Inventory Policy
Decisions
Lecturer: Arsalan Siddiqui
9-1
CR (2004) Prentice Hall, Inc.
CONTROLLING
Customer
service goals
• The product
• Logistics service
• Ord. proc. & info. sys.
Transport Strategy
• Transport fundamentals
• Transport decisions
PLANNING
Inventory Strategy
• Forecasting
• Inventory decisions
• Purchasing and supply
scheduling decisions
• Storage fundamentals
• Storage decisions
ORGANIZING
Inventory Decisions in
Strategy
Location Strategy
• Location decisions
• The network planning process
9-2
CR (2004) Prentice Hall, Inc.
Nature of Demand
•Perpetual demand
-Continues well into the foreseeable future
•Seasonal demand
-Varies with regular peaks and valleys throughout
the year
Accurately forecasting
demand is singly the
•Lumpy demand
most important factor
-Highly variable (3  Mean)
in good inventory
•Regular demand
management
-Not highly variable (3 < Mean)
•Terminating demand
-Demand goes to 0 in foreseeable future
•Derived demand
-Demand is determined from the demand of another9-3
item of which it is a part
Inventory Management
Philosophies
•Pull
-Draws inventory into the stocking location
-Each stocking location is considered independent
-Maximizes local control of inventories
•Push
-Allocates production to stocking locations based on
overall demand
-Encourages economies of scale in production
•Just-in-time
-Attempts to synchronize stock flows so as to just
meet demand as it occurs
9-4
-Minimizes the need for inventory
CR (2004) Prentice Hall, Inc.
Inventory Management
Philosophies (Cont’d)
•Supply-Driven
-Supply quantities and timing are unknown
-All supply must be accepted and processed
-Inventories are controlled through demand
•Aggregate Control
-Classification of items:
›Groups items according to their sales level
based on the 80-20 principle
›Allows different control policies for 3 or more
9-5
broad product groups
CR (2004) Prentice Hall, Inc.
Pull vs. Push Inventory Philosophies
PUSH - Allocate supply to each
warehouse based on the forecast
for each warehouse
PULL - Replenish inventory with
order sizes based on specific needs
of each warehouse
Demand
forecast
Warehouse #1
Q1
A1
A2
Q2
Plant
Warehouse #2
A3
Demand
forecast
Q3
A = Allocation quantity to each warehouse
Q = Requested replenishment quantity
by each warehouse
CR (2004) Prentice Hall, Inc.
Warehouse #3
Demand
forecast
9-11
Costs Relevant to Inventory
Management
•Carrying costs
-Cost for holding the inventory over time
-The primary cost is the cost of money tied up in
inventory, but also includes obsolescence,
insurance, personal property taxes, and storage
costs
-Typically, costs range from the cost of short term
capital to about 40%/year. The average is about
25%/year of the item value in inventory.
9-7
CR (2004) Prentice Hall, Inc.
Relevant Costs (Cont’d)
•Procurement costs
-Cost of preparing the order
-Cost of order transmission
-Cost of production setup if appropriate
-Cost of materials handling or processing at the
receiving dock
-Price of the goods
9-8
CR (2004) Prentice Hall, Inc.
Relevant Costs (Cont’d)
•Out-of-stock costs
-Lost sales cost
›Profit immediately foregone
›Future profits foregone through loss of goodwill
-Backorder cost
›Costs of extra order handling
›Additional transportation and handling costs
›Possibly additional setup costs
9-9
CR (2004) Prentice Hall, Inc.
Inventory Management Objectives
Good inventory management is a careful balancing act
between stock availability and the cost of holding
inventory.
Customer Service,
i.e., Stock Availability
Inventory Holding costs
•Service objectives
-Setting stocking levels so that there is only a
specified probability of running out of stock
•Cost objectives
-Balancing conflicting costs to find the most 9-10
economical replenishment quantities and timing
CR (2004) Prentice Hall, Inc.
Inventory’s Conflicting Cost Patterns
Minimum cost
reorder quantity
Cost
Total cost
Procurement cost
Stockout cost
CR (2004) Prentice Hall, Inc.
Replenishment quantity
9-16
FUNCTIONS OF LOGISTICS
Procurement or purchasing
 Inward transport
 Receiving
 Material Handling
 Warehousing
 Inventory control

9-12
FUNCTIONS OF LOGISTICS (CONT)
Order picking
 Outward transport
 Physical distribution
 Recycling, returns and waste disposal
 Location
 Communication

9-13
PROCUREMENT OR PURCHASING



Procurement or purchasing which usually initiates the flow
of materials through an organization by sending a purchase
order to a supplier
This means that procurement has to find suitable
suppliers, negotiate terms, set conditions, organize
delivery, arrange insurance, authorize payment, and do
everything needed to get materials into the organization.
In the past, this has been a largely clerical job centered on
order processing, but now it is recognized as being
responsible for major expenditure and giving a critical link
with supplier
9-14
CONTINUED
Inward transport or traffic which actually moves
materials from suppliers to the organization’s
receiving area
 Important decisions concern the mode of
transport (road, rail, air, etc.), policies for
outsourcing, choice of transport operator, route,
safety and legal requirements, timing of
deliveries, costs, etc.
 Receiving makes sure that materials delivered
correspond to the order, acknowledges receipt,
unloads delivery vehicles, inspects materials for
damage, and sorts them.

