Inventory Management Logistics: Methods and Best Practices

Introduction

A company's supply chain is used to coordinate the acquisition of materials needed for manufacture, but there is far more involved in the inventory management function than simply ordering, storing, and using these materials. Identifying and maintaining optimal inventory levels is a complicated and challenging enterprise. Inventory levels that are too high can cause problems, just as inventory levels that become too low can create havoc along the entire production line. Today, however, there are a number of manual and computer-assisted methods available that can help organizations of all types and sizes improve their inventory management function. To gain fresh insights into these methods and technologies, this paper provides a review of the relevant peer-reviewed and scholarly literature, followed by a summary of the research and important findings in the conclusion.

Companies of all types and sizes face many of the same problems when it comes to identifying and establishing appropriate inventory levels (Thierauf, 1998). According to the definition provided by Shim and Siegel (2001), inventory management is "maintaining the optimum inventory level through inventory records. This is done to maximize profits by creating a good balance between inventory investment and smooth, continuous production, for a profit-oriented firm" (p. 247). There is also a need for not-for-profit organizations to optimize their inventory management practices. In this regard, Shim and Siegel add that, "For a non-profit entity, this means minimizing costs" (2001, p. 247). These issues have been the source of increasing attention for almost a century, with interest in developing more effective inventory management practices beginning around 1915 (Thierauf, 1998). In the intervening years, manual analytical processes have been supplemented and even replaced by increasingly sophisticated computer-based applications specifically designed for effective inventory management. According to Thierauf, "The reason for greater attention to inventory is that this asset, for many firms, is the largest one appearing on the balance sheet" (p. 55). Significant and typically expensive problems can result when inventory levels are either too high or too low (Thierauf, 1998).

The Fundamentals of Inventory Management

There are three general types of inventory: (a) raw materials — materials purchased from a supplier that will be used to manufacture goods; (b) work-in-progress — partially completed goods that exist at the end of an accounting cycle; and (c) finished goods — completed goods that are waiting to be sold (Shim & Siegel, 2007). Regardless of which category of inventory is involved, identifying optimal inventory management practices is usually a complicated and challenging enterprise. As Shim and Siegel note, "Inventory management involves a trade-off between the costs associated with keeping inventory versus the benefits of holding inventory" (2007, p. 112).

On the one hand, there are significantly higher costs involved in keeping inventory levels high, including storage, insurance, spoilage, and the interest on funds borrowed to finance inventory acquisitions (Shim & Siegel, 2007). On the other hand, higher inventory levels can help prevent lost sales opportunities from stockouts, as well as disruptions to the manufacturing process due to a lack of needed components (Shim & Siegel, 2007). These points are also made by Stout and Bedenis (2007), who add that, "For virtually any manufacturer, proper inventory management ensures the availability of the right items at the right time and in the right place. This, in turn, supports organizational objectives of customer service, productivity, profit, and return on investment" (p. 9). Conversely, Stout and Bedenis also cite the downsides of higher inventory levels: "There are, however, both out-of-pocket and opportunity costs associated with inventory holdings. For example, inventory ties up capital, uses storage space, requires handling, deteriorates, becomes obsolete, incurs property taxes, requires insurance, and sometimes is lost or stolen" (2007, p. 9).

Given the enormous amounts of money involved in formulating optimal inventory levels and the significant outcomes at stake, it is not surprising that over the past four decades a growing number of companies of all types and sizes have sought improvements in their inventory management methods (Allen, 1999). As one practitioner notes, "Improving inventory management can be a fruitful place to look for savings" (Bendix, 2009, p. 25). Likewise, Thierauf (1998) emphasizes that, "Effective inventory management can make a significant contribution to a company's profit" (p. 57).

These trends in inventory management have also been fueled by the internationalization of trade in an increasingly globalized marketplace. There has been a corresponding need for companies to become leaner in their inventory management practices in order to remain competitive and achieve a competitive advantage, and a number of approaches have been developed in response to these needs. For example, identifying the most appropriate inventory management approach represents a basic way that companies can facilitate the movement of inventory along the entire supply chain. Allen (1999) reports that more efficient inventory management has been achieved by many companies through the use of just-in-time management techniques as well as a wide range of emerging technologies.

