CHAPTER 7: Inventory

1. CHAPTER 7: Inventory McGraw-Hill/Irwin

2. Key concepts for discussion • Risk Assessment • Inventory carrying cost • Inventory management parameters • Advanced planning and scheduling • Minimizing inventory through commonality

3. Overview of inventory • Inventory functionality and definitions • Inventory carrying cost • Planning inventory • Managing uncertainty • Inventory management policies • Inventory management practices

4. Why do we have inventories? Because the customer usually isn’t sitting at the plant exit! Queen Elizabeth research station in Antarctica

5. Why hold inventory? Economies of scale Purchasing advantages Transportation advantages Manufacturing advantages Balancing supply and demand Seasonality/Speculative Maintaining supply sources Buffering against uncertainty Uncertainty in demand Uncertainty in supply

6. Factors influencing inventory levels Average inventory Number of products Service level objectives Supply chain structure Financial implications of inventory Companies rely on forecasts (demand/supply) to assist in determining how much inventory to carry

7. Aggregate inventory

8. Sources of organizational risk • Market Risk • Demand based risk • Market risk • Competitive risk • Customer risk • Service risk • Product • Portfolio • Development • Launch • Sales Planning and Forecasting • Life-Cycle Risk Management • Supply Risk • Business strategy • Supplier • Operations • Logistics • Inventory • Financial Risk • Investment • Tax • Expatriation of funds

9. Supply risk • Business strategy • Outsourcing philosophy • Control • Information technology • Intellectual property • Supplier • Strategic sourcing • Selection • Contracting • Supplier management • Operations • Capability • Capacity • Flexibility • Logistics • Capacity • Availability • Security • Lead time • Inventory • Policies • Ownership • Visibility • Obsolescence • Financial Planning

10. Risks associated with holding inventory • Typical measures of exposure to investments in inventory • Time duration • Depth of commitment • Width of commitment • Supply chain exposure based on location • Manufacturer’s exposure is typically narrow, but deep and of long duration • Wholesaler’s exposure is wider than manufacturers and somewhat deep • Duration is medium • Retailer’s exposure is wide, but not very deep • Duration is usually short except for specialty retailers

11. Functions of inventory • Geographical specialization allows us to specialize production across different locations • Decoupling allows us to run processes for maximum economic lot sizes within a single facility • Supply/Demand balancing accommodates the elapsed time between inventory availability and consumption • Bufferinguncertainty accommodates uncertainty related to • Demand in excess of forecast or • Unexpected delays in delivery (aka safety stock)

12. Inventory policy • Inventory policy is a firm’s guidelines concerning • What to purchase or manufacture • When to take action • In what quantity should action be taken • Where products should be located geographically • Firm’s policy also includes decisions about which inventory management practices to adopt

13. Service level • Service level is a performance target specified by management and defines inventory performance objectives • Common measures of service level include • Performance cycle is the elapsed time between release of a purchase order by the buyer to the receipt of shipment • Case fill rate is the percent of cases ordered that are shipped as requested • Line fill rate is the percent of order lines (items) that were filled completely • Order fill is the percent of customer orders filled completely

14. Inventory definitions • Inventory includes materials, components, work-in-process, and finished goods that are stocked in the company’s logistical system • The cycle inventory (base stock) is the portion of average inventory that results from replenishment • Order quantity is the amount ordered for replenishment • Transit inventory represents the amount typically in transit between facilities or on order but not received • Obsolete inventory is stock that is out-of-date or is not in recent demand • Speculative inventory is bought to hedge a currency exchange or to take advantage of a discount • Safety stock is the remainder of inventory in the logistics system

15. Average inventory is the typical amount stocked over time • Average inventory equals the maximum inventory plus the minimum inventory divided by two • Typically equal to ½ order quantity + safety stock + in-transit stock Figure 7.1 Inventory Cycle for Typical Product

16. Smaller replenishment order quantities results in lower average inventory • Policy must decide how much inventory to order at a specified time • Reorder point defines when a replenishment order is initiated • However, other factors are important like performance cycle uncertainty, purchasing discounts, and transportation economies Figure 7.2 Alternative Order Quantity and Average Inventory

