51
Inventory Concepts
INVENTORY IS A
LARGE AND COSTLY
INVESTMENT
“Every management mistake ends up in inventory.”
Michael C. Bergerac
Former Chief Executive
Revlon, Inc.
What are Inventories?
•Finished product held for sale
•Goods in warehouses
•Work in process
•Goods in transit
•Any owned or financially controlled
raw material, work in process, and/or
finished good or service held in
anticipation of a sale but not yet sold
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
(inventory Carrying 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
economical replenishment quantities and timing
CR (2004) Prentice Hall, Inc.
4
3
Inventory Management Answers
Four Important Questions

How to order?

When to order?

What to order?

How much to order?
42
Why Hold Inventory?
1.
2.
3.
4.
5.
It enables the firm to achieve economies of
scale
It balances supply and demand
It enables specialization in manufacturing
It provides protection from uncertainties in
demand and order cycle
It acts as a buffer between critical interfaces
within the channel of distribution
Economies of Scale

Inventory is required if an organization is to
realize economies of scale in purchasing,
transportation, or manufacturing.

Per unit price reductions!

The cost of maintaining this inventory must
be “traded off” against the production
savings realized.
Balancing Supply and
Demand
Seasonal supply or demand may make it
necessary for a firm to hold inventory. (finished
goods)
 Demand for a product may be relatively stable
throughout the year, but raw materials may be
available only at certain times during the year.
 Ex: Canned fruits and vegetables

Specialization




Inventory makes it possible for each of a firm’s
plants to specialize in the products that it
manufactures.
The finished products can be shipped to field
warehouses where they are mixed to fill customer
orders.
Whirlpool Co.- cost savings through specializing
manufacturing by plant location and the
consolidation of warehouse operations
Focused Factories-specialization by facility
Protection From
Uncertainties

Inventory is held as protection from
uncertainties; that is, to prevent a stock out
in the case of variability in demand or
variability in the replenishment cycle.

Inventory planning is critical to successful
manufacturing operations to protect from
uncertainties.
Inventory As A Buffer

Inventory is held throughout the supply chain
to act as a buffer for the following critical
interfaces:
–
–
–
–
–
–
* supplier-procurement
* procurement-production
* production-marketing
* marketing-distribution
* distribution-intermediary
* intermediary-customer/user
TYPES OF INVENTORIES
Inventories can be classified based on the reasons
for which they are accumulated.






In-transit inventories
Speculative stock
Seasonal stock
Dead stock
Cycle stock
Safety or buffer stock
In-transit Inventories

In-transit inventories are items that are en
route from one location to another

For calculating inventory carrying costs,intransit inventory should be considered as
inventory at the place of shipment origin
since the items are not available for use,
sale ,etc.
Speculative Stock

Speculative stock is inventory held for reasons
other than satisfying current demand

Materials may be purchased in volumes larger
than necessary:
to receive quantity discounts,
because of a forecasted price increase
materials shortage,
to protect against the possibility of a strike.




Seasonal Stock

Seasonal stock is a form of speculative
stock that involves the accumulation of
inventory before a seasonal period begins

This often occurs with agricultural products
and seasonal items.

Ex: back-to-school
Dead Stock

Dead stock refers to items for which no demand has been
registered for some specified period of time.

Dead stock might be obsolete throughout a company or
only at one stock keeping (SKU) location.

J.C. Whitney Company-sells auto parts that are no longer
produced

Transshipment of dead stock-Asia markets
Cycle Stock

Cycle stock is inventory that results from
replenishment of inventory sold or used in production.

It is required in order to meet demand under
conditions of certainty; that is, when the firm can
predict demand and replenishment times (lead times).

Orders are scheduled to arrive just as the last unit is
sold-no extra inventory beyond the cycle stock is
required.
Cycle Stock
Lot or batch size: The quantity that a stage of supply
chain either produces or purchases at a given time

Q: quantity in a lot or batch size

Cycle stock: Q / 2
Safety or Buffer Stock

Safety or buffer stock is held in excess of cycle stock
because of uncertainty in demand or lead time.

