1 6 Inventory Management

“Every management mistake ends up in inventory.” Michael C. Bergerac Former Chief Executive Revlon, Inc.

Inventory Management Philosophies Just-in-time (production philosophy) Attempts to synchronize stock flows so as to just meet demand as it occurs Minimizes the need for inventory CR (2004) Prentice Hall, Inc.

Impact of Demand Patterns on Inventory Management PULL versus PUSH SYSTEMS PULL SYTEM: The company waits to produce products until customer demand it PUSH SYSTEM: The firm produces to forecasted or anticipated sales to customers INDEPENDENT versus DEPENDENT DEMAND Whether the demand for an item depends on demand for something else-dependent demand demand for an item depends on demand for something else

Pull strategy In a pull-based supply chain, production and distribution are demand driven so that they are coordinated with actual customer orders, rather than forecasted demand. Draws inventory into the stocking location Each stocking location is considered independent Maximizes local control of inventories

Push Strategy Products are pushed through the channel, from the production side up to the retailer. The manufacturer sets production at a level in accord with historical ordering patterns of retailers. It takes longer for a push-based supply chain to respond to changes in demand, which can result in overstocking or bottlenecks and delays (the bullwhip effect), unacceptable service levels and product obsolescence. Allocates production to stocking locations based on overall demand Encourages economies of scale in production

Push-Pull Boundary A supply chain is almost always a combination of both push and pull, where the interface between the push-based stages and the pull-based stages is known as the push-pull boundary. Dell- Inventory levels of individual components are determined by forecasting general demand, but final assembly is in response to a specific customer request. The push-pull boundary would then be at the beginning of the assembly line.

Inventory Management Inventory management Carrying costs Decisions drive other logistics activities Objectives can differ for different functional areas of an organization Must consider inventory costs Carrying costs Ordering costs Stockout costs © Pearson Education, Inc. publishing as Prentice Hall

Inventory Carrying Cost Inventory carrying costs are those costs associated with the amount of inventory stored. Inventory carrying costs are made up of a number of different costs. Unfortunately, many companies have never calculated inventory carrying costs, even though these costs are both real and substantial. Benchmarking the percentage of inventory carrying costs-Avon /Revlon

Calculating Inventory Carrying Costs Inventory carrying costs should include only those costs vary with the quantity of inventory and that can be categorized into the following groups; capital costs, inventory service costs, storage space costs, inventory risk costs.

Inventory Carrying Cost Methodology Costs Inventory Investment Insurance Taxes Obsolescence Pilferage Inventory Carrying Cost Methodology Storage space costs Capital costs Inventory service costs Inventory risk costs Plant warehouses Public warehouses Rented warehouses Company-owned warehouses Damage Relocation costs 5 3

1. Capital Costs on Inventory Investment Holding inventory ties up money that could be used for other types of investments (Opportunity Cost of the Capital) Some companies differentiate among projects by categorizing them according to their risk and looking for rates of returns that reflect the perceived level of risk.

Calculating Capital Costs on Inventory Investment Cost of money In the situation of financing the inventory: cost of money is actual cost of borrowing Shortage of capital-cost of money for inventory decisions is high-decrease in inventory Abundance of cash- cost of money for inventory is low-increase in inventory

2. Inventory Service Costs Inventory service costs are comprised of ad valorem-personal property costs taxes, fire and theft insurance paid as a result of holding the inventory.

3. Storage Space Costs Storage space costs relate to four general types of facilities: Plant warehouse costs Public warehouse costs Rented or leased(contract) warehouses Company owned(private) warehouses

4. Inventory Risk Costs Inventory risk costs vary form company to company, but typically include charges for; Obsolescence cost is the cost of each unit that must be disposed of at a loss because it can no longer be sold at a regular price. Damage costs incurred during shipping should be considered a throughput cost, since they will continue regardless of inventory levels. Shrinkage costs are becoming an increasingly important for businesses (inventory theft, poor record keeping,shipping wrong quantities…) Relocation costs are incurred when inventory is transshipped from one warehouse location to another for avoiding obsolescence.

Inventory and Corporate Profitability Excessive inventory levels can lower corporate profitability in two ways; 1.Net profit is reduced by out of pocket costs associated with holding inventory, such as insurance, tax,storage, obsolescence, damage, and interest expense, if the firm borrows money specifically to finance inventories, 2.Total assets are increased by the amount of the inventory investment, which decreases asset turnover, or the opportunity to invest in other more productive assets foregone.

Inventory and Least Total Cost Logistics Inventory carrying cost is related with the decision of logistics system design, customer service levels, number and location of DCs, transportation modes, inventory levels production schedules.

