What inventory is, and why it matters
What is held
Why it is held
What it costs
Where and how much
Policy, aggregate, item
How finance sees it
A necessary cost
Organizations carry inventory because it is a cost of doing business. Because it is a cost, they keep searching for the optimum level: the one that maximizes profit, production efficiency, and customer service.
A strategic asset
Managed correctly, inventory is an investment. It can decouple demand and supply, protecting the organization against variability on either side.
Before adding stock: five alternatives
Using inventory to protect against variability costs money and uses space, so management may look for ways to avoid carrying more than desired:
Sharper demand signals
Improve demand forecasting and/or use actual demand orders.
Steadier supply
Reduce variability in the quality, amount, and timing of supply deliveries.
Shorter cycles
Shorten production cycle times.
Reliable equipment
Maintain production equipment carefully.
Keep it moving
Keep inventory in motion rather than waiting in queues and warehouses.
Five types, defined by where inventory sits
Each type serves particular functions, and all of them add flexibility to the supply chain when they are held at optimum levels. The first three types follow the product through the plant; the last two cut across them.
- Raw materials, WIP, finished goods: the production sequence.
- In-transit: some amount of every other type is always on the move.
- MRO: supports production but never enters the product.
Raw materials
Purchased parts, materials, or subassemblies that have been acquired but have not yet entered production.
Work in process (WIP)
Goods in various stages of completion, from material released for processing to material awaiting final inspection and acceptance. Value has been added but it is not yet finished. It can include held subassemblies for a bill of materials.
Finished goods
Finished, ready-to-use products waiting to be purchased by the customer.
In-transit (distribution)
Material moving between locations that are usually geographically separated, for example finished goods shipped from a plant to a distribution center.
MRO
Spare parts, lubricants, hand tools, and cleaning supplies needed to maintain production but not part of the final product.
Expensed, not an asset
In-transit: the easy-to-miss stock
Counting only what is currently in stock can omit a significant share of total inventory. A typical example is inventory on containerships in international shipments.
It is measured as the average annual inventory in transit, a function of transit time in days and annual demand. Reducing it means finding ways to cut transit time, because less volume needs to be in transit at any moment.
MRO: its own management challenges
MRO supports routine maintenance and emergency repairs. Attention to machinery and MRO forecasting can cut equipment costs and downtime.
- Often kept in several dispersed locations, so accumulation and use are hard to account for
- Risks: obsolescence, buying items already in stock, unnoticed pilferage
- Purchase requisitions are often the only trigger, and their frequency and small size are an administrative burden
Where organizations find improvement
Investing management time in MRO can pay off. The module points to four levers: the size of the MRO investment, the number of suppliers, the controls over MRO, and the ordering process.
- Corporate credit cards for small-value items
- A full-service distributor with an online requisition system
- With enough volume, a distributor employee on site, offering fast replenishment so less needs to be stocked
- Centralized MRO storage
Why hold inventory at all?
| Function | What it does | Key points from the module |
|---|---|---|
| Cycle stock / lot-size inventory | Depletes gradually as customer orders arrive and is replenished cyclically when supplier orders arrive | The main function of inventory (available-for-sale or sold goods). In aggregate, it may be called pipeline inventory. It is lot-size inventory when bought or made in quantities larger than needed, for quantity or full-truck discounts or to match production batch sizes |
| Anticipation inventory | Extra stock above basic pipeline stock to cover projected demand | Covers rising sales trends, planned promotions, seasonal swings, plant shutdowns, and vacations. It supports the demand plan, including peaks and valleys. Under a level production strategy, it may mean building inventory before it is needed |
| Buffer inventory | Keeps throughput steady at work centers | Materials awaiting further processing or a work backlog deliberately kept behind a work center. In the theory of constraints, buffers can be time or material. Some organizations adjust buffer sizes dynamically as a lever to protect throughput |
| Safety stock (fluctuation inventory) | Protects against miscalculations of timing or quantity | Reduces variability in demand and/or supply, supports service targets, and cuts stockout costs. Example: a supplier suddenly goes bankrupt and safety stock keeps production going while a replacement is found |
| Hedge inventory | Manages risk by building, buying, or contractually securing extra stock at a set price | Used when supply could be threatened or prices could rise. It involves speculating on weather, the economy, strikes, civil strife, or political action. The term is not widely used, but the practice is |
Decoupling: the idea behind buffers and safety stock
Raw-material example
A stock of raw materials decouples a manufacturer from its suppliers. The sawmill wants a ready supply of trees; the furniture maker wants enough lumber to process. Supply and demand can then run at different, independent rates.
