INVENTORY MANAGEMENT Fundamentals Harvard

IES448
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PN-484-E
March 2012
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Fundamentals and Key Concepts of Inventory Management
In this technical note, we will address the analysis and management of stocks1 in an operations
system.2 Stocks are generally considered a “necessary evil” that we try to minimize. We need
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them in order to produce and provide good customer service, but they represent a cost to the
company, as they are tied-up capital that provide no profitability until the stocks are sold (in
many companies they account for up to 90% of the working capital and more than a third of
the current assets). In addition, their operational management (e.g., storage, handling,
transportation, etc.) often represent a significant cost item. Thus:
“The main objective of inventory management is to satisfy customer (or production) needs in
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terms of product availability and response time, while minimizing the total management and
financing costs.”
Most managers are well aware of the importance and challenges of inventory management.
General managers should not be in charge of the details of stock operations – an area that is
the responsibility of their companies’ operations managers. They should, however, have good
business judgment to decide on the cornerstones of the inventory model they want for their
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business, as well as for the level of performance they demand.

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1 We will use the terms “inventories” and “stocks” interchangeably. In this technical note, we focus on the inventory
management of products with an independent demand, i.e., demand for different items is unrelated. For dependent demands (for
example, the assembly of several parts) it is preferable to use material requirements planning (MRP) techniques, an area for
which we refer readers to other technical notes.
2 For the definition and description of the fundamental parameters of an operations system, see the technical note by Philip G. Moscoso,
Alejandro Lago and Marc Sachon, “Fundamental Concepts and Parameters of Operations Management,” PN-458-E, IESE, 2010.
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This technical note was prepared by Professors Alejandro Lago, Philip G. Moscoso and Marc Sachon. March 2012.
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PN-484-E Fundamentals and Key Concepts of Inventory Management
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Understanding the fundamentals and key concepts of inventory management will enable you to:
x Understand the functions of stocks and their costs.
x Understand the variables and factors that primarily determine stock levels and which
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ones to act on in order to improve inventory management. This will reveal how
service can be improved without having to increase stock levels or how stock levels
can be lowered to free up working capital and reduce the risk of obsolescence.
x Assess whether the most suitable inventory logic is being applied, taking into account
the characteristics of the company and its sector.
x Define the relevant indicators for measuring inventory levels and understand the
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associated cost levers.
Finally, from an operational standpoint, inventory management involves deciding how and
when items (whether goods or clients) should flow through an operations system. As we will
discuss in detail later, inventory management cannot be separated from the management of
throughput times and customer service. Furthermore, in practice, the most powerful means of
reducing flow times is often by reducing stock (in progress) levels.
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1. The Traditional View of Stocks: Its Classification and "Accounting"
Measurement
Stocks have traditionally been defined as follows:
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“Stocks are all items that are purchased (or manufactured) by an organization for subsequent
processing (or sale). The items that make up the stocks can be sold in the acquired form (e.g.,
brokering) or following some form of transformation (e.g., assembly), or serve as raw
materials for transformation.”3
A manager’s initial contact with stocks usually occurs from a financial or accounting
viewpoint while analyzing the company’s balance sheet. On this basis, inventories are usually
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classified according to their place in the production process: raw materials, work in progress
and finished goods, plus a fourth category, maintenance, repairs and operations (MRO),
which is often classified as raw material stocks. This type of classification generally arises
from accounting requirements. Note that value is added during the process of transformation
from raw material to work in progress and finished product, therefore it is less expensive to
maintain a stock of raw materials than a stock of finished goods.
To illustrate this concept, we will use the example of a small manufacturer of resins and
conglomerates for do-it-yourself (DIY) and construction (see Example 1a).
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3 However, an organization’s “permanent” resources, such as production equipment and employees, are not considered stocks.
2 IESE Business School-University of Navarra
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Fundamentals and Key Concepts of Inventory Management PN-484-E
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Example 1a. Pegamentos Pegasa. Balance and inventories (in millions of euros)
Pegasa is a manufacturer and national distributor of DIY materials. Its catalog features some 5,000
different items or finished goods, of which 70% are manufactured in-house and 30% are third-party
products. It also supplies over 500 raw material products. In 2011, Pegasa’s sales were €38 million
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(€25 million from products manufactured in-house and €13 million from marketing third-party
products). To understand the impact of the inventory, let us analyze its balance from 2011:
Total assets 32,500 Total liabilities 32,500

Current assets 15,300 Total short-term 10,000
Cash and other current assets 600
Clients 8,700 Suppliers 4,500
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Inventories 6,000 Short-term credits 5,500
Raw material 2,000
Work in progress 100
Finished goods 3,600
Goods for marketing 900
Own production 2,700
Supplies 300
Total fixed assets 17,200 Total capital and long- 22,500
term credits
Land 5,000 Long-term credits 12,000
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Buildings 10,000 Capital 20,500
Furniture 2,200
According to this classification, there are four main types of stock:

1. Raw materials include items that have been acquired from third parties for manufacture but
have not yet been processed. At Pegasa, such stock mainly comprises calcareous sands and
chemical reagents that are blended to make adhesives and packaging materials (tubes, plastic
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jars, lids and boxes).

2. Work in progress4 includes all items that have already undergone some form of transformation
(or are in the process of transformation). In this example, materials (chemical reagents and
containers) are considered to be a “work in progress” once they are included in an issued
manufacturing order. By definition, if a product takes 10 days to manufacture, we will
inevitably have a work-in-progress inventory of at least 10 days. Given that manufacturing
times at Pegasa are comparatively short, the work-in-progress inventory is relatively small.
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3. Finished goods include all items that have already been transformed and are ready to be
delivered to the customer. Pegasa distinguishes between finished goods for distribution (i.e.,
those purchased from third parties for direct distribution) and goods manufactured in-house,
due to the substantially different margins of the two groups. Given the different operational
models, Pegasa’s managers decided to create different indicators.
4. Pegasa’s managers also decided to put the stocks aimed at MRO – essentially machinery parts
and lighting and office materials – into a separate account.
Working capital equals current assets minus current short-term liabilities (i.e., 15.3 - 5.5 = 9.8), which
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emphasizes the importance of inventories for Pegasa.
4 Also known as work in process (WIP).
IESE Business School-University of Navarra 3
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Absolute inventory volumes are often rather uninformative when it comes to quantifying
stock levels. It is more revealing to calculate relative indicators (e.g., to sales) and monitor
their progress over time. The most commonly used metrics are:
(a) The inventory turnover, that is, the number of times inventories are turned in terms of
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sales volume in a year:
Turnover = Annual sales (euros)/Average inventory (euros)5
Or the equivalent inverse measure:
(b) The days of inventory, that is, the number of sale days that can be covered with the
inventory levels available:
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Days of inventory = [Average inventory (euros)/Annual sales (euros)] x 365 days6
Example 1b. Pegamentos Pegasa. Management indicators
Pegasa can determine whether inventory levels have increased or decreased according to the evolution
of sales by calculating the turnover or days of inventory (based on the data from Example 1a). In the
analysis, we separate finished products that are manufactured in-house, from distributed products and
raw materials:
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Inventory turnover Days of inventory
(millions of dollars) (millions of dollars)
Finished goods that are 9.2 times/year 39.4 days

manufactured in-house (= 25/2.7) (= 365 days x 2.7/25)
Finished goods that are distributed 14.4 times/year 25.2 days

