Inventory

Chapter 17

Inventory
Inventory: Stock of any item used in an

organization.

Two Views of Inventory

Pressure for high inventory Pressure for low inventory

Pressure for High Inventory

1. 2. 3. 4. 5. 6. 7.

To achieve economies of scale in production or purchases (cycle inventory) To provide a buffer between successive operations (decouple operations) To protect against unanticipated events To protect against price increases and take advantage of quantity discount To satisfy periods of high seasonal demand Economies of scale offered by transportation companies Delivery lead times

Cycle Inventory
Cycle inventory is the average inventory in a supply

chain due to either production or purchases in lot sizes that are larger than those demanded by the customer
Cycle inventory = Lot size / 2

Decoupling Inventory

Pressure for Low Inventory

Holding costs Cost of coordinating production Quality issue Low customer responsiveness Increased waste

Types of Manufacturing Inventories

Manufacturing Inventory: Items that contribute to or

become part of a firms product.

Raw material

Physical inputs at the start of the production process.

Work-in-process
Inventory between the start and end points of a product routine (yet

to become finished products)

Finished goods
End item ready to be sold at the end of

routine

Types of Manufacturing Inventory (Work-in-process)

Manufacturing Inventory
Maintenance / Repair /

Operating Supplies (MRO)

Pipeline or Transit Stock Inventory ordered but not yet

received by customer

Service Inventory
Inventory: Tangible goods necessary to administer

the services in various types of service organizations (hospitals, banks)

Hospitals: (medicines, syringes, blood, sutures,

glucose bottles, bandages etc.)

Banks: brochures, pamphlets, currency notes, coins

Levels of Inventory
High Levels
Tying more financial capital High interests

Low Levels
Stock outs

Goal of Materials Manager

Optimal Level of Inventory Key Questions;
What should be the size (how

much) of order to

the supplier?

When should the order be placed?

Measures of Inventory Management

Inventory turnover Costs of goods sold --------------------------------------------------------

Average aggregate inventory value

Cost of goods sold is finished goods valued at cost, not the

final sale price Average aggregate inventory value is the total value at cost of all items (RM, WIP, Finished goods) being held in inventory

Measures of Inventory Management

Days (or weeks) of inventory in hand

average aggregate value of inventory = --------------------------------------------------

(cost of goods sold) / 365 days

Inventory Velocity: The rate at which inventory

(material) moves through the supply chain

Average Flow Time (Littles Law)

average inventory Avg. flow time = ---------------------------average flow rate

Q/2 Avg. flow time = -------------D

Selective Control of Inventory

FSN Classification Based on movement of inventory
F: fast moving, S: slow moving, N: non-moving

VED Classification (relevant in case of maintenance

items)

Based on criticality of items

V: Vital, E: essential, D: desirable

ABC Classification Based on cost of items consumed and quantity

ABC Classification System

ABC classification method divides inventory items into

three group

A items (high rupee volume)

B items (moderate rupee volume) C items (low rupee volume)

Note: Rupee volume is a measure of importance; an item low in cost but high in volume can be more important than a high-cost item with low volume.

ABC Classification System

In ABC analysis each class of inventory requires

different levels of inventory monitoring and control the higher the value of the inventory, the tighter the control

ABC Inventory Planning

A items 10 to 20% of # of items

60 to 70% of annual rupee value of inventory

Tight inventory control B items

Represent 30% of # items and 15% of inventory value

C items 50 to 60% of # of items

10 to 15% of annual rupee value of inventory

Less stringent inventory control

ABC Analysis
Classify all inventory items as either A, B, C Each item is assigned a rupee value Total cost is obtained by multiplying rupee cost of

one item by the annual demand For example,

10% A items, next 30% B items, last 60% C items

ABC Inventory Planning

Item No. Annual Demand Unit Cost Annual dollar value Classification

8 5 3 6 1 4 12 11

1,000 3,900 1,900 1,000 2,500 1,500 400 500

$4,000 700 500 915 330 100 300 200

$4,000,000 2,730,000 950,000 915,000 825,000 150,000 120,000 100,000

A A B B B C C C

9
2 7 10

8,000
1,000 200 9,000

10
70 210 2

80,000
70,000 42,000 18,000

C
C C C

ABC Inventory Planning

Item No 22 68 27 3 82 Annual Rupee Usage 95000 75000 25000 15000 13000 % of Total Value 40.69 32.13 10.71 6.43 5.57

