LOGISTICS AND INVENTORY MANAGEMENT

Logistics is all about managing inventory, whether the inventory is in motion or sitting, whether it is in a raw state, in process, or completed (finished goods). And true to the cliché noted in Chapter 2, which suggests that you cannot make something out of nothing, you must have inventory to sell anything. The promise to serve a customer cannot be extended assuredly unless the product is on hand or can be made available in a timely manner. The challenge comes when customers demand the product NOW and you have to speculate about what they will want, in what quantities, and where to position it. The imperative, therefore, becomes having inventory available when and where customers want it.

Logistics professionals often recite the “Bill of ‘Rights’” when describing what it is that they do: delivering the right product to the right place at the right time in the right quantity and condition, and at the right cost. Having the right inventory on hand and near customers is the simplest way to ensure that they walk away happy. But like anything that is good for you and necessary for survival, it is possible to have too much of a good thing. We all need proper nutrition to survive, yet we also know what too many calories can do to the waistline. Unfortunately, as alluded to in Chapter 1, the strange truth of the matter is that many of us are addicted to inventory. How many plant managers do you know who stash an extra box of parts in their office like a forbidden pack of cigarettes to cover them when a craving becomes too strong? It is an obsession that afflicts more people and companies than you might imagine.

THE TEMPTATION OF INVENTORY

Inventory reduction is the driving force behind many a “Lean” initiative. It is one of the forms of “muda,” or waste, originally identified by Taiichi Ohno in his list of seven. Inventory is also perhaps the most visible form of waste.* The fact that we have warehouses and distribution centers is a testament to the fact that we have inventory and, usually, lots of it. Inventory often represents somewhere between 5 and 30 percent of a manufacturer’s total assets and may represent half of a retailer’s total assets. These estimates are based on end-of-quarter or fiscal year-end observations, when inventories are at their most depleted state for the sake of periodic financial reporting. They may lurk considerably higher over the course of the period. And, like any asset, inventory has to be managed. It has to be acquired, received, housed, paid for, and insured — adding cost on top of the original purchase price for the goods or materials.

So why does it happen so often that we have more inventory than we really need? We hold inventory because in the absence of instantaneous manufacturing and delivery, we have to position inventory in the distribution channel in advance of demand to meet today’s “I want it now!” society. Lofty expectations for in-stock availability drive the placement of these inventories not only in retail consumer channels but also in industrial (business-to-business) environments. Until we can achieve instantaneous mass-customized manufacturing and Star Trek–like beaming capabilities, the fact is that we must anticipate what customers want, the quantities they want, and where they want them when the expectation of perfect in-stock availability is in place. With this in mind, we make our best guess at demand (i.e., forecast) and acquire supplies in advance to support the expected demand.

The one thing that is absolute about a forecast is that it will be precisely wrong. The two important questions are “How wrong will we be?” and “In which direction will we be off — under or over forecast?” Some forces within a company make common practice of keeping the forecast (and ensuing expectations) low in order to beat the forecast, indicating perseverance and goal accomplishment. Others push the forecast higher to justify added capacity or to signal future sales to current and prospective investors. This inventory must often be sold off at discount, disposed of, or maintained until inventories eventually become depleted.

Many companies realize that working within a shorter planning horizon holds several important benefits. First, it allows a company to rely less on the long-range forecast, which we all know will inevitably be wrong. By relying less on the forecast and more on actual demand, we can reduce the risk of miscalculating the future and, in turn, hold less inventory. The shorter planning horizon also supports more frequent replenishment and smaller lot sizes, which should translate into fresher products available for customers and less risk of obsolescence.

When demand is highly seasonal, we often must engage in long-range planning, buying materials and producing products well in advance of the peak season, given an economic inability to make everything necessary to satisfy the seasonal spike in the immediate term. Still others concern themselves little with the fact that continuous, large-batch production leads to excess inventory. In many process industries like petroleum refining and paper milling, shutting down the machines is the equivalent of shutting down the ocean; you just cannot do it. Achieving the lowest per-unit production cost is still the single highest priority in many industries today. This mind-set also leads many companies and entire industries to seek offshore manufacturing activity to reduce production costs.

That speaks to the normal scope of business activity, but what about when something strange happens in supply or demand? Imagine an unplanned plant shutdown at a key supplier. Imagine all of the ports along the western coast of the United States being closed for an indefinite time period. Imagine the delivery truck that gets slowed by inclement weather or stuck in traffic or the driver who simply gets lost. Unfortunately, it does not take a wild imagination to conjure up these images; they can happen at any time to any company. And what about something positive like the new product that really soars into the marketplace, exceeding anyone’s “realistic” sales expectations? Or what about the sales promotion that really had traction? Demand, too, can surprise us. And so we hold extra inventory to cover us in these situations when an unexpected hiccup occurs in a supply chain process or demand exceeds the forecast. What is interesting is that we NEVER expect to use the safety stock; if we did, it would be factored in the planned cycle stock.