17. Inventory carrying cost is the expense associated with maintaining inventory • Inventory expense is • Annual inventory carrying cost percent times average inventory value • Cost components • Cost of capital is specified by senior management • Taxes on inventory held in warehouses • Insurance is based on estimated risk or loss over time and facility characteristics • Obsolescence results from deterioration of product during storage • E.g. food and pharmaceutical sell-by dates • Storage is facility expense related to product holding rather than product handling

18. Final carrying cost percent used by a firm is a managerial policy Table 7.2 Inventory Carrying Cost Components

19. Inventory ordering cost components • Order preparation costs • Order transportation costs • Order receipt processing costs • Material handling costs • Total cost is driven by inventory planning decisions which establish when and how much to order

20. R R = = D D × × T T + SS When to order • Basic reorder formula if demand and performance are certain • R = Reorder point in units • D = Average daily demand in units • T = Average performance cycle length in days • If safety stock is needed to accommodate uncertainty the formula is • R = Reorder point in units • D = Average daily demand in units • T = Average performance cycle length in days • SS = Safety stock in units

21. How much to order • Economic order quantity is the amount that balances the cost of ordering with the cost of maintaining average inventory • Assumes demand and costs are relatively stable for the year • Does not consider impact of joint ordering of multiple products Figure 7.4 Economic Order Quantity

22. Standard mathematical solution for EOQ

23. Example EOQ solution using Table 7.3 • Total ordering cost is $152 = (2400/300 x $19.00) • Inventory carrying cost is $150 = [300/2 x (5 x 0.20)]

24. Simple EOQ model assumptions • All demand is satisfied • Rate of demand is continuous, constant and know • Replenishment performance cycle time is constant and known • Constant price of product that is independent of order quantity or time • An infinite planning horizon exists • No interaction between multiple items of inventory • No inventory is in transit • No limit is placed on capital availability

25. Relationships useful for guiding inventory planning • EOQ is found at the point where annualized order placement cost and inventory carrying cost are equal • Average base inventory equal one-half order quantity • Value of the inventory unit, all other things being equal, will have a direct relationship with replenishment order frequency • Higher value products will be ordered more frequently

26. Typical adjustments to EOQ • Volume transportation rates offer a freight-rate discount for larger shipments • Compare total cost with each transportation rate option • Quantity discounts offer a lower per unit cost when larger quantities are purchased • If discount is sufficient to offset added inventory carrying cost less the reduced cost of ordering then it is viable choice • Other EOQ adjustments • Production lot size • Multiple-item purchase • Limited capital • Dedicated trucking • Unitization

27. Uncertainty in inventory management • Inventory policy must deal with uncertainty • Demand uncertainty — when and how much product will our customers order? • Performance cycle uncertainty — how long will it take to replenish inventory with our customers? • Variations must be considered in both areas to make effective inventory planning decisions

28. Demand uncertainty can be managed using safety stock • To protect against stockout when uncertain demand exceeds forecast we add safety stock to base inventory • Planning safety stock requires three steps • Determine the likelihood of stockout using a probability distribution • Estimate demand during a stockout period • Decide on a policy concerning the desired level of stockout protection

29. Probability theory enables calculation of safety stock for a target service level • Service level is equal to 100% minus probability % of stockout • E.g. a service level of 99% results in a stockout probability of 1% • The most common probability distribution for demand is the normal distribution • From analysis of historical demand data the safety stock required to ensure a stock out only 1% of the time is possible • A one-tailed normal distribution is used because only demand that is greater than the forecast can create a stockout

30. Example of historical demand analysis using a normal distribution Figure 7.6 Historical Analysis of Demand History Figure 7.7 Normal Distribution

31. Performance cycle uncertainty means operations cannot assume consistent delivery Table 7.10 Calculation of Standard Deviation of Replenishment Cycle Duration

32. Safety stock with combined uncertainty • Planning for both demand and performance cycle uncertainty requires combining two independent variables • The joint impact of the probability of both demand and performance cycle variation must be determined • Direct method is to combine standard deviations using a convolution formula

