What is Inventory Management?
Inventory management is a component of the supply chain management that helps in overseeing the order and storage of items that an organisation uses in the production of final goods for selling purpose. Inventory management focuses on the detailed recording of products or their components at various stages from warehouses and points of sale. It involves determining the ways of ordering raw material, semi-finished or finished goods and their quantity.
Inventory management helps in identifying the most effective source of supply. It includes all activities of planning, forecasting and replenishment that help an organisation in maintaining a good inventory level by balancing the excess and shortage of inventory. The main aim of inventory management is lowering of the difference between customers’ demand and availability of goods caused by customers’ demand fluctuations, inconsistent suppliers and inventory inaccuracy.
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Objectives of Inventory Management
The prime objective of inventory management is the maintenance of inventory at an optimum level to prevent excess or shortage of inventory. Inventory management helps decrease the holding costs related to inventory. It ensures that the flow of raw material and finished goods stays uninterrupted during the production processes. The objectives can be classified into two categories, which are as follows:
Operating Objectives
Operating objectives are associated with the operational activities of the business, such as purchase, production and sales.
Some of these are listed as follows:
- To ensure uninterrupted supply of materials
- To minimise interruptions in the production process
- To reduce the risks and losses incurred due to shortage of inventory
- To remove duplication in ordering or replenishing of inventory
- To enhance customer services
Financial Objectives
Financial objectives are concerned with cutting down the pointless and wasteful investments in inventory and decreasing the working capital that is tied up in inventory.
Some of these are as follows:
- To maintain optimum investment in the inventory
- To minimise inventory costs for maximising profitability
- To help generate economy in purchase
- To minimise revenue leakage through lost sales
- To compete on shorter delivery times to increase sales
The other objectives of inventory management are to reduce the undesirable consequences of holding excess inventory which are:
- Unnecessary tying up of funds and reduced profitability
- Increase in carrying costs
- Loss of cash flow
- Depreciation, pilferage, wastage and damage in inventory
Importance of Inventory Management
Inventory is the most important item in the current assets category on the balance sheet of an organisation. Any issues with inventory can lead to business losses or even failures. Good inventory management attempts to strike a balance between the inflow and outflow of inventory.
Inventory management is all about ensuring an effective flow of goods and services which helps an organisation in maintaining a smooth production process. In addition, it also enables an organisation to make accurate forecasts on how much inventory is needed based on sales activity and place orders accordingly; thereby preventing the situations of overstocking and stock-outs.
The following points explain the importance of inventory management:
- Effective Allocation of Inventory
- Reduced Costs
- Improved Service Level
- Better Utilisation of Warehouse Space
Effective Allocation of Inventory
An enormous amount of money is spent by an organisation in purchasing inventory. Thus, it is crucial for the organisation to constantly monitor where its inventory resides in the supply chain and allocate inventory accordingly. Good inventory management practices enable the organisation to have a holistic view of how much inventory is owned by it and where its inventories exist. Also, inventory management allows the organisation to have detailed information on which inventories are damaged, returned, rejected or on hold, which, in turn, avoids situations of theft and loss.
Reduced Costs
Inventory costs include three major costs, namely ordering costs, carrying costs and shortage costs. Inventory management helps an organisation to know its re-order point and the right time to place new orders. This prevents expenses the organisation bears on storing excess items and reduces the risk of shortage costs that are associated with disappointed customers. In addition, by knowing its re-order point, the organisation can order in small quantities and reduce the size of its storage facilities.
Improved Service Level
Customer satisfaction is important for organisations of all sizes. To survive in today’s competitive market, organisations are constantly searching new ways to improve customer service. Customers who do not receive orders on time are likely to be unsatisfied and may switch to other sellers. Inventory management helps organisations to avoid the problem of stockouts and reduce lead times to a great extent. This ultimately benefits organisations in terms of enhanced order fulfilment process, on-time deliveries of orders and repeat business.
