Capacity and Management Control

Capacity is often defined as the capability of an object, whether it is a machine, work

center, or operator, to produce output for a specific time period, which can be an hour, a day, etc.
Some companies—especially those that don't have supply chain optimization as a core
business strategy—ignore the measurement of capacity, assuming that their facilities have
enough capacity. But, oftentimes, they don't.
Capacity is the maximum amount of work that an operation can do over a specific period
of time.
Two important questions while considering the capacity:
1. How much?
2. How long?

Capacity of an organization consists of many elements:

 Facilities
 Equipment
 Human Resource
 Skills

Measuring Capacity
Companies measure capacity in different ways using either:
 the input,
 the output, or
 the combination of the two
For example, a recycling company calculates its capacity based on the amount of material
they clear from the inbound trailers at the plant, i.e. the input; whereas a textile company
calculates capacity based on the amount of yarn produced, i.e. the output.
Companies use two measures of capacity—theoretical and rated. The theoretical capacity is
defined as the maximum output capacity that does not allow for any downtime, whereas the rated
capacity is the output capacity that can be used for calculation purposes, as it is based on a long-
term analysis of the actual capacity.
How can capacity be measured accurately
 By reducing changeover set-ups
 Re-examining preventive maintenance
 Allocate work in different manner
  Overall equipment effectiveness
 Method of judging effectiveness of equipment

Measuring Demand and Capacity

Forecasting the demand
Forecasting is important for planning and control. Without the forecasting or estimate of future
demand, it is impossible to plan for the future capacity.
But the forecast or prediction should have 3 qualities.
1. Forecasting should be expressed in terms, which are useful for capacity planning. For
example, in units such as machine hour per year, space required, how many hours, how
much etc.
2. Should be accurate as possible wrong forecast making planning useless. For example,
recruiting new staff after the forecast will end up in wasting money.
3. Should give the indication about the potential or possible uncertainty.
How much difference can be expected in actual demand? It has to be clear. For example, if the
change from average demand is predicted a mange in a supermarket can arrange the staff for the
peak and lean period.

Capacity Strategies
Within supply chain optimization and manufacturing and production management, there are
three basic capacity strategies used by different organizations when they consider increased
demand:
1. The lead capacity strategy
2. The lag capacity strategy
3. The match capacity strategy

Lead Capacity Strategy

As the name suggests, the lead capacity strategy adds capacity before the demand actually
occurs. Companies often use this capacity strategy, as it allows a company to ramp up production
at a time when the demands on the manufacturing plant are not so great.
If any issues occur during the ramp-up process, these can be dealt with so that when the demand
occurs, the manufacturing plant will be ready.
Companies like this approach as it minimizes risk. As customer satisfaction becomes
increasingly important, businesses do not want to fail to meet delivery dates due to the lack of
capacity.
Another advantage of the lead capacity strategy is that it gives companies a competitive
advantage. For example, if a toy manufacturer believes a certain item will be a popular seller for
the Christmas period, it will increase capacity prior to the anticipated demand so that it has the
product in stock while other manufacturers would be playing “catch up.”
However, the lead capacity strategy does carry some risks. If the demand does not materialize,
the company could quickly find itself with unwanted inventory as well as the expenditure of
ramping up capacity unnecessarily.

Lag Capacity Strategy

This is the opposite of the lead capacity strategy. With the lag capacity strategy, the company
will ramp up capacity only after the demand has occurred.
Although many companies follow this strategy, success is not always guaranteed. However,
there are some advantages to this method.
Initially, it reduces a company’s risks. By not investing at a time of lesser demand and delaying
any significant capital expenditure, the company will enjoy a more stable relationship with its
bank and investors.
Secondly, the company will continue to be more profitable than companies who have made the
investment in increased capacity.
Of course, the downside is that the company would have a period where the product is
unavailable until the capacity is finally increased.

