Elements of Inventory Management

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Inventory is defined as a stock of items kept on hand by an organization to use to meet customer demand. Virtually every type of organization maintains some form of inventory. A department store carries inventories of all the retail items it sells; a nursery has inventories of different plants, trees, and flowers; a rental car agency has inventories of cars ; and a major league baseball team maintains an inventory of players on its minor league teams . Even a family household will maintain inventories of food, clothing, medical supplies , personal hygiene products, and so on.

Inventory is a stock of items kept on hand to meet demand .

The Role of Inventory

A company or an organization keeps stocks of inventory for a variety of important reasons. The most prominent is holding finished goods inventories to meet customer demand for a product, especially in a retail operation. However, customer demand can also be in the form of a secretary going to a storage closet to get a printer cartridge or paper, or a carpenter getting a board or nail from a storage shed. A level of inventory is normally maintained that will meet anticipated or expected customer demand. However, because demand is usually not known with certainty , additional amounts of inventory, called safety , or buffer , stocks , are often kept on hand to meet unexpected variations in excess of expected demand.

Additional stocks of inventories are sometimes built up to meet seasonal or cyclical demand. Companies will produce items when demand is low to meet high seasonal demand for which their production capacity is insufficient. For example, toy manufacturers produce large inventories during the summer and fall to meet anticipated demand during the Christmas season . Doing so enables them to maintain a relatively smooth production flow throughout the year. They would not normally have the production capacity or logistical support to produce enough to meet all of the Christmas demand during that season. Correspondingly, retailers might find it necessary to keep large stocks of inventory on their shelves to meet peak seasonal demand, such as at Christmas, or for display purposes to attract buyers .

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A company will often purchase large amounts of inventory to take advantage of price discounts , as a hedge against anticipated future price increases , or because it can get a lower price by purchasing in volume. For example, Wal-Mart has long been known to purchase an entire manufacturer's stock of soap powder or other retail items because it can get a very low price, which it subsequently passes on to its customers. Companies will often purchase large stocks of items when a supplier liquidates to get a low price. In some cases, large orders will be made simply because the cost of an order may be very high, and it is more cost-effective to have higher inventories than to make a lot of orders.

Many companies find it necessary to maintain in-process inventories at different stages in a manufacturing process to provide independence between operations and to avoid work stoppages or delays. Inventories of raw materials and purchased parts are kept on hand so that the production process will not be delayed as a result of missed or late deliveries or shortages from a supplier. Work-in-process inventories are kept between stages in the manufacturing process so that production can continue smoothly if there are temporary machine breakdowns or other work stoppages. Similarly, a stock of finished parts or products allows customer demand to be met in the event of a work stoppage or problem with the production process.

Demand

A crucial component and the basic starting point for the management of inventory is customer demand. Inventory exists for the purpose of meeting the demand of customers. Customers can be inside the organization, such as a machine operator waiting for a part or a partially completed product to work on, or outside the organization, such as an individual purchasing groceries or a new stereo. As such, an essential determinant of effective inventory management is an accurate forecast of demand. For this reason the topics of forecasting (Chapter 15) and inventory management are directly interrelated.

In general, the demand for items in inventory is classified as dependent or independent. Dependent demand items are typically component parts, or materials, used in the process of producing a final product. For example, if an automobile company plans to produce 1,000 new cars, it will need 5,000 wheels and tires (including spares ). In this case the demand for wheels is dependent on the production of cars; that is, the demand for one item is a function of demand for another item.

Dependent demand items are used internally to produce a final product .

Alternatively, cars are an example of an independent demand item. In general, independent demand items are final or finished products that are not a function of, or dependent upon, internal production activity. Independent demand is usually external, and, thus, beyond the direct control of the organization. In this chapter we will focus on the management of inventory for independent demand items.

Independent demand items are final products demanded by an external customer .

Inventory Costs

There are three basic costs associated with inventory: carrying (or holding) costs, ordering costs, and shortage costs. Carrying costs are the costs of holding items in storage. These vary with the level of inventory and occasionally with the length of time an item is held; that is, the greater the level of inventory over time, the higher the carrying cost(s). Carrying costs can include the cost of losing the use of funds tied up in inventory; direct storage costs, such as rent, heating, cooling, lighting, security, refrigeration, record keeping, and logistics; interest on loans used to purchase inventory; depreciation; obsolescence as markets for products in inventory diminish; product deterioration and spoilage; breakage ; taxes; and pilferage.

Inventory costs include carrying, ordering , and shortage costs .

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Carrying costs are normally specified in one of two ways. The most general form is to assign total carrying costs, determined by summing all the individual costs mentioned previously, on a per-unit basis per time period, such as a month or a year. In this form, carrying costs would commonly be expressed as a per-unit dollar amount on an annual basis (for example, $10 per year). Alternatively, carrying costs are sometimes expressed as a percentage of the value of an item or as a percentage of average inventory value. It is generally estimated that carrying costs range from 10% to 40% of the value of a manufactured item.

Ordering costs are the costs associated with replenishing the stock of inventory being held. These are normally expressed as a dollar amount per order and are independent of the order size . Thus, ordering costs vary with the number of orders made (i.e., as the number of orders increases, the ordering cost increases). Costs incurred each time an order is made can include requisition costs, purchase orders, transportation and shipping, receiving, inspection, handling and placing in storage, and accounting and auditing.

Ordering costs generally react inversely to carrying costs. As the size of orders increases, fewer orders are required, thus reducing annual ordering costs. However, ordering larger amounts results in higher inventory levels and higher carrying costs. In general, as the order size increases, annual ordering costs decrease and annual carrying costs increase.

Shortage costs , also referred to as stockout costs , occur when customer demand cannot be met because of insufficient inventory on hand. If these shortages result in a permanent loss of sales for items demanded but not provided, shortage costs include the loss of profits. Shortages can also cause customer dissatisfaction and a loss of goodwill that can result in a permanent loss of customers and future sales. In some instances the inability to meet customer demand or lateness in meeting demand results in specified penalties in the form of price discounts or rebates. When demand is internal, a shortage can cause work stoppages in the production process and create delays, resulting in downtime costs and the cost of lost production (including indirect and direct production costs).

Costs resulting from immediate or future lost sales because demand could not be met are more difficult to determine than carrying or ordering costs. As a result, shortage costs are frequently subjective estimates and many times no more than educated guesses.

Shortages occur because it is costly to carry inventory in stock. As a result, shortage costs have an inverse relationship to carrying costs; as the amount of inventory on hand increases, the carrying cost increases, while shortage costs decrease.

The objective of inventory management is to employ an inventory control system that will indicate how much should be ordered and when orders should take place to minimize the sum of the three inventory costs described here.

The purpose of inventory management is to determine how much and when to order .