Inventory in the Supply Chain

In this section, we discuss the role that inventory plays in the supply chain and how managers use inventory to drive supply chain performance.

1. Role in the Supply Chain

Inventory exists in the supply chain because of a mismatch between supply and demand. This mismatch is intentional at a steel manufacturer, where it is economical to manufacture in large lots that are then stored for future sales. The mismatch is also intentional at a retail store where inventory is held in anticipation of future demand or when the retail store builds up inventory to prepare for a surge in sales during the holiday season. In these instances, inventory is held to reduce cost or increase the level of product availability.

Inventory affects the assets held, the costs incurred, and responsiveness provided in the supply chain. High levels of inventory in an apparel supply chain improve responsiveness but also leave the supply chain vulnerable to the need for markdowns, lowering profit margins. A higher level of inventory also facilitates a reduction in production and transportation costs

because of improved economies of scale in both functions. This choice, however, increases inventory holding cost. Low levels of inventory improve inventory turns but may result in lost sales if customers are unable to find products they are ready to buy. In general, managers should aim to reduce inventory in ways that do not increase cost or reduce responsiveness.

Inventory also has a significant impact on the material flow time in a supply chain. Mate­rial flow time is the time that elapses between the point at which material enters the supply chain to the point at which it exits. For a supply chain, throughput is the rate at which sales occur. If inventory is represented by I, flow time by T, and throughput by D, the three can be related using Little’s law as follows:

I = DT                                                                        (3.1)

For example, if an Amazon warehouse holds 100,000 units in inventory and sells 1,000 units daily, Little’s law tells us that the average unit will spend 100,000/1,000 = 100 days in inventory. If Amazon were able to reduce flow time to 50 days while holding throughput constant, it would reduce inventory to 50,000 units. Note that in this relationship, inventory and throughput must have consistent units.

EXAMPLE 3-2 Amazon.com

Amazon attempts to provide a wide variety of books (among other products) to its customers. Best-selling books are stocked in many regional warehouses close to customers for high respon­siveness. Slower-moving books are stocked at fewer warehouses to lower the cost of inventory at the expense of some responsiveness. Some of the slowest-moving books are not held in inven­tory but are obtained from the publisher/distributor or printed on demand when requested by a customer. Amazon changes the form, location, and quantity of inventory it holds by the level of sales of a book to provide the right balance of responsiveness and efficiency.

2. Components of inventory Decisions

We now identify major inventory-related decisions that supply chain managers must make to effectively create more responsive and more efficient supply chains.

Cycle inventory Cycle inventory is the average amount of inventory used to satisfy demand between receipts of supplier shipments. The size of the cycle inventory is a result of the produc­tion, transportation, or purchase of material in large lots. Companies produce or purchase in large lots to exploit economies of scale in the production, transportation, or purchasing process. With the increase in lot size, however, comes an increase in carrying costs. As an example of a cycle inventory decision, consider an online book retailer. This e-retailer’s sales average around 10 truckloads of books a month. The cycle inventory decisions the retailer must make are how much to order for replenishment and how often to place these orders. The e-retailer could order 10 truckloads once each month or it could order one truckload every three days. The basic trade­off supply chain managers face is the cost of holding larger lots of inventory (when cycle inven­tory is high) versus the cost of ordering more frequently (when cycle inventory is low).

Safety inventory Safety inventory is inventory held in case demand exceeds expectation; it is held to counter uncertainty. If the world were perfectly predictable, only cycle inventory would be needed. Because demand is uncertain and may exceed expectations, however, compa­nies hold safety inventory to satisfy an unexpectedly high demand. Managers face a key deci­sion when determining how much safety inventory to hold. For example, a toy retailer such as Toys “R” Us must calculate its safety inventory for the holiday buying season. If it has too much

Safety inventory, toys will go unsold and may have to be discounted after the holidays. If the company has too little safety inventory, however, then Toys “R” Us will lose sales, along with the margin those sales would have brought. Therefore, choosing safety inventory involves mak­ing a trade-off between the costs of having too much inventory and the costs of losing sales owing to not having enough inventory.

SEASONAL INVENTORY Seasonal inventory is built up to counter predictable seasonal vari­ability in demand. Companies using seasonal inventory build up inventory in periods of low demand and store it for periods of high demand, when they will not have the capacity to pro­duce all that is demanded. Managers face key decisions in determining whether to build sea­sonal inventory and, if they do build it, in deciding how much to build. If a company has volume flexibility and can rapidly change the rate of its production system at very low cost, then it may not need seasonal inventory. However, if changing the rate of production is expensive (e.g., when workers must be hired or fired), then a company would be wise to establish a smooth production rate and build up its inventory during periods of low demand. Therefore, the basic trade-off supply chain managers face in determining how much seasonal inventory to build is the cost of carrying the additional seasonal inventory versus the cost of having a more flexible production rate.

LEVEL OF PRODUCT AVAILABILITY Level of product availability is the fraction of demand that is served on time from product held in inventory. A high level of product availability provides a high level of responsiveness but increases cost because much inventory is held but rarely used. In contrast, a low level of product availability lowers inventory holding cost but results in a higher fraction of customers who are not served on time. The basic trade-off when determining the level of product availability is between the cost of inventory to increase product availability and the loss from not serving customers on time.

INVENTORY-RELATED METRICS Inventory-related decisions affect the cost of goods sold, the C2C cycle, the assets held by the supply chain, and its responsiveness to customers. A manager should track the following inventory-related metrics that influence supply chain performance:

• C2C cycle time is a high-level metric that includes inventories, accounts payable, and receivables.
• Average inventory measures the average amount of inventory carried. Average inventory should be measured in units, days of demand, and financial value.
• Inventory turns measure the number of times inventory turns over in a year. It is the ratio of average inventory to either the cost of goods sold or sales.
• Products with more than a specified number of days of inventory identifies the prod­ucts for which the firm is carrying a high level of inventory. This metric can be used to identify products that are in oversupply or to identify reasons that justify the high inven­tory, such as price discounts or a product being a very slow mover.
• Average replenishment batch size measures the average amount in each replenishment order. The batch size should be measured by SKU in terms of both units and days of demand. It can be estimated by averaging over time the difference between the maximum and the minimum inventory (measured in each replenishment cycle) on hand.
• Average safety inventory measures the average amount of inventory on hand when a replenishment order arrives. Average safety inventory should be measured by SKU in both units and days of demand. It can be estimated by averaging over time the minimum inven­tory on hand in each replenishment cycle.
• Seasonal inventory measures the amount by which the inflow of product exceeds its sales (beyond cycle and safety inventory). Seasonal inventory is built up solely to deal with anticipated spikes in demand.
• Fill rate (order/case) measures the fraction of orders/demand that were met on time from inventory. Fill rate should be averaged not over time but over a specified number of units of demand (say, every thousand or million).
• Fraction of time out of stock measures the fraction of time that a particular SKU had zero inventory. This fraction can be used to estimate the lost sales during the stockout period.
• Obsolete inventory measures the fraction of inventory older than a specified obsoles­cence date.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.