Session Six

1
Session Six

• Inventory Fundamentals

2
Course Outline

• Session 1 Introduction to Supply Chain
  Management.
• Session 2 Forecasting.
• Session 3 Master Planning.
• Session 4 Material Requirements Planning.
• Session 5 Capacity Management Production
  Activity Control.
• Session 6 Inventory Fundamentals.
• Session 7 Inventory Management.
• Session 8 Physical Distribution.
• Session 9 Quality Management and Purchasing.
• Session 10 Just-in-Time Manufacturing.

3
Objectives of Session

• Present to participants the fundamentals of
  inventory including the classification of
  inventory, objectives and functions of
  inventory management, costs of inventory,
  classification and control of various inventory
  items and simple financial statements

4
Session 6 Outcomes

• After completing this session participants should
  be able to
• State the importance of good inventory
  management.
• Classify inventory based on flow of material
• Describe the functions inventories perform.
• Discuss the objectives of inventory management

5
Session 6 Outcomes (cont.)

• Define all the costs that are relevant to
• inventory decisions.
• Read and develop simple financial statements
• Define and interpret simple inventory turns
  ratio
• Conduct ABC analysis and suggest inventory
• control for each class.

6
What is Inventory

• Those stocks or items used to
• support production (raw materials and work-
  in-process items),
• supporting activities (maintenance, repair and
  operating supplies), and
• customer service (finished goods and spare
  parts)
• - APICS Dictionary

7
Aggregate Inventory Management

• Deals with managing according to its
  classification as raw materials, work in
  process, and finished goods inventory as groups
• Finance oriented
• Involves
• Flow and kind of inventory needed
• Supply and demand patterns
• Functions inventory perform
• Objectives of inventory management
• Costs associated with inventory

8
Item Inventory Management

• Management must establish decision rules about
• individual inventory items
• Importance of inventory items
• How they are to be controlled
• How much to order at one time
• When to place an order

9
Inventory and the Flow of Materials
10
Inventory Types

• Inventory can be classified into the following
• Raw material
• Work in process
• Finished goods
• Distribution
• Maintenance, repair, operating supplies (MRO)

11
Reasons for Carrying Inventory

• The only good reason for carrying inventory
  beyond current needs is if it costs less to carry
  it than not.
• Inventory allows the company to operate with
  different production rates and batch sizes
  throughout the supply production, and
  distribution systems.

12
Reasons for Carrying Inventory

• Decouples
• Demand from supply
• Customer demands from finished goods
• Finished goods from component
• availability
• Output of one operation from output of
• preceding operation
• Materials to begin from suppliers of
• production materials

13
Functions of Inventory

• Anticipation anticipate future demand
• Fluctuation cover fluctuation in supply or
• demand (safety stock)
• Lot size purchase more than needed
• Transportation cover material movement time
• Hedge protect against price fluctuation

14
Inventory Objectives

• Best customer service
• Low-cost plant operation
• Minimum inventory investment

15
Basic Problem

• Balance cost of carrying inventory with costs of
  not carrying inventory
• Customer service
• Changing production levels
• Placing orders
• Sum of the cost of carrying inventory and the
  cost of not carrying inventory should be as low
  as possible

16
Inventory Costs

• Item costs
• Carrying costs
• Ordering costs
• Stock-out costs
• Capacity-related costs

17
Item costs

• Cost of item and all costs to get item into the
  plant
• Product
• Transportation
• Customs duties
• Insurance
• Direct material, direct labor, and factory
  overhead

18
Carrying Costs

• Carrying costs can be broken down into three
  categories
• Capital costs Money tied up in inventory
• Storage costs Space, personnel, and equipment
• Risk costs Obsolescence, damage, pilferage,
  insurance, and deterioration
• These costs increase with the amount of inventory
  carried

19
Problem 6.1

• Given the following percentage costs of carrying
  inventory, calculate the annual cost if the
  average inventory is 1,000,000. capital costs
  are 6, storage costs are 9 of the average
  inventory value, and risk costs are 10.

20
Problem 6.1

• Total costs of carrying inventory
• 6 9 10 25
• Annual carrying cost
• 0.25 ? 1,000,000 250,000

21
Ordering Costs

• Costs of placing and order with the factory or
• outside supplier
• Costs include
• Production control
• Setup and teardown
• Lost capacity
• Purchase order

22
Problem 6.2

• Given the following data, calculate the average
• cost of placing one order.
• Annual production control cost 200,000
• Average cost of setup and teardown 200
• Number of orders per year 20,000

23
Problem 6.2

• Annual production control cost 200,000
• Average cost of setup and teardown 200
• Number of orders per year 20,000
• Average cost of placing an order
• 200,000
• 20,000

200 210
24
Stock-out costs

• If demand during the lead time exceeds forecast
• and available inventory, we can expect a stock-
• out, causing
• Backorder costs
• Lost sales costs
• Lost customer costs

25
Capacity-Related Costs

• Cost of changing production levels
• Over-time/under-time
• Hiring
• Layoff
• Training
• Shift premiums
• Can be avoided by leveling production (but may
  build inventory)

26
Problem 6.3

• Next year quarterly sales forecast is 2000, 3000,
  
• 4000, and 3000. Calculate a level production
  plan,
• quarterly ending inventory, and average quarterly
  
• inventory.
• Assume average quarterly inventory is the average
  
• of the quarters starting inventory and ending
• inventory. Opening and ending inventories zero.
• If inventory carrying costs are 3 per unit per
• quarter, what is the annual cost of carrying
• inventory?

