What is Inventory Management?


In one sentence, inventory management is the balance between ensuring product availability while trying to minimize the cost of carrying a product (based on a desired level of product availability or fill-rate). In inventory management you want just the right amount of inventory at just the right time because there is a cost associated with holding onto excess inventory. Having too much inventory takes up precious shelf space and not only does the shelf space have a cost associated with it, but a product that has greater velocity (selling more quickly) could be on that shelf rather than a slower moving product. Alternatively, the cost of not having enough inventory is a lost sales opportunity. Inventory Management is an art and science in business; providing great customer service by having what the customer wants when they want it, while attempting to keep costs down by having the least amount of inventory possible for any one product.

 

There are two primary components of inventory control;
1. Product Availability
2. Inventory Related Costs

 

Product Availability


At its core, product availability is based on probabilities. An organization can set a fixed fill-rate1 for each item in their inventory, or more complicated math can be used by analyzing combinations of items and looking at the probability, or likelihood, of these combinations of items being sold based on frequency of orders and established fill-rate criteria. An organization would look at each item and set a fill-rate for each individual product. This would provide a Weighted Average Fill Rate. The objective is to fill all orders without having a stock-out, because a stock-out will result in a lost sales opportunity. An organization knows there is a cost benefit trade off and it would be impossible to have all the combinations of all products on the shelf to ensure 100% availability, so essentially an organization looks at how much it costs to maintain the inventory and how much it costs to experience a lost sales opportunity. In theory, as long as carrying the inventory costs less than the cost of a lost sale, then the business will carry the inventory.

 

Inventory Related Costs


There are three primary categories of cost:
1. Procurement Cost
2. Carrying Cost
3. Stockout Cost


Each of these costs are taken into consideration while evaluating how much inventory an organization wants to maintain.

 

Procurement Cost


Some procurement costs are considered a fixed cost as many simimilar functional activities are required to complete each order process. This is done by looking at the time it takes for each activity times the average cost of labor for the functions that complete the activity. There are a lot of processes involved in procurement and depending on the size of the organization there may be many individuals, in many areas, completing the process. While this is a high-level overview, the process may include sending out a Request for Quote (RFQ), negotiating price and quantity, filling-out paperwork (or data entry), receiving the product, invoicing, and payment. However, there are procurement costs that aren't fixed; manufacturing, transportation, handling costs, and the order size can impact procurement costs. These are typically dealt with separately on a case by case basis.

 

Carrying Cost


Carrying costs are all the costs associated with carrying inventory. These costs include the cost of the warehousing (or storage), the cost of capital, insurancee and taxes, and costs as a result of shrinkage (theft), damage, and obsolescence.

 

Stockout Cost


There are two types of stockout cost; a lost sale and a back order. A stock out cost as a result of a lost sale occurs when a customer orders an item that isn't in stock and decides to buy the product somewhere else. In the case of a back order cost, while the sale wasn't necessarily lost, there are additional costs associated with a back order. For example, there may be additional transportation, shipping and handling, or administrative costs. These additional costs "cut" into the profit that could have been made had that product been in inventory when the customer ordered.

 

Push Inventory Control


In inventory management, a push inventory control approach is generally used when production or purchasing is the primary factor in determining inventory levels. From the production perspective, when production requirements exceed available space inventory will be pushed. For example to capture economies of scale an organization decides to have a production run for a product and as a result they produce a lot more than is in demand, but due to space constraints they can't keep the inventory at their facility. They will push the inventory to stocking points until demand catches up. Push inventory control is typically the result of "too much" inventory.

 

Pull Inventory Control


In contrast to push inventory, pull inventory control is driven by demand or stocking point costs. A pull inventory control approach is determined by low levels of inventory where demand "pulls" the inventory. Demand, in this case, can be influenced by one-time buys or cylclical demand (seasonal variability). Additionally, if an agreement is established with a set inventory level, demand for the product is "pulled" based on that set level.

 


Footnotes:

1. Fill-Rate: The level of service an organization seeks to provide for a given product. Pending how the organization calculates their desired inventory levels, this can be as simple as setting a 95% fill-rate for example, or it can be more complicated through the use of z-scores.