By Dr. Hermann Gruenwald

Companies used to measure their muscle by the size of their inventory. Bigger was better. Vast warehouses filled to capacity ensured efficient assembly lines and guaranteed that, come hell or high water, production would never stop. Who cared about carrying costs? They would be erased by increased sales. But now that equation has changed.

Lowering inventories is one of the quickest ways to decrease working capital needs. Performance measurements, such as the old standby ROA (return on assets) and the newer EVA (economic value added), as well as other measures that gauge how efficiently capital is used, have become more common organizational drivers. In fact, many times an executive's bonus depends, at least in part, on how efficiently capital is used. Couple the drive for efficient capital use with the need to respond more quickly to changes in customer demand, with shorter and shorter order-to-delivery cycle times, and you have a problem that is challenging many organizations.

Leaner and Meaner

In the big picture, American business has succeeded in its quest to run lean. But almost all these gains in inventory reduction happened from 1981 to 1991, and the past 10 years have not seen much improvement. Inventory as a percent of GDP held steady at 3.8 percent from 1992 to 2000. Rather than being eliminated, inventory has 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 that measures total cost of goods sold divided by average inventory, and serves as a valuable indication of how often a company sells out its inventory (the higher the better) - 55.2 percent between 1996 and 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 for the big boys like GM and Wal-Mart.

Inventory Management Theory

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

Reasons for Holding Inventory:

• Inventory balances supply and demand

• Inventory acts as a buffer between critical Supply Chain interfaces
  • 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 as a buffer between supply and demand fluctuations and irons out supply chain system failures.  The smoother your supply chain operates and the better you are able to forecast the less inventory you have to hold, unless you gain some economies of scale in purchasing, transportation and or manufacturing.  

Categories of Inventory

• Raw Material Inventory

• Work-in-progress Inventory

• Finished Goods Inventory

There are three categories of inventory; too much in either may be a bad thing unless you have reasons for it such as seasonality, production runs, and prevention of stockouts or improvement of customer 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 is necessary. In transit inventory is usually accounted for on the place of shipment as it is not available at the destination. In-transit stock can be reduced through faster modes of transportation. Safety or buffer stock is a result of uncertainty of demand and lead time. Speculative stock is inventory held for reasons other than satisfying current demand, often acquired to reach economies of scale or to generate seasonal stock. Dead stock includes items for which no demand has been registered and may become obsolete. 

Inventory Management Conditions

• Certainty

• Uncertainty

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

EOQ =        2PD

               √ CV

P = ordering cost   ($/order)

D = annual demand  (number of units)

C = annual inventory carrying cost  (% of product cost)

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

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

Most of us don’t work in a place called perfect, and are facing uncertainties. Life ends up throwing monkey wrenches into the production of widgets. For those of you who love math look at the operations management literature and you will find ways to calculate fill rates, safety stock, and standard deviation of replenishment 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 increase and at the same time you are faced with increasing cancelled orders. Reverse logistics may be tasking as well as your number of returns increase, and you end up loosing customers, while accumulating obsolete items which among other things may lead to lack of storage space. You may face these inventory symptoms, but the 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 with vendors/suppliers

The above mentioned ways to reduce inventory levels should be part of a system approach to improving Inventory Management

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 their relative importance/profitability (Category A items are more important than category B items, and so on). A distribution by value report usually forms the basis of an ABC analysis. Better sales forecasting and advanced order processing systems as part of a larger marketing plan will reduce inventory. And Enterprise Resource Planning (ERP) system such as SAP will eliminate stove pipes and information silos and contribute to information sharing along with a company knowledge management (KM) system. Top management may see Vendor-Managed Inventory (VMI) as a way to out-source the inventory problem. But one has to be careful as it requires a high degree of transparency and integration between the partners. Such a marriage may bring a lot of benefits during the honeymoon period but also may have a costly divorce lurking in the background.

Inventory is a poor investment alternative for cash, but imperative to achieve required service levels. Maintaining the appropriate levels and types of inventory is essential to providing quality, timely service and products to your customers. Preventing stock-outs without overstocking products requires a disciplined process and information system that can dynamically manage this balance. Two of the keys to optimizing inventories are to improve reliability and reduce variability in the supply chain to meet your customer's demand while being cost effective. To order just in time and just enough.

References

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

Prentice Hall, Upper Saddle River, NY

Narasimhan, S., Mcleavy, D. and Billington, P. (1995). Production Planning and    Inventory Control 2^nd ed. Prentice Hall, Upper Saddle River, NY

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

Stock, J. and Lambert, D. (2001). Strategic Logistics Management 4^th ed. McGraw-Hill, NewYork, NY.

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