Basics of Inventory Control System
by Andres Eduardo Posada Pelaez
November 21, 2019
Managing inventories is a challenge, especially in today’s volatile market.
Andres answers the questions on how to best manage the inventories keeping in mind the present conditions. How to manage the holding cost and the pressures involved in low inventories.
Krishna: Hello everyone! Welcome to this brand new series of podcasts.
My name is Krishna. And Stephen and I from Orderhive are happy to welcome you to our very first episode of the podcast on the basics of inventory management. And we are very lucky to have an industrial engineer and a supply chain management expert, Mr. Andres Posada, who has been in this field 19 years and he has the talent to turn the inventory from a cost center to a profit center with his professional skills in optimizing the supply chain. He has worked with top-notch companies like Pfizer, Johnson and Johnson, Baxter Laboratories, and is right now heading the supply chain management for the Andean region at Boston Scientific.
Welcome, Mr. Andres!
Andres: Thank you very much, Krishna. It is a pleasure to be here with you. I feel very lucky to be with all the people who are listening to us. so as you said today we are going to talk about inventory management and its importance to a company.
Andres: So let’s begin…
Krishna: Ya so let’s just start with the basics and what better start than to start with What is an inventory? so if you could just let us know more about inventory and its standard definitions and how do you perceive it and how do you manage it.
Andres: ok so what is an inventory?
According to the APICS Dictionary Inventory is defined as Those stocks used to support production, such as raw material and work in Process, supporting activities, such as maintenance, repair, and operating supplies, and finally Customer Service in the form of finished goods and spare parts.
According to Krajewski inventory is created when the receipt of materials, parts, or finished goods exceeds their disbursement; it is depleted when their disbursement exceeds their receipt.
Inventory represents one of the most important assets for a company because the turnover represents revenue to the company. In the Balance sheet Inventory is classified as a current asset, and why a current asset? because it is an asset that should be turning fast. become cash really fast.
So it is like what is the importance, you know, of managing the inventory.
Krishna: It is just that I read it somewhere earlier that inventory at times is also considered a liability because of the costings that are involved in keeping the inventory and all that so, how do you basically best manage the inventory. so why is it important to manage the inventory.
Why is it important to manage and control inventories
Planning and controlling inventories in order to meet the objectives of the organization is a key priority to Supply Chain managers in all industries. Effective inventory management is essential in order to realize the full potential of the value chain. The objective is not to bring inventories close to zero to reduce cost or to have excess so as to ensure 100% availability, but to have the right amount that will help the company achieve its goals in the most efficient way.
Inventories affect everyday operations of an organization because they must be counted, paid for, stored, delivered and managed. Inventories require an investment, just as a machine or a marketing campaign would. Money invested in inventory is money that cannot be used in other things, thus representing a drain in the cash flow of a company in the form of working capital. Despite this companies need inventories to operate, and having the right products available at the right time in the right quantities to meet customer requirements is key to meeting the company’s objectives. This is why inventory management and control becomes essential to the organization.
Stephen: So Hi Andres! this is Stephen here. (Hi Steve! can I call you Steve?) Ya, you can! I would love it. As you mentioned that it is very essential to balance the inventories at all points. so, can you like, brief us about what kinds of pressures are involved when it comes to inventory management and control?
What are the pressures for low inventories?
As inventory managers, it is our responsibility to find the right balance between the tradeoffs of having high and low inventories. The main reason why we want to keep low inventories is that they represent an investment of money, as mentioned earlier. In this regard, it represents an opportunity cost, also known as the cost of capital; in other words, the money used for inventories could be invested for other purposes. By having inventory, the company also incurs in other costs such as storage and handling costs, taxes, insurance, and Shrinkages. The sum of all these costs is also known as inventory holding cost and varies with the inventory levels.
Let’s go a little bit deeper into the components of Holding Cost.
Cost of Capital: It is the opportunity cost of investing in an asset relative to the expected return on assets of similar risk. As mentioned before inventory is an asset, and as such, the company should use a measure that adequately reflects its approach to financing assets. The most common measure is the Weighted Average Cost of Capital or WACC. The WACC is the average of the required return on a firm’s stock equity and the interest rate on its debt, weighted by the proportion of equity and debt in its portfolio. The cost of capital often is the largest component of the holding cost. Companies usually update the WACC every year.
Storage and Handling Costs. Inventory takes up space, and it must be picked, packed and moved into and out of the storage facility and this does not come for free. If the company rents space or outsources through a 3PL, storage and handling costs will be incurred. If the company owns the space, labor needs to be hired, and the space used in inventory could be sued for other purposes.
Taxes and Insurance. The more inventory at year-end a company has the more taxes it has to pay, the same occurs with insurance the higher the inventory value the higher the insurance cost. Insurance protects the company against natural or manmade disasters.
