Introduction of Inventory Management:
Inventory management is an important aspect of any successful business. It is
the process of overseeing and controlling the flow of inventory units a business
uses in the production or manufacture of goods for sale or distribution.
Inventories are usually made up of a combination of goods, raw materials and
finished products, and effective management of these items is essential to
ensure optimal stock levels and to maximize the earning potential of the
company. It also allows a business to prevent or mitigate any inventoryassociated losses. Inventory management software is used by businesses for
various reasons: it can track the costs of inventory throughout the manufacture
and sales process, tell businesses when to replenish stock, and allow them to
track profits. It can also be used to forecast inventory levels and prices, as well
as expected product demand.
Effective inventory management is important as not only is inventory one of the
most valuable assets to a business; there is a direct link between inventory
levels and company profits. Inventory represents an investment that is tied up
until either the item is sold, or it is used in the production of another item that is
sold. Businesses are reliant on having items in stock; otherwise customers will
simply go to a competitor who can provide what they want.
However, holding inventory in stock is not without costs storage, insurance
and maintenance all must be considered. When it comes to replenishing stock
levels, most management plans seek to strike a balance between having
enough units when required, and ensuring supplies are not overstocked. This is
why having an inventory management system can be advantageous.
An inventory management system monitors all aspects of a companys
inventory as items move through the production and sales process. The process
involves tracking customer orders, shipping, costs, stock and sales. Whether or
not a business has some form of inventory software in place, there are some
critical elements every system needs in order to function efficiently.
This
includes well-organized location names, easy to read and unambiguous location
labels, unique item numbers, units of measure, a good starting count, good
policies and most importantly people who know and can follow those
policies.
What is Inventory?
I think of inventory as a company's goods on hand, which is often a significant
current asset. Inventory serves as a buffer between a company's sales of goods
and its production or purchase of goods. Companies strive to find the proper
amount of inventory to avoid lost sales, disruptions in production, high holding
costs, etc.
What is Inventory Management?
Inventory management is the overseeing and controlling of the ordering,
storage and use of components that a company will use in the production of the
items it will sell as well as the overseeing and controlling of quantities of
finished products for sale.
Types of Inventory:
Inventory comes in many shapes and sizes, as shown in Figure:
Most manufacturing firms have the following types of inventory.
Raw material: Raw material are the purchased items or extracted materials
that are transformed onto components or products. For example, gold is a raw
material that is transformed into jewelry.
Components: Components are parts or subassemblies used in building the
final product. For example, a transformer is a component in an electronic
product.
Work-in-process (WIP): WIP refers to all items in process throughout the
plant. Since product are not manufactured instantaneously, there is always
some WIP inventory flowing through the plant.
Finished goods: After the product is completed, it becomes finished goods.
The bicycles, stereos, CDs, and automobiles that the company sells its
customers.
Distribution inventory: distribution inventory consists of finished goods and
spare parts at various points in the distribution system. For example, stored in
warehouses or in transit between warehouses and consumers. Maintenance,
repair, and operational (MRO) inventory are supplies that are used in
manufacturing but not become part of the finished product. Examples of MRO
are hand tools, lubricants, and cleaning supplies.
How companies use their Inventory:
Companies have different kinds of inventory. They also use inventory for
different purposes. Lets look at six ways of using inventory.
1. Anticipation inventory or seasonal inventory is built in anticipation
of future demand, planned promotional programs, seasonal fluctuations,
plant
shutdowns,
and
vacations.
Companies
build
anticipation
inventory to maintain level production throughout the year. For example,
the toy industry build toys throughout the year in anticipation of high
seasonal sales in December.
2. Fluctuation inventory or safety stock is carried as a cushion to
protect against possible demand variation, just in case of unexpected
demand. For example, you might keep extra food in the freezer just in
case unexpected company drops in. Fluctuation inventory or safety
stock is also called buffer stock or reserve stock.
3. Lot-size inventory or Cycle Stock results when a company buys or
produces more than is immediately needed. The extra units of lot-size
inventory are carried in inventory and depleted as customers place
orders. Consider what happens when you buy a 24-can case of soda. You
do not normally drink all 24 cans at once. Instead, what you do not need
right way, you store for future consumption. You may buy more of an item
than you need to take advantage of lower unit cost or quantity discounts.
Cycle stock also occurs when making products and the process has a
minimum greater than is needed.
