The Effect of Inventory Management on Supply Chain

The issue of inventory management constantly summons practical interest from the second half of the 20 years of XX century. Prior to the development of professional logistics, inventory management techniques had been elaborated in this field. First of all, such developments were performed in accordance to mathematical perspective. Modern management contains described logic of the stock movements and the possibility of inventory modeling. Background and experience have shown undoubted urgency of studying the effect of reserves on the supply chain for modeling of inventory management that helps determine its reasonable volume.

Statement of the Problem

The purpose of the current study was to determine the effect of inventory on supply chain of business and to provide information regarding right management of this effect.

Significance of the Study

Three primary groups may benefit from the given study.

• The first group includes companies – participants of the modern market of logistics services, as well as enterprises – manufacturers possessing supply chain elements. Such companies will be able to use Wilson and other models to manage the optimal level of inventory.
• The second group that may gain from the study is the participants of supply chains, who offer their own logistics services. They will be able to manage inventory, and handle its impact on the supply chain.
• The third group of educators can include the study into their teaching plans.

Scope of the Study

The study is theoretic and it is not limited by a certain geographic area.

Review of Related Literature

Ricardo Charles, Pierre Dennery, Asresh Guttikonda and Katie O’Connor research Supply Chain Risk. They mention the risks derived from the supply chain of Toyota in 2011 due to the lack of inventory management (Charles, Dennery, Guttikonda & O’Connor, 2015). Chief Supply Chain Officer Insights progressed further in the study of stocks, pointing to possible strategies to improve its management, and as a consequence, the coordination of the supply chain (Chief Supply Chain Officer Insights, 2011). Constantino with his colleagues also confirmed the necessity to control inventory, limiting its impact on SC (Constantino, Di Gravio, Shabah & Tronci, 2015). Craig mentioned the inverse effect of reserves on demand, as well as sources of influence on demand (Craig, DeHoratius & Raman, 2016). Dittmann (2015) and Kot (2011) and the other researchers agreed with the necessity of modeling of inventory levels as a tool to monitor the impact of supply.

Methods of the Study

There are several methods used in the study. The method of a theoretic knowledge is used to reflect the events and ongoing internal communications, processes and laws. Formalization method is a reflection of the received thinking results in statements or exact terms regarding inventory. Its classification is the union of different elements and approaches used to divide the inventory elements into groups basing on common attributes. Analysis is performed in a form of decomposition of a unified system of SCM regarding inventory into its constituent parts and studying them separately. Modeling is the study of the inventory effect on supply chain through models with transfer the acquired knowledge to the original.

General Theory: The Importance of Inventory Management

Wholesale goods, organized by the distributor, must provide the rhythmic supply of consumer goods with appropriate range, quantity, and quality of demand (Kot, Grondys & Szopa, 2011). An important issue is the need value of stocks, which the company creates to secure own production from unforeseen disruptions of supply or possible seasonal surge in consumer demand. It is obvious that reserves worsen financial results of operations (due to freezing of funds in stocks), but provide stability and liquidity of the company. However, the need for inventory management relates to changes in demand for specific products. Deficiency causes production stoppages, the fall in sales volumes, and, in some cases, an urgent need to acquire the necessary raw materials at higher prices (Charles, Dennery, Guttikonda & O’Connor, 2015). The result is a shortfall of possible profit. Inventory is the liquid asset, and its decline worsens the current liquidity. Inventory surplus leads to increased costs for their storage, increased property tax, losing the possible income due to the freezing of financial resources in stocks, losses as a result of physical deterioration and obsolescence of reserves (Simchi-Levi, Wang & Wei, 2015).

Assessment Methods of Inventory Costs

With the continuous growth of prices, the real value of inventory may be considerably higher than cost of its purchase at the time of its production or consumption. Depending on the selected method of evaluating stocks, financial indicators of industrial activity can vary greatly (Meng, 2006). In the practice of accounting, a company has the right to evaluate stocks or to reflect the real value of the stocks issued for production in one of the following methods:

• The cost of each unit of inventory.
• Average inventory cost.
• The cost of the first stockpile acquisition time (FIFO – First In First Out).
• The cost of the last stockpile acquisition time (LIFO – Last In First Out).

The choice of method depends on several factors (Oballah, Waiganjo & Waiganjo, 2015). In certain situations (for example, in case of the state order), an enterprise is required to assess the stocks at the actual cost of each unit of inventory. LIFO method reduces the effect of inflation in the formation of the profit. Conditions of constant price increase make this method more objective. At the same time, FIFO method helps improve financial indicators (liquidity), increase the cost of residues, reduce costs, and increase the profit.

Approaches to Management of Inventory Formation

Theory of financial management considers three main approaches to the formation of inventory in a company from the perspective of a reasonable ratio between the level of profitability and risk of financing activities (Charles, Dennery, Guttikonda & O’Connor, 2015). A conservative approach involves not only the full satisfaction of the current needs of all types of inventory, but also the creation of large size of its reserves in case of raw materials supply disruptions, deterioration of the conditions of production, delays in collection of receivables, intensification of customer demand etc. This approach has a negative impact on the level of profitability and turnover (Dittmann, 2015). In this case, margins are minimal, as well as the potential risk.

