Chapter 6: Managing Inventory Flows in the Supply Chain

Chapter 6:

Managing Inventory Flows in the Supply Chain

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Learning Objectives - After reading this chapter, you should be able to do the following:

• Understand the importance of coordinated flows of inventory through supply chains.

• Understand the impact of effective inventory management upon the return on assets (ROA) for a company.

• Appreciate the role and importance of inventory in the economy and why inventory levels have declined relative to Gross Domestic Product (GDP).


Learning Objectives

• Understand the major reasons for carrying inventory.

• Explain the role of inventory to major functional areas in the company.

• Discuss the major types of inventory-related costs and their relationships to inventory decisions.


Learning Objectives

• Understand how inventory items (stock-keeping units) can be designed to maximize the efficiency of managing inventory.

• Appreciate the importance and value of inventory visibility to increasing supply chain effectiveness.

• Understand how companies can evaluate the effectiveness of their inventory management techniques.


Logistics Profile: Micros and More

• “Inventory, inventory, inventory….I am sick and tired of hearing complaints about our inventory levels and the costs associated with carrying inventory,” muttered the COO.

• What is the role of inventory?• What are the important trade-offs in the

management of inventory?• What are the relevant inventory costs?• Can the supply chain help control inventory?


Management of Inventory Flows in the Supply Chain: Introduction

• Inventory as an asset has taken on increased significance as companies struggle to reduce investment in fixed assets that accommodate inventory (plants, warehouses, etc.).

• Changes in inventory affect return on assets (ROA), an important internal and external metric.

• Ultimate challenge is to balance supply and demand for inventory.


Inventory in the Economy

• Inventory in the Economy has decreased.– As a percentage of the GDP, from 1985 to 2000,

inventory levels have decreased from 5.4% to about 3.8%

– Examine Table 6-1.


Table 6-1: Macro Inventory Cost in Relation to U.S. Gross Domestic Product


On the Line: Inventory Turns

• Think of inventory turns as a measure of how well a company’s products are doing in the market and how well its inventory is managed.

• There is a continuing move away from traditional build-to-forecast manufacturing models to more flexible build-to-demand systems.

• Increasing emphasis on fully integrated supply chain means inventories barely spend any time sitting idle.

• “Ideally, zero inventory will maximize cash flow.”

• Inventory turnover potential is 30 to 40 times/year.

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Inventory in the Firm: Rationale for Inventory

• Product Line Proliferation– Depth & breath of product lines trending up.– Results in larger inventories.

• Examine Table 6-2 Total Logistics Costs-1999.

• Inventory carrying costs of $332 billion approach 35 percent of total logistics costs for companies.

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Table 6-2Total Logistics Costs --- 1999

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Inventory in the Firm: Batching Economies/Cycle Stocks

• Price discounts– Result in trade-offs between large purchases qualifying

for quantity discounts and costs of storing inventory.– Because physical supply inventory is often raw

materials, storage costs are often less than savings from buying in bulk, so supplies are stockpiled.

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• Transportation rate discounts– Large quantities often result in carload freight rates.– Largest shipments may qualify for even lower multiple

truckload, carload or trainload rates.– Lower freight rates are often reflected in lower

consumer prices.

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• Production economics favor long production runs.– Results in cycle stock that must be stored.– Cycle stocks can be beneficial as long as the

appropriate analysis is done to cost justify the inventory.

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Sawtooth Models

200

600

400

20 40 60Time

Uni

ts

1/2Q

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Mathematical Formulation• Total Annual Cost = Annual Inventory Carrying

Cost + Annual Ordering Cost• Letting TAC = Annual Total Cost ($)

R = Annual demand (units)

A = Cost of placing a single order ($)

V = Value of one unit of inventory ($)

W = Inventory carrying cost as a % of product value

Q = EOQ

• Then: TAC = 1/2 QVW + A (R/Q)• and: the EOQ that minimizes the TAC is:

QRA

VW

2

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Example of EOQ

R = Annual demand = 600 units

A = Order cost = $4/order

V = Product value = $240/unit

W = inventory carrying cost = 20% = 0.20

QRA

VW

2 2 600 4

240 0 20

( )

( )( . )

4 800

48

,

100 =

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Example of TAC:

