Inventory Management

Inventory management, also known as stock control (or inventory control), aims to maintain adequate stock levels to minimize stock costs. The purchasing department must not only get the right quality at the right price. However, this department must also ensure inputs arrive at the right time and quantity.

Maintaining adequate stock is essential for smooth operations. In addition, it also affects operating costs and efficiency.

Holding stock incurs costs, including warehouse holding costs. And it ties up working capital. The more inventory, the more money tied up in inventory. Thus, less money is available for other business purposes, such as increasing advertising spending.

Conversely, running out of inventory can also cause problems. For example, an operation stops because no raw materials are available for processing. Thus, there is no output. Moreover, problems can get bigger if the inventory of finished goods is insufficient to meet demand, leaving the company unable to optimize revenue.

Therefore, purchasing departments must manage their inventory levels and address issues related to overstocking and understocking.

Inventory

Inventory or stock is any material or item owned and stored by a business for use in production or sales. They include raw materials, work-in-progress, and finished products.

Inventory types

• Raw materials and components
• Work-in-progress
• Finished goods
• Consumables

Raw materials are the basic materials for making products. For example, aluminum plates are used to produce car frames. Managing them requires companies to consider factors such as:

• How reliable is the supply
• How stable are their prices
• How much is needed for the production process
• How big is the demand

Components are finished and processed goods but are part of the product. Examples are engines, tires, radiators, and batteries for car production. The factors considered in managing them are the same as when managing raw materials.

The work-in-progress still needs to be completed and is still on the production line. For example, a manufacturer may have processed materials to produce a car, but it is not entirely finished. Retaining them is a way to protect production if there are problems with other supplies, for example, when raw materials arrive at a production facility late.

Finished goods refer to the final output. They are ready to be delivered to consumers. Managing them requires considerations such as:

• Order received
• Future demand trends
• Production volume

Consumables refer to items consumed during the production process. Companies have to replace them regularly as they are consumed or worn out. Examples are engine oil, nuts, and bolts. Managing them takes into account factors such as:

• Supply reliability
• Price
• Production volume

Reasons for holding stock

Several reasons underlie the company holding sufficient stock. These reasons can vary between types of inventory. For example:

• The company saves raw materials to meet production needs. They must be available enough to convert. Insufficiency can cause problems such as cessation of production processes, machine inefficiencies, and less-than-optimal sales.
• The company holds work-in-progress to maintain and ensure the production process takes place continuously. Work-in-progress is also needed to achieve greater flexibility in production, as well as to support better utilization of time and machines.
• The company holds finished goods inventory to meet customer demands on time and at the required level. For example, when demand increases seasonally, a company does not need to increase production. Instead, they only need to sell the inventory in the warehouse.
• The company maintains equipment and spare parts stored to support sales and production.

And in general, the reason to hold a stock is to control working capital. Keeping inventory ties up the company’s money. Thus, an increase in inventory means more money is tied up, unable to be used for other purposes.

On the other hand, if inventories are low, production volumes may be unable to keep up with demand, especially when orders increase. As a result, the company cannot optimize sales. This means less money being made than there should be.

Overstocking

Overstocking is when a company purchases more than it needs. Although often associated with increased costs, however, it has several benefits.

Benefits related to overstocking

• Companies enjoy economies of scale because they can buy in bulk.
• Production flexibility because businesses have sufficient stock at any given time, for example, when demand suddenly spikes.
• Machines and factories can operate at full capacity at all times because they have inventory to process.
• Adequate stock is available to support production and optimize sales, especially when orders increase more than anticipated.

Costs related to overstocking

• Overstocking carries high holding costs.
• More money is tied up in inventory and cannot be invested elsewhere.
• Supplies can become obsolete or damaged. Some may also be out of date.
• The business must write off obsolete or damaged inventory as a loss.
• Administrative and financial costs associated with inventory, such as insurance, increase.
• Resources become wasteful, especially when market demand is low.

Understocking

Understocking is when there is less stock than needed. This can create problems. For example, suppose a customer places an order but finds the company running out of inventory. In that case, they will feel dissatisfied and frustrated.

Costs associated with understocking

• Production stopped due to insufficient inventory to process.
• Machines and equipment become inefficient because they operate below capacity.
• Businesses cannot fulfill orders on time and deliver as agreed, leading to dissatisfaction.
• It is difficult for companies to optimize sales, especially during peak demand periods or unexpectedly large orders.
• Customers perceive the company as unreliable for being unable to fulfill orders, resulting in a damaged reputation.

