1. Inventory Fundamentals
Chapter 9

2. What is Inventory? Financial View = An asset in the form of material
Less is better
Dollars tied up in material
Operations View = Finished goods, raw material, WIP or materials used in production
More is better

3. Different Perspectives
Sales Department
High inventories are good for customer service
Accounting Department
See inventory as a necessary evil, but one that ties up capital
Production Department
Do not see the cost on inventory and believe it should have no restrictions

4. What is inventory?
Provide a stock of goods to meet anticipated customer demand and provide a “selection” of goods
De-couple suppliers from production and production from distribution
Allow one to take advantage of quantity discounts
To provide a hedge against inflation
To protect against shortages due to delivery variation
To permit operations to continue smoothly with the use of “work-in-process”

5. Categories of Inventory
Inventory as production materials
Preproduction materials
Maintenance materials

6. Inventory Fundamentals
Materials and supplies that a business or institution carries either for sale or to provide inputs or supplies to the production process
Represents between 20 to 60% of assets

7. Inventory Fundamentals
Aggregate Inventory Management
Managing inventories according to their classification rather than at the individual item level.
Generally involves:
Flow and kinds of inventory needed
Supply and demand patterns
Functions that inventories perform
Objectives of inventory management
Costs associated with inventories

8. Inventory Fundamentals
Item Inventory Management
The organization must establish some decision rules about inventory items for overall direction.
Rules include:
Which inventory items are most important
How individual items are to be controlled
How much to order at one time
When to place an order

9. Inventory Fundamentals
Inventory and the Flow of Material
Raw materials
Purchased items received which have not entered the production process
Work-in-process
Raw materials that have entered the manufacturing process and are being worked on or waiting to be worked on

10. Inventory Fundamentals
Inventory & Flow of Material
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, & Operational Supplies (MRO)
Items used in production that do not become part of the product

11. Inventory Fundamentals
Function of Inventories
Batch manufacturing - basic purpose of inventories is to disengage supply & demand
Inventory serves as a buffer between:
Supply and demand
Customer demand and finished goods
Operations
Suppliers and queues

12. Inventory Fundamentals
Function of Inventories
Anticipation inventory
Inventory built up in anticipation of future demand
Fluctuation Inventory
Inventory held to cover random unpredictable fluctuations in supply and demand or lead time

13. Inventory Fundamentals
Function of Inventories
Lot-size Inventory
Also called cycle stock
Items purchased or manufactured in quantities greater than immediately needed.
Allows the firm to take advantage of quantity discounts and to reduce shipping, clerical, and setup costs

14. Inventory Fundamentals
Function of Inventories
Transportation Inventory
Also called pipeline or movement inventories
Inventory in transit because of the time to move goods from one location to another
MROs
Used to support general operations and maintenance, but do not become part of the product

15. Example: Transportation Inventory
Q: A company is using a carrier to deliver goods to a major customer. The annual demand is $5,000,000, and the average transit time is 8 days. Another carrier promises to deliver in 6 days. What is the reduction in transit inventory?
A: Average annual inventory in transit (I) = tA/365
Where t = transit time in days (8 - 6 = 2 days)
A = annual demand ($5,000,000)
I = (2 X $5,000,000) / 365
I = $27,397.26

16. Inventory Fundamentals
Inventory Management
Responsible for planning and controlling inventory from raw material to customer.
Objectives:
Maximize customer service
Low-cost plant operations
Minimum inventory investment

17. Inventory Fundamentals
Customer Service
The ability of a company to satisfy the needs of customers.
The availability of items needed
Inventories help to maximize customer service by protecting against uncertainty

18. Inventory Fundamentals
Operating Efficiency
Inventory helps manufacturing to be more productive by:
Allowing operations with different rates of production to operate separately.
Assist with production planning and production leveling through lower costs.
Allowing for longer production runs
Allowing the purchase of larger quantities

19. Inventory Fundamentals
Operating Efficiency
Inventory investment must be balanced with:
Customer service
Cost of changing production levels
Cost of placing orders
Transportation costs
If inventory is carried there must be a benefit that exceeds the costs of carrying that inventory.