R = Annual demand = 600 units

A = Order cost = $4/order

V = Product value = $240/unit

W = inventory carrying cost = 20% = 0.20

Then:

TAC = 1/2 QVW + A (R/Q)

1/2 (10) (240) (0.20) + (4) (600/10)

240 + 240

$480

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Reorder Point (when to order)The Goal is to have a shipment of EOQ units to arrive as the Balance-

On-Hand > 0

Reorder Point (ROP)= minimum amount of inventory to last during the replenishment or lead

time

= [Lead time length (in days)] X [Demand per day (in units per day)]

Continuing Example: (Assume 300 days per year)Lead time length = 12 days

Then Demand per day = 600 / 300

= 2 units/day

ROP = ( 12 days) ( 2 units/day)

ROP = 24 units

Additional exercises to do at home: CBL, pp. 230, #7 and 8

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EOQ Review

• Perhaps the most well-know, traditional approach to managing inventory

• computes an “optimum’ value for the economic order quantity (EOQ) based on a trade-off of two types of cost:– Inventory carrying cost– Ordering cost or setup cost

• Replenishment orders placed when inventory-on-hand reaches a pre-determined “ROP”

• currently declining in popularity and frequency of use:– Too much emphasis on carrying inventory– Not very useful for systems with multiple distribution centers– Greater emphasis today on approaches which “synchronize”

delivery of shipments with timing of actual need (e.g., JIT)

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Related Concepts

• “Two-bin” system

• “Min-max” system– demand may occur in larger increments than with

the traditional EOQ approach

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EOQ in Condition of Uncertainty

• Uncertainty = variation in demand and/or lead time

• Requires holding of safety stock inventory

• Policy: Cost of carrying safety stock should be

balanced with expected cost of stockouts

• Average inventory = 1/2 EOQ + Safety Stock

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Inventory Model UnderConditions of Uncertainty

• EOQ is still the amount ordered each time• Assumes that over time, uncertainty periods balance out

Time

Inventory Level(Units)

ROP

SafetyStock

Qm

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Explanation of Graph

• Demand rate changes slope– Varying demand during cycle can make line non linear

• Lead time changes – Reorder point to receipt

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Fixed Order Interval

• Involves ordering of inventory at fixed or regular intervals

• Amount order depends on how much is on-hand at the time of ordering (NOT EOQ)

• Implications:– Does not require close surveillance of inventory

levels– Inventory monitoring less expensive– Over time, it results in higher safety stock levels

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Fixed Interval Modal

$1,000

$4,000

$3,000

$2,000

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2Time (weeks)

Uni

ts

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Inventory in the Firm: Uncertainty/Safety Stocks

• Reasons for uncertainty are commonplace.– Net results are the same: companies accumulate

safety stock to buffer themselves against uncertainty.– Safety stock more challenging and complex to manage

for many firms.

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Inventory in the Firm: Uncertainty/Safety Stocks

• Impact of information on uncertainty– Trade-off analysis appropriate to assess risk and

measure inventory cost.– Information technology can be used in the supply chain

to reduce inventory.– Collaborative planning and forecasting requirements

(CPFR) is an example.– Bar coding, EDI, the Internet have enabled companies

to reduce uncertainty.

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Inventory in the Firm: Time/In-Transit and Work-In-Process Stocks

• Time-related trade-offs from using slower to faster transport modes– Faster modes cost more but may save a larger amount

in inventory carrying costs.

• Work-In-Process inventory should be examined for possible trade-offs especially in the production of high value goods.– Scheduling and actual production times can be closely

examined to reduce inventory.

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Quick Response (QR)

• How did it evolve?• QR is a method of maximizing the efficiency of the

supply chain by reducing inventory investment where partners commit to meet specific service performance criteria.

– shorter, compressed time horizons– Real-time information by SKU– Seamless logistics network– Partnership relationships throughout the supply chain– Commitment to Quality

• What were results?

