What is Inventory Management?
It doesn’t matter if you are running a manufacturing or a service business; inventory usually just a natural part of the operations. To produce products you need raw materials inventory, in the process we could generate what we call work-in-process inventory, we could have sub-components that are generated and then you could have finished goods.
And in the context of a service provider (to provide the service), you may also have facilitative inventory. For example, if you run an automobile garage then you are going to need an inventory of items such as engine oil, lubricants, spark plugs, and a whole bunch of items that you need to provide the service. In a restaurant, just think about all of the raw materials, the different food items that are necessary to produce a recipe then all of those things have to be in stock.
So, inventory management is a rather important topic in any operations management. And in today’s article, we’re going to be talking about Inventory Management and the various components that makes it.
What is the Purpose of Inventory Management?
Let’s get the basics covered.
Personally, the objective of inventory management is to strike a balance between inventory investment and customer service. The important thing to keep in mind is that inventory costs money at the same time it is necessary for us to meet service requirements.
So, if somebody wants an item, we have to be able to provide it and we need to be able to balance between those two things. When you keep inventory in stock you are investing in capital and at the same time, you need the inventory to provide customer service so you want to balance between your investment in inventory and the service level that you are able to provide.
Inventory is a very expensive asset and, for some, it could constitute as much as 50% of your total capital investment. When we think about the cost of goods sold depending on the kind of product that we are talking about, usually inventory makes up a fairly significant chunk of that.
So why do we need inventory? We hear often these days about trying to minimize levels of inventory just-in-time and manufacturers really try to eliminate as much as they can the need for inventory. But inventory is not always bad as it does have a function and so, let’s see what some of those functions are.
In short, inventory equals to assets, and assets equates to cash.
Functions of Inventory
Inventory allows us to decouple or separate various parts of the production process.
What do we mean by that?
Let’s say you own a manufacturing plant but there is no inventory storage in the plant. And, on a random day, the plant shuts down, the plant will be out of inventory. However, if we were to keep a certain amount of inventory at a distribution center, and the plant shuts down for two days, the distribution center can continue to supply to customers.
So, in that way we have decoupled two parts of the system – (1) the manufacturing section and (2) the retailers who would need supplies for their customers.
The other function of inventory is to decouple the firm from fluctuations in demand and provide a stock of goods that will provide a selection for customers. The idea behind this is that because you have variation in demand, one of the ways to hedge against that is to actually keep inventory in stock. So, if demand is extremely high all of a sudden and you kept some inventory it might help you deal with that sudden change in the demand. Of course, there can be a negative effect if you overstocked inventory and the demand drops significantly then you are stocked with a high number of items. So, it is important to always have to balance those two things.
Take advantage of quantity discount, if you have been told that if you double your order, you will get a ten or twenty percent discount on the price, then inventory becomes a way of actually achieving that benefit and you would only do that if the added investment in keeping inventory is less than the savings that you get from the discount. So, the discount has to make sense.
To hedge against inflation in prices, if you manage to keep a certain amount of inventory in stock you may very well have weathered a slight change in the price of an item, particularly if that change is an increase.
Types of Inventories
1. Raw Material Inventory
In a restaurant or in a manufacturing facility, we need raw materials first to be able to produce the goods that we are making.
2. Work-in-Process Inventory
Inventory that has undergone some changes but not completed a function of cycle time for a product.
Work-in-process inventory is really as the term suggests, that the item is actually in process. If we are producing a bicycle and so far, we have produced the frame and then we have now assembled two wheels on that frame but there is no handlebar, seats, or braking system then that item is actually in progress. So, it is usually when the inventory is at some stage in the manufacturing of a particular product.
3. Maintenance/Repair/Operating (MRO) Inventory
Inventory that is necessary to keep machinery and processes productive.
Basically, if you think about a company that has a number of engines. For example, a power plant has to maintain the turbines, or a company that has a fleet of trucks that needs to be maintained, will keep inventory items and stock necessary to be able to maintain those pieces of equipment.
4. Finished Goods Inventory
Inventory of completed products awaiting shipment.
Note: Depending on the type of goods you store, you might want to know more about storage as well.
But How Do We Manage Inventory?
Image source: State Food Safety
All of the different items involved in inventory management have different cost structures and different strategies of maintaining them. To help us to be efficient on how we manage inventory, we could consider a system called ABC analysis. ABC analysis does a simple thing, which is, it basically says the A items are your most important items, the C items are the least important, and the B items are somewhere in the middle. That system was kind of useful before point-of-sale systems because if you had thousands of stock-keeping units and you didn’t want to treat each and every one of them equally, this can help.
This rule is applied in a way where approximately 20 percent of your items are responsible for 80% of the value – which is the classic 20/80 rule.
So, you try to find the most important 20 percent and classify as A items. Then the next 30 percent of the items you can classify as your B items and in the last 50 percent of the items, you will classify them as your C items. So, you tend to manage the C items on what we call a periodic review system which is once in a month. For B items, you may take a look at the inventory levels/ once a week or once every two weeks and so on. You’d want to monitor the class-A items on a day-to-day basis because they are very important and it contributes so much to your value.
Now with point-of-sale systems, of course, we still use ABC classification but now we actually could monitor every single item if we wanted to. And that’s because the date information has been updated in real time. However, because you have so many items you do not want to give the same amount of time or attention to every single item. So, we still need ABC classification even though we do have point-of-sale systems that have made life a whole lot easier for us.
Record Accuracy and Why is it Important?
Now, because the investment in inventory is usually quite significant, depending on the kind of organization that you engage with, the accuracy of the records is very important. So, you need to know just how much money is tied up in inventory because that is a loss of opportunity in other types of investment if your money is tied up in the capital. In a case like that organizations want to make sure that they have a really good sense of what the inventory levels actually are.
To do that, typically firms would have stock taking days where they would shut down parts of the plant or whatever it is to count all the stock in that area. Or sometimes they will just shut down for a few days and then try to count all the items. But that’s not very efficient because you still want to keep running while you are checking on your inventory levels. So, there has to be a better way to do this and the way in which you can do that is a flow process called cycle counting.
Even though we have point-of-sale systems – where items are supposed to be updated in the inventory database as soon as they are being consumed – there’s always a discrepancy. And that’s usually between what is actually there and what’s being shown on a computer screen. So, from time to time, companies need to do physical counts to really get the accuracy levels up.
Hence, cycle counting would be useful.
If you hold any form of goods and you want to track it, then having inventory management is inevitable. The next question lies in how detailed you want it to be, and, of course, if you want to use an inventory software to help automate these activities.