20. Inventory Fundamentals
Inventory Costs
Item Cost
Price paid plus other direct costs associated with getting the time into the plant
Carrying Costs
All the expenses incurred by the firm because of the volume of inventory carried.
Capital costs
Storage costs
Risk costs

21. Inventory and Bottom-Line Profits
Excess inventory* has a negative impact on cash flow.
Carrying costs include warehousing, racking, shelving, interest costs and insurance premiums (typically represents 8% to 14% of inventory costs).
Reduction in inventory can apply 10% to the bottom line.
*Excess Inventory: On-hand balances in excess of amount needed to support demand

22. Example: Carrying Costs
Q: A bakery carries an average inventory of $15,000. If they estimate the cost of capital is 10%, storage costs are 5%, and the risk costs are 8%, what does it cost per year to carry this inventory?
A: Total cost of carrying inventory = 10% + 5% + 8%
= 23%
Annual cost of carrying inventory = 0.23 X $15,000
= $3,450

23. Inventory Fundamentals
Inventory Costs
Ordering Costs
Costs associated with placing an order
Cost of placing an order does not depend on quantity
Annual ordering costs depend on number of orders placed per year
Ordering costs would include:
Production control costs
Setup and teardown costs
Lost capacity cost
Purchase order cost

24. Example: Ordering Costs
Q: Annual purchasing salaries are $85,000, operating expenses for the purchasing department are $35,000, and inspecting and receiving costs are $30/order. If the purchasing department places 12,000 orders/year, what is the average cost of ordering? What is the annual cost of ordering?
A: Average ordering cost = (fixed costs / number of orders) + variable cost
= (($85,000 + $35,000) / 12,000) + $30
= $40
Annual ordering cost = (Average ordering cost)(number of orders)
= ($40)(12,000)
= $480,000

25. Inventory Fundamentals
Inventory Costs
Stockout Costs
Stockouts occur when demand during leadtime exceeds the forecast.
Could include back-order costs, lost sales and customers
Capacity Associated Costs
Costs associated with changing the level of output
Overtime, hiring, training, shifts, layoffs…..etc

26. Inventory Fundamentals
Financial Performance Measures
Widely used as a measure of inventory performance
Lumps all inventory together thereby hiding obsolete and slow movers
Inventory Turns Ratio:
Inventory Turns = Annual Cost Of Goods Sold
Average Inventory $

27. Example: Inventory Turns
Q: What will be the inventory turns if the annual cost of goods sold is $32 million a year and the average inventory is $8 million?
A: Inventory turns = annual cost of goods sold / average inventory in $
= $32,000,000 / $8,000,000
= 4
Q: What would be the reduction in inventory if inventory turns were increased to 8 times per year? If the carrying costs for inventory is 25%, what are the projected savings?
A: Average Inventory= annual cost of goods sold / inventory turns
= 32,000,000 / 8
= $4,000,000
Reduction in inventory = $8,000,000 - $4,000,000 = $4,000,000
Savings = Inventory reduction X 25% = $4,000,000 X 0.25 = $1,000,000

28. Inventory Fundamentals
ABC Inventory Control
A scheme where inventory is classified by level of importance in terms of annual sales dollars
To control inventory
What is the importance of the inventory item?
How are they to be controlled?
How much should be ordered at one time?
When should an order be placed?

29. Inventory Fundamentals
ABC Inventory Control
Based on Pareto’s Law:
A items
15-20% of items that account for 75-80% of annual inventory value
B items
30-40% of items that account for 15% of annual inventory value
C items
40-50% of items that account for 5-10% of annual inventory value

30. ABC Concept

31. Inventory Fundamentals
ABC Analysis Steps
Establish item characteristics
Usually annual dollar usage
Classify items into groups based on criteria
Apply control appropriate to classification

32. Inventory Fundamentals
ABC Inventory Control
Classify annual $ usage by:
Determine annual usage for each item
Multiply annual usage of each item by its cost to get total annual dollar usage
List items according to their annual dollar usage
Calculate cumulative annual dollar usage and cumulative percentage of items
Examine annual usage distribution & group items into A, B, and C groups based on % of annual usage

33. Inventory Fundamentals
Walk Through Example Problem on page 251

34. Inventory Fundamentals
Control Based on ABC Classification
Two general rules:
Have plenty of low-value items - C items are only important if there is a shortage of one of them - then they become extremely important - so a supply should always be on hand.
Use the money & control effort saved to reduce the inventory of high-value items - A items are extremely important and deserve the tightest control & the most frequently reviewed

35. Inventory Fundamentals
Tight Control
Complete, accurate records
Regular, frequent review by management
Frequent review of forecasts
Close follow-up
Normal Control
Good records
Normal processing
Simplest possible control
Make sure there are plenty
Simple or no records
Large order quantities
A Items
B Items
C Items

36. Inventory Fundamentals
SUMMARY