Inventory Management
 
Introduction 
Inventory definition
The Basic Relationship- Average Inventory 
Types of Inventory
Reasons to Hold Inventory
Methods to Supervise Inventory
Visible Costs of Inventory
Hidden Costs of Inventory
What Increases Inventory
Inventory Management 
Effective Inventory Management 
Myths in Inventory Management
Why is Inventory Management Important
Economic Order Quantity (EOQ)
Just-In-Time Management (JIT)
Essential Aspects of JIT
Kanban
JIT is Not Possible Without...
Key Features of JIT Approach
JIT Purchasing
EOQ vs. JIT
Conclusion
 
 
Introduction
 
Introduction

The key decision in manufacturing, retail and some service industry businesses is how much inventory to keep on hand. Inventory is usually a business’s largest asset. The instant inventory levels are established, they become an important input to the budgeting system. Inventory decisions involve a delicate balance between three classes of costs: ordering costs, holding costs, and shortage costs.

Before we venture further, what does inventory mean? According to the Merriam- Webster Dictionary, Inventory is defined as,“ the quantity of goods or materials on hand”

Inventory is also known as “an itemized list of goods or valuables, with their estimated worth; specifically, the annual account of stock taken in any business” by the online Dictionary.Com.
 
References:
1.) http://www.inventorymanagement.com/ccrecac1.htm
2.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13-14, p. 407,p.218
3.) Galloway R, Principles of Operations Management, Routledge
4.) Hill T, Production/Operations Management, Prentice Hall, 1991
5.) Saunders, Strategic Purchasing and Supply Management, Pitman
6.) Slack N, Chambers S, Harland C, Harrison A and Johnston R, Operations Management, Pitman, 1995

 

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Inventory Definitions
 
 

a.) Base stock - that portion of inventory that is replenished after it is sold to customers.
b.) Safety stock - the second portion of inventory that is held to protect against the impact of uncertainty.

References:
1.) http://sol.brunel.ac.uk/~jarvis/bola/operations/stock/systems.html
 

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The Basic Relationship- Average Inventory
 
Without safety stock:

Average inventory = 1/2 order quantity

With safety stock:

Average inventory = 1/2 order quantity + safety stock

 References:
1.) Hill T, Production/Operations Management, Prentice Hall, 1991
2.) Slack N, Chambers S, Harland C, Harrison A and Johnston R, Operations Management, Pitman, 1995

 
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Types of Inventories
 
  There are several types of inventory. Raw materials, purchased parts and supplies work-in process, and component parts are inventories to many businesses. Businesses also need tools, machinery and equipment as part of their capital inventory. In most businesses however, finished goods are mainly the consistent inventory, especially for small businesses.
 
 References:
1.) http://hyperserver.engrg.uwo.ca/es492b/Lectures/Lect12/tsld004.htm

 
 

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  Reasons to Hold Inventory

Most businesses hold inventory for many reasons. Among them are:

 
 
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Methods to Supervise Inventory
 
    The success of a business depends on how well the owner(s)’s ability to maintain adequate quantities of items sold. Records provided by an inventory control system should call attention to the need  for reorder when necessary or eliminate “dead wood” inventory when called for. Inventories are controlled and supervised by three (3) methods:

(a) Perpetual Inventory Control-
The perpetual method is the most frequently used method. It is more costly than the other two but it is an efficient way of keeping count. In this system, complete data records are kept on each item of merchandise and additions or subtractions are made with each transaction. There is an inventory balance plus a receipt of sale, minus the actual sale to reflect the quantity at
hand.

(b) Actual Counting Piece- This is another method used to control and supervise  inventory. It is used to actually count inventory item-by-item. This is an exhausting task and not many companies or businesses do it. Salespeople are usually involve in this process and there is a large margin of error to be considered as the salespeople go through the monotonous and tiring task of counting everything.
 
(c) “Looking It Over”- The third method is “Looking over” the inventory. It is the easiest and cheapest way of controlling and supervising inventory, but there is bound to be errors. With this method, it is hard to pinpoint the inventory levels, the items that need to be ordered, and the items that the store is overstocked with. Almost all financial statements that include inventory figures based on this method cannot be completed accurately.
 
