Inventory Management Review

Dell Computers: A Case Study in Low Inventory

When managers discuss low inventory levels, Dell is invariably discussed. Hell, even I've mentioned Dell on this site. So why all the commotion? Has their low inventory REALLY helped out that much? In short, yes. This article is primarily going to discuss how much it helped. This article will not discuss how they achieved such high inventory turns using a state of the art just in time inventory system.

Reasoning behind need for lower inventory

The first thing that needs to be discussed is why low inventory has such a great effect on Dell's overall performance. The reason is quite simple: computers depreciate at a very high rate. Sitting in inventory, a computer loses a ton of value. 

As Dell's CEO, Kevin Rollins, put it in an interview with Fast Company: 

"The longer you keep it the faster it deteriorates -- you can literally see the stuff rot," he says. "Because of their short product lifecycles, computer components depreciate anywhere from a half to a full point a week. Cutting inventory is not just a nice thing to do. It's a financial imperative." 

We're going to assume that the depreciation is a full point per week (1%/week) and use that to determine how much money high inventory turns can save Dell. 

This means that for every 7 days a computer sits in Dell's warehouses, the computer loses 1% of its value. Ok, now that we know how much Dell loses for each day, let's take a look at some of Dell's data over the past 10 years that I pulled from www.themanufacturer.com 

What I got from this was the inventory turns. An inventory turn, as this website successfully describes it, is "cost of goods sold from the income statement divided by value of inventory from the balance sheet". Typically, this is turned into a value showing how many days worth of inventory a firm has by dividing inventory turnover by 365. I divided the inventory turnover by 52 in order to show how many weeks worth of inventory Dell holds. 

Here are the results:

Dell’s Inventory Turnover Data 

Year      Inventory Turnover         Week's Inventory

1992      4.79                                10.856
1993      5.16                                10.078
1994      9.4                                  5.532
1995      9.8                                  5.306
1996      24.2                                2.149
1997      41.7                                1.247
1998      52.40                               0.992
1999      52.40                               0.992
2000      51.4                                1.012
2001      63.50                              .819 

Key point to notice here is that Dell was carrying over 10 weeks worth of inventory in 1993. By 2001, Dell was carrying less than 1 week's worth of inventory. This essentially means that inventory used to sit around for 11 weeks and now it sits around for less than 1 week.

So what does this mean for Dell?

Remember, computers lose 1 percent of their value per week. This isn't like the canned food industry where managers can let their supplies sit around for months before anyone bats an eye. Computers aren’t canned goods, and as Kevin Rollins of Dell put it, computers “rot”. The longer a computer sits around, the less it is worth. 

That said, due to depreciation alone, in 1993 Dell was losing roughly 10% per computer just by allowing computers to sit around before they were sold. In 2001, Dell was losing less than a percent. Based on holding costs alone, Dell reduced costs by nearly 9%. 

Since 2001, Dell has continueed to lower inventory. Looking at their latest annual reports, day's inventory has dropped by approximately a day. 

Hopefully this article provided you with a practical example that demonstrates the positive effects lower inventory can have on a firm's overall costs. For more information regarding lawyers in the Texas area, check out Dallas Fort Worth trucking accident attorney. For more basic information regarding holding costs, please read A Simplified Look at the Pros and Cons of Inventory.

Inventory Holding Costs Quantified

I have been receiving a lot of inquiries regarding the specifics of calculating holding costs. By and large, you can read about what drives holding costs in my article A Simplified Look at the Pros and Cons of Inventory. This article is intended to provide greater detail regarding the quantification of holding costs. The first section is going to discuss rough estimates and the second section will discuss methods involved with detailed holding cost analysis.

Rough Estimatations

Typically, holding costs are estimated to cost approximately 15-35% of the material's actual value per year. The primary factors that drive this up include additional rent needed, great insurance premiums to protect inventory,opportunity costs, and the cost of capital to finance inventory.

