4.2.1 Managing inventory costs
Now take up Reading 5.1 'The benefits of smart inventory management'. This short reading covers the wide range of topics that we will touch upon in this chapter. As such, it is a good introduction to our discussion to follow.
Reading 4.1
Broome, JT (1999), 'The benefits of smart inventory management', Nation's Business , June 1999, pp18 - 19.
From this basic understanding, we come to some important questions that an organisation must address:
- What should be stocked?
- When should orders be placed for more stock?
- What quantity should be ordered?
The most fundamental is the first question. The answer is not straightforward. Because stock outs are expensive, there is a risk-averting tendency in managers, which often leads to tendency to overstock. When overstocking is identified, stocks are often drastically cut and the process starts all over again. Deciding upon the timing and size of re-orders fixes the level of stocks, the amount of money tied up in inventory, the risk involved in maintaining the inventory and the service that can effectively be provided to the customer.
Holding a high level of stocks is costly. The trade-off then has to be made between lowering the level of stock, thus reducing costs, and sacrificing some of the benefits of a high level of stock. If the lower level of stock leads to a stock out, will that be acceptable? If operations have to be rescheduled due to a lack of some component in inventory, will that be acceptable occasionally?
The aim is to minimise overall cost, and the control of inventory is vital. Being vital, it has become subject to rigorous attention on the part of not only managers, but academics in the field of business. The lowest overall cost must define the various elements we have mentioned above - stock levels, amount of capital tied up in inventory, and the level of customer service that is acceptable.
Reading 4.2
Kilty, G (May 2000), 'Inventory management within the supply chain', Hospital Material Management Quarterly , pp18 - 24.
In this reading, the writer identifies the need to study the entire chain of events from procurement to distribution. In other words, the total cost must be the focus of study to reduce inventory costs. Basically, inventory holding costs can be divided into the following broad categories:
- the cost of buying one item, i.e., the purchase price
- the cost or re-ordering the item, i.e., order preparation, follow-up, receipt of item, transport costs, quality check, and sorting
- the cost of storing the item for a given period of time
- the stock out cost.
The last one is the most complicated, possibly the highest cost, because it involves the estimating of externalities and knock-on effects, including loss of customer, disruption to operations, cost of overcoming these and so forth.
Re-ordering. Looking at the first three items, we need to consider the cost of ordering small and frequent deliveries of items against large and infrequent ones. The small deliveries obviously cost less in direct terms but may cost more in indirect terms when the cost of reordering and transport etc are included. So, the frequent deliveries will have low inventory costs but high processing costs. The reverse is true in the large deliveries but infrequent ordering situation. In logistics related literature, we come across a term economic order quantity (EOQ). EOQ is expressed as
Placing an order. Now that the optimum order size is decided, the next question is: when should a re-order be placed? This depends on two variables that we have pointed out in the last chapter - lead time and demand. If demand remains fairly predictable, the re-order should be placed when lead time will equal to zero stock. The new stock will then arrive just as the existing stock is finishing. In practice, this accuracy of prediction and consumption is the elusive grail. Organisations, therefore, maintain a safety stock. Re-order then occurs when existing stock reaches a level which is:
demand in the lead time + safety stock
This situation can be expressed diagrammatically, as shown in your textbook in Figure 10-8 A basic pull inventory control model for a replenishment part .
In the drive to solve the problems of lead times and re-order points, some work has been done to identify best ways to control and reduce inventory costs. One such process is a classic one - statistical process control , devised to solve quality problems in 1931 by Shewart. This process is widely discussed in quality related literature but it is interesting to read its application to the logistics context and to optimising inventory holding.
Reading 4.3
Pfhol, H-C, Cullmann, O and Stolzle, W (1999), 'Inventory management statistical process control: Simulation and evaluation', Journal of Business Logistics , vol 20, no. 1, pp 101 - 120.
Let us now step back and look at the two types of inventory controls described in your text.
Previous Page