1.
2.
4.
7.
9.
10.
11.
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a
fter reading this chapter, you should be able to do the following:
•
Appreciate the role and importance of inventory in the economy.
•
List the major reasons for carrying inventory.
•
Discuss the major types of inventory, their costs, and their relationships to
inventory decisions.
•
Understand the fundamental di erences among approaches to managing
inventory.
•
Describe the rationale and logic behind the economic order quantity (EOQ)
approach to inventory decision making, and be able to solve some problems of
a simple nature.
•
Understand alternative approaches to managing inventory—just-in-time (JIT),
materials requirement planning (MRP), distribution requirements planning
(DRP), and vendor-managed inventory (VMI).
•
Explain how inventory items can be classi ed.
•
Know how inventory will vary as the number of stocking points change.
•
Make needed adjustments to the basic EOQ approach to respond to several
special types of applications.
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Chapter 9
One clear by-product of the improving economy can be found in the current state of U.S.
inventory levels.
Remember, it was not that long ago that the “inventory glut” was a real drag on transportation
productivity on a couple of levels, whether it was decreased production or slower and longer
transit times.
And let’s not forget that when higher inventory levels are in place there’s less freight moving on
the
roads, rails, in the air, and aboard U.S.-bound container vessels.
But now the inventory outlook has improved signi cantly. Perhaps the best place to con rm
this is by
taking a look at the inventory-to-sales ratio data from the United States. The inventory-to-sales
ratio
is derived from dividing the number of sales compared to available inventory—with the higher
ratio
meaning inventory levels are running too high.
Based on data issued last month by the Department of Commerce’s U.S. Census Bureau, the
total
business inventories-to-sales ratio based on seasonally adjusted data at the end of March was
1.34,
marking a 0.04 percent annual gain. That is a pretty good number, especially considering back
in
January 2016 the ratio was 1.41.
This data may signal that the period of high inventories is in the rearview mirror, with the
inventoryto-sales ratio for total business inventories coming in at 1.36 or lower in nine of the last 13
months
through March 2018. That may not be quite enough to hang your hat on, but pretty good
overall.
Bob Costello, chief economist for the American Trucking Associations (ATA), recently laid out
the
current state of inventory on a conference call hosted by investment rm Stifel. He explained
that
the current inventory cycle is in a much better place than it has been going back to 2014,
which he
called a “great year for trucking.” But things started to weaken in 2015, 2016, and into early
2017
due to higher inventories.
“That was due to a host of reasons, including factory outputs slowing down and the economy
over
all slowing down,” said Costello. “Thus, companies overshot the inventory cycle. They have
since
brought it down. However, you can see that we’re not at all-time lows there, and certainly if you
went back even further than 2014 this ratio was even lower. I would argue that we’re not going
to
go down to those all-time lows. Online sales are a fast growing part of retail sales, and when
you
have more and more online sales, demand to have these products delivered in just a couple of
days
also increases.”
Costello took the online sales impact a step further, noting that current inventory levels appear
to be
in the “zone” they will remain in for a while, with the rapid pace of online sales preventing
inventory
levels from getting down to all-time lows for some time.
This is something Costello tells motor carrier eets to keep an eye on, because as the ratio
starts to
head up, it could translate into a freight slowdown. “However, not since we’ve come out of the
great
recession have all of these factors come together to provide an environment where freight is
this
solid,” he said. “So again, it’s very unusual because we’re so late in the inventory cycle.”
Old Dominion Freight Line (ODFL) president and CEO Greg Gantt o ered up some practical
analysis
regarding the impact of current inventory levels on the less-than-truckload sector in a recent
interview.
“I think you will continue to see just-in-time movements, as it can be too expensive for
shippers to
invest a lot in space,” said Gantt. “If you don’t have to have it, then why make those
investments?
I don’t see that changing. I would expect to continue to see just-in-time to continue growing.
What
we’re seeing is shorter lengths of haul to warehouses and more ful llment centers, with
customers
moving them closer to their business and closer to their customers.”
Supply Chain
p
ro le
Don’t Underestimate the
Inventory-to-Sales Ratio
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duplicated, in whole or in part. Due to electronic rights, some third party content may be
suppressed from the eBook and/or eChapter(s).
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learning experience. Cengage Learning reserves the right to remove additional content at any
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Managing Inventory in the Supply Chain
289
With lower inventories come quicker cycle and replenishment times, as well as a more uid and
e cient supply chain and transportation network. While much is made of what may be viewed
as
more attractive economic indicators, don’t forget the inventory-to-sales ratio. It’s more
important
than most people think.
Source:
Je Berman,
Logistics
Management
, June 2018, p. 15. Reprinted with permission of Peerless
Media, LLC.
