7

Inventory Management: For Lean Supply Chain

After reading the chapter, the students should be able to understand:

• Inventory classification and functions
• Inventory-related costs
• Role of inventory in the supply chain
• Inventory planning models and control techniques
• Inventory policy guidelines

 

Inventory is technically an asset, but it is indirectly taxing on the profitability of the firm. Hence, besides the various activities associated with a lean supply chain, corporations across the world are always finding different methods and techniques to reduce the investments in inventory. With the latest IT tools and communication technologies, it has become comparatively easier than before to size and control this single largest cost-spinner in the supply chain. It is probably common sense that inventory should be held only when the benefits of holding inventory exceed the cost of holding it.

“Inventory accuracy starts with an understanding of conditions under which error occurs and ends with error-resistant processes, intelligent use of technology, a well-trained and highly motivated workforce, and ongoing process of continuous improvement.”

—David J. Piasecki

7.1 INVENTORY—ASSET OR LIABILITY?

Inventory generally constitutes the second largest item after fixed asset in the financial balance sheet of a manufacturing company. From a financial perspective, inventory is one of the major current assets that can contribute to maximizing the value of the firm and no significant disadvantages are seen in carrying more inventory. But investments in inventory carry cost. Funds invested in inventory cost the firm by way of interest on working capital borrowings from the bank at the current interest rates. Therefore, reduction in inventory will reduce inventory handling and carrying costs. The benefits of inventory reduction will be reflected in terms of increase in profit margins, return on investment (ROI) and economic value addition (EVA).

Today, inventory investment is viewed as a supply chain cost driver rather than as a material asset. Hence, the lean supply chain operating on material requirement planning (MRP), distribution requirement planning (DRP) or the just-in-time (JIT) system is preferred, since it has the maximum inventory turns (ratio of sales to average inventory) for reducing cost on inventory investments and enhancing the bottom line and return on investments.

7.2 INVENTORY FUNCTIONS

Inventory management is a strategic area in logistics operation and has an impact on efficiency and effectiveness of the overall supply chain system. As the cycles of production and consumption never match, goods have to be kept in stock to get over the uncertainties in demand and supply. However, higher inventory levels will affect the bottom line of the company. This is a high-risk and high-impact area, which has to strike a balance between the two polemic goals of lower cost and a higher level of customer service.

Companies block sizable funds in their inventories, which would otherwise have been invested in more productive areas. The general categories of inventory are as follows:

• Raw material and components inventory
• Work -in-progress inventory
• Finished goods inventory
• Maintenance, repairs and operating supplies inventory
• Pipeline or in-transit inventory

To give an idea of inventory-related investments, Table 7.1 indicates the values of the different categories of inventory in the various industries.

 

 

Not only external customers make demands on the inventories but internal customers such as the top management, manufacturing, finance and distribution also have different expectations (see Figure 7.1).

Inventories are held in warehouses that have an inescapable accountability for the inventories in their charge. The inventory levels in the company also affect the efficiencies of the other divisions. Inventory acts as a protective cushion for continuous operation in the customer supply chain. The top management views inventory as cash investment and expects to derive profits from it through effective and efficient customer service. Investments in inventory can cause cash-flow problems if the inventories are poorly managed by way of inaccurate forecast and excess production. Inventory management is both an art and a science and is concerned with the following:

• Right level of inventory
• Trade-off between inventory cost and customer service
• Treating inventory as a liability or asset

The industry will have to manage basically three types of inventories that are held at the various stages of the supply chain of a company. These are:

1. Raw materials and components on the procurement side
2. In-process or work-in-progress inventory
3. Finished goods inventories (at source and distribution centers)

In logistics we are mainly concerned with the finished goods inventories, which again are divided into the following three parts:

• Non-excise paid goods at plant warehouse
• Inventory in transit
• Channel inventory

Inventory blocks capital; that is, investments in inventory cannot be used for creating assets, producing other goods or investing in other productive ventures or projects. Inventory carries the risk of theft, pilferage or obsolescence. However, the nature of risk varies with the enterprise’s position in the distribution channel.