Shrinkages: they present in three forms:
- Obsolescence: when inventory cannot be used or sold at its full value, this happens when a new model is launched, a new season comes in, demand drops, etc
- Deterioration: Happens when products reach the end of their shelf life (Pharmaceutical products, foods, and beverages, medical devices) when damages result from the shipping and handling process.
These shrinkages affect directly the margins of the company by deteriorating them, and increase as inventory levels increase.
Stephen: Ok like that was very well said. Keeping in mind the Holding cost and the pressure for keeping low inventory levels, can you give us some reasons like how to keep high inventories. What exactly are the reasons to keep high inventories?
We talked about Holding costs and the pressure for keeping low inventory levels, now let’s mention some of the reasons to keep high inventories.
Customer Service. Inventories can speed up delivery and reduce the probability of stockouts and backorders. A stockout happens when an item is not available to satisfy demand and a lost sale occurs. On the other and a backorder is a customer order that cannot be filled at the time it is demanded but it is filled later. Customers usually are not willing to wait, this is when a BO turns into a stockout.
Ordering Cost. Each time a company places a new purchasing or manufacturing order it incurs an ordering cost. This includes all the activities needed to prepare the order, it does not depend on the size of the order. Many companies are streamlining this cost with technology, now there are options like automatic replenishment, e-orders, blockchain platforms, etc.
Setup Costs. It is the cost of preparing a machine to manufacture a different item. It includes labor and time needed for this changeover and the scrap generated at the start of the production run. As the ordering cost, it does not depend on the size of the order, therefore it is optimized by using larger production runs and building up inventory.
Labor and Equipment utilization. By producing more inventory, the company can increase productivity. Setup costs are reduced, rescheduling is reduced, and helps the company stabilize output rates when demand is seasonal, this is, during slack periods the company builds up inventory getting ready for peak season.
Transportation Cost. Bigger loads help optimize freight costs, also by having inventory on hand the probability of having to use more expensive transportation modes to expedite delivery is reduced.
Economies of scale or Quantity Discounts. This happens when the unit price drops as the order quantity gets larger.
Last but not least, in the healthcare industry, one unit of product can make the difference for a patient.
Having talked about this, it is then the responsibility of Managers to manage the tradeoffs between higher and lower inventory levels and come up with alternatives that will streamline both financial KPIs and customer service.
Stephen: so, as you mentioned all these points, after that like what exactly are the types of inventory? We came to know why high inventories are kept, what exactly are the types of inventories that the retailers are using these days.
What are the types of inventory?
Andres: Inventories can be classified by how they are created. Cycle Stock, Safety Stock, anticipation stock and Pipeline stock. Even though physically they are all the same, they are all created in entirely different ways:
Cycle Stock. it varies directly with the lot size. The quantity varies with the elapsed time between orders, the longer the time, the larger the cycle stock. For example, if you order every two weeks, your cycle stock will be equivalent to two weeks’ demand.
Safety Stock. safety stock is used to avoid customer service problems and the cost associated with this. It protects against uncertainties in demand, in lead time and supply variations. The higher the service level you want to provide the higher the safety stock will be. In the same way, the higher the lead time and the higher the demand variations are, the higher the safety stock will be.
Anticipation Stock. It is inventory used to absorb uneven demand rates. Some company that has a predictable seasonal demand, build up inventory during low demand periods so that when high demand periods come production rate is not affected and face possible capacity issues.
Pipeline Stock. It is the inventory that is constantly moving from one point into another in the supply chain. It consists of the orders that have been placed but have not been received yet.
Krishna: What are some basic inventory Reduction strategies?
Andres: For starters a strong S&OP process could help the company reduce inventory levels, increase visibility, speed up decision making, increasing service levels, reduce total cost to serve and streamline margins. Making sure that demand and supply are in balance begins with S&OP. In a later podcast, we will have a deep dive into the S&OP Process.
Cycle Stock, for example, can be reduced simply by increasing the order frequency, thus reducing the lot size. However, in manufacturing, this would come at the expense of higher setup costs. for this reason, it is important to streamline also setup process. One way, for example, is the use of group technology, which as defined in the APICS dictionary, is a manufacturing and engineering philosophy that identifies the physical similarities of parts and establishes their effective production.
Safety Stock can be reduced by improving demand forecasts which in turn can be achieved by working closely with customers and understanding better demand at the point of sale, in the future forecast we will have a deep dive into demand planning and collaborative forecasting planning and replenishment.
Safety stock can also be reduced by reducing lead times of purchased and manufactured products. This can be achieved first by working closely with vendors and sharing information such as expected future demand and production schedules, Also by having reliably transportation partners. These improvement strategies will also impact the pipeline inventory.
Anticipation inventory can be reduced simply by matching the production rate to the demand, however, this could come at the risk of running out of capacity during high demand periods, extra costs such as overtime, night shifts, among others. A more strategic approach could be to add products with different seasonality patterns so that peak demand for one product compensates for a low season of the other.