The just-in-time inventory management system was introduced by Toyota using its now well-known "Kanban" method, in which two Kanban cards were manually placed in buckets by workers to signal their completion of one task and the need for parts for the next (Young & Nie, 1999). According to Young and Nie, "The Toyota system was simple and it worked. It was a variation of a commonly used inventory system called a 'two-bin system,' in which parts are pulled from a front storage bin, and a second bin's parts are pushed to the first bin, signaling the need to reorder" (p. 56).

These straightforward but tried-and-true manual steps facilitated inventory management at Toyota on the line; however, the major innovation occurring at this time as a concomitant of the JIT method was the change taking place in the relationship between manufacturer and suppliers, with responsiveness and nimbleness being the keys to success. In this regard, Young and Nie report that, "The real innovation of the Toyota system was going on at the receiving area of the plant. Toyota arranged for its suppliers to deliver parts shortly before they were actually used, requiring some suppliers to deliver more than once a day and many other suppliers to make daily deliveries" (1999, p. 56). By the time suppliers had managed to become efficient with Toyota's inventory management approach, they had essentially become inextricable parts of Toyota. As Young and Nie point out, "This changed the whole nature of the buyer-supplier relationship. Since the buyer of parts was so dependent on the delivery of parts by the supplier, the traditional adversarial relationship had to be dispensed. Suppliers became part of the firm" (1999, p. 56).

Just-in-Time Inventory and Supplier Relationships

Another important change that took place in inventory management as a result of just-in-time approaches was the streamlining of the supply chain to more vertically organize companies in ways that also tend to bind them together. Young and Nie conclude that, "Whether a company decides to go to a JIT system or not, the JIT sourcing philosophies apply to all organizations. The move is on to reduce the supplier base. A philosophical shift has taken place — the old approach was to have multiple sources for a commodity, the new approach is to seek a primary source" (1999, p. 56).

Just as companies have reduced the number of suppliers they use, the goal of just-in-time inventory management is to reduce the amount of inventory needed to an absolute minimum. The technique is typically used by manufacturers so that needed components are available only at the time they are needed during production, contributing to organizational productivity and profitability (Mckay & Shank, 2008). Likewise, Hughen, Livingstone, and Upton (2011) report that, "Inventory reduction is a goal under lean inventory and manufacturing systems, such as just in time" (p. 27).

Effectively managing inventory and factory production levels becomes a major challenge when orders differ, requiring supply chain partners to retain more items in their respective inventories (Haines & Hough, 2010). Fortunately, innovations in radio-frequency identification (RFID) readers and tags, bar codes, and computerized inventory management systems that can track inventory levels and automatically issue purchase orders have improved inventory management practices at companies such as Dell, Cisco, and Pfizer in significant ways in recent years (Jablonsky & Barsky, 2001). Likewise, Rogers (2009) reports that, "The Dairy Queen chain used technology to assess its distribution, transportation, and inventory management for a national rollout of new products. Result: $1.8 million or 29 percent cost reduction" (p. 240), and Fitz-Enz (2009) emphasizes that, "Superior inventory management helped Wal-Mart take the number one position in retailing" (p. 21). Conversely, Michman and Greco (1999) point out that, "Some department stores have failed because many have provided a stale and unexciting physical environment to customers. Another reason has been that some department stores have been unable to implement effective inventory management systems, thereby lowering costs to either match or at least approach the prices offered by discounters" (p. 4).

Effectively managing inventory also requires the ability to monitor current inventory levels with an accurate inventory system. To the extent that inventory records are inaccurate is likely the extent to which managers will be required to spend disproportionately larger amounts of time expediting materials or placing orders for excessive inventory (Young & Nie, 1999). According to these authorities, "A general rule-of-thumb is that the 'A' items should be the most accurate of all inventory items" (Young & Nie, 1999, p. 55). Recommendations provided by the American Production and Control Society (APICS) indicate that inventory records for "A" items should be approximately 99.5% accurate, "B" items approximately 99%, and "C" items approximately 95% (Young & Nie, 1999).

Although these optimal inventory accuracy levels may appear straightforward to achieve, the reality for most organizations is that their inventory records are not sufficiently timely or accurate to provide managers with the information they need to make informed decisions. As Young and Nie emphasize, "These percentages do not appear difficult to achieve, but the fact is that many inventory record systems fall painfully shy of these standards" (1999, p. 55). Although cyclical inventory accounting can help resolve these discrepancies, a number of factors must be taken into account in developing optimal inventory management practices that avoid inventory inaccuracy. The causes of inventory inaccuracy include, but are not limited to, the following:

1. Unit-of-issue difference. Products may be received in cases of four boxes and then distributed in individual boxes. Failure to convert from cases to boxes could cause count errors.

