Role of Inventory Management
in SCM
Chapter 10
SUPPLY CHAIN MANAGEMENT
Process,System, and Practice
Oxford University Press
ISBN: 9780198063025
Dr.N.Chandrasekaran
Learning objectives
• Understand the importance of inventory in supply chain
• Understand the types and classification of inventory
• Gain an insight into the costs to be reckoned while
holding inventory
• Understand the importance of inventory management
• Gain an insight into the control of inventories in retail
and services
• Comprehend the inventory models
• Appreciate the role of inventory in supply chain with
respect to efficiency and effectiveness
Definition
• Inventory refers to any owned or financially
controlled raw material, works in process,
and/or finished good or service held in
anticipation of a sale but not yet sold.
• Also include all those items and goods that
indirectly contribute to production processes
such as stores and consumables items.
• All these will have a financial impact on the
income statement and the balance sheet of
the company.
Inventory across supply chain Network
Importance
• Customer service by providing product
availability
• Encourages production, purchase and
transportation economies
• Act as a hedge against price changes
• Hedge against uncertainties in demand and
lead times
• Hedge against contingencies that one
experiences because of events like strikes
Classification of Inventory
Inventory can be categorized in three different
ways, including raw materials, work-in-
progress, and finished goods.
In accounting, inventory is considered a current
asset because a company typically plans to sell
the finished products within a year.
Classification of Inventory
Cycle inventory: The average inventory that
builds up in the supply chain as purcahse lots
are bigger than demand lots.
– Lot size refers to quantity that a supply chain stage
either produces or orders at a given time.
– Cycle inventory = Q /2
– Average flow time = Average inventory / Average
flow rate
– Average flow time from cycle inventory = Q / 2d
Role of Cycle Inventory
in a Supply Chain
Q = 1000 units
d = 100 units/day
Cycle inventory = Q/2 = 1000/2 = 500 = Avg inventory level from cycle
inventory
Avg flow time = Q/2d = 1000/(2)(100) = 5 days
• Cycle inventory adds 5 days to the time a unit spends in the supply
chain
• Lower cycle inventory is better because:
– Average flow time is lower
– Working capital requirements are lower
– Lower inventory holding costs
Safety inventory
• Safety Inventory carried for the purpose of satisfying demand
that exceeds the amount forecasted in a given period
• Forecasts are rarely completely accurate
• If average demand is X units per week, then half the time
actual demand will be greater than X, and half the time actual
demand will be less than X; what happens when actual
demand is greater than X?
• If you kept only enough inventory in stock to satisfy average
demand, half the time you would run out and there is a lost
sale.
Seasonal Inventory
• Refers to inventory that is used to absorb
uneven rates of demand or supply that
businesses face
• Holding seasonal inventory is meant for
meeting the volatility in demand and supply
Pipeline Inventory
• Inventory moving from one node to another in
materials flow system is called pipeline
inventory
• Refers to orders placed but not served
• Can be reduced by reducing stock locations,
improving materials handling and avoiding
delays in distribution
Costs to be reckoned
• Inventory holding (carrying) cost
• Storage and handling cost
• Taxes, insurance and shrinkage costs
• Ordering cost
Cycle counting - Advantages
• Eliminates the shutdown and interruption of production
necessary for annual physical inventories.
• Eliminates annual inventory adjustments as adjustments are
finished as and when counting is completed on a day.
• Allows the cause of the errors to be identified and remedial
action to be taken.
• Maintains accurate inventory records.
• Improves Audit personnel effectiveness because of limited
and routine action.
Managing inventory at retail
• Good personnel selection, training, and discipline.
• Demand estimation and revisions on a near dynamic
state and rework pricing
• Tight control of incoming shipments.
• Effective control of all goods leaving the facility.
• Deployment of right analytics to understand
customer choices, preferences and feedback and
improve on loyalty programme.
Inventory related costs
Cost factor Cost Range as % of
value
Storage cost 2-4
Holding cost (Cost of capital - Function of inventory turnover 6 - 12
and capital employed)
Material handling cost 1-3
Labour cost 2–4
Insurance, pilferage & Obsolescence cost 1-5
Inventory Decisions
• There are two important questions that need
to be addressed:
– when to order
– how much to order
• The following independent demand models
are discussed:
– Basic economic order quantity (EOQ) model.
– Production order quantity model.
– Quantity discount model.
Assumptions
• Demand is known, constant, and independent.
• Lead time is known and constant.
• Inventory from an order arrives in one batch at one time.
• There is no quantity discounts.
• The only variable costs are the cost of setting up or placing an
order (setup cost) and the cost of holding or storing inventory
over time (holding or carrying cost).
• Stockouts (shortages) are not there
Basic Economic Order Quantity model
EOQ & Reordering point
One can determine setup and holding costs and solve for Q*:
Q = Number of pieces per order
Q* = Optimum number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Q* = √ (2DS/H)
Total annual cost = Setup Cost + Holding Cost
TC = (D/Q)*S + (Q/2) * H
ROP = (Demand per day) (Lead time for a new order in days)
=d*L
Production Order Quantity Model
Applicable under two situations:
(1) When inventory continuously flows or
builds up over a period of time after an order
has been placed or
(2) when units are produced and sold
simultaneously.
