Chapter 7

INVENTORY
MANAGEMENT

Prepared by Mark A. Jacobs, PhD

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duplicated, or posted to a publicly accessible website, in whole or in part.
 Wisner

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 Introduction

▪ Inventory can be one of the most expensive assets of an

organization
▪ Inventory may account for more than 10% of total revenue
or 20% of total assets
▪ Management must reduce inventory levels yet avoid
stockouts and other problems

This chapter will discuss:

▪ Dependent & independent demand
▪ Tools for managing inventory
▪ Basic types of inventories
▪ Various inventory management approaches
 Matching Supply & Demand

▪ Suppliers must accurately forecast demand so they

can produce & deliver the right quantities at the right
time at the right cost
▪ Suppliers must find ways to better match supply &
demand to achieve optimal levels of cost, quality, &
customer service to enable them to compete with other
supply chains
▪ Problems that affect product & delivery will have
ramifications throughout the chain
 Dependent & Independent
Demand
Inventory management models –
Generally classified as dependent demand and
independent demand models
▪ Dependent Demand –
Describes the internal demand for parts based on the
demand of the final product in which the parts are used.
Subassemblies, components, & raw materials are
examples of dependent demand items.

▪ Independent Demand –
The demand for final products & has a demand pattern
affected by trends, seasonal patterns, & general market
conditions.
 Concepts and Tools of
Inventory Management
Functions and Basic Types of Inventory
▪ The primary functions of inventory are to –
▪ Buffer from uncertainty in the marketplace &
▪ Decouple dependencies in the supply chain (e.g., safety
stock)

▪ Four broad categories of inventories

▪ Raw materials- unprocessed purchase inputs.
▪ Work-in-process (WIP)- partially processed materials not
yet ready for sales.
▪ Finished goods- products ready for shipment.
▪ Maintenance, repair & operating (MRO)- materials used in
production (e.g., cleaners & brooms).
 Concepts and Tools of Inventory
Management (Continued)

Inventory Costs
▪ Direct costs- directly traceable to unit produced (e.g.,
labor)
▪ Indirect costs- cannot be traced directly to the unit
produced (e.g., overhead)
▪ Fixed costs- independent of the output quantity (e.g,
buildings, equipment, & plant security)
▪ Variable costs- vary with output level (e.g., materials)
▪ Order costs- direct variable costs for making an order. In
mfg, setup costs are related to machine setups
▪ Holding or carrying costs- incurred for holding inventory
in storage
 Concepts and Tools of Inventory
Management (Continued)

Inventory Investment
▪ Firms should diligently measure inventory investment to
ensure that it does not adversely affect competitiveness.
Measures include:
▪ Absolute value of inventory (found on balance sheet)
▪ Inventory turnover or turnover ratio- how many times
inventory “turns” in an accounting period. More is
better because its faster!

Cost of Revenue
Inventory Turnover Ratio =
Average Inventory
 Concepts and Tools of Inventory
Management (Continued)

ABC Inventory Control System

Determines which inventories should be counted &
managed more closely than others
▪ Groups inventory as A, B, & C Items
▪ A items are given the highest priority with larger safety stocks.
A items, which account for approximately 20% of the total
items, are about 80% of the total inventory cost
▪ B & C items account for the other 80% of total items & only
20% of costs. The B items require closer management since
they are relatively more expensive (per unit), require more
effort to purchase/make, & may be more prone to
obsolescence
▪ C items have the lowest value and hence lowest priority
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 Concepts and Tools of Inventory
Management (Continued)

• Radio Frequency Identification (RFID)

✓ Successor to the barcode for tracking individual unit of
goods. RFID does not require direct line of sight to read a
tag and information on the tag is updatable.
✓ Electronic product code (EPC)
✓ Components of a Radio Frequency Identification
System
✓ An RFID solution consists of four parts: the tag, reader,
communication network and RFID software.
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 Concepts and Tools of Inventory
Management (Continued)

▪ How Radio Frequency Identification Automates the

Supply Chain
▪ Materials Management – goods automatically counted
and logged as they enter the supply warehouse
▪ Manufacturing – assembly instructions encoded on
RFID tag provide information to computer controlled
assembly devices
▪ Distribution Center – shipment leaving DC
automatically updates ERP to trigger a replenishment
order and notify customer for delivery tracking
▪ Retail Store – no check out lines as scanners link
RFID tagged goods in shopping cart with buyers
credit card
 Inventory Models

▪ The Economic Order Quantity (EOQ) Model –

A quantitative decision model based on the trade-off
between annual inventory holding costs & annual order
costs

The EOQ model seeks to determine an optimal order

quantity, where the sum of the annual order cost &
the annual inventory holding cost is minimized.
• Order Cost is the direct variable cost associated
with placing an order.
• Holding Cost or carrying cost is the cost incurred
for holding inventory in storage.
 Inventory Models (Continued)

▪ Assumptions of the EOQ Model

▪ Demand must be known & constant.
▪ Delivery time is known & constant.
▪ Replenishment is instantaneous.
▪ Price is constant.
▪ Holding cost is known & constant.
▪ Ordering cost is known & constant.
▪ Stock-outs are not allowed.
▪ Deriving the Economic Order Quantity
 Inventory Models (Cont.)

