Chapter 9Inventory Fundamentals
IM417 Manufacturing Resources Analysis
Southeast Missouri State University
Compiled by Bart Weihl
Spring 2001
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Inventory Fundamentals
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Inventory
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Materials and supplies that a business or institution
carries either for sale or to provide inputs or
supplies to the production process
Represents between 20 to 60% of assets
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http:www/inventoryops.com
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Inventory Fundamentals
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Aggregate Inventory Management
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Managing inventories according to their
classification rather than at the individual item level.
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Generally involves:
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Flow and kinds of inventory needed
Supply and demand patterns
Functions that inventories perform
Objectives of inventory management
Costs associated with inventories
Inventory Fundamentals
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Item Inventory Management
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The organization must establish some decision
rules about inventory items for overall direction.
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Rules include:
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Which inventory items are most important
How individual items are to be controlled
How much to order at one time
When to place an order
Inventory Fundamentals
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Inventory and the Flow of Material
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Raw materials
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Work-in-process
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Purchased items received which have not entered the
production process
Raw materials that have entered the manufacturing
process and are being worked on or waiting to be worked
on
Inventory Fundamentals
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Inventory and the Flow of Material
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Finished Goods
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Distribution inventories
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Finished goods located in the distribution system
Maintenance, Repair, and Operational Supplies
(MRO)
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Finished products of the production process that are ready
to be sold as completed items.
Items used in production that do not become part of the
product
Inventory Fundamentals
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Supply and Demand Patterns
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Demand for many products is not constant enough
to set up a flow system
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Many products are made in lots or batches
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Work moves in lots from one workstation or process
to another as determined by the routings
Inventory Fundamentals
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Function of Inventories
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In batch manufacturing, the basic purpose of
inventories is to decouple supply and demand
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Inventory serves as a buffer between:
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Supply and demand
Customer demand and finished goods
Operations
Suppliers and queues
Inventory Fundamentals
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Function of Inventories
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Anticipation inventory
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Fluctuation Inventory
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Inventory built up in anticipation of future demand
Inventory held to cover random unpredictable fluctuations
in supply and demand or lead time
Inventory Fundamentals
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Function of Inventories
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Lot-size Inventory
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Also called cycle stock
Items purchased or manufactured in quantities greater than
immediately needed.
Allows the firm to take advantage of quantity discounts and
to reduce shipping, clerical, and setup costs
Inventory Fundamentals
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Function of Inventories
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Transportation Inventory
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MROs
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Also called pipeline or movement inventories
Inventory in transit because of the time to move goods from
one location to another
Used to support general operations and maintenance, but
do not become part of the product
Example: Transportation Inventory
Q: A company is using a carrier to deliver goods to a major customer. The
annual demand is $5,000,000, and the average transit time is 8 days. Another
carrier promises to deliver in 6 days. What is the reduction in transit inventory?
A: Average annual inventory in transit (I) = tA/365
Where t = transit time in days (8 - 6 = 2 days)
A = annual demand ($5,000,000)
I = (2 X $5,000,000) / 365
I = $27,397.26
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Inventory Fundamentals
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Inventory Management
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Responsible for planning and controlling inventory
from raw material to customer.
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Objectives:
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Maximize customer service
Low-cost plant operations
Minimum inventory investment
Inventory Fundamentals
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Customer Service
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The ability of a company to satisfy the needs of
customers.
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The availability of items needed
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Inventories help to maximize customer service by
protecting against uncertainty
Inventory Fundamentals
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Operating Efficiency
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Inventory helps manufacturing to be more
productive by:
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Allowing operations with different rates of production to
operate separately.
Assist with production planning and production leveling
through lower costs.
Allowing for longer production runs
Allowing the purchase of larger quantities
Inventory Fundamentals
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Operating Efficiency
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Inventory investment must be balanced with:
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Customer service
Cost of changing production levels
Cost of placing orders
Transportation costs
If inventory is carried there must be a benefit that
exceeds the costs of carrying that inventory.
Inventory Fundamentals
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Inventory Costs
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Item Cost
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Price paid plus other direct costs associated with getting the time
into the plant
Carrying Costs
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All the expenses incurred by the firm because of the volume of
inventory carried.
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Capital costs
– Storage costs
– Risk costs
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Inventory and Bottom-Line Profits
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Excess inventory* has a negative impact on cash flow.
Carrying costs include warehousing, racking, shelving,
interest costs and insurance premiums (typically
represents 8% to 14% of inventory costs).
Reduction in inventory can apply 10% to the bottom
line.
Slow moving, or obsolete, inventory reduces profits
with financial reserves and possible write-offs.
