Essential Elements of an Effective Inventory Management Strategy

Published November 3, 2021

A successful inventory management strategy can reduce the stocking of redundant inventories in different links in the supply chain. In addition to reducing costs for partners across the chain, it also reduces the chance of obsolete inventory becoming clogged in the pipeline while competing supply chains are moving products to market.

Developed after World War II, traditional inventory management theory was philosophically limited in its view to a single link in the supply chain. The science included the use of comparative economics to address cycle stock, statistics to address safety stock and logic to address stocking policies. Today we see inventory management as a collaborative process, with multiple links of the supply chain working together to create a competitive advantage.

The dynamics of the supply-demand interactions between links are better understood today. In particular, we understand that long-term customer satisfaction is dependent on more than the link from which the customer directly purchases a product. Information visibility and collaboration between multiple links of the supply chain can completely rewrite the old rules and enable companies to achieve new levels of inventory performance.

An Effective Inventory Management Strategy Is Important

Regardless of length or complexity, inventory plays a central role in every supply chain. After network configuration and volume through each channel, inventory is the most fundamental characteristic of product flow from raw material supplier to end consumer.

Inventory’s Conflicting Roles

Inventory is not universally well understood. It is variously characterized in both positive and negative ways, depending on your viewpoint, including the following:

• An economic asset
• A non-income producing use of capital funds
• A potential opportunity for improving cash flow
• A vehicle for serving customer needs promptly
• A buffer from customer demand fluctuation
• An insurance policy against supply disruption

Of course, all of these are true and yet none tell the complete story. Only when considered simultaneously in light of all of the quality, customer service and economic aspects-from the purchasing, manufacturing, sales and finance perspectives-does the whole story become evident.

An Asset

Assuming that it is sellable, inventory is an asset in the financial sense, although an asset with no return in the traditional sense (some incremental increases in safety stock inventory do provide a return in terms of increased revenue).

Aside from accounting’s balance sheet, inventory is an asset to business in day-to-day operations, as it provides prompt customer service and reduces workflow complexity. For purchased products, holding inventory reduces the number of purchase orders to be issued and processed through accounts payable. For manufactured products, holding inventory reduces the number of equipment changeovers or setups required to support short-term customer needs-for example, allowing a plant to manufacture 100 products on any given day while shipping 10,000 products on the same day. Above and beyond the financial benefit, changeover reduction also significantly increases manufacturing capacity, minimizing the need for additional shifts, equipment and/or complete plants.

But Not Really an Asset

On the other hand, inventory is not an asset in the sense that it represents a draw down on capital funds that would have otherwise been available for investments providing a satisfactory return. Most important, funds tied up in inventory may delay internal investments in core business areas that are key to the future of the company. Further, inventory can cover up a variety of sloppy practices in purchasing, warehousing and transportation in all supply chains, as well as in production scheduling in manufacturing operations.

Objectives

The objectives of inventory management are clear and include the following:

• Direct
  • Achieve the desired customer service level
  • Minimize acquisition transaction costs
  • Minimize inventory working capital
• Indirect
  • Facilitate efficient product flow
  • Maximize profit

Inventory Strategy

At the core of inventory strategy for all supply chains is providing customers with what they want when they want it. In manufacturing, the primary objective becomes ensuring flow to maximize equipment utilization, while in maintenance, the focus becomes ensuring immediate inventory availability with little or no notice.

Then there is the matter of cost-variable purchasing, manufacturing, warehousing and transportation expenses, as well as the working capital invested. Cost may be subordinated to customer service but only up to a point.

Assuming that the customer requirements are known, three questions are implicit in forming an inventory strategy: What does the customer want? When will it be needed? What options do we have to meet the need?

Therefore, the driving forces for inventory are:

• The need for good service to individual customers, often in the absence of good information on individual customer needs, in terms of both product availability and timing
• Variability in demand for all individual customers, taken as a whole, having the potential to exceed short-term supply capacity
• Fluctuations in inbound lead time from suppliers
• The need to eliminate-or at a minimum, control-both transaction-related expenses and working capital investment

There are several major approaches to inventory, both for meeting customer needs and controlling costs, including:

• Strategic
  • Reducing uncertainty through information sharing
  • Increasing responsiveness
  • Reducing the cost of surprises
• Tactical
  • Scheduling techniques
  • Holding inventory

The three strategic approaches noted are designed to address the underlying issues of inadequate planning information (lack of communication, forecasting error, etc.), acquisition lead time greater than customer lead time, and transaction cost (purchase, setup, changeover, etc.), respectively. Or, to express it differently:

• If customer demand was known, through trustworthy, partnering relationships leading to increased visibility, then acquisition schedules could be coordinated with customer need schedules, and there would be little or no need for safety stock or cycle stock inventory.
• If delivery was more responsive by virtue of a reduced supply lead time, then the issue of inadequate information can be mitigated to some extent. Thus, if supply lead time is less than customer lead time, more products can be readily available for specific customer orders.
• If transaction unit costs were reduced, again in the absence of adequate information, then the cost penalty for mid-stream change to meet a specific customer’s needs is reduced, and less cycle stock inventory will need to be held.

To the extent that the strategic approaches cannot be completely implemented for all products, tactical approaches must be used-generally requiring some inventory, while minimizing the cost impact. The two tactical approaches noted work in conjunction with one another, with the scheduling techniques being applied first, then holding inventory being the last resort.

