A major portion of the investment of the company is in inventory. Hence, the company must assure itself of at least a minimum amount of return on this investment. As the same time, experts in the field of accounts have found it difficult to exactly quantify the trade-off between the amounts invested in the inventory and the service levels, and operating efficiencies. In other words, it cannot be exactly quantified as to the amount of ‘loss’ suffered with regard to service offered to client, or how much other operating efficiencies have gone down, because of the money invested in inventory. Due to this, many enterprises carry an average amount of inventory that can exceed their basic requirement. This can be understood better by studying four prime functions underlying inventory commitments.
1. Geographical Specialization
Because of the requirements of factors of production such as power, materials, water and labor, the economical location for manufacturing is often at a considerable distance from the major market.
For example: for an automobile industry, components such as tyres, batteries, transmission, and springs are essential components but a tyre industry prefers to be located at a place when materials for tyre manufacturing are easily available because this minimizes transportation cost for that industry. Same is the case regarding the manufacturer of other components. This geographical separation of the components manufacturing units will reduce the cost of the components produced. But, for the final assembly, these components have to be transported to the main’ assembly plant of the automobile company.
Geographical separation also requires manufactured goods from various locations to be collected at a stage warehouse. These are then combined as a mixed product shipment and sent to the required destination.
For example: Procter and Gamble uses its distribution centers to combine products from its laundry, food, and health care divisions to offer the customer a single integrated shipment. For an enterprise geographical separation, permits economic specialization between the manufacturing and distribution unit. Let us once again consider the case of automobile factory. Because of the proximity of the availability of power, water, materials and labor the tyre plant, the spring manufacturing plant will be located at different geographical points. Each geographical location of course will require its basic inventory. The economies gained through geographical specialization are expected to more than offset increased inventory and transportation cost, in case the company had decided to manufacture all the required components at it main assembly plant.
A second inventory function, decoupling provides maximum operating efficiency within a single manufacturing facility by stockpiling work-in-progress between production operations. Decoupling processes permit each product to be manufactured and distributed in economic lot sizes that are greater than market demands. For example, let us consider a tyre-manufacturing unit. This unit once the production operation begins will continue to produce a certain type of tyre till an economic lot size is produced. There may not be a market demand for the entire lot of production. But the production of the lot was carried out keeping in mind the future demand as well as the economies of production. Customer can be sent large shipments with full-load capacity of trucks at minimum freight cost. In a way, therefore, decoupling tends to “buffer” or “cushion” the operations of an enterprise from uncertainty. Decoupling, therefore, enables increased operating efficiency at a single location. In contrast, geographical specialization looks at the operating efficiency at multiple locations because from these multiple locations, goods have to be dispatched to the main manufacturing unit.
3. Balancing supply and demand
A third inventory function, balancing, is concerned with the elapsed time between consumption and manufacturing. Balancing inventory means the availability of supply is attempted to reconcile or match with the demand for the product. The most notable example is seasonal production and year-round consumption. In the West, Orange juice is consumed to a great extent throughout the year. But the production (i.e., reaping or harvesting) of oranges is basically seasonal. So the seasonal availability of oranges has to be reconciled to the year-round demand for orange juice. Balancing of inventories, therefore, attempts to link the economies of manufacturing with the variations of consumption. When the demand for a product is concentrated in a very short selling season, manufacturers, wholesalers, and retailers are forced to plan about stocking of goods in advance of the point of selling period. In our country we can take the example of a particular festival season, say Diwali. Every retailer, wholesaler and manufacturer expects a boom for gift articles, sweet and new clothes. But these enterprises have to plan out the amount of goods and products that are required to be manufactured ,and stockpiled. There should be a proper balance between the expected demand and the availability of supply. This is to minimize the risk of carryover into the next selling season. If such situation arises then the quality of goods and its marketability will be the problems for its sale.
4. Buffer uncertainties
The safety stock or buffer stock function concerns short range variation in either demand or replenishment. The safety stock requirement results from uncertainly concerning future sales. Safety stocks protects against two types of uncertainties :
Demand can be in excess of the forecast, during the performance cycle
Delays in the length of the performance cycle itself.
In the first type of uncertainly the customer may demand more than what he had actually planned. It can also happen that the demands from the customer may also fall, which can also upset inventory. In the second type of uncertainly, there can be delay in order-receipt from the customer, or delay in processing of the order, or delay in transportation of required material. This brings about an uncertainly in the length of the performance cycle.
To tide over these uncertainties, there are statistical and mathematical techniques which help managers to plan the levels of safety or buffer stock. With these available techniques, the probability and the magnitude of each type of uncertainly can be reasonably estimated, The function of buffer or safety stock 9nventory is to provide a specified degree of protection against this type of uncertainty.
5. Service level
The service level is the target specified by the management. It defines the performance objectives, which the inventory function must be capable of achieving. The service level can be defined in terms of an order cycle time, case fill rate, line fill rate, order fill rate, or any combination of these. • The order cycle time (performance cycle) is the elapsed time between the release of a purchase order by a customer and the receipt of the corresponding shipment.
A case fill rate
defines the percentage of cases or units ordered that can be shipped as requested. For example, a 95 percent case fill rate indicates that, on an average 95 cases out of 100 could be filled from available stock. The remaining 5 cases would be back-ordered or deleted.
A line fill rate is the percentage of order lines that could be filled completely. Each line on an order is a request for an individual product, so an order may have multiple lines. For example, when a customer order is received for 80 units of product A and 20 units of product B, the order contains 100 cases and 2 lines. If there are only 75 units of product A available and all 20 units of product B, the case fill would be 95 percent [(75 + 20) / (80 + 20)] and the line fill would be 50 percent (1/2).
Order fill rate is the percentage of customer orders that could be filled completely. In the above example, the order could not be completely filled. So the resulting order fill would be zero.