Inventory  Management:  A  Study  Of  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   
 
Will  Riley  
000548664  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Executive Summary

This report looks at inventory management and analyses the best attitude to take to
inventory management and the best approaches to take at all stages of planning and
implementing inventory management. The first question that needs to be answered is
whether a company should keep I high or low level of inventory, and what the
advantages and disadvantages are of doing so. This report has looked at the thinking
of key academics and the practices of the best-placed companies when it comes to the
ideas around inventory management, the overwhelming train of thought is that
companies that wish to have an effective inventory management policy should look to
minimise their levels of inventory, this means that holding costs will be reduced and
they will avoid other costs such as depreciation of their stock. This however means
that they will need to be able to forecast demand effectively so that they are not court
out by an increase or decrease in demand leading to over or under stocking,
companies can do this in a number of ways. The most commonly used methods for
predicting how much inventory to order are either the Economic Order Quantity
model, which helps companies predict the most efficient amount to order by looking
at purchase cost, the ordering cost and the holding cost in the form of an equation, or
the extrapolation method that can tell a company the demand that is likely to be
expected and the amount that should be order by looking at historical data. This report
then looks at the best practices to implement to help manage your company’s
inventory, the most widely used and heralded method is a Just In Time production
plan, this means that the company will try to keep as lower level of inventory as
possible by ordering the right amount at the right time. Companies need to take into
account the possibility for fluctuation in demand when managing their inventory
levels and policies, one issue they have to be weary of is the bullwhip effect, this is a
phenomenon the occurs in the supply chain when a companies have ineffective and
poorly implemented inventory management practices and there is an unexpected, but
slight, change in demand from the end user, this small change gets larger and larger as
it progresses up the supply chain like small motion with the handle of the whip will
have a large effect on the tip. In conclusion this report finds that inventory
management is an important part of today’s business world, it is important to use
inventory management at all stages of the value and supply chain to help make your
products offer the best value possible and to help your company be as profitable as
possible

Introduction

The subject that that will be looked into in this report will be inventory management,
this is the process of closely monitoring the level of inventory that a company carries
and trying to keep it at a pre-determined optimum level, this practice requires a
company to have an intimate knowledge of their own processes, the market within
which they operate and the value and supply chains that they are a part of (Howard
1974). In order to have good inventory management a company needs to also have an
effective way of forecasting and predicting demand so that will always have enough
stock to fulfil orders but not excess stock that will waste space and money. This report
will look into the different ways that companies can effectively manage their
inventory levels through looking at academic theories on the subject and through
looking into the practices used by some of the world leading companies in this field.
This report will also look into the best approaches to determining the levels of
inventory that need to be held by companies and the advantages and disadvantages of
holding high or low levels of inventory. Another area that will be looked into is how
inventory management can be affected by, and needs to take into account, both the
customer and the business, and also where it fits into a standard value chain and how
this can effect the management of inventory.

Main Body

The first issue that this report will look into is the advantages and disadvantages of
either holding a very high level of inventory or holding a very low level of inventory,
and the effects this could have on a company. Howard and Lancioni (1978) saw that
one advantage of carrying a high level of inventory in stock was that it enabled a
company to react quickly to serge in demand, this would mean that they would be
well placed to make money on trends because they would have a lot of stock already
so would be able to fulfil a lot more orders before needing to reorder than other
companies with a lower level of stock. Howard and Lancioni (1978) also argue that
this ease in fulfilling orders that comes from holding high levels of inventory helps
companies develop a high level of customer service, although they stress that
customer service is more than just the speedy fulfilment of orders. Ching-Jong and
Chih-Hsiung (1999) also highlight an advantage to holding a high level of inventory,
they argue that if you hold and therefore order your inventory in large quantities then
you can use economies of scale to get a better price when purchasing your goods,
therefore when you go on to sell these goods on at a higher level of profit, however
they add that this profit will be effected by the increased storage costs that may occur
from increased inventory. Barlow (2010) shows a different view however and
illustrates how holding large amounts of inventory can be bad for a business, the
number one disadvantage is that a high level of inventory means that there is a lot of
money tied up in it, this means that the money that was needed to by this excess stock
is essentially wasted as it did not need to have been spent, the stock that was purchase
will usually depreciate in value and even if it doesn’t the money would be better off
being invested elsewhere where it could make the company money.

