Why Firms Manage Inventory
Inventory is necessary for production facilities, retailers and wholesalers. Manufacturers require raw materials and components in order to produce their final products. Retailers require those final products to keep the shelves full on the sales floor or in the warehouse. When retailers and suppliers increase their inventory levels they are also increasing their availability to service their customers, which has a positive impact on customer service and potentially a negative impact on the bottom line. Funds that are tied up in inventory or allocated to accounts payable are not able to be used elsewhere, which can have a significant opportunity cost. If the inventory levels increase without a proportional increase in sales then profitability is decreased. When inventory has to be handled, moved, counted or secured then that increases the financial burden. Since these operational activities do not increase the value of the products being sold then there is no added value being passed on to the customer, making it difficult to justify an increase of the selling price. A manufacturing manager would likely prefer that parts on hand are kept at maximum levels so that the production process can continue to run without scrutiny, while a financial manager perceives this as an investment that, if it is not increasing profitability, must be reduced to the minimum required levels.


Traditional Methods focus on Production and Cost

The ABC method, commonly used in manufacturing, suggests keeping a lower quantity of high dollar items and a higher quantity of lower cost items. In this method, the firm would typically focus higher methods of control on the higher cost items, or item group A, while mid-cost items, group B are checked periodically and lower cost items, group C are controlled in bulk or by lots rather than by unit. A car dealership using this method would keep detailed records of every vehicle that is purchased and sold, count received orders and spot-check common parts such as brake pads, and check in and out cases of antifreeze. One downside to this method is that it does not consider the actual use of the inventory. If the car dealership sells five cars per month while consuming only five bottles of antifreeze per month, then the ABC method would cause them to quickly run out of cars to sell while they continue to build up an excess amount of antifreeze.

The Reorder Point method suggests maintaining enough quantity on hand to keep up with the expected production levels, then reorder more parts based on the lead time. Using the car dealership example, if there is a 2-week lead time for brake pads and the dealership expects to use ten sets of brake pads per week, then their reorder point is at an inventory level of 20 brake pads, plus safety stock. Production continues to consume the parts on hand, and two weeks after the order is placed, the inventory level is expected to be at zero when the new shipment arrives and the cycle continues. One issue with this method is that it does not consider sales forecast. In the same example of the car dealership, it would be more advantageous if they considered when people would be most likely to replace their brakes, such as, at the end of the month when car inspections are due, or just before winter when many people are preparing for the harsh weather. This method also fails to consider assemblies or sub-assemblies and the relationship between different parts. When replacing brake pads, the service department would need anti-squeal pads, brake fluid, and possibly rotors and drums. Finally, while there is typically a required level of safety stock kept on hand, this method assumes that inventory can always be replenished as required within the specified time. As many companies found out in March of 2011 when a tsunami shut down the nuclear plant in Fukushima, Japan and destroyed many other manufacturing facilities in the area, a firm can not always assume that inventory levels will be replenished at the scheduled intervals. (Gitman & Zutter, 2015)


Using Technology to Improve Inventory Management
The historical methods of inventory management are becoming just that - history. With the advances in technology in every aspect of business, it only makes sense to apply the same developments in the area of inventory management. Retailers can quickly see sales trends, stock levels, lead times and business impact without having to touch a single piece of merchandise. Sales forecasts can be used to drive MRP (Materials Requirement Planning) systems with the aid of inventory availability and needs as provided by computerized stocking software.

Many firms are quickly realizing the financial benefits of using analytics software with MRP systems for inventory management. Columbia Sportswear, a manufacturer of athletic clothing and accessories, experienced a 25% increase in net sales from 2013 to 2014 while only increasing inventory 17% by using supply chain analytics software to track and manage their inventory, which helped them to better supply merchandise to their retailers. This software not only helped them to align inventory levels with customer demand, but also helped them to reduce the amount of overstock, which means that they avoided the situation of having to discount their merchandise in order to clear inventory for the next season. With the help of this software, Columbia Sportswear increased its operating income 51% and net profit by 45% from 2013 to 2014 . (Boulton, 2015)