4. Transportation or Pipeline Inventory is in transit between the
manufacturing plant and the distribution warehouse. Transportation
inventory are items are not available for satisfying customer demand
until they reach the distribution warehouse, so the company needs to
decide between using slower, inexpensive transportation or faster, more
expensive transportation. To calculate the average amount of inventory in
transit, we use the formula
ATI
tD
365
Where ATI = average transportation inventory (in units)
t = transit time (in days)
D = annual demand (in units)
Example:
Suppose the Nadan Company, a producer of brass sculptures, needs to ship
finished goods from its manufacturing facility to its distribution warehouse.
Annual demand at Nadan is 1460 units. The company has a choice of sending
the finished goods regular parcel service (three days transit time) or via public
carrier, which takes eight days transit time. Calculate the average annual
transportation inventory for each of the alternatives. Note that the average
transportation inventory does not consider shipment quantity but only transit
time and annual demand. To reduce transit inventory, you reduce transit time.
Solution:
When using the regular parcel service,
ATI
When using the public carrier,
3 1460
=12units
365
ATI
8 1460
=32units
365
5. Speculative or Hedge Inventory is a buildup to protect against some
future event such as a strike at your supplier, a price increase, or the
scarcity of a product that may or may not happen. A company typically
builds speculative
inventory
to ensure a continuous supply of
necessary items. Think about booking an airline flight three months in
advance so you can take advantage of a reduced fare. You assume that
the airfare will not be reduced further and that you will still need the ticket
three months from now. It is a gamble.
6. Maintenance, Repair, and operating (MRO) Inventory includes
maintenance supplies, spare parts, lubricants, cleaning compounds, and
daily operating supplies such as pens, pencils, and note pads. MRO items
support general operations and maintenance but are not part of the
product the company builds.
Inventory plays multiple roles in a company operations. For this reason,
companies develop
inventory management objective and
performance measures to evaluate how will they are handling
their inventory
investment.
Functions of Inventory:
Anticipation Inventory:
Items built in anticipation of future demand. Allows company to maintain a level
production strategy.
Fluctuation Inventory:
Protects against unexpected demand variations. Assure customer service levels.
Lot-size Inventory:
Results from the actual quantity purchased. Allows for lower unit costs.
Transportation Inventory:
Items in movement between locations. Inventory moves from manufacturer to
distribution facilities.
Speculative Inventory:
Extra inventory built up or purchased to protect against some future event.
Allows for continuous supply.
MRO:
Includes maintenance supplies, spare parts, lubricants, cleaning agents, and
daily operating supplies. Facilitates day-to-day operations.
Objectives of Inventory Management:
The main objective of inventory management is to maintain inventory at
appropriate level to avoid excessive or shortage of inventory because both the
cases are undesirable for business. Thus, management is faced with the
following conflicting objectives:
Customer service:
Customer service is a company ability to satisfy the needs of its customers.
When we talk about customer service in inventory management, we mean
whether or not a product is available for the customer when the customer wants
it. In this sense, customers service measures the effectiveness of the
companys inventory management. Customers can be either external or
internal: any entity in the supply chain is considered a customer.
Suppose your company, Kayaks; Incorporated, offers a line of kayaks and
kayaking equipment through catalog sales and an accompanying web site. As
product manager, you need to know whether the inventory management
system you introduced is effective. One way to measure its effectiveness would
be to measure the level of customer service: are customers getting the
kayaking equipment they request, and are their orders shipped on time? To
answer your questions, you can measure the percentage of orders shipped on
schedule, the percentage of line items shipped on schedule, the percentage of
dollar volume shipped on schedule, or manufacturing idle time due to inventory
shortages.
Percentage of Orders Shipped on Schedule:
Percentage of orders shipped on schedule is a good measure for finished goods
customer service, such as your kayaking equipment company, if all orders and
customers have similar value and late deliveries are not excessively late. For a
different kind of company, such as one that design computer networks, some
customers have much greater value. Obviously, this method does not
adequately capture the value of those customers orders.
For example, if the book publishing company John Wiley & Sons, Inc. represents
50 percent of your demand but is only 1 out of 20 orders on the schedule,
delivering late to Wiley is certainly more harmful to your company than shipping
a smaller order late. With this measure, however, all late orders are treated
equally. If you have only one late shipment, the customer service level is 95
percent (19 of 20 shipped on schedule). But if the late order is to Wiley, you
have meet only 50 percent of your demand.
Percentage of Line Items Shipped on Schedule:
Percentage of line items shipped on schedule recognizes that not all orders are
equal but fails to take into account the dollar value of orders. This measure
needs more information the number of line items instead of the number of
orders than the previous measure. Therefore, this measure is more expensive to
use and is most appropriate for finished goods inventory.
