Inventory Terminology and Techniques

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MGMT Fulfilling Supply Chain Demand

The way we were

Back in the day, how was demand fulfilled? If you were lucky, you lived in a town with a general store. Or maybe the peddler would come by with his wagon. Or maybe, if you needed it, you just made it yourself.

But what’s the problem? It almost didn’t matter what you wanted, you could only get what was offered, or what you had the skills to make.

Times change

Along came the shopping center, then the mall….and the consumer found more and more variety…… and then….

And then….

There was WalMart….a general store on steroids…..your one stop shop for anything you could want, at an everyday low price….

But…..

The geeks were coming, even for WalMart. With the explosion of online shopping

even the megastores had competition, at least for those items that the customer could

wait a day or two to receive.

And the internet……

And behind all of them….

A warehouse…. Full of inventory

Overview: Managing Inventories

Check out the video below that describes an Amazon warehouse. It gives a great idea of what it takes for a company with huge amounts of inventory to processes it.

Watch for:

The inventory process—receiving goods, stocking them, picking orders and packaging them

How technology is used in this process

Amazon Warehouse Operations http://www.youtube.com/watch?v=i6H7nfHjHtY

Managing Inventories

Overview

The Inventory Dilemma

Inventory Reorder Strategies

Overview: Managing Inventories

Do you order from Amazon?

If so, why?

Convenience?

Price?

Free shipping?

Variety?

Availability?

The answer for most of us is “All of the above”

Overview: Managing Inventories

If you shop with Amazon, why? Because:

We want what we want! (The right stuff)

We want it when we want it! (The right time)

We want to pay what we want for it! (The right price)

And we want it now! (The

right time)

And we are no longer going to tolerate being constrained by what the retailer wants to stock…..or the lead time the retailer wants to offer. If you remember from your Driving Revenues course, this may also be one definition of customer service.

Overview: Managing Inventories

Amazon can deliver on all of those “wants”.

After working out the kinks in the early days, Amazon is a model of efficiency in managing their inventories. But the future of Amazon may not even be in product, but in providing the service of process and data management. Watch the following 2-3 minute video for more details.

amazon redshift http://www.youtube.com/watch?v=AUvn49gey8Y

Overview: Managing Inventories

We’ve been looking inventories at familiar retail operations and the dynamics don’t change as we look farther back in the supply chain. Manufacturers are customer too. They have the same demands (requirements) that consumers have…..and sometimes even more.

The following slide includes common inventories found in manufacturing businesses. Do they look familiar from your managerial accounting course?

Overview: Managing Inventories Source: Freeland & Landel, University of Virgina, 2009

The following inventory categories are used to manage inventory at manufacturing organizations:

Raw Materials – components, subassemblies, etc. purchased for manufacturing

Work-in-Process – Parts or products in various stages of completion during manufacturing operations

Maintenance Parts and Supplies – Items used to maintain or repair equipment

Finished Goods – Completed products ready for sale to customers

Overview: Managing Inventories

Companies hold inventory for different reasons, such as extra inventory to avoid stock-outs and building up inventory for seasonal demand like holidays.

Click here to read more

about types of inventory.

These terms will be used throughout the course.

Overview: Managing Inventories Source: Freeland & Landel, University of Virgina, 2009

Another way to classify inventory is based on the attention given each category and the level of controls needed to protect it from theft or damage.

ABC Classification

A Items – High value or items that require special control or scrutiny (proprietary, security concerns, etc)

10% of total

B Items – Second tier, valuable but more routine. Average unit costs, high volume.

20% of total

C Items – Low unit cost, may be high or low volume

70% of total items, 10% of total value

Some companies use D Items – used for nuts, bolts, screws other hardware

Common in manufacturing.

Overview: Managing Inventories

In simpler terms, ABC classification is a way insure you spend your efforts on items that matter. You class expensive, hard to get or critical items as “A” and tightly control those. You class easy to get, or inexpensive items as “C” or”D” since the benefit of tight control is minimal.

Think of a jewelry store. The diamonds are clearly

“A” items, the little silicone backs for earrings

are “C” or “D”. Everyone cares if a diamond goes

missing but who cares if the little earing back get lost?

When you look at bringing out of control inventory under control, breaking the overall items down into these classifications is one of the first things you should do.

Start by looking at most expensive items first, then go to the least. You will be prioritizing your efforts.

Managing Inventories

Overview

The Inventory Dilemma

Inventory Reorder Strategies

The inventory dilemma occurs when companies must balance holding enough inventory to provide goods when the customer wants them, but at the same time minimizing the costs incurred to hold that inventory.

The Inventory Dilemma

The inventory dilemma is the trade-off between (1) inventory to meet customer needs, but (2) minimizing the costs of holding that inventory, including costs to finance it.

