1 Inventory Fundamentals Chapter 9. 2 What is Inventory? Financial View = An asset in the form of material –Less is better –Dollars tied up in material.

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Inventory Fundamentals

Chapter 9

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What is Inventory?

• Financial View = An asset in the form of material– Less is better

– Dollars tied up in material

• Operations View = Finished goods, raw material,

WIP or materials used in production

– More is better

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Different Perspectives

• Sales Department– High inventories are good for customer service

• Accounting Department– See inventory as a necessary evil, but one that

ties up capital

• Production Department– Do not see the cost on inventory and believe it

should have no restrictions

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What is inventory?

• Provide a stock of goods to meet anticipated customer demand and provide a “selection” of goods

• De-couple suppliers from production and production from distribution

• Allow one to take advantage of quantity discounts

• To provide a hedge against inflation

• To protect against shortages due to delivery variation

• To permit operations to continue smoothly with the use of “work-in-process”

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Categories of Inventory

• Inventory as production materials

• Preproduction materials

• Maintenance materials

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• Inventory– Materials and supplies that a business or

institution carries either for sale or to provide inputs or supplies to the production process

– Represents between 20 to 60% of assets

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• Aggregate Inventory Management– Managing inventories according to their classification

rather than at the individual item level.

– Generally involves:• Flow and kinds of inventory needed

• Supply and demand patterns

• Functions that inventories perform

• Objectives of inventory management

• Costs associated with inventories

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• Item Inventory Management– The organization must establish some decision

rules about inventory items for overall direction.

– Rules include:• Which inventory items are most important

• How individual items are to be controlled

• How much to order at one time

• When to place an order

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• Inventory and the Flow of Material– Raw materials

• Purchased items received which have not entered the production process

– Work-in-process• Raw materials that have entered the manufacturing

process and are being worked on or waiting to be worked on

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• Inventory & Flow of Material– Finished Goods

• Finished products of the production process that are ready to be sold as completed items.

– Distribution Inventories• Finished goods located in the distribution system

– Maintenance, Repair, & Operational Supplies (MRO)• Items used in production that do not become part of the product

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• Function of Inventories– Batch manufacturing - basic purpose of

inventories is to disengage supply & demand

– Inventory serves as a buffer between:• Supply and demand

• Customer demand and finished goods

• Operations

• Suppliers and queues

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• Function of Inventories– Anticipation inventory

• Inventory built up in anticipation of future demand

– Fluctuation Inventory• Inventory held to cover random unpredictable

fluctuations in supply and demand or lead time

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• Function of Inventories– Lot-size Inventory

• Also called cycle stock

• Items purchased or manufactured in quantities greater than immediately needed.

• Allows the firm to take advantage of quantity discounts and to reduce shipping, clerical, and setup costs

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• Function of Inventories– Transportation Inventory

• Also called pipeline or movement inventories

• Inventory in transit because of the time to move goods from one location to another

– MROs• Used to support general operations and

maintenance, but do not become part of the product

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Example: Transportation Inventory

Q: A company is using a carrier to deliver goods to a major customer. The annual demand is $5,000,000, and the average transit time is 8 days. Another carrier promises to deliver in 6 days. What is the reduction in transit inventory?

A: Average annual inventory in transit (I) = tA/365

Where t = transit time in days (8 - 6 = 2 days)

A = annual demand ($5,000,000)

I = (2 X $5,000,000) / 365

I = $27,397.26

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• Inventory Management– Responsible for planning and controlling

inventory from raw material to customer.

– Objectives:• Maximize customer service

• Low-cost plant operations

• Minimum inventory investment

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• Customer Service– The ability of a company to satisfy the needs of

customers.

– The availability of items needed

– Inventories help to maximize customer service by protecting against uncertainty

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• Operating Efficiency– Inventory helps manufacturing to be more

productive by:• Allowing operations with different rates of

production to operate separately.

• Assist with production planning and production leveling through lower costs.

• Allowing for longer production runs

• Allowing the purchase of larger quantities

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• Operating Efficiency– Inventory investment must be balanced with:

• Customer service

• Cost of changing production levels

• Cost of placing orders

• Transportation costs

– If inventory is carried there must be a benefit that exceeds the costs of carrying that inventory.

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• Inventory Costs– Item Cost

• Price paid plus other direct costs associated with getting the time into the plant

– Carrying Costs• All the expenses incurred by the firm because of the

volume of inventory carried.– Capital costs– Storage costs– Risk costs

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Inventory and Bottom-Line Profits

• Excess inventory* has a negative impact on cash flow.