Moderate approach aims at creating reserves in case of the most common failures in the operating activities of the enterprise. The calculation of the required quantities of insurance reserves should be performed on the basis of data for a number of previous years, allowing to identify the types of stocks in which the additional needs existed. In this case, the company has average profitability and average risks may arise (Dittmann, 2015).
Aggressive approach tends to minimize all forms of inventory until its complete absence. If the operating process does not have any failures, the company can achieve the highest rate of production efficiency. However, any failure in the implementation of the normal course of operations entails significant financial losses due to the fall in output and sales. In this case, the risk is the greatest.

Factors of Influence on Volume of Inventory in the Supply Chain

For the enterprise, inventory shortage and its surplus influence its operation in the negative way. The most significant factors, which have an impact on the volume of stocks of the company, are the following (Dittmann, 2015):

• Stock purchase conditions (volumes of schedule lines, the frequency of orders, possible discounts and benefits);
• The conditions of finished products sales (change in sales volumes, price discounts, and a state of demand, sophistication and reliability of the dealer network);
• The conditions of the production process (duration of preparatory and primary process, especially technology);
• The cost of inventory storage (stock costs, possible damage, the freezing of funds etc). Thus, a certain algorithm should be developed to design optimal stock handling and positive impact on a supply chain.

Algorithm of Optimal Strategies Design of Inventory Impact Managing

• At the first stage, the formation of a database with information that may be useful for management reserves has to be done (Chief Supply Chain Officer Insights, 2011). Typically, such data describe processes of products consumption, as well as provide notion on the key features of the supply chain, which may influence the choice of inventory management strategy (Meng, 2006).
• At the second stage, the statistical processing and analysis of data regarding expenditures and reserves reductions are performed (Constantino, Di Gravio, Shabah & Tronci, 2015). Data analysis includes the calculation of average consumption values, order fulfillment time, an assessment of including the extreme (maximum, minimum) values into the total sample, variance series analysis, and correlation analysis.
• The third step includes the division of the whole range of material assets or the stocks into groups: ABC, XYZ, αβγδ (Craig, DeHoratius & Raman, 2016). ABC analysis allows identification of the nomenclature group positions representing the largest economic interest for inventory management. XYZ analysis allows assessing the degree of stochasticity and the accuracy of forecasting of the individual commodity item costs. αβγδ analysis allows identification of the cost process nature (a rare demand, seasonality, extreme demand) (Lwiki, Ojera, Mugenda & Wachira, 2013).
• At the fourth stage, the expert assessment of the causes leading to the emergence of deficits, excessive stocks and other negative manifestations of the inventory levels dynamics in warehouses of a company should be performed.
• The fifth stage includes the selection procedure, as well as the adjustment of inventory control strategy in accordance with the characteristics of a demand for material resources and key characteristics of supply chain.
• At the sixth stage, the calculation of the basic parameters of inventory control strategies is performed, such as the amount and periodicity of orders for inventory replenishment, the amount of safety stock, normative (desirable) level of the current stock.
• The seventh step includes the implementation of the strategy in the process of products supply. At the last eighth stage, the monitoring of the status of inventory management system and updating inventory management strategies on the basis of changes is performed, basing on the changes of demand and supply chains parameters. Thus, models, described above should be investigated.

Management Models

To optimize the size of the current inventory, a number of models are used, including a model of an economically feasible size of order by Wilson (economic ordering quantity model – EOQ), which becomes the most widespread model nowadays. EOQ model can be used to optimize the size of both the inventories and stocks of finished products, giving the answer to the question, how much of the stock of such type enterprise should acquire at the same time (Lwiki, Ojera, Mugenda & Wachira, 2013). The optimum size of the order refers to the volume of a regular supply, which provides the necessary number of company stocks and minimizes the total cost of purchase and storage of inventory in stock.

The calculation is based on the division of costs associated with inventory (excluding the cost of its acquisition, the total amount of which is unchanged, considering the fact that it depends only on the size of the annual consumption of this type of stock) into two groups, depending on changes in total costs with changing the volume of the order (Lwiki, Ojera, Mugenda & Wachira, 2013):

• 1) The costs that are associated with the purchase of another batch of stocks (including the cost of transportation and acceptance of goods) and do not depend on the size of the party.
• 2) Inventory costs of the goods spent for warehousing for a certain time, which depend on the volume of stocks. It is obvious that from the standpoint of minimizing the cost of the first group, it is profitable for an enterprise to import raw materials or goods for resale. The larger the size of each schedule line, the smaller the number of orders in the period under review. Consequently, the aggregate amount of the operating costs of order, the delivery of the ordered goods to the warehouse, and their acceptance will also be low.

