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Module 5: Inventory
Management
Module 5 looks

at inventory management, which is largely concerned with

planning and controlling inventories. The sections in this
module cover the following:

Section A discusses

inventory types, functions, and targets as well as basic

accounting and valuation.

Section B discusses
safety stock and service levels as well as inventory costs
and their associated tradeoffs. This section also covers
ABC inventory segmentation.

Section C looks

at order systems and lot sizes.

Section D discusses

inventory moving through the supply chain, including

special handling and lot control. This section also covers
reverse logistics and all of the types of inventory that
comprise it.

Section E covers
inventory auditing, which often relies on ABC item
segmentation. This section also discusses sources of
inventory loss and methods to address it.

Section F concludes

the module with an examination of how inventory is

distributed throughout the supply chain.

 
Section A: Inventory
Investment/Days of Supply
After completing this section, students will be able to
Define inventory and inventory management
Describe two key objectives of aggregate inventory
management
List the different types of inventory
Identify the various functions of inventory
Describe the purpose and function of accounting
inventory statements, including the balance sheet, the
income statement, and the statement of cash flows
Define GAAP (generally accepted accounting principles)
Describe the differences between accounting valuation
methods, including first-in, first-out (FIFO), last-in, first-out
(LIFO), average cost, and standard cost.

This section discusses the basics of how inventory is

managed and the goals that organizations try to achieve
through inventory management. To understand those goals,
you must understand what the types and functions of
inventory are. Since the goals of inventory management
relate to inventory investment, discussions surrounding
basic accounting and inventory valuation methods are
necessary.

Topic 1: Foundations of
Inventory
Inventory and the management of it are crucial to the
success or failure of a business due to the large financial
investments that organizations make that are not
recoverable until products are sold.

Inventory and Inventory Management

The APICS Dictionary, 16th edition, defines inventory in
part as follows:

Those stocks or items used to support production

(raw materials and work-in-process items),
supporting activities (maintenance, repair, and
operating supplies), and customer service (finished
goods and spare parts). Demand for inventory may
be dependent or independent. Inventory functions
are anticipation, hedge, cycle (lot size), fluctuation
(safety, buffer, or reserve), transportation
(pipeline), and service parts.
Inventory is fed into production, and different types of
inventory are produced as a result. Production and inventory
management are inseparable, and they need to be
managed together during each phase of manufacturing
planning and control.

The Dictionary defines inventory management as “the

branch of business management concerned with planning
and controlling inventories.”

Managing inventory levels is essential, because inventory

represents a huge investment of money that is not returned
until the units are sold. According to Chapman et al. in
Introduction to Materials Management, 8th edition,
inventory represents between 20 and 60 percent of all
assets on an organization’s books. In addition to being
money tied up until items are sold, inventory has a carrying
cost, or a cost for the warehouses and staff and other
expenses. It also may spoil or become obsolete. Therefore,
organizations want to make and sell inventory as quickly as
possible.

Inventory management takes place at two levels: aggregate

and item. Aggregate inventory management is part of long-
term planning, for example, strategic planning,
manufacturing business planning, sales and operations
planning, and production planning. It is concerned with
overall categories of inventory in the aggregate based on
their financial value, such as the value of all raw materials.
Aggregate inventory management studies how inventory
flows through production, how it is used to balance supply
with demand, and the functions that it is used to perform.
Inventory impacts customer service levels (in that it can
prevent stockouts) as well as the efficiency of operations (in
that it can prevent plant shutdowns). However, these
functions are provided only at a cost. Inventory objectives
are set at this aggregate level to ensure that inventory
supports the organization’s strategy and that the benefits of
carrying inventory are worth the costs.

Topic 2: Inventory Targets

For most organizations, inventory is a necessary cost of
doing business, but because reducing costs directly
increases profit, a primary objective of inventory
management at the aggregate level is to minimize total
inventories. This can conflict with other organizational
objectives related to inventory. Here we’ll look at two key
objectives of aggregate inventory management:
Minimize inventory investment.
Maximize manufacturing efficiency.

Note how the first objective is a reason not to hold inventory

while the second is a reason to hold inventory. In addition,
an organization may choose to hold inventory to meet
targeted levels of customer service. Each organization’s
strategy will shape how much priority is placed on each of
these conflicting objectives and how the organization
balances the objectives.

Minimizing Inventory Investment

The total investment in inventory can be viewed from
several different perspectives, and which perspective the
organization takes can result in very different decisions
related to how to work toward the goal of minimizing
inventory investment. Within the organization, in addition to
finance, purchasing may have an incentive to push for
minimum inventory levels, depending on performance
measures. Measures may include minimizing inventory costs
overall or minimizing the cost per unit. Minimizing the cost
per unit will provide incentive to order in bulk to reduce
various costs, but this will tend to increase overall inventory
and thus inventory carrying costs.

From the perspective of the entire organization, the

incentive may be to minimize inventories at the expense of
others in the supply chain. An assemble-to-order
organization, for example, might order components only in
response to customer orders while requiring suppliers to
maintain inventories ready for fast delivery. This helps the
organization’s finances look good to investors, but this
practice may mean that more inventory is held overall in the
supply chain. (Inventory is held in smaller lots but in more
places upstream, so total inventory—and thus inventory
cost—is higher.)

Other organizations, including those that use lean practices,

take the perspective of total supply chain inventory
investment. When viewing inventory across the supply
chain, stores of inventories at any point add to total costs
and the total cost to customers, thus increasing the final
price of the product. Organizations that take a supply chain
view of inventory work to reduce all inventories so the price
of the final product can be lower and overall sales higher. If
a supplier maintains low inventories, it can charge less for
its goods, and these savings are passed on. Of course, a
plant stoppage or a missed sale due to a stockout will
increase costs or reduce revenues, so minimization of
inventory investment often has a lower limit.

Maximizing Manufacturing Efficiency

Manufacturing efficiency is about managing the flow of
materials into, through, and out of the production process.
Materials management and purchasing will have
performance incentives that encourage them to ensure that
production flows smoothly, with no stoppages or over- or
undercapacity. (The latter is an opportunity cost because
idle staff and equipment cost money but are not producing
anything.) Organizations can use inventories to maximize
manufacturing efficiency in several ways.

The first way is called decoupling, and inventory used for

this purpose may be called decoupling inventory. The APICS
Dictionary, 16th edition, defines decoupling inventory as
follows:

An amount of inventory maintained between

entities in a manufacturing or distribution network
to create independence between processes or
entities. The objective of decoupling inventory is to
 disconnect the rate of use from the rate of supply of
the item.

Inventory can decouple supply from demand at the supply

chain level by, for example, allowing raw materials to be
pulled from inventory rather than relying on order lead
times, or by maintaining inventories of finished goods rather
than producing based on actual orders.

Decoupling can also occur between work centers in a plant.

This may be desired when work centers operate at different
rates or the demand for work centers varies and is difficult
to schedule. The organization’s productivity measurement
system is usually what promotes the use of decoupling in
the first place. A key measure of worker and equipment
productivity is the utilization rate (hours actually worked
divided by available time). Conventional manufacturing
planning and control systems work to maximize the
utilization of both workers and equipment to reduce the
opportunity costs of idle investments. Decoupling between
work centers—especially in intermittent (work center or
batch) process types—can also allow the work centers to
operate more independently. Different batches will share
some common work centers, and the orders will have
competing due dates. In this situation, bottlenecks can form
somewhat spontaneously at various work centers based on
the competing dates.

Another reason for decoupling is to take advantage of times

when capacity and materials are available sooner than
actually needed. Manufacturing planning and control may
choose to accept the tradeoff of higher inventory by using
this capacity or these materials now so as to reduce
capacity constraints later. A better option would be to
readjust the due dates in material requirements planning to
balance out capacity without these added costs, but this is
not always feasible given the additional need to prevent
system nervousness.

Inventories are also used to enable level production.

Building the same amount in each period results in high
inventories in periods of low demand but increases
manufacturing efficiency by lowering or eliminating
overtime or subcontracting, reducing the need for expensive
excess capacity and reducing staffing costs such as hiring,
layoffs, and training.

Another way to increase manufacturing efficiency is to have

long production runs with few changeovers, which results in
higher levels of inventory since more units of a particular
type will need to be made than are in demand right away.
However, a tradeoff is that long runs can harm customer
service because some units will need to wait to be produced
and so lead times will be longer for some customers. Also,
units of other items in demand that are not being produced
at that time will need to be in inventory to satisfy demand.
However, long production runs lower setup costs overall and
thus the per-unit cost related to setups, because the one-
time setup cost is spread over more units. Also, more units
overall can be run, because more time is spent producing
units and less is spent on changeovers. On an annual basis,
the number of units produced can be significantly higher.
Minimizing the number of setups is often done for
bottleneck work centers to maximize their output.

Finally, if purchasing buys raw materials and components in

large lots, it decreases ordering costs (fewer orders need to
be processed), cost per unit (if there are bulk discounts),
and transportation costs (if full truckloads can be ordered).
The tradeoff is larger inventories and thus higher carrying
cost.

Balancing Inventory Objectives

Balancing inventory objectives starts with the organization’s
strategy. Some strategies will prioritize customer service,
and others will prioritize minimizing cost or maximizing
efficiency. A chase production strategy, for example, will
minimize inventories while increasing costs related to high
variability in production. This is a good strategy if the
benefits exceed the costs relative to other choices. In other
words, the only good reason to carry inventory is when not
carrying it would be more costly overall.

A benefit-cost analysis for a given set of strategic priorities

would evaluate the benefits of targeted levels of customer
service and production efficiency against the costs related
to changing production levels and placing orders,
transportation costs, and inventory carrying costs. If there is
an alternative that also fits with the strategy but has lower
inventory levels, these costs and benefits can also be
compared. The option with the best value can then be
selected. Note that some benefits will be hard to estimate,
such as a change in customer loyalty.

Topic 3: Types and Functions of

Inventory
As organizations work to meet inventory targets, they have
to make decisions on inventory across the organization.
These decisions may differ depending on the type of
inventory being considered and how the organization is
using it to meet customer service and production goals.

Types of Inventory
The APICS Dictionary, 16th edition, defines the following
types of inventory:

Raw material: Purchased items or extracted

materials that are converted via the manufacturing
process into components and products.

Work in process (WIP): A good or goods in

various stages of completion throughout the plant,
including all material from raw material that has
been released for initial processing up to
completely processed material awaiting final
inspection and acceptance as finished goods
inventory. Many accounting systems also include
the value of semifinished stock and components in
this category.

Finished goods inventory: Those items on which

all manufacturing operations, including final test,
have been completed. These products are available
 for shipment to the customer as either end items or
repair parts.

Distribution inventory: Inventory, usually spare

parts and finished goods, located in the distribution
system (e.g., in warehouses or in transit between
warehouses and the consumer).

Maintenance, repair, and operating (MRO)

supplies: Items used in support of general
operations and maintenance such as maintenance
supplies, spare parts, and consumables used in the
manufacturing process and supporting operations.

The operations and maintenance function is responsible for

ordering MRO inventory and maintaining its levels. A term
related to finished goods and MRO supplies is service
parts, defined in the Dictionary as “those modules,
components, and elements that are planned to be used
without modification to replace an original part.” An
organization can sell service parts to satisfy independent
demand for the parts, so in this case, they are a type of
finished good. However, when the organization buys service
parts for its own use, they do not become part of the final
product and thus are MRO supplies.
Exhibit 5-1 shows how these types of inventory interrelate
as they flow through the supply chain. Note that distribution
inventories include both transportation inventories
(inventory in transit in the distribution network) as well as
units being stored in distribution centers.

Exhibit 5-1: How Inventory Flows Through Supply Chain

Exhibit 5-1 is from the perspective of the manufacturer.

Since suppliers are often manufacturers in their own right,
they will have their own raw material, WIP, finished goods,
MRO, and distribution inventories. Their finished good
becomes this manufacturer’s raw material.

The inventory types described here are used in aggregate

inventory management to help determine where inventory
is accumulating and where it is not. For example, WIP
inventory might be accumulating during production due to
long queues before work centers and long wait times after.
Tracking inventories by these categories helps finance
determine areas where improvements can be made rather
than just summing all inventory no matter where it is in the
system.

The strategic choices related to manufacturing environment,

process type, and process layout will impact which types of
inventory are likely to accumulate. Project, work center, and
batch process types will have more opportunity to
accumulate excess WIP inventory than line and continuous
process types, simply because these latter methods have a
relatively fixed and thus low amount of WIP inventory by
their very nature. In assemble-to-order, WIP inventory might
be shipped to distribution centers for final assembly, but
accounting would want to decide whether to call this WIP or
distribution inventory to avoid double-counting it.

Functions of Inventory
In addition to analyzing inventory by where it is in the
system, organizations justify maintaining inventory (or
advocate for its reduction) based on the reason the
inventory is being held in the first place. These functions
include the following:
Safety stock
Decoupling
Buffers
Anticipation inventory
Lot-size inventory
Transportation inventory
Hedge inventory

Each of these functions (except decoupling, which is

covered elsewhere) is discussed next.

Safety Stock
The APICS Dictionary, 16th edition, defines safety stock and
related terms as follows:

Safety stock: 1) In general, a quantity of stock

planned to be in inventory to protect against
fluctuations in demand or supply. 2) In the context
of master production scheduling, the additional
inventory and capacity planned as protection
against forecast errors and short-term changes in
the backlog. Overplanning can be used to create
safety stock.
 Fluctuation inventory: Inventory that is carried
as a cushion to protect against forecast error.

Inventory buffer: Inventory used to protect the

throughput of an operation or the schedule against
the negative effects caused by delays in delivery,
quality problems, delivery of an incorrect quantity,
and so on.

Safety stock typically refers to raw materials (usually

nonperishable), work-in-process (WIP), or finished goods
inventory set as the minimum inventory level for a
particular stockkeeping location. This is inventory held just
in case demand is higher than expected, there is supply
disruption or breakdown, a quality problem is discovered,
and so on, much like an insurance policy is used to protect
against rare but costly risks.

Safety stock levels are set by determining a targeted level

of customer service and then calculating the amount of
safety stock needed to provide that level. Safety stock
should not be needed often, but if it is needed only rarely,
this is usually a sign that the inventory level is too high at
that location. The second part of the definition shows that
production might produce more than needed to generate
safety stocks.
Note that safety stock is sometimes called an inventory
buffer because it is a buffer against uncertainty. However,
the term buffer is more commonly identified with the theory
of constraints, where it serves a very specific purpose that is
not related to safety stock.

Buffer
In the context of the theory of constraints, buffer refers to
raw materials, WIP, or a work backlog maintained at a
predetermined level just before a bottleneck work center
and at a few other key points. A primary purpose is to
ensure that the bottleneck work center is continuously busy.

Anticipation Inventory
The Dictionary defines anticipation inventories as

additional inventory above basic pipeline stock to

cover projected trends of increasing sales, planned
sales promotion programs, seasonal fluctuations,
plant shutdowns, and vacations.

Anticipation inventory is accumulated in anticipation of

future demand. A common purpose is to prepare for a peak
selling season, such as a major holiday, using level
production. The Dictionary defines seasonal inventory as
 inventory built up to smooth production in
anticipation of a peak seasonal demand.

Other purposes may be in anticipation of a new corporate

customer, a new product launch, a temporary plant
shutdown, a business move, or a sales promotion. The cost
of anticipation inventory is calculated by summing the
average inventory level per time bucket and then
multiplying this by the inventory carrying cost.

Lot-Size Inventory
When items are purchased in large lots to gain quantity and
transportation discounts and reduce ordering costs, the
inventory build-up is denoted as cycle stock, cycle
inventory, or lot-size inventory to indicate the purpose of
the build-up. The Dictionary defines two of these terms as
follows:

Lot-size inventory: Inventory that results

whenever quantity price discounts, shipping costs,
setup costs, or similar considerations make it more
economical to purchase or produce in larger lots
than are needed for immediate purposes.

Cycle stock: One of the two main conceptual

components of any item inventory, the cycle stock
is the most active component. The cycle stock
 depletes gradually as customer orders are received
and is replenished cyclically when supplier orders
are received. The other conceptual component of
the item inventory is the safety stock, which is a
cushion of protection against uncertainty in the
demand or in the replenishment lead time.

Lot-size inventory or cycle stock depletes gradually as

orders consume the units and then jumps up higher in
sawtooth fashion as new shipments are received, repeating
cyclically.

Transportation Inventory
Transportation inventory is inventory in the transportation
network. The Dictionary defines it and related terms as
follows:

Transportation inventory: Inventory that is in

transit between locations.

Transit inventory: Inventory in transit between

manufacturing and stocking locations.

Pipeline stock: Inventory in the transportation

network and the distribution system, including the
flow through intermediate stocking points. The flow
time through the pipeline has a major effect on the
amount of inventory required in the pipeline. Time
 factors involve order transmission, order
processing, scheduling, shipping, transportation,
receiving, stocking, review time, and so forth.

In-transit inventory: Material moving between

two or more locations, usually separated
geographically; for example, finished goods being
shipped from a plant to a distribution center.

The average amount of inventory that is in transit at any

given time is a function of the average transit time in days.
Reducing average transit time in days is the only way to
reduce transportation inventory levels. This can be done by
using faster modes of transport or by selecting suppliers
that are closer to the organization. This reduces both cost
and lead times. (If faster transport is used, however, its
increased cost may offset any cost savings.)

Note that transportation inventory also includes inventory in

motion within the plant, such as from one work center to
another. This time is measured as the move time
component of manufacturing lead time.

Hedge Inventory
Hedging is a way of locking in prices for something now to
reduce uncertainty in case the price is too high later. This
can be done with financial products such as futures, or it
can be done by buying inventory sooner than it is needed
when prices are low. When the latter is done, it is called
hedge inventory.

The Dictionary defines hedge inventory as follows:

A form of inventory buildup to buffer against some

event that may not happen. Hedge inventory
planning involves speculation related to potential
labor strikes, price increases, unsettled
governments, and events that could severely impair
a company’s strategic initiatives. Risk and
consequences are unusually high, and top
management approval is often required.

Another use of the term hedge inventory is for inventory

that is made or planned at a higher level than needed in the
event that the mix or demand changes.

Topic 4: Basic Accounting

This topic introduces three financial statements—the
balance sheet, the income statement, and the statement of
cash flows—since it is important for production and
inventory control professionals to understand how to
interpret these statements and understand the motivations
of finance professionals. Aggregate inventory management
is concerned with how inventory levels impact the balance
sheet and the income statement as well as the timing of the
flow of cash into and out of the organization. The topic also
includes some performance measures important to
inventory management.

Balance Sheet
The APICS Dictionary, 16th edition, defines a balance
sheet as

a financial statement showing the resources owned,

the debts owed, and the owner’s share of a
company at a given point in time.

One part of the balance sheet shows what the organization

owns; the other part shows how it came to own these
things.

What the organization owns are called assets. Current

assets are those assets that are cash or can be converted
into cash quickly and include accounts receivable, while
fixed assets are assets that would take longer to sell, such
as property, plant, and equipment.
There are three ways an organization might come to own
these assets. They may have raised cash or paid for the
asset by issuing a liability, for example, taking on debt or
buying goods on credit. The Dictionary defines liabilities as
follows:

An accounting/financial term (balance sheet

classification of accounts) representing debts or
obligations owed by a company to creditors.
Liabilities may have a short-term time horizon, such
as accounts payable, or a longer-term obligation,
such as mortgage payable or bonds payable.

Alternately, the organization’s owners (or shareholders) may

have invested cash into the organization to pay for these
assets. Since organizations try to make money doing
business, the third way to pay for assets is to use profits
that were reinvested in the business, which are called
retained earnings. The sum of owner investment plus
retained earnings is owners’ equity. An organization can also
lose money doing business, and all losses come out of
owners’ equity since debts and other liabilities must be paid
regardless of profit or loss. The Dictionary defines owners’
equity (also called shareholders’ equity or simply equity) as
 an accounting/financial term (balance sheet
classification of accounts) representing the residual
claim by the company’s owners or shareholders, or
both, to the company’s assets less its liabilities.

