Companies need to know how much product to stock before it is needed so that they can satisfy consumer demand. However, there is a delicate line between overstocking the product, with increasing inventory costs, and not stocking enough, hence losing sales to competitors and other alternative products. Thus, every company eventually needs to successfully manage its inventory control systems to predict the optimum amount of products to order and store. In this context, a good inventory control system should have two features: a sound demand forecasting system, and a successful cost inventory management system.
Where consumer demand and ordering and holding costs are constant, there is less need for demand forecasting. Similarly, if demand lead time (how often to order the product to meet the demand) is almost fixed or constant, then the company can achieve the lowest costs possible by calculating the economic order quantity (EOQ). EOQ can be formulated as follows:
Where D is “(annual) Demand Quanitiy”
K is “Fixed Costs of Ordering, Shipping and Handling per order” h is “storage costs per unit”
EOQ indicates the order quantity where total logistic costs (inventory carrying costs + ordering costs) are minimized. The company should therefore always seek to achieve the lowest possible total costs by keeping inventory carrying costs and ordering costs at manageable levels (see Fig. 5.4).
However, consumer demand is not always perfectly fixed or constant; it is very difficult to predict and many forecasting models fail to calculate the right amount of demand most of the time. Thus, companies always try to order more than they need to (precautionary and/or safety stocks) in order to reduce the potential sales loss and consumer dissatisfaction caused by an out-of-stock situation. The amount of these precautionary stocks can be a costly problem if the demand does not fluctuate more than expected.
If an increase in demand is anticipated, every middleman will be placing high orders with some level of safety stocks, creating a domino effect in the
Fig. 5.4 Economic order quantity (EOQ)
distribution channels as the amount of product reaches levels higher than required. Once the middleman has dealt with the high inventory costs, they will make more conservative predictions and try to reduce inventory levels. In general, if a middleman predicts that the demand will be low in markets, he will eventually reduce the order, which reduces the amount of product in the distribution channel. The unpredictability of demand eventually creates abnormality in stocking decisions and unexpected highs and lows in orders. Thus, many distribution channel members face higher inventory costs than necessary. This phenomenon is called a bull- whip effect.
Figure 5.5 illustrates that there are big differences between order quantity and actual stock levels for each middleman. A small unexpected change in consumer demand can lead to a big wave of unpredictability in stocking decisions (first graph of Fig. 5.5), creating an excessive amount of safety stocking all along the distribution channel to tame the wild demand movement. Needless to say, this will eventually increase the inventory costs for every middleman in the distribution channel. Synchronizing the demand with the correct amount oforder is not achieved all the time, thus companies end up with out-of-stock costs.
Fig. 5.5 Bullwhip effects