Chapter 8 - Discussion Questions - Answers
1.
Inventory planners have to make critical decisions about how much inventory
to stock. What key components of inventory management must the planner
take into consideration when planning for inventories?
Answer:
Once an organization decides that inventory needs to be stocked, inventory
planners must make several key inventory-related decisions that will influence
how that inventory is to be managed. Six key decision points are detailed below.
 Cycle inventory. A critical inventory decision is determining exactly how
much inventory planners can expect to have on hand for any given item.
Cycle inventory is defined as the average amount of stock on hand to satisfy demand between receipts of production or supplier shipments. The
size of the cycle inventory depends on the produced or purchased lot size.
Trade-off decisions center on the cost of carrying larger lots versus the
cost of generating more frequent replenishment orders.
 Safety inventory. Safety inventory is defined as excess stock held in case
demand exceeds the cycle inventory. The basic trade-off for safety stock
is between excess inventory costs and the cost of lost sales due to stock
out.
 Seasonal inventory. Many businesses sell products subject to seasonal demand. Normally, companies will build a seasonal item in periods of low
demand and store it during periods of high demand, when production capacities are limited. The basic trade-off for seasonal items is calculating
the cost of carrying seasonal inventory versus the cost of expanding capacities or establishing more flexible production during the peak season.
 Cost. Stocking inventory to satisfy customer demand comes at a cost.
There are two critical components of cost that will be used as a basis for
discussion throughout the course. The first is the carrying cost. This is
the cost of holding inventories while they are waiting to be sold or used
in production. The other component is ordering cost. This is the cost of
creating the orders to buy materials or produce assemblies.
 Measuring inventory performance. The effective management of inventory requires inventory planners to deploy a series of possible metrics
that measure how closely inventory quantities are meeting cost and responsiveness targets.
 Overall trade-off: responsiveness versus efficiency. All things considered, the fundamental decision inventory managers must make regarding
inventories is how well they are meeting the opposing objectives of low
cost (efficiency) and high customer responsiveness established in the
firm’s business plan.
2.
Explain the distinction between independent and dependent demand in the
management of inventories.
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Answer:
Perhaps the most fundamental point in managing inventory is understanding
the difference between independent and dependent demand. Independent demand is defined as demand for an item that is unrelated to the demand for other
items. Demand for finished goods, parts required for destructive testing, and
service parts requirements are examples of dependent demand.
Dependent demand is defined as demand that is directly related to or derived
from the bill of material structure for other items or end products. Such demands are therefore calculated and need not and should not be forecasted. Typical items subject to dependent demand include raw materials, purchased assemblies, ingredients, attachments, kits, and accessories.
One of the most important purposes of the independent/ dependent rule is to
help planners select the most appropriate ordering techniques to be applied to
individual items. Independent demand items stand alone in inventory and must
be calculated from past history using forecasting techniques. This type of demand is characteristic of a classical distribution or retail environment. In these
types of businesses, planners normally use ordering methods driven by statistical calculations depending on demand history. Since the goal is to have just the
right quantity on hand to service the customer, these ordering methods are concerned with the correct calculation of cycle and safety stocks, and cost/benefit
trade-offs between money spent in stocking inventory versus the cost of lost
sales. A manufacturer, on the other hand, will use time-phased ordering methods found in their ERP systems to manage independent demand. Statistical
methods should never be used to manage dependent demand items.
3.
Discuss the various techniques of replenishing inventory available to the inventory planner.
Answer:
There are several basic techniques for ordering inventory:
 Visual review. This is a simple technique in which replenishment is determined by physically reviewing the quantity of inventory on hand. If replenishment is required, a target quantity is ordered that restores balances
to a pre-established stocking level.
 Two-bin. This technique is a fixed order system in which inventory is
carried in two containers, one located in the picking area and the other
held often in reserve in a non-picking location in the stockroom. Procedurally, when the picking bin is emptied, the reserve bin is brought forward to service demand. The empty bin serves as the trigger for replenishment.
 Periodic review. In this system, a fixed review cycle is established for
each product, and replenishment orders are generated at the conclusion of
the review to meet a predetermined maximum stock level.
 Order point. In this system, a targeted stocked quantity is statistically determined that is used as the trigger point. When the inventory position
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4.
falls below this trigger point, reorder action must be taken to replenish
quantities back above the order point.
