Inventory Management - Controlling Inventory in a Highly Volatile Demand-Supply Environment

4/1/15 Supply Chain Planning and Design

Table of Contents

Sl No. Title Page No

Executive Summary 2

1. Introduction 3

2. Inventory Management 4

2.1 Rationale for Inventory Management and Control 5

3. Common Analysis Techniques, Tools and Methods in Inventory Control 6

3.1 Economic Order Quantity 7

3.2 Analysis Techniques - ABC, VED Analysis 8

3.3 Technical & Management Frameworks - EDI, VMI, CPFR 9

3.3.1 EDI & their Challenges 9

3.3.2 VMI & their Challenges 10

3.3.3 CPFR & their Challenges 11

4. Challenges in Inventory Control - A Broader Perspective 13

5. Conclusion 14

6. References 15

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INVENTORY MANAGEMENT – CHALLENGES IN CONTROLLING INVENTORY IN A HIGHLY VOLATILE DEMAND-SUPPLY ENVIRONMENT

Executive Summary

The objective of this study is to find out the impact of inventory management practices in a

highly volatile demand-supply environment and how the proper control of inventory can

improve business performance of companies. For the literature review we look at what

inventory management is all about and look into some of the contemporary methods

inventory control. The paper initially focuses on the EOQ, a basic method of determining the

inventory needed and then looks into other inventory analysis techniques such as ABC and

VED analysis. The contemporary technical and management frameworks such as EDI

(Electronic Data Interchange), VMI (Vendor Managed Inventory) and CPFR (Collaborative

Planning, Forecasting and Replenishment) are discussed. The challenges and barriers faced

by firms in using these frameworks are brought to light. Finally we look at the challenges of

inventory control at broader perspective where other issues such as the changing Socio-

economic environment, effect of mergers and acquisitions, effect of government policies,

market strategies that affect inventory control are discussed.

For the purpose of the study, research papers from leading international journals on inventory

management and control, thesis reports from international universities, whitepapers, news

articles and web documents written by experts in the field were used.

The main findings of the study are that though inventory is an important and integral

component of the supply chain the lack of effective planning mechanism could have

devastating effects on company performance. The current issues faced by firms in their

inventory control mechanism are mainly the lack of cohesiveness among the various

stakeholders, technology and marketing strategies along with inadequate visibility that is

needed across the supply chain.

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Introduction

Over the past couple of decades, the world has seen huge fluctuations in the economic

environment. Leading up to year 2007, the world economy grew at a large. In the 90's

countries like U.S and U.K witnessed a period of continued growth as a result of increase in

productivity created by the internet. Even developing countries like India and China saw

tremendous growth post 2000, thanks to Information Technology sector. However most firms

could not foresee what was going to hit them.

“Failing to plan is planning to fail" - Winston Churchill.

The recent economic downturn substantiates this statement as many companies have

regretted the huge amount of capital that had been invested in inventories. These fluctuations

either due to the economic scenario or other factors such as natural calamities, changing

government policies, makes the job of the demand or inventory planner quite intensive and

difficult. In 2009, when recession was at its peak, many firms cut down on inventories with a

"slash and burn” approach with the main aim of corporate survival. These techniques did

pay dividends in the short run. But as the economies recovered and supply chain networks

became more complex, managing inventories in this manner i.e. at a particular level or nodes

(inventory stocking points) was no longer good enough. Firms have realized the need of a

holistic approach to bring inventory levels down while maintaining as well as improving

customer satisfaction.

In this paper we make an attempt to uncover what are the challenges of inventory control and

the contemporary mechanisms that are used by firms. We also look at the barriers in

implementing these mechanisms and suggest ways to improve their utilization that would

enable firms achieve the optimum inventory level.

2. Inventory Management

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Inventory is nothing but usable idle resources that a business holds that have economic value

(Saxena 2009). These sources are not just associated with final product but occur across

various point in the supply chain such as in factories, warehouses, shops and retail outlets

(Ballou 2004). (Richard 1978) broadly divides inventory into four categories - (i) Raw

materials, (ii) Component which is the subassembly of the final product and are usually

consumed during production process (iii) Work -in -process ( found throughout the

manufacturing process ) and finally the (iv) finished goods. Latest literature also includes

inventories called "MRO" (maintenance, repair and operating supplies) needed for

maintenance or repair, also known as "spare part inventories". These resources form an

integral part of supply chain management and are needed for the smooth production process,

preventing "stock outs" or lost sales, improve responsiveness in the chain, meeting customer

satisfaction and also helps when there is speculation of surge in market prices of these

materials. (Ballou 2004) describes how they help in offsetting cost associated with holding