Scheduling example
Many products are made in batches on shared work centers, so some production may happen earlier than needed to avoid bottlenecks. That builds some WIP before it is needed, which is a trade-off to optimize across the whole flow.
Managers look for a cheaper route
Decoupling is often necessary, but supply chain managers look for ways to reach the same goals without the holding costs, by reducing variability in quality, quantity, or delivery time.
Six costs that pull against each other
This balancing is needed at every stage: the retailer and distributor order finished goods, the manufacturer orders components and supplies, the supplier orders its own materials, and so on. An order schedule helps coordinate these flows.
Acquisition cost
The cost to obtain one or more units: order quantity × unit cost. Also called product cost or purchase price.
Landed cost
Product cost plus logistics (warehousing, transportation, handling). Purchased: price paid + transport to site + customs + insurance. Internally sourced: direct labor, direct materials, and factory overhead.
Carrying (holding) cost
A percentage of inventory value per unit of time, usually one year. A variable cost that rises with the inventory level. Detailed below.
Ordering cost
Costs that rise with the number of orders, not their size: clerical work to prepare, release, monitor, and receive orders; physical handling; inspections; and setup costs.
Backorder, lost sale, lost customer
Customer-service costs. A backorder (stockout) is an unfilled order or commitment. Hard to quantify, but can be proxied, for example by the % of orders shipped on schedule.
Capacity variance cost
The cost of changing capacity beyond a "normal" range: overtime, extra shifts, layoffs, or plant closings.
Carrying cost in detail
Storage costs
Rent, operating cost, taxes, material handling, equipment leases, depreciation, power. Allocated to SKUs by cube, weight, or density.
Large, dense, or hard-to-handle goods cost more to store.
Capital costs
The return creditors and investors expect because the money could be invested elsewhere (opportunity cost). Financing comes from debt and equity (including retained earnings).
The weighted mix is the WACC, usable as a required return that inventory sales must exceed.
Risk costs
Sensitivity to loss of value: perishability, speed of obsolescence, likelihood of theft. Includes insurance, value reductions, and write-offs.
Risk can be quantified subjectively, as in the example below.
Risk cost, illustrated
The module's example attaches a subjective risk to inventory: a 2% decline in value per day from obsolescence. At that rate, stock held longer than 50 days is considered valueless.
Chart drawn from the example's stated rate (2% × 50 days = 100%). It illustrates the idea; it is not an exhibit from the module.
Ordering, backorder, and capacity variance: where the trade-offs sit
| Lever | Cost that falls | Cost that can rise |
|---|---|---|
| Order less often | Ordering cost (fewer orders) | Inventory holding cost |
| Level production through the year | Capacity variance cost (no overtime, layoffs, closings) | Inventory holding cost in low-demand periods |
| Hold more safety stock | Stockout, lost sale, and lost customer cost | Inventory costs (policy balances the two) |
Ways to cut ordering cost
- Electronic forms and payment transfers
- Less frequent ordering (at the price of more holding cost)
- Prepare setups off the work site while machines are still running the prior order, shortening shutdown time
What setup cost includes
Labor to clean machinery and make necessary adjustments or modifications. It requires shutting machines down, which is why reducing shutdown time matters.
Planning mode, location, and level
Centralized
Inventory is pushed to later stages by the lead organization or channel master. Later stages, such as DCs, have no say in what they receive, though the central system tries to replace what sells and plans for seasonal effects.
Can minimize overall inventory · But may respond slowly to local demand
Decentralized
Each stage determines its own requirements and places orders independently, so there is no coordination expense.
Risk the bullwhip effect, especially if actual customer demand is not visible to all stages
Hybrid
Centralized planning up to a certain point in the chain (for example, the distribution centers), then decentralized planning at all later points.
Centralized and hybrid planning have grown in popularity because decentralized planning can create bullwhip effects.
Where should inventory be located?
Inventory belongs wherever in the distribution network it can serve a valid purpose: as a buffer between stages, to reduce overall cost, and to meet customer service goals. It can sit in warehouses, in retail locations, or in transit.
