CHAPTER 7:
Inventory
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Key concepts for discussion
• Risk Assessment
• Inventory carrying cost
• Inventory management parameters
• Advanced planning and scheduling
• Minimizing inventory through commonality
7-2
Overview of inventory
• Inventory functionality and
definitions
• Inventory carrying cost
• Planning inventory
• Managing uncertainty
• Inventory management
policies
• Inventory management
practices
7-3
Why do we have inventories?
Because the customer usually isn’t sitting at the
plant exit!
Queen Elizabeth research station in Antarctica
7-4
Why hold inventory?
• Economies of scale
– Purchasing advantages
– Transportation advantages
– Manufacturing advantages
• Balancing supply and demand
– Seasonality/Speculative
– Maintaining supply sources
• Buffering against uncertainty
– Uncertainty in demand
– Uncertainty in supply
7-5
Factors influencing inventory levels
•
•
•
•
•
Average inventory
Number of products
Service level objectives
Supply chain structure
Financial implications of inventory
Companies rely on forecasts (demand/supply) to
assist in determining how much inventory to carry
7-6
Aggregate inventory
2500
0.80%
0.70%
2000
1500
0.60%
0.50%
0.40%
1000
500
Inventory
Inventory/GDP
0.30%
0.20%
0.10%
0.00%
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
0
7-7
Sources of organizational risk
• Market Risk
– Demand based risk
– Market risk
• Competitive risk
• Customer risk
• Service risk
– Product
• Portfolio
• Development
• Launch
– Sales Planning and Forecasting
– Life-Cycle Risk Management
• Supply Risk
–
–
–
–
–
Business strategy
Supplier
Operations
Logistics
Inventory
• Financial Risk
– Investment
– Tax
– Expatriation of funds
7-8
Supply risk
•
Business strategy
–
–
–
–
•
Outsourcing philosophy
Control
Information technology
Intellectual property
•
– Capability
– Capacity
– Flexibility
•
Strategic sourcing
Selection
Contracting
Supplier management
Logistics
–
–
–
–
Supplier
–
–
–
–
Operations
•
Capacity
Availability
Security
Lead time
Inventory
–
–
–
–
–
Policies
Ownership
Visibility
Obsolescence
Financial Planning
7-9
Risks associated with holding inventory
• Typical measures of exposure to investments in inventory
– Time duration
– Depth of commitment
– Width of commitment
• Supply chain exposure based on location
– Manufacturer’s exposure is typically narrow, but deep and of long
duration
– Wholesaler’s exposure is wider than manufacturers and
somewhat deep
• Duration is medium
– Retailer’s exposure is wide, but not very deep
• Duration is usually short except for specialty retailers
7-10
Functions of inventory
• Geographical specialization allows us to specialize
production across different locations
• Decoupling allows us to run processes for maximum
economic lot sizes within a single facility
• Supply/Demand balancing accommodates the elapsed
time between inventory availability and consumption
• Buffering uncertainty accommodates uncertainty related
to
– Demand in excess of forecast or
– Unexpected delays in delivery (aka safety stock)
7-11
Inventory policy
• Inventory policy is a firm’s
guidelines concerning
– What to purchase or manufacture
– When to take action
– In what quantity should action be
taken
– Where products should be
located geographically
• Firm’s policy also includes
decisions about which
inventory management
practices to adopt
7-12
Service level
• Service level is a performance target
specified by management and defines
inventory performance objectives
• Common measures of service level include
– Performance cycle is the elapsed time between
release of a purchase order by the buyer to the
receipt of shipment
– Case fill rate is the percent of cases ordered that
are shipped as requested
– Line fill rate is the percent of order lines (items)
that were filled completely
– Order fill is the percent of customer orders filled
completely
7-13
Inventory definitions
•
Inventory includes materials, components, work-inprocess, and finished goods that are stocked in the
company’s logistical system
– The cycle inventory (base stock) is the portion of
average inventory that results from replenishment
– Order quantity is the amount ordered for
replenishment
– Transit inventory represents the amount typically in
transit between facilities or on order but not received