Benefits associated with understocking

• Storage and administrative costs are reduced.
• Less capital is tied up in inventory.
• Wastage is minimized, especially when demand is reduced.
• The company minimizes the risks and costs associated with decay or obsolescence.

Inventory management

Inventory management is vital to avoid problems due to overstocking and understocking. Therefore, companies must have a system to ensure sufficient inventory in their warehouses at a minimal cost.

Advances in technology help companies to achieve adequate stock. For example, they can utilize barcodes and information technology to convey information about sales to warehouses and production facilities. Thus, when inventory drops below the minimum level, the system will automatically notify other departments to reorder and replenish stock levels.

Stock control charts

Inventory control charts or stock control charts help ensure sufficient inventory is available when needed.

Maximum stock level is the highest inventory a business must hold. It is limited by storage capacity and the costs associated with holding higher stock levels.

• Maximum stock level = Economic order quantity (EOQ) + Buffer Stock

Reorder level is the inventory level at which new stock is ordered, which requires some lead time for the ordered stock to arrive. It is affected by the economic order quantity (EOQ).

Economic order quantity or EOQ refers to the order level at which stock holding costs and ordering costs are minimal.

On the one hand, holding less stock means less costs associated with storage and administration. But, on the other hand, ordering costs increase because companies have to order more frequently. Also, companies cannot get discounts for buying in bulk. So, lower stock holding costs can lead to increased ordering costs.

EOQ requires the company to reach a point where both costs are minimal. And it depends on the following:

• Storage costs
• Price discount
• Waste costs
• Administration and insurance costs
• Interest on capital

Minimum stock level is the lowest level of inventory a business must hold to fulfill production. Inventory at this level is called buffer stock, which is the minimum inventory that must be held by the company regardless of any conditions. They are important for anticipating problems such as delayed shipments or unexpectedly large orders.

Optimum stock level to be held refers to the stock level held by a business to promote smooth production. It is also known as the optimal inventory level. These stock levels correspond to actual customer demand, so companies always have enough inventory to meet that demand. Therefore, at that level, the total stock cost is minimum.

• Total stock cost = Stock holding costs + Out of stock costs

Order quantity indicates how many orders a business must place to return inventory levels to their maximum.

Lead time refers to the time from ordering until stock is received, inspected, and ready for use. The company requires a higher minimum stock if it takes more time between ordering new stock and shipping it (higher lead time).

Just in time (JIT)

JIT is an inventory control system in which companies ship raw materials and components to arrive exactly when needed instead of holding inventory as a buffer. So, the company doesn’t count on the occasional large shipment to the warehouse. Instead, raw materials and components arrive exactly when needed and are immediately taken to the factory floor.

Inputs such as raw materials are scheduled to arrive when needed for production and in the right quantities. Thus, JIT requires effective inventory management, which, in turn, requires integrated information systems and good relationships with suppliers. In addition, companies also need to match production with demand to minimize inventory.

Several important criteria for JIT to work effectively include:

Accurate demand forecasting. JIT relies on producing according to demand. Thus, an accurate demand forecast allows the company to make a reliable production schedule. In addition, it will assist in calculating the exact quantities to produce and the inputs to be supplied during a given time.

Good relationship with suppliers. Selecting a reliable supplier is vital. In addition, the company must also build a good relationship with them. Thus, they can deliver inputs according to specifications at the right quantity and time.

Worker flexibility. Companies must have workers with many skills. In addition, they must be able to change jobs quickly. Thus, the excess stock does not accumulate.

Machine flexibility. JIT relies on modern and computerized machines to quickly produce various products.

Reliable flow of information. JIT requires companies to maintain computerized sales records and inventory levels to achieve minimum inventory. In addition, electronic communication with suppliers and parts along the supply chain will enable accurate delivery of supplies.

Zero defects. JIT requires strict quality control. Goods must be produced right the first time because companies do not keep spare stocks.

JIT advantages and disadvantages

JIT advantages

• Warehouse costs are reduced because less storage and warehousing space is required.
• Money is not tied up in inventory, so it can be used elsewhere.
• Waste is minimized by reducing obsolete or outdated stock.
• Lower inventory levels are easier to manage, reducing the risk of theft.
• Product quality improvement through strict quality control to support JIT work.

JIT disadvantages

• Shipping and administration costs increase as companies have to send inputs more frequently.
• Companies lose purchasing economies of scale from bulk purchase discounts.
• Delays in receiving inputs from suppliers will result in production halting.
• Sales are suboptimal due to inaccuracies in demand forecasts or unexpected changes in demand.

