Inventory

Management
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 Inventory

Stockpile of goods for future use

- Raw materials
- Work In Process (WIP)
- Finished goods

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• https://www.census.gov/mtis/www/da
ta/pdf/mtis_current.pdf

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• With USD 1.932 Trillion tied up in
stock, the firms operating in the US
incur a cost of at least USD 1.61
Billion per month !

• (Their foregone profit on the capital

tied up in physical stock with annual
US Treasury interest rate of 1%.)
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Why carry inventories?
• Exploit economies of scale
• Obtain quantity discounts
• Hedging against future price movements
• Decouple operations in mfg
• Hedge against delivery/availability
uncertainties
• Hedge against demand uncertainties

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Why carry inventories?

• Exploit economies of scale

• Hedge against uncertainties

in demand/supply/price

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 Why not carry?
• Inventories are costly to hold
– Warehousing/depot costs
– Cost of capital tied up inventories
• Items may perish/decay/become
obsolete/get damaged

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• Inventory management is concerned
with the trade-off btw pros and cons
of carrying inventories.

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 Inventory

Stockpile of goods for future use

- Raw materials
- Work In Process (WIP)
- Finished goods

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 Types
• ‘Fashion goods’

• Commodities

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 ‘Fashion goods’

– Typically single selling season

– Product has no or little value after
season
– Replenishment opportunity once at
season start
– Decides how much to stock (Initial
stocking level)

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 Commodities
– Items that continue to be sold for a
‘long’ time
– Leftover items can be carried into the
next periods without loss of value
– Items dot perish/decay
– Replenishment decisions
• How much to order
• When to order

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Inventory Management
• Monitoring of inventory ‘levels’
– Periodic review (One ‘period’, every
‘period’)
– Continuous review (real time)

• Replenishment decisions
– When to order
– How much to order

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Inventory management is the
technical core of Supply Chain
Management (SCM)

SCM deals with interaction of

multiple decision makers, typically in
a game theoretic setting.

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• Inventory control related costs

• Inventory control models

• ABC Analysis – prioritization of

managerial effort

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 ABC Analysis
A classification scheme of SKUs
(stock keeping units) to identify
‘important’ categories of items so
that inventory management efforts
are focused on them

Typically, SKUs are ranked on basis

of ‘Annual demand X unit cost’

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ABC Example
Item Annual Demand Cost/Unit
A2 3000 50
B8 4000 12
C7 1500 45
D1 6000 10
E9 1000 20
F3 500 500
G2 300 1500
H2 600 20
I5 1750 10
J8 2500 5

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 Inventory Costs
• (Fixed) ordering costs
• (Variable) acquisition costs
• (Variable) holding costs
• (Variable) shortage costs

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 Ordering Cost
• It is fixed – that is, the ordering cost
does not depend on the quantity that
is ordered (replenished)
• K – for retail settings
• S – for mfg settings
• Measured in monetary units ($ per
order)

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 Acquisition Cost
• Variable – that is, per unit of product
• c
• Measured in monetary units per unit
of product ($ per product)

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 Holding cost
• Variable – that is, computed on the basis
of a unit of the product
• Consists of two parts
– Cost of capital
– Physical storage (warehousing) costs
• h
• Measured monetary units per unit of
product carried in inventory per unit of
time ($ per product per year)

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 Shortage Costs
• Variable – that is, computed per unit of
product
• Can be of two types
– Per unit of demand not satisfied immediately
– Per unit of demand not satisfied immediately
per unit of time
• Can be expressed in two ways
– Explicit in monetary terms
– Implicit in terms of ‘service levels’

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 Inventory Costs
• (Fixed) ordering costs
• (Variable) acquisition costs
• (Variable) holding costs
• (Variable) shortage costs

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Costs Example

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Inventory Management
• Considers two fundamental trade-
offs

1) Between (fixed) ordering and holding

costs
2) Between holding and shortage costs

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• Concepts and models can be used
for both production and retail
settings

• Demand can be deterministic

(known) or stochastic (random,
unknown)

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 Important
• Structure of demand
(deterministic/known vs.
random/unknown)

• Delivery lead times (zero, positive,

random, ‘finite replenishment rate’)

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 Basic Models

• Economic Order Quantity (EOQ)

• Economic Production Quantity (EPQ)
• Single period model (Newsvendor
model)
• Lotsize-reorder point, (Q,r) model

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 Basic Models

• Economic Order Quantity (EOQ)

• Economic Production Quantity (EPQ)
• Single period model (Newsvendor
model)
• Lotsize-reorder point, (Q,r) model

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 Newsvendor Model
• Single period (newsboy selling
newspaper; Xmas trees)
• One replenishment opportunity at period
start, Q
• Demand random with known distribution,
F
• Excess (overage or holding) costs for
leftovers, Ce
• Shortage (underage) costs for unsatisfied
demand, Cs
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Objective is to minimize the expected
total (overage and underage) costs
which will be incurred at the end of
the selling period.