Time phased order point (TPOP). This is a computerized method that
plans inventory needs in a priority-sequenced, time-phased manner to
meet customer and forecast demand as it occurs. This technique is at the
heart of MRP.
Lean. Formerly termed just-in-time (JIT), this method focuses on using
non-computer tools, such as kanban cards, to trigger replenishment. Mechanically, lean methods work like the two-bin system. The difference is
that in the lean philosophy, the system components are not fixed. Planners should continuously improve processes so that the number of kanbans or bins will be reduced through time.
Discuss the difference between continuous review and periodic review systems.
Answer:
One fundamental decision that must be made when using inventory replenishment techniques is determining when an item's inventory position should be
reviewed. The inventory review interval can be considered from two perspectives. Replenishment models can be described as subject to continuous or periodic review. Once this choice has been made for each item, planners can then
assign appropriate replenishment models that will govern the mechanics of how
the company’s inventory will be managed.
When using continuous review techniques, planners will examine the quantity level of each item after a transaction occurs and then match the ending
balance against the item's established trigger point. Order action occurs when
the trigger point is reached. To make this system work, it is imperative that all
inventory transactions be recorded on a timely basis and a new balance record
be created as soon as possible. Normally a computer system is used to perform
these tasks as well as to provide the planner with action messages to perform
order release. This system is often called a variable cycle/fixed order quantity
method because planners do not intend to review the item for reorder until the
order trigger is reached. When the trigger point is reached, a fixed-order quantity is placed with the supplier.
The mechanics of a periodic review system, on the other hand, are very different from continuous review. There are two critical components of periodic
review that need to be established on an item-by-item basis: (1) a fixed review
interval and (2) an order-up-to target inventory level. The review interval is
fixed because the balance record of inventory is reviewed at a specific point in
time regardless of the actual inventory balance on hand. As the review interval
date for each item arrives, inventory planners will determine the inventory balance record for each item under review and generate a replenishment order in
sufficient quantities to raise the inventory position to the order-up-to point.
During the period between order intervals, inventory stocking level records are
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not reviewed. The system is often called a fixed-cycle/variable-order quantity
method because planners will review item balances at a set time and then order
enough stock to move the balance up to the order-up-to level.
5.
Describe the components of the order point model.
Answer:
Order point mechanics are based on three critical components. The first component is demand. Demand is defined as the volume of sales experienced by a
product over time. The demand rate in effect provides data that can be used as
a sort of forecast to project anticipated demand by extrapolating what it had
been in the past. Normally, planners will use demand data for a full year. The
second critical component is lead time. This element is the time it takes to replenish an item. It is defined as the time that transpires from the moment a
requirement is identified until the point the replenishment quantity has been
received into stock and is ready for shipment. The final component is safety
stock. This element is defined as the amount of inventory above the cycle inventory that is kept in stock to guard against possible stock out. This inventory
is necessary to prevent stock out if demand exceeds the cycle stock that has
been planned based on the anticipated usage rate.
Based on these three critical elements, it is possible to create a formula that
can be used to determine when a replenishment order needs to be generated.
The formula is expressed as:
Demand (D) x Lead Time (LT) + Safety Stock (SS) = Order Point (OP)
6.
What are the key components in calculating the optimal order quantity?
Answer:
Once a replenishment order has been triggered, the next step for inventory planners is to determine the order quantity. Determining the optimal order quantity
requires planners to understand the role costs play in the order quantity decision. There are two critical costs involved in inventory replenishment. The first
relates to ordering costs. These costs consist of such elements as salaries and
overhead for the purchasing staff, requisition processing, supplier negotiations,
purchase order generation, computerized inventory system, order transmission,
order status tracking, receiving, inspection, and stock put-away.
The second cost area consists of inventory carrying costs. These costs are
directly related to the size, value, and length of time inventory is held in stock.
Capital expended for inventory, taxes, insurance, obsolescence, facilities, and
handling are all forms of cost that mount as the level of inventory rises. Other
costing issues revolve around shortage or stock out costs and incremental costs.