References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13-14, p. 407,p.218
2.) Anonymous. Successful Small Business Management. Los Angeles Times, January 20 1980

 

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Visible Costs of  Inventory
 
As mentioned earlier, inventory decisions involve a delicate balance between three classes of cost. These costs are:
  Examples of costs in each of these categories are given in Exhibit (a)
 

Exhibit (a). Inventory Ordering, Holding, and Shortage Costs
 
 
      Ordering Cost
  • Clerical costs of preparing purchase orders 
  • Some spent finding suppliers and expediting orders 
  • Transportation costs 
  • Receiving costs (E.g. unloading and inspection) 
       Holding Costs 
  • Costs of storage space (E.g. warehouse depreciation) 
  • Security 
  • Insurance 
  • Forgone interest on working capital tied up in inventory 
  • Deterioration, theft, spoilage, or obsolescence 
       Shortage Costs
  • Disrupted production when raw materials are unavailable : 
               Idle workers 
               Extra machinery setups 
  • Lost sales resulting in dissatisfied customers 
  • Loss of quantity discounts on purchases 
 
 
  References:
1.) http://hyperserver.engrg.uwo.ca/es492b/Lectures/Lect12/tsld006.htm
2.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.407
3.) http://www.ainet.com/opt/csus/invntory.htm

 

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Hidden Costs of Inventory
Having inventory constantly at hand is good but sometimes there are hidden costs that would prove to be a menace for businesses. These costs include could cause:
  References:
1.) http://hyperserver.engrg.uwo.ca/es492b/Lectures/Lect12/tsld007.htm
 
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                                                                     What Increases Inventory?
 

Inventories are increased “just in case”...
 

 References:
1.) http://hyperserver.engrg.uwo.ca/es492b/Lectures/Lect12/tsld014.htm
2.) http://www.inventorymanagement.com/news.htm
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Inventory Management

Business must have methods and procedures that offer ample flexibility to meet unusual and sometimes unreasonable demands on their resources -- personnel, equipment and facilities and operational. Exceptional customer service also includes providing top quality products at reasonable costs.

Businesses must keep a careful rein on their inventories. Having too much inventory and/or not having enough stock is considered primary direct causes of business failures.

There are several definitions of Inventory Management. Among them are:

Inventory Management is “the practice of planning, directing and controlling inventory so that it contributes to the business' profitability”. Inventory management can help business be more profitable by lowering their cost of goods sold and/or by increasing sales.

Inventory Management is “making sure that items are available when customers call for it, but not too much stock so that inventory turnover goals are met”
                                                                                  - Juhi Gonzales, Inventory Management and Systems Consulting-
Inventory Management is “the art and science of managing to have the RIGHT PRODUCT, at the RIGHT TIME and PLACE, in exactly the RIGHT AMOUNT, at the BEST POSSIBLE PRICE”.
 

References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13-14, p. 407,p.218
2.) http://www.freenet.edmonton.ab.ca/imasc/#IncomeStatement
3.) http://www.cris.com/~kthill/inventry.htm
4.) http://www.execpc.com/~matplan/page2.html
5.) http://www.ainet.com/opt/csus/invntory.htm

 
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Effective Inventory Management
 
"Effective inventory management allows a distributor to meet or exceed his (or her) customers’ expectations of product availability with the amount of each item that will maximize the distributor’s net profits."

References:
1.) http://www.effectiveinventory.com/whatis.html

 
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Myths in Inventory Management
Amazingly, there are so many myths about Inventory Management. Some of them sound idiotic but they do really happen in the “Real World” of business. Sometimes, it’s best to learn from other people’s (business people?) mistakes or misunderstandings and incorporate our findings in our own business.
 

Myth: The “SALES” data that we have in our company records, is all we need for inventory management”

WRONG! : Inventory management systems do not use sales data. They must be supported by accurate demand information-which is totally different!
 

MythThe more expensive a software system is, the better it will help us control our inventory.

WRONG! : The BEST inventory forecasting and planning system available today, costs under $1000 and they work as well as any other system in the market.

Myth: “Our real problem is our people- they just don’t do their jobs the way they should!”

WRONG! : In working with thousands of inventory managers, no one is that stupid or lazy! The problem is that most managers have received NO training, and/ or have the wrong tools (systems) to work with, or none at all. This is rarely their fault!

Myth: We keep all of our sales histories by month, and this data is all we need to make good forecasts for inventory planning.

WRONG! : Using monthly sales data is one of the major contributors to poor inventory forecasting and planning. It inevitably leads to inaccurate safety stock calculations and other projections and, thus, not having the inventories that our companies need when we need them!

Myth: Our company’s accounting system includes an “Inventory Control” module and, therefore, if our people would only use it right, our inventories should be fine.

WRONG! : The GREATEST MYTH of all! No accounting system- no matter how good it may be at performing acconting functions, and most are very good- can ever provide the data and/ or analysis required to precisely manage any company’s inventories! Your company or business needs (No! MUST Have) an inventory management system.
 

