2. Advances in Supply Chain Management
Chapter 2a: Advancements in Inventory Management

3. Lec 5 : Learning Objectives
Distinguish dependent from independent demand inventories
Describe the four basic types of inventories & their functions
Understand the costs of inventory & inventory turnovers
Understand ABC classification, ABC inventory matrix & cycle counting
Know RFID & how it can be used in inventory management
Understand the EOQ model & its underlying assumptions
Understand the Quantity Discounts & the EMQ Models & their relationships with the basic EOQ model
Understand & able to distinguish among the various statistical ROP models
Describe the continuous review & periodic review systems

4. SUMMARY of Last Lecture
key performance measures are presented in detail in order to understand the excellence a supply chain achieves. The focus was on the importance of the integration of partners for the overall performance of the supply chain. For the optimization of inventory, the main principle of inventory management has to be considered: The objective is to balance the costs arising from holding inventories and the benefits of it. Furthermore, this trade-off has to be handled for each separate component. In the coming lectures, we will show how APS can support this critical task of inventory management.
The focus of the present lecture is to present different concepts and models, evolved over the period of time, that can be used inventory management.

5. LAYOUT Introduction Dependent and Independent Demand of inventory
Concepts and Tools of Inventory Management
ABC Inventory Analysis System
RFID
Inventory Models
The continuous and periodic review system

6. Introduction (inventory management)
Inventory can be one of the most expensive assets of an organization
Inventory may account for more than 10% of total revenue or 20% of total assets
Management must reduce inventory levels yet avoid stock outs and other problems
Matching Demand and Supply
Suppliers must accurately forecast demand so they can produce & deliver the right quantities at the right time at the right cost
Suppliers must find ways to better match supply & demand to achieve optimal levels of cost, quality, & customer service to enable them to compete with other supply chains
Problems that affect product & delivery will have ramifications throughout the chain

7. Dependent and Independent Demand
Inventory management models –
Generally classified as dependent demand and independent demand models
Dependent Demand –
Describes the internal demand for parts based on the demand of the final product in which the parts are used. Subassemblies, components, & raw materials are examples of dependent demand items.
Independent Demand –
The demand for final products & has a demand pattern affected by trends, seasonal patterns, & general market conditions. Demand for tooth paste, plasma TV, cars are example of independent demand.

8. Concepts and Tools of Inventory Management
Functions and Basic Types of Inventory
The primary functions of inventory are to –
Buffer from uncertainty in the marketplace &
Decouple dependencies in the supply chain (e.g., safety stock)
Four broad categories of inventories (already discussed in detail in the last lecture)
Raw materials- unprocessed purchase inputs.
Work-in-process (WIP)- partially processed materials not yet ready for sales.
Finished goods- products ready for shipment.
Maintenance, repair & operating (MRO)- materials used in production (e.g., cleaners & brooms).

9. Total Inventory Cost Formula
Cont’d….
Inventory Costs – The cost of holding goods in stock. Expressed usually as a percentage of the inventory value, it includes capital, warehousing, depreciation, insurance, taxation, obsolescence and shrinkage costs.
In other words, Total Inventory Cost is the sum of the carrying cost and the ordering cost of inventory
Total Inventory Cost Formula
TIC = C (Q/2) + F (D/Q)
Where,
C=Carrying cost per unit per year
Q=Quantity of each order
F=Fixed cost per order
D=Demand in units per year

10. Direct costs- directly traceable to unit produced (e. g
Direct costs- directly traceable to unit produced (e.g., labor) When determining and accounting for direct and indirect labor costs, it is best to begin with the direct labor costs. Direct labor costs are those costs accumulated as a result of workers producing the product. Because this cost is a single cost, it is easier to determine than indirect labor costs. Various factors can go into direct labor costs, but for the most part direct labor can be determined by multiplying the number of units produced by the number of hours required to produce the product. The resulting figure then is multiplied by the cost of labor per hour to determine the direct labor cost for that product. If multiple products are produced, the cost is determined for each product and then added together. Indirect costs- cannot be traced directly to the unit produced (e.g., overhead) The indirect costs associated with the manufacturing process are any costs not directly attributable to the cost of labor. Therefore, the simplest way to

11. determine the total of a company's indirect costs is to use accounting records to determine the overall expenditures and subtract the direct labor costs from the total cost. Since many expenses are included in these indirect costs, it may difficult to have an accurate and up-to-date figure. Companies often will use estimates based on the previous year's expenditures to determine these costs.
All the costs faced by companies can be broken into two main categories: fixed costs and variable costs.
Fixed costs- Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc.
Variable costs- Variable costs are costs that vary with output. Generally variable costs increase at a constant rate relative to labor and capital. Variable costs may include wages, utilities, materials used in production, etc.

