SCM04 Inventory Management

INVENTORY MANAGEMENT
© Krishnan Subramaniam
Inventory
• Inventory can be visualized as stacks of money sitting
on forklifts, on shelves, and in trucks and planes while
in transit.
• For many businesses, inventory is the largest asset
on the balance sheet at any given time.
• Inventory can be difficult to convert back into cash.
• It is a good idea to try to get your inventory down as
far as possible.
– The average cost of inventory in the United States is 30 to 35
percent of its value.
20-2
Supply Chain Inventory Models
20-3
Inventory Models
Single-period model
• Used when we are making a one-time purchase of an item
Fixed-order quantity model
• Used when we want to maintain an item “in-stock,” and

when we restock, a certain number of units must be ordered
Fixed–time period model
• Item is ordered at certain intervals of time
20-4
Definitions
• Inventory: the stock of any item or resource

used in an organization
– Includes raw materials, finished products,
component parts, supplies, and work-in-process
– Manufacturing inventory: refers to items that
contribute to or become part of a firm’s product
• Inventory system: the set of policies and
controls that monitor levels of inventory
– Determines what levels should be maintained,
when stock should be replenished, and how
large orders should be
20-5
Purposes of Inventory
To maintain To allow flexibility in

To meet variation in
independence of production
product demand
operations scheduling
To provide a
To take advantage of
safeguard for
economic purchase
variation in raw
order size
material delivery time
20-6
Inventory Costs
Holding (or carrying) costs Setup (or production change)

• Costs for storage, handling, costs
insurance, and so on • Costs for arranging specific
equipment setups, and so on
Costs
Ordering costs Shortage costs

• Costs of placing an order • Costs of running out
20-7
Demand Types
Independent demand – the

demands for various items are
unrelated to each other
• For example, a workstation may produce
many parts that are unrelated but meet
some external demand requirement
Dependent demand – the need

for any one item is a direct result
of the need for some other item
• Usually a higher-level item of which it is
part
20-8
Independent and Dependent Demand
Inventory
• Independent demand
– items demanded by external customers
(Kitchen Tables)
• Dependent demand
– items used to produce final products (table
top, legs, hardware, paint, components, etc.)
– Demand determined once we know the type
and number of final products
Independent and Dependent Demand
Inventory Management
• Independent demand
– Uncertain
– Forecasted
– Continuous Review
– Periodic Review
• Dependent demand
– Planned
– Materials Requirements Planning
– Just in Time
Inventory Systems – Comparison
Single-period inventory model
• One-time purchasing decision (e.g.,
vendor selling T-shirts at a football
game)
• Seeks to balance the costs of inventory
overstock and under stock
Multi-period inventory models

• Fixed-order quantity models
• Event triggered (e.g., running out of
stock)
• Fixed-time period models
• Time triggered (e.g., monthly sales call
by sales representative)
Single Period Model Applications
Overbooking of airline flights
Ordering of clothing and other fashion items
One-time order for events – e.g., t-shirts for a concert
20-13
Multi-Period Models
Fixed-order quantity models

- Also called the economic
order quantity, EOQ, and Q-model
- Event triggered
Fixed–time period models

- Also called the periodic system,
periodic review system, fixed-
order interval system, and P-mode
- Time triggered
20-14
Multi-Period Models – Comparison
Fixed-Order Quantity
• Inventory remaining must
Fixed-Time Period
• Counting takes place only at
be continually monitored the end of the review period
• Has a smaller average • Has a larger average
inventory inventory
• Favors more expensive
items • Favors less expensive items
• Is more appropriate for • Is sufficient for less-
important items important items
• Requires more time to • Requires less time to
maintain – but is usually maintain
more automated
• Is less expensive to
• Is more expensive to implement
implement
20-15
Inventory Management
Cycle counting – a physical

Inventory accuracy – refers inventory-taking technique
to how well the inventory in which inventory is
records agree with physical counted on a frequent basis
count rather than once or twice a
year
20-19
Types of Inventory
Inputs Outputs
• Raw Materials • Finished Goods
• Purchased parts Process • Scrap and Waste
• Maintenance and Repair
Materials (in warehouses, or in transit )
In Process
• Partially Completed Products
• Sub-assemblies
(often on the factory floor)
Water Tank Analogy for Inventory
Inventory Level
Supply Rate
Buffers the Demand Rate