Manufacturer

As the manufacturer has to simultaneously keep inventories of raw materials, work in progress and finished goods, the depth of risk is highest among the other members of the supply chain. Inventory commitments of the manufacturer are of a longer period, even though his product lines are narrower as compared to wholesalers or retailers. Inventory commitments are closely related to the investments made in anticipation of the returns budgeted; lead time of the raw materials and components; complexity and width of the distribution network; unit value of the product; and the nature of demand.

Wholesaler

The product lines handled by the wholesaler are more than for the manufacturer. The wholesaler’s risk is spread over the different products. These different products may face cycling variations in the market at different points of time and hence the risk factor is limited to the non-performing product lines. For seasonal products, the wholesaler purchases the inventory in advance in anticipation of future sales, thus widening the risk element. Inventory commitments of the wholesaler are not of a longer duration than for the manufacturer.

Retailer

The retailer’s risk duration is much shorter than for the wholesaler and manufacturer. His commitment to inventory is not deep. Moreover, the risk is spread over a range of products. The retailer basically buys and sells and does not stock the material for a longer duration. He faces the risk of marketing rather than of inventory.

7.3 INVENTORY FUNCTIONALITY

Irrespective of its location in the supply chain, product inventory essentially serves the following functions:

Balancing Supply and Demand. The production and consumption cycles never matches. The sudden requirement of a product in large quantities may not be fulfilled immediately as the production cannot be taken up so soon. In such a case, the products are manufactured in advance in anticipation of demand and kept in stock for supply during the peak period.

Periodic Variation. For seasonal products the demand is at its peak for a certain period while it is lean for the rest of the year. Production runs in the factory are taken based on the average demand for the year. Excess production during the lean period is kept as inventory to take care of the peak demand. In cases where raw material for manufacturing food products is available seasonally, the products are manufactured and stocked as inventory to meet the demand of the finished product throughout the year.

Scale Economics. Products are manufactured at focused factories to achieve economies of scale. This is done because of the availability of the latest technology, raw materials, and skilled labour. Hence the produce is kept in stock for distribution to consumption centers as and when it is required. Distribution is done in economical lot sizes for system efficiencies in speed and cost.

In short, inventories provide demand utility for products at the time and places they are required for consumption.

7.4 REASONS FOR CARRYING INVENTORIES

Inventory is required for producing finished goods, extending service to customers and to keep the customer’s manufacturing operations running. Hence, inventory plays a crucial role in the supply chain of an organization. It helps to keep a smooth flow of products across the supply chain. On the other hand, excess inventory in the supply chain means additional cost of holding inventory, which exceeds the benefits derived from it. The benefits and losses of carrying inventory should be examined in light of the following reasons.

Meeting Production Requirements

Raw material, components and parts are required for producing finished goods. A manufacturing organization keeps stocks of the material to meet the continuous requirements of production. Companies operating on the JIT principle also keep some inventory on hand to meet contingencies. However, these stocks are quantitatively insignificant. The work-in-progress inventory constitutes a major portion of the production-related inventory. Reduction in this category of inventory results in inventory-related investments in the production process.

Supporting Operational Requirements

To support production operations, inventories are required for repairs, maintenance and operational support. These inventories include spare parts of production machineries, consumables such as lubrication oils and welding rods, chemicals, pallets, and the like. Companies do not have a correct picture of their investments in this category of inventory. Many times excess stock is held to avoid rushing to the market for buying inventory in small quantities in an emergency.

Customer Service Considerations

Products like equipments, machinery or appliances require replacement of spare parts for troublefree and smooth operations. Suppliers maintain an inventory of these parts to extend after-sales service to their valued clients. Availability of spare parts when required at the customer’s end is crucial for customer satisfaction and may be used as a tool for competitive advantage. Maintaining a significant level of inventory and keeping it replenished requires a major investment. This is closely related to the level of customer service offered by the company.

Hedge Against Future Expectations

To take care of shortages in material availability or an anticipated increase in the prices of products, the customer usually buys in excess of current requirement, stocking a critical material or product, for keeping their operations running without interruptions. This obviously increases the inventory level for a short period. However, in the above circumstances, the benefits derived from keeping excess inventory outweigh its carrying cost.

