Inventory Policy

Decisions
Lecturer: Arsalan Siddiqui

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CR (2004) Prentice Hall, Inc.

 Inventory Decisions in
Strategy
Inventory Strategy
• Forecasting Transport Strategy
• Inventory decisions • Transport fundamentals

CONTROLLING
• Purchasing and supply

ORGANIZING
• Transport decisions
scheduling decisions Customer

PLANNING
• Storage fundamentals service goals
• Storage decisions • The product
• Logistics service
• Ord. proc. & info. sys.

Location Strategy
• Location decisions
• The network planning process

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CR (2004) Prentice Hall, Inc.

 Nature of Demand
•Perpetual demand
-Continues well into the foreseeable future
•Seasonal demand
-Varies with regular peaks and valleys throughout
the year Accurately forecasting
•Lumpy demand demand is singly the
-Highly variable (3  Mean) most important factor
in good inventory
• Regular demand management
-Not highly variable (3 < Mean)
•Terminating demand
-Demand goes to 0 in foreseeable future
•Derived demand
-Demand is determined from the demand of another9-3
item of which it is a part
 Inventory Management
Philosophies
•Pull
-Draws inventory into the stocking location
-Each stocking location is considered independent
-Maximizes local control of inventories
•Push
-Allocates production to stocking locations based on
overall demand
-Encourages economies of scale in production
•Just-in-time
-Attempts to synchronize stock flows so as to just
meet demand as it occurs
-Minimizes the need for inventory
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CR (2004) Prentice Hall, Inc.

 Inventory Management
Philosophies (Cont’d)
•Supply-Driven
-Supply quantities and timing are unknown
-All supply must be accepted and processed
-Inventories are controlled through demand
•Aggregate Control
-Classification of items:
›Groups items according to their sales level
based on the 80-20 principle
›Allows different control policies for 3 or more 9-5
broad product groups
CR (2004) Prentice Hall, Inc.
 Pull vs. Push Inventory Philosophies
PUSH - Allocate supply to each PULL - Replenish inventory with
warehouse based on the forecast order sizes based on specific needs
for each warehouse of each warehouse

Demand
forecast
Warehouse #1
Q1

A1

A2 Q2 Demand
Plant forecast
Warehouse #2
A3

Q3

A = Allocation quantity to each warehouse

Q = Requested replenishment quantity Demand
by each warehouse Warehouse #3 forecast
CR (2004) Prentice Hall, Inc. 9-11
 Costs Relevant to Inventory
Management
•Carrying costs
-Cost for holding the inventory over time
-The primary cost is the cost of money tied up in
inventory, but also includes obsolescence,
insurance, personal property taxes,
and storage costs
-Typically, costs range from the cost of short term
capital to about 40%/year. The average is
about 25%/year of the item value in
inventory. 9-7

CR (2004) Prentice Hall, Inc.

 Relevant Costs (Cont’d)

•Procurement costs
-Cost of preparing the order
-Cost of order transmission
-Cost of production setup if appropriate
-Cost of materials handling or processing at the
receiving dock
-Price of the goods
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CR (2004) Prentice Hall, Inc.

 Relevant Costs (Cont’d)

•Out-of-stock costs
-Lost sales cost
›Profit immediately foregone
›Future profits foregone through loss of goodwill
-Backorder cost
›Costs of extra order handling
›Additional transportation and handling costs
›Possibly additional setup costs 9-9

CR (2004) Prentice Hall, Inc.

Inventory Management Objectives
Good inventory management is a careful balancing act
between stock availability and the cost of holding
inventory.
Customer Service, Inventory Holding costs
i.e., Stock Availability

•Service objectives
-Setting stocking levels so that there is only a
specified probability of running out of stock
•Cost objectives
-Balancing conflicting costs to find the most 9-10
economical replenishment quantities and
timing
CR (2004) Prentice Hall, Inc.
Inventory’s Conflicting Cost Patterns

Total cost Minimum cost

reorder quantity
os t
g c
yin
Cost

a r r
C

Procurement cost

Stockout cost

CR (2004) Prentice Hall, Inc.

