1Session 5 & 6: Managing Inventory Flow on Supply Chains and Inventory

decision making

Chapter 6&7

Objectives:

Understanding the importance of coordinated flows of inventory through supply chains

Appreciate the role of inventory and understand the reasons for carrying/ holding inventory

Assess the types of inventory related costs

Understand how companies can manage inventory using simple tools and techniques

Inventory - Definition

The number of units and/or value of the stock of goods held by a company

Types of Inventory

Raw material Work-in-process Finished goods Support parts MROs (maintenance,

repairs & operating supplies)

In-transit Stock Regular Or Cycle Stock Safety Stock Obsolete, Dead Or

Shrinkage Seasonal Stock Speculative Stock Promotional Stock

A stock (fast-moving stock) B stock C stock (slow-moving stock)

In The Pipeline

Called in-transit stock

Regular Or Cyclical Stock

Inventories required to meet average demand between replenishments.

Dependant upon: sales demand or production lot size replenishment lead times price-quantity discount schedules economical

shipment quantities storage space limitations

2Safety Stock

Hedge against variability in supply, demand and replenishment lead time

Added to regular stock Calculated by statistical procedures Accurate forecasting is essential If demand and lead time 100% correct, no

need for safety stock

Obsolete, Dead, Shrinkage Stock

Includes out of date, lost or stolen stock.

Where products expensive or easily stolen-must have special precautions.

Seasonal Stock

Inventories held in advance of production or sales requirements

Speculative Stock

Inventories built up in anticipation of future price increases

Promotional Stocks

For marketing promotion purposes Trial product Sampling Free gift

Reasons for holding inventory

3enables firms to achieve economics of scale

A firm can realiseeconomics of scale in purchasing, manufacturing, distribution.

Purchasing in large volumes

Realising lot quantity discounts

Transport can move large quantities, reducing freight costs per unit through better vehicle utilisation

Manufacturing long production runs

helps balance supply and demand

helps balance supply and demand when demand or supply is seasonal

Raw materials supply may be available only at certain times during the year.

Demand may be seasonal By manufacturing to stock,

production can be kept level throughout the year. This reduces idle capacity and maintains a relatively stable workforce.

allows for production specialisation

Inventory allows firms with subsidiaries to specialise -focused factories

Instead of producing a variety of products, each plant can manufacture a product and then ship the finished products to field warehouses where they are mixed to fill customer orders.

protects against uncertainties

A primary reason to hold inventory is to offset uncertainties in demand and supply.

Supply shortage in raw materials -production shuts down.

Customer orders outstrip finished goods supply, stockouts occurs-lose customers.

acts as a buffer

Inventory can buffer key interfaces, creating time and place utility

Key interfaces:Supplier-procurementprocurement-productionproduction-marketingmarketing-distributiondistribution-intermediary intermediary-customer

Conflicting objectives of functional areas

Marketing wants high inventories over broad range of products to allow quick response to customer demands

Production wants high inventories to support long production runs and to realise economics of scale through the reduction of per unit fixed costs

Finance normally prefers low inventories to increase inventory turns

MarketingMarketing ProductionProduction FinanceFinance

4Total cost concept

Order processing &information costs

Lot quantitycost

Inventorycarrying costs

Warehousingcosts

Transportationcosts

Customerservice

Inventory covers problems

Sea of inventory

Quality

problems

Machinebreakdown Lineimbalance

Long transportationLong

set-up

time

Lack ofhouse-keeping

Vendor delivery

Poor

schedulin

g

Finish product to customer

Rawmaterial

Commun

ication

problem

Absenteeism

Cost of inventory

Does it cost to carry/hold inventory?

inventory costs categories

Carrying costcosts associated with physically storing a product. Includes only those costs that vary with the quantity of inventory. Usually expressed as a % of product value.

Ordering cost costs of placing an

order. Setup cost

refers to modifying the production process to make different goods.

