Firms treat inventory as a buffer against uncertainty. Purchasing managers buy more than the needed quantities of raw and packing materials not only to hedge against possible changes in production schedules but also to counter sudden supply shortfalls from vendors. Meanwhile, production planners build inventories of finished goods because most factories have limited flexibility to run a firm’s entire product line at one time.
Some of the companies I’ve worked with mandate inventory reduction as a way of trimming working capital and maximizing cash flow. This is an over-simplistic strategy as it could fail to take into account several factors, such as whether lower inventory would result in frequent product out-of-stock and late deliveries, which would then translate to lost sales.
Indeed, executives tend to complain that having too much inventory negatively affects their balance sheets. After all, product sitting in storage doesn’t earn money and is prone to risk of damage or obsolescence.
The search for the optimal inventory level that balances the ideal customer service outcome and the best working capital numbers has been a holy grail of sorts for supply chain managers. But just because it’s hard to define doesn’t mean there couldn’t be a “right” or a satisfactory approach, at least for the short-term.
I have noted that most companies that arbitrarily mandate across-the-board reductions in inventory don’t have a clear inventory management strategy with which to start.
Inventories should be managed against a firm's cost, cash flow, and sales objectives. If the company wants to be more customer service-oriented, it should consider having more stock to ensure less stock-outs and incomplete deliveries; if it's bent on reducing cost or working capital, it could tighten stock levels and perhaps institute a more responsive supply system.
Firms would also do well to review their products on a per category, per brand, or even on a per item level. This is because some goods don’t move as fast as others, some cost more to make, and some may sell more in one region than in another.
High-end appliances such as microwave ovens, for instance, would find a bigger market in cities than in provinces as wealthier families tend to congregate in urban centers. An appliance firm could thus choose a separate location dedicated to storing inventory for dealers, and decide inventory levels on the basis of its sales history to the said dealers while maintaining a low level (or none at all) for the balance provincial market.
There are industries in which inventories are forced not just by demand uncertainty but also by the need for supply continuity. For one, firms that own farms and market finished products from agricultural sources cannot adjust supply to demand behavior instantly as one cannot cancel harvests from taking place.
Similarly, those that produce steel products usually have equipment such as furnaces that cannot be shut down once demand drops, as doing so puts the company at risk of facing the huge costs of re-start-ups. In such cases, supply chain planners can allocate excess supply by scheduling the production of faster-moving items. On the opposite condition where supply is unable to keep up with demand, planners can prioritize higher profit-margin items upon information gathered from the marketing or sales department. This suggests a degree of flexibility in planning how much inventory to stock.
Supply chain professionals are advised to constantly study demand and supply variations as it is in these variations that inventory level targets are determined. Whether the latter should be set high—having more stock to cover most variations but at the risk of higher working capital—or low—having less stock and lower working capital but at the risk of demand outstripping what’s on hand—will in turn require guidance from top management.
Some executives, however, would not be too familiar with the intricacies of inventory management. This is where supply chain professionals could demonstrate the value of their function. Data gathering and analyses are very important. An understanding of inventory patterns, which can be as detailed as day-to-day logs, will let one appreciate the causes for differences in inventory. Moreover, simulations of inventory levels resulting from forecasted demand and supply would provide additional basis for justifying how much stock to keep.
The right inventory level greatly depends on what the firm wants to achieve. It is normally a trade-off between several corporate objectives—cost, cash and customer service. It doesn’t necessarily have to be optimal, but it has to be good enough for the company to meet key objectives and to allow it to continually improve via an integrated corporate initiative.
Jovy Jader is a consultant and regional speaker on Supply Chain Management. He has directed and implemented supply chain management projects both local and international which have resulted to company-wide improvements in inventory, total cost, response time, quality, and on-time delivery. Mr. Jader was formerly with Procter & Gamble Philippines and Coopers & Lybrand/PricewaterhouseCoopers. Should you have questions or comments, e-mail them to email@example.com.
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