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Basic Elementsof QR

Timehorizons

Information

Supplier/Manufacturerrelationships

Philosophical/Cultural change

Manufacturingoperations

Logistics

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QR Profit Sources

Faster Order PlacementShorter Lead Times

Rapid Reaction to DemandMore Reliable Lead Times

Fast Response toSales Trends

Higher SalesLower Markdowns

Greater Profitability

Reduced TotalChannel Costs

Reduced Cycle Stock

Reduced Safety Stock

Lower MarkdownsHigher Sales

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Time Savings from QR

0

10

20

30

40

50

60

70

80

Present Q.R. Q.R.+

Retail

Apparel

Textile

Fiber

66

46

21

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Efficient Consumer Response (ECR)

Supplier Distributor Retail StoreConsumer Household

Timely, accurate, paperless information flow

Smooth, continual product flow matched to consumption

Source: Kurt Salmon Associates, Inc. Efficient Consumer Response: Enhancing Consumer Value in the Grocery Industry

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ECR• Components

– Category management (Managing product groups as strategic business units)

– Integrated electronic data interchange (EDI)– Activity-Based Costing (ABC)– Continuous replenishment programs– Flow-through cross-dock replenishment

• Benefits– Better - products, assortments, in-stock performance, and

prices– Leaner, faster, more responsive, less costly supply chain– Improved asset utilization

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ECR Impact on Dry Grocery Chain

61 days

SupplerWarehouse

27 days

RetailStore

22 days

DistributorWarehouse

12 days

ECR Dry Good Chain

Current Dry Good Chain

SupplerWarehouse

38 days

RetailStore

26 days

DistributorWarehouse

40 days104 days

Packing Line

Consumer

Purchase

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ECR’s Effect on Cost

Current ECR

Operating Profit

Store Ops

AdministrationLogistics

Selling/Buying

Marketing

Cost of Goods

12.1

18.3

5.0

8.14.1

9.7

42.7

9.8

16.4

4.8

6.23.08.2

40.8

100

89.2

Source: FoodMarketing Inst.,

ECR, 1993.

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Inventory in the Firm: Seasonal Stocks

• Seasonality can occur on the inbound and/or outbound side of the firm’s logistics systems.

• Perishable supply in agricultural products or seasonal-related transportation problems.

• Seasonal demand compressing selling seasons in some industries results in smaller plants producing for stock.

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Inventory in the Firm: Anticipatory Stocks

• In some cases, companies anticipate that some forecasted event will negatively impact the production cycle.

• For example, labor strikes, shortage of supplies due to weather or political event, or significant price increases may prompt the firm to build inventory levels higher than normal.

• Risk assessment is important in these cases.

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Inventory in the Firm: The Importance of Inventory in Other Functional Areas

• Marketing uses inventory to provide strong customer service.

• Manufacturing uses inventory to schedule longer production runs.

• Finance wants inventory turnover ratios to be kept high so that risk of inventory loss is reduced and rate of return on assets kept competitively high.

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Inventory Costs: Why are they so important?

• First, inventory costs are a significant portion of total logistics costs for many firms.

• Second, inventory levels affect customer service levels.

• Third, inventory cost trade-off decisions affect inventory carrying costs.

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Inventory Costs: Inventory Carrying Cost

• Capital Cost– Opportunity cost associated with investing in inventory,

or any asset.– What is the implicit value of having capital tied up in

inventory, instead of some other worthwhile project?– Minimum ROR expected from any asset.– Debate on inventory valuation at fully allocated or

variable costs only.

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• Storage Space Cost– Handling costs, rents, utilities.– Logistics develops a cost formula for storage space

costs based on cost behaviors.• Public space mostly variable.

• Private space a mix of fixed and variable.

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• Inventory Service Cost– Insurance and taxes on stored goods.– Varies according to the value of the goods.

• Inventory Risk Cost– Largely beyond the control of the firm.– Due to obsolescence, damage, theft, employee

pilferage.

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Table 6-3 Example of Carrying Cost Components for Computer Hard Disks

Cost Percentage of Product Value

Capital 12 %

Storage space 2

Inventory service 3

Inventory 8

Total 25 %

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Inventory Costs: Calculating the Cost of Carrying Inventory

• Step 1 - Identify the value of the item stored in inventory (e.g. $100).

• Step 2 - Measure each individual carrying cost component as a percentage of product value (e.g. 25%).

• Step 3 - Multiply overall carrying cost (as a percentage) times the dollar value of the product (e.g. $100 times 25% = $25 inventory carrying cost per year.

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Inventory Costs: Nature of Carrying Cost

• Items with basically similar carrying costs should use the same estimate of carrying cost per dollar.

