IBS3002 Logistics & International Trade

Chapter 4
Inventory management

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Contemporary logistics, Murphy (2015)
Topic areas

 Inventory
 Classifying inventory
 Inventory costs
 Inventory decisions
 Inventory flow patterns
 Inventory management
 Contemporary approaches to managing inventory

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Inventory

 Inventory: stocks of goods and materials that are maintained for many purposes, the most
common being to satisfy normal demand patterns
 Inventory management: is a systematic approach to sourcing, storing, and selling inventory
—both raw materials (components) and finished goods (products).
 Inventory management is a key component in logistics & SCM because its decisions are a
driver for other business activities

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Inventory

 Management must reduce inventory levels yet avoid stockouts and other problems
 Important of inventory in other organizational functions:
 Marketing – more inventory for higher customer service
 Manufacturing – more inventory to schedule longer productions runs
 Finance – less inventory to keep inventory turnover ratios high (reduce risk inventory loss)
and to keep Return on Assets (ROA) high (increase competitiveness)

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Inventory classifications

 Cycle (base) stock: inventory that is needed to satisfy normal demand during the course of
an order cycle
 Safety (buffer) stock: inventory that is held in addition to cycle stock to guard against
uncertainty in demand or lead time
 Pipeline (in-transit) stock: inventory that is en route between various fixed facilities in a
logistics system (plant, warehouse, store…)
 Speculative stock: inventory that is held for several reasons, including seasonal demand,
projected price increases and potential shortages of product

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Inventory classifications

 Cycle (base) stock: inventory that is needed to satisfy normal demand during the course of
an order cycle
 Safety (buffer) stock: inventory that is held in addition to cycle stock to guard against
uncertainty in demand or lead time
 Pipeline (in-transit) stock: inventory that is en route between various fixed facilities in a
logistics system (plant, warehouse, store…)
 Speculative stock: inventory that is held for several reasons, including seasonal demand,
projected price increases and potential shortages of product

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Inventory costs

 Inventory costs are important:

- Represent a significant component of costs in many organizations
- Inventory levels kept affect the level of service the organization can offer its customers
- Cost tradeoff decisions in logistics depend on and ultimately impact inventory carrying
costs
 Inventory costs include:
- Carrying costs
- Ordering costs
- Stockout costs
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Inventory costs

 Carrying costs:
 Carrying costs refer to the costs associated with holding inventory
 Inventory costs are expressed in percentage terms & this percentage is multiplied by the
inventory’s value
 Components of inventory carrying costs:
- Obsolescence costs - Taxes
- Inventory shrinkage - Interest costs
- Storage costs
- Handling costs
- Insurance costs 8
 Inventory costs
 Carrying costs:
 Obsolescence cots: are incurred when an item in inventory becomes obsolete before it is sold
or used (i.e. perishable products-meat, milk…)
 Inventory shrinkage: is the excess amount of inventory listed in the accounting records, but
which no longer exists in the actual inventory (i.e. damage, loss, theft..)
 Storage costs: costs associated with occupying space in a plant, storeroom, or warehousing
facility
 Handling costs: costs of employing staff to receive, store, retrieve, move inventory
 Insurance costs: insure inventory against fire, flood, theft, other perils…
 Interest costs: money required to maintain the investment in inventory
 Taxes 9
Inventory costs
 Ordering costs:
 Ordering costs refer to the costs associated with ordering inventory, including order costs
and setup costs
 Order costs: the costs of receiving an order. They include:
+ The transaction costs associated with making an international purchase: international wire
transfers, letters of credit, and bank fees.
+ The document costs, such as certificates of origin, import license, customs brokerage
fees.
+ The time spent, as all international purchases take more time than domestic purchases.

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Inventory costs

 Ordering costs:
 Setup costs: are those necessary to modify production processes to make the products
necessary to satisfy particular orders. They include:
+ The process-change costs associated with switching from making one type of part to
making another type of part. Different raw materials, different settings, different speed.
+ The time involved in making the change, from employees’ costs to production downtime
costs.