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(= 13/0.9) (= 365 days x 0.9/13)
Raw materials 7 times/year 52.1 days

(= 14/2) (= 365 days x 2/14)
Note: to estimate the cost of goods sold (COGS), we have considered a raw materials cost of €14 million for €35 million in sales (a gross
margin of 60%).
In one year, stocks of in-house products turned approximately nine times and directly distributed
products turned 14.4 times, which means that one unit spent an average of 40 and 25 days in stock,
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respectively. Distributed products appear to have a relatively higher turnover (less stock is needed
because the buying and selling process is more agile).
The stock of raw materials was comparatively very high (almost two months of sales of raw materials),
and managers should question why this is.7
5 Consistency should be ensured when valuing the numerator and denominator by cost or sale price. If valued by cost, the
numerator should include the cost of goods sold (COGS); if valued by sale price, the net sales price should be used. For finished
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goods, the monetary value of sales is used to calculate the turnover; for raw materials, it is preferable to consider the costs
incurred over the course of a year, excluding production costs.
6 Ideally, the average annual inventory should be used. If the balance value does not reflect this average (if, for example, the
company’s inventories are more or less unstable over the course of a year), an average should be calculated.
7 For a company as a whole, the period between paying for raw materials and charging for the finished product is known as the
“cash conversion cycle” (CCC). The CCC (= inventory days + receivable days - payable days) is an indicator that reflects a
company’s inventory management model and its comparative excellence in its implementation. In some sectors, such as food
retailing, this value can even be negative (when customers pay before suppliers are paid).
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2. The “Operational” View of Stocks: Functions, Needs and Costs
The accounting classification is useful for identifying ways in which stocks can be stored and
tracked, but it reveals little about their true function in the operational process. If the aim is
to minimize stock levels, it is worth asking the following questions: Why do we need stocks?
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How much stock do we need and where? Finally, what is the cost of stocks compared to their
operational benefits? We will now address each of these questions briefly.
The “Operational” Functions of Stocks: Why Do We Need Them?

Stocks are needed for the following operational reasons:
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1. To produce, i.e., to maintain a certain production rate (the so-called “work-in-progress
stock” that is closely related to the work-in-progress product volume in a balance
sheet). This stock level depends on the characteristics of the process and the desired
production rate. 8 When determining the size of the work-in-progress stock, certain
“inventory buffers” need to be defined to decouple activities and ensure targeted work
speed at each station. This is the case when resources have different work speeds on
the same production line or when there is a great deal of variability in production
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speeds.
2. To accommodate or advance production during seasonal production demands or

capabilities (anticipation or seasonal stocks). In some industries with highly seasonal
demand patterns (e.g., toys or Christmas candies), it is advisable to produce more
continuously and advance part of the production to accumulate stocks of finished goods
and later sell them during peak demand periods. For similar reasons, it is also advisable
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to stockpile raw materials and then use them more continuously (e.g., the harvesting of
seasonal fruits).
3. To reduce production or transportation costs (batch or cycle stocks). Even if demand is

stable and continued in time, it may be worth purchasing, producing or serving in
batches due to the benefits of economies of scale. For example, suppliers can offer
discounts if a certain quantity of goods are purchased, or a full truckload of goods
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may be ordered to save costs. Similarly, during product manufacture it may be more
profitable to produce in batches because it takes time to prepare machines for changes
in product type.9 By working with batches, stock is consumed as demands are made
and, when more stock is needed, a new order or batch is released.
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8 The production rate is the amount of items that are processed per time unit in an operations system. The longer the production
process and the higher the production rate, the more work-in-progress stock is required. This relationship is reflected in Little’s
law. See the technical note by Philip G. Moscoso, Alejandro Lago and Marc Sachon, “Fundamental Concepts and Parameters of
Operations Management,” PN-458-E, IESE, 2010.
9 For the impact of batches on a resource’s capacity, see the technical note by Alejandro Lago, Philip G. Moscoso and Marc
Sachon “Capacity Management in Operations Systems,” PN-464-E, IESE, 2010, which focuses on capacity calculations.
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4. To provide customer service while solving uncertainty in demand and supply (safety
stock).10 The most important function with which stocks are often associated is their
role as a “buffer” that absorbs variability in demand or supply. Production and supply
times are often much longer than customers’ willingness to wait. In addition, due to
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uncertainty in demand, these stocks should be sized to accommodate possible
variations and ensure the availability of a product. These stocks usually represent the
main part of many companies’ stock of finished goods. At Pegasa, for example, most
stocks of finished goods are safety stocks, i.e., they are aimed at accommodating the
demand that may arise over time.
5. Finally, there may be reasons that are speculative or legal, rather than strictly
operational, for a company to decide to maintain stock. For example – in cases of raw
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materials trading – stocks are held to speculate against price changes, or changes
demanded by regulators in the case of critical supplies (e.g., natural gas).
Stocks and Processing (Order) Times: Make to Stock or Make to Order?

