Inventory Management

This presentation covers Inventory Management. It explains why inventory

optimisation is beneficial; shows how inventory models can be used to influence the
amount of stock held, and describes an approach to running an inventory
management project.
On completion of this module, the reader is expected to understand the general
principles of the subject and have an appreciation of its terminology and issues.
Most organisations who wish to improve their supply chains will at some point turn
their attention to inventory. If you dont have enough of it, it will be difficult to
maintain service levels. However, if you have more than you need, it costs money
and risks adding complication to the business.
During this module, we will discuss the way in which inventory impacts the
businesss finances; the models of inventory that allow you to change its level, and
the approach that you might take to try and optimise a businesss inventory.
Throughout this presentation we will be using the words inventory and stock
interchangeably as seems to be the case in most global businesses.
1. Why reduce inventory?

Before we enter the technical discussion of how to reduce or at least optimise

inventory, lets look at why we would want to do that.
Your first instinct might be to think of inventory as a good thing. We all like shopping
in stores that are well stocked and able to supply goods immediately, so why should
a business customer be any different.
There are at least four reasons why this first instinct is wrong, as this page shows.
Lets go through them one by one.
Firstly, and perhaps most importantly, inventory ties up cash in the form of
working capital. If you have $1m tied up in stock, thats $1m that cannot be
in the bank earning interest and cannot be used to pay for materials and
other business expenses.

Secondly, inventory ties up space. Although its often difficult to attribute a

direct cost to space in an existing factory or warehouse, it becomes very real
if your inventory accumulates to a point where you need to start renting offsite space to store it.
Thirdly, most inventory has a shelf life. Thats obvious for things like
foodstuffs, but even spare parts for aeroplanes can become obsolete if the
planes design is updated, or it reaches the end of its useful life.
The final reason is a little less direct. A company that holds too much
inventory is often inefficient. It takes longer to find the part you need,
because you have to search through more junk; theres a greater risk of
things getting lost both physically and on systems records; and the fact that
the business hasnt sorted out its inventory is probably symptomatic of other
areas of disorganisation.
At the end of the day, inventory optimisation is about a trade off between these
factors and the ability to maintain service levels; and that trade-off will be different
for each organisation. If you run a book-shop whose unique selling point is to have
even the most obscure title available on the shelf, you will accept a higher level of
inventory than most.
2. The financial benefit of reduced inventory

As mentioned in the previous point, the most compelling reason to reduce inventory
is often the directly financial one, avoiding your funds being tied-up unnecessarily.
Before we get into detail, let us clarify one thing that people often get wrong. If you
reduce you inventory by $1m in a given year, your profit in that year is not
increased by $1m, only by the cost of servicing that working capital. Let us explain.
Imagine you have a house worth $1m (wouldnt that be nice), and you have a
mortgage on that house at an interest rate of 5% per annum.
If you sell the house, you are not instantly $1m better off, because you need to
repay the mortgage with the money you make. You will however be $50k per year
better-off because you will no longer have to pay the interest.
For those who know a little more about business

Now relate that back to a businesss inventory. You reduce inventory by $1m, but
your annual profit only increases by the amount of interest that you would have
paid on that capital.
Actually its a little more complex than that. When a business is making financial
decisions, it will use a cost-of-capital percentage which is typically higher than
normal bank interest rates. This is because it should judge any investment not only
against the cost of borrowing money, but also against all the more profitable uses to
which that money might be put. Dont get too hung up on this, but recognise that
cost of capital is typically higher than base interest rate.
Lets say that our example business has a cost-of-capital judged at 8%.
Now lets look at the impact on each of its main financial statements, of reducing
inventory by $1m.
The Profit and Loss account shows an annual improvement of $80k. As we have just
explained this is effectively the impact of not paying interest on the cash that you
previously had tied up in stock.
The balance sheet can be affected in one of two ways. If you reduce your inventory
and keep or re-spend the resulting cash, the balance sheet value does not change;
youve simply swapped one type of asset for another. If you use the funds to repay
a loan, the balance sheet value will drop as youve reduced both your assets and
your related liabilities.
The cash flow statement is the only one that is directly impacted by the full $1m. By
reducing the inventory you make available $1m of cash that flows into the business
as a one-off benefit.
Irrespective of all these complexities, reducing inventory is clearly financially
beneficial, and thats why it is often at the top of a businesss priorities.
3. The Nature of Stock Finished goods-01

So why does a business hold the level of inventory that it does?

Inventory covers anything from raw materials, through work-in-progress, to
finished goods, but for the time being, lets just look at finished goods and
consider five different reasons why this finished goods stock may exist. These
arent in any particular order.

