Quantifying the impact of inventory holding cost and reactive capacity on an apparel manufacturer's profitability

Production and Operations Management, Fall 2002 by Raman, Ananth, Kim, Bowon

QUANTIFYING THE IMPACT OF INVENTORY HOLDING COST AND REACTIVE CAPACITY ON AN APPAREL MANUFACTURER'S PROFITABILITY*

This paper was motivated by the operational problems faced by Northco, a school uniform manufacturer in the Northeastern United States. Northco was facing high working capital costs while also incurring high stockout and markdown costs. This paper models the impact of inventory holding cost and reactive capacity on Northco's targeted understocking and overstocking cost and offers a solution methodology for such problems. We quantify the impact of varying inventory carrying costs (and hence, high working capital costs) on stockout costs and the value of additional capacity. Our results illustrate that apparel manufacturers with high working capital costs, and hence high inventory carrying costs, should target higher stockout costs and achieve lower capacity utilization. The results presented have application beyond Northco because high working capital cost is endemic to many supply chains.

(INVENTORY PLANNING; INVENTORY MANAGEMENT; WORKING CAPITAL MANAGEMENT; CAPACITY MANAGEMENT; DYNAMIC PROGRAMMING)

1. Introduction

This paper was motivated by the problems at Northco, a school uniform manufacturer. The company was facing high inventory carrying costs (caused by high working capital costs) while also having to manage high stockouts and markdowns caused by unpredictable demand for its products. The paper makes multiple contributions. First, using a case study, it demonstrates how operations research methodologies can be used to better manage stockouts and markdowns when inventory-carrying costs are also high. Two, it quantifies the linkage between inventory carrying costs and a firm's target stockout cost at Northco. Three, it shows that, in this industry, firms with high working capital costs should target substantially higher stockout costs and capacity levels, and quantifies the relationship among these measures using data from Northco.

Firms often are forced to deal concurrently with high inventory carrying, stockout, and markdown costs. Multiple authors have noted the magnitude of stockout and markdown costs in industries such as fashion apparel, personal computers, and consumer electronics (see Fisher, Hammond, Obermeyer, and Raman 1994). Moreover, many of these supply chains also have to contend with high working capital costs. For example, apparel manufacturers, in the United States and overseas, have to contend with inadequate or expensive working capital. U.S. apparel manufacturers tend, like Northco, to be small and are seldom audited externally. Hence, banks are reluctant to lend money to these companies in the absence of substantial collateral. Apparel manufacturers located in developing countries suffer from high working capital costs caused by weaknesses in the banking infrastructure in these countries. Raman (1996) documented acute working capital shortage problems faced by Indian apparel exporters. Similarly, Moore and Ihlwan (1998) highlight working capital shortage faced by apparel manufacturers in many Asian countries.

This paper has two important messages for such manufacturers. First, it demonstrates, through an application at a small manufacturer, how such a company can use operations research model-based approaches. Second, the paper quantifies the linkage between inventory carrying cost and target understocking and overstocking cost for apparel manufacturers. High inventory-carrying costs can lead to high stockout and markdown costs for style-goods manufacturers. Hence, reducing working capital cost can have the added benefit of reducing stockout and markdown costs as well. Companies can reduce their working capital costs in a number of ways. For example, companies can negotiate with banks and channel partners to obtain more favorable terms. Palmieri and Africk (1999) offer an example of a banking mechanism that lowers inventory carrying costs in the supply chain by subsidizing the accounts receivables at a firm. Northco, the company studied in this paper, found an inexpensive source of working capital by acquiring another business. The company also reduced its need for working capital by investing in additional plant capacity, and thus was able to schedule a greater portion of demand later in the season.

We present the context in which we study our problem in Section 2 and review the relevant literature in Section 3. In Section 4, we develop a model of the production-planning problem at Northco, a small school uniform manufacturer, and in Section 5, we estimate demand and cost parameters using Northco data. Our solution procedure is described in Section 6. We present our results and discuss managerial implications in Section 7. The changes adopted by Northco based on the analysis presented in the paper are summarized in Section 8.

2. Research Context: Northco

Founded in 1920 and located in the northeastern United States, Northco manufactured uniforms for a number of private and parochial schools. The "school uniform industry," of which Northco was a part, comprised companies that sold uniforms directly to students enrolled in private or parochial schools. It did not, for example, include companies that sold components of school uniforms such as gray slacks or white shirts through department stores. Against annual sales of $450 million in 1995, most firms in this extremely fragmented industry sold less than $5 million each year. Annual sales at Northco were roughly $3 million. The company possessed a broad customer base, selling school uniforms on an exclusive basis to over 91 schools. The company produced in wool, corduroy, serge, and polyester blends for children in kindergarten through grade 12. Products included pants, skirts, shorts, culottes, dresses, blazers, shirts, blouses, jumpers, tunics, and kilts.