Assuming that a company wants to keep their level of inventory reasonably low they
will need to know how much stock to order and when they need to order it to make
sure that the company always has the correct level of inventory, enough to fulfil
orders but not overload their storage facilities or necessitate large storage premises.
One way that companies can determine the optimum inventory level, and therefore
know when to order stock and how much to order, is the Economic Order Quantity
model that was developed by Wilson (1934) from the original model created by
Harris (1913). EOQ is a formula that determines the optimum size of order that will
minimise the total cost that will be incurred by the company; the total cost is made up
of the purchase cost, this is the cost of the good purchased, the ordering cost, this is
the fixed cost of placing the order, and the holding cost, this is any cost incurred
through storing inventory. The EOQ formula will find the amount of goods that
should be ordered and the amount of orders that need to be made in order to minimise
the total cost. Borgonovo (2010) criticises the standard EOQ model believing it to be
too simplistic as there is no room for fluctuation in the demand for a product and
claims that it relies too much on averages in calculations, Borgonovo (2010) also feels
that the model relies too heavily on assumptions, for example the model assumes that
the cost will always stay the same throughout the year, however this may not be the
case as the price of goods may rise and fall during the year, due to a shortage in
supply, an increase in demand or even through a rise in tax, such as a VAT increase.

Wanger and Whitin (1958) developed an algorithm to calculate how much stock to
order and when to order it by adapting the EOQ formula to take account of demand
and setup, holding and production costs, they called this a dynamic lot size model.
Many saw this algorithm as far too complex to implement, (Vargas 2009), so many
such as Federgruen and Tzur (1995) have made alterations to it in an attempt to make
it easier to implement.

One very popular and widely used way to manage and predict the inventory that a
company needs to carry is through the use of extrapolation. This is the process of
predicting the future demand for products by looking at historical data, the most
common form of extrapolation is Exponential Smoothing, this process favours the
more recent data and uses it to ‘smooth’ fluctuations in order to forecast trends that
show the demand that a company can expect for their products in the near future
(Armstrong & Green 2006). The demand is forecasted through the calculation and
study of averages and trends from this ‘smoothed’ historical data (Makridakis,
Wheelwright & Hyndman 1998). Armstrong (2001) feels that this forecasting
technique is very effective for companies to use as it is one of the most cost effective
ways to calculate demand for products and therefore aid the company’s inventory
management, he also believes that extrapolation is useful to companies as the
forecaster does not have to have a particularly deep knowledge of the products, only
the figures. Ando (2000) also felt that the best way for a company to predict how
much inventory to carry at any time was to know the demand to expect for their
products at that time, but he felt that extrapolation did not go far enough to give an
accurate prediction of demand, so he developed a system that could help companies
forecast the demand to expect for their products that he felt would give a more
accurate prediction of demand. His method combines forecasting demand by looking
at data from the same period in the previous year to get the general demand trends that
occur through an ordinary year and through using up to date figures from the current
year to get an idea of the real time trends that are going on at that time. Ando (2000)
believes that this is the most effective way to forecast demand as it takes into account
both seasonal and real time trends when calculating demand.

