Inventory Management

Inventory Management


Managing inventory is one of the most challenging undertakings for the supply chain professional as well as the organization.  Inventory in its various forms tie up needed cash that can be used in other areas of the business.  Because cash is the life blood of the business, effective inventory and working capital management is crucial for the sustained financial health and profitability of the firm.  We address several inventory management tools in this block to include inventory costing, ABC (Pareto) classification, lean supply, JIT and kanban systems, and supply chain inventory management.


  • Cost of Inventories – For every item carried in inventory, the costs of having it must be less than the costs of not having it.  This is the main reason we have inventory, barring all of the forms and functions of inventory.  Inventory costs are real, but they are not easy to quantify.


Carrying, holding, or possession costs include handling charges, the cost of storage facilities or warehouse rentals; the cost of equipment to handle the inventory; storage, labor, and operating costs; insurance premiums; breakage; pilferage; obsolescence; taxes; and investment or opportunity costs.  In short, any cost associated with having, as opposed to not having, inventory is included.


Ordering or purchase costs include the managerial, clerical, material, telephone, mailing, fax, e-mail, accounting, transportation, inspection, and receiving costs associated with a production order.


Set-up costs are all costs associated with setting up a production run.


Stockout costs are the costs of not having the required parts or material on hand when and where they are needed.


Variation in delivered costs are associated with purchasing in quantities or at times when prices or delivery costs are higher than at other quantities or times.


Many inventory costs are difficult to identify, and hard to trace back to the income statement or balance sheet.  Many of these costs are “intermingled” with other costs, so one would have to conduct a separation of element in cost of goods sold (COGS) and in part of operating costs.


  • ABC Classification – A widely used classification of both purchases and inventories is based on monetary value.  In the 19th century, the Italian economist Vilfredo Pareto observed that, regardless of the country studied, a small portion of the population (20%) controlled most of the wealth (80%).  This observation led to the Pareto Curve, whose general principles hold in a wide range of situations.  For materials management,  the Pareto curve usually holds for items purchased, number suppliers, items held in inventory, and in many other aspects.  The Pareto curve is often called the 80-20 rule, which in inventory management is call ABC analysis.  A items can encompass from 0-20% of items by number or cost; B items can encompasses 20-50% (or the next 30%) of the items inventory; C items encompass the 50% up to 80% of the amount of inventory.  A items are particularly critical in financial terms and are, therefore, barring other considerations, normally carried in small quantities and ordered and reviewed frequently.  B items fall between A and C items and are well suited to a systematic approach with less frequent reviews than A items.  It should be noted that some B or C items may require A care because of their special nature, supply risk, and other considerations.


  • Vendor- or Supplier-Managed Inventory (VMI/SMI) – We have discussed VMI and consignment earlier, some just a cursory review is required here.  VMI/SMI has been used most frequently in buying stationery and office supplies, repetitive items, maintenance and repair materials, and operating supplies (MRO).



  • Lean Supply, Just-in-Time (JIT), and Kanban Systems – Lean thinking is a management philosophy focused on eliminating seven forms of waste: (1) Overproduction; (2) Waiting, time in queue; (3) Transportation; (4) Nonvalue-adding processes; (5) Inventory; (6) Motion; and (7) Costs of quality, scrap, rework, and inspection.


    • Lean Supply – Lean supply is an approach in which relationships with suppliers are managed based on a long-term perspective to eliminate waste and add value.
    • Just-in-Time (JIT) – Components, raw materials, and services arrive at work centers exactly as they are needed.  One of the necessary corollaries of having components and materials arrive just as they are needed is that the arriving items must be perfect.  In JIT, a number of interrelated principles are used to ensure high-quality output from each step in the production process
      • Responsibility for quality rests with the maker, not quality control.
      • Production workers build quality in a product or process rather than inspecting it in.
      • JIT insists on compliance to quality standards.  Refer to the Week Seven materials for a better insight on the quality process.


    • Kanban Control Systems – Kanban systems require the small lot size features of JIT and discrete production units.  Kanban in Japanese means “card.” The kanban system is driven by the user department pulling material through the system by the use of kanban.  The main managerial tools in this system are the container size and the number of containers (and therefore kanban) in the system.  The control is very precise, flexible, and responsive.  It prevents an unwanted build-up of inventory.
    • JIT and Inventory Management – Inventories often exist to cover up problems in supply or inside the organization.  With JIT, the deliberate lowering of inventory to uncover such malpractices forces an organization to identify and solve the underlying problems or causes for high and undesirable inventories.
    • JIT Implications for Supply Management – There are a number of implications of JIT for procurement.  First suppliers must deliver high and consistent quality with high reliability.  This implies that concentrating purchases with fewer nearby suppliers maybe necessary.  In JIT, there is a close cooperation between supplier and purchaser to solve problems, and suppliers and customers have stable, long-term relationships.


  • Managing Supply Chain Inventories – Decisions regarding what inventory to have in the supply chain and where to have it have important implication for customer service, cost, working capital commitments, and ultimately profitability.  Supply chain inventory management involves managing information flows and establishing operational design of the physical flow of the goods and services.  The key to efficiently and effectively managing inventory along the supply chain is to have not only internal alignment in the organization, but alignment among all supply chain partners and channel members as a whole.  In some cases, a supply chain member may have to absorb more costs so that the whole supply chain can benefit.  Benefits and profits have to be shared all along the chain; unfortunately, supply chains are working towards this “utopia” but are not nearly there yet.  Supply chain members (who have the power in the supply chain) tend to move costs to other members of the supply chain instead of taking costs out of the chain.  Storing and keeping inventory is the main aspect of costs in the chain, and supply chain members use their power to force firms in holding inventories and absorbing a disproportionate share of the cost.  The supply chain operations reference (SCOR) and EVA attempt to explain the benefits of supply chain cooperation for the whole chain, but so far there is not a full proof practice where total cooperation works in reality.