1. CHAPTER 8 Inventory Management © Pearson Education, Inc. publishing as Prentice Hall

2. Learning Objectives To learn about the ways that inventory can be classified To discuss inventory costs and the trade-offs that exist among them To identify when to order an how much to order, with a particular emphasis on the economic order quantity © Pearson Education, Inc. publishing as Prentice Hall 8-2

3. Learning Objectives To differentiate the various inventory flow patterns To discuss special concerns with inventory management To identify several contemporary approaches to managing inventory © Pearson Education, Inc. publishing as Prentice Hall 8-3

4. Key Concepts The Functions of Inventories – Definition of Inventories – Inventory Analysis Costs Associated with Inventories – Carrying Costs – Acquisition Costs – Economic Order Quantity Types of Inventory Control Systems – Cyclical or Fixed Order Interval System – The Just-In-Time (JIT) Approach – Material Requirements Planning (MRP) System – Order Point or Fixed Order Quantity System

5. Inventory Management Key Terms ABC analysis of inventory Back order Complementary products Cycle (base) stock Economic order quantity (EOQ) Fixed order interval system Fixed order quantity system Inventory Inventory carrying (holding) costs Inventory shrinkage 8-5 © Pearson Education, Inc. publishing as Prentice Hall

6. Inventory Management Key Terms Inventory turnover Just-in-time (JIT) approach Lean manufacturing (lean) Ordering costs Pipeline (in-transit) stock Psychic stock Reorder (trigger) point (ROP) Safety (buffer) stock Service parts logistics Speculative stock Stockout costs Substitute products Vendor-managed inventory (VMI) 8-6 © Pearson Education, Inc. publishing as Prentice Hall

7. Inventory Management Inventory refers to stocks of goods and materials that are maintained for many purposes, the most common being to satisfy normal demand patterns. © Pearson Education, Inc. publishing as Prentice Hall 8-7

8. Inventory Management Basic Questions – For which items must new orders be planned? – What quantity must be ordered for each item? – When must each order arrive, and where? – When must each order be shipped or production be initiated? August 22, 2007Logistics 110

9. Roles of Inventory 7–9 Balancing supply and demand: decouples differences in supply and demand requirements Buffers against uncertainties: variation in supply and demand are managed with buffer (safety) stock Economies: price discounts or reduced shipping costs Geographic Specialization: supply and demand locations vary Supply Demand

10. Reasons to hold Inventory (Roles) Enables firm to achieve economies of scale – Purchasing – Transportation – Manufacturing Balances Supply and Demand – Ex. Seasonality, Cyclicality, Upward trends in sales Enables Specialization in manufacturing – Several specialized plants to one distribution warehouse Provides buffer for uncertainty in demand – Price increase worries – Disasters – Strikes Acts as a buffer between critical interfaces in the supply chain – Supplier  manufacturing  distribution  customer “No product moves until information and cash moves”

11. Inventory Management Inventory management – Decisions drive other logistics activities – Objectives can differ for different functional areas of an organization © Pearson Education, Inc. publishing as Prentice Hall 8-11

12. Inventory Costs Inventory costs in the twenty-first century represent approximately one-third of total logistics costs. Inventory is always valued at cost, not selling price. Inventory cost should factor into an organization’s inventory management policy. Inventory costs include: – Carrying cost – Ordering cost – Stockout cost © Pearson Education, Inc. publishing as Prentice Hall 8-12

13. Inventory Classifications (Types) Cycle or base stock refers to inventory that is needed to satisfy normal demand during the course of an order cycle. Safety or buffer stock refers to inventory that is held in addition to cycle stock to guard against uncertainty in demand or lead time. © Pearson Education, Inc. publishing as Prentice Hall 8-13

14. Inventory Classifications (Types) Pipeline or in-transit stock is inventory that is en route between various fixed facilities in a logistics system such as a plant, warehouse, or store. Speculative stock refers to inventory that is held for several reasons, including seasonal demand, projected price increases, and potential shortages of a product. Psychic stock is inventory carried to stimulate demand (retail). © Pearson Education, Inc. publishing as Prentice Hall 8-14

15. September 14, 2007Logistics 110 Cycle Stock Also called DDLT – Demand During Lead Time The amount to stock needed to get through to the next delivery of product Assumes demand is known and certain Lead Time = 2 weeks Order 1 placed Order 1 arrives Order 2 placed Order 2 arrives Order 3 placed Order 3 arrives Order 4 placed 2 weeks Average Cycle Inventory

16. September 14, 2007Logistics 110 Cycle Stock - Problem Your lead time is 2 weeks Your demand during lead time is 200 units Your order quantity is 200 units What is your average cycle inventory? Lead Time = 2 weeks Order 1 placed Order 1 arrives Order 2 placed Order 2 arrives Order 3 placed Order 3 arrives Order 4 placed 2 weeks Average Cycle Inventory 200 Units ?

