Lecture 21 Inventory Fundamentals Books Introduction to Materials Management, Sixth Edition, J. R. Tony Arnold, P.E., CFPIM, CIRM, Fleming College, Emeritus, Stephen N. Chapman, Ph.D., CFPIM, North Carolina State University, Lloyd M. Clive, P.E., CFPIM, Fleming College Operations Management for Competitive Advantage, 11th Edition, by Chase, Jacobs, and Aquilano, 2005, N.Y.: McGraw-Hill/Irwin. Operations Management, 11/E, Jay Heizer, Texas Lutheran University, Barry Render, Graduate School of Business, Rollins College, Prentice Hall

Objectives Inventory Fundamentals Aggregate inventory management How company use their inventory Objectives of Inventory management Relevant inventory cost Inventory function Types of inventory Material Flow Functions of inventory Inventory cost Inventory turns

Amazon.com Amazon.com started as a “virtual” retailer – no inventory, no warehouses, no overhead; just computers taking orders to be filled by others Growth has forced Amazon.com to become a world leader in warehousing and inventory management

Amazon.com Each order is assigned by computer to the closest distribution center that has the product(s) A “flow meister” at each distribution center assigns work crews Lights indicate products that are to be picked and the light is reset Items are placed in crates on a conveyor. Bar code scanners scan each item 15 times to virtually eliminate errors.

Amazon.com Crates arrive at central point where items are boxed and labeled with new bar code Gift wrapping is done by hand at 30 packages per hour Completed boxes are packed, taped, weighed and labeled before leaving warehouse in a truck Order arrives at customer within a week

Inventory Fundamentals What is inventory? Materials and supplies that a business or institution carries either for sale or to provide inputs or supplies to the production process. 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

Inventory Fundamentals Can production be planned without managing inventory? since inventory either results from production or supports it, the two cannot be managed separately separately and must be coordinated Production planning is concerned with overall inventory Master planning is concerned with end items Material requirements planning is concerned with component parts and raw material

Aggregate Inventory Management Aggregate inventory management is concerned with managing inventories according to their classifications (raw material, work-in-process, finished goods, etc.) and the function they perform. It is financially oriented and is concerned with the costs and benefits of carrying the classifications of inventories.

Aggregate Inventory Management Aggregate inventory management involves Flow and kind of inventory needed Supply and demand patterns Functions inventory performs Objectives of inventory management Costs associated with inventory

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

How Companies Use Their Inventory Anticipation or seasonal inventory Fluctuation Inventory or Safety stock: buffer demand fluctuations Lot-size or cycle stock: take advantage of quantity discounts or purchasing efficiencies Transportation or Pipeline inventory Speculative or hedge inventory protects against some future event, e.g. labor strike Maintenance, repair, and operating (MRO) inventories

Objectives of Inventory Management Provide desired customer service level Customer service is the ability to satisfy customer requirements Percentage of orders shipped on schedule Percentage of line items shipped on schedule Percentage of $ volume shipped on schedule Idle time due to material and component shortages

Inventory Objectives con’t Provide for cost-efficient operations: Buffer stock for smooth production flow Maintain a level work force Allowing longer production runs & quantity discounts Minimum inventory investments: Inventory turnover Weeks, days, or hours of supply

Customer Service Level Examples Percentage of Orders Shipped on Schedule Good measure if orders have similar value. Does not capture value. If one company represents 50% of your business but only 5% of your orders, 95% on schedule could represent only 50% of value Percentage of Line Items Shipped on Schedule Recognizes that not all orders are equal, but does not capture $ value of orders. More expensive to measure. Ok for finished goods. A 90% service level might mean shipping 225 items out of the total 250 line items totaled from 20 orders scheduled Percentage Of Dollar Volume Shipped on Schedule Recognizes the differences in orders in terms of both line items and $ value

Inventory Turnover: Weeks/Days of Supply: Inventory Investment Measures Example: The Coach Motor Home Company has annual cost of goods sold of $10,000,000. The average inventory value at any point in time is $384,615. Calculate inventory turnover and weeks/days of supply. Inventory Turnover: Weeks/Days of Supply:

Relevant Inventory Costs Item Cost Includes price paid for the item plus other direct costs associated with the purchase Holding Costs Include the variable expenses incurred by the plant related to the volume of inventory held (15-25%) Capital Costs The higher of the cost of capital or the opportunity cost for the company

Relevant Inventory Costs Ordering Cost Fixed, constant dollar amount incurred for each order placed Shortage Costs Loss of customer goodwill, back order handling, and lost sales Risk costs Obsolescence, damage, deterioration, theft, insurance and taxes Storage costs Included the variable expenses for space, workers, and equipment related to the volume of inventory held

Determining Order Quantities Lot-for-lot Order exactly what is needed Fixed-order quantity Specifies the number of units to order whenever an order is placed Min-max system Places a replenishment order when the on-hand inventory falls below the predetermined minimum level. Order n periods Order quantity is determined by total demand for the item for the next n periods

