Inventory Management

What Is Inventory?
Stock of items kept to meet future demand Purpose of inventory management

how many units to order when to order

Types of Inventory
Inputs

Raw Materials Purchased parts Maintenance and Repair Materials

Outputs

Finished Goods Scrap and Waste

In Process

Partially Completed Products and Subassemblies

Inventory
Def. - A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state. Raw Materials Works-in-Process Finished Goods Maintenance, Repair and Operating (MRO)

Inventory control
It means stocking adequate number and kind of stores, so that the materials are available whenever required and wherever required. Scientific inventory control results in optimal balance

Definition
It is concerned with planning, organizing and controlling the flow of materials from their initial purchase through internal operations to the service point through distribution. OR Material management is a scientific technique, concerned with Planning, Organizing &Control of flow of materials, from their initial purchase to destination.

Four basic needs of Material management

1. To have adequate materials on hand when needed 2. To pay the lowest possible prices, consistent with quality and value requirement for purchases materials 3. To minimize the inventory investment 4. To operate efficiently

Reasons To Hold Inventory

Meet variations in customer demand: Meet unexpected demand Smooth seasonal or cyclical demand Pricing related: Temporary price discounts Hedge against price increases Take advantage of quantity discounts Process & supply surprises Internal upsets in parts of or our own processes External delays in incoming goods Transit

Reasons To NOT Hold Inventory

Carrying cost

Takes up valuable factory space

Financially calculable

Inventory covers up problems

Especially for in-process inventory That are best exposed and solved

Driver for increasing inventory turns (finished goods) and lean production/Just in time for work in process

Inventory Hides Problems

Bad Design Lengthy Setups Inefficient Layout Poor Quality Machine Breakdown Unreliable Supplier

To Expose Problems: Reduce Inventory Levels

Bad Design Lengthy Setups Inefficient Layout Poor Quality Machine Breakdown Unreliable Supplier

Definitions
Inventory-A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state. Inventory System- A set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be

Zero Inventory?

Reducing amounts of raw materials and purchased parts and subassemblies by having suppliers deliver them directly. Reducing the amount of works-in process by using just-in-time production. Reducing the amount of finished goods by shipping to markets as soon as possible.

Inventory Positions in the Supply Chain

Raw Materials

Works in Process

Finished Goods

Finished Goods in Field

Nature of Inventory: Adding Value through Inventory

Quality - inventory can be a buffer against poor quality; conversely, low inventory levels may force high quality Speed - location of inventory has gigantic effect on speed Flexibility - location, level of anticipatory inventory both have effects Cost - direct: purchasing, delivery, manufacturing indirect: holding, stockout.

Reasons for Inventories

Improve customer service Economies of purchasing Economies of production Transportation savings Hedge against future Unplanned shocks (labor strikes, natural disasters, surges in demand, etc.) To maintain independence of supply chain

AIM OF MATERIAL MANAGEMENT To get 1. The Right quality 2. Right quantity of supplies 3. At the Right time 4. At the Right place 5. For the Right cost

Two Forms of Demand

Dependent
Demand for items used to produce final products Tires stored at a Goodyear plant are an example of a dependent demand item Demand for items used by external customers Cars, appliances, computers, and houses are examples of independent demand inventory

Independent

Independent Demand
Independent demand items are finished products or parts that are shipped as end items to customers. Forecasting plays a critical role Due to uncertainty- extra units must be carried in inventory

Dependent Demand
Dependent demand items are raw materials, component parts, or subassemblies that are used to produce a finished product. MRP systems---next week

Independent and Dependent Demand Inventory

Independent demand

items demanded by external customers (Kitchen

Tables)

Dependent demand

items used to produce final products (table top, legs,

hardware, paint, etc.) Demand determined once we know the type and number of final products

Independent and Dependent Demand Inventory Management

Independent demand

Uncertain / forecasted Continuous Review / Periodic Review

Dependent demand

Requirements / planned Materials Requirements Planning / Just in Time

Inventory and Quality Management

Customers usually perceive quality service as availability of goods they want when they want them Inventory must be sufficient to provide highquality customer service in TQM

Objectives of Inventory Control

1) Maximize the level of customer service by avoiding under stocking. 2) Promote efficiency in production and purchasing by minimizing the cost of providing an adequate level of customer service.

