Inflation’s effects on inventory management policies are likely far from top of the mind of Logistics Viewpoints readers in today’s challenging times. However, today’s elevated rate of inflation warrants a closer look at optimal inventory policies.
Earlier this month my colleagues and I published our 2022 Supply Chain Predications. One of my predictions within that article is that inflation will hinder supply chain resiliency efforts. My stated logic was that inflation pressures would deter companies from engaging in higher cost efforts such as commissioning new warehouse locations to minimize disruption risks. Instead, they are likely to carry higher levels of inventory as a lower cost alternative to minimizing disruptions. I will describe in this article some ways in which carrying higher levels of inventory can be an efficient means of inventory and risk management in an inflationary environment.
Inventory Costs and Risks
First, let’s list out the categories of inventory costs. There are costs “directly” associated with physical inventory movement storage, and other costs that are a bit more abstract. Inventory purchasing costs and ordering costs [think economic order quantities (EOQ)] are the first that come to mind. Also, time can decrease the value of inventory. This is common with perishable foods, cutting-edge technology, and fashion items. Then there are the financial costs. These come in the form of interest, or cost of capital, and taxation. Companies can save on taxes by accounting for higher inventory costs, resulting in smaller profit margins and lower taxable income. Finally, there are probability-based costs such as lost sales. This is where risk management plays a role at minimizing stock-outs or other ways that a lack of inventory can cause lost sales opportunities.
Inflation Tips the Balance Toward Larger Inventory Holdings
An article from Decision Sciences, titled “Inventory decisions under inflationary conditions” [1] describes in detail the relationship between the various cost categories with respect to EOQ. The conclusion with respect to the relationship between inflation and the cost of capital (excluding other factors) is that one would want to order as large an ordering quantity as possible when inflation is greater than the cost of capital. This is because gains from owning an appreciating asset (the inventory) will outstrip the cost of financing that inventory. Inflation above the cost of capital is likely the case for many organizations at this time. However, many additional factors are relevant in the decision to hold inventory. Storage costs and the ability for a given type of inventory to hold value are the most relevant to a specific situation. Clearly high storage costs would lower the ideal quantity of inventory to be held. As would inventory spoilage or obsolescence issues. Another criterion to consider is an organization’s ability to pass on inflation to its customers. Generally speaking, it is difficult to pass on 100 percent of inflationary costs. But the bottom line is this – an inflationary environment subsidizes an organization’s inventory holding costs. And that is beneficial when looking to hold inventory at levels to minimize stockouts or lost sales.
[1] Bierman, H., and Thomas, J., “Inventory decisions under inflationary conditions”, Decision Sciences 8(1) (1977) 151-155