Under these circumstances, we take into
account daily production (or inventory-flow)
rate and daily demand rate.
Order Quantity
• Setup cost = (D/Q) S
• Holding cost = ½ HQ [1 – (d / p)]
• Set ordering cost equal to holding cost to
obtain Q*p:
(D / Q) S = ½ HQ [1 – (d / p)]
Q2 = 2Ds / H [1 – (d/p)]
Q*p = √2DS / H [1 – (d / p)]
Quantity Discount Model
The total annual inventory cost can be
calculated as follows:
Total cost = Setup cost + Holding cost + Product
cost (or)
TC = (D/Q) S + (QH/2) + PD
Where Q = Quantity ordered; D = Annual
demand in units; S = Ordering or setup cost
per order or per setup; P = Price per unit
H = Holding cost per unit per year
Quantity Discount Model
This process involves four steps:
• Step 1: For each discount, calculate a value for optimal order
size Q*, using the following equation: Q* = √2DS / IP
• Step 2: If the order quantity is too low to qualify for the
discount, adjust the order quantity upward to the lowest
quantity that will qualify for the discount.
• Step 3: Using the preceding total cost equation compute a
total cost for every Q* determined in steps 1 and 2.
• Step 4: Select the Q* that has the lowest total cost, as
computed in step 3. It will be the quantity that will minimize
the total inventory cost.
Illustration
A buyer is offered discounts on price of his purchases
based on quantity bought. This quantity schedule
was shown in Exhibit. The normal cost for the item is
Rs.10/- per unit. For orders between 3,000 and 5,999
units, the unit cost drops to Rs.9.30; for orders of
6,000 or more units, the unit cost is only Rs.9.00.
Furthermore, ordering cost is Rs.240 per order, annual
demand is 24,000 units, and inventory carrying
charge, as a percentage of cost, I, is 20%. What order
quantity will minimize the total inventory cost?
DISCOUNT DISCOUNT DISCOUNT (%) DISCOUNT PRICE
NUMBER QUANTITY (P)
1 0 TO 2999 NO Discount Rs.10.00
2 3,000 TO 5,999 7 Rs.9.30
3 6,000 AND Over 10 Rs.9.00
The first step is to compute Q* for every
discount in Exhibit 10.7. This is done as
follows:
• Q*1 = √2 (24,000) (240) / (.2) (10.00) = 2400
units
• Q*2 = √2 (24,000) (240) / (.2) (9.30) = 2489
units
• Q*3 = √2 (24,000) (240) / (.2) (9.00) = 2530
units
DISCOUNT UNIT ORDER ANNUAL ANNUAL ANNUAL TOTAL Rs.
NUMBER PRICE QUANTITY PRODUCT ORDERING COST HOLDING
COST Rs. Rs. COST Rs
1 10 2400 .240000 2400 2400 244800
2 9.30 3000 223200 1920 2790 227910
3 9.00 6000 216000 960 5400 222360
One may note that factors like price, quantity
and holding costs would be critical.
Probability Models with constant lead time
• If the probability of a stock out is 0.05, then the service level
is 0.95. Uncertain demand raises the possibility of a stock out
can be addressed through safety stock.
• It involves adding a number of units as a buffer to the reorder
point. Reorder point = ROP = d * L; Where d = Daily demand
• L = Order lead time, or number of working days it takes to
deliver an order
The inclusion of safety stock (ss) changes the expression to
ROP = d * L + ss .
• Annual stock out costs = (the sum of the units short )* (the
probability )*( the stock out cost / unit )* (the Number of
orders per year)
Demand is probabilistic
Demand during lead time (the reorder period) follows a
normal curve, only the mean and standard deviation define
the inventory requirement
We use a normal curve with a known mean (µ) and standard
deviation () to determine the reorder point and safety stock
necessary for a 95% service level.
We use the following formula:
ROP = Expected demand during lead time + Z
Where Z = Number of standard deviations;
= standard deviation of lead time demand
s for any given service level.
Inventory Level in a Fixed – Period (P)
system
In a fixed – period, or P system inventory is ordered at the
end of a given period. Only the amount necessary to
bring total inventory up to a pre-specified target level is
ordered.
Fixed – period systems have several of the same
assumptions as the basic EOQ fixed – quantity system:
• The only relevant costs are the ordering and holding
costs.
• Lead times are known and constant.
• Items are independent of one another.
Inventory Planning
inventory planning is the process of
determining the optimal quantity and
timing of inventory to align it with sales
and production capacity.
Inventory planning affects a company's cash
flow and profits while contributing to an
efficient supply chain.
Inventory Control
The control tools and measures facilitate good control on
inventory are:
• ABC analysis of the assortment categorized by stock
value/volume
• Variance in throughput time of the product group in totality
• The number of damages/claim
• Mean throughput time of the product group / vendor wise/
location wise
• Reliability of the inventory regarding quantity and correct
place.