From the standpoint of reducing the cost of the second group, it is advantageous to minimize the amount of inventory in any given stock, in some cases to the minimum standard level, because the large size of reserves entail high transaction costs for their storage. Thus, with an increase in the order lot size, operating costs regarding ordering are reduced and operating costs regarding the storage of inventory in the warehouse organization (cost of the second group) are increased, and vice versa. EOQ model optimizes batch size of the order in a way that the total amount of cost can be minimal.

Total annual costs of inventory storage TCC (Total Carrying Cost), are calculated as follows (Lwiki, Ojera, Mugenda & Wachira, 2013).:
TCC = C Q / 2.
Annual costs associated with the acquisition of TOC Order Batch of goods (Total Ordering Cost):
TOC = F N = F S / Q.
The total annual costs associated with the acquisition and storage of stocks of TIC (Total Inventory Cost):
TIC = TCC + TOC = C Q / 2 + F S / Q.

Using this model involves a number of assumptions, which are, nevertheless, not limit to the possibilities of their practical application. The model is applied to one particular type of product, the amount of which is continuously measured. At the same time, the level of demand for the product is known, and is constant and independent over time. Moreover, the delivery time and order costs are constant, while inventory flow is continuous. It does not consider the case of additional deliveries of goods, discounts for high volume delivery, the cost of storing inventory units per year. In its turn, such units may include renting of additional storage space, fee for special storage conditions, product damage or obsolescence, alternative income, the volume of orders in the production units, the annual requirement of the enterprise in this product (in the same units), the number of orders in the year ( N = S / Q), and the cost of orders.

The resulting expression can be considered as the functional dependence of the magnitude from the volume of the order. An analytic formula for calculating the optimal batch size of the order, known as EOQ (Economic ordering quantity), is the following: EOQ = √ (2 F S / C). This formula is also called Wilson’s equation.

Analyzing this formula, every firm can draw conclusions that are useful in the practice of the enterprise. The conclusion is that the total cost for this order is the smallest when ordering costs are equal to the costs for maintenance of the respective inventory. Within certain limits (near the minimum point), the total cost of the orders of different volume changes is very little. However, the costs are changing or falling outside such limits. In most cases, a company would incur more costs ordering too little goods for order. Changes in the costs of inventory storage have a greater impact on the optimal order quantity, compared to the changes in the costs for registration of the batch of goods. The resume point of order, known as RP (Reorder Point), is called the amount of stock in the warehouse, where the next order of stock should be done.

It is important to determine a moment, when an enterprise should order a new batch of goods. The amount depends on the intensity of consumption of this type of inventory, the time required for the manufacture and delivery of the batch of goods, and the value of the insurance reserve, defined by the company for this type of product (Craig, DeHoratius & Raman, 2016):

RP = RQ + DQ · T,
DQ – daily consumption of stocks;
T – the time of manufacture and delivery of the batch of goods (in days).

To build effective systems of control over the movement of inventory at the enterprises, the ABC system is often used. The ABC control over inventory is a system of volume – value analysis, which allows sharing all kinds of inventory in the group in accordance with the volume of sales and the size of profits (Lwiki, Ojera, Mugenda & Wachira, 2013).

In most cases, it appears that the bulk of sales (70-80%) is provided by very few nomenclature positions (10-20%). It is the so-called Pareto principle. Focusing on the most important products for the company allows managing them more efficiently without spending extra time and money on less important positions (Craig, DeHoratius & Raman, 2016).

The essence of this system is to divide the totality of reserves inventory items into three categories based on their value, volume, and consumption frequency, the negative consequences of their lack of operations progress, and financial results etc.

The category A includes the most expensive kinds of stocks with a long cycle of performance of the order, which require constant monitoring due to the serious financial consequences caused by fault. The frequency of such category of inventory delivery is determined, as a rule, by the EOQ model (Craig, DeHoratius & Raman, 2016). The number of specific inventory items included in category A is usually limited and requires weekly monitoring within SC.

The category B includes material assets with less importance in ensuring the smooth operational process and the formation of the final financial results. The reserves of this group are controlled usually once a month within SC movement. The category C includes all other goods and materials with low cost, which do not play a significant role in shaping the final financial results. The volume of purchases of such values can be large, so the control of their movement within SC is performed not more than once per quarter. Thus, each inventory category can be handled to achieve good results.

Conclusion

As a result, the need for inventory management relates to changes in demand for specific products. At the same time, the deficit or the surplus of inventory directly affect the supply chain, creating a need to acquire urgently the necessary raw materials at inflated prices or create an increase in their storage costs. Therefore, inventory must constantly be managed, using different models (ABC Inventory system management, Wilson’s equation) to define its correct volume and to direct its impacts correctly. The necessity of inventory levels modeling as a tool to monitor the impact on supply chain is obvious. Thus, it shows the achievement of the purpose of the given study as the effect of inventory on supply chain was investigated.