Perhaps the most well known inventory management technique that companies can
put into place in Just In Time (JIT), this is a system that is concerned with reducing
the amount of inventory held by a company, so that, ideally, the inventory level will
match the orders exactly, so that no money is wasted on storing unnecessary stock
(Ohno 1995). This is done by the close monitoring of the levels of stock held by the
company, and the use of Kanban, this is essential a system that alerts managers when
an order is needed (Azadeh, Bavar & Ebrahimipour 2010). Ohno first developed JIT,
with the help of Shingo and Toyodo, from 1948 to 1975, it was initially called the
Toyota Production System as it was developed for use by Toyota, Ohno (1995) is
seen as the father of JIT by many scholars due to his major role in the creation and
development of the model. There are many benefits to a system that allows a
company to keep minimum stock levels such as reduced holding costs, however
Sepehri (1986) outlined some specific areas where he felt that JIT was beneficial to
the workings of a company; one benefit of implementing JIT setup time is reduced,
allowing companies to reduce inventory for changeover time, also when using JIT the
flow of goods in the warehouse is improved, this means that the management of
inventory is greatly simplified and is being regulated, JIT also makes for excellent
business relationships with both suppliers and customers, as in order to implement JIT
effectively it is important to communicate with and have god relationships with both
suppliers and customers. There are problems with the JIT model however, it requires
companies to have close relationships with suppliers and have a lot of trust in them,
this is because there is little to no backup stock if an order for stock cannot be fulfilled
on time, also the suppliers to a company using the JIT model are open to supply
shocks, this is because the company using JIT will potentially make irregular orders
(Gupta & Snyder 2009).

Technology has had a big impact on inventory management and no more so than in
the introduction of Radio Frequency Identification (RFID) technology. This
technology is most commonly used in barcodes or microchips, and can be used to
track the number of items that are in stock, and then automatically reorder goods
when the stocks drop below a predetermined point. This means that with the use of
RFID technology companies can have an entirely automated inventory management
system that can essential re-stock its self, needing workers only to unload and stock
orders (Sarac, Absi & Dauzère-Pérès 2010). They also have a marketing aspect, when
used in supermarkets in conjunction with loyalty cards they can track what each
person buys, this then means that companies such as Tesco can then devise a
marketing strategy with this real life market research. Michael and McCathie (2005)
assessed the use of RFID technology in inventory management and found that there
were significant advantages to be gained through the use of them, the argue that RFID
can offer unprecedented levels of accurate and up to date information about the
quantities and movement of inventory within a company to help to reduce inventory
levels and lower handling and distribution costs, they will also prevent out-of-stock
situations and as some products are out of stock up to 17% of the time this is a very
important advantage to using RFID technology in inventory management. Michael
and McCarthie (2005) also acknowledge that there are some disadvantages to using
RFID technology however, one of these is the high setup cost for installing it in the
manufacturing sector, they claim that they is pressure being put on manufacturers by
retailers to upgrade their systems to incorporate RFID technology, companies who do
not operate using RFID technology face the prospect of being shut out by large
retailers. Another issue highlighted by Stambaugh and Carpenter (2009) is the issue of
privacy, this is more a problem for the retail sector than manufacturing sector where it
is also an important tool in inventory management, the main concern being that
consumers aren’t particularly comfortable with companies knowing so much about
them, also there is a thought that RFID tags would continue to work after the
consumers brought the items.

One company that has excelled through the use of inventory management in recent
years is Allison Transmission. They are one of the world’s largest manufacturers of
automatic transmissions and hybrid drive systems for commercial use; they supply to
over two hundred and fifty vehicle manufacturers the world over
(http://www.allisontransmission.com/). The company started to move to the
implementation of lean manufacturing in the 1990s and into the 2000s (Witt 2003),
lean manufacturing is the practice of trying to eliminate waste in the production
process without compromising the value or quality of the finished product, it was
inspired by the Toyota Production System developed by Toyota and uses the ideas of
reducing the amount of inventory held to improve the production process and help to
cut costs (Ncube 2010). Allison Transmission knew that if they lean manufacturing
strategy was going to work effectively they would need to play close attention to the
way in which they managed their inventory, they decided to use a simple card based
kanban system that would replenish stock once it dropped below a certain point. This
inventory management system has help to reduce the inventory carried by Allison
Transmission by 90%, and, with the help of the change in their manufacturing
procedures, has helped them to reduce the customer order time from seven months to
just three days (Witt 2003). Allison Transmission’s practice of lean manufacturing has
it critics however, lean manufacturing techniques can put too much pressure on
employees, and often the focus is on forcing a change in behaviour in search of
results, this can lead to employees being pushed outside of their comfort zone and
becoming unhappy (http://hubpages.com/hub/Criticisms-Six-sigma-and-lean-
manufacturing 2008).

