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By Dr. Hermann Gruenwald
Companiesused to measure their muscle by the size of their inventory. Bigger wasbetter. Vast warehouses filled to capacity ensured efficient assemblylines and guaranteed that, come hell or high water, production wouldnever stop. Who cared about carrying costs? They would be erased byincreased sales. But now that equation has changed.
Loweringinventories is one of the quickest ways to decrease working capitalneeds. Performance measurements, such as the old standby ROA (return onassets) and the newer EVA (economic value added), as well as othermeasures that gauge how efficiently capital is used, have become morecommon organizational drivers. In fact, many times an executive's bonusdepends, at least in part, on how efficiently capital is used. Couplethe drive for efficient capital use with the need to respond morequickly to changes in customer demand, with shorter and shorterorder-to-delivery cycle times, and you have a problem that ischallenging many organizations.
Leaner and MeanerInthe big picture, American business has succeeded in its quest to runlean. But almost all these gains in inventory reduction happened from1981 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 to2000. Rather than being eliminated, inventory has been pushed down intothe lower reaches of the supply chain, from manufacturers to top-tiersuppliers to lower-tier suppliers. GM, for example, improved inventoryturns, a common metric that measures total cost of goods sold dividedby average inventory, and serves as a valuable indication of how oftena company sells out its inventory (the higher the better) - 55.2percent between 1996 and 2001. However, the company that supplies itstires, Goodyear, saw its inventory turns decline21 percent during that same time. In other words, lower-tier suppliersare left holding the bag for the big boys like GM and Wal-Mart.
Inventory Management TheoryInventory and the management thereof belong to everyone in the company but nobody wants to own it.
InventoryManagement is truly interdisciplinary and spans from financial andmanagerial accounting, to operations research, material handling tologistics. The following is a quick overview of InventoryControl/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
The smoother your supply chainoperates and the better you are able to forecast the less inventory youhave 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
Thereare three categories of inventory; too much in either may be a badthing unless you have reasons for it such as seasonality, productionruns, and prevention of stockouts or improvement of customersatisfaction 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 stockis necessary. 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 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
Ina perfect world as described in business school text books and casestudies one manages in a world of certainty. And the best orderingpolicy can be determined by minimizing the total of inventory carryingcosts 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.
Mostof 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 to calculatefill rates, safety stock, and standard deviation of replenishmentcycles.
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