from Supply Rate
Inventory Level
Demand Rate
Reasons to hold Inventory
• Meet variations in customer demand
– Meet unexpected demand
– Smooth seasonal or cyclical demand
• Pricing related
– Temporary price discounts
– Hedge against price increases
– Take advantage of quantity discounts
• Process & Supply surprises
– Internal – upsets in parts of or our own
processes
– External – delays in incoming goods
• Transit
Reasons To NOT Hold Inventory
• Carrying cost
– Financially calculable
• Takes up valuable factory space
– Especially for in-process inventory
• Inventory covers up problems …
– That are best exposed and solved
Driver for increasing inventory turns (finished goods)

and Lean production/Just in time for work in process
Inventory Hides Problems
Bad
Design
Lengthy Poor
Setups Quality
Machine
Inefficient Breakdown Unreliable
Layout Supplier
To Expose Problems:
Reduce Inventory Levels
Bad
Design
Lengthy Poor
Setups Quality
Machine
Inefficient Breakdown Unreliable
Layout Supplier
Remove sources of problems and repeat
the process
Poor
Quality
Lengthy
Setups
Bad
Design Machine
Inefficient Unreliable
Breakdown
Layout Supplier
Inventory Cost Structures
• Ordering (or setup) cost
• Carrying (or holding) cost:
• Cost of capital
• Cost of storage
• Cost of obsolescence, deterioration, and loss
• Stock out cost
• Item costs, shipping costs and other cost
subject to volume discounts
Costs in Inventory system
Four types of relevant costs:

1. cost of the item itself
2. costs associated with procuring the
materials
3. costs associated with keeping the items in
inventory
4. costs associated with being out of stock
when units are needed but are unavailable
Inventory carrying costs should include
the following groups:
1. Capital costs
2. Inventory service costs
3. Storage space costs
4. Inventory risk costs
Typical Inventory Carrying Costs
Costs as % of
Inventory Value
Housing cost: 6%
– Building rent or depreciation (3% - 10%)
– Building operating cost
– Taxes on building
– Insurance
Material handling costs:
– Equipment, lease, or depreciation 3%
– Power (1% - 4%)
– Equipment operating cost
Manpower cost from extra handling and supervision
3%
(3% - 5%)
Investment costs:
– Borrowing costs
– Taxes on inventory 10%
– Insurance on inventory (6% - 24%)
Pilferage, scrap, and obsolescence
5%
(2% - 10%)
Overall carrying cost
(15% - 50%)
Inventory control Management
A definition …
Stocking adequate number and kind of

stores so that the materials are available
whenever required and wherever required
at the least possible cost.
Scientific inventory control results in

optimal balance
Inventory Management Systems
• Functions of Inventory Management

– Track inventory
– How much to order
– When to order
• Prioritization
• Inventory Management Approach
– EOQ
– Continuous
– Periodic
ABC Prioritization
• Based on Pareto concept (80/20 rule)

and total usage in dollars of each item.
• Classification of items as A, B, or C
often based on $ volume.
• Purpose: Set priorities for management
attention.
Pareto Analysis
Vilfredo Pareto
(19th Century Italian Economist, 1848-1923, studied wealth & income)
80 / 20 Rule
20% of the people hold 80% of the wealth
The vital few and the trivial many
20% of our customers give us 80% of our
business
20% of our suppliers give us 80% of the
problems
20% of the inventory is 80% of the value
ABC Prioritization
• A items: 20% of SKUs, 80% of dollars
• B items: 30 % of SKUs, 15% of dollars
• C items: 50 % of SKUs, 5% of dollars
• Three classes is arbitrary; could be any

number.
• Percents are approximate.
• Danger: dollar use may not reflect
importance of any given SKU!
Inventory Management approaches
• A-items
– Track carefully (e.g. continuous review)
– Sophisticated forecasting to assure
correct levels
• C-items
– Track less frequently (e.g. periodic
review)
– Accept risks of too much or too little
(depending on the item)
ABC Classification
Items kept in inventory are not of equal importance in
terms of:
•dollars invested % of
$ Value A
•profit potential
B
% of C
•sales or usage volume
Use
•stock-out penalties
Identify inventory items based on % of total dollar value, where
A items - top 20 %,
B items - next 30 %,
C items - Lower 50% © Krishnan Subramaniam
How to perform the classification
a) List the items and their annual usage

b) Multiply annual usage by unit cost to obtain total
annual cost
c) Rank order the items by total annual cost
d) Calculate cumulative total annual cost and
cumulative percentages
e) Assign a classification designator, some
guidelines are as follows:
Performing the classification
Classification Value as % of No. of items as %
Total Annual Cost of Total
A 75-80% 15-20%
B 15% 30-40%
C 5-10% 40-50%
ABC Analysis Example
100 — +Class C
+Class B
90 —
Class A
80 —
Percentage of dollar value
70 —
60 —
50 —
40 —
30 —
20 —
10 —
0—
10 20 30 40 50 60 70 80 90 100
Percentage of items
ABC Analysis
(ABC = Always Better Control)
This is based on cost criteria.
It helps to exercise selective control when confronted with

large number of items it rationalizes the number of orders,
number of items & reduce the inventory.
About 10 % of materials consume 70 % of resources

