Inventory Management Review

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.

Choosing your location

Deciding where to put your warehouse, factory, and offices can become complex, but is a crucial step in managing your operations and in helping you cut down your inventory costs. First I will discuss its importance and then the steps involved.

The most important reason for choosing a good location is to cut down on shipping costs. It is essential to minimize both inbound and outbound shipping costs throughout the entire supply chain when determining your ideal location. This reason should be fairly straightforward. Setting up a factory in the same state where the warehouse, distributor and bulk of the sales come from would save a company an incredible amount of money. It is also important to try obtain parts from suppliers that are located in close proximity to your in-house operations.

As far as inventory management is concerned, inbound and outbound logistics can be greatly affected by having a prime location. The reason for this is because of lead times. In a recent article, I discussed the Re-Order Point. A large reason inventory is kept is because of uncertainty in demand. If demand rises above sales forecasts expectations, inventory is in place to help fulfill orders until more parts can arrive. With today’s overnight shipping, this may not seem like a big deal, but a location close to suppliers can help facilitate shorter lead times.

A less objective advantage to consider is regarding whether or not you really want to travel so far every time you have to go to one of the locations involved in your supply chain. Objectively speaking, travel costs can really begin to add up.

In order to figure out your location, it is essential to determine where all of your inbound parts are coming from, and also where all of your outbound goods will be shipped to. You will also need to determine how many of each good you will be shipping or receiving and how much each weighs. Ultimately, you need to take a weighted average of shipping costs per mile and then use the following formula to determine your optimal selection. More specifically you need to treat each mile traveled as a cost per mile and then take the global latitude in which they are traveling from and use it find an average, and then do the same for the longitude.

For example, if you have a supplier that charges $.0010 per mile, per good and is located at a latitude of 40 degrees and a longitude 100 degrees. Assume you also have a distributor and the cost to ship to him is $.0015 per mile per good and the longitude is 10 degrees and the latitude is 80 degrees. Both locations are in the northwest hemispheres. Annually you need to ship out 100,000 units and need to ship in 200,000 units.

Ideally the center of gravity formula results in an ideal longitude of 20.5 degrees N, and ideal latitude of 75.3 degrees W. Because the formulas are a bit more complex than previous ones discussed on the site, I have made an excel spreadsheet covering these formulas with the example solved.

These ideal values are only suggestions. State taxes, state wages, available land, labor, and other resources should also be taken into consideration. The center of gravity should be used specifically as a way to find a location close to where you should be.

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.