33. Typical situation where both demand and performance cycle variation exists Figure 7.8 Combined Demand and Performance Cycle Uncertainty

34. Summary of alternative solutions to combined uncertainty Table 7.12 Average Inventory Impact Resulting from Changes in EOQ

35. The fill rate is the magnitude rather than the probability of a stockout • Increasing the replenishment order quantity decreases the relative magnitude of potential stockouts • The formula for this relationship is

36. Number of stockouts is reduced from two to one when order quantity is increased Figure 7.9 Impact of Order Quantity on Stockout Magnitude

37. Increased order size can be used to compensate for decreasing the safety stock Table 7.15 Impact of Order Quantity on Safety Stock

38. Dependent demand replenishment • Inventory requirements are a function of known events that are not generally random • Dependent demand does not require forecasting because there is no uncertainty • No specific safety stock is needed to support time-phased procurement programs (e.g. MRP) • No safety stock assumes • Procurement replenishment is predictable and constant • Vendors and suppliers maintain adequate inventories to satisfy 100% of purchase requirements

39. Three approaches to introduce safety stock into dependent demand situations • Put safety time into the requirements plan • E.g. order a component earlier than needed to assure timely arrival • Over-planning top-level demand is a procedure to increase the requisition by a quantity specified by some estimate of expected plan error • E.g. assume plan error will not exceed 5 percent • Utilize statistical techniques to set safety stocks directly for a component rather than to the item of top-level demand

40. Approaches to implementing inventory management policies • Reactive (or pull) approach responds to customer demand to pull the product through the distribution channel • Planning approach proactively allocates inventory on the basis of forecasted demand and product availability • Hybrid approach uses a combination of push and pull

41. Inventory control using reactive approaches • Inventory control defines how often inventory levels are reviewed to determine when and how much to order • Perpetual review continuously monitors inventory levels to determine inventory replenishment needs • Periodic review monitors inventory status of an item at regular intervals such as weekly or monthly

42. Reorder point formulas for reactive methods Perpetual Review Periodic Review

43. Assumptions of classical reactive inventory logic • All customers, market areas, and product contribute equally to profits • Infinite capacity exists at the production facility • Infinite inventory availability at the supply location • Performance cycle time can be predicted and that cycle lengths are independent • Customer demand patterns are relatively stable and consistent • Each distribution warehouse’s timing and quantity of replenishment orders are determined independently of all other sites, including the supply source • Performance cycle length cannot be correlated with demand

44. Planning approaches coordinate requirements across multiple locations in the supply chain • Two planning approaches • Fair share allocation provides each distribution facility with an equitable distribution of available inventory • Limited ability to manage multistage inventories • Requirements planning integrates across the supply chain taking into consideration unique requirements • Materials requirements planning (MRP) is driven by a production schedule • Distribution requirements planning (DRP) is driven by supply chain demand

45. Example of fair share allocation method • Allocation of 500 available units from plant • Warehouse 1 = 47 • Warehouse 2 = 383 • Warehouse 3 = 70 Figure 7.11 Fair Share Allocation Example

46. Integrated planning approach for raw materials, work-in-process, and finished goods MRP system DRP system Figure 7.12 Conceptual Design of Integrated MRP/DRP System

47. Figure 7-13Distribution Requirements Planning example Eastern Distribution Center Safety stock – 100 Order quantity – 400 Lead time – 2 weeks Plant Warehouse Safety stock –100 Batch Size – 600 Lead time – 1 week Western Distribution Center Safety stock – 50 Order quantity – 150 Lead time – 1 week Requirement Shipment

48. DRP Spreadsheet • Load included DRP spreadsheet

49. Advanced Planning and Scheduling example Eastern Distribution Center Safety stock – 100 Order quantity – 400 Lead time – 2 weeks Plant Warehouse Safety stock –100 Batch Size – 600 Lead time – 1 week Western Distribution Center Safety stock – 50 Order quantity – 150 Lead time – 1 week Requirement Shipment

50. Supply chain network Plant Warehouse Eastern Distribution Center Western Distribution Center