Inventory refers to the quantity of goods which is held in the premises of a business enterprise. These goods may be held “in-house” for the immediate use or in distant distribution centers or warehouses for the future use. More specifically, inventory refers to the goods that are in excess of the quantity which is required for an efficient production within a few hours (Martha, Douglas, Lambert & Janus 1997).
Inventory management refers to the activities that are employed to facilitate optimal levels of inventory. Balancing the inventory needs reduces the cost of obtaining and warehousing the inventory items. Inventory management facilitates an uninterrupted production, customer-service, and sales level, what enables the business enterprise to offer its merchandise at favorable prices. Since inventory is a powerful current asset, mismanagement of a business enterprise would result into losses and, at times, failure of the business. Therefore, it is paramount for a business enterprise to balance its inventory requirements with the necessity to minimize costs that result from obtaining and warehousing the stock (Sherer 2005).
Reasons for Maintaining Extra Inventory
Successful business enterprises focus on customer satisfaction. The current uncertainty in the market complicates businesses short and long-term strategies, a situation which prompts some of them to maintain “excess inventory”. The following are some of the reasons why businesses cannot disregard maintaining extra inventory.
For a business enterprise to remain in business, it must provide the goods that its customers need in a timely manner. Maintaining a level of inventory that is just enough for a day or two would disorient the customers, especially when supply disruptions occur. In such instances, an entrepreneur would be forced to back-order and this would, in effect, require the customer to wait. When such a situation persists, customers opt to acquire their goods from other sources. Therefore, inadequate inventory results in sales losses, and, therefore, reduced profitability.
A manufacturing enterprise ought to have an adequate level of raw materials, subassemblies, and components in order to maintain an optimum level of production. Running out of an item can bar the manufacturer from continuing with the production process. Moreover, the depletion of inventory as the firm engages in dependent operations decouples the dependency of the processes. For instance, in most enterprises, work centers depend on the products from previous stages of manufacturing to provide the necessary components. Therefore, a failure at a work center disorients all the subsequent centers, meaning that most machines can only maintain their operations for a short time. Production failures cause loss of sales, a situation which is difficult to recover even when operations return to their full capacity (Sherer 2005).
The lead time refers to the time duration between ordering and delivery. In this case, ordering denotes the placing of a purchase order at a shop or at the floor of the factory. There are some instances when customers unexpectedly order large volumes of goods for one reason or the other. For the enterprise to supply the goods demanded on time, it must keep an inventory that is slightly higher than the approximated optimum. The volume of inventory ought to be determined by considering the time it takes for the enterprise to get supplies from its suppliers. A long lead time means that it takes an extended period of time before the ordered goods are available for sale. In such a case, it would be important for an enterprise to maintain a large volume of inventory so as to avoid disruptions (Martha, Douglas, Lambert & Janus 1997).
On the other hand, just-in-time manufacturers can manage to run their operations smoothly with low inventory levels. These manufacturers, nevertheless, have to maintain a constant supply throughout the day. In contrast, there are firms with a lead time of over, say, three months. This requires their customers to order in time so as to enable them to plan their future sales. To secure that their operations run continuously, they have to retain an on-hand inventory of the number of months that the new supplies take to reach the premises.
In some instances, an extra level of inventory hedges the enterprise against the increase in price and inflation. With regard to this, salespersons make routine calls to their purchasing agents before prices are hiked. This enables them to acquire inventory that is in excess of the optimum level at a reduced price. As such, they are cushioned from the challenge that results from an increase in prices, and this enables them to service their customers uninterruptedly (Walters & Lancaster 2000).
The reduction in operational costs avails funds for the enhancement of the service delivery. This boosts the enterprise’s growth and expansion, thereby reducing the challenges that were encountered by the customers. For this reason, firms take advantage of the quantity discounts, which are the offers made by the suppliers for purchasing in bulk. As such, the enterprise acquires a level of inventory which is higher than the optimum, making the meeting of current and future demands easier. The decision to buy in bulk is justifiable, especially in situations where the amount of discount can sufficiently offset the costs resulting from an extra duration of warehousing (Clemmer 1990).
Enterprises that deal with numerous part numbers may find it challenging to monitor their levels of inventory for each one of them. In such circumstances, the use of an ABC approach facilitates the control of inventory. The ABC approach is founded on the Pareto Analysis, which is also referred to as the eighty-twenty rule. The eighty-twenty rule is based on Pareto’s findings that twenty percent of the society holds eighty percent of the entire wealth. With regard to the inventory, this can, therefore, be restated as: approximately twenty percent of inventory represents eighty percent of the costs (Walters & Rainbird 2004). This means that an enterprise can control eighty percent of inventory-related costs by monitoring twenty percent of its inventory requirements. For this approach to succeed, the inventory being controlled must be twenty percent (Clemmer 1990).
