4th Quarter 2005 • 20(4) A publication of the CHOICES American Agricultural The magazine of food, farm, and resource issues Economics Association , Inventory Control, and Supply Chain by Frank Dooley

Many argue that the focus point (and perhaps the linch- Many agribusiness firms do not actively manage inven- pin) of successful is inventories tory. This does not mean that they ignore inventory. and inventory control. So how do food and agribusiness Rather, they hold large inventories because any potential companies manage their inventories? What factors drive savings from inventory reductions are far outweighed by inventory costs? When might it make sense to keep larger the inventory-induced reductions in production, procure- inventories? Why were food companies quicker to pursue ment, or transportation costs. Often economies of size inventory reduction strategies than agribusiness firms? cause long productions runs which lead to inventory accu- In 1992, some food manufacturers and grocers formed mulation. Simultaneously, seasonality leads to inventory Efficient Consumer Response to shift their focus from buildups of key inputs like seed as well as outputs like controlling logistical costs to examining supply chains corn. Economies in procurement such as forward buying (King & Phumpiu, 1996). Customer service also became a in the food industry and quantity discounts increase key competitive differentiation point for companies inventories. Similarly, unit trains and other forms of bulk focused on value creation for end consumers. In such an shipping discounts contribute to inventory buildups. environment, firms hold inventory for two main reasons, Yet, such firms must be alert to changing conditions to reduce costs and to improve customer service. The that may require more exact inventory management. One motivation for each differs as firms balance the problem of example would be if crops are marketed as small lots of having too much inventory (which can lead to high costs) value-added grain instead of commodities. Production versus having too little inventory (which can lead to lost proliferation in the seed industry may be another instance. ). Finally, whether due to food safety concerns, GMOs, food A common perception and experience is that supply labeling, or the growth of organic food markets, identity chain management leads to cost savings, largely through preservation requires more precise inventory control. reductions in inventory. Inventory costs have fallen by about 60% since 1982, while transportation costs have The Importance of Demand fallen by 20% (Wilson, 2004). Such cost savings have led Inventory management is influenced by the nature of many to pursue inventory-reduction strategies in the sup- demand, including whether demand is derived or inde- ply chain. To develop the most effective logistical strategy, pendent. A derived demand arises from the production of a firm must understand the nature of product demand, another product. For example, when John Deere knows its inventory costs, and supply chain capabilities. demand for a tractor, it can simply compute the demands Firms use one of three general approaches to manage for the parts, materials, and components needed to pro- inventory. First, most retailers use an inventory control duce that tractor. Manufacturers of all sizes use such calcu- approach, monitoring inventory levels by item. Second, lations which are part of flow management to manage manufacturers are typically more concerned with produc- inventories, schedule deliveries for inputs, and manage tion scheduling and use flow management to manage capacity. Flow management software has evolved from inventories. Third, a number of firms (for the most part Materials Requirements Planning (or MRP) in the 1960s those processing raw materials or in extractive industries) to the much more complex Enterprise Resource Planning do not actively manage inventory. (or ERP) of the 1990s. A flow management is set in

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4th Quarter 2005 • 20(4) CHOICES 287 motion by the demand for end prod- ucts. Independent demand arises from Sales response function demand for an end product. End Logistical costs products are found throughout a supply chain. Wheat is an end prod- uct for a grain elevator, as is flour for $ a miller or cereal for a grocer. By def- inition, an independent demand is uncertain, meaning that extra units or safety stock must be carried to guard against stockouts. Managing this uncertainty is the key to reduc- ing inventory levels and meeting cus- 65% 70% 75% 80% 85% 90% 95% 100% tomer expectations. Supply chain Customer service coordination can decrease the uncer- Figure 1. Incremental sales and logistical costs. tainty of intermediate product demand, thereby reducing inventory vice is provided, a firm can expect ucts. The obvious difficulty is pre- costs. sales to increase (Figure 1). However, dicting how long each stage will last as a firm tries to provide perfect cus- and how abruptly sales will fall in the Customer Service and Inventory tomer service, logistical costs increase decline stage. The availability of inventory provides exponentially. Also, if a firm holds The life cycle strategy typically customer service. The Item Fill Rate too much inventory, it can lead to involves getting to profitability (IFR) measures how often a particu- low inventory turnover and hide quickly recuperating startup costs, lar product (often called a stock operational problems. For example, then sustaining high profits for as keeping unit or SKU) is available. A carrying too much stock means that long as possible, and finally acting common metric of customer service, you might not discover that your decisively for products in decline to IFR is expressed as the percentage of supplier is frequently late with deliv- minimize losses. Understanding this time that a customer can obtain the ery times. life cycle can help managers select item they seek. A firm may set its logistical tactics, inventory levels and customer service order policy at 95%, The Product Life Cycle, Demand supply chain designs. The ultimate seeking to fill 95% of the orders for Uncertainty, and Inventory for companies should be to have an item from inventory. The structure of independent just enough inventory to satisfy con- However, life is a bit more com- demand and logistical requirements sumer demand. plicated. A customer might not vary by stage in the product life cycle Another life cycle attribute is that obtain what they seek for several rea- (introduction, growth, maturity, and demand uncertainty shifts as we sons. The seller may have run out of decline). During introduction, logis- progress through time. Product man- a product due to an inaccurate fore- tics must support the business plan agers face substantial uncertainty cast. Or the supplier may have for product launch, while preparing during the introduction and growth shipped an incorrect package size or to handle potential rapid growth by stages, relative stability during matu- flavor. Products in inventory may be quickly expanding distribution. At rity, and increasing uncertainty in unfit for sale because of damage or an maturity, the logistical decline. This uncertainty drives fore- expired shelf life. Finally, a seller may emphasis shifts to become cost casting accuracy and the level of not have the capability to accurately driven. In the decline stage, cash safety stock required to meet cus- track inventory in their stores or dis- management, inventory control, and tomer service expectations. tribution centers. abandonment timing become criti- The coefficient of variation (CV) To avoid shortfalls or stockouts, cal. Over-abundance of products in measures the stability of a product’s firms carry extra inventory known as the late maturity or decline stage will demand, comparing the variability in safety stock. As more customer ser- eventually result in obsolete prod- demand to the size of the average demand (Figure 2). High demand

