Week 2:

In which industries inventory is important?

In mostly every industry that have low volume high demand, high volume low demand, etc.
We should look KPI indicator of the industry.
Key performance indicator (KPI) as inventory as percentage of the total asset.
Where the inventory is important is country depended.
But we can see that in US & China for the following industries, the inventory is important:

-Food staple retailing

-Consumer durables and apparel

In additional comment, inventory is critical for real state in China but US.

Refresher on Inventory Turns / Days

COGS: Cost Of Goods Sold.

Definition:

 Inventory turns = Annual COGS / Inventory Investment

 Inventory days (DOS) = # Of business days in a year / inventory turns

Meaning:
 Inventory Turns: How many times inventory is sold and replaced
 Inventory Days: Average days the item is held in inventory (or how many days of demand can
you satisfy by the inventory)
Which industries have the lowest inventory turns or the highest inventory days?

To answer this, we need to look at Efficiency Analysis in Industrial Comparison. The analysis compares
these industries on cost efficiency, labor productivity, inventory turns and market power.

.
Week 2:

Why hold or not hold inventory?

Why or why not companies hold inventory:

Why Hold Inventory

 To take advantage of the scale economy (economía de escala)

 Fixed ordering & switch over times (to reduce fixed ordering cost and switch over times).
 The inventory carried for this purpose is Cycle Stock

 To protect against uncertainty

 To prepare for unexpected demand surge.
 Suppliers stock-out
 The inventory carried for this purpose is Safety Stock

 To take advantage of price discount

 Forward-buy stock (when an investor negotiates the purchase of a commodity at a price
negotiated today but takes actual delivery at some point in the future). This is more
common in retail industry: A great use case for making a forward buy (aka, investment
buy) is the tariff situation. When you know prices are likely to go up, or when there’s
opportunity to take advantage of a discount that won’t be available later, then forward
buying is a very smart way for you to do that. (Or could be a supplier price discount)

 To ship products over a long distance

 Furthermore, we may have to ship our products over a long distance and inventory in transit
is called Pipeline stock
El inventario (o stock) en tránsito tambien denominado de “Pipe-Line”, se define como: la
suma de stocks de productos acabados en fábrica, mercancias en tránsito y recepción
de mercancias aún no ubicadas en el almacén.

 To make up for the limited production capacity

 Seasonal demand due to limited production capacity. Prebuilt stock
Inventory Diagram and Decisions

The inventory fluctuates over time with the reorder and the depletion of the Cycle Stock.
On the bottom there sits, the Safety Stock to protect against uncertainty
The key question to answer are
First, when to order?
This question is related to SS.
Second, how much order?
This question is related to the Cycle Stock.

Why NOT Hold Inventory

 Requires additional space and handling

 This increase cost.

 Opportunity cost of capital

 The money tied up in inventory cannot be invested elsewhere and thus leads to the
opportunity cost of capital

 Spoilage / Obsolescence
 Inventory often subject to spoilage and obsolescence and represent a lost of investment.

 Hide problems in manufacturing processes, causing quality problems

 Too much inventory may hide problems in production and cost quality issues.

Inventory Holding Cost Breakdown:

This is just an example

Inventory holding cost: % of product value

Opportunity cost of alternative investment -8% of cost capital
Cost of storage -6% of cost storage
Taxes and insurance -2% taxes and insurance
Breakage, spoilage & obsolescence -1% breakage & spoilage
 Total cost: -17% total annual interest rate
The objective of Inventory Management: Improve customer satisfaction level & reduce
inventory at the same time

That means, we need to reduce or avoid dead inventory. Reduce excessive inventory and
only keep active inventory.
How Many Inventory Drive Companies’ Financial Performance?

We will US retailing industry as an illustrating example.

To understand the impact of inventory on a company’s bottom line more systematically, we can conduct a
value driver analysis.
What are the 4 value drivers?
Business appraisals are driven by four value drivers:  the historic income stream, the future net cash
flow, the market value of the stockholders' equity and the discount rate. That’s an example the
value driver can change depends on we want to analysis.

Where we selected the X variable to be inventory turn over and the Y variable to be operating cost
over total revenue.
We selected companies in retailing industry in US, from 2016 to 2018.
We can see here that when the inventory days increase the operating cost over total revenue decrease in
this industry for all the years. Which implies that a high inventory turnover may lead to a lower operating
cost for retailing.

For the same analysis, we now chose the same X variable to be inventory turn over and the Y variable
to be gross margin.
Be found that as inventory turnover increases, the gross margin may decrease. Which may come from a
higher cost of goods sold for the products due to, perhaps, the loss of scale economies in buying less
bulk.

And the last analysis, we selected X variable to be inventory turn over and the Y variable to be the
asset turnover.

We found that the inventory turnover clearly has a positive impact on the asset turnover for the US
retailing industry. That is, as the inventory turnover increasing the asset turnover increases for the US
retailing

Asset turnover = Rotación de activos

How Do I Know That I Have An Inventory Problem?