12. Order costs- direct variable costs for making an order
Order costs- direct variable costs for making an order. In mfg, setup costs are related to machine setups - Ordering costs are costs of ordering a new batch of raw materials. These include cost of placing a purchase order, costs of inspection of received batches, documentation costs, etc. Ordering costs vary inversely with carrying costs. It means that the more orders a business places with its suppliers, the higher will be the ordering costs. However, more orders mean smaller average inventory levels and hence lower carrying costs. It is important for a business to minimize the sum of these costs which it does by applying the economic order quantity model. Holding or carrying costs- incurred for holding inventory in storage- The associated price of storing inventory or assets that remain unsold. Holding costs are a major component of supply chain management, since businesses must determine how much of a product to keep in stock.

13. Holding costs include an opportunity cost because money that’s tied up in inventory can’t benefit the company in another way, such as an investment in new product development. In addition, maintaining inventory levels greater than required to support a particular level of customer service leads to unnecessary holding costs. To lower holding costs, you can limit the volume of inventory you store in a warehouse and limit the time the inventory stays there. This is especially important if you use refrigerated warehouse space, a relatively expensive type of storage. You can also control holding costs by improving warehouse space use -- selecting the right warehouse design, for example, or using proper storage methods.

14. Cont’d…. Inventory Investment
Firms should diligently measure inventory investment to ensure that it does not adversely affect competitiveness. Measures include:
Absolute value of inventory (found on balance sheet)
Inventory turnover or turnover ratio- how many times inventory “turns” in an accounting period. More is better because its faster!
Cost of Revenue
Average Inventory
Inventory Turnover Ratio =

15. ABC Inventory Control System
Determines which inventories should be counted & managed more closely than others
Groups inventory as A, B, & C Items
A items are given the highest priority with larger safety stocks. A items, which account for approximately 20% of the total items, are about 80% of the total inventory cost
B & C items account for the other 80% of total items & only 20% of costs. The B items require closer management since they are relatively more expensive (per unit), require more effort to purchase/make, & may be more prone to obsolescence
C items have the lowest value and hence lowest priority

16. Inventory Models
The Economic Order Quantity (EOQ) Model – A quantitative decision model based on the trade-off between annual inventory holding costs & annual order costs
The EOQ model seeks to determine an optimal order quantity, where the sum of the annual order cost & the annual inventory holding cost is minimized.
Order Cost is the direct variable cost associated with placing an order.
Holding Cost or carrying cost is the cost incurred for holding inventory in storage.

17. Demand must be known & constant. Delivery time is known & constant.
Assumptions of the EOQ Model
Demand must be known & constant.
Delivery time is known & constant.
Replenishment is instantaneous.
Price is constant.
Holding cost is known & constant.
Ordering cost is known & constant.
Stock-outs are not allowed.

18. EOQ Model

19. Ilustration
Inventory on hand & relationships to – EOQ, average inventory, lead time, reorder point, & order cycle

20. EOQ for constant Demand & Lead Time
Order
placed IP Q OH
Order
received Q OH
placed IP
Time
On-hand inventory
Order
received R
TBO L
TBO L

21. Impact of lead time and uncertainty in demand
Lead time has NO impact if the demand is deterministic and at a constant rate.
Uncertainty in the demand creates the need for safety stock
Lead time under uncertain demand requires even a larger safety stock!

22. EOQ for Uncertain Demand and Constant Lead Time
Order
received Q
placed IP OH
Time
On-hand inventory R
TBO1
TBO2
TBO3 L

23. The Statistical Reorder Point (ROP)
The lowest inventory level at which a new order must be placed to avoid a stock out.
Demand and delivery lead time are never certain and require safety stock.
The models used under uncertainty are –
Statistical ROP with Probabilistic Demand and Constant Lead Time
The Statistical ROP with Constant Demand and Probabilistic Lead Time
The Statistical ROP when Demand and Lead Time are both Probabilistic

24. Finding Safety Stock With a normal Probability Distribution, for an 85% Cycle-Service Level
Average demand during lead time
Average demand (D) during lead time
Cycle-service level = 85%
Probability of stockout
(1.0 – 0.85 = 0.15)
zL R

25. Finding Safety Stock and R
Records show that the demand for dishwasher detergent during the lead time is normally distributed, with an average of 250 boxes and L = 22. What safety stock should be carried for a 99 percent cycle-service level? What is R?
Safety stock (SS) = zsL
= 2.33(22) = 51.3
= 51 boxes
Reorder point = DL + SS =
= 301 boxes
2.33 is the number of standard deviations, z, to the right of average demand during the lead time that places 99% of the area under the curve to the left of that point.

