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Relationship Between Inventory Holding Levels And Forecast Accuracy Economics Essay


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1. Explain the relationships that exist between customer service levels, inventory holding levels and forecasting/forecast accuracy and explain how this might be managed. Ensure you include discussion of the issues arising if these relationships are poorly managed. A detailed explanation of each (customer service levels, inventory holding levels and forecasting/forecast accuracy) is not required.

The activities associated with the inventory and material management are very important for the company not only at operational level but also in terms of cost; it is worth mentioning that the aforementioned activities absorb around 26% of the logistics cost for the company. If products demand was known with high degree of certainty and these products could be pushed directly in the market then it would not be necessary to have stocks and consequently warehouse management operations. However, the aforementioned hypothetical case is not only not economically efficient but also in the majority of the cases in the real business environment not possible. Therefore, there is an urgent need for a proper, cost-effective, and operational effective management of the inventory which may well lead to the balance of the storage costs by reducing transport costs and the cost related to the non-availability of the product avoiding the negative consequences of the high fluctuations in demand.

A company is compelled to use warehouses for the following reasons: i) to reduce transport and production costs, ii) to link supply and demand, iii) to support the production operations, and iv) to support the marketing activities of the company. As far as transport cost reduction is concerned, although the warehouse management activities and the level of inventory are increasing the logistics costs, these can better be balanced by the lower costs incurred through increased efficiency in transport and production operations.

Companies that are able to produce their products only a certain period of time are forced to hold inventory in order to meet customers demand. This is also the case for companies which while having the ability to produce whenever they want within the year, they are forced to sell their products at certain period(s) of the year. In addition, in case that the raw materials of a company present high price fluctuations within the year then it is often of interest buying these raw materials when prices are very low in order to ensure self-sufficiency for the upcoming increase in demand of these products and economic efficiency from buying these materials at low prices that can cover the inventory holding costs.

There are many times that the stock can support production operations from the view that many products require some time in order to mature. Also during the maturation period, the company is not obliged to pay taxes on finished products, which are still "in progress" (work-in-progress inventory). Finally, the inventory management operations add value to the product, since storing a product close to customers reduces the delivery time and the product is readily available for the customer which also increases the level of service offered to the customer and it is also possible to increase sales.

It is a common business practice that the logistics manager produces his/her own forecasts with regards to the customer demand, transport and delivery times, and the relative logistics costs, which are used in strategic and operational planning and control of the company. In many cases the aforementioned required long-term forecasts are either provided by other departments of the company (not the logistics department) or it is partial responsibility of the logistics department of the company.

The most widespread medium-term forecasting methods which are extremely useful for the decision-maker are the following: i) the exponential normalization method, ii) the time series analysis, and iii) the multiple regression analysis. The exponential smoothing method is perhaps the most widely used short-term forecast method, since it requires minimum data used for repeated applications providing satisfactory results in adaptive changes.

Most of the problems in the forecast operations occur in: i) the start of the process usually due to the lack of prior information, ii) the irregular patterns of time series, and iii) in the geographic division of the data, and iv) in the trial combinations used in order to reduce the prediction error. Nevertheless, the logistics management should be aware that there are alternatives to the problems occurring from the forecasting operations and these are related to planning the supply chain so that it is flexible and responds quickly in changes so that supply meets demand when the latter occurs.

Inventory is the most important cost factor within the supply chain, which should be within the minimum possible levels, balancing direct and indirect costs to the desired levels while maintaining the availability of products to the customers. The reasons related to the holding of inventory are either related to the level of service offered to the customers or related to the reduction of the incurred costs.

Firstly, inventory can lead to better and increased response to the customer requirements for products or services as it will enable the company to respond quickly to demand. This can not only maintain the sales levels but also to increase them. Secondly, a company by holding inventory can encourage the production of economies of scale in order to produce more in bigger and longest production cycles. The inventory can serve as intermediate areas which will lead to the release of the production output from variations in demand.

Thirdly, the company by buying and keeping a cost-effective level of inventory (higher that its immediate needs) is important since it can buy in higher quantities thus reducing transport costs. Fourthly, the company by holding inventory which is purchased in order to cover future needs of the company, pays this inventory in today prices and not by future prices, which are generally higher, thus reducing substantially the purchasing costs.

Fifthly, inventory helps the normalization of the negative effects caused by the variation in the time of production and transportation of products. Finally, inventory can be used to overcome emergency problems such as strikes, natural disasters, etc.

The maintenance of inventory has not only positive but also negative effects. Firstly, the inventory does not add immediate value to the products but even binds capital that could be better invested improving the company productivity and competitiveness. Secondly, the inventory is able to hide the problems of quality raised since it is used in order to serve as a direct compensation for the product of low quality, thus correcting quality problems slower. Finally, inventory leads to the isolation of the company's departments from each other and does not promote their unique design and collaboration, which would happen if inventories did not exist.

