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Inventory Decisions
Author :
Thursday, October 27, 2016

The three essential questions in item inventory management are – where to have the material, how much to reorder, when to reorder. All other parameters are merely an outcome of these three decisions. Inventory turnover and customer service are both very much dependent on these three decisions. Thus for designing an effective (or in some cases efficient) supply chain it is absolutely necessary that we understand the impact of these three decision parameters.

Per se it may seem that inventory management in a supply chain is a huge and confusing task. By reducing the task to these three simple chores, we can significantly reduce the complexity in the chain. A key element is that all of these three parameters should be designed into the supply chain. They cannot be arbitrary numbers that evolve out of thumb rules that become established over a period of time.

Where to hold the material

A supply chain generally has many layers of players between the manufacturer and the final consumer. There could be the factory depots, central distribution centres (CDCs), regional distribution centres (RDCs) and also stocks kept by the distributors, wholesalers and retailers. In many cases the final consumers also have inventory. The entire material inventory, at any point of the supply chain pipe line, has one purpose – to satisfy the demand of the final consumer at a reasonable cost.

In case it is absolutely essential to have a close to 100% satisfaction of customer orders, a large portion of the inventory has to be kept closer to the customer. Thus, hospitals keep huge safety stock. Excess inventory is always kept for critical maintenance spares at the site. For all multi-location business keeping a large inventory closer to consumer, would result in large inventory stocks. There would have to be inventory at every location. So, while this mode ensures high customer service, it also builds up inventory cost.

An easy way to reduce inventory would be to pool inventory. So instead of all retail locations having inventory, a warehouse is created that holds inventory for multiple retail locations. The same service levels can thus be established at a lower cost. However, this method could increase the cost of operating and maintaining a warehouse and it also increases an additional loading and unloading transaction.

Depending on these tradeoffs firms have to decide on where to have inventory in the supply chain. In cases of some industrial products like pumps and motors, the dealers keep a very low stock. They merely take the order and then have the material despatched from some warehouse location. In cases of items like bearings, gaskets and other maintenance spares, local retailers keep a large inventory.

How much to reorder

The simplest methods for reorder quantity are based on thumb rules. Material is sometimes ordered in truck load or some part load quantities. At times there are constraints on a fixed minimum order. There are cases when the fixed reorder quantity is not a thumb rule, but calculated using the cost profiles of carrying cost, ordering cost, stock-out cost, etc. Both these cases are called fixed lot ordering systems.

Fixed lot systems are very easy to manage. The task of calculating the lot size for every order can be minimised. Also, by keeping a certain lot size, discounts can be availed of. The lot sizes are sometimes matched with the production batch size, thus minimising the inventory that is held up at the factory warehouse.

The other extreme is to order exactly the quantity that is needed at the given time. This is called lot for lot (L4L) type of reordering system. L4L works wonderfully for firms operating on JIT pattern. It is also used for item with highly variable and intermittent demand. Here the inventory can be minimised, but it may result in frequent ordering and hence an increased level of transactions and the related costs.

On a broad scale, materials that are relatively inexpensive are ordered as per fixed lot systems – the inventory is higher but the transactions are minimised. Since the materials are inexpensive, the inventory costs do not hurt as much. In a similar pattern, the L4L system can be used to control the stocks or relatively expensive items.

When to reorder

This is the last and a very important decision in item inventory management. There are two basic types in this decision parameter – fixed period and variable period. In the fixed period the inventory position is reviewed after every fixed period of time and a decision to place an order is taken. The fixed review period can be a day, a week or even a month. This system is used when multiple items are to be ordered from one vendor or one market.

 

Fixed lot size

Lot for Lot

Fixed period ordering

Category 1

Category 2

Reorder point systems

Category 3

Category 4

In case of a retail pharmacy store, they review the stock of medicines from one pharmaceutical company once a week and place the order of all the items from that company at one time. In case of milk runs for auto firms, they have a review period of a few hours and collect all the items from one geographical location in every review period.

Again, by collecting the orders for many items that are required from one vendor or one location, the transportation costs as well as the transaction related costs can be significantly reduced. Also, the firm is relieved of the pressure of real time and every day monitoring of the stocks. Of course, with this type of fixed interval ordering the inventory levels are generally higher. Thus the fixed period ordering systems is generally used for C class material.

The variable period systems are also called reorder point systems. Here a certain inventory level is fixed as a target for every item. As soon as the inventory level reduces to the target, at whatever point of time, a reorder is generated. In these reorder point systems, the reorder may be generated at any random time, whenever the inventory levels reach the reorder point.

With reorder point systems, firms can have a very good control over inventory. There is of course the issue of having to maintain a real time vigil over inventory levels, but for A class items, the reorder point systems can have a very positive effect.

Conclusion

Depending on the cost of the material, its criticality, importance to the customer, etc. the three decision of where, when and how much have to be taken. Generally it is not possible to take these decisions individually for every item. Items are classified under some pattern and then a policy is fixed for every category in that pattern. This concept of classification will be the topic of the next article. 

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