Match Capacity Strategy

The match capacity strategy is one in which a company tries to increase capacity in smaller
increments to coincide with the increases in volume.
Although this method tries to minimize the overcapacity and under-capacity of the other two
methods, companies also get the worst of the two, as they can find themselves over capacity and
under capacity at different periods.
To optimize your supply chain, you need to be able to supply your customers with what they
want, when they want it—and accomplish that by spending as little money as possible. By
understanding and taking advantage of your facility's actual manufacturing and
production capacity, you can accomplish this all-important supply chain optimization goal.
 WHAT IS INVENTORY MANAGEMENT?
Inventory management is a systematic approach to sourcing, storing, and selling inventory—both
raw materials (components) and finished goods (products).
In business terms, inventory management means the right stock, at the right levels, in the right
place, at the right time, and at the right cost as well as price.
INVENTORY MANAGEMENT DEFINITION
As a part of your supply chain, inventory management includes aspects such as
controlling and overseeing purchases — from suppliers as well as customers — maintaining the
storage of stock, controlling the amount of product for sale, and order fulfillment.
Naturally, your company’s precise inventory management meaning will vary based on
the types of products you sell and the channels you sell them through. But as long as those basic
ingredients are present, you’ll have a solid foundation to build upon.
Small-to-medium businesses (SMBs) often use Excel, Google Sheets, or other manual
tools to keep track of inventory databases and make decisions about ordering.
However, knowing when to reorder, how much to order, where to store stock, and so on
can quickly become a complicated process. As a result, many growing businesses graduate
to an inventory management app, software, or system with capabilities beyond manual
databases and formulas.
With these systems, the procedures of inventory management extend beyond basic
reordering and stock monitoring to encompass everything from end-to-end production and
business management to lead time and demand forecasting to metrics, reports, and even
accounting.
RETAIL INVENTORY MANAGEMENT
 Retail is the broadest catch-all term to describe business-to-consumer (B2C) selling.
There are essentially two types of retail separated by how and where a sale takes place.
 First, online retail (eCommerce) where the purchase takes place digitally.
 Second, offline retail where the purchase is physical through a brick-and-mortar
storefront or a salesperson.
Wholesale, on the other hand, refers to business-to-business (B2B) selling. Knowing the
differences and best practices of retail and wholesale is critical to success.
Most businesses maintain stock across multiple channels as well as in multiple locations. The
diversity of retail inventory management adds to its complexity and drives home its importance
to your brand.
IMPORTANCE OF INVENTORY MANAGEMENT
For any goods-based businesses, the value of inventory cannot be overstated, which is
why inventory management benefits your operational efficiency and longevity.
From SMBs to companies already using enterprise resource planning (ERP), without a
smart approach, you’ll face an army of challenges, including blown-out costs, loss of profits,
poor customer service, and even outright failure.
From a product perspective, the importance of inventory management lies in
understanding what stock you have on hand, where it is in your warehouse(s), and how it’s
coming in and out.
Clear visibility helps you:
 Reduce costs
 Optimize fulfillment
 Provide better customer service
 Prevent loss from theft, spoilage, and returns
In a broader context, inventory management also provides insights into your financial
standing, customer behaviors and preferences, product and business opportunities, future trends,
and more.
INVENTORY MANAGEMENT PROGRAM
Before digging into strategies, techniques, and processes, let’s take a look at some of
the inventory management basics for beginners: namely, the terminology and formulas you’ll
need.

Inventory management terms

Barcode scanner
 Physical devices used to check-in and check-out stock items at in-house fulfillment
centers and third-party warehouses.
Bundles
Groups of products that are sold as a single product: selling a camera, lens, and bag as
one SKU.
Cost of goods sold (COGS)
Direct costs associated with production along with the costs of storing those goods.
Deadstock
Items that have never been sold to or used by a customer (typically because it’s outdated
in some way).
Decoupling inventory
Also known as safety stock or decoupling stock; refers to inventory that’s set aside as a
safety net to mitigate the risk of a complete halt in production if one or more components are
unavailable.
Economic order quantity (EOQ)
EOQ refers to how much you should reorder, taking into account demand and your
inventory holding costs.
Holding costs
Also known as carrying costs; the costs your business incurs to store and hold stock in a
warehouse until it’s sold to the customer.
Landed costs
These are the costs of shipping, storing, import fees, duties, taxes and other expenses
associated with transporting and buying inventory.
Lead time
The time it takes a supplier to deliver goods after an order is placed along with the
timeframe for a business’ reordering needs.
Order fulfillment
The complete lifecycle of an order from the point of sale to pick-and-pack to shipping to
customer delivery.