– Obsolete inventory is stock that is out-of-date or is
not in recent demand
– Speculative inventory is bought to hedge a currency
exchange or to take advantage of a discount
– Safety stock is the remainder of inventory in the
logistics system
7-14
Average inventory is the typical
amount stocked over time
• Average inventory equals the maximum inventory plus the minimum
inventory divided by two
– Typically equal to ½ order quantity + safety stock + in-transit stock
Figure 7.1 Inventory Cycle for Typical Product
7-15
Smaller replenishment order quantities
results in lower average inventory
• Policy must decide how much inventory to order at a specified time
– Reorder point defines when a replenishment order is initiated
• However, other factors are important like performance cycle
uncertainty, purchasing discounts, and transportation economies
Figure 7.2 Alternative Order Quantity and Average Inventory
7-16
Inventory carrying cost is the expense
associated with maintaining inventory
• Inventory expense is
– Annual inventory carrying cost percent times average inventory
value
• Cost components
– Cost of capital is specified by senior management
– Taxes on inventory held in warehouses
– Insurance is based on estimated risk or loss over time and
facility characteristics
– Obsolescence results from deterioration of product during
storage
• E.g. food and pharmaceutical sell-by dates
– Storage is facility expense related to product holding rather than
product handling
7-17
Final carrying cost percent used by a
firm is a managerial policy
Table 7.2 Inventory Carrying Cost Components
7-18
Inventory ordering cost components
•
•
•
•
•
Order preparation costs
Order transportation costs
Order receipt processing costs
Material handling costs
Total cost is driven by inventory planning
decisions which establish when and how much to
order
7-19
When to order
• Basic reorder formula if demand and performance are certain
R= D × T
– R = Reorder point in units
– D = Average daily demand in units
– T = Average performance cycle length in days
• If safety stock is needed to accommodate uncertainty the formula is
R = D × T + SS
–
–
–
–
R = Reorder point in units
D = Average daily demand in units
T = Average performance cycle length in days
SS = Safety stock in units
7-20
How much to order
• Economic order quantity
is the amount that
balances the cost of
ordering with the cost of
maintaining average
inventory
– Assumes demand and
costs are relatively stable
for the year
– Does not consider impact of
joint ordering of multiple
products
Figure 7.4 Economic Order Quantity
7-21
Standard mathematical solution for EOQ
7-22
Example EOQ solution using Table 7.3
• Total ordering cost is $152 = (2400/300 x $19.00)
• Inventory carrying cost is $150 = [300/2 x (5 x 0.20)]
7-23
Simple EOQ model assumptions
• All demand is satisfied
• Rate of demand is continuous, constant and know
• Replenishment performance cycle time is constant and
known
• Constant price of product that is independent of order
quantity or time
• An infinite planning horizon exists
• No interaction between multiple items of inventory
• No inventory is in transit
• No limit is placed on capital availability
7-24
Relationships useful for guiding inventory
planning
• EOQ is found at the point where annualized order
placement cost and inventory carrying cost are
equal
• Average base inventory equal one-half order
quantity
• Value of the inventory unit, all other things being
equal, will have a direct relationship with
replenishment order frequency
– Higher value products will be ordered more frequently
7-25
Typical adjustments to EOQ
• Volume transportation rates offer a freight-rate discount for larger
shipments
– Compare total cost with each transportation rate option
• Quantity discounts offer a lower per unit cost when larger quantities
are purchased
– If discount is sufficient to offset added inventory carrying cost less the reduced
cost of ordering then it is viable choice
• Other EOQ adjustments
–
–
–
–
–
Production lot size
Multiple-item purchase
Limited capital
Dedicated trucking
Unitization
7-26
Uncertainty in inventory management
• Inventory policy must deal with uncertainty
– Demand uncertainty — when and how much product
will our customers order?
– Performance cycle uncertainty — how long will it take
to replenish inventory with our customers?