inventories by indirectly reducing operating costs as they are needed in other supply chain

activities. They also form part of risk mitigation strategies, where they are used to counter the

uncertainties of demand surges, unexpected delays in transportation and distribution, labour

strikes, natural calamities and so on. However holding inventories poses their own challenges

as well. Firstly they use up capital that could be used to improve productivity or

competitiveness in other areas (Ballou 2004). Many products have short "shelf life", for

example in healthcare where adequate amount or "safety stock" is always needed, but

overstocking could lead to severe losses. Even in the electronics industry which has

witnessed drastic reduction in life spans (Johar 2010) and the retail industry such as fashion

apparel (Sen 2008) or other consumer goods the cost of holding inventories drastically effects

business as there are lot of wastages not only in terms of the lost sales but overall wastage in

terms of resources, of manpower, machine and time. Inventory management encompasses all

the process involved in managing these resources and ensuring they are available at the "right

place", at the "right time" and at the "right price" while ensuring costs incurred in achieving

this are kept as low as possible. The ultimate goal is to ensure neither overstocking nor

shortages occur from raw material to finished goods as well in the reverse logistics network.

2.1 Rationale for Inventory Control

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Controlling inventory is a core part of any supply chain management process and has many

ramifications on business performance. Almost all business functions such as marketing,

sales, engineering and R&D, finance and accounting have an impact or impacted by

inventory (Toomey 2000). Inventory Control is needed for the effective optimization of

inventory as well people, process and other resources associated with them which can pay

huge dividends in a firm’s triple bottom-line (or the 3p's of people, planet and profit).

However many companies find it difficult to cope with fluctuating demand in highly volatile

environment with a fragmented, just in time supply chain inventory strategy. A survey carried

out by (CSCO Insights 2011) highlights that nearly 58 percent of fortune 500 companies

attributed commodity pressures as posing greater risks to profits.

Figure 1 - Poor Inventory Practices Affects the Overall Company Value, Source - (Genpact 2013)

Figure1 shows how they affect business performance from a financial standpoint. As

illustrated a suboptimal inventory level effects company’s cash flow, revenue cost structure

and the overall company valuation. Companies need to hold the right amount of stock and

ensure their smooth flow in a way that doesn’t jeopardize the production process or sales

while maintaining lower inventory costs. (Richard 1978) elucidates how the proper control of

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inventory protects firms from losses arising due to obsolescence, depreciation as well falling

market prices of their products.

Figure2 - Scope of Inventory Control

The process of determining "how much” and “how often” products need to be produced and

distributed is an elaborate process and is dependent on various socio-economic factors, such

as inflation, currency valuation, fuel prices, market strategies, buying patterns. As illustrated

in the figure2. It involves framing the right inventory policies and determining the EOQ

(Economic Order quantity), the various stock levels, the lead time and then examining the

policy that best fits the firm’s present scenario. Determining these parameters require a

careful and systematic approach with the use of appropriate tools and techniques which is

discussed next.

3. Common Analysis Techniques, Tools and Methods in Inventory Control

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The inventory control mechanisms used by firms should encompass all material handling

functions, warehousing, monitoring and tracking of materials, information sharing as well as

replenishment techniques. A typical inventory planning and control cycle is shown in figure3.

Figure3- Inventory Planning and Control Cycle

For companies to successfully manage its inventory, it needs to use all available techniques at

its disposal while ensuring it fits the firm's business environment. There are various

approaches to inventory management and can be classified based on the way it is viewed

"internal" or "external".

3.1 Economic Order Quantity (EOQ)

The EOQ technique is one of the oldest and popularly used internal mechanism when

inventory is viewed just "as it is" irrespective of form or source (Choi 2014). Here the

quantity is determined in a manner that minimizes the ordering, holding and carrying costs.

Though this is good basic technique to calculate the economic lot size, it has its limitations.

The model parameters used is based on the assumption that demand occurs continuously and

at a constant known rate. It may not be the possible to determine lot size when there is

fluctuation in demand or price as well as the fact that EOQ is not "time-phased" procedure

(Muckstadt 2010). The standard deviation in demand calculated is an estimate and dependent

on various factors, some of which will be discussed later. Firms need to use this as the first

step in their analysis but the challenge is to look at the demand patterns more holistically

before arriving at the right quantity.

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Figure4 - Economic Order Quantity, Original Source - (Harris 1913)

3.2 Analysis Techniques - ABC, VED, FSN Analysis

In addition, inventory are of many types and all do not need the same type of treatment.