Order management
Backend or “back office” mechanisms that govern receiving orders, processing payments,
as well as fulfillment, tracking and communicating with customers.
Purchase order (PO)
 Commercial document (B2B) between a supplier and a buyer that outlines types,
quantities, and agreed prices for products or services.
Pipeline inventory
Any inventory that is in the “pipeline” of a business’ supply chain — e.g., in production
or shipping — but hasn’t yet reached its final destination.
Reorder point
Set inventory quotas that determine when reordering should occur, taking into account
current and future demand as well as lead time(s).
Safety stock
Also known as buffer stock; inventory held in a reserve to guard against shortages.
Sales order
The transactional document sent to customers after a purchase is made but before an
order is fulfilled.
Stock keeping unit (SKU)
Unique tracking code (alphanumeric) assigned to each of your products, indicating style,
size, color, and other attributes.
Third-party logistics (3PL)
Third-party logistics refers to the use of an external provider to handle part or all of your
warehousing, fulfillment, shipping, or any other inventory-related operation. Fourth-party
logistics (4PL) takes this a step further by managing resources, technology, infrastructure, and
full-scale supply chain solutions for businesses.
Variant
Unique version of a product, such as a specific color or size.

TYPES OF INVENTORY MANAGEMENT

Typically, inventory types can be grouped into four categories: (1) raw materials, (2)
works-in-process, (3) maintenance, repair, and operations (MRO) goods , and (4) finished goods.
Raw materials
are any items used to manufacture components or finished products. These can be items
produced directly by your business or purchased from a supplier. For example, a candle-making
business could purchase raw materials such as wax, wicks, and decorative ribbons.
Works-in-progress inventory
refers to unfinished items moving through production but not yet ready for sale. In the
case of a candle-making business, work-in-progress inventory might be candles that are drying
and unpackaged.
Maintenance, repair, and operations (MRO) goods
are items used to support and facilitate the production of finished goods. These items are
usually consumed as a result of the production process but aren’t a direct part of the finished
product. For instance, disposable molds used to manufacture candles would be considered MRO
inventory.
Finished goods
are products that have completed the production process and are ready to be sold: the
candles themselves.
As you’ll see, there are other terms such as “decoupling inventory” and “pipeline
inventory” used to describe types of stock-based on its theoretical purpose and use. Nonetheless,
physical inventory almost always falls into one of the four categories above.
SKUs: Organizational building blocks
Stock keeping units — commonly known as SKUs — are product codes that you and
others use to search and identify stock on hand from lists, invoices, or order forms.
Setting up an easy-to-understand system for SKUs is important because it’s the main way
you’ll identify and differentiate product variants; this includes monitoring:
 Stock availability
 Product locations and types
 Sell rates, margins, profitability, or lack thereof
 Inventory shrinkage due to theft, spoilage, or other loss
Stick to an alphanumeric system for your SKUs and avoid accents and symbols that can
cause formatting issues in Excel or elsewhere. Remember that the more stock you have, the
harder it is to go back and develop a naming system, so it’s best to choose one as soon as you
start holding it.
Inventory Management Techniques
Inventory management techniques
1. Bulk Shipments
2. ABC Inventory Management
3. Backordering
4. Just in Time (JIT)
5. Consignment
6. Dropshipping and Cross-docking
7. Cycle Counting
1. Bulk shipments
This method banks on the notion that it is almost always cheaper to purchase and ship
goods in bulk. Bulk shipping is one of the predominant techniques in the industry, which can be
applied for goods with high customer demand.
 The downside to bulk shipping is that you will need to lay out extra money on
warehousing the inventory, which will most likely be offset by the amount of money saved from
purchasing products in huge volumes and selling them off fast.
Pros of bulk shipments
 Highest potential for profitability
 Fewer shipments mean lower shipping costs
 Works well for staple products with predictable demand and long shelf lives
Cons of bulk shipments
 Highest capital risk potential
 Increased holding costs for storage
 Difficult to adjust quickly when demand fluctuates

2. ABC inventory management

ABC inventory management is a technique that’s based on putting products into
categories in order of importance, with A being the most valuable and C being the least. Not all
products are of equal value and more attention should be paid to more popular products.
Although there are no hard-and-fast rules, ABC analysis leans on annual consumption
units, inventory value, and cost significance. Categories typically look something like:
Category A
Items of high value (70%)
and small in number (10%)
Category B
Items of moderate value (20%)
and moderate in number (20%)
 Category C
Items of small value (10%)
and large in number (70%)
The key is to operate each category separately, particularly when selective control,
allocation of funds, and human resources are required.

