In our warehousing post, we noted that the main (and obvious) function of having a warehouse is storing inventory to buffer against unexpected orders and increase efficiency by consolidating orders. Inventory management is how companies decide what items to keep in a warehouse. There are two main inventory management factors that influence this decision: a) Deciding whether to use a Push or Pull strategy in filling the warehouse; b) Optimizing the total cost of holding the inventory.
Push and Pull Process in Inventory Management
Push/Pull process is the inventory management method of deciding how and when items flow through inventory from supplier to customer:
- Push Process assumes the supply chain is proactive and built upon predicted demand. Products are ordered (or manufactured) prior to the actual orders and order volumes are based on forecasted demand for an item.
- Pull Process assumes that supply chain is reactive and based on actual demand. Products are ordered (or manufactured) only after the order comes from the customer and volumes are based on the real demand for the particular item.
In inventory management, the point where Push and Pull processes meet each other is called Push/Pull point or Push/Pull boundary.
To make inventory management more relatable, think about how a meal in a restaurant or cafe uses the Push/Pull process:
- Any restaurant buys (or bakes) bread in advance, so it can be served as soon as the customer orders it. This inventory management strategy is based almost entirely on Push process and is called “Make to Stock” strategy.
- Restaurants buy meat and other ingredients in advance but wait for the order from the customer before preparing the meal. This strategy is largely based on Push process and is called “Make to Order” strategy.
- You can order a wedding dinner at a restaurant with decorations and special dishes, but do so well in advance to give the restaurant time for planning and preparation. This strategy is based almost entirely on Pull process and is called “Engineered to Order.”
In real life, the pure Pull systems, where the supplier has no idea about the raw materials, are extremely rare. For example, in construction, a company does not know which materials it will use until it’s decided on during the planning stage. Pure Push systems, on the other hand, are quite common. Any fast food shop or local store is a Push system. But companies usually have a large inventory which increases spoilage risks.
The most widely used are blended systems, where both Push and Pull processes are used in inventory management. The main challenge with this approach is to decide where to draw this Push/Pull line. There is no hard rule, but the general tendency is to use Push process for raw materials and components and to use Pull process for finished products. This approach gives us an opportunity to achieve the maximum amount of finished products with a minimal amount of raw materials. For example: two types of bread and cheese, three types of meat and four types of sauce gives us almost 2000 different sandwich choices.
Total Cost of Inventory
In inventory management, it is important to understand the total cost of holding the inventory. This is more complex than the price of the goods. When considering the total cost of inventory we should think about the following equation:
Total Cost = Cost of Items + Ordering Cost + Holding Cost + Cost of Stockout
Here is a brief explanation of each component:
- Cost of items - This is simply the cost we pay per unit of purchased item, multiplied by the ordered quantity. This also includes all the shipping, packaging, customs and import duties etc.
- Ordering Cost - This is a cost of placing an order. It is a total spending that we have to be able to place orders per year for example (purchasing staff salaries, office equipment, and supplies etc.), divided by the total number of orders placed that year. This is a not a trivial number to calculate. Usually, this is set by the company's management.
- Holding Cost - This is the combined expenses needed to hold the inventory, like warehouses, machinery, and equipment, manpower etc.
- Cost of Stockout - This is the cost or loss that occurs if we are short in inventory. This may vary from simply losing a profit due to not selling one more unit, up to the halting continuous production process because of the inability to provide necessary inventory in time.
Optimizing inventory expenses is a big part of inventory management. One of the methods of optimizing the inventory costs is a tradeoff between ordering costs and holding costs. A business should decide which option is better: ordering smaller amounts more often and saving on the inventory holding cost, or ordering larger amounts less often and saving on ordering costs.
In today's competitive world companies try their best to win the customer. Often times they do this by lowering their prices, thus risking their business. Efficient inventory management may hold the key for these companies.