ABC Analysis
Cycle count - Illustration
Item classification Quantity Policy Number of items to be
counted each day
A 1000 Every 20 working days 1000 / 20 = 50
B 3000 Every 60 working days 3000 / 60 = 50
C 16000 Every 160 working days 16000 / 160 = 100
Inventory Control Model
ABC analysis
• There are a few different types of ABC analysis.
Some will focus more on the monetary cost of
each item, while others focus more on
the supply and demand or usage rates. In any
case, the objectives of ABC analysis follow
what’s called the ‘Pareto Principle’ or ‘80/20
rule,’ which states that 80% of inventory costs
come from 20% of inventory.
Inventory Control Model
• A items: These big-ticket items might just make up 20%
of your inventory, but they hold 80% of its annual value.
• B items: These make up 30% of your inventory but make
up 15% its annual value.
• C items: These lower-value items make up the remaining
50% of your inventory but hold just 5% of its annual
value.
Inventory Control Model
• The ABC analysis theory states that you should focus
the most attention on the A items since they hold the bulk
of your inventory’s value. Interclass or B items also
deserve some attention, with some controls to protect
against loss. However, with C items the ABC analysis
states that it’s not cost-effective to implement strict
controls because the risk of loss is not as important due
to their low value.
Inventory Control Model
Benefits:
• One can reduce losses by maintaining stricter controls over the
higher-value A and B items.
• One can use your stock management resources more efficiently.
• Avoid wasting time on C items that don’t generate very much profit.
Consider devoting more time and money to the A and B classes.
• Improve production efficiency with a greater understanding of what
customers are buying.
Inventory Control Model
VED analysis of inventory control stands
for Vital, Essential, and Desirable. There
are numerous items in the inventory. Not
all things are equally important. As a
result, the company should give things
with high utilization values greater
attention and care while undervaluing
those with low usage values.
Inventory Control Model
An XYZ analysis divides items into three
categories. X items have the lowest demand
variability. Y items have a moderate amount of
demand variability, usually because of a
known factor. Z items have the highest
demand variability and are therefore the
hardest to forecast.
Inventory Control Model
FSN stands for fast-moving, slow-moving
and non-moving items. Essentially, this
segments inventory into three
classifications. It looks at quantity,
consumption rate and how often the item
is issued and used. Fast-moving items are
items in your inventory stock that are
issued or used frequently.
Inventory Control Model
SOS Analysis. It is an analysis technique used in
cases where price and supply change
seasonally. It is mainly used in the supply of
raw materials and semi-finished products.
S: Season > Easy to source and low prices.
OS: Off-Season > Difficult to supply and high
prices.
Inventory Control Model
GOLF analysis, an acronym for Government
Supply, Ordinarily Available, Local
Availability, and Foreign Source of
Supply, provides a structured framework for
inventory categorization, enabling businesses
to optimize procurement strategies, streamline
inventory processes, and minimize costs.
Inventory Control Model
P&Q system:
In the Q system, you always order a fixed
amount of inventory (EoQ) at variable times
depending on when your reorder point is hit,
the P system will be ordering at fixed time
intervals (say every quarter), with a new EoQ
calculated each time up to the max holding
quantity.
Sum up
Inventory management decisions involve trade-offs among
the conflicting objectives of low inventory, high resource
utilization and good customer service.
For making supply chain leaner, firms are using selective
control techniques like EOQ, ABC, etc. and other inventory
control models.
Inventory should be held only when the benefits of holding it
exceeds the cost of carrying the inventory.
Inventory Control System
An inventory control system is a technology
solution that manages and tracks a company's
goods through the supply chain. This
technology will integrate and manage
purchasing, shipping, receiving, warehousing,
and returns into a single system. The best
inventory control system automates a lot of
manual processes.
Inventory Control System
Four popular inventory control methods include
Last In First Out (LIFO)
and First In First Out (FIFO);
batch tracking;
and safety stock.
Inventory Control Process
A perpetual inventory review system works by
updating inventory counts continuously as
goods are bought and sold. This inventory
accounting method provides a more accurate
and efficient way to account for inventory than
a periodic inventory system.
Inventory Control Process
Perpetual inventory review is a continuous
accounting practice that records inventory
changes in real-time, without the need for
physical inventory, so the book inventory
accurately shows the real stock. Warehouses
register perpetual inventory using input
devices such as point of sale (POS) systems
and scanners.
Inventory Control Process
A periodic review system is a method of
inventory replenishment that involves
checking the stock levels of items at fixed
intervals and ordering enough to meet the
expected demand until the next review. This
system can help you reduce inventory costs,
avoid stockouts, and simplify ordering
decisions.
Inventory Control Process
Example of Periodic Systems.
Periodic system examples include accounting for
beginning inventory and all purchases made
during the period as credits. Companies do not
record their unique sales during the period to
debit but rather perform a physical count at the
end and from this reconcile their accounts.
