Chapter 9
MANAGING
INVENTORY IN THE
SUPPLY CHAIN
Learning Objectives
After reading this chapter, you should be able to do the following:
● Appreciate the role and importance of
inventory in the economy.
● Understand the major reasons for carrying
inventory.
● Differentiate the major types of inventory,
their costs, and their relationships to
inventory decisions.
● Understand the fundamental differences
among approaches to managing inventory.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
2
Learning Objectives, continued
● 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).
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
3
Learning Objectives, continued
● Explain how inventory items can be
classified.
● Know how inventory will vary as the
number of stocking points changes.
● Make needed adjustments to the basic
EOQ approach to respond to several
special types of applications.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
4
Introduction
● Inventory is an asset on the balance sheet
and a variable expense on the income
statement.
● Inventories also have an impact on return
on investment (ROI) for an organization.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Inventory in the U.S. Economy
● Nominal GDP grew by 106.7% between
1994 and 2010.
● The value of inventory increased by 83.1%
during the same time period.
● Inventory costs as a percent of GDP
declined from 15.9% in 1994 to 14.1% in
2010.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Table 9.1
Macro Inventory vs. GDP
Source: 22nd Annual State of Logistics Report, CSCMP 2011
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
7
Reasons for Inventory in the Firm
● Batching Economies or Cycle Stocks
• Arises from three sources.
○ procurement
○ production
○ transportation
● Uncertainty and Safety Stocks
• All organizations are faced with uncertainty.
• On the demand side, there is usually uncertainty in
how much customers will buy and when they will buy
it.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Inventory in the Firm, continued
● Uncertainty and Safety Stocks, continued
• On the supply side, there might be uncertainty about
obtaining what is needed from suppliers and how long
it will take for the fulfillment of the order.
● Time/In-Transit and Work-in-Process
Stocks
• The time associated with transportation means that
even while goods are in motion, an inventory cost is
associated with the time period. The longer the time,
the higher the cost.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
9
Inventory in the Firm, continued
● Time/In-Transit and Work-in-Process
Stocks, continued
• WIP inventories, associated with manufacturing, can
be significant while the length of time the inventory
sits in a manufacturing facility waiting and should be
carefully evaluated in relationship to scheduling
techniques and the actual manufacturing/assembly
technology.
● Seasonal Stocks
• Seasonality can occur in the supply of raw materials,
in the demand for finished product, or in both.
• Those faced with seasonality issues are constantly
challenged when determining how much inventory to
accumulate.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
10
Inventory in the Firm, continued
● Seasonal Stocks, continued
• Seasonality can impact transportation.
● Anticipatory Stocks
• A fifth reason to hold inventory arises when an
organization anticipates that an unusual event might
occur that will negatively impact its source of supply.
● Inventory in Support for Other Functional
Areas
• Logistics interfaces with an organization’s other
functional areas.
○ Marketing
○ Manufacturing
○ Finance
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
11
Table 9.2
Logistics Costs – 2010
Source: 22nd Annual State of Logistics Report, CSCMP 2011
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
12
Figure 9.1
ABC Power Tools – In-Transit Inventory Analysis
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
13
Table 9.3
ABC Power Tools In-Transit Inventory Analysis – Current
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
14
Table 9.4
ABC Power Tools In-Transit Inventory Analysis –
Proposed
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
15
Inventory Costs
● Inventory Carrying Costs
• Capital Cost (interest or opportunity cost)
○ cost of capital tied up in inventory and the resulting lost
opportunity from investing that capital elsewhere
○ hurdle rate
○ weighted average cost of capital (WACC)
● Storage Space Cost
• Includes handling costs associated with moving
products into and out of inventory, as well as such
costs as rent, heat, and light.
• Can be variable.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Inventory Costs, continued
● Inventory Service Cost
• Includes insurance and taxes.
● Inventory Risk Cost
• Reflects the possibility that inventory value might
decline for reasons beyond firm’s control.
● Calculating the Cost of Carrying Inventory
• First, determine the value of the item stored in
inventory.
• Second, determine the cost of each individual
carrying cost component to determine the total direct
costs consumed by the item while being held in
inventory.
• Third, divide the total costs calculated in Step 2 by the
value of the item determined in Step 1.
17
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Table 9.5
ABC Power Tools – Inventory Carrying cost for Item 1
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
18
Table 9.6
ABC Power Tools – Inventory Carrying cost for Item 1 to
Customer
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
19
Table 9.7
Inventory Carrying Costs for ABC Power Tools
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
20
Inventory Costs, continued
● Order and Setup Cost
• Order Cost
○ cost of placing order which may have both fixed and variable
components
• Setup Costs
○ expenses incurred each time an organization modifies a
production or assembly line to produce a different item for
inventory
● Expected Stockout Cost
• Back order - results in the vendor incurring incremental variable
costs associated with processing the extra shipment.
