Objectives:

Session 5 & 6: Managing Inventory

Flow on Supply Chains and Inventory
decision making

Understanding the importance of coordinated flows

of inventory through supply chains
Appreciate the role of inventory and understand the
reasons for carrying/ holding inventory
Assess the types of inventory related costs
Understand how companies can manage inventory
using simple tools and techniques

Chapter 6&7

Types of Inventory

Inventory - Definition
The number of units and/or
value of the stock of goods held
by a company

Raw material
Work-in-process
Finished goods
Support parts
MROs (maintenance,
repairs & operating
supplies)

In-transit Stock
Regular Or Cycle Stock
Safety Stock
Obsolete, Dead Or
Shrinkage
Seasonal Stock
Speculative Stock
Promotional Stock

A stock (fast-moving stock)

B stock
C stock (slow-moving stock)

In The Pipeline
Called in-transit stock

Regular Or Cyclical Stock

Inventories required to meet average
demand between replenishments.
Dependant upon:
sales demand or production lot size
replenishment lead times
price-quantity discount schedules economical
shipment quantities
storage space limitations

Safety Stock
Hedge against variability in supply,
demand and replenishment lead time
Added to regular stock
Calculated by statistical procedures
Accurate forecasting is essential
If demand and lead time 100% correct, no
need for safety stock

Seasonal Stock
Inventories held in advance of production
or sales requirements

Obsolete, Dead, Shrinkage Stock

Includes out of date, lost or stolen
stock.
Where products expensive or easily
stolen-must have special
precautions.

Speculative Stock
Inventories built up in anticipation of future
price increases

Promotional Stocks
For marketing promotion purposes
Trial product
Sampling
Free gift

Reasons for holding inventory

enables firms to achieve economics of

scale
A firm can
realise
economics of
scale in
purchasing,
manufacturing,
distribution.

Purchasing in large volumes

Realising lot quantity discounts
Transport can move large
quantities, reducing freight costs
per unit through better vehicle
utilisation

helps balance supply and demand

helps balance
supply and
demand when
demand or
supply is
seasonal

Raw materials supply may be

available only at certain times
during the year.
Demand may be seasonal
By manufacturing to stock,
production can be kept level
throughout the year. This
reduces idle capacity and
maintains a relatively stable
workforce.

Manufacturing long
production runs

allows for production specialisation

Inventory allows
firms with
subsidiaries to
specialise focused factories

Instead of producing a
variety of products, each
plant can manufacture a
product and then ship the
finished products to field
warehouses where they are
mixed to fill customer orders.

acts as a buffer
Inventory can
buffer key
interfaces,
creating time and
place utility

Key interfaces:
Supplier-procurement
procurement-production
production-marketing
marketing-distribution
distribution-intermediary
intermediary-customer

protects against uncertainties

A primary reason
to hold inventory
is to offset
uncertainties in
demand and
supply.

Supply shortage in
raw materials production shuts
down.
Customer orders
outstrip finished
goods supply,
stockouts occurslose customers.

Conflicting objectives of functional areas

Marketing
Marketing wants
high inventories
over broad range
of products to
allow quick
response to
customer
demands

Production
Production wants
high inventories to
support long
production runs and
to realise economics
of scale through the
reduction of per unit
fixed costs

Finance
Finance normally
prefers low
inventories to
increase inventory
turns

Total cost concept

Inventory covers problems

Customer
service
Raw
material

Inventory
carrying costs

Transportation
costs

Lot quantity
cost

Finish product
to customer

Sea of inventory
M ac
h
brea ine
kdow
n

Line
imbalance

n
atio
nic
mu m
Com proble

Warehousing
costs

ho Lac
k
us
e-k of
ee
pin
g

Order processing &

information costs

lity
Qua ms
le
prob

Lo
trans ng
porta
tion
r
Poo ng
li
ed u
sch

Ab
se
nt
ee
i

sm

p
set-u
Long e
tim

Vendor
delivery

inventory costs categories

Cost of inventory

Two types of costs are associated

with inventory

Does it cost to carry/hold inventory?

Carrying cost
costs associated with
physically storing a
product. Includes only
those costs that vary
with the quantity of
inventory. Usually
expressed as a % of
product value.