Inventory Ordering Costs Ordering costs refer to those costs associated with ordering inventory, such as order costs and setup costs. © Pearson Education, Inc. publishing as Prentice Hall

Inventory Ordering Costs Examples of order costs include: Costs of receiving an order (wages) Conducting a credit check Verifying inventory availability Entering orders into the system Preparing invoices Receiving payment © Pearson Education, Inc. publishing as Prentice Hall

Trade-Off between Carrying and Ordering Costs Ordering cost = number of orders per year x ordering cost per order Carrying cost = average inventory x carrying cost per unit © Pearson Education, Inc. publishing as Prentice Hall

Inventory Stockout Costs Stockout cost is an estimated cost or penalty that is realized when a company is out of stock when a customer wants to buy an item. Stockout costs involve an understanding of a customer’s reaction to a company being out of stock. © Pearson Education, Inc. publishing as Prentice Hall

General Rules Regarding Stockout Costs The higher the average cost of a stockout, the better it is for the company to hold some amount of inventory (SS) to protect against stockouts. The higher the probability of a delayed sale, the lower the average stockout costs and the lower the inventory that needs to be held by a company. © Pearson Education, Inc. publishing as Prentice Hall

Trade-Off between Carrying and Stockout Costs Higher inventory levels (higher carrying costs) result in lower chances of a stockout (lower stockout costs) © Pearson Education, Inc. publishing as Prentice Hall

Table 8-4: Determination of Safety Stock Level © Pearson Education, Inc. publishing as Prentice Hall

Inventory carrying cost should be traded off with other logistics costs. Place/ customer service levels Product Promotion Price Order processing and information costs Warehousing costs Transportation costs Inventory carrying costs Lot quantity costs LOGISTICS MARKETING Source: Adapted from Douglas M. Lambert, The Development of an Inventory Costing Methodology: A Study of the Costs Associated with Holding Inventory (Chicago, IL: National Council of Physical Distribution Management, 1976), p. 7. 5 1

Inventory Turns Inventory Turns (Inventory Turnover): The number of times that a company’s inventory cycles or turns over per year. It is one of the  most commonly used Supply Chain Metrics showing how fast a company is selling through its inventory and efficiently managing its resources Current Year's Cost of Goods Sold or Cost of Revenues / The average inventory for the period

Inventory Turnover Comparisons

The Impact of Inventory Turns on Inventory Carrying Costs 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 $750,000 375,000 250,000 187,500 150,000 125,000 107,143 93,750 83,333 75,000 68,182 62,500 57,692 53,571 50,000 $300,000 100,000 60,000 42,857 37,500 33,333 30,000 27,273 25,000 23,077 21,428 20,000 - $150,000 15,000 10,000 7,143 5,357 4,167 3,333 2,727 2,273 1,923 1,649 1,428 Inventory Turns Average Carrying Cost at 40 Percent Savings The Impact of Inventory Turns on Inventory Carrying Costs

Relationship between Inventory Turns and Inventory Carrying Costs $ 3 , 1 2 4 5 6 7 8 9 Inventory carrying costs

Annual Inventory Carrying Costs Compared to Inventory Turnovers Variable Manufacturing Cost Carrying Cost % Annual Cost to Carry in Inventory Monthly Cost (1/12) $100 x 30% $30 $2.50 Inventory Turns Inventory carrying costs (per unit) 1 2 3 4 5 6 7 8 9 15.00 12.50 10.00 7.50 5.00 3.75 2.50 $30.00 6.00 10

Symptoms of Poor Inventory Management Increasing numbers of back orders. Increasing investment in inventory with back orders remaining constant. High customer turnover rate. Increasing number of orders canceled. Periodic lack of sufficient storage space. Wide variance in turnover of major inventory items between distribution centers. Deteriorating relationship with intermediaries, as typified by dealer cancellations and declining orders. Large quantities of obsolete items.

Methods for Reducing Inventory Multiechelon inventory planning.(ABC analysis) Lead time analysis. Delivery time analysis. Elimination of low turnover and/or obsolete items. Analysis of pack size and discount structure. Examination of procedures for returned goods. Encouragement/automation of product substitution. Installation of formal reorder review systems. Measurement of fill rates by storekeeping units.

Methods for Reducing Inventory (Cont’d) Analysis of customer demand characteristics. Development of a formal sales plan and emend forecast by predetermined logic. Expand view of inventory to include inventory management and information sharing at various levels in the SC. Reengineering inventory management practices to realize improvements in product flow.

ABC Analysis-Pareto 80/20 concept is useful in distribution and inventory management. The top 20 %-A ~ wide geographic distribution through many warehouses with high levels of stock availability The next 30 %- B The remainder 50 %- C~distributed from a single, central stocking point

Problem: Suppose that a certain warehouse is to store 11 of the 14 items shown previously. The turnover ration for A group items is 7 to 1, for B items 5 to 1, For C items 3 to 1. If the annual sales through the warehouse are forecasted to be $ 25,000 , how much inventory investment in the warehouse can be expected?

HW 4 Textbook, Chapter 8, questions 2,4,5,6,8, 12 and Case 8.1, question 1 on p.170-171 Following problem: Economic Order Quantity