Inventory Constituents and Types

While inventories can be classified several ways, every individual SKU can be categorized as having independent demand or dependent demand. Independent demand items are directly affected by trends in the marketplace, while dependent demand items are directly related to the demand for other items. Independent demand is based on forecasts, while dependent demand is calculated from the bill of materials for independent items.

Constituents

Inventories have two constituents-cycle stock and safety stock. Cycle stock is intended for routine consumption, while safety stock is only used to meet excess demand or delays in supply. The underlying driving force for cycle stock is economics, while the underlying driving force for safety stock is customer service.

Types

Inventories can be categorized based on function, permanence and a variety of status characteristics.

Function-based

In the broadest functional sense, inventories include the following types:

• Decoupling: Inventory created to decouple supply from demand
• Hedging: Inventory created as a hedge against possible events or disruptions, including unpredictable demand spikes, political instability, labor strikes or price increases
• Anticipation: Inventory created in anticipation of known upcoming events, including promotions, seasonal demand and pending shutdowns
• Transportation (pipeline): Inventory in transit, either between purchaser and supplier or between purchaser locations

Permanence-based

Above and beyond their function, some inventories are more permanent in nature, while others are clearly temporary. Temporary inventories, in which different SKUs are on hand at different times, include the following:

• Transportation (pipeline)
• Work-in-process (WIP)

Transportation inventory is in motion, and the quantity depends on the unit volume per period and transit time from shipment to receipt. If the product is being shipped between purchaser and supplier, transportation inventory can be reduced by using higher velocity transportation and/or by acquiring product from physically closer suppliers. Reducing transportation inventory is in conflict with minimizing transportation expenses.

While most transportation inventory travels by trucks, railroad cars or ships, staged product in a warehouse is also a type of transportation inventory, and the quantity can be determined in the same manner.

In manufacturing, WIP includes released raw materials and partially completed product. In supply chain areas external to manufacturing, WIP is inventory that is temporarily unavailable for disposition, due to the need for inspection or processing.

Permanent inventories, in which the same SKUs are expected to be on hand at essentially all times, can be further differentiated by their orientation, including the following:

• Flow-oriented
  • Raw materials
  • Finished goods
  • Consumable maintenance, repair and operating supplies (MRO)
• Service-oriented
  • Spare parts
  • Used equipment
  • Retained samples
  • Tools
  • Files and records
  • Fleets of returnable containers
  • Fleets of mobile equipment – Forklifts, railroad cars, truck tractors and trailers, etc.

Flow-oriented inventories are driven by product purchases and sales, while service-oriented inventories are driven by a variety of factors.

Status-based

Inventories of all types typically have a status associated with them that further defines their availability, quality, disposition, control or ownership, including the following:

• Availability-based
  • On order, in transit, unloaded, received, available, allocated, etc.
• Quality-based
  • On/off specification, hold for retest, quarantined, waste, etc.
• Contents-based
  • Filled, product name, quantity, etc.
  • Empty-dirty, empty-clean, empty-former product (to be refilled), etc.
• Control-based
  • Push, pull, vendor managed inventory (VMI), etc.
• Ownership-based
  • If transportation: FOB origin, FOB destination, FAS, etc.
  • If decoupling, hedging or anticipation: Paid, consigned, etc.
• Location-based
  • Facility X, Staging Area Y, vehicle scheduling problem (VSP), etc.

Supply Chain Location-based

None of the above characterizations are independent. For example, all or a portion of a raw materials inventory may simultaneously: 1) have been acquired in anticipation, 2) be consigned, 3) be allocated, 4) be quarantined, and 5) be located in Staging Area X in 6) Facility Y. Characterization of an inventory in different ways is useful for different purposes. Beyond all of the above, however, the location of the inventory in the supply chain affects both the planning for and the expectations of performance from any inventory. The following breakdown has been constructed to make the point that all inventories are sequential parts of supply chains, whether the flow of product is within or between organizations. This concept will be helpful in understanding, for example, how a supplier’s changeover cost matters with respect to their finished goods inventory as well as to the purchaser’s raw materials inventory.

Single link examples (sequential inventories across organizational boundaries but within ownership boundaries):

• Manufacturer
  • Raw Materials – WIP
  • WIP – Finished Goods
  • Finished Goods – Customer(s)
• Value-added distributor
  • Not Priced – Price Ticketed
  • Loose – Overwrapped, etc.

Multiple link examples (sequential inventories across ownership boundaries):

• Multiple companies
  • Supplier – Manufacturer(s)
  • Manufacturer – Manufacturer(s)
  • Manufacturer – Retailer(s)
  • Manufacturer – Distributor(s)
  • Distributor – Distributor(s)
  • Distributor – Catalog/Internet Customer(s)
  • Distributor – Retailer(s)
  • Retailer – Customer(s)
• Multiple tiers within the same company
  • Retail Distribution Centers – Retail Stores
  • Manufacturing Warehouses – Distribution Centers
  • Inbound Consolidation Points – Next Destinations
  • Last Destinations – Outbound Pool Points

Having the right products in the right place at the right time is critical to remain competitive and ensure customer satisfaction. Contact us today to learn how to create a comprehensive inventory management strategy to meet your company’s unique requirements.