Stocks and throughput times are intimately linked. In fact, they are two sides of the same coin.
For example, when a company like Pegasa decides to buy raw materials in large batches (say,
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the equivalent of one month’s production), it is implicitly deciding to stock raw materials from
zero to up to 30 days before use; or, when a 15-day safety stock is set to guarantee service, the
company is deciding that its finished goods stock will spend an average of 15 days in storage
before being sold. Other times, products are accumulated due to production variations, which
create work-in-progress stocks that are not necessarily desired and increase throughput times.
Consequently, the manner in which we manage the flow of items in the system creates stocks
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(which can be classified as described above) and associated processing and waiting times.11 The
stock-time dichotomy leads us to the first fundamental conclusion:
“Decisions regarding stocks will always have an impact on the production system’s
throughput time structure, i.e., on production and delivery lead times. Similarly, a decrease in
stocks will reduce throughput times.”
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Thus, decisions about where and how to keep stocks must be linked above all to how we wish
to compete as a company in terms of service and processing times; and, if we want to reduce
our processing time, we can work on decreasing our stock levels. In particular, it is essential
to decide whether to make to stock or make to order.
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10 One definition of “safety stock” is the average amount of stock that is in storage when a new batch order is received.
11 A buildup of items is often called a “queue,” and it is considered the expression of a certain type of stock.
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Make to order. Imagine that a client gives us a lead time for product delivery that is long
enough to accommodate provisioning, manufacturing and delivery. In this case, we could
make to order, i.e., start producing once the delivery dates and quantity of the order are
confirmed. 12 However, there would still be stock in progress, and even stocks in batches
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(depending on the purchasing policy, customer orders can be aggregated and supplied in
batches, resulting in longer delivery times), but we would not need any additional safety
stock of raw materials or finished goods since there would be no demand uncertainty. In this
case, we replace stocks with waiting of the customer. Our decisions on lot sizes and work in
progress will depend on how long we can make our customers wait (or how long they are
willing to wait).
Make to stock. Evidently, there is a second scenario in which the customer wants a product
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immediately. In this case, stocks of finished goods are needed to ensure a certain level of
service to customers. Make to stock involves manufacturing to replenish stocks according to
the demand forecast and defining a production plan (store replenishment) based on total
throughput times. Our safety stock decisions will thus depend on service levels, and our
decisions on purchase batches and work in progress will condition the forecast period (if it
takes two weeks to supply an order, including the purchase batches and times, demand must
be predicted at least two weeks in advance).
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In practice, the two models always need to be combined by making to order according to the
customer’s lead time, and by making to stock the goods that precede it on the value chain.
Pegasa’s customers, for instance, negotiate different delivery lead times, which may range
from one or two days (when made to stock) to 15 or more (when made to order). But even in
the latter case, a stock of raw materials (e.g., aggregates) is required because, although there
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is enough time to manufacture the products (10 days are needed), there is not enough time to
acquire the raw materials. In this case, raw materials represent the stock decoupling point.
This brings us to another fundamental conclusion regarding inventory management:
“The decision to have more or less stock of one kind or another is based on how we decide to
compete, taking into account the amount of time customers give us to deliver the product
(their willingness to wait) compared to what it takes to produce goods cost-effectively. In
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turn, our manufacturing times will depend on our stock level decisions (work in progress and
production batches, purchase and transportation).”
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12 This production logic is known as a pull because it is not released until the customer “pulls” the production. Most service
companies work like this because they cannot produce in advance (for example, a hairdresser’s).
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Costs Associated With Inventories
The costs associated with stocks should be classified and managed according to their nature.
Since stocks represent a major cost (and an asset), optimization relies on the analysis of stock
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returns. Too much stock has a high impact on the balance and hence on the income
statement; having too little can lead to a loss in sales or a rise in production costs due to low
efficiency. Some costs are easily quantifiable and can be included in decisions to determine
appropriate inventory levels using mathematical models (see Sections 3 and 4). However,
other costs are harder to measure and quantify, but are no less relevant.
The main types of cost are:
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Purchase cost: incurred to acquire the required items. In principle, the cost increases with the
amount purchased. However, this increase is not always linear because suppliers offer
volume discounts above certain amounts.13
Cost of placing an order (administration or release) and transportation: resulting from the
release of a purchase order, including transportation (but not from the product itself). It also
includes the costs generated by a production order (costs of changing machines). Although
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these costs are not directly attributable to the existence of stock, they do have a bearing on
decisions regarding purchase or production batches and therefore on decisions regarding
stock. Generally, these costs are based on economies of scale (the cost per order is relatively
unaffected by the size of the order), which encourages customers to place larger orders but
less frequently.
Inventory maintenance (or possession) costs: the sum of the variable costs of possessing
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inventory. A distinction should be made between:
x Logistics costs and costs arising from the physical maintenance of stocks:
warehouse rent, insurance, labor associated with warehouse handling, etc. They should
also include shrinkage costs (theft, loss, etc.).
x Financial costs: the opportunity cost of having capital invested in stock (this value
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depends on each company). But it can also include the cost of product obsolescence, which
reflects an item’s loss in value over time. In industries in which goods have a very short
shelf life (fashion or electronics), obsolescence far outweighs any other financial cost.
Stock maintenance costs increase in line with inventory levels (often linearly) and, because
these costs are often higher than other stock costs, they are clearly an incentive for
inventories to be small.
Cost of breakage: caused by the shortage of a product when needed. In the context of finished
products, these costs refer to the value of lost sales due to stockouts; in the context of raw
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materials, they refer to impact on production (delays, machine downtime, production

adjustments, etc.). It is difficult for many companies to quantify their impact (customers fail to
report their inability to buy due to stockouts, certain products are replaced with others, etc.).
13 With regard to inventory management, the supplier’s payment deadline does not affect decisions on order size unless the
supplier’s financing causes a decrease in the company’s average capital financing cost.
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Cost associated with a lack of quality or flexibility: this cost is often overlooked because it
is not easy to quantify or identify. It refers to stocks that are included in a system because
they facilitate operations but that may be concealing problems related to quality and lack of
flexibility. Let us consider the example of a machine that breaks down often. If there is a
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great deal of work in progress between this machine and the next one, the second one will
not be affected by repeated stops because they will be decoupled with the stock. This type of
stock not only leads to an increase in costs and lead times but it also may hide the root of
the problem. Lean management approaches analyze work in progress from this operational
improvement perspective.
The Main Methods of Inventory Control
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To compute stock costs, it is necessary to know first how much stock the company holds.
Generally speaking, four main dimensions should be considered: the type of product;14 the
production phase or added value; the physical location; and the time dimension of the
information (for example, real time vs. annual count). The inventory can then be measured in
terms of physical units or economic value. In the first case, the measurement unit and
conversion between formats should be considered if necessary (e.g., liters, bottles, boxes,
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etc.). In the second case, the inventory valuation reference (purchase or production cost, sales
price, contribution margin, other accounting valuations, etc.) should be specified.
Not all of the items produced or sold by a company are considered to be equally important
for the business. The ABC inventory classification enables companies to optimize allocation
of their management resources (be it management attention or investments in information
systems). This analysis primarily classifies inventory items according to a company’s most
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relevant management dimensions (Pareto principle). For example, a very common

classification is to consider 20% of the highest selling goods as group A products (in many
sectors, this group accounts for 70% to 80% of sales); the following 30% of highest selling
goods as group B products; and the remaining 50% of goods (which often represent only
10% of sales) as group C products. Logically, this classification will have implications in
terms of product tracking15, management models and even relationships with suppliers. In
general, more efforts should be exerted on the management of group A stocks because their
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economic impact (and customer impact) will be much higher than those in groups B or C.
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14 The classification of goods should not be limited to a sales point of view. The term stock keeping unit (SKU) indicates that the
criterion for assigning a different reference derives from the need to keep one’s own inventory record.
15 New advances such as radio frequency identification (RFID, in which electronic devices are attached to the product or
packaging) enable real-time tracking by radio frequencies but have relevant costs associated.
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3. Stock Management: Main Decisions
The level of professionalism and sophistication in stock management varies widely between
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companies: some follow very basic rules, such as maintaining an average stock equal to 15
days of demand, while others implement inventory management systems that are based on
elaborate algorithms. In the academic field, meanwhile, scores of complex theoretical models
applied to particular industrial situations have been developed in recent decades. Considering
the broad range of models that exist, our general philosophy is that, with the exception of
special cases (e.g. highly valuable products with complex but predictable demands), stock
management should be based primarily on robust decisions and rules that provide stability to
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stock policies and are intelligible to management. From there on companies should try to
gradually optimize stock levels.
Managers need to understand the determinants and impact of their decisions and, by
extension, the key rules to be established in order to implement a good inventory
management. The problem is not so much about implementing simple rules such as “15 days
of inventory” but about understanding whether these rules apply to all products, rather than
simply extrapolating satisfying experiences with certain products. Similarly, it is about
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understanding the improvement potential of implementing more elaborate policies.
To facilitate understanding, we will begin by considering the simple case of a single finished
product. From there, we will discuss the challenges that companies face in practice and see
how models fit according to product types.16
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Two Key Decisions: Batch Size and Safety Stock Level

