Inventory Fundamentals Session Six Inventory Fundamentals

Course Outline Session 1: Introduction to Supply Chain Management. Session 2: Forecasting. Session 3: Master Planning. Session 4: Material Requirements Planning. Session 5: Capacity Management & Production Activity Control. Session 6: Inventory Fundamentals. Session 7: Inventory Management. Session 8: Physical Distribution. Session 9: Quality Management and Purchasing. Session 10: Just-in-Time Manufacturing. 6-1a

Objectives of Session Present to participants the fundamentals of inventory including the classification of inventory, objectives and functions of inventory management, costs of inventory, classification and control of various inventory items and simple financial statements

Session 6 Outcomes After completing this session participants should be able to: State the importance of good inventory management. Classify inventory based on flow of material Describe the functions inventories perform. Discuss the objectives of inventory management 6-2a

Session 6 Outcomes (cont.) Define all the costs that are relevant to inventory decisions. Read and develop simple financial statements Define and interpret simple inventory turns ratio Conduct ABC analysis and suggest inventory control for each class. 6-2b

What is Inventory Those stocks or items used to: support production (raw materials and work- in-process items), supporting activities (maintenance, repair and operating supplies), and customer service (finished goods and spare parts) - APICS Dictionary 6-3

Aggregate Inventory Management Deals with managing according to its classification as: raw materials, work in process, and finished goods inventory as groups Finance oriented Involves Flow and kind of inventory needed Supply and demand patterns Functions inventory perform Objectives of inventory management Costs associated with inventory 6-4

Item Inventory Management Management must establish decision rules about individual inventory items: Importance of inventory items How they are to be controlled How much to order at one time When to place an order 6-5

Inventory and the Flow of Materials Supplier raw material Components MRO Work in process Finished goods Warehouse Customer 6-6a

Inventory Types Inventory can be classified into the following: Raw material Work in process Finished goods Distribution Maintenance, repair, & operating supplies (MRO) 6-6b

Reasons for Carrying Inventory The only good reason for carrying inventory beyond current needs is if it costs less to carry it than not. Inventory allows the company to operate with different production rates and batch sizes throughout the supply production, and distribution systems. 6-7a

Reasons for Carrying Inventory Decouples Demand from supply Customer demands from finished goods Finished goods from component availability Output of one operation from output of preceding operation Materials to begin from suppliers of production materials 6-7b

Functions of Inventory Anticipation: anticipate future demand Fluctuation: cover fluctuation in supply or demand (safety stock) Lot size: purchase more than needed Transportation: cover material movement time Hedge: protect against price fluctuation 6-8

Inventory Objectives Best customer service Low-cost plant operation Minimum inventory investment 6-9

Basic Problem Balance cost of carrying inventory with costs of not carrying inventory Customer service Changing production levels Placing orders Sum of the cost of carrying inventory and the cost of not carrying inventory should be as low as possible 6-10

Inventory Costs Item costs Carrying costs Ordering costs Stock-out costs Capacity-related costs 6-11

Item costs Cost of item and all costs to get item into the plant Product Transportation Customs duties Insurance Direct material, direct labor, and factory overhead 6-12

Carrying Costs Carrying costs can be broken down into three categories: Capital costs Money tied up in inventory Storage costs Space, personnel, and equipment Risk costs Obsolescence, damage, pilferage, insurance, and deterioration These costs increase with the amount of inventory carried 6-13

Problem 6.1 Given the following percentage costs of carrying inventory, calculate the annual cost if the average inventory is $1,000,000. capital costs are 6%, storage costs are 9% of the average inventory value, and risk costs are 10%. 6-14a

Problem 6.1 Total costs of carrying inventory = 6% + 9% + 10% = 25% = 6% + 9% + 10% = 25% Annual carrying cost = 0.25  1,000,000 = $250,000 6-14b

Ordering Costs Costs of placing and order with the factory or outside supplier Costs include Production control Setup and teardown Lost capacity Purchase order 6-15

Problem 6.2 Given the following data, calculate the average cost of placing one order. Annual production control cost = $200,000 Average cost of setup and teardown = $200 Number of orders per year = 20,000 6-16a

Problem 6.2 Annual production control cost = $200,000 Average cost of setup and teardown = $200 Number of orders per year = 20,000 Average cost of placing an order 200,000 20,000 = + 200 = $210 6-16b

Stock-out costs If demand during the lead time exceeds forecast and available inventory, we can expect a stock- out, causing Backorder costs Lost sales costs Lost customer costs 6-17