7.5 INVENTORY-RELATED COSTS

The major portion of the working capital of a firm is blocked in inventory. If the inventory is in excess of the optimum level, more funds will be blocked that cannot be used for other productive purposes, resulting in opportunity loss. Hence these funds are tied up unnecessarily. There are other costs related to inventory. The incidence of those costs will also be higher if inventories are in excess of the optimum level.

Inventory-related costs are divided into the following six categories (see Figure 7.2).

Inventory Cost. Inventory blocks funds. Funds once blocked cannot be invested in any other productive activities. The lost opportunity cost is not so easy to quantify. However, the cost of blocked funds in excess of the optimum cost is computed in terms of inventory-carrying cost discussed below.

Carrying Cost. The second major cost contributor is carrying cost. Funds invested in inventory attract interest charges on working capital borrowed from the bank. The current bank rate of interest on working capital borrowring is 12–15 per cent. Thus, the interest charges investment on excess inventory will erode the bottom line.

Ordering Cost. This refers to the cost involved in the ordering process. The paperwork, faxes, phone calls, and so on will add to the inventory-related cost.

Warehousing Cost. This is the cost for product holding in the warehouse. Depending on the kind of warehouse (private, public or contract), there will be a cost related to space occupancy based on the duration of storage. This cost varies from 1.5 to 4 per cent and may be taken into consideration while computing inventory-related costs.

Damage, Pilferage and Obsolesce Cost. Material stored carries the risk of damage, shrinkage and loss of weight. A product also carries the risk of pilferage or obsolescence due to technology change or availability of substitutes. The percentage varies from 0.5 to 2 per cent depending on the product.

Exchange Rate Differentials. In case of imported inventories, the valuation is done based on the current currency exchange rates in the market. Any fluctuation may increase or decrease the value of the inventory. Due to exchange rate fluctuations, there is the risk of selling the material at prices lower than the landed cost.

7.6 INVENTORY CONTROLS

The variability in customer demand if not conveyed properly or conveyed with distortion as it travels upstream in the supply chain—the phenomenon called ‘bullwhip effect’—causes either stockouts or inventory pile-ups in the distribution logistics chain. The bullwhip effect is a deformation in information when it goes upstream in the supply chain. The ripple effect of demand volatility results in inventory problems impacting on profitability and customer service of the firm. This happens due to lack of smooth and speedy information flow, resulting in improper coordination and synchronization of actions of supply chain partners. More precisely, the demand of the customer is put out of shape each time it goes from a one decision point to another. Assuming the demand of the customer is quasi-constant, this deformation appears through the amplification of the first mini-fluctuations. Problems tend to escalate in supply chains where communication is minimal between the supply nodes. The situation can be compared to the small wave in the middle of the ocean that may end up as a tidal wave near the shore.

The after-effects of the bullwhip phenomenon can be minimized by using the latest inventory control techniques supported by an efficient and effective information flow system for the supply chain. The ultimate objective of the inventory control program is to provide maximum customer service at minimum cost. The objectives of inventory management are similar to the objectives of cash management. Various control systems have been developed, which can be classified into two groups.

Selective Control Techniques

In these methods the degree of control varies with the importance of the item in the supply chain. The following are the various methods in practice that are commonly used in industries:

ABC Analysis

This relates to the annual usage cost of a particular item. A detailed analysis of inventory may indicate that only 10 per cent of items generally account for nearly 70 per cent of usage value. Another 20–30 per cent of items may account for 20 per cent of usage value and the balance 60–70 per cent account for the remaining 10 per cent of usage value. The items are classified per the usage value. While items in class A are less in number, they cost approximately 60–70 per cent of the total cost of the inventory. Class B items cost 20–30 per cent of the total inventory cost, whereas class C items are in greater numbers, yet carry less than 10 per cent of the cost of the entire inventory. In short, this is a financial evaluation for ranking and comparison of inventories. The objective of the classification is to know which item should receive the most attention. An item in class A should have your perpetual attention, while a class C item may be reviewed with less periodicity than class B items. For ABC classifications of inventory see Table 7.2. The first ten items have a value equal to 79.65 per cent of the total inventory value (43 items).