The top twenty percent of the most expensive items in an enterprise are termed as “A” items. They are estimated to represent eighty percent of the entire cost of inventory. “C” items refer to the inexpensive or the least demanded goods. “B” items are those items that fall in between the “A” and the “C” items. Although firms vary these percentages, “B” items represent approximately thirty percent of the entire volume of inventory, which, in most cases, represents fifteen percent of the cost. “C” items, therefore, constitutes fifty percent of the inventory items. Nevertheless, “C” items incur about five percent of the cost of inventory.
The classification of each item in the inventory as A, B, or C facilitates the determination of the optimum resources that ought to be dedicated to them. These resources include money, effort, and time. In most instances, items in “A” category are monitored more closely than those in other categories. Nevertheless, the management ensures periodic checks for items in categories B and C so as to meet customers’ needs in an effective manner (Clemmer 1990).
The ABC concept presents another control method which is referred to as cycle counting. In recent years, cycle counting has been preferred to the traditional yearly inventory counts. During the yearly counts, enterprises are forced to shut down, sometimes for days, so as to facilitate a physical count of every inventory asset. The aim of this process is to reconcile possible discrepancies that may be present in an enterprise’s inventory records. Cycle counting is customer friendly in that inventory items are assessed as the enterprise continues its daily routines. An enterprise ought to count the items in a certain section before proceeding to the next. This is repeated until all the inventory items have been counted. In some instance, a firm may opt to count all of the A items before counting those in category B and C respectively. Nevertheless, the counting frequency varies with the manner in which the items are classified. For instance, an enterprise may prefer to conduct a monthly count for A items before performing a quarterly count for B items. In such a case, C items are, most probably, counted on a yearly basis. Successful business enterprises ensure that their inventory records are accurate, with the category A items commanding the highest level of accuracy due to the monetary value that is involved (Martha, Douglas, Lambert & Janus 1997).
Balancing Inventory Levels with Costs
As elaborated in the earlier sections, the aim of conducting an inventory management is to maintain enough supply of merchandise while reducing inventory costs. Enterprises make choices according to what they deem as the adequate level of inventory. The process of balancing inventory level with costs begins with the evaluation of the costs that are involved. Inventory costs are categorized into three groups: set-up costs, purchasing costs, and holding costs.
Holding costs are also termed as carrying costs. These costs are incurred during the maintenance of inventory. Inventory that exceeds a current demand requires the holder to provide a storage space for the portion which is not in use. The storage area could be a distribution center or a warehouse that is situated near the center of production or a storage facility, which necessitates a massive movement of inventory over a long distance. The storage of inventory is costly as it requires the engagement of personnel during the movement of goods when required. Additionally, such movements necessitate a careful track keeping as this would facilitate monitoring. In situations where the inventory items are bulky and heavy, the enterprise incurs an extra cost of acquiring machineries such as folk lifts (Clemmer 1990).
In some instances, storage facilities would require water, cooling, heating, and lighting. The enterprise must also remit taxes as par the inventory they hold. The enterprise incurs an opportunity cost as a result of missed opportunities resulting from holding funds in the excess inventory. Additionally, the excess inventory is exposed to the risk of theft, shrinkage, and obsolescence. Therefore, as much as the enterprise attempts to meet the needs of its customers in a timely manner, the management must evaluate the risk which is associated with carrying and holding extra inventory items.
Determining the annual cost of holding a unit of inventory enables the firm to evaluate the annual holding expense. The figure is calculated by multiplying the average number of inventory units with the cost of holding one unit. The average inventory, Q/2 is assumed to be half the amount of items that are acquired when the order is successfully honored. The annual holding cost is, therefore, expressed as H (Q/2).
Set-up costs are those costs which are incurred when preparing the machinery for the process of manufacturing goods. In a manufacturing enterprise, the set-up cost would necessitate the hiring of skilled technicians. The technicians ought to be proficient in disassembling tooling, which is presently in use so as to facilitate the repair and maintenance. Once the repair work has been completed, technicians reassemble the machine in readiness to the resumption of operations. In this regard, the preparation and maintenance of machinery costs the enterprise a substantial amount of money (Clemmer 1990).
An enterprise may reduce its set-up costs by purchasing a significant amount of its inventory instead of manufacturing. Through purchases, however, the enterprise incurs order costs. Ordering costs incorporate salaries of staff members like the purchasing agents as well as travelling and entertainment allowances. Other ordering costs include secretarial and administrative support, office and copier supplies, rental costs, phone bills, as well as computer systems installation and maintenance costs (Friedman 2005).