These two parts of the balance sheet—assets on the one

side and liabilities plus owners’ equity on the other side—
are always in balance, simply because owners’ equity is the
difference between assets and liabilities, or what is left from
assets after liabilities are deducted. (Owners’ equity can be
negative.) This relationship is called the balance sheet
equation:

Given any two of these amounts (assets, liabilities, owners’

equity), one can find the third value. If assets are $5,000
and liabilities are $3,000, then owners’ equity must be
$2,000. This is found by rearranging the equation as follows:

If the initial owner investment was $1,000, then the

organization currently is worth $1,000 more than it cost to
establish. If the organization pays $1,000 in dividends
(payments to owners), both assets and liabilities would
decrease equally. Paying $1,000 in cash (assets) reduces
assets to $4,000 and owners’ equity by $1,000, so both
sides are now at $4,000.

Exhibit 5-2 shows a set of balance sheets for two years for
an organization, with some descriptions of relevant parts of
this statement. Note how the total assets are equal to the
total liabilities and owners’ equity for each year.

Exhibit 5-2: Balance Sheet for Two Years

The assets on the balance sheet are items of value to the
organization. Assets are listed in the order of their liquidity,
or how easily and quickly they can be converted to cash. At
the top are cash and cash equivalents (financial
investments that can be easily sold), followed by inventory
(which would include raw materials, work in process, and
finished goods), accounts receivable (sales on credit), and
fixed assets (which are difficult to liquidate), including
property, plant, and equipment. Since fixed assets decrease
in value over time due to wear and tear, their value is
reduced each year based on their expected life. This
deduction is called depreciation. Assets can also include
patents and the like.

Note that inventory is frequently a large percentage of the

total assets of a manufacturing organization. While having
assets might be thought a good thing, finance professionals
want only as many assets as are absolutely necessary,
because having assets requires having more liabilities or
owner investment, and these things cost money (e.g., debts
pay interest, owners may expect dividends).

The liabilities on the balance sheet are the financial

obligations of the business, and they are listed with current
liabilities (amounts to be repaid within a year) first, followed
by long-term liabilities (amounts to be repaid more than a
year from now). Current liabilities include accounts payable
(purchases on credit), wages payable (wages earned but not
yet paid), and short-term notes payable (debts). Long-term
liabilities include long-term debts (e.g., like a mortgage).

Owners’ equity for a publicly traded organization will include

common stock and additional paid-in capital, and these
together are what is received from selling shares of stock.
Private organizations will list owner investment.

While the balance sheet is like a snapshot (usually at the

end of the year) of accounts that are constantly changing,
the income statement is the summary of the results of an
entire year (or other period).

Income Statement
The APICS Dictionary, 16th edition, defines the income
statement as “a financial statement showing the net
income for a business over a given period of time.”

Also called the statement of profit and loss, the income

statement shows sources of revenue (sales in cash or as
accounts receivable, which are sales on credit), followed by
various types of expenses incurred throughout the period.
The relationship is basically one of subtraction, starting with
revenue and deducting various expenses. The amount left
after all expenses have been deducted is the net income
(profit or loss). This equation follows, along with an example
of one type of income called gross profit, which is discussed
more below. (Note that while the following exhibit is listed in
millions, this example lists the actual amounts.)

Exhibit 5-3 shows two years of income statements for an

organization.
 Exhibit 5-3: Income Statements for Two Years

Note how the expense deductions occur in stages; this

shows which costs are the most significant. The first
deduction is revenue minus the cost of goods sold (COGS).
This results in gross margin, which is also called gross profit.
The Dictionary defines COGS and some related terms as
follows:

Cost of goods sold (COGS): An accounting

classification useful for determining the amount of
direct materials, direct labor, and allocated
overhead associated with the products sold during
a given period of time.

Direct labor: Labor that is specifically applied to

the good being manufactured or used in the
performance of the service.

Direct material: Material that becomes a part of

the final product in measurable quantities.

Overhead: The costs incurred in the operation of a

business that cannot be directly related to the
individual goods or services produced. These costs,
such as light, heat, supervision, and maintenance,
are grouped in several pools (e.g., department
overhead, factory overhead, general overhead) and
distributed to units of goods or services by some
standard allocation method such as direct labor
hours, direct labor dollars, or direct materials
dollars.

Fixed overhead: Traditionally, all manufacturing

costs—other than direct labor and direct materials
—that continue even if products are not produced.
Although fixed overhead is necessary to produce
the product, it cannot be directly traced to the final
product.

Gross margin: The difference between total

revenue and the cost of goods sold.
Direct materials and direct labor are costs that can be
directly attributed to producing specific units that were
actually sold during the year (or other period). Overhead
costs are allocated to units sold in some way, such as by a
percentage of the cost per unit.

Gross profit minus operating expenses, depreciation, and

interest expenses on debt results in net income (profit)
before taxes. Operating expenses include
Selling expenses such as salespersons’ commissions or
advertising
General and administrative expenses such as executive
and clerical wages and benefits (The Dictionary defines
general and administrative expenses [G&A] as “the
category of expenses on an income statement that
includes the costs of general managers, computer
systems, research and development, etc.”)
Insurance
Lease expenses such as for office space or vehicles.

The amount of depreciation on fixed assets for the year (or

other period) is also deducted. This reduces tax liability,
even though it is not a cash expense because no money is
paid out.
Net income before taxes minus taxes is then net income
(profit), also called the net profit margin. The Dictionary
defines profit margin from a perspective of gross profit
margin as

1) The difference between the sales and cost of

goods sold for an organization, sometimes
expressed as a percentage of sales. 2) In traditional
accounting, the product profit margin is the product
selling price minus the direct material, direct labor,
and allocated overhead for the product, sometimes
expressed as a percentage of selling price.

The net profit margin is the proverbial “bottom line,” and it

could be positive (profit) or negative (loss). Profits might be
used to pay off debts or to pay dividends to owners, or they
could be put into cash or cash equivalents. Thus, profits
may improve the balance sheet while losses will make it
worse.

From an inventory management perspective, the raw

materials and work-in-process inventory that became
finished goods and that were sold during the period are
included in COGS and thus become an expense that offsets
revenue and reduces profit. The Dictionary definition of
product cost illustrates how inventory starts as a balance
sheet asset and becomes an expense on the income
statement when it is sold:

Cost allocated by some method to the products

being produced. Initially recorded in asset
(inventory) accounts, product costs become an
expense (cost of sales) when the product is sold.

One way to increase profit is to reduce these manufacturing

and purchasing costs. This may include reducing variable
costs such as materials or labor or reducing fixed costs that
are summed up as overhead. Examples of cost savings in
inventory management include investing in more-efficient
equipment that uses less energy, reducing materials
handling through process improvements, or using better
packaging to reduce product damage and insurance costs.

However, note that only the inventory that is sold impacts

the income statement. Inventory that has been produced
but not sold, although considered an asset, is neither
revenue nor an expense. (The expenses are tracked in the
enterprise resources planning system but are not entered on
the income statement until the period in which the sale is
made.) If you increase inventory over the year without
increasing sales by the same amount, you will be making
more assets but not more revenue or profit. Inventory on
the books is not as good as inventory that is converted into
products and then sold. This is partly because cash is tied
up in inventory and cannot be used to pay bills or wages.
The faster inventory is converted, the better.

Statement of Cash Flows

The APICS Dictionary, 16th edition, defines cash flow as
follows:

The net flow of dollars into or out of the proposed

project. The algebraic sum, in any time period, of all
cash receipts, expenses, and investments. Also
called cash proceeds or cash generated.

Cash pays wages, interest and principal on debt, and

accounts payable. If an organization has no cash on hand
and cannot raise enough cash quickly, it will default on its
debts or fail to pay workers, and many organizations have
gone out of business in this way. Financial professionals
perform a cash flow analysis on a regular basis to determine
whether cash flow issues will need to be addressed in the
near future.
Cash flows for the year or another period are summarized
on a statement of cash flows, as is shown in Exhibit 5-4.
How accountants produce this statement is beyond the
scope of this part of the course, but some key points of how
to interpret its line items are noted in the exhibit. A key line
of interest is the “Increase/Decrease in Inventory” line,
which shows whether more or less cash is tied up in
inventory relative to the prior period.

Exhibit 5-4: Statement of Cash Flows

From a manufacturing standpoint, cash is invested in
purchases of raw materials and value is added through
manufacturing as the units become work-in-process
inventory and then finished goods. The value equals the
direct labor and direct materials per unit plus the amount of
factory overhead a given unit is allocated (called absorbing
overhead). While unsold inventory is not recorded as
revenue and a related expense until sold, it does convert
cash, a very liquid asset, into a different and less liquid type
of asset, inventory. This is an opportunity cost. The cash was
paid out when the raw materials were paid for and the
wages and other bills were paid, but it will not be available
for some other purpose until the inventory is sold and paid
for. The faster this investment is returned, the faster the
cash can be invested in new inventory or other
opportunities.

Financial Inventory Performance

Measures
One simple way to measure the performance of inventory is
to measure the unit cost, which the APICS Dictionary, 16th
edition, defines as
 total labor, material, and overhead cost for one unit
of production (e.g., one part, one gallon, one
pound).

These costs are said to be value added from an accounting

perspective, but they may or may not be value added from
a customer utility perspective. The Dictionary defines value
added as follows:

1) In accounting, the addition of direct labor, direct

material, and allocated overhead assigned at an
operation. It is the cost roll-up as a part goes
through a manufacturing process to finished
inventory. 2) In current manufacturing terms, the
actual increase of utility from the viewpoint of the
customer as a part is transformed from raw
material to finished inventory; the contribution
made by an operation or a plant to the final
usefulness and value of a product, as seen by the
customer. The objective is to eliminate all non-
value-added activities in producing and providing a
good or service.

Other financial inventory performance measures help show

how quickly cash is converted into inventory and then back
into cash (or an account receivable and then cash). These
are measures of velocity, which the Dictionary defines as
 1) The rate of change of an item with respect to
time. 2) In supply chain management, a term used
to indicate the relative speed of all transactions,
collectively, within a supply chain community. A
maximum velocity is most desirable because it
indicates higher asset turnover for stockholders and
faster order-to-delivery response for customers.

Velocity measures include inventory turnover and days of

supply.

Inventory Turnover
The Dictionary defines inventory turnover (also called
inventory turns) as follows:

The number of times that an inventory cycles, or

“turns over,” during the year. A frequently used
method to compute inventory turnover is to divide
the annual cost of sales by the average inventory
level. For example, an annual cost of sales of $21
million divided by an average inventory of $3
million means that inventory turned over seven
times.

Inventory turnover can be calculated using average

inventory, which the Dictionary defines as follows:
 One-half the average lot size plus the safety stock,
when demand and lot sizes are expected to be
relatively uniform over time. The average can be
calculated as an average of several inventory
observations taken over several historical time
periods; for example, 12-month ending inventories
may be averaged. When demand and lot sizes are
not uniform, the stock level versus time can be
graphed to determine the average.

Average inventory can be calculated from the balance sheet

if two or more years are shown, since the inventory at the
beginning of the year is the same as that at the end of the
prior year. Here is one way to calculate average inventory.
(Note: Numbers have been inserted as examples.)

The other input for inventory turnover is the annual cost of

goods sold (COGS), which is listed on the income statement.
Note that the definition of inventory turnover calls this cost
of sales, but this is a synonym for COGS. The calculation for
inventory turnover follows (again including numbers as
examples):
This organization invests cash into inventory and gets it
back 2.77 times per year. In general, higher inventory
turnover levels are desired, but the normal range will differ
by industry.

Days of Supply
The Dictionary defines days of supply as follows:

1) Inventory-on-hand metric converted from units to

how long the units will last. For example, if there
are 2,000 units on hand and the company is using
200 per day, then there are 10 days of supply. 2) A
financial measure of the value of all inventory in the
supply chain divided by the average daily cost of
goods sold rate.

Days of supply is useful for understanding how long

inventory will last given the current rate of demand. This
may go down to zero inventory or to a safety stock level. (If
so, safety stock would be excluded from the calculation.)
The equation is as follows. (The example is from the above
definition.)
Inventory policy might be set using days of supply, for
example, to have each type of unit have 10 days of supply.
For slow-selling inventory, this might be very few units; for
fast-selling items, it might be many. Days of supply can also
be used to determine when to reorder. For example, if 10
days is the lead time required to get more inventory, then
10 days of supply should be ordered.

In general, organizations want to keep days of supply low, or

at least low enough to maintain a targeted customer service
level.

Topic 5: Inventory Valuation

On the financial statements, the value of inventory needs to
be estimated in some way, since the market value cannot
be known for certain until a sale is made. When inventory is
produced or purchased, these costs can be recorded, but,
because of inflation, these costs tend to rise over time.
Prices might also fall. If prices are changing quickly or
inventory is held for many years, the accounting method
chosen can result in a high or low inventory value in
comparison to the actual market value. The main
requirement is to pick a method and stick with it, since any
change requires justification and will make it harder to
interpret the financial statements. This topic covers the
methods that may be chosen.

Inventory Valuation Methods

In the United States, accountants follow generally
accepted accounting principles (GAAP), which the
APICS Dictionary, 16th edition, defines as

accounting practices that conform to conventions,

rules, and procedures that are generally accepted
by the accounting profession.

GAAP allows three methods of accounting for the value of

inventory: first-in, first-out (FIFO), last-in, first-out (LIFO),
and average cost. In most of the rest of the world, only FIFO
and average cost are allowed (under the International
Financial Reporting Standards, IFRS). If your organization is
a public firm that publishes financial statements, it will be
using one of these methods even if you don’t know it, since
the methods are basically used only for updating the
enterprise resources planning (ERP) system’s records and
preparing financial statements.

Neither FIFO, LIFO, or average cost has anything to do with

how inventory is actually picked in the warehouse, unless it
is a coincidence. That is, picking is dictated by its own
requirements such as perishable inventory being picked
from the oldest items first, which is sometimes called first-
in, first-out, but the same warehouse might use a different
method for nonperishable inventory. Conversely, a company
that sells bricks might always have to pick inventory from
the top (newest placed there) due to the difficulty of getting
at older items, and this is sometimes called last-in, first-out.
For such a company, this would not be much of a hardship
because the product does not lose much value with age.
Again, the same company might use a different method of
picking for some other type of inventory. Average cost,
however, cannot be used to describe the picking of discrete
inventory at all; it is impossible to pick an average item,
only a specific one. However, average cost as an accounting
method might be the only possible method to account for
items stored in bulk such as chemicals, petroleum products,
or agricultural items like grain.
In contrast to the use of these terms to describe inventory
movement, accountants will need to select one of the
allowed methods and stick with it for all inventory valuation.
Why one is selected over another may involve choosing
between tradeoffs that could include tax minimization or
presenting the best picture of the organization’s finances to
investors. Regulators desire firms to pick the method that
best describes their actual activities, so a brick company
(based in the U.S.) might choose LIFO, a company with
mostly perishable inventory or products that go obsolete
fast might choose FIFO, and a chemical company that has
intermingled chemicals stored in bulk may use average
cost. Companies that have volatile material prices may also
use average cost to average out the cost per unit.

For internal management decision making, standard cost

accounting might also be used, and this or a similar system
will be more familiar to persons outside of the accounting
department.

We’ll look at these inventory valuation methods next.

FIFO
With the FIFO method, the first unit put into inventory is the
first unit removed from the ERP system’s inventory records
when a sale occurs. The oldest items are sold first. When
prices are rising, the recorded cost of goods sold (COGS) will
be less than the actual current cost of goods sold, thus
understating these costs. When prices are falling, the
opposite is true. The value of unsold inventory will be fairly
current.

LIFO
With LIFO, the last unit put into inventory is the first
removed from the ERP inventory records when there is a
sale, and the newest items are sold first. When prices are
rising or falling, the recorded COGS will be the actual
current cost of goods sold, since the cost of the materials
reflects the most recent purchases. The problem with this
method comes with the valuation of unsold inventory, since
it reflects the costs of the oldest unsold inventory. When
prices are falling, existing inventory will be overvalued;
when prices are rising, it will be undervalued. Given price
increases from inflation over longer periods of time, this
value can become grossly understated.

Average Cost (Weighted Average Cost)

The average cost, also called the weighted average cost, is
the average of all costs paid for or internally invested in
inventory for COGS and balance sheet inventory valuation.
It is basically an average of the oldest and newest costs, so
the valuation falls somewhere between FIFO and LIFO.
Because it is an average, it does not reflect actual prices
paid whether prices are rising or falling.

Standard Cost Accounting

Standard cost accounting, also called job costing, is used for
internal inventory valuation purposes. The Dictionary
defines some relevant terms as follows:

Standard costs: The target costs of an operation,

process, or product including direct material, direct
labor, and overhead charges.

Job costing: A cost accounting system in which

costs are assigned to specific jobs. This system can
be used with either actual or standard costs in the
manufacturing of distinguishable units or lots of
products.

Variance: 1) The difference between the expected

(budgeted or planned) value and the actual. 2) In
statistics, a measurement of dispersion of data.

The standard hours, standard materials, and so on are used

to estimate direct materials, direct labor, and factory
overhead costs. At the end of the period, once all actual
costs are known, these estimates are adjusted by stating
the difference as a variance.

Note that an organization might use standard cost

accounting for its internal decision making while
simultaneously using FIFO, LIFO, or average cost for
preparing financial statements. (The latter methods will be
less visible to persons outside of the accounting
department.)
Section B: Safety Stock/Item
Segmentation
After completing this section, students will be able to
Describe how to determine the level of safety stock an
organization should hold
Define service levels and relate a chosen level of service
to the amount of safety stock an organization should hold
Describe how an organization should use inventory
policies
List the various types of inventory costs
Define ABC item segmentation
Describe Pareto’s law
Apply ABC classification to inventory, known as ABC
inventory control.

Topic 1 of this section starts by defining safety stock and

relating it to decisions on targeted service levels. The
calculations that dictate how much safety stock a company
will hold are also covered. Topic 2 discusses different classes
of inventory costs, including item, carrying, ordering,
stockout, and other capacity-related costs. Topic 3 discusses
the primary method used to classify inventory for control
and auditing purposes, ABC classification.

Topic 1: Safety Stock and

Service Levels
Safety stock is designed to protect against fluctuations in
supply and demand. The amount of safety stock an
organization chooses to hold will be driven by the level of
service they choose to provide.

Safety Stock
Safety stock is partially defined in the APICS Dictionary,
16th edition, as follows:

In general, a quantity of stock planned to be in

inventory to protect against fluctuations in demand
or supply.

After the decision is made to hold safety stock at a

particular stockkeeping location, how much to hold must be
determined. Decisions on these quantities are related to the
following factors:
Demand variability during the lead time. When
demand variability is high, forecast error rates will be
high, and higher amounts of safety stock will be needed to
provide a targeted customer service level.

Targeted customer service level. The customer service

ratio (fill rate) can be specified as part of the
organization’s strategy, and safety stocks will be
calculated to meet this level. One way the customer
service ratio might be expressed is as the acceptable
number of stockouts per period, which is related to order
frequency.

Order frequency. When orders are less frequent, they

must also be in higher quantities to meet a given demand
level. The only time a stockout can occur is when
inventory is about to be reordered, because this is when
the inventory will be running low. Thus, less-frequent
orders result in fewer chances of stockouts (but higher
carrying costs).

Duration of the lead time. When resupply takes longer,

there is more chance for demand variability to become an
issue and, thus, more safety stock is needed. Reducing
lead times reduces safety stock requirements. If the lead
 time were zero, there would be no need for safety stock,
since resupply would be instantaneous. The
manufacturing environment will also affect lead-time
duration. For example, a make-to-order organization may
or may not need safety stocks of raw materials depending
on customer lead-time expectations versus the lead time
required to order these materials, produce, and ship.
(They won’t have finished goods safety stocks because
these are made-to-order.)

Order frequency and lead-time changes also impact when

stockouts can occur, so this may impact how service levels
are set for specific products.

Establishing Service Levels

The APICS Dictionary, 16th edition, defines level of service
as follows:

A measure (usually expressed as a percentage) of

satisfying demand through inventory or by the
current production schedule in time to satisfy the
customers’ requested delivery dates and quantities.
In a make-to-stock environment, level of service is
sometimes calculated as the percentage of orders
picked complete from stock upon receipt of the
customer order, the percentage of line items picked
 complete, or the percentage of total dollar demand
picked complete. In make-to-order and design-to-
order environments, level of service is the
percentage of times the customer-requested or
acknowledged date was met by shipping complete
product quantities.

