Inventory Management

Prof. Himanshu Rathore

IIM Lucknow
 What is inventory ?

In the broadest sense, inventory is any idle resource that has

potential economic value (e.g., raw material, cash, capacity of a
hospital, stock of apparel in a retail store etc.).
 Inventory Turnover?
Inventory turnover ratio signifies the rate at which inventory is
transformed into a product with realized economic value.

“Inventory is not just piles of cash, it is also piles of carbon and water. It is
your natural resources. Save inventory, save the environment”….Robert
Brynne (CEO, Terra Technology)
Inventory Turnover
 In view of the discussion, have a keen look at the balance sheet (for good 20 seconds) and
answer the following question. One who answers first, gets brownie points for CP.

Average
inventory=??

29,993.57 (Ans.)
TASK: Look at the financial statements and determine the inventory turnover ratio and days of
inventory held by the company.
 Performance on Inventory Turnover Ratio of Indian industry for the
year 2018: Sector wise

Food and Textiles Chemicals Consumer Construction Metals Machinery Transport

agro and goods materials and metal equipment
based chemical products
products products
Worst 0.9 1.3 1.8 1.6 1.8 1.5 0.9 1.2
Average 5.5 6.3 5.6 6.9 4 13.7 6 7.9
Best 21.2 25.9 17.1 27.6 8.5 93.7 26.5 22.9

1. Higher the inventory turnover ratio, the better.

2. While analysing inventory turnover ratios of a company, compare with the
respective industry average.
 Clue: It is a current asset and
ideally not meant for long-term
(unless, of course, if the firm
wants to keep it forever!

How is it indicated in the Balance Sheet?

 What is
average
inventory?
 Where are Inventories?
Material Inbound Production Outbound Finished goods Customers
sources transportation transportation warehousing

Receiving
Production
materials

Inventories
in-process

Shipping
Finished goods

Inventory
locations
 Classification of
Inventory
By its
By its
stage in the
function
process
Cumulative inventory
Raw Pipeline of all types in the
supply chain at all
Material Inventory stages

Work in Inventory required to

Cycle inventory meet the demand
process between any two
(Lot Size) successive
replenishments.
Finished
goods Safety Inventory which is
meant to meet
inventory unexpected demands
(acts as a buffer)
Ancillary
 Based on its function
Qualcomm Semiconductor ZTE
technologies chips Technologies

FUN FACT
U.S based firm which makes ZTE is a Chinese
semiconductor chips amongst telecommunications
other things. Major supplier equipment manufacturer. It
to ZTE technologies. was blacklisted by U.S. for
flouting economic sanctions on
Iran
 Costs relevant to Inventory Management

Carrying Order Stockout Backorder

costs costs costs costs

“When I took the job, I knew that there were two crimes to avoid: being
out-of-stock and being overstocked.“
--------Sir Stuart Rose (ex-CEO of Marks and Spencer)
• Carrying costs/ holding costs are proportional to the quantity of
inventory held.
It is expressed as annual interest rate charged on the unit cost of the inventory
item.
• Order costs are independent of the quantity of inventory held.
• Stockout costs occur due to lost opportunity of making profits and
due to loss of customer goodwill. Frequent stockouts may result in
loss of repeat customers.
• Backorder costs are constituted of extra administrative expenses
which are incurred due to processing an extra order consisting of
items which were placed earlier.
Holding/Carrying costs (25-40%)
Capital
costs Inventory investment

Inventory Insurance
service
costs Taxes

Inventory Plant warehouses

carrying
costs Storage Public warehouses
space costs
Rented warehouses

Company-owned warehouses

Obsolescence

Inventory Damage
risk costs
Pilferage
Relocation costs
Order/Procurement
Costs

Cost of preparing the order

Cost of order transmission
Cost of production setup
Cost of material handling or processing at the receiving dock
Out-of-stock costs

Loss of goodwill
Lost revenue
Customer may switch to different retailer
altogether. Thus, resulting in cumulative losses
in the form of customer lifetime value

In an out-of-stock situation, backorder costs are incurred when firm

promises the customer to fulfill the order later when the stock is
replenished.
Costs of extra order handling
Additional transportation and handling costs
Possibly additional setup costs
Inventory Management: Little’s Law

Material flow time/Average flow time (T): Is a time that elapses

between the point at which material enters the supply chain to the
point at which it exits.

