The Importance of Inventory Management

A company's inventory is one of its most valuable assets. In retail, manufacturing, food
services, and other inventory-intensive sectors, a company's inputs (such as raw materials)
and finished products are the core of its business. A shortage of inventory when and where it's
needed can be extremely detrimental.

At the same time, inventory can be thought of as a liability (if not in an accounting sense). A
large inventory carries the risk of spoilage, theft, damage, or shifts in demand. Inventory must
be insured, and if it is not used up or sold in time it may have to be disposed of at clearance
prices—or simply destroyed.

For these reasons, inventory management is important for businesses of any size. Knowing
when to restock, what quantities to purchase or produce, and when to sell and at what price
can easily become complex decisions. Small businesses will often keep track of stock
manually and determine the reorder points and quantities using spreadsheet (Excel) formulas.
Larger businesses may use specialized enterprise resource planning (ERP) software. The
largest corporations use highly customized software as a service (SaaS) applications.
Companies are also calling on artificial intelligence to optimize these processes.

Appropriate inventory management strategies vary depending on the industry. An oil depot is
able to store large amounts of inventory for extended periods of time, allowing it to wait for
demand to pick up if necessary. While storing oil is expensive and risky—a fire in the U.K. in
2005 led to millions of pounds in damage and fines—there is no risk that the inventory will
spoil or go out of style. For businesses dealing in perishable goods or products for which
demand is extremely time-sensitive—2024 calendars or fast-fashion items, for example—
sitting on inventory is not an option, and misjudging the timing or quantities of orders can be
costly.

For companies with complex supply chains and manufacturing processes, balancing the risks
of inventory glut and shortages is especially difficult. To achieve these balances, they may call
on several methods for inventory management, including just-in-time (JIT) and materials
requirement planning (MRP).

just-in-time (JIT)

Description
This manufacturing and inventory management model originated in Japan in the 1960s and
1970s. Toyota Motor (TM) is credited with contributing the most to its development.

The just-in-time (JIT) inventory system is a management strategy that aligns raw-material
orders from suppliers directly with production schedules. Companies employ this inventory
strategy to increase efficiency and decrease waste by receiving goods only as they need them
for the production process, which reduces inventory costs. This method requires producers to
forecast demand accurately.

The terms short-cycle manufacturing, used by Motorola, and continuous-flow manufacturing,

used by IBM, are synonymous with the JIT system.

Special Considerations

For JIT manufacturing to succeed, companies must have steady production, high-quality
workmanship, glitch-free plant machinery, and reliable suppliers.

Kanban is a Japanese scheduling system that's often used in conjunction with lean
manufacturing and JIT. Taiichi Ohno, an industrial engineer at Toyota, developed kanban in
an effort to improve manufacturing efficiency.

The Kanban system highlights problem areas by measuring lead and cycle times across the
production process, which helps identify upper limits for work-in-process inventory to avoid
overcapacity.

Advantages of JIT

JIT inventory systems have several advantages over traditional models. Production runs are
short, which means that manufacturers can quickly move from one product to another. Also,
this method reduces costs by minimizing warehouse needs. Companies also spend less money
on raw materials because they buy just enough resources to make the ordered products and no
more.

The just-in-time (JIT) inventory system minimizes inventory and increases efficiency. JIT
production systems cut inventory costs because manufacturers receive materials and parts as
needed for production and do not have to pay storage costs. Manufacturers are also not left
with unwanted inventory if an order is canceled or not fulfilled.

Disadvantages of JIT
The disadvantages of JIT inventory systems involve potential disruptions in the supply chain.
If a raw-materials supplier has a breakdown and cannot deliver the goods promptly, this could
conceivably stall the entire production line. A sudden unexpected order for goods may delay
the delivery of finished products to end clients.

For instance, at the beginning of the 2020's economic crisis, everything from ventilators to
surgical masks experienced disruption as inputs from overseas could not reach their
destinations in time to meet a surge in demand.

examples

The JIT inventory system is popular with small businesses and major corporations alike
because it enhances cash flow and reduces the capital needed to run the business. Retailers,
restaurants, on-demand publishing, tech manufacturing, and automobile manufacturing are
examples of industries that have benefited from just-in-time inventory.