Two types of costs are associated with inventory

Inventory carrying costs

Carryingcost

Carryingcost

Service cost

Service cost

Capital/opportunity cost

Capital/opportunity cost

insuranceinsurance

Inventory investmentInventory investment

TaxesTaxes

Plant warehousesPlant warehouses

Public warehousesPublic warehouses

Rented warehousesRented warehouses

Company warehousesCompany warehouses

ObsolescenceObsolescence

DamageDamage

RelocationRelocation

TheftTheft

Storage cost

Storage cost

Inventoryrisk cost

Inventoryrisk cost

Calculating Inventory Carrying Cost an Example

10247

23%

CapitalStorage spaceInventory serviceInventory risk costTotal

% of product valueCost

5Ordering/setup costs

Orderingcost

Orderingcost

selecting suppliersselecting suppliers

processing order requestprocessing

order request

preparing payment

preparing payment

Reviewinginventory level

Reviewinginventory level

Setupcost

Setupcost Capital

equipment costCapital

equipment cost

Personnelcost

Personnelcost

stock checking

Inventory Costs: Expected Stock-out Cost

Cost of not having product available when a customer wants it.

Includes : backorder costs (special order). Losing one item profit by substituting a competing firms

product. Losing a customer permanently if customer finds they

prefer the substituted product and/or company.

STOCKOUT COSTS CALCULATION

COST POSSIBILITY

Wait until normal replenishment $0 10%Back order $10 40%Lost of sales $50 30%Lost of customer $100 20%

Total :$0*10% + $10x40% + $50x30% + 100x20% =$39

Trade-off: carrying costs vs ordering cost

Ordering costOrdering cost

InventoryInventorycarrying costcarrying costA

nnua

l cos

t ($)

Ann

ual c

ost (

$)

Size of orderSize of order

ABC Analysis

Single-Criterion ABC Analysis: Based on the notion: 'Vital few, trivial many' Separating inventory items into three groupings

according to their annual cost volume usage. A items having high dollar usage B items having an intermediate dollar usage C items having a low dollar usage.

The Pareto (80-20) effect

% of items

% o

f tot

al s

ales

20

20

100

100

80

80

620% of customers,products, parts

80% of thecompany's revenueand inventoryinvestment

These are called"A" customers, "A"products, "A" parts

30% of customers,products, parts

15% of thecompany's revenueand inventoryinvestment

These are called"B" customers, "B"products, "B" parts

50% of customers,products, parts

5% of thecompany's revenueand inventoryinvestment

These are called"C" customers, "C"products, "C" parts

A-B-C analysis: An Example

SKU Annual Quantity % of total Annual $ % of total Used Item Purchases Purchases

1 1023 9.4 3600000 11.82 574 5.3 6200000 20.43 3906 36 1100000 3.64 521 4.8 15400000 50.75 1145 10.5 2300000 7.66 3754 34 1800000 5.9

Total 10923 100 30400000 100

Highest

Lowest

A-B-C Analysis (Contd)

SKU Annual Quantity % of total Annual $ % of total Used Item Purchases Purchases

4 521 4.8 15400000 50.72 574 5.3 6200000 20.41 1023 9.4 3600000 11.85 1145 10.5 2300000 7.66 3754 34 1800000 5.93 3906 36 1100000 3.6

Total 10923 100 30400000 100

71.1% of purchases10.1% of items

Pareto analysis (Example)

% o

f tot

al s

ales

10.1

100

100

71.1

90.5

30

A

B

C

10.1%

19.9%

70%

9.5%

19.5%

71.1%

A = 2, 4

B = 1, 5

C = 3, 6

Inventory management policy

The purpose of classifying items into categories is to establish the appropriate degree of control over each item.