Distribution center (DC): typically a finished-goods warehouse built for rapid, demand-driven distribution to retailers, wholesalers, or directly to customers. Cross-docking warehouses are another type.
Echelons: a level of supply chain nodes
Treating each stage of inventory handling as an echelon is a good way to reason about locations. Each echelon adds operating expense, holds inventory, adds to cycle time, and expects to make a profit.
Choosing the number of echelons
- Organizations decide how many echelons to have; each one adds material, labor, overhead, and inventory cost.
- Consolidation warehouses could be omitted entirely.
- A direct-to-customer model has no wholesalers or retailers.
- Strategic network design sets the optimum number, then analysis sets the number and geographic location of sites, using network modeling, operations research, and decision support systems to find the lowest total cost of ownership of storage, handling, and transportation for a chosen service level.
Echelon inventory policy
Inventory at a given point is defined to include all inventory at that echelon and at every later point, including all in-transit stock after it.
Benefit: demand from all lower points is aggregated, giving more accurate order quantities and levels. The process repeats, in more detail, at each lower echelon. Hybrid systems can use it up to where centralized planning ends and rely on visibility after that.
What each echelon contributes
| Node | Benefit it can provide |
|---|---|
| Suppliers' warehouses | A buffer against manufacturing orders |
| Consolidation warehouses | Lower transportation cost by grouping shipments from several sources into fewer shipments to a manufacturer or assembler |
| Manufacturing warehouses | A buffer for the process (raw materials and WIP) and for later echelons (finished goods), i.e., decoupling between nodes |
| Distribution centers | A buffer for later echelons; as break-bulk sites they receive large shipments (economies of scale) and ship individual orders; they can also consolidate shipments from many vendors |
| Wholesalers | May buffer, consolidate, or break bulk |
| Retailers | Immediate access to inventory, and possibly other services |
Consolidation and break-bulk
Cut transport cost and can reduce inventory, especially slow movers, which can ship in smaller quantities when combined with other stock.
Sorting
Cross-docking, assembly, and mixing.
Seasonal storage
Produce year-round, sell in one season.
Reverse logistics
Sites for returns, remanufacturing, repair, remarketing, and disposal or recycling.
Levels of inventory
Policy, aggregate view, and item view
Supply chain perspective
Concerned with inflows and outflows at each stage, from ordering raw materials to handing finished goods to the customer. It benefits strongly from inventory visibility (the extent to which inventory information is shared within a firm and with partners) and from supply chain collaboration.
Enterprise (internal process) perspective
Inventory feeds into production and results from it, so planners, master planners, and production schedulers coordinate with each other at each level of production planning.
Competing interests
| Function | What it wants from inventory management (Exhibit 4-25) |
|---|---|
| Purchasing and materials management | Adequate raw materials at low inventory cost |
| Manufacturing and finance | Efficient, low-cost production balanced against low inventory cost |
| Sales and marketing | Enough inventory to meet customer delivery requests and service levels |
Inventory is managed both as an overall strategic concern (aggregate) and at the individual item level. Each method is necessary, and together they cover strategic and operational needs.
Inventory policy
Inventory policy formalizes strategic inventory decisions so they are implemented consistently. It can be broad (centralized or decentralized planning and warehousing, communication and coordination frequency, a geographic positioning strategy such as postponement) or specific (rules for order quantities and timing, when to act on exceptions, how much of an item to buy versus make).
Organizations weigh six factors when setting it:
Customer demand
Known in advance or forecast; policy must compensate for forecast variability.
Planning horizon
Its length affects needed levels; long-term plans may leave time to change system capacity.
Replenishment lead time
A key input, especially when lead times are long or highly variable.
Product variety
Similar products compete for budget and shelf space, so policies interlock. Families are planned together. Too much variety means too many SKUs and much higher holding cost for make-to-stock products.
Inventory costs
Order costs (production and transportation) and carrying costs.
Customer service requirements
Sets safety stock per item and location, balancing failures to fill orders in acceptable time against rising inventory cost.
Aggregate vs item inventory management
Aggregate level (strategic)
Focus: the financial impact of inventories, aiming for the level that produces the greatest overall profit for the organization and supply chain.
