Organizations and Inventory

1. Why do organizations hold inventory?

The primary objective of an organization to hold inventories is to balance the
mismatch between supply and demand. Mismatch between supply and demand
happens due to the fact that
-

Demand is highly variable and cannot be estimated accurately

Supply cannot be planned exactly as per the demand due to other
considerations such as economies of scale in production as well as economies
of purchasing in larger lots.

Hence companies maintain inventory to hedge against reducing service levels as

well as achieving scale economies.
2. Supply Chain Strategy and Impact on Inventory
Inventory is maintained in the supply chain to service the demand to the maximum
extent at the minimum possible inventory (and cost). Depending on the industry
that organizations operate in, they adopt a supply chain structure based on its
competitive strategy. It is to be noted that an increase in inventory would also mean
higher transportation and associated logistics costs, including storage and facility
costs. The supply chain strategy details the level of inventory that an organization
maintains in its system. This can be explained through the Supply Chain
Responsiveness Efficiency spectrum. If an organizations strategy is to remain
efficient, it can choose to deploy lesser inventory at centralized locations, offsetting
the service level of the supply chain. For e.g. in the case of large steel producers
such as TATA and Nippon Steel, it is imperative to remain cost-efficient with rising
input costs and increasing competition. Hence, these companies adopt a strategy of
minimal inventory to remain efficient. Alternately, a company with a strategy to
maintain higher responsiveness would deploy higher levels of inventory closer to
the customer (at distributed locations), increasing the overall inventory cost. For
e.g. retailers such as seven-eleven maintain high levels of inventory to ensure that
most of the customer demand is met.

Responsiveness Efficiency Frontier

Effi
cien
t
Sup
ply
Cha
in

Inv
ent
ory
Cos
Lev
t
el

Res
pon
sive
Sup
ply
Cha
in

With evolving supply chain practices globally, organizations have evolved to adopt
hybrids of supply chain strategy exploiting Push-Pull boundary efficiencies to decide
on the levels of inventory at various stages in their supply chain. For example, Dell
has adopted a strategy of higher inventory of spares while maintaining a lower
inventory of assembled final products. This strategy has enabled Dell to remain cost
efficient by minimizing the holding cost of final product while remaining responsive
to market demand by providing for availability of spares to assemble the final
product.
3. Types of Inventory and Drivers of Inventory
Organizations plan for the required inventory based on a variety of factors internal
and external to the organization. External factors include demand related while
internal factors include supply related and supply also dependent on the supply
chain structure. The main types of inventory and the key drivers of inventory in an
organization are the following:
a. Cycle Inventory
Deterministic demand is the portion of the predicted demand that is
considered as the steady demand for any period of time. Companies
address the deterministic demand through Cycle Inventory defined as
the average amount of inventory necessary to meet the deterministic
demand between two replenishment cycles. The Cycle Inventory in a
supply chain system is a function of various factors including the
Deterministic (Mean) Demand, Replenishment Frequency (Lead Time) and
Economies of Scale.

b. Safety Inventory
Unpredictable demand or Uncertain Demand is the portion of the demand
that is considered the unpredictable variability in demand (and this is more
or less equal to the error in the forecast). Hence to address variable
demand, companies deploy Safety Inventory. The Safety Inventory in a
supply chain is a function of various factors including Variability in Demand
(or the Forecast Error), Lead Time, Lead Time Variability and the Service
Levels (Cycle Service Level / Fill Rates).
c. Seasonal Inventory
Seasonal Demand is the portion of the demand that is considered a
predictable variation in demand, especially in the case of seasonal
products and where production capacity is not flexible (i.e. production
cannot be ramped up immediately to meet spike in demand during a
particular season). Companies thus deploy or build Seasonal Inventory to
address predictable seasonal demand variations. This phenomenon can be
widely seen in aerated beverages manufacturers such as Pepsi and Coca
Cola, where summer season witnesses a high seasonal demand. Seasonal
Inventory is predominantly affected by the seasonality in demand
(measured by a seasonality index) and the mismatch between available
capacity and expected capacity.
Thus,

Total Inventory=Cycle Inventory + Safety Inventory + Seasonal Inventory

Organizations decide on the volume of inventory based on a holistic

understanding of all the above mentioned factors. From the various types
of inventory and the discussion of the various drivers of inventory, the
impact on total inventory can be summarized below:
Increase in Factor
Mean Demand
Replenishment Lead Time
Inventory Holding Cost
Demand
Variability
(Unpredictable / Seasonal)
Lead Time Variability
Required Service Level
Demand Seasonality
Production Flexibility

Impact on Inventory
Cycle
Safety
Seasonal
Inventory
Inventory
Inventory
Increase
No Impact
No Impact
Increase
Increase
Increase
Decrease
No Impact
No Impact
No Impact
Increase
Increase
No
No
No
No

Impact
Impact
Impact
Impact

4. Inventory and impact on working capital

Increase
Increase
No Impact
No Impact

Increase
Increase
Increase
Increase

Working Capital measures the short-term liquidity of an organization, and is

defined as Current Assets and Current Liabilities. A company with negative
working capital would mean that a company cannot repay its short-term
liabilities through its liquid assets. Cash, Inventory and Receivables are two main
current asset accounts while Payables constitute the majority of the current
liabilities.
Thus,

WorkingCapital=Cash+ Inventory+ ReceivablesPayables

To maintain solvency, a company would strive to maintain a positive working

capital, while also reducing. The amount of inventory in a supply chain
influences the level of other working capital accounts namely cash and
receivables. Inventory decisions can influence companies based on the nature of
the industry they operate in. In the case of retailers such as WalMart, who
operate with minimal credit sales, an increase in inventory is offset by minimal
receivables generating quicker cash. However, in industries with higher quantum
of credit sales such as HP and Dell (typical B2B environment), an increase in
inventory could result in cash crunch, impacting solvency. This can be
understood from the business cycle below.
Cash Inventory Receivables Cash
Cash is expended into buying inventories. Inventory is sold to consumers and
generates receivables ultimately realizing cash through the collection of the
receivables. If a companys strategy is to maintain a high inventory, Cash would
be expended to buy or manufacture inventory and is locked up as capital in the
companys balance sheet. Thus, a higher inventory would lead to cash deficit.
And similarly, a cash deficit would lead to delayed payments to suppliers and
external borrowings, increasing the payables. Thus, an increase in the inventory
would lead to a cascading effect of a simultaneous deficit in cash and an
accompanied reduction in working capital.

Bibliography
Blanchard, D. (2010). Supply Chain Management Best Practices. John Wiley & Sonc.
Chopra, P. M. (2006). Supply Chain Management. Pearson.
Gupta, H. (2008). Network Design and Safety Stock Placement For a Multi-Echelon
Supply Chain. MIT .
Hugos, M. (2003). Essentials of Supply Chain Management. John Wiley & Sons.
Iocco, J. D. (2009). Multi-Echelon Multi-Product Inventory Strategy in a Steel
Company. MIT PhD Thesis.