Risks in Keeping Inventory

1. Outcomes of Poor Inventory Management

1a. Inventory Loss (Shrinkage)

In the last tutorial, we briefly described the benefits of maintaining inventory to keep work flowing and customers happy, but there are also costs. These costs go well beyond the cost of actual storage, even for items that require temperature and humidity control to maintain quality.

The biggest risk is loss of inventory due to theft, breakage, spoilage, administrative errors, such as discounts, and other problems like termites or mold that make the inventory unsalable and unsalvageable. Shrinkage is an umbrella term for all the ways inventory is lost. Of these, theft is the most common loss factor and the factor that gets the most attention and investment from companies (Kenton, 2023). Theft can be internal (employee theft) or external (such as shoplifting in retail).

EXAMPLE

A warehouse manager at the prestigious Augusta National Golf Club was convicted for stealing millions of dollars in merchandise between 2009 and 2022 (Feurer, 2024). Because the golf club hosts an annual major tournament, the club had access to highly valued memorabilia.

Since shrinkage technically refers to a discrepancy between the recorded inventory and actual inventory, it may occur due to administrative error—such as items being removed but not recorded, or inaccurately counted. In retail, incorrect pricing can lead to items being sold at a loss; this is also considered shrinkage since value of stock is lost. There is also a small risk of vendor fraud, where there are fewer items delivered than were ordered, or the product is not of the expected quality, meaning the actual value is less than the recorded value.

EXAMPLE

An engine parts company sold thousands of airplane engine parts with fake documentation, resulting in improperly documented parts installed in jet engines (Johnson, et al., 2023).

term to know

Shrinkage

Any reasons for loss of inventory, such as theft, damage, and spoilage.

1b. Product Depreciation/Obsolescence

Items in inventory may be carefully maintained for quality but lose their value due to changes in fashion or technological change, or due to seasonal factors. Effective inventory control requires acknowledging the potential for product depreciation and obsolescence. While traditional inventory depreciation focuses on physical deterioration, a more comprehensive approach considers the decline in value due to external factors.

Product obsolescence arises from changes in technology, consumer preferences, or market saturation. This can render perfectly functional inventory unsellable at its original price. Inventory control systems should be designed to identify slow-moving or outdated stock, allowing for proactive measures like price reductions, promotions, or bundling with more desirable products. Businesses can optimize inventory levels, minimize financial losses, and ensure the accuracy of their financial statements by mitigating the impact of product depreciation and obsolescence.

For example, a retailer may have an overstock of mittens and gloves in early spring and will not be able to sell them until the following fall unless they sell them at extreme discounts. Retail stores usually have limited storage space, so simply setting the items aside until next year is not an option. Depreciation reflects the physical deterioration of an item due to wear and tear. Obsolescence, however, arises from external factors that render the product less desirable. Careful monitoring of these factors is crucial for effective inventory management. Businesses should strive to maintain optimal stock levels to minimize the risk of holding outdated or excess goods that incur holding costs and ultimately lead to reduced profitability.

Other products may never again be salable. Home electronics may become undesirable to consumers who want the latest models. Merchandise that’s tied in with recent movies and popular TV shows will seem dated in a few months. Further up the supply chain, unfinished goods may lose value if they become incompatible with the latest technology, or the public loses interest.

EXAMPLE

Hot summer movies often lead to merchandise boons during the holiday season, but sometimes enthusiasm for the movie fades before the items even reach the shelves. This has happened for Walt Disney movies like Wish in 2023.

1c. Supplier Unreliability and Supply Chain Issues

Similarly, a product that requires a particular material to complete that suddenly becomes unavailable will gather in inventory while the manufacturer waits for the materials. In a Sloan Management Review article, Lee and Billington (1992) note that potential supply issues are not usually considered at the product design and development phase or by top-level operations decision makers.

EXAMPLE

A brewer may see the popularity of Imperial Pale Ale (IPAs) and commit a lot of resources to developing and producing a new IPA product under their brand, unaware of a shortage of hops, a crucial ingredient in most beers that is particularly important to IPAs (Snider, 2023).

Supply chain issues may even occur within a company, such as a manufacturer that does production in different plants and has poor coordination between the two. Lee and Billington describe this as another potential pitfall and another issue that must be resolved by top-level managers.

EXAMPLE

If an auto manufacturer produces some parts in one plant, and ships to another plant for assembly, these two efforts need to be closely aligned so the timing is correct for receipt of the parts.

2. Causes of Poor Inventory Management

2a. Overstocking

As we saw in the previous challenge, issues in stocking may be psychological rather than systematic; research shows that even managers with excellent information about demand tend to over-order (Lee & Billington, 1992). For example, a retail manager may be more anxious about angering or disappointing customers than having too much inventory, and thus over-order an item that is in high demand even if they know that the fad may die out, that some items will be returned, or that the product is seasonal. Further up the supply chain, those ordering materials that will be turned into goods may be further driven by fears that materials will go up in price or become unavailable.

EXAMPLE

A brewer knowing that hops crops have suffered due to drought may over-order due to anxiety that hops will become expensive or unavailable; this contributes to the problem with the shortage and may lead to having more hops in inventory than can be safely stored in the brewer’s refrigeration unit or used before they spoil.

2b. Insufficient or Inaccurate Recordkeeping

Although human errors will still contribute to potential problems, they can be largely mitigated—and some avoided—with the best possible information about how much of a material or good is in stock, how much is needed, the lead time for receiving new orders, etc. In the subsequent tutorials we will look at these inventory management systems.

2c. Communication and Coordination

As mentioned earlier, one pitfall to inventory identified by Lee and Billington (1992) is the separation of decision making from those most familiar with the supply chain, inventories, and other operations issues. For larger companies, this may also mean poor coordination or communication between facilities, such as two arms of the organization both stocking up on the same materials with the idea that any extra can be used by the other facility. While communications technology has improved considerably since this study, the surplus of information presents its own problems. Throughout a company there may be several different communication and data systems, leading to inconsistencies between processes and information overload for operations managers.

2d. Executive Decision Making

As Lee and Billington also described, some issues stem from executives being insufficiently aware of, or concerned with, supply chain issues as they make decisions about product development or other key decisions that don’t take supply chain or inventory needs into account. In addition, an understanding of how to manage the risk of inventory, predict supply chain distributions, and track potential obsolescence are key roles to prevent or reduce inventory issues.

REFERENCES

Feurer, T. (2024, May 15). Ex-Augusta National worker admits to stealing more than $5 million in Masters merchandise, including Arnold Palmer's green jacket. CBS News. www.cbsnews.com/chicago/news/richard-brendan-globensky-guilty-plea-theft-augusta-national-masters-memorabilia/

Johnson, J., Beene, R., Philip, S.V., & Meddings, S. (2023, October 11). Ghost in the Machine: How Fake Parts Infiltrated Airline Fleets. Bloomberg. www.bloomberg.com/news/features/2023-10-11/fake-parts-found-on-boeing-airbus-jets-plague-airlines

Kenton, W. (2023, April 10). Shrinkage in Business: Definition, Causes, and Impact. Investopedia. www.investopedia.com/terms/s/shrinkage.asp

Lee, H.L. & Billington, C. (1992, April 15). Managing Supply Chain Inventory: Pitfalls and Opportunities. MIT Sloan Management Review. sloanreview.mit.edu/article/managing-supply-chain-inventory-pitfalls-and-opportunities/

Sinider, H. (2023, October 10). Could a beer shortage be looming? Changing weather could hit hops needed in brews. USA Today.www.usatoday.com/story/money/2023/10/10/beer-shortage-weather-hops-threatened-climate/71132739007/