Why aggregate? Analyzing a large number of items one by one is impractical, and aggregate forecasts are more accurate than item-level forecasts because aggregation reduces variability. Aggregate only as far as the groups still give effective analysis.
Used to:
- Decide which types of inventory to hold
- Optimize inventory flow and set buffers between stages
- Match supply with demand
- Set inventory objectives and policy
- Calculate inventory costs by category
- Support S&OP (including production planning), demand management, and resource planning
Item level (operational)
Focus: short-term operational decisions using rules set in inventory policy and/or IT systems.
Rules specify:
- When to order
- How to determine order size
- The relative importance of each item
- Control procedures for individual items
Goal: translate strategic inventory goals into measurable results: proper production and distribution of each product or SKU.
Link to planning: S&OP plans production at the family (aggregate) level; master scheduling plans it at the item level. Retail locations also need both views. Item management is implemented through inventory planning, inventory models, and inventory control.
Ways to aggregate inventory
Demand pattern
Women's vs men's running shoes
Production process
Both shoe lines made on the same line
Stage of production flow
Raw materials, finished goods
Product or SKU family
Similar functions, different models, packaging, colors, or styles
Distribution pattern
Same source and/or same delivery location or customer zone
Relative value
ABC classification, covered next
ABC inventory classification
| Class | Share of items | Share of value |
|---|---|---|
| A | about 10–20% | about 50–70% |
| B | about 20% | about 20% |
| C | about 50% | about 10–30% |
ASCM Dictionary ranges, as cited in the module.
Pareto at work
ABC applies the Pareto principle: a small share of the population (about 20%) drives a large share of the impact (about 80%). It is a general rule, but often meaningful enough to use. The classic form puts 80% of value in 20% of part numbers (A), 15% in 30% (B), and 5% in 50% (C).
What ABC can be used to drive
More effort and money on relationships with A-item suppliers, and none on C-item suppliers
Secure storage and extra care in transport for A items, plus quick access to fast-turnover goods
More rigorous demand forecasts for A items
Prioritizing cycle counting. ERP systems usually keep a separate ABC field for counting, so using ABC as inventory policy may need a different data field
Other aggregate classification methods exist, based on criteria such as individual cost or utility value.
How finance sees inventory
Inventory can be seen as the buffer that hides flaws in the supply chain, and also as the lubricant that keeps it flexible. A flexible chain responds quickly to internal and external changes such as demand swings, so inventory management strongly affects cash flows and financial position.
The supply chain professional's goal: manage inventory level and cost efficiently while maintaining and improving customer satisfaction.
Too much
Fast delivery and strong satisfaction, but cash tied up in inventory can lead to financial failure.
Too little
Costs cut to nearly nothing, but the company may be unable to deliver, and customers go elsewhere.
Balance sheet
The balance sheet (statement of financial position) has two sections that must balance under the accounting equation. Inventory is a current asset. In internal management reports it may be split into raw materials, WIP, and finished goods; externally available balance sheets typically show total inventory only.
Raw materials, WIP, finished goods
They do not touch the income statement until the inventory is sold, reduced to fair market value, or written off as obsolete.
MRO inventory
It is expensed on the income statement in the period it is bought, not carried as an asset.
An asset also needs financing
To finance assets, more liabilities are needed. Some current assets are also less liquid than others (liquidity is how quickly they convert to cash).
The optimum holding equals projected sales in the demand plan plus an optimal safety stock. Stock expected to sell soon is more liquid; stock beyond the demand plan is less liquid.
Average inventory (quick estimate)
Software can compute it at any time. For a quick estimate, add the inventory value at the start of the period to the value at the end and divide by two.
It is used in performance measures and in inventory space calculations. The module's worked example (Exhibit 4-28) is an image, so no figures are reproduced here.
Risks of carrying too much inventory
Embedded cost
Balance-sheet value includes production cost. On sale, direct materials, direct labor, and factory overhead become an expense offsetting revenue and reducing cash, so only the margin contributes to net income.
Magnified quality issues
If a defect is found, more stock with the same defect multiplies scrap, repair, or replacement cost.
Obsolescence and spoilage
The longer stock sits on the books, the likelier it is written down to fair market value or written off entirely.
Write-off consequences
Physical removal, and an expense for materials, labor, and overhead with no offsetting revenue. Strict accounting rules apply. Accountants often create an inventory reserve in anticipation.
