Operation Management Online quiz

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Independent
Demand Inventory

Chapter 6

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Learning Objectives

List the reasons for and against having inventory.

Learn the basic types of inventory.

Apply the continuous review and periodic review systems. Describe other important inventory systems.

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The Wal-Mart Effect

Wal-Mart became the world’s largest retailer in large part because of its excellent management of inventory.
The company:

has sales of over $300 billion and operates more than 3,500 stores in the US (and more than 2,500 stores in 15 other countries).

employs more than 1.3 million people.

has more than 6,000 stores and 10,000 stock-keeping units (SKUs) at each stores.

manages 60 million individual stocking locations and at least a quarter of a million line-item orders per day.

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The Wal-Mart Effect

Wal-Mart’s inventory decisions have been dubbed “the Wal-Mart Effect.”
Wal-Mart announced a major effort to reduce its inventory costs by $6 billion in 2006, or 20 percent of its yearly total, and suppliers took notice.
Wal-Mart accounts for 10 to 30 percent of many suppliers’ sales.
The correction of Wal-Mart’s inventory also affects shippers, with estimates of a $300 to $400 million reduction in freight revenue.
Wal-Mart’s inventory reduction reflects its strategy of cutting costs and improving margins.

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Inventory

Inventory: the physical stock of any items or resources used in an organization
The objective of an inventory system is to specify:

When items should be ordered.

What quantity of each item should be ordered.

In manufacturing, types of inventory include raw materials, work in process, finished goods, component parts and supplies.
In services, inventory refers to tangible goods that are sold as part of the service and maintenance, repair, and operating (MRO) supplies that are necessary.

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Inventory Equilibrium

Determining the proper amount of inventory
Similar to balancing a scale
Assesses the benefits of carrying larger amounts of inventory against the drawbacks and the risks of carrying that inventory

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Discussion Starter

What purpose does inventory serve for companies?

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Reasons to Carry Inventory

Set-up and ordering costs
Customer service and variation in demand
Labor and equipment utilization
Transportation cost
Costs of materials/quantity discounts

Source: © Image Source/Corbis

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Reasons to Reduce Inventory

Storage and Handling
Interest and opportunity cost
Property taxes and insurance premiums
Shrinkage and spoilage

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Inventory Types

There are several basic types of inventory:

Cycle

Safety stock

Anticipation

Pipeline

Work-in-process

Remanufactured/reconditioned

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Cycle Inventory

Cycle inventory: a quantity of inventory that varies in proportion to order quantity

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Figure 6.2: Cycle Inventory

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Safety Stock Inventory

Safety stock inventory: excess Inventory that a company holds to guard against uncertainty in demand, lead time, and supply

Source: © Image Source/Corbis

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Anticipation Inventory

Anticipation inventory: inventory that is held for future use at a time when demand will exceed available capacity

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Pipeline Inventory

Pipeline inventory: inventory that is in the process of moving from one location in the supply chain to another

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Work-in-process (WIP) Inventory

Work-in-process inventory: inventory that is in the process of being transformed from one state to another
It cannot be sold to a customer because it is not yet finished.

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Remanufactured/reconditioned

Remanufactured/reconditioned inventory: products that have been used by a customer and then reacquired by a company and either remanufactured or reconditioned for resale

What are some examples of

remanufactured inventory?

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Independent versus
Dependent Demand

Independent demand: demand for items that are considered end items that go directly to a customer, and for which demand is influenced by market conditions and not related to inventory decisions for any other item.
Dependent demand: demand for items that are used to make another item or are considered to be component parts

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Independent/Dependent Demand Items

Penfield Arrow Company makes arrows for the hunting industry.

There are three components that make up it’s arrow: the arrowhead, shaft, and feathers.

Feather Shaft Arrowhead

Is the arrow an independent item, or are the feathers, shaft, and arrowhead independent?

Arrow

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Inventory Systems

An inventory system provides the structure and operating policies for maintaining and controlling goods to be stocked in inventory.
The system is responsible for ordering, tracking, and receiving goods.

There are two essential policies:
1. How much or what quantity of an item to order?

2. When should an order for that item be placed?

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Figure 6.3: Inventory
Management as a Water Tank

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Discussion Starter

Water Tank Analogy – What does the water hide?

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Two Types of Systems

Continuous review system: an inventory system that always orders the same quantity of items but has differing periods of time between orders
Periodic review system: an inventory system that has a fixed time between orders but has different order quantities from order to order

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Table 6.1: Differences
Between Inventory Systems

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Continuous Review Systems

Inventory position: on-hand inventory plus outstanding orders, minus any backorder quantities (items promised to a customer but not yet delivered)

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Setting the Order Quantity

The goal for the inventory system is to minimize total annual inventory cost:
The total annual inventory cost is the

sum of the cost of holding inventory

and the cost of ordering inventory.