Capacity-Related Costs Cost of changing production levels Over-time/under-time Hiring Layoff Training Shift premiums Can be avoided by leveling production (but may build inventory) 6-18

Problem 6.3 Next year quarterly sales forecast is 2000, 3000, 4000, and 3000. Calculate a level production plan, quarterly ending inventory, and average quarterly inventory. Assume average quarterly inventory is the average of the quarter’s starting inventory and ending inventory. Opening and ending inventories = zero. If inventory carrying costs are $3 per unit per quarter, what is the annual cost of carrying inventory? 6-19a

Problem 6.3 (Solution) Q1 Q2 Q3 Q4 Sale 2,000 3,000 4,000 Production Ending inventory Average inventory Inventory cost Annual inventory carrying cost = 6-19b

Problem 6.3 (Solution) Q1 Q2 Q3 Q4 Sale 2,000 3,000 4,000 Production Ending inventory 1,000 Average inventory 500 Inventory cost 1,500 Annual inventory carrying cost = 1500 + 3,000 + 1,500 + 0 = $6,000 6-19c

Accounting Systems Accounting systems classify activities of a company into five types of accounts balance sheet accounts income statement accounts Assets Liabilities Owner’s equity Revenues Expenses 6-20

Balance Sheet Equation Assets = Liabilities + Owners’ equity Assets: Anything of value Liabilities: Amounts owed Owners’ equity: What is left over after liabilities are paid 6-21

Problem 6.4 If the owner’s equity is $1,000 and liabilities are $800, what are the assets worth? Assets = 6-22a

Problem 6.4 If the owner’s equity is $1,000 and liabilities are $800, what are the assets worth? Assets = Liabilities + Owner’s equity = 800 + 1,000 = $1,800 6-22+

Problem 6.4 If the assets are $1,000 and liabilities are $600, what is the owners’ equity? Owners’ equity = 6-22b

Problem 6.4 If the assets are $1,000 and liabilities are $600, what is the owners’ equity? Owners’ equity = Assets – liabilities = 1,000 – 600 = $400 6-22b+

Income Statement Income = Revenue – Expenses Revenue: Comes form the sale of goods and services Increases owners’ equity Expenses: Costs incurred in earning revenue Decreases owners’ equity Classified as: - Cost of goods sold (labor, material, OH) - General and administrative expense 6-23

Income Statement Revenue $1,000,000 Cost of goods sold Direct labor $200,000 Direct material 400,000 Overhead 200,000 Total cost of goods sold – 800,000 Gross margin (gross profit) $ 200,000 General and admin. expense – 100,000 Net income (profit) $ 100,000 6-24

Problem 6.5 A. Given the following data, calculate the gross margin and net income. Revenue = $1,500,000 Direct labor = $300,000 Direct material = $500,000 Overhead = $400,000 General & admin expenses = $150,000 6-25a

Problem 6.5 Revenue $________ Cost of goods sold Direct labor $________ Direct material $________ Overhead $________ Total cost of goods sold $________ Gross margin (gross profit) $________ General & admin expense $________ Net income (profit) $________ 6-25b

Problem 6.5 Revenue $1,500,000 Cost of goods sold Direct labor $300,000 Direct material $500,000 Overhead $400,000 Total cost of goods sold $1,200,000 Gross margin (gross profit) $300,000 General & admin expense $150,000 Net income (profit) $150,000 6-25b+

Problem 6.5 B. How much would profits increase if, through better materials management, material costs were reduced by $50,000? If material costs were reduced by $50,000, income would increase by: 6-25c

Problem 6.5 B. How much would profits increase if, through better materials management, material costs were reduced by $50,000? If material costs were reduced by $50,000, income would increase by: $50,000 6-25c+

Cash Flow Analysis The inflow and outflow of cash in the business over a given period of time To survive, a business must have the cash available to pay its bills 6-26

Cash Flow Inventory state Effect on cash flow Raw material Cash outflow Work in process Cash outflow Finished goods Cash outflow Accounts receivable paid Cash inflow 6-27

Inventory Turns A measure of how effectively inventory is being used Example Annual cost of goods sold = $1,000,000 Average inventory = $500,000 6-28

Problem 6.6 If the annual cost of goods sold is $10 million and the average inventory is $2.5 million: What is the inventory turn ratio? What would be the reduction in average inventory if, through better materials management, inventory turns were increased to 10 times per year? If the cost of carrying inventory is 20% of the average inventory, what is the annual savings? 6-29a

Problem 6.6 a. Turns Ratio = = b. = $________________ Reduction in inventory = = c. Annual savings = 6-29b