Determining the cost of a unit setup, S, or of an order, the firm acquires the capability to determine the annual ordering/set-up costs. These costs are evaluated by finding the product of a unit set-up and the total number of set-ups or orders that has been made in during the trading period. Supposing that a firm whose annual demand (D) is 1,000 units places orders of 100 units (Q) on a regular basis, there will be 10 orders annually (D/Q). Therefore, the annual ordering/set-up costs are expressed as S (D/Q).
Purchasing costs are the sum of purchase prices of the acquired items. The annual purchasing expense is the product with the cost of one unit and the number of units that are demanded during the year. This price is denoted by PD. The total cost of inventory is expressed as:
H (Q /2) + S (D / Q) + PD
When curves of the set-up and holding costs are plotted on a graph, their point of intersection indicates the least inventory cost. Therefore, ordering the quantity, Q, which corresponds to the value denoted by the point of intersection, would facilitate the reduction of the inventory costs. Equating the two values facilitates the evaluation of the quantity, Q:
H (Q /2) = S (D / Q)
Q = 2 DS / H
This quantity, Q, is called the Economic Order Quantity (EOQ). In an endeavor to minimize the inventory cost, an enterprise ought to order items of quantity Q. The application of the Economic Order Quantity necessitates certain assumptions to be made (Ramsay, 2005). These assumptions include:
- the involvement of a single product;
- existence of a deterministic demand (i.e., a demand which can be established with certainty);
- existence of a constant demand (i.e., a demand which is stable throughout the trading period);
- absence of quantity discounts;
- existence of constant cost (i.e., the absence of irregular price increases).
Although these assumptions would appear to make the application of the EOQ in a realistic situation irrelevant, its application is possible where the levels of demand are independent. Independency means that the demand for an item is not deduced from that of a parent item. For instance, while the demand of steering wheels would be in line with that of cars, purses have an independent demand as no item influences their necessity (Friedman 2005).
In addition to EOQ, there are other lot-sizing techniques that influence the inventory management. These techniques include part-period balancing, single-period mode, fixed order interval model, and fixed order quantity.
Fixed Order Quantity Model
The fixed order quantity model is utilized where orders are made at fixed intervals, for instance, weekly, monthly, or quarterly. The size of a lot is dependent on the amount of inventory that is needed between the placements of two orders. This time is referred to as the order cycle. Enterprises ought to conduct periodic checks of the inventory levels so as to meet the expectations of their customers in a timely manner. Such checks are particularly necessary in grocery and drug stores (Koontz & Weihrich 2006).
Single Period Model
This model is utilized in situations where the enterprise wish to order for such perishables as flowers and food or items that have a limited life like, for example, newspapers. In such instances, it is impossible to carry over the unused or unsold commodities from a trading period to another, a situation which necessitates an enterprise to employ disposal costs. The single period model attempts to balance the opportunity cost and the costs incurred due to the lost customer goodwill with the expense, which is incurred on the wasted portion of the inventory (Koontz & Weihrich 2006).
Part Period Balancing
The part period balancing is a strategy that is aimed at selecting the durations that are covered with the ordered inventory in an attempt to evaluate the entire amount of carrying costs. In an effective operation, the carrying costs ought to be almost similar to the order/set-up cost.
Other Philosophies about Inventory Management
MRP and MRP II
MRP and MRP II refer to the computer-based management resources, which are designed for the inventory items whose demands are dependent. MRP and MRP II resources are used to evaluate the ordered quantities period-by-period. The evaluation allows for discrete ordering, a situation which facilitates the maintenance of low inventory levels. Discrete ordering is a necessity for the inventory items that possess dependent demands (Prahalad & Hamel 1990).
Just-in-time, JIT, refers to the philosophy which advocates for the extremely low levels of inventory. The philosophy explicates that enterprises ought to keep inventory items in their right quantity and quality. The default lot size in JIT is equal to one.
Theory of Constraints (TOC)
The theory of constraints, TOC, is a philosophy which requires the actions of management to be centered on the constraints that restrain operations in an enterprise. Though the theory agrees with the Just-in-time philosophy on the aspect of lowering the levels of inventory, it proceeds to advocate for the maintenance of buffer inventory items around the factors which restrain the capacity of production (Hai 2010).