This analysis categorizes items based on their annual consumption value. Sometimes, Inventory
Managers can use Pareto’s Principle for classification.
Pareto’s Principle classifies the important items in a certain group that usually constitute
a small portion of the total items in the group. Then, the majority of the items, as a whole,
will seem to be of minor significance.

Pros of ABC inventory management

 Aids demand forecasting by analyzing a product’s popularity over time
 Allows for better time management and resource allocation
 Helps determine a tiered customer service approach
 Enables inventory accuracy
 Fosters strategic pricing
Cons of ABC inventory management
 Could ignore products that are just starting to trend upwards
 Often conflicts with other inventory strategies
 Requires time and human resources
3.Backordering
Backordering refers to a company’s decision to take orders and receive payments for out-
of-stock products. It’s a dream for most businesses but it can also be a logistical nightmare … if
you’re not prepared.
When there’s just one out-of-stock item, it’s simply a case of creating a new purchase
order for that one item and informing the customer when the backordered item will arrive. When
it’s tens or even hundreds of different sales a day, problems begin to mount.
Nonetheless, enabling backorders means increased sales, so it’s a juggling act that many
businesses are willing to take on.
As a general rule, the bigger the item value (physically and monetarily), the more “delivery
tolerance” you get from customers.
If you’re a small retailer, it may not be feasible to risk overstocking. In this case, you
might consider labeling the item’s “Buy now” button as “Pre-order” or “Get yours when it comes
back in stock.” This creates a reasonable expectation for customers that it will take a bit longer to
arrive.
Alternatively, some businesses run with a “no-stock” approach which involves taking
only backorders until they’ve generated enough sales to then place a large bulk in order with a
supplier.
Pros of backordering
 Increased sales and cash flow
 More flexibility for small businesses
 Lower holding costs and lower overstock risk
Cons of backordering
 Higher risk of customer dissatisfaction
 Longer fulfillment times
4. Just in Time (JIT)
Just In Time (JIT) inventory management lowers the volume of inventory that a business
keeps on hand. It is considered a risky technique because you only purchase inventory a few
days before it is needed for distribution or sale.
JIT helps organizations save on inventory holding costs by keeping stock levels low and
eliminates situations where deadstock - essentially frozen capital - sits on shelves for months on
end.
However, it also requires businesses to be highly agile with the capability to handle a
much shorter production cycle.

If you’re considering adopting a Just in Time inventory management strategy, ask yourself
the following:
 
Are my suppliers reliable enough to get products to me on time every time?
Do I have a thorough understanding of customer demand, sales cycles, and seasonal
fluctuations?
Is my order fulfillment system efficient enough to get orders to customers on time?
 Does my inventory management system offer the flexibility needed to update and manage
stock levels on the fly?
Pros of JIT
 Lower inventory holding costs
 Improved cash flow
 Less deadstock
Cons of JIT
 Problems fulfilling orders on time
 Minimal room for errors
 Risk of stockouts

5. Consignment
Consignment involves a wholesaler placing stock in the hands of a retailer, but retaining
ownership until the product is sold, at which point the retailer purchases the consumed stock.
Typically, selling on consignment involves a high degree of demand uncertainty from the
retailer’s point of view and a high degree of confidence from the wholesaler’s point of view.
For retailers, selling on consignment can have several benefits, including the ability to:
 • Offer a wider product range to customers without tying up capital
• Decrease lag times when restocking products
• Return unsold goods at no cost
While most of the risk in selling on consignment falls on the wholesaler, there are still a number
of potential advantages for the supplier:
• Test new products
• Transfer marketing to the retailer
• Collect useful information about product performance
If you consider selling on consignment — as either a retailer or wholesaler — set terms clearly
regarding the:
• Return, freight, and insurance policies
• How, when, and what customer data is exchanged
• Percentage of the purchase price retailer will be taking as sales commission

