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Managing Inventories

COLLIER/EVANS

Explain the importance of inventory, types of inventories, and key decisions and costs

Describe the major characteristics that impact inventory decisions

Describe how to conduct an ABC inventory analysis

LEARNING OUTCOMES

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Explain how a fixed-order-quantity inventory system operates, and how to use the EOQ and safety stock models

Explain how a fixed-period inventory system operates

Describe how to apply the single-period inventory model

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LEARNING OUTCOMES (continued)

Inventory Management

Planning, coordinating and controlling:

Acquisition, storage, handling, movement, distribution, and possible sale of raw materials

Component parts and subassemblies

Supplies and tools

Replacement parts

Other assets that are needed to meet customer wants and needs

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Types of Inventory

Raw materials, component parts, subassemblies, and supplies: Inputs to manufacturing and service-delivery processes

Work-in-process (WIP) inventory: Partially finished products in various stages of completion that are awaiting further processing

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Types of Inventory

Finished goods inventory: Completed products ready for distribution or sale to customers

Safety stock inventory: Additional amount of inventory that is kept over and above the average amount required to meet demand

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12.1 Role of Inventory in the Value Chain

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Exhibit

Managing Inventories in Global Supply Chains

Requires good technology, processes, and information technology (IT) support

Purchasing must focus on:

Global sourcing and total system cost

Ensure quality, delivery performance, and technical support

Seek new suppliers and products and be able to evaluate the potential to the company

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Managing Inventories in Global Supply Chains

Environmentally preferable purchasing (EPP): Affirmative selection and acquisition of products and services that effectively minimize negative environmental impacts

Over their life cycle of manufacturing, transportation, use, and recycling or disposal

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Inventory Management Decisions

Right time to order items from a supplier

Quantity required to order each time a supplier order is placed

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Categories of Inventory Costs

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Ordering costs or setup costs

Result of the work involved in placing purchase orders with suppliers

Expenses associated with carrying inventory

Shortage costs or stockout costs

Associated with a SKU being unavailable when needed to meet demand

Unit cost

Price paid for purchased goods or the internal cost of producing them

Inventory-holding costs or inventory-carrying costs

Inventory Characteristics

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Number of items

Nature of demand

Number and duration of time periods

Lead time

Stockouts

Number of Items

Each item is identified by a unique identifier, called a stock-keeping unit (SKU)

Stock-keeping unit (SKU): Single item or asset stored at a particular location

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Nature of Demand

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Independent demand

Demand for an SKU that is unrelated to the demand for other SKUs and needs to be forecast

Dependent demand

Demand directly related to the demand for other SKUs and can be calculated without needing to be forecast

Static demand

Demand that is stable in nature

Dynamic demand

Demand that varies over time

Number and Duration of Time Periods

Firms are concerned with planning inventory requirements over an extended number of time periods

Approaches

Single period

Multiple time periods

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Lead Time

Time between placement of an order and its receipt

Affected by:

Transportation carriers

Buyer order frequency and size

Supplier production schedules

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Stockouts

Inability to satisfy demand for an item

Backorder: Occurs when a customer is willing to wait for an item

Lost sale: Occurs when the customer is unwilling to wait and purchases the item elsewhere

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ABC Inventory Analysis

Categorizes SKUs into groups according to the total annual dollar usage

A items - Account for a large dollar value but a relatively small percentage of total items

Example, 10% to 30 % of items, yet 60% to 80% of total dollar value

C items - Account for a small dollar value but a large percentage of total items

Example, 50% to 60% of items, yet about 5% to 15% of total dollar value

B items - Items between A and C

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Managing Fixed Quantity Inventory Systems

Fixed quantity system (FQS): Order quantity or lot size is fixed

Same amount, Q, is ordered every time

Order quantity (Q) can be any quantity of product

Does not have to be economically determined

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Managing Fixed Quantity Inventory Systems

Process of triggering an order is based on the inventory position

Inventory position (IP): On-hand quantity (OH) plus any orders placed but which have not arrived (scheduled receipts, or SR), minus any backorders (BO)

IP = OH + SR – BO

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Managing Fixed Quantity Inventory Systems

When inventory falls at or below a certain value, r, called the reorder point, a new order is placed

Reorder point: Value of the inventory position that triggers a new order

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12.5 Summary of Fixed Quantity System (FQS)

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Exhibit

12.6 Fixed Quantity System (FQS) under Stable Demand

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Exhibit

12.7 Fixed Quantity System (FQS) with Highly Variable Demand

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Exhibit

Economic Order Quantity (EOQ) Model

Classic economic model that minimizes the total cost

Which is the sum of the inventory-holding cost and the ordering cost

Developed in the early 1900s

Key assumptions

Only a single item (SKU) is considered

Entire order quantity (Q) arrives in the inventory at one time

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Economic Order Quantity (EOQ) Model

Key assumptions

Types of costs that are relevant

Order/setup

Inventory holding

No stockouts are allowed

Demand for the item is deterministic and continuous over time

Lead time is constant

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Economic Order Quantity (EOQ) Model