The video link below from the Logistics Bureau provides details about the costs of holding inventory and what to do to minimize them. I suggest you take notes about:

Costs of holding inventory

Types of inventory affecting how much to hold: Critical, noncritical and scheduled delivery

Techniques to minimize costs: Vendor-managed inventory and postponement logistics

Inventory Management Basics http://www.youtube.com/watch?v=qkZQxXJuqKo

The Inventory Dilemma

The previous video focused on inventory-related costs. What about having enough inventory on hand?

In a study published in the International Journal of Physical Distribution and Logistics Management …

The occurrence of a stock-out had a pervasive negative impact on consumers' assessment of their online transactional experience and repurchase intentions. Overall, it was found that consumers' reaction to the “shock” effect of a stock-out was best explained by an expectation confirmation-disconfirmation model (they usually have it and didn’t) rather than expecting some stock-outs sometimes.

In between all the academic mumbo jumbo, do you return to a website that has disappointed you?

The Inventory Dilemma

When WalMart comes to town, should you cut prices or boost inventory to compete? That's one question a Northwestern University finance professor grapples with in his new research on the long-term impact of supermarkets' inventory strategies. While companies' decisions about acceptable levels of out-of-stock items often center on short-term financial projections, even a slight increase in inventory shortfalls can send some shoppers to a competing store. Over the long term, a retailer’s brand image can be affected, says David Matsa, Northwestern University's Kellogg School of Management.

Matsa would say it’s important to boost inventory! - Ann Meyer Examining the Walmart Effect on Inventory and Profits

Retail Leader, www.retailleader.net

In another study stock identifies costs as not just the lost sale in the short-run, but the lost customer in the long run.

The Inventory Dilemma

A real world example of an inventory dilemma:

A major manufacturer held 250,000 units in the warehouse and each unit cost was $100.

Inventory-related costs were 6% of unit cost or $6

A customer offered to purchase units at $95/unit—under cost!

Do you think the company should sell the products? (See the notes below this slide to find out what really happened.)

Carrier Air Conditioning faced this dilemma in 2000. I actually made the recommendation that we do the deal. It was a better financial decision to sell at a $5 loss than to hold the inventory for a year and incur $6 additional cost.

The Inventory Dilemma Source: Freeland & Landel, University of Virgina, 2009

Inventory decisions are pretty darn complex.

Sometimes economic factors may indicate that the economic benefits of holding more inventory is greater than inventory-related costs, for example:

Volume purchase discounts

Hedge against inflation or spiked demand

Transportation costs

Click here to read about the results of a real-life inventory trade-off.

Volume purchase discounts—buying large amounts of inventory may result in much lower prices/unit

Hedge: Buy at lower prices if expected to go up or prepare for expectation that demand will spike.

Transportation costs: It’s often much less expensive to ship a full truck-load or shipping container than to ship them at less than full.

Managing Inventories

Overview

The Inventory Dilemma

Inventory Reorder Strategies

As you saw, managing inventories efficiently and effectively is complex. That’s why strategies were developed to help managers get closer to meeting that goal.

Inventory Reorder Strategies

In a perfect world a company balances customer needs and inventory holding costs to set the ideal amount of inventory to have on hand. But . . .

Inventory is used or sold a little at a time. When should the company order additional inventory and how much should be ordered?

Companies use basic approaches to answer this question.

Inventory Reorder Strategies

Order point

Inventory is ordered when a set order point is reached. Quantity ordered is based on economic order quantity or supplier limitations or constraints

Min/Max

Inventory is ordered when a minimum quantity is reached. Order quantity will bring the inventory level back to Maximum

Demand Replenishment

Can be as simple as sell or use one, then replace one. Requires accurate forecasts and tightly integrated supply chain. We will discuss this in Weeks 2 & 3

Helps to answer the question “How much to order.”

Inventory Reorder Strategies

Before we look in detail at the Order point strategy, let’s answer the question “How much should we order?”

Most common approach

is the Economic Order

Quantity (EOQ).

Inventory Reorder Strategies Economic Order Quantity

EOQ is commonly calculated using the formula shown. It’s also represented in the graph to the left.

More trade-offs! The pink line represents inventory holding costs for each order quantity and the teal line represents the costs of acquiring the inventory (costs of ordering, transportation, etc.). What combination of those costs result in the lowest total cost? EOQ!

(See below for more detail.)

EOQ is commonly calculated using the formula shown. It can also be found by plotting costs – per order acquisition cost (placing the order, setup cost, tranportation cost, etc) versus inventory carrying costs. Where those plots intersect, you find the EOQ. It also generally corresponds with the point at which the total variable cost curve flattens or bottoms out. Note that in either example, the particular unit cost of the item is not considered.

Inventory Reorder Strategies Economic Order Quantity

So, everyone needs a chance to lighten up when talking about something as dry as inventory management. So here’s a video that explains EOQ.

