Stock

4
/ Inventory management
The management of stock/ inventory is a key aspect of working capital
management.

The objectives of inventory management

Inventory is a major investment for many companies. Manufacturing

companies can easily be carrying inventory equivalent to between
50% and100% of the revenue of the business. It is therefore essential
to reduce the levels of inventory held to the necessary minimum.
Importance of inventory management

The challenge of of good inventory management is to determine:

 the optimum re-order level (how many items are left in inventory
when the next order is placed), and
 the optimum re-order quantity (how many items should be
ordered when the order is placed)

In practice, this means striking a balance between holding costs on the

one hand and stockout and re-order costs on the other.

Costs of high inventory levels

Keeping inventory levels high is expensive due to:

 purchase costs
 holding cost (storage, stores administration, risk of
theft/damage/obsolescence)

Carrying inventory involves a major working capital investment and

therefore levels need to be very tightly controlled. The cost is not just
that of purchasing the goods, but also storing, insuring, and managing
them once they are in inventory.

Costs of low inventory levels

If inventory levels are kept too low, the business faces alternative
problems:
  stockouts (lost contribution, production stoppages, emergency
orders)
 high re-order/setup costs
 lost quantity discounts.
The balancing act: Profitability v Liquidity

The balancing act between liquidity and profitability is key to

good inventory management. This could also be considered to be a
trade-off between holding costs and stockout/re-order costs.

Economic order quantity (EOQ)

For businesses that do not use just in time (JIT) inventory

management systems, there is an optimum order quantity for
inventory items, known as the EOQ.

The aim of the EOQ model is to minimise the total cost of holding and
ordering inventory. To do this, it is necessary to balance the relevant
costs.

. The calculation
The EOQ can be more quickly found using a formula:
where:

CO = cost per order

D = annual demand

CH = cost of holding one unit for one year.

Reorder levels

Companies must identify how much inventory to re-order, and when

to re-order. To do this the company needs to identify a level of
inventory which can be reached before an order needs to be placed.
This is known as the reorder level.
Calculating the re-order level (ROL)

When demand and lead time (the time to receive inventory from the
time it is ordered) are known with certainty the ROL may be
calculated exactly, i.e. ROL = demand in the lead time.

Where there is uncertainty, an optimum level of buffer (or safety)

inventory must be carried. This depends on:

 variability of demand
 cost of holding inventory
 cost of stockouts.

In reality, demand will vary from period to period, and the reorder
level (ROL) must allow some buffer (or safety) inventory, the size of
which is a function of maintaining the buffer (which increases as the
levels increase), running out of inventory (which decreases as the
buffer increases) and the probability of the varying demand levels.

Inventory management systems

A number of systems have been developed to simplify the inventory

management process.
  bin systems
 periodic review
 JIT.
Bin systems

A simple visual reminder system for re-ordering is to use a bin system.

Two-bin system

This system utilises two bins, e.g. A and B. Inventory is taken from A
until A is empty. An order for a fixed quantity is placed and, in the
meantime, inventory is used from B. The standard inventory for B is
the expected demand in the lead time (the time between the order
being placed and the inventory arriving), plus some 'buffer' inventory.

When the new order arrives, B is filled up to its standard level and the
rest is placed in A. Inventory is then drawn as required from A,and the
process is repeated.
One-bin system

The same sort of approach is adopted by some firms for a single bin
with a red line within the bin indicating the ROL.

These methods rely on accurate estimates of:

 lead time
 demand in lead time.
Action must therefore be taken if inventory levels:

 fall below a preset minimum

 exceed a preset maximum.
Control levels

Minimum inventory level usually corresponds with buffer inventory.If

inventory falls below that level, emergency action to replenish maybe
required.

Maximum inventory level would represent the normal peak

holding,i.e. buffer inventory plus the re-order quantity. If the
maximum is exceeded, a review of estimated demand in the lead time
is needed.
Periodic review system (constant order cycle system)

Inventory levels are reviewed at fixed intervals, e.g. every four weeks.
The inventory in hand is then made up to a predetermined level,which
takes account of:

 likely demand before the next review

 likely demand during the lead time.

Thus a four-weekly review in a system where the lead time was two
weeks would demand that inventory be made up to the likely
maximum demand for the next six weeks.
Just in Time (JIT) systems

JIT is a series of manufacturing and supply chain techniques that aim

to minimise inventory levels and improve customer service by
manufacturing not only at the exact time customers require, but also in
the exact quantities they need and at competitive prices.

In JIT systems the balancing act is dispensed with. Inventory is

reduced to an absolute minimum or eliminated altogether.

Aims of JIT are:

 a smooth flow of work through the manufacturing plant

 a flexible production process which is responsive to the
customer's requirements
  reduction in capital tied up in inventory.

This involves the elimination of all activities performed that do not

add value = waste.

Examples of waste are:

 raw material inventory

 WIP inventory
 finished goods inventory
 materials handling
 quality problems (rejects and reworks, etc.)
 queues and delays on the shop floor
 long raw material lead times
 long customer lead times
 unnecessary clerical and accounting procedures.

JIT attempts to eliminate waste at every stage of the manufacturing

process. Jit should result in:

 a smooth flow of work through the manufacturing plant

 a flexible production process which is responsive to the
customer's requirements
 reduction in capital tied up in inventory.

A JIT manufacturer looks for a single supplier who can provide high
quality, frequent and reliable deliveries, rather than the lowest price.
In return, the supplier can expect more business under long-term
purchase orders, thus providing greater certainty in forecasting activity
levels. Very often the suppliers will be located close to the
company. Smaller, more frequent deliveries are required at shorter
notice.

JIT therefore has inventory holding costs which are close to zero,
however, inventory ordering costs are high.