• Variations must be considered in both areas to
make effective inventory planning decisions
7-27
Demand uncertainty can be managed
using safety stock
• To protect against stockout when uncertain demand
exceeds forecast we add safety stock to base
inventory
• Planning safety stock requires three steps
– Determine the likelihood of stockout using a probability
distribution
– Estimate demand during a stockout period
– Decide on a policy concerning the desired level of
stockout protection
7-28
Probability theory enables calculation of
safety stock for a target service level
• Service level is equal to 100% minus probability % of
stockout
– E.g. a service level of 99% results in a stockout probability of 1%
• The most common probability distribution for demand is the
normal distribution
– From analysis of historical demand data the safety stock required
to ensure a stock out only 1% of the time is possible
– A one-tailed normal distribution is used because only demand
that is greater than the forecast can create a stockout
7-29
Example of historical demand analysis
using a normal distribution
Figure 7.6 Historical Analysis of Demand History
Figure 7.7 Normal Distribution
7-30
Performance cycle uncertainty means operations
cannot assume consistent delivery
Table 7.10 Calculation of Standard Deviation of Replenishment Cycle Duration
7-31
Safety stock with combined
uncertainty
• Planning for both demand and performance cycle
uncertainty requires combining two independent
variables
• The joint impact of the probability of both demand
and performance cycle variation must be
determined
– Direct method is to combine standard deviations using a
convolution formula
7-32
Typical situation where both demand
and performance cycle variation exists
Figure 7.8 Combined Demand and Performance Cycle Uncertainty
7-33
Summary of alternative solutions to
combined uncertainty
Table 7.12 Average Inventory Impact Resulting from Changes in EOQ
7-34
The fill rate is the magnitude rather than the
probability of a stockout
• Increasing the replenishment order quantity decreases the
relative magnitude of potential stockouts
• The formula for this relationship is
7-35
Number of stockouts is reduced from two to one
when order quantity is increased
Figure 7.9 Impact of Order Quantity on Stockout Magnitude
7-36
Increased order size can be used to
compensate for decreasing the safety stock
Table 7.15 Impact of Order Quantity on Safety Stock
7-37
Dependent demand replenishment
• Inventory requirements are a function of known events that
are not generally random
• Dependent demand does not require forecasting because
there is no uncertainty
– No specific safety stock is needed to support time-phased
procurement programs (e.g. MRP)
• No safety stock assumes
– Procurement replenishment is predictable and constant
– Vendors and suppliers maintain adequate inventories to satisfy
100% of purchase requirements
7-38
Three approaches to introduce safety stock
into dependent demand situations
• Put safety time into the requirements plan
– E.g. order a component earlier than needed to assure timely
arrival
• Over-planning top-level demand is a procedure to
increase the requisition by a quantity specified by some
estimate of expected plan error
– E.g. assume plan error will not exceed 5 percent
• Utilize statistical techniques to set safety stocks directly for
a component rather than to the item of top-level demand
7-39
Approaches to implementing inventory
management policies
• Reactive (or pull) approach responds to customer
demand to pull the product through the distribution
channel
• Planning approach proactively allocates inventory
on the basis of forecasted demand and product
availability
• Hybrid approach uses a combination of push and
pull
7-40
Inventory control using reactive
approaches
• Inventory control defines how
often inventory levels are
