Effective Inventory Management: Classes, Critical Factors, and Costs
Item-16 Inventory Management Concept
Inventory is a collection of items accumulated or stored, pending subsequent use or claim.
Main Function
To balance the flow of production and the flow of demand across different timeframes. Inventories (raw materials, work in progress, etc.) represent around 20% of the total assets of Spanish companies. Therefore, inventories are critical assets impacting profitability, liquidity, and business taxation.
Inventory-related decisions are crucial for coordinating production, marketing, and finance to determine the optimal inventory levels.
Inventory Classes
According to Their Nature
- Finished products
- Commodities
- Ongoing or semi-finished products
- Base materials and packaging
According to Their Functional Categories
- Cycle inventories
- Safety stock
- Seasonal inventory
- Inventories in transit
Cycle Inventories
It’s often impractical to buy or produce items as they are needed. Ordering larger quantities than current needs leads to cycle inventory, which is consumed over time.
Safety Stock
Safety stock protects against demand and delivery uncertainties, preventing stockouts that could halt production or dissatisfy customers.
Seasonal Inventory
Seasonal inventory aims to meet expected sales increases, such as ice cream in summer.
Inventories in Transit
Inventories in transit are items circulating through production and distribution stages, like between a finished goods warehouse and a regional distribution center.
Often, inventory situations combine several functional characteristics. For example, cycle inventory can be both seasonal and safety stock.
Critical Factors in Inventory Management
Two fundamental questions in inventory management are:
- How much of each material or product to order?
- When to order?
To answer these, consider:
- The nature of demand
- The supply time
- Inventory costs
Nature of Demand
- Certain Demand: Known with certainty.
- Probabilistic Demand: A random variable.
In reality, certain demand is mainly seen in companies working exclusively on order. However, assuming known demand can simplify decision-making.
Differentiate between:
- Independent Demand: Demand for an item is unrelated to other items.
- Dependent Demand: Demand for an item depends on the demand for another item.
Delivery Time
Delivery time is the time elapsed from order placement to receipt, whether from a supplier or internal production. It can be certain or random.
Inventory Costs
Inventory costs include acquisition, ordering, storage, and stockout costs.
- Acquisition Cost (CA): Cost to acquire items from suppliers or internal manufacturing cost.
CA = D * P (D = annual demand, P = unit price) - Ordering or Renewal Cost (CE): Costs associated with placing an order or issuing a production warrant.
CE = E * D / Q (E = unit ordering cost, Q = order quantity, D/Q = number of orders) - Possession or Storage Cost (CP): Costs of physical storage, including rent, and the cost of funds tied up in inventory.
CP = A * Q / 2 + i * P * Q / 2 (A = annual storage cost per item, i = average profitability or interest rate, Q/2 = average inventory level) - Stockout Cost: Costs incurred when demand cannot be met, including downtime, lost sales, and damage to reputation.
Costs can be categorized as:
- Increasing with order quantity (e.g., storage cost).
- Decreasing with order quantity (e.g., ordering and stockout costs).