MANAGING INVENTORY IN THE SUPPLY CHAIN

Chapter 9

MANAGING INVENTORY IN THE SUPPLY CHAIN

MANAGING INVENTORY IN THE SUPPLY CHAIN

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After reading this chapter, you should be able to do the following:

Learning Objectives

●Appreciate the role and importance of inventory in the economy.

●Understand the major reasons for carrying inventory.

●Differentiate the major types of inventory, their costs, and their relationships to inventory decisions.

●Understand the fundamental differences among approaches to managing inventory.

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●Describe the rationale and logic behind the economic order quantity (EOQ) approach to inventory decision making, and be able to solve some problems of a simple nature.

●Understand alternative approaches to managing inventory—just-in-time (JIT), materials requirement planning (MRP), distribution requirements planning (DRP), and vendor-managed inventory (VMI).

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Learning Objectives, continued


●Explain how inventory items can be classified.

●Know how inventory will vary as the number of stocking points changes.

●Make needed adjustments to the basic EOQ approach to respond to several special types of applications.

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Learning Objectives, continued


●Inventory is an asset on the balance sheet and a variable expense on the income statement.

●Inventories also have an impact on return on investment (ROI) for an organization.

Introduction


●Nominal GDP grew by 106.7% between 1994 and 2010.

●The value of inventory increased by 83.1% during the same time period.

●Inventory costs as a percent of GDP declined from 15.9% in 1994 to 14.1% in 2010.

Inventory in the U.S. Economy


Table 9.1

Macro Inventory vs. GDP

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Source: 22nd Annual State of Logistics Report, CSCMP 2011


●Batching Economies or Cycle Stocks• Arises from three sources.

○procurement○production○transportation

●Uncertainty and Safety Stocks• All organizations are faced with uncertainty.

• On the demand side, there is usually uncertainty in how much customers will buy and when they will buy it.

Reasons for Inventory in the Firm


●Uncertainty and Safety Stocks, continued

• On the supply side, there might be uncertainty about obtaining what is needed from suppliers and how long it will take for the fulfillment of the order.

●Time/In-Transit and Work-in-Process Stocks• The time associated with transportation means that

even while goods are in motion, an inventory cost is associated with the time period. The longer the time, the higher the cost.

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Inventory in the Firm, continued


●Time/In-Transit and Work-in-Process Stocks, continued

• WIP inventories, associated with manufacturing, can be significant while the length of time the inventory sits in a manufacturing facility waiting and should be carefully evaluated in relationship to scheduling techniques and the actual manufacturing/assembly technology.

●Seasonal Stocks• Seasonality can occur in the supply of raw materials,

in the demand for finished product, or in both.• Those faced with seasonality issues are constantly

challenged when determining how much inventory to accumulate.

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●Seasonal Stocks, continued

• Seasonality can impact transportation.

●Anticipatory Stocks• A fifth reason to hold inventory arises when an

organization anticipates that an unusual event might occur that will negatively impact its source of supply.

●Inventory in Support for Other Functional Areas• Logistics interfaces with an organization’s other

functional areas.○Marketing○Manufacturing○Finance

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Table 9.2

Logistics Costs – 2010

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Source: 22nd Annual State of Logistics Report, CSCMP 2011


Figure 9.1ABC Power Tools – In-Transit Inventory Analysis

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Source: Robert A. Novak, Ph.D.


Table 9.3ABC Power Tools In-Transit Inventory Analysis – Current

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Table 9.4ABC Power Tools In-Transit Inventory Analysis – Proposed

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●Inventory Carrying Costs• Capital Cost (interest or opportunity cost)

○cost of capital tied up in inventory and the resulting lost opportunity from investing that capital elsewhere○hurdle rate○weighted average cost of capital (WACC)

●Storage Space Cost • Includes handling costs associated with moving products into and out of inventory, as well as

such costs as rent, heat, and light.

• Can be variable.

Inventory Costs


●Inventory Service Cost • Includes insurance and taxes.

●Inventory Risk Cost • Reflects the possibility that inventory value might

decline for reasons beyond firm’s control.

●Calculating the Cost of Carrying Inventory• First, determine the value of the item stored in

inventory.

• Second, determine the cost of each individual carrying cost component to determine the total direct costs consumed by the item while being held in inventory.

• Third, divide the total costs calculated in Step 2 by the value of the item determined in Step 1.

