Inventory and Little’s Law: A Little formula goes a long way
February 7, 2023
2 min read
Carrying too much inventory is risky and inefficient. The drawbacks of excessively high inventory levels are the high costs of carrying it and the risk that it won’t sell and then you are stuck moving it at a discount or end up eating the costs. There are benefits to carrying inventory that we will now explore. Inventory acts as a buffer against the vagaries of Demand. You want to design enough capacity to accommodate customers when there is a rush. The optimal capacity can be calculated by measuring flow rate and flow time and applying statistics. Inventory decouples supply from demand as you have a buffer which can also enhance your ability to accommodate a rush. Inventory protects against the variability of demand and process time (how long it takes to make a product). You can have operations that make to stock or make to order.
Think of a sandwich counter. If you wait until the lunch rush and then make sandwiches to order you will have a significant line and wait time. If however, in the morning you prepare some standard sandwiches that have proven popular, customers can grab a pre-make sandwich and make a transaction quickly. This is more convenient for them and a better business model for you.
Little’s Law states that I = R * T
I is Inventory
R is Flow Rate
T is Flow Time
This equation codifies the relationship between flow and inventory. Here is an example: if you have 250 emails in you in box and you can answer 50 per day on average, how long will it take you to answer them?
I = 250
R = 50
I/R = T
250/50 = 5 days
By knowing the inventory and the rate you can calculate the time. If you know two of the variables you can solve for the third.
As a general rule a company’s goal is to sell more in order to generate more profits with less inventory. Inventory turnover is directly related to the efficiency and profitability of a firm. The more inventory turns in a given period the more profitable and efficient the operation. It means that the enterprise is generating its sales while maintaining a relatively low level of average inventory. Two formulas for calculating and thinking about inventory turnover are:
Inventory turns = COGS/Inventory
COGS stands for Cost of Goods Sold.
From Little’s Law:
I = R*T
Inventory Turns = 1/T
Inventory is a major component of Working Capital. The higher the level of inventory, the more money tied up to finance it. Items in inventory also risk becoming obsolete, spoiling, or being stolen. Managing inventory levels is a critical function of operations.
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