19.5 Inventory Management

Inventory management is crucial for businesses, balancing costs and customer satisfaction. It involves managing ordering, carrying, shortage, and purchase costs to optimize working capital and profitability.

Effective inventory control impacts profitability, customer satisfaction, and overall business performance. Key strategies include demand forecasting, setting reorder points, and managing inventory cycles. The Days in Inventory ratio helps measure efficiency and identify areas for improvement.

Inventory Management

Components of inventory cost

• Ordering costs
  • Expenses associated with placing and receiving inventory orders (purchase orders, shipping, receiving)
  • Higher ordering costs increase working capital requirements by tying up funds in the ordering process
• Carrying costs
  • Expenses incurred from holding and storing inventory (storage space, insurance, obsolescence, opportunity cost of capital)
  • Higher carrying costs raise working capital needs as more funds are allocated to maintaining inventory
  • Includes maintaining safety stock to buffer against unexpected demand or supply chain disruptions
• Shortage costs
  • Losses incurred when demand cannot be met due to insufficient inventory (lost sales, customer dissatisfaction, potential loss of future business)
  • Shortages may necessitate additional working capital to expedite orders or find alternative suppliers to meet demand
• Purchase costs
  • The actual expense of buying inventory items influenced by factors such as quantity discounts and supplier credit terms
  • Lower purchase costs reduce working capital requirements by minimizing the funds needed to acquire inventory

Inventory management's business impact

• Profitability
  • Efficient inventory management minimizes total inventory costs leading to higher gross margins and profitability
  • Optimal inventory levels reduce the risk of obsolescence and write-offs (perishable goods, technology products)
• Customer satisfaction
  • Adequate inventory levels ensure product availability and timely order fulfillment building customer loyalty and repeat business
  • Stockouts lead to lost sales and dissatisfied customers (during peak shopping seasons)
• Balancing act
  • Inventory management must strike a balance between cost minimization and service level optimization
  • Too much inventory increases costs and reduces profitability while too little risks stockouts and customer dissatisfaction

Days in inventory ratio

• Days in inventory (DII) ratio measures the average number of days a company holds inventory before selling it
  • Formula: $DII = \frac{Average\ Inventory}{Cost\ of\ Goods\ Sold} \times 365$
  • Lower DII indicates more efficient inventory management and faster turnover (retail industry)
• Interpreting DII involves comparing it to industry benchmarks and competitors and tracking over time to identify trends
  • High DII may indicate excess inventory, slow-moving products, or poor demand forecasting (seasonal items)
  • Low DII suggests efficient inventory management but may also risk stockouts if too low
• Improving DII can be achieved through:
  1. Implementing just-in-time (JIT) inventory management to reduce holding costs
  2. Optimizing reorder points and quantities based on demand forecasts and lead times
  3. Regularly reviewing and adjusting inventory levels based on sales data and market trends

Inventory Control Strategies

• Demand forecasting: Predicting future customer demand to optimize inventory levels
• Reorder point: The inventory level at which a new order should be placed, considering lead time and expected demand
• Inventory cycle: The recurring process of ordering, receiving, and depleting inventory
• Stock-keeping unit (SKU): A unique identifier for each distinct product and its attributes, used for inventory tracking and management