A More Detailed Look at Holding Costs

First of all, it is generally best to think of holding costs in terms of  their annual costs. To do this, you will need accurate representations of your annual inventory levels. My previous article, Average Inventory Levels, details this step by step. Personally, I suggest tracking inventory month by month and using these values to find the average holding cost as opposed to taking the year's beginning, the year's end and averaging the two.

So now you have your average inventory. This needs to be performed for finished goods, work in process, and raw materials inventory.

Now, you need to figure out what percentage of the total value of the good is being incurred as a holding cost. Cost of capital and opportunity costs should be the first things you think of. If you are financing the goods with a 10%/year loan then the holding costs are at least 10% annually. When you are evaluating the total value, include the value of any labor that has been added to the goods.

Next step would be to consider the cost of storage. Based on the inventory you need to carry, how much space do you need and how much does that space cost per unit as a percentage of each good.

Again, determine the insurance cost that should be allocated to each good as a percentage of that good.

Evaluate the probability that a good will rot, or otherwise become obsolete and assess the average rate at which this occurs and use this to quantify the average holding cost per good as a percentage of that good on an annual basis.

Determine if there are any other costs you can think of that are incurred simply by being in possession of a good. If you can think of any, treat them as holding costs.

Add up all of these percentages and together they make your holding costs.

Average Inventory Levels

I have recently received a lot of inquiries regarding average inventory levels so I thought I would devote and article regarding how to find them. The first half of this article covers how to find what inventory levels should be, and the second half covers what they have been in the past.

Part I: How to Optimize Average Inventory Levels

This section is mainly here to provide a brief description for how optimal inventory levels for materials are kept assuming the company is a textbook example with no strange variables. Essentially, this section can serve as a starting point for inventory managers. 

First thing you need to determine the ideal inventory levels is a material's Economic Order Quantity (EOQ). This is the amount you should be ordering when you place orders.

Next you need to determine your Safety Stock (SS). This is the amount that you should have remaining when the EOQ arrives. 

Basically, safety stock is the average bare minimum you will have at any give time, and EOQ+SS is the average maximum amount you will have at any given point in time. This should be intuitive because safety is what you have when your shipment arrives and when the order arrives (EOQ) it gets added to the safety stock. 

I say average minimum and maximum because you might not receive the EOQ exactly when you planned to and therefore may have more or less. On average you should have the SS amount when you receive shipments. Between these two average minimum and maximum values lies your long-term average inventory. 

The formula for this is:

Optimal Average Inventory=(EOQ+SS+SS)/2 

This is for materials. For finished goods, you should aim to keep an inventory level designed to prevent a stock out. This level would be a safety stock of finished goods, thus making the ideal average inventory for finished the safety stock value based on your company's service level. 

Part II: How to Assess Inventory Levels 

Simplistic Method - Historical Inventory Levels

Most methods of accounting take the beginning inventory of a period, add it to the ending inventory of a period, and divide by 2. This essentially provides the mathematical average for a given month. 

For example, if your inventory level for a good is 2000 on July 1st, you produce 3000 units and sell 1000 units by July 31st. This leaves you with 4000 units. The formula is: 

Avg. Inventory = (Beginning Inventory+(Beginning Inventory+Units Produced-Units Sold))/2 

Avg. Inventory = (2000+(2000+3000-1000))/2 = 3000 

Or more simply:

Avg. Inventory = (Beginning Inventory+Ending Inventory)/2 

Avg. Inventory=(2000+4000)/2=3000 

So this covers historical looks using an accounting approach. A lot of firms use this method to evaluate their average inventory levels. Personally, I have a problem with this method which I believe the following example will help to illustrate: 

Daily Weighted Average Inventory Approach

Suppose you start with 10,000 units on May 1st. Also suppose you produce 10,000 units in that month spread out across 21 business days. Now (and this is the important part) suppose you sold 20,000 units in May. This brings the ending inventory to 0. Using accounting methods, the formula gives us 10,000 as the average inventory. 