ABC Analysis – A items
Small in number, but consume large amount of

resources. Must have:
• Tight control
• Rigid estimate of requirements
• Strict & closer watch
• Low safety stocks
• Managed by top management
ABC Analysis – C items
Larger in number, but consume lesser amount of
resources
Must have:
•Ordinary control measures
•Purchase based on usage estimates
•High safety stocks
ABC analysis does not stress on items those are

less costly but may be vital
ABC Analysis – B items
Intermediate
Must have:
• Moderate control
• Purchase based on rigid requirements
• Reasonably strict watch & control
• Moderate safety stocks
• Managed by middle level management
VED Analysis
• Based on critical value & shortage cost of an item
• It is a subjective analysis
• Items are classified into
• Vital: Shortage cannot be tolerated.
• Essential: Shortage can be tolerated for a short period.
• Desirable: Shortage will not adversely affect, but may
be using more resources. These must be strictly
Scrutinized
CATEGORY 1 - NEEDS CLOSE MONITORING & CONTROL

CATEGORY 2 - MODERATE CONTROL.
CATEGORY 3 - NO NEED FOR CONTROL
SDE Analysis
Based on availability
Scarce
Managed by top level management
Maintain big safety stocks
Difficult
Maintain sufficient safety stocks
Easily available
Minimum safety stocks
FSN Analysis
Based on utilization.
•Fast moving.
•Slow moving.
•Non-moving.
Non-moving items must be periodically reviewed to

prevent expiry & obsolescence
HML Analysis
Based on cost per unit
High
Medium
Low
This is used to keep control over consumption

at departmental level for deciding the frequency of
physical verification.
SAFETY STOCK
“In general, a quantity of stock planned to
be in inventory to protect against
fluctuations in demand and/or supply”
Safety Stock
Inventory level
Reorder
point
Safety
0 stock
LT Time LT
Objectives of Safety Stock
Use of Safety Inventory to Improve Service Level
Responsiveness in Presence of Unpredictable
Supply and Demand
How Much Safety Stock Should Be Kept to Meet

Desired Service Level?
Can We Reduce Safety Stock Without Affecting

Service Level?
Safety Stock
Companies carry safety stock because of the

reality of errors in their forecasts of demand and
lead time. Essentially four factors affect the size
of safety stocks:
1. Accuracy of projected demand

2. Accuracy of projected lead time
3. Reorder frequency
4. Desired customer service level
Setting Safety Stock
1. A fixed quantity
2. A fixed amount of time (say 20 days) multiplied by the
average daily demand.
3. A percentage of expected demand during lead time
(EDDLT)
4. Based on the deviation of daily demand - assumption of
normal distribution
5. Using frequency distributions for demand during lead
time and a desired percentage of coverage
6. Based on MAD (Mean absolute deviation) of the
forecasted demand during lead time
7. The square root of expected demand during lead time
MAD
Mean Absolute Deviation

The average of the absolute value, or the difference
between actual values and their average value, and is
used for the calculation of demand variability. It is
expressed by the following formula.
Lead Time - Components
• Inventory review and preparation of

requisition
• Purchasing time
• Vendor time
• Transportation
• Customs Clearance
• Receiving, inspection and storage
Receive Do not
P.R. Check Exist Create
From Specs Specs
TO
Create specs
User In System
TA
Prepare
LReceive
Technical Commercial
Le
RFQs Evaluation Evaluation
From Quotations (if needed) and
Bidders
list clarifications ad Selection
tim Inspect,
Issue
P.O.
Confirm.
from
Supplier
Time
Transp
and e Issue
or Store
Supplier Clearance
LEAD TIME – Methods to control
• Good relationship with vendor

• Proper selection of vendor
• Simple and efficient ordering and
purchasing procedures
• Delegation of approval authority
• Following-up of each step (component)
For some reason, the actual lead time end up to
be longer than the estimated lead time
Why? R.O.P. is not realistic
Late delivery from vendor
Information from user not clear
Transportation and clearance
Poor coordination with vendor
Economic order quantity
• Re-order level
• stock level at which fresh order is
placed.
• Lead time
• Duration time between placing an
order & receipt of material
• Ideal – 2 to 6 weeks?
Zero Inventory?
• Reducing amounts of raw materials and

purchased parts and subassemblies by
having suppliers deliver them directly.
• Reducing the amount of works-in process by

using just-in-time production.
• Reducing the amount of finished goods by

shipping to markets as soon as possible.
Economic Order Quantity (EOQ)
Model
• Demand rate D is constant, recurring, and known

