Managing Inventory

Managing Inventory

Distribution Inventory

TYPES OF INVENTORY

Manufacturing Inventory

Total Supply Chain Inventory Multi- Echelon Inventory

• Raw Material

• Work-In-Process

Echelon Inventory

• Finished Goods

• Saleable Spares

Maintenance Repair Operating Supplies

Depot Echelon Inventory

Dealer

Depot

FactoryEchelon Inventory

SupplierEchelon Inventory

Receiving Stores Holding Stores

FPS

DepotEchelon Lead time

Factory Echelon Lead time

SupplierEchelon Lead time

PlantPlantPlantPlant

MULTI-ECHELON INVENTORY

Suppliers

DealerDealerDealer

INVENTORY MANAGEMENT

Inventory Management Comprises Inventory Planning Inventory Control

Inventory Planning Carried Out at All Levels of Management Master Planning Level – End Products Overall Inventory Level

• Production Planning – Overall Company • Master Production Scheduling (MPS) – End Items/ Finished Goods• Material Requirement Planning (MRP) – Components/ Parts/ Raw Material

Inventory Created By Production Also Supports it & Needs to be Managed Together in a Coordinated Way (Not Separately)

Good Inventory Management Essential for Profitable Running of Any Organization

Value of Inventory Converts into Cash as Inventories Used by Operations Resulting in improved Cash Flow/ Return on Investment

Carrying Inventory Absorbs Costs Increasing Operating Costs & Decreasing Profits

LEVELS OF INVENTORY MANAGEMENT

Aggregate Inventory Management Manage Inventory as Per Classification & Functions They Perform

• Raw Material• Work-in-Process• Finished Goods

Financially Oriented & Concerned with Costs & Benefits of Carrying Different Classifications of Inventory

Aggregate Inventory Management Looks into Flow & Kinds of Inventory Needed Supply & Demand Patterns Functions that Inventories Perform Objectives of Inventory Management Inventory Costs

Item-Level Inventory Management Involves Establishing Decision Rules for Controlling Inventory at the Item Level & Includes

Identifying Items Most Important for Business How Individual Items Will be Controlled How Much to Order at One Time When To Place an Order

INVENTORY CLASSIFICATION BY FLOWS

Major Classification of Inventory Based on Flow of Material Into/ Through and Out of a Manufacturing Organization Raw Material – Purchased Items Received But Not Issued to Production

& Include Component/ Parts/ Sub-assemblies Work-In-Process (WIP) - Raw Materials Issued to Production Being Processed/ Waiting for Next Stage in Processing

Finished Goods – End Product of the Production Process Ready for Sale Held at Factory/ Central Warehouse

Distribution Inventories – Stocked in Various Points in the Distribution System

Maintenance, Repair & Operational Supplies (MRO) – Items that Support the Production Process But Do Not Become Part of Product – Hand Tools/ Machine Spares/ Lubricants/ Cleaning Supplies

Supplier

Supplier

Supplier

Raw MaterialsPurchased PartsSub-Assemblies

WorkIn

Process

FinishedGoods

Warehouse

Warehouse

Warehouse

CUSTOMERSInventories/ Flow of Materials

FUNCTIONAL VIEW OF INVENTORY

Anticipation Inventory In Anticipation of Future Demand Ahead of Peak Selling Season/ Sales Promotion/ Vacation Shutdown/ Threat of Strike

Fluctuation Inventory (Safety Stock) To Cover Random Unpredictable Fluctuations in Supply/ Demand/ Lead Time Safety Stock/ Buffer Stock/ Reserve Stock Prevents Disruption in Manufacturing/ Deliveries To Customers Due To Stock Out Resulting from Un-Anticipated Delays

Lot-Size Inventory (Cycle Stock) Purchased/ Manufactured Quantities Greater Than Immediate Need Create Cycle Stock To Take Advantage Of Quantity Discounts/ Reduce Shipping/ Set Up Costs When Making/ Purchasing of Items at Rate Same as These Will Be Used/ Sold Cycle Stock is Portion of Inventory That Depletes Gradually as Customer Order Comes in and is Replenished Cyclically When Suppliers Deliver Supplies

Maintenance, Repair & Operating Supplies (MRO) Items that Support the Production Process But Do Not Become Part of Product – Hand Tools/ Machine Spares/ Lubricants/ Cleaning Compounds/ Pencils/ Erasers

Transportation Inventory (Pipeline/ Movement Inventory) Inventory in Transit Created as Time Required to Move Inventory from Plant To Distribution Centre/ Customer Transit Inventory Not Dependent on Shipment Size But on Transit Time-T, in Days & Annual Demand-A, in Units Average Annual Inventory in Transit, I=TA/ 365 in Units Reduction in Annual Average Transit Inventory Possible by Reducing Transportation Time

Hedge Inventory Inventory Procured To Take Benefit of Low Prices When Supply More Than Demand in Global Markets Such Products Normally are Minerals/ Grains/ Animal Products

Delivery of goods from a supplier is in transit for ten days. If the annual demand is 4, 200 Units, what is the Average Annual Inventory in Transit?