Replenishment quantity 9-16
FUNCTIONS OF LOGISTICS

 Procurement or purchasing
 Inward transport

 Receiving

 Material Handling

 Warehousing

 Inventory control

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FUNCTIONS OF LOGISTICS (CONT)

 Order picking
 Outward transport

 Physical distribution

 Recycling, returns and waste disposal

 Location

 Communication

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PROCUREMENT OR PURCHASING

 Procurement or purchasing which usually initiates the flow of

materials through an organization by sending a purchase order to a
supplier
 This means that procurement has to find suitable suppliers, negotiate
terms, set conditions, organize delivery, arrange insurance, authorize
payment, and do everything needed to get materials into the
organization.
 In the past, this has been a largely clerical job centered on order
processing, but now it is recognized as being responsible for major
expenditure and giving a critical link with supplier

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CONTINUED
 Inward transport or traffic which actually moves
materials from suppliers to the organization’s receiving
area
 Important decisions concern the mode of transport (road,
rail, air, etc.), policies for outsourcing, choice of
transport operator, route, safety and legal requirements,
timing of deliveries, costs, etc.
 Receiving makes sure that materials delivered
correspond to the order, acknowledges receipt, unloads
delivery vehicles, inspects materials for damage, and
sorts them.
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MATERIAL HANDLING
 Material handling moves materials from receiving and
puts them into stores
 It is responsible for all movements of materials within an
organization, so it also removes materials from stores,
takes them to the place they are needed, and generally
moves materials between operations

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CONTINUED
 Warehousing or stores takes care of materials held in
stock until they are needed.
 Warehousing makes sure that materials have the right
conditions, treatment and packaging to keep them in
good condition, and are available quickly when needed.
 Stock or inventory control sets the overall policies for
stock, considering the materials to store, investment,
customer service, stock levels, order sizes, order timing
and so on.

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CONTINUED
 Order picking finds and removes materials from stores.
 Typically materials for a customer order are located,
identified, checked, removed from racks, consolidated
into a single load, wrapped and moved to a departure
area for loading onto delivery vehicles.
 Outward transport takes materials from the departure
area and delivers them to customers (with concerns that
are similar to inward transport).

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CONTINUED
 Physical distribution is a general term for the activities
that deliver finished goods to customers.
 It is often aligned with marketing and forms an
important link with downstream activities.

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RECYCLING, RETURNS AND WASTE
DISPOSAL
 There are sometimes problems with delivered materials – perhaps
faults, the wrong materials or too much delivered – and logistics has
to collect them and bring them back to the supplier
 This reverse logistics also collects associated materials such as
pallets, delivery boxes, cable reels and containers (the standard 20-
foot-long metal boxes that are used to move goods).
 Some materials are brought back for recycling (such as metals,
glass, paper, plastics and oils) while others are brought back for safe
disposal (such as dangerous chemicals).

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CONTINUED
 Location finds the best site for those activities that can be in
different places.
 Stocks of finished goods, for example, can be held at the end of
production, moved to nearby warehouses, sent to large centralized
facilities, put into stores near to customers, passed on to be managed
by other organizations, or a range of alternatives.
 Communication Alongside the physical flow of materials is the
associated flow of information
 This links all parts of the supply chain, passing information about
products, customer demand, materials moved, timing, stock levels
and etc.

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INVENTORY AND LOGISTICS
 These Functions reinforces the point that all logistics activities have
a direct impact on the stocks
 To take one example, we can look at the mode of transport, which
describes the type of delivery vehicle used. The alternative modes
are road, rail, air, inland waterway, ocean shipping or pipeline – and
the choice is determined by locations, infrastructure, weight and
volume carried, value of goods, customer service offered, urgency
and a series of other factors. But this choice has a direct effect on
stocks.
 Air travel is fastest and most expensive while shipping is slowest
and cheapest – so the choice affects lead times and delivery costs. It
also affects the amount of pipeline stocks (which are the materials in
transit between locations), with airfreight having little stock on short
journeys and shipping having weeks of stock out at sea.
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 Top
Mgt.
---------
STRATEGIC

Mid-Mgt.
-------------
TACTICAL

First-Line Mgt.
--------------------
OPERATIONAL
LEVEL OF DECISIONS
 Strategic decisions are most important, have effects over the long
term, use many resources and are the most risky. These set the
overall direction for operations. (Customer service is a strategic
issue when designing the supply chain)
 Tactical decisions are concerned with implementing the strategies
over the medium term; they look at more detail, involve fewer
resources and some risk. (a tactical issue when organizing transport
for delivery)
 Operational decisions are concerned with implementing the tactics
over the short term; they are the most detailed, involve few
resources and little risk. (an operational issue when scheduling the
next delivery)

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Supply Chain Management: Strategy, Planning, and Operation, 5/e Authors: Sunil Chopra, Peter Meindl and D. V.
Kalra
 Inventory

• Role in competitive strategy

Form, location, and quantity of inventory allow a supply chain to
range from being very low cost to very responsive
Objective is to have right form, location, and quantity of
inventory that provides the right level of responsiveness at
the lowest possible cost

Supply Chain Management: Strategy, Planning, and Operation, 5/e Authors: Sunil Chopra, Peter Meindl and D. V.
Kalra
 Single Order Purchasing
Make a one-time purchase of an item. How much to order?
Procedure: Balance incremental profit against incremental loss.

