Dooley, Frank J.

English

Research Papers in Economics

CHOICES
The magazine of food, farm, and resource issues
4th Quarter 2005 • 20(4) CHOICES 287
A publication of the
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4th Quarter 2005 • 20(4)
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Logistics, Inventory Control, and Supply 
Chain Management 
by Frank Dooley
Many argue that the focus point (and perhaps the linch-
pin) of successful supply chain management is inventories
and inventory control. So how do food and agribusiness
companies manage their inventories? What factors drive
inventory costs? When might it make sense to keep larger
inventories? Why were food companies quicker to pursue
inventory reduction strategies than agribusiness firms? 
In 1992, some food manufacturers and grocers formed
Efficient Consumer Response to shift their focus from
controlling logistical costs to examining supply chains
(King & Phumpiu, 1996). Customer service also became a
key competitive differentiation point for companies
focused on value creation for end consumers. In such an
environment, firms hold inventory for two main reasons,
to reduce costs and to improve customer service. The
motivation for each differs as firms balance the problem of
having too much inventory (which can lead to high costs)
versus having too little inventory (which can lead to lost
sales). 
A common perception and experience is that supply
chain management leads to cost savings, largely through
reductions in inventory. Inventory costs have fallen by
about 60% since 1982, while transportation costs have
fallen by 20% (Wilson, 2004). Such cost savings have led
many to pursue inventory-reduction strategies in the sup-
ply chain. To develop the most effective logistical strategy,
a firm must understand the nature of product demand,
inventory costs, and supply chain capabilities.
Firms use one of three general approaches to manage
inventory. First, most retailers use an inventory control
approach, monitoring inventory levels by item. Second,
manufacturers are typically more concerned with produc-
tion scheduling and use flow management to manage
inventories. Third, a number of firms (for the most part
those processing raw materials or in extractive industries)
do not actively manage inventory. 
Many agribusiness firms do not actively manage inven-
tory. This does not mean that they ignore inventory.
Rather, they hold large inventories because any potential
savings from inventory reductions are far outweighed by
the inventory-induced reductions in production, procure-
ment, or transportation costs. Often economies of size
cause long productions runs which lead to inventory accu-
mulation. Simultaneously, seasonality leads to inventory
buildups of key inputs like seed as well as outputs like
corn. Economies in procurement such as forward buying
in the food industry and quantity discounts increase
inventories. Similarly, unit trains and other forms of bulk
shipping discounts contribute to inventory buildups. 
Yet, such firms must be alert to changing conditions
that may require more exact inventory management. One
example would be if crops are marketed as small lots of
value-added grain instead of commodities. Production
proliferation in the seed industry may be another instance.
Finally, whether due to food safety concerns, GMOs, food
labeling, or the growth of organic food markets, identity
preservation requires more precise inventory control.
The Importance of Demand
Inventory management is influenced by the nature of
demand, including whether demand is derived or inde-
pendent. A derived demand arises from the production of
another product. For example, when John Deere knows its
demand for a tractor, it can simply compute the demands
for the parts, materials, and components needed to pro-
duce that tractor. Manufacturers of all sizes use such calcu-
lations which are part of flow management to manage
inventories, schedule deliveries for inputs, and manage
capacity. Flow management software has evolved from
Materials Requirements Planning (or MRP) in the 1960s
to the much more complex Enterprise Resource Planning
(or ERP) of the 1990s. A flow management system is set in288 CHOICES 4th Quarter 2005 • 20(4)
motion by the demand for end prod-
ucts. 
Independent demand arises from
demand for an end product. End
products are found throughout a
supply chain. Wheat is an end prod-
uct for a grain elevator, as is flour for
a miller or cereal for a grocer. By def-
inition, an independent demand is
uncertain, meaning that extra units
or safety stock must be carried to
guard against stockouts. Managing
this uncertainty is the key to reduc-
ing inventory levels and meeting cus-
tomer expectations. Supply chain
coordination can decrease the uncer-
tainty of intermediate product
demand, thereby reducing inventory
costs. 
Customer Service and Inventory 
The availability of inventory provides
customer service. The Item Fill Rate
(IFR) measures how often a particu-
lar product (often called a stock
keeping unit or SKU) is available. A
common metric of customer service,
IFR is expressed as the percentage of
time that a customer can obtain the
item they seek. A firm may set its
customer service order policy at 95%,
seeking to fill 95% of the orders for
an item from inventory. 
However, life is a bit more com-
plicated. A customer might not
obtain what they seek for several rea-
sons. The seller may have run out of
a product due to an inaccurate fore-
cast. Or the supplier may have
shipped an incorrect package size or
flavor. Products in inventory may be
unfit for sale because of damage or an
expired shelf life. Finally, a seller may
not have the capability to accurately
track inventory in their stores or dis-
tribution centers. 
To avoid shortfalls or stockouts,
firms carry extra inventory known as
safety stock. As more customer ser-
vice is provided, a firm can expect
sales to increase (Figure 1). However,
as a firm tries to provide perfect cus-
tomer service, logistical costs increase
exponentially. Also, if a firm holds
too much inventory, it can lead to
low inventory turnover and hide
operational problems. For example,
carrying too much stock means that
you might not discover that your
supplier is frequently late with deliv-
ery times. 
The Product Life Cycle, Demand 
Uncertainty, and Inventory 
The structure of independent
demand and logistical requirements
vary by stage in the product life cycle
(introduction, growth, maturity, and
decline). During introduction, logis-
tics must support the business plan
for product launch, while preparing
to handle potential rapid growth by
quickly expanding distribution. At
market maturity, the logistical
emphasis shifts to become cost
driven. In the decline stage, cash
management, inventory control, and
abandonment timing become criti-
cal. Over-abundance of products in
the late maturity or decline stage will
eventually result in obsolete prod-
ucts.  The obvious difficulty is pre-
dicting how long each stage will last
and how abruptly sales will fall in the
decline stage. 
The life cycle strategy typically
involves getting to profitability
quickly recuperating startup costs,
then sustaining high profits for as
long as possible, and finally acting
decisively for products in decline to
minimize losses. Understanding this
life cycle can help managers select
logistical tactics, inventory levels and
supply chain designs. The ultimate
goal for companies should be to have
just enough inventory to satisfy con-
sumer demand.
Another life cycle attribute is that
demand uncertainty shifts as we
progress through time. Product man-
agers face substantial uncertainty
during the introduction and growth
stages, relative stability during matu-
rity, and increasing uncertainty in
decline. This uncertainty drives fore-
casting accuracy and the level of
safety stock required to meet cus-
tomer service expectations. 
The coefficient of variation (CV)
measures the stability of a product’s
demand, comparing the variability in
demand to the size of the average
demand (Figure 2). High demand
 