Problem 6.6 a. Turns Ratio = = 4 b. = = $1,000,000 Reduction in inventory = 2,500,000 – 1,000,00 = $1,500,000 c. Annual savings = 20%  1,500,000 = $300,000 6-29c

Strategic Performance Measures Strategic performance measures relate to a company’s long-range goals Measures include Profitability Market share Growth Productivity 6-30

Problem 6.7 Given the following information, calculate the annual cost of carrying inventory. Orders placed per year = 1,000 Receiving cost per order = $15 Annual office expense = $8,000 Average inventory = $500,000 Cost of capital = 10% of average inventory value Cost of storage = 8% of average inventory value 6-31

Problem 6.7 Orders placed per year = 1,000 Receiving cost per order = $15 Annual office expense = $8,000 Average inventory = $500,000 Cost of capital = 10% of ave. inventory Cost of storage = 8% of ave. inventory Annual cost of carrying inventory = 6-32a

Problem 6.7 Orders placed per year = 1,000 Receiving cost per order = $15 Annual office expense = $8,000 Average inventory = $500,000 Cost of capital = 10% of ave. inventory Cost of storage = 8% of ave. inventory Annual cost of carrying inventory = Ave. inventory×(cost of capital + cost of storage) = 500,000 × (0.10 + 0.08) = $90,000 6-32b

Problem 6.8 An importer operates a small warehouse that has the following annual costs. Wages for purchasing are $80,000, purchasing expenses are $70,000, and customs brokerage is $45 per order. The estimated cost of financing the inventory is 10%, storage costs are 7%, and risk costs are 10%. The average inventory is $500,000, and 10,000 orders are placed in a year. What are the annual ordering and carrying costs? What is the average ordering cost? 6-33a

Problem 6.8 Annual ordering cost = Annual carrying cost = Total annual cost = Average ordering cost = 6-33b

Problem 6.8 Annual ordering cost = 80,000 + 70,000 + (45  10,000) = $600,000 Annual carrying cost = 0.27  500,000 = $135,000 Total annual cost = 600,000 + 135,000 = $735,000 Average ordering cost = 600,000  10,000 = $60 6-33c

Problem 6.9 Given the following data, calculate the gross margin and net income. Revenue = $2,000,000 Direct labor = $200,000 Direct material = $800,000 Overhead = $600,000 General & admin expenses = $200,000 6-34a

Problem 6.9 Revenue $________ Cost of goods sold Direct labor $________ Direct material $________ Overhead $________ Total cost of goods sold $________ Gross margin (gross profit) $________ General & admin expense $________ Net income (profit) $________ 6-34b

Problem 6.9 Revenue $2,000,000 Cost of goods sold Direct labor $200,000 Direct material $800,000 Overhead $600,000 Total cost of goods sold $1,600,000 Gross margin (gross profit) $ 400,000 General & admin expense $ 200,000 Net income (profit) $ 200,000 6-34c

Problem 6.10 If the annual cost of goods sold is $48 million and the average inventory is $12 million: What is the inventory turns ratio? What would be the reduction in average inventory if, through better materials management, the turns ratio were increased to six times per year? If the cost of carrying inventory is 25% of the average inventory, what is the annual savings? 6-35a

Problem 6.10 a. Turns Ratio = b. Average inventory = Reduction in inventory = c. Annual savings = 6-35b

Problem 6.10 a. Turns Ratio = = 4 b. = = $8,000,000 Reduction in inventory = 12,000,000 – 8,000,00 = $4,000,000 c. Annual savings = 25%  4,000,000 = $1,000,000 6-35c

ABC Inventory Control For basic questions must be answered: What is the importance of the inventory items? How are they to be controlled? How much should be ordered at one time? When should an order be placed? 6-36a

Concept of ABC Inventory Control A small number of items will present the most critical values. ABC inventory control separates the most significant items from the less important. It is used to determine the degree and level of control used. 6-36b

ABC Classification A items 20% of the items account for 80% of the total dollar usage B items 30% of the items account for 15% of the total dollar usage C items 50% of the items account for 5% of the total dollar usage 6-37

ABC Process 1. Establish the item characteristics that influence the results of inventory management Annual dollar usage Scarcity of material Quality problems 6-38

ABC Process 2. Classify items into groups based on the criteria established 3. Apply a degree of control in proportion to the importance of the group 6-39

Example of ABC Analysis Part number Annual unit usage Unit cost ($) Annual usage ($) 1 1,100 2 2,200 600 40 24,000 3 100 4 400 1,300 5 60 6,000 6 10 25 250 7 200 8 1,500 3,000 9 500 Total $38,250 6-40