 

The ABC inventory classification method is thus used to categorize inventory into groups based upon certain activity characteristics. It is the process of classification of products per the level of importance in terms of their relative criteria such as purchase or sales volume. Examples of ABC classification include:

• ABC by velocity (times sold),
• ABC by sales in rupees,
• ABC by quantity sold or consumed,
• ABC by average inventory investment,
• ABC by margin.

ABC classification is used to develop inventory planning policies; set count frequencies for cycle counting; slot inventory for optimized order picking; and other inventory management activities. It can be described as a technique that is used in a business sense for denoting a categorization of a large volume of data into groups. These groups thereafter can be marked as A, B and C. This means that activities that are considered high on priority are classified as A, those with a lesser priority are grouped under B and the group of activities that are last on the list of priority are classified as C.

VED Analysis

This relates to Vital, Essential and Desirable status of the inventory items. As the term implies, certain parts and items are considered to be vital for meeting operational requirements and this aspect is taken into consideration while making

The forecast. The modified version of this is ABC-VED analysis that takes into consideration both value and the criticality of the item. High-value and critical items are under continuous review and ordered in low quantities, while low-value, least critical items are periodically reviewed and ordered in large quantities with lower safety stock requirements.

SAP Analysis

Scarce, Available and Plenty status of inventory item is used for planning & forecasting of inventory requirement. The ordered quantity is governed by the scarcity factor. The limitations in supply or obsolescence of an item in the near future will be the guideline for procurement policy decision.

FSN analysis

Fast, Slow or Normal determines the consumption pattern of an item. However, a consumption pattern where the production run is slowed down for various reasons may not give a realistic picture for procurement action

In all these control techniques, the degree of control varies with the importance of items (Figure 7.3). For example, for the A class vital, scarce and fast-moving items perpetual reviews are recommended, while for B class essential, medium-moving items periodic reviews will be OK. In the case of C class desirable, slow-moving items the periodicity of review will be longer.

Inventory Planning Models

Inventory is the main culprit in the supply chain and can influence the bottom line of an organization to a great extent. Over the years, experts have suggested various models for controlling inventory. Only a few models have stood the test of market dynamics. However, the results depend on the model you choose for the right application. Selection of the models depends on various factors as shown in Figure 7.4.

Approaches to inventory control can be categorized into the traditional and modern. Commonly used traditional approaches like EOQ and EBQ are based on certain assumptions that are not valid in dynamic markets. However, these formulas give certain guidelines rather than deciding on exact quantity (see Figure 7.5).

Economic Order Quantity

The economic order quantity (EOQ) or economic lot size model is referred to as Wilson-Harris square root formula, since it was devised by Ford Harris and R.H. Wilson independently. The assumptions under this model are:

• Demand is known. It is constant and uniformly spread over a period of time.
• There is no lead time for re-supply of material (i.e. material is supplied instantaneously.)
• The cost of ordering per unit is the same irrespective of the lot size.

In this model, inventory-carrying cost may be taken to be proportional to the average inventory held during a period. Therefore, by reducing the inventory, its carrying cost can be reduced. On the other hand, a smaller lot size will increase the number of lot sizes per year to cover the annual demand and so the cost of ordering will be more. Hence, an economical lot size will have to balance these two opposite costs.

The mathematical formula for economical lot size is:

Where Q = economic order quantity in units

S = cost of placing an order in Rs.

D = average annual consumption in units

H = percentage of inventory cost vis-à-vis unit cost

C = cost per unit

To go per the formula will be rarely possible because of the following reasons:

• The ordered quantity figure may be modified to take into account the standard pack size available in the market.
• To avail of the quantity discount offered by the suppliers, the order quantity figure may be modified.
• The availability of funds will force the buyer to go for the less than minimum ordered quantity.
• To take care of the anticipated shortage of material in the market, the higher quantities may be ordered.

The EOQ formula is normally used as a guideline rather than to decide on the exact material requirements.

Modern Inventory Control Systems

The modern approach to control inventories is focused on the following three factors:

Flow It is concerned with the movement of product from supplier to distribution centers and ultimately to the customer. Here comes the role of logistics operation for planning material flow across the distribution networks based on market demand. This is supported by production planning at the factory.