Figure 1. Incremental sales and logistical costs.
65% 70% 75% 80% 85% 90% 95% 100%
Customer service
$
Sales response function
Logistical costs4th Quarter 2005 • 20(4) CHOICES 289
variability in the introductory stage
means it is difficult, if not impossi-
ble, to forecast demand. Thus, high
levels of inventory must be held to
meet even minimal customer service
levels. In contrast, lower variability
during maturity means that demand
forecasts are quite accurate. However,
inventory levels may still be large
because they are based on larger sales
volumes. 
In addition to the vagaries associ-
ated with product life cycle stage, two
other sources of uncertainty also
drive the level of inventory. First,
demand can vary from day to day,
week to week, or seasonally. Second,
there may be variability in lead time,
or the time from when an order is
placed until delivery is made. 
Forecasting demand used to be
more exact because products stayed
in the mature product life cycle phase
for a long time. Today many compa-
nies find it far more difficult to fore-
cast sales because of product prolifer-
ation. Product line extensions result
in more products that cannibalize
sales and shorten the life cycle. Thus,
more sales are coming from products
in the erratic earlier stages of life, as
opposed to sales from products in the
mature stage of the life cycle. 
Inventory Costs
Different models are used to manage
inventory for products that are con-
tinually available (like milk) or prod-
ucts available for limited time (like
seed). The Economic Order Quan-
tity (EOQ) model determines the
least cost level of inventory to carry,
as well as costs. News Vendor models
are used for products only available
for a single period. 
EOQ and News Vendor models
have proved useful for managing
inventory for many years, analyzing
tradeoffs among major cost compo-
nents. These models are robust and
easy to customize to particular indus-
tries. Their approach to costing is
similar reflecting levels of inventory,
as well as shipping costs or quantity
discounts.
Inventory costs fall into three
classes: 1) carrying costs of regular
inventory and safety stock; 2) order-
ing or setup costs; and 3) stockout
costs. Inventory control systems bal-
ance the cost of carrying inventory
against the costs associated with
ordering or shortfalls (Figure 3).  
First, carrying cost (or a cost to
hold inventory) is comprised of capi-
tal costs, service costs, storage costs,
and risk costs. A carrying cost
involves the opportunity cost for
holding inventory. If the firm did not
have money tied up in inventory, it
could either use the savings to make
investments in other assets or pay
down debt. Thus, a firm should first
determine what it would do with any
savings from a reduction in inven-
tory. If the dollars are used to buy
capital equipment, an appropriate
opportunity cost is the firm’s hurdle
rate or its “required rate of return.” If
the dollars are used to pay down
debt, the interest rate on the loan
should be used to value the inven-
 