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Inventory costs

An offset printing machine incurs a setup cost

when production changes from one job to
another.
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Inventory costs
 Stockout costs:
 Stockout costs (shortage costs) are costs caused by product shortages on the shelf.
 They may be an effect of wrong forecasting, supplier-retailer communication and/or
logistics management.
 It involves an understanding of a customer’s reaction to a company being out of stock when
a customer wants to buy an item
 There are 3 types of customer response to a stockout:
+ delayed sale (brand loyalty)
+ lost sale (switches and comes back)
+ lost customer
=> cost of stockout 13
Inventory costs
 Trade-off between Carrying & Ordering costs:
• The trade-off that exists between carrying and ordering costs is that they respond in opposite
ways to the number of orders or size of orders
• An increase in the number of orders leads to higher order costs & lower carrying costs

 Trade-off between Carrying & Stockout costs:

• The trade-off between carrying and stockout costs is that both move in opposite directions –
higher inventory levels (higher inventory carrying costs) result in lower chances of a
stockout (lower stockout costs)

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Inventory costs

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 Lead time

 The lead time is the period between the moment an order is placed and the time at which it
arrives.

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When to order

 Fixed order interval system: the time interval is constant, the order size may fluctuate

-> The inventory is replenished at regular intervals, and the quantity of goods re-ordered
changes.

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When to order

 Fixed order quantity system: the time interval may fluctuate, the order size stays constant

-> The inventory is replenished whenever inventory level reaches a certain

point. The periodicity changes
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When to order

 Reorder point (trigger point): the level of inventory at which a replenishment order is
placed.
• The firm reorders the goods when the inventory level has reached a point that is equal to the
expected demand during the lead time.

ROP = DD x RC
- ROP: reorder point
- DD: average daily demand (unit)
- RC: replenishment cycle (day/ week/ month)

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When to order

 Example: Average daily demand is 40 units, the replenishment cycle is 4 days

The order point is 40x4=160 units
-> when the inventory level reaches 160 units, a reorder is placed
 Reorder point is used for an efficient fixed order quantity system -> require relatively
frequent monitoring of inventory levels
 Inventory levels are monitored much less frequent in fixed order interval system -> make
this system much more susceptible to stockout situations -> higher levels of safety stock

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When to order

 Reorder point can be calculated in the other manner:

ROP = (DD x RC) + SS
SS: safety stock

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How to order

 Economic Order Quantity (EOQ):

 Economic order quantity (EOQ) is the ideal order quantity a company should purchase to
minimize inventory costs
 EOQ deals with calculating the proper order size with respect to two costs: carrying costs &
ordering costs
 EOQ determines the point at which the sum of carrying costs & ordering costs is minimized
(the point at which carrying costs equal ordering costs)
 EOQ formula was created by Ford W. Harris in 1915

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How to order

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 How to order

 Economic Order Quantity (EOQ):

 The basic EOQ model is grounded in the following assumptions:
1. A continuous, constant, & known rate of demand
2. A constant & known replenishment or lead time
3. A constant purchase price that is independent of the order quantity
4. All demand is satisfied (no stockouts are allowed)
5. No inventory in transit
6. Only one item in inventory or no interaction between inventory items
7. An infinite planning horizon
8. Unlimited capital availability 24
How to order

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How to order

EOQ  2 AB / C
- EOQ: the most economic order size, in dollars
- A: annual usage, in dollars
- B: administrative costs per order of placing the order
- C: carrying costs of the inventory (expressed as an annual percentage of the inventory
dollar value)

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How to order

 Example: suppose that $1000 of a particular items is used each year, the order costs are $25
per order submitted, inventory carrying costs are 20%. EOQ in dollars

EOQ  2 x1000 x 25 / 0.2  250000  500dollars

-> Therefore, EOQ is $500 order size

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How to order

EOQ  2 DB / IC
- EOQ: the most economic order size, in units
- D: annual demand, in units
- B: administrative costs per order of placing the order
- C: carrying costs of the inventory (expressed as an annual percentage of the inventory
dollar value)
- I: dollar value of the inventory, per unit