These occurrences represent the many different ways in which variance manifests. It is the goal of Six Sigma to control the variation, to improve supply chain processes so that the job gets done better on a consistent basis. Six Sigma also captures the experience and expectations of the customer, reducing the likelihood of developing products and services that are inconsistent with market wants and needs, but also alleviating the risk of being caught off guard when a product tanks or skyrockets. Those companies that engage in offshore manufacturing experience the brunt of these swings even more when they send their operations away from the home market, often moving operations away from not only the customer but also away from the predominant supply base. While production costs most definitely can be reduced through this action, most companies have learned that offshore manufacturing leads to an entirely different set of problems in the supply chain: variances. Variances in inbound and outbound logistics and variances in production control areas such as quality, quantity, and time make many question whether it was worth the leap. All these variances instill greater need for inventory.

Extra inventory is sometimes acquired for reasons other than protection from supply chain disruptions and demand spikes. Companies in many industries take on inventory for speculative purposes given the possibility that supplies might come into shortage or that price increases are on the horizon. Scrap recyclers, for instance, make a necessary habit of acquiring high-quality scrap materials whenever they become available. Dealers of limited-edition automobiles and other collectibles engage in similar opportunistic buying. Meanwhile, commodity dealers like those in the oil and gas industry, precious metals, and grain marketing keep close eyes on the futures market, with the prospect of arbitrage (buy low now, sell high later) driving their purchasing behavior.

THE COSTS OF HOLDING INVENTORY

Regardless of the reason, what companies have to realize is that there are very real costs associated with holding all inventory. The costs go well beyond the outlay of the inventory “investment.” We will review the elements of inventory carrying cost that should be applied to the value of average inventory to determine the annual dollar cost of holding inventory (see Figure 3.1).

Inventory carrying costs serve up an interesting concept, representing both accounting costs and economic costs. An “accounting cost” is one that is explicit and calls for a cash outlay and registers on the books of the company. An “economic cost” is implicit; it does not necessarily involve an outlay, but rather an opportunity cost. Most companies recognize that there is some cost associated with holding inventory and apply a round figure to the problem of determining carrying cost, but there is rarely any idea of where that figure originated. Too often, a company’s inventory carrying cost percentage is determined every great while and rarely understood, and even less commonly challenged. This lack of understanding and reluctance to challenge the carrying cost percentage often results in gross miscalculation in determining annual inventory

Figure 3.1. Inventory Carrying Cost Calculation.

carrying costs, usually erring on the side of underestimation. Let’s tackle the problem by examining the key components of the carrying cost percentage.

The single biggest factor is the opportunity cost of consuming capital on the hunch of future demand and supply events. So, aside from having $300,000, $3 million, or $300 million invested in inventory, what else could you do with that amount of capital if it were not tied up in inventory? This cost of capital component is the single largest piece of inventory carrying cost. Most companies simply apply the debt rate (cost of acquiring capital) for this component, but that implies that paying off debt is the best (and perhaps only) alternative for those funds. Keep in mind that inventory carrying cost should reflect the opportunity cost of the capital. The hurdle rate, or internal rate of return, at most companies easily exceeds the market-based cost of capital, and this hurdle rate (or weighted average cost of capital) should be the figure applied to the cost-of-capital component of the carrying cost percentage.*

The fact that inventory is viewed by the IRS and many state governments as taxable assets means that you must also apply the applicable property tax rates in the carrying cost percentage. And don’t forget to tack on the insurance rate paid to provide coverage against loss or damage to the assets. Along the same lines, factor in the rates of product obsolescence, damage, and pilferage. Highly valuable products that seem to vanish more commonly than other goods will have a higher cost attached to them than lesser valued goods that are rarely pilfered — not that low-value goods are never picked over.

Finally, there is a component for the variable cost of storage. This component refers to the costs associated with handling inventory and variable storage costs such as those associated with hiring outside warehouses to hold excess inventory. The trick here is not to include fixed warehousing costs (costs that do not change with the volume of inventory maintained), but to include only those costs that increase as the volume of inventory increases. So, the fixed costs tied to the company-owned distribution center or the plant warehouse are not reflected here. These are fixed storage (i.e., warehousing) costs that should be determined in total logistics cost, but distinct from inventory carrying cost. In sum, the variable costs of warehousing belong in the inventory carrying cost component, while the fixed costs of storage and handling belong in the “warehousing” costs in a total cost analysis. The components of inventory carrying cost are summarized in Figure 3.2.