Decision variable: Initial stocking

level, Q

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 Newsvendor Example
Selling price/unit = $150
Acquisition cost/unit = $120
Salvage value/unit = $70

* What is the desired Service Level?

* What is the corresponding
(optimal) stocking quantity?

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 Demand Distribution
Demand, X Prob(x)
0 0.05
1 0.20
2 0.25
3 0.25
4 0.15
5 0.10
6+ 0.00.
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 Trade-off 1
• The total expected excess (holding)
costs EQUALS the total expected
shortage costs when (continuous) Q
satisfies the desired service level,
SL.

Newsvendor model BALANCES the

holding and shortage cost rates!
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 A special case
When demand is normally distributed
with mean m and standard deviation s

Q = m + z_a s

where a stands for the service level

(the probability of no stock-out)

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Newsvendor Example

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 EOQ
• Demand is known (constant rate), D
• Zero delivery lead time
– Infinite replenishment rate
• No shortages allowed
• Order arrives in one batch
• Costs do not vary
• Infinitely repeating process

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Objective is to minimize the total
cost rate (which is total cost per unit
of time, say, a year.)

Decision variable: Order quantity, Q

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 Trade-off 2
• The total average (annual) ordering
costs EQUALS the total average
(annual) holding costs at Q=EOQ.

• EOQ model BALANCES the ordering

and holding cost rates!

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 EOQ Example
Annual demand = 12000 units
(constant)
Unit cost = $10
Fixed ordering cost = $1000
Cost of capital = 6% per year
Physical storage = $ 0.5 per month

Optimal Order Size? Annual Cost?

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 (Q,r) Model
The lot size – reorder point model
combines:
- the EOQ model for the quantity
decision, Q
- the newsvendor model (within a
lead time period) for the timing
(reorder point) decision, r

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 Service Levels
• Lead time service level : Same as
that in newsvendor model –
corresponds to the probability of not
running out during the period
• Annual service level : Fraction of
demand that is not immediately
satisfied – the expected number of
shortages
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(Q,r) Model Formulas

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Example

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Supply Chain
Management
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Supply Chain Management
Strategic coordination of stages
along a supply chain to integrate
supply and demand management –
a smooth flow of
goods/information/cash
Typically, involves multiple
independent actors in a game
theoretic setting
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 SCM Practices
• Based on fundamental inventory
management trade-offs
• Can be understood via basic
inventory models

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 Trade-offs
• Lotsize-inventory trade-off: inventory mgt
• Inventory-transportation cost trade-off :
cross-docking
• Lead time-transportation cost trade-off
• Variety-inventory trade-off : Delayed
differentiation
• Cost-customer service trade-off :
disintermediation

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 Bullwhip Effect
• Demand variations begin at the customer
end & become increasingly large as they
go upstream along the supply chain
• Occurs because of:
– Batching effects
– Rationing
– Promotion seasonality
– Little forecasting transparency/visibility

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 Vendor Managed Inventory
(VMI)
• Vendors monitor goods and
replenish retail inventories
themselves

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 Lean Operations
• Just-in-Time (JIT)

A highly coordinated processing

system in which goods move
through the system, and services are
performed, just when they are
needed.

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 JIT enablers
• Reduced uncertainty
• Setup time reduction
• Delivery lead time reduction
• Pull vs. Push control
– kanban

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 Performance Metrics
• Financial (ROI,Cost, Profit,Cash flow)
• Suppliers (Quality,On-time delivery,
Cooperation, Flexibility)
• Customers (Satisfaction, % of
customer complaints)
• Operations (Productivity, Quality)

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• Inventory (Average value, Turnover,
Weeks of supply)
• Order fulfillment (Order accuracy,
Time to fill orders, % of incomplete
orders, % of orders delivered on
time)

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 Furthermore,
• Supply contracts – e.g., Buyback
contracts (risk sharing)
• Aggregation of demand points (risk
pooling)
• Game theory
• Supplier partnerships
• Closed loop supply chains
• Green supply chains

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 Buyback Contract
The producer guarantees to buy back a
portion or all of the leftovers from the
seller at a salvage value typically larger
than unit cost.

Enables the seller to ‘take more risk’

due to lower excess costs and
increases all players’ profits.
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 Take-aways from
Zara …
• Better forecasts
– Very short lead times
– Direct sales data from stores
– Imitate other brands
• Stock levels lower
• Shortages are effectively less costly
– Stockouts encourage customers to buy
fast
– Excesses at one store used to cover
shortages elsewhere