Figure 2. Product life cycle and uncertainty.
Figure 3. Inventory costs by order size.
0
10
20
30
40
50
60
70
80
90
100
Introduction Growth Maturity Decline
Stage of life cycle
U
n
i
t
 
s
a
l
e
s
0%
10%
20%
30%
40%
50%
60%
70%
80%
C
o
e
f
f
i
c
i
e
n
t
 
o
f
 
v
a
r
i
a
t
i
o
n
Unit sales
CV
0 5,000 10,000 15,000 20,000 25,000 30,000
Order size
$
Carry Order
Safety Stockout290 CHOICES 4th Quarter 2005 • 20(4)
tory.  The other three aspects of car-
rying cost are non-capital costs.
The service costs are often
masked in a firm’s fixed costs. A firm
should determine how much of its
insurance and tax expense is associ-
ated with inventory. This is especially
important in states that have an
inventory tax. A firm has cash outlays
for warehouses and materials han-
dling equipment, either owning or
leasing space from a distributor. In
either case, the firm should deter-
mine how much is spent on space.
Inventory risk reflects characteristics
of the product. Some items are more
prone to be stolen, others are more
likely to be damaged, yet others may
become obsolete before a sale is
made. In any case, risk means that if
too much inventory is held, a certain
proportion of the inventory will be
unavailable for production or sale.
To determine the cost of carrying
inventory, one needs to know the
average quantity of inventory, an
inventory carrying cost (as a percent
of product cost), and the average cost
per unit of inventory. If a firm plans
to use inventory reductions to fund
other capital assets, inventory carry-
ing cost might be 30% (25% for an
opportunity cost and 5% for the ser-
vice, space, and risk costs). If the firm
plans to use the savings to reduce
debt, the appropriate rate might be
12% (7% for the interest rate and
5% for the other costs). Regardless of
the carrying cost rate being used, as a
firm holds more inventory, carrying
cost increases (Figure 3). 
Firms carry extra inventory to
guard against uncertain events.
Known as safety stock, the purpose of
this inventory is to provide protec-
tion against stockouts. Safety stock is
costed just like regular inventory, it is
an interest rate times the level of
safety stock. The level of safety stock
required to guard against a stockout
depends upon the customer service
level, the standard deviation of
demand of the product, and lead
time. Let’s explain in greater detail.
Assume that it takes 10 days from
the time an order is placed until a
shipment arrives and that on an aver-
age 20 cases are sold each day. Thus,
over the 10 days that we are waiting
for the delivery (our lead time), we
expect to sell 200 cases. If we trusted
our forecast, supplier, and trucking
company, we would simply hold 200
cases for the 10 days. But we realize
that forecasts are inaccurate, some
suppliers are unreliable, and shipping
times vary. If less is sold than
expected during the 10 days or if the
shipment arrives early, we will still
have inventory on the 10th day and
no customer service problems are
encountered. However, if sales are
above expectations during the 10
days or deliveries are late, we might
run out (or stockout) of product. 
Managing the uncertainty sur-
rounding safety stock is the key to
reducing inventory levels. But in
today’s competitive environment, it is
difficult to lower safety stock require-
ments for two reasons. First, some
buyers (especially large retailers) are
requiring higher customer service lev-
els, which raise safety stock levels.
Second, the product mix for many
firms includes more new products
with the corresponding greater
demand variability. Thus, most firms
seeking to reduce safety stock can
o n l y  d o  s o  b y  f o c u s i n g  o n  a g g r e s -
sively cutting lead times. 
The second cost to consider is
ordering costs. Ordering costs
include a cost for transmitting the
order, receiving the product and plac-
ing it into storage, inbound transpor-
tation, and processing the invoice.
Recent advancements in information