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Inventory Costs, continued


Table 9.5ABC Power Tools – Inventory Carrying cost for Item 1

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Table 9.6ABC Power Tools – Inventory Carrying cost for Item 1 to Customer

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Table 9.7Inventory Carrying Costs for ABC Power Tools

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●Order and Setup Cost • Order Cost

○cost of placing order which may have both fixed and variable components

• Setup Costs ○expenses incurred each time an organization modifies a

production or assembly line to produce a different item for inventory

●Expected Stockout Cost• Back order - results in the vendor incurring incremental variable

costs associated with processing the extra shipment.

• Customer might decide to purchase a competitor’s product resulting in a direct loss for the supplier.

• Customer might decide to permanently switch to a competitor’s product with loss of income.

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Table 9.9

Summary of Inventory and Order Cost

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Source: C. John Langley, Ph.D.


Figure 9.2

Inventory Costs

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●In-Transit Inventory Carrying Cost • Owner of product while it is in transit will incur

resulting carrying costs.• In-transit inventory carrying cost becomes especially

important on global moves since both distance and time from the shipping location both increase.

• Owner should consider its delivery time part of its inventory carrying cost.

●Key Differences Among Approaches to Managing Inventory• Dependent versus Independent Demand

○independent when such demand is unrelated to the demand for other items

○dependent when it is directly related, or derives from, the demand for another inventory item or product

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Figure 9.3

Safety Stocks and Service Levels

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Figure 9.4

Inventory and Service Levels

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●Key Differences Among Approaches to Managing Inventory, continued

• Pull versus Push○The “pull” approach relies on customer orders to move

product through a logistics system, while the “push” approach uses inventory replenishment techniques in anticipation of demand to move products

●Principle Approaches & Techniques for Inventory Management• Fixed order quantity model involves ordering a fixed

amount of product each time reordering takes place

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●Principle Approaches & Techniques for Inventory Management, continued

• Simple EOQ Model○The following are the basic assumptions of the simple EOQ

model: A continuous, constant, and known rate of demand A constant and known replenishment or lead time All demand is satisfied A constant price or cost that is independent of the order

quantity (i.e., no quantity discounts) No inventory in transit One item of inventory or no interaction between items Infinite planning horizon Unlimited capital

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Figure 9.5

Fixed Order Quantity Model with Certainty

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Source: John C. Coyle, DBA


Figure 9.8

Inventory Costs

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●Principle Approaches & Techniques for Inventory Management, continued

• Simple EOQ Model, continued○Mathematical formulation

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Figure 9.11

Graphical Representation of EOQ

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Figure 9.12

Fixed Order Quantity with Uncertainty

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Figure 9.13

Normal Distribution

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●The Just-in-Time (JIT) Approach • Four major elements underlie the JIT approach.

○zero inventories (?)○short, consistent lead times○small, frequent replenishment quantities○high quality, or zero defects

●Materials Requirements Planning• Deals specifically with supplying materials and

component parts whose demand depends on the demand for a specific end product.

Additional Approaches to Inventory Management


●Materials Requirements Planning, continued

• Consists of a set of logically related procedures, decision rules, and records designed to translate a master production schedule into time-phased net inventory requirements and the planned coverage of such requirements for each component item needed to implement this plan.

• Uses the following elements:○Master production schedule (MPS)○Bill of materials file (BOM)○Inventory status file (ISF)○MRP program○Outputs and reports

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Additional Approaches to Inventory Management, continued


Figure 9.18

Normal Distribution

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Source: Adapted from William M. Boyst III, “JIT American Style”, Proceedings of the 1988 conference of the American Production and Inventory Control Society (1988) 468


Figure 9.15

An MRP System

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Figure 9.16

MRP Egg Timer Example

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Table 9.19Inventory Status File: MRP Egg Timer Example

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Figure 9.17

Master Schedule: MRP Egg Timer Example

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●Distribution Requirements Planning (DRP)• Purpose is to more accurately forecast demand and

to explode that information back to develop production schedules.

• Firm can minimize inbound inventory in conjunction with production schedules.

• Outbound (finished goods) inventory is minimized

• DRP develops a projection for each SKU requiring the following:

○Forecast of demand for each SKU○Current inventory level of the SKU (balance on hand, BOH)○Target safety stock○Recommended replenishment quantity○Lead time for replenishment

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Table 9.20

DRP Table for Chicken Soup

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Source: A.J. Stenger, “Distribution Resources Planning”, Penn State Univ. class example


●Vendor-Managed Inventory (VMI)• The basic principles:

○The supplier and its customer agree on which products are to be managed using in the customer’s distribution centers.