A category items: must be frequently reviewed and should be

ordered more frequently. Attempt must be made to reduce the average lot

size For C category items:

much looser control is appropriate higher lot size and higher inventory is tolerated

For B category items

Basic approaches to managing inventory

Basic questions:

How much to order? When to order? Balance cost with service

7Differences among approaches

Push and pull system

Dependent and independent demand

System-wide and single-facility solution

Key Differences among Approaches to Managing

Inventory

Pull versus Push Pull approach is a reactive system, relying on

customer demand to pull product through a logistics system. MacDonalds is an example.

Push approach is a proactive system, and uses inventory replenishment to anticipate future demand. Catering businesses are examples of push

systems.

PUSH MODEL

EOQ Economic Order Quantity MRPI Material Requirements Planning MRPII Manufacturing Resource Planning DRP Distribution Requirements Planning ERP Enterprise Resource Planning

PULL MODEL JIT

Key Differences among Approaches to Managing

Inventory

Dependent versus Independent Demand Dependent demand is directly related to the

demand for another product. For many manufacturing processes, demand is dependent. JIT, MRPI and MRPII are generally associated with items

having dependent demand.

Independent demand is unrelated to the demand for another product.

For many end-use items, demand is independent. EOQ & DRP models are generally associated with items

exhibiting independent demand.

Economic order quantity (EOQ)

Based on some unrealistic assumptions: Demand is known and constant Lead time is known and constant Receipt of inventory is instantaneous No stock-out Quantity discount is not allowed.

Economic order quantity (EOQ)

8EOQ Formula-how many to buy?

LetA = cost of placing an order (or setup

cost) ($ per order)R = annual demand (units)W = annual inventory carrying cost (as

a % of product cost)V = value or cost of one unit of

inventory ($).Q = quantity ordered lot size (units).

R/Q = number of orders(R/Q)*A = annual ordering (setup) cost.Q/2 = average inventory(Q/2)*W*V = annual inventory carrying

cost

Note that optimal total cost occurs at a point where annual carrying cost is equal to annual ordering (setup) cost.

Therefore,(R/Q)*A = (Q/2)*W*V (i)

From expression (i) we can calculate Economic Order Quantity (EOQ):

Q = EOQ = (2RA/WV)

Re-order point: When to buy?

Reordering point - ROP = d x L

Where d = demand rate; L = average lead time

ROP = (R /12 )x L (when L expressed in months) ROP = (R /52) x L (when L expressed in weeks) ROP=? (When L expressed in days)

Classroom Exercise

The Williams Manufacturing Company Purchases 8000 units of a product each year at a unit cost of $10.00. The order cost is $30.00 per order, and the holding cost per unit peryear is $3.00. What are the:

(1) EOQ, (2) total annual inventory

expenses(3) number of orders to place in

one year(4) ROP when the lead time is 2

weeks?

Q* = 2RA/WV = (2 x 30 x 8000)/3 = 400 units

TIC = VR + RA/Q* + WVQ*/2= 10 x 8000 + 30 x 8000/400

+ 3 x 400/2= $81200.00

N = R/Q* = 8000/400 = 20 orders /year

ROP = R x L /52 = (8000/52)x2 = 307.7 = 308 units

Graph

Q* = 400

ROP = 308

LT = 2 Wks

Q* = 400

d = 8000/52=308/2 = 154 units

Two important insights of EOQ

An optimal policy balances between inventory holding cost and ordering or setup cost.

Total inventory cost is insensitive to order quantities within certain range, that is, changes in order quantities have relatively small impact on annual setup costs and carrying costs. 1.00 1.200.60 0.80 1.40

10.0

5.0

0.00

15.0

20.0

When Q < 40% Q* total variable cost increases by 14%When Q > 40% Q* total variable cost increases by about 6%

9Inventory under uncertainty

Demand varies Lead time varies

2 127

Demand distribution

Lead timeVaries between 3 and 5Average lead time = 4

Example: sales data (Demand)

Day Sales Day Sales1 100 14 802 80 15 903 70 16 904 60 17 1005 80 18 1406 90 19 1107 120 20 1208 110 21 709 100 22 10010 110 23 13011 130 24 11012 120 25 9013 100

