Inventory Management: Methods, Techniques, Theories

Learn about key strategies and best practices for effective inventory management to optimize stock levels, reduce costs, and improve business efficiency. In this article, we will understand the purpose of inventory, characterize the inventory policies in EOQ model, discuss other issues in inventory management, and discuss supply chain strategies in practice.

Inventory Management: Basics

What is inventory?

Inventory is the stock of any item or resource used in an organization. It refers to the accumulations of materials, customers, or information as they flow through processes or networks. Physical inventory is the storage of physical materials such as components, parts, finished goods, or physical (paper) information records.

Inventory, also known as stock or resources, are either used in the provision of goods and services or used to facilitate the running of an operation or supply chain.

For many businesses, inventory is the largest asset on the balance sheet at any given time. The main problem with inventory is that it can be difficult to convert back into cash.

Purpose of Holding Inventory?

The main objective of inventory management is to strike a balance between inventory investment and customer service.

A company may hold different types of Inventory, such as:

• Raw material: Purchased but not processed
• Work-in-process (WIP): Undergone some change but not completed
• Finished goods: Completed product awaiting shipment
• Maintenance/repair/operating (MRO): Necessary to keep machinery and processes productive

There are various purposes of Holding Inventory:

Uncertainty in customer demand: Uncertainty in customer demand (shorter product lifecycles, more competing products) is one of the main reasons for maintaining inventory.

Uncertainty in supplies: Despite the contractual agreements with suppliers there can still be mishaps that can impact supplies.

Uncertainty or delay in Delivery lead times (refers to the time that a cmpany must wait between when an order is placed and the date the goods are available for use)

There are also incentives for larger shipments such as economies of scales, lower unit cost, discounts.

Useful Metrics

Average inventory: expected amount of inventory over time.

Inventory turnover : number of times inventory is cycled through over time, a measure of how efficiently inventory is used.
Inventory Turnover = net sales/average inventory.

What is Inventory Management?

Efficiently managing these accumulations is known as ‘inventory management’.

Managing inventory is important because material inventories in a factory can represent a substantial proportion of cash tied up in working capital. Efficiently managing inventory so that you hold as much is needed, can release large quantities of cash.

Operations and supply chain managers often have a ‘love-hate’ attitude towards inventories. Where inventory can be risky and costly, sometimes hold up a considerable amount of working capital, they are also can provide some security in an uncertain environment, enabling the prompt delivery of goods and services to consumers. This is also known as the inventory dilemma.

Related: More Operations Management Concepts

Inventory Costs & Economic Order Quantity

Maintaining inventory incurs costs for a business. If it is too low, it leads to stock-outs which could lead to consequences such as external customers taking their business elsewhere and internal customers will suffer process inefficiencies.

If the inventory is too high, it leads to storage costs which are associated with the physical storage of inventory. These costs are summarised into holding costs and ordering costs.

The aim of an operations and supply chain manager is to strike a balance between these costs which leads to the benefits of economic order quantity.

Important Questions in Inventory Management

How many/much inventory should be held?

• Too high inventory increases carrying cost.
• Too low inventory can reduce customer satisfaction/service level.

When stock should be replenished / reordered?

• Too early can increase inventory level
• Too late can increase stock out cost

Key Factors in Inventory Management

• Estimation of customer demand – are there any forecasting tools that can be used?
• Replenishment lead time – is this known at the time an order is placed?
• The number of different products being considered- what are you ordering, do you have the budget and space, your priorities?
• The length of the planning horizon
• Costs to consider:
  Ordering cost which incudes Product cost (fixed cost + variable cost) plus Transportation cost.
  Inventory holding cost (or inventory carrying cost) which includes state taxes, property taxes, insurance on inventories, Maintenance costs, Obsolescence cost, Opportunity costs.
  
• Service level requirements – if you cannot meet customer orders 100% , what is the acceptable level (specific service level target)- can this be changed over time?

Inventory Policies

When reviewing inventory, companies usually follow a Continuous Review Policy or Periodic Review Policy.

Continuous Review Policy

In this method, inventory level is reviewed continuously (when an item is removed from inventory). Computerized inventory systems are used to continuously review inventory.

Example: (Q, R) policy

The (r, Q) policy also known as reorder-point/order-quantity policy is one of the most common practical policies in inventory control systems.

Whenever inventory level falls to a reorder level R, place an order for Q units (similar to single period inventory with initial inventory model).

R: average inventory during lead time (average daily demand X lead time) + safety stock/inventory (the amount of inventory that the distributor needs to keep at the warehouse/in the pipeline to protect against deviations from avg. demand during lead time).

Periodic Review Policy

In this method, Inventory level is reviewed periodically at regular intervals. An appropriate quantity is ordered after each review. This method is useful when it is impossible or inconvenient to frequently review inventory and place orders if necessary.

Short Intervals (e.g. Daily). Example: (s, S) policy

In this scenario, two inventory levels s and S are defined. During each inventory review, if the inventory position falls below s, order enough to raise the inventory position to S.

Longer Intervals (e.g. Weekly or Monthly). Example: Base-stock level policy

In this scenario, it makes sense to always order after an inventory level review.
A target inventory level is determined (the base-stock level). During each review period, the inventory position is reviewed. The company must order enough to raise the inventory position to the base-stock level.

When and How Much to Order

Single Stage Inventory Control: Economic Lot Size Model

Economic Lot Size (ELS), also known as Economic Order Quantity (EOQ), is the quantity of units that a company should ideally buy to minimize inventory costs while meeting demand.