Incremental costs result from decisions to increase inventory quantities that
will require the firm to incur costs above normal overhead costs. For example,
a decision to increase inventories may require hiring a new purchaser, improving existing inventory control systems, or buying additional material handling
equipment. Once a requirement is identified, the order quantity must optimize
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the cost of carrying the inventory as well as the cost to order it. This balance is
achieved by applying the economic order quantity (EOQ).
7.
Discuss the two forms of inventory demand. Why are they so important to inventory planners?
Answer:
The two forms of demand are independent and dependent demand. Demand for
a given item is independent when it is unrelated to demand for other items. The
source of independent demand comes from direct orders arising from customer
and inter-branch requirements. For the most part, demand for products in the
distribution environment can be described as independent demand. Inventory
is usually received as a finished product from the manufacturer, warehoused,
and then sold directly to the customer. Planners normally use statistical ordering methods to order independent demand items. Conversely, an item is subject
to dependent demand when it is directly related to, or derived from, demand for
another item. Normally planners will use MRP to order dependent demand
items. Item dependencies can be described as vertical, such as when a component is required to build an assembly, or horizontal, as in the case of an accessory that must accompany the product. Dependent demand is characteristic of
production inventories in a typical manufacturing company. Manufacturers will
purchase raw materials, components, or subassemblies that are rarely sold as
received but are stocked and then issued in matched sets to build the finished
products the firm does sell.
8.
Explain the concept of stock replenishment.
Answer:
Stock replenishment ordering systems are primarily used by distributors and
retailers that sell inventory off the shelf with very short or no customer lead
time. In this environment, the goal is always to have just the right quantity of
stock on hand to meet demand during the replenishment cycle. The theory behind stock replenishment is that for each item, an optimal stocking and ordering
quantity can be determined either statistically or through some form of validated heuristic. Replenishment means to become full again; to restore to a state
of original fullness. Simplistically, the object of stock replenishment techniques
is to ensure that the optimum stocking level for each item is maintained to meet
a targeted service level. Stock replenishment techniques are structured to compensate for the inability of planners to determine the precise timing and quantity of demand in the short-term future. Since it is often difficult to know exactly when a customer order will arrive, planners using replenishment
techniques must project the anticipated demand and always have sufficient onhand stock to satisfy the customer orders that do materialize. Incorrectly determined inventory levels or failure to re-supply on a timely basis risks item stock
out.
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9.
Why is the EOQ such a valuable tool for calculating inventory order quantities?
Answer:
The EOQ is best used for items subject to constant demand where the ordering
system provides a variable review cycle with a fixed order quantity. The key to
managing such as system is determining the optimal fixed order quantity. Two
critical issues are relevant. First, the order quantity must be large enough to
cover the demand until the next order cycle. The EOQ formula solves this problem by utilizing the average of past demand as the source in determining the
inventory required. Second, the EOQ determines the optimal cost. It does this
by including ordering and carrying costs in the calculation. These two costs are
in opposition. The less an item is ordered the lower the ordering cost, but the
higher the carrying cost. Conversely, if inventory is ordered more often the
carrying cost will decline but the ordering cost will increase. The EOQ seeks
to determine the optimal point where the cost of ordering and the cost of carrying inventory are in equilibrium.
10. Why is the customer service level so important in calculating safety stock?
Answer:
If a company had a totally captive marketplace where customer demand was
deterministic, expected item usage during lead time could be calculated accurately with a great deal of certainty. In such an environment, safety stock would
be unnecessary. Supply orders would arrive just in time to replenish stock to
meet new demand. In reality, demand usage is subject to uncertainties. A wide
variety of factors, such as prevailing economic conditions; cycles in popular
taste; government regulation; technology; and changes in customer buying habits, transit times, order processing times, and production schedules, can cause
wide variances in demand. In addition, uncertainties caused by variations in
supplier lead times and delivery quantity and quality can expose the firm to
potential stock out.
In calculating safety stocks, inventory planners must decide on just how
much of an inventory buffer to keep on-hand. A firm, obviously, could not possibly carry inventory to cover all probable levels of demand for all the products
stocked. The best way is to determine safety stocks by choosing a level of desired customer service and multiplying it by the service factor. Just what the
service level will be is determined by several factors:
 How many stock outs is the firm willing to accept?
 What is the degree of variability of demand and supply?
 What are the competitive pressures?
 What level of capital investment is permissible?
 Are there physical space and material handling limitations?
 Does the inventory have a short shelf life?