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Inventory Determination

Inventory is quantities of goods in stock. This is true for any product, material, or good. Consider the books or CDs on your bookshelf. They comprise an inventory of books. They provide you with a certain value from enjoying them to the monetary value you paid for them. They cost money to purchase—money that cannot be used for something else. The same is true for inventory companies hold in stock. When we talk about inventory we are simply talking about quantities of materials a company has in storage. This material serves many purposes, but it also ties up a great deal of funds. As a result, managing inventory throughout the entire supply chain is important.

All organizations—both manufacturing and service organizations—carry inventory. A great deal of inventory must be carried to support basic processes of the operation. In manufacturing, inventory can take a variety of forms. This includes raw materials and component parts, which are delivered from suppliers, work-in-process (WIP) inventory, or finished goods. Inventory also includes supplies and equipment. Inventory can tie up funds if it sits unutilized in stock; however, not having enough inventory when needed can mean stockouts or production delays. As a result managing inventory is a critical part of operations management.

The major decisions in inventory relate to when to replenish stock, and how large orders should be. This is called an inventory policy. An inventory policy addresses the basic questions of when and how much to order. To understand more about determining an inventory policy we need to first look at some reasons for carrying inventory.

Reasons for Carrying Inventory

Organizations carry inventory for many reasons, and all companies—even those that practice lean systems—carry inventory. In fact, organizations cannot run without a certain amount of inventory. Some reasons that organizations carry inventory are as follows:

  1. Protect against stockouts—One reason for carrying inventory is that goods cannot arrive immediately when you run out of stock. A certain amount of lead time is needed for goods to be produced and delivered. You have to make sure that you have enough inventory in stock to cover demand during the period of lead time. Lead time will have a certain amount of variation, which may result from shipping delays, production problems at the supplier site, lost orders, defective materials, and numerous other problems so you have to plan to be prepared. Also, sources of supply are rarely at the same location as demand, and you cannot locate a production facility everywhere there is demand. As a result, inventory has to be transported from one location to another, and sometimes held in a distribution center to be distributed when needed at the various locations. The result is the need to carry inventory to protect against possible stockouts.
  2. Maintain independence of operations—During the production process as well as the supply chain, the product is moved through many different operations that have different processing rates. The challenge is balancing different processing capabilities, and it is not always possible. Therefore, you need a cushion between operations, and inventory at different points in the system serves this purpose. Extra inventory strategically placed evens out differences in processing capability. Extra stores of inventory can be placed at various points in the supply chain network, or at work centers within a facility, to give it flexibility.

    Just consider the high interdependence of work stations on an assembly line. Inventory is typically placed between work stations to decrease their interdependence. Otherwise, work stoppage at one station may disrupt or otherwise shut down the entire assembly line. Also consider that there is natural variation in processing times between identical operations due to randomness. As a result it is desirable to create a cushion of inventory so that output can occur at a constant rate.

  3. Balance supply and demand—Balancing supply on one side of the supply chain with demand on the other is always a challenge. Demand is never known with certainty and holding extra inventory enables an organization to meet unexpected surges in demand. Also, consider that demand occurs intermittently, rather than on a continuous basis. An example might be retail sales, which are slower on weekday mornings but high over the weekends. Not having extra inventory might mean missed sales. Carrying inventory helps to address these natural variations in demand.

    Seasonal demand patterns also contribute to high and low periods of demand, such as ice cream sales in the summer or snow shovel sales in the winter. It would be costly for production facilities to produce products in unison with the seasonality of demand. This might mean closed facilities and unemployed workers during low seasons, and overtime production during high seasons. A more common strategy is for companies, and their supply chains, to produce at a more uniform rate during the year. In this case extra products are stored in inventory and used during peak seasons.

  4. Protect against uncertainty—Many unexpected events occur that impact both supply and demand. This is due to randomness and could be anything from a batch of damaged goods being received, to an unexpected delay due to weather, or a strike at a supplier’s plant. Companies carry extra inventory in stock to protect themselves, or buffer, against these uncertainties. This is a “just in case” scenario. However, companies know that they have to be prepared so that they don’t run out of stock.
  5. Economic purchase orders—You have heard about keeping inventories low, but in this scenario inventory may be purchased in large quantities. There are a number of reasons why this might be advantageous. For example, suppliers sometimes offer price discounts to encourage customers to purchase larger quantities at one time. Similarly, buying in large quantities might result in savings associated with transporting larger quantities at one time. Also, anticipating some type of price increase, shortage, or disruption might lead companies to buy larger quantities. Purchasing larger quantities in anticipation of shortages, for example, is a common supply chain strategy.

Types of Inventory

To better understand inventory we need to look at different types of inventories and their purposes, as their quantities are computed differently. Together they collectively add up to inventory costs for the organization. Let’s look at these here:

  • Cycle stock—This category of inventory is computed for immediate use and is also called lot size inventory. It is computed based on expected demand over a certain time period and assumes demand is known. This simply computes how much stock is needed to cover demand over a set period of time. It also accounts for the fact that products are typically produced in batches. This is the quantity, or the size, of the batch that is produced during the production cycle. Therefore it is called cycle stock.
  • Safety stock—This is inventory carried to serve as a cushion for uncertainties in supply and demand. It can be in the form of finished goods to cover unexpected demand, raw materials to guard against supply problems, or work-in-process inventories to guard against production stoppages.
  • Seasonal inventory—These inventories are carried to compensate for differences in the timing of supply and demand, and to smooth out the flow of products throughout the supply chain. They are called seasonal inventories as they are often used when demand fluctuations are significant, but predictable, such as with seasonal variation. This is where companies carry extra inventory during a low season in anticipation of higher demands during the high season. Finally, these are inventories that are carried in anticipation of a price increase or a shortage or products. For this reason they are sometimes called hedge inventory.
  • Transportation or pipeline inventory—This is inventory that is in transit and exists merely because the points of demand and supply are not same. At any one time a global supply network has a large percentage of its inventory in transit—on a barge, truck, or rail—being moved from one location to another, or waiting to be loaded or unloaded.
  • Maintenance, repair, and operating (MRO) items—In addition to inventories that directly support product creation, other inventories are used indirectly. These are MRO items and include everything from office supplies and forms, to toilet paper and cleaning supplies, to tools and parts needed to repair machines. Collectively, MRO items make up a significant amount of inventory and need to be managed like all other inventories. Just think about the amount of paper, pencils, and other supplies in an office. You expect them to be there, and without them work can be significantly hampered.
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