Inventory Control Systems

Continuous system (fixedorder-quantity)

constant amount ordered when inventory declines to predetermined level

Periodic system (fixed-timeperiod)

order placed for variable amount after fixed passage of time

Objective of material management

Primary
Right price High turnover Low procurement & storage cost Continuity of supply Consistency in quality Good supplier relations Development of personnel Good information system

Secondary
Forecasting Inter-departmental harmony Product improvement Standardization Make or buy decision New materials & products Favorable reciprocal relationships

PURPOSE OF MATERIAL MANAGEMENT To gain economy in purchasing To satisfy the demand during period of replenishment To carry reserve stock to avoid stock out To stabilize fluctuations in consumption To provide reasonable level of client services

Basic principles of material management

1. Effective management & supervision It depends on managerial functions of Planning Organizing Staffing Directing Controlling Reporting Budgeting 2. Sound purchasing methods 3.Skillful & hard poised negotiations 4.Effective purchase system 5.Should be simple 6.Must not increase other costs 7.Simple inventory control programme

Inventory Costs
Procurement costs Carrying costs Out-of-stock costs

Inventory Costs

Carrying cost
cost of holding an item in inventory

Ordering cost
cost of replenishing inventory

Shortage cost
temporary or permanent loss of sales when demand cannot be met

Procurement Costs
Order processing Shipping Handling Purchasing cost: Mfg. cost:

Carrying Costs
Capital (opportunity) costs Inventory risk costs Space costs Inventory service costs

Out-of-Stock Costs
Lost sales cost Back-order cost

Types of Inventory
Raw materials Purchased parts and supplies Work-in-process (partially completed) products (WIP) Items being transported Tools and equipment

Design of Inventory Mgmt. Systems: Micro Issues

Order Quantity
Economic Order Quantity

Order Timing

Reorder Point

Balance in Inventory Levels

When should the company replenish its inventory, or when should the company place an order or manufacture a new lot? How much should the company order or produce? Next: Economic Order Quantity

ABC Classification
Class A 5 15 % of units 70 80 % of value Class B 30 % of units 15 % of value Class C 50 60 % of units 5 10 % of value

ABC ANALYSIS
(ABC = Always Better Control) This is based on cost criteria. It helps to exercise selective control when confronted with large number of items it rationalizes the number of orders, number of items & reduce the inventory. About 10 % of materials consume 70 % of resources About 20 % of materials consume 20 % of resources About 70 % of materials consume 10 % of resources

A ITEMS

Small in number, but consume large amount of resources

Must have: Tight control Rigid estimate of requirements Strict & closer watch Low safety stocks Managed by top management

C ITEMS Larger in number, but consume lesser amount of resources Must have: Ordinary control measures Purchase based on usage estimates High safety stocks ABC analysis does not stress on items those are less costly but may be vital

B ITEM Intermediate
Must have: Moderate control Purchase based on rigid requirements Reasonably strict watch & control Moderate safety stocks Managed by middle level management

ABC Classification: Example

PART 1 2 3 4 5 6 7 8 9 10 UNIT COST $ 60 350 30 80 30 20 10 320 510 20 ANNUAL USAGE 90 40 130 60 100 180 170 50 60 120

ABC Classification: Example (cont.)

PART TOTAL % OF TOTAL % OF TOTAL PART VALUE COST ANNUAL USAGE UNIT VALUE QUANTITY % CUMMULATIVE

9 8 2 1 4 3 6 5 10 7

$30,600 1 16,000 2 14,000 3 5,400 4 4,800 5 3,900 3,600 6 3,000 7 2,400 8 1,700

9 $85,400 10
CLASS A B C

35.9 60 $ 18.7 350 16.4 30 6.3 5.6 80 4.6 30 4.2 20 3.5 10 2.8 320 2.0

% OF TOTAL ITEMS VALUE 9, 8, 2 71.0 1, 4, 3 16.5 6, 5, 10, 7 12.5

510 20

6.0 5.0 4.0 9.0 6.0 10.0 18.0 13.0 12.0 17.0

% OF TOTAL QUANTITY 15.0 25.0 60.0

6.0 90 40 11.0 130 15.0 24.0 60A 30.0 100 40.0 180B 58.0 170 71.0 50 83.0 100.0 60C 120

Example 10.1

Classifying Inventory Items

ABC Classification (Pareto Principle) A Items: very tight control, complete and accurate records, frequent review B Items: less tightly controlled, good records, regular review C Items: simplest controls possible, minimal records, large inventories, periodic review and reorder

