Inventory Policy
Decisions
Chapter 9
CR (2004) Prentice Hall, Inc.
9-1
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
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9-2
Inventory in the Economy

Inventory in the Economy has
decreased.
– As a percentage of the GDP, from 1985 to
2000, inventory levels have decreased
from 5.4% to about 3.8%
– Examine Table 6-1.
9-3
Table 6-1: Macro Inventory Cost in
Relation to U.S. Gross Domestic
Product
9-4
Inventory Costs: Why are they so
important?


First, inventory costs are a significant
portion of total logistics costs for many
firms.
Second, inventory levels affect
customer service levels.
9-5
Table 6-2
Total Logistics Costs --- 1999
9-6
Management of Inventory Flows
in the Supply Chain: Introduction



Inventory as an asset has taken on increased
significance as companies struggle to reduce
investment in fixed assets that accommodate
inventory (plants, warehouses, etc.).
Changes in inventory affect return on assets
(ROA), an important internal and external
metric.
“Ideally, zero inventory will maximize cash flow.”
9-7
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
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9-8
Where are Inventories?
Inbound
transportation
Production
Outbound
transportation
Finished goods
warehousing
Customers
Receiving
Material
sources
Production
materials
Finished goods
Shipping
Inventories
in-process
Inventory
locations
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9-4
Reasons Against Inventories
•They consume capital resources that might be put to
better use elsewhere in the firm
•They too often mask quality problems that would more
immediately be solved without their presence
•They divert management’s attention away from careful
planning and control of the supply and distribution
channels by promoting an insular attitude about
channel management
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9-10
Reasons for Inventories







Purchase economy
Transport economy
Production savings
Safety stocks
Seasonal stocks
Speculative purchase
Improve customer service
9-11
Types of Inventories
•Pipeline
-Inventories in transit
•Speculative
-Goods purchased in anticipation of price increases
•Regular/Cyclical/Seasonal
-Inventories held to meet normal operating needs
•Safety
-Extra stocks held in anticipation of demand and
lead time uncertainties
•Obsolete/Dead Stock
-Inventories that are of little or no value due to being
out of date, spoiled, damaged, etc.
9-12
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
-Minimizes the need for inventory
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9-13
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
Inventory Costs:
Inventory Carrying Cost

Capital Cost
– Opportunity cost associated with investing
in inventory, or any asset.
– What is the implicit value of having capital
tied up in inventory, instead of some other
worthwhile project?
– Minimum ROI expected from any asset.
– Debate on inventory valuation at fully
allocated or variable costs only.
9-15
Inventory Costs:
Inventory Carrying Cost

Storage Space Cost
– Handling costs, rents, utilities.
– Logistics develops a cost formula for
storage space costs based on cost
behaviors.
• Public space mostly variable.
• Private space a mix of fixed and variable.
9-16
Inventory Costs:
Inventory Carrying Cost

Inventory Service Cost
– Insurance and taxes on stored goods.
– Varies according to the value of the goods.

Inventory Risk Cost
– Largely beyond the control of the firm.
– Due to obsolescence, damage, theft,
employee pilferage.
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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
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9-18
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
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9-19
Stockouts

Four possible outcomes from a stockout
– Customers wait
– Back orders
– Lost sales
– Lost customers
9-20
Expected Costs of Stockouts
Event
Probability
Costs
Expected
Costs
Back Order
70%
$ 6.00
$ 4.20
Lost Sale
20%
$20.00
$ 4.00
Lost
Customer
10%
$200.00
$ 20.00
Estimated
cost per
stockout
100%
---
$ 28.20
9-21
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
economical replenishment quantities and timing
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Inventory’s Conflicting Cost Patterns
Minimum cost
reorder quantity
Cost
Total cost
Procurement cost
Stockout cost
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Replenishment quantity
9-16
Reorder Point Method Under Certainty
for a Single Item
Quantity on-hand
plus on-order
Q
Reorder
point, R
0
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Lead
time
Order
Order
Placed Received
Lead
Time
time
Order
Order
Placed
Received
9-22
Quantity on hand
Reorder Point Control for a Single Item
Q
Place
order
Q
DDLT
ROP
Receive
order
0
P
Stockout
LT
LT
Time
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9-25
Periodic Control for a Single Item
Quantity on hand
M
Q2
~
Q1
q
Stock
level
reviewed
Order
received
0
LT
T
M = maximum level
M - q = replenishment quantity
LT = lead time
Time
LT
T
T = review interval
q = quantity on hand
Qi = order quantity
9-39
Min-Max Inventory Control
Add increment ROPq to order size
Quantity on hand
M
Q1
~
Q2
Q*
ROP
q
LT
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LT
Time
9-54
Classifying Inventory:
ABC Analysis

Ranking system
– Developed in 1951 by H. Ford Dicky of
General Electric3.
– Suggested that GE classify items
according to relative sales volume, cash
flows, lead time, or stockout cost.
– Most important inventory put in Group A.
– Lesser impact goods put in Groups B and
C respectively.
9-28
Classifying Inventory:
ABC Analysis

Pareto’s Rule (80-20 Rule)
– Based on a nineteenth century
mathematician’s observation that many
situations were dominated by a very few
elements.
– Conversely, most elements had very little
influence in most situations.
– Separates the “trivial many” from the “vital
few”.
9-29
Classifying Inventory:
ABC Analysis

80-20 Rule
– 80% of sales will come from 20% of the
inventory SKUs.
– 20% of sales will come from 80% of the
inventory SKUs.

The 80-20 Rule has been found to
explain many phenomena that interest
managers.
– For example, 80% of sales come from 20%
of customers; and vice versa.
9-30
100
90
Total sales (%)
80
70
60
50
40
30
A items
B items
C items
20
10
0
0
CR (2004) Prentice Hall, Inc.
20
40
60
Total items (%)
80
100
Aggregate Inventory Control
Product items can be grouped according to 80-20
curve, each with different stocking policies
9-72
Risk Pooling (Cont’d)
Safety stock in 1 warehouse
SSc 1.96(19.07) 0.5  26.43 units
Total inventory
AIL = Regular stock + Safety stock
Two
warehouses
AIL = 59.75 + 27.66 = 87.41 units
In a one-warehouse channel
AIL = 42.56 + 26.43 = 68.99 units
Conclusion There is a reduction in the average
inventory level of an item as the number of stocking
points in the supply channel is decreased. In this
example, both regular stock and safety stock decline.
CR (2004) Prentice Hall, Inc.
9-77
Evaluating the Effectiveness of a
Company’s Approach to Inventory
Management




Are customers satisfied with the
current level of customer service?
How frequently does backordering or
expediting occur?
How is the inventory turns relative to
industry average?
Is inventory cost as percentage of
sales higher or lower than industry
average?
9-33