Module 1 Overview of Inventory Management

Introduction to the Module

Inventory is an idle asset, in various forms, held for current and future use (sale or distribution). Because
an idle asset represents an underutilized resource, inventory can end up being a financial burden for the
company. Despite the risks associated with inventory, many companies want to keep inventory to meet
anticipated customer demand and not lose sales opportunities. Without it, it is difficult to make products
available to customers when they are needed. It is regarded as a viable alternative for future production
and procurement and is often perceived to be a necessary evil for meeting customer service requirements.

In particular, inventory can be problematic when it exceeds actual customer demand or it becomes
obsolete. As a general rule of thumb, inventory is considered to be “excess” when the amount at hand
exceeds the twelve-month projected customer demand. It is also considered to be “obsolete” when it has
no forecasted usage and little or no usage in the past six months. Either excess or obsolete inventory will
be wasted, because many companies will sell such inventory at a discounted price or write it off to free up
storage space and ease their tax burden. Considering these two contrasting faces of inventory, the careful
policies, planning, and control are necessary to keep the right amount of inventory at the right place
essential for customer service and to keep the cost of maintaining inventory at minimum. Therefore,
inventory management is more than inventory control. In this module you will be learning about Inventory
Management and its relations to Customs Administration. This includes ABC and XYZ Analysis, inventory
discounts, Lead time, Forecasting and Production Management

Topic 1 Role, Functions and Types of Inventory

Time Frame Week 1 | 3 hours

Learning Outcomes | At the end of this topic, you should be able to:

1. Discuss the importance and benefits of Inventory management, balance inventory investment and
increased customer service level;
2. Discuss some most important issues in inventory management;
3. Discuss safety and cycle inventory used by managers to improve product availability in the
presence of uncertainty.

Materials

1. Pen and paper

 Vocabulary Lists

1. Fluctuating demand - a demand in the industrial sector which rises and falls sharply in
response to changing economic conditions and consumer spending patterns.
2. Monetary value - a value in currency that a person, business, or the market places on a
resource, product, or service.

Acronyms

1. SCOM – System Center Operations Manager.

2. WIP - Work-in-process
3. MRO -Maintenance/repair/operating

Discussion

Introductory Case-Study: Amazon, Volkswagen, and DELL

The trade-off “service level vs. costs” is one of the most important issues in inventory management. Its
resolution strongly depends on manufacturing, sourcing, distribution, and SC strategies. Consider three
examples.

Amazon
Founded in 1994, Amazon.com, Inc. is the world’s largest online retailer. It started as an online bookstore,
but has diversified over the last 20 years selling DVDs, CDs, MP3, software, games, furniture, food, toys,
and more. The basic idea is that everybody with access to the internet can buy a massive range of products
at any time and get them delivered wherever they want from (nearly) anywhere in the world. Amazon
apps make it possible to buy their products easily with smartphones or tablets. Their inventory
management for books is based on the number of sales for each book. Best-selling books are stocked in
many regional warehouses to enable fast responsiveness for customers in any region. Books with a smaller
number of sales are stocked in only a few regional warehouses to reduce inventory costs. The slowest
moving books are not even held in stock, but are obtained directly from the publisher or distributor.
Through this strategy, it is possible for Amazon to reduce inventory costs for slow-moving products and to
have the best possible service level and reliability for their customers.

Volkswagen
Founded in Germany in 1937, Volkswagen implemented the JIT-based SC strategy in Germany. This means
that components and items are delivered to the assembly line when they are needed. Only a small amount
of safety stock is held for critical parts. This strategy helps to reduce inventory, transport, labor, and
administration costs. Often suppliers locate their plants close to the manufacturer to deliver the required
components and items at the right moment and to reduce their transport costs. This choice of location
reduces the risk of delivery delays and supply shortages. Examples of these JIT components are dashboards
with all the electronic devices or seats. JIT is normally used for A-, B-, X-, and Y-items. For C-items,

Volkswagen uses a Kanban replenishment system so that they are in stock at any time. These items
normally have low inventory holding costs. Based on the JIT strategy and Kanban replenishment system,
Volkswagen is able to minimize inventory costs

DELL
Founded in US in 1983, DELL runs a MTO production strategy. The assembly starts and materials are
replenished only after a customer orders. In such a business model, DELL is able to drastically reduce its
inventory. For some components, DELL has 90 inventory turns a year which means that inventory is only
on hand 4 days on average. Such inventory dynamics allows Dell to respond to a wide range of demand
quantities, meet short lead times, handle a large variety of products, build innovative products, and
handle supply uncertainty.

The role of inventory management is to strike a balance between inventory investment and customer
service. Inventory is one of the most expensive assets of many companies, representing as much as 50%
of total invested capital. In SCOM we must therefore balance inventory investment and customer service
level.

Inventory has different functions:

• to decouple the company and the SC from fluctuations in demand and hold a stock of goods that
will provide a selection for customers;
• to increase SC flexibility by placing inventory in the right places;
• to hedge against facility disruptions in the event of natural catastrophes;
• to decouple or separate various parts of the production process;
• to take advantage of quantity discounts and hedge against inflation.

Typically, inventory is classified according to the following types:

• Raw material. These are the items which are purchased but not processed;
• Work-in-process (WIP). These are the items which underwent some changes, but are not
completed;
• Maintenance/repair/operating (MRO). These are the items which are necessary to keep
machinery and processes productive;
• Finished goods. These are completed product awaiting shipment

In making decisions in the scope of inventory management, the following two basic questions are put to
the forefront for consideration:
1. How much should I replenish?
2. When should I replenish?