• There are exceptions for items that are subject to special consideration for purposes of quick obsolescence or high degree of theft, etc.

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Table 6-4Inventory and Carrying Cost Information for Computer Hard Disks

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Inventory Costs: Order/Setup Costs

• Order costs– MIS costs for inventory stock level tracking.– Preparing and processing purchase orders and

receiving reports.– Inspecting and preparing inventory for sale.

• Setup Costs– Incurred when production changes over from one

product to another.

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Table 6-5 Order Frequency and Order Cost for Computer Hard Disks

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Inventory Costs: Carrying Cost versus Order Cost

• Examine Table 6-6.

• Order costs and carrying costs respond in opposite ways to increases in volume.

• This reinforces the logisticians need to be able to separate costs by how they behave in relation to changes in volume.

• Assistance from managerial accountants is available for cost-volume-profit analysis.

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Table 6-6 Summary of Inventory and Cost Information

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Figure 6-1 Inventory Costs

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Inventory Costs: Expected Stockout Cost

• Cost of not having product available when a customer wants it.

• Includes backorder costs (special order).

• Losing one item profit by substituting a competing firm’s product.

• Losing a customer permanently if customer finds they prefer the substituted product and/or company.

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Inventory Costs: Expected Stockout Cost

• Possible to handle this by adding safety stock.

• In a manufacturing firm, a stockout may result in lost hours of production until the item is restocked.

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Inventory Costs: Inventory in Transit Carrying Cost

• Any product inbound to the firm using F.O.B. origin should be counted.

• Any product outbound from the firm using F.O.B. destination should be counted.

• In transit carrying cost is generally less than for regular inventory because some cost components are not present.– No storage costs, no taxes, and reduced risk of

obsolescence.

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Classifying Inventory:ABC Analysis

• Ranking system– Developed in 1951 by H. Ford Dicky of General

Electric3.– Suggested that GE classify items according to

relative sales volume, cash flows, lead time, or stockout cost.

– Most important inventory put in Group A.– Lesser impact goods put in Groups B and C

respectively.

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• Pareto’s Rule (80-20 Rule)– Based on a nineteenth century mathematician’s

observation that many situations were dominated by a very few elements.

– Conversely, most elements had very little influence in most situations.

– Separates the “trivial many” from the “vital few”.

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• 80-20 Rule– 80% of sales will come from 20% of the

inventory SKUs.– 20% of sales will come from 80% of the

inventory SKUs.

• The 80-20 Rule has been found to explain many phenomena that interest managers.– For example, 80% of sales come from 20% of

customers; and vice versa.

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Figure 6-2 ABC Inventory Analysis

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Table 6-7 ABC Analysis for Big Orange Products, Inc.

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Inventory Visibility

• The ability of the firm to “see” inventory on a real-time basis throughout the supply chain system requires:– Tracking and tracing inventory SKUs for all

inbound and outbound orders.– Providing summary and detailed reports of

shipments, orders, products, transportation equipment, location, and trade lane activity.

– Notification of failures in inventory flow.

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Inventory Visibility: General Benefits

• Improved customer service

• Decreased cost-of-sales

• Improved vendor relations and cost

• Increased Return on Assets

• Improved cash flow

• Improved response time and service recovery

• Improved performance metrics

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Evaluating the Effectiveness of a Company’s Approach to Inventory Management

• Are customers satisfied with the current level of customer service?– If standards have been set in consultation with

the customer, this question can be answered objectively.

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• How frequently does backordering and/or expediting occur?– If records of these events are kept, the answer

to this question can point out the need for a modification or adoption of new inventory strategies.

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• Is the company calculating an Inventory Turnover ratio for each product SKU?– This ratio can provide good information on

whether the inventory is being effectively and efficiently managed.

– Examine Table 6-8, Figure 6-3 and Figure 6-4.

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• How does inventory level behave as sales rise or fall?– From sales records, the firm can determine if

inventory levels rise as much as sales, less than sales, or stay about the same regardless of sales levels.

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Table 6-8 The Relationship among Inventory Turnover, Average Inventory, and Inventory Carrying Costs

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Figure 6-3 Saving Inventory Dollars by Inventory Turns

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Figure 6-4 Past and Projected Inventory Turnover of Finished Goods

Documents

Chapter 6: Managing Inventory Flows in the Supply Chain