• Carrying costs include warehousing, racking, shelving, interest costs and insurance premiums (typically represents 8% to 14% of inventory costs).

• Reduction in inventory can apply 10% to the bottom line.

*Excess Inventory: On-hand balances in excess of amount needed to support demand

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Example: Carrying Costs

Q: A bakery carries an average inventory of $15,000. If they estimate the cost of capital is 10%, storage costs are 5%, and the risk costs are 8%, what does it cost per year to carry this inventory?

A: Total cost of carrying inventory = 10% + 5% + 8%

= 23%

Annual cost of carrying inventory = 0.23 X $15,000

= $3,450

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• Inventory Costs– Ordering Costs

• Costs associated with placing an order• Cost of placing an order does not depend on quantity • Annual ordering costs depend on number of orders placed per

year• Ordering costs would include:

– Production control costs– Setup and teardown costs– Lost capacity cost– Purchase order cost

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Example: Ordering Costs

Q: Annual purchasing salaries are $85,000, operating expenses for the purchasing department are $35,000, and inspecting and receiving costs are $30/order. If the purchasing department places 12,000 orders/year, what is the average cost of ordering? What is the annual cost of ordering?

A: Average ordering cost = (fixed costs / number of orders) + variable cost

= (($85,000 + $35,000) / 12,000) + $30

= $40

Annual ordering cost = (Average ordering cost)(number of orders)

= ($40)(12,000)

= $480,000

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• Inventory Costs– Stockout Costs

• Stockouts occur when demand during leadtime exceeds the forecast.

• Could include back-order costs, lost sales and customers

– Capacity Associated Costs• Costs associated with changing the level of output

– Overtime, hiring, training, shifts, layoffs…..etc

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• Financial Performance Measures– Widely used as a measure of inventory performance

– Lumps all inventory together thereby hiding obsolete and slow movers

– Inventory Turns Ratio:

Inventory Turns = Annual Cost Of Goods Sold

Average Inventory $

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Example: Inventory Turns

Q: What will be the inventory turns if the annual cost of goods sold is $32 million a year and the average inventory is $8 million?

A: Inventory turns = annual cost of goods sold / average inventory in $ = $32,000,000 / $8,000,000 = 4

Q: What would be the reduction in inventory if inventory turns were increased to 8 times per year? If the carrying costs for inventory is 25%, what are the projected savings?

A: Average Inventory= annual cost of goods sold / inventory turns

= 32,000,000 / 8

= $4,000,000

Reduction in inventory = $8,000,000 - $4,000,000 = $4,000,000

Savings = Inventory reduction X 25% = $4,000,000 X 0.25 = $1,000,000

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• ABC Inventory Control– A scheme where inventory is classified by level

of importance in terms of annual sales dollars

– To control inventory• What is the importance of the inventory item?

• How are they to be controlled?

• How much should be ordered at one time?

• When should an order be placed?

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• ABC Inventory Control– Based on Pareto’s Law:

• A items– 15-20% of items that account for 75-80% of annual

inventory value

• B items– 30-40% of items that account for 15% of annual inventory

value

• C items– 40-50% of items that account for 5-10% of annual inventory

value

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ABC Concept

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• ABC Analysis Steps– Establish item characteristics

• Usually annual dollar usage

– Classify items into groups based on criteria

– Apply control appropriate to classification

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• ABC Inventory Control– Classify annual $ usage by:

1. Determine annual usage for each item

2. Multiply annual usage of each item by its cost to get total annual dollar usage

3. List items according to their annual dollar usage

4. Calculate cumulative annual dollar usage and cumulative percentage of items

5. Examine annual usage distribution & group items into A, B, and C groups based on % of annual usage

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• Walk Through Example Problem on page 251

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• Control Based on ABC Classification– Two general rules:

• Have plenty of low-value items - C items are only important if there is a shortage of one of them - then they become extremely important - so a supply should always be on hand.

• Use the money & control effort saved to reduce the inventory of high-value items - A items are extremely important and deserve the tightest control & the most frequently reviewed

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A Items

B Items

C Items

Tight Control• Complete, accurate records• Regular, frequent review by management• Frequent review of forecasts• Close follow-upNormal Control• Good records• Normal processingSimplest possible control• Make sure there are plenty• Simple or no records• Large order quantities

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• SUMMARY

1 Inventory Fundamentals Chapter 9. 2 What is Inventory? Financial View = An asset in the form of material –Less is better –Dollars tied up in material.

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