Inventory storage and warehousing

Companies need warehouses to store and distribute inventory. They may buy or rent it.

Warehouses must be secure to prevent theft or damage to stock. In addition, choosing warehouse facilities and locations should also ensure inventory is easily accessible, cost-effective, and well-maintained.

There are two choices of types of warehousing or storage, each of which has its pros and cons. Both are:

1. Centralized warehousing
2. Decentralized warehousing

Centralized warehousing

Under centralized warehousing, companies rely on a central location for their warehousing. The warehouse keeps all the stock. Then, the company will distribute inventory from the central warehouse according to demand.

Relying on centralized warehousing offers several advantages, including:

• Reducing stock duplication and administrative costs
• Easily accessible because centralized warehouses are often strategically located and near good infrastructure
• Reduce shipping costs by delivering to and from one location
• Supports bulk ordering – and therefore economies of scale purchasing – due to large warehouse capacity
• More organized because the company can recruit staff and implement equipment, standard procedures, and special inventory systems to manage goods in the warehouse.

However, relying on centralized storage comes with some downsides, including:

• High costs because companies need to buy or rent large storage facilities
• Additional costs as the company has to recruit specialist staff and equipment
• More complex inventory management, which can lead to increased delays in receiving stock and delivery times
• More challenging to meet special requirements or requests on a small scale
• Possible waste from storing large amounts

Decentralized warehousing

Decentralized warehousing is when a company operates multiple warehouses in several different locations. Each is responsible for ordering and keeping their own stock.

Companies usually implement decentralized warehousing if they operate production facilities or serve customers in several locations. By selecting several different locations, they can shorten the delivery route.

Decentralized warehousing offers several advantages, such as:

• Improved accessibility by relying on different locations to deliver goods
• Reduce potential delays when operating production facilities or servicing requests in different locations
• Be more responsive to local market needs and changes
• Allows companies to keep a small amount of stock to prevent wastage

But, decentralized warehousing also comes with costs, such as:

• Increased shipping costs because the company relies on separate logistics for each warehouse
• Disorganized due to low need to recruit specialist staff and equipment to deal with stock
• Warehouse costs swell because you have to buy or rent several warehouses

Enterprise Resource Planning

Enterprise Resource Planning (ERP) refers to an information system using a central database to integrate information from all functions, including accounting, manufacturing, supply chain management, sales, marketing, and human resources. It relies on software and integrated computer systems to automate business processes and provide insight and internal control.

ERP is carefully designed to increase organizational efficiency. It allows information to flow freely within the organization, related to functional aspects, and information related to outside stakeholders such as customers, suppliers, and government.

ERP systems are usually available in modules according to their respective business functions, such as production, finance, and marketing. This module will replace standalone computer packages in each area. Everyone in each business function can access the central database.

Modules allow different functions to maintain their own systems and information. However, they are connected to each other. Thus, communication between functions is more straightforward.

ERP benefits

• Information integration for all departments or business functions
• Supports better reporting with real-time information and one integrated database for all business processes
• Improved customer service through better access to customer information, faster response times, and on-time delivery
• Better inventory management by only carrying as much inventory as needed
• Improved cash flow with better invoicing and collection management to bring in cash faster
• Improve business processes by automating manual or routine tasks and implementing smarter workflows
• Better supply chain management with effective demand forecasting and lean inventory, and reduced production bottlenecks

ERP limitations

• Expensive to implement and can cost between $150,000 and $750,000 for a medium-sized business
• Suitable for medium-large scale businesses, but not for small businesses
• Requires thorough training in all business functions to use ERP software
• Disaster for the company if there is a failure in the computer system

Increased efficiency by implementing ERP

There are many ways ERP helps companies to increase efficiency.

Inventory management. The ERP system allows all departments to know exactly the information about:

• What supplies are stored
• How much raw material is needed
• How many unsold stocks

This information can be used to manage inventory effectively. Thus, stock storage costs can be reduced to support efficiency.

Pricing. ERP allows companies to accurately calculate the cost for each order. This will enable companies more easily to set prices to turn a profit. Related costs are integrated into the system, including wages, materials, and fixed costs. By integrating this information, administrative and associated costs can be reduced.

Capacity utilization. Through integrated information, ERP helps companies to know precisely what orders are coming in, how much, and when orders must be fulfilled. In addition, the system also tells what materials are needed to fulfill orders and how much. This information is essential for planning production and ensuring production facilities are optimized close to full capacity to reduce production costs and increase efficiency.