So why is this so bad? In short, because the average inventory is not 10,000 units. In fact, there were only two days in which 10,000 units or less were held and these days were May 1st (10,000 units) and May 31st (0 Units). Assuming that production was level through the 21 day working month, this means that 500 units were produced daily, thus raising inventory by 500 units a day until inventory was dropped by 20,000 on the 31st. Here is what the inventory levels look like in the month of May (each record represents the end of 1 working day in a 21 day work month). 

1) 10,500
2) 11,000
3) 11,500
4) 12,000
5) 12,500
6) 13,000
7) 13,500
8) 14,000
9) 14,500
10) 15,000
11) 15,500
12) 16,000
13) 16,500
14) 17,000
15) 17,500
16) 18,000
17) 18,500
18) 19,000
19) 19,500
20) 0
Average=14048 

Clearly, this method of average inventory provides much different average inventory values than accounting procedures. It gives each day of the month an equal weight as opposed to giving the first and the last day of the month 50% weight each which I believe to provide more accurate results.

My example may seem a bit extreme, but consider a company who produces large runs of goods for another company and agrees to hold onto their inventory delivering once a month. In this case the supplier could start and end with 0 units each month end ship it all off, ending with 0 units each month making the average finished goods inventory 0. Their average inventory sure as hell isn't 0. They are higher, and they may be much higher. For this reason, it is very important to carefully choose how you assess your average inventory levels.

Why are inventory levels so important?

To put it simply, average inventory levels are important because they allow you to determine how much money you have tied up in inventory and how much value your inventory assets hold. Helping to determine what they should be can help cut back on unneeded inventory, and knowing what they are can help you determine average warehouse usage, inventory risk, percentage of assets that are made up inventory, holding costs, etc. To review information regarding high and low inventory levels, refer to my previous article, The Pros and Cons of Inventory.

Questions from an IMR Reader

This is a post answering some well thought questions posed by IMR reader Jack Vinson regarding a previous post of mine, What to do About Seasonality.  Jack Vinson's questions and comments are quoted in bold text.

"How accurate are these forecasts?"

Jack,
First of all, the degree of accuracy of forecasts can vary.  Essentially, the more accurate the forecasts are, the fewer inventory you can get away with holding.  A major reason that inventory needs to be held is because of such uncertainty in demand.

Inventory is essentially a safety net against varying degrees of stock out probabilities.  In other words, there is always a chance that you COULD run out.  Let's say you have a demand forecast that looks to be about an average of 100 units a day with a standard deviation of 10 units.  So, if you want, you could produce 100 a day, but on the days when the demand deviates above 100 units, you'll run out and get back on track when you have a day under 100.

Inventory provides you with additional protection against a stock out even on those days when you deviate in the positive direction.  Depending on how safe you want to be, you could hold more or less inventory, but even if you hold 10,000 units, remember that there is always some percentage, even if it is very small that you could have a REALLY big day and sell out. (Another option is to keep capacity slack in order to fulfill big days).

How far into the future are these forecasts accurate?

Demand forecasts can constantly change.  For example, perhaps you sell parts required for hybrid cars.  Your demand projections may be set at 1,000 units a day with a standard deviation of 200 units, but if gas prices soar to $8 a gallon, you can appreciate that your demand would be likely to increase. This increase in demand could be long term and the forecasts resulting from it may be very inaccurate for months to come.  As I hope I have demonstrated, demand can change very quickly.

How much work goes into putting them [forecasts] together?

Typically, a lot.  I won't go into details, but there are a ton of variables that go into demand forecasts and this is something a marketing specialist would be more equipped to help you with.  Based on my limited work with deriving a demand, I can tel you that it can be very difficult.
However, if you're lucky and demand has been steady for a long period of time and looks to be staying steady, it can be fairly simple if decent demand records have been kept.

"Let's look at the opposite end of the spectrum.  In what situations would it be possible to manage without a detailed forecast?"

In response to your next set of questions, my answer is that without a detailed demand forecast, proper inventory levels cannot be accurately set.  If you have no clue what your demand is going to be, one of three situations will befall your firm:

1) You under produce and are left with a large backorder log/lost business to competitors/both.

