Introduction to Inventory Management: Principles and Strategies for the Efficient Flow of Inventory across the Supply Chain
- Apr 24, 2014
In June 2013 the Council of Supply Chain Management Professionals (CSCMP) released its annual State of Logistics Report. The document consists of several key logistics-related trends and data analyses that provide the reader with a snapshot of the emerging issues in the discipline and a source for benchmarking supply chain activities of a firm. One of the primary aspects of the report was the discussion of inventory trends. According to the report, inventories in the retail, wholesale, and manufacturing sectors all rose in 2012. Interestingly, retail inventories increased by 8.3 percent, more than twice the increase of wholesale inventories and more than six times that of manufacturing inventories. Likewise, inventory-related costs increased, with inventory carrying costs up by 4 percent. Perhaps even more interesting was the fact that these inventories were not necessarily moving, as the retailers reported significant overstocks through the latter half of 2012.
As the CSCMP report highlights, inventory is a fundamental measure of the overall health of supply chain and logistics activities. Because supply chain management efficiencies and executional excellence have become core strategic goals for most major firms over the last two decades, there has been a surge in C-level executives who focus on inventory-related costs and measures. Inventory reduction initiatives have become commonplace, with many supply chain and logistics professionals indicating that inventory-related efficiencies have become a culture and mindset within their organizations.
With so much emphasis on inventory, we feel it necessary to start this book with the basic fundamentals and foundations of the concept. So, we open with a question...
What Is Inventory?
What is inventory?1 This may seem like somewhat of a rhetorical question. Perhaps, at the very least, it could be considered a question with an obvious answer. However, inventory is one of the most interesting, intriguing, and misunderstood business phenomena. At the root of this misunderstanding are the various perspectives on what inventory represents. Thus, the next sections present the predominant definitional perspectives on inventory.
The GAAP Perspective
According to Generally Accepted Accounting Principles (GAAP), the primary framework for financial accounting standards, inventory is a current asset. In particular, inventory represents “tangible personal property which are held for sale in the ordinary course of business; are in process of production for such sale; or, are to be currently consumed in the production.” In other words, inventory (in the form of “work-in-process,” “raw materials,” or “finished goods”) is an asset because it represents property that is likely to be converted to revenue, as the ultimate goal of inventory is to facilitate sales for an organization. Thus, Accounting 101 would indicate that inventory is properly accounted for on financial statements by being reported in dollar value terms as a current asset on the balance sheet.
Several years ago, an undergraduate student asked one of the authors an insightful question. “If inventory is an asset, then why are so many firms engaging in ‘inventory reduction initiatives’?” This question underscores the intriguing nature of inventory. Yes, according to GAAP, it is an asset, as it represents potential revenues. However, the management of inventory renders it an asset that comes with a price tag. Thus, inventory management is why inventory is such an interesting business phenomenon. It’s the art of managing an asset that is often viewed as a liability even though it is an asset. Various measures of inventory in the supply chain are perhaps the most salient metrics for the efficiency and effectiveness of the supply chain.
The Supply Chain Management Efficiency Perspective
One of the primary goals of supply chain management is to ensure that operations within and across firms in a supply chain are efficient. In many cases, the means to ensure efficiencies is in inventory; more specifically, in inventory reductions. Considering this, inventory is often viewed as a liability to efficient supply chain management. While supply chain managers recognize the necessity of inventory, the unwritten (and in many cases, written) rule is to keep inventory at a bare minimum. This goal gave rise to many of the popular supply chain management frameworks that are ubiquitous today: just-in-time inventory management; lean inventory; and even collaboration initiatives like collaborative planning, forecasting, and replenishment (CPFR). Overall, these strategic initiatives were all developed with the goal of streamlining inventories across the supply chain and keeping inventory investment as low as possible.
The concept of inventory investment is, perhaps, the underlying reason why supply chain managers attempt to keep inventories low. The cost investment associated with having inventories can be high. These costs are addressed in much more detail later in the book, but suffice it to say, for now, that these costs include the cash outlay required to actually purchase the inventory, the costs of holding the inventories (which includes the cost of having invested in inventories instead of something else), and the costs associated with managing the inventory. Considering this, the managerial approach of keeping inventories as low as possible is not necessarily because it’s inventory, per se, but because it’s money—money tied up in something that costs even more money as it sits idle. In addition, metrics such as return on assets are affected by inventory since inventory is in the asset category on the balance sheet.
The Risk Management Perspective
Perhaps another interesting answer to the “what is inventory?” question is the risk management perspective. An interesting shift occurred recently regarding inventory. Though most firms still attempt to keep inventories as low as possible because of the costs associated with holding and managing it, there has been a growing emphasis on the costs of not having or effectively managing inventories.2 In other words, inventory has been increasingly viewed from a risk management perspective, where the costs and impacts of stockouts, missed service opportunities, and unforeseen supply chain interruptions have become a primary decision-driver for firms. This has resulted in firms becoming much more favorable to concepts (discussed in much more detail later in the book) such as safety stock. Their rationale has been the sentiment, “we can’t afford to not have safety stock inventory!” Because of this, inventory has interestingly become a means of managing risks.
In general, there appears to be much more sensitivity to the risk of potential supply chain disruptions.3 In many cases, these disruptions are the result of some uncertainty involved in managing supply chain processes. Sometimes the uncertainty is because of poor information availability; sometimes it is associated with uncertainty in supplier lead times; sometimes it is uncertainty in execution of specific tasks in various supply chain processes. In any case, uncertainty is the primary culprit involved in supply chain disruptions. One way that many firms have chosen to deal with such uncertainties is to hedge against them with inventory investment. Although this philosophy is cause for much debate, the reality is that many businesses engage in this practice for various reasons and, therefore, view inventory as a means of managing and mitigating risks.
Another popular variation of the risk management perspective is investing in inventory as a means of hedging against currency and price fluctuations. Vendors often offer short-term volume discounts, the prices of many raw materials are based on market value, and purchasing from global suppliers involves currency exchange rates. To hedge against these potential fluctuations and changes, many firms opt to invest in inventory as a means of locking in prices and currency valuations. Doing this ultimately prevents them from being susceptible to the risk of inventory costs going above budgetary and capital constraints.
The Balanced Perspective
As all the preceding definitional perspectives suggest, inventory has a variety of meanings and symbolic roles within supply chains. This understanding is perhaps the most important and fundamental starting point for effective inventory management. Inventory is an asset, but an asset that firms don’t want too much of. Yet not having “too much” could put the firm at risk of potential supply chain disruptions and unforeseen extreme costs. As such, the key to effective inventory management is balance—maintaining adequate inventories to ensure smooth production and merchandising flows while simultaneously minimizing inventory investment to ensure firm financial performance. This balance is often referred to as optimal.
The quest for optimal inventory levels is not an easy undertaking. It involves an interweaving of several analytical methods and techniques. Moreover, several interconnected decisions must be made to maintain optimal flows and seamless exchange of inventories along the supply chain. These issues are the focus of this book and are discussed in much detail in the forthcoming chapters.