reviewed to determine when
and how much to order
– Perpetual review continuously
monitors inventory levels to
determine inventory
replenishment needs
– Periodic review monitors
inventory status of an item at
regular intervals such as weekly
or monthly
7-41
Reorder point formulas for reactive
methods
Perpetual Review
Periodic Review
7-42
Assumptions of classical reactive inventory
logic
•
•
•
•
All customers, market areas, and product contribute equally to profits
Infinite capacity exists at the production facility
Infinite inventory availability at the supply location
Performance cycle time can be predicted and that cycle lengths are
independent
• Customer demand patterns are relatively stable and consistent
• Each distribution warehouse’s timing and quantity of replenishment
orders are determined independently of all other sites, including the
supply source
• Performance cycle length cannot be correlated with demand
7-43
Planning approaches coordinate requirements
across multiple locations in the supply chain
• Two planning approaches
– Fair share allocation provides each distribution facility
with an equitable distribution of available inventory
• Limited ability to manage multistage inventories
– Requirements planning integrates across the supply
chain taking into consideration unique requirements
• Materials requirements planning (MRP) is driven by a
production schedule
• Distribution requirements planning (DRP) is driven by supply
chain demand
7-44
Example of fair share allocation
method
Figure 7.11 Fair Share Allocation Example
• Allocation of 500 available units from plant
– Warehouse 1 = 47
– Warehouse 2 = 383
– Warehouse 3 = 70
7-45
Integrated planning approach for raw materials,
work-in-process, and finished goods
MRP
system
DRP
system
Figure 7.12 Conceptual Design of Integrated MRP/DRP System
7-46
Figure 7-13
Distribution Requirements Planning example
Eastern Distribution Center
Safety stock – 100
Weeks
1
2
3
4
5
6
7
8
Order quantity – 400
Gross Requirements
100
120
150
130
100
80
70
90
Lead time – 2 weeks
Scheduled Receipts
0
0
400
0
0
0
400
0
300
180
430
300
200
120
450
360
400
0
0
0
400
0
0
0
Past Due
Projected On-hand
400
Planned Orders
Plant Warehouse
Safety stock –100
Weeks
Batch Size – 600
Lead time – 1 week
Past Due
1
2
3
4
5
6
7
8
Gross Requirements
400
150
0
150
550
0
0
0
Scheduled Receipts
0
600
0
600
0
0
0
0
200
650
650
1100
550
550
550
550
600
0
600
0
0
0
0
0
Projected On-hand
600
Planned Production
Western Distribution Center
Safety stock – 50
Order quantity – 150
Weeks
Past Due
1
2
3
4
5
6
7
8
Gross Requirements
40
50
60
90
70
100
40
30
Scheduled Receipts
0
0
150
0
150
150
0
160
110
200
110
190
240
200
0
150
0
150
150
0
0
Projected On-hand
Planned Orders
200
Lead time – 1 week
0 Requirement
170
0 Shipment
7-47
DRP Spreadsheet
• Load included DRP spreadsheet
7-48
Advanced Planning and Scheduling example
Eastern Distribution Center
Safety stock – 100
Weeks
Past Due
1
2
3
4
5
6
7
8
Gross Requirements
100
120
150
130
100
80
70
90
Scheduled Receipts
0
0
400
0
0
0
400
0
300
180
430
300
200
120
450
360
400
0
0
0
400
0
0
0
Projected On-hand
400
Planned Orders
Order quantity – 400
Lead time – 2 weeks
Plant Warehouse
Safety stock –100
Weeks
Batch Size – 600
Lead time – 1 week
Past Due
1
2
3
4
5
6
7
8
Gross Requirements
400
150
0
150
550
0
0
0
Scheduled Receipts
0
600
0
600
0
0
0
0
200
650
650
1100
550
550
550
550
600
0
600
0
0
0
0
0
Projected On-hand
600
Planned Production
Western Distribution Center
Safety stock – 50
Weeks
Past Due
Order quantity – 150
1
2
3
4
5
6
7
8
Gross Requirements
40
50
60
90
70
100
40
30
Scheduled Receipts
0
0
150
0
150
150
0
160
110
200
110
190
240
200
0
150
0
150
150
0
0
Projected On-hand
Planned Orders
200
Lead time – 1 week
0 Requirement
170
0 Shipment
7-49
Supply chain network
Plant Warehouse
Western Distribution
Center
Eastern Distribution
Center
7-50