Flexibility It relates to the flexibility in frequency and volumes in delivery of products to customers. The role of warehouse management is crucial to the success of logistics operations designed to tune in to the service level demanded by target customers.

Balancing Inventory levels have a bearing on the customer-satisfaction level. An inadequate inventory level will create customer dissatisfaction. On the other hand, excess inventory will increase the carrying cost. The latest inventory models are focused on maintaining the delicate balance between the two polemic goals.

Integration The supply chain efficiency and effectiveness is very much dependent on integration. Inventory models are developed for a strategic fit, for both forward and backward integration, to meet the objectives of lower inventory-carrying cost and enhanced customer satisfaction.

Material Requirements Planning

The material requirements planning (MRP) concept was developed in the 1970s following the introduction of high-speed computers. MRP system does the work of materials manager to control inventory of items to lean the supply chain. The forecast of inventory items is controlled by the production item on which their demand is dependent. MRP is typically applied to manage inbound material movement in the enterprise and is based on production requirements and scheduling.

MRP system is suitable for both push- and pull-type supply chain systems. In a push system information is required in the form of elaborate material requirement planning for a master production schedule which is further used for creating schedules for suppliers for inventory part/component types, quantities and delivery dates. In the pull system, information is required on actual demand, which needs to be transmitted extremely quickly throughout the entire supply chain so that production and distribution of parts or products can accurately reflect the real demand (Figure 7.6).

Manufacturing Resource Planning—MRP II

MRP II is defined by APICS as a method for the effective planning of all resources of a manufacturing company. It started out as MRP (material requirements planning) and was concerned with ordering and scheduling materials based on inventory. The large-scale introduction of computers led to extensions into a closed-loop MRP II system concerned with the whole manufacturing environment. MRP II works on “push” where a forecast is generated, a manufacturing plan is derived and the plan then drives the manufacturing process via work orders or the purchasing process via purchase orders.

MRP II systems begin with MRP (material requirements planning). Sales forecasts from marketing are input to MRP. These forecasts determine the raw materials demand. MRP and MRP II systems draw on a master production schedule (MPS)—the breakdown of specific plans for each product on a line. While MRP allows for the coordination of raw materials purchasing, MRP II facilitates the development of a detailed production schedule that accounts for machine and labour capacity, scheduling production runs according to the arrival of materials. An MRP II output is a final labour and machine schedule. MRP II system provides data on the cost of production, machine time, labour time and materials consumed and the final output to accounting and finance. MRP is concerned primarily with manufacturing materials, while MRP II is concerned with the coordination of the entire manufacturing and other resources required for manufacturing production, including materials, finance, and human relations. MRP II is not a proprietary software system and can thus take many forms.

In short, MRP II is a long-term planning tool for complex products. It can give an accurate completion date at the time of order, The system fits in with conventional accounting and the progress of manufactures and inventory sizes which are available at all times. It tightly controls work orders and changes therein. However, in MRP II it is necessary to maintain an accurate database. Inventory accuracy requirement is vital to the extent of 99 per cent. MRP II is a computer-based system, inflexible and relies on forecast.

Distribution Requirement Planning

Distribution requirement planning (DRP) is one of latest IT tools for controlling inventory in the distribution system of an organization. It is a logical extension of MRP. DRP is guided by customer demand, whereas MRP is based on production requirement. DRP allocates inventory from the mother warehouse to the various distribution centers based on the following:

• Demand pattern
• Safety stock provision
• Order quantity
• Reorder point
• Average performance cycle length

DRP also coordinates finished goods requirements across the distribution network (Figure 7.7). DRP system success is dependent on the accuracy of the forecast with respect to location and time of the requirement across the distribution centers. Consistency performance cycle for timely movement of goods across the system is a must for system effectiveness. Uncertainty in performance cycles may defeat the very purpose of the DRP system. Like MRP, DRP is used along with enterprise resource planning (ERP), rather than as a stand-alone system, so as to get the full benefits of ERP on both the procurement and distribution sides. The major benefits of using DRP are:

• Improvements in customer service level
• Effective marketing efforts for high value stock items
• Decrease in inventory level resulting in a decrease in carrying cost

• Decrease in inventory reduces warehouse space requirements
• Helps in effective simulation of transportation and inventory requirements for shipment coordination that results in reduction of inventory-carrying and transportation costs.