Profit = Price per unit  Cost per unit

Loss = Cost per unit  Salvage value per unit

If CPn is probability of n units being sold, then Daily stocking of

newspapers in
CPn x Loss = (1  CPn) x Profit vending
machines is a
or
good example
CPn = Profit/(Profit + Loss)

Now, increase order quantity until CPn just matches cumulative

probability of selling additional units.

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CR (2004) Prentice Hall, Inc.
 Single Order Purchasing (Cont’d)
Example A clothing item is purchased for a seasonal sale.
It costs $35, but it has a sale price of $50. After the
season is over, it is marked down by 50% to clear the
merchandise. The estimated quantities to be sold are:
Probability of
Number of selling exactly n Cumulative
items, n items probability
10 0.15 0.15
15 0.20 0.35
20 0.30 0.65
25 0.20 0.85
30 0.10 0.95
35 0.05 1.00
1.00
CR (2004) Prentice Hall, Inc. 9-19
Single Order Purchasing (Cont’d)

Solution

Profit = $50 35 = $15

Loss = $35  (0.5)(50) = $10
CPn = 15/(15 + 10) = 0.60

CPn is between 15 and 20 items, round up and order 20

items.
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CR (2004) Prentice Hall, Inc.

 Turnover Ratio
Annual sales
Turnover ratio 
Average inventory
A fruit grower stocks its dried fruit products in 12 warehouses
around the country. What is the turnover ratio for the
distribution system?

Ware- Annual Average Ware- Annual Average

house warehouse inventory house warehouse inventory
no. throughput, $ level, $ no. throughput, $ level, $
1 21,136,032 2,217,790 7 43,105,917 6,542,079
2 16,174,988 2,196,364 8 47,136,632 5,722,640
3 78,559,012 9,510,027 9 24,745,328 2,641,138
4 17,102,486 2,085,246 10 57,789,509 6,403,076
5 88,228,672 11,443,489 11 16,483,970 1,991,016
6 40,884,400 5,293,539 12 26,368,290 2,719,330
Totals 425,295,236 43,701,344

$425,295,236
TO ratio   9.7 $ are at cost
9-31
$43,701,344
CR (2004) Prentice Hall, Inc.
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9-33
 Virtual Inventories
•Stockouts are filled from other stocking locations in
the distribution network
• Customers assigned to a primary stocking location
• Backup locations are usually determined by
“zoning” rules
• Expectation is that lower system-wide inventories
can be achieved while maintaining or improving
stock availability levels
• Total distribution costs should be lower to support
the cross filling of customer demand
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CR (2004) Prentice Hall, Inc.

ABC INVENTORY CLASSIFICATION

ABC classification is a method for determining level of control

and frequency of review of inventory items
 A Pareto analysis can be done to segment items into value
categories depending on annual dollar volume
 A Items – typically 20% of the items accounting for 80% of
the inventory value-use
 B Items – typically an additional 30% of the items accounting
for 15% of the inventory value-use
 C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value ©
Wile
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ABC ANALYSIS
 A items are the few most expensive ones that need
special care.

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 B items are ordinary ones that need standard care

 C items are the large number of cheap items that need

little care.

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CONCLUSION

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©
Wiley
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ANALYSIS ON ITS ENTIRE INVENTORY BUT HAS
DECIDED TO TEST THE TECHNIQUE ON A SMALL
SAMPLE OF 15 OF ITS SKU’S. THE ANNUAL USAGE AND
UNIT COST OF EACH ITEM IS SHOWN BELOW

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©
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(A) FIRST CALCULATE THE ANNUAL
DOLLAR VOLUME FOR EACH ITEM

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B) LIST THE ITEMS IN DESCENDING ORDER BASED ON ANNUAL
DOLLAR VOLUME. (C) CALCULATE THE CUMULATIVE ANNUAL
DOLLAR VOLUME AS A PERCENTAGE OF TOTAL DOLLARS. (D)
CLASSIFY THE ITEMS INTO GROUPS

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 GRAPHICAL SOLUTION FOR AAU CORP
SHOWING THE ABC CLASSIFICATION OF
MATERIALS
 The A items (106 and 110) account for 60.5% of the value and 13.3% of the items
 The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the items

© Wiley 2010
 The C items make up the last 14.5% of the value and 60% of the items
 How might you control each item classification? Different ordering rules for each?

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PRACTICE PROBLEM
 A company manufactures a line of ten items. The usage and unit cost are shown in the
following table, along with the annual dollar usage. The latter is obtained by multiplying
the unit usage by the unit cost.
 a. Calculate the annual dollar usage for each item. b. List the items according to their
annual dollar usage.
 c. Calculate the cumulative annual dollar usage and the cumulative percentage of items.

 d. Group items into an A, B, C classification

 ,
,

 ,

 ,