ABC Analysis Example

100 +Class C

+Class B

Percentage of dollar value

90 Class A 80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80 90 100

Percentage of items

Economic order of quantity

EOQ = Average Monthly Consumption X Lead Time [in months] + Buffer Stock Stock on hand

ECON Q

Models for Inventory Management:

EOQ

EOQ minimizes the sum of holding and setup costs Q = 2DCo/Ch

D = annual demand Co = ordering/setup costs Ch = cost of holding one unit of inventory

Assumptions of Basic EOQ Model

Demand is known with certainty and is constant over time No shortages are allowed Lead time for the receipt of orders is constant Order quantity is received all at once

Inventory Order Cycle

Order quantity, Q

Reorder point, R

Inventory Level

Demand rate

Lead time Order Order placed receipt

Lead time Order Order placed receipt

Time

Models for Inventory Management:

EOQ

EOQ minimizes the sum of holding and setup costs Q = 2DCo/Ch

D = annual demand Co = ordering/setup costs Ch = cost of holding one unit of inventory

Re-order level: stock level at which fresh order is placed. Average consumption per day x lead time + buffer stock Lead time: Duration time between placing an order & receipt of material Ideal 2 to 6 weeks.

Reorder Point
Quantity to which inventory is allowed to drop before replenishment order is made Need to order EOQ at the Reorder Point:

ROP = D X LT D = Demand rate per period LT = lead time in periods

Reorder Point

Level of inventory at which a new order is placed R = dL where d = demand rate per period L = lead time

Reorder Point: Example

Demand = 10,000 yards/year Store open 311 days/year Daily demand = 10,000 / 311 = 32.154 yards/day Lead time = L = 10 days R = dL = (32.154)(10) = 321.54 yards

Safety Stocks

Safety stock
buffer added to on hand inventory during lead time

Stockout
an inventory shortage

Service level
probability that the inventory available during lead time will meet demand

Variable Demand with a Reorder Point

Q

Inventory level

Reorder point, R

LT Time

LT

Reorder Point with a Safety Stock

Inventory level

Q
Reorder point, R

Safety Stock

LT Time

LT

Water Tank Analogy for Inventory

Inventory Level Supply Rate

Inventory Level

Buffers Demand Rate from Supply Rate

Demand Rate

Remove Sources of Problems and Repeat the Process

Poor Quality

Lengthy Setups Bad Design Machine Breakdown

Inefficient Layout

Unreliable Supplier

Inventory Cost Structures

Ordering (or setup) cost Carrying (or holding) cost:

Cost of capital Cost of storage Cost of obsolescence, deterioration, and loss

Stock out cost Item costs, shipping costs and other cost subject to volume discounts

Costs Associated with Goods for Sale

1. Purchasing costs include transportation costs. 2. Ordering costs include receiving and inspecting the items in the orders. 3. Carrying costs include the opportunity cost of the investment tied up in inventory and the costs associated with storage.

Costs Associated with Goods for Sale

4. Stockout costs occur when an organization runs out of a particular item for which there is a customer demand. 5. Quality costs of a product or service is its lack of conformance with a prespecified standard.

Economic-Order-Quantity Decision Model Assumptions

1. The same quantity is ordered at each reorder point. 2. Demand, ordering costs, carrying costs, and purchase-order lead time are known with certainty. 3. Purchasing costs per unit are unaffected by the quantity ordered.

Economic-Order-Quantity Decision Model Assumptions

4. No stockouts occur. 5. Quality costs are considered only to the extent that these costs affect ordering costs or carrying costs.

Economic-Order-Quantity Decision Model Assumptions

The EOQ minimizes the relevant ordering costs and carrying costs. Video store sells packages of blank video tapes. Video purchases packages of video tapes from Oaks, Inc., at $15/package.

Economic-Order-Quantity Decision Model Assumptions

Annual demand is 12,844 packages, at the rate of 247 packages per week. Video requires a 15% annual return on investment. The purchase-order lead time is two weeks. What is the economic-order-quantity?