2) You overproduce and are left with more inventory than you know what to do with.  Hopefully the holding costs are low and even more hopefully, your product won't become obsolete before you can sell it all.

3)  You get lucky and you produce exactly what you need when you need it.  Without a detailed forecast, luck is exactly what you are going to need in order to achieve this.

"What operational policies would need to be in place?"

The operational policies without a detailed forecast would likely be driven by the holding costs and the backorder costs.  If you have low holding costs, and high backorder costs than it makes sense to overproduce.  Worse case scenario you hold onto extra inventory.  This might be considered a small price to pay to prevent the potential loss of business from the backorders.  Also, if your company has a guaranteed on-time delivery clause with whom you supply units to, backorders may be a very costly option.

If however, backorders result in a minimal cost and holding costs are through the roof, then under producing is likely a better option.

"The goal, of course is to ensure the right products are in the right place at the right time."

You are right, this is the "goal"  However, there are certainly exceptions to this.  I believe I have explained why, but just to reiterate, sometimes the only way to ensure that the products can be delivered at the right time is to over produce, providing your firm a safety net of inventory.  In the event that holding costs (which would be incurred in the event that demand is LESS than you project it to be) are very high, it is much wiser to run the risk of under producing.  Yes, this will have a backorder cost.  This cost needs to be compared to the holding costs and a decision needs to be made, in respect to other company policies, regarding whether or not the risk of over producing, or under producing should be made.

I hope that answers your questions, Jack, and thanks for reading.

A Subjective Look at Order Quantities

For the most part, this site focuses on mathematical optimization techniques and descriptions of optimization techniques. This article is intended to give a brief introduction of other factors to consider when managing inventory levels.

In a previous article, I detailed the economic order quantity (EOQ), which is the mathematically "perfect" amount of inventory to order designed to minimize holding costs and ordering costs based on a given demand. Generally speaking, this is a very good level to order. Now I am going to provide potential reasons why perhaps it might be a good idea to order a different amount: 

EOQ is too large

For whatever reason, your holding costs are very low for a particular item and you simply do not want to hold that much inventory. Maybe you don’t even have enough space for it. In some cases the EOQ may necessitate an increase in warehouse space which will drive up fixed costs to an undesirable level. 

A large economic order quantity may result in inventory levels that carry too much risk. Computer companies such as Dell or Apple have a particular level of concern regarding obsolescence risk. Ordering a year's worth of processors may prove to be a poor decision in the event that a better processor is released three months after the shipment arrives. The fashion industry is also at great risk for obsolescence. 

Other firms may be more concerned about damage to large levels of inventory in the event of theft, fire, or other natural disasters. The less inventory you have on hand, the less than can be destroyed while you are responsible for it. 

EOQ is too small

Potentially, you may feel that the EOQ is too low for a number of possible reasons. Perhaps you fear a rise in the cost of your raw materials and a futures contract isn't appropriate for your situation. You may decide that the additional holding costs incurred by ordering a large quantity are less than the raise in price your supplier could soon be charging you. 

Perhaps you just don't want to bother with the EOQ. One firm I worked with had so much excessive space and was ordering materials that were so inexpensive compared to the rest of their operations that it wasn't even worth a second thought in trying to determine how many suppliers to order. They decided it was worth their while to just order as many as they thought they could reasonable expect to eventually use up.

  I generally don't recommend this method for firms with large inventory expenses, but if inventory is a very small part of an overall operation, maybe it's not worth the hassle to try and optimize.

Prefer to use multiple suppliers

Many firms feel more comfortable when they order from multiple suppliers, which can have many advantages. Two that come to mind right away are potential price and quality leveraging advantages and reliability insurance. Having multiple suppliers provides the opportunity to keep suppliers fighting to give you the best quality at the best price in fear that they may lose your business. Multiple suppliers also allow reliability because one supplier's inability to fill your order can be another supplier's opportunity to gain business. 