Better Utilisation of Warehouse Space
Effective inventory management practices lead to an organised warehouse. For example, inventory management provides an idea of fast-moving items in stock. These items are generally placed in easily accessible areas, such as near shipping, staging and receiving areas. This, in turn, helps speed up the order fulfilment process and optimal use of warehouse space.
Inventory Control Techniques
Once sold, inventory turns into revenue. Before being sold, inventory (although reported as an asset on the balance sheet) is deemed as cash. Thus, overstocking hold financial resource and affects the smooth cash flow. Here, the role of inventory control comes into the picture. The value of inventory control extends from cost reduction to customer satisfaction. Good inventory control saves the business time, resources and money. However, without control over inventory, the business’s profitability will suffer.
ABC
The ABC system relies on the Pareto principle or the 80/20 rule according to which, for most events, roughly 80% of the effects come from 20% of the cause. To translate this in terms of inventory, a small number of key products drive the majority of profits and most other warehouse items have considerably less impact. Therefore, inventory management decisions need to be made keeping in mind this data.
ABC inventory classification can be attempted in multiple ways, but the most common classification method is as follows:
- A type inventory accounts for roughly 20 percent of the items in the warehouse and 80 percent of dollar expenditure.
- B type inventory accounts for roughly 30 percent of the items and 15 per cent of dollar expenditure.
- C type inventory accounts for roughly 50 percent of the items and 5 percent of dollar expenditure.
Other criteria to attempt an ABC classification may be unit cost, transaction usage, supplier lead time, customer ranking, carrying costs and expiration dating or a mixture of more than one criterion.
Table shows the classes of ABC inventory management:
| Type | Importance | Percentage of Total Inventory | Annual Consumption Value | Controls | Records |
|---|---|---|---|---|---|
| Class A | High dollar value | 10% – 20% | 70% – 80% | Tight | High Accuracy |
| Class B | Medium dollar value | 30% | 15% – 20% | Medium | Good |
| Class C | Low dollar value | 50% | 5% | Basic | Minimal |
VED
VED stands for Vital, Essential and Desirable. It is a qualitative inventory classification approach wherein inventory is divided into three categories, namely vital items, essential items and desirable items.
These three categories are explained as follows:
- V: Vital items are so critical, without that them, an organisation cannot run. In other words, the non-availability of these items can affect the process line.
- E: Essential items are the ones without which the organisation can function, but the quality, speed or cost of service will be damaged. Unavailability of essential items may result in temporary loss of production or disrupted production activities.
- D: Unavailability of desirable items does not affect the functioning of the organisation, but may lead to minor costs or short-term disruptions.
Typically, the number of vital items will be the least while most items will fall in the desirable and essential group. The decision concerning the number of items to be maintained depends on how crucial the items are from the functional standpoint, but the annual consumption cost of items (ABC classification) also needs to be considered.
Example 1: The following shows the VED analysis of a medical equipment manufacturer:
| VITAL (V) | ESSENTIAL (E) | DESIRABLE (D) |
|---|---|---|
| Defibrillator | X-ray machine | Air curtains |
| Ventilator | Electric cautery | Ultrasonic wash machine |
| Oxygen regulator | Patient trolley | Electronic BP machine |
- Column 1 contains most important items like defibrillator, ventilators and oxygen regulators that are critical for patient care and require control by the administrator himself.
- Column 2 contains items of intermediate importance, which require control by store in-charge.
- Column 3 contains items of least importance and can be controlled by storekeeper.
Items with high criticality (V) but are required in small quantity should receive highest priority, while items with low criticality (D) and are required in a large quantity should receive least priority. It should be noted that the grouping essentially depends upon the strategy of management and the environment of functioning.
FSN
The criterion for FSN classification is the rate of consumption. In this classification, items are grouped into Fast-moving (F), Slow-moving (S) and Non-moving (N) items. The main objective of FSN analysis is to extract information on the rate of consumption of products. This information is further used for making decisions related to picking and packing, reducing time and labour, deciding the frequency of reordering or even phasing out of certain items.
