In logistics management, cost control is significant for two reasons. Firstly, because logistics costs account for 5 to 40% of a product’s price, the savings potential associated with logistics is significant.
Secondly, logistics, unlike marketing, is often perceived as a source of costs rather than an area that offers the possibility of increasing sales profitability. The level of customer service, largely determined by activities related to logistics, is an extremely important factor in shaping sales.
The role of inventory in logistics management
A significant portion of logistics costs (usually 20 to 30%) is generated by held inventory. Hence, controlling inventory holding costs becomes an important issue for logistics management. The logistics costs resulting from holding inventory consist of the 3 factors listed below.
• Capital costs
Capital costs are of particular importance in the case of storing goods with high unit value (for example, electronic components). Every day of holding inventory of this type of item creates a high cost. This may be because it is necessary to take out loans for the purchase of stored goods or because the capital invested in stored goods could have been engaged in more profitable ventures.
• Storage space costs
Storage space costs are of particular importance in the case of goods with a large volume in relation to unit value (for example, toilet paper or wood). Storage space costs are caused by space requirements for storing goods, investments in warehouse equipment, as well as additional space necessary for order picking.
• Risk associated with losing the opportunity to sell goods
The risk of losing the opportunity to sell particularly concerns those goods that have a specific expiration date. This primarily refers to food and pharmaceuticals, as well as all those goods that are characterized by a short product life cycle (for example, computers). Food items and pharmaceuticals cease to be suitable for sale and use after reaching a specific date. Of course, this does not apply to the aforementioned computers, which, although they can be sold, will certainly be sold at a much lower price. An excessively high level of inventory in both cases is a factor that increases costs.
Reasons for holding inventory
If inventory creates such high costs, why hold it at all? Along the entire length of the supply chain, individual types of inventory are created for various reasons.
• Work-in-process inventory
Work-in-process inventory is the inventory necessary for optimization between two independent processes in one chain. An example of such a situation can be inventory held between two successive stages of production. If there is no inventory at all between two phases, it is necessary to produce exactly as many components (the effects of completing the first phase) as are needed to simultaneously start the second phase. On one hand, keeping in mind the timing of production, inventory is created when, as an effect of completing the first phase, a component is ready too early. If there is a delay in producing any of the components, the next phase is delayed. On the other hand, from the point of view of economies of scale, producing small batches may prove more expensive than holding inventory.
• Safety stock
Safety stock is the inventory necessary to be held in order to ensure the required level of customer service. If sales volumes were exactly predictable, there would be no need to hold safety stock. However, such a situation never occurs because sales volumes can only be predicted with a certain probability. Safety stock provides a guarantee, with an appropriate probability, that it will be possible to meet peak demand.
• Seasonal inventory
Seasonal inventory is necessary to meet requirements related to the seasonality of demand. In order to effectively utilize production capacity, inventory is built up throughout the entire period of low demand to a level sufficient to meet demand during the peak period. A good example of seasonal inventory can be ice cream production. The peak of ice cream sales falls in the warmer period of the year, and the production necessary to meet summer demand must last all year round.
• Transit inventory
Transit inventory is the inventory between two elements of the supply chain. This type of inventory can only be reduced by minimizing distance or transport time, however, it will always exist.
• Cycle stock
Cycle stock is the inventory required to meet regular demand in a specific time interval, for example, between two deliveries.
• Speculative inventory
Speculative inventory protects the company against price increases or limited product availability, which may result, for example, from the state’s customs policy. Anticipating supply constraints, companies stock up on speculative inventory, usually to maintain the continuity of their own production.