References:
1.) http://www.execpc.com/~matplan/page3.html

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 Why is Inventory Management Important?

1.) Inventory management can help business be more profitable by lowering their cost of goods sold and/or by increasing sales.

Consider a typical company - ABC Company with the following income statement:

         Sales                           $                 2,000,000
         Cost of Goods Sold                       1,100,000
         Gross Profits                                     900,000
         Gen. Administrative Expenses            402,000
         Marketing Expenses                          350,000
         Net Income before taxes           $      148,000
                                                        ==========

Not bad -- return on sales is over 7%.

Now, suppose that through application of sound inventory management principles, ABC Company was able to reduce the cost of goods sold by 3%. And because there is less inventory, let's say that carrying costs (warehouse storage charges, insurance, finance charges, etc) is reduced by 2% of the general administrative expense. Those minimal cost reductions result in significant increase on net income:

         Sales                                             $ 2,000,000
         Cost of Goods Sold                          1,067,000
         Gross Profits                                       933,000
         Gen. Administrative Expenses              394,000
         Marketing Expenses                            350,000
         Net Income before taxes                  $   189,000
                                                            ===========

Small costs reductions due to application of sound inventory management principles resulted in very significant increase (28%) in net income!

Lower cost of goods sold is achieved by making the inventory smaller and therefore turn more often; while making sure that stocks are large enough will result in increased sales because products are available when Customers call for it. Inventory management is balancing those two opposing factors for optimum profitability.
 

2.) Conduct an inventory audit that answers the following questions:
 

3.) Improve Customer Service

4.) Reduce Inventory Investment

5.) Increase Productivity

6.) Prevent Poor Inventory Record Accuracy
     Inventory record errors are costly. No computer system, be it old or new, will work properly if the transactions are not entered correctly. The costs of poor inventory record accuracy are not always apparent to management. Consider the following results, all of which increase production costs and reduce profits:

Some of these costs can be quantified. Others are intangible, but nevertheless do exist and can be substantial. It is important to have inventory records, which are accurate. Most experts agree that this accuracy must be at least 95% and even higher for critical or high unit value items. The key to accurate records is the implementation of a sound cycle counting system.

References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13-14, p. 407,p.218
2.) http://www.freenet.edmonton.ab.ca/imasc/#InvMgmt
3.) http://sol.brunel.ac.uk/~jarvis/bola/operations/stock/systems.html
 

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Economic Order Quantity
Economic Order Quantity, better known as EOQ, is a mathematical tool for determining the order quantity that minimizes the costs of ordering and holding inventory. It attempts to minimize total inventory cost by answering the following two questions.

1) How much should I order? ( Economic Order Quantity )

2) How often should I place each order? ( Cycle Time )

This model assumes that the demand equation faced by the firm is linear. In other words, the rate of demand is constant or at least nearly constant.

The goal is to minimize total inventory cost. Inventory costs are made up of Holding and Ordering cost. Holding cost include the cost of financing the inventory along with the cost of physically maintaining the inventory. These costs are usually expressed as a percentage of the value of the inventory. Ordering cost include the cost associated with actually placing the order. These include a labor cost as well as a material and overhead cost. The equation for total inventory cost is developed as follows:

Total Inventory Cost (TIC) = Holding Cost + Ordering Cost

TIC = (Average Inventory)(Holding cost per unit) + (Number of orders per year)(Ordering cost per order)

Assumptions of Basic EOQ Model:
 


 
 
 Simple Economic Order Quantity Example:

A truck manufacturer uses 120,000 headlight assemblies a year in the production of a certain model truck. Daily production of this truck is reasonably stable through out the year. The cost of each headlight assembly is $150.00. The company's incremental order (acquisition) cost is $40.00 per order. Its incremental inventory carrying cost is 33% of the average inventory value per year.
 