• Customer might decide to purchase a competitor’s product
resulting in a direct loss for the supplier.
• Customer might decide to permanently switch to a competitor’s
product with loss of income.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
21
Table 9.9
Summary of Inventory and Order Cost
Source: C. John Langley, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
22
Figure 9.2
Inventory Costs
Source: C. John Langley, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
23
Inventory Costs, continued
● In-Transit Inventory Carrying Cost
• Owner of product while it is in transit will incur
resulting carrying costs.
• In-transit inventory carrying cost becomes especially
important on global moves since both distance and
time from the shipping location both increase.
• Owner should consider its delivery time part of its
inventory carrying cost.
● Key Differences Among Approaches to
Managing Inventory
• Dependent versus Independent Demand
○ independent when such demand is unrelated to the demand
for other items
○ dependent when it is directly related, or derives from, the
demand for another inventory item or product
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
24
Figure 9.3
Safety Stocks and Service Levels
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
25
Figure 9.4
Inventory and Service Levels
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
26
Inventory Costs, continued
● Key Differences Among Approaches to
Managing Inventory, continued
• Pull versus Push
○ The “pull” approach relies on customer orders to move
product through a logistics system, while the “push” approach
uses inventory replenishment techniques in anticipation of
demand to move products
● Principle Approaches & Techniques for
Inventory Management
• Fixed order quantity model involves ordering a fixed
amount of product each time reordering takes place
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
27
Inventory Costs, continued
● Principle Approaches & Techniques for
Inventory Management, continued
• Simple EOQ Model
○ The following are the basic assumptions of the simple EOQ
model:








A continuous, constant, and known rate of demand
A constant and known replenishment or lead time
All demand is satisfied
A constant price or cost that is independent of the order
quantity (i.e., no quantity discounts)
No inventory in transit
One item of inventory or no interaction between items
Infinite planning horizon
Unlimited capital
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
28
Figure 9.5
Fixed Order Quantity Model with Certainty
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
29
Figure 9.8
Inventory Costs
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
30
Inventory Costs, continued
● Principle Approaches & Techniques for
Inventory Management, continued
• Simple EOQ Model, continued
○ Mathematical formulation
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
31
Figure 9.11
Graphical Representation of EOQ
Source: C. John Langley, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
32
Figure 9.12
Fixed Order Quantity with Uncertainty
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
33
Figure 9.13
Normal Distribution
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
34
Additional Approaches to Inventory
Management
● The Just-in-Time (JIT) Approach
• Four major elements underlie the JIT
approach.
○
○
○
○
zero inventories (?)
short, consistent lead times
small, frequent replenishment quantities
high quality, or zero defects
● Materials Requirements Planning
• Deals specifically with supplying materials and
component parts whose demand depends on the
demand for a specific end product.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Additional Approaches to Inventory Management, continued
● Materials Requirements Planning, continued
• Consists of a set of logically related procedures,
decision rules, and records designed to translate a
master production schedule into time-phased net
inventory requirements and the planned coverage of
such requirements for each component item needed
to implement this plan.
• Uses the following elements:
○
○
○
○
○
Master production schedule (MPS)
Bill of materials file (BOM)
Inventory status file (ISF)
MRP program
Outputs and reports
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
36
Figure 9.18
Normal Distribution
Source: Adapted from William M. Boyst III, “JIT American Style”, Proceedings of the 1988 conference
of the American Production and Inventory Control Society (1988) 468
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
37
Figure 9.15
An MRP System
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
38
Figure 9.16
MRP Egg Timer Example
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
39
Table 9.19
Inventory Status File: MRP Egg Timer Example
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
40
Figure 9.17
Master Schedule: MRP Egg Timer Example
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
41
Additional Approaches to Inventory Management, continued
● Distribution Requirements Planning (DRP)
• Purpose is to more accurately forecast demand and
to explode that information back to develop
production schedules.
• Firm can minimize inbound inventory in conjunction
with production schedules.
• Outbound (finished goods) inventory is minimized
• DRP develops a projection for each SKU requiring the
following:
○
○
○
○
○
Forecast of demand for each SKU
Current inventory level of the SKU (balance on hand, BOH)
Target safety stock
Recommended replenishment quantity
Lead time for replenishment
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
42
Table 9.20
DRP Table for Chicken Soup
Source: A.J. Stenger, “Distribution Resources Planning”, Penn State Univ. class example
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
43
Additional Approaches to Inventory Management, continued
● Vendor-Managed Inventory (VMI)
• The basic principles:
○ The supplier and its customer agree on which products are to
be managed using in the customer’s distribution centers.
