May 09, 2005
Today's Inventory Management
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.
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