The Future of Inventory Management
Concerns for the environmental management have presented a new dimension with regard to the inventory management as well as the logistics involved in the reverse supply chain. Concerns for the environmental management have increased the varieties of inventories that enterprises ought to coordinate. For instance, in addition to the acquisition and storage of raw materials, finished products, MRO goods, and work-in-progress, contemporary enterprises have to deal with the post-consumption items like scrap, recyclable or reusable containers, returned goods, and a variety of items that may require repair, recycling, secondary use, and recycling. Retailers face the same challenges as suppliers and manufacturers because they have to deal with defective goods (Koontz & Weihrich 2006). In this case, supply and value chain management have significant impacts on the inventory management. For instance, in addition to the engagement in activities that maximizes profits while reducing the costs, individual enterprises make decisions that are aimed at benefiting the entire chain of supply.
Effective value chain and inventory management require an enterprise to evaluate the merchandise it has on hand. Inventory management, therefore, refers to the process of overseeing a constant and efficient flow of items in relation to the existing inventory. The process necessitates an effective control of the units being transferred as this avoids the need to hold extreme levels of inventory. An enterprise should ensure that its levels of inventory are not dwindling or unnecessarily high as such situations would put the operations of an enterprise into jeopardy. As such, competent inventory management practices aim at controlling the expenses that are associated with holding the inventory. An enterprise ought to consider the value of the commodities it holds as well as the tax burden that they generate (Laseter & Oliver 2003).
Effective balancing of the tasks associated with the inventory management necessitates an evaluation of three characteristic aspects of inventory. The first aspect is about time. With regard to time, it is necessary to understand the period that a supplier needs for an effective processing and delivery of an order. Additionally, the inventory management requires an understanding of the time it takes for materials to be transferred out of an established inventory. Understanding of these aspects of lead time enables the management of an enterprise to determine the appropriate moment for placing an order as well as the number of units that ought to be ordered so as to maintain a smooth running of the production process (Koontz & Weihrich 2006).
The second aspect is about the amount of buffer stock. In essence, buffer stock refers to the amount of items which is beyond the optimum number that is necessary for the maintenance of the optimal production levels. For instance, the management of an enterprise may consider stocking extra spare parts of a machine, a move that would enable the organization to handle any arising emergency cases. Creating such a buffer or cushion minimizes the number of interruptions to the production process, even when some of the parts prove to be defective. The enterprise, therefore, maintains a level of inventory that enables it to meet its customers’ needs optimally (Hai 2010).
Some of the core activities during the inventory management involve the documentation of deliveries and the movement of items into the operational process. Enterprises analyze the movement of inventory items as they undergo multiple stages of production. At this point, the items are termed as work-in-progress inventory (Porter 1985). It is essential to track materials as they are consumed in the manufacturing of the finished products. The tracking facilitates the procedure of adjusting the orders that relate to raw materials so as to prevent them from getting low or inflated. For this reason, inventory management necessitates the keeping of accurate data so as to manage the items that are ready for the shipment. It is, therefore, necessary to post the amount of the newly manufactured goods to the total inventory figures. Similarly, recent shipments to the buyers ought to be subtracted from the inventory figures so as to maintain a credible record (Laseter & Oliver 2003). Upon their improvement, these goods are reclassified as second grade quality or refurbished, and they can, therefore, be offered for sale at a reduced price. The maintenance of accurate figures facilitates the communication with the sales personnel. The communication is aimed at informing them about the items that are available for the shipment at a given time.
Inventory management involves the control of movement and volume of various items of inventory. The management, therefore, facilitates the preparation of records that can be utilized during the assessment of taxes, which result from holding every item in the inventory. It provides precise records of the units that are utilized in each phase of the production process, a situation which enables an enterprise to calculate accurate tax amounts. This helps to avoid tax evasion penalties which can cause the collapse of an enterprise.
Determining the ideal inventory levels ought to start with the setting up of an effective management and control system. The structures of the system should be based on the needs and expectations of the customers. In this case, it would be possible to maintain an inventory level that facilitates timely delivery of commodities to their intended consumers (Hai 2010). The establishment of the proper level of inventory is determined by a number of factors which include:
- the availability of capital;
- the consumer demand and its effect on the sales projection;
- the past sales figures as well as the average sales for the last trading period;
- the carrying costs involved;
- the availability of a storage space.
An effective control system necessitates the evaluation of mathematical formulas, ratios, as well as the rules relating to these factors. The evaluation, therefore, enables the management to come up with the desired order quantities, turnover rates, and consequently, the optimal inventory level. Finally, it is necessary to recognize that extra inventory items consume the cash-in-hand. It increases the level of the investment on risky assets, and as such, an improper business management would lead to a total bankruptcy (Friedman 2005). It would, therefore, be beneficial to have an inventory control system that ensures the maintenance of optimum levels of inventory as this would reduce the rate of customer turnover.