○ An agreement is made on reorder points and economic order
quantities for each of these products.
○ As these products are shipped from the customer’s
distribution center, the customer notifies the supplier, by
SKU, of the volumes shipped on a real-time basis.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
44
Figure 9.19
Inventory Management Techniques in the Logistics
Network
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
45
Classifying Inventory
● ABC Analysis
• Assigns inventory items to one of three groups
according to the relative impact or value of the items.
○ A items are considered to be the most important
○ B items being of lesser importance
○ C items being the least important
• Pareto’s Law, or the “80–20 Rule”
○ Many situations were dominated by a relatively few vital
elements
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Figure 9.20
ABC Inventory Analysis
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
47
Table 9.21
ABC Analysis for Big Orange
Source: John C. Coyle, DBA
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
48
Figure 9.21
Quadrant Model (another technique to
classify inventory)
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
49
Classifying Inventory, continued
● Inventory at Multiple Locations—The
Square-Root Rule
• The square-root rule states that total safety stock
inventories in a future number of facilities can be
approximated by multiplying the total amount of
inventory in existing facilities by the square root of the
number of future facilities divided by the number of
existing facilities.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
50
Table 9.22
Example of Square-Root Rule of Inventories
Source: Robert A. Novak, Ph.D.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
51
Summary
● Inventory as a percent of overall business activity
continues to decline. Explanatory factors include greater
expertise in managing inventory, innovations in
information technology, greater competitiveness in
markets for transportation services, and emphasis on
reducing cost through the elimination of non-valueadding activities.
● As product lines proliferate and the number of SKUs
increases, the cost of carrying inventory becomes a
significant expense of doing business.
● There are a number of principal reasons for carrying
inventories. Types of inventory include cycle stock, workin-process, inventory in transit, safety stock, seasonal
stock, anticipatory stock, and anticipatory stock.
52
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Summary, continued
● Principal types of inventory cost are inventory carrying
cost, ordering and setup cost, expected stockout cost,
and in-transit inventory carrying cost.
● Inventory carrying cost is composed of capital cost,
storage space cost, inventory service cost, and inventory
risk cost. There are precise methods to calculate each of
these costs.
● Choosing the appropriate inventory model or technique
should include an analysis of key differences that affect
the inventory decision. These differences are determined
by the following questions: (1) Is the demand for the item
independent or dependent? (2) Is the distribution system
based upon a push or pull approach? (3) Do the
inventory decisions apply to one facility or to multiple
facilities?
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
53
Summary, continued
● Traditionally, inventory managers focused on two
important questions to improve efficiency, namely, how
much to reorder from suppliers and when to reorder.
● The two aforementioned questions were frequently
answered using the EOQ model, trading inventory
carrying cost against ordering costs, and then calculating
a reorder point based on demand or usage rates.
● The two basic forms of the EOQ model are the fixed
quantity model and the fixed interval model. The former
is the most widely used. Essentially, the relevant costs
are analyzed (traded off), and an optimum quantity is
decided. This reorder quantity will remain fixed unless
costs change, but the intervals between orders will vary
depending on demand.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
54
Summary, continued
● The basic EOQ model can be varied or adapted to focus
more specifically on decisions that are impacted by
inventory-related costs, such as shipment quantities
where price discounts are involved.
● Just-in-time inventory management captured the
attention of many U.S. organizations during the 1970s,
especially the automobile industry. As the name implies,
the basic goal is to minimize inventory levels with an
emphasis on frequent deliveries of smaller quantities and
alliances with suppliers or customers. To be most
effective, JIT should also include quality management.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
55
Summary, continued
● Materials requirements planning and distribution
requirements planning are typically used in conjunction
with each other. In addition, a master production
schedule is utilized to help balance demand and supply
of inventory. DRP is used on the outbound side of a
logistics system. Demand forecasts of individual SKUs
are developed to drive the DRP model. Then, an MPS
schedule is developed to meet the scheduled demand
replenishment requirements.
● VMI is used to manage an organization’s inventories in
its customers’ distribution centers. Using pull data,
suppliers monitor inventory levels and create orders to
ship product to bring inventory levels up to an economic
order quantity in the customers’ distribution centers.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
56
Summary, continued
● ABC analysis is a useful tool to improve the
effectiveness of inventory management. Another useful
tool is the quadrant model.
● When organizations are adding warehouses to their
logistics networks, a frequently asked question is, “How
much additional inventory will be required?” The square
root rule is a technique that can be used to help answer
this question.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
57