Ordering cost
costs of placing an
order.
Setup cost
refers to modifying
the production
process to make
different goods.

Calculating Inventory Carrying Cost

an Example

Inventory carrying costs

Inventory
Inventory investment
investment
insurance
insurance
Taxes
Taxes
Capital/
Capital/
opportunity
opportunity cost
cost

Carrying
Carrying
cost
cost

Service
Service
cost
cost
Storage
Storage
cost
cost
Inventory
Inventory
risk
risk cost
cost

Plant
Plant warehouses
warehouses

Cost

% of product value

Public
Public warehouses
warehouses
Rented
Rented warehouses
warehouses
Company
Company warehouses
warehouses
Obsolescence
Obsolescence
Damage
Damage
Relocation
Relocation
Theft
Theft

Capital
Storage space
Inventory service
Inventory risk cost
Total

10
2
4
7
23%

Inventory Costs:
Expected Stock-out Cost

Ordering/setup costs

stock checking

Ordering
Ordering
cost
cost

Personnel
Personnel
cost
cost

selecting
selecting
suppliers
suppliers

processing
processing
order
order request
request

Setup
Setup
cost
cost

Cost of not having product available when a

customer wants it.
Includes :
backorder costs (special order).
Losing one item profit by substituting a competing firms
product.
Losing a customer permanently if customer finds they
prefer the substituted product and/or company.

Capital
Capital
equipment
equipment cost
cost

preparing
preparing
payment
payment
Reviewing
Reviewing
inventory
inventory level
level

STOCKOUT COSTS CALCULATION

Wait until normal replenishment

Back order
Lost of sales
Lost of customer

POSSIBILITY

$0
$10
$50
$100

Annual cost ($)

COST

Trade-off: carrying costs vs ordering

cost

10%
40%
30%
20%

Inventory
carrying cost
Ordering cost

Total :
$0*10% + $10x40% + $50x30% + 100x20% =$39

Size of order

ABC Analysis

100
20
% of total sales

Single-Criterion ABC Analysis:

Based on the notion: 'Vital few, trivial many'
Separating inventory items into three groupings
according to their annual cost volume usage.
A items having high dollar usage
B items having an intermediate dollar usage
C items having a low dollar usage.

The Pareto (80-20) effect

80

80
20

% of items

100

A-B-C analysis: An Example

20% of customers, 80%
of
the
products, parts
company's revenue
and
inventory
investment
30% of customers, 15%
of
the
products, parts
company's revenue
and
inventory
investment
50% of customers, 5%
of
the
products, parts
company's revenue
and
inventory
investment

These are called

"A" customers, "A"
products, "A" parts
These are called
"B" customers, "B"
products, "B" parts
These are called
"C" customers, "C"
products, "C" parts

Lowest

SKU Annual Quantity

Used
1
1023
2
574
3
3906
4
521
5
1145
6
3754
Total
10923

% of total Annual $ % of total

Item
Purchases Purchases
9.4
3600000
11.8
5.3
6200000
20.4
36
1100000
3.6
4.8
15400000
50.7
10.5
2300000
7.6
34
1800000
5.9
100
30400000
100
Highest

A-B-C Analysis (Contd)

Pareto analysis (Example)

10.1% of items

9.5%
100
90.5
% of total sales

SKU Annual Quantity % of total Annual $ % of total

Used
Item
Purchases Purchases
4
521
4.8
15400000
50.7
2
574
5.3
6200000
20.4
1
1023
9.4
3600000
11.8
5
1145
10.5
2300000
7.6
6
3754
34
1800000
5.9
3
3906
36
1100000
3.6
Total
10923
100
30400000
100

19.5%

A = 2, 4

71.1

C
B
A

The purpose of classifying items into categories is to

establish the appropriate degree of control over each
item.
A category items:
must be frequently reviewed and should be
ordered more frequently.
Attempt must be made to reduce the average lot
size
For C category items:
much looser control is appropriate
higher lot size and higher inventory is tolerated
For B category items

70%

C = 3, 6

19.9%

10.1%

71.1% of purchases

Inventory management policy

B = 1, 5

71.1%

10.1

30

100

Basic approaches to managing

inventory
Basic questions:
How much to order?
When to order?
Balance cost with service

