IntroductionInventory plays a major role in a supply chain's ability to support a company's strategy. If the strategy calls for responsiveness (fulfilling orders quickly and keeping products available), the company can carry more inventory. If it calls for efficiency (lower costs), the company can reduce inventory and the costs that come with it. The fundamental trade-off, then, is between responsiveness with more inventory and efficiency with less. [1]Within a company, that trade-off creates competing priorities:DepartmentWhat it wants from inventoryWhySalesHigh finished-goods inventoryTo avoid lost sales and deliver immediatelyProductionHigh raw-material inventory and large production batchesTo keep the line running and spread machine setup costs over more unitsPurchasingBulk purchasesTo secure discounts and lower shipping costsFinanceLow inventoryTo tie up less capital and improve cash flowBecause each department pulls in a different direction, management must set an inventory policy for the whole organization to follow. Without one, departments make their own decisions, producing the result we saw in lesson 1: each optimizes its own part while the overall operation suffers.Inventory policyAn inventory policy should be set by the company's senior management, which gives the inventory control team its targets and objectives. The policy establishes standards for those who plan and control inventory, as well as criteria for measuring inventory management performance.In short, it is a plan: developing an inventory policy means that production, sales and finance agree on how inventory will be controlled, coordinated and organized. A policy typically sets out, among other things:service level targets (for example, 98% for critical items and 90% for the rest);the maximum investment in inventory, or the minimum expected turnover;which items must be kept in stock and which will be purchased only when an order is placed;criteria for setting safety stock, reorder points and purchase quantities;how often physical inventory counts are conducted.For the policy to work, the company needs to monitor:stocked items, assessing their profitability and the company's position in the market;the receipt and proper storage of goods;periodic physical counts to assess the quantity and condition of stock;the replenishment lead time for each product;the best product mix;the ideal turnover for key products.To identify which stock items matter and how to plan for each one, ask the following questions: [2]How many items are strategically important to operations, and which are they?How does demand for the item relate to inventory, production and sales?How much is needed, and how long does replenishment take?Who are the suppliers, and what alternatives are available?Most common challengesSupply problems with vendors: long or uncertain replenishment lead times, inconsistent material quality, an inefficient purchasing process or weak supplier relationships.Supply problems in internal production.Errors in forecasting demand for an item.Serious losses when an item runs out.Errors in product records and identification (product code, label, barcode or QR code).The policy says where the company wants to go. To see whether it is getting there, the company needs performance measures. The four most widely used are service level, inventory accuracy, turnover and days of supply.Service levelService level measures how effectively inventory meets requests from users or customers. The most common measure is the proportion of requisitions (or orders) filled: [2]Service level = requisitions filled ÷ total requisitions receivedWhat counts as "filled" depends on what matters most to the business, so the measure has several variations:requisitions filled in full ÷ total requisitions: counts only requisitions delivered in full, to the requested specifications and quantities;requisitions filled on time ÷ total requisitions: counts only requisitions delivered by the deadline;units delivered ÷ units requested: measures the quantity supplied rather than the number of orders;1 − stockout rate: if materials were unavailable for 13% of requisitions, the service level is 87%.Watch the denominator: it is the total number of requisitions received, not just those filled. Dividing by the number filled would hide the very requests the company failed to meet.According to Iarozinski (2004), the most important aspects of customer service, in order, are product availability; delivery time (lead time); meeting delivery deadlines; delivery frequency; systems for correcting failures; flexibility; support with physical delivery; information systems; and post-delivery support. [3]Is a 90% service level good? The honest answer is: it depends. It might be fine for an inexpensive item with an available substitute, but not for a part whose absence would shut down a production line. Different customers require different service levels, and companies often set a target (93%, 95%, 98%…) for each group of items. Falling below that target signals a problem to investigate. In the lesson on safety stock, we will see that each additional point of service level requires progressively more inventory.In one month, the storeroom received 400 requisitions. Of those, 30 could not be filled because materials were unavailable, and 20 were filled only in part. What was the service level measured by requisitions filled in full?Answer: 87.5% — requisitions