One example of a JIT inventory system is a car manufacturer that operates with low inventory
levels but heavily relies on its supply chain to deliver the parts it requires to build cars on an
as-needed basis. Consequently, the manufacturer orders the parts required to assemble the
vehicles only after an order is received.

Economic order quantity (EOQ)

Description

Economic order quantity (EOQ) is the ideal quantity of units a company should purchase to
meet demand while minimizing inventory costs such as holding costs, shortage costs, and
order costs. This production-scheduling model was developed in 1913 by Ford W. Harris and
has been refined over time. The economic order quantity formula assumes that demand,
ordering, and holding costs all remain constant.

The goal of the EOQ formula is to identify the optimal number of product units to order. If
achieved, a company can minimize its costs for buying, delivering, and storing units. The
EOQ formula can be modified to determine different production levels or order intervals, and
corporations with large supply chains and high variable costs use an algorithm in their
computer software to determine EOQ.

The formula for EOQ is:

Q=2DSH
where:

Q=EOQ units

D=Demand in units (typically on an annual basis)

S=Order cost (per purchase order)

H=Holding costs (per unit, per year)

Advantages of EOQ

EOQ is an important cash flow tool. The formula can help a company control the amount of
cash tied up in the inventory balance.

For many companies, inventory is its largest asset other than its human resources, and these
businesses must carry sufficient inventory to meet the needs of customers. If EOQ can help
minimize the level of inventory, the cash savings can be used for some other business purpose
or investment.

Economic order quantity is important because it helps companies manage their inventory
efficiently. Without inventory management techniques such as these, companies will tend to
hold too much inventory during periods of low demand while also holding too little inventory
during periods of high demand. Either problem creates missed opportunities.

Disadvantages of EOQ

The EOQ formula assumes that consumer demand is constant. The calculation also assumes
that both ordering and holding costs remain constant.

This fact makes it difficult or impossible for the formula to account for business events such
as changing consumer demand, seasonal changes in inventory costs, lost sales revenue due to
inventory shortages, or purchase discounts a company might realize for buying inventory in
larger quantities.

Example of How to Use Economic Order Quantity (EOQ)

EOQ takes into account the timing of reordering, the cost incurred to place an order, and the
cost to store merchandise. If a company is constantly placing small orders to maintain a
specific inventory level, the ordering costs are higher, and there is a need for additional
storage space.
Assume, for example, that a retail clothing shop carries a line of men’s jeans, and the shop
sells 1,000 pairs of jeans each year. It costs the company $5 per year to hold a pair of jeans in
inventory, and the fixed cost to place an order is $2.

The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost) or
28.3 with rounding. The ideal order size to minimize costs and meet customer demand is
slightly more than 28 pairs of jeans. A more complex portion of the EOQ formula provides the
reorder point.

Material Requirements Planning (MRP)

Description

Material requirements planning (MRP) is a software-based integrated inventory and supply

management system designed for businesses.

Companies use MRP to estimate quantities of raw materials, maintain inventory levels, and
schedule production and deliveries.

The first MRP systems of inventory management evolved in the 1940s and 1950s, using
mainframe computers to extrapolate information from a bill of materials for a specific
finished product into a production and purchasing plan. MRP systems expanded to include
information feedback loops so that production managers could change and update the system
inputs as needed.

The next generation of MRP, manufacturing resources planning (MRP II), also incorporated
marketing, finance, accounting, engineering, and human resources aspects into the planning
process.

How Material Requirements Planning (MRP) Works

MRP helps businesses and manufacturers define what is needed, how much is needed, and
when materials are needed and works backward from a production plan for finished goods.

MRP converts a plan into a list of requirements for the subassemblies, parts, and raw
materials needed to produce a final product within the established schedule. MRP helps
manufacturers get a grasp of inventory requirements while balancing both supply and
demand.
Using MRP, managers can determine their need for labor and supplies and improve their
production efficiency by inputting data into the MRP scheme such as:

Item Name or Nomenclature: The finished good title, sometimes called Level "0" on BOM.

Master Production Schedule (MPS): How much is required to meet demand? When is it
needed?

Shelf life of stored materials.

Inventory Status File (ISF): Materials available that are in stock and materials on order from
suppliers.

Bills of materials (BOM): Details of materials and components required to make each
product.

Planning data: Restraints and directions like routing, labor and machine standards, quality and
testing standards, and lot sizing techniques.

Advantages of MRP

 Materials and components are available when needed

 Minimized inventory levels and associated costs
 Reduced customer lead times
 Increased manufacturing efficiency
 Increased labor productivity

Disadvantages of MRP

 Heavy reliance on input data accuracy

 Expensive to implement
 Lack of flexibility in the production schedule
 Less capable than an overall ERP system

Days Sales of Inventory (DSI)

Description

The days sales of inventory (DSI) is a financial ratio that indicates the average time in days
that a company takes to turn its inventory, including goods that are a work in progress, into
sales.
DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in
inventory (DII), days sales in inventory, or days inventory and is interpreted in multiple ways.
Indicating the liquidity of the inventory, the figure represents how many days a company’s
current stock of inventory will last. Generally, a lower DSI is preferred as it indicates a shorter
duration to clear off the inventory, though the average DSI varies from one industry to
another.

Formula and Calculation

DSI= COGS/Average inventory×365 days

where:

DSI=days sales of inventory

COGS=cost of goods sold

To manufacture a salable product, a company needs raw material and other resources which
form the inventory and come at a cost. Additionally, there is a cost linked to the
manufacturing of the salable product using the inventory. Such costs include labor costs and
payments towards utilities like electricity, which is represented by the cost of goods sold
(COGS)

Average Inventory=Ending Inventory

or

Average Inventory= (Beginning Inventory + Ending Inventory)/2

COGS value remains the same in both the versions.

What DSI Tells You

Since DSI indicates the duration of time a company’s cash is tied up in its inventory, a smaller
value of DSI is preferred. A smaller number indicates that a company is more efficiently and
frequently selling off its inventory, which means rapid turnover leading to the potential for
higher profits (assuming that sales are being made in profit). On the other hand, a large DSI
value indicates that the company may be struggling with obsolete, high-volume inventory and
may have invested too much into the same. It is also possible that the company may be
retaining high inventory levels in order to achieve high order fulfillment rates, such as in
anticipation of bumper sales during an upcoming holiday season.
DSI is a measure of the effectiveness of inventory management by a company. Inventory
forms a significant chunk of the operational capital requirements for a business. By
calculating the number of days that a company holds onto the inventory before it is able to sell
it, this efficiency ratio measures the average length of time that a company’s cash is locked up
in the inventory.

However, this number should be looked upon cautiously as it often lacks context. DSI tends to
vary greatly among industries depending on various factors like product type and business
model. Therefore, it is important to compare the value among the same sector peer companies.
Companies in the technology, automobile, and furniture sectors can afford to hold on to their
inventories for long, but those in the business of perishable or fast-moving consumer goods
(FMCG) cannot. Therefore, sector-specific comparisons should be made for DSI values.

Example of DSI

The leading retail corporation Walmart (WMT) had inventory worth $54.9 billion and cost of
goods sold worth $490 billion for the fiscal year 2023.

DSI is therefore:

DSI = (54.9/490) x 365= 40.9 days

While inventory value is available on the balance sheet of the company, the COGS value can
be sourced from the annual financial statement. Care should be taken to include the sum total
of all the categories of inventory which includes finished goods, work in progress, raw
materials, and progress payments.

Since Walmart is a retailer, it does not have any raw material, works in progress, and progress
payments. Its entire inventory is comprised of finished goods.

conclusion

effective inventory control is vital for businesses seeking to optimize their operations, reduce
costs, and enhance customer satisfaction. Various methods and techniques, such as Just-in-
Time (JIT), Economic Order Quantity (EOQ), ABC Analysis, and safety stock management,
provide frameworks for maintaining optimal inventory levels while minimizing waste and
inefficiencies.

Each method offers unique advantages and challenges, making it essential for businesses to
assess their specific needs, industry dynamics, and supply chain capabilities when selecting
the most appropriate strategies. By implementing a combination of these techniques,
companies can achieve greater visibility and control over their inventory, ensuring they meet
customer demand while maintaining financial health.

Ultimately, robust inventory management not only supports operational efficiency but also
contributes to long-term business success by fostering resilience in supply chains and
enhancing overall competitiveness in the marketplace.