Inventory management can be simply defined as the quantity and placement of stocked produce to minimise the variable costs of holding inventory. This all falls under the operations of a business which is crucial to most product based companies as opposed to those providing a service. It is a necessity for inventory management to be used during the production stage whether that’s in a facility or within a supply network to ensure a predictable course of production and to prevent any random disturbance to the production process such as lack of materials. Furthermore, Inventory management carries a wide scope for the business, concerning carrying cost of production, replenishment, lead time, available space for inventory, inventory valuation, inventory forecasting and carrying the cost of inventory.
Inventory then can be kept on the premises, for immediate use when required which is typical of just-in-time production or may be held in storage somewhere away from production for the near future as safeguard or “hedge” against changes in demand, however storing and monitoring inventory, are costly to the business so why doesn’t every business use just-in-time production?
With so many factors influencing success of a business and inventory management having such a wide scope within a company, it often comes into contact with these factors and can make or break a business. Inventory management has its advantages and disadvantages, therefore throughout this report I will discuss the pros and cons of holding inventory and different models and methods available to businesses for inventory management as there is not one specific model suitable for all scenarios in the business environment.
The advantages and disadvantages of holding Inventory
Holding inventory is best described as a company storing excess inventory for purposes such as reducing order cost, smoothing demand, to meet demand and keep operations running in the face of an unexpected event. Despite the obvious costs such as storage which are incurred from holding inventory there are a number of advantages to having excess inventory on hand.
One of the business fundamentals in order for a retailer to stay in business is to meet demand. It must have the products that the customer wants, on hand whenever the customer needs them. If not, the retailer will have to back-order the product. If the customer can get the good from some other source, he or she may choose to do so. Hence, in many instances, if a product is not in inventory, a sale is lost forever.
However demand is not so clear cut to forecast, and can fluctuate depending on the market in which the business operates and this ties in with another advantage to holding inventory which is to smooth out demand requirements. Had the business which lost the customer held excess inventory, a sale would have been made and this would justify the cost of holding extra inventory because it has effectively paid for itself. Furthermore holding inventory can be beneficial where an order has been put in to order goods in bulk as a result if the discount from ordering in bulk is large enough to meet the extra cost incurred from holding extra stock then this also justifies the decision to buy in bulk.
Another advantage of holding stock is to remove the risk of running low on stock via the control of lead time which is the time that elapses between the placing of an order (either a purchase order or a production order issued to the shop or the factory floor) and actually receiving the goods ordered. If a supplier (an external firm or an internal department or plant) cannot supply the required goods on demand, then the client firm must keep an inventory of the needed goods. The longer the lead time, the larger the quantity of goods the firm must carry in inventory. A just-in-time operating firm can maintain low levels of inventory. However, steel manufacturers may have a lead time for arguments sake of 2-3 months. Therefore a company that uses steel produced at the mill must place orders at least three months in advance of their need.
However, despite a large inventory having its benefits, it also carries with it some great risks and disadvantages. For example, an obvious disadvantage of holding inventory is the space required to store the goods. Storage space like warehouses and private storage companies such as big yellow storage cost money to rent and maintain. Storage facilities require workers to maintain stock and make sure they’re ready to be transported from one place to another; furthermore high levels of inventory can lead to higher insurance costs.
Also keeping a large inventory can be dependant in what market a business decides to operate itself in. A company that operates with perishable goods will find that carrying a large inventory will run the risk that not all of the products will be sold and may have to be discarded. Also in the technology industry, some electronic or machine become obsolete and depreciate quickly, a good example is the news that 3D printing could eventually being able to replace out dated machines and perhaps even labourers where it has now been developed to the extent it can print the bodies of cars.
Models available for order quantity and re-order level
Fixed Order Quantity Model
The fixed order quantity model is an arrangement in which inventory level is continuously monitored and replacement goods are ordered in fixed quantities whenever at-hand stock falls to the reordering point. Economic Order quantity is an example of the fixed-order-quantity model since the same quantity is ordered every time an order is placed when inventory levels drop to the reorder point. EOQ also looks to minimise total variable costs needed to order and maintain inventory.
Economic order quantity in essence is a formula which determines the level that the combination of order costs and inventory holding costs are the lowest. “In purchasing this is known as the order quantity, in manufacturing it is known as the production lot size.” “A” in this formula represents annual demand with “Cp” being cost to place a single order and “Ch” is the cost to maintain one unit of inventory for a year. The result is the most cost effective quantity to order. However without a re-ordering point formula, EOQ becomes useless because we have no idea when to order our stock and could end up ordering too much or too less.
The re-order level is the level of inventory at which a new order for supply of materials is to be placed as a result, this level is fixed somewhere between maximum and minimum levels. Where current inventory level matches the re-order level, a new order will be put into place however order points are subject to certain factors such as usage during time necessary to requisition order, and receive materials, plus an allowance for protection against running out of inventory.
“Re-order level = Maximum daily or weekly or monthly usage × Lead time. The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable: Re-order level = Maximum daily or weekly or monthly usage × Lead time + Safety stock.”
Clearly, a high re-order level will lower shortage costs and increase holding costs. Conversely a low re-order level will increase shortage costs and lower holding costs. At some intermediate value for the re-order level, the sum of shortage and holding costs will be minimized.