Differences among approaches

Push and pull system

Dependent and independent demand
System-wide and single-facility solution

PUSH MODEL

EOQ
MRPI
MRPII
DRP
ERP

Economic Order Quantity

Material Requirements Planning
Manufacturing Resource Planning
Distribution Requirements Planning
Enterprise Resource Planning

PULL MODEL
JIT

Key Differences among

Approaches to Managing
Inventory
Pull versus Push
Pull approach is a reactive system, relying on
customer demand to pull product through a
logistics system.
MacDonalds is an example.
Push approach is a proactive system, and uses
inventory replenishment to anticipate future demand.
Catering businesses are examples of push
systems.

Key Differences among

Approaches to Managing
Inventory
Dependent versus Independent Demand
Dependent demand is directly related to the
demand for another product.

For many manufacturing processes, demand is dependent.

JIT, MRPI and MRPII are generally associated with items
having dependent demand.

Independent demand is unrelated to the demand for

another product.
For many end-use items, demand is independent.
EOQ & DRP models are generally associated with items
exhibiting independent demand.

Economic order quantity (EOQ)

Economic order quantity (EOQ)

Based on some unrealistic assumptions:

Demand is known and constant
Lead time is known and constant
Receipt of inventory is instantaneous
No stock-out
Quantity discount is not allowed.

Re-order point: When to buy?

EOQ Formula-how many to buy?

Let
A = cost of placing an order (or setup
cost) ($ per order)
R = annual demand (units)
W = annual inventory carrying cost (as
a % of product cost)
V = value or cost of one unit of
inventory ($).
Q = quantity ordered lot size (units).

Note that optimal total cost occurs at a point

where annual carrying cost is equal to
annual ordering (setup) cost.
Therefore,
(R/Q)*A = (Q/2)*W*V (i)

Reordering point - ROP = d x L

Where d = demand rate; L = average lead time

ROP = (R /12 )x L (when L expressed in months)

ROP = (R /52) x L (when L expressed in weeks)
ROP=?
(When L expressed in days)

From expression (i) we can calculate Economic

Order Quantity (EOQ):

Q = EOQ = (2RA/WV)
R/Q = number of orders
(R/Q)*A = annual ordering (setup) cost.
Q/2 = average inventory
(Q/2)*W*V = annual inventory carrying
cost

Classroom Exercise
The Williams Manufacturing
Company Purchases 8000 units
of a product each year at a unit
cost of $10.00. The order cost is
$30.00 per order, and the
holding cost per unit per
year is $3.00. What are the:
(1) EOQ,
(2) total annual inventory
expenses
(3) number of orders to place in
one year
(4) ROP when the lead time is 2
weeks?

Graph

Q* = 2RA/WV = (2 x 30 x
8000)/3 = 400 units
TIC = VR + RA/Q* + WVQ*/2
= 10 x 8000 + 30 x 8000/400
+ 3 x 400/2
= $81200.00

Q* = 400

Q* = 400

ROP = 308

N = R/Q* = 8000/400 = 20 orders

/year
ROP = R x L /52 = (8000/52)x2 =
307.7 = 308 units
LT = 2 Wks

d = 8000/52=308/2 = 154 units

Two important insights of EOQ

An optimal policy balances between inventory

holding cost and ordering or setup cost.

20.0
15.0
10.0

Total inventory cost is insensitive to order

quantities within certain range, that is, changes
in order quantities have relatively small impact
on annual setup costs and carrying costs.