Just-in-Time System

Just-in-time (JIT) is a concept based on the fact that an activity should not take place until there is need for it. Hence an inventory item should not be brought into the system until it is required for making the final product. JIT is characterized by maintaining zero inventories of raw materials and assemblies at the assembly plant. Therefore, the JIT system involves the close coordination of the buyer and the suppliers on a real-time basis. This means frequent receipts of materials from suppliers. The following are prerequisites to a successful JIT system:

• Buyer-seller partnership
• Online communication and information sharing
• Commitment to zero defects from both the sides
• Frequent and small lot size shipments

The success of the JIT system depends on the mutual trust and commitments of both seller and purchaser. In a nutshell, it is the philosophy of “Help, to get helped.” However, there is also the flip side. The main barriers to the successful operation of the JIT system are:

• Organization structure
• Organization culture
• Technology differentials at buyer and supplier ends
• Reluctance to information sharing
• Dispersed suppliers

The JIT system has its success stories in Japan where it originated. The adoption of JIT by Americans could not bring in the desired benefits, resulting in their moving to other techniques. The reason for the Americans’ unsuccessful adoption of the system lies in the decision-making culture required to operate the JIT system. Success depends on collaborative relationship and decisions reached by group consensus rather than made by individuals empowered by an organization based on an authority structure. To make JIT a success, total cultural and structural changes are needed in both buyer and purchaser organizations and they should operate from mutually beneficial policy platforms.

Vendor-Managed Inventory

Vendor-managed inventory (VMI) is a new concept that has been made popular by the Bose Corporation. It is now widely used in the industry with encouraging results. In VMI the supplier takes charge of inventory management of products and manages the replenishment process based on the consumption pattern of the customer. They use EDI or other inter-organizational software packages or place the supplier’s representative at the customer’s place.

In India a leading commercial vehicle manufacturer allowed the tyre supplier to open a small inventory shop in his manufacturing premises to supply tyres for the day’s production of commercial vehicles. The supplier keeps three days inventory in the area allocated to him along with his representative to manage the shop and hand over tyres to the customer per the assembly line requirements for the day. Inventory replenishing is done once in two days by direct truckloads of tyres from the supplier’s manufacturing plant. This is based on the advanced production planning for the coming week. A daily payment by cheque is made for the quantity of tyres drawn from the supplier’s shop. The result is a huge reduction in the inventory level, now down to 3 days’ stock (inventory stock for 15 days was held before by the vehicle manufacturer). Besides, the inventory is now entirely managed by the vendor, who gets the payment daily for the supplies made. This truly is a win-win situation, beneficial to both the buyer and the supplier.

For VMI to be successful, three things are essential, viz. the right partners, the right set of products and mutual trust. By “right partners” is meant, those who have proved themselves on consistency in quality, low cost transactions and reliability as far as on-time delivery is concerned. VMI is appropriate for products that have high volumes and values, involve huge carrying cost for the inventory to be maintained. In VMI, the partnership is based on mutual trust, which implies a willingness on the part of the buyer to share information and capabilities with the supplier as well as allow the latter to partake of the benefits resulting from a close collaboration of this kind; and an assurance on the part of the supplier to be reliable and consistent on agreed delivery schedules. The benefits of VMI are reduction in inventory-related costs risk of stockouts and for the vendor speedy payment realization, reduction in transaction cost, and the assured business. It is rightly said that VMI is the starting point for greater collaboration among supply chain partners and by graduating from a one-sided replenishment responsibility to collaborative replenishment results in greater value being derived for the supply chain.

7.7 KANBAN

It is basically an information system to support JIT inventory for manufacturing operations. It signals supply of material when used. Kanban, meaning signboard or label, is used as a communication tool in the inventory system. A kanban is attached to every box of parts as they go to the assembly lines. Because these parts are funneled to the line as needed, the kanban can be returned as parts are used to serve both as record of work done and as order for a new lot. Kanban coordinates the inflow of parts and components to the assembly line, minimizing replenishment processing. Kanban is used in process logistics for movement of parts and components on the shop floor of a manufacturing plant (Figure 7.8). The system was first evolved at the Toyota Motor Company in Japan to support the concept and practice of JIT in the assembly line. The philosophy behind it is “use one, buy one.”