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How to order

 Example: suppose that $1000 of a particular items is used each year, the product has a cost
of $5 per unit, the order costs are $25 per order submitted, inventory carrying costs are 20%
- Annual demand: D = 1000/5 = 200 units

EOQ  2 DB / IC  2 x 200 x 25 / 0.2 x5  10000 / 1  100units

-> Therefore, EOQ is 100 units

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How to order

The total cost calculations for several other order size:

-> The total cost is minimized at EOQ

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Inventory flows

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How to order

* Assumption:
EOQ: 120 units
Safety stock: 60 units
Average demand: 30 units per day
Order cycle: 2 days
Beginning inventory = EOQ + safety stock = 120 + 60 = 180 units
Reorder point = (daily demand x replenishment cycle) + safety stock
= 30x2 + 60 = 120 units

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How to order

• Safety stock can prevent against two problem areas: an increased rate of demand and a
longer-than-normal replenishment
• When a fixed order quantity system (EOQ) is used, the time between orders may vary
• Requirement of using a fixed order quantity system: that the level of inventory must
constantly be monitored, when the reorder point is hit, the fixed order quantity is ordered
-> use technology advances to monitor inventory constantly
-> reorder point is established electronically

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Inventory management: special concerns

 ABC Analysis of Inventory:

 ABC analysis of inventory is the classification of a group of items in decreasing order, based
on their value to the business. The A group is the most important in terms of the value
contributing to the company, whilst C items are the least valuable.
 The 80/20 rule: 80% of a company’s sales come from 20% of its products & conversely
 Company should focus on the 20% of products that generate the 80% of sales
-> decrease inventory carrying costs

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Inventory management: special concerns

 ABC Analysis of Inventory:

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Inventory management: special concerns

 ABC Analysis of Inventory:

 Measures to determine ABC status: sales volume in dollars, sales volume in units, the
fastest-selling items, item profitability & item importance
 Group A usually represents 10-20% by number of items and accounts for 50-80% of dollar
volume
 Group C contains 60-70% of the items but only accounts for 10-30% of the dollar volume
 Group B has more items than group C but less than group A, with the value is higher than
group C but far less than group A in volume

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Inventory management: special concerns
 ABC Analysis of Inventory:
 The determination of what percentage of items should be classified as A, B, C may have
effect on the efficiencies of inventory
-> too high or too low a percentage of A items may reduce the potential efficiencies to be
gained from the classification technique
 ABC analysis can determine stocking patterns in warehousing facilities
 ABC analysis could be used to determine how frequently inventory gets monitored

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Inventory management: special concerns
 ABC Analysis of Inventory:
 A items might be checked daily (increasingly, hourly)
 B items weekly
 C items monthly

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Inventory management: special concerns
 Dead Inventory:
 Dead inventory (dead stock) refers to a product for which there is no sales during a 12-
month period
 Dead inventory increases inventory carrying costs, takes up space in warehousing facilities
-> need to have structured process for managing
 How to deal with dead stock?
-> drastic price reductions
bunching it with more attractive products,
use deadstock broker, donations…

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Inventory management: special concerns
 Inventory Turnover:
 Inventory turnover: the number of times that inventory is sold in a one-year period
 Inventory turnover can be calculated:
Inventory turnover = the cost of goods sold / the average inventory
The average inventory = (beginning inventory + ending inventory) / 2

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Inventory management: special concerns
 Inventory Turnover:
 Inventory turnover measures how fast a company sells inventory & compare it to
competitors or industry averages
-> organization’s competitiveness & efficiency
 A low turnover: weak sales, overstocking
 A high turnover: strong sales, low level of inventories
 Inventory turnover related to trade-offs involving organizational functions:
marketing (price) – finance (profit) – logistics (inventory turnover)