27
Problem 6.3 (Solution)
Q1 Q2 Q3 Q4
Sale 2,000 3,000 4,000 3,000
Production
Ending inventory
Average inventory
Inventory cost
Annual inventory carrying cost
28
Problem 6.3 (Solution)
Q1 Q2 Q3 Q4
Sale 2,000 3,000 4,000 3,000
Production 3,000 3,000 3,000 3,000
Ending inventory 1,000 1,000 0 0
Average inventory 500 1,000 500 0
Inventory cost 1,500 3,000 1,500 0
Annual inventory carrying cost 1500 3,000
1,500 0 6,000
29
Accounting Systems

• Accounting systems classify activities of a
• company into five types of accounts
• balance sheet accounts
• income statement accounts

30
Balance Sheet Equation

• Assets Liabilities Owners equity
• Assets Anything of value
• Liabilities Amounts owed
• Owners equity What is left over after
  liabilities are paid

31
Problem 6.4

• If the owners equity is 1,000 and liabilities
  are 800, what are the assets worth?
• Assets

32
Problem 6.4

• If the owners equity is 1,000 and liabilities
  are 800, what are the assets worth?
• Assets Liabilities Owners equity
• 800 1,000
• 1,800

33
Problem 6.4

• If the assets are 1,000 and liabilities are
  600, what is the owners equity?
• Owners equity

34
Problem 6.4

• If the assets are 1,000 and liabilities are
  600, what is the owners equity?
• Owners equity Assets liabilities
• 1,000 600
• 400

35
Income Statement

• Income Revenue Expenses
• Revenue Comes form the sale of goods and
• services
• Increases owners equity
• Expenses Costs incurred in earning revenue
• Decreases owners equity
• Classified as
• - Cost of goods sold (labor, material, OH)
• - General and administrative expense

36
Income Statement

• Revenue 1,000,000
• Cost of goods sold
• Direct labor 200,000
• Direct material 400,000
• Overhead 200,000
• Total cost of goods sold 800,000
• Gross margin (gross profit) 200,000
• General and admin. expense 100,000
• Net income (profit) 100,000

37
Problem 6.5

• A. Given the following data, calculate the gross
  margin and net income.
• Revenue 1,500,000
• Direct labor 300,000
• Direct material 500,000
• Overhead 400,000
• General admin expenses 150,000

38
Problem 6.5

• Revenue ________
• Cost of goods sold
• Direct labor ________
• Direct material ________
• Overhead ________
• Total cost of goods sold ________
• Gross margin (gross profit) ________
• General admin expense ________
• Net income (profit) ________

39
Problem 6.5

• Revenue 1,500,000
• Cost of goods sold
• Direct labor 300,000
• Direct material 500,000
• Overhead 400,000
• Total cost of goods sold 1,200,000
• Gross margin (gross profit) 300,000
• General admin expense 150,000
• Net income (profit) 150,000

40
Problem 6.5

• B. How much would profits increase if, through
  better materials management, material costs were
  reduced by 50,000?
• If material costs were reduced by 50,000, income
  would increase by

41
Problem 6.5

• B. How much would profits increase if, through
  better materials management, material costs were
  reduced by 50,000?
• If material costs were reduced by 50,000, income
  would increase by
• 50,000

42
Cash Flow Analysis

• The inflow and outflow of cash in the business
  over a given period of time
• To survive, a business must have the cash
  available to pay its bills

43
Cash Flow

• Inventory state Effect on cash flow
• Raw material Cash outflow
• Work in process Cash outflow
• Finished goods Cash outflow
• Accounts receivable paid Cash inflow

44
Inventory Turns

• A measure of how effectively inventory is being
• used
• Example
• Annual cost of goods sold 1,000,000
• Average inventory 500,000

45
Problem 6.6

• If the annual cost of goods sold is 10 million
• and the average inventory is 2.5 million
• What is the inventory turn ratio?
• What would be the reduction in average inventory
  if, through better materials management,
  inventory turns were increased to 10 times per
  year?
• If the cost of carrying inventory is 20 of the
  average inventory, what is the annual savings?

46
Problem 6.6

• a. Turns Ratio
• b.
• ________________
• Reduction in inventory
• c. Annual savings

47
Problem 6.6

• a. Turns Ratio 4
• b.
• 1,000,000
• Reduction in inventory 2,500,000 1,000,00
  1,500,000
• c. Annual savings 20 ? 1,500,000 300,000

48
Strategic Performance Measures

• Strategic performance measures relate to a
  companys long-range goals
• Measures include
• Profitability
• Market share
• Growth
• Productivity

49
Problem 6.7

• Given the following information, calculate the
• annual cost of carrying inventory.
• Orders placed per year 1,000
• Receiving cost per order 15
• Annual office expense 8,000
• Average inventory 500,000
• Cost of capital 10 of average inventory value
• Cost of storage 8 of average inventory value

50
Problem 6.7

• Orders placed per year 1,000
• Receiving cost per order 15
• Annual office expense 8,000
• Average inventory 500,000
• Cost of capital 10 of ave. inventory
• Cost of storage 8 of ave. inventory