technology have lowered this cost by
a factor of six for many industries. A
manufacturer uses the cost of a pro-
duction setup instead of an ordering
cost. 
Finally, stockout costs involve lost
sales when no inventory is on hand.
Such costs fall as inventory (and cus-
tomer service) levels increase. The
relationship between stockout costs
and inventory depends upon the
accuracy of the demand forecast and
the ability of the firm to recognize
and react to a change in demand.
Stockout costs depend on how a cus-
tomer reacts to a stockout, the fre-
quency of stockouts, and the avail-
ability of substitute products.
Stockout costs can be very high if a
lack of substitute products means
that a customer will switch suppliers.
In contrast, if buyers simply substi-
tute a different product, stockout
costs may be inconsequential. 
In practice, many firms do not
assess stockout costs because different
divisions of a firm cannot reach
agreement on what is the cost of run-
n i n g  o u t .  M a r k e t i n g  m a y  d e s i r e  a
very high stockout cost to force a
penalty cost on running out. Opera-
tions or finance may resist this as it
leads to inventory buildups.
Service level goals can differ by
the value placed on stockouts and
indirectly carrying costs. A high
stockout valuation will result in
higher inventories and higher service
levels. One way to evaluate an inven-
tory management policy is to choose
a service level target. From this target,
the inventory policy will determine
the inventory requirements and asso-
ciated costs of providing that level of
service. A higher service level implies
that more inventory will be held as
safety stock. The tradeoff decision
occurs at the point where the cost of
carrying extra safety stock balances
the stockout cost.4th Quarter 2005 • 20(4) CHOICES 291
Closing Thoughts
Inventory levels are affected by cus-
tomer service expectations, demand
uncertainty, and the flexibility of the
supply chain. For products with rela-
tively certain demand and a long
product life, it should be relatively
easy to maintain desirable customer
service standards even as inventories
are reduced. However, for products
characterized by erratic demand, a
short life cycle, or product prolifera-
tion, a more responsive supply chain
and larger buffer inventories may be
needed to meet a desired customer
service level.
Consumers are demanding more
customer service from firms through-
out the supply chain. Firms with
high customer service levels may gain
a competitive advantage over those
that do not have the supply chain
capabilities in place or the ability to
manage them. Firms who understand
their demand recognize stockout
costs and carry appropriate levels of
inventory are ultimately better able
to effectively manage inventory and
provide the desired service level to
customers. As industrialization
affects agribusiness and agriculture in
general, the importance of customer
service and competitiveness will
become critical for firms and supply
chains.
For More Information
Ballou, R. (2004). Business logistics/
supply chain management, 5th ed. 
Upper Saddle River, NJ: Prentice 
Hall. 
Fisher, M. (1997). What is the right 
supply chain for your product? 
Harvard Business Review, Mar/
Apr., pp. 105-116.
Institute for Supply Management. 
Available online: http://
www.napm.org/.
King, R., & Phumpiu, P. (1996). 
Reengineering the food supply 
chain: The ECR initiative in the 
grocery industry. American Jour-
nal of Agricultural Economics, 78, 
1181-1186.
Wilson, R. (2004). 15th Annual State 
of Logistics Report. Council of 
Supply Chain Management Pro-
fessionals. Available online: http:/
/www.cscmp.org/.
Frank Dooley (dooleyf@purdue.edu)
is Professor, Department of Agricul-
tural Economics and the e-Enterprise
Center at Discovery Park, Purdue
University, West Lafayette, Indiana.

Logistics, Inventory Control, and Supply Chain Management

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