INVENTORY: MANAGE YOUR SUPPLY CHAIN SO IT DOESN’T MANAGE YOU
Every year, certain toys are designated “the hot thing this season.” Some of these become runaway hits, while others are temporary fads. In the thirties, the Ideal Toy and Novelty Company sold 45 million dollars worth of Shirley Temple dolls, which were (at least according to NBC News) the first of the “celebrity-driven dolls.” You may have heard the term “Chatty Cathy,” but you might not know it was a best-selling doll from the sixties that talked (one version of which featured the voice of “Brady Bunch” actress Maureen McCormick). Then there were Cabbage Patch Kids, Teddy Ruxpin, the Furby, and of course, Tickle Me Elmo.
All of these toys were in such demand that stores sold out of them prior to Christmas, prompting parents to search furiously — and sometimes, to pay scalpers’ prices — lest they disappoint their kids Christmas morning. More recently, the popularity of Disney’s “Frozen” franchise prompted toy scalpers and eager parents to buy up the toys faster than they could be made, producing a thriving secondary market for the merchandise at prices far higher than MSRP.
These crazes happen every year. They represent just one aspect of a failure to properly manage inventories. It doesn’t matter if you have a best-selling product that everyone wants... if you don’t have units on the shelves to sell, the financial outcome is the same as not having a product at all.
Inventory management involves planning and control of all types of inventories. This may include forecasting demand, purchasing materials, and fulfilling sales orders. Inventory management is built on two frequently made decisions:
1.When to order
2.How much to order
Business leaders, to manage their inventories, must also decide whether an item should be stocked. If an item is not stocked in anticipation of future demand, the firm must make, assemble, or buy the item to meet surges in demand. This results in customers having to wait for the product on backorder unless the production and order-fulfillment lead time (the time it takes to make and fulfill the customer’s order) is so short that it is part of the expected delivery time — and therefore customers don’t experience additional delays (the Dell computer order fulfillment process is a good example).
The objective of inventory management is to strike the best balance between inventory investment and customer service.
FUNCTIONS OF INVENTORY
Inventories serve multiple functions. Among these are the following:
•To provide a selection of goods for anticipated customer demand and to protect the firm from fluctuations in that demand
•To decouple various parts of the production process
•To take advantage of quantity discounts for inputs of production
•To hedge against inflation and upward price changes, which increase the cost of inputs and labor
TYPES OF INVENTORY
There are multiple types of inventory. These include the following:
•Raw material inventory– Materials, usually purchased, that have yet to enter the manufacturing process
•Work-in-process inventory– Products or components that are no longer raw materials, but which have yet to become finished products
•MROs – Maintenance, Repair, and Operating materials
•Finished goods inventory – End items or products ready to be sold
In many companies, inventory represents a significant portion of total invested capital. Costs associated with managing inventory include:
•Holding costs –The costs of holding or “carrying” inventory over time
•Ordering costs –The costs of placing an order and receiving goods
•Setup costs –Cost to prepare a machine or process for manufacturing an order, which may correlate significantly with setup time
To manage inventory, business leaders must recognize that there are two types of demand for inventory. There is demand for finished products, and there is demand for components, parts, and raw materials (the inputs of production). These are termed independent demand and dependent demand, respectively.
•Independent demand –The demand for the item is independent of the demand for any other item in inventory.
•Dependent demand –The demand for the item depends on the demand for some other item in the inventory.
INVENTORY TURNOVER
A key metric in inventory management is inventory turns or inventory turnover. Inventory turnover is the number of times that the inventory is “turned” or replaced during a time period, usually a year. More turns equals better inventory management, which translates to a high rate of throughput and conversion to sales (cash) for the business. Companies that are managed well, especially those whose leaders have implemented TPS and Lean, typically exhibit high inventory turnover.
FIXED QUANTITY AND FIXED PERIOD INVENTORY CONTROL MODELS
There are two basic models in inventory control. These are fixed quantity (Q) and fixed period (P).