Example ABC Analysis-cont. Part number Annual $ usage Cumulative $ usage Cumulative % $ usage Cumulative % of items 2 24,000 63 10 5 6,000 30,000 78 20 8 3,000 33,000 86 30 1 2,200 35,200 92 40 4 1,300 36,500 95 50 500 37,000 97 60 3 400 37,400 98 70 9 37,800 99 80 6 250 38,050 90 7 200 38,250 100 6-41a

Example ABC Analysis-cont. Part number Annual $ usage Cumulative $ usage Cumulative % $ usage Cumulative % of items 2 24,000 63 10 5 6,000 30,000 78 20 8 3,000 33,000 86 30 1 2,200 35,200 92 40 4 1,300 36,500 95 50 500 37,000 97 60 3 400 37,400 98 70 9 37,800 99 80 6 250 38,050 90 7 200 38,250 100 6-41b

Example ABC Analysis-cont.

Problem 6.11 Item no. Annual $ usage 1 13,189 2 156,127 3 334 4 8,493 5 42,749 6 5,589 7 19,562 8 241,873 9 1,962 10 10,112 Total 500,000 Analyze the given data to produce an ABC classification based on annual dollar usage. 6-42a

Problem 6.11 Item no. Annual $ usage Cum. $ usage Cum. % $ usage Cum. % of items Item Class 6-42b

Problem 6.11 Item no. Annual $ usage Cum. $ usage Cum. % $ usage Cum. % of items Item Class 8 241,873 48.37 10 A 2 156,127 398,000 79.60 20 5 42,749 440,749 88.15 30 B 7 19,562 460,311 92.06 40 1 13,189 473,500 94.70 50 10,112 483,612 96.72 60 C 4 8,493 492,105 98.42 70 6 5,589 497,694 99.54 80 9 1,962 499,656 99.93 90 3 344 500,000 100.00 100 Total $500,000 6-42b+

Problem 6.11 A B C 6-42c

Control Based on ABC Classification Two general rules to follow Have plenty of low-value items Use control effort saved to reduce the inventory of A items A items: Tight control B items: Normal control C items: Simplest possible control 6-43

Inventory Control of A Items A items: Tight control Complete, accurate records Regular, frequent review by management Frequent review of forecasts Close follow-up 6-44

Inventory Control of B Items B items: Normal control Good records Normal processing 6-45

Inventory Control of C Items C items: Simple control Make sure there are plenty Simple or no records Large order quantities 6-46

Problem 6.12 Item Annual Demand Unit cost $ 1 21,000 2 5,000 40 3 1,600 4 12,000 5 1,000 100 6 50 7 800 8 10,000 9 4,000 10 Use the given data to classify into A, B, C groups based on annual dollar usage (demand). 6-47a

Problem 6.12 Item no. Annual Demand Unit cost $ Annual $ usage Rank Class 1 21,000 2 5,000 40 3 1,600 4 12,000 5 1,000 100 6 50 7 800 8 10,000 9 4,000 10 Total 6-47b

Problem 6.12 Item no. Annual Demand Unit cost $ Annual $ usage Rank Class 1 21,000 4 B 2 5,000 40 200,000 A 3 1,600 4,800 7 C 12,000 5 1,000 100 100,000 6 50 2,500 9 800 10 8 10,000 30,000 4,000 Total 380,900 6-47b+

Problem 6.12 Item no. Annual $ usage Cum. $ usage Cum. % $ usage Cum. % of items Class 6-47c

Problem 6.12 Item no. Annual $ usage Cum. $ usage Cum. % $ usage Cum. % of items Class 2 200,000 52.5 10 A 5 100,000 300,000 78.8 20 8 30,000 330,000 86.6 30 B 1 21,000 351,000 92.2 40 4 12,000 363,000 95.3 50 5,000 368,000 96.6 60 C 3 4,800 372,800 97.9 70 9 4,000 376,800 98.9 80 6 2,500 379,300 99.6 90 7 1,600 380,900 100.0 100 6-47c+

Problem 6.12 A B C 6-47d

Session 6 Outcomes After completing this session participants should be able to: State the importance of good inventory management. Classify of inventory based on flow of material Describe the functions inventories perform. Discuss the objectives of inventory management 6-2a

Session 6 Outcomes (cont.) Define all the costs that are relevant to inventory decisions. Read and develop simple financial statements Define and interpret simple inventory turns ratio Conduct ABC analysis and suggest inventory control for each class. 6-2b