Customer service is often expressed using the customer

service ratio (also called the fill rate), which is basically the
percentage of time units were shipped on schedule. Note
that there are many variants of this ratio, such as those
listed in the definition. No one method is best for all
purposes. Depending on the manufacturing environment,
customer service might mean the percentage of stockouts
or backorders. Thus, whether or not inventories are held,
customer service is important. One metric that can be used
even with organizations that engineer- or make-to-order is
on-time schedule performance, defined by the
Dictionary as follows:

A measure (percentage) of meeting the customer’s

originally negotiated delivery request date.
Performance can be expressed as a percentage
based on the number of orders, line items, or dollar
value shipped on time.
Safety stock levels can be calculated to result in a particular
customer service level, such as a 95 percent chance that
units will be in stock when needed. If this is the service
level, then the stockout percentage would be its
complement, or 1 – 0.95 = 0.05 or 5 percent. The Dictionary
defines stockout percentage in part as follows:

A measure of the effectiveness with which a

company responds to actual demand or
requirements. The stockout percentage can be a
comparison of total orders containing a stockout to
total orders, or of line items incurring stockouts to
total line items ordered during a period.

The idea is that safety stock protects against uncertainty in

supply or demand and uncertainty caused by forecasting
error.

Sales and marketing functions will have an incentive to

maximize the customer service level and thus increase
inventory levels to ensure that no sales or due dates are
missed. Distributors, wholesalers, and retailers will also
have an incentive to ensure that stockouts are rare. In
addition to missing sales, customers may become
dissatisfied and shop elsewhere or have less customer
loyalty, so the impact of missed sales may translate to lower
market share.

However, the amount of safety stock needed to increase

customer service grows more quickly as you approach 100
percent customer satisfaction, as shown in Exhibit 5-5. (An
exception would be perfectly stable demand, which could
achieve perfect satisfaction with no safety stock.)

Exhibit 5-5: Safety Stock Requirements at High Service

Levels

Providing 100 percent customer service is prohibitively

expensive. Therefore, the customer service objective is
better stated as achieving a targeted level of customer
service than as maximizing customer service. It should be
noted that improvements in customer service can be made
in other ways than safety stock, including shortening lead
times and increasing manufacturing flexibility.

Calculating Safety Stock for Service

Level
One way to calculate safety stock levels is standard
deviation (SD). While SD is not calculated here, note that it
is a method of calculating the deviation from the average
(mean) result and so is useful in setting safety stocks
because it is a measurement of stable versus dynamic
demand. Furthermore, some practitioners substitute
forecast error in the standard deviation calculations in place
of the mean; this method is called root mean squared error
(RMSE). Here we show how to calculate safety stocks using
mean absolute deviation, or MAD, (because it is relatively
easy to calculate and understand), but note that SD (and its
variant, RMSE) are more precise calculations and are more
commonly used in practice.

Forecast error can be caused by bias or by random

variation. When bias is detected, the goal is to eliminate its
root cause. A good forecast should lack bias but will still
have some random variation. Assuming that the forecast
has minimized bias to the degree possible, the amount of
error from random variation will dictate how much safety
stock to hold, because this error level expresses the
demand variability during the lead time. If there is zero
random variation, there would be no need for safety stock; it
would mean that the forecast was always right and there
would never be a stockout.

Safety stock can be related to error rates. As error rates

increase or decrease, the safety stock levels can be
recalculated or may even be set to automatically increase or
decrease if forecast error rates are directly linked to the
inventory control system.

Elsewhere we calculated MAD for one forecasting technique.

Exhibit 5-6 shows the results of that error analysis on a bell
curve: One MAD was calculated to be 28 units of a
commercial door family, two was 56 units, and three was 84
units. (The example does show some bias, but let’s assume
that the variation was entirely random.)
Exhibit 5-6: Mean Absolute Deviation from Previous Forecast

Note the phrase “50% Chance of Overstock” at the top of

the exhibit. Half of the time, even with no safety stock,
there will not be a stockout. There will instead be some
amount of overstock. The further one goes to the left, the
higher the overstock would be, but the likelihood of this also
becomes less and less. If you carry one MAD worth of safety
stock, you will add the 50 percent chance of overstock plus
the 30 percent for holding those extra 28 units, to have
about an 80 percent chance of no stockout. Similarly, if you
hold 56 units of safety stock, you will raise this to about a
95 percent chance, and, with 84 units of safety stock, you
would have sufficient stock about 99 percent of the time.

Given an error rate in either standard deviations or MADs,

one can then set a specific customer service level for safety
stocks instead of relying on these whole numbers of 1, 2, or
3 MADs or standard deviations.

The calculations required to get to a particular customer

service level have been precalculated in what is called a
safety factor table, which is shown in Exhibit 5-7. One
simply selects the desired customer service level from the
left column and then multiplies either the standard
deviation in units or the MAD in units by the factor in the
appropriate column. For example, the calculation for a
customer service level of 90 percent is

Exhibit 5-7: Safety Factor

Table
Percentile SD MAD
Customer (Units x (Units x
Service Factor Factor
Level Below) Below)

50.00 0.00 0.00

75.00 0.67 0.84
80.00 0.84 1.05
84.13 1.00 1.25
85.00 1.04 1.30
89.44 1.25 1.56
90.00 1.28 1.60
93.32 1.50 1.88
94.00 1.56 1.95
94.52 1.60 2.00
95.00 1.65 2.06
96.00 1.75 2.19
97.00 1.88 2.35
97.72 2.00 2.50
98.00 2.05 2.56
98.61 2.20 2.75
99.00 2.33 2.91
99.18 2.40 3.00
99.38 2.50 3.13
99.50 2.57 3.20
99.60 2.65 3.31
99.70 2.75 3.44
99.80 2.88 3.60
99.86 3.00 3.75
99.90 3.09 3.85
99.93 3.20 4.00
99.99 4.00 5.00
 Source: www.supplychainchannel.org

Note a couple of things about this table. First, no safety

stock is needed to achieve the 50 percent customer service
level due to the overstock probability. Second, the chance of
a stockout at exactly 3 MADs is actually 99.18 percent
rather than the approximation shown in the bell curve in
Exhibit 5-6. The factor is just a fractional number of
standard deviations or MADs. A 99.99 percent service level
would require 5 MADs or 140 units of safety stock. This
would have a significant carrying cost.

An aggregate service level can be one overall level, but

individual products or SKUs (stockkeeping units) might have
different service levels based on the relative importance of
the inventory and the need for control at that location.
Overall, these service levels should conform to the
aggregate customer service goal, but some might be higher
and others lower.

Setting Safety Stock Based on

Number of Stockouts
A stockout could be an inconvenience to customers in some
situations and a major disaster in others. Once the
organization decides how problematic a stockout would be
for a particular SKU (stockkeeping unit), it can specify the
customer service level as a particular number of allowed
stockouts per period.

Exhibit 5-8 illustrates how order frequency impacts the

number of chances of a stockout.

Exhibit 5-8: Stockout Opportunities Are Based on Order

Frequency

In the top scenario, there are two orders during the period
for 500 units each. (Q stands for order quantity.) Inventory
will approach zero—and there will be a chance of a stockout
—twice, just before the resupply order arrives. In the bottom
scenario, there are four orders during the period for 250
units each, which reduces average inventory from 250 units
to 125 but results in four chances of a stockout instead of
two. The quantity of orders and the frequency of ordering
are interrelated (increasing one will decrease the other,
assuming that demand remains the same), and the proper
balance will be determined based on minimizing the
carrying cost plus the ordering cost. The duration of the lead
time will also impact safety stock requirements.

Given information on the annual demand and the order

quantity per order, the number of orders that need to be
made per period can be calculated, as follows. (Assume an
annual demand of 8,000 units and an order quantity of 400
units.)

If management decides that this item can risk two stockouts

per year, this can be translated into a customer service
level using the following formula:
In this case, the customer service level is 90 percent. Next,
the safety factor must be determined. (See the excerpt from
the safety factor table in Exhibit 5-9.)

Exhibit 5-9: Excerpt from

Safety Factor Table

Percentile SD MAD
Customer (Units x (Units x
Service Factor Factor
Level Below) Below)

85.00 1.04 1.30

89.44 1.25 1.56
90.00 1.28 1.60
93.32 1.50 1.88
94.00 1.56 1.95

Source: www.supplychainchannel.org

If one MAD for this product is 28 units, then the safety factor
is 1.60, resulting in the following:
Another way to get to the same customer service level
would be to order less frequently in larger quantities but
hold less safety stock. The costs of these alternatives might
be compared and the least costly method chosen.

Adjusting Safety Stock Based on Lead

Time Change
When lead times increase or decrease for a product or
product family, the standard deviation or mean absolute
deviation error rate can be recalculated, since these error
rates increase for longer lead times. (This is because there
is more room for variability in this longer period of time.)
The duration of the lead time in this case refers to the time
starting from when an order is placed to when it arrives.
That is, slower shipping methods or other delays between
order entry and order receipt will create a larger chance of a
stockout than a shorter duration of time, so more safety
stock will be needed.

However, given the large number of products with different

lead times that many organizations carry, often a method of
approximation is all that is needed. Using the example of 45
units of safety stock to provide a 90 percent customer
service level, assume that the product has a six-week lead
time. We can approximate what the safety stock level would
need to be if the lead time changed to five or seven weeks
using the following formula:

Thus, reducing the lead time reduces the safety stock

requirement, while increasing the lead time increases the
safety stock requirement.

Inventory Policies
Organizations use policies to ensure that inventory
objectives are implemented in accordance with strategy.
Inventory policies break down inventory guidelines set at
aggregate levels into decisions for individual products—and
for individual stockkeeping units. The APICS Dictionary, 16th
edition, defines stockkeeping unit (SKU) as follows:
 1) An inventory item. For example, a shirt in six
colors and five sizes represents 30 different SKUs.
2) In a distribution system, an item at a particular
geographic location. For example, one product
stocked at the plant and at six different distribution
centers would represent seven SKUs.

This means that inventory policies are set not only by

unique part number but also by unique stockkeeping
location. For example, two identical water pumps stored in
different distribution center locations would have different
SKUs, and each might have different levels of safety stock
and different ordering policies. Note that this discussion
does not refer to part numbers used to identify parts used in
a plant. Part numbers used in manufacturing and listed on a
bill of materials will not change until the part receives
further processing and becomes a different part number.
Moving a part to a new storage location does not change
the part number. However, the inventory record would track
the new location of the part.

Inventory policies used to maintain customer service at a

targeted level include setting levels for safety lead time or
safety stock per stockkeeping location. A policy could set
minimum and maximum inventory levels per location.
Another example of an inventory policy is how to store and
handle raw materials at a plant. The policy may be to hold
certain items in the plant warehouse to ensure that the
plant never needs to cease operations, or the plant may
work to minimize inventory costs by ordering only what is
needed. Another option is to design the plant to avoid
needing a warehouse by specifying a wall-to-wall inventory
policy. The Dictionary defines wall-to-wall inventory as

An inventory management technique in which

material enters a plant and is processed through
the plant into finished goods without ever having
entered a formal stock area.

Inventory Policies to Protect Against

Uncertainty
The root cause of stockouts is uncertainty in supply or
demand. This can be in the form of lead time uncertainty or
quantity uncertainty. For supply, a delivery could be late or
in the wrong quantity, or other supply interruptions could
occur. For demand, a customer could order earlier than
usual or want a different quantity than expected. In addition
to safety stock, another conventional method to protect
against uncertainties in supply or demand is safety lead
time.
Safety Lead Time
The APICS Dictionary, 16th edition, defines safety lead
time as follows:

An element of time added to normal lead time to

protect against fluctuations in lead time so that an
order can be completed before its real need date.
When used, the MRP system, in offsetting for lead
time, will plan both order release and order
completion for earlier dates than it would
otherwise.

As the definition states, safety lead time can be used in

material requirements planning (MRP), and one way to do
this is to create a firm planned order. Safety lead time can
also be used for independent demand ordering systems,
meaning that the order for resupply would be placed earlier
than the demand during the lead time would otherwise
require. Using safety lead time will result in a temporary
spike in inventory that quickly resolves itself. Safety lead
time is often preferred over safety stock for items that are
only sporadically in demand, because it reduces uncertainty
without resulting in more units that may not sell for a long
time. However, safety lead time can be implemented
incorrectly, which will increase average inventory levels.
Much like how the bullwhip effect creates more and more
variability in orders as they go upstream in the supply chain,
if upstream partners view early ordering as a sign of
increased demand, they may in turn order earlier and so on.
Therefore, if this method is used, it should be
communicated as such to supply chain partners.

Topic 2: Inventory Costs

Inventory costs are broken down into categories to help
when determining the tradeoffs of various decisions. The
following are common inventory costs:
Item costs
Carrying costs
Ordering costs
Stockout costs
Capacity-related costs

The basic idea is to understand each of these costs so that

costs in total can be minimized. Total costs include
consideration of all cost impacts, rather than just one cost
impact, on customer service improvement.

Item Costs
Item costs are the purchase price plus other direct costs
required to get the units to where they need to be, for
example, the plant. Item costs are a large portion of the
landed costs, because item costs include not only
transportation but also customs and insurance costs. Items
produced in house will also have item costs; these will be
direct materials, direct labor, and the portion of factory
overhead allocated to the units.

Carrying Costs
The APICS Dictionary, 16th edition, defines carrying cost,
also called holding cost, as follows:

The cost of holding inventory, usually defined as a

percentage of the dollar value of inventory per unit
of time (generally one year). Carrying cost depends
mainly on the cost of capital invested as well as
costs of maintaining the inventory such as taxes
and insurance, obsolescence, spoilage, and space
occupied. Such costs vary from 10 percent to 35
percent annually, depending on type of industry.
Carrying cost is ultimately a policy variable
reflecting the opportunity cost of alternative uses
for funds invested in inventory.

Components of Carrying Costs

Carrying costs have three main components:

Capital costs. Capital cost, also called the cost of capital

(finance professionals may use the term weighted
average cost of capital, or WACC, but it is not defined
here) reflects the opportunity cost of carrying inventory. If
money was borrowed to finance the inventory, the capital
cost is the direct cost of the loan. Even if this is not the
case, money invested in inventory is tied up and cannot
be used for another purpose. Finance will estimate the
capital cost of inventory by determining the interest rate
that could have been earned from making an investment
in something of similar risk. This could be either the
prevailing interest rate for a financial instrument or the
return expected from an alternative business investment.

Storage costs. Storage costs reflect the fact that

warehouses cost money—for the land, the building, the
material-handling equipment, the labor, and the
overhead, such as utilities. These costs are expressed as a
percentage.

Risk costs. Inventory might be perishable, in which case

it could spoil, but even nonperishable inventory can suffer
from deterioration such as damage from rot or
 evaporation. Another risk is obsolescence. When new and
improved products come on the market, the old model
loses value. Some products lose value simply because
tastes change. Transportation and materials handling also
pose a risk of product damage. Goods may be subject to
pilferage, which includes theft as well as goods that are
misplaced. The cost of insurance for the inventory may be
included. Perishable goods, innovative technology, and
items with a high street value can have high risk costs,
while other products will have low risk costs. Estimates of
the types of risks are made by product, and an average
percentage risk cost is determined.

Calculating Carrying Costs

The sum of the percentages of the carrying cost
components can be multiplied by the average annual
inventory level to determine the carrying cost. Consider an
organization that has a capital cost of 9 percent, a storage
cost of 8 percent, and a risk cost of 7 percent. The sum of
these is 24 percent. If the average inventory level is $3
million per year, then the calculation of carrying cost would
be 0.24 × $3,000,000 = $720,000. Dividing this by 365
results in a daily rate of about $1,973 per day. If the
organization reduces this annual average to $2,500,000, the
figure would be $600,000, or about $1,644 per day. Note
how carrying cost will increase or decrease based on the
average annual inventory level. The percentages could also
be reestimated and impact carrying cost.

Many organizations, especially those with strong seasonal

variations in inventory levels, perform a more finely grained
study of carrying costs by doing the calculations by quarter
or month. If an annual carrying cost is used as an input, it
will need to be translated into a quarterly or monthly rate
before it can be multiplied against quarterly or monthly
average inventory levels. For example, to translate the 24%
annual carrying cost into a quarterly carrying cost, divide by
4 (for the four quarters): 0.24/4 = 0.06 or a 6% quarterly
carrying cost. This would then be multiplied by the average
quarterly inventory. The four quarterly carrying costs could
then be summed, and a more precise carrying cost can be
found.

Ordering Costs
The APICS Dictionary, 16th edition, defines ordering costs
as follows:

The costs that increase as the number of orders

placed increases. Used in calculating order
 quantities. Includes costs related to the clerical
work of preparing, releasing, monitoring, and
receiving orders; the physical handling of goods;
inspections; and setup costs, as applicable.

Ordering costs are incurred for purchasing and for placing

orders for production at the plant.

For purchasing, ordering costs include the cost of the

purchasing cycle for managing and expediting purchase
orders. This will include the cost of each purchase order that
is issued or, if contract buying is used, the cost of releasing
orders against a contract, although the latter is much lower
in cost per order.

For factory orders, the following costs are included in

ordering cost:

Production control costs. The cost of issuing, closing,

scheduling, loading, dispatching, moving, and expediting
open orders. These costs are made up of the costs for
labor, supplies, and operating expenses for the
operations.

Setup costs. Setup goes from the last good part of the
prior operation to the first good part of the next operation,
 so it includes teardown costs. This cost is incurred per
order. (Run time is calculated per unit.)

Lost capacity cost. Whenever another order is placed,

the setup time reduces the available run time for the work
center, so it is an opportunity cost related to capacity. This
is especially problematic for bottleneck work centers that
need as much of their capacity as possible for run time.
Each order that requires setup time at a bottleneck will
reduce sales and profit.

Ordering cost varies in proportion to the number of types of

orders placed in a year or other period. The quantity
ordered is not a factor; ordering 50 or 50,000 will have the
same ordering cost. This promotes ordering in larger
quantities. The tradeoff, however, is higher carrying cost,
because larger quantities ordered or longer production runs
increase average inventory levels. As the number of orders
placed per year varies, so will the ordering cost.

Some of the above costs might be included in fixed costs,

such as production control salaries, supplies, and operating
expenses. However, setup costs will vary per order and are
already variable costs. Assume that fixed costs include
production control wages that average $200,000 per year
plus production control supplies and operating expenses
that average $80,000 per year, and assume that 4,000
orders are placed per year on average. Assume also that
average setup costs are $100 per order (the variable cost).
The following calculation can determine the average
ordering cost per order:

A similar calculation for ordering cost per order could be

made for purchasing.

Stockout Costs
The APICS Dictionary, 16th edition, defines stockout costs
as follows:

The costs associated with a stockout. Those costs

may include lost sales, backorder costs, expediting,
and additional manufacturing and purchasing costs.

Stockouts will occur in situations in which an organization is

producing to forecast when demand during the lead time
exceeds the forecast and safety stock levels. Stockouts can
also occur when suppliers have failures or production
problems occur.

Stockouts that result in a missed sale (rather than a

backorder) are opportunity costs, because the revenue is
not earned. Stockout costs are an estimate not only of
missed sales and the cost of lost customers (both of which
could be significant, especially if the stockout persists over
time, but are hard to estimate) but also administrative costs
for backorders or expediting and higher purchasing or
manufacturing costs. Safety stock can reduce stockout costs
but has a carrying cost. After performing estimates of these
various costs, organizations might indicate the number of
stockouts per year that are acceptable for a given type of
inventory or simply state it as a required customer service
level percentage.

Capacity-Related Costs
The APICS Dictionary, 16th edition, defines capacity-
related costs in part as

costs generally related to increasing (or decreasing)

capacity in the medium- to long-range time horizon.
Any type of organization will have capacity-related costs
when there is a sustained shift in demand that requires
changing production plans. Capacity-related costs include
overtime and shift premiums, hiring and layoff costs, costs
for unused capacity, training costs, and so on. Organizations
that use chase or hybrid production will have capacity-
related costs each time they vary production levels. Level
production tends to avoid these costs but instead incurs
higher carrying costs.

Topic 3: ABC Classification

This topic describes ABC classification, which is based on
Pareto’s law. This classification can help organizations better
manage inventory.

