Inventory Management

Chapter 24
 Operations efficiency can be improved if a business manages inventory well by
balancing the holding cost against the cost of running out of essential supplies

 Reasons for holding inventory : Businesses hold inventory to ensure smooth

operations and meet customer demands. The reasons for holding inventory
are categorized as follows:
• Raw Materials and Components: Purchased from external suppliers and
stored until needed for production. Enable quick production to meet increased
demand efficiently.
• Work in Progress: Refers to materials currently undergoing production
processes. Especially significant in industries like construction or batch
production, where inventory levels are higher due to extended production
timelines.
• Finished Goods: Fully manufactured items stored until sold or dispatched to
customers. Help manage unexpected spikes in demand and improve sales
opportunities. Stockpiled for seasonal or anticipated demand surges (e.g., toys
during festivals).
 The costs of holding inventory include:
• Opportunity Cost: Capital tied up in inventory could be used for other
purposes, such as paying loans, investing in new equipment, or capital left in
the bank to earning bank interest. The opportunity cost of holding
inventory refers to the potential benefits lost when capital tied up in
inventory could have been used for other purposes. More capital tied up
in inventory means greater potential returns are sacrificed elsewhere.
During periods of high interest rates, the cost of tying up capital in
inventory rises, as the potential earnings from alternative uses, like
investments or savings, increase.
• Storage Costs: Includes expenses for secure warehouses, special storage
conditions (e.g., refrigeration), employee wages for handling, insurance, and
loan interest for financing stored goods.
• Risk of Wastage and Obsolescence: Unsold or unused goods may deteriorate,
become outdated, or get damaged, reducing their value and potential sale
price.
 Why do inventories need to be managed effectively ?
 Effective inventory management is essential to avoid the following problems:
• Insufficient Inventories: There might be insufficient inventories to meet
unforeseen changes in demand. Failure to meet unexpected demand
changes can lead to lost sales and customer dissatisfaction.
• Obsolete or Outdated Stock might be held if proper rotation system is not
used. For example items like fresh food or fast-evolving tech products can
become unusable.
• Inventory Wastage: Mishandling or poor storage conditions can result in
damaged goods.
• High Costs: Excessive inventory levels lead to increased storage expenses and
opportunity costs.
• Supply Issues: Poor purchasing management can cause late deliveries, missed
supplier discounts, or excessive orders that exceed storage capacity.
 The benefits of holding inventory include:
• Reduces Risk of Lost Sales: Adequate inventory ensures product availability,
reducing the chance of losing customers to competitors due to stock outs.
• Ensures Continuous Production: Prevents production stoppages caused by
shortages of raw materials, avoiding costly downtime of equipment and labor.
• Avoids Costly Special Orders: Having sufficient stock eliminates the need for urgent
orders that may incur higher administrative and delivery costs.
• Cost Savings Through Large Orders: High inventory levels from bulk purchasing
allow businesses to benefit from discounts and lower transport costs due to fewer
deliveries.
• However optimum inventory level balances these benefits against holding costs to
minimize total costs. The optimum inventory level will be at the lowest point of
total costs on the total inventory cost graph

Graph: Total Inventory–holding cost

• Advantages of Large Orders: Lower ordering and administrative costs due to
fewer orders. Ensures continuous production and avoids costs of special urgent
orders.
• Drawbacks of Large Orders: Higher inventory holding costs due to increased
storage requirements. Increased opportunity costs from capital tied up in excess
stock. Greater risk of goods becoming obsolete or outdated.
• The optimum order size ensures that inventories are purchased in quantities that
balance costs and operational needs.
• The economic order quantity (EOQ) is a method to calculate the ideal order size
(optimum order size) for minimizing total inventory costs. It varies depending on
the business and type of inventory.
 Inventory control charts are visual tools used to monitor and manage a business’s
inventory levels over time.
- These charts record over time the numbers of goods held, inventory deliveries, buffer
levels and maximum inventory.
- They provide critical insights to help managers optimize ordering (order in time) and
storage decisions ( order quantity).
- They also allow an analysis of what would happen to inventory levels if an unusual event
occurred, such as a competitor operating a very successful promotion campaign.
• Key features include:
• Buffer Inventories: Safety stock maintained to handle uncertainties in delivery or
production. If delivery time or production levels are uncertain, higher buffer levels are
needed to compensate, as well as to account for the greater costs of shutting down and
restarting production. Therefore greater the potential cost saving from higher buffer level
of inventories.
• Maximum Inventory Level: Determined by storage space or financial constraints of
holding even higher inventories. One way to calculated Maximum Inventory level is by
adding buffer inventory to the the economic order quantity (EOQ) of that item.
• Re-order Quantity: will be based on the EOQ.
• Lead Time: Lead time is the time taken for suppliers to deliver new stock. Longer lead
times require higher buffer levels.
• Re-order Level: The inventory level at which a new order is triggered, accounting for lead
time and usage rate. Automated systems often handle re-orders to prevent stock outs.
• Inventory control charts also helps to analyze the impact of demand fluctuations,
such as promotional campaigns, and support informed decision-making for future
inventory management.
 Supply Chain Management (SCM) is the process of overseeing and coordinating the flow
of goods, services, and information from the initial sourcing of raw materials to the
delivery of finished products to customers.
- It involves managing all the interconnected activities, resources, and relationships across
the supply chain to ensure efficiency, cost-effectiveness, and customer satisfaction.
- Supply chain management consist of planning, sourcing , production, logistics and returns
ensuring efficient flow of goods, services and information.