6. Dropshipping and cross-docking

This inventory management technique eliminates the cost of holding inventory
altogether. When you have a dropshipping agreement, you can directly transfer customer orders
and shipment details to your manufacturer or wholesaler, who then ships the goods.
Similar to dropshipping, cross-docking is a practice where incoming semi-trailer trucks or
railroad cars unload materials directly onto outbound trucks, trailers, or rail cars.
Essentially, it means you move goods from one transport vehicle directly onto another
with minimal or no warehousing. You might need staging areas where inbound items are sorted
and stored until the outbound shipment is complete. Also, you will require an extensive fleet and
network of transport vehicles for cross-docking to work.

7. Inventory Cycle counting

Cycle counting or involves counting a small amount of inventory on a specific day
without having to do an entire manual stocktake. It’s a type of sampling that allows you to see
how accurately your inventory records match up with what you actually have in stock.
This method is a common part of many businesses’ inventory management practices, as it
ultimately helps ensure that customers can get what they want, when they want it, while keeping
inventory holding costs as low as possible.
Pros of cycle counting
 More time- and cost-efficient than doing a full stocktake
 Can be done without disrupting operations
 Keeps inventory holding costs low
Cons of cycle counting
 Less comprehensive and accurate than a full stocktake
 May not account for seasonality

The Three Levels of Inventory Management

The three levels of Inventory Management pyramid essentially are three different stages/levels of
Inventory Management expertise that an organization must achieve in its journey towards
achieving Inventory Management excellence. 

First Stage: Inventory Control

This stage is the foundation of path towards achieving Inventory Management excellence.
In Inventory control stage, the focus is on activities like recording all Inventory transactions,
establishing processes for inventory valuation and establishing processes of maintaining
inventory accuracy like cycle counting. Since this stage lays the foundation of the organization's
inventory management journey, the organization needs to invest significantly in terms of people,
processes and technology to make sure that the foundation is strong. With advances in
Information
Technology, this stage is relatively easier to achieve these days and most of the
companies that are willing and/or capable to invest in systems and processes will be able to
achieve this stage of Inventory Management.
Second Stage-Inventory Planning
Now that you have visibility into your inventory and have established processes to
maintain accuracy and valuation in the first stage, it is time to get tactical with Inventory
Management. In this second state, Inventory Planning, organizations deploy quantitative models
to determine inventory policy, which are essentially used to make two fundamental decisions:
 How much to order?
 When to order?
 These quantitative models help calculate parameters like reorder point, order up to levels,
optimal order quantities and safety stock etc., which essentially help answer the two questions
above. At this stage you also need to make some tactical decisions, for example, whether
you would implement a continuous review policy or a periodic review policy for your
items/Product groups (multi-period policies).
A key aspect of this stage is defining what policy will be suitable for your different product
groups since each of your product groups will have different characteristics and hence may
require different inventory policies.
Third Stage-Strategic Inventory Optimization
Organizations that are innovators reach this level of Inventory management and it is after
achieving expertise at this stage that an organization can expect to leverage its inventory
management process as a competitive differentiator. Examples of best practices that are achieved
by organizations at this level are:
 Adopting Inventory management best practices like Vendor managed Inventory (VMI),
Collaborative Planning, Forecasting and Replenishment (CPFR), Just in Time, Cross
Docking etc.
 Improving the accuracy of forecasts by developing better forecasting models and by
promoting better communications between supply chain managers and marketing and
sales personnel.
 Leveraging optimization and simulation tools to decide optimal points in the network to
hold Inventory and how much to hold at each location. Essentially, instead of optimizing
locally (Inventory Planning stage), you optimize Inventory across your network.
 Collaborating with suppliers to reduce lead times and hence reduce Inventory.
 Implementing best in class processes that reduce Demand and Supply uncertainty so that
safety stock needs can be reduced.
 Postponing product customization to downstream stages of supply chain.