9-1
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290
Chapter 9
The results of this aggressive management of inventories can be seen in Table 9.1, which
shows inventory investment as a percent of U.S. gross domestic product (GDP) from 2000
through 2018. As would be expected, the level or value of inventory increases with growth
in the U.S. economy. However, the important question is whether total inventory in the
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ntroduction
As discussed in Chapter 1, the e ective management of inventories in the supply chain
is one of the key factors for success in any organization. Inventory as an asset on the balance
sheet and as a variable expense on the income statement has taken on greater importance as
organizations attempt to more e ectively manage assets and working capital. As discussed
in Chapter 8, however, inventory takes on added importance because of its direct impact
on service levels. As such, inventory management has taken a strategic position in many
rms today.
Inventories also have an impact on return on investment (ROI) for an organization, which
will be discussed as return on net worth in Chapter 13. ROI is an important nancial metric
from both internal and external perspectives. Reducing inventories usually causes a shortterm improvement in ROI because it reduces assets and increases available working capital.
Inventory increases have the opposite e ect on assets and working capital. Important here
is the fact that inventory consumes an organization’s resources and is also responsible for
generating revenues. Thus, decisions regarding inventories must take into consideration the
tradeo s between costs and service.
The ultimate challenge in managing inventories is balancing the supply of inventory with
the demand for inventory. This was presented in Chapter 7. In other words, an organization
ideally wants to have enough inventory to satisfy the demands of its customers for its products with no lost revenue because of stockouts. However, the organization does not want to
have too much inventory on hand because it consumes valuable working capital. Balancing
supply and demand is a constant challenge for organizations to master but is a necessity to
compete in the marketplace.
This chapter will o er a comprehensive view of managing inventories in the supply chain.
Special importance will be placed on discussing why inventory is important, the nature of
inventory costs, and the various approaches to managing inventories. The next section will
o er an overview of the importance of inventory in the U.S. economy.
9-2
i
nventory in the
u
.S.
e
conomy
The in uence of information technology during the late 1990s and its impact on inventories was re ected in the U.S. economy’s ability to grow dramatically while holding in ation
in check. This exchange of “information for inventory” showed the impact that inventories
have on our economy. With information technology advances escalating in the early twentyrst century, organizations are still implementing programs to take inventories out of the
supply chain.
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duplicated, in whole or in part. Due to electronic rights, some third party content may be
suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially a ect the overall
learning experience. Cengage Learning reserves the right to remove additional content at any
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economy grows at the same rate as GDP. Obviously, it is best for inventory to increase at a
slower rate than GDP. This means that the economy is generating more revenue with less
assets and working capital investment.
Table 9.1 shows that the nominal GDP grew by 106 percent in the time period between
2000 and 2018. Similarly, the value of business inventory increased by 86 percent during the
same time period. However, inventory costs as a percent of GDP declined from 14.9 percent
in 2000 to 13.4 percent in 2018. So, even though the absolute value of inventory increased dur
ing this time period, it decreased as a percent of GDP. This declining trend indicates that the
economy is producing more revenue with less assets and working capital. While the trend is
down, the year-to-year changes indicate the element of volatility faced by many organizations.
t
able 9.1
Macro
i
nventory in
r
elation to
u
.S.
g
ross Domestic
p
roduct
YEAR
ALL VALUE
BUSINESS
INVENTORY
($ BILLION)
INVENTORY
CARRYING RATE
(PERCENT)
INVENTORY
CARRYING COSTS
($ BILLION)
NOMINAL GDP
($ TRILLION)
INVENTORY
CARRYING AS A
PERCENT OF GDP
INVENTORY
COSTS AS A
PERCENT OF GDP
2000
$1,478
25.3
374
9.95
3.8
14.9
2001
1,403
22.8
320
10.29
3.1
13.6
2002
1,451
20.7
300
10.64
2.8
13.6
2003
1,508
20.1
304
11.14
2.7
13.5
2004
1,650
20.4
337
11.87
2.8
13.9
2005
1,782
22.3
397
12.64
3.1
14.1
2006
1,859
24.0
446
13.4
3.3
13.9
2007
2,015
24.1
485
14.06
3.4
14.3
2008
1,962
21.4
419
14.37
2.9
13.7
2009
1,929
19.3
372
14.45
2.6
13.4
2010
2,016
18.5
374
14.99
2.5
13.4
2011
2,247
17.7
398
15.54
2.6
14.5
2012
2,338
17.5
409
16.2
2.5
14.4
2013
2,395
17.8
426
16.78
2.5
14.3
2014
2,524
16.2
408
17.52
2.3
14.4
2015
2,514
17.0
427
18.22
2.3
13.8
2016
2,528
16.3
413
18.71
2.2
13.5
2017
2,029
16.4
430
19.49
2.2
13.5
2018
2,750
18.0
494
20.50
2.4
13.4
Source:
Cresting the
Hill CSCMP’s Annual State of Logistics Report, 2018.