Overall, we assume that demand, ordering cost and lead time are all constant for EOQ allowing the reorder level to be easily predicted, however demand during any period is uncertain and both ordering costs and lead time are dependant on the supply and no supplier is 100% reliable, furthermore if you’ve got a high periodicity or seasonality to your consumption, or your usage is very minimal. EOQ should only be applied to higher volume items that are worth inventorying ideal for Wooden Wonders Ltd.
Fixed Order Interval Model
Fixed order interval model is best described as “an inventory control system where stock level is reviewed regularly at fixed intervals (daily, weekly, monthly) not continuously like fixed order quantity, and whenever stock falls below a certain level, an order to replenish inventory to the required level is placed.”
Looking at Fixed Order Interval in manufacturing, when the stock level of a product is not sufficient to maintain the production operation, an order is placed by management to replenish the inventory. How often reviews take place is determined with the degree of control desired by management. An item might be reviewed weekly, monthly, quarterly depending on factors such as demand.
When to order in fixed order interval again, is controlled by the dates set by the inventory manager. If material usage remains constant, an order is typically placed at each review of a product. The order date is also impacted by the volume of inventory last ordered.
One of the many reasons this inventory management system is employed is to physically control and monitor produce closely and to achieve low variable costs in the production process. Therefore the order quantity typically is what is needed to cover the time span between the reviews; lead time is also taken into account also a small safety stock is usually carried using the method and is based on the variability of lead time.
This model operates most effectively in a company that has a constant operation function, in which demand is remains steady and measured with reasonable accuracy. In this case using this model tends to keep inventory levels lower in comparison to other forms of inventory control could.
To summarise, the fixed order interval model is most effective in organisations that operate largely with a demand that’s easily predictable and struggles in fast changing or usually seasonal markets. To conclude, the cyclical system finds its greatest usage in organizations that have large numbers of independent demand items to control, or in relatively simple process operations where dependent item demand can be projected easily from the production schedule. However, as a product becomes increasingly complex, a large number of items maybe be used in one product this becomes a virtually impossibility to manual review accurately if large quantities are shipped out despite the regularity so historical demand data tends to be the basis on which the order quantity is determined as a result this leads unusually high inventory levels and costs.
An Alternative Method of Inventory management
Just in time is a model of production where the orders themselves provide the signal for production of a good to begin. The actual orders allow a firm to produce only what is needed, in the right quantity at the right time.
This then means that inventory levels of materials, work in progress and finished goods can be kept to a minimum as are the costs of holding inventory where almost no inventory is held at all. This requires a carefully planned scheduling and flow of resources through the production process. Modern manufacturing firms use sophisticated production scheduling software to plan production for each period of time, which includes ordering the correct stock. Information is exchanged with suppliers and customers through Electronic Data Interchange to help ensure that every detail is correct.
Supplies are delivered right to the production line only when they are needed. For example, a car manufacturing plant (such as General motors, Ford motor company, Toyota Motor company who all use J.I.T) might receive exactly the right number and type of tyres for one day’s production, and the supplier would be expected to deliver them to the correct loading bay on the production line within a very narrow time slot.
On one hand, Just-in-time production means that the business is holding fewer inventories therefore the business will see a reduction in storage space which saves them rent costs and possibly insurance. Furthermore J.I.T can be beneficial to companies in the perishable goods industries, as stock is only obtained when absolutely necessary freeing working capital tied up in stock and significantly reduces the risk of stock perishing or becoming out of date.
Demand can be forecast but never guaranteed within business, and sudden changes in consumer trends can leave companies holding large inventories with unsold or unfinished products with money tied up in useless stock. J.IT however avoids this build up of useless stock that goes hand in hand with the sudden changes in demand. With less company time being spent of quality assurance, the emphasis becomes getting it right first off and the production becomes more efficient as employees become more competent.
On the other hand, with minimal stock being kept for re-working faults there is no room for errors and quality of the product may suffer as a result. Furthermore, production in this manner is dependant upon reliable suppliers and as I previously mentioned in the report, there is not one supplier that can guarantee perfect service throughout the year and if suppliers are delayed for whatever reason then the whole production process can be delayed.
A final disadvantage of J.I.T is that without excess inventory, there is no spare finished products to meet an unexpected rise in demand because products are made to meet actual orders from customers conversely J.I.T can be a responsive method of production although it is difficult to respond a production catastrophe.
“Toyota, found this out the hard way. A fire at Aisin seiki Company’s plant stopped the delivery of all break parts to Toyota. By Tuesday, Toyota had to close down all of its Japanese assembly line. By the time the supply of break parts had been restored, Toyota had lost an estimated $15 billion in sales.” (Toyota to Recalibrate, International Herald Tribune, February 8, 1997.)
In short this could be an ideal process for Wooden Wonders Ltd and suits the FIFO method of recording inventory. Operating in the household furniture market, demand is unlikely to fluctuate and with large multinational manufacturing companies like General Motors using J.IT, it proves larger businesses can operate under this system and with many of Wooden Wonders customers being department stores from across Europe, this could be an ideal inventory management system.