Average Annual Inventory in Transit, I = TA/ 365 = (10×4200)/ 365=115.06 Units

FUNCTIONAL VIEW OF INVENTORY

EXAMPLES

2. If Transit Time is eleven days and the Annual Demand for an item is 10, 000 Units. What is the Average Annual Inventory in Transit?

1. Delivery of goods from a supplier is in transit for twelve days. If the annual demand is 5, 500 Units, what is the Average Annual Inventory in Transit?

Average Annual Inventory in Transit, I = TA/ 365 = (12×5500)/365=180.82 Units

Average Annual Inventory in Transit, I = TA/ 365 = (11×10000)/365=301.36 Units

3. A company is using a carrier to deliver goods to a major customer. Annual demand is Rs 2,000,000 and the average transit time is 10 days. Another carrier promises delivery in 7 days. What will be the reduction in transit inventory if the company accepts the offer?

Current Average Annual Inventory in Transit= TA/ 365 = (10×2000000)/365=Rs 54,794.52If offer Accepted, Average Annual Inventory in Transit= TA/ 365 = (7×2000000)/365=14000000/365= Rs. 38,356.16 Reduction in transit inventory= 54, 794.52-38, 356.16=Rs. 16, 438.36

INVENTORY MANAGEMENT OBJECTIVES

Maximum Customer Service

Increased Efficiency in Operations

Minimum Investment in Inventory

Effective Inventory Management Helps in Maximizing Profits

While Providing Excellent Customer Service as Desired By Customers

Making Products Available Exactly When Needed By Customer is Providing Customer Service in Terms of Inventory

Stock-Out Leads to Customer Dissatisfaction

Condition of Stock-Out Occurs If No Stock Available When Customer Requires it

Inventory Helps to Maximize Customer Service By Protecting Against Uncertainty

Stock Availability is a Tool to Measure Effectiveness of Inventory Management System in Organization

Customer Could Be Purchaser/ Distributor/ Another Plant in the Organization/ Next Workstation Where Next Operation will Take Place

Often Extra Inventory Held as Safety Stock to Avoid Stock-Outs

PROVIDING CUSTOMER SERVICE

IMPROVING OPERATING EFFICIENCY

Inventories Help Manufacturing Operations To be More Productive in 4 Ways

Inventories Allow Operations with Different Rate of Production To Operate Separately and More Economically

Subsequent Operations That Have Different Production Rates & Must be Operated More Efficiently Will Build Up Inventories Between Them

Strategy of Satisfying Need for Seasonal Products with Non-uniform Demand Using Anticipatory Inventory Built Up Through Uniform Level Round the Year Production Result in Lower

Overtime Costs Hiring/ Firing Costs Training Costs Sub-Contracting Costs Capacity Requirement

Inventories Allow Longer Production Runs That Result in Reduced Setup Costs Per Item - With Single Set Up More Quantities Produced Increase in Production Capacity as Processing Time Greater Than Setup Times

Inventories Allow Purchase in Larger Quantities Lowering Ordering Cost Per Unit While Taking Advantage of Quantity Discounts As well

OPERATION LEVELING

Jan Mar Jun Sep Dec

Seasonal Demand

Production

Qu

anti

ty

Capital Costs: Depends On Interest Rate/ Credit Rating of Firm/ Other Investment Opportunities

• Money Invested in Inventory & Not Available for Other Uses Thus Representing Loss Opportunity Cost.• Minimum Cost is Loss of Interest

Storage Costs: Depends on Location & Type of Storage Needed • Costs Related to Storing Space/ Workers/ Handling Equipment

Risk Costs: Normally Low Value But 100% of Item Value for Perishable Items • Obsolescence-Loss of Product Value Due to Model/ Style/ Technology Change• Damage – Product/ Packaging Damage in Store/ Transit• Pilferage – Goods Lost/ Stolen • Deterioration – Rots/ Dissipates in Storage/ Limited Shelf Life

Carrying/ Holding Costs Expressed as Percentage of Rupee Value of Inventory per Unit of Time (Usually One Year)–Normally 20-35 % Per Year/Higher for Fashion Items

Item Cost/ Landed Cost Purchased Item=Purchase Price+Transportation Cost+Insurance+Customs Duties Manufactured Item= Direct Material + Direct Labour + Factory Overhead

Carrying Costs/ Holding Costs: Incurred Due To Volume of Inventory Carried that Increases/ Decreases When Volumes Increase/ Decreases

INVENTORY COSTS

EXAMPLES A company carries average annual inventory of Rs. 2, 000,000. They estimated their costs of capital, storage and risk are 10%, 7% and 6% respectively. Calculate how much it costs annually to carry the inventory

Total Cost of carrying Inventory = Cost of Capital + Storage Cost + Risk Cost

= 10% + 7% + 6% = 23%

Annual cost of carrying Inventory = 23/100 ×2,000,000 = Rs. 460,000.00

A florist carries an average inventory of $10, 000 in cut flowers. The flowers need special storage and are highly perishable. The florist estimates capital cost at 10%, storage cost at 25% and risk costs at 50%, What is his annual carrying cost?