17. September 14, 2007Logistics 110 Cycle Stock – Problem 2 Your lead time is 2 weeks Your demand during lead time is 200 units Your order quantity is 400 units (Full Truckload) What is your average cycle inventory? Lead Time = 2 weeks Order 1 placed Order 1 arrivesOrder 2 arrivesOrder 3 arrives 2 weeks Average Cycle Inventory400 Units ?Order 2 placed Order 3 placed Order 4 placed

18. Inventory Classifications (Forms) Raw Materials (RM) Work In Progress (WIP) Finished Goods (FG)

19. September 14, 2007Logistics 110 Manufacturing Strategies Make-to- Stock Design InventoryManufactureAssembleShip Delivery Lead Time ManufactureInventoryAssembleShip ManufactureAssembleInventoryShip PurchaseManufactureAssembleShip Engineer- to-Order Make-to- Order Assemble- to-Order Delivery Lead Time 1-12 Cumulative Lead Time

22. Inventory Costs Inventory carrying (holding) costs are the costs associated with holding inventory. © Pearson Education, Inc. publishing as Prentice Hall 8-22

23. Table 8-1: Magnitude of Inventory Costs © Pearson Education, Inc. publishing as Prentice Hall 8-23

24. Table 8-2: Components of Inventory Carrying Costs © Pearson Education, Inc. publishing as Prentice Hall 8-24 Obsolescence costs Inventory shrinkage Storage costs Handling costs Insurance costs Taxes Interest costs

25. Inventory Carrying Cost Considerations Valuation of Inventory – First In, First Out (FIFO) – Last In, First Out (LIFO) – Average Cost Volume Transportation Rates Quantity Discounts Fill Rate Business Model (Push vs. Pull) Market Conditions

26. Inventory Turns/ Inventory Carrying Cost Example: COGS = $750 – Turns = 1; Inventory = $750 – Turns = 2; Inventory = $375 – Turns = 4; Inventory = $188 – When is customer service impacted?

27. Inventory Costs © Pearson Education, Inc. publishing as Prentice Hall 8-27 Ordering costs refer to those costs associated with ordering inventory, such as order costs and setup costs.

28. Inventory Costs © Pearson Education, Inc. publishing as Prentice Hall 8-28 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

29. Inventory Costs © Pearson Education, Inc. publishing as Prentice Hall 8-29 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

30. Inventory Costs © Pearson Education, Inc. publishing as Prentice Hall 8-30 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.

31. Table 8-3: Determination of the Average Cost of a Stockout © Pearson Education, Inc. publishing as Prentice Hall 8-31

32. Table 8-4: Determination of Safety Stock Level © Pearson Education, Inc. publishing as Prentice Hall 8-32

33. Inventory Costs © Pearson Education, Inc. publishing as Prentice Hall 8-33 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.

34. Inventory Costs 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 8-34

35. When to Order Fixed order quantity system Fixed order interval system Reorder (trigger) point (ROP) ROP = DD x RC under certainty ROP = (DD x RC) + SS under uncertainty Where DD = daily demand RC = length of replenishment cycle SS = safety stock © Pearson Education, Inc. publishing as Prentice Hall 8-35

36. How Much to Order Economic order quantity (EOQ) in dollars EOQ = √2AB/C Where EOQ = the most economic order size, in dollars A = annual usage, in dollars B = administrative costs per order of placing the order C = carrying costs of the inventory (%) 8-36 © Pearson Education, Inc. publishing as Prentice Hall

37. How Much to Order Economic order quantity (EOQ) in units EOQ = √2AB/IC Where EOQ = the most economic order size, in units A = annual demand, in units B = administrative costs per order of placing the order C = carrying costs of the inventory (%) I = dollar value of the inventory, per unit © Pearson Education, Inc. publishing as Prentice Hall 8-37

38. Figure 8-1: Determining EOQ by Use of a Graph © Pearson Education, Inc. publishing as Prentice Hall 8-38

39. Table 8-5: EOQ Cost Calculations Number of orders per year Order size ($) Ordering cost ($) Carrying cost ($) Total cost (sum of ordering and carrying cost) ($) 11,000 25100125 2 500 50 100 3 333 75 33108 4 250 100 25125 5 200 125 20145 © Pearson Education, Inc. publishing as Prentice Hall 8-39

40. Figure 8-2: Inventory Flow Diagram © Pearson Education, Inc. publishing as Prentice Hall 8-40

41. Inventory Flows Safety stock can prevent against two problem areas – Increased rate of demand – Longer-than-normal replenishment When fixed order quantity system like EOQ is used, time between orders may vary When reorder point is reached, fixed order quantity is ordered © Pearson Education, Inc. publishing as Prentice Hall 8-41

42. Inventory Management: Special Concerns ABC Analysis of Inventory recognizes that inventories are not of equal value to a firm and as such all inventory should not be managed in the same way. Dead inventory (dead stock) is a fourth category to ABC analysis which refers to product for which there is no sales during a 12 month period. Inventory Turnover refers to the number of times that inventory is sold in a one-year period. © Pearson Education, Inc. publishing as Prentice Hall 8-42

43. Managing Inventory – ABC Analysis ABC analysis: ranking inventory by importance Pareto’s Law: small percentage of items have a large impact on sales, profit or costs C Items B Items A Items 0 20 50 100 Cumulative Percentage of Items 100 95 80 50 0 Cumulative Percentage of Revenue Figure 7-1 7–43