Fixed quantity (Q) system – An ordering system in which the same amount Q is ordered each time whenever the inventory level falls below the reorder point (ROP). This requires a perpetual inventory system in which records are updated every time an item is added or withdrawn from inventory.
Fixed period (P) system – A system in which inventory orders are made at regular time intervals (P). Inventory is ordered at the end of a given period (such as a shift, day, week or month). Then and only then is on-hand inventory counted. Only the amount necessary to bring total inventory up to a prescribed target level (T)is ordered. The shorter the period, the higher the inventory turns. In JIT or TPS/Lean environments, periods can be as short as every shift or even every hour.
An important concern in inventory management is maintaining an adequate service level in the face of variation or uncertainty in demand and/or replenishment lead time. Service level (which measures the performance of the system, and which should not be confused with fill rate, a measure of how effective inventory is at meeting demands) is the complement of the probability of a stockout. (Stockout is when an inventory item runs out.)
Probabilistic inventory control, which uses the average demand for inventory items to predict the demand at various service levels, accounts for such variations. Reorder points (ROP) and target inventory levels (T) are adjusted to accommodate the variation in demand and lead time for a stated service level, typically at 95%.
In JIT or TPS/Lean environments, such variation or uncertainty is minimized or even eliminated.
SUPPLY CHAIN MANAGEMENT
Supply chain management describes the coordination of all supply chain activities, starting with raw materials and ending with a satisfied customer. It includes activities required to manage the flow of materials, information, people, and money from the suppliers’ suppliers to the customers’ customers.
Supply chain management is the integration of and coordination between a number of traditional business functions, including purchasing, operations, transportation, distribution and logistics, marketing and sales, and information systems and technology.
The objective of supply chain management is to coordinate activities within the supply chain to maximize the supply chain’s competitive advantage and its benefits to the end user and consumer.
MANAGING INVENTORIES AND SOURCING
Good supply chain management produces lower total system cost (lower inventory, higher quality, higher service levels, increased revenues, and increased profits for the supply chain). A key issue revolves around how the supply chain will share the benefits of improvements among players or partners in the supply chain.
SOURCING ISSUES: MAKE OR BUY VS. OUTSOURCING
Business leaders face another important decision when it comes to sourcing inventory. Will they produce it in-house, or will they have it produced outside the company? Make or buy is a phrase commonly used in inventory management to refer to producing inventory internally, while outsourcing refers to obtaining products and services external to the company.
Outsourcing offers certain benefits compared to producing inventory in-house. Outsourcing transfers certain traditional internal activities and resources to outside vendors, who may benefit from specialization and therefore be able to produce certain inputs or finished products more efficiently. This allows the company to focus on its core competencies. For example, a skilled manufacturer of machine parts may not necessarily have the equipment or skills in-house to produce LEDs as efficiently as Cree, one of the world’s best-known LED manufacturers. The company could outsource production of LEDs to Cree while still building most of its products, such as flashlights, in-house. This allows the business to focus on what it does well while purchasing externally those items it can’t easily produce.
SOURCING STRATEGIES
There are a number of common sourcing strategies a business may employ to obtain inputs of production (or finished goods). These include the following:
•Many suppliers may be used for commodity products, where purchasing is typically based on price. The suppliers compete with each other, which produces cost savings for the buyer.
•Few or single supplier means the buyer forms longer-term relationships with fewer suppliers to create value through economies of scale and learning-curve improvements. Suppliers are more willing to participate in JIT programs and contribute design and technological expertise, but the cost of changing suppliers (and bringing them up to speed) is high.
•Vertical integration is another strategy. Integration may be forward, towards the customer, or backward, towards suppliers. This can improve cost, quality, and inventory, but it requires capital, managerial skills, and demand. It is also risky in industries experiencing rapid technological change.
•Joint ventures represent another strategy in which companies formally collaborate with one another. Skills are enhanced, supply is secured, and costs are reduced, producing benefits for all of the participants.