288 CHOICES 4th Quarter 2005 • 20(4)

Inventory Costs 100 80% Unit sales Different models are used to manage 90 70% CV 80 inventory for products that are con- 60% tinually available (like milk) or prod- 70 ucts available for limited time (like 60 50% seed). The Economic Order Quan- 50 40% tity (EOQ) model determines the 40 Unit sales Unit 30% least cost level of inventory to carry, 30 20% as well as costs. News Vendor models 20 Coefficient of variation are used for products only available 10% 10 for a single period. 0 0% EOQ and News Vendor models Introduction Growth Maturity Decline have proved useful for managing Stage of life cycle inventory for many years, analyzing Figure 2. Product life cycle and uncertainty. tradeoffs among major cost compo- nents. These models are robust and easy to customize to particular indus-

Carry Order tries. Their approach to costing is similar reflecting levels of inventory, Safety Stockout as well as shipping costs or quantity discounts.

$ Inventory costs fall into three classes: 1) carrying costs of regular inventory and safety stock; 2) order- ing or setup costs; and 3) stockout costs. Inventory control bal- ance the cost of carrying inventory 0 5,000 10,000 15,000 20,000 25,000 30,000 against the costs associated with Order size ordering or shortfalls (Figure 3). First, carrying cost (or a cost to Figure 3. Inventory costs by order size. hold inventory) is comprised of capi- tal costs, service costs, storage costs, variability in the introductory stage or the time from when an order is and risk costs. A carrying cost means it is difficult, if not impossi- placed until delivery is made. involves the opportunity cost for ble, to forecast demand. Thus, high demand used to be holding inventory. If the firm did not levels of inventory must be held to more exact because products stayed have money tied up in inventory, it meet even minimal customer service in the mature product life cycle phase could either use the savings to make levels. In contrast, lower variability for a long time. Today many compa- investments in other assets or pay during maturity means that demand nies find it far more difficult to fore- down debt. Thus, a firm should first forecasts are quite accurate. However, cast sales because of product prolifer- determine what it would do with any inventory levels may still be large ation. Product line extensions result savings from a reduction in inven- because they are based on larger sales in more products that cannibalize tory. If the dollars are used to buy volumes. sales and shorten the life cycle. Thus, capital equipment, an appropriate In addition to the vagaries associ- more sales are coming from products opportunity cost is the firm’s hurdle ated with product life cycle stage, two in the erratic earlier stages of life, as rate or its “required rate of return.” If other sources of uncertainty also opposed to sales from products in the the dollars are used to pay down drive the level of inventory. First, mature stage of the life cycle. debt, the interest rate on the loan demand can vary from day to day, should be used to value the inven- week to week, or seasonally. Second, there may be variability in lead time,