54
36 19 23

7500
1500 800 425

3.21
0.64 0.34 0.18

41

225
233,450

0.1
100%

ABC Inventory Planning

Classification

Item No.

Annual Rupee Usage

% of Total

A B C

22, 68 27, 03, 82 54, 36, 19, 23, 41

Rs 170,000 53,000 10,450

72.90% 22.7 4.4

A Typical ABC Breakdown

Key Use of ABC Concepts

Use in customer service
Focus on essential aspects

Guide to cycle counting

Physical counting of items in inventory To avoid discrepancy indicated by inventory records and actual quantities

ABC Analysis
Annual Rupee Value

Rs >10,000 Rs 3,000 10,000 Rs 250 3,000 <= Rs 250

Review Period 30 days 45 days 90 days 180 days

Experts recommend following accuracy: A items: 0.2%, B: 1%, C: 5%

Independent Demand vs. Dependent Demand

Independent Demand: Final products demanded by

external customers, i.e., any demand that originates outside the system
Driven by customer tastes, preferences, and

purchasing patters Example: Demand for cars, refrigerators

Independent Demand vs. Dependent Demand

Dependent Demand: Items used internally to produce the final product or independent demand products
Example: Demand for tires, wheels, speedometers

depend on demand for cars

Inventory
Independent Demand A Dependent Demand

B(4)

C(2)

D(2)

E(1)

D(3)

F(2)

Independent demand is uncertain. Dependent demand is certain.

Managing Independent Demand

This chapter focuses on managing independent

demand

Inventory Costs
Two types of costs Ordering costs (administrative costs associated with placing
an order, trucking cost to transport the order, and labor cost to receive the order, independent of order size)

Set-up Costs When a firm produces its own inventory, the cost of machine set-up (arranging tools, drawings) are ordering costs

Identification of sources of supply Price negotiation, purchase order generation Follow-up and receipt of materials Inspecting goods upon arrival for quality and quantity Stationery, postage, telephone and electricity bills Trucking costs to transport the order

Inventory Costs
Holding or Carrying costs in warehouse (cost of carrying one unit in inventory for a specified period of time, usually one year) Cost of storage facilities (rent, if rented) Heat, electricity Cost of capital tied up in inventory Material handling Interest charges Insurance and taxes Pilferage, scrap, & obsolescence Cost of personnel to protect, ship, receive Software for maintaining inventory status

Inventory Costs
Shortage Costs (or stock out costs)
Loss of profits Loss of goodwill Late charges

Basic Inventory Control Systems

Two types Fixed order quantity model (Q Model)
Also known as Perpetual

system or Continuous inventory System Event or quantity triggered

Fixed time period model (P-

model)

Also known as Periodic

Review System Time Triggered

Economic Order Quantity (EOQ) Model

Assumptions Annual demand for item is constant and uniform throughout Lead time is constant Price per unit of product constant Inventory holding cost is based on avg. inventory Ordering or set-up costs are constant Instantaneous replenishment There are no quantity discounts Inventory incurred no cost in transit
purchased inventory on delivered price basis

Q-Model
Lead Time: Time between placing an order and its

receipt
Reorder Point: The inventory level at which a new

order should be placed.

Q-Model

Inventory on hand Q

Demand Rate
Avg. Inventory (Q/2)

R Reorder Pt. L
Order Placed Order Receipt

Time

L = Lead Time R = Reorder Point

Time

Cycle, Pipeline, and Safety Inventory

Average Inventory Levels and Number of Orders

Total Cost Curve

Minimum Total Cost

The total cost curve reaches its minimum where the carrying and ordering costs are equal.