Some businesses need to mature their stock before it can be used.

Think about cheese or vintage wine. A drug manufacturer may produce
a batch of tablets and discover in testing that a vitamin level is too
high. Rather than scrap the batch, they may me able to hold it in stock
until the level naturally depletes.
Pipeline stock is held to offset the time it would take to get hold of
replacement goods. A business selling goods made in Fareast in the US
market will hold more stock than if those goods were made locally.
Safety stock is held as a guard against two risks.
One that goods may sell more quickly than expected and
The other that manufacture or delivery of replacement goods
may be delayed.
Cycle stock is what you hold if you make or buy goods in bulk and then
sell them gradually. If you sell 100 items per week and make a batch of
100 once every week, you will have an average of 50 on stock at any
one time.
Finally, seasonal or strategic stock is held to anticipate shortages in
capacity. If you make seasonal gifts, you do not size your
manufacturing plant to cater for peak sales. You size it for average
sales, and make goods in the quiet sales periods that are held in stock
waiting for the busy periods.
If you wish to reduce inventory, you should first understand what proportions
of your current stock are held for each of these reasons, and then take action
to reduce one or all of them.
4. Nature of stock - finished goods-02

c
Now lets look at how the inventory level of a particular manufactured item varies
over time.
The first thing to note is that you are unlikely to always have the same level of
inventory, so its often sensible to talk about average levels rather than levels at a
point in time.
Many manufactured items are made in batches so, for example you may sell 10 per
day but choose to make a batch of 140 on one day every two weeks. The result is
the type of saw tooth pattern that you see on this page, where the inventory level
jumps up when a batch is produced, and then declines gradually as the goods are
sold.

The simplified aim in this example is to reach a point where you have zero units left
in stock at the point that you make the next batch, so you start the period with 140
and then sell 10 per day for fourteen days until you have none left.
In reality, there are two reasons why you need to hold a bit of extra inventory, over
and above this basic saw tooth pattern.
The first is to guard against unexpected things like selling more than the average 10
per day, or something going wrong during the production batch. In case these
happen, you hold whats referred to as Safety Stock. This starts to get consumed if
sales increase or production is late. The amount of safety stock you hold varies
depending on how much of a disaster it would be to run out of stock.
The other reason for holding more inventory, is to cater for the amount of time the
goods spend in transit. If your factory is a long way from your retail store, you will
have to hold inventory that has been produced, but is not yet ready for sale,
because its not yet reached the store.
This is the concept of pipeline stock.

5. The Nature of Stock Pipeline stock

Pipeline stock refers to any inventory which is on its way to the point at which it can
be sold, but has not yet reached that point.
As well as goods which are actually on the move, this could include goods that are
waiting for customs clearance at a port, or are in a loading bay waiting to go on a
truck.
6. How inventory is expressed

When we talk about reducing inventory, we should be careful to talk in ratios

rather than absolute cash values. It can be a mistake to talk about reducing
inventory by $1m if your business is growing because all other things being
equal inventory value will tend to increase as the businesss revenue grows.
A perfectly acceptable target may be just to maintain inventory at its current
value instead of allowing it to grow.
To really understand how a businesss inventory position has changed, it
should be expressed in terms of the businesss annual revenue, and this can
be done in one of two ways as shown below.
Stock cover says how many days worth of sales could I cover with
my current inventory. This is commonly used in retail businesses as it
helps them understand how long they could carry on trading if they
didnt receive any fresh deliveries. In an efficient supply chain, the
stock cover should be kelp low perhaps in the order of 10 days for a
retail warehouse.
Stock turns is just a different way of expressing the ratio. It says how
many times will I sell the value of my inventory in a year, and is more
commonly used in manufacturing businesses. In an efficient supply
chain, the stock turns should be kept high perhaps in the order of 30
turns per year for a company making consumer packaged goods.
If you set an inventory target expressed in stock cover or stock turns, the
target should be equally achievable whether annual revenue grows, declines
or stays constant.
7. Understanding trade-offs The stock service trade off

Lets now go back to the important subject of safety stock, and the decision about
how much of it to hold.
As this shown, the calculation depends on a trade-off between the cost that would
be incurred if you ran out referred to as the costs of lost sales or COLS; and the
cost of holding excess stock referred to as the cost of stock or COS.
If you dont need to provide a very reliable service, the cost of lost sales is low so
its not worth incurring the cost of holding additional stock.
If however your target service level is high, the cost of lost sales must be significant
and it can therefore be worth holding additional stock despite the cost.
Lets clarify what we mean by the cost of lost sales and cost of stock.
Firstly, the cost of lost sales is often more than just the revenue that you lost by
missing a sale. It could include loss of reputation, permanent loss of business from
dissatisfied customers or worse. Imagine the consequence if a pharmaceutical
manufacturer runs out of a life-saving drug.
Equally, the cost of stock is (as we have previously discussed) more than just the
cost of storage space. It also includes the working capital tie up in inventory and the
risk of obsolescence or shelf-life issues.
At the end of the day, the decision about how much safety stock to hold is very
subjective. It depends highly on the circumstance of the business or the individual
product.