To decide which item is falling under which category (F, S, N), the following need to be determined:
- Average stay of items in the inventory
- Consumption rate of items
- Period for analysis
Once the average stays and consumption rates have been calculated for each product in inventory, the cumulative average stays and cumulative consumption rates can be calculated with subsequent percentages of the total derived from which F, S and N statuses can be assigned. Cumulative average stays and consumption rates can be calculated when ordered into a descending order.
For cumulative average stays, fast-moving items contribute to 10% or less of the average cumulative stay, slow-moving items contribute to the next 20% and non-moving items contribute to the remaining 70% of the average cumulative stay. This implies F products move faster and remain in inventory for 10% or less of the average stay of all inventory items. They are essentially sold more quickly as they spend the least amount of time sitting in inventory.
For cumulative consumption rates, 70% of the average consumption rate is categorised as F, the next 20% as S and the remaining 10% as N. This implies F products are consumed (or sold) at a rate of 70% orhigher of the average consumption rate for all products in inventory. They are essentially sold in greater amounts and have a higher turnover.
Example 2: The following table lists down six materials purchases by a company with their average stays and consumption rates:
| Item code | Average Stay | Consumption Rate |
|---|---|---|
| 1 | 4.76 | 6.5 |
| 2 | 6.5 | 4.2 |
| 3 | 8 | 3 |
| 4 | 3.63 | 7 |
| 5 | 7.69 | 5.23 |
| 6 | 10 | 1.23 |
| 7 | 12.45 | 2.5 |
| 8 | 6.76 | 5.64 |
| 9 | 9.6 | 3.39 |
| 10 | 5.14 | 7.86 |
Now, we will classify the products based on their cumulative average stay percentage by arranging them in a descending order with the highest number of average stay on the top.
| Item Code | Average Stay | Cumulative avg. stay | % average stay | FSN classification |
|---|---|---|---|---|
| 7 | 12.45 | 12.45 | 16.704 | N |
| 6 | 10 | 22.45 | 30.12 | N |
| 9 | 9.6 | 32.05 | 43.00 | N |
| 3 | 8 | 40.05 | 53.73 | N |
| 5 | 7.69 | 47.74 | 64.054 | N |
| 8 | 6.76 | 54.5 | 73.12 | S |
| 2 | 6.5 | 61 | 81.84 | S |
| 10 | 5.14 | 66.14 | 88.74 | S |
| 1 | 4.76 | 70.9 | 95.12 | F |
| 4 | 3.63 | 74.53 | 100 | F |
JIT
The excellence of the JIT production process is hinged on steady production, high-quality workmanship, no machine breakdowns and reliable suppliers. Just-in-time (JIT) inventory systems enhances efficiency. The JIT production system lessens storage costs because the manufacturer receives materials and parts required for production and does not have to shell out storage costs. If an order is cancelled or not fulfilled, the manufacturer will not have unwanted inventory left.
JIT inventory systems have a slew of merits over conventional models. Production runs are short, which infers manufacturers can swiftly move from one product to another. Also, this method cuts down costs by curtailing warehouse needs. Organisations also spend less money on raw materials as they buy just enough resources to make the ordered products.
The JIT inventory system is most popularly used in the automobile sector that functions with low inventory levels, but largely relies on its supply chain to deliver the parts it needs to produce vehicles as and when required. Subsequently, the manufacturer orders the parts needed to assemble the vehicles only after an order is obtained. Apple’s Chief Executive Officer (CEO) Tim Cook transformed Apple’s manufacturing process using his years of supply management experience he gained working at IBM and Compaq Computers.
When he became Apple’s chief operating officer (COO) in 1998, he pulled the company out of manufacturing and closed warehouses and factories around the world. Instead, he opted to establish just-in-time relationships with independent manufacturing contractors located especially in China where labour and cost of goods were much cheaper. These chain improvements acted as a key factor in Apple’s growth and profitability.
