Methods of Inventory Management - Business Plan Example

Methods of Inventory Management Introduction Inventory is any unused asset that is lying in the stock without participating in the value adding process. Inventory includes a company’s raw material; work in process; supplies used in operations and finished goods (Muller, 2003). The process of planning and controlling the inventories is termed as the process of Inventory Management (APICS, 1998). There are various methods of inventory management such as ABC analysis, EOQ, VMI, CMI etc. ABC Analysis The Technique Often, in a typical organization only 5-20% of the items incur about 60-75% of the inventory expense; these items are called ‘A-items’. The items in this class call for close attention, and continuous reviewing. The ‘B’ class of items generally accounts for 20-50% of the entire items and are about 15% of the inventory items. The remaining items that are of the minimum costs and require minimum controls are the items of ‘C-Class’ (Silver and Peterson, 1985). The type of inventory management that is based on this Pareto principle is called ABC inventory management. This type of inventory management is shown in Figure 1. Advantages and Disadvantages Efficient ABC inventory management results in selective controls on the inventory leading to better management and avoid wastage of precious management time. Selective controls also reduce the confusion that may arise out of too many management controls. The technique results in improvement in inventory cycle time and service levels. However, ABC Inventory management calls for record accuracy and Cycle counting. Moreover, the technique may lead managers to completely ignore the C category which may result in delays in production. Implementation Most of the ERP packages available in the market provide ABC analysis tools. For example JD Edwards can be used by organizations to classify items on the basis of total sales, gross margin, or on-hand value. The package also enables different ranking percentages in each category. Besides this, SAP, PeopleSoft and Oracle E-business suite also enable ERP analysis. Small and medium sized companies can implement ABC analysis using a simple spreadsheet application. EOQ Model The Technique One of the basic requirements of an efficient inventory management requires inventory to be low enough to avoid excessive inventory holding costs but high enough to reduce the ordering and setup costs. The quantity that balances these contrasting pressures and represents the best cycle inventory level for an item is called the Economic Order quantity. Advantages and Disadvantages The basic EOQ model assumes a lot of factor. As a result it can be used only if the carrying cost and ordering costs are known and stable. It is more beneficial if the firm follows a ‘make-to-stock’ strategy. The model can not be used if the order size is constrained by limitations such as transportation capacity limits. The method can be very successfully applied to the concept of JIT (Cannon and Crandall, 2004). EOQ model when applied to sensitivity analysis reveals useful insights into inventory management. For example, an increase in the Demand of the item will lead to an increase in lot-size. More importantly, the model is fairly insensitive to errors in the estimation of D, H and S. However, the assumptions that are used to derive the EOQ model are too idealistic and rarely hold true in the real world. Still, EOQ model can be efficiently used by managers to have an approximate knowledge of the order size. Vendor Management Inventory The Technique Vendor Managed Inventory is an inventory management technique where the supplier has complete information of he customer’s inventory data and is responsible for maintaining the inventory level required by the customer (Krajewski, Rirtzman, and Malhotra, 2008). VMI is applicable in different forms in various industries. For example, JITD (Just-in-Time Distribution) is applicable to automobile industry whereas Efficient Consumer Response (ECR) is useful for grocery and apparel industries. The basic elements of a VMI system are: Collaborative environment: VMI requires complete trust and accountability between the supplier and customer. Written Agreement: The two parties should understand the responsibilities and roles of each partner through a written agreement. Centralized Forecasting: The technique calls for a centralized forecasting that requires access to all the information with both the supplier and customer. Advantages and Disadvantages The advantages of such a system can be many. With collaborative effort, suppliers and customers remove the excess inventory through better operational planning thereby reducing cost. The method also leads to a reduction in administrative and inventory holding and ordering costs. The technique requires the supplier to be fully involved in the operations of the customer. This leads to a reduction in response time and stock out costs. The method leads to a reduction in the data entry errors because of the use of techniques such as EDI. The partnership that fosters as a result of the VMI gives benefits that are much more than proper inventory management. However, the method raises certain issues. The method leads to a reduction in the level of control at the side of the supplier. The system may also lead to a reduction in the compensation of the sales force leading to drop in motivation and satisfaction levels. The