8. The Nature of Stock The need for safety stock

Weve already said that the need to hold safety stock is to overcome uncertainty.
Uncertainty in production success, sales levels or the timing of the next production
run. So how can safety stock be reduced, other than by accepting a lower service
level. Here are a few options:

If theres a risk about the reliability of production, work to increase that

reliability and improve productions conformance to plan. If you intend to
make 140 items every two weeks (as per our old example), understand why
this does not always happen and seek to redress those issues. Maybe its
because a bit of production machinery is not properly serviced and has a
tendency to break down; or maybe its because you have an unreliable rawmaterial supplier who could be replaced.
If sales often exceed forecast, perhaps the forecasting processes are at fault.
The better your understanding of expected sales, the less the chance of
running out of goods. Forecasts can be made better if they are revised more
frequently and if they are agreed between all parties in the supply chain. This
subject features in the next module of this training course, on supply chain
planning.
The next approach to minimising safety stock is to increase production
frequency. The more often you plan to produce goods, the shorter the period
during which unexpected events can take place. If sales are running higher
than expected and you risk running out of goods, its better to wait only one
week for the next production run that to wait two weeks.
Finally, uncertainty can be reduced by fixed cycle scheduling. If you are
unsure when you will next have the opportunity to make a particular product,
you must hold enough safety stock to last. By being certain about production
timing, you can reduce this uncertainty and hold less safety stock.
Theres something of a chicken-and-egg relationship between stable planning
and safety stock levels. If you hold too much safety stock there will be a
tendency to allow production plan variations to take place. After-all, you have
enough inventory to ride the gap. But if you get in the habit of accepting
schedule changes, you will need more safety stock anyway.
The most efficient businesses stick to their plans, have accurate forecasts of
sales and hold a carefully optimised level of safety stock.

9. Safety Stock levels vary with forecast accuracy

Picking up on the importance of forecast accuracy, this diagram illustrates the

interrelationship between inventory level (expressed as stock cover), forecast
accuracy and service level.
By increasing forecast accuracy moving from the blue curve to the red one you
can either provide a higher level of service with the same amount of safety stock or
provide the same level of service with less stock.
As the accuracy of sales forecasting declines, the business must either hold more
stock (as a buffer) or provide a lower level of service to its customers.
10.
The Nature of Stock: How Demand Variability determines
Safety Stock levels

Forecasting is particularly important if demand is variable. Note that variability and

predictability are two very different things. Just because a demand varies does not
mean that it cannot be predicted. For example, sales of drinks increase in hot
weather and on national holidays, but hot weather can be forecast and holidays are
in the calendar, so there is no excuse for failing to forecast the increase in sales.
Variability of demand is often expressed through the statistical measure of standard
deviation. Consider the top and bottom diagrams on this page.
At the top is a demand that varies substantially and is therefore said to have a high
standard deviation.
On the bottom graph, the average level of demand is the same, but the degree of
variation around this average is much lower. This has a lower standard deviation.
The effort of forecasting the top example is likely to be much higher and more
important than that on the bottom example
11.

The Nature of Stock Safety stock

The diagram above attempts to show variation in demand, and its effect on the
now familiar saw tooth pattern of inventory consumption.
Of the three angled lines, the one in the middle marked forecast sales represents
the expected rate of sales, and the rate therefore at which inventory is expected to
decline.
The shallower line represents the minimum rate of sales, given a particular standard
deviation of demand. On this line, the inventory will decline more slowly and there is
likely to be excess stock still available when the time comes for the next production
run.
The steeper line shows the likely maximum rate of sales. On this line, the inventory
will decline faster and more quickly eat into safety stock.
Should you hold enough inventory to cater for the maximum rate of sales, or should
you allow inventory to run out in the unlikely event of this steep sales line
occurring? Thats back to a judgement based on the cost of lost sales and the cost
of holding inventory.
The shaded portion of the graph on this page shows how you might choose to draw
a line that represents that greatest variability of demand that you are willing to
cater for in your management of inventory.