Unfortunately, if you do decide to receive shipments from multiple suppliers, you may lose out on quantity discounts and you may be forced to spend more time ordering. In an ideal situation you could switch off between the suppliers and order from two or more with the frequency in which you would order from just one. Regardless of increased ordering, utilizing multiple suppliers does bring up questions regarding the strict following of EOQ which should be evaluated prior to switching to or from multiple suppliers. 

What I have just listed is a partial list of reasons that could be taken into consideration with evaluating EOQ at your firm. This article is intended as a reminder that there are more variables to order quantities than merely holding costs, ordering costs, and demand. This is not to say that the EOQ formula is worthless, but rather that while it is an important part of managing inventory, it should not be followed blindly. Like all aspects of inventory management, remember to look at the inventory policy in conjunction to the rest of your firm’s policies.

A Simplified Look at the Pros and Cons of Inventory

I'm selling it sooner or later anyway, aren't I?

I spend so much time working with inventory that I often forget how confusing it can be to beginners. The most common mistake, and the one I made when I first started learning about inventory, is that it shouldn't matter how much you have because you're going to sell it sooner or later anyway. In a sense, this is true. Even if you turn your inventory over once every 3 years, you are selling all of it and the inventory helps to prevent stock outs and backorders. However, there are some serious costs to holding inventory. 

Anytime inventory is held, there are holding costs. Holding costs are simply the costs that are incurred just by holding onto inventory. These costs can come from a variety of sources. Here are just a few common costs associated with high levels of inventory: 

Higher rent from increased need for extra warehouse space to hold extra inventory. 

Higher premiums needed to insure extra inventory. 

Potentially, the inventory could spoil, expire, or become outdated and lose value. 

Oppurtunity costs. What else could you have invested the money and warehouse space in had you not been spending it on inventory? 

Remember, companies have a limited amount of assets available to them. These assets are aquired from money raised through equity and debt. Excessive inventory is a misuse of these assets because it essentially an investment in something that is just going to sit around. 

So why hold inventory?

The simple answer is that inventory is held in order to fill unexpected changes in demand and deliveries from suppliers. If there were never any changes in demand and if suppliers could constantly deliver supplies in the quantities needed, then there would be no need for inventories (excluding work in process inventories and negligible day's end inventories waiting for outbound shipping). 

However, demand does fluctuate, as do lead times from suppliers. Because demand fluctuates companies are not sure how much of a certain good to produce on a given day. Companies can make predictions, but the fact of the matter is, predictions typically only give a rough estimate of what will be needed on any particular day. One solution to this problem is to maintain a workforce with a very high unutilized capacity and to simply not use it most of the time, but to have it available in the event of a day with high demand. The other solution is to carry inventory. 

Inventory is a way or preserving excess capacity. On the days when demand was light, the workforce overproduced. Their work was stored as inventory and now if there is a day with very high demand that is beyond the capacity of the workforce, the inventory is there as a safety net against backorders. 

So why not hold loads and loads of inventory?

Well, don't forget about those damn holding costs. 

So why not maintain a workforce with a ton of slack capacity?

As much as the work staff would enjoy this, you can imagine this would be very expensive to maintain.
(On a side note, this is essentially what service sectors of the economy have to do. I remember I worked as a hotel valet when I was younger and there would be plenty of times when it would be so dead I wouldn't park a car for hours. But when it got busy, boy would it get busy. You can't inventory services and the ramifications of a stock out (in this case that would mean that there is no one to get your car) are too costly to deal with in many service positions.) 

So how much inventory should I hold?

This is subject to a wide variety of conditions. Simply put, you need to evaluate your holding costs, your backorder costs, and your demand. From there, it gets pretty tricky and I unfortunately already named this article "A Simplified Look at the Pros and Cons of Inventory" so as much as I'd like to help you, my hands are tied...what with the tiltle already being up and all.  Luckily some of my previous posts deal with some of the mathematics involved in determining some facets of optimized inventory levels.