Total Cost of carrying Inventory = 10%+25%+50% = 85%

Annual cost of carrying Inventory = 0.85×10,000 = $8,500.00

Given the following percentage costs of carrying inventory, calculate the annual carrying cost if the average inventory is $1 million. Capital costs are 10%, storage costs are 6% and risk costs are 7%.

Total Cost of carrying Inventory = 10%+6%+7% = 23%

Annual cost of carrying Inventory = 0.23×1,000,000 = $230,000.00

INVENTORY COSTS

Ordering Costs Costs Associated With Placing an Order with Factory/ Supplier Not Dependent on Quantity Mentioned in the Order Annual Cost of Ordering Depends On Number of Orders Placed During the Year

Production Control Costs • Annual Costs & Effort Expended in Production Control Depend on Number of Production Orders Placed Not the Quantities Ordered in Each • Costs Related to Issuing/ Closing Orders/ Scheduling/ Machine Loading/

Dispatching/ Expediting

Lost Capacity Costs• Every Time Order Placed with Work Centre Time Taken to Set Up is Lost Productive Output Time• Particularly Important & Costly are Set Up Costs at Bottleneck Work Centres

Set Up & Teardown Costs• Work Centres Need to be Set Up Every Time To Run New Production Order & Tear Down The Set Before New Order is Taken Up• Costs Not Dependent On Order Quantity But on Number of Orders Placed Per Year

Ordering Costs in Manufacturing Include

Stock-Out Costs When Demand During Lead Time of Supply Exceeds Forecast Stock- Out Costs Increases due to

• Back-Order Costs• Lost Sales• Lost Customers

Carrying Extra Inventory Protects Against Stock Outs

Capacity-Associated Costs When Output Levels Need To be Changed Cost incurred in Overtime/ Hiring/ Training/ Running Extra Shifts / Layoffs Costs Can be Avoided By Leveling Production & Producing at Same Rate During Slack Times for Sale During Peak Periods Production Leveling Builds Inventory During Slack Periods

Ordering Costs in Purchasing

Purchase Order Cost• Costs Incurred to Place an Order Depends on Number of Orders Not Ordered Quantities• Related to Order Preparation/ Follow Up/ Expediting/ Receiving/ Authorizing Payments• Quality Inspection/ Transportation Costs• Accounting Cost of Receiving/ Paying the Invoice

INVENTORY COSTS

EXAMPLE

Calculate average cost of placing one order with the annual costs given below:• Production Control department salaries= Rs60,000• Supplies & operational expenses for PC department= Rs15,000• Cost of setting up work centres for an order= Rs120• Orders placed each year= 2,000

Average cost of One order= Fixed Cost/ No. of orders + Variable Cost

= (60000+15000)/2000 + 120= Rs157.50

Annual purchasing salaries are $65,000, operating expenses for the purchasingDepartment are $25,000 and inspecting & receiving costs are $25/ order. If the purchasing department places 9,000 orders a year, what is the average cost of ordering? What is the annual cost of ordering?

Average cost of ordering=Fixed Cost/ No. of Orders + Variable Cost

= (65000+25000)/ 9000 + 25=$35.00

Annual cost of ordering=Fixed Cost + Variable Cost × Annual No. of Orders

= (65000+25000) + 9000 × 25=$315,000

EXAMPLE

An importer operates a small warehouse that has the following annual costsWages for purchasing are $45,000, purchasing expenses are $30,000, customsand brokerage costs are $25/ order, the cost of financing the inventory is 8%,Storage costs are 6% and the risk costs are 10%. The average inventory is $250,000 and 5,000 orders are placed in a year. What are the annual orderingand carrying costs?

Total Cost of carrying Inventory = Cost of Capital+Storage Costs+Risk Costs

= 8% + 6% + 10% = 24%

Annual cost of carrying Inventory = 0.24 ×250,000 = $60,000

Average cost of One Order= Fixed Cost/ No. of Orders + Variable Cost

= (45000+30000)/5000 + 25= $40

Annual cost of Ordering=Average Cost of One Order × No. of Annual Orders

= 40 × 5000=$200,000

EXAMPLE

A company makes and sells a seasonal product. Quarterly Sales forecasts for the product are 2,000, 3,000, 6,000, 5,000 Items for the next year. Calculate level production plan, quarterly ending inventory and average quarterly inventory.If inventory carrying costs are $3 per unit per quarter, what will be the annual cost of carrying inventory? Assume opening and closing inventoriesas zero.

Sales Forecast 2000 3000 6000 5000 16000

Q1 Q2 Q3 Q4 Total

Production Plan 4000 4000 4000 4000 16000

Ending Inventory 0 2000 3000 1000 0

Average Inventory 1000 2500 2000 500

Inventory Cost ($3/Unit) 3000 7500 6000 1500 18000.00

Average Inventory = Opening Inventory + Ending/Closing Inventory 2

EXAMPLE

1000 2000 3000 2000

Q1 Q2 Q3 Q4 Total

Annual cost of carrying anticipatory Inventory = $6,000

A company manufactures and sells a seasonal product. Based on the Quarterly sales forecasts that follows, calculate level production plan, quarterly ending Inventories and average quarterly inventories. Assume thatthe average quarterly inventory is the average of starting and ending inventory for the Quarter. If inventory carrying costs are $3 per unit per quarter, what will be the annual cost of carrying this anticipation inventory? Opening and ending Inventories are zero.