Scenario 1 - Base APS example
EASTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
100
Projected on hand
400
300
Scheduled receipts
Planned Orders
400
100
400
2
2
120
180
Average
0
3
150
430
400
0
4
130
300
0
0
5
100
200
0
400
6
80
120
0
0
7
70
450
400
0
8
90
360
0
0
9
100
260
0
0
10
110
150
0
0
105
293
133
100
1
400
200
0
600
100
600
1
2
150
650
600
0
3
0
650
0
0
4
150
500
0
600
5
400
700
600
0
6
150
550
0
0
7
0
550
0
0
8
0
550
0
0
9
0
550
0
0
10
0
550
0
0
156
544
150
150
WESTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
40
Projected on hand
200
160
Scheduled receipts
0
Planned Orders
0
50
150
1
2
50
110
0
150
3
60
200
150
0
4
90
110
0
150
5
70
190
150
0
6
100
90
0
150
7
40
200
150
0
8
30
170
0
0
9
40
130
0
0
10
60
70
0
0
58
154
56
56
PLANT
WAREHOUSE
Safety Stock
Order Quantity
Lead Time
Past Due
Requirements
Projected on hand
Scheduled receipts
Planned Orders
600
7-51
APS comparative scenarios
•
•
Scenario 1 – Base case
Scenario 2 – Increase safety stock levels by 20 percent
– Order frequency impact
– Average inventory impact
– In-transit inventory impact
•
Scenario 3 – Increase batch size or replenishment quantity by 20 percent
– Order frequency impact
– Average inventory impact
– In-transit inventory impact
•
Scenario 4 – Decrease batch size or replenishment quantity by 20 percent
– Order frequency impact
– Average inventory impact
– In-transit inventory impact
7-52
Scenario 2 – 20 percent safety stock
reduction
EASTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
100
Projected on hand
400
300
Scheduled receipts
Planned Orders
400
80
400
2
2
120
180
Average
0
3
150
430
400
0
4
130
300
0
0
5
100
200
0
400
6
80
120
0
0
7
70
450
400
0
8
90
360
0
0
9
100
260
0
0
10
110
150
0
0
105
293
133
100
1
400
200
0
0
80
600
1
2
0
200
0
600
3
150
650
600
0
4
150
500
0
0
5
400
100
0
0
6
0
100
0
600
7
150
550
600
0
8
0
550
0
0
9
0
550
0
0
10
0
550
0
0
156
356
150
150
WESTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
40
Projected on hand
200
160
Scheduled receipts
0
Planned Orders
0
40
150
1
2
50
110
0
0
3
60
50
0
150
4
90
110
150
150
5
70
190
150
0
6
100
90
0
0
7
40
50
0
150
8
30
170
150
0
9
40
130
0
0
10
60
70
0
0
58
116
56
56
PLANT
WAREHOUSE
Safety Stock
Order Quantity
Lead Time
Past Due
Requirements
Projected on hand
Scheduled receipts
Planned Orders
600
7-53
Scenario 2 comparison
Scenario 1
Eastern DC
Western DC
Plant
Warehouse
Total
Average Onhand
293
154
544
991
Average
Receipts
133
56
150
339
Total
1,330
Scenario 2
Average Onhand
293
118
358
769
Average
Receipts
133
56
150
339
Total
1,108
7-54
Scenario 3 – 20 Percent Batch Size
Increase
EASTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
100
Projected on hand
400
300
Scheduled receipts
Planned Orders
480
100
480
2
2
120
180
Average
0
3
150
510
480
0
4
130
380
0
0
5
100
280
0
0
6
80
200
0
480
7
70
130
0
0
8
90
520
480
0
9
100
420
0
0
10
110
310
0
0
105
313
160
120
1
480
120
0
720
100
720
1
2
180
660
720
0
3
0
660
0
0
4
0
660
0
0
5
180
480
0
720
6
480
720
720
0
7
0
720
0
0
8
0
720
0
0
9
0
720
0
0
10
0
720
0
0
165
593
180
180
WESTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
40
Projected on hand
200
160
Scheduled receipts
0
Planned Orders
0
50
180
1
2
50
110
0
180
3
60
230
180
0
4
90
140
0
0
5
70
70
0
180
6
100
150
180
0
7
40
110
0
0
8
30
80
0
0
9
40
220
180
0
10
60
160
0
0
58
131
45
45
PLANT
WAREHOUSE
Safety Stock
Order Quantity
Lead Time
Past Due
Requirements
Projected on hand
Scheduled receipts
Planned Orders
600
7-55
Scenario 3 comparison
Scenario 1
Eastern DC
Western DC
Plant
Warehouse
Total
Average Onhand
293
154
544
991
Average
Receipts
133
56
150
339
Total
1,330
Scenario 3
Average Onhand
313
131
593
1,037
Average
Receipts
160
45
180
385
Total
1,422
7-56
Scenario 4 – 20 percent batch size
increase
EASTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
100
Projected on hand
400
300
Scheduled receipts
Planned Orders