filled in full = 400 − 30 − 20 = 350, and 350 ÷ 400 = 0.875. The 92.5% answer overlooks the 20 partially filled requisitions and counts only the 30 that were not filled.Inventory accuracyInventory accuracy measures whether the stock shown in the system is actually on the shelf. It compares records (in the system or on stock cards) with the physical count taken during an inventory check. Data-entry errors, incorrect records, identification mistakes, losses and theft all reduce accuracy.Inventory accuracy = items without discrepancies ÷ total items countedIt can also be calculated by value (R$ value of items with correct records ÷ R$ total value counted). Low accuracy undermines every other measure: if the record is wrong, the system orders replenishment at the wrong time, and the service level falls even when the records show stock "to spare."Inventory turnover and days of supplyTurnoverTurnover measures how many times inventory is replenished over a period. It is usually calculated annually. [2]Turnover for the period = demand (total stock issued) during the period ÷ average inventory during the periodIt can be calculated in units for an individual item or for the entire inventory. Because total inventory contains different materials, the overall calculation uses value: the cost of goods sold (or consumed) divided by the value of average inventory. Use the same basis on both sides of the calculation: comparing sales at selling prices with inventory at cost overstates turnover because the profit margin appears only in the numerator.A month's average inventory can be approximated as (opening inventory + closing inventory) ÷ 2. For several months, use the average of the monthly averages.Days of supplyDays of supply measures how long inventory can meet demand without replenishment. It is the inverse of turnover, expressed as a length of time:Days of supply = average inventory ÷ average demand per period (in months if demand is monthly; in days if it is daily)Equivalently, days of supply = number of days (or months) in the period ÷ turnover for the period.To find out how long the stock on hand today will last, use current inventory instead of average inventory. This measure helps with planning and reduces the risk of a stockout: an item with 3 days of supply and a replenishment lead time of 10 days will run out.Worked exampleA company introduced a computerized inventory control system. Opening inventory in month 1 was R$ 160,000. The receipts and stock issued over the following six months are shown below. What were inventory turnover and days of supply for the six-month period?The calculation is: closing inventory = opening inventory + receipts − stock issued; one month's closing inventory becomes the next month's opening inventory; monthly average inventory = (opening + closing) ÷ 2.MonthOpening inventoryReceiptsStock issuedClosing inventoryAverage inventory1160,000130,000115,000175,000167,5002175,000098,00077,000126,000377,000235,00090,000222,000149,5004222,000190,000105,000307,000264,5005307,000080,000227,000267,0006227,000110,000120,000217,000222,000Total / average608,000199,417Turnover for the six-month period = 608,000 ÷ 199,417 ≈ 3.05 times.Days of supply = 6 months ÷ 3.05 ≈ 1.97 months ≈ 59 days (assuming 30-day months). The other formula gives the same result: 199,417 ÷ (608,000 ÷ 6) = 1.97 months.Opening, closing and average inventory for each month in the example: the six-month average inventory is used to calculate turnoverOver a year, turnover of 3.05 times per six months would amount to about 6 turns, meaning inventory is replenished roughly every two months.A store has an annual cost of goods sold of R$ 480,000 and average inventory of R$ 60,000. If it increases turnover to 12 times a year without changing sales, and its annual inventory carrying cost is 20% of average inventory, how much will it save each year?Answer: R$ 4,000 — current turnover is 480,000 ÷ 60,000 = 8. At 12 turns, average inventory falls to 480,000 ÷ 12 = 40,000, a reduction of R$ 20,000; 20% of 20,000 = R$ 4,000 a year. R$ 20,000 is the reduction in inventory, not the annual savings.An item has 300 units in stock, average consumption of 25 units a day and a replenishment lead time of 15 days. What does its days of supply tell us?Answer: There are 12 days of supply, less than the replenishment lead time: if an order is not placed now, stock will run out — 300 ÷ 25 = 12 days. An order placed today will not arrive for 15 days, leaving a shortfall of about 3 days of consumption (75 units). 7,500 comes from multiplying 300 × 25 instead of dividing.Return on capital invested in inventoryReturn on Capital (RC) measures the return on money invested in inventory: annual profit from sales divided by the capital invested in inventory.RC = annual profit from sales ÷ capital invested in inventoryThe higher, the better. To assess the figure, compare it with the company's cost of capital (what it would pay to borrow the money or earn by investing the same amount elsewhere). An RC below that cost suggests that too much capital is tied up in inventory for the profit it generates. Inventory carrying costs are covered in the lesson on inventory costs.References[1] COSTA, Taise Dalla; BORGES, Igor Roberto; KAERCHER, Adi Regina; FONSECA, Gabriela de Bem. Políticas para o gerenciamento de estoques: um estudo de caso em uma empresa do ramo metalmecânico de médio porte. XXXII ENEGEP, Bento Gonçalves, 2012.