Let us take one of Pegasa’s finished goods (purchased from suppliers); for example, drill bit
sets. The inventory management of these sets can be summarized with two fundamental
questions:17
1. How many sets should I order at a time? To determine the annual amount required,
this will logically be related to the number of orders that must be placed in one year.
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2. When exactly should I place the order? Or, equivalently, what safety stock “buffer”
should I have when I place the order?
In theory, the first question involves deciding on the batch size (cycle stock). It is a decision
based mainly on economic issues and related to the economies of scale of certain production
processes. An “equilibrium” needs to be found between increasing the batch quantity to take
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16 The management of work-in-progress stock levels and anticipated seasonal stocks has already been addressed in other
technical notes that focus on flow management in the production process.
17 For practical reasons, we will analyze the issues involved in separating the two questions into the “How” (e.g., cycle stock)
and the “When” (e.g., safety stock). Although these dimensions are logically interrelated, as we will see in the summary,
analyzing them at once increases the complexity and rarely provides significant economic advantages.
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advantage of discounts and save transportation costs, and reducing it to finance and manage
less stock. Other factors such as production flexibility18 should also be considered.
The second question requires deciding on the reorder point, i.e., the amount of stock that is
available (e.g., 100 bit sets), below which an order will be placed. In simple terms, the reorder
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point is the amount of stock needed to meet demand during the time it takes for the order to
reach us, plus some safety stock to hedge against uncertainty during this time. For example,
if the supplier takes four days to restock us and every day the average demand is for 10 sets,
a new order will be placed when the stock falls to 40 sets, or perhaps to 50 sets, in order to
keep an additional 10 sets in case the demand during this time is greater or the supplier is
delayed. In this example, safety stock will be made up of 10 sets, some of which will have
been used by the time the order arrives, although this is not always the case.
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Stock management based on these two decisions can be represented graphically as shown
in Figure 1, which illustrates a product’s stock evolution over time (assuming demand is
stable and there is time for replenishment). Note that we distinguish between stock on hand
(the sum of the safety stock plus the cycle stock), in brown, and the stock position (the
stock on hand plus all the orders in transit). So every time the reorder point is reached, a
Q-size order (batch) is released and the inventory position rises to reflect the order in
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transit. When the order arrives following the replenishment lead time (LT), the order
becomes inventory on hand.
Figure 1
Cycle and safety stock
Replenishment time
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Inventory position
(on hand + in
transit) at t*
Stock in transit at t*
Batch
(Q)
Reorder
Stock on
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point hand at t*
Order Safety
cycle stock
t* Time (days)
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18 As mentioned above, reducing the size of the order (or batch) is one of the main measures proposed by lean management to
improve the agility of an operations system. In some cases, companies may choose to reduce the size below that suggested by
inventory models because they prioritize operational flexibility over maintenance or order costs.
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The Batch Size: A Decision Regarding Economies of Scale
The decision regarding the purchase (or production) batch is based on the assumption that
there are reasonably long periods during which product demand is more or less stable, so
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orders are placed regularly. A manager may then wish to purchase the same amount each
time (purchase batch), with a similar time lapse between orders (for example, if 60 sets are
ordered at a time, and the average demand is one set per day, an order would need to be
made every 60 days, or around six times per year on average). Similarly, a manager may
decide to always buy at a fixed rate (purchase cycle), for example, every two months, and
to order what is needed to reach an inventory of at least 60 sets. If demand suddenly
changes during a later period, the analysis should be redone and the batch should be
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changed.
As we have already mentioned, choosing the right batch size involves balancing the
logistical and financial costs that arise during the period under consideration (which is the
period for which different batch sizes are compared; for instance, one year if demand is
reasonably stable).
On the one hand, due to the effect of economies of scale, the costs related to a product’s
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manufacture and transportation often decrease as the batch size increases, although not
necessarily linearly. In particular:
x Suppliers frequently offer volume discounts, and preparation times (and costs)
decrease when a larger batch is manufactured in-house.
x Similarly, given that they are not usually affected by the size of the order, the
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administrative costs of orders decrease because fewer orders result in lower costs.
x The transportation cost is also reduced because the unit transportation cost also
decreases with fewer but larger shipments.
On the other hand, the costs related to stock maintenance and financing increase in line with
the size of the batches, given that the average stock to maintain and finance also increases.
These costs generally include:
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x The cost of physical storage space.
x The handling and warehouse maintenance costs, which also tend to increase with
larger shipments as larger batches are generally more difficult to handle (although this
may vary depending on the handling methods).
x The financial cost of maintaining stocks, as on average they will be larger.
An optimal batch quantity can be calculated that represents a compromise between

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increasing and diminishing costs. The mathematical calculation can be done in two ways: (1)
by using formulas that directly provide a figure, but may involve assumptions that are not
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necessarily fulfilled in our specific case; (2) by analyzing several batch sizes until an optimal
or reasonable size is reached.19
Example 2a shows the typical estimate of the total cost (logistical and financial) for different
batch sizes. Depending on the type of product and operations of a company, one can
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introduce as much detail in these calculations as desired to allocate each of the costs.
However, generally speaking, an approximate analysis that assumes a stable demand is
usually sufficient for several reasons. First, the size range of reasonably “optimal” batches is
usually quite stable and robust against sudden changes in demand. Second, an “optimal”
batch is barely sensitive to small deviations in the assumptions for calculating the unit costs
of ordering and shipping. Third, it is difficult to include certain hidden costs or advantages in
the numerical analysis (for example, the flexibility that comes with working with smaller
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batches, or the complexity that is introduced by considering impractical batches). It is
therefore advisable to use cost analysis as the first approach to define reasonable batch
ranges and, within these ranges, to choose units that are practical in terms of operations and
tend to be on the low side. The analysis should only be more fine-tuned when demand for
products is rapidly changing, or when logistical costs represent a very high percentage of the
product value.
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Example 2a. Achieving the economical batch
Let us imagine that Pegasa uses historical records to estimate an average daily demand of 10 bit sets
per day (assuming that the year has 300 days). Furthermore, the following unit costs are known:
x The purchase cost is €15 per set, with a 10% discount for orders of more than 200
sets.
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x Managing each order costs €5 (based on 20 minutes being the time devoted) and the
administrative assistant’s standard cost per hour is €15.
x The carrier charges €2 per set, but for more than 1,000 sets the price drops to €1.75
(because a full truck can be sent for €1,750).
x The storage space (rent) and stock handling costs are equivalent to €10 per year for
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one palette, or approximately €0.50 per set stored per year (based on 50 sets per
pallet).
x The financing cost (interest) is 20% per year.

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19 For very simplified cases, rather than calculating the costs for different sizes, a direct formula for the economic order quantity
(EOQ) can be applied. The problem is that the formula’s assumptions never apply in practice and it is believed that, rather than
calculating an optimal number, the cost levers and sensitivity to them should be considered (for example, if EOQ = 921.3 sets,
then surely it would be preferable to order 1,000 sets). Spreadsheets can be used to calculate variations and generate a graphical
representation of the analysis.
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Assuming that demand conditions are stable for a period of one year, the yearly costs for batches of
100 to 1,000 sets can be calculated as follows using a spreadsheet:
If we order a batch of 100 sets If we order a batch of 1,000 sets
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Purchase cost: Purchase cost:
• The purchase cost per batch is €1,500 (100 sets at • The purchase cost per batch is €13,500 (1,000 sets at
€15/set). €13.50/set, with a 10% discount).
• 30 orders must be made per year (annual demand is for • Three orders must be made per year (annual demand
3,000 sets [300 days at 10 sets/day], which is equivalent is for 3,000 sets [300 days at 10 sets/day], which is
to 30 orders of 100 sets). equivalent to three orders of 1,000 sets).
• Thus, the purchase cost amounts to €45,000 • Thus, the purchase cost amounts to €40,500
(30 orders at €1,500). (three orders at €13,500).
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Order and transportation costs: Order and transportation costs:
• The cost per order is €205 (100 sets at • The cost per order is €1,755 (€1,750 for a full truck,
€2/set, plus €5 for managing the order). plus €5 for managing the order).
• 30 orders must be placed per year. • Three orders must be placed per year.
• The annual order and transportation costs are €6,150. • The annual cost is €5,265.
Storage and handling costs: Storage and handling costs:

• The annual cost per set is €0.50. • The annual cost per set is €0.50.
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• A maximum annual space is required for 100 sets. • A maximum annual space is required for 1,000 sets.
• The annual cost is €50 (100 sets at €0.50). • The cost is €500 (1,000 sets at €0.50).
Financial cost: Financial cost:

• The average inventory during the year is 50 sets • The average inventory during the year is 500 sets
(half of the batch). (half of the batch).
• The average inventory value is €750 • The average inventory has a value of €7,500
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(or 50 sets at €15/set). (or 50 sets at €15/set).