Average inventory at a stock keeping location that
experiences demand or lead time variability = half the
order quantity (cycle stock)+ the safety stock
44
The Effect of Reorder Quantity on
Average Inventory Investment with
Constant Demand and Lead Time
Demand:20
units
A. Orderquantity of 400 units
Inventory
Order
arrival
400
Order
placed
Order
arrival
Order
placed
Average
cycle
inventory
200
0
Days
10
20
30
40
50
60
4
5
The Effect of Reorder Quantity on
Average Inventory Investment with
Constant Demand and Lead Time
Demand:20
units
B. Order quantity of 200 units
Inventory
Order
arrival
Order
placed
200
Average
c cle
inventory
y
100
0
Days
10
20
30
40
50
60
4
6
The Effect of Reorder Quantity on
Average Inventory Investment with
Constant Demand and Lead Time
Demand:20
units Inventory
C. Order quantity of 600 units
600
Order
arrival
Average
cycle
inventory
Order
placed
300
0
Days
10
20
30
40
50
60
11
4
Average Inventory Investment
Under Conditions of Uncertainty
Demand:2025 units
A. With variable demand
Inventory
200
Average
cycle
inventory
100
{{
Ave ra ge
inve ntory
(150)
S afety
s tock
(50)
8
10
20
30
Days
40
12
4
Average Inventory Investment
Under Conditions of Uncertainty
If orders arrive 2 days late
B. With variable lead time
Inventory
200
Average
cycle
inventory
100
{{
Ave ra ge
inve ntory
(140)
S afety
s tock
(40)
10
12
20
30
Days
40
13
4
Average Inventory Investment
Under Conditions of Uncertainty
C. With variable demand and lead time
Inventory
200
Average
cycle
inventory
100
{{
Ave ra ge
inve ntory
(200)
S afety
s tock
(10 0)
8
10
12
20
30
Days
40
4 14
Factors Influencing
Safety Stocks

Forecast error

Exposure to stockout

Lead time

Service level
requirement
Impact of Demand Patterns
on Inventory Management
•Just-in-time (production philosophy)
-Attempts to synchronize stock flows so as to just
meet demand as it occurs
-Minimizes the need for inventory
•
INDEPENDENT versus DEPENDENT DEMAND
- Whether the demand for an item depends on
demand for something else-dependent demand
– - demand for an item depends on demand for something
else
• Pull strategy

production and distribution are demand driven so that
they are coordinated with actual customer orders,
rather than forecasted demand.
• Draws inventory into the stocking location
• Each stocking location is considered independent
• Maximizes local control of inventories
•Push Strategy

Products are pushed through the channel, from the
production side up to the retailer.

The manufacturer sets production at a level in accord
with historical ordering patterns of retailers.

It takes longer for a push-based supply
respond to changes in demand, which can
overstocking or bottlenecks and delays (the
effect), unacceptable service levels and
obsolescence.
chain to
result in
bullwhip
product
– - Allocates production to stocking locations based on
overall demand
– - Encourages economies of scale in production
•Push-Pull Boundary

the interface between the push-based stages and the pullbased stages is known as the push-pull boundary.

Dell- Inventory levels of individual components are
determined by forecasting general demand, but final
assembly is in response to a specific customer request. The
push-pull boundary would then be at the beginning of the
assembly line.
Inventory Carrying Cost

Inventory carrying costs are those costs associated
with the amount of inventory stored.

Inventory carrying costs are made up of a number
of different costs.

Unfortunately, many companies have never
calculated inventory carrying costs, even though
these costs are both real and substantial.

Benchmarking the percentage of inventory
carrying costs-Avon /Revlon
5
3
Normative Model of Inventory Carrying
Cost Methodology
Capital
costs
Inventory
service
costs
Inventory
Carrying
Costs
Inventory Investment
Insurance
Taxes
Plant warehouses
Storage
space costs
Public warehouses
Rented warehouses
Company-owned
warehouses
Obsolescence
Inventory
risk costs
Damage
Pilferage
Relocation costs
MAIN AIMS OF INVENTORY
MANAGEMENT

To improve cash flows

To improve return on investment (ROI)
Inventory and Least Total
Cost Logistics
Inventory carrying cost is related with the decision of