Automated Inventory Tracking System (AITS)

This system is adopted by the leading U.S. retail chain giant Wal-Mart to track inventory based on the sales generated. The system involves usage of the electronic data interchange (EDI) system to track the flow of inventory through the supply chain. The system connects suppliers, manufacturers, distribution hubs and retail stores and institutional buyers. The system is based on integrating EDI and the bar coding system to track inventory for controlling inventory investment through the supply chain.

7.8 INVENTORY POLICY GUIDELINES

These are the guidelines for inventory procurement, maintenance, positioning and placement with respect to quantity, time and customer service. Policy decisions are also concerned with managing inventory independently or interdependently across the various distribution centres. Defining policy helps in improving the inventory effectiveness across the supply chain.

Centralized/Decentralized System

In the centralized system inventories are stocked at one central location for distribution to customers or depots. The centralized system helps maintain tight controls on inventory movement both for replenishment and dispatches. The greatest disadvantage of the centralized system, especially as the volume of transaction grows, is a longer order performance cycle and delayed response time for the smaller but nevertheless larger number of customers. On the other hand, the decentralized systems are closer to the customer and make decisions independently. The decentralized system offers better customer service with quick response and a shorter performance cycle time. However, the controls are lax and the operating cost is higher. The management has to make a policy decision to strike a balance between customer service, controls and the cost.

Service Level

Service-level target is decided by the management. The inventory function should gear up to achieve the service-level target. The basis of service level is defined in terms of the following:

• Order cycle time
• Case fill rate
• Order fill rate

The order cycle time is the amount of time from the date of release of an order by the customer to the receipt of the entire ordered material at his doorstep. The case fill rate means the percentage of material available for dispatch to the quantity ordered by the customer. For example, the customer orders 10 items and only nine are available for supply, then the case fill rate is 90 per cent. The order fill rate is the percentage of orders that could be filled completely. Say, out of 100 orders received only 60 could be filled completely, then the order fill rate is 60 per cent. The traditional approach to meet the targeted customer service level is to increase the inventory level. However, the modern approach considers a faster transportation mode, better communication means, and alternative sources of supply to meet the desired customer level.

Stock Levels

To meet the desired level of customer service, the average level of inventory stocks to be maintained at any point of time is determined in terms of the number of days of sales value. The average inventory includes the base-level inventory, safety stock inventory and in-transit inventory (Figure 7.9).

Stocks deplete daily after orders are filled. To maintain the average level as decided before, inventory has to be ordered and replenished before it further depletes to zero. The reorder level is called a base-level inventory.

The other part of the average inventory is stock maintained to meet uncertainties or emergencies. Safety stocks are maintained to meet inventory demand that is in excess of the anticipated consumption. In fact, safety stock inventory covers short-range variations in demand. The average inventory includes one half of the ordered quantity and the safety stock inventory.

The in-transit or pipe inventory is of importance to the consigner, as the ownership of this inventory still lies with him till it reaches the destination and is handed over to the consignee. There is great uncertainty associated with the transit inventory. This inventory is not accessible and cannot be used. The whereabouts of the transit inventory are not known unless you have a sophisticated vehicle-tracking system. This is an excise-paid inventory and it covers a major portion of the value of the inventory of a company. In the JIT system the emphasis is on small consignments with frequent delivery schedules, resulting in the maximum portion of inventory in transit phase.

7.9 SQUARE ROOT LAW (SRL) OF INVENTORY

As regards inventory, many a time companies believe that centralization will cost them more as compared to decentralization. However, as per the business expert D.H. Maiser, maintaining the inventory in a variety of warehouses instead of just one would result in saving money. This he proved mathematically in 1976. His law is known as the square root law of inventory. This law is the basis of the concepts of risk pooling and inventory centralization. According to SRL:

“Total safety stock inventories in a future number of facilities can be approximated by multiplying the total amount of inventory at existing facilities by the square root of the number of future facilities divided by the number of existing facilities.”