IC = Total Annual Cost

D = Annual Demand Q = Order quantity

S = Setup or ordering cost H = Holding cost

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Figure 6.4: Annual Inventory Costs

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Economic Order Quantity

Economic order quantity: the order quantity that minimizes the total annual cost of ordering and holding inventory for a particular item

EOQ = Economic Order Quantity

D = Annual Demand S = Setup or ordering cost H = Holding cost

Go to Page 205 for Example

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Setting the Reorder
Point with Certain Demand

Reorder point (R): the predetermined level that an inventory position must reach for an order to be placed
Lead time (L): is the time between when an order is placed and when it is expected to arrive or be finished

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Inventory Position

IP = OH + SR - BO

Inventory Position (IP): The timing or place determined

to be the point an order is to be placed

SR - Scheduled Receipt:

Order has been placed but not yet received

OH – On Hand Delivery:

Amount of a unit that is physically available

BO – Backorder:

Order promised to a customer but is not currently

in inventory

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Figure 6.5: Cycle
Inventory When Demand is Certain

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Figure 6.6: Demand, Orders, and Actual versus Calculated Inventory Position

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Figure 6.7: Reorder
Point When Demand is Uncertain

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Figure 6.8: Finding Safety
Stock with a Normal Probability
Distribution with Low and High Variance

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Special Cases of the
Economic Order Quantity

Two relevant costs: ordering/setup (S) and holding (H)
Constant demand
Item independence
Certainty in demand, lead time and supply
Some version of the EOQ is used in almost every company or organization dealing with inventory.
The EOQ works despite the fact that the assumptions are not strictly true for two reasons:

It is relatively insensitive to errors because it involved a square root.

The EOQ works despite its slightly flawed assumptions that adjustments for uncertainty are included in the overall inventory system.

Assumption 3 states that items are independent.

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EOQ with Quantity Discounts

Many companies offer discounted pricing for items that they sell.
This is done to take advantage of economies of scale in production and in the supply chain.

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EOQ with Discounts

Calculate the EOQ:

Arrange the prices from lowest to highest. Starting with the lowest price, calculate the EOQ for each price until a feasible EOQ
is found.
If the first feasible EOQ is for the lowest price, this quantity is optimal and should be used.

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Figure 6.9: Quantity
Discount Cost Curve

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Technological Applications

The biggest change in inventory management over the past 20 years is the ability of companies to use sophisticated software and hardware to track and monitor inventory very closely.
Enterprise Resource Planning (ERP): a large, integrated information system that supports most enterprise processes and data storage needs across the entire organization
Radio Frequency Identification (RFID): an automatic identification method that relies on storing and remotely retrieving data using devices such as RFID tags or transponders

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Periodic Review Systems

A periodic review system (P-system) requires a precise counting of inventory only at specific times, often once a week, once a month, or once a quarter.
One situation in which a P-system is useful is when a manufacturer such a Pepsi or Kellogg’s assigns drivers to various stores.

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VMI and EDI

Vendor-managed inventory (VMI): vendors monitor sales at the retailer and replenish inventories when supplies are low
Electronic data interchange (EDI): a technology that allows companies or units within a company to exchange orders, forecasts, and invoices electronically without human intervention to enter data into the receiving system

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Figure 6.10: Periodic Review System

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Determining the Period and Order Quantity for a Periodic Review System

The period (a convenient time period) may be chosen to approximate the average time between orders (TBO).

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Target Inventory

Target inventory: the desired quantity of inventory that will cover expected demand during the protection interval plus enough safety stock to provide the desired cycle-service level

Q-System (Continuous Review)	P-System (Periodic Review)
How much to order	Q = 104	Q = T – I = 139 – I
When to order	When Inv ≤ R = 27	Every P = 5 weeks
Protection interval	L = 1 week (lead time)	P + L = 6 weeks (period + lead time)
Safety stock	6 units	13 units

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Other Types of Inventory Systems

Variations on the basic types of continuous and

periodic reviews:

ABC Systems

Bin Systems

Can Order Systems

Base Stock Systems

The Newsvendor Problem

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ABC Systems

ABC systems: inventory systems that utilize some measure of importance to classify inventory items and allocate control efforts accordingly
They take advantage of what is commonly called the 80/20 rule, which holds that 20 percent of the items usually account for 80 percent of the value.

Category A contains the most important items.

Category B contains moderately important items.

Category C contains the least important items.

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ABC Systems

A items make up only 10 to 20 percent of the total number of items, yet account for 60 to 80 percent of annual dollar value.
C items account for 50 to 70 percent of the total number of items, yet account for only 10 to 20 percent of annual dollar value.
C items may well be of high importance, but because they account for relatively little annual inventory cost, it may be preferable to order them in large quantities and carry excess safety stock.

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Bin Systems

Bin system: a type of inventory system that uses either one or two bins to hold a quantity of the item being inventoried; an order is placed when one of two bins is empty or a line on a single bin is reached

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Can Order Systems

Can order system: a type of inventory system that reviews the inventory position at fixed time intervals and places orders to bring the inventory up to an expected target level, but only if the inventory position is below a minimum quantity, similar to the reorder point in a continuous review system

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Base Stock System

Base stock system: a type of inventory system that issues an order whenever a withdrawal is made from inventory

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Newsvendor Problem

Newsvendor problem: a technique that determines how much inventory to order when handling perishable products or items that have a limited life span
Shortage cost: the lost profit from not being able to make a sale, plus any loss of customer goodwill
Excess cost: the different between the purchase cost of an item and its salvage or discounted value

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Figure 6.11A: Newsvendor Problem for Pink Swimsuits: Shortage Costs Exceed Excess Costs

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Figure 6.11B: Newsvendor Problem for Pink Swimsuits: Excess Costs Exceed Shortage Costs

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Inventory Accuracy

The amount of inventory in the system (i.e., the computer) often differs from the amount of physical inventory that is on hand.
Common approaches for minimizing the problem:

Assign specific employees to issue and receive orders and materials and to enter transaction data.

Place inventory in a locked and secured location.

Cycle counting: a system in which employees physically count a percentage of the total number of items stocked in inventory and correct any errors that are found