Q H 2

DS Q

Q Model
Q opt=
2DS H Q answers the how

much question directly

(constant demand, so no safety stock)

Reorder Point, R = d L

Where, d = average daily demand L = Lead time in days

The square root formula is the

EOQ, also referred as economic lot size

Learning
Inventory costs money, inventory hides

problems So reduce inventory

Reducing lot sizes (EOQ) Lowering order costs through E-bidding Examine holding cost. If understated, larger H will reduce EOQ Reducing safety stock Reduce lead time

Bringing suppliers close to the buyer

Reorder Point in EOQ

When to Reorder with EOQ

If demand and lead time are both constant, the

reorder point is

ROP = D X LT
where, d = Demand rate (units per day or week) LT = Lead time in days or weeks

Q-Model
Optimal number of orders = D / Q Time between orders = Q* / D (answers

when

question OR Time between orders = #work days / Expected # orders

Fixed Order Quantity Model (Q-model)

Total Annual Cost = Annual Purchase Cost + Annual Ordering Cost + Annual Holding Cost

TC = DC + (D/Q) S + (Q/2) H
Where, TC = Total annual cost D = Demand C = Unit cost Q = Quantity to be ordered S = Ordering cost or set-up cost R = reorder point L = Lead Time H = Annual holding or storing cost per unit of average inventory

Q Model
Item cost (P D) is not a function of the order

quantity there are no quantity discounts so the amount PD is constant. Therefore, the value of Q that minimizes the equation is the value that minimizes the sum of the ordering costs and holding costs, called the total inventory cost or total stock cost. This quantity is called Economic Order Quantity (EOQ).

EOQ with Purchasing Cost

Adding purchasing cost does not change EOQ

Total Cost Curve Near EOQ

The Total Cost Curve is flat near EOQ

Littles Law
Average Inventory Average Flow time = ---------------------------------------Flow Rate (Average demand) The average amount of inventory in a system is equal to the product of average demand and the average time a unit is in the system

Observation
If demand increases by a factor k, the optimal

lot size increases by factor k. The number of orders placed per year should also increase by a factor k. Flow time attributed to cycle inventory should decrease by a factor of k.

Production Order Quantity Model or EPQ Model

It is a variant of EOQ model Assumptions
Annual demand known Usage rate constant Usage occurs continually, but production occurs

periodically Production rate constant No quantity discounts

Production Quantity Model

Production Order Quantity Model

Production Order Quantity Model

Stock out Occurrence

Excessive Consumption During Lead Time

Undue Stretching of Lead Time by Supplier

When to Reorder with EOQ

When variability is present in demand or lead time,

it creates the possibility that actual demand will exceed expected demand
Therefore, it is necessary to carry safety stock to

avoid stock out

Safety Stock
EOQ model assumed deterministic demand

Demand in reality varies from day-to-day Probability of stock out during lead time Need to keep safety stock in addition to expected demand
To hedge against the possibility of stock out

Amount of safety stock depends on Service Level

Probability that inventory on hand during lead time in

sufficient to meet expected demand, i.e., the probability that stock out will not occur.

Safety Stock Avoids Stock Out Caused by Excessive Consumption

Safety Stock Avoids Stock Out by Undue Stretching of LT by Suppliers

Fixed Order Qty Model With Safety Stock

Service Level
Probability that the demand will not exceed supply

during lead time

Example: Service level of 95% implies a probability of 95% that demand will not exceed supply during lead time, and probability of stock out is 5%
Service Level = 100% - Stock out risk

Lead Time Demand

Normal Distribution of Demand During Lead Time

Normal Distribution Curve During Lead Time

Dependence of Demand During LT on Service Level

Safety Stock

Reorder Point (ROP)

If expected demand during lead time and its standard deviation are

available, then ROP = d L + safety stock ROP = Expected demand during lead time + ZdLT Where, z = Number of standard deviations dLT = The standard deviation of lead time demand ZdLT = Safety Stock Note: smaller the risk a manger is willing to accept, greater the

Other Three Probabilistic Models

1. 2. 3.