Minimum sales

Maximum sales

Standard deviation of sales = 20 units

Average sales = 100 units

Example: lead time data

# Lead time # Lead time1 9 14 122 8 15 113 9 16 114 13 17 135 11 18 126 7 19 87 12 20 98 11 21 99 9 22 1010 9 23 1011 8 24 912 9 25 1113 10

Minimum lead time

Maximum lead time

Lead time = 7 - 13 days

Average Lead time = 10 days

Standard deviation of LT=1.63

Inventory under uncertainty

) Safety stock =(AvgLT*s2d + Avgd2*sLT2) z= (10*400 + 10000* (1.63)2)z

84.13% = 1 x standard deviation; z=1; safety stock = 175

97.72% = 2 x standard deviation; z=2; safety stock = 350

99.87% = 3 x standard deviation; z=3; safety stock = 525

Probability Distribution

Total sales=840 average sales=840/12=70

80116056012606

601040470910039087021007501

salesperiodsalesperiod

10

1800fd2=4000

900302N=12

100

40040020190

10010010180

000270

400100-10460

400400-20150

900900-30140

fd2Deviation squared

d2

Deviation from

average

Frequency(f)

sales

19112

40001

2

===nfd

S

Average lead time=118/158

18

fd2=46932

n=151156

442110

21129

00028

51-157

84-226

99-315

fd2Deviation squared

(d2)

Deviation from

average

Frequency(f)

Lead time in days

8.1115

461

2

===nfd

LT

) Safety stock =(AvgLT*s2d + Avgd2*sLT2) *z= (8*192 + 702* (1.8)2) *z=137* z

MRPI

Material Requirements Planning

11

61

The McGraw-Hill Companies, Inc., 2004

Firm orders from knowncustomers

Forecastsof demand

from randomcustomers

Aggregateproduct

plan

Bill ofmaterial

file

Engineeringdesign

changes

Inventoryrecord file

Inventorytransactions

Master productionSchedule (MPS)

Primary reportsSecondary reports

Planned order schedule for inventory and production control

Exception reportsPlanning reportsReports for performance control

Materialplanning(MRP

computer program)

MRPII (Closed Loop MRP)

Master Production Scheduling

Realistic?No

Feedback

Execute

Yes

Feedback

Manufacturing Resource Planning (MRP II)

Goal: Plan and monitor all resources of a manufacturing firm : manufacturing marketing finance engineering

DRP

Distribution Requirements Planning

Distribution Requirements Planning

Market Market Market

Regional warehouse

Regional warehouse

FactoryCentral warehouse

12

Distribution Requirements Planning

Inventory planning What to distribute How much to distribute

Transport planning Time & Frequency Vehicle & Driver Route

Warehouse planning Space Receiving Processing Dispatch

Customer order planning Order cycle management

Etc.

Just In Time (JIT)

Produces and delivers finished goods just in time to be sold

Produces sub-assemblies just in time to be assembled into finished goods

Produces fabricated parts produced just in time to make sub-assemblies

Purchases raw materials just in time to make fabricated parts

JIT is a Pull model

JIT pulls materials and products through production plant and distribution channels in response to customer or downstream demands.

PullPullflexible manufacturing demand responseShorter production runs

lower inventory levels

Inventory at Multiple Locations The Square Root Law (SQL)

Used to reduce inventory at multiple locations.

As locations increase, inventory also increases, but not in the same ratio as the growth in facilities.

Inventory at Multiple Locations The Square Root Law

X2= (X1) * (n2/n1) Where:

n1 = number of existing facilitiesn2 = number of future facilitiesX1 = total inventory in existing facilitiesX2 = total inventory in future facilities

Square Root Law Example

Current distribution 40,000 units Eight facilities shrinking to two Using the square root law:

X2 = (40,000) *(2/8)X2 = 20,000 units