8000

Production Plan 2000 2000 2000 2000 8000



Inventory Cost 1500 3000 1500 0 $6,000

Sales Forecast

($3/ Unit)

5000 8000 8000 10000

Q1 Q2 Q3 Q4 Total

31000

Production Plan 7750 7750 7750 7750 31000

Ending Inventory 2750 2500 2250 0


Inventory Cost 8250 15750 14250 6750 $45,000

Sales Forecast

Given the following data, calculate a level production plan, quarterly ending Inventory and average quarterly inventory. If inventory carrying costs are $6 per unit per quarter, what is the annual carrying cost? Opening and ending Inventories are zero.

EXAMPLE

0

$6



Inventory Cost $6 8850 16350 14850 7350 $47,400

If the company always carries 100 units of safety stock, what is the annual cost of carrying it?

SELECTIVE CONTROL OF INVENTORY

Inventory Managed By Controlling Individual Items – Stock-Keeping Units (SKU) & That Involves Costs

For Effective Inventory Control at Reasonable Cost Large Number of Items in Inventory Are Classified According To Importance of The SKU for Operations/ Business

Different Inventory Control Methods Used for Items Based On Different Selection Criteria

Annual Usage Value Unit Price of Item Criticality of Item Difficulties in Procurement Procurement Source

Classifications Used To Render Selective Treatment to Different Category of Material

Each Classification Emphasizes On a Particular Aspect Seasonality Stock Turnover Rate Consumption Rate Value of Stocks

SELECTIVE INVENTORY MANAGEMENT

A-B-C (Always Better Control) Annual Usage Value

Item Classification Criteria for Selection

H-M-L (High, Medium, Low) Unit Price of Item

V-E-D (Vital, Essential, Desirable) Criticality of Item

S-D-E (Scarce, Difficult, Easy) Difficulties in Procurement

G-O-L-F (Government, Ordinary, Procurement Source Local, Foreign)

S-OS (Seasonal, Off- Seasonal) Nature of Supplies

F-S-N (Fast, Slow, Non Moving) Consumption Rate

XYZ Value of Items in Stores

M-N-G (Moving, Non Moving, Ghost Items) Stock Turnover Rate

Categorizing Items in Stock Into Manageable Groups Facilitates Inventory Control with the Right Focus

A-B-C CLASSIFICATION - METHODOLOGY

1. Determine Annual Usage of Each Item

2. Multiply Annual Usage of Item by Its Cost To Get Total Annual Usage Value

3. List Items According to Annual Usage Value in a Descending Order

4. Calculate the Cumulative Annual Usage Value & Cumulative Percentage of Items

5. Examine Annual Usage Distribution & Group Items into A/ B/ C Groups Based on Percentage of Annual Usage

Used in Controlling Inventories of Raw Material/ Components/ WIP/ Finished Goods

A-B-C CLASSIFICATION

10 25 100

75

90

100

Cumulative Value %

% ItemsCCAA

A - A -

B -B -

C - C -

10% of Items10% of Items75% of Value75% of Value



A–Frequently Monitored+ Lower Safety Stock To Avoid Stock Outs

C– Least Frequently Monitored+ Highest Safety Stock

BB

Item Unit Usage

Unit Cost

Rs.

Annual Usage Rs

A 1100 2 2200

B 600 40 24,000

C 100 4 400

D 1300 1 1,300

E 100 60 6,000

F 10 25 250

G 100 2 200

H 1500 2 3000

I 200 2 400

J 500 1 500

A company manufactures a line of 10 items. Their usage and unit cost are shown in the accompanying table along with annual Rupee value usage of each. Group items into ABC Classification.

EXAMPLE

ItemUnit

UsageUnit Cost (Rs.)

Annual Usage (Rs)

Cum Usage (Rs)

Cum % of Rs Usage

Class

B 600 40 24,000 24,000 62.75 A

E 100 60 6,000 30,000 78.43 A

H 1500 2 3,000 33,000 86.27 B

A 1100 2 2,200 35,200 92.03 B

D 1300 1 1,300 36,500 95.42 B

J 500 1 500 37,000 93.73 C

I 200 2 400 37,400 97.78 C

C 100 4 400 37,800 98.82 C

F 10 25 250 38,050 99.48 C

G 100 2 200 38,250 100.00 C

A-Class• 20% - Items• 78.43%-Value

B-Class• 30% -Items• 16.99%-Value

C-Class• 50% -Items• 4.58%-Value

SOLUTION

INVENTORY CLASSIFICATION - ABC ITEMS

A-Class Items High Priority Items Represent About (10-15)% of Items that Account for About 70-80% of Value Tight Control on Inventory