9-15
MATERIAL HANDLING
Material handling moves materials from
receiving and puts them into stores
 It is responsible for all movements of materials
within an organization, so it also removes
materials from stores, takes them to the place
they are needed, and generally moves materials
between operations

9-16
CONTINUED
Warehousing or stores takes care of materials
held in stock until they are needed.
 Warehousing makes sure that materials have the
right conditions, treatment and packaging to
keep them in good condition, and are available
quickly when needed.
 Stock or inventory control sets the overall policies
for stock, considering the materials to store,
investment, customer service, stock levels, order
sizes, order timing and so on.

9-17
CONTINUED
Order picking finds and removes materials from
stores.
 Typically materials for a customer order are
located, identified, checked, removed from racks,
consolidated into a single load, wrapped and
moved to a departure area for loading onto
delivery vehicles.
 Outward transport takes materials from the
departure area and delivers them to customers
(with concerns that are similar to inward
transport).

9-18
CONTINUED
Physical distribution is a general term for the
activities that deliver finished goods to customers.
 It is often aligned with marketing and forms an
important link with downstream activities.

9-19
RECYCLING, RETURNS AND WASTE
DISPOSAL



There are sometimes problems with delivered materials –
perhaps faults, the wrong materials or too much delivered
– and logistics has to collect them and bring them back to
the supplier
This reverse logistics also collects associated materials such
as pallets, delivery boxes, cable reels and containers (the
standard 20-foot-long metal boxes that are used to move
goods).
Some materials are brought back for recycling (such as
metals, glass, paper, plastics and oils) while others are
brought back for safe disposal (such as dangerous
chemicals).
9-20
CONTINUED




Location finds the best site for those activities that can be in
different places.
Stocks of finished goods, for example, can be held at the
end of production, moved to nearby warehouses, sent to
large centralized facilities, put into stores near to
customers, passed on to be managed by other
organizations, or a range of alternatives.
Communication Alongside the physical flow of materials is
the associated flow of information
This links all parts of the supply chain, passing
information about products, customer demand, materials
moved, timing, stock levels and etc.
9-21
INVENTORY AND LOGISTICS



These Functions reinforces the point that all logistics
activities have a direct impact on the stocks
To take one example, we can look at the mode of transport,
which describes the type of delivery vehicle used. The
alternative modes are road, rail, air, inland waterway,
ocean shipping or pipeline – and the choice is determined
by locations, infrastructure, weight and volume carried,
value of goods, customer service offered, urgency and a
series of other factors. But this choice has a direct effect on
stocks.
Air travel is fastest and most expensive while shipping is
slowest and cheapest – so the choice affects lead times and
delivery costs. It also affects the amount of pipeline stocks
(which are the materials in transit between locations), with
airfreight having little stock on short journeys and
shipping having weeks of stock out at sea.
9-22
Top
Mgt.
--------STRATEGIC
Mid-Mgt.
------------TACTICAL
First-Line Mgt.
-------------------OPERATIONAL
LEVEL OF DECISIONS