logistics system design,
customer service levels,
number and location of DCs,
transportation modes,
inventory levels
production schedules.
Inventory turnover as a Measure Of
Inventory Management Effectiveness
Inventory turnover= Total cost of goods sold
/Average inventory at cost
Average inventory at cost = beginning inventory
(cost) + ending inventory (cost) / 2
Inventory Turns (Inventory Turnover): The number of
times that a company’s inventory cycles or turns over per
year.
It is one of the most commonly used Supply Chain Metrics
showing how fast a company is selling through its inventory
and efficiently managing its resources
Coca-Cola
Balance Sheet
Inventories
2000
1999
$1,066,000,000
$1,076,000,000
Income
Statement
Cost of Goods
Sold
$6,204,000,000
5.79 times each year
5
8
The Impact of Inventory Turns
on Inventory Carrying Costs
Inventory
Turns
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Average
Inventory
$750,000
375,000
250,000
187,500
150,000
125,000
107,143
93,750
83,333
75,000
68,182
62,500
57,692
53,571
50,000
Carrying Cost
at 40 Percent
$300,000
150,000
100,000
75,000
60,000
50,000
42,857
37,500
33,333
30,000
27,273
25,000
23,077
21,428
20,000
Carrying Cost
Savings
$150,000
50,000
25,000
15,000
10,000
7,143
5,357
4,167
3,333
2,727
2,273
1,923
1,649
1,428
9
5
Relationship between Inventory
Turns and Inventory Carrying Costs
Inventory carrying costs
$300,000
$275,000
$250,000
$225,000
$200,000
$175,000
$150,000
$125,000
$100,000
$75,000
$50,000
$37,500
$25,000
0
1
2
3
4
5
6
7
8
Inventory Turns
9
10
11
12
13
14
15
10
5
Annual Inventory Carrying Costs
Compared to Inventory Turnovers
Inventory carrying costs (per unit)
$30.00
Variable Manufacturing Cost
$100
Carrying Cost %
x 30%
Annual Cost to Carry in Inventory $30
Monthly Cost (1/12)
$2.50
15.00
12.50
10.00
7.50
6.00
5.00
3.75
2.50
0
1
2
3
4
5
6
7
8
Inventory Turns
9
10
11
12
ABC Analysis-Pareto
80/20 concept is useful in distribution
and inventory management.
 The top 20 %-A ~ wide geographic
distribution through many warehouses
with high levels of stock availability
 The next 30 %- B
 The remainder 50 %- C~distributed from
a single, central stocking point

4
The EOQ Model
7
EOQ =
2PD
CV
where:
P = The ordering cost (dollars per order)
D = Annual demand or usage of the product
(number of units)
C = Annual inventory carrying cost (as a percentage
of product cost or value)
V = Average cost or value of one unit of inventory
8
4
Cost Trade-offs Required to Determine
the Most Economic Order Quantity
Total cost
Annual cost
(dollars)
Lowest total cost
(EOQ)
Inventory
carrying
cost
Ordering cost
Size of order
9
4
Cost Trade-offs Required to Determine
the Most Economic Order Quantity
Order
Quantity
40
60
80
100
120
140
160
200
300
400
Number
of Orders
(D/Q)
120
80
60
48
40
35
30
24
18
12
Ordering
Cost
PX (D/Q)
$ 4,800
3,200
2,400
1,920
1,600
1,400
1,200
960
720
480
Inventory
Carrying
Cost
1/2 Q X C X V
$ 500
750
1,000
1,250
1,500
1,750
2,000
2,500
3,750
5,000
Total
Cost
$ 5,300
3,950
3,400
3,170
3,100
3,150
3,200
4,460
4,470
5,480
10
Assumptions of the Simple
EOQ Model
4









A continuous, constant, and known rate of
demand.
A constant and known replenishment cycle or
lead time.
A constant purchase price that is independent of
the order quantity or time.
A constant transporation cost that is independent
of the order quantity or time.
The satisfaction of all demand (no stockouts are
permitted).
No inventory in transit.
Only one item in inventory, or at least no
interaction among items.
An infinite planning horizon.
No limit on capital availability.
Symptoms of Poor Inventory
Management








Increasing numbers of back orders.
Increasing investment in inventory with back orders remaining
constant.
High customer turnover rate.
Increasing number of orders canceled.
Periodic lack of sufficient storage space.
Wide variance in turnover of major inventory items between
distribution centers.
Deteriorating relationship with intermediaries, as typified by
dealer cancellations and declining orders.
Large quantities of obsolete items.
Methods for Reducing
Inventory









Multiechelon inventory planning.(ABC analysis)
Lead time analysis.
Delivery time analysis.
Elimination of low turnover and/or obsolete items.
Analysis of pack size and discount structure.
Examination of procedures for returned goods.
Encouragement/automation of product substitution.
Installation of formal reorder review systems.
Measurement of fill rates by storekeeping units.
Methods for Reducing Inventory
(Cont’d)




Analysis of customer demand characteristics.
Development of a formal sales plan and emend forecast by
predetermined logic.
Expand view of inventory to include inventory management and
information sharing at various levels in the SC.
Reengineering inventory management practices to realize
improvements in product flow.