Firms need to identify the type of inventory and form strategies and polices accordingly. The

most common analysis methods of identifying products and forming appropriate strategies to

control inventory include the ABC analysis, VED (Vital, Essential and desirable), FSN

( Fast, Slow and Non- moving), SOS (seasonal or off seasonal), GOLF ( Government,

Ordinary, Local or Foreign) to name a few. The ABC approach derived from Pareto's 80/20

rule classifies inventory into decreasing order of their criticality. A category constitutes of

the most valuable goods (about 70% of the total budget ) but count for less than 10 percent of

total items. These items require tighter control. The B category are neither costly nor cheap

which require moderate safety stock and moderate control and roughly constitute about 20

percent of total items. The C items are cheapest but constitute of 70 percent of total items

which require lesser control (there are no fixed thresholds). VED, FSN, SOS, and GOLF are

the other common methods of classifying inventory that can help firms in prioritizing and

allocating resources more effectively thereby improving business processes. It also helps in

identifying wasteful products and processes associated with it.

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However each of these techniques poses challenges of its own. (Rojas 2015) elucidates how

some of these approaches can be expensive and time consuming. In addition these analysis

techniques is hugely dependent on interpretation of data which often can often be confusing

especially while interpreting it with accounting data that leads to bad decision making. But

with the advancement in technologies such EDI, ERP and use of RFID, these analysis

techniques have become more elaborate and accurate. They use range forecasting, planning,

price optimization and POS (Point of Sales) driven replenishment which better tackle the

challenges faced by sudden changes in supply or demand (Genpact 2013). However there

still exists challenges with some of these contemporary technical & management frameworks

which are discussed next.

3.3 Technical & Management Frameworks - EDI, VMI, CPFR

3.3.1 Electronic Data Interchange (EDI) & their Challenges

There are various information sharing mechanism and the most common method used by

organizations is the EDI that uses computers to communicate electronically. It has different

facets. It could either enable the supplier (retailer or distributor) to receive information

regarding the inventory levels or sales data or by the customer, in communicating the

requirements to the supplier and place orders in a timely fashion (Homburg 2007).

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Figure5- How does EDI Work, Source - (Opentext 2015)

It helps in faster communication and avoids paper trail of purchase orders that can be

automatically saved. The responsibility of who does the replenishment depends on the buyer

supplier relationship. One of the main challenges for EDI is the level of trust and information

sharing between partners. In addition (Namagembe 2012) states that it is important for chain

partners to implement such systems which is not always the case. Lack of advanced tools and

technologies on the supplier end could lead to mismatches that effect the control mechanism.

Also many of these solutions are bought "off the shelf" and lack the proper customization

based on the requirements, at both the ends (supplier and the customer) which leads to

improper planning of inventory. There is also the need of constant up gradation of tool, and

the service provider should ensure that this happens seamlessly at both the sending and

receiving companies. In addition the lack of expertise of the workforce to manage inventory

though EDI does no good either. (SOB 2014) study indicates that inadequate training of the

non-IT staff, lack of top management support and general awareness among all stakeholders

are some of the main challenges in the effective implementation of EDI.

3.3.2 Vendor Managed Inventory (VMI) & their Challenges

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More recently what firms are turning to is VMI (Vendor Managed Inventory) also known as

CRP (Continuous replenishment planning) or supplier managed inventory (SMI). Here the

supplier is responsible for the control and management of the customer’s inventory. Wal-

Mart is one company that have benefited from this approach extensively (Çetinkaya 2000).

Here the supplier has the access to customers data (usually through EDI & web-based access)

and is responsible for generating purchase orders. It provides huge benefits if the vendor

manages inventory well. It helps in preventing lost sales due to stock outs, reduces lead time,

lesser burden for the customer it terms of managing many vendors within a product group,

lower risks and lower cost for the customer. However there are downsides and challenges

associated with it. Even here the problem is the kind of data that is shared, the relevance and

real-time nature of the information. Market strategies and sales data are sensitive information

and in a competitive environment any leakage of these firm specific strategies could

adversely impact business. (Piasecki 2012) highlights this fact along with some of the other

drawbacks of VMI, such as the lack of flexibility once it is implemented. As some amount of

control is given to the vendor who could be charging for inventory that is never received by

the customer. It's imperative for firms to give the right amount of control to the vendor while

entering into VMI arrangement, neither being too restrictive nor giving them complete

control. It addition clear expectations out of arrangement should be set and should be a

mutually beneficial relationship for both the supplier and the buyer.