• The Quantity Discount Model or price-break model

▪ Relaxes the constant price assumption by allowing purchase
quantity discounts.
▪ Considers the tradeoff between purchasing in large quantity to
take advantage of the price discount and issuing fewer orders,
against holding higher inventory.
▪ Due to the step-wise shape of the total inventory cost curve, the
optimal order quantity lies on either one of the feasible EOQs or
at the price break point.
▪ A fairly straightforward two-step procedure can be used to solve
the quantity discount problem.

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 Inventory Models (Cont.)

• The Economic Manufacturing Quantity Model or

Production Order Quantity Model

▪ Relaxes the instantaneous replenishment assumption by

allowing usage during production or partial delivery.

▪ The EMQ model is especially appropriate for a manufacturing

environment with simultaneous manufacture and consumption

▪ Inventory builds up gradually during the production period

rather than at once as in the EOQ model.

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 Inventory Models (Continued)

▪ The Statistical Reorder Point (ROP)

▪ The lowest inventory level at which a new order must be placed
to avoid a stockout.
▪ Demand and delivery lead time are never certain and require
safety stock.

▪ The models used under uncertainty are –

▪ Statistical ROP with Probabilistic Demand and Constant Lead
Time
▪ The Statistical ROP with Constant Demand and Probabilistic
Lead Time
▪ The Statistical ROP when Demand and Lead Time are both
Probabilistic
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 Inventory Models (Continued)

• The Continuous Review and the Periodic Review Inventory

Systems
▪ A continuous review of the physical inventory is required
to make sure that orders are initiated when physical
inventories reach their reorder points.
▪ In practice, a continuous review system can be difficult to
achieve and very expensive to implement.
▪ Inventory review costs can be lowered by using a periodic
review system instead, where physical inventory is
reviewed at regular intervals, such as weekly or monthly.
▪ However, more safety stock would be required for the
periodic review system to buffer the added variation due to
the longer review period.
 Inventory Models (Continued)

• The Continuous Review and the Periodic Review

Inventory Systems
▪ When analyzing the continuous review and the periodic review
systems, the following symbols are used:
s = order point
S = maximum inventory level
Q = order quantity
R = periodic review
n = 1, 2, 3…
 Inventory Models (Continued)

• The Continuous Review and the Periodic Review

Inventory Systems
▪ The Continuous Review System
• (s, Q) continuous review policy
• (s, S) continuous review policy
▪ The Periodic Review System
• (nQ,s, R) periodic review policy
• (S, R) periodic review policy
• (s, S, R) policy
 Chopra: ch-11

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 Aggregating Multiple
Products in a Single Order
• Savings in transportation costs
§ Reduces fixed cost for each product
§ Lot size for each product can be reduced
§ Cycle inventory is reduced
• Single delivery from multiple suppliers or single truck
delivering to multiple retailers
• Reduce receiving and loading costs to reduce cycle
inventory
 Managing Multiechelon Cycle
Inventory (1 of 2)

• Multiechelon supply chains have multiple stages with

possibly many players at each stage
• Lack of coordination in lot sizing decisions across the
supply chain results in high costs and more cycle
inventory than required
• The goal is to decrease total costs by coordinating
orders across the supply chain
Managing Multiechelon Cycle Inventory (2 of 2)

Figure 11-6 Inventory Profile at Retailer and Manufacturer with No

Synchronization
 Integer Replenishment Policy (1 of
4)

• Divide all parties within a stage into groups such that all
parties within a group order from the same supplier and have
the same reorder interval
• Set reorder intervals across stages such that the receipt of a
replenishment order at any stage is synchronized with the
shipment of a replenishment order to at least one of its
customers
• For customers with a longer reorder interval than the
supplier, make the customer’s reorder interval an integer
multiple of the supplier’s interval and synchronize
replenishment at the two stages to facilitate cross-docking
 Integer Replenishment Policy (2 of
4)

• For customers with a shorter reorder interval than the supplier,

make the supplier’s reorder interval an integer multiple of the
customer’s interval and synchronize replenishment at the two
stages to facilitate cross-docking
• The relative frequency of reordering depends on the setup
cost, holding cost, and demand at different parties
• These polices make the most sense for supply chains in which
cycle inventories are large and demand is relatively
predictable
 Integer Replenishment Policy (3 of 4)

Figure 11-7 Illustration of an Integer Replenishment Policy

 Integer Replenishment Policy (4 of 4)