• Keep Complete & Accurate Records• Regular + Frequent Review of Demand Forecasts• Close Follow-Up + Expediting Supplies To Reduce Lead Time

B-Class Items Medium Priority Items Represent About (10-15)% of Items that Account for About (10-15)% of Value Normal Control on Inventory

• Keep Good Records • Regular Attention To Demand Forecasts• Normal Processing

C-Class Items Lowest Priority Items Represent About (70-50)% of Items that Account for About (10-15%) of Value Simplest Possible Control On Inventory - Stock Large Quantities

• Simple Records with Periodic Review of Stocks• Order Large Quantities & Carry Safety Stocks

H-M-L ANALYSIS

H - Category of Items High Priced Items

• Tight Control on Consumption• More Frequent Verification of Stocks• Purchase Policies for Closer Control on Purchase• Higher Storage Security (Locked in Steel Cupboards)

M - Category of Items Medium Priced Items

• Medium Control on Consumption• Frequent Verification of Stocks• Medium Control on Purchase• Medium Security of Storage

L - Category of Items Low Priced Items

• Less Control on Consumption• Less Frequent Verification of Stocks• Less Stringent Control on Purchase• Standards Security Provided

Used In Controlling Purchased Inventory

V-E-D ANALYSIS

V - Category of Items: Vital for Production/ Consumers Item in C Category May Come Under Vital Category If

• Non-Availability Will Cause Serious Problems/ High Stock-Out Costs • Large Lead Time for Procurement• Non-Standard Item Purchased Against Purchaser’s Design

Criteria of Selection - Criticality of Item

E - Category of Items: Essential Items High Cost of Stock-Out

D - Category of Items: Desirable Items Nominal Cost of Stock-Out Not Affecting Business in a Big Way

Factors for Deciding VED Category of Items Stock-Out Costs Lead Time for Procurement Nature of Item: Standard/ Supplier Designed/ Buyer Designed Source of Supply: Local/ Outstation/ Imported/ Controlled Item

ABC & VED Analysis Normally Used Together for Controlling Inventory of Spares/ Parts

S-D-E ANALYSIS

Items Classified Under 3 Groups Scarce

• Short Supply/ Long Lead Time/ Imported/ Through Govt. Agencies• Best to Limit No. of Times to Order

Difficult• Available Locally• No/ A Few Reliable Source Available• Needs Advance Notice/ Long Lad time of Procurement

Easy: Readily Available Standard Products

S-D-E Analysis Mostly Used in Purchase Department For Deciding Purchase Methods of Different Category of Items Allocating Responsibility By Seniority Levels of Purchasers/ Buyers

S-D-E Analysis Based on Problems Related To Procurement Non-Availability/ Scarcity of Items Unusually Long Lead Time Geographical Location of Suppliers Reliability of Suppliers

Used in Lead Time Analysis & Purchase Strategy Formulation

Based on Nature of Suppliers that Determine Quality of Items Lead Time of Supply Terms of Payment Continuity of Supplies Administrative Work Involved

Classifies Items into 4 Groups By Source of Supplies G: Government Suppliers – Public Sector Undertakings

• Involves Long Lead Times• Payment in Advance/ Against Delivery

O: Ordinary (Non-Government) Suppliers• Moderate Delivery Lead Times• Credit Facility Available

L: Local Suppliers• Easy Availability• Purchased Against Cash/ Blanket Orders

F: Foreign Suppliers• Large Amount of Administrative/ Procedural Time & Costs Involved• Extensive Sourcing Necessary for Identifying the Right Supplier• Letter of Credit Method for Payment• Shipping/ Port/ Customs Clearance Needs Special Efforts/ Costs

G-O-L-F ANALYSIS

Used in Procurement Strategies

S-OS ANALYSIS

Items Grouped into 2 Groups Based on Seasonality of Product S: Seasonal OS: Off Seasonal

Seasonal Availability But Marketing Round the Year• Items Available Only During Season – Mangoes/ Oranges/ Fruits• Procured for Use in Packaged Food Industry for the Whole Year

Seasonal But Available Round the Year• Price Lowest During Harvesting Time• Procurement Based on Cost Comparison Between

• Buying at Lower Price During Harvest Season & Holding Stocks for Whole Year• Buying Throughout the Year

Seasonal Market But Available Round the Year – Winter Garments• Produced Round the Year to Meet High Seasonal Demand• Higher Inventory Carrying Cost Balanced By Lower Cost of Producing at Uniform Level in Meeting The Seasonal Demand

Seasonal

Off Seasonal – Non-Seasonal Items

Used in Procurement/ Holding Strategies forSeasonal Items – Agricultural Products

M-N-G ANALYSIS Based on Stock Turnover Rate Items Classified as

M: Moving Items – Regular Consumption N: Non-Moving Items – Not Consumed for last 1 Year G: Ghost Items – No Stocks/ No Receipt & Issue Last Financial Year

F-S-N ANALYSIS Used in Controlling Stock Obsolescence Last Date of Receipt/ Issue Considered To Calculate Period When Stocks Did Not Move for Classifying Items