4th Quarter 2005 • 20(4) CHOICES 289 tory. The other three aspects of car- depends upon the customer service manufacturer uses the cost of a pro- rying cost are non-capital costs. level, the standard deviation of duction setup instead of an ordering The service costs are often demand of the product, and lead cost. masked in a firm’s fixed costs. A firm time. Let’s explain in greater detail. Finally, stockout costs involve lost should determine how much of its Assume that it takes 10 days from sales when no inventory is on hand. insurance and tax expense is associ- the time an order is placed until a Such costs fall as inventory (and cus- ated with inventory. This is especially shipment arrives and that on an aver- tomer service) levels increase. The important in states that have an age 20 cases are sold each day. Thus, relationship between stockout costs inventory tax. A firm has cash outlays over the 10 days that we are waiting and inventory depends upon the for warehouses and materials han- for the delivery (our lead time), we accuracy of the demand forecast and dling equipment, either owning or expect to sell 200 cases. If we trusted the ability of the firm to recognize leasing space from a distributor. In our forecast, supplier, and trucking and react to a change in demand. either case, the firm should deter- company, we would simply hold 200 Stockout costs depend on how a cus- mine how much is spent on space. cases for the 10 days. But we realize tomer reacts to a stockout, the fre- Inventory risk reflects characteristics that forecasts are inaccurate, some quency of stockouts, and the avail- of the product. Some items are more suppliers are unreliable, and shipping ability of substitute products. prone to be stolen, others are more times vary. If less is sold than Stockout costs can be very high if a likely to be damaged, yet others may expected during the 10 days or if the lack of substitute products means become obsolete before a sale is shipment arrives early, we will still that a customer will switch suppliers. made. In any case, risk means that if have inventory on the 10th day and In contrast, if buyers simply substi- too much inventory is held, a certain no customer service problems are tute a different product, stockout proportion of the inventory will be encountered. However, if sales are costs may be inconsequential. unavailable for production or sale. above expectations during the 10 In practice, many firms do not To determine the cost of carrying days or deliveries are late, we might assess stockout costs because different inventory, one needs to know the run out (or stockout) of product. divisions of a firm cannot reach average quantity of inventory, an Managing the uncertainty sur- agreement on what is the cost of run- inventory carrying cost (as a percent rounding safety stock is the key to ning out. Marketing may desire a of product cost), and the average cost reducing inventory levels. But in very high stockout cost to force a per unit of inventory. If a firm plans today’s competitive environment, it is penalty cost on running out. Opera- to use inventory reductions to fund difficult to lower safety stock require- tions or finance may resist this as it other capital assets, inventory carry- ments for two reasons. First, some leads to inventory buildups. ing cost might be 30% (25% for an buyers (especially large retailers) are Service level can differ by opportunity cost and 5% for the ser- requiring higher customer service lev- the value placed on stockouts and vice, space, and risk costs). If the firm els, which raise safety stock levels. indirectly carrying costs. A high plans to use the savings to reduce Second, the product mix for many stockout valuation will result in debt, the appropriate rate might be firms includes more new products higher inventories and higher service 12% (7% for the interest rate and with the corresponding greater levels. One way to evaluate an inven- 5% for the other costs). Regardless of demand variability. Thus, most firms tory management policy is to choose the carrying cost rate being used, as a seeking to reduce safety stock can a service level target. From this target, firm holds more inventory, carrying only do so by focusing on aggres- the inventory policy will determine cost increases (Figure 3). sively cutting lead times. the inventory requirements and asso- Firms carry extra inventory to The second cost to consider is ciated costs of providing that level of guard against uncertain events. ordering costs. Ordering costs service. A higher service level implies Known as safety stock, the purpose of include a cost for transmitting the that more inventory will be held as this inventory is to provide protec- order, receiving the product and plac- safety stock. The tradeoff decision tion against stockouts. Safety stock is ing it into storage, inbound transpor- occurs at the point where the cost of costed just like regular inventory, it is tation, and processing the invoice. carrying extra safety stock balances an interest rate times the level of Recent advancements in the stockout cost. safety stock. The level of safety stock technology have lowered this cost by required to guard against a stockout a factor of six for many industries. A

290 CHOICES 4th Quarter 2005 • 20(4) Closing Thoughts that do not have the supply chain Harvard Business Review, Mar/ capabilities in place or the ability to Apr., pp. 105-116. Inventory levels are affected by cus- manage them. Firms who understand Institute for Supply Management. tomer service expectations, demand their demand recognize stockout Available online: http:// uncertainty, and the flexibility of the costs and carry appropriate levels of www.napm.org/. supply chain. For products with rela- inventory are ultimately better able King, R., & Phumpiu, P. (1996). tively certain demand and a long to effectively manage inventory and Reengineering the food supply product life, it should be relatively provide the desired service level to chain: The ECR initiative in the easy to maintain desirable customer customers. As industrialization grocery industry. American Jour- service standards even as inventories affects agribusiness and agriculture in nal of Agricultural Economics, 78, are reduced. However, for products general, the importance of customer 1181-1186. characterized by erratic demand, a service and competitiveness will Wilson, R. (2004). 15th Annual State short life cycle, or product prolifera- become critical for firms and supply tion, a more responsive supply chain of Logistics Report. Council of chains. and larger buffer inventories may be Supply Chain Management Pro- fessionals. Available online: http:/ needed to meet a desired customer service level. For More Information /www.cscmp.org/. Consumers are demanding more Ballou, R. (2004). Business logistics/ th Frank Dooley ([email protected]) customer service from firms through- supply chain management, 5 ed. is Professor, Department of Agricul- out the supply chain. Firms with Upper Saddle River, NJ: Prentice tural Economics and the e-Enterprise high customer service levels may gain Hall. Center at Discovery Park, Purdue a competitive advantage over those Fisher, M. (1997). What is the right University, West Lafayette, Indiana. supply chain for your product?

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