customer may also face certain issues such as the loss of power through data sharing and the fear of inventory being pushed upon them. Moreover a successful implementation of VMI requires extensive use of IT tools such as EDI which may not be possible for smaller players. Implementation Successful implementation of VMI requires integration of the role of sales into marketing, a thorough training program of the customers and employees, raising realistic expectations, and appointment of a neutral negotiator in meetings amongst various parties involved if required. Nevertheless, VMI is a technique that has gained considerable interest in the last few years. Companies such as Wal-Mart, AT&T, Dell, and Bose are some of the prominent names that have gained superior inventory management through this technique. VMI at Wal-Mart and P&G One of the first organizations that made use of this technique was the Wal-Mart. Wal-Mart along with its prime suppliers P&G incorporated a VMI program in the late 1980s. A team of employees form P&G was always stationed at Wal-Mart headquarters. The team was primarily responsible for making the procurement decisions of P&G products for Wal-Mart only. The team had direct link to Wal-Mart POS terminals and would continuously monitor sales data, pattern, inventory levels and shipping issues. In the beginning, the companies managed inventory levels of disposable diapers through it, but later implemented the system to other high value products as well. The advantages achieved through this were tremendous: doubling of returns and reduction in operating costs of Wal-Mart and increase in the market share of P&G (Cid et al., 2000). Conclusion The various methods of inventory management have their specific advantages and disadvantages. Besides these, certain new techniques such as CMI, RFID are also some of the possible options that organizations can look to. Before implementing a particular inventory management system, the organization shall look into its strategy and its competitive positioning. Mass Customization and Postponement Introduction For an organization to succeed it is necessary that the company’s supply chain operations are closely integrated with the company’s competitive priorities and strategy. This relationship between the two factors has led to various supply chain strategies such as Mass customization and lean Supply chains. Mass Customization The Technique The last few years have witnessed a considerable change in the market dynamics. Customers now are no longer satisfied with the normal homogenous products. This has led to the development of the concept of Mass customization which is aimed at creating variety and customization through flexibility and quick responsiveness. Mass customization is a supply chain technique that is an amalgamation of two older systems of management: mass production and customization of goods and services leading to mass production of individualized goods and services (Pine and Davis, 1999). The technique enables firms to proactively manage product variety in the environment of rapidly evolving markets and products, niche markets and sell customized products or services either through online or offline means (Anderson, 2004). Advantages and Disadvantages: The technique of mass customization provides organizations with many competitive advantages (Flynn, 2000): Managing Customer Relationships: Mass customization requires extensive inputs from the customers so that excellent good or service can be produced. The inputs from the customer can help the company learn a lot about its customer. This knowledge can be very useful in deciding target markets, marketing strategy and the product portfolio of the company. Elimination of finished goods inventory: Forecasts of estimated demand are not perfect. Over estimation of demand will lead to an increase in the inventory costs while under estimation will lead to stock-outs and loss in customer goodwill. Therefore it is more efficient to produce to customer’s demand rather than a demand forecast. Increase in perceived level of value of services and products: The concept of mass-customization results in the customers being more satisfied and they perceive higher value to the services and products purchased. This high perceived value of the customers can be used by firms to increase their margin and charge higher prices. Mass Customization at Lands’ End For example, at Lands’ End, customers can fill up a brief profile form about things such as height, weight, shoe size and many other body measurements. The information is then used by a program called the Archetype which creates a mathematical model of the body. The customer also has the option to choose things such as pocket size, pattern etc. Once he click submit, the customized jeans is made. The process of implementing mass-customization involves the generation of basic body fit preferences and basic fabric patterns from the software Archetype. The files are then sent to a contractor in Mexico. The contractor cuts the various pieces of the pants. The pants are then eight-machine sewing process at the end of which the pants are checked for five critical measurements. The pants that pass the quality test are sent to a distribution center which ships the pants to individual customers (Drickhammer, 2002; D’Innocenzino, 2002). Other Examples of companies using Mass customization The technique can also be employed in service companies. British