Safeway, a West-Coast based grocery store chain teamed up with one of its largest suppliers, PepsiCo, a food and beverage supplier, to initiate data visualization software to improve forecasting and inventory management. This advanced software technology provides visual graphs, maps, charts and other aids to provide a clearer picture of trends and patterns that can help a business to better understand what is going on across the market and why. It also allows the user to provide more detailed input than they would typically use on a simple spreadsheet, allowing the software to analyze information down to each individual UPC. By using these visual aids to graphically depict the patterns, the firm is able to make more sense of the data and identify areas of improvement and focus . From there, the firm can make better decisions on what changes to make and where. (Data Visualization Helps Safeway Keep Shelves Stocked, 2013)

Some firms like Neiman Marcus, a high end department store chain, are turning their attention to the new age of retail - ecommerce and mobile apps. Five years ago, their associates would call other stores one at a time to find out if they had merchandise in stock when a customer was looking for something. Now the sales associate can go into the computerized management system to instantly see if any of the 41 stores or warehouses had the item and order it on the spot for the customer to complete the sale. Additionally, when customers order merchandise online, it could be filled by one of the stores or warehouses rather than being limited to only the distribution centers, giving the e-commerce customers the same availability as in-store customers. This allowed Neiman Marcus to focus their inventory fulfillment based on their broad target market in each geographical location without neglecting the unique group of customers in each area. (Wahba, 2014)
Walmart, a retail chain of discount department stores, managed inventory for its distribution centers and warehouses using a computer system starting in 1975 to help understand inventory movement and requirements. Today the firm uses cross-docking at the warehouses, where inventory moves between arriving and departing trucks without going to the warehouse where it will take up space and require more labor hours to maintain, search for, and relocate merchandise. This is possible through an inventory software program called TradeGecko, which boasts lower cost for inventory storage and transportation. Using this software, owning the land where the warehouses are located rather than leasing, and staffing the trucking and warehouse departments with their own employees, allows Walmart to keep their storage spaces at a minimum while also maintaining strict and enforceable methods to keep costs low. (Alliance, 2015)


Strategic Alliances between Suppliers and Retailers

When suppliers and retailers work together, it is a mutually beneficial relationship. By opening doors to each other and sharing vital information, including sales forecasting and inventory levels, the supplier can better plan for anticipated upward trends, and the retailer can rely on the supplier to be able to fill orders as they come up. When PepsiCo approached Safeway to suggest that they work together on the data visualization endeavor, the two companies worked together, sharing information and building a system that helped them both to better understand each other’s inventory needs and limitations. Many other firms have taken the same approach with their suppliers and retailers.

Costco, a membership-only wholesaler, has built strategic alliances with most of its suppliers including Kimberly-Clark, a personal care producer of mostly paper-based goods. By sharing sales and inventory data directly with Kimberly-Clark, the supplier can manage the inventory levels of their products and send them only as needed to restock the retailer’s stores. This has contributed to Costco’s ability to turn over their inventory 12 times per year and increase inventory by only 3.3% while the sales have grown 12.6% from 2007 to 2008. With this high inventory turnover rate, Costco’s accounts receivable have a much shorter timeline than their accounts payable, meaning that they can keep those funds within the company in order to produce more profit long before they have to pay their suppliers. (Graham, 2008)

Walmart had put this method into practice when Costco was only starting to come into the market. Walmart started dealing directly with their suppliers in the 1980’s by developing a method called Vendor Managed Inventory, or VMI, where the supplier manages the inventory in the retailer’s stores to ensure that products were always available. Walmart has also been able to use its influence and strong market presence to increase their accounts payable balance while also increasing their accounts payable timeline, which allows them to keep the cash from accounts receivable for longer periods of time and to use those funds to increase their cash assets. In fact, according to a Forbes article from 2010, Walmart is able to earn more than $2 million per day by maintaining accounts payable of $30 billion while the accounts receivable are only a fraction of that at $4 billion. (Team, 2010)


Combining MRP with Reorder Point
Some companies are taking a hybrid approach to inventory management. Firms that use a variety of inventory that vary in price, size and usage may have traditionally followed the Reorder Point method, which basically means that when there is only enough inventory left to last through the lead time required to receive new stock then the firm orders more so that their inventory is replenished before they are expecting to completely run out. When combining this with the MRP method, which is Material Requirements Planning, the firm can realize powerful improvements to their bottom line.

