douglas M. and Robert Quinn. 1981. Business Quarterly. 46 (3): 65.