In calculating inventory amounts, the following costs are typically considered:

• Holding costs (variable)—the costs of holding inventory over time;
• Ordering costs (fixed)—the costs of placing an order and receiving goods;
• Setup costs (fixed)—the costs of preparing a machine or process for manufacturing an order;
• Stockout costs (variable)—the costs of lost customer orders resulting from product shortage, loss
of-goodwill costs.

Holding costs include operating costs, labor costs, material handling costs, etc. and vary considerably
depending on the business, location, and interest rates. Generally, these costs are greater than 15% of the
item price, but some items have holding costs greater than 40%. Holding costs depend on the order
quantity. Setup costs (in manufacturing) and ordering costs (in procurement) are fixed and do not depend
on the order quantity. This cost tends less for e-business developments. At the same time, setup/ordering
costs can be increased in the event there is a high variety of assortment and market dynamics. According
to inventory functions and types, inventory can be used to manage:

• Economy of scale—this is cycle inventory;

• Uncertainty—this is safety inventory.
Ordering costs are the expenses incurred to create and process an order to a supplier. These costs are
included in the determination of the economic order quantity for an inventory item. Examples of ordering
costs are:

• Cost to prepare a purchase requisition

• Cost to prepare a purchase order
• Cost of the labor required to inspect goods when they are received
• Cost to put away goods once they have been received
• Cost to process the supplier invoice related to an order
• Cost to prepare and issue a payment to the supplier
There will be an ordering cost of some size, no matter how small an order may be. The total amount of
ordering costs that a business incurs will increase with the number of orders placed. This aggregate order
cost can be mitigated by placing large blanket orders that cover long periods of time, and then issuing
order releases against the blanket orders.
An entity may be willing to tolerate a high aggregate ordering cost if the result is a reduction in its total
inventory carrying cost. This relationship occurs when a business orders raw materials and merchandise
only as needed, so that more orders are placed but there is little inventory kept on hand. A firm must
monitor its ordering costs and inventory carrying costs in order to properly balance order sizes and thereby
minimize overall costs.
Setup cost is those costs incurred to configure a machine for a production run. This cost is considered a
fixed cost of the associated batch, so its cost is spread over the number of units produced. Setup costs
include the following:

• Labor to position tools and materials next to the machine

• Labor to configure the machine
• Scrap cost of test units run on the machine
The real cost of a setup is the time wasted while a machine is not operational, since this can represent lost
income (if there is a backlog of work). Consequently, there is usually an emphasis on shortening equipment
setup times in order to reduce setup costs.
Stockout cost is the lost income and expense associated with a shortage of inventory. This cost can arise
in two ways, which are:

• Sales-related. When a customer wants to place an order and there is no inventory available to sell
to the customer, the company loses the gross margin related to the sale. In addition, the customer
may be lost permanently, in which case the company also loses the margins associated with all
future sales.
• Internal process-related. When a company needs inventory for a production run and the inventory
is not available, it must incur costs to acquire the needed inventory on short notice.
For example, the firm may need to pay a rush fee and overnight delivery charges to obtain the inventory.
In addition, the production planning staff must scramble to adjust the production plan, advancing some
other job in the schedule to replace the job that cannot be run until the required inventory has been
received.

It is not always easy to discern the stockout costs incurred by a business. This is because lost sales do not
appear on its income statement, and the costs associated with rush purchases are usually buried in the
cost of goods sold line item.
A business can avoid stockout issues by maintaining a high level of inventory record accuracy and a
reasonable safety stock level that is adjusted to match ongoing changes in customer demand.

Cycle inventory exists as a result of producing or purchasing in large lots or batches. A lot or batch size is
the quantity that a stage in the SC either produces or purchases at a time. The SC can exploit economy of
scale and order in large lots to reduce fixed costs. With the increase in lot size, however, also comes an
increase in carrying costs. As an example of a cycle stock decisions, consider an online book retailer. This
retailer’s sales average around ten truckloads of books per month. The cycle inventory decisions the
retailer must make include how much to order for replenishment and how often to place these orders.
We will consider cycle inventory optimization in the “Deterministic models” section (for one period) and
“Dynamic lot-sizing models” section for many periods.

Safety inventory is carried to satisfy demand subject to unpredictable demand fluctuations and to reduce
product shortages. Safety inventory can help the SC manager improve product availability in the presence
of uncertainty. In the presence of safety inventory, shortage costs or overage costs can occur. The
calculation of safety inventory is based on a predetermined service level. Choosing safety inventor involves
making a trade-off between the costs of having too much inventory and the costs of losing sales due to
inventory shortage. We will consider methods to support decisions on safety inventory in the “Stochastic
models” section.

For many industries, some products are sold in high quantities in the summer, and lower quantities in the
winter (e.g., mineral water). Seasonal inventory is built up to counter predictable variability in demand.
Companies using seasonal inventory buildup inventory in periods of low demand and store it for periods
of high demand when they will not have the capacity to produce all that is demanded. Managers face key
decisions in determining whether to build up seasonal inventory, and, if they do build it up, in deciding
how much. If a company can rapidly change the rate of its production system at a very low cost, then it
may not need seasonal inventory, because the production system can adjust to a period of high demand
without incurring large costs. The basic trade-off SCOM managers face in determining how much seasonal
inventory to build up is the cost of carrying the additional seasonal inventory versus the cost of having a
flexible production rate.