• The annual cost is €150 • The annual cost is €1,500 (€750 stock value at 20%
(€750 stock value at 20% per year). per year).
The total annual cost is €51,350 (€45,000 purchase cost The total annual cost is €47,765 (€40,500 purchase
and €6,350 logistics cost). cost and €7,265 logistics cost).
The same calculations can be done for different batch sizes. Taking into account these two sizes (100
or 1,000 sets), the distributor will probably prefer to order a full truckload of goods given that the
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transportation savings and discounts clearly outweigh the higher financing and storage costs. Other
factors that have not been explicitly reflected in the above cost analysis should also be considered. For
example, the distributor may conclude that, although more expensive, a batch of 200 sets is preferable
in terms of flexibility (placing three orders for 1,000 sets per year is much less flexible than placing
one order every 20 days, just in case demands change).
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The Safety Stock and Reorder Point: A Decision to Ensure Service Levels
As we have already suggested, the decision regarding the reorder point (when should an order
be released?) should be based on how much stock is needed to ensure that goods do not
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completely run out before the next order is delivered. Let us imagine that the daily demand is
constant, fixed and known (rather than uncertain) and that the quantities and delivery lead
times are known and reliable. In this case, an order would be placed so it is delivered just in
time to avoid any stockout. But since this is seldom the case in practice, a “buffer” of
additional stock known as “safety stock” is usually kept to absorb these deviations in demand
(or dates) without stocking out. Whereas the average behavior was considered in the batch
decision, when considering the safety stock it is necessary to keep in mind that demand is
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random (uncertain). Example 2b illustrates how the reorder point and safety stock are
conceptually related.
Example 2b. The reorder point and safety stock
Let us imagine that Pegasa has estimated that its best purchase batch is 200 sets (an order is placed
approximately once every 20 days or once a month) and that the supplier takes five days to deliver the
order. Two situations can be envisaged:
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1. Without variability. If unaware of the variability in demand, the distributor will ideally place
an order every time the stock is equal to the demand of five days, that is, when there is
sufficient stock to withstand the five days it takes to deliver the order. In other words, the
reorder point will equal the average demand during the replenishment lead time (50 sets =
5 days x 10 sets/day of demand) or, if preferred:
Reorder point (ROP) =
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= Average daily demand x Replenishment lead time =

= 10 sets/day x 5 days = 50 sets
2. With variability. We know from the historical data that demand is variable on each of these
five days and can range from less than 10 sets a day to peaks of 100 sets.
In this case, a distributor who wants to be covered for the worst case scenario will place an
order (set the reorder point) when the stock is equivalent to 100 sets. This will provide an
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additional safety stock of 50 sets. If preferred:

ROP = Average daily demand x Replenishment lead time + Safety stock =
= 10 sets/day x 5 days + 50 extra sets of safety stock = 100 sets
With this decision, the distributor hopes to be fully covered. The schematic representation in
Figure 2 shows that demand varies, so there may be more or less safety stock when the order is
delivered. However, this safety stock is precisely what prevents stockout. A similar logic can be
applied if we know that the supplier sometimes takes up to six days to deliver the order, which
means that the time (and demand) covered must be greater. The decision regarding safety stock
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will require a compromise between the cost of additional stock and the cost of stockout.
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Figure 2
Safety stock and reorder point (logic)
Stock
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Reorder
point
Average
demand (LT)
Historical demand data

during lead time
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Safety (deviation histogram)
stock
Replenishment time
(or lead time)
Three key variables are required to determine the safety stock:
x The period of vulnerability to demand, which is usually directly associated with the
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supplier’s replenishment lead time. This means that the longer the replenishment lead
time, the greater the amount of safety stock required. However, the “actual
replenishment period” may be longer for several reasons, such as due to the frequency
with which the stock level is reviewed. According to this information, we must decide
whether or not to place an order (for example, if we review the stock every 15 days,
the period of vulnerability will be the 15 days of review plus the replenishment lead
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time). Time is also added due to order consolidation times (of loading trucks, for
example). The reliability of the replenishment lead times and order review times
should also be considered, as their variability will increase the need for safety stock.
x The demand distribution during the period of vulnerability. We generally want to have
an idea of the possible demand distribution during periods of time similar to that of the
vulnerable phase. This information can be obtained using the historical data or forecasts
from the commercial team. Logically, the greater the variability or uncertainty of the
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forecasts (rather than the volume), the greater the safety stock needed to provide a
specific service. Likewise, variability can be offset, so two days of demand does not
necessarily have double the variability of one day.20
x The level of coverage or service during demand deviations. What percentage of cases
of extreme demand do we want to cover? If there is no safety stock, logically demand
can be met in half of the cases (when the demand is equal to or less than the average),
but a stockout will occur in the other half. Without safety stock, service will be at
only 50%. Furthermore, in order to meet 100% of the demand, we can intuitively see
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that the stock needed will tend to infinity (assuming normal demand distributions, see
Figure 3).
20 In this technical note we are only going to consider the probability of stockout and not the number of units short, for which
there are other analysis techniques. See the technical note by Álex Grasas and Jaume Ribera, “Inventory Management – Safety
Stock,” PN-428, IESE, 2003.
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The analysis of the relationship between these three variables and the safety stock can be
represented as follows:
Safety stock = Degree of desired coverage x Standard deviation of demand (or forecast)
during the vulnerability period (VP):
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SS = z V VP
Where the degree of required coverage is a function of the service level, whose behavior is
shown in Figure 3. As we approach very high service levels (99%), it is clear that the
necessary safety stock becomes prohibitive.
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Figure 3
Service level and safety stock
Safety stock
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Service level
50% 100%
Therefore, it is key for managers is to understand that their stock and service levels are
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mainly determined by their decisions (cost vs. service) and procedures (demand forecasting,
supplier delivery times, etc.). The main decision for adjusting safety stock levels involves
defining the level of service (or coverage) that the company wants to offer its customers in
exchange for the costs associated with maintaining the safety stock. That is, the larger the
safety stock, the lower the risk of stockout but the higher the maintenance and financing
costs (in fact, safety stock is equivalent to paying “insurance” against unforeseen events that
result in high demands).
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There are many analytical models for optimizing safety stock based on the assumptions made
regarding demand. In practice, however, the decision regarding the appropriate levels of
safety stock is not as direct. While the cost of maintaining stock can usually be estimated
directly, the cost of stockout can be difficult to assess. In the best case scenario, the impact of
a stockout will only bring about a loss in the gross margin due to lost sales, but it can also
lead to the loss of a customer or bring the production line to a standstill due to lack of
supply.21 Thus, there are different philosophies for defining the safety stock levels required
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for cases in which it is difficult to determine stockout costs.
21 In some cases, a stockout is equivalent to a lost sale (for example, in a bakery) when a customer does not postpone a
purchase and even decides not to buy any other products; in other cases the sale is not lost, but simply transferred or postponed;
and in others still, the sale is delayed but only after a discount is applied (for example, fashion sales).
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x According to the service level mandated by the industry or context: for example, the
aim with fast moving consumer products is to secure the supply of products on
shelves by applying a minimum service level (e.g., 95%).
x According to experience: the same philosophy for safety stock is applied to all
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products in a company because the company is known to work well in that range (for
example, “three weeks of demand”).
x Cost minimization: an attempt is made to minimize the costs of stockout, maintenance