Demand is variable, and LT constant Lead time is variable, demand constant Both lead time and demand are variable

Demand and LT Variable

dLT = Standard deviation of lead time demand

Demand Variable and LT Constant

LT Variable and Demand Constant

Discounts
Quantity Discounts
Suppliers offer quantity discounts on bulk purchases

Example: 5% discounts if purchases made in lots of 10,000 syringes or more in a hospital

Differential discounting

Quantity 100 - 449 450 - 899 >900

Discount 2% 4% 5%

Quantity Discount Model

Two general cases
Carrying cost constant Carrying cost is a % of purchase price

Total Cost Curve with Constant Carrying Cost

When carrying costs are constant, all curves have same minimum points at the same quantity

Quantity Discounts With Constant Carrying Costs

Total Cost with Carrying Cost as % of Unit Price

When carrying costs are % of unit price, minimum points dont line up

Procedure for Determining Overall EOQ when Carrying Costs are Constant
Compute the common minimum point If the feasible minimum point is on the lowest price

range, that is the optimal quantity

If the minimum point is in any other range, compute the

total cost for the minimum point and for the price breaks of all lower unit costs. Compare the total costs; the quantity (minimum point or price break) that yields the lowest total cost is the optimal order quantity

Determining Best Purchase Quantity when Carrying Costs are % of Purchase Price
Begin with lowest unit price, compute the minimum

points for each price range until you find a feasible minimum point (i.e. until a minimum point falls in the quantity range for its price)

If the minimum point for the lowest unit price is

feasible, it is the optimal order quantity. If the minimum point is not feasible in the lowest price range, compare the total cost at the price breaks for all lower prices with the total cost of the feasible minimum point. The quantity which yields the lowest total cost is the optimum

Problems
Carrying Costs are % of price

Total Annual Costs With Quantity Discounts

Fixed Time Period Model (P-Model) or Periodic Review System

Inventory checked only at fixed intervals of time,

rather than on a continuous basis Time between orders is constant On-hand inventory counted Only the amount necessary to bring the total inventory up to a pre-specified target (or order-up to level) is ordered (order size varies depending on on-hand inventory)

Fixed Time Period Model

Order up to level

Fixed Time Period Model

P-Model

OI Order Interval

Fixed Time Period with Safety Stock

Order Qty = Avg. demand + Safety Stock - Inventory on hand

Q = d (tb + L) + z dtb+L - I
Where, d= average demand rate tb = the fixed time between orders L = Lead Time Z = # standard deviations for a specified service level d = standard deviation of demand z d tb+L = Safety stock I = current inventory in stock Q = Quantity to be ordered

P Model
Advantages Practical approach if the inventory withdrawals cant be closely monitored Inventory counted only before the next review period Convenient administratively More appropriate for C-items Disadvantages No tally of inventory during review period Possibility of stock out Large amount of safety stock because need to protect against shortages during order interval and lead time

Differences (Q vs. P Models)

Q model Order Qty: Q fixed When order: ROP triggered Monitoring: Close Record keep: Each time material withdrawn Size of Inv: Less than P model Time to maintain: High If Higher than normal demand Shorter time between orders Type of items: High priced, critical, important items
A items

P model Order Qty: variable (varies each time order is placed due to demand variability) When order: Review period (time triggered) Record keep: Counted only at review period Administration: Easy Size of Inv: Larger than Q model Type of items: Retail, drugs
Appropriate when large number of

items ordered from same supplier resulting in consolidation and lower freight rates

Choosing Between Q and P

Not an easy decision
Part science and part human judgment It depends on variety of factors Total SKUs monitored Computerized or manual system ABC profile Strategic focus Cost minimization or customer service

Case
Zhou Bicycle Company