Cycle inventory: Results from purchasing or producing in larger lots than are needed for immediate consumption or sale

Average cycle inventory = (Maximum inventory + Minimum inventory)/2

Average cycle inventory = Q/2

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12.8 Cycle Inventory Pattern for the EOQ Model

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Exhibit

Economic Order Quantity (EOQ) Model

Inventory holding cost - Cost of storing one unit in inventory for the year, Ch

Ch = (I)(C)

Where,

I = Annual inventory-holding charge expressed as a percent of unit cost

C = Unit cost of the inventory item or SKU

Annual inventory holding cost = (Average inventory)(Annual holding cost per unit) = ½ QCh

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Economic Order Quantity (EOQ) Model

Depends only on the ordering cost

If D = annual demand and Q units are ordered each time, then D/Q orders/year is placed

Annual ordering cost is computed as:

Annual ordering cost = (Number of orders per year)(Cost per order) = D/Q x C0

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Economic Order Quantity (EOQ) Model

Total annual cost

Sum of the inventory holding cost plus the order or setup cost

TC = ½ QCh + D/Q x C0

Economic order quantity

Minimizes the total annual cost

Q* =

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Economic Order Quantity (EOQ) Model

Calculating the reorder point

Reorder point, r, depends on the lead time and demand rate

Multiply the fixed demand rate, d, by the length of the lead time, L

r = Lead time demand

= (demand rate)(lead time)

= (d)(L)

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Safety Stock and Uncertain Demand in a Fixed Order Quantity System

When demand is uncertain, using EOQ based on the average demand will result in a high probability of a stockout

Safety stock: Additional planned on-hand inventory that acts as a buffer to reduce the risk of a stockout

Service level: Desired probability of not having a stockout during a lead-time period

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Safety Stock and Uncertain Demand in a Fixed Order Quantity System

When a normal probability distribution provides a good approximation of lead time demand, the expression for reorder point is:

r = L + zL

Where,

L = Average demand during the lead time

L = Standard deviation of demand during the lead time

z = Number of standard deviations necessary to achieve the acceptable service level

zL represents the amount of safety stock

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Safety Stock and Uncertain Demand in a Fixed Order Quantity System

Suppose that and t are the mean and standard deviation of demand for some time interval t

If the distributions of demand for all time intervals are identical to and independent of each other, then:

L = L

L = t √L

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Managing Fixed Period Inventory Systems

Fixed period system (FPS): Inventory position is checked only at fixed intervals of time, T, rather than on a continuous basis

Principal decisions in an FPS

Time interval between reviews (T)

Replenishment level (M)

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Managing Fixed Period Inventory Systems

EOQ model provides the best economic time interval for establishing an optimal policy for an FPS system under the model assumptions

T = Q*/D

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Managing Fixed Period Inventory Systems

Optimal replenishment level without safety stock

M = d(T + L)

Where,

d = Average demand per time period

L = Lead time in the same time units

M = Demand during the lead time plus review period

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12.11 Summary of Fixed - Period Inventory Systems

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Exhibit

12.12 Operation of a Fixed Period Systems (FPS)

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Exhibit

Managing Fixed Period Inventory Systems

Uncertain demand

Compute safety stock over the period T + L

Replenishment level is computed as:

M = T+L + zσT+L

T+L = t (T + L)

σT+L = σt √T + L

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Single-Period Inventory Model

Applies to inventory situations in which one order is placed for a good in anticipation of future selling season where demand is uncertain

At the end of the period, the product has either sold out or there is a surplus of unsold items to sell for a salvage value

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Single-Period Inventory Model

Marginal economic analysis - Compares the cost or loss of ordering one additional item with the cost or loss of not ordering one additional item

cs = Cost per item of overestimating demand

Represents the loss of ordering one additional item and finding that it cannot be sold

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Single-Period Inventory Model

cu = Cost per item of underestimating demand

Represents the opportunity loss of not ordering one additional item and finding that it could have been sold

Optimal order quantity Q* must satisfy:

P(demand ) = cu/ cu+ cs

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Inventory is an asset held for future use or sale

Inventory characteristics

Number of items

Nature of demand

Number and duration of time periods

Lead time

Stockouts

SUMMARY

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Economic order quantity (EOQ) model is a classic economic model that minimizes the total cost

which is the sum of the inventory-holding cost and the ordering cost

SUMMARY

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Backorder

Cycle inventory

Dependent demand

Dynamic demand

Economic Order Quantity (EOQ) Model

Environmentally preferable purchasing (EPP)

Finished goods inventory

Fixed period system (FPS)

Fixed quantity system (FQS)

KEY TERMS

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Independent demand

Inventory

Inventory Management

Inventory position (IP)

Inventory-holding costs or inventory-carrying costs

Lost sale

Ordering costs or setup costs

Raw materials, component parts, subassemblies, and supplies

KEY TERMS

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Reorder point

Safety stock

Safety stock inventory

Service level

Shortage costs or stockout costs

Static demand

Stock-keeping unit (SKU)

Unit cost

Work-in-process (WIP) inventory

KEY TERMS

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