320
100
320
2
2
120
180
Average
0
3
150
350
320
0
4
130
220
0
320
5
100
120
0
0
6
80
360
320
0
7
70
290
0
0
8
90
200
0
0
9
100
420
320
0
10
110
310
0
0
105
253
107
80
1
320
280
0
0
100
500
1
2
120
160
0
0
3
0
160
0
500
4
440
220
500
500
5
120
600
500
0
6
0
600
0
0
7
0
600
0
0
8
0
600
0
0
9
0
600
0
0
10
0
600
0
0
125
403
125
125
WESTERN DISTRIBUTION CENTER
Safety Stock
Order Quantity
Lead Time
Past Due
1
Requirements
40
Projected on hand
200
160
Scheduled receipts
0
Planned Orders
0
50
120
1
2
50
110
0
120
3
60
170
120
0
4
90
80
0
120
5
70
130
120
120
6
100
150
120
0
7
40
110
0
0
8
30
80
0
0
9
40
160
120
0
10
60
100
0
0
58
124
45
45
PLANT
WAREHOUSE
Safety Stock
Order Quantity
Lead Time
Past Due
Requirements
Projected on hand
Scheduled receipts
Planned Orders
600
7-57
Scenario 4 comparison
Scenario 1
Eastern DC
Western DC
Plant
Warehouse
Total
Average Onhand
293
154
544
991
Average
Receipts
133
56
150
339
Total
1,330
Scenario 3
Average Onhand
253
124
403
780
Average
Receipts
107
45
125
277
Total
1,057
7-58
Comparative results
Scenario 1 - Base
Scenario 2 – 20
percent reduced
safety stock
Scenario 3 – 20
percent increase
batch
Scenario 4 – 20
percent reduced
batch
• Reduced on-hand
inventory
• No change in intransit inventory
• Likely reduced
service
• Likely no change
in transportation
charges
• Increased on-hand • Reduced on-hand
inventory
and in-transit
• Increase in-transit
inventory
inventory
• Likely reduced
• Likely improved
service
service
• More
• Fewer
replenishment
replenishment
orders and
orders and likely
increased
reduced
transportation cost
transportation cost
7-59
Conclusion
• Advanced planning and scheduling system
application
– Time phased
– Multi-stage or multi-echelon
– Systematically evaluate the trade-offs between service
level (stockout cost), inventory carrying cost, and
transportation cost
– Recommend the best combination of safety stock and
batch size (order quantity) for each supply chain location
7-60
Limitations to planning approaches
• Requires accurate and
coordinated forecasts for each
warehouse
• Requires consistent and
reliable product movement
between warehouse facilities
• Subject to frequent
rescheduling (system
nervousness) because of
production breakdowns or
delivery delays
7-61
Collaborative inventory replenishment
programs
• Replenishment programs are designed to streamline the
flow of goods within the supply chain
– Intent is to reduce reliance on forecasting and position inventory
using actual demand on a just-in-time basis
• Quick response (QR) is a technology-driven cooperative
effort between retailers and suppliers to improve inventory
velocity while matching supply to consumer buying patterns
• Vendor-managed inventory (VMI) is a modified QR that
eliminates the need for replenishment orders
• Profile replenishment (PR) extends QR and VMI by giving
suppliers the right to anticipate future requirements
according to their knowledge of a product category
7-62
Managerial considerations when
developing an inventory policy
Table 7.18 Suggested Inventory Management Logic
7-63
Inventory management practices
• Product/market classification groups products, markets, or
customers with similar characteristics to facilitate inventory
management
– E.g. classify by sales, profit contribution, inventory value, usage rate or item
category
• Segment strategy definition specifies all aspects of inventory
management process for each segment of inventory
– E.g. service objectives, forecasting method, management technique, and
review cycle
• Policies and parameters must be defined at a detailed level
– E.g. data requirements, software applications, performance objectives, and
decision guidelines
7-64
Example of product classification by
sales
Table 7.19 Product Market Classification (Sales)
7-65
Sample illustrating segment strategy
definitions
Table 7.20 Integrated Strategy
7-66