3.3.3 Collaborative Planning, Forecasting and Replenishment (CPFR) & their

Challenges

The CPFR is a cross-industry initiative technique that combines the EDI and VMI (Prater

2013). Here the focus is wider and objective goes beyond the replenishment strategy as in the

case with VMI. Participants from the supplier to the final retailer are more involved in the

planning, forecasting as well as replenishment stages of the product life cycle. As the name

suggests there is an increased level of information sharing and collaboration between the

stakeholders with the ultimate goal of achieving customer satisfaction. Wal-Mart was the first

establish CPFR with Warner Lambert in one of their new products (Pecar 2004). Figure 6

illustrates the difference between CPFR and other inventory control mechanisms.

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Figure6 - Difference between CPFR and other Inventory control mechanisms, Source - (Singh 2011)

The effective implementation of CPFR is dependent on the alignment and collaboration of

trading partners and all the other players involved such as manufacturing, marketing, sales

and distribution teams which also happens to be the main challenge. (Singh 2011) in his study

finds out that lack of trust among the trading partners and lack of internal communication as

the two main barriers as shown in figure7.

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Figure7 - Barrier to CPFR implementation in India, Source - (Singh 2011)

The forecast mechanisms used in such an approach must have "data aggregation"

considering inputs from all stakeholders that must be aligned to achieve the same objective

which often is not the case. As pointed out by (Pecar 2004) it leads to the phenomenon

known as "tragedy of the commons" where each stakeholder is trying to maximize his gain.

He explains how CPFR an initiative adopted by firms in reducing the "bullwhip effect"

sometimes instead adds on to it as result of safety margins applied by all the participants.

Some of the other barriers of implementing CPFR pointed out by (Barratt 2001) is the lack of

shared targets, combustive nature of managing exceptions in sales and order forecast along

with the review process, lack of joined planning in the promotion and new product

development. Forecasting errors arise mainly due to lack of sharing information which may

be presumed to be sensitive or simply wrong data is circled around. (Saxena 2009) lists out

the main reasons for forecasting inaccuracy as inaccurate or shortage of data, more emphasis

on sales information rather than demand statistics, bias towards sales targets or the

overzealous marketing strategy and the poor assessment of supply capability. Improper

recording of products brought in or shipped are the main culprits of inaccurate data. Though

technologies like RFID and barcodes have made monitoring and tracking automated with

lesser errors, the lack of implementation across the chain causes this inaccuracy. Frequently it

so happens that when there is a physical audits that some of these mismatches are discovered.

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In addition (Chopra 2013) points out that there may be differences in forecasts or other

metrics used by two or more parties for reasons mentioned earlier. These gaps or exception

need to be resolved for the CPFR framework to be successful. Some of the procedures for

doing this can be found in (VICS CPFR Committee 2004).

The fragmented nature of information sharing standards, lack periodic reviews, lack of timely

communication and collaborating internally are some of the other issues identified by

(Fliedner 2003). When CPFR is implemented properly it can enable trading partners to add

economic value and build intellectual capital that wouldn't be possible with an individual

vertically integrated chain (O'Keeffe 2001).

4. Challenges of Inventory Control - A Broader Perspective

As seen in this study inventory is one of the most difficult asset to manage for an

organization in terms of the physical and financial sense. (CSCO Insights 2011) highlights

some of the main challenges faced by organizations in managing inventory in a broader

perspective. Firstly with globalization, managing the increasing global reach has put a lot of

pressure on organizations. Supply chain networks are constantly changing as result of

mergers and acquisitions which causes alteration in inventory control mechanisms. The

constantly shrinking product life cycles is another challenge as firms need to act quicker in

terms of response times to avoid loss of revenues. The paper also describes the loss of

visibility and control as a result of increased virtualization. Figure8 illustrates what the

respondents of the survey felt as barriers to implement a more effective cross network

inventory management. Main barriers include demand volatility, technological integration,

visibility and misaligned metrics. These challenges are vexing problem which affects the

entire supply chain, in terms of their operational efficiency, customer satisfaction and overall

revenue earned. One of the most cited reasons for business failure is to do with poor

inventory management and control.

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Figure8 - Barriers to Effective Cross Network Inventory Management, Source - (CSCO Insights 2011)

5. Conclusion

From the study we see that firms need to carefully plan their strategy and need to determine

“how much” and “how often” products need to be produced and distributed at a regular basis.

However as seen in this paper, this is easier said than done. It is a complicated task and

various factors need to be considered at various stages across the supply chain before arriving

at the optimal level of inventory. The most crucial aspect is the availability of reliable up to

date information. For inventory control mechanisms such as EDI, VMI and CPFR there needs

to be transparency and collaboration across the various stakeholders in the network. Increased

user involvement in the planning, design and implementation of such frameworks leads to

better inventory control. Having a well-managed and organized information system gives

better visibility across the chain, helps in better forecasting, improved inventory turns, lower

costs and eventually increased customer satisfaction.

6. References

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