[2] RAZZOLINI FILHO, Edelvino. Administração de material e patrimônio. Curitiba: IESDE Brasil, 2012.[3] IAROZINSKI (2004), list of customer service items, as cited in the article Indicador de nível de serviço, Administração Plena blog, 2013.ExercisesTry solving these before checking the answer key at the end of the lesson.Easy1) (Logistics exam, CEFET/RJ, 2018) Calculate inventory accuracy, given that, out of 16,915 items counted (4,910 class A, 9,125 class B and 2,880 class C), discrepancies were found in 268 class A items, 438 class B items and 55 class C items.2) (Logistics exam, CEFET/RJ, 2018) ZW, a building materials company, had sales of R$ 26,000 last year, with average inventory of R$ 2,470. Calculate turnover and days of supply, using a 365-day year.3) Over 6 months, Indústria LAMA's central storeroom received 560 materials requisitions, averaging 6 units per requisition. It delivered 2,800 units. What was its service level?4) Over 6 months, the Verde-Amarelo storeroom had a service level of 90%. It received 390 requisitions averaging 3 items each. How many items were supplied?5) A company has annual sales of R$ 1,200,000, annual profit of R$ 65,000 and R$ 240,000 invested in inventory (raw materials, ancillary and maintenance supplies, work in progress and finished goods). What is its return on capital invested in inventory?Hard6) Company MX holds about 10,000 different items in stock, with an average of 20 units of each item. Each person can count an average of 100 units per minute. How many people are needed to count the entire inventory in 2 days, working 8 hours a day?7) Three months after the count in exercise 1, the same company again compared its records with a physical count and found these discrepancy rates: class A, 2.5%; class B, 6.8%; class C, 8.5%. What is inventory accuracy now?8) What is inventory turnover if annual cost of goods sold is R$ 36,000 and average inventory is R$ 6,000? How much would inventory fall if turnover rose to 12 times a year? If the holding cost is 25% of average inventory per year, how much would the company save?9) A manufacturer introduced a computerized inventory control system. Opening inventory in month 1 was R$ 135,000. Over the following four months, receipts were R$ 115,000, R$ 0, R$ 235,000 and R$ 186,000, and stock issued was R$ 112,700, R$ 95,500, R$ 98,000 and R$ 106,000. Build the inventory table, calculate days of supply for the period and explain what it means.10) A company gathered the following annual data: value of materials consumed during the year, R$ 5,345,287.35; value of average inventory, R$ 386,435.00; average stockout rate, 13%. Determine the service level, turnover and days of supply (365-day year).Answer key1) About 95.5%. Discrepancies: 268 + 438 + 55 = 761 items. Items without discrepancies: 16,915 − 761 = 16,154. Accuracy = 16,154 ÷ 16,915 ≈ 0.955.2) Turnover = 26,000 ÷ 2,470 ≈ 10.5 times a year (10.53). Days of supply = 365 ÷ 10.53 ≈ 34.7 days. If sales are at selling prices and inventory at cost, the real turnover is lower than this; ideally, you would use the cost of goods sold.3) About 83.3%. Units requested: 560 × 6 = 3,360. Service level in units = 2,800 ÷ 3,360 ≈ 0.833.4) 1,053 items. Requested: 390 × 3 = 1,170; supplied: 90% × 1,170 = 1,053.5) RC = 65,000 ÷ 240,000 ≈ 0.27, or 27% a year. Each real tied up in inventory is associated with 27 centavos of profit a year. To judge whether that is good, compare it with the company's cost of capital. (Sales of R$ 1,200,000 do not enter the calculation: they are extra data, so that you pick the right figure.)6) 3 people.Units: 10,000 × 20 = 200,000.Counting time: 200,000 ÷ 100 = 2,000 minutes; 2,000 ÷ 60 ≈ 33.3 hours.Hours per person over the two days: 2 × 8 = 16 hours.People: 33.3 ÷ 16 ≈ 2.08. Since there is no such thing as a fraction of a person, round up: 3. With 2 people, the count would not finish on time.7) About 94.2%.Items with discrepancies: class A, 4,910 × 2.5% = 122.75; class B, 9,125 × 6.8% = 620.5; class C, 2,880 × 8.5% = 244.8. Total ≈ 988.Accuracy = 1 − 988 ÷ 16,915 ≈ 0.942.A simple average of the three percentages will not do, because the classes contain different numbers of items.8) Turnover = 36,000 ÷ 6,000 = 6 times a year.At a turnover of 12, average inventory becomes 36,000 ÷ 12 = R$ 3,000: a reduction of 6,000 − 3,000 = R$ 3,000.Savings: 25% × 3,000 = R$ 750 a year.9) Days of supply ≈ 1.35 months (about 40 days).Closing inventory = opening + receipts − issues; one month's closing inventory is the next month's opening inventory; average = (opening + closing) ÷ 2.MonthOpeningReceiptsIssuesClosingAverage1135,000115,000112,700137,300136,1502137,300095,50041,80089,550341,800235,00098,000178,800110,3004178,800186,000106,000258,800218,800Total / average412,200138,700Average monthly issues: 412,200 ÷ 4 = 103,050.Days of supply = 138,700 ÷ 103,050 ≈ 1.35 months; turnover = 412,200 ÷ 138,700 ≈ 2.97 over the four months (and 4 months ÷ 2.97 ≈ 1.35 months, the same result).This means that, on average, the inventory held during the period could cover about 1.35 months of issues without replenishment. Note that the closing inventory of 258,800 already covers 258,800 ÷ 103,050 ≈ 2.5 months: inventory is growing.10) Service level = 1 − 0.13 = 87%.Turnover = 5,345,287.35 ÷ 386,435.00 ≈ 13.8 times a year (13.83).Days of supply = 365 ÷ 13.83 ≈ 26.4 days.
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