Valuation on the books
Financial accounting methods
Valuation follows specific rules based on the age distribution of inventory. Methods can leave the accounting value closer to or further from market value:
For managerial accounting, inventory can be valued at standard cost; variances from actual cost are adjusted at period end and show up in the financial statements.
The reported figure may also include inventory that is reserved, obsolete, damaged, or otherwise unsalable, some of which will later be written off.
Income statement and cash flow
Income statement
Gross profit = revenue − COGS. COGS covers the direct labor, direct materials, and factory overhead of goods sold in the year, so reducing those elements raises gross profit directly.
Cutting costs lifts profit faster than raising sales volume, because variable costs rise with revenue. Lowering variable supply chain costs raises the margin on inventory without raising prices.
Caution on building ahead: producing inventory early can defer COGS until it sells, but operating (period) expenses are expensed as incurred, which can strain financial ratios, and cash goes out during the build-up. Finance needs to plan for it.
Statement of cash flows
A company does not want all of its capital tied up in inventory. Insufficient cash means expensive borrowing, or quick failure if funds cannot be raised.
Inventory changes can also affect loan covenants: lender requirements to maintain certain financial ratios. Even a reduction can cause one-time adjustments that affect reporting, though the long-term effect of reducing inventory is usually positive.
Case: when a good idea breaches a covenant
A supply chain manager finds slow-selling stock and proposes cutting inventory by €60 million. The CFO raises a concern: the bank's loan covenant requires owners' equity to be twice liabilities (2:1).
Inventory cut. Best case, cash rises by a few million euros; worst case, the company pays to scrap the stock.
Equity falls. Assuming no net change in income, retained earnings drop by the same amount to keep the balance sheet in balance.
Liabilities must fall by half as much to hold the 2:1 ratio, a large burden on cash flow.
If the covenant fails, the company is in technical default and its debts could become due immediately, so the change cannot be made right away.
Terms at a glance
| Term | Plain-language meaning |
|---|---|
| Cycle stock / pipeline inventory | Stock that depletes with orders and is replenished cyclically; pipeline inventory in aggregate |
| Lot-size inventory | Cycle stock bought or made in larger quantities than needed, for discounts or batch sizes |
| Anticipation inventory | Extra stock to cover planned peaks, promotions, seasons, and shutdowns |
| Buffer inventory | Material or time kept in front of a work center to protect throughput |
| Safety stock | Stock held against errors in timing or quantity of demand and supply |
| Hedge inventory | Extra stock secured at a set price against supply threats or price rises |
| Decoupling | Making supply and use independent so one operation's swings do not constrain the next |
| Acquisition cost | Order quantity × unit cost |
| Landed cost | Product cost plus logistics (and, for purchases, transport, customs, insurance) |
| Carrying (holding) cost | Percentage of inventory value per year: storage, capital, and risk |
| Ordering cost | Cost that rises with the number of orders, including setup |
| Backorder (stockout) | An unfilled customer order or commitment |
| Echelon | A level of supply chain nodes, each adding expense, inventory, cycle time, and an expected profit |
| Inventory visibility | How far inventory information is shared inside a firm and with partners |
| ABC classification | Ranking items by annual dollar volume and grouping them into A, B, and C classes |
| Inventory reserve | An accounting account that lowers inventory value in anticipation of write-offs |
Six reflection questions for your organization
DISCUSSION QUESTIONS
Drawn from Topic 1 as material for team discussion. Answers depend on each organization's situation and should be backed by facts rather than perception.
- Counting everything. Does your view of total inventory include in-transit stock and the way MRO is treated (expensed, dispersed, ordered by small requisitions)?
- Type vs function. For your largest stock positions, which function does each one serve (cycle, anticipation, buffer, safety, hedge)? Is any stock held without a clear purpose?
- Trade-offs. When someone proposes reducing one inventory cost (fewer orders, level production, less safety stock), which other cost would rise, and who bears it?
- Position and policy. How many echelons does your chain have, is planning centralized, decentralized, or hybrid, and is actual customer demand visible to every stage?
- Aggregate and item. Are your ABC classes still defensible (value only, or margin, turnover, quality, and upcoming changes too), and are controls tighter where value is concentrated?
- Finance first. Before the next significant stock reduction or build-up, has finance reviewed the effect on covenants, cash flow, reserves, and write-offs?