July 1997 • Volume 7 • Number 7
Understanding The Nature Of Inventory
By Steven A. Melnyk and R.T. "Chris" Christensen
The nice thing about writing your own column is that you can change the focus. In last month's column, we told you that we would continue to study the nature of capacity within processes. However, since then, we found ourselves in several long discussions with practitioners. At the heart of this discussion lies an interesting point — inventory. The managers understand the need to manage inventory. They understand the basics of stockroom control. They understand that inventory consumes resources. However, what they have difficulty with is the notion that inventory is a residual. That is, you can never attack inventory directly. Inventory exists because it is a response to the need for a certain function that it provides. It is this need that you must attack, not inventory. This position seems to confuse many managers. Because of this, we have decided to explore inventory for the next couple of articles. We think that you will find the resulting discussion both interesting and insightful.
Inventory — an overview
What is inventory? Let us start with understanding this very basic but important concept. Accountants will tell us that inventory is an asset. It is something that the firm owns. On the balance sheet, inventory is treated as part of the liquid assets of the firm. What this means is that inventory can be converted in money relatively easily and quickly. However, this is not always the case. We know, for example, that obsolete inventory is not as liquid. Often its real value is very different from its book or accounting value. The Just-in-Time (JIT) experts will tell you that inventory is an evil. Inventory consumes resources and it hides problems. As a result, inventory should be avoided. This is a blanket statement and not always true. There are times when inventory has a real value. For example, if you are going on vacation and your distributor shorts out, then you are very pleased when your dealer has a replacement distributor in stock.
Inventory is simply the positive difference between supply and demand. It occurs over a period of time when you make more than you consume. Inventory is also an asset over which you may have title (ownership), but not possession. For example, the software package coming to you from a mail order house in California is inventory. You own it, but you do not have it in your hands.
This positive balance occurs because of either
unintentional (we forecasted more than was actually sold) or
intentional reasons. Our focus is on the intentional
reasons. Inventory occurs when the costs associated with not
having inventory exceed the costs of having inventory. Yet,
why do we need inventory? The reason is that we need
inventory because of the functions it provides.
Functions of inventory
We do not have inventory because we like inventory per se.
We have inventory because it helps us cope with a problem or
remediate the effects of a situation. We buy the function
provided by inventory. To understand the functions provided
by inventory, we turn to a scheme that was developed by one
of the greatest operations management teachers of our time
— Bob Britney of the University of Western Ontario
(London, Ontario). This teacher (now deceased) developed
this taxonomy as a way of teaching his students the reasons
for inventory.
This scheme identifies six functions provided by inventory:
Transit: The transit function occurs because of geographical differences between the places where demand and supply occur. It occurs, for example, because your supplier is located in San Jose, Calif., and you are located in Falls Church, Va. When the inventory leaves the supplier's plant in San Jose, we have title to it. The amount of transit inventory is a function of three factors: (1) the distance; (2) the quantity; and (3) the method of transportation. If we want to eliminate this function of inventory, we can invest either in a faster mode of transportation (e.g., replacing rail shipments by air), or we can look for a supplier who is located closer to us.
Decoupling: Decoupling occurs primarily within manufacturing facilities. It occurs because there is an imbalance between the rate at which products are supplied and the rate at which they are consumed. For example, we could have two machines — A and B. A feeds B. A produces 200 units per hour; B consumes 150 units per hour. These differences could be due to problems in preventive maintenance. They could also reflect inherent differences in machine rates. Without inventory between A and B, we would have to run machine A for 45 minutes to every one hour of machine B's production rate. However, by having inventory between A and B, we decouple (separate) A from B. A now produces to inventory; B consumes from inventory. To eliminate this inventory, we must balance the production and consumption rates. This may require different criteria for selecting equipment to buy (we now stress system balance as compared to getting the most output for the money from each machine). Alternatively, we could invest in improved preventive maintenance. Unless the underlying reasons for the imbalance are identified and remedied, we are hard-pressed to eliminate the need for inventory.
Lot Sizing: This function typically occurs because of large setup costs. When we have large setup costs, we do not find it economical to produce in lots of one unit. Rather, we produce in quantities where the average setup costs equal the average holding costs. To avoid lot sizing, we must reduce setup costs. This is the reason that JIT experts focus on setup reduction. It is necessary to eliminate the lot sizing function. With the lot sizing function eliminated, we can think in terms of lot sizes of one (the goal of JIT).
Anticipatory: This function occurs when we expect changes in the conditions of supply. These conditions refer to either the availability of products in the near future or the price at which they are offered. For example, we would tend to invest in this function of inventory when we expect a strike at our supplier or when we think that our supplier is about either to increase the price or to reduce the allotment of product that we are to receive. To reduce this function of inventory, we have to either lock our suppliers into long-term contracts or identify more stable sources of supply.
Seasonal: This function exists because of imbalances between supply and demand. These imbalances should be of a regular and predictable nature. The imbalances exist because demand may occur year round, while supply is limited to one brief period (as in the case of blueberries here in Michigan and Wisconsin). Alternatively, the demand may be limited, but the supply takes place year round (as in the case of a toy company). Inventory becomes the method of coping with this imbalance. To eliminate this inventory, we must either coordinate supply and demand (e.g., selling only when the supply is available, as in the case of blueberries). Alternatively, we would try to lengthen the demand period as a toy company would try to do to the demand for toys.
Buffer: The final function of inventory refers to
inventory which is held because of uncertainties. These
uncertainties could be in demand (either in quantity and
timing). They could also be internal as in the case of scrap
rates. Finally, they could also result from supplier
problems. For example, the lead time for our suppliers might
be highly variable. Alternatively, we might have a situation
where the actual quantity delivered is variable. This occurs
in cases where the amount delivered is based on weight, not
piece units. In each case, we must first identify the source
of uncertainty and eliminate it before we can reduce buffer
inventories.
Applying the functions approach
With this approach, we have a better way of attacking
inventory. The first step is to classify inventory according
to the function that it provides. Once we have identified
the various functions provided, we can use these functions
to identify the underlying root causes. It is these causes
which we must attack and eliminate before we can hope to
eliminate the associated inventory. This is why inventory is
a residual. Inventory is a symptom. You never attack
symptoms directly.
Steven A. Melnyk, Ph.D., CPIM, is software editor for
APICS—The Performance Advantage. He is also an
instructor in the Department of Marketing and Supply Chain
Management at Michigan State University in East Lansing.
R.T. "Chris" Christensen is the director of the executive
education program at the University of Wisconsin,
Madison.
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