F: Fast Moving S: Slow Moving N: Non-Moving

S & N Category of Items Further Analyzed Conducting Ageing Analysis To Decide on Appropriate Ways of Disposing Stocks

X-Y-Z ANALYSIS Used to Review Inventories & Consumption at Scheduled Intervals Based On Value of Stocks in Stores

X Items: High Value of Inventory Y Items: Moderate Value of Inventory Z Items: Low Value of Inventory

INVENTORY CONTROL IN COMBINATION

X-Y-Z Analysis Used Along with ABC/ FSN Analysis Helps To Identify Few Items Comprising Large Value Locked Up in Inventory Indicate Actions Need to be Taken for Improving Company’s Stock Profile

Class of Items A B CX Work to Reduce Work to Convert Dispose Off Stocks To Z category To Y Category Surplus Stocks

Y Convert To Z category Tighten Control

Z Review Stock Levels More Often

Class of Items F S N

X Tighten Control Reduce Stocks Dispose Off To Low Levels at Optimum Prices

Y Reduce Stocks Dispose Off Earliest

Z Lessen Control Dispose Off Even

To Reduce Admin Costs At Lower Prices

X Items: High Value of Inventory Y Items: Moderate Value of Inventory Z Items: Low Value of Inventory

INVENTORY CONTROL

Manage & Control Inventory To Balance

Inventory Management & Control Affects

Customers

Suppliers

Major Departments in Organization

Required Level of Product Availability

Cost of Providing Desired Product Availability

Inventory Control Exercised Through Inventory Performance Measures

INVENTORY PERFORMANCE METRICS

Product Availability (Service Level)

Quantity of An Item Available as Required During a Period

Total Demand for The Item During That Period× 100 =

Higher Service Level Implies Higher SC Responsiveness

Inventory = Throughput × Cycle Time

Reduce Inventory By Reducing Cycle Time

FINANCIAL PERFORMANCE METRICS

Inventory Turnover Ratio/ Inventory Turns Financial Measure of How Effectively inventory is Used in Making Sales

Inventory Turns= Average Inventory in Money Value

Annual Costs of Goods Sold

Days of Supply Financial Measure of Equivalent Number of Days of Inventory On Hand Based on Daily Usage Rate

Inventory in Days of Supply= Average Daily Usage

Inventory On Hand

Financial Metrics Relates To Sales/ Revenues Generated By the Inventory

Financial Metrics Measure Inventory Management Performance Better than Just Measuring Cost of Inventory Managed

Higher Inventory Turns Imply Higher Efficiency in Using Inventory Asset

EXAMPLE

A company has 9000 Units on hand and the annual usage is 48,000 units.Assuming 240 working days in a year calculate what is the inventory in termsof days of supply?If the annual cost of the goods sold is Rs 24 million a year and Value of Average inventory held is Rs 6 million what will be the inventory turns? Whatwill be the reduction in inventory if the turns are increased to 12 times/ year? If cost of carrying inventory is 25% of average inventory, calculate the Savings

1. Inventory in days of supply= Average inventory on hand/ Average daily use

= 9000/ (48,000÷240) = 45 Days of Sales

2. Inventory turns=Annual Cost of Goods Sold/ Average inventory

= 24 ÷ 12 = $2 Million3. When Inventory turns increased to 12, Average Inventory= Annual COGS/ Turns

= 24 ÷ 6 = 4

4. Reduction in average inventory= 6,000,000 – 2,000,000 = $4 Million

Carrying cost of inventory=25%

Savings=25%× 4,000,000= $1,000,000

DEFINITIONS IN INVENTORY CONTROL

Stock Keeping Unit - Items Packed as Individual Units in Inventory Controlled By Quantity & Time of Procurement

Same Products with Different Colour/ Size/ No. Packed – Different SKU

Lot/ Batch – Quantity Produced/ Purchased Together Sharing Same Production/ Purchase Costs & Specifications

Lot-for-Lot Rule–Order Exactly As Needed & When Required Ordered Quantity Changes Every Time Requirement Changes Unused Lot-Size Inventory Not Created as SKU Ordered When Needed Applicable for High Value Items & JIT Applications

Fixed-Order Quantity Rule – Arbitrarily Specifies No. of Units/ SKU To Order Each Time Order is Placed

Based On Usage Rate/Lead Time/Future Demand For Given Time Period Does Not Minimize Costs Involved

Min-Max System – A Variation of Fixed Order Rule When Quantity On Hand Reaches Reorder Level New Order Placed for Quantity = Max Level – Quantity On Hand

INVENTORY COSTS

Ordering/ Set Up Costs

Carrying/ Holding Costs

Stock-Out Costs

Inventory Costs are in Trade-Off With Each Other

Space

Capital

Inventory Servicing

Inventory Risk

Total Annual Inventory Costs (TAIC) = Annual (Material Cost + Ordering Cost + Carrying Costs)