*Excess Inventory: On-hand balances in excess of the amount
needed to support demand
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Example: Carrying Costs
Q: A bakery carries an average inventory of $15,000. If they estimate the
cost of capital is 10%, storage costs are 5%, and the risk costs are 8%, what
does it cost per year to carry this inventory?
A: Total cost of carrying inventory = 10% + 5% + 8%
= 23%
Annual cost of carrying inventory = 0.23 X $15,000
= $3,450
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Inventory Fundamentals
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Inventory Costs
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Ordering Costs
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Costs associated with placing an order either with the factory or a
supplier.
Cost of placing an order does not depend on quantity ordered.
Annual ordering costs depend on the number of orders placed per
year.
Ordering costs would include:
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Production control costs
– Setup and teardown costs
– Lost capacity cost
– Purchase order cost
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Example: Ordering Costs
Q: Annual purchasing salaries are $85,000, operating expenses for the
purchasing department are $35,000, and inspecting and receiving costs are
$30/order. If the purchasing department places 12,000 orders/year, what is
the average cost of ordering? What is the annual cost of ordering?
A: Average ordering cost = (fixed costs / number of orders) + variable cost
= (($85,000 + $35,000) / 12,000) + $30
= $40
Annual ordering cost = (Average ordering cost)(number of orders)
= ($40)(12,000)
= $480,000
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Inventory Fundamentals
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Inventory Costs
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Stockout Costs
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Stockouts occur when demand during leadtime exceeds
the forecast.
Could include back-order costs, lost sales and customers
Capacity Associated Costs
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Costs associated with changing the level of output
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Overtime, hiring, training, shifts, layoffs…..etc
Inventory Fundamentals
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Financial Performance Measures
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Inventory Turns Ratio:
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Inventory Turns = Annual COGS/Avg. Inventory $
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Widely used as a measure of inventory performance
Lumps all inventory together thereby hiding obsolete and slow
movers
Between 1977 and 1997, typical US high-tech manufacturer
nearly doubled its inventory performance – from 2.4 to 4.8
turns/year*
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*1998 PRTM study http://www.prtm.com
Example: Inventory Turns
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Q: What will be the inventory turns if the annual cost of goods sold is $32
million a year and the average inventory is $8 million?
A: Inventory turns = annual cost of goods sold / average inventory in $
= $32,000,000 / $8,000,000
=4
Q: What would be the reduction in inventory if inventory turns were
increased to 8 times per year? If the carrying costs for inventory is 25%,
what are the projected savings?
A: Average Inventory= annual cost of goods sold / inventory turns
= 32,000,000 / 8
= $4,000,000
Reduction in inventory = $8,000,000 - $4,000,000 = $4,000,000
Savings = Inventory reduction X 25% = $4,000,000 X 0.25 = $1,000,000
Inventory Fundamentals
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ABC Inventory Control
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A scheme where inventory is classified by level of
importance in terms of annual sales dollars.
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Based on Pareto’s Law:
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A items: 20% of items accounts for 80% of usage
B items: 30% of items account for 15% of usage
C items: 50% of items account for 5% of usage
Inventory Fundamentals
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ABC Analysis
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Establish item characteristics
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Usually annual dollar usage
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Classify items into groups based on criteria
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Apply control appropriate to classification
Inventory Fundamentals
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Control Based on ABC Classification
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Have plenty of low-value items
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Use the money and control effort saved to reduce
the inventory of high-value items
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A items get the tightest control and attention
B items get normal controls
C items get simple controls
Inventory Quality Ration (IQR)
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Developed by materials managers from 35
companies.
Collectively reduced inventories by $500M in
two years.
Implementation typically reduces inventories of
manufacturing and distribution companies by
an average of 25%.
Inventory Quality Ration (IQR)
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A true dollar-based performance measure
includes:
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Establishing inventory classes (based on $ Rqmts.)
Setting target inventory levels
Measuring the dollars invested in inventory
Establishing specific inventory objectives
Analyzing the data
Continuously improve
IQR Logic and Methodology
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Use ABC-type classifications using
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Establish a rule or target balance for each item
Group inventory
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Future dollar requirements
Past dollar usage
Current balances on hand
Active (A)
Future Requirements
Excess (E)
Slow moving (SM)
Recent Past Usage
Neither
No moving (NM)
IQR and its Effects
A1 + A2
IQR = A1 + A2 + E1 + E2 + SM + NM
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Active $
= Total $
Perfect condition (i.e., no excess, slow moving
or no moving inventories), the IQR = 100%
Average IQR = 30% – 45% range
For Next Week. . .
Do Problems:
 9.1
 9.3
 9.5
 9.7
 9.14
 9.16
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