ABC Inventory Control

The APICS Dictionary, 16th edition, defines ABC
classification, also called ABC analysis, as follows:

The classification of a group of items in decreasing

order of annual dollar volume (price multiplied by
projected volume) or other criteria. This array is
then split into three classes, called A, B, and C. The
A group usually represents 10 percent to 20 percent
 by number of items and 50 percent to 70 percent
by projected dollar volume. The next grouping, B,
usually represents about 20 percent of the items
and about 20 percent of the dollar volume. The C
class contains 60 percent to 70 percent of the items
and represents about 10 percent to 30 percent of
the dollar volume. The ABC principle states that
effort and money can be saved through applying
looser controls to the low-dollar-volume class items
than to the high-dollar-volume class items. The ABC
principle is applicable to inventories, purchasing,
and sales.

An ABC classification system is based on Pareto’s law,

which the Dictionary defines as follows:

A concept developed by Vilfredo Pareto, an Italian

economist, that states that a small percentage of a
group accounts for the largest fraction of its impact
or value. In an ABC classification, for example, 20
percent of the inventory items may constitute 80
percent of the inventory value.

Note that this 80-20 relationship is just a rule of thumb. The

size of each category might differ based on the products
and their characteristics.
When applied to inventories, the ABC classification can be
called ABC inventory control. ABC inventory control is
concerned with determining the relative importance of
inventory and the level of control that is required.

To determine relative importance, organizations often select

annual dollar usage, which is the number of units sold
annually multiplied by their cost (or, sometimes, price, as
per the definition above). Other criteria might include
bottleneck materials, shelf life, replenishment lead time,
importance of a stockout to customers, inventory turnover
rate, and so on. For example, ABC classification based on
inventory turnover is sometimes used to organize
warehouse layout so that the fastest-selling items are
closest at hand.

Once the criteria are determined, all products the

organization sells are ranked according to the criteria and
placed into three groups. One factor is generally the most
important. Often this is dollar usage, because it reflects the
value of the inventory to the organization. The other factors
might be used to bump up some items into a higher
category or bump others down into a lower category. Once
the groups are finalized, they will then be used to specify
the relative level of control that will be applied. Rather than
applying time-consuming and administratively expensive
controls to all inventory, applying control only where it is
needed saves time and money that can be reinvested in
controls for the most important inventory. An example of an
A item that might be downgraded to a B or C item might be
huge coils of steel that are difficult to misplace and hard to
damage. The downgrade would be based on ease of control.

Items in category A will have the highest degree of control

and, due to high inventory cost, this may equate to tight
control of inventory levels, carefully calculated (low) safety
stock levels, more frequent ordering in lower quantities,
frequent inventory counting for accuracy, higher physical
security, more frequent review of demand forecasts and
errors, and closer attention to order status and expediting.
Examples might include circuit boards or vehicle
transmissions.

Items in category B will have normal levels of control,

inventory, safety stock, and record keeping in the areas just
mentioned. Examples might include belts or filters.

Items in category C will have the least complex controls and

record keeping, for example, minimal time spent on
inventory counting for accuracy. Examples might include
nuts and bolts. The main thing about C items when they are
ranked by annual dollar usage is that they will have very low
inventory carrying cost, so it will make sense to maintain
plenty of days of supply, have high levels of safety stock,
and order few times per year (perhaps just once) in large
quantities to limit the number of chances of a stockout. This
is because these items only become a problem when there
is a stockout. Overstocks will be relatively inexpensive.

Assuming that annual dollar usage is the key criterion, here

are the steps in the ABC inventory control process:

1. Multiply the annual unit usage by the unit cost to find the
annual dollar usage per product or product family.

2. Rank the products by their annual dollar usage from

highest to lowest.

3. Calculate the cumulative percentage of total items.

4. Calculate the cumulative percentage of annual dollar

usage.

5. Assign A, B, and C classifications based on the items’

cumulative percentage of dollar usage, with A items
 within about 50 percent to 70 percent of cumulative
value, B at about 20 percent more of the cumulative
value, and C at the remainder. (These percentages are
from the definition of ABC classification given above;
others can be used. For example, in Introduction to
Materials Management, Chapman says that A is about 20
percent of the items and 80 percent of the value, B is
about 30 percent of the items and 15 percent of the value,
and C is about 50 percent of the items and 5 percent of
the value.)

It is important to note, however, that it is not necessarily the

case that A items are expensive and C items are cheap. The
classification is used to identify the cumulative value of the
items used.

Exhibit 5-10 shows how a ranked list might be created. (The

example assumes that there are only 10 products sold by
the organization.)
Exhibit 5-10: ABC Inventory Ranked by Annual Dollar Usage

The first row in Exhibit 5-10 shows 0 percent, so the graph

in Exhibit 5-11 below based on these data will start from 0
percent. Exhibit 5-11 shows how an ABC inventory analysis
will start off with steep increases in value and then level off
as the B and C categories are approached.
Exhibit 5-11: ABC Inventory in Chart Form
Section C: Order Quantity and Item
Replenishment
After completing this section, students will be able to
Differentiate between centralized and decentralized
inventory control
Describe how order point systems operate
Describe the three main methods of determining when the
order point is reached: kanban, perpetual inventory, and
two-bin inventory
Identify the situations that periodic review order systems
are best suited for
Define product costs
List the main lot-size decision rules
Define economic order quantity
List the simplifying assumptions used with economic order
quantity
Calculate economic order quantity
Explain the purpose and goals of distribution inventory
planning systems
Define distribution requirements planning.

Order systems and lot sizes are discussed in this section.

Topic 1: Push and Pull Methods
Two major types of distribution inventory planning systems
are pull systems, which decentralize control, and push
systems, which centralize it. A third type, distribution
requirements planning, uses a combination of the two.

Pull (Decentralized) Systems

The APICS Dictionary, 16th edition, defines decentralized
inventory control as “inventory decision making exercised
at each stocking location for SKUs [stockkeeping units] at
that location.” Such systems are also called pull inventory
planning, because distribution center (DC) demand pulls
inventory from suppliers. However, this is usually just orders
that are pulling inventory, not ultimate customer demand.
Thus, decentralized pull systems use independent demand
ordering systems, and a common method for regional or
centralized DC reordering is an order point system.

When an order point system is used, the orders will be for

fixed amounts (possibly the economic order quantity), but
the timing of when the order point occurs will vary.
Assuming that demand on the DC is relatively stable, the
order point timing will be fairly uniform, but it will still result
in lumpy demand at the central supply and even more so at
the factory because of the large fixed orders followed by no
orders between the order point. In addition, when fewer
order points are used to minimize the number of chances for
a stockout, order sizes are even larger and the lumpiness of
demand is further exaggerated.

The primary advantage of a pull system is that DCs have

autonomy and can order or not order based on their
knowledge of local demand. This also entails reduced
expense for maintaining communications and relationships
with other supply chain partners. A main disadvantage is
that this is the primary cause of the bullwhip effect. Other
disadvantages include that the needs of other customers
(DCs) are not considered and the available inventory at the
central supply might be consumed by the first orders
received rather than being distributed more fairly. It also
does not consider the needs of the master production
schedule at the factory, and these schedules may not only
be lumpy but also be disrupted by requests for expedited
orders. One reaction to this is to centralize inventory
planning.

Push (Centralized) Systems

The APICS Dictionary, 16th edition, defines centralized
inventory control as “inventory decision making for all
stockkeeping units exercised from one office or department
for an entire company.” This is also called push inventory
planning because inventory is pushed out to the central
distribution center (DC) and from there to the regional DCs
based on information on demand, promotions, and so on.

A key advantage of this method is that total distribution

inventory levels can be controlled carefully. However,
usually this is possible only when the organization owns the
distribution channel, since independent DCs would need to
agree to accept (and pay for) whatever inventory was sent,
even when this results in overstocks or stockouts. To be fair,
inventory levels would be communicated to central planning
so they can replenish the inventory that is used, and an
advantage is that the organization will include planned
promotions and seasonality in forecasts. A key disadvantage
of this method is that local information on demand may not
be gathered sufficiently or in a timely manner and service
errors are therefore more likely to occur. For example,
central planning may not have information on local retailer
promotions or other reasons for variations in ordering. For
this reason, many organizations have turned to a third
option, called distribution requirements planning.

Distribution Requirements Planning

The APICS Dictionary, 16th edition, defines distribution
requirements planning (DRP) in part as follows:

The function of determining the need to replenish

inventory at branch warehouses. A time-phased
order point approach is used where the planned
orders at the branch warehouse level are
“exploded” via MRP logic to become gross
requirements of the supplying source. In the case of
multilevel distribution networks, this explosion
process can continue down through the various
levels of regional warehouses (master warehouse,
factory warehouse, etc.) and become input to the
master production schedule. Demand on the
supplying sources is recognized as dependent, and
standard MRP logic applies.

As the definition indicates, if you understand MRP (material

requirements planning) logic, it is a very small leap to
understand DRP logic. Planned order releases from regional
distribution centers (DCs) become gross requirements for
central supply, which in turn become planned order releases
at the factory as direct inputs to the master production
schedule’s forecast of demand. Therefore, the factory has
more time to plan for when large orders will need to be
released. The Dictionary defines a time-phased order
point (TPOP), as discussed in the prior definition, as
follows:

MRP-like time planning logic technique for

independent demand items, where gross
requirements come from a forecast, not via
explosion. Can be used to plan distribution center
inventories as well as to plan for service (repair)
parts, because MRP logic can readily handle items
with dependent demand, independent demand, or a
combination of both. An approach that uses time
periods, thus allowing for lumpy withdrawals
instead of average demand. When used in
distribution environments, the planned order
releases are input to the master schedule
dependent demands.

DRP has features of both pull and push inventory systems.

The regional DCs determine their own planned orders and
so can respond to local customer information on demand
but, because they enter planned orders in advance of their
release, central supply and the factory receive immediate
information on future demand so they can better level
production. Because the systems are integrated, the factory
can generate planned order recommendations and
exception or action messages for central supply, and central
supply can do the same for regional DCs. Production
planners will have good information on inventory levels at
all integrated stockkeeping locations. They can suggest
different planned order sizes at various locations; this way
all locations get sufficient inventory rather than the first to
order getting what is available and the others having
stockouts.

Exhibit 5-12 shows an example of three DRP grids, which

have the same logic and appearance as an MRP grid. Grids
for DC A and B feed to a DRP grid for central supply. This in
turns feeds the master schedule grid in the form of gross
requirements.
 Exhibit 5-12: DRP Grids Feed to Central Supply and Master
Schedule

Note how each DC will have its own lot sizes, lead times,
and safety stock levels for the particular inventory item.
Each will also modify its gross requirements by its projected
available balances to determine net requirements and
schedule planned order receipts based on these net
requirements. DC A has a lead time of one week, so a
planned order release is set for week 6. DC B has a two-
week lead time, so a planned order receipt for week 8 is
also planned to be released in week 6. These orders for 400
and 500 units (the respective lot sizes) are summed and
appear on the central supply grid as a gross requirement for
900 units in week 6. After calculating its net requirements, it
also schedules a planned order receipt for its lot size of 600
units and offsets this by the three-week lead time for a
planned order release in week 3 to the master schedule
grid. This becomes a gross requirement, and the normal
master scheduling process converts these into the master
production schedule.

In addition to this big-picture view, note also that the net

requirements are shown for DCs A and B and for central
supply. Using the calculation rules for MRP, the DC A net
requirements for week 7 would be calculated as follows:

However, note that this DC has a safety stock requirement

of 70 units, so the prior projected available will be reduced
by the safety stock requirement as follows:
This same change to net requirements would be made in
MRP when safety stocks are held. In this way, the projected
available will not fall below the safety stock level. The other
net requirements in the prior exhibit are likewise calculated
after accounting for safety stocks.

Topic 2: Independent Demand

Ordering Systems
We’ll now look at when to order when not using dependent
demand. (When to order for dependent demand is
controlled by material requirements planning, kanban in
lean, or drum-buffer-rope in the theory of constraints.) The
main factors in deciding when to order are avoiding
stockouts and avoiding excess inventory. Orders placed late
will risk a stockout; orders placed early will result in extra
carrying cost. Therefore, the main objective of independent
demand ordering systems is to minimize the total of
stockout costs plus carrying costs.

Order Point Systems

The APICS Dictionary, 16th edition, defines order point
systems and some related terms as follows:

Inventory ordering system: Inventory models for

the replenishment of inventory. Independent
demand inventory ordering models include fixed
reorder cycle, fixed reorder quantity, optional
replenishment, and hybrid models, among others.
Dependent demand inventory ordering models
include material requirements planning, kanban,
and drum-buffer-rope.

Order point system: The inventory method that

places an order for a lot whenever the quantity on
hand is reduced to a predetermined level known as
the order point.

Order point: A set inventory level where, if the

total stock on hand plus on order falls to or below
that point, action is taken to replenish the stock.
The order point is normally calculated as forecasted
usage during the replenishment lead time plus
safety stock.

Replenishment lead time: The total period of

time that elapses from the moment it is determined
that a product should be reordered until the product
is back on the shelf available for use.
Order point systems usually work with fixed order
quantities, but the timing of when to order can vary. The
method assumes that demand is relatively stable but will be
subject to some amount of random variation. The order
point is allowed to be sooner than normal if demand is
higher than average and later than normal if demand is
lower than average. This inventory level is determined in
part by the lead time required to order and receive the
resupply order and in part by the demand that is expected
to occur during this lead time. The inventory reorder point
will also account for any required safety stock.

Exhibit 5-13 shows an example of hydraulic door closers

featuring both the economic order quantity (discussed
elsewhere) and a level of safety stock at the bottom, so the
minimum inventory level goes down to this point rather
than zero as long as demand is stable. Note that the
following abbreviations are used in the exhibit:
Q—order quantity
LT—lead time
DDLT—demand during the lead time
OP—order point
SS—safety stock
 Exhibit 5-13: Order Point System

In this exhibit, the demand during the lead time follows a

predictable slope each time, which is based on the average
demand (the mean of a bell curve). However, demand might
vary due to random variation. If demand is higher than the
rate shown, the slope will fall more quickly, while demand
that is lower will have a more gradual slope. This is why
safety stock is held, so that if the inventory falls more
quickly than the average, the stockout will not actually
occur until the safety stock is depleted. The safety stock
level is calculated based on the relative amount of
variability around that average and the desired service
level.
The demand during the lead time can be calculated if we
know the average rate of demand (estimated using
forecasting) and the lead time for replenishment (based on
historical data). In Exhibit 5-13, the hydraulic door closer is
sold as an independent demand item. It has an economic
order quantity of 400 units, and the average demand is 80
units per week, with 50 units of safety stock and a lead time
of two weeks to order and receive units at the distribution
center. The DDLT can be calculated as follows:

Given the 50 units of safety stock, the order point (OP) can
then be calculated:

With safety stock, the average inventory is no longer half of

the order quantity. The average is raised by the amount of
safety stock, so the formula is as follows:
Note that the average inventory is still technically the
opening inventory plus ending inventory divided by 2, but
since safety stocks are included in both opening and ending
inventory, the equation just shown will result in the same
answer.

Order point systems work well when demand varies only to

the degree accounted for in the safety stock calculations.
When actual demand is less than expected, reorders are
delayed, so this keeps inventory levels from growing too
large. However, if the average demand during the lead time
changes, the order point will also need to be recalculated or
it will be too early (effectively increasing the safety stock
level) or too late (reducing the safety stock level and risking
more stockouts). Since the order point is determined when a
particular inventory level is reached at the stockkeeping
location, the next thing to determine is when the order point
is reached.

Determining When Order Point Is

Reached
Three basic methods can be used to determine when the
order point is reached: perpetual inventory, two-bin
inventory, and kanban. There are variations of each of these
models.

Perpetual Inventory Systems

The APICS Dictionary, 16th edition, defines a perpetual
inventory record as

a computer record or manual document on which

each inventory transaction is posted so that a
current record of the inventory is maintained.

A perpetual inventory system, which could be part of an

inventory management or enterprise resources planning
system (it could also be a manual system), keeps track of
inventory levels at each stockkeeping location. When a
transaction occurs that adds or deducts inventory, the
inventory levels are immediately updated. The system may
also track inventory allocated to specific orders but not yet
issued, quantities on order but not yet received, and
quantities received. The balance on hand will then be the
total inventory, while the available balance will be the
balance on hand less any allocated inventory. Issuance
means that an allocated order has been removed from
inventory, so this will cancel the related allocation and the
on-hand inventory will be reduced. Orders, allocations,
issuances, and receipts will track dates, order numbers, and
quantities.

In addition to this dynamic information, these systems store

static information such as part number, name, description,
storage location, order point, order quantity, lead time,
safety stock, and supplier(s). Exhibit 5-14 shows a perpetual
inventory record for hydraulic door closers, listing this static
information at the top and the dynamic transactional
information below that. Note that when allocations are used,
the order point will occur when available inventory reaches
the order point.

Exhibit 5-14: Perpetual Inventory Record Triggering Reorder

Point

Average demand for this item is 80 units per week. In week

1, 70 units are allocated to orders, which does not affect the
on-hand balance but does reduce the available balance. The
available balance is still above the order point of 210 units,
so nothing happens. In week 2, an order for 80 units is
allocated. The available balance at the end of the week is
now below the order point of 210, so the system prompts
the purchaser to place an order. The order for 400 is placed
at the beginning of week 3. In week 3, the week 1 allocation
of 70 units is now issued and there is an allocation of 90
units, which brings the available balance to 110 units. Due
to the one-week lead time, the 400 units ordered in week 3
arrive in week 4. During this week, the week 2 allocation
(80) is also issued, and there is a further allocation of 85,
which brings the available balance to 425. In week 5, the
allocation from week 3 (90 units) is issued, and 75 are
allocated. This leaves the available balance at 350.

This system works well unless the inventory level has

become inaccurate due to errors or shrinkage. The more
manual steps there are in the process, the more errors there
will be. Often these systems will incorporate devices such as
bar code scanners linked to the system that automatically
adjust inventory records to reduce chances for error.

Two-Bin Inventory Systems

The Dictionary defines the two-bin inventory system as
follows:

A type of fixed-order system in which inventory is

carried in two bins. A replenishment quantity is
ordered when the first bin (working) is empty.
During the replenishment lead time, material is
used from the second bin. When the material is
received, the second bin (which contains a quantity
to cover demand during lead time plus some safety
stock) is refilled and the excess is put into the
working bin. At this time, stock is drawn from the
first bin until it is again exhausted. Also used
loosely to describe any fixed-order system even
when physical “bins” do not exist.

A related term, visual review system, is defined in the

Dictionary as follows:

A simple inventory control system where the

inventory reordering is based on actually looking at
the amount of inventory on hand. Usually used for
low-value items, such as nuts and bolts.

A two-bin system places the order point quantity in one bin

and all excess inventory in a second bin (or other container
or storage area). The second bin is drawn from until empty.
When the first bin needs to be used, an order for resupply is
placed. A tag can also be placed in inventory at the location
of the order point. Once the inventory with the tag is picked,
the order point is reached. This system can be useful for C
items in ABC inventory control because it is easy to use and
administer. Staff will need training to know to place the
order when the second bin or other marker is accessed.

Kanban Systems
Much like the two-bin system, kanbans—such as a card, a
light, or an empty container— provide a visual signal of
when to reorder and the quantity to reorder. Lean uses
kanban systems for all types of inventory because it is a
visual demand-pull signal and there is no need to spend
time on record keeping.

Periodic Review Systems

An order point system that varies when to order can be
impractical in environments where there are thousands of
inventory items to reorder on different dates, especially if
sets of these items can be reordered using a common
shipment and can be added as line items to a single order.
Since order cost includes transportation and ordering,
consolidating orders will save on ordering costs. Rather than
posting many transactions to inventory, it can be simpler
and less costly to post multiple transactions during a single
review period. This will frequently be true in retail,
supermarkets, and online shopping distribution centers.
These systems are also used for perishable items with a
short shelf life, because often the order interval is short, in
part due to necessity and in part because ordering costs can
be kept low. A periodic review system, also called a fixed
reorder cycle inventory model, will make more sense in
these cases.