Transportation/ Receiving/ Inspection

CARRYING COST ELEMENTS

Interest & Opportunity Costs ……. 82%

Obsolescence & Physical Depreciation Costs .. 14%

Storage & Handling Costs ……. 3.25%

Taxes …….. 0.50%

Insurance ……… 0.25%

Annual Carrying Costs 20% to 35% of Value of Inventory

ANNUAL TOTAL COST Cost of Ordering & Carrying Inventory Depend on No. of Orders Placed in a Year & Quantity Ordered Each Time Relevant Costs for Inventory Control

Annual Costs for Placing Order: Ordering Cost

Annual Costs of Carrying Inventory: Annual Carrying Cost as % of Annual Average Inventory

S = Annual Demand in UnitsCu = Unit Price (Rs)q = Order Quantity in UnitsCp = Ordering Cost/ Order (Rs)i = Inventory Carrying Cost as Percentage of Average Inventory Investment

• Annual Ordering Cost = No. of Orders/Year × Ordering Cost =

ATC = (S/q × Cp) + (q/2 × i × Cu)

• Annual Carrying Cost = Average Inventory × Inventory Carrying Cost

= ½ × Order Quantity × Carrying Cost(%) × Unit Price = q/2 × i × Cu

• Annual Total Cost = Annual Ordering Cost + Annual Carrying Cost

S/q × Cp

EOQ FORMULA DEVELOPMENT

Optimizing of Inventory Model Involves Calculating Order Quantity ‘q’ That Minimizes Annual Total Cost (ATC)

Differentiating ATC with Respect to ‘q’ & Setting First Derivative to Zero will Minimize Annual Total Cost

S × Cp q²

ATC= (S/q × Cp) + (q/2 × i × Cu)

d(ATC) dq = – +

i × Cu

2

= 0Or

2.S.Cp

i.Cu

Or q =

Or q² =2.S.Cp

i.Cu

EOQ =2 × Annual Demand × Ordering Cost/ Order

Inventory Carrying Cost × Unit Price

Ori × Cu

2

=S × Cp q²

Ordering Cost vis-à-vis Carrying Cost Trade-off

Co

st

Quantity

Total Cost/Unit Time

Inventory Carrying Cost

Ordering/ Set up Cost

EOQ

2 × Annual Demand × Ordering Cost/ Order EOQ = Inventory Carrying Cost × Unit Price

Total Annual Cost Gets Optimized When Ordering Cost=Carrying Cost

ECONOMIC ORDER QUANTITY

Economic Order Quantity Ensures Optimal Annual Total Cost of Inventory

EXAMPLE

A company uses 75 number of an item per month. Each unit coststhe company Rs 25/-. Cost of placing each order & inventory carrying charges per month are computed at Rs 36/- and 1.5% of the average inventory investment respectively. Calculate the economic lot size for purchase of the item to minimize total cost.

EOQ =2 × Annual Demand × Ordering Cost/ Order

Inventory Carrying Cost × Unit Price

Annual Demand = 75 × 12 = 900 Units

Ordering Cost/ Order = Rs 36

Inventory Carrying Cost/ Year = 1.5/100 × 12 = 0.18

EOQ =2 × 900 × 36

0.18 × 25 = 120 Units

ASSUMPTIONS IN EOQ MODEL

Annual Demand is Known & Remains Constant

Known Delivery Time that Does Not Change

Replenishment of Stock is Instantaneous

Unit Price Fixed & No Quantity/ Price Discounts Allowed

Inventory Carrying Cost Known and Remains Constant

Ordering Cost is Known and Remains Constant

No Stock-Outs Allowed

One Variation of Classical EOQ Model is Quantity Discount/ Price-Break Model

Items Can be Procured Free From Any Restriction

Constant Unit Price Condition Relaxed & Purchase Quantity Discounts Allowed

Purchase Cost & Total Annual Inventory Cost are Important Criteria For Determining Optimal Order Size

For Each Purchase Price Calculate EOQ

If EOQ Too Low To Qualify for Price Discounts Increase Quantity to Match Lowest Qualifying Order Quantity

Calculate TAIC for Each Price & Corresponding Quantity

Select Price/ Quantity Combination that Results in Lowest TAIC (Total Annual Inventory Costs)

Procedure to Arrive at Best Order Quantity

Lowest TAIC (Total Annual Inventory Costs) = Annual Material Costs + Annual Ordering Costs + Annual Carrying Costs

QUANTITY DISCOUNT/ PRICE-BREAK MODEL

QUANTITY DISCOUNT/ PRICE-BREAK MODEL

Soccer Ball Example

Supplier’s Offer: Order Qty. of Soccer Balls Price ($) Below 1, 000 5.00 Between (1, 001 – 2, 000) 4.50 Above 2, 000 4.00

Customer Data:Ordering Cost = $40Annual Demand = 15, 000Carrying Cost = 25%

EOQ with $5 price = [2×15000×40] ÷ [0.25 × 5] = 980 Balls

EOQ with $4.5 price = [2×15000×40] ÷ [0.25 × 4.5] = 1, 032 Balls

EOQ with $4..0 price = [2×15000×40] ÷ [0.25 × 4)] = 1, 095 Balls

Right Quantity & Price to Achieve Best Savings is the Combination That Results in Lowest Total Annual Inventory Cost (TAIC)