Development of EOQ Model
The development of the EOQ (Economic Order Quantity) inventory model consists of five steps:

(a.) List ASSUMPTIONS concerning the inventory situation
      Assumptions are:
 

(b.) Develop a COST EQUATION (MODEL) QUALITATIVELY
 
(c.) Develop a COST EQUATION (MODEL) QUANTITIVELY

      MODEL QUANTITIVELY:

        TC = K(D/Q) + HC(Q/2) + DC

(d.) Minimize the total cost equation (model)

(e.) Find REORDER QUANTITY & REORDER POINT

      OPTIMAL RE-ORDER QUANTITY

       Q* = square root [(2 x D x K)/(H x C)]

       Where:     D = annual demand in units

                      K = ordering cost per order

                      H = carrying cost per unit expressed as a fraction of cost of an individual unit
 
                      Q = reorder quantity

                    Q* = optimal reorder quantity

                      C = cost of an individual item

                     TC = total annual inventory cost
 

References:
1.) http://www.wvsc.edu/academics/dept/business/lewis/eoq.html
2.) http://hyperserver.engrg.uwo.ca/es492b/Lectures/Lect12/tsld014.htm
3.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p. 407
4.) http://www.ainet.com/opt/csus/invntory.htm
5.) http://garnet.acns.fsu.edu/~dwilson/4700/Notes/invntor1.html
6.) http://mscmga.ms.ic.ac.uk/jeb/or/invent.html
7.) http://server.nich.edu/~wshell/mgt368/368-l9a.html#basiceoq

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Just-In-Time Management (JIT)
 
 
In traditional settings, inventories of raw materials and parts, finished goods and all, were kept as a buffer against the possibility of running out of needed item. In recent years, however, managers have come to realize that large buffer inventories are costly. Consequently, many companies have completely changed their approach to production and inventory management. These manufacturers have adapted a new strategy for controlling the flow of manufacturing in a multistage production process.

In a just-in-time (or JIT) production system, raw materials and parts are purchased or produced just in time to be used at each stage of the production process. This approach to inventory and production management brings considerable cost savings from reduced inventory levels.

 The key system to the JIT System is the “pull” approach to controlling manufacturing. To visualize this approach, look at Exhibit (c), which displays a simple diagram of a multistage production process. The flow of manufacturing activity is depicted by the solid arrows running down the page from one stage of production to the next. However, the signal that triggers more production activity in each stage comes from the next stage of production. These signals, depicted by the dashed- line arrows, run up the page. We begin with sales at the bottom of the exhibit. When sales activity warrants more production of finished goods, the goods are “pulled” from the production stage III by sending a signal that more goods are needed. Similarly, when production employees in stage III need more input, they send a signal back to stage II. This triggers production activity in stage II. Working our way back up to the beginning of the process, purchases of raw materials and parts are triggered by a signal that they are needed in stage I. This pull system of production management, which characterizes the JIT approach, results in a smooth flow of production and significantly reduced inventory levels. The result is considerable cost savings for the manufacturer.
 

References:
1.) http://www.inventorymanagement.com/imijita2.htm
2.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13, p.14, p.218, p. 407
3.) http://www.ainet.com/opt/csus/invntory.htm
4.) http://server.nich.edu/~wshell/mgt368/368-l9a.html#imc

 
 
( CHART )
 
 
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Essential Aspects to JIT
 
1.reduction/minimisation of inventory in supply chains. Lessons have been learnt from Japanese methods where substantial efficiencies are gained from frequent deliveries of small quantities to meet immediate demands. This compares with methods of stock control such as the calculation of economic order quantities.
 
2.the application of Kanban - a "pull" system of production/materials control

3.an employee participation and involvement strategy involving the securing of commitment and changed work practices leading to elimination of waste
 

References:
1.) http://www.inventorymanagement.com/imijita2.htm
2.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13, p.14, p.218, p. 407
3.) http://www.ainet.com/opt/csus/invntory.htm
4.) http://sol.brunel.ac.uk/~jarvis/bola/jit/jit.html

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  Kanban
At Toyota, the production system used tickets/cards to control immediate material flows between a work station and another down-stream . The up-stream station (the server) receives tickets calls for small, fixed quantities from a down-stream user (the client). On sending the supplies, a production "kanban" is generated requesting the previous upstream server to make/supply a replacement quantity. Thus:
       With the integration of computer systems internally and externally with suppliers systems - Kanban data and instructions can flow between the linked systems.
 

References:
1.)  Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13, p.14, p.218, p. 407
2.)  http://sol.brunel.ac.uk/~jarvis/bola/jit/jit.html
 
 

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JIT is Not Possible Without....
 
 
References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13, p.14,  p. 407
2.) http://sol.brunel.ac.uk/~jarvis/bola/jit/jit.html
 
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Key Features to JIT Approach
 
 
 How does a JIT system achieve its vast reductions in inventory and associated cost savings? A production-systems expert lists the following key features of the JIT approach.

1) A smooth, uniform production rate. An important goal of a JIT system is to establish a smooth production flow, beginning with the arrival of materials from suppliers and ending with the delivery of goods to customers. Widely fluctuating production rates result in delays and excess work-in-process inventories. These non-value-added costs are to be eliminated.