26. The Continuous Review System versus The Periodic Review System
Order quantity & ROP models assume that the physical inventory is precisely known at every point in time
Reality shows that stock records and actual quantity are different & requires continuous review of inventory to determine when to reorder
A Continuous Review System is costly to conduct but requires less safety stock than the
The Periodic Review System, which reviews physical inventory at specific points in time and requires higher level of safety stock

27. Continuous Review Systems
Selecting the reorder point with variable demand and constant lead time
Reorder point = Average demand during lead time + Safety stock
= dL + safety stock
Where
d = average demand per week (or day or months)
L = constant lead time in weeks (or days or months)

28. Demand During Lead Time
Specify mean and standard deviation
Standard deviation of demand during lead time
σdLT = σd2L = σd L
Safety stock and reorder point
Safety stock = zσdLT
where
z = number of standard deviations needed to achieve the cycle-service level
σdLT = stand deviation of demand during lead time
Reorder point R = dL + safety stock

29. Continuous Review Systems General Cost Equation
Calculating total systems costs
Total cost = Annual cycle inventory holding cost + Annual ordering cost + Annual safety stock holding cost
C = (H) (S) + (H) (Safety stock) Q 2 D

30. Periodic Review System (P)
Fixed interval reorder system or periodic reorder system
Four of the original EOQ assumptions maintained
No constraints are placed on lot size
Holding and ordering costs
Independent demand
Lead times are certain
Order is placed to bring the inventory position up to the target inventory level, T, when the predetermined time, P, has elapsed

31. Periodic Review System (P)
Time
On-hand inventory T
Order
placed
received IP OH Q1 Q2 Q3
IP3
IP1
IP2 L P
Protection interval
Figure – P System When Demand Is Uncertain

32. How Much to Order in a P System
EXAMPLE
A distribution center has a backorder (BO) for five 36-inch color TV sets. No inventory is currently on hand (OH), and now is the time to review. How many should be reordered if T = 400 and no receipts are scheduled (SR)?
SOLUTION
IP = OH + SR – BO
= – 5 = –5 sets
T – IP =
400 – (–5) = 405 sets
That is, 405 sets must be ordered to bring the inventory position up to T sets.

33. Inventory Management Example 1
An auto parts supplier sells Hardy-brand batteries to car dealers and auto mechanics. The annual demand is approximately 1,200 batteries. The supplier pays $28 for each battery and estimates that the annual
holding cost is 30 percent of the battery's value. It costs approximately $20 to place an order (managerial and clerical costs). The supplier currently orders 100 batteries per month.
a. Determine the ordering, holding, and total inventory costs for the current order quantity.
b. Determine the economic order quantity (EOQ).
c. How many orders will be placed per year using the EOQ?
d. Determine the ordering, holding, and total inventory costs for the
EOQ. How has ordering cost changed? Holding cost? Total inventory cost?

34. Cont’d…. Solution, We are given the following information:
annual demand: D = 1200 batteries per year
item cost: c = $28 per battery
holding cost: C=H= ic = 30% of (28) = $8.40 per battery per year
order cost: F=S= $20 per order
current order quantity: Q = 100 batteries
a. The current ordering and holding costs are: TIC = C (Q/2) + F (D/Q)
= 100/2(8.40) +1200/100(20) = = $660.

35. Cont’d….

36. EXAMPLE 2
Foster Drugs, Inc., handles a variety of health and beauty aid products. A particular hair conditioner product costs Foster $2.95 per unit. The annual holding cost rate is 20 percent. Using an EOQ model, they determined that an order quantity of 300 units should be used. The lead time to receive an order is one week, and the demand is normally distributed with a mean of 150 units per week and a standard deviation of 40 units per week. a. What is the reorder point if the firm is willing to tolerate a 1-percent chance of a stock out during an order cycle? b. What safety stock and annual safety stock cost are associated with your recommendation in part a? c. Foster is considering making a transition to a periodic-review system in an attempt to coordinate ordering of some of its products. The review period would be two weeks and the delivery lead time would remain one week.

37. What target inventory level would be needed to ensure the same 1-percent risk of stockout?
d. What is the safety stock associated with your answer to part c? What is the annual cost associated with holding this safety stock?
e. Compare your answers to parts b and d. If you were the manager of Foster Drugs, would you choose a continuous- or periodic-review system?

40. Radio Frequency Identification (RFID)
Successor to the barcode for tracking individual unit of goods. RFID does not require direct line of sight to read a tag and information on the tag is updatable.

41. Automates the supply chain:
RFID
Automates the supply chain:
Materials Management – goods automatically counted and logged as they enter the supply warehouse
Manufacturing – assembly instructions encoded on RFID tag provide information to computer controlled assembly devices
Distribution Center – shipment leaving DC automatically updates ERP to trigger a replenishment order and notify customer for delivery tracking
Retail Store – no check out lines as scanners link RFID tagged goods in shopping cart with buyers credit card

42. SUMMARY
The present lecture has further analyzed the concepts and models related to inventory management. It included basic types of inventories, distinguished between independent and dependent demand, cost of inventories and their turnover. Explanation of ABC classification was also included. How RFID can be used in inventory management, EOQ model and its underlying assumption, the relationship of quantity discount and EMQ models with EOQ model. Further distinguished among various statistical ROP models and described the continuous and periodic review system of inventory management. The purpose is the optimization of inventory: to balance the costs arising from holding inventories and the benefits of it. In the coming lectures, we will show how APS can support this critical task of inventory management.