Strategic decisions are most important, have effects over the
long term, use many resources and are the most risky.
These set the overall direction for operations. (Customer
service is a strategic issue when designing the supply
chain)
Tactical decisions are concerned with implementing the
strategies over the medium term; they look at more detail,
involve fewer resources and some risk. (a tactical issue
when organizing transport for delivery)
Operational decisions are concerned with implementing the
tactics over the short term; they are the most detailed,
involve few resources and little risk. (an operational issue
when scheduling the next delivery)
9-24
Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.
Supply Chain Management: Strategy, Planning, and Operation, 5/e Authors: Sunil Chopra, Peter Meindl and D.
V. Kalra
• Role in competitive strategy
Form, location, and quantity of inventory allow a supply chain to
range from being very low cost to very responsive
Objective is to have right form, location, and quantity of
inventory that provides the right level of responsiveness at
the lowest possible cost
Supply Chain Management: Strategy, Planning, and Operation, 5/e Authors: Sunil Chopra, Peter Meindl and D.
V. Kalra
Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.
Inventory
Single Order Purchasing
Make a one-time purchase of an item. How much to order?
Procedure: Balance incremental profit against incremental loss.
Profit = Price per unit  Cost per unit
Loss = Cost per unit  Salvage value per unit
If CPn is probability of n units being sold, then
CPn x Loss = (1  CPn) x Profit
or
CPn = Profit/(Profit + Loss)
Daily stocking of
newspapers in
vending
machines is a
good example
Now, increase order quantity until CPn just matches cumulative
probability of selling additional units.
CR (2004) Prentice Hall, Inc.
9-18
Single Order Purchasing (Cont’d)
Example A clothing item is purchased for a seasonal sale.
It costs $35, but it has a sale price of $50. After the
season is over, it is marked down by 50% to clear the
merchandise. The estimated quantities to be sold are:
Probability of
Number of selling exactly n
items, n
items
10
0.15
15
0.20
20
0.30
25
0.20
30
0.10
35
0.05
1.00
CR (2004) Prentice Hall, Inc.
Cumulative
probability
0.15
0.35
0.65
0.85
0.95
1.00
9-19
Single Order Purchasing (Cont’d)
Solution
Profit = $50 35 = $15
Loss = $35  (0.5)(50) = $10
CPn = 15/(15 + 10) = 0.60
CPn is between 15 and 20 items, round up and order 20
items.
9-30
CR (2004) Prentice Hall, Inc.
Turnover Ratio
Annual sales
Turnover ratio 
Average inventory
A fruit grower stocks its dried fruit products in 12 warehouses
around the country. What is the turnover ratio for the
distribution system?
Warehouse
no.
1
2
3
4
5
6
Annual
Average
warehouse
inventory
throughput, $
level, $
21,136,032
2,217,790
16,174,988
2,196,364
78,559,012
9,510,027
17,102,486
2,085,246
88,228,672 11,443,489
40,884,400
5,293,539
TO ratio 
$425,295,236
 9.7
$43,701,344
CR (2004) Prentice Hall, Inc.
Warehouse
no.
7
8
9
10
11
12
Totals
Annual
warehouse
throughput, $
43,105,917
47,136,632
24,745,328
57,789,509
16,483,970
26,368,290
425,295,236
$ are at cost
Average
inventory
level, $
6,542,079
5,722,640
2,641,138
6,403,076
1,991,016
2,719,330
43,701,344
9-31
9-32
9-33
Virtual Inventories
•Stockouts are filled from other stocking locations in
the distribution network
• Customers assigned to a primary stocking location
• Backup locations are usually determined by
“zoning” rules
• Expectation is that lower system-wide inventories
can be achieved while maintaining or improving
stock availability levels
• Total distribution costs should be lower to support
the cross filling of customer demand
9-34
CR (2004) Prentice Hall, Inc.
ABC INVENTORY CLASSIFICATION
ABC classification is a method for determining level
of control and frequency of review of inventory items
 A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
 A Items – typically 20% of the items accounting for
80% of the inventory value-use
 B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use
 C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value
©
Wile
y
201
0
ABC ANALYSIS
A items are the few most expensive ones that
need special care.
 B items are ordinary ones that need standard
care
 C items are the large number of cheap items
that need little care.

36
©
Wiley
2010
37
©
Wiley
2010
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©
Wiley
2010
CONCLUSION
39
©
Wiley
2010
ANALYSIS ON ITS ENTIRE INVENTORY BUT HAS DECIDED TO
TEST THE TECHNIQUE ON A SMALL SAMPLE OF 15 OF ITS
SKU’S. THE ANNUAL USAGE AND UNIT COST OF EACH
ITEM IS SHOWN BELOW
40
©
Wile
y
201
0
(A) FIRST CALCULATE THE ANNUAL
DOLLAR VOLUME FOR EACH ITEM
41
B) LIST THE ITEMS IN DESCENDING ORDER BASED ON ANNUAL DOLLAR
VOLUME. (C) CALCULATE THE CUMULATIVE ANNUAL DOLLAR VOLUME
AS A PERCENTAGE OF TOTAL DOLLARS. (D) CLASSIFY THE ITEMS INTO
GROUPS
42
GRAPHICAL SOLUTION FOR AAU CORP
SHOWING THE ABC CLASSIFICATION OF
MATERIALS



© Wiley 2010

The A items (106 and 110) account for 60.5% of the value and 13.3% of the
items
The B items (115,105,111,and 104) account for 25% of the value and 26.7% of
the items
The C items make up the last 14.5% of the value and 60% of the items
How might you control each item classification? Different ordering rules for
each?
43
PRACTICE PROBLEM
A company manufactures a line of ten items. The
usage and unit cost are shown in the following
table, along with the annual dollar usage. The
latter is obtained by multiplying the unit usage by
the unit cost.
 a. Calculate the annual dollar usage for each item.
,
b. List the items according to their annual dollar
usage.
 c. Calculate the cumulative annual dollar usage
and the cumulative percentage of items.
 d. Group items into an A, B, C classification

,

,

,