Economic-Order-Quantity Decision Model Assumptions

Relevant ordering cost per purchase order: $209 Relevant carrying costs per package per year: Required annual ROI (15% $15) $2.25 Relevant other costs 3.25 Total $5.50

Economic-Order-Quantity Decision Model Example

EOQ =

2DP C

D = Demand in units for a specified time period P = Relevant ordering costs per purchase order C = Relevant carrying costs of one unit in stock for the time period used for D

Economic-Order-Quantity Decision Model Example

EOQ

2 x12 ,844 x$209 $5.50

976144 ,

988 packages

Economic-Order-Quantity Decision Model Example

What are the relevant total costs (RTC)? RTC = Annual relevant ordering costs + Annual relevant carrying costs D Q RTC = Q P + 2 C or DP QC + 2 Q

Q can be any order quantity, not just the EOQ.

Economic-Order-Quantity Decision Model Example

When Q = 988 units, RTC = (12,844 $209 988) + (988 $5.50 2) = $5,434 total relevant costs How many deliveries should occur each time period? D 12,844 EOQ = 988 = 13 deliveries

Economic-Order-Quantity Decision 10,000 Model Example

Relevant Total Costs (Dollars)
8,000 Annual relevant total costs

6,000 5,434 4,000 Annual relevant carrying costs Annual relevant ordering costs

2,000

Order Quantity (Units)

600

988 1,200 EOQ

1,800

2,400

20 - 15

Reorder Point

Reorder point = Number of units sold per unit of time Purchase-order lead time EOQ = 988 packages Number of units sold/week = 247 Purchase-order lead time = 2 weeks Reorder point = 247 2 = 494 packages

Reorder Point
988 Reorder Point 494 Reorder Point

Weeks

3
Lead Time 2 weeks

7
Lead Time 2 weeks

This exhibit assumes that demand and purchase-order lead time are certain: Demand = 247 tape packages/week Purchase-order lead time = 2 weeks
20 - 17

Safety Stock Example

Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. Videos expected demand is 247 packages per week. Management feels that a maximum demand of 350 packages per week may occur.

Safety Stock Example

How much safety stock should be carried? 350 Maximum demand 247 Expected demand = 103 Excess demand per week 103 packages 2 weeks lead time = 206 packages of safety stock.

Considerations in Obtaining Estimates of Relevant Costs

What are the relevant incremental costs of carrying inventory? only those costs of the purchasing company that change with the quantity of inventory held

Cost of Prediction Error

Predicting relevant costs requires care and is difficult. Assume that Videos relevant ordering cost is $97.84 instead of the $209 prediction used. What is the cost of this prediction error?

Evaluating Managers and Goal-Congruence Issues

The opportunity cost of investment tied up in inventory is a key input in the EOQ decision model. Some companies now include opportunity costs as well as actual costs when evaluating managers.

Just-In-Time Purchasing

Just-in-time (JIT) purchasing is the purchase of goods or materials such that a delivery immediately precedes demand or use. Companies moving toward JIT purchasing argue that the cost of carrying inventories (parameter C in the EOQ model) has been dramatically underestimated in the past.

JIT Purchasing and EOQ Model Parameters

The cost of placing a purchase order (parameter P in the EOQ model) is also being re-evaluated. Three factors are causing sizable reduction in the cost of placing a purchase order (P). 1. Companies increasingly are establishing long-run purchasing arrangements.

JIT Purchasing and EOQ Model Parameters

2. Companies are using electronic links, such as the Internet, to place purchase orders. 3. Companies are increasing the use of purchase order cards (similar to consumer credit cards like Visa and Master Card).

Economic Order Quantity (EOQ) Model

Demand rate D is constant, recurring, and known Amount in inventory is known at all times Ordering (setup) cost S per order is fixed Lead time L is constant and known. Unit cost C is constant (no quantity discounts) Annual carrying cost is i time the average $ value of the inventory No stockouts allowed. Material is ordered or produced in a lot or batch and the lot is received all at once

EOQ Lot Size Choice

There is a trade-off between lot size and inventory level.

Frequent orders (small lot size): higher ordering

cost and lower holding cost. Fewer orders (large lot size): lower ordering cost and higher holding cost.

EOQ Inventory Order Cycle

Demand rate Order qty, Q

Inventory Level

ave = Q/2 Reorder point, R 0

As Q increases, average inventory level increases, but number of orders placed decreases

Lead time Order Order Placed Received

Lead Time time Order Order Placed Received

Total Cost of Inventory EOQ Model

Planning for Uncertainty

changing lead times changing demand Uncertainty creeps in:

Safety stock - allows manager to determine the probability of stock levels - based on desired customer service levels

Plug in safety stock