Functions of Inventory To decouple or separate various parts of the production process To decouple the firm from fluctuations in demand and provide a stock of goods that will provide a selection for customers To take advantage of quantity discounts To hedge against inflation

Types of Inventory Raw material Work-in-process Purchased but not processed Work-in-process Undergone some change but not completed A function of cycle time for a product Maintenance/repair/operating (MRO) Necessary to keep machinery and processes productive Finished goods Completed product awaiting shipment

The Material Flow Cycle Cycle time 95% 5% Input Wait for Wait to Move Wait in queue Setup Run Output inspection be moved time for operator time time

Inventory Management How inventory items can be classified How accurate inventory records can be maintained

Inventory and the Flow of Materials Inventory can be classified according to the following flow: Raw material Work-in-process (WIP) Raw and In-Process (RIP) Finished goods Distribution Maintenance, repair, and operating supplies (MRO)

Inventory and the Flow of Materials Raw materials - purchased materials, component parts, and subassemblies. Work-in-process (WIP) - materials that have entered the manufacturing process and are being worked on or waiting to be worked on. Raw and in-process (RIP) - raw materials or work-in-process, a term used in JIT to account for shipments to point-of-use.

Inventory and the Flow of Materials Finished goods - finished products of the production process that are ready to be sold as completed items. Distribution inventories - finished goods located in the distribution system. Maintenance, repair, and operational supplies (MROs) - items used in production that do not become part of the product.

Functions of Inventories Inventory serves as a buffer between: supply and demand customer demand and finished goods finished goods and component availability requirements for an operation and the output from the preceding operation parts and materials to begin production and the supplies of materials

Functions of Inventories Purposes of inventory Anticipation inventory - to anticipate future demand built up to help level production and to reduce costs of changing production rates Examples: created ahead of a peak selling season, a promotion program, vacation shutdown, or possibly a strike

Functions of Inventories Purposes of inventory (continued) Fluctuation inventory - to cover random fluctuations in supply and demand or lead time (commonly called safety stock) Purpose - to prevent disruptions in manufacturing or deliveries to customers

Functions of Inventories Purposes of inventory (continued) Lot-size inventory - to purchase or manufacture in quantities greater than needed immediately Purpose - to take advantage of quantity discounts, to reduce shipping, clerical, and setup costs, and in cases where it is impossible to make or purchase items at the same rate they will be used or sold

Functions of Inventories Purposes of inventory (continued) Transportation inventory - to cover the time needed to move goods from one location to another (sometimes called pipeline inventory) Hedge inventory - to protect against price fluctuations

Inventory Objectives Inventories must be coordinated to meet three conflicting objectives: Maximize customer service Low-cost plant operation Minimum inventory investment

Inventory Costs Costs used for inventory management decisions Item costs Carrying costs Ordering costs Stockout costs Capacity-related costs

Inventory Costs Item costs Item costs include the cost of the item and all costs to get the item into the facility: product transportation customs duties insurance direct material, direct labor, and factory overhead

Inventory Carrying Costs Carrying cost include all costs caused by the amount of inventory carried. Three categories used are: Capital costs money tied up in inventory Storage costs space, personnel, and equipment Risk costs Obsolescence, damage, pilferage, insurance, and deterioration

Inventory Carrying Costs The annual carrying costs depend on the average inventory carried. The more that is ordered at one time, the higher the average inventory. The annual cost of carrying inventory can be decreased by ordering less at one time.

Inventory Ordering Costs Ordering costs - include the costs of placing an order with a factory or outside supplier. Categories included in ordering cost are: Production control costs Setup and teardown costs Lost capacity costs Every time an order is placed on a work center, the time taken to set up is lost as productive output time. It is particularity important with bottleneck operations. Purchase order costs

Inventory Ordering Costs The annual ordering cost depends on the number of orders placed in a year The annual cost of ordering can be reduced by decreasing the cost of placing an order and by reducing the number of orders placed The number of orders per year can be reduced by ordering more at any one time

Inventory Costs Stockout costs If demand during lead time exceeds the forecast and available inventory, we can expect a stockout. Possible costs of a stockout include: Backorder costs Lost sales costs Lost customer costs

Inventory Costs Capacity-related costs These costs are those of changing production levels. They include: Overtime / slack time Hiring Layoff Training Shift premiums

Inventory Turns Inventory turns: a measure of how effectively inventories are being used. The ratio of Annual Cost of Goods Sold divided by average inventory in dollars

Inventory Turns Example Example from Page 238 What will be the inventory turns ratio if the annual cost of goods sold is $24 million and the average inventory is $6 million? Inventory turns = Annual COGS / Avg. inv. $ = $24 million / $6 million = 4

Inventory Turns Example What would be the reduction in inventory if inventory turns were increased to 12? Avg. inv. $ = Annual COGS / Inventory Turns = $24 million / 12 = $2 million Reduction = $6 million - $2 million = $4 million If the carrying cost is 25%, what will the savings be? Savings = $4 million X 25% = $1 million!

End of Lecture 21