Chapter 4 inventory management

Chapter 4 Inventory management IBS3002 Logistics International Trade 9232020 1 IBS3002 Logistics International Trade Chapter 4 Inventory management 1 Contemporary logistics, Murphy (2015) Topic areas  Inventory  Classifying.

IBS3002 Logistics & International Trade

 Inventory: stocks of goods and materials that are maintained for many purposes,

the most common being to satisfy normal demand patterns

 Inventory management: is a systematic approach to sourcing, storing, and selling

inventory—both raw materials (components) and finished goods (products)

 Inventory management is a key component in logistics & SCM because its

decisions are a driver for other business activities

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Inventory

 Management must reduce inventory levels yet avoid stockouts and other problems

 Important of inventory in other organizational functions:

 Marketing– more inventory for higher customer service

 Manufacturing– more inventory to schedule longer productions runs

 Finance – less inventory to keep inventory turnover ratios high (reduce risk

inventory loss) and to keep Return on Assets (ROA) high (increase

competitiveness)

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Inventory classifications

 Cycle (base) stock: inventory that is needed to satisfy normal demand during the

course of an order cycle

 Safety (buffer) stock: inventory that is held in addition to cycle stock to guard against

uncertainty in demand or lead time

 Pipeline (in-transit) stock: inventory that is en route between various fixed facilities

in a logistics system (plant, warehouse, store…)

 Speculative stock: inventory that is held for several reasons, including seasonal

demand, projected price increases and potential shortages of product

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Inventory classifications

 Cycle (base) stock: inventory that is needed to satisfy normal demand during the

course of an order cycle

 Safety (buffer) stock: inventory that is held in addition to cycle stock to guard against

uncertainty in demand or lead time

 Pipeline (in-transit) stock: inventory that is en route between various fixed facilities

in a logistics system (plant, warehouse, store…)

 Speculative stock: inventory that is held for several reasons, including seasonal

demand, projected price increases and potential shortages of product

Inventory costs

 Inventory costs are important:

- Represent a significant component of costs in many organizations

- Inventory levels kept affect the level of service the organization can offer its

 Carrying costs refer to the costs associated with holding inventory

 Inventory costs are expressed in percentage terms & this percentage is multiplied

by theinventory’s value

 Components of inventory carrying costs:

- Inventory shrinkage - Interest costs

- Storage costs

- Handling costs

Inventory costs

 Carrying costs:

 Obsolescence cots: are incurred when an item in inventory becomes obsolete before

it is sold or used (i.e perishable products-meat, milk…)

 Inventory shrinkage: is the excess amount of inventory listed in the accountingrecords, but which no longer exists in the actual inventory (i.e damage, loss, theft )

 Storage costs: costs associated with occupying space in a plant, storeroom, orwarehousing facility

 Handling costs: costs of employing staff to receive, store, retrieve, move inventory

 Insurance costs: insure inventory against fire, flood, theft, other perils…

 Interest costs: money required to maintain the investment in inventory

Inventory costs

 Ordering costs:

 Ordering costs refer to the costs associated with ordering inventory, including order

costs and setup costs

 Order costs: the costs of receiving an order They include:

+ The transaction costs associated with making an international purchase:

international wire transfers, letters of credit, and bank fees

+ The document costs, such as certificates of origin, import license, customs

brokerage fees

+ The time spent, as all international purchases take more time than domestic

purchases

Inventory costs

 Ordering costs:

 Setup costs: are those necessary to modify production processes to make the

products necessary to satisfy particular orders They include:

+ The process-change costs associated with switching from making one type of

part to making another type of part Different raw materials, different settings,

An offset printing machine incurs a

setup cost when production changes

from one job to another.

Inventory costs

 Stockout costs:

 Stockout costs (shortage costs) are costs caused by product shortages on the shelf

 They may be an effect of wrong forecasting, supplier-retailer communication and/or

logistics management

 It involves an understanding of a customer’s reaction to a company being out of

stock when a customer wants to buy an item

 There are 3 types of customer response to a stockout:

+ delayed sale (brand loyalty)

+ lost sale (switches and comes back)

+ lost customer

Inventory costs

 Trade-off between Carrying & Ordering costs:

• The trade-off that exists between carrying and ordering costs is that they respond in

opposite ways to the number of orders or size of orders

• An increase in the number of orders leads to higher order costs & lower carrying

costs

 Trade-off between Carrying & Stockout costs:

• The trade-off between carrying and stockout costs is that both move in opposite

directions – higher inventory levels (higher inventory carrying costs) result in lower

chances of a stockout (lower stockout costs)

-> The inventory is replenished whenever inventory level reaches a certain

point The periodicity changes

When to order

 Reorder point (trigger point): the level of inventory at which a replenishment order

is placed

• The firm reorders the goods when the inventory level has reached a point that is

equal to the expected demand during the lead time

ROP = DD x RC

- ROP: reorder point

- DD: average daily demand (unit)

- RC: replenishment cycle (day/ week/ month)

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When to order

 Example: Average daily demand is 40 units, the replenishment cycle is 4 days

The order point is 40x4=160 units-> when the inventory level reaches 160 units, a reorder is placed

 Reorder point is used for an efficient fixed order quantity system -> require relatively

frequent monitoring of inventory levels

 Inventory levels are monitored much less frequent in fixed order interval system ->

make this system much more susceptible to stockout situations -> higher levels of

safety stock

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 Economic Order Quantity (EOQ):

 Economic order quantity (EOQ) is the ideal order quantity a company should

purchase to minimize inventory costs

 EOQ deals with calculating the proper order size with respect to two costs: carrying

costs & ordering costs

 EOQ determines the point at which the sum of carrying costs & ordering costs is

minimized (the point at which carrying costs equal ordering costs)

 EOQ formula was created by Ford W Harris in 1915

How to order

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How to order

 Economic Order Quantity (EOQ):

 The basic EOQ model is grounded in the following assumptions:

1 A continuous, constant, & known rate of demand

2 A constant & known replenishment or lead time

3 A constant purchase price that is independent of the order quantity

4 All demand is satisfied (no stockouts are allowed)

5 No inventory in transit

6 Only one item in inventory or no interaction between inventory items

7 An infinite planning horizon

How to order

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How to order

- EOQ: the most economic order size,in dollars

- A: annual usage, in dollars

- B: administrative costs per order of placing the order

- C: carrying costs of the inventory (expressed as an annual percentage of the

inventory dollar value)

C AB

How to order

 Example: suppose that $1000 of a particular items is used each year, the order

costs are $25 per order submitted, inventory carrying costs are 20% EOQ in dollars

-> Therefore, EOQ is $500 order size

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dollars x

x EOQ  2 1000 25 / 0 2  250000  500

How to order

- EOQ: the most economic order size,in units

- D: annual demand, in units

- B: administrative costs per order of placing the order

- C: carrying costs of the inventory (expressed as an annual percentage of the

inventory dollar value)

- I: dollar value of the inventory, per unit

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IC DB

How to order

 Example: suppose that $1000 of a particular items is used each year, the product

has a cost of $5 per unit, the order costs are $25 per order submitted, inventory

carrying costs are 20%

- Annual demand: D = 1000/5 = 200 units

-> Therefore, EOQ is 100 units

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units x

x x

IC DB EOQ  2 /  2 200 25 / 0 2 5  10000 / 1  100

How to order

The total cost calculations for several other order size:

-> The total cost is minimized at EOQ

 Safety stock: 60 units

 Average demand: 30 units per day

 Order cycle: 2 days

Beginning inventory = EOQ + safety stock = 120 + 60 = 180 units

Reorder point = (daily demand x replenishment cycle) + safety stock

= 30x2 + 60 = 120 units

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How to order

• Safety stock can prevent against two problem areas: an increased rate of demand

and a longer-than-normal replenishment

• When a fixed order quantity system (EOQ) is used, the time between orders may

vary

• Requirement of using a fixed order quantity system: that the level of inventory must

constantly be monitored, when the reorder point is hit, the fixed order quantity is

ordered

-> use technology advances to monitor inventory constantly

-> reorder point is established electronically

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Inventory management: special concerns

 ABC Analysis of Inventory:

 ABC analysis of inventory is the classification of a group of items in decreasing

order, based on their value to the business The A group is the most important in

terms of the value contributing to the company, whilst C items are the least valuable

 The 80/20 rule: 80% of a company’s sales come from 20% of its products &

conversely

 Company should focus on the 20% of products that generate the 80% of sales

-> decrease inventory carrying costs

Inventory management: special concerns

 ABC Analysis of Inventory:

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Inventory management: special concerns

 ABC Analysis of Inventory:

 Measures to determine ABC status: sales volume in dollars, sales volume in units,

the fastest-selling items, item profitability & item importance

 Group A usually represents 10-20% by number of items and accounts for 50-80% of

dollar volume

 Group C contains 60-70% of the items but only accounts for 10-30% of the dollar

volume

 Group B has more items than group C but less than group A, with the value is

higher than group C but far less than group A in volume

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Inventory management: special concerns

 ABC Analysis of Inventory:

 The determination of what percentage of items should be classified as A, B, C may

have effect on the efficiencies of inventory

-> too high or too low a percentage of A items may reduce the potential

efficiencies to be gained from the classification technique

 ABC analysis can determine stocking patterns in warehousing facilities

 ABC analysis could be used to determine how frequently inventory gets monitored

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Inventory management: special concerns

 ABC Analysis of Inventory:

 A items might be checked daily (increasingly, hourly)

 B items weekly

 C items monthly

Inventory management: special concerns

-> need to have structured process for managing

 How to deal with dead stock?

-> drastic price reductions

bunching it with more attractive products,

use deadstock broker, donations…

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Inventory management: special concerns

 Inventory Turnover:

 Inventory turnover: the number of times that inventory is sold in a one-year period

 Inventory turnover can be calculated:

Inventory turnover = the cost of goods sold / the average inventory

The average inventory = (beginning inventory + ending inventory) / 2

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Inventory management: special concerns

 Inventory Turnover:

 Inventory turnover measures how fast a company sells inventory & compare it to

competitors or industry averages

-> organization’s competitiveness & efficiency

 A low turnover: weak sales, overstocking

 A high turnover: strong sales, low level of inventories

 Inventory turnover related to trade-offs involving organizational functions:

marketing (price)– finance (profit) – logistics (inventory turnover)

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Inventory management: special concerns

 Inventory Turnover:

 How to increase inventory turnover?

-> reducing average inventory

-> how to reducing average inventory?

-> ABC analysis & Dead inventory

Inventory management: special concerns

 Complementary and Substitute

products:

 Complementary goods are products

which are consumed and distributed

together (i.e razor blades and razors)

-> pressure on retailers/wholesalers

involving inventory maintenance

-> need to consider the amount of

inventory to be carried because

complementary products is necessary

to support the sale of its complement

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Inventory management: special concerns

 Complementary and Substitute products:

 Substitute goods refer to products that can fill the same need or want as another

product

- The substitutability can occur at a specific product level (i.e Coca-Cola &

Pepsi) or across product classes (i.e potatoes & rice)

- Implications for stockout costs and the maintaining of

size of safety stock

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Contemporary issues with managing inventory

 Lean Manufacturing (Lean)

 Lean manufacturing is the methodology that

focuses on the elimination of waste and the

increase of speed and flow

 The idea of lean manufacturing was first

championed by the model “The Toyota Way”

(Toyota Production System) in the 1930 at

Toyota - Japan

 It was officially called “Lean” in the book “The

1990s

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Contemporary issues with managing inventory

 Lean Manufacturing (Lean)

 Lean thinking aims to identify and remove wastes from work processes

 Waste is any action or step in a process that does not add value to the customer In

other words, waste is any process that the customer does not want to pay for

 7 major sources of waste – TIMWOOD

 TIMWOOD - Transportation, Inventory,

Motion, Waiting, Overproduction,

Overprocessing and Defects

Contemporary issues with managing inventory

 Just-in-time (JIT)

 JIT approach seeks to minimize inventory by reducing (if not eliminating) safety

stock, and by having the required amount of materials arrive at the production

location at the exact time that they are needed

 JIT inventory management focuses on minimizing inventory and increasing

efficiency in logistics

 JIT emphasizes minimal inventory levels, low (no) safety stock & defective materials

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 Trucking is an important mode of transportation in

the JIT approach to meet some requirements from

JIT system: smaller orders, more frequent

shipments, closer supplier location

 The aim of JIT: encompass movement of materials

and component parts from supplier to producer

Contemporary issues with managing inventory

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Contemporary issues with managing inventory

 ECR & QR

 Efficient consumer response (ECR) and Quick response (QR) tend to focus on

product movement from manufacturer to retailer

 ECR is associated with the grocery and beverage industries

 QR is associated with the apparel industry

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Contemporary issues with managing inventory

 Service Part Logistics

 Service parts logistics involves designing a network of facilities to stock service

parts, deciding upon inventory ordering policies, stocking the required parts, and

transporting parts from stocking facilities to customers