As an example of the percentage of line items shipped on schedule, consider
the following. You sister company, White Water Rafts, Inc., determines that from
the 20 orders scheduling for delivery this month, customers requested 250
different line items. White Water can ship 225 of these line items on schedule.
Their customer service level is 90 percent (225 items shipped on time divided
by 250 line items requested).
Percentage of Dollar Volume Shipped on Schedule:
Percentage of dollar volume shipped on schedule recognizes the differences in
orders in terms of both line items and dollar value. Instead of measuring line
items to determine the customer service level, a company totals the value of
the orders. For example, if the 20 orders to the Palm Pilot handheld-computers
manufacturing company had a total value of $400,000 and the company
shipped on schedule handheld computers valued at $380,000, the customer
service level is 95 percent ($380,000 shipped, divided by $400,000 ordered).
Idle Time Due to Material and Component Shortages:
Idle time due to material and component shortages applies to internal customer
service. This is an absolute measure of the manufacturing or service time lost
because material or parts are not available to the workforce. Absolute measures
make sense when a company has historical data to use in comparisons. For
example, Kayaks; incorporated supplier historically has lost no more than two
manufacturing days per year because of material and component shortages.
This year, however, it has lost four manufacturing days for this reason.
Obviously, this years case is worse and needs managements attention.
These are only a few of the measures companies use to evaluate customer
service. The desired level of customer service should be consistent with the
companys overall strategy. If customer service is you companys competitive
advantage, the company must achieve a very high level of customer service.
Even when customer service isnt the primary focus, your company must still
maintain an acceptable level of customer service.
Now lets look at how inventory helps manufacturers operate efficiently.
Cost-Efficient Operations:
Companies can achieved cost-efficient operations by using inventory in the
following ways. First, companies use work-in-process inventory to buffer
operations. Suppose one of the Hewlett-Packard (HP) printed circuit board (PCB)
manufacturing facilities runs two or more operations in a sequence at different
rates of output. In this case, buffer inventories build up between the
workstations to ensure that each of the operations runs efficiently. For example,
PCBs flow from Kens workstation (takes take 120 seconds) to Barbaras
workstation (tasks take only 90 seconds). If there are no PCBs between the two
workstations, Barbara will be idle for 30 seconds out of every 120 seconds
because she finishes her tasks 30 seconds before Ken finishes his.
If the flour supervisor, Maria ensures that there is buffer stock between the
workstations, Barbaras idle time will be eliminated so she can produce more
PCBs.
Second, inventories allow manufacturing organizations to maintain a level
workforce throughout the year despite seasonal demand for production. A
company can do this by building inventory in advance of seasonal demands.
This in turn allows the company maintain a level workforce throughout the year
and to reduce the costs of overtime, hiring and firing, training, subcontracting,
and additional capacity.
Third, by building inventory in long production runs, the setup cost is spread
over a larger number of units, decreasing the per unit setup cost. Setup cost
include the cost of scrap (wasted material and labor), calibration, and downtime
to prepare the equipment and material for the next product to be manufactured.
Longer runs mean that the equipment does not need as many setups, so less
machine time is lost preparing for production.
Fourth, a company that is willing to acquire inventory can buy in larger
quantities at a discount. These larger purchases decrease the ordering cost per
unit. For example, the Rustic Garden Furniture Company needs 50,000 pieces of
wrought iron annually. Rustic supplier has offered a unit price of $1.10 if Rustic
buys the wrought iron in orders of 10,000 or more pieces at a time. If Rustic
chooses to buy in smaller quantities, the unit price is $1.29.
Now lets look at ways to measure inventory investment.
Minimum Inventory Investment:
A company can measure its minimum inventory investment by its Inventory
turnover that is, by the level of customer demand satisfied by the supply on
hand. We calculate the inventory turnover measure as
Inventory turnover=
annual cost of goods sold
average inventory dollars
Inventory Investment Measures Example:
The Coach Motor Home Company has annual cost of goods sold of $10,000,000.
The average inventory value at any point in time is $384,615. Calculate
inventory turnover and weeks/days of supply.
Inventory Turnover:
Turnover
annual cost of goods sold $10,000,000
26 inventory turns
average inventory value
$384,615
Weeks/Days of Supply:
Weeks of Supply
Days of Supply
average inventory on hand in dollars
$384,615
2weeks
average weekly usage in dollars
$10,000,000/52
$384,615
10 days
$10,000,000/260