The APICS Dictionary, 16th edition, defines a fixed reorder

cycle inventory model in part as follows:

A form of independent demand management model

in which an order is placed every n time units. The
order quantity is variable and essentially replaces
the items consumed during the current time period.
If M is the maximum inventory desired at any time
and x is the quantity on hand at the time the order
is placed, then in the simplest model, the order
quantity equals M minus x. The quantity M must be
large enough to cover the maximum expected
demand during the lead time plus a review interval.

A related term is periodic replenishment, which the

Dictionary defines as
 a method of aggregating requirements to place
deliveries of varying quantities at evenly spaced
time intervals rather than variably spaced
deliveries of equal quantities.

Exhibit 5-15 shows that, unlike the regular sawtooth pattern

formed when the order quantity is fixed, a periodic review
system will allow lot sizes to vary but will always order on a
fixed schedule.

Exhibit 5-15: Periodic Review System

Note that the order intervals (called review period duration,

R, below) are fixed (identical) in length, as are the order
lead times (called lead time duration, or L, below). Orders
are placed at the start of the review period and end when
the next review period begins. The review period is set in
this way because the order is based on the demand during
the review period. Much like the order point system, this will
be a demand per time period, such as per week or, more
often, per day, since the order intervals are often weekly.

As indicated in the definition the order quantity will be the

target level, or the maximum inventory level minus the
quantity on hand, so the first thing to determine is this
target level (T). This requires knowing demand per period
(D), lead-time duration (L), review period duration (R), and
safety stock (SS). For example, assume that multiple items
are ordered every seven days with a lead time of two days.
One of these items has average demand of 50 units per day,
and there are 100 units of safety stock. The target
(maximum) inventory level is calculated as follows:

If the on-hand inventory level (I) is 150 units during a

particular review period, the order quantity (Q) can be
calculated as follows:
Because the inventory will continue to fall after the order is
placed (during the lead time), the replenishment will reach
the maximum inventory only if demand is zero during the
lead time.

Topic 3: Product Costs

This topic describes the basics of product costs and briefly
discusses holding costs.

Product Costs and Holding Costs

The APICS Dictionary, 16th edition, defines product costs
as follows:

Cost allocated by some method to the products

being produced. Initially recorded in asset
(inventory) accounts, product costs become an
expense (cost of sales) when the product is sold.

Products are usually designed to be produced with as low a

cost as possible. When products are poorly designed, they
can add costs in myriad ways:
Components may be designed in a way that prevents
them from being produced in the most economical way.
 Part design may hinder manufacturing operations, such as
requiring special handling or requiring excess material to
be removed unnecessarily.
Lack of standardized parts can reduce efficiencies as
manufacturing processes scale up, limiting batch sizes.
Excessive part requirements can increase difficulties and
costs associated with planning of material flows and
sourcing suppliers.

Holding costs, also known as carrying costs, are discussed in

detail elsewhere. They are made up of three main
components (capital costs, storage costs, and risk costs)
and are ultimately a policy variable reflecting the
opportunity cost of alternative uses for funds invested in
inventory. Because of this, organizations will typically work
to reduce unnecessarily high holding costs.

Topic 4: Lot-Size Formulas and

Calculations
While order quantities for dependent demand items are
calculated using material requirements planning, the order
quantity rules discussed in this topic can be used to set lot
sizes.
Order quantities for independent demand items also need to
be determined. Typically, distribution centers, wholesalers,
and retailers will use the methods discussed in this topic to
determine how much to reorder. Master production
scheduling can use these methods to set lot sizes for
production of independent demand items. Inventory
managers at manufacturing organizations might also use
these order quantity systems for maintenance, repair, and
operating (MRO) materials and components or raw materials
stored in inventory.

After addressing the objectives of order quantity systems,

this topic discusses lot-size decision rules, including lot-for-
lot, fixed order quantity, and ordering n periods of supply.
Another method, economic order quantity (EOQ), is
addressed after that. EOQ can be used to better manage
cost tradeoffs.

Objectives of Order Quantity Systems

Order quantity systems are used to determine how much to
order at a given time to balance the various inventory costs
while providing the desired level of customer service. The
costs are summed to find the quantity that results in the
lowest cost at the targeted customer service level. These
general objectives are then translated into decision rules so
that those responsible for ordering will know how much to
order when needed.

Lot-Size Decision Rules

The APICS Dictionary, 16th edition, defines lot size as

the amount of a particular item that is ordered from

the plant or a supplier or issued as a standard
quantity to the production process.

Lot sizes for manufacturing are based on optimizing

manufacturing efficiency and inventory levels at a targeted
level of customer service. For independent demand items,
lot sizes are based on decision rules that work to minimize
certain costs, for example, ordering and transportation
costs, use of quantity discounts, and carrying costs. Some of
the following methods are better than others at minimizing
the sum of all costs involved. Note that economic order
quantity might be considered a lot-size decision rule as well
but is addressed elsewhere since it can be applied to more
than one method.

Lot-for-Lot
The Dictionary defines lot-for-lot as
 a lot-sizing technique that generates planned
orders in quantities equal to the net requirements
in each period.

Lot-for-lot orders only what was sold or removed from

inventory since the last reorder point, effectively setting the
lot size at one unit. For example, small hardware store
chains typically use lot-for-lot to replenish each retail store
with just what was sold, perhaps using information from a
point-of-sale system to automatically determine reorder
quantities. The Dictionary defines point of sale (POS) as

the relief of inventory and computation of sales

data at the time and place of sale, generally
through the use of bar coding or magnetic media
and equipment.

For manufacturing, the master production schedule or the

material requirements plan provides the time-phased
information required to know how much to reorder. If lot-for-
lot is used for material requirements planning, the order
quantity will vary based on the amount of components
actually needed rather than being in round lots. In lean, the
lot size is likely to be near or at one unit, and it carries this
through to purchasing.
Lot-for-lot prevents inventory build-ups because inventory is
always replenished to the exact level desired, no more and
no less. Lot-for-lot is frequently used to reorder perishable
SKUs (stockkeeping units), level A items in ABC inventory
control, and items that consume significant warehouse
space due to their size or handling requirements.

Fixed Order Quantity

The Dictionary defines fixed order quantity terms as follows:

Fixed order quantity: A lot-sizing technique in

MRP or inventory management that will always
cause planned or actual orders to be generated for
a predetermined fixed quantity, or multiples
thereof, if net requirements for the period exceed
the fixed order quantity.

Reorder quantity: 1) In a fixed reorder quantity

system of inventory control, the fixed quantity that
should be ordered each time the available stock
(on-hand plus on-order) falls to or below the reorder
point. 2) In a variable reorder quantity system, the
amount ordered from time period to time period
varies.

Fixed order quantity orders the same fixed amount of SKUs

per order. This may be based on judgment and demand
history, on an economic order quantity (EOQ; discussed
elsewhere), on the size of an economically efficient
production batch, or on the size of a case, pallet, or
truckload. The reorder point will vary based on demand for
the SKU. (In general, no reorder will be made as long as
inventory remains above a particular level.)

While fast and easy, with the exception of the EOQ method,
fixed order quantity does not minimize the costs involved. It
produces lot-size inventory, which jumps up and then falls
gradually. This increases aggregate inventory levels, and it
can result in high inventories of items that are infrequently
in demand, since an entire case or more may be ordered but
not be consumed quickly.

One variation of fixed order quantity is a min-max system,

defined in the Dictionary as follows:

A type of order point replenishment system where

the minimum (min) is the order point, and the
maximum (max) is the “order up to” inventory
level. The order quantity is variable and is the result
of the max minus available and on-order inventory.
An order is recommended when the sum of the
available and on-order inventory is at or below the
min.
A min-max system sets a maximum inventory level and an
order point (min) inventory level. When inventory falls below
the order point level, it is reordered. The quantity to order is
calculated as the maximum inventory minus the available
quantity on hand. If the max is 100 units, the order point is
50 units, and the quantity actually available is 30 units
when the order point is reached (e.g., an order for 25 units
has brought inventory from 55 to 30 units), then the amount
to order is calculated as 100 – 30 = 70 units.

Order n Periods of Supply

The order n periods of supply method is sometimes called
period order quantity, because it is designed to work with
period order quantity systems. The Dictionary defines
period order quantity as follows:

A lot-sizing technique under which the lot size is

equal to the net requirements for a given number of
periods (e.g., weeks into the future). The number of
periods to order is variable, each order size
equalizing the holding costs and the ordering costs
for the interval.

This method orders enough SKUs to satisfy demand for n

periods, where n stands for a particular number of periods
such as weeks or days. For example, if days of supply are
known and are relatively stable for SKUs at a particular
location, a certain number of days of supply could be
ordered. This method is typically used when the order
period is fixed (when orders are always submitted on a set
schedule). It can be applied to dependent and independent
demand items and does not generate lot-size inventory. It is
often used for SKUs that are low in relative value (C items in
ABC ordering systems).

Economic Order Quantity

The APICS Dictionary, 16th edition, defines economic
order quantity (EOQ) in part as follows:

A type of fixed order quantity model that

determines the amount of an item to be purchased
or manufactured at one time. The intent is to
minimize the combined costs of acquiring and
carrying inventory.

EOQ calculates an amount to order when using the fixed

order quantity or order n periods of supply methods. (In the
latter case, the fixed time reorder point will be timed to
occur when n periods of supply equal the economic order
quantity.)
How EOQ Manages Tradeoffs
Economic order quantity manages the tradeoffs between
carrying costs and ordering costs by finding the point where
the sum of these two costs is minimized. Carrying costs are
minimized when orders are in small quantities; ordering
costs are minimized when few orders are placed. Economic
order quantity will fall somewhere between these individual
minimum points. Exhibit 5-16 shows how the economic
order quantity, or lowest total cost, will be above the point
where the ordering cost curve and the carrying cost curve
intersect.

Exhibit 5-16: Economic Order Quantity at Lowest Total Cost

Note that the equations shown at the bottom of the exhibit
(AS/Q and Qci/2) are covered later in this topic.

EOQ Assumptions
EOQ makes certain simplifying assumptions that, if true or
close to being true, mean that the order quantity will be the
lowest total cost or very close to it. Here are those
assumptions:
Demand is known and relatively constant.
Items are purchased or made in batches or lots.
Ordering costs and carrying costs are known and the
curves are stable.
Replacement occurs all at once. (The full reorder is
available at receipt.)

While these assumptions will not be true in many actual

ordering environments, these are simplifying assumptions
used to enable this calculation to be made. Even when there
is some variation in demand, for example, the calculation
results will still show the range in which near-optimal
decisions can be made. That is, the lowest total cost area
tends to be a fairly broad range (e.g., in Exhibit 5-16, the
order quantities from 350 units to 450 units are all near-
optimal quantities). Therefore, the model helps set the order
quantity better than if the model were not used even if real-
world factors cause the exact point of optimal cost
balancing to shift a small amount on a regular basis.
However, there is a limit to this, so EOQ is useful only when
the factors used to calculate it do not change too much or
too frequently. If demand is highly variable, the EOQ would
be very different in each period and thus cease to be a fixed
order quantity. EOQ is not useful for engineer- or make-to-
order, since these specify an exact quantity. It is also not
useful for perishable inventory or other inventory with a
short shelf life, or in situations when the manufacturing
process requires or cannot exceed a particular batch size,
for example, if the tools used to run a batch wear out after a
certain number of units. For manufacturing, lot-for-lot is
more often used, but there are variants of EOQ that can be
used to determine manufacturing lot sizes.

EOQ Process
The process that was used to initially develop the economic
order quantity equation can help show how and why the
equation works. The process starts by calculating the annual
ordering cost and the annual inventory carrying cost. These
costs are summed to find the total annual cost. Trial and
error can then be used to evaluate alternative order
quantities until the lowest total cost is found. The EOQ
formula was developed to avoid the need for trial and error,
so this will be presented after showing the trial-and-error
method.

Let’s assume that a distribution center (DC) sells hydraulic

door closers as an independent demand item for a door
manufacturer, and this DC has an annual demand (A) of
8,000 units. Currently the lot-size quantity (Q) is 500 units
(since the lot size is what we are trying to determine,
consider this a starting point), and the cost per order is $20.
The number of orders is calculated as follows:

The annual ordering cost is then calculated as follows:

These two calculations can be combined and done at the

same time, using S to denote the cost per order:
Next we calculate the annual inventory carrying cost, which
requires knowing the average inventory at a given
stockkeeping location. Exhibit 5-17 shows why the average
inventory will be half of the lot size when order quantities
are fixed. Note that if safety stock is carried, the average
will be safety stock plus half the order quantity.

Exhibit 5-17: Average Inventory Is Half of Lot Size

Notice also the sawtooth pattern that lot-size inventory

creates. The Dictionary defines a sawtooth diagram as

a quantity-versus-time graphic representation of

the order point/order quantity inventory system
 showing inventory being received and then used up
and reordered.

To continue the example, average inventory is calculated as

follows:

Next we calculate the annual inventory carrying cost in

dollars by multiplying the average inventory by the cost per
unit (c) and the carrying cost rate (i). The cost per unit is the
sum of the direct materials, direct labor, and overhead per
unit. The carrying cost rate is the sum of the capital,
storage, and risk cost percentages. Assume for this example
that a hydraulic closer costs $10 and the carrying cost rate
is 20 percent, or 0.2.

Another way to write this equation is as follows:

Now the total cost is determined by summing the annual
ordering cost and the annual inventory carrying cost:

The economic order quantity is defined as the point where

the annual ordering cost equals the annual carrying cost.
Since this is not true for our example, clearly the initial lot
size was not correct. One way to find the correct order
quantity is to simply try many quantities until one finds the
values that are closer and closer to the lowest total cost
(trial and error). Exhibit 5-18 shows how this might be done.
Note how all of the variables are held constant (based on
those initial assumptions) except the order quantity (Q).
This allows results to be comparable.
 Exhibit 5-18: Calculating EOQ Using Trial and Error

Note that an order quantity of 400 units results in both the

ordering and carrying costs equaling $400, so this is the
EOQ. However, this is called the trial-and-error method for a
reason. In many cases, you will get close to the EOQ, but
the amounts will not be exactly equal for any of the results.
The calculations need to be repeated using a smaller range
of numbers around the result that was the lowest total cost.
The increment between the numbers will also be smaller, for
example, only 50, then 10, and then one unit. Eventually,
the EOQ will be found. This type of repetitive process would
best be done in a spreadsheet.

Since this is time-consuming, a calculation can instead be

made to determine EOQ in one step.
Calculating EOQ
Since the annual carrying cost needs to equal the annual
ordering cost, we can just set these to be equal to each
other. (Note that in the equations below, we omit the
multiplication signs [Qci instead of Q × c × i; AS instead of A
× S], but these variables are still multiplied together.)

Since the order quantity (Q) is what we need to know, the

following versions of the same formula are solved for Q in
several steps. In the last step, Q is replaced by EOQ since
these are now the same thing:

Where:
EOQ or Q = Order quantity = (the economic order
quantity we are calculating)
A = Annual demand = 8,000 units
 S = Order costs = $20 per order
c = Cost per unit = $10 per unit
i = Carrying cost rate = 20 percent = 0.2

Exhibit 5-16, which appeared earlier in this topic, shows how

400 units is the lowest total cost order quantity, given the
various assumptions about costs and demand.

Using Continual Improvement to

Change EOQ
Assuming that the organization can use EOQ because
demand is relatively stable, carrying and ordering costs are
known, and so on, the next thing to realize is that the
organization can make improvements in various areas to
further reduce the total of these two costs—in effect,
shifting the curves and where the curves intersect.

Some things are partly controllable by the organization but

not necessarily by manufacturing and inventory control
professionals. This includes annual demand. If annual
demand increases, the EOQ will also increase, but annual
demand is partly controlled by market forces and partly by
the effectiveness of marketing.

A lower unit cost will increase the EOQ. For purchased

components, purchasing might negotiate lower purchase
prices and thus lower total unit costs. Similarly,
manufacturing might make process improvements or
eliminate waste to lower manufacturing costs. These types
of changes usually call for a longer planning horizon, since
they usually require process improvements or capital
investments on the part of suppliers or plants.

Reducing the annual carrying cost will also increase the

EOQ. However, the cost of carrying inventory is only partly
controllable. The organization might be able to reduce risks,
reduce warehouse staffing or overhead costs, and so on, but
these changes are possible only over a long planning
horizon. Other parts of carrying cost are not controllable. For
example, the cost of capital is based partly on market rates.
Also, many risks and costs are based on the particular
products being sold and thus must be accepted when selling
those products.

Over a shorter planning horizon, the best method of

continuous improvement is to reduce annual ordering cost.
This lowers the EOQ amount, because orders can be made
more frequently and average inventory levels are reduced.
Manufacturing professionals can reduce ordering cost by
reducing setup costs. Purchasing can reduce ordering costs
by replacing individual purchase orders with more contract
buying. Organizations can reduce ordering costs by
automating steps in the purchasing cycle and in contract
buying. An example of automation can be seen with lean.
Lean automates its ordering as much as possible, such as by
using backflushing. Lean also emphasizes drastically
reducing setup times to further reduce ordering cost.
Section D: Tracking Inventory
Through Supply Chain/Basics of
Reverse Logistics
After completing this section, students will be able to
Describe how it is determined who pays transportation
costs and insurance costs and who is responsible for
customs paperwork
Define the terms free on board and Incoterms
Describe potential uses for blockchain technology
Describe cold chains
Discuss the importance of lot control and traceability
Define reverse logistics
Describe the role that remanufacturing plays in the
manufacturing environment
Explain how an organization may use rework
Explain how organizations can reduce costs by carefully
planning reverse logistics.

This section discusses inventory moving through the supply

chain. Topic 1 covers how ownership is transferred as a
product moves through the supply chain and how inventory
is tracked as it moves. Topic 2 discusses how the
complexities of shipping products with special requirements
are addressed using special packaging and cold chain
technology. Topic 3 discusses lot control and traceability.
Topic 4 covers the basics of reverse logistics and the
associated operations that may make up reverse logistics
for an organization.

Topic 1: From Origin to

Customer
As products move through the supply chain, ownership may
change between one or more parties depending on the
shipping agreements. This, and the methods used to
actually track shipments in progress, are discussed in this
topic.

Tracking Movement and Transferring

Ownership
As a product travels through the supply chain, from supplier
to manufacturer to final customer, certain responsibilities
must be addressed. Whoever owns the product during
portions of the transportation process determines who
Pays transportation costs
 Insures the product
Is responsible for certain documentation, such as customs
declarations.

Internationally, these terms are dictated by Incoterms,

which are defined in the APICS Dictionary, 16th edition, as

a set of rules established by the International

Chamber of Commerce that provides internationally
recognized rules for the interpretation of the most
commonly used trade terms in foreign trade and is
routinely incorporated in the contracts for the sale
of goods worldwide to provide guidance to all
parties involved in the transaction.

In North America, the term used is free on board (FOB),

which is defined by the Dictionary as

the terms of sale that identify where title passes to

the buyer.

Tracking a shipment from origin to destination has been a

major challenge for supply chains, as it has historically been
manual and paper-based and could require over 50
documents. Ambiguity about where a product is in the
supply chain could contribute to the bullwhip effect, causing
downstream inventory issues.
Sensor technologies and global positioning systems (GPS)
can be useful for tracking products through the supply
chain. Sensors, such as radio frequency identification tags,
can help enable end-to-end monitoring of shipments and
equipment and can send alerts when incidents are detected.

GPS systems are typically battery-powered and cycle on and

off at set intervals to capture updated location information.
They may also record locations when sensors record an
activity, for example, when the container door opens. By
automating this location information, shipping information
can be provided to the next customer in the supply chain.
Automation also provides an additional layer of security.

In addition to sensors and GPS, technology such as

blockchain can assist with this process and simplify it.
Blockchain is described by the Dictionary as follows:

A continuously growing list of records, called blocks,

which are linked and secured using cryptography.
Each block typically contains a cryptographic hash
of the previous block, a timestamp and transaction
data. The data in any given block cannot be altered
retroactively without the alteration of all
subsequent blocks, inherently making it resistant to
modification.
When properly employed, blockchain can record the transfer
of goods throughout the supply chain. This may be
especially applicable to industries where having a record of
the origin location of a product is crucial for safety or
certification purposes.

This information can be crucial during recalls, which are

defined by the Dictionary as

a step in the reverse logistics process where parts

or products are returned due to a product defect or
potential hazard resulting from government
regulations or liability concerns.

