Following on the heels of our discussion of JIT methodologies is the concept of Inventory Management. While it is fairly easy to decide to have supplies arrive just in time for production, and goods available for sale at the exact moment a customer wants them, it is another thing altogether to implement. If we imagine a grocery store, it is absurd to think of a stock person running in from suppliers with a box of cereal at the exact moment a shopper turns down the cereal aisle. At the same time, you can imagine that it would be prohibitively expensive for a grocery store owner to carry a year’s supply of every type of cereal in order to avoid disappointing his customer.
There are 6 main reasons that a business keeps inventory.
- Variations in Lead Time – Unless you are 100% certain that your suppliers can deliver the goods to meet your needs in an exactly specified period of time, overages are carried in inventory.
- Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and delivery.
- Economies of scale – Many suppliers offer volume discounts.
- Appreciation in Value - In some situations, some inventory gains the required value when it is kept for some time to allow it reach the desired standard for consumption, or for production. For example; beer in the brewing industry
- To protect against price increases – in some cases, a particular supply may be offered at a deep discount for a limited time.
- To smooth seasonal production or sale requirements
All of these must be balanced with the costs of expending capital ahead of the need date, and storing the inventory. Associated Costs of Inventory
There are three costs associated with inventory:
- Holding – also known as “carrying” costs and involves the costs of physically storing inventory. Costs include warehousing costs, insurance, opportunity costs of funds used for inventory, spoilage and obsolescence and security. Holding costs are stated in two ways: either as a percentage of unit cost or as a dollar amount per unit.
- Ordering – costs that include all aspects of making an order except for the actual price of the inventory ordered. Costs include the time it takes staff for tracking inventory, placing an order, processing orders, transportation, receiving and inspecting shipments as well as the time it takes processing and paying the invoice. Ordering costs are more difficult to track because it usually involves the time of your staff and therefore is difficult to track. For manufacturers that produce their own inventory, ordering costs occur during the ordering of raw materials as well as setting up for production runs.
- Shortage – the costs that result when demand exceeds inventory levels. Costs include the opportunity cost of not making a sale (i.e. unrealized profit), decrease in customer satisfaction, late charges and rush order costs to expedite delivery. For manufacturers, the shortage of raw materials or component parts leads to costs such as lost production and downtime.
Demand Forecasts and Lead Time Information
Since one of the main purposes of inventories is to meet future demand for sales and usage, it is extremely important to have accurate demand forecasts (forecasting techniques will be discussed in the upcoming Forecasting section).
It is also extremely important to know the purchase lead time, the time it takes for an order to be processed and delivered. For manufacturing, lead time refers to the time it takes for a batch of a product to be produced, packaged and made ready for sale.
The variability of lead times and demand is also important, the high the variability the greater the risk of unexpected stock-outs due to high lead times or increased demand.
Inventory management is a balancing act. You need enough inventory to serve customers and not so much inventory on hand that you are wasting valuable resources. It is a matter of balancing customer service (having the right goods, in sufficient quantities in the right place at the right time) and cost control (avoiding tying up too much working capital in inventories and decreasing your company’s liquidity). To balance the needs of the business successfully, your purchaser must carefully consider both the timing and the size of all orders.
Accounting for Inventory
There are two basic methods for accounting for your inventory
- Perpetual – You have a system that keeps constant track of all inventory that is adjusted every time a purchase or a sale is made.
- Periodic – You count your inventory at the end or beginning of a predetermined period of time.
Neither of these methods are better than the other, but one of these two methods will likely be better for you and your particular business. If your business relies on accurate supply or product levels, you will want to invest in a system that can facilitate that. If you do not need to know the exact number of goods or supplies you have, don't put time and energy into tracking these numbers for their own sake.
Answer the following questions about the way you currently handle inventory in your business.
How much inventory will you keep? How will you account for it, and how often, how will you monitor levels? who is in charge, and are you going to keep constant track of your inventory or count it after certain periods? These are the questions you will need to answer when you build your inventory control systems.
Inventory Management System
If applicable to your business, and if you haven't already done so, design the system for controlling your inventory. Depending on your business, it may be appropriate for you to invest in an electronic system that will track your inventory levels automatically. You set this up from a financial perspective in “Finance,” but you may not have the systems in place yet for controlling the actual mechanics of this process.
As we discussed in “Finance,” inventory control is a place that theft can easily occur if not properly monitored. Also, an inventory system is your only sure method for holding your inventory at a consistent level, one of the keys to controlling your cash flow.
A grocer had gone broke and the receivers were taking an inventory. Upon inspection, they found the store filled to the brim with bread. There was bread in the front and bread in the back. They found white bread, whole wheat bread, French bread, rye bread, potato bread, cracked wheat bread, roman meal bread, and many other kinds of bread. They asked the grocer, “You sure sold a lot of bread, didn't you?” “Oh no,” replied the grocer, “but the fellow who called on me from the bakery, sure did!”
The following questions will help you design your Inventory Management System.
If you maintain any type of inventory in your business, how do you organize your production materials? Do you keep them in boxes? Do you store them in a computer? Are they in a filing cabinet?
How do they get there and who is responsible for making sure they do?
Is there any need for security, once they are stored? If so, how is this accomplished?
How are they retrieved when they are needed?