2) A pull method of coordinating steps in the production process. Most manufacturing  processes occur in  multiple stages. Under the pull method, goods are produced in each manufacturing stage only as they are needed at the next stage. This approach reduces or eliminates work-in-process inventory between production steps. The result is a reduction in waiting time and its associated non-value-added cost.

The pull method of production begins at the last stage of the manufacturing process. When additional materials and parts are needed for final assembly, a message is sent to the immediate preceding work center to send the amount of materials and parts that will be needed over the nexrt few hours. Often this message is in the form of a withdrawal Kanban, a card indicating the number and type of parts requested from the preceding work center. The receipt of withdrawal Kanban in the preceding work center triggers the release of a production Kanban, which is another card specifying the number of parts to be manufactured in that work center. Thus, the parts are “pulled” from a particular work center by a need for parts in the subsequent work center. This pull approach to production is repeated all the way up the manufacturing sequence toward the beginning. Nothing is manufactured at any stage until its need is signaled from the subsequent process via a Kanban. As a result, no parts are produced until they are needed, no inventories build up, and the manufacturing process exhibits a smooth, uniform flow of production.

3) Purchase of materials and manufacture of subassemblies and products in small lot sizes. This is an outgrowth of the pull method of production planning. Materials are purchased and goods are produced only as required, rather than for the sake of building up stocks. The result is a reduction in storage and waiting time, and the related non-value-added costs.

4) Quick and inexpensive setups of production machinery. In order to produce in small lot sizes, a manufacturer must be able to set up production runs quickly. Advanced manufacturing technology aids in this process, as more and more machines are computer-controlled.

5) High quality levels for raw material and finished products.

6) Effective preventive maintenance of equipment. If goods are to be manufactured just in time to meet customer orders, a manufacturer cannot afford significant production delays. By strictly adhering to routine maintenance schedules, the firm can avoid costly down time from machine breakdowns.

7) An atmosphere of teamwork to improve the production system. A company can maintain a competitive edge in today’s worldwide market only if it is constantly seeking ways to improve its product or service, achieve more efficient operations, and eliminate non-value-added costs.

8) Multiskilled workers and flexible facilities.

References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13, p.14, p.218, p. 407
 

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  JIT Purchasing
 
In addition to a JIT production approach, an effective business should implement JIT purchasing. Under this approach, materials and parts are purchased from outside vendors only as they are needed. This avoids the costly and wasteful buildup of raw material inventories. The following are five (5) key features of JIT purchasing.

1. Only a few suppliers. This results in less time spent on vendor relations. Only highly reliabled vendors are used, who can deliver high quality goods on time.

2. Long- term contracts negotiated with suppliers.

3. Materials and parts delivered in small lot sizes immediately before they are needed.

4. Only minimal inspection of delivered materials and parts.
 

5. Grouped payments to each vendor. Instead of paying for each delivery, payments are made for batches of deliveries according to the terms of the contract. This reduces costly paperwork for both the vendor and the purchaser.
 

JIT is an important operational system for manufacturing and supplying companies to adopt and implement. Technically, procedurally and managerially it requires attention to:
 

If change is piecemeal and management attention wanes then JIT may fail. An integrated perspective is needed with coherent strategic direction and increases in productivity/effectiveness at each operational level so that the whole supply chain has a competitive edge
 

References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p.13, p.14, p.218, p. 407
 

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EOQ vs. JIT
 
The EOQ model minimizes the total cost of ordering and holding purchased inventory. Thus, this inventory management approach seeks to balance the cost of ordering against the cost of storing inventory. Under the JIT philosophy, the goal is to keep all inventories as low as possible. Any inventory holding costs are seen as inefficient and wasteful. Moreover, under JIT purchasing, ordering costs are minimized by reducing the number of vendors, negotiating long- term supply agreements, making less frequent payments, and eliminating inspections. The implication of the JIT philosophy is that inventories should be minimized by more frequent deliveries in smaller quantities.
 

References:
1.) Hilton, Ronald W., Managerial Accounting. McGraw-Hill,Inc (1994). p. 407
 

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Conclusion
In any business, make it big or small, we must understand that taking good care of our inventory is very important. If we as managers do not understand the concept of good inventory management, we must learn to be familiar with it and its applications. One of the reasons for the failure of a business is its inventory management. There are many ways to fight failure, and we can start from here. There are new technology that can help us maintain and supervise our inventory. What we can do is learn, implement and evaluate our business. And you can start with your INVENTORY!!!!!
 
 
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