that make them to the final assembly line. The net effect: Inventories fell nearly
40 percent even as sales increased by 30 percent.
However, as Table 16-3 indicates, there are costs associated with holding too little
inventory, and these costs can be severe. Generally, if a business carries small invento-
ries, it must reorder frequently. This increases ordering costs. Even more important,
firms can miss out on profitable sales, and also suffer a loss of goodwill that can lead to
lower future sales. So, it is important to have enough inventory on hand to meet cus-
tomer demands.
Suppose IBM has developed a new line of notebook computers. How much inven-
tory should it produce and have on hand when the marketing campaign is launched? If
it fails to produce enough inventory, retailers and customers are likely to be frustrated
because they cannot immediately purchase the highly advertised product. Rather than
wait, many customers will purchase a notebook computer elsewhere. On the other
hand, if IBM has too much inventory, it will incur unnecessarily high carrying costs. In
addition, computers become obsolete quickly, so if inventory levels are high but sales
are mediocre, the company may have to discount the notebooks to sell them. Apart
from reducing the profit margin on this year’s line of computers, these discounts may
push down computer prices in general, thereby reducing profit margins on the com-
pany’s other products as well.
What are the three categories of inventory costs?
What are some components of inventory carrying costs?
What are some components of inventory ordering costs?
Supply Chain Management
Herman Miller Inc. manufactures a wide variety of office
furniture, and a typical order from a single customer might
require work at five different plants. Each plant uses compo-
nents from different suppliers, and each plant works on or-
ders for many customers. Imagine all the coordination that
is required. The sales force generates the order, the purchas-
ing department orders components from suppliers, and the
suppliers must order materials from their own suppliers.
Then, the suppliers ship the components to Herman Miller,
the factory builds the product, the different products are
gathered together to complete the order, and then the order
is shipped to the customer. If one part of that process mal-
functions, then the order will be delayed, inventory will pile
up, extra costs to expedite the order will be incurred, and the
customer’s goodwill will be damaged, which will hurt future
sales growth.
To prevent such consequences, many companies are
turning to a process called supply chain management
(SCM). The key element in SCM is sharing information all
the way from the point-of-sale at the product’s retailer to the
suppliers, and even back to the suppliers’ suppliers. SCM re-
quires special software, but even more important, it requires
cooperation between the different companies and depart-
ments in the supply chain. This new culture of open com-
munication is often difficult for many companies—they are
reluctant to divulge operating information. For example,
EMC Corp., a manufacturer of data storage systems, has be-
come deeply involved in the design processes and financial
controls of its key suppliers. Many of EMC’s suppliers were
initially wary of these new relationships. However, SCM has
been a win-win situation, with increases in value for EMC
and its suppliers.
The same is true at many other companies. After imple-
menting SCM, Herman Miller was able to reduce its days of
inventory on hand by a week, and to cut two weeks off of de-
livery times to customers. Herman Miller was also able to
operate its plants at a 20 percent higher volume without ad-
ditional capital expenditures. Heineken USA can now get
beer from its breweries to its customers’ shelves in less than
six weeks, compared with 10 to 12 weeks before implement-
ing SCM. As these and other companies have found, SCM
increases free cash flows, and that leads to higher stock
prices.
Sources:Elaine L. Appleton, “Supply Chain Brain,” CFO,July 1997, 51–54;
and Kris Frieswick, “Up Close and Virtual,” CFO,April 1998, 87–91.
Inventory 595
590 Working Capital Management