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duplicated, in whole or in part. Due to electronic rights, some third party content may be
suppressed from the eBook and/or eChapter(s).
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learning experience. Cengage Learning reserves the right to remove additional content at any
time if subsequent rights restrictions require it.
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Managing Inventory in the Supply Chain
291
The focus of these data should be on the trend, which clearly indicates a relative decline
in inventory value and inventory carrying cost as a percent of GDP—a positive metric for
the economy and business organizations in general. Inventories represent a cost of doing
business and are included in the prices of products and services. Reductions in inventory
costs, especially if there is no decline in customer service, are bene cial to both buyers
and sellers.
As discussed in Chapter 2, the major cost tradeo in logistics is between transportation
and inventory. That is, the faster and more reliable (and more expensive) the transportation,
the less the cost of inventories. Like inventory costs, transportation costs as a percent of GDP
declined during the 1990s. However, the cost of fuel today, coupled with capacity constraints
in the transportation industry, has escalated the costs of transportation. The economics of
this rapid rise in transportation costs have not yet been determined. However, it will be
interesting to see if the traditional tradeo s between transportation and inventory costs will
remain the same in this new environment.
9-3
i
nventory in the Firm:
r
ationale for
i
nventory
As indicated previously, inventory plays a dual role in organizations. Inventory impacts
the cost of goods sold as well as supporting order ful llment (customer service). Table 9.2
reports total logistics costs for the economy and shows that inventory carrying costs are on
average about 30.2 percent of total logistics costs for organizations. Transportation costs
comprise about 63.4 percent of all logistics costs.
Consumer packaged goods (CPG) rms
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292
Chapter 9
t
able 9.2
t
otal
l
ogistics Costs—2018
$ BILLION
Carrying Costs—$2.750 Trillion All Business Inventory
Interest
192.5
Taxes, Obsolescence, Depreciation, Insurance
148.1
Warehousing
153.1
fi
fi
and the wholesalers and retailers that are a
part of their distribution channels face a special challenge in keeping inventories at acceptable levels because of the di culty of forecasting demand and the increasing expectations
from customers concerning product availability. Both of these factors are magni ed by these
rms increasing the complexity of their product o erings. For example, if Hershey forecasted aggregate demand for Kisses
TM
for the rst quarter next year to be 1 million cases, it
would have to break this number down by stock-keeping unit (SKU), packaging, geography,
and so on. This could result in hundreds or thousands of SKUs that require some level of
inventory and safety stock. Consumer preferences can change quickly, which makes managing inventory levels a special challenge.
To illustrate the cost side of the challenge, assume that Hershey expects to carry an aver
age monthly inventory during the rst quarter of the year of 250,000 cases of Kisses. If each
case is valued at $25, the value of the inventory would be $6.25 million (250,000 cases ×
$25). If its cost of carrying inventory (to be explained later in this chapter) is 25 percent, its
cost of carrying inventory during this period would be $1,562,500. If the average inventory
increased to 350,000 cases, this would result in an additional $2.5 million of inventory cost.
If the increase in inventory was not accompanied by an equal or greater increase in revenue,
Hershey would face a reduction in pretax pro t.
Hopefully, the point has been made that managing inventory is a critical factor for success
in many organizations. Many organizations have responded to this challenge—as indicated
by the macro data presented in the previous section—and have reduced inventory levels
while maintaining appropriate customer service levels. Their ability to achieve the twin
goals of lower inventory (e ciency) and acceptable customer service levels (e ectiveness)
is based on a number of factors discussed in this chapter. A good starting point is an under
standing of why organizations usually have to carry inventories and the resulting tradeo s
and relationships.
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duplicated, in whole or in part. Due to electronic rights, some third party content may be
suppressed from the eBook and/or eChapter(s).
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learning experience. Cengage Learning reserves the right to remove additional content at any
time if subsequent rights restrictions require it.
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SUBTOTAL
493.7
Transportation Costs—Motor Carriers
Truck—Intercity
668.8
Truck—Local
104.9
SUBTOTAL
773.7
Transportation Costs—Other Carriers
Railroads
88.4
Water (international 31, domestic 9)
45.7
Oil Pipelines
53.0
Air (international 12, domestic 16)
76.5
SUBTOTAL
263.6
Carrier Support Activities
52.3
Shipper’s Administrative Costs
52.1
TOTAL LOGISTICS COST 1,635.46
Source:
Cresting the
Hill4
, CSCMP’s Annual State of Logistics Report, 2018.