5.0
0.00
0.60 0.80 1.00 1.20 1.40
When Q < 40% Q* total variable cost increases by 14%
When Q > 40% Q* total variable cost increases by about 6%

Example: sales data (Demand)

Inventory under uncertainty

Day
1
2
3
4
5
6
7
8
9
10
11
12
13

Demand distribution

Demand varies
Lead time varies

12

Lead time
Varies between 3 and 5
Average lead time = 4

#
14
15
16
17
18
19
20
21
22
23
24
25

Lead time
12
11
11
13
12
8
9
9
10
10
9
11

Day
14
15
16
17
18
19
20
21
22
23
24
25

Minimum lead time

)
Maximum lead time

Lead time = 7 - 13 days

Average
Lead time = 10 days
Standard deviation of LT=1.63

Sales
80
90
90
100
140
110
120
70
100
130
110
90

Minimum sales
Maximum sales
Average sales = 100 units
Standard deviation
of sales = 20 units

Inventory under uncertainty

Example: lead time data

# Lead time
1
9
2
8
3
9
4
13
5
11
6
7
7
12
8
11
9
9
10
9
11
8
12
9
13
10

Sales
100
80
70
60
80
90
120
110
100
110
130
120
100

Probability Distribution

Safety stock =
(AvgLT*s2d + Avgd2*sLT2) z
= (10*400 + 10000* (1.63)2)z

84.13% = 1 x standard deviation; z=1;

safety stock = 175
97.72% = 2 x standard deviation; z=2;
safety stock = 350
99.87% = 3 x standard deviation; z=3;
safety stock = 525

Total sales=840

average sales=840/12=70

period
1
2

sales
50
70

period
7
8

sales
100
90

100

70

40

10

60

5
6

60
60

11
12

80
60

fd2

sales

Frequency
(f)

Deviation
from
average
-30

Deviation
squared
d2
900

40

50

900

-20

400

400

60

-10

100

400

70

80

10

100

100

90

20

400

400

100

2
N=12

30

900

1800
fd2=4000

S =

fd

n 1

4000
= 19
12 1

Average lead time=118/158

Deviation
squared
(d2)
9

fd2

Deviation
from
average
-3

-2

-1

0
2

Lead time
in days

Frequency
(f)

5
6

10

11
56

2
n=15

18

Safety stock =
(AvgLT*s2d + Avgd2*sLT2) *z
= (8*192 + 702* (1.8)2) *z
=137* z

LT =

fd

n 1

46
= 1.8
15 1

fd2=46

MRPI
Material Requirements Planning

10

61
Aggregate
product
plan

Firm orders
from known
customers

Engineering
design
changes

Master production
Schedule (MPS)

Bill of
material
file

Primary reports
Planned order schedule for
inventory and production
control

Material
planning
(MRP
computer
program)

Forecasts
of demand
from random
customers

MRPII (Closed Loop MRP)

Master Production Scheduling
Inventory
transactions

Inventory
record file

No
Realistic?

Feedback

Feedback

Secondary reports

Yes

Exception reports
Planning reports
Reports for performance
control

Execute

The McGraw-Hill Companies, Inc., 2004

Manufacturing Resource Planning

(MRP II)
Goal: Plan and monitor all resources of a
manufacturing firm :

manufacturing
marketing
finance
engineering

Distribution Requirements Planning

DRP
Distribution Requirements Planning

Market

Market

Market

Regional
warehouse

Regional
warehouse

Factory
Central warehouse

11

Distribution Requirements Planning

Inventory planning

Produces and delivers finished goods just in time to be sold

What to distribute
How much to distribute

Produces sub-assemblies just in time to be assembled into

finished goods

Transport planning
Time & Frequency
Vehicle & Driver
Route

Produces fabricated parts produced just in time to make subassemblies

Warehouse planning

Just In Time (JIT)

Space
Receiving
Processing
Dispatch

Purchases raw materials just in time to make fabricated parts

Customer order planning

Order cycle management

Etc.

Inventory at Multiple Locations The

Square Root Law (SQL)

JIT is a Pull model

JIT pulls materials and products through
production plant and distribution channels
in response to customer or downstream
demands.
flexible manufacturing
demand response
Shorter production
runs
lower inventory levels

Pull

Inventory at Multiple Locations The

Square Root Law

X2= (X1) * (n2/n1)

Where:
n1 = number of existing facilities
n2 = number of future facilities
X1 = total inventory in existing facilities
X2 = total inventory in future facilities

Used to reduce inventory at multiple

locations.
As locations increase, inventory also
increases, but not in the same ratio as
the growth in facilities.

Square Root Law Example

Current distribution 40,000 units
Eight facilities shrinking to two
Using the square root law:
X2 = (40,000) * (2/8)
X2 = 20,000 units

12