and in many cases transportation in order to reach the optimal stock levels.
One particular policy may be more suitable than others depending on the strategic
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environment (e.g., growth or maturity of a certain industry or product). But an incremental
increase in service levels means that more safety stock is required, as shown in Figure 3. In
other words, an increase in service from 90% to 91% has a higher incremental cost than an
increase from 50% to 51%.
The Stock Position as the Key Management Number

The other key aspect of a stock policy is to control a product’s inventory position, i.e., the
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total available stock (and not just the stock stored). The inventory position can be defined as:
Inventory position = Stock on hand + Stock in transit (orders released but not delivered) -
Back orders
Thus, the inventory position is the number that should be compared with the reorder point to
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determine when to place an order. It is a common mistake to focus decisions solely on the
stock that is available in storage, as this usually leads to unnecessary repeat orders. This
problem is worsened in cases of long delivery lead times, which usually cause orders to
overlap; i.e., the average interval between several orders is lower than the delivery lead time,
so there are always multiple orders in transit, which must be taken into account when
quantifying the stock position.
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4. Inventory Management Policies and Methods

As we saw in the previous section, an inventory management model should state for each
product item: (1) the size (batch) of the order; (2) the safety stock level; and (3) when an
order should be released. In practice, these decisions can be structured in different types of
stock policies. The discussion that follows is somewhat specialized. We advise readers who
are not interested in further details to skip to Section 5.
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Stock Policies and Product Types
In general, stock policies depend largely on the type of products to be managed. In terms of
inventory management, the following two key dimensions of a product should be considered:
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x Product life cycle: stocks of products with a long life cycle that are not sold in one
replenishment cycle (e.g., one season) can be sold in the next period. By contrast,
products with a short life cycle (e.g., fashion products and electronics) usually have a
higher obsolescence cost and thus an increased risk.
x Value (or volume) of the product: inventory management requires that monitoring
costs (e.g., SI costs, records and stocktaking costs, order costs, etc.) be compared with
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the savings that can be achieved with a more efficient management. The higher the
value or volume (product A in an ABC model), the greater the savings due to
improved stock management, so efforts will be compensated.22
Based on these two dimensions, certain fundamental inventory management models (see
Table 1) can be identified that represent a specific management logic.
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Table 1
Classification of the Main Stock Management Models
A. Short life cycle B. Long life cycle
Value Any High value Low value

Type of Fixed release Continuous review Periodic review
review (Variable period) (Fixed period)
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Models Critical fractile I. Reorder point with fixed batch I. Periodic review and point of
(“newsvendor”) model (s, Q) reference
II. Reorder point with reference II. Periodic review with reorder and
inventory point (s, S) reference point
Examples Fashion, books, toys, etc. Consumer electronics, jewelry, etc. Office supplies, chemicals, etc.
Long Life Cycle With Continuous Review Policies

The continuous review system is the most intuitive (in fact, it was the one we implicitly used
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in the previous sections). It follows the inventory position of each individual product
continuously over time. Once the stock position falls below the reorder point, another order
is released. The reorder point is defined according to the inventory position (and therefore the
safety stock), as defined in Section 3.
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22 In practice, companies such as large retail stores may have more than 50,000 different products, so this review may be
relevant.
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In general, continuous review policies are preferable with high value or high volume products.
For high value products, the impact of financing costs is usually high, and because this
system is highly reactive and robust, it enables safety stocks to be significantly reduced.
Likewise, although it has high tracking costs, with high volume products this system will
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further consolidate optimal batch quantities and thus compensate for tracking costs.
We can differentiate between two main variants according to the size of the order (see Figure 4):
x Reorder point system and fixed order batch (s, Q): a reorder point s is defined
and, when the point is reached, a fixed batch Q* (usually the most economical
batch) is released. This system is very simple and robust, and it provides suppliers
with predictable batches, thus optimizing production and transport. This is of
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particular interest when transport units are rigid (for example, when a tanker
always carries a single product).
x Reorder point and maximum reference point system (s, S): an order is released
when the established reorder point s is reached. The order is the size needed to
achieve a desired level of stock (fixed).23 That is, a size (S – s) order is released that
takes the stock position from its current level (s) to the desired stock level (S), so
the ordered batches will be variable. This variant is often used when the possible
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orders or transport units are not overly restrictive, but the cost of financing or the
space available are (for example, full truckloads are not required but there is
limited space in the warehouse).
Figure 4
Continuous review system with a fixed order
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Continuous stock review Continuous stock review

system (s, Q) system (s, S)
The order batch
Q order may change
batch is slightly
always the Maximum
same stock level S
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Reorder Delivery Delivery

Time
Reorder
Point s time
point s
The order
cycle may
Q order is vary Q order is
released released
Order Cycle 1 Order Cycle 2 Order Cycle 1 Order Cycle 2
Time Time
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23 The definition of this level (point S) is a function of the optimal batch quantity, but it is analytically more complex and is
not part of this technical note. Due to the possible range of S, this management system is also known as “minimax.”
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Long Life Cycle With Periodic Review Policies
In a periodic review system, an order is released every fixed time period. Specifically, a fixed
order cycle and day is established (for example, every fifteen days or the first Monday of
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every month). Unlike what occurs with continuous review systems, here the period is fixed
and an attempt is made to ensure that the levels of available safety stock are always
sufficient at the beginning of each cycle. More safety stocks are required because the safety
stocks should cover not only the supplier’s delivery time but also the review period.24
The periodic review is especially suitable for low value or low volume products. For this type
of product (e.g., office equipment), the management, production and transportation costs
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tend to be higher than the inventory costs, so a common cycle should be defined for all
products in order to consolidate the quantities of several products in a single shipment or
batch (or a fixed product rotation sequence in the manufacturing line should be defined for a
production cycle). Moreover, management costs are lowered by consolidating orders and
avoiding differentiated stock tracking, so a very advanced computer system is not required.
These aspects often offset the higher levels of stock required. Again, we can differentiate
between two main management systems (see Figure 5):
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x Periodic review and point of reference system for each product. Here, the review
period is defined globally for all products (e.g., once a week). Generally, an aggregate
economic batch is calculated for all products, according to the period of time needed
to consolidate a mixed truckload (with units of all products), and orders are completed
with other products in order to fill the transport vehicle. Depending on the fixed
period, the desired stock position for each product is defined to ensure coverage
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during the review period plus the replenishment lead time. In other words, the target
level of stock derives from the sum of the estimated demand for the total period of
vulnerability (review time plus delivery lead time) and the desired safety stock.
x Periodic review system with reorder point and reference point. This system is
similar to the previous one, except that the stock position is checked every R period. If
it is at the reorder point or below, an order is released to make the stock position
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equal to its reference point S. This hybrid system tries to combine the advantages of
the periodic review and the continuous review systems. However, defining the values
(number of periods and points of order and reference) is not a simple task and is not
within the pedagogical objectives of this technical note.
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24 If we place an order every Monday, we must ensure (taking into account the stock in transit) that we can cover contingencies
in demand until the following Monday, plus the time it takes for the supplier to deliver the order from that Monday.
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Figure 5
Periodic review systems
Sistema de Revisión
Periodic Periódica
review system (R, (R,
S) S) Sistema de Revisión
Periodic Periódica
review system (R, (R, s, S)
s, S)
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Posición
Stock Posición de
Stock
dePosition
Stock ii Ciclocycle
Order de pedido R siempre
R is always theessame
el mismo Stock ii
Position Ciclo de
Order pedido
cycle R isRalways
siemprethe
es el mismo
same
S
S S
S
El lote
The order
de
batch AnNO se is
order lanza
NOT
pedido
may un pedido:i >i >
released: s
change
puede s
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from
cambiar
order to
de
order
pedido a
pedido ss
Se order
An lanzaisun
pedido (S
released (S–– i)
i)
Se order
An lanzaisun
pedido (S
released (S–– i)
i)
Tiempo
Time Tiempo
Time
Critical Fractile Policies for Short Life Cycle Products