To answer this question, we will use Amazon and Macy’s as the illustrating example.
Here is principal:

If my revenue is half than of yours but I hold as much as inventory as you do,
then I must have an inventory problem

Let’s first do a KPI benchmarking on inventory days for industries groups in the US in 2018.
In the chart the fist 10~20 percentile are the best performance companies , Level 2 .

In addition to this, we ranked the companies in the same industry by Inventory Days.
The example industry is Retailing.
Then we compare Macys and Amazing by Efficiency through years
Amazon have better inventory days, cash convertion cycle and labor productivity.
Amazon also consistently treats its supplier better than Macy’s.

From KPI examination of Caterpillar we can see the following;

An operating margin of 0.134 (high for the industry)
A good Financial Health, thus Free Cash Flow/ Total Cost is 0.107
And a Net Income Growth Rate of 1.164 (that is normal for Industrial Industry).
Inventory Days of 143 days (high)
Cash Conversion Cycle of 117 days (high)

From KPI examination of Cummins we can see the following;

An operating margin of 0.092 (normal)
A Normal Financial Health, thus Free Cash Flow/ Total Cost is 0.067
And a Net Income Growth Rate of 0.191 (that is normal for Industrial Industry).
Inventory Days of 87 days (normal)
Cash Conversion Cycle of 51 days (normal)
Classifying Inventory

We will learn how to apply the 80/20 rule to classify inventory by an ABC analysis.
 ABC Analysis: A technique first introduce by General Electric to classify inventory items for raw
materials.
 The method classifies items of different importance. Three categories of inventory items of
different importance and strategies – A, B, C, depending on their percentages of
spend/consumption. Then it’ll use different inventory strategy to manage them.

The Key Idea (idea principal)

The key idea behind the ABC analysis is the 80/20 rule. That is, we like to focus on the critical items,
often a small percentage of the total, say 20% that drives the majority of the cost, say 80%.

Classification of Inventory Items

 Class A
 10 – 20 % of items
 60 – 80 % of the cost
 Class B
 20 – 30 % of items
 20 – 30 % of the cost
 Class C
 50 – 70 % of items
 <20 % of the cost
Steps in ABC Analysis

1. Determine the usage (annually, monthly, weekly, etc.. in units) of each item.
2. Multiply the usage by unit cost to get the spend or consumption for each item.
3. Rank the spend or consumption from high to low
4. Calculate the cumulative spend in $ and in %
5. Classify the items into A,B,C classes or types, and draw the Pareto Chart.

Managing Inventory

Managing “A” items

 “A” Items
 You frequently used
 Accounted for the most of your cost / spend
 Most important -> close monitoring and control

 For this purpose:

 You may need to develop a relationship with the supplier
 For example, sign a long-term contract to guarantee a lower price and secured
supply.

 Adjusting demand forecast and inventory policies frequently:

 To incorporate any latest changes in market movement.

 Prioritize them at purchasing deptm. and delivery

 This can be done at purchasing, shipping and receiving dptms.

 Order them frequently

 Due to their large volume, you may order them frequently such as weekly to
achieve a balance between economy of scale in ordering and inventory
carrying cost.

Managing “B” items

 “B” Items
- You occasionally use
- Accounting for a small but not negligible part of your cost / spend
- Less important -> require less attention and control

 Adjust demand forecast and inventory policy less frequently

 Order them less frequently (such as monthly)

Managing “C” items

 “C” Items
- You rarely used
 - Enormus in variety but each is negligible in cost (however, the total
may not be) and thus these items are harder to manage.
- Some of them may be critical at times, but because of their small
volume and rare usage it is not worthy to carrying inventory for them.
- May be important but not worthy of carrying inventory -> delegate to
suppliers or a 3rd party.
- An example can be spare parts that are used just in failure which are
likely rare events.

 The best inventory strategy is perhaps to delegate them to suppliers or 3rd parties
to hold inventory for you and Order as Needed.

Example of management

To summarize:
  The ABC analysis applies the 80-20 rule to classifying inventory according to its spend
or consumption, and thus single out the most important items. 

 It allows the purchasing managers to focus on the critical few, that is A items, instead of
the trivial many, that is the C items, so they can set priority, maximize efficiency, and
maximize saving.

 For different classes or inventory, you should use different strategies and inventory

control policies.

Inventory Management in Practice

- Quantitative approaches: better models and software inventory management (16.2%).

- Reduced lead time (15%).
- Improved forecasting (10.7%).
- More attention to inventory management, e.g., tight management of usage rates, lead
times and safety stock (6.6%).
- Reduction in SKU (5.1%)
- Other companies shift more inventory, or inventory ownership, to trading partners
(suppliers).

The impact of Quantitative Models:

The weekly inventory can be reduce significantly without stock-out by using a forecast model.
A designed model can optimize the inventory levels.