In other words, the increase in number of warehouses of a company will cause a specific increase in certain costs. Thus, with lesser number of warehouses, the company will enhance its savings of certain costs. This increase, either in a positive or negative direction, can be mathematically computed using the square root law indicated below:

where n₁ = number of existing facilities

n₂ = number of future facilities

X₁ = total inventory in existing facilities

X₂ = total inventory in future facilities.

For example, if a business firm has a network of 15 field warehouses for stocking their inventory, their costs would likely be almost 75 per cent greater than if they used a single warehouse. Also, if Company B originally had five warehouses and decided to centralize their inventory, they would see a saving ofjust over 50 per cent.

The following data from an actual company demonstrate how average inventory level increases as the number of stocking locations increase. Though the number is given as average inventory, this level is directly related with safety inventory (see Table 7.3).

 

 

The assumptions to square root law are as follows:

• Inter-location inventory transfer is not at the same common level
• Lead times do not vary
• No change in customer service level
• Normal distribution of demand at each location

The most important limitation attached to the effectiveness of SRL (Zinn, Levi and Bowersox 1989) is the demands across the markets served by the various stocking points. This means that SRL will be most effective when markets have demands that are negatively correlated, and there is little or no benefit from consolidation when demands faced by the various stocking points are positively correlated. Hence, more the uncertainty of demand at each location, measured by the coefficient of variation, the better the SRL of inventory works.

According to this formula, with the multiplicity of warehouses the fixed costs increase in the same proportions. In addition, multiple warehouses are more difficult to manage because keeping track of the inventory at several locations, watching stock amounts, handling orders, and planning distribution are all the more complicated when a company has to deal with more than one or two warehouses. Switching to a more centralized warehouse system may not seem possible to many businesses, but the change is possible. Manufacturing companies can collaborate with logistics vendors in reducing their own stocking points. SRL cannot be used in isolation. The decision on the number of warehouses considering SRL should be weighed in light of other factors like transportation costs, lead time, inventory availability and warehouse proximity.

SUMMARY

Inventory is a critical element in the supply chain. They are broadly classified as raw materials and components, work-in-progress, fished goods and operational support inventories. Inventories are maintained for meeting production requirements, supporting the operations, extending customer service and as hedge against future uncertainties. Traditionally, inventories are reflected as current assets in the balance sheet of the firm and no appreciable disadvantages are viewed in carrying more inventory. The cost associated with inventory investment was always ignored in the past. However, the investment in inventory has implications on the bottom line of the firm. The inventory-carrying cost consists of the cost of the funds invested in inventory; its handling cost; damage and obsolescence cost; and opportunity cost. The carrying cost is approximately 18–20 per cent of the investment in inventory. In the supply chain system, inventory is viewed as a liability that reduces both profits and return on investment. For making the supply chain leaner, firms today use selective control techniques such as EOQ, ABC, EVD and FMS, as well as inventory control models such as MRP DRP JIT, VMI and AITS. For managing inventories across the supply chain, policy guidelines have to be framed for inventory procurement, maintenance, positioning and placement with respect to quantity, time and customer service. In a nutshell, an inventory should be held only when the benefits of holding the inventory exceed the cost of carrying the inventory.

REVIEW QUESTIONS

1. Discuss the role of inventory in the logistic supply chain system.
2. How can inventory be used as a measurement system for performance evaluation of the supply chain?
3. Discuss the various techniques for inventory control with their merits and demerits.
4. Illustrate how line inventory classification can be used for the product and market segments. What are the benefits and considerations in classifying inventory by product-market?
5. Discuss the various approaches to control inventory investment.
6. How are inventories categorized? Do the control techniques differ with inventory category?
7. “Inventory control is a key to profitable running of business.” Comment

INTERNET EXERCISES

1. Visit http://www.microsoft.com/dynamics/nav/product/demos.mspx for a demonstration of inventory management software.
2. Visit Professor Hossein Arsham’s E-labs for studying inventory management at http://home.ubalt.edu/ntbarsh/Business-stat/otherapplets/ Inventory.htm
3. For vendor management resources visit http://www.datalliance.com
4. Visit “Institute for Working Future” for studying square root law of inventory at http://www.marcbowles.com/courses/adv_dip/module4/module4/m4four1.htm

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