9-3a
Batching Economies or Cycle Stocks
Batching economies
or
cycle stocks
usually arise from three sources—procurement,
production, and transportation. Scale economies are often associated with all three, which
can result in the accumulation of inventory that will not be used or sold immediately—which
means some cycle stock or inventory will be used up or sold over some period of time.
In the procurement area, it is not unusual for a seller to have a schedule of prices that
re ects the quantity purchased. In other words, larger purchased volumes result in lower
prices per unit and vice versa. Purchase discounts are also prevalent for personal consumption items. For example, buying a package of 12 rolls of paper towels at Sam’s Club would
result in a lower price per roll than if the 12 rolls were bought separately. When the larger
package is purchased, cycle stock is created. What is not consumed immediately will have
to be stored. When organizations buy raw materials and supplies, particularly in our global
economy, they are often o ered price discounts for larger quantities. The tradeo logic that
was mentioned earlier suggests that the price discount savings have to be compared to the
additional cost of carrying inventory. This is a relatively straightforward analysis, which is
discussed later in this chapter. In spite of the framework available for analyzing discount
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suppressed from the eBook and/or eChapter(s).
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learning experience. Cengage Learning reserves the right to remove additional content at any
time if subsequent rights restrictions require it.
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Managing Inventory in the Supply Chain
293
tradeo s, sometimes organizations just focus on the price savings and do not justify the
discount against the additional inventory carrying cost.
A related discount situation occurs with transportation services. Transportation rms
usually o er rate or price discounts for shipping larger quantities. In the motor carrier industry, a common example is the lower rate or price per pound for shipping truckload quantities
versus less-than-truckload quantities. The motor carrier saves money in pick-up, handling,
and delivery costs with the truckload shipment, and these are re ected in a lower rate or
price to the shipper. The larger shipment quantities to justify the discount have the same
e ect as the purchase quantities—that is, cycle stocks. The tradeo requirement is the same.
Do the costs savings from the larger shipment o set the additional inventory carrying cost?
Note that purchase economies and transportation economies are complementary. That
is, when organizations buy larger quantities of raw materials or supplies, they can ship larger
quantities, which can result in transportation discounts. Therefore, they are frequently the
recipients of two discounts for the same item purchased, which can make the tradeo evaluation positive. One of the big challenges, discussed later in this chapter, is that many organizations might not calculate their carrying costs accurately.
The third batching economy is associated with production. Many organizations feel that
their production costs per unit are substantially lower when they have long production runs
of the same product. Long production runs decrease the number of changeovers to a production line but increase the amount of cycle stock that must be stored until sold. Traditionally,
organizations rationalized long productions runs to lower unit costs without really evaluating the resulting inventory carrying costs, which can be high for nished goods. There is
also a related concern about obsolescence of nished goods when high inventories are kept.
Most organizations have cycle stocks, even if they do not purchase products, because of
the purchase of supplies. Obviously, cycle stocks can be bene cial as long as the appropriate
analysis is done to justify the cost of the inventory.
9-3b
Uncertainty and Safety Stocks
All organizations are faced with uncertainty. On the demand or customer side, there is
usually uncertainty in how much customers will buy and when they will buy it. Forecasting
demand (discussed in Chapter 7) is a common approach to resolving demand uncertainty,
but it is never completely accurate. On the supply side, there might be uncertainty about
obtaining what is needed from suppliers and how long it will take for the ful llment of the
order. Uncertainty can also arise from transportation providers in terms of receiving reliable delivery. The net result of uncertainty is usually the same: organizations accumulate
safety stock to bu er themselves against stockouts. The challenge and analysis are di erent
for safety stock than for cycle stock; safety stock is much more complex and challenging to
manage because it is redundant inventory.
If a production line shuts down because of a supply shortage or a customer does not
receive a delivery, problems will arise. Tradeo analysis is appropriate and can be accomplished using the appropriate tools to assess the risk and measure the inventory cost. In
addition, organizations today are taking a more proactive approach to reducing uncertainty
by using the power of information to help reduce the need for safety stocks. A previous
discussion noted that information can be used to replace inventory. There has literally been
an information revolution because of the technology now available to transmit and receive
timely and accurate information between trading partners. Collaboration in the sharing of
information in some supply chains has yielded signi cant results in reducing inventories and
ff
improving service at the same time. Collaborative planning, forecasting, and replenishment
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suppressed from the eBook and/or eChapter(s).
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learning experience. Cengage Learning reserves the right to remove additional content at any
time if subsequent rights restrictions require it.