Throughput/ Average flow rate (D): Is the rate at which sales

occurs.
If average inventory is represented by I then, the three can be
related using little’s law as follows:
I = DT
 Opposing Views of Inventory

Why holding
Why should we want
inventories can be
to hold inventories
inimical?

Inventory is a necessary evil

This line is ‘inspired’ from
somewhere. Ring a bell?
 Why would we want to hold inventories

Improve customer service (Provide immediacy in product availability)

Control costs: Keeping inventory can lower the costs necessary to monitor inventory. For
instance, sufficient inventory stock may require periodic review of inventory whereas when the
inventory stock is less continuous review may be required. Continuous review requires more
man-hours (in case it is physical inspection) or more complex ERP systems as compared to periodic
review.
Economies of scale: It is probably cheaper to order or produce in large batches than in small
batches. Discounts can be availed in large batches leading to lower per unit price of the commodity.
Large shipment sizes (such as full truck load) have lower transportation costs.
Uncertainties: Demand uncertainty, lead time uncertainty and supply uncertainty make a case for
holding inventory.
Speculation: Inventories may be held in anticipation of a rise in their value or cost.
Transportation: Some inventory is almost always caught up in transit (pipeline inventory). We need
to minimise pipeline inventory as much as possible but at the same time keep provisions for that in
capacity.
Smoothing: Inventory can smooth out demand variations, production and workforce
fluctuations.
 Inventory is not just piles of cash, it is
Why We Don't Want to Hold also piles of carbon and water. It is
Inventories your natural resources. Save
inventory, save the
environment…CEO (Terra Technology)

They consume capital resources that might be put to better use elsewhere in
the firm
They divert management’s attention away from careful planning and control
of supply and distribution channels by promoting an insular attitude about
channel management.
Inventory can often conceal underlying problems and thus can impede
improvement efforts.
Work-in-process buffers may make a manufacturing process appear to run
smoothly, hiding problems that cause unnecessary process variability. E.g. high
inventory levels may hide the surge in number of defective units in the process.
Interpreting inventory related
entries in financial statements
Consider that you work for Amazon.
You are part of a process improvement team which aims at reducing
costs attributed to inventory handling at Amazon.
By undertaking some process-improvement initiatives your team has
been able to reduce the time of transit (flow time) between a supplier
to an Amazon warehouse by 3 weeks.
Your team’s performance is to be audited by the management. You and
your team understand that your initiatives will eventually lead to
reduction in inventory held by Amazon which will subsequently lead to
cost reduction.
How would you make a business case for your team’s contribution in
view of the financial statements of Amazon provided in the next slide.
Consider the following income
statement and Balance sheet.
Interpret info regarding inventory
from the relevant entries
•
Time is of essence here!
• Is 13 weeks too long? Should the company’s average inventory holding period be shorter?
These are the questions supply chain managers should find answers to.
• If the holding period is longer than necessary (industry benchmark),
too much capital is being tied up in inventory. Or, the company
may be cash poor because it keeps too much money in inventory
and not enough in the bank.
• Suppose that with better inventory management the company reduced its average
inventory holding period to, say, 10 weeks. That would lead to an inventory turnover ratio
of 52/10= 5.2 times.
• An Inventory turnover ratio of 5.2 times at the given COGS of 33800 implies inventory of
33800/5.2= $ 6500 which is $(8450-6500)= $1950 lesser.
• This means, the company would have needed $ 1,950,000 less capital, or would have had
this much more cash balance at its disposal.
• It also means that the company saves holding costs for inventory worth rupees $
1,950,000 and that will be evident as a decrease in the COGS of P&L statement.
Company may have $ 1950 more at disposal
which can be put to other uses. SC managers
can use such analysis to make a business case
for inventory management to the senior
management