For example, if contaminated produce is responsible for an

outbreak of foodborne illness, it is helpful to be able to track
the outbreak to specific regions or farms. By doing so and
determining where produce from the affected areas ended
up, the outbreak can be quickly and accurately addressed.

Topic 2: Special Handling

Products that are perishable or easily damaged may require
the use of special packaging or shipping technology to
maintain safe shipping conditions and to verify that shipping
conditions didn’t exceed allowable conditions.

Packaging and Cold Chain

Packaging is crucial to the successful transportation of
products through the supply chain. Fragile products or
components or those that easily suffer cosmetic damage
may require additional special handling to prevent damage
in transit.

Hazardous materials may also require special considerations

and handling. Organizations may have strict internal safety
rules for handling things such as dangerous chemicals, or
local laws and regulations may specify handling
requirements.

Additionally, perishable goods often require special

considerations throughout the supply chain. Certain
products may require humidity control to prevent rust, rot,
mold, or other issues during transportation. In addition to
humidity control, certain goods may require temperature
control. Foods and pharmaceuticals are two common
examples of perishable goods that require strict
temperature controls throughout the transit process. This is
achieved by use of a cold chain, which is defined by the
APICS Dictionary, 16th edition, as follows:

A term referring to the storage, transfer, and supply

chain of temperature-controlled products. Industries
in the cold chain include food and agriculture,
pharmaceuticals, and chemicals.

Note that a cold chain may handle many different products

featuring different temperature controls. Additionally,
despite the perishability of the items being transferred, the
cold chain does not always use the fastest mode of
transportation.

For example, pharmaceuticals may be small and lightweight

enough to be transferred via air transportation. However,
perishable food may not be able to be shipped in large
enough quantities overseas using any method other than
water transportation. Additionally, within the food category,
different products may require special handling to prevent
spoilage but at different temperatures. Some tropical fruits
may be susceptible to damage from low temperatures, while
other fruits may require low temperatures to survive the
trip. Some products may be best transported while frozen.
No matter the requirement, temperature maintenance is
crucial, as time spent above the ideal transportation
temperature may cause rapid deterioration and loss of
value. Temperature sensors to indicate if a shipment was
outside acceptable temperature ranges for the product may
be used. Due to the variability of temperature requirements,
refrigerated containers are increasingly selected over
refrigerated ships, as they can handle smaller lot sizes.

Topic 3: Lot Control

Inventory must be accurately controlled to ensure that
production activities aren’t interrupted and that the flow of
materials can be traced back through the supply chain in
the event of defective batches or safety concerns.

Inventory Control
Inventory controls are used to ensure that inventory policies
are executed correctly, in accordance with inventory
objectives and overall strategy. The APICS Dictionary, 16th
edition, defines inventory control as

the activities and techniques of maintaining the

desired levels of items, whether raw materials,
 work in process, or finished products.

Another category of inventory control relates to inventory

traceability. The Dictionary lists a few important terms
related to this concept:

Traceability: 1) The attribute allowing the ongoing

location of a shipment to be determined. 2) The
registering and tracking of parts, processes, and
materials used in production, by lot or serial
number.

Lot control: A set of procedures (e.g., assigning

unique batch numbers and tracking each batch)
used to maintain lot integrity from raw materials
from the supplier through manufacturing to
consumers.

The control point for inventory levels per location is the

reorder point. Ordering at the right time and in the right
quantities keeps inventory levels in accord with policy; using
the wrong ordering system or just guessing usually results
in inventories that are too high or too low. Two aggregate-
level decisions related to inventory control need to be
determined before two other item-level controls can be
properly applied. The high-level decisions include
The importance of the inventory item to the organization
 The level of control that is necessary.

These decisions can be made in many ways, but one way is

ABC inventory control, which develops three categories—A,
B, and C—with A being the highest priority and C being the
lowest. Once inventory is categorized by its importance and
need for control, organizations group various SKUs
(stockkeeping units) into each category and specify which
stockkeeping location controls to use. These controls specify
how much and when to order.

Topic 4: Reverse Logistics

This topic discusses reverse logistics and associated
operations, including remanufacture, rework, reuse, and
recycling.

Reverse Logistics Processes

The APICS Dictionary, 16th edition, defines reverse
logistics as

a complete supply chain dedicated to the reverse

flow of products and materials for the purpose of
returns, repair, remanufacture, and/or recycling.
The reverse logistics process can be initiated by the
ultimate customer or by a supply chain partner, such as a
distribution center returning seasonal goods that did not sell
(if allowed by contract) or products that were defective or
damaged. The definition states many of the reasons why
products might flow upstream. These may result in asset
recovery, or the return of products to the manufacturer.
Organizations may require returns to be authorized using a
process with particular rules based on avoiding return costs
while maintaining a desired level of customer service.
Liberal returns policies can increase sales, but reverse
logistics costs can also be significant. In some cases, the
goods can be resold, but they may need new packaging or
repairs.

Repairs may also require authorization, and who pays for

shipping should be specified. Remanufacture involves
buying back used goods or offering a discount on a new
purchase. The Dictionary defines remanufacturing as
follows:

1) An industrial process in which worn-out products

are restored to like-new condition. In contrast, a
repaired product normally retains its identity, and
only those parts that have failed or are badly worn
 are replaced or serviced. 2) The manufacturing
environment where worn-out products are restored
to like-new condition.

The used goods are reprocessed with some new

components and sold as remanufactured products. For
example, Caterpillar does this for industrial vehicles.

There is a similar process known as rework, which the

Dictionary defines as “reprocessing to salvage a defective
item or part.”

Reuse consists of using scrap or byproducts from one

process in another process. For example, packaging from
incoming materials may be reused to package outgoing
products, or leftover waste material from the production of
large components can be used to manufacture other smaller
components.

Reverse logistics is part of green logistics when

manufacturers use the process to take back dangerous
materials or to reduce waste. The Dictionary defines green
reverse logistics as

the responsibility of the supplier to dispose of

packaging materials or environmentally sensitive
materials such as heavy metals.
Recycling can be done to recover rare or dangerous
materials. It includes mandatory programs such as the
European Union’s laws requiring manufacturers to take back
certain electronics at no cost to the consumer. Reverse
logistics can also be used to return reusable packaging. This
industrial packaging can take the form of stackable bins and
so on that the manufacturer can use for future deliveries.

Reverse logistics is a significant cost for organizations, in

part because returns come from many places but in
relatively small amounts compared to the forward supply
chain. The assortment is irregular, so there are relatively
high transportation and materials-handling costs to return
the items to inventory, recover useful components, or
recycle them. Reverse logistics is therefore a significant
expense that can reduce profits unless proactively planned
and managed as its own supply chain separate from the
forward supply chain. Many organizations simply sell all
returned goods to third parties and/or outsource the reverse
supply chain to organizations that have this as a core
competency.
Section E: Inventory Accuracy
Audits/Addressing Inventory Loss
After completing this section, students will be able to
Define physical inventory and inventory accuracy
Describe the purpose of the periodic inventory audit
Explain the process of cycle counting
List the various sources of inventory loss
Explain how organizations may attempt to prevent or
minimize inventory loss
Describe the danger posed by incomplete enforcement
and exceptions.

Topic 1 discusses physical inventory, inventory accuracy,

and the two main processes for auditing inventory records:
periodic inventory audits and cycle counting. Topic 2 starts
with a brief discussion of the common sources of inventory
loss that companies may face, including shrinkage, scrap,
shelf life, theft, damage, and obsolescence. Topic 3 looks at
how an organization may attempt to address and prevent
losses due to these common issues.
Topic 1: Physical Inventory and
Inventory Accuracy
This topic looks at physical inventory and how it is routinely
audited to ensure that it remains accurately recorded.

Physical Inventory
Inventory records and physical inventory levels are not
always the same. The APICS Dictionary, 16th edition,
defines the following relevant terms:

Physical inventory: 1) The actual inventory itself.

2) The determination of inventory quantity by
actual count. Physical inventories can be taken on a
continuous, periodic, or annual basis.

Inventory accuracy: When the on-hand quantity

is within an allowed tolerance of the recorded
balance. This important metric usually is measured
as the percent of items with inventory levels that
fall within tolerance. Target values usually are 95
percent to 99 percent, depending on the value of
the item. For logistical operations (location
management) purposes, it is sometimes measured
as the number of storage locations with errors
divided by the total number of storage locations.
Inventory can become inaccurate due to shrinkage or errors.

Errors include failing to log an inventory movement,

misplacing inventory so it cannot be found, or entering the
wrong information into the inventory management system,
such as the wrong quantities or the wrong inventory
number. In general, this type of record accuracy issue can
affect many other areas of production and inventory control.
The Dictionary defines record accuracy as

a measure of the conformity of recorded values in a

bookkeeping system to the actual values; for
example, the on-hand balance of an item
maintained in a computer record relative to the
actual on-hand balance of the items in the
stockroom.

Regardless of the reason, poor inventory records result in

incorrect financial valuations for financial statement
reporting as well as a higher chance of a stockout, since
inventory that should be present may not be. This can lead
to expensive consequences such as plant shutdowns in
addition to harming customer service.

Two primary methods exist for auditing inventory records:

the older periodic inventory audit method and cycle
counting.

Periodic Inventory Audit

In the not-too-distant past, there was only one way to
determine if inventory levels were accurate: shutting down
the plant and stopping everything at the end of the year,
and enlisting every employee in counting every item of
inventory to determine actual inventory levels. This is called
periodic inventory. The APICS Dictionary, 16th edition,
defines periodic inventory as

a physical inventory taken at some recurring

interval (e.g., monthly, quarterly, or annual physical
inventory).

The primary purpose of a periodic inventory audit is to

provide the value of assets for financial accounting, and
external auditors may direct the process. Thus the objective
is to determine the total asset value in dollars as accurately
as possible. This primarily benefits the owners or
shareholders, but a side purpose can be to correct inventory
records. However, as the audit is usually done only once a
year, any improvement in inventory accuracy will tend to be
short-lived. Also, finding the root causes of the inventory
inaccuracies is not the focus. The focus is usually getting
the job done as accurately and as quickly as possible to
enable production to resume.

Periodic inventory is problematic, because the persons

doing it may not be well trained and thus could be prone to
making errors, meaning that the inventory may not be
completely accurate even after the count. Periodic inventory
also typically requires an expensive halt in production as
well as labor costs and the costs of administrative
accounting.

When periodic inventory is used, it requires good

preparation, such as by gathering identical parts in the
same place and, if possible, grouping them into easily
counted bundles or sealed cartons. Preparation may also
entail staff with experience in inventory control clearly
tagging all parts with their part numbers prior to the count.
Participants then need to be given training to reduce
chances for errors, and this should be repeated before each
inventory audit, since it will typically have been at least a
year since the last time they helped.

Usually the process of periodic counting involves counting

each inventory of items at least twice and recording the
count each time. In some cases, sampling is used because
there are too many items to count. When the counts agree,
and when they agree with the inventory records, this
inventory is not counted again. Wherever discrepancies
exist between the two counts or there are differences from
the inventory record, the inventories get closer scrutiny. The
inventory records are then adjusted to show the actual
levels. The Dictionary defines inventory adjustment as
follows:

A change made to an inventory record to correct

the balance in order to bring it in line with actual
physical inventory balances. The adjustment either
increases or decreases the item record on-hand
balance.

Cycle Counting
The APICS Dictionary, 16th edition, defines cycle counting
as follows:

An inventory accuracy audit technique where

inventory is counted on a cyclic schedule rather
than once a year. A cycle inventory count is usually
taken on a regular, defined basis (often more
frequently for high-value or fast-moving items and
less frequently for low-value or slow-moving items).
Most effective cycle counting systems require the
 counting of a certain number of items every
workday with each item counted at a prescribed
frequency. The key purpose of cycle counting is to
identify items in error, thus triggering research,
identification, and elimination of the cause of the
errors.

Cycle counting has a different focus than periodic inventory.

Ensuring ongoing part count accuracy for material
requirements planning (MRP) is the main reason cycle
counting is a value-added service for manufacturing
planning and control. While periodic counting works to
determine total asset value in dollars, overvaluation in one
place might cancel out undervaluation in another and thus
still be accurate valuation in the aggregate, but the item-
level inaccuracies would create problems in MRP and
manufacturing execution. Therefore, the objective of cycle
counting is to ensure ongoing inventory accuracy at the
item level, both by counting more often and by reducing the
frequency of errors occurring in the first place.

Cycle counting is a continuous process performed by

dedicated, trained staff whose job is to count small amounts
of inventory each workday. Which items to count when is
directed by policy, item importance, and timing issues such
as least disruption to production or counting when counting
is fastest and most efficient. Cycle counters are trained not
only to avoid counting errors but also to look for root causes
of errors and suggest process improvements or technology
improvements.

ABC inventory classification is often used to determine how

often to count each type of inventory. A items will be
counted the most times each year, B items will be counted
less frequently, and C items the least frequently. Items with
high street value or that otherwise are prone to shrinkage
might be raised to the higher categories even if they do not
otherwise qualify for those levels. Note how the definition
mentions that fast- or slow-moving items may be criteria for
what to count rather than just ranking by value. Counting
fast-moving items more often will help keep inventory levels
more accurate. Exhibit 5-19 shows how a cycle count
schedule might be scheduled based on ABC classifications.
 Exhibit 5-19: Cycle Counting

In the exhibit, the number of items (unique part numbers) to

count times the annual frequency is the number of counts
per year. The number of counts per year divided by the sum
of all counts (in this case, 22,600) provides the percentage
of total counts. The number of counts per year divided by
the number of manufacturing calendar days in the year
provides the daily amount of each class to count.

Cycle counting can often be performed without stopping

production much or at all. This is accomplished by having
cycle counting staff coordinate with production planners to
determine what types of inventory will not be accessed on
particular days. Cycle counters can also reduce the amount
of work that needs to be done—and thus the cost of
counting—by selecting bins to count when they are at or
near zero inventory, which will often be after an order is
placed but not yet received. (Doing so will also prioritize
fast-moving inventory.) A similar method is to perform a
count when inventory is received, since staff are already
heading to the stockkeeping location to deliver the new
inventory. Finally, stock is counted when there are obvious
errors such as negative inventory levels or inventory levels
are lower than records indicate.

Cycle counting’s use of dedicated staff with formal

processes tends to produce a high degree of inventory
accuracy. Often cycle counting provides external or internal
auditors with enough confidence that inventory levels are
accurate, meaning that they may omit the periodic audit
entirely.

Topic 2: Inventory Loss

Inventory loss typically arises from shrinkage, scrap, shelf
life issues, obsolescence, theft and damage.

Sources of Inventory Loss

The APICS Dictionary, 16th edition, defines several sources
of inventory loss as follows:

Shrinkage: Reductions of actual quantities of items

in stock, in process, or in transit. The loss may be
 caused by scrap, theft, deterioration, evaporation,
and so forth.

Scrap: Material outside of specifications and

possessing characteristics that make rework
impractical.

Shelf life: The amount of time an item may be

held in inventory before it becomes unusable.

Obsolescence: 1) The condition of being out of

date. A loss of value occasioned by new
developments that place the older property at a
competitive disadvantage. A factor in depreciation.
2) A decrease in the value of an asset brought
about by the development of new and more
economical methods, processes, or machinery. 3)
The loss of usefulness or worth of a product or
facility as a result of the appearance of better or
more economical products, methods, or facilities.

Along with theft and damage, these are the main sources of
inventory loss in an organization. Note that shrinkage can
be used as an umbrella term that covers many sources of
inventory loss.

Each of these sources of loss may affect different supply

chains with varying severity. For example, an organization
that produces dairy products is likely to deal with more
significant losses to shelf life than an automobile
manufacturer does. Conversely, obsolescence would be
more likely to be a significant loss source for an automobile
manufacturer if it relies on specialized equipment that
cannot handle significant design changes from model year
to model year.

Topic 3: Strategies to Mitigate

Losses
Organizations have a wide range of tools available to them
to mitigate inventory losses, which may be selected based
on the specific needs of the organization.

Company Policy and Mitigation

Inventory loss due to shelf life issues, obsolescence, or
unintentional damage may be addressed through a variety
of methods, including
Setting proper manufacturing strategies and inventory
levels and working to improve inventory turns to prevent
obsolescence
 Choosing more protective product packaging and
smoother transportation modes where possible to prevent
unintentional damage
Selecting more rapid modes of transportation and taking
advantage of things such as cold chain shipping to
prevent loss due to shelf life issues.

Ensuring that inventory levels are accurate through regular

audit procedures and at key points in the supply chain can
help identify discrepancies caused by theft and other
sources of loss or damage before they can cause
unnecessary financial harm. Some emerging technologies
such as blockchain can help isolate sources of loss to
particular interactions between a supply chain participant
and the product.

Loss of goods due to theft or intentional damage can be

mitigated by insurance, but insurance cannot immediately
replace inventory, nor will it fully reimburse a loss if there is
a deductible. Proper security and handling procedures can
reduce the occurrence of internal and external threats to
inventory loss. Many of these procedures involve setting
and enforcing proper operational and financial controls. One
example of a key control is segregation of duties. For
example, a warehouse employee should not be able to
approve a material move and also carry out the move.
Matching of invoice to purchase order and receiving
documents is another control.

Incomplete enforcement or special exceptions for controls

can cause problems. For example, one organization had a
rule that prohibited unauthorized vehicles from parking in
the warehouse yard. An exception was made for one
employee, and one night after work he discovered a
package taped to the underside of his bumper. He informed
security and they left the package in place, eventually
discovering a ring of warehouse employees engaging in
theft. While the employee with the vehicle was trustworthy,
the exception to the control had been costly to the
organization.
Section F: Planning and Managing
Distribution Inventory
After completing this section, students will be able to
Describe how warehousing and transportation function as
a distribution network
Differentiate between private, public, and contract carriers
Select the best mode of transportation for a given set of
product characteristics and requirements
List the pros and cons for each type of transportation
mode
Explain warehousing processes and activities
Describe warehousing objectives.

This section examines how inventory is distributed

throughout the supply chain, looking at distribution
inventory planning systems, warehousing, and
transportation.

Topic 1: Distribution Inventory

Distribution inventory is an issue in make-to-stock
environments, and who decides how it is replenished is the
subject of this topic. These decisions involve issues of
autonomy versus control versus system integration and so
usually require negotiation among partners.

Objectives of Distribution Inventory

Planning Systems
The objectives of distribution inventory planning systems
include providing the targeted level of customer service at
the lowest cost and with the smoothest interaction between
supply chain partners (e.g., factories or distribution
centers).

Here the customer service objective is to meet customer

service targets or fill rates at each stockkeeping location.
Distribution networks often have a central supply DC
(distribution center) that in turn provides inventory to a set
of regional DCs, but the regional DCs may vary which
inventory items they hold based on demand patterns,
ordering other items only on demand.

The major costs to minimize include transportation and

carrying costs (which include materials-handling and other
warehouse costs). Efficient transactions with suppliers can
also reduce costs (including stockout costs), so part of this
objective is to minimize scheduling problems, such as by
communicating the reasons for larger or smaller orders than
normal (e.g., to increase safety stock, due to excess
inventory) rather than keeping the factory guessing.

Two major controllable costs for distribution inventory

planning are materials handling and inventory turnover.
Finding ways to reduce the number of times materials need
to be handled reduces carrying cost. Similarly, moving
materials more quickly to their destinations makes for faster
turnover. One example of a way to do both is cross-docking,
where the DC unloads unit loads from various suppliers and
sorts them immediately into assortments for other DCs or
other types of downstream customers. This minimizes
materials handling, since the units skip the handling to put
the materials into inventory and later to pick them from
inventory. It increases turnover because the units are not
sitting in inventory for a duration of time.

Topic 2: Distribution Networks

and Warehousing
The distribution network consists of all warehouses used to
move inventory through the supply chain.
Distribution Network Structure
Distribution network structure is defined in the APICS
Dictionary, 16th edition, as follows:

The planned channels of inventory disbursement

from one or more sources to field warehouses and
ultimately to the customer. There may be one or
more levels in the disbursement system.

This structure may exist as any combination of

manufacturing facilities, warehouses, and/or retail locations,
connected by transportation that carries inventory from
location to location.

Transportation and Warehousing

To understand how transportation and warehousing work
together to minimize distribution costs, we need to first look
at shipping patterns and shipping costs.