MANATING AN INTEGRATED SUPPLY CHAIN
There are many issues in managing the integrated supply chain. These issues include the following:
•Local optimization can magnify fluctuations. The bullwhip effect occurs when orders are relayed through the supply chain, increasing at each step.
•Incentives push merchandise into the supply chain for sales that have not occurred.
•Large lots reduce shipping costs, but increase inventory holding costs and do not reflect actual sales.
Opportunities to address some of these issues include the following:
•Accurate “pull” data, shared information
•Lot size reduction coupled with reduced ordering costs
•Single-stage control of replenishment where there is a single supply chain member responsible for ordering
•Vendor Managed Inventory (VMI), a common practice at the downstream supply chain partner
•Collaborative planning, forecasting, and replenishment (CPFR) throughout the supply chain
•Blanket orders against which actual orders are released
•Electronic ordering and funds transfer speed transactions and reduce paperwork
•Drop-shipping and special packaging bypasses the seller and reduces costs
SUPPLY CHAIN RISKS
Some of the associated supply chain risks include the following:
•More reliance on supply chains means more risk
•Fewer suppliers increase dependence
•Globalization and logistical complexity
•Vendor reliability and quality risks
•Political and currency risks
RISK AND MITIGATION TACTICS
Business leaders can cope with or mitigate risks through the following tactics:
•Research and assess possible risks
•Innovative planning
•Reduce potential disruptions
•Prepare responses for negative events
•Flexible, secure supply chains
•Diversified supplier base
REAL-WORLD RISK MITIGATION EXAMPLES
The following are a couple of examples of risks, risk reduction tactics and how companies address them:
•When McDonalds opened in Russia, there was a real risk that local suppliers would fail to deliver the inputs ordered. One relevant risk reduction tactic is to use multiple suppliers, employ contracts with penalties, pre-plan the supply chain, and keep other subcontractors on retainer. Every plant involved in McDonalds production in Russia — bakery, meat, chicken, fish, and lettuce — is closely monitored to ensure strong links and thus make on-time delivery more likely.
•Darden Restaurants, in an effort to avoid supplier quality failure, engages in careful supplier selection, training, certification, and monitoring. It has placed extensive controls, including third-party audits, on supplier processes and logistics. This ensures constant monitoring and thus reduction of risk.
•Walmart has its own trucking fleet and employs numerous distribution centers throughout the United States. Using multiple, redundant transportation modes and warehouses, secure packaging, and contracts with penalties is one way to prevent logistics delays and damage to inputs. When necessary, Walmart finds alternative origins and delivery routes, bypassing problem areas.
•Toyota trains its dealers around the world to monitor, select, and contract carefully with its distributors. The principles of the Toyota Production System help dealers to improve customer service, used-car logistics, and body and paint operations. Toyota also provides an excellent example of how to deal with the risk of natural disasters, such as earthquakes, fires, and tsunamis. It maintains at least two suppliers in different geographical regions for each component.
•Boeing uses a state-of-the-art internal communication system that transmits engineering, scheduling, and logistics data to Boeing facilities and suppliers worldwide. The use of redundant databases, secure IT systems, and training of supply chain partners on proper interpretations and uses of information, helps prevent information loss or distortion.
•Honda and Nissan have moved manufacturing out of Japan as a means of combating economic risk. Hedging to combat exchange rate risk, and employing purchasing contracts that address price fluctuations, are other methods used to combat economic risk. The exchange rate for the Japanese yen makes Japanese-made automobiles more expensive... at least for the time being.
TO POSITION YOURSELF FOR PROFIT, YOU MUST MANAGE INVENTORY
Managing the inputs of production — and ultimately making sure you have a product on the shelves to sell your customers — is a critical part of managing your business. To position itself for economic advantage, a company must manage its inventory if it is to meet the anticipated demand for what it produces. Savvy business leaders must come to terms with inventory management as a critical component of ongoing operations.
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