Airways for example keeps track of its customer’s preferences. This knowledge helps the airline to have a more accurate plan for each flight. The system leads to a reduction in costs as the airline does not pack things that might not be required by its flyers. Companies in the computer industry such as Dell and Gateway allow customer to configure their own computers from a set of components that are available in stock from the website. Postponement The concept of postponement is the latest paradigm that has evolved in the supply chain management. In this technique, manufacturers postpone the assembly of final product until actual customer demand is known. Postponement requires a thorough analysis of the production process and determining the steps that can be postponed to a later stage. This technique which holds inventory in a less finished state has a lot of advantages. It results in companies being able to respond more quickly to the customer’s demand and offer greater customization options. This leads to the achievement of benefits of mass customization. The advantages are all the more visible in financially tough times as these. When the economy is at a downtrend inaccurate forecasting and made to stock strategy might lead to large inventory costs. On the other hand the strategy also raises certain issues. The strategy requires a complete overhaul of the manufacturing process of the organization. The technique also requires complete collaboration and visibility across the entire supply chain of an organization. Conclusion Mass customization as a supply chain strategy provides organization with tremendous benefits. Companies that want to differentiate themselves from others may implement the methodology to provide customizable value added fast services to the customer. With the changing market environment, this technique can very efficiently be used to emerge as the market leader. Appendix 1: Bases for ABC Inventory Classification There are various bases on which the classification of the items can be made: Item’s price, item’s criticality, item’s non-availability or availability, item’s size, item’s weight, lead time, obsolescence etc. Single-criterion ABC Analysis makes use of just one parameter (Annual Cost volume usage which is equal to unit cost multiplied by annual usage). Multiple-criteria ABC analysis also incorporates other factors while managing inventories. Most of the non-cost factors can be summed up as the factor called Criticality which measures factors such as the severity of the effect of zero inventories, the time in which the item can be procured, and availability of a suitable substitute (Flore and Wybark, 1986). Appendix 2: Mathematical derivation of EOQ Model The model of EOQ presented below is based on the assumption of constant demand, no constraints, definite lead time, and no shortages. Figure 2 is a graph showing the ordering and holding costs of the inventory for an organization. We can see that the holding cost keeps on increasing in the trend of a straight line as the lot size of the order is increased. The ordering costs decreases following an exponential pattern as the lot size is kept on increasing. Where, C = total annual cycle-inventory cost Q = lot size H = Holding cost per unit in inventory D = annual demand S = cost or ordering or setting up one lot (£/lot) At the level of minimum total cost, Annual holding cost = Annual ordering cost Various modifications of this basic EOQ model have been proposed to make it suitable to more realistic conditions. The above model can not be applied in situations where quantity discounts are available (Matsuyama, 2001). Researchers have developed various models that are applicable to situations that relax the assumptions of this basic model (Hopp and Spearman 2000). Still, the basic model is an excellent tool that can give the managers a reasonable figure in many situations. References Anderson, D.M. (2004). Build-to-Order & Mass Customization, the Ultimate Supply Chain and Lean Manufacturing Strategy for Low-Cost On-Demand Production without Forecasts or Inventory. CIM Press. APICS Dictionary.1998. 9th ed., Falls Church, VA: American Production and Inventory Control Society. Cid, F., Gordon, R., Kearns, B., Lennick, P., and Sattleberger, A. (2000). Vendor Managed Inventories. Kellogg Graduate School of Management. [Online]. Available at: http://www.google.co.in/url?sa=t&source=web&ct=res&cd=1&url=http%3A%2F%2Fforecast.umkc.edu%2Fftppub%2Fba544%2Fvmi.doc&ei=WC3PSr3HCdiOkQXi7vTwAw&usg=AFQjCNHsz-zOl8GMfwYvgc8fYbNr3P1jEg&sig2=H93H04AWn1H2LtRkFlT6eQ [Last accessed on 8th October 2009] Cannon, A.R. & Crandall, R.E. (2004). The Way Things Never Were. APICS-The Performance Advantage, (January): pp. 32-35. D’Innocenzino, A. (2002). 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Available at: http://www.resourcesystemsconsulting.com/blog/archives/tag/demand-segmentation . Lean Sigma Supply Chain. [Last accessed at: 7th October 2009]. Matsuyama, K., The EOQ-models modified by introducing discount of purchase price or increase of setup cost. Int. J. Prod. Econ., 2001, 73, 83–99. Muller, M. 2003. Essentials of Inventory Management. AMACOM Div American Mgmt Association. Pine, B.J., and Davis, S. (1999). Mass customization: the new frontier in business competition. Harvard Business Press. Silver, E.A. & Peterson, R. (1985). Decision Systems for Inventory Management and Production Planning (2nd ed). New York: Wiley Sons. Read More