44. Inventory Management: Special Concerns Inventory Turnover refers to the number of times that inventory is sold in a one-year period. (Compare with competitors or benchmarked companies.) Inventory turnover = cost of goods sold average inventory Complementary Products are inventories that can be used or distributed together, i.e. razor blades and razors. Substitute Products refer to products that can fill the same need or want as another product. © Pearson Education, Inc. publishing as Prentice Hall 8-44

45. Measures of Inventory Performance Inventory turnover: ratio of average inventory on-hand and level of sales = Cost of goods sold / Average inventory at cost = Net sales / Average inventory at selling price = Unit sales / Average inventory in units With an annual cost of goods sold of $500M and average inventory of $80M. Inventory turns = $500/$80 = 6.25 turns 7–45 Example 7-1

46. Measures of Inventory Performance cont’d Advantages of high turn over: – ‘Fresh’ inventory from high sales – Reduced risk or mark down from obsolescence – Reduced total carrying costs – Lower asset investment and higher productivity Dangers of high turnover: – Stockouts may mean lower sales – Increased costs from missing quantity requirements – Increased ordering costs 7–46 ↑ Turn over ↓ Turn over

47. Measures of Inventory Performance cont’d Days of Supply: length of time operations can be supported with inventory on-hand Days of supply = Inventory/Daily demand If inventory is 2M and daily demand is 25,000 day Days of supply = 2M/25,000 = 80 days Service Level: ability to meet customer demand without a stock out Stock out: no inventory is available 7–47 Figure 7-2

48. Managing Inventory Across the Supply Chain Bullwhip Effect: variation increases upstream in the supply chain (from consumer to manufacturers) 7–48 Figure 7-2

49. Contemporary Approaches to Managing Inventory Lean Manufacturing Service Parts Logistics Vendor-Managed Inventory (VMI) Consignment Quick Response (QR) Enhanced Consumer Response (ECR) Collaborate Planning Forecasting and Replenishment (CPFR) © Pearson Education, Inc. publishing as Prentice Hall 8-49

50. Managing Inventory Across the Supply Chain Vendor-managed Inventory (VMI): the vendor is responsible for managing inventory for the customer – Vendor monitors and replenishes inventory balances – Customer saves holding costs – Vendor has higher visibility of inventory usage Collaborative planning, forecasting and replenishment (CPFR): supply chain partners sharing information 7–50

51. Contemporary Approaches to Managing Inventory ABC Analysis (Pareto Analysis – 80/20 Rule Just-in Time (JIT) Approach – No Safety Stock – Inventory is waste (Inventory only when you need it) – Close supplier locations – Smaller, more frequent shipments (Trucking) ERP-Materials Requirements Planning Vendor-Managed Inventory (VMI)

52. Strategies in Managing Inventory and reducing Inventory Costs VMI – Vendor Managed Inventory (Consignment) Quick Response (QR) and Enhanced Consumer Response (ECR) VMOI – Vendor Managed and Owned Business Models – Anticipatory Business Model vs. Reactive Business Model (Push vs. Pull) – Make to Stock vs. Make to Order vs. Assemble to Order (Chapter 7)

53. Ways in Managing Inventory and reducing Inventory Costs Forecasting (Time Series Models, Cause and Effect, Judgmental, Regression, Delphi) Collaborative Planning Forecasting and Replenishment (CPFR) Postponement Models – Manufacturing Postponement – Geographic Postponement (Logistics Postponement)

54. Financial Impact of Inventory Carrying (Holding) Costs – Opportunity cost (including cost of capital) – Storage and warehouse management – Taxes and insurance – Obsolescence, spoilage, & shrinkage – Material handling, tracking and management Ordering and Set-up Cost – Purchased items: placing and receiving orders – Make items: change-over between items Stockout Cost – Lost sales or customer loyalty – Expediting – Schedule disruption 7–54 Carrying cost Stockout cost Ordering cost

55. September 14, 2007 Logistics 110 Income Statement Sales -Cost of goods sold Gross Profit (Margin) -Expenses -Taxes Net Profit 100 -55 45 (45%) -35 -5 5

56. September 14, 2007 Logistics 110 Balance Sheet Assets Current Assets – Inventory – Receivables – Other Current Assets Fixed Assets Total Assets 31  19  10  2 29 60

57. September 14, 2007 Logistics 110 Key Financial Ratios Return on Assets (ROI) – Net Profit/ Total Assets Asset Turnover – Net Sales/ Total Assets Financial Leverage – Total Asset/ Net Worth Return on Equity (ROE) – Net Profit/ Net Worth Inventory Turnover – COGS/ Inventory Value  5/60  100/60  60/30  5/30  55/19

58. Calculating Inventory Carrying Cost

59. Inventory Fundamentals Summary 1.Multiple types of inventory 2.Multiple roles of inventory 3.Inventory is an asset, and has multiple costs 4.Multiple performance metrics 5.ABC analysis determine relative importance of inventory items 6.Each item must have a unique identifier 7.Bullwhip describe increasing upstream variation 8.VMI and CPFR help supply chain partners better manage inventory 7–59