 Importance of Supply Chain Management

- Supply chain management is crucial for improving operational efficiency, minimizing
costs, and enhancing customer service.
- It is increasingly vital for businesses of all sizes as it helps shorten the time required to
transform raw materials into finished products.
- Supply chain management aims to reduce time period by:
• Improved Supplier Communication: Ensures timely delivery of the right quality and
quantity of goods.
• Efficient Transport Systems: Reduces material delivery time.
• Faster Product Development: Enhances competitiveness by accelerating new product
launches.
• Streamlined Production: Utilizes technology and flexible workforces to speed up
processes.
• Waste Minimization: Reduces costs by cutting waste at all production stages.
 Benefits of Effective Supply Chain Management
• Improved Customer Service: Ensures timely delivery of high-quality products, leading to higher
customer satisfaction.
• Reduced Operating Costs: Lowers purchasing, inventory, and production costs by streamlining
processes.
• Enhanced Profitability: Boosts profits through reduced waste, efficient inventory management,
and cost-effective operations.

 Just-in-time (JIT) inventory management

• aims to achieve zero buffer inventories.
• Components and other supplies arrive just as they are needed on the production line.
(example : automobile Companies)
• Finished goods are delivered to customers as soon as they are completed.

 Comparing JIT and JIC Inventory Management

• Just-In-Time (JIT) minimizes inventory by producing goods only as needed, reducing costs
and improving efficiency. In contrast, Just-In-Case (JIC) maintains high inventory buffers to
prevent supply disruptions and meet unexpected demand.
• While JIT is widely adopted for its cost-saving advantages, the COVID-19 pandemic
exposed its vulnerability to supply chain disruptions, highlighting the trade-offs between
these systems.
Advantages Just In Time Disadvantages Just in Time

Capital invested in inventory and the opportunity Failure to receive supplies on time, due to strikes,
transport issues, or IT failures, causes costly
cost of holding inventory are reduced. production delays.
Storage and inventory holding costs decrease, Increased delivery costs due to frequent small
freeing up space for more productive uses. deliveries required by JIT.

Lower risk of outdated or obsolete inventory; Order administration costs may rise from
reduced risk of damage or wastage. processing numerous small orders.
Greater flexibility enables quicker responses to Reduced bulk discounts from suppliers due to
changes in consumer demand or tastes. smaller order sizes.
Multi-skilled, adaptable staff required for JIT may Business reputation heavily depends on external
experience improved motivation. factors like supplier reliability and traffic delays.

Advantages Just in Case Disadvantages Just in Case

Low risk of running out of inventory,
High capital costs due to significant
ensuring production continuity even during
investment in inventory.
supply delays.
Less reliance on accurate sales forecasting High storage, insurance, and associated
compared to JIT. costs for maintaining inventory.
Risk of inventory losing value due to
Economies of scale can be achieved with
changes in fashion or technology while
large orders of supplies or components.
being stored.
 Conditions for Successful JIT Implementation
• Strong Supplier Relationships: Reliable suppliers must deliver quickly and
consistently, often with a single supplier per component to build trust.
• Multi-Skilled Workforce: Employees must be flexible to switch production
tasks at short notice to match demand changes.
• Flexible Machinery: Modern, adaptable equipment allows small batch
production and rapid product switching, minimizing inventory.
• Accurate Demand Forecasting: Precise predictions enable efficient production
scheduling and inventory management.
• Advanced IT Systems: Data-based tools track sales, trends, and reordering
needs, facilitating real-time communication with suppliers.
• Positive Employee-Employer Relations: Strong industrial relations help avoid
disruptions that could halt production.
• Quality Focus: Ensuring high-quality outputs is critical, as JIT lacks buffer
inventory for defects.
 Evaluation of JIT
• JIT fosters a lean production culture by minimizing waste and emphasizing
accountability, reliability, and efficiency. While widely adopted in
manufacturing, it has limitations:
• Advantages:
– Reduces waste and inefficiency.
– Promotes lean production principles.
• Challenges:
– Production halts due to supply delays can be costlier than holding buffer
inventories.
– Small businesses may lack resources for necessary IT systems.
– Inflation and high transport costs may favor bulk purchasing over frequent
small orders.
– Service industries risk damaging customer satisfaction if zero inventories
hinder service delivery.
• JIT is highly effective for many but not universally applicable across all
industries and conditions.