○An agreement is made on reorder points and economic order quantities for each of these products.

○As these products are shipped from the customer’s distribution center, the customer notifies the supplier, by SKU, of the volumes shipped on a real-time basis.

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Figure 9.19Inventory Management Techniques in the Logistics Network

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●ABC Analysis• Assigns inventory items to one of three groups

according to the relative impact or value of the items. ○A items are considered to be the most important○B items being of lesser importance○C items being the least important

• Pareto’s Law, or the “80–20 Rule”○Many situations were dominated by a relatively few vital

elements

Classifying Inventory


Figure 9.20

ABC Inventory Analysis

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Table 9.21

ABC Analysis for Big Orange

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Figure 9.21

Quadrant Model (another technique to classify inventory)

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●Inventory at Multiple Locations—The Square-Root Rule• The square-root rule states that total safety stock

inventories in a future number of facilities can be approximated by multiplying the total amount of inventory in existing facilities by the square root of the number of future facilities divided by the number of existing facilities.

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Classifying Inventory, continued


Table 9.22

Example of Square-Root Rule of Inventories

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Summary

● Inventory as a percent of overall business activity continues to decline. Explanatory factors include greater expertise in managing inventory, innovations in information technology, greater competitiveness in markets for transportation services, and emphasis on reducing cost through the elimination of non-value-adding activities.

● As product lines proliferate and the number of SKUs increases, the cost of carrying inventory becomes a significant expense of doing business.

● There are a number of principal reasons for carrying inventories. Types of inventory include cycle stock, work-in-process, inventory in transit, safety stock, seasonal stock, anticipatory stock, and anticipatory stock. 52


● Principal types of inventory cost are inventory carrying cost, ordering and setup cost, expected stockout cost, and in-transit inventory carrying cost.

● Inventory carrying cost is composed of capital cost, storage space cost, inventory service cost, and inventory risk cost. There are precise methods to calculate each of these costs.

● Choosing the appropriate inventory model or technique should include an analysis of key differences that affect the inventory decision. These differences are determined by the following questions: (1) Is the demand for the item independent or dependent? (2) Is the distribution system based upon a push or pull approach? (3) Do the inventory decisions apply to one facility or to multiple facilities?

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Summary, continued


● Traditionally, inventory managers focused on two important questions to improve efficiency, namely, how much to reorder from suppliers and when to reorder.

● The two aforementioned questions were frequently answered using the EOQ model, trading inventory carrying cost against ordering costs, and then calculating a reorder point based on demand or usage rates.

● The two basic forms of the EOQ model are the fixed quantity model and the fixed interval model. The former is the most widely used. Essentially, the relevant costs are analyzed (traded off), and an optimum quantity is decided. This reorder quantity will remain fixed unless costs change, but the intervals between orders will vary depending on demand.

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Summary, continued


● The basic EOQ model can be varied or adapted to focus more specifically on decisions that are impacted by inventory-related costs, such as shipment quantities where price discounts are involved.

● Just-in-time inventory management captured the attention of many U.S. organizations during the 1970s, especially the automobile industry. As the name implies, the basic goal is to minimize inventory levels with an emphasis on frequent deliveries of smaller quantities and alliances with suppliers or customers. To be most effective, JIT should also include quality management.

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Summary, continued


● Materials requirements planning and distribution requirements planning are typically used in conjunction with each other. In addition, a master production schedule is utilized to help balance demand and supply of inventory. DRP is used on the outbound side of a logistics system. Demand forecasts of individual SKUs are developed to drive the DRP model. Then, an MPS schedule is developed to meet the scheduled demand replenishment requirements.

● VMI is used to manage an organization’s inventories in its customers’ distribution centers. Using pull data, suppliers monitor inventory levels and create orders to ship product to bring inventory levels up to an economic order quantity in the customers’ distribution centers.

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Summary, continued


● ABC analysis is a useful tool to improve the effectiveness of inventory management. Another useful tool is the quadrant model.

● When organizations are adding warehouses to their logistics networks, a frequently asked question is, “How much additional inventory will be required?” The square root rule is a technique that can be used to help answer this question.

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Summary, continued

MANAGING INVENTORY IN THE SUPPLY CHAIN

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