Figure 11-8 A Multiechelon Distribution Supply Chain

 Managerial Levers to Reduce
Cycle Inventory (1 of 4)
• Three factors drive lot sizing decisions
§ Fixed costs associated with production or
purchasing
§ Quantity discounts offered by suppliers
§ Short-term price discounts offered by suppliers
 Managerial Levers to
Reduce Cycle Inventory (2 of 4)
• If buildup is due to large lots associated with fixed costs
§ reduce fixed costs
§ Decrease changeover times

• If buildup is due to transportation – facilitate aggregation

§ Coordinating orders
§ Using intermediate locations to aggregate from
multiple suppliers
§ Use milk runs for pickup and delivery
 Managerial Levers to
Reduce Cycle Inventory (3 of 4)
• If buildup is due to order placement and receiving –
employ appropriate technologies
§ Electronic order placement
§ Advanced shipping notices
§ RFID
• If buildup is due to lot sizing decisions
§ check supplier’s fixed costs
§ Reduce fixed costs
§ Employ volume-based discounts
 Managerial Levers to Reduce
Cycle Inventory (4 of 4)
• If buildup is due to short-term discounts
§ limit forward buying
§ EDLP
§ Link discount to sell-through rather than sell-in
§ Limit quantity purchased
 Chopra: ch-12

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 Product Substitution

• The use of one product to satisfy demand for a different

product
1. Manufacturer-driven substitution
• Allows aggregation of demand
• Reduce safety inventories
• Influenced by the cost differential, correlation of
demand
2. Customer-driven substitution
• Allows aggregation of safety inventory
 Postponement (1 of 2)

• Delay product differentiation or customization until

closer to the time the product is sold
▪ Have common components in the supply chain for
most of the push phase
▪ Move product differentiation as close to the pull
phase of the supply chain as possible
▪ Inventories in the supply chain are mostly aggregate
 Postponement (2 of 2)

Figure 12-6 Supply Chain Flows without and with Postponement

 Managing Safety Inventory in
a Multiechelon Supply Chain
• In multiechelon supply chains, stages often do not know
demand and supply distributions
• Inventory between a stage and the final customer is
called the echelon inventory
• Reorder points and order-up-to levels at any stage
should be based on echelon inventory
• Decisions must be made about the level of safety
inventory carried at different stages
 Managerial Levers to
Reduce Safety Inventory
• Reduction of supply uncertainty
§ Sharing information
§ Coordinated demand
• Reduction of lead times
§ Delays contribute more to lead time than production
and transportation time
• Reduction of demand uncertainty
§ Reduce information distortion through sharing
§ Aggregate demand
 Chopra: ch-3

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 Transportation

• Role in the Supply Chain

§ Moves inventory between stages in the supply chain
§ Affects responsiveness and efficiency
§ Faster transportation allows greater responsiveness
but lower efficiency
§ Also affects inventory and facilities
§ Allows a firm to adjust the location of its facilities and
inventory to find the right balance between
responsiveness and efficiency
 Transportation

• Components of Transportation Decisions

§ Design of transportation network
▪ Modes, locations, and routes
▪ Direct or with intermediate consolidation points
▪ One or multiple supply or demand points in a
single run
 Transportation

§ Choice of transportation mode

▪ Air, truck, rail, sea, and pipeline
▪ Information goods via the Internet
▪ Different speed, size of shipments, cost of
shipping, and flexibility
 Transportation

• Overall Trade-off: Responsiveness Versus Efficiency

§ The cost of transporting a given product (efficiency)
and the speed with which that product is transported
(responsiveness)
§ Using fast modes of transport raises responsiveness
and transportation cost but lowers the inventory
holding cost
 Information (1 of 2)

• Role in the Supply Chain

§ Improve the utilization of supply chain assets and the
coordination of supply chain flows to increase
responsiveness and reduce cost
§ Information is a key driver that can be used to provide
higher responsiveness while simultaneously
improving efficiency
 Information (2 of 2)

• Role in the Competitive Strategy

§ Improves visibility of transactions and coordination of
decisions across the supply chain
§ Right information can help a supply chain better meet
customer needs at lower cost
§ More information increases complexity and cost of
both infrastructure and analysis exponentially while
marginal value diminishes
§ Share the minimum amount of information required to
achieve coordination
 Components of Information
Decisions (1 of 3)
• Demand Planning
§ Best estimate of future demand
§ Include estimation of forecast error
• Coordination and Information Sharing
§ Supply chain coordination, all stages of a supply
chain work toward the objective of maximizing total
supply chain profitability based on shared information
§ Critical for success
 Components of Information
Decisions (2 of 3)
• Sales and Operations Planning (S&OP)
§ The process of creating an overall supply plan
(production and inventories) to meet the anticipated
level of demand (sales)
§ Can be used to plan supply chain needs and project
revenues and profits