• Amount in inventory is known at all times
• Ordering (setup) cost S per order is fixed
• Lead time L is constant and known.
• Unit cost C is constant (no quantity discounts)
• Annual carrying cost is i time the average $ value of
the inventory
• No stockouts allowed.
• Material is ordered or produced in a lot or batch and
the lot is received all at once
EOQ Lot Size Choice
• There is a trade-off between lot

size and inventory level.
– Frequent orders (small lot size):
higher ordering cost and lower
holding cost.
– Fewer orders (large lot size): lower
ordering cost and higher holding cost.
EOQ Inventory Order Cycle
Demand
Order qty, Q
rate
Inventory
Level
ave = Q/2
Reorder point, R
0 Lead Lead Time

time time
As Q increases, average Order Order Order Order
inventory level increases,
but number of orders placed
Placed Received Placed Received
decreases
Fixed-Order Quantity Models – Assumptions
• Demand for the product is constant and

uniform throughout the period.
• Lead time (time from ordering to receipt) is
constant.
• Price per unit of product is constant.
• Inventory holding cost is based on average
inventory.
• Ordering or setup costs are constant.
• All demands for the product will be satisfied.
20-69
Fixed-Order Quantity Model
Always order Q units Inventory is consumed at a

when inventory reaches constant rate, with a new
reorder point (R). order placed when the
reorder point (R) is
reached once again.
Inventory arrives after lead

time (L). Inventory is raised
to maximum level (Q).
20-70
Economic Order Quantity (EOQ)
The optimal order
quantity (Qopt) occurs
where total costs are at
their minimum
20-72
Establishing Safety Stock Levels
Safety stock – refers to the amount of inventory
carried in addition to expected demand.
• Safety stock can be determined based on many different criteria.
A common approach is to simply keep a certain

number of weeks of supply.
A better approach is to use probability.
• Assume demand is normally distributed.

• Assume we know mean and standard deviation.
• To determine probability, we plot a normal distribution for
expected demand and note where the amount we have lies on
the curve.
Questions ?

SCM04 Inventory Management

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

SCM04 Inventory Management

Uploaded by

Copyright:

Available Formats

INVENTORY MANAGEMENT

• Used when we are making a one-time purchase of an item

Fixed-order quantity model

• Used when we want to maintain an item “in-stock,” and

Fixed–time period model

• Item is ordered at certain intervals of time

• Inventory: the stock of any item or resource

To maintain To allow flexibility in

Holding (or carrying) costs Setup (or production change)

Ordering costs Shortage costs

Independent demand – the

Dependent demand – the need

Multi-period inventory models

Overbooking of airline flights

Ordering of clothing and other fashion items

One-time order for events – e.g., t-shirts for a concert

Fixed-order quantity models

Fixed–time period models

Cycle counting – a physical

Buffers the Demand Rate

Driver for increasing inventory turns (finished goods)

Four types of relevant costs:

Stocking adequate number and kind of

Scientific inventory control results in

• Functions of Inventory Management

• Based on Pareto concept (80/20 rule)

• Three classes is arbitrary; could be any

a) List the items and their annual usage

It helps to exercise selective control when confronted with

About 10 % of materials consume 70 % of resources

Small in number, but consume large amount of

ABC analysis does not stress on items those are

CATEGORY 1 - NEEDS CLOSE MONITORING & CONTROL

Non-moving items must be periodically reviewed to

This is used to keep control over consumption

How Much Safety Stock Should Be Kept to Meet

Can We Reduce Safety Stock Without Affecting

Companies carry safety stock because of the

1. Accuracy of projected demand

Mean Absolute Deviation

• Inventory review and preparation of

• Good relationship with vendor

Why? R.O.P. is not realistic

Late delivery from vendor

Information from user not clear

Transportation and clearance

Poor coordination with vendor

• Reducing amounts of raw materials and

• Reducing the amount of works-in process by

• Reducing the amount of finished goods by

• Demand rate D is constant, recurring, and known

• There is a trade-off between lot

0 Lead Lead Time

• Demand for the product is constant and

Always order Q units Inventory is consumed at a

Inventory arrives after lead

• Safety stock can be determined based on many different criteria.

A common approach is to simply keep a certain

A better approach is to use probability.

• Assume demand is normally distributed.

You might also like