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Inventory management: special concerns
 Inventory Turnover:
 How to increase inventory turnover?
-> reducing average inventory
-> how to reducing average inventory?
-> ABC analysis & Dead inventory

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Inventory management: special concerns
 Complementary and Substitute products:
 Complementary goods are products which
are consumed and distributed together (i.e.
razor blades and razors)
-> pressure on retailers/wholesalers
involving inventory maintenance
-> need to consider the amount of
inventory to be carried because
complementary products is necessary
to support the sale of its complement

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Inventory management: special concerns
 Complementary and Substitute products:
 Substitute goods refer to products that can fill the same need or want as another product
- The substitutability can occur at a specific product level (i.e. Coca-Cola & Pepsi)
or across product classes (i.e. potatoes & rice)
- Implications for stockout costs and the maintaining of
size of safety stock

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Contemporary issues with managing inventory

 Lean Manufacturing (Lean)

 Lean manufacturing is the methodology that
focuses on the elimination of waste and the
increase of speed and flow
 The idea of lean manufacturing was first
championed by the model “The Toyota Way”
(Toyota Production System) in the 1930 at Toyota
- Japan
 It was officially called “Lean” in the book “The
Machine that Changed the World” in the
1990s
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Contemporary issues with managing inventory

 Lean Manufacturing (Lean)

 Lean thinking aims to identify and remove wastes from work processes
 Waste is any action or step in a process that does not add value to the customer. In other
words, waste is any process that the customer does not want to pay for.
 7 major sources of waste – TIMWOOD
 TIMWOOD - Transportation, Inventory,
Motion, Waiting, Overproduction,
Overprocessing and Defects

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 Contemporary issues with managing inventory
 Just-in-time (JIT)
 JIT approach seeks to minimize inventory by reducing (if not eliminating) safety stock, and
by having the required amount of materials arrive at the production location at the exact
time that they are needed
 JIT inventory management focuses on minimizing inventory and increasing efficiency in
logistics
 JIT emphasizes minimal inventory levels, low (no) safety stock & defective materials
 Trucking is an important mode of transportation in the JIT
approach to meet some requirements from JIT system:
smaller orders, more frequent shipments, closer supplier
location
 The aim of JIT: encompass movement of materials and 47
component parts from supplier to producer
Contemporary issues with managing inventory

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Contemporary issues with managing inventory
 ECR & QR
 Efficient consumer response (ECR) and Quick response (QR) tend to focus on product
movement from manufacturer to retailer
 ECR is associated with the grocery and beverage industries
 QR is associated with the apparel industry

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Contemporary issues with managing inventory
 Service Part Logistics
 Service parts logistics involves designing a network of facilities to stock service parts,
deciding upon inventory ordering policies, stocking the required parts, and transporting parts
from stocking facilities to customers

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Contemporary issues with managing inventory
 Vendor-Managed Inventory (VMI)
 Vendor-managed inventory (VMI) is an inventory management technique in which a
supplier of goods, usually the manufacturer, is responsible for optimizing the inventory held
by a distributor.
 The size and timing of replenishment orders are the responsibility of the manufacturing
(vendor)
 VIM requires the access to EDI or Internet

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Contemporary issues with managing inventory
 Vendor-Managed Inventory (VMI)
 VMI allows manufacturers to have access to a distributor’s or retailer’s sales and inventory
data -> to plan inventory and place orders
 Benefits of VMI: reduced inventories, fewer stockouts, improved customer retention,
reduced reliance on demand forecasting
 Drawbacks of VMI: inadequate data sharing between the relevant parties, increase cost in
technology (EDI), resistance in the change to a new system

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Inventory management as a marketing tool
 A benefit of good inventory management is that companies are able to deliver goods to their
customers when the goods are needed. There is a greater likelihood that the item is in
inventory and available for sale.
 Good inventory practices also lower costs, which allows a company to be more profitable or
allows a company to sell at a lower price, which translates into a competitive advantage.
 Good inventory practices (an MRP) allows companies to inform their customers of the
status of an order.

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