Inventory Management Review:

In my last article, I discussed some of the many changes inventory management has undergone in recent decades. A major reason this has become possible is because of the software that is currently in place to help firms make decisions. Decision support software (DSS) is capable of instantly analyzing data that once was nearly impossible to analyze without the aid of computers. What does this result in for us as managers? Better decisions.

Take for example the issue of economic order quantity (EOQ). I mentioned in my first article that this is the quantity that should be ordered to keep the combination of holding costs and ordering costs as low as possible. As an inventory manager, if you are not attempting to optimize your EOQ, then you really are not doing your job. The formula for this is:

EOQ = SqRt [(2 * Demand * Ordering Costs) / Holding Costs]

This is simple enough if demand, ordering costs, and holding costs are all constant, but in reality, this is rarely the case. A typical manager needs to account for fluctuations in all of these variables. Demand typically is the variable that fluctuates the most. Unfortunately, even without fluctuations, determining EOQ for an entire firm can be incredibly time consuming. So how is a manager supposed to have time for anything else? Decision support systems are the most viable option.

Today, software packages are available that integrate a company’s DSS needs. So, for the EOQ example, here is what can be performed with the software package. Bill over in marketing can come up with his most recent sales forecasts. Bill then enters the numbers onto the company’s network. The inventory manager now has an updated demand (one of the variables in EOQ). The inventory manager will then determine the ordering costs and the holding costs and enter those into the system. The amount that eventually gets ordered will transfer over to the finance department where Ted over in accounting will be satisfied because he can instantly get the numbers he needs. Overall, the entire firm is transferring essential information all through the firm’s software network.

Software packages today are capable of finding the EOQ using the information entered. In addition to this DSS will take into account additional variables such as how much warehouse space you have, or how much a supplier will allow you to order based on your line of credit and the software will help you make a more advanced decision based on this information. Still, you might be asking yourself whether you want to spend any of your department’s budget on software that solves the EOQ formula. No should be the answer to this, but DSS is capable of much more.

On its own, EOQ is simple. Mix it with the Re-Order Point (ROP) formulas and aggregate planning and it can become very tricky. Take my word for it when I say that advanced DSS is capable of saving you time. Prior to DSS, I had spent countless hours modeling the best results I could attain using nothing but Microsoft Excel. I once spent 60 hours in a week tweaking an aggregate plan to help minimize the projected costs of a project over its entire life. While I eventually built some pretty powerful spreadsheets, they were never as accurate or time-efficient as the software that had already been written by professionals. That same project I had spent 60 hours on, I might only need to spend 5 hours on with DSS. DSS is very powerful software that is essential to any business that wants to compete.

Traditionally, the focus on inventory management has always been about not running out of finished goods. Manufacturers would stockpile excessive amounts of raw materials, work in process, and finished goods with regard not for holding costs but only for protecting against a stock-out. If demand was higher than expected or a supplier missed a shipment, inventory would bail the manager out. As long as outbound shipments were satisfied, so were the operations managers.

Even today, I see this policy in everyday situations. Recently, I came into contact with a mailing room manager whose inventory policy was simple; buy as many supplies as he can fit in the office. As I was eating my lunch, I saw the same policy when I looked into the kitchen – a two-year supply of baked beans. So what’s the problem with this policy? The problem is holding costs and traditionally, because of a lack of technology, most managers have ignored them.

Holding costs can be defined as the annual costs that are incurred by holding onto inventory (includes RM, WIP, and FG). The dollar amount for holding costs typically ranges between 20-40% of annual average inventories. For example, if a firm has average inventories of $100,00, the firm would have an annual holding cost at least $20,000. Common factors that drive up holding costs include opportunity costs, increased rent required for the space of the inventory, higher premiums to insure the inventory, and cost of obsolete goods.

Opportunity costs are frequently the highest cost. For example, if a firm has an average inventory level resulting in $100 million worth of goods, the firm effectively has $100 million tied up in inventory. Assuming these funds are not being loaned to the firm (which immediately results in interest expenses), then these are funds that should be used in other investments.

In the case of the mailing room and the baked beans, perhaps I was over-analyzing the holding costs during my lunch break. After all, even 40% annually for the restaurant’s $300 supply of baked beans doesn’t amount to much. It certainly doesn’t amount to the costs involved to put inventory optimization software into place, but think about the firm in the example. Isn’t it worth a second look at unneeded inventory for a firm with $100 million in inventory? How about if the firm’s inventory decreased substantially in value from day to day? Or a firm whose inventory isn’t as small as baked beans. It is worth a second look and that second look is achieving incredible results.

Using today’s technology, manufacturers and retailers are achieving inventory turns that are as astonishing as the supply chains that produce them. Take for example Dell. Dell has achieved a system that at times leaves them with average inventories for long enough to last only three days. Instead of incurring holding costs, Dell doesn’t order until the demand is in place.

The system Dell has achieved is referred to as a Just In Time (JIT) system. JIT is designed to keep inventories as low as possible by producing only what is needed and when it is needed. The technology involved allows customers to place an order on Dell’s website and receive their computer within days. Dell’s website is connected to their electronic data interchange (EDI) system which allows suppliers to see what parts Dell requires as soon as the customer orders the computer. The suppliers, who make multiple shipments to Dell daily, supply Dell with the parts they need when, and only when, they require them. Although the software is costly, for Dell, and some many other firms, the result is savings that give competitive advantage. However, JIT is an extremely difficult system to set up that requires years of practice and extremely cooperative suppliers to perfect. For many firms, this is not an option. In particular, this system is not designed for products that have a very large backorder cost.

Backorder costs are the costs associated with failing to meet demand. Maybe the product is a commodity and the cost is nothing more than lost revenue, but maybe the backorder results in bad word of mouth that drives the cost even higher than the lost revenue. It is important for a firm to determine the approximate costs tied to backorders. When this is achieved, managers can compare holding costs to backorders in order to help determine what optimal inventory levels are. Unfortunately, backorder costs and holding costs aren’t the only variables involved with optimal inventory levels. Other costs such as ordering costs (costs associated with ordering. Includes paperwork, inventory counts, etc.) , supplier lead times (how long it takes between ordering and receiving materials), and supply lead time and demand variations are also important variables that can’t be ignored. All of these variables can make optimal inventory levels very difficult for managers to determine. Today, software business solutions help to both ease the workload and drive down costs (in particular, ordering costs).

Technology is bringing inventory management to places never though possible. Radio Frequency Identification Tags send out radio waves that allow managers to track inventories without physical counts. EDI orders supplies automatically. Software is capable of producing spreadsheets that perform complex optimizations. Technology is showing us what should be done; managers need to make it happen. Marketing directors need to create accurate forecasts. Relations need to be built with suppliers. Assembly workers need to work at efficient levels. These are the responsibilities of today’s inventory manager.