Shipping Patterns
Exhibit 5-20 shows how shipping patterns have distinct legs
regardless of the shipping mode used. Local delivery is from
a shipper (seller) to a local terminal, then there is a long
line-haul leg to another terminal, and this is followed by a
final local delivery leg from the terminal to the consignee
(buyer). Line haul refers to the main portion of the trip,
while the other portions are called local delivery or pickup
and delivery.

Exhibit 5-20: Shipping Patterns

The APICS Dictionary, 16th edition, defines terminals as

follows:

In transportation, locations where carriers load and

unload goods to and from vehicles. Also used to
make connections between local pickup and
delivery service and line-haul service. Functions
performed in terminals include weighing
connections with other routes and carriers, vehicle
 routing, dispatching, maintenance, paperwork, and
administration. Terminals may be owned and
operated by the carrier or the public.

A terminal might be a shipping port, a truck terminal, a rail

terminal, an airport, or a pipeline terminal, depending on
the line-haul mode.

Another shipping pattern is a single trip from the shipper to

the consignee. In this pattern, there is only a line haul, with
materials handling at each end. Yet another pattern is called
a milk run, where mixed loads may be picked up from
several suppliers.

Shipping patterns help define shipping costs and carrier

rates.

Shipping Costs and Carrier Rates

There are four basic types of shipping costs:

Line-haul costs. The Dictionary defines line-haul costs

as follows:

Basic costs of carrier operation to move a

container of freight, including drivers’ wages and
usage depreciation. These vary with the cost per
 mile, the distance shipped, and the weight
moved.

Line-haul costs are costs for the main portion of the

transportation journey. Usage depreciation refers to
charges for vehicle wear and tear. Total line-haul costs,
which the Dictionary defines in part as costs that “vary
with the distance shipped and the cost per mile,” are
treated as variable costs because distance is the primary
factor involved. (Transport mode is also a factor, because
it impacts the cost per mile or kilometer.) Total line-haul
costs do not depend primarily on weight. Vehicle weight is
usually the majority of the total weight, so an empty
vehicle will bear most of the same costs as a full one.

Pickup and delivery costs. The Dictionary defines

pickup and delivery costs as follows:

Carrier charges for each shipment pickup and the

weight of that shipment. Costs can be reduced if
several smaller shipments are consolidated and
picked up in one trip.

These are costs for local pickup at the shipper for delivery
to the terminal or for pickup from a terminal for delivery to
a consignee. The costs depend primarily on the weight of
the pickup and the number of pickups rather than the
distance, meaning that the time spent on the task is more
of a cost factor than the distance. Pickup and delivery
costs are usually treated as fixed costs in cost analyses. If
one consolidated pickup can be made instead of two, this
reduces costs. Similarly, if weight can be reduced (e.g.,
shipping cola syrup rather than cola with water added),
this will reduce costs.

Terminal-handling charges. The Dictionary defines

terminal-handling charges as follows:

1) Carrier charges dependent on the number of

times a shipment must be loaded, handled, and
unloaded. Cost can be reduced by consolidating
shipments into fewer parcels or by shipping in
truckload quantities. 2) For shipping lines, the
costs of paying container terminals for unloading
and loading during shipment. These costs are
borne by the shipping lines at the port of
shipment or destination.

These are fees charged by the terminal for materials

handling, inspections, and possibly customs. They are also
fixed costs, and they depend on the number of times
materials are handled, including loading and unloading.
 Full loads can often be handled by large equipment (e.g.,
a crane for containers), while partial loads usually need to
be unloaded and consolidated with other loads. Since
rates are based on handling, any form of consolidation will
reduce costs (e.g., shipping only full pallets). The use of
bar codes or other automated identification methods (e.g.,
radio frequency identification, or RFID) also reduces costs.

Billing and collecting costs. These are the fixed

administrative costs related to paying for the services
described above. Fewer shipments or fewer pickups and
deliveries will reduce these costs (similar to ordering
costs).

Shipping costs are heavily dependent on carrier rates.

Carriers—organizations that provide transportation services
—may be subject to price regulation in a particular country,
but transportation has been deregulated for the most part
(other than for safety regulations). Carriers have two basic
rate structures, one for full loads and another for partial
loads. The full load rate is usually called a truckload (TL)
rate, but similar terms exist for other modes of transport,
such as carload for rail or containerload for water. The
partial load rate is usually called less-than-truckload (LTL),
and, likewise, there are related terms like less-than-carload
or less-than-containerload. Due to additional pickup and
delivery, terminal handling, other materials handling, and
billing and collection costs related to LTL, the rates for this
service are much higher than for TL shipments. Therefore,
shipping by TL is much less expensive, not only because the
rates are less but also because there will be fewer total
loads to transport.

One tradeoff of using TL shipping is that it creates lot-size

inventory (cycle stock), and this will increase overall
carrying costs. This tradeoff may or may not overtake the
other cost savings from using TL shipments, since the
carrying cost rate would need to be fairly high to do so, but
it could be a factor to consider in total cost analysis.

In addition to rates charged based on TL and LTL, carriers

charge different rates based on what is being shipped and
how it is packaged. Here are some factors that influence
these rates:
Hazardous materials cost more and may require
specialized vehicles and certified handlers.
Perishable, frozen, and refrigerated goods may require
special vehicles and handling equipment.
 High-value goods have premium charges for providing
security and to compensate for the carrier’s increased
liability related to damages.
Goods that are susceptible to damage cost more, but the
quality of packaging can reduce these risks and thus also
the charges.
Goods that are packaged for easy handling (e.g., on
pallets) have lower rates than items that need more
handling or specialized handling equipment.

There is also a relationship between density and volume.

Less dense goods will fill the available volume faster and
less can be shipped, so carrier rates are higher. Dense
goods cost relatively less to ship—except when they are so
dense that a vehicle weight limit is reached before the
volume is maximized. Reducing transportation costs
involves working to fill a vehicle’s payload to the maximum
amount for each trip. Generally this means maximizing the
weight being shipped, which will in turn reduce the per-unit
or per-weight line-haul costs. This works well up to the
vehicle’s weight limit. Other goods that cannot reach this
weight limit will work instead to maximize the volume of the
payload used (e.g., stacking higher).
There may also be fees charged for backhauling to less
frequented locations, but these might be avoided if the
carrier can find a way to transport a full or partial load
rather than an empty backhaul. The Dictionary defines
backhauling as follows. (Note that the definition refers to a
U.S. law deregulating how backhauling can occur.)

The process of a transportation vehicle returning

from the original destination point to the point of
origin. The 1980 Motor Carrier Act deregulated
interstate commercial trucking and thereby allowed
carriers to contract for the return trip. The backhaul
can be with a full, partial, or empty load. An empty
backhaul is called deadheading.

Finally, carriers may charge fees or premiums for expediting

(requesting faster or more direct delivery than originally
promised) or for delays.

How Warehousing Can Reduce Transportation

Costs
Based on these costs, and, in particular, on the difference
between TL and LTL costs, warehousing can play a value-
added role in reducing transportation costs. However,
warehouses cost money. This includes the cost of the facility
and its equipment and the cost of labor for materials
handling. The cost savings from using warehouses therefore
need to be higher than the cost of the warehouse. One
example of how warehouses can add value is by allowing
multiple LTL shipments to be combined into fewer TL
shipments for the line-haul part of a trip and then using the
distribution center (DC) to split these loads into local
deliveries to customers. Exhibit 5-21 illustrates this
difference.

Exhibit 5-21: Warehousing Adds Value by Enabling TL for

Line Hauls

In the initial scenario, orders are shipped directly to

customers (e.g., retailers) using separate LTL shipments. In
the second scenario, the shipments are combined into a
single TL shipment to a DC in the local area of the same
customers. The DC splits the loads into local deliveries,
which is called break-bulk. The Dictionary defines break-
bulk as follows:

1) Dividing truckloads, railcars, or containers of

homogeneous items into smaller, more appropriate
quantities for use. 2) A distribution center that
specializes in break-bulk activities. 3) Unitized
cargo in bales, boxes, or crates that is placed
directly in a ship's holds rather than in containers.

If the cost of the transportation and warehousing services

involved in the second scenario is less than the cost in the
first scenario, then the DC is adding value. DCs provide
many similar value-added services, such as consolidation of
LTLs from various suppliers into TLs prior to the line haul.
The Dictionary defines freight consolidation as follows:

The grouping of shipments to obtain reduced costs

or improved utilization of the transportation
function. Consolidation can occur by market area
grouping, grouping according to scheduled
deliveries, or using third-party pooling services such
as public warehouses and freight forwarders.
When freight consolidation is performed at a DC that
supplies to retailers or at a fulfillment center (a type of DC
used for fulfilling direct online orders to consumers), it is
sometimes called product mixing. This provides the same
general benefit of reducing the number of individual orders
the customer needs to place with different suppliers.

Analyses of whether to use DCs are often made for all

shipments on an annual basis. Let’s look at an example in
which the cost of each alternative is calculated and the
least-cost method is chosen. Assume that the annual
shipping volume is 40,000 tons, the cost of LTL direct to
customers is $100 per ton, the cost of TL shipments to the
DC is $50 per ton, the cost of local delivery is $10 per ton,
and the DC’s inventory carrying cost is $12 per ton. Exhibit
5-22 shows the results of these calculations of tons times
the cost per ton.
 Exhibit 5-22: Comparing LTL Direct to TL with DC Costs

In this case, the DC with full truckload line hauls saves $28
dollars per ton, or $1.1 million at 40,000 tons.

Note that these analyses might differentiate between fixed

and variable cost components for DCs. (For example, the
capital costs of the facility and the equipment are fixed
costs.) This results in a type of break-even analysis. Above a
particular shipping volume, it will be advantageous to use a
DC. Below that break-even point, it is better to ship directly.

Warehousing
The APICS Dictionary, 16th edition, defines warehousing
as

the activities related to receiving, storing, and

shipping materials to and from production or
distribution locations.
Warehouses are often called distribution centers to
emphasize their need to add value and keep inventory
turning over rather than storing goods indefinitely. The
Dictionary defines distribution center (DC) as follows:

Typically a finished goods warehouse designed for

demand-driven rapid distribution to retailers (retail
distribution centers), wholesalers, or direct
shipments to customers (order fulfillment centers).
Cross-docking warehouses are another type of
distribution center.

A related term, distribution warehouse, is defined in the

Dictionary as follows:

A facility where goods are received in large-volume

uniform lots, stored briefly, and then broken down
into smaller orders of different items required by
the customer. Emphasis is on expeditious
movement and handling.

Warehouses can have a value-added effect by reducing the

total cost of transportation. Organizations also need to
decide on the best number of warehouses and their
locations. Having more warehouses will lower some costs
while raising others and can increase customer service by
reducing lead times.
Warehousing Objectives
A key objective of warehousing is to add value to the supply
chain. Adding value can include reducing total costs
compared to transportation without warehousing, reducing
delivery lead times to customers, improving delivery
reliability, or providing other value-added services. Value-
added warehousing services include break-bulking, freight
consolidation, and cross-docking.

One way warehousing provides this value at an acceptable

cost is by maximizing materials-handling efficiency. The
APICS Dictionary, 16th edition, defines materials handling
as follows:

Movement and storage of goods inside the

distribution center. This represents a capital cost
and is balanced against the operating costs of the
facility.

Warehousing also needs to facilitate throughput and

maximize inventory turnover. Finally, it needs to keep goods
secure and safe from damage. One way distribution centers
(DCs) simultaneously minimize materials-handling costs and
risk to goods is to handle each item as little as possible. This
might be accomplished using unitization, which generates
unit loads both for warehousing and transportation. The
Dictionary defines these terms as follows:

Unitization: In warehousing, the consolidation of

several units into larger units for fewer handlings.

Unit load: A shipping unit made up of a number of

items; bulky material arranged or constrained so
the mass can be picked up or moved as a single
unit. Reduces material handling costs. Often shrink-
packed on a pallet before shipment.

Unit loads can include cases, sheets, racks, pallets, and

even shipping containers. The load can then be easily
handled by the proper materials-handling equipment, such
as a forklift for pallets.

Warehousing Processes and Activities

Exhibit 5-23 provides a flowchart of some of the processes
and activities that may be performed in a warehouse.
Starting at the top, the enterprise resources planning (ERP)
system may include an order management system, a
warehouse management system (WMS), and a
transportation management system (TMS); these could also
be separate systems. Order management is used to enter
and manage customer orders. The warehouse may interface
with suppliers’ order management systems as orders are
placed, and, on the outbound side, the warehouse may
process orders for outbound customers. A WMS manages
and controls materials handling within a warehouse; a TMS
helps schedule transportation and control transportation
costs. Together, these systems form the inputs, processes,
and outputs from a transactional and control perspective.
An example of control is when a WMS requires one person to
authorize a material move and a different person to perform
the move, as a way to prevent fraud.

Exhibit 5-23: Warehousing Processes and Activities

When products are physically received at the warehouse
docks, they may take one of three basic paths: cross-
docking, flow-through, or conventional. Some warehouses
will use only one of these paths; others will perform two or
more.

The fastest path is cross-docking, and often this is done at

specialized distribution centers (DCs) designed for just this
task. The APICS Dictionary, 16th edition, defines cross-
docking as follows:

The concept of packing products on incoming

shipments so they can be easily sorted at
intermediate warehouses or for outgoing shipments
based on final destination. The items are carried
from the incoming vehicle docking point to the
outgoing vehicle docking point without being stored
in inventory at the warehouse. Cross-docking
reduces inventory investment and storage space
requirements.

Cross-docking unloads full truckloads from various suppliers,

brings them to a staging area, and immediately loads
different assortments on trucks at the shipping area. For
example, one truck may contain all lawn mowers from one
company, another will have all garden tools, and so on. The
outgoing vehicles will get an assortment of the various
products, such as an order for a retail store.

Flow-through also emphasizes throughput, but it involves

using some or all of a shipment to immediately replenish a
picking area. A picking area is where palletized goods are
broken down into individual cases or units for picking
(defined below).

Conventional storage involves placing the goods into

storage areas, which might be tiers of storage racks for
pallets or bulk storage areas for items such as grain or
gravel.

The following are some of the important activities performed

in a warehouse:

Receiving. The Dictionary defines receiving as

the function encompassing the physical receipt of

material, the inspection of the shipment for
conformance with the purchase order (quantity
and damage), the identification and delivery to
destination, and the preparation of receiving
reports.
Receiving may also involve preparation for put-away or
moving pallets to staging for cross-docking.

Put-away. Put-away involves moving goods to picking or

storage areas as directed by the WMS and recording the
completion of the move and the storage location.

Storage. Activities performed on goods in storage include

physical security, inventory accuracy auditing such as
cycle counting, and authorized relocations.

Order picking. The Dictionary defines order picking as

selecting or “picking” the required quantity of

specific products for movement to a packaging
area (usually in response to one or more shipping
orders) and documenting that the material was
moved from one location to shipping.

Picking is usually authorized and directed by a WMS,

which will often indicate the route to use to maximize
picking efficiency. Automation may also be used, for
example, Amazon uses robots to bring the goods to the
picker. Specific picking methods are discussed more later.

Packaging. Packaging includes adding industrial

packaging to protect shipments from damage. It may
involve placing individual units into containers or boxes,
palletizing and shrink-wrapping orders, and forming other
unit loads.

Post-manufacturing services. Postponement and other

delayed manufacturing strategies may require light
manufacturing to assemble-to-order or other delayed
differentiation, such as adding the power supply,
documentation, and packaging for a given country.

Staging (marshalling). Staging, or marshalling, involves

assembling individual orders, which may include
rearranging pallets or other unit loads; generating pallets,
cartons, or other unit loads from individual items;
checking orders for completeness; rectifying omissions or
errors; and recording backorders or other variances in
both shipping documents and system records.

Shipping. Shipping involves verifying orders, preparing

bills of lading and other documents, and loading outgoing
vehicles in the proper sequence as directed by the WMS
or TMS. (Vehicles may be traveling to more than one
destination and need to be unloaded in the right order.)
Since picking can be labor-intensive and thus expensive, the
methods used can impact warehouse costs.

Picking Methods
The Dictionary defines many varieties of order picking,
including the following:

Discrete order picking: A method of picking

orders in which the items on one order are picked
before the next order is picked.

Batch picking: A method of picking orders in

which order requirements are aggregated by
product across orders to reduce movement to and
from product locations. The aggregated quantities
of each product are then transported to a common
area where the individual orders are constructed.

Wave picking: A method of selecting and

sequencing picking lists or items to minimize the
waiting time of the delivered material. Shipping
orders may be picked in waves combined by
common carrier or destination, and manufacturing
orders in waves related to work centers.

A fourth type is zone picking. The Dictionary defines zone in

part and zone picking as follows:
 Zone: The specific warehouse location assigned to
an order picker. In picking items for an order, the
stock picker gets only the items for each order that
are within his/her zone. The picker then fills the
next order for items from his/her zone.

Zone picking: A method of subdividing a picking

list by areas within a storeroom for more efficient
and rapid order picking. A zone-picked order must
be grouped to a single location before delivery or
must be delivered to different locations such as
work centers.

Order pickers will be supplied with a picking list, which the

Dictionary defines as “a document that lists the material to
be picked for manufacturing or shipping orders.” This list
could be printed or exist electronically and be read from a
handheld or wearable reader, or it could take the form of
voice-prompted directions.

Inventory Location Systems

When warehouse put-away into storage is required, two
ways to place inventory in the warehouse include fixed- and
random-location systems. In addition, there is a hybrid
method called zone. The APICS Dictionary, 16th edition,
defines these terms in part as follows:
 Fixed-location storage: A method of storage in
which a relatively permanent location is assigned
for the storage of each item in a storeroom or
warehouse. Although more space is needed to store
parts than in a random-location storage system,
fixed locations become familiar, and therefore a
locator file may not be needed.

Random-location storage: A storage technique in

which parts are placed in any space that is empty
when they arrive at the storeroom. Although this
random method requires the use of a locator file to
identify part locations, it often requires less storage
space than a fixed-location storage method.

Zone: A warehouse location methodology that

includes some of the characteristics of fixed and
random location methods. Zone locations hold
certain kinds of items, depending on physical
characteristics or frequency of use.

Fixed-location storage increases the required inventory

storage space. When inventory is received, it will require a
certain maximum designated amount of space, but, since
average inventory is half of a fixed quantity order plus
safety stock, about 50 percent of the time (or a little less,
given safety stock) about half of the inventory storage
locations will be empty and cannot be used to store other
things due to the fixed nature of the locations. The fixed-
location storage method is less popular, due to the high cost
of warehouse space in general and the wide availability and
use of WMS systems that can manage random-location
storage.

Random-location storage (also known as floating-location

storage) maximizes cube utilization, meaning that it
maximizes the use of warehouse space in three dimensions
(since vertical storage racks can be used) by assigning
goods to any available empty location. When inventory is
stored on pallets, cube utilization is calculated by
determining the necessary number of pallet positions. The
Dictionary defines pallet positions as follows:

A calculation that determines the space needed for

the number of pallets for inventory storage or
transportation based on a standard pallet size.
Pallet dimensions vary around the globe, but are
typically a constant in regional markets. The term is
frequently used to quote storage and transportation
rates.

The WMS will track where the inventory is located and will
direct pickers to these locations. A variety of sophisticated
methods exist to efficiently direct pickers to locations that
would otherwise not be easy to determine. Automated
storage and retrieval systems also exist. The Dictionary
defines the following two methods that are often used to
speed inventory identification and thus make materials
handling more efficient and less error-prone:

Bar code: A series of alternating bars and spaces

printed or stamped on parts, containers, labels, or
other media, representing encoded information that
can be read by electronic readers. A bar code is
used to facilitate timely and accurate input of data
to a computer system.

Radio frequency identification (RFID): A system

using electronic tags to store data about items.
Accessing or retrieving this data is accomplished
through a specific radio frequency and does not
require close proximity or line-of-sight access.

The zone method, also called zone random, establishes

zones for categories of items but allows for random storage
in that zone. An advantage over a pure random system is
that if an item is misplaced, only the zone needs to be
searched rather than the whole warehouse. The random
component of this method still provides most of the benefits
of cube utilization.
Exhibit 5-24 summarizes some pros and cons of each
method.