EOQ = -----------------------------------------------2 × Annual Demand × Ordering Cost

Carrying Cost × Unit Price

QUANTITY DISCOUNT/ PRICE-BREAK MODELSoccer Ball Example

TAIC ($5) = (15, 000×5) + {(980/ 2)(0.25)×5} + {(15, 000/ 980)(40)} = $ 76, 225

Total Annual Inventory Costs (TAIC) = Annual Material Cost (AMC) + Annual Holding Cost (AHC) + Annual Ordering Cost (AOC)

Best Combination for Purchase of Soccer Ball Is the Combination of Lowest Quantity Providing Highest

Savingsi.e. 2, 001 Balls at Discounted Price of $4 per Ball

TAIC ($4.5) = (15, 000×4.5)+{(1,032/ 2)(0.25)×4.5}+{(15, 000/ 1,032)(40)} = $ 68, 662

TAIC ($4.0) = (15, 000×4)+{(2,001/ 2)(0.25)×4}+{(15, 000/ 2,001)(40)} = $ 61, 300

TAIC = (Annual Demand × Unit Price) + {(EOQ ÷ 2)×(Carrying %) ×Unit Price} + {(Annual Demand÷ EOQ) × Ordering Cost}

EOQ MODEL IN BUSINESS

EOQ Derived From Mathematical Model Used as Guideline & Often Modified To Suit Business Requirements & Constraints

A Few Constraints That Demands Modification of EOQ Model

Supplier’s Minimum Order Quantity Conditions

Lead Time Government Regulations Seasonal Availability

Packing Size Space Restriction Price Discounts

Risk of Obsolescence & Deterioration

Unstable Market Conditions

EOQ Normally Modified To Take Care of Current Business Environment – MOQ (Modified Order Quantity)

Top Management Involved in Developing Inventory Policy To Match Company’s Strategic/ Marketing/ Financial/ SCM Goals

INVENTORY POLICY ELEMENTS

Quantity To Order/ Lot Size Decision

Time To Order

Safety Stock To Insure Against Uncertainty

Use Factor Z from Normal Distribution Chart

Supply Lead Time Variability

Desired Delivery Service Level

Inventory Policy Implemented ThroughStock Replenishment Models

Product Fill Rate

Order Fill Rate

Cycle Service Level (CSL)

STOCK REPLENISHMENT MODELS

Fixed Order Quantity (FOQ) Replenishment Model – Also Known as Order Point Systems

• A Critical Stock Level of Each Item is Defined Based On Average Demand During Lead Time: Reorder Level• If Stock Falls below This Level a Replenishment Order Placed• Plot of Stock Against Time will Follow a Saw-Tooth Pattern • Requires Continuous Monitoring of Stock Levels • Assumes Past Demand Good Indication of Future Demand • Order Quantity Fixed But Order Interval Varies with Demand• Perpetual & Two-Bin Systems Follow the Fixed Order Quantity Models

Fixed Review Period (FRP) Replenishment Model • Stocks of Group of Products Reviewed at Regular Intervals• Sufficient Quantity Ordered so that Stock Levels Fall to Safety Levels by the Time of Delivery after Next Review Period • Fixed Interval Between Orders But Quantity Varies with Demand• Periodic & Optional Replenishment Systems (Min-Max System) Follow Fixed Review Models

Order Point System Works Well With Steady & Continuous Demand

INVENTORY MODELS

Buffer

Reorder Level

Q Q Q Q

Time

Quantity

FOQ Model

Q - Fixed Order Quantity

L – Lead Time of Supply

L

Buffer

Quantity

Time

Order Up to Level

P - Fixed Review Period

L – Lead Time of Supply

P

L

P

FRP Model

P P

Maximum Level

Average Level

INVENTORY COMPOSITION

Reduce Variations to Reduce Safety Stock

Cycle Stock

EOQ × ½

Safety/ Buffer Stock Based on Variation in Demand & Lead Times

Average Stock

Cycle Stock + Safety Stock

Random Variation with Normal Distribution Assumed

Seasonal Stock

To Counter Predictable Demand Variability

SAFETY STOCK

Extra Stock To Protect from Stock Out Due To Uncertainty in Supply & Demand

Quantity Uncertainty - Occurs When Amount of Supply/ Demand Varies – Demand Greater/ Less Than Expected in a Given Period

Uncertainty in Supply & Demand Occurs in 2 Ways

Timing Uncertainty - Occurs When Time of Receipt of Supply/ Demand Differs From That Expected

Quantity Uncertainty is Protected By Carrying Safety Stocks & Timing Uncertainty Handled By Ordering/Receiving Early/ Late Safety Stock Mostly Used To Buffer Against Uncertainty

Quantity of Safety Stock Required Depends on

Variability of Demand During Lead Time Reordering Frequency

Desired Service Level Lead Time Duration

Safety Stock Quantities Calculated Using Statistical Tools

Documents

Managing Inventory