Read: EOQ benefits and calculations

Forecasting

When forecasting demand, a company must have understanding about the purpose of the forecast, how the forecast will be used, dynamics of system for which forecast will be made, and accuracy of the past history in predicting the future.

Various demand forecasting techniques include:

• Judgment Methods: Sales-force composite, Experts panel, Delphi method
• Market research/survey
• Time Series: Moving Averages, Exponential Smoothing
• Trends: Regressions
• Seasonal patterns: Seasonal decomposition
• Trend + Seasonality: Winter’s Method
• Causal Methods

Role of Information in Inventory

Information has become more important than Inventory, consider factors such as the Bullwhip effect.

Information enables the coordination of manufacturing and distribution systems and strategies, enables lead time reductions, helps suppliers make better forecasts, accounting for promotions and market changes, and helps reduce variability in the supply chain.

It enables retailers to react and adapt to supply problems more rapidly, enables them to better serve their customers by offering tools for locating desired items.

IT systems can help improve inventory visibility, Track inventory (RFID), and enables efficient coordination in the supply chain.

Supply Chain Strategies for Inventory Management

ABC Classification

ABC classification is a method for determining level of control and frequency of review of inventory items (The boundary between different classes might not be as sharply defined).

A Pareto analysis can be done to segment items into value categories depending on annual dollar volume.

• A Items– typically 20% of the items accounting for 80% of the inventory value
• B Items– typically an additional 30% of the items accounting for 15% of the inventory value
• C Items– typically the remaining 50% of the items accounting for only 5% of the inventory value

ABC classification allows policies and controls to be established for each class, e.g., A items probably will receive tighter physical inventory control, placed in a more secure area and accuracy of its records verified frequently , more care given to A.

Cycle Counting: The cycle counting approach is a technique that segments inventory based on an ABC analysis and sets up a time schedule for when items should be counted throughout the year- continuing audit and reconciliation of inventory with inventory records.

Cycle counting has the following benefits:

• Fewer mistakes in item identification.
• The ability to identify and correct record errors.
• The operation does not have to be shutdown during a cycle count.
• Fewer, more experienced people are used to perform a cycle count.
• There is a systematic improvement in the processes that dictate inaccurate records.

Postponement

Postponement strategy involves delaying product differentiation or customization until closer to the time the product is sold:

• Have common components in the supply chain for most of the push phase
• Move product differentiation as close to the pull phase of the supply chain as possible Inventories in the supply chain are mostly aggregate

Push-Based Strategy

In Push-Based strategy, production and distribution decisions are based on long-term forecasts. Manufacturer demand forecasts based on orders received from the retailer’s warehouses.

There are downsides to this strategy.

There is longer reaction time to changing marketplace:

• Inability to meet changing demand patterns.
• Obsolescence of supply chain inventory as demand for certain products disappears.
• Variability of orders received much larger than the variability in customer demand due to the bullwhip effect.
  Companies have excessive inventories due to the need for large safety stocks. There are larger and more variable production batches. One observes unacceptable service levels and product obsolescence.

Examples: KFC, Walmart, Kmart

Pull-Based Strategy

In pull-based strategy, production and distribution is demand driven. It is coordinated with true customer demand rather than forecast demand. Firms do not hold any inventory and only responds to specific orders.

This approach looks intuitively attractive as there is less variability in the system, decreased inventory at the manufacturer due to the reduction in variability, reduced lead times through the ability to better anticipate incoming orders from the retailers, reduced inventory since inventory levels increase with lead times.

Pull-based strategy is often difficult to implement especially when lead times are long and its impractical to react to demand information. More difficult to take advantage of economies of scale.

Examples: Subway, Maccas customized burgers, fast fashion retailers.

Choosing Between Push and Pull Strategy

Here are things to consider when choosing Push/Pull strategy:

Demand Uncertainty: Higher demand uncertainty leads to a preference for pull strategy. Lower demand uncertainty leads to an interest in managing the supply chain based on a long-term forecast: push strategy.

Economies of scale: The higher the importance of economies of scale in reducing cost, the greater is the value of aggregating demand, and the greater is the importance of managing the supply chain based on long-term forecast, a push-based strategy.

When Economies of scale are not important, Aggregation does not reduce cost and a pull-based strategy makes more sense.

Here’s how companies can leverage the benefits of Push and Pull.

Typically the initial stages of the supply chain are operated in a push-based manner and remaining stages employ a pull-based strategy.

The interface between the push-based stages and the pull-based stages is the push–pull boundary. Based on extent of customisation, the position of the boundary on the timeline is decided. The point where differentiation has to be introduced is the push-pull boundary. Examples: furniture, PCs.

In the Push Portion of a Push-Pull Strategy, there is Low uncertainty, Service level is usually not an issue, Focus is on cost minimization, there are longer lead times, complex supply chain structures, and Supply Chain Planning processes are applied. Cost minimization is achieved by better utilizing resources such as production and distribution capacities, and by minimizing inventory, transportation, and production costs.

In the Pull Portion of a Push-Pull Strategy, there is High uncertainty, simple supply chain structure, shorter cycle time, Focus is on service level which is achieved by deploying a flexible and responsive supply chain, and Order-fulfillment processes are applied.

While implementing Push-Pull strategy, achieving the appropriate design depends on factors such as product complexity, manufacturing lead times, supplier–manufacturer relationships.

There are many ways to implement a push–pull strategy. For example, Dell locates the push–pull boundary at the assembly point whereas furniture manufacturers locate the push–pull boundary at the production point.