EOQ explained

https://www.youtube.com/watch?list=SP58A60640A39C98DA&feature=player_detailpage&v=YWi-JqaO1Wo

Inventory Reorder Strategies Order Point Strategy

Now that we know the EOQ, when should we make the order?

Order point

Fixed review time

We’ve looked

Inventory Reorder Strategies When to Order

We’ve looked at how much to order. The next question is – when should we place that order?

Terms to know before looking at an answer:

Order point: Inventory level used to trigger a reorder

Safety Stock: Inventory held as a buffer against variability in demand, delivery time and unforeseen emergencies Lead time: The time between placing an order and delivery of the goods

Order cycle time: The time between placing one set of orders and then next.

Order Point Strategy

Order Point

As inventory is consumed, the order point is reached. The quantity ordered

is based on known demand, and will be (hopefully) received before the safety stock

Point Is reached.

EOQ = Order Point?

EOQ does not equal Order Point!

EOQ

How much do we order based on the economic model that looks at unit cost, process cost, transport cost, setup/manufacture cost, etc.

Order Point

When do we order to ensure that we have enough to cover demand until the new order arrives.

Inventory Reorder Strategies Order point calculation

Inventory Reorder Strategies Min/Max

Max

Min

Order

Quantity

Inventory is consumed by usage or sales. When the minimum is reached,

an order is placed to bring the level back to maximum. Inventory continues to be

consumed while we wait for the new order to arrive.

Inventory Reorder Stratgies What makes Min/Max interesting?

Inventory managers like min/max systems because it takes a lot of the guesswork out

of their world. The calculate minimum the same way we calculated order point in the

earlier example.

Order point = (lead time + safety stock + basic inventory) * usage per day

But order quantity is fairly easily calculated….. It is the difference between current

quantity (order point) and the maximum level we have agreed. Maximums are set

based on a variety of factors including, cost and space. We may allot a fixed about of space

in the warehouse (or on the shelf) for an item – this will determine the maximum. Or,

we may say that we can never have more than a certain dollar value tied up in a single

item. This too would set the maximum.

To place the order, simply figure out the difference. All that higher math we needed

to get EOQ goes out the window.

Inventory Reorder Strategy Fixed review period

Max

Order

Point

Order

Quantity

Review periods are indicated by the black bars

1 2 3 4

But . . . if review period doesn’t coincide with order point, inventory balance goes to zero. If the quantity isn’t adjusted for that fact, the maximum is never reached. That means sales will be lost.

Inventory Reorder Strategies Order Point Concerns

Quantity only

Is the order point to high or too low?

Will we get our new order before we run out?

Fixed review period

Both of the problems of quantity only plus:

What if we run out between review periods?

What if we review and we are close to order point, but do not order?

Inventory Reorder Strategies What happens if?

Order point and min/max systems work fine if:

Demand is steady and predictable

Inventory costs can be supported

But if demand changes:

May run out if demand increases

May be left with unacceptably high levels of inventory if demand weakens

And what if your supplier cannot deliver????

One afternoon in Valencia Spain…

Just outside of Valencia Spain, on the road to the airport, lies an industrial park and

warehouse complex. One very hot August afternoon we were sitting under an orange

tree enjoying a cool libation when we watched the following unfold.

An air conditioning installer pulled up to the door of our warehouse. He went in, and

and within 5 minutes he came back out. He jumped in his truck and drove to our

next door neighbor (and competitor). Once again, in he went, and out he came. The

scene repeated twice more until he finally got what he wanted.

What was the problem? We didn’t have the product he needed for his customer. We

lost the sale. We learned a lesson that day. We learned that our order point system

was broken. We were not satisfying our customers. This in spite of the fact that our

warehouse was jammed with stuff. We changed our process as a result, and we

found that our stock-outs were reduced.

We were lucky. We saw what happened and reacted. And we didn’t lose the customer.

In fact, we worked with him to improve the process, and made a customer for life.

Inventory Reorder Strategies Danger Will Robinson!!!!!

All you need to do is look at those two order point diagrams to see the risk. If customer demand changes, or if order points (minimums) are set incorrectly, it is easy to run out of product.

And as we have seen before, running out of product has consequences.

Angry customers…

Lost sales….

Lower profits….

Lost jobs for inventory managers…..

What’s the bottom line?

Order point, min/max work just fine in many businesses … if demand is steady.

Sometimes the business model is simple enough that simple systems work best.

How much of a system do you need to sell heavy road equipment? Probably not complex for the graders, probably very complex for parts.

When thinking about EOQ, whose economy is more important? Yours or the supplier’s? (For Walmart, it’s them, not their suppliers.)

Managing Inventories

Overview

The Inventory Dilemma

Inventory Reorder Strategies

Presentation Summary

The challenge for the inventory manager is to balance customer demands with constraints of space, cost, product mix,

Traditional methods result in wide variation in inventory levels.

Traditional methods work best if demand is constant

Assumption is that customers don’t change what or when they want things. They assume what they do meets the customer needs.