Along with challenging the carrying cost determination is the prospect of doing so frequently. Inventory carrying cost should be dynamic, as dynamic as a company’s business opportunities. As a company’s expected rate of return on new investments evolves, so too must the inventory carrying cost percentage. The percentage determined at one point in time should not be held in such

Figure 3.2. What Costs Go into Inventory Carrying Cost? (Adapted from Lambert, Douglas M., The Development of an Inventory Costing Methodology: A Study of the Costs Associated with Holding Inventory, National Council of Physical Distribution Management, 1976, p. 68. Diagram courtesy of the Council of Supply Chain Management Professionals [CSCMP], Oak Brook, IL.)

regard that it cannot be questioned over time and revisited. Inventory carrying cost is not likely to change dramatically within the course of a year, but should always reflect the reality of the company’s changing cost conditions and investment opportunities.

Once you have a better handle on what it is really costing you to hold inventory, interest should turn to how sales can be maximized with the least amount of inventory. All other things being equal, you should try to cover demand by ordering smaller quantities more frequently from your supply sources, thus achieving more inventory turns. “Inventory turns” refers to the number of times each year that average inventory sells. The number of turns is usually determined based on the value of average inventory and the sales volume at cost, expressed mathematically as:

Achieving more turns means that you are holding less inventory, on average, while presumably fulfilling demand (see Figure 3.3). Clearly, having no inventory on hand when demand surfaces is not a good situation, although it can make average inventory levels and inventory turns look appealing. Rather, the model for frequent, small-quantity replenishment that more closely matches demand is the method for keeping customers happy with less inventory: improving turns.

A key question is “How many turns are enough?” Many companies will benchmark their competitors and companies in similar industries to gauge how many turns they should achieve in their distribution network. But like inventory

Figure 3.3. Inventory Turns and Average Inventory.

carrying cost percentages, the desired number of turns is unique to a company. In fact, a company’s inventory carrying cost percentage and estimations of annual inventory carrying cost will factor into the decision. While achieving many turns suggests that average inventory is minimal and yet customers remain satisfied, the costs associated with shipping in smaller quantities and handling more orders (albeit smaller orders, on average) can offset the savings achieved in frequent, small-order replenishment and high inventory turns. So, again, there is a limit to a good thing. Finding this limit is the mandate of total cost analysis — understanding the trade-offs among logistics-related cost and service factors.

Companies can sometimes get carried away with pursuit of a singular objective that leads to suboptimal performance of the larger system, leading to dissatisfied customers, higher total cost, or both. A case in point was an aftermarket automotive supplier that devised the goal of replenishing its customers on a much more frequent basis than the typical once-a-week arrangement with which it had been conducting business for several years. The goal was established to provide daily replenishment to large customers and every-other-day service to smaller ones. While the customers were pleased with the prospect of more frequent deliveries and higher in-stock availability with less inventory, they were less enthusiastic about the mounting transportation costs required to support the frequent, small-quantity deliveries. In fact, it was determined that at the proposed level of delivery frequency, inventory savings and in-stock improvements would not offset the increase in transportation costs.

So while some level of inventory is necessary for meeting near-term demand and providing coverage for critical disruption or unforeseeable spikes, the focal problem becomes one of “right-sizing” the inventory. How much do we really need? Can we see through our addiction and hold only what is necessary? Recognizing the volume of inventory that supports customer requirements yet results in the lowest total cost represents the desired outcome. Putting an accurate price tag on the cost of carrying inventory is an important element of the solution.

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* Taiichi Ohno developed a list consisting of seven basic forms of muda: (1) defects in production, (2) overproduction, (3) inventories, (4) unnecessary processing, (5) unnecessary movement of people, (6) unnecessary transport of goods, and (7) waiting by employees. Womack and Jones added to this list with the muda of goods and services that fail to meet the needs of customers. (Sources: Ohno, Taiichi, The Toyota Production System: Beyond Large-Scale Production, Productivity Press, Portland, OR, 1988 and Womack, James P. and Jones, David T., Lean Thinking, Simon & Schuster, New York, 1996.)

* For an excellent treatment of inventory carrying cost determination, see Stock, James R. and Lambert, Douglas M., Strategic Logistics Management, 4th ed., McGraw-Hill Higher Education, New York, 2001.