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For products with short life cycles and long replenishment times (e.g., fashion items, toys,
magazines, promotional runs, etc.), a “single shot” inventory policy is often applied, i.e., a
single initial order is placed for each product because normally there is no time for
replenishments.
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To assimilate previous variables, the policy in this case is to decide on the size of the batch
and the safety stock simultaneously in order to define the total stock level (batch plus safety
stock) that is available for sale at the beginning of the season or period.
Two aspects should be taken into account when defining the desired order:
x If the order exceeds the demand, excess stock must either be sold at a discount or it
will be lost (for example, the previous day’s newspaper). Thus, there will be an
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overstock cost for each unsold unit (we call it Cs) that consists of the discount applied
to sell the product or the total loss of its value.
x If the order is lower than the demand, a stockout will occur and sales will be
unrecoverably lost given the product’s life cycle (we call this cost Cr , and it is
equivalent to the lost margin).
The challenge is to find an order batch that generates a balance between the two costs.
Analytical methods such as the critical fractile models, also known as “newsvendor” models,25
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are commonly used to decide on the optimal order for short-cycle cases. The basic idea behind
these models is to find the reorder point that balances the expected costs of overstock and
stockout. Logically, the greater the lost sale margin compared to the cost of having to throw
25 The name stems from the fact that newspaper sales are the typical example of a product that has a daily circulation and must
be destroyed if it is not sold by the end of the day.
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away a product, the more one should overstock, and vice versa (see Example 3 for more
information on the critical fractile).
In many industries, such as the fashion and electronic supplies sectors, products have
increasingly short life cycles that may even be measured in weeks. This, together with the
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outsourcing of production to low-labor-cost countries, which lengthens delivery lead times, is
a significant inventory management challenge.
Example 3. Short cycle and critical fractile
Let us assume that Pegasa wants to launch a campaign that involves selling tool kits with the
company logo and that of a famous DIY fair that only lasts one week. The kits must be ordered from a
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local manufacturer one month in advance and cost €5 each. The company is thinking of selling them
for €15, but after the event they will have to give those left away because no one will want to buy
them. According to forecasts based on previous years, they expect to sell an average of 300 kits, but
the demand may vary in number between 150 and 450. (Note: the distributor can offer little statistical
information, so for the sake of simplicity we will assume that the distribution demand is uniform, i.e.,
there is equal probability of 150, 200, 300 or 450 tool kits being sold, but no more; however, a normal
distribution type would probably be more reasonable).
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Playing with averages. Common sense may suggest that the company should order a batch of 300
tool kits (the average demand), thus risking falling short (50%) or overstocking (50%). However, let us
not forget that the cost of a lost sale (lost margin of €10) is twice that of the unsold overstock (€5 for
the cost of the kit); thus, one batch above the average should be ordered to ensure a greater chance of
not stocking out.
Critical fractile. It would actually be best to order one batch, so that the “marginal” probability26 of
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stocking out is half that of overstocking. That is, the expected “marginal” cost of a lost sale (33% x
€10) is equal to being one unit overstocked (66% x €5). Therefore, it would be advisable to order a
batch of 350 units (or a batch of 300 units and a safety stock of 50 units to meet the overdemand).
To calculate the order batch X in a general case, see Figure 6 (only for those interested in how the
calculation was done).
Given the cost of overstock (Cs) and stockout (Cr), the critical fractile (FC, in a percentage) is defined
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as the “marginal” probability of outstocking by an additional unit; it is given by:
FC = Cr/(Cr + Cs) x 100
The order batch X*, which corresponds to the critical fractile FC, should be determined according to
the demand’s cumulative probability distribution: X* = F-1 (FC) (in the case of a normal demand, X*
would leave a percentage FC under the Gaussian curve which lies to the left of the desired order batch
X* to the left in Figure 6).
Then, depending on the production and transportation constraints, the order could be adjusted (for
example, to order a number of full containers), as discussed in the case of the optimal batch quantity.
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In practice, there may also be an opportunity for replenishment (a “second shot”), for example, when
part of the first shot is saved in a centralized warehouse and stores can then ask for it, so the decision
may become more complicated.
26 We say “marginal” because what matters here is the first unit that is left over or the first one missing. This nuance should be
irrelevant for the general (non-mathematical) reader.
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Figure 6
The critical fractile concept
Critical Fractile : Random demand, short life cycle
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Demand
distribution Overstock Goal: to find a balance between overstock costs
probability and stockout costs
c s cost per unit
Stockout probability
c r cost per unit
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1-p
Demand
Critical Fractile : p = c s /
(co + c s )
Optimal order: X stock units
X = NormInv (p, mu,
sigma)
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5. Practical Implications for a Manager
We would like to conclude by summarizing the main practical implications for managers.
First, we wish to emphasize the importance of stocks for a company both in economic
terms and for customer service. Second, by making good decisions and taking the
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appropriate steps, managers can have a significant impact on the stocks (and therefore on
the cost and service) of their company. The main objective of this technical note is to
provide guidance in this managerial task and additionally dispel some widespread but
erroneous beliefs such as the idea that, by definition, improving customer service requires
more inventory, or that the ideal way of reducing stocks is to improve the sales forecast.
In many companies there is the potential to significantly improve stocks, but it is also
true that only a small fraction of this potential can be achieved by applying simple
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measures (e.g., by improving stock level calculations or centralizing them) and most
require more challenging measures (e.g., improving supplier performance, reducing items,
etc.), as detailed below.
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Key Questions for Gauging Inventory Management
Managers who want to gauge their inventory management should consider a number of key
questions. The first is to find out how much inventory they have and why. In other words, they
should make sure the company is familiar with the role of the four main types of inventories
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(work in progress, seasonal, cycle and safety) and whether separate numbers are monitored for
these stocks. Depending on the sector in which the company operates, management will need
to pay comparatively more attention to one type or another. For example:
x In consumer product sectors, safety stocks have a significant bearing on stockouts