One phenomenon that can have a huge impact on and even disrupt inventory
management is the Bullwhip effect. Developed by Forrester (1961) it is also known as
the Forrester Effect, and is concerned with the chain reaction that is caused by and can
create a change in the demand for a product or goods. The idea behind the Bullwhip
effect is that a small change at the end of the supply chain can build so that the effects
grow and grow as it gets further down the supply chain, just like a small action at the
end of a whip creates a larger action at the other. This phenomenon happens when
company’s carry safety or buffer stock to cover themselves against inaccurate
forecasts of demand, as you move up the supply chain towards the raw materials
suppliers there is a need to have a higher level of safety stock due to the increased
levels of variation, this is why when the demand for the final product rises or falls the
effects are amplified as you move up the supply chain (Shukla, Naim & Yaseen
2009). If a company has an effective inventory management policy and production
system then they should be able to minimize the effects of the Bullwhip, a well
implemented JIT system would help to reduce variation, uncertainty and lead time,
and therefore reduce the likelihood of being effected by a Bullwhip type of scenario
(Dejonckheere, et al. 2003). Another way that a company can avoid the Bullwhip
effect is to implement an effective and accurate forecasting technique, this way they
will not be caught off guard by changes in demand.

The idea of inventory management is vital at all stages of the value and supply chain,
from the material supplier to the final retailer there is a definite need to have a system
in place that will keep the inventory at the correct amount. Cachon (2000) believes
that inventory management has an addition role to play in the supply and value chain,
he claims that the increase in the sharing of information about demand and inventory,
that is facilitated and made easier, quicker and less expensive by exploiting inventory
management techniques, can help all the links in the supply and value chain cut their
costs, in some cases by up to around 14%. This process of information sharing
through inventory management can also help to reduce lead times and batch sizes, and
help to speed up and cut the costs of order processing. An inventory management
system that helps companies reduce that amount of stock they carry such as JIT or
lean production can help to add value to products being created, and also help them to
make a higher profit through cutting the costs of production and holding costs
(Morash 2001).
Conclusion

In conclusion inventory management is an important part of today’s business world, it

is important to use inventory management at all stages of the value and supply chain
to help make your products offer the best value possible and to help your company be
as profitable as possible. This report set out to investigate inventory management and
to look at the best approach to inventory management in particular the advantages and
disadvantages of holding high or low levels of inventory, and the ways in which
companies can implement an effective inventory management policy, including how
to forecast demand, the inventory management techniques that can be implemented
and what to take into account when planning for inventory management. This report
found that the best approach according to academics and the examples set by the
front-runners in business is to keep a relatively low level of inventory to reduce
holding costs, and avoid other costs such as depreciation of inventory purchased.
Once a company has made the choice that they want to keep a low level of inventory
they need to implement a way to forecast the demand that they feel they will get for
their products and predict how much inventory to order, there are a few different ways
to do this the most popular being either the Economic Order Quantity model, which
calculates the optimum amount of inventory to order using the purchase cost, the
ordering cost and the holding cost, or simple extrapolation, which simple calculates
demand by looking at historical data. The report then moved on to look at the best
ways that companies can apply this information and help themselves manage their
inventory to keep it low, the most common way for companies to run an effective
inventory management scheme is through the use of a Just In Time production plan,
this means that the company will try to keep as lower level of inventory as possible by
ordering the right amount at the right time. The bullwhip effect is a phenomenon that
can effect a company with a poorly implemented inventory management system, as it
can create a dramatically irregular demand from a slight change in the habits of the
end consumer.
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Web Links

http://www.allisontransmission.com/

http://hubpages.com/hub/Criticisms-Six-sigma-and-lean-manufacturing (2008)