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Financial impact of inventory management
Managing inventory is essential, because inventory represents a huge investment of money that are not returned until goods are sold.
According to Chapman et al. in an introduction to materials management 8th edition, inventory represents between 20 and 60 percent of all assets in the organization’s books. In addition to being money tied up until items are sold, inventory has a carrying cost, or a cost of the warehouse and staff and other expenses. It also may spoil or become obsolete. Therefore an organization wants to sell inventory as quickly as possible.Financial impact of inventory management
Below exhibit shows what happens to inventory over time:
Inventory can move from being required to excess inventory or no longer desired, it even moves quicker to being inactive, liable to shrinkage or, obsolete and then to be scrapped.
That is why it is very important to manage inventory effectively.
Good inventory management represents careful balance between risk and opportunity, it is important to:
- Maximize operational efficiencies
- Minimize financial investment
- Optimizing customer service rate
Aggregate inventory management concerned with controlling the overall levels of inventory and establishing metrics for assessing inventory management performance, these metrics include inventory turnover rate and average age of inventory:
Note that the turnover rate should be considered with the industry, turnover will vary based on industry type` for example fashion manufacturer will have high turnover rate while device producer might own lower turns.
Turnover rate= Annual COGS/Avg. inventory in dollars
Meanwhile the average age of inventory is established to track inventory obsolescence.
Average age of inventory= 365/inventory turnover rate
Other considerations in planning aggregate inventory levels:
- And the goal of course is to achieve balance between marketing, operations, and finance.
While itemized inventory management supporting purchasing decisions, especially how much to order, when to order, and how much safety stock to carry.
Carrying or holding cost are all the costs that are related to volume of inventory such as capital cost which can vary depending up on industry, storage costs include things like warehousing and equipment, risk costs incurred when inventory value is reduced either by reduction of quantity or through scrap after damage. Together these costs are calculated as percentage of inventory and summed to be carrying cost ratio. For example if we have 5% capital cost, 13% storage cost, and 2% risk cost, the carrying cost will be 5+13+2= 20%
One of the factors that drives the need for safety stocks is the uncertainty in demand and also the uncertainty in supply. Manufacturing planning and control for supply chain management notes that most effective way to buffer against uncertainty is the safety stock, rather than increasing the order quantities.
Safety stock can be determined in in three methods:
- Time period
- And, fixed
Statistical method will rely heavily on demand forecast and standard deviation, time period will focus on the lead time, while fixed will be used in products with no historical data. All three methods are liable to risk.
When deciding how much to order Inventory managers and planners must consider inventory storage, flow, and handling. The major challenge with storage are storage capacity utilization, protecting stocks from damage and theft, and balancing accessibility with control.
Capacity utilization of storage space is measured by determining how much of the available cubic space is being used for storage. The goal is increase the cube utilization, which can be through the use of different layouts and storage designs.
Protecting inventory may require special detection equipment and risk management system for stocks.
The issue of balancing accessibility and control influences the decision on where to store inventory.
The plans include:
- Fixed location or (assigned locations)
- Random locations (location is the nearest spot)
- Zone storage (combine aspects of fixed and random locations) provides high cube utilization.
Each option has its advantages and disadvantages and must be considered when making a decision about the best layout and/or storing plan to house those valuable inventories.
One other important aspect when designing inventory management is tracking inventories. Supply chain managers will devise a way of tracking inventory, these options may include:
- Bar codes,
- Radio frequency identification (RFID)
Tracking and tracing products such as foods and drugs has been an issue for many years and prominently associated with recalls of contaminated products. Traceability concerns about adulterated and counterfeit drugs. This includes additional labeling and packaging requirements that enable manufacturers and regulators to demonstrate tracking for SKUs in terms of shipping, tracking, ownership, and storage conditions.
In this way, we can manage inventory to achieve balance and have good inventory management.
ancial impact of inventory management