The objective of inventory management is twofold. On the one hand there is the strive for increasing the customer service which is performed by the increased availability of the products and on the other hand the aim is to reduce the cost of providing this availability.

The availability of the product at a specific time and at a certain quantity is estimated by the probability of fulfilling an order by the existing stock. The probability is referred to as the service level and the level of service of a product is defined as:

Level of Service = 1 - (expected number of lost sales due to non-availability of the product / annual total demand)

It appears that the level of service is expressed by a value between 0 and 1, which is usually pre-defined as an objective for the company. The main aim is to control the expected number of lost sales due to non-availability of the product. When the products offered by a company is more than one, the problem increases in difficulty.

The cost of providing the required service level can be divided into three broad categories, each one is in conflict or balance to the other. These costs are: i) the procurement costs, ii) the inventory costs, and iii) the cost of non-availability of the product.

The procurement costs associated with the acquisition of products for replenishment of inventory and are often an important economic force which often determines the quantity of the orders. It usually contains the manufacturing cost of the product, the cost related to the preparation of the production process, the cost of processing and transmission of orders and the materials management cost. Some of these costs are fixed and not dependent on the size of the order while others such as transportation costs or production costs are fully dependent on the order size.

The cost of maintaining the related inventory includes the cost related to the use of the relative space necessary for the storage of products, the capital binding costs, the cost of the services related to holding the inventory such as insurance and taxes, and the cost related to the risk of keeping the inventory, such as the cost associated with deterioration, damage, obsolescence or theft of goods.

The cost of non-availability of a product occurs when the request can not be met from the existing stock. This cost can be divided into cost of lost sales, which occurs when the order is withdrawn due to lack of the product in stock and the cost of delay in fulfilling the order which creates particular bureaucratic costs. Of course there is also the defamation cost due to product shortage, which is the essential cost of future lost sales but which cannot be measured.

In conclusion, the logistician frequently finds it necessary to provide his/her own forecasts of demand, lead times, prices and costs for use in strategic and operational planning. However, the accuracy of these forecasts highly affects the inventory levels hold by the company. In case that the forecasts are of low accuracy then either the inventory levels are high and the capital binded to inventory is high, which leads to low competitiveness and lost investing opportunities for the company, or the inventory levels are low and the company faces all the negative consequences mentioned at the previous paragraphs (e.g., lost sales due to unavailability of the products) and the level of service offered to its customers is low. Therefore, a proper and cost-efficient balance is required between the logistician's forecasts for customers demand, the required inventory levels and the desired by the company level of service offered to its customers.

2. Choose a different type of environment from manufacturing and discuss how the principles of Logistics still apply in fulfilling the customer demand.


It is easiest to think of logistics / supply chain in terms of moving and storing a physical product in a manufacturing setting. However, the logistics / supply chain principles and concepts can be applied to such areas as service industries, and environment management.

Many companies designated as service firms in fact produce a product. Examples include: Starbucks (coffee-shops), Springer (Publisher), and the European Central Bank. These companies carry out all the typical supply chain activities of any manufacturing firm. However, for service companies such as the Hilton Corporation, and Alcester Hospital, supply chain activities, especially those associated with physical distribution are not obvious.

For example, a hospital may want to extend the emergency medical care throughout the community and must make decisions as to the locations of the centres. Another example may be the following: DHL must locate terminals and route pick up and delivery trucks. The Southern California Gas company inventories natural gas in underground wells during the off-season in the region where demand will occur. The Alpha Bank in Greece must locate and have cash inventory on hand for its ATMs. The Federal Reserve Bank in U.S. must select the methods of transportation to move cancelled checks among member banks. The Orthodox Church must decide the number, location, and size of the churches needed to meet shifts in size and location of congregations, as well as to plan the inventory of its priest's staff. Epson's repair service for copying equipment is also a good example of the logistics decisions encountered in a service operation.

Therefore, even though many service oriented companies may be distributing an intangible, non-physical product, they do engage in many physical distribution activities and decisions. The techniques, concepts, and methods of supply chain management and logistics are as applicable to the service sector as they are to the manufacturing sector. The key according to Theodore Levitt, may be in transforming an intangible service into a tangible product. Problems will remain in carefully identifying the costs associated with the distribution of an intangible product. Perhaps because of this, few service firms or organizations have a physical distribution manager on their staff, although they frequently do have materials manager to handle supply matters. However, managing logistics in service industries does represent a new direction for the future development of logistics practice.

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