Walking Equipment Company, a manufacturer and reseller of walking canes and other devices, combined the Reorder Point method with MRP. Higher ticket items are limited to a very low quantity based on the anticipated number of turns as determined by sales forecasting and historical data. These same parts are also managed by the lead time required to receive new parts, along with all of the other components required to assemble their products, and so they balance the demand of their customers with the supply of their vendors to make sure that they can continue to run smoothly without having an excessive amount of inventory. The company also uses a software program which points employees to the locations of items in the warehouse so that they can more easily and completely fill orders, and the same software generates a purchase order when that employee “picks” the inventory item off of the shelf. This not only automates the process, but also eliminates the need for counting individual pieces of inventory by hand. Human error with a manual counting method is eliminated, and those employees can spend more time adding value to the products sold to their customers. All of these improvements contributed to a 5% increase in profitability and a $15,000 reduction in labor costs. (Quittner, 2008)

Super Lawn Trucks, a residential and commercial landscaping equipment manufacturer, found that a very simple and readily available commercial software program not only met their business accounting needs, but also helped them to better understand and manage their inventory. After several months of analyzing invoices, sales reports and other data, all of the vital elements of the business were entered into QuickBooks Pro software. Through this, the company was able to better understand how much inventory was actually needed on hand for each product and for customer demand . They could also see exactly where all of the components were located in the facility so that they did not have to waste time tracking down each item. Using this software program also helped them to see where they had excess inventory and where they were deficient, and through the use of this program and better understanding of their required reorder points, they were able to decrease their inventory management labor, reallocate those skilled people to add more value to the products, and decrease their production lead time nearly in half. The decreased lead time led to higher customer satisfaction and increased sales. Contributing this and a $50,000 decrease in labor only for inventory management naturally led to a significant increase in profitability. (Quittner, 2008)

Not everyone learned the same lesson. John Deere Company, a manufacturer of lawn and farming equipment, tried the “build to order” approach rather than maintaining overstock. While this did decrease the amount of inventory on hand by 28%, it also greatly increased turnaround time and subsequently decreased their customer base. While John Deere was trying to keep their bottom line in check by maintaining low levels of inventory, they failed to understand the lead times required for the necessary parts for their merchandise and the amount of time required to produce a final product. During the off-season, when most people were not purchasing new farm and landscaping equipment, this firm maintained low levels of inventory and decreased production. When the seasons changed and customers were ready to start purchasing equipment, there were not enough products available for immediate purchase, and so a lot of merchandise was available only on back order. Retailers that counted on these products from John Deere experienced 20% decrease in sales and complained that they were losing half a dozen deals every month. In the farming business, timing is crucial, because the weather will not stand still until the equipment is ready and crops will not stop growing until the harvesting machinery arrives. John Deere experienced a 19% reduction in sales in 2010 and lost many customers who were loyal to their brand over the years. Even after the firm resolved their lead time issues, some of those customers were not ready to forgive and forget. (Singh, 2010)

The Bottom Line

Inventory management has a huge impact on the bottom line. It is difficult to find the delicate balance between minimizing inventory levels while also keeping up with the customer demand. When firms increase their inventory levels they are also increasing their availability to service their customers. If inventory levels increase without a proportional increase in sales then profitability is decreased. When a firm reduces their inventory level below the customer demand, they risk pushing their customers towards the competition. When a firm increases their inventory too far above the customer demand, they waste money on labor to manage the supplies and tie up their assets which prevent them from being used elsewhere. Unsold inventory is a cost to the company - not only in labor but also, as long as it remains unsold it represents capital that is not available to increase profits through other means. Firms need to find that delicate balance to continue increasing sales and profitability, minimizing costs, maintaining production and managing inventory. Whether the firm utilizes traditional methods, analytics software, or builds a strategic alliance, the inventory management technique needs to continue to provide adequate support for the operations of the firm so that they can continue to take care of the customer.