Exhibit 5-24: Pros and Cons of Storage Methods

Location Pros Cons

System

Fixed-location Minimal record On average, 50

system
keeping percent of cube
Low information space not utilized
system (IS) cost Higher carrying
Easy put- costs
away/picking Poor choice if
Good for small or space is at a
simple premium
warehouses
Random- Maximizes cube May require
location system
utilization and investment in IS
efficiency and put-
Good for large or away/picking
complex technology
warehouses IS accuracy is
vital
Zone Good cube May still require
utilization good and
Easier inventory accurate IS
error correction
Public versus Private Warehousing
Warehouses can be owned and operated in different ways to
suit different strategies.

Organizations can own or lease their own warehouses,

which are called private warehouses, but sufficient volume
is required to make this a cost-effective alternative.
Manufacturing organizations will often use private
warehousing for their raw materials and finished goods at
the plant. These warehouses should be sized appropriately
for the volumes they store and the storage method
selected.

Public warehousing involves third parties offering warehouse

space to the public. This might be warehouse space offered
on a first-come, first-served basis or dedicated space
arranged through a contract. Public warehousing may be
used, for example, to allow an organization to focus on its
core competencies, to provide a fast solution to warehouse
undercapacity (e.g., such as for a fast-growing product), to
test entry into a new market, to serve as a regional
warehouse, or to allow for seasonal inventory accumulation.
The advantages of public warehouses include that they are
flexible and the space used can be increased or decreased
in size easily. A disadvantage may be that these services are
provided on a for-profit basis and costs may be higher in the
long term.

Topic 3: Transportation Modes

This topic addresses the main modes of transportation
(water, rail, road, air, pipeline, and intermodal) as well as
types of carriers.

Water
Two major subsets of water transport include ocean and
inland waterway. Ocean transport includes containerships as
well as many other types of ocean vessels for specialty
hauling. Inland waterways include rivers, canals, and so on.
The transportation medium is provided by nature and/or is
maintained by governments, so carriers do not bear any
capital cost for this. However, there may be fees for using
waterways, especially for the use of locks and dams, such
as in the Panama Canal. Terminals may be provided by
governments, but private ownership is becoming more
common. Carriers pay fees for the use of the terminals.
These fees are passed on to customers. Carriers may own or
lease their vessels; this is the main capital (fixed) cost for
carriers.

Water transport is slow but low in cost because most vessels

have large cargo areas and can spread the fixed cost of the
vessel over many units. Water is one of the few
economically viable options for moving very dense, low-
value cargo such as ore. It is available only for end-to-end
shipments between shipper and consignee when both are
located on a waterway. Otherwise, some type of local pickup
and delivery will also be needed.

Rail
Rail transport, like water transport, is low in cost. The
variable cost is very low, due to the fact that one engine
and crew can haul about 100 railcars, some of which may be
double-stacked. Each railcar can haul about 160,000 pounds
(~72,575 kilograms). High fuel efficiency plus the high
hauling capacity makes the variable cost per unit of weight
very low. However, unlike water transport, rail operators
own and maintain all of their own rail lines (or lease access
from other railroads). Therefore, railway transport has a high
fixed cost, and high volumes of traffic are needed so the
cost can be spread over as many units as possible.
Rail is best for durable, dense, and low-value goods, in part
because the line-haul cost is lower than that for road,
especially for dense cargo. Rail is also useful for hauling
shipping containers with many types of goods over long
distances—provided the goods are protected from the rough
ride typical of rail transport. However, while rail speed over
long distances is good, delays can be a problem. Delays can
be due to competing uses for the lines or terminal switching.
In Europe, delays—and added costs—are caused by the
differences in rail gauge between countries (e.g., between
Spain and France). Also, unless both shipper and consignee
are on a connected rail line, pickup and delivery charges will
apply.

Road
Road transport includes semis as well as a large variety of
short-haul and specialty vehicles, including transportation of
containers without unloading them. The roadways are
maintained by governments, and these costs are not
generally passed on other than in the form of taxes and
fees. Road terminals are typically owned and operated by
the carriers, but government or private ownership also
occurs. Vehicles may be owned or leased, but they
represent a small capital cost, especially in comparison to
rail. The main costs, including labor, fuel, and charges for
vehicle wear and tear (depreciation), are variable. A major
plus for road is flexibility: It can provide direct end-to-end
transport. Road is used for all sorts of transport, but it is
better than other modes at transporting small volumes to
diverse destinations. A truck payload can be up to about
100,000 pounds (~45,359 kilograms), less than for a railcar
load. Road transport is relatively fast and moderately priced,
especially if truckload quantities are shipped. It is, however,
more expensive than rail or water given long distances.

Air
Air transport includes dedicated cargo planes (e.g., UPS) as
well as cargo space on commercial flights. Air is by far the
most expensive form of transport, but it is also faster than
any other form. It can cut lead times from weeks to a day or
two, including pickup and delivery. Air transport is very
gentle on cargo, and very little packaging is needed, but
there are limits to both cargo space and weight. Air is
primarily a variable cost due to high fuel and other
operating costs and the variable costs airlines pay for
terminal access. The terminals are paid for by governments,
but the cost of the leased or owned aircraft is very high and
makes up the largest portion of the carrier’s costs. There
must be suitable airports within an acceptable distance to
the supplier and the customer.

Air is generally an option for emergency expediting, despite

the higher net cost, as well as for expensive and light goods
or expensive perishable goods such as fresh fish. In some
industries, it might be the primary mode of transport. Air
can also be an option offered to customers simply by
passing the added cost on to them.

Pipeline
Pipelines move high volumes of liquids and slurries (ores
such as coal or iron suspended in liquid) but are generally
constructed for just one type of material such as crude oil.
They have very high capital costs and very low operating
costs. For industries that can use them, they are far less
expensive than rail, the main alternative. They are
unaffected by weather and operate continuously. On the
downside, getting new lines approved often takes years due
to regulatory hurdles, environmental challenges, and the
right-of-way permissions required. They can also suffer from
power outages and need to be maintained to prevent the
steel from corroding.

Intermodal Transport
The APICS Dictionary, 16th edition, defines intermodal
transport as follows:

1) Shipments moved by different types of

equipment combining the best features of each
mode. 2) The use of two or more different carrier
modes in the through movement of a shipment.

Intermodal transport is used for line haul, and it requires

special logistics. This is often done with containers, which
can be transported on trucks to a terminal, then on an
ocean carrier to a terminal, then on rail, and so on. An
example is the use of a containership to transport goods
from Asia to the U.S. West Coast, then transporting
containers by rail to the East Coast, thus avoiding the high
Panama Canal fees.

Pros and Cons of Transportation

Modes
Exhibit 5-25 lists some pros and cons of each transportation
mode.
 

Exhibit 5-25: Pros and Cons of Transportation Modes

Mode Pros Cons

Water Low cost (fixed cost Slow (long lead times)

spread over many Fees for terminals,
units) locks and dams
Free or low-cost High carrying cost
medium (ocean, river, Greater forecast
etc.) reliance
Best for dense, low- Less production
value cargo; flexibility
commodities
Rail Low cost (very low High fixed cost for
variable cost per unit) lines; unused lines are
Good long-distance discontinued
speed Rough ride
Best for durable, European rail gauge
dense, low-value cargo changes
Pickup and delivery
fees
 Mode Pros Cons

Road Fast and moderately Less-than-truckload

priced (mainly variable quantities are more
cost) expensive
Flexible: Direct end-to- Given long enough
end transport distances, more
Roadways are expensive than water
government expense or rail
Best for small volumes Terminal fees
to diverse destinations
Air Very fast Most expensive mode
Very short lead times Shipments can get
Minimizes carrying cost bumped
and need for safety Cargo space and
stock weight limits
Best for light, high- High fixed cost of
value goods; aircraft
emergencies Requires suitable
Airports are airports
government expense
Gentle ride (less
packaging)
Pipeline Very low operating cost Only good for one type
Far less expensive than of material (e.g., crude
rail oil)
Unaffected by weather Slow permitting
Continuous operation Environmental and
terrorist risks
 Mode Pros Cons

Intermodal Flexible alternative to Requires special

single-mode options logistics
Can avoid lock and
dam fees
Containers limit
materials handling

Carriers
Legal classifications of carriers had more importance in the
past when carriers were more heavily regulated, especially
in the United States. Regulations differ by country, but most
countries have few regulations related to rates or services.
However, carriers may be licensed to carry only specific
types of goods.

The following types of carriers exist:

Private carriers. The APICS Dictionary, 16th edition,

defines a private carrier as “a group that provides
transportation exclusively within an organization.” This is
a fleet of vehicles owned or leased by an organization for
its private use. For example, Frito Lay resupplies its
snacks using a private fleet. The investment in assets,
staffing, maintenance, and insurance is high for a private
carrier. Therefore, large volumes in all seasons are needed
to justify the investment. Others with a core competency
in transportation might do it better for less, so return on
investment must be considered.

For-hire (public) carriers. These are carriers that offer

transportation services to others. They include the
following subtypes. (Note that the definition of common
carrier refers to a U.S. regulatory body, but international
equivalents may exist.)

Common carriers. The Dictionary defines a common

carrier as follows:

Transportation available to the public that does

not provide special treatment to any one party
and is regulated as to the rates charged, the
liability assumed, and the service provided. A
common carrier must obtain a certificate of
public convenience and necessity from the
Federal Trade Commission for interstate traffic.

Common carriers are licensed to carry specific types of

goods or commodities and to offer their services to
anyone willing to pay their rates. However, pricing is
highly competitive, and this service is generally treated
 as a commodity itself, though dependability may be a
differentiator.

Contract carriers. According to the Dictionary, a

contract carrier is

a carrier that does not serve the general public,

but provides transportation for hire for one or a
limited number of shippers under a specific
contract.

These carriers offer dedicated carrying capacity to their

clients per a formal contract. The contract specifies
rates, customer service levels, and delivery details. This
method can provide the benefits of a private carrier
without the asset investment or management.

Carriers may specialize their services to enable more

competitive pricing, such as operating only in certain areas
or on certain schedules. One example of specialty carriers
are truckload (TL) carriers, which the Dictionary defines
as “carriers that deliver/charge only for full truckload
shipments.”

Selection factors may be primarily price-dependent, but

other factors in the decision may include the organization’s
core competencies and the desired level of control, the need
for scalability, or the ability to provide the desired level of
customer service (e.g., neither early nor late deliveries).
Another option is to rely on package shipping companies
such as UPS or on postal services.
Index
A

ABC analysis [1]

ABC classification [1]
Accounting standards
Generally accepted accounting principles (GAAP) [1]
Activity ratios
Inventory turnover [1]
Aggregate inventory management [1]
Air transport [1] , [2]
Anticipation inventory [1]
Assets [1]
Audits
Inventory audits [1]
Automatic identification systems
Bar codes [1]
Average cost [1]
Average inventory [1]

B
Backflush [1]
Backhauling [1]
Balance sheet [1]
Bar codes [1]
Batch picking [1]
Billing costs [1]
Break-bulk [1]
Buffer inventory [1]
Buffers
Inventory buffers [1]

C
Capacity-related costs [1]
Capital costs [1]
Carrier rates [1]
Carriers
Common carriers [1]
Contract carriers [1]
Truckload carriers [1]
Carrying costs [1] , [2] , [3] , [4]
Cash flows [1]
See also: Statement of cash flows
Centralized inventory control [1]
CI [1]
COGS [1]
Cold storage warehouses [1]
Common carriers [1]
Consolidation [1]
Containers
Temperature-controlled containers [1]
Continuous improvement [1]
Contract carriers [1]
Costing
Job costing [1]
Standard cost accounting [1]
Cost of goods sold (COGS) [1]
Costs
Inventory costs [1]
Overhead costs [1]
Product costs [1] , [2]
Shipping costs [1]
Standard costs [1]
Transportation costs [1]
Cross-docking [1]
Cross-docking warehouses [1]
Customer service [1]
Customer service levels [1] , [2]
Cycle counting [1]
Cycle stock [1]
D
Damage [1]
Days of supply [1]
DCs [1]
Decentralized inventory control [1]
Decoupling [1]
Direct labor [1]
Direct loading [1]
Direct materials [1]
Discrete order picking [1]
Distribution [1] , [2]
Distribution centers (DCs) [1]
Distribution inventory [1] , [2] , [3]
Distribution network structure [1]
Distribution requirements planning grids [1]
Distribution warehouses [1]
DRP grids [1]
See also: Distribution requirements planning (DRP)
Duty paid-warehouse [1]

E
Economic order quantity (EOQ) [1] , [2]
Efficiency [1]
EOQ [1] , [2]

F
FIFO [1]
Financial statements
Balance sheet [1]
Income statement [1]
Statement of cash flows [1]
Finished goods inventory [1]
Fixed-location storage [1]
Fixed order quantity (FOQ)
Economic order quantity (EOQ) [1] , [2]
Fixed overhead [1]
Fixed reorder cycle inventory models [1]
Fluctuation inventory [1]
FOQ [1]
Freight consolidation [1]
Funds flow statements [1]

G
GAAP [1]
Generally accepted accounting principles (GAAP) [1]
Green reverse logistics [1]
See also: Reverse logistics
Gross margin [1]
Gross profit margin [1]

H
Hedge inventory [1]
Holding costs [1] , [2] , [3] , [4]

I
Income statement [1]
Incoterms [1]
Incoterms trade terms [1]
Intermodal transport [1] , [2]
International Commercial Terms [1]
In-transit inventory [1] , [2] , [3]
Inventory
Anticipation inventory [1]
Average inventory [1]
Cycle stock [1]
Fluctuation inventory [1]
Hedge inventory [1]
In-transit inventory [1] , [2] , [3]
Lot-size inventory [1]
Obsolete inventory [1]
Physical inventory [1]
 Pipeline inventory [1]
Safety stock [1] , [2] , [3] , [4] , [5]
Scrap [1]
Seasonal inventory [1]
Transit inventory [1]
Transportation inventory [1]
Wall-to-wall inventory [1]
Work-in-process inventory [1]
Inventory accuracy [1]
Inventory adjustment [1]
Inventory audits
Cycle counting [1]
Periodic inventory audits [1]
Inventory buffers [1]
Inventory control [1] , [3] , [5]
See also: Inventory management
Inventory costs
Capacity-related costs [1]
Capital costs [1]
Carrying costs [1] , [2] , [3] , [4]
Item costs [1]
Ordering costs [1] , [2] , [3]
Risk costs [1]
Stockout costs [1]
 Storage costs [1]
Unit costs [1]
Inventory investment [1]
Inventory management
Aggregate inventory management [1]
Item inventory management [1]
Inventory metrics
Inventory turnover [1]
Inventory ordering systems
Fixed order quantity (FOQ) [1]
Lot-for-lot (L4L) [1]
Min-max systems [1]
Order point systems [1] , [2] , [3] , [4]
Periodic review systems [1]
Period order quantity [1] , [2]
Time-phased order point (TPOP) [1]
Inventory planning [1]
Inventory policies [1] , [2]
Inventory turnover [1]
Inventory turns [1]
Inventory valuation [1]
Item costs [1]
Item inventory management [1]
J
Job costing [1]
Job-order costing [1]

K
Kanban [1]

L
L4L [1]
Lead time
Replenishment lead time [1]
Safety lead time [1]
Lean [1]
Lean manufacturing [1]
Lean production [1]
Levels of service [1] , [2]
Liabilities [1]
LIFO [1]
Line-haul costs [1]
Lot control [1]
Lot-for-lot (L4L) [1]
Lot-size inventory [1]
Lot sizes [1]
Lot sizing [1]
M
MAD [1]
Malfeasance risks
Damage [1]
Manufacturing [1]
Materials handling [1]
Mean absolute deviation (MAD) [1]
Min-max systems [1]
Modes of transportation [1] , [2] , [3] , [4] , [5] , [6] , [7]

O
Obsolescence [1] , [2]
Obsolete inventory [1]
See also: Shelf life
On-time schedule performance [1]
Ordering costs [1] , [2] , [3]
Order picking
Batch picking [1]
Discrete order picking [1]
Wave picking [1]
Zone picking [1]
Order points [1] , [2]
Order point systems [1] , [2] , [3] , [4]
Order quantities [1]
Order quantity systems [1] , [2] , [3] , [4]
Order selection [1]
Overhead costs
Fixed overhead [1]

P
Packaging [1] , [2]
Pallet positions [1]
Pareto's law [1]
See also: 80-20 rule, Pareto charts
Performance measurement [1]
Periodic inventory audits [1]
Periodic inventory reviews [1]
Periodic replenishment [1]
Periodic review systems [1]
Period order quantity [1] , [2]
Perpetual inventory records [1]
Physical inventory [1]
Picking lists [1]
Pickup and delivery costs [1]
Pipeline inventory [1]
Pipeline stock [1]
Pipeline transport [1] , [2]
Point-of-sale (POS) systems [1]
POS [1]
Private carriers [1]
Private warehouses [1]
Product costs [1] , [2]
Profitability ratios
Profit margin [1]
Profit margin
Gross profit margin [1]
Public warehouses [1]
Pull systems [1]
See also: Push systems
Push systems [1]
See also: Pull systems
Put-away [1]

R
Rail transport [1] , [2]
Random-location storage [1]
Raw materials [1]
Raw materials inventory [1]
Recalls [1]
Record accuracy [1]
Recycling [1]
Reefers [1]
Remanufacturing [1]
Reorder points (ROPs) [1] , [2]
Reorder quantity [1]
Replenishment
Periodic replenishment [1]
Replenishment lead time [1]
Reverse logistics [1]
See also: Green reverse logistics
Rework [1]
Risk costs [1]
Road transport [1] , [2]
ROPs [1] , [2]

S
Safety lead time [1]
Safety stock [1] , [2] , [3] , [4] , [5]
Sawtooth diagrams [1]
Scrap [1]
See also: Waste
Seasonal inventory [1]
Service levels [1] , [2]
Service parts [1]
Shareholders' equity [1]
Shelf life [1] , [3]
See also: Obsolete inventory
Shipping [1]
Shipping costs
Billing costs [1]
Line-haul costs [1]
Pickup and delivery costs [1]
Terminal-handling charges [1]
Total line-haul costs [1]
Shrinkage [1] , [2]
SKUs [1]
Standard cost accounting [1]
Standard costing [1]
Standard costs [1]
Statement of cash flows [1]
See also: Cash flows
Stockkeeping units (SKUs) [1]
Stockout costs [1]
Stockout percentages [1]
Stockouts [1] , [2]
Storage
Fixed-location storage [1]
Random-location storage [1]
Zoned-location storage [1]
Storage costs [1]
Supply chain cost
Cost of goods sold (COGS) [1]

T
Target inventory levels [1]
Temperature-controlled containers [1]
Terminal-handling charges [1]
Terminals [1]
Theory of constraints (TOC) [1]
Three Vs
Velocity [1]
Time-phased order point (TPOP) [1]
TL carriers [1]
TOC [1]
Total line-haul costs [1]
TPOP [1]
Traceability [1]
Tracking [1]
Transit inventory [1]
Transportation [1]
Transportation costs [1]
Transportation inventory [1]
Transportation management [1]
Trigger points [1] , [2]
Truckload carriers [1]
Two-bin inventory systems [1]

U
Uncertainty [1]
Unit costs [1]
Unitization [1]
Unit loads [1]

V
Valuation
Inventory valuation [1]
Value added [1]
See also: Non-value-added
Variance [1]
Velocity [1]
Visual review systems [1]

W
Wall-to-wall inventory [1]
Warehouse functions
Break-bulk [1]
Consolidation [1]
 Cross-docking [1]
Warehouse management strategies [1]
Warehouse processes
Order picking [1]
Packaging [1] , [2]
Put-away [1]
Receiving [1]
Shipping [1]
Warehouse receiving [1]
Warehouses
Cold storage warehouses [1]
Cross-docking warehouses [1]
Distribution centers (DCs) [1]
Distribution warehouses [1]
Private warehouses [1]
Public warehouses [1]
Warehousing [1] , [2] , [3] , [4] , [5]
Water carriers
Private carriers [1]
Water transport [1] , [2]
Wave picking [1]
Weighted average cost [1]
WIP inventory [1]
Work in process [1]
Work-in-process inventory
Finished goods inventory [1]
Raw materials inventory [1]

Z
Zoned-location storage [1]
Zone picking [1]