and obsolescence can represent a significant cost.
x In industrial sectors such as steel, which feature large quantities of few items, the
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batch size is critical and requires a consensus on the potential production economics
compared to the cost of the resulting stock.
x In service sectors such as airline companies, batch sizes are managed according to the
size of aircraft and their use. In contrast, safety stock has a greater bearing on the
planes that are kept in reserve to cover any incidents that may occur, and a balance
between service and costs should be sought.
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The next important question is whether the company’s inventory management policy is based
on standardized criteria and, if so, whether it is the most suitable. Rather than being as
sophisticated as possible, it must be robust and avoid erroneous simplifications and
continuous exceptions. The disadvantage of working with simple rules such as “15 days of
inventory for factory two” is that they are often based on experiences with products that are
barely representative. We recommend regularly reviewing the information on forecasts and
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delivery lead times, their uniformity among different departments and their implications.
The third key question is who really decides the company’s stock policy. As discussed in the
technical note, inventory management has components that are of financial, operational and
commercial importance. It is therefore a mistake for inventory management to be left
exclusively in the hands of a specific department or for stock levels to play a small part of the
incentive system of certain departments. For example, operations departments must be aware
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of the forecasted commercial promotions. Moreover, inventory management will depend not
only on the stock held, but also on strategic issues such as warehouse networks, product range,
distribution models and type of suppliers and the agreements reached with them. Given the
complexity of this issue, it is also dangerous for companies to fully automate the replenishment
process and leave everything up to a computer system. Instead, these decisions should be the
responsibility of a multi-departmental team, which will also be responsible for slowly
improving the company’s inventory management model. We should keep in mind that
inventory levels determine the costs that appear in the income statement and that inventories
also require a vision from the perspective of the company’s balance sheet, as proper
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management is essential for improving a company’s working capital and circulating capital.
The last key question is what mechanisms are in place to improve the company’s inventory
management? Do we merely treat the symptoms of overstock or stockouts rather than
analyze the causes? Are we familiar with the levers that influence stock volumes and do we
know what to do about them? We will devote the next section to answering these questions.
t
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The Main Levers for Improving Inventory Management
Managers can influence the levers or factors that affect stock sizing. The main ones are
summarized as follows:
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1. Acting on the batch size. To reduce batch sizes, we must act on the variables that require
us to work with large batches, mainly by reducing the preparation costs and times of
changing batches or by seeking alternatives to exploit transport economies. Thus, lean
management programs typically include a subsection for reducing changeover times, for
example by eliminating unnecessary tasks or redesigning them to perform in parallel to
the process, and making the tools required available or improving their design. To benefit
from transport economies, agreements can be made to consolidate shipments with other
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manufacturers or outsource operations. According to the factors that affect the economic
batch quantity, we can conclude that a product with a high turnover does not require a
proportionately larger batch size. This is a clear example of economies of scale, which
always favor the biggest competitor in a sector.
2. Acting on the demand variability (either in quantity or time) to reduce safety stocks. A typical
mistake is to assume that variability is caused by the environment. Stock reduction is often
obtained through collaboration with customers or suppliers, for example by sharing
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information or collaborating on forecasts. With the centralization of stocks and forecasts, the
relative variability of demand is also reduced, as local demand is pooled to the regional
demand. This reality, coupled with more efficient transportation systems, has led many
companies to opt for more centralized stocks in recent years. Again, this reflects clear
economies of scale, since those who have a higher demand for a product need relatively less
safety stock to provide the same service. Similarly, the number of products that are offered to
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meet a given demand should be closely monitored. Commercial departments should be aware
that an increase in similar products (color, size, etc.) leads to an increase in uncertainty and
in the ability to make forecasts because it atomizes demand and thus generates a need for
more stock with equal total revenues (we “remove” economies of scale).
3. Acting on the delivery lead time. We have seen that the higher the lead time, the more
safety stock is needed. It is preferable to improve the availability of stocks by acting on
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speed rather than by increasing stock levels. To do so, we can: improve collaboration with
suppliers or customers to reduce unnecessary delivery delays; examine the review
periods, which are often imposed by administrative processes that fail to take into
account the impact on the stock; or use faster means of transport when demand
uncertainty is very high, given that, although transport costs may increase, they can be
significantly offset by reducing the cost of inventory maintenance (for example, in the
fashion or electronics sectors). Rather than responding with more stock, we will be able
to reduce the need for stock within a certain service level.
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4. Acting at the service level. It is not uncommon for companies to have exaggerated
service levels due to overzealous business practices or operational convenience. As
managers, we are responsible for properly setting the service level so that it fits into the
company’s competitive situation. This involves “forecasting” all costs associated with
inventory management in order to seek a compromise between business departments that
work to ensure customer service (sales) and control costs.

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IES448

business, as well as for the level of performance they demand.

Last edited: 6/28/12

x Understand the functions of stocks and their costs.

2 IESE Business School-University of Navarra

Total assets 32,500 Total liabilities 32,500

According to this classification, there are four main types of stock:

jars, lids and boxes).

emphasizes the importance of inventories for Pegasa.

4 Also known as work in process (WIP).

IESE Business School-University of Navarra 3

Turnover = Annual sales (euros)/Average inventory (euros)5

Or the equivalent inverse measure:

Finished goods that are 9.2 times/year 39.4 days

Finished goods that are distributed 14.4 times/year 25.2 days

(= 13/0.9) (= 365 days x 0.9/13)

Raw materials 7 times/year 52.1 days

4 IESE Business School-University of Navarra

The “Operational” Functions of Stocks: Why Do We Need Them?

2. To accommodate or advance production during seasonal production demands or

3. To reduce production or transportation costs (batch or cycle stocks). Even if demand is

IESE Business School-University of Navarra 5

Stocks and Processing (Order) Times: Make to Stock or Make to Order?

6 IESE Business School-University of Navarra

This brings us to another fundamental conclusion regarding inventory management:

IESE Business School-University of Navarra 7

The main types of cost are:

inventory. A distinction should be made between:

materials, they refer to impact on production (delays, machine downtime, production

8 IESE Business School-University of Navarra

The Main Methods of Inventory Control

relevant management dimensions (Pareto principle). For example, a very common

IESE Business School-University of Navarra 9

Two Key Decisions: Batch Size and Safety Stock Level

10 IESE Business School-University of Navarra

IESE Business School-University of Navarra 11

x The cost of physical storage space.

x The financial cost of maintaining stocks, as on average they will be larger.

An optimal batch quantity can be calculated that represents a compromise between

12 IESE Business School-University of Navarra

x The financing cost (interest) is 20% per year.

IESE Business School-University of Navarra 13

If we order a batch of 100 sets If we order a batch of 1,000 sets

Storage and handling costs: Storage and handling costs:

Financial cost: Financial cost:

(or 50 sets at €15/set). (or 50 sets at €15/set).

14 IESE Business School-University of Navarra

Example 2b. The reorder point and safety stock

= Average daily demand x Replenishment lead time =

additional safety stock of 50 sets. If preferred:

IESE Business School-University of Navarra 15

Historical demand data

Three key variables are required to determine the safety stock:

16 IESE Business School-University of Navarra

for cases in which it is difficult to determine stockout costs.

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x Cost minimization: an attempt is made to minimize the costs of stockout, maintenance

The Stock Position as the Key Management Number

4. Inventory Management Policies and Methods

18 IESE Business School-University of Navarra

A. Short life cycle B. Long life cycle

Value Any High value Low value

Long Life Cycle With Continuous Review Policies