2. Inventory used without proper accounting. For example, a clerk fails to record the distribution of a box of copier paper to an office.

Technology and Inventory Accuracy

3. Inventory is lost, misplaced, or stolen (Young & Nie, 1999, p. 55).

A number of companies conduct physical inventories only once a year, but more frequent cycles help managers identify inaccurate inventory levels as quickly as possible to avoid further problems up and down the supply chain (Young & Nie, 1999). Even here, however, there are important trade-offs and cost-benefit analyses involved. Young and Nie point out that, "A greater frequency of cycle counts helps reduce the record discrepancy that builds up over time. As the cycle counting frequency increases, the labor cost of cycle counting increases, stockouts decrease, and record accuracy increases" (1999, p. 56). To facilitate the control process, managers should arrange for automatic computer-generated notices to identify the need for an inventory cycle (Young & Nie, 1999). Because every organization will be unique in some fashion, the cost-benefit analysis in this area will ultimately depend on the specific circumstances. Young and Nie conclude that, "Ultimately, the choice of how frequently to cycle count is an economic decision. The total cost of inventory accuracy becomes the sum total of the cost of cycle counting and the cost of stockouts" (1999, p. 55).

This cost-benefit analysis can be facilitated by the application of some basic inventory management practices. According to Thierauf (1998), "The fundamental concerns of management in formulating basic inventory decisions are: the quantity to order at one time and when to order this quantity. In approaching these two decisions, one path is ordering large amounts (to minimize ordering costs), while the other path is ordering small amounts (to minimize inventory carrying costs)" (p. 58). Regardless of which type of inventory is involved, best industry practices indicate that a middle-ground approach is appropriate for many situations. Thierauf cautions that, "Either course pushed too far will have an unfavorable effect on profits," and concludes that, "The best course in terms of minimizing costs is a compromise between the two extremes" (1998, p. 58).

Because the fundamental aim of developing effective inventory control methods is to minimize the total costs associated with inventory levels, it is first necessary to identify these costs — following the maxim that in order to improve something it must first be measured. The costs associated with inventory can be grouped into three basic categories: (a) ordering costs, (b) inventory carrying costs (which are interrelated with ordering costs), and (c) outage costs, experienced when stockouts of items occur (Thierauf, 1998, p. 58).

The first two costs — ordering and inventory carrying — are interrelated because of the potential to lose sales if there is insufficient inventory available, or to disrupt production if inventory levels are not maintained (Thierauf, 1998). A basic inventory management model assumes that stockouts do not occur; that is, optimally, inventory is received in specified quantities and then used for sales or production at a constant rate (Thierauf, 1998). Formulating the basic inventory management control model therefore involves first identifying ordering and inventory carrying costs without regard to stockouts. As Thierauf advises, "Under these idealized conditions, the firm experiences no stockouts. Hence, only ordering costs and inventory carrying costs are needed in formulating basic inventory control models" (1998, p. 58). These three inventory management cost categories are described below.

These are the costs associated with acquiring purchased items until they are placed in a company's inventory. Such costs are incurred whenever orders are placed, beginning with the purchase requisition and also including issuing the purchase order, follow-up, receiving the goods, quality control, placing them into inventory, and paying suppliers (Thierauf, 1998). According to Thierauf, "Acquisition costs pertaining to company-manufactured items include several of the above-mentioned items, but they also comprise other categories" (p. 58). A representative list of costs for both purchased and manufactured items is provided below.

Table 1: Sample List of Costs for Purchased versus Manufactured Items

Conclusion

Effective inventory management practices attempt to maintain optimal inventory levels through an analysis of inventory records in an effort to maximize profits by developing a good balance between inventory investment and seamless production. The research showed that organizations of all types and sizes — including both for-profit and non-profit organizations — can benefit from improved inventory management practices, with the latter involving reductions in the costs associated with acquiring, maintaining, and selling inventory. The research also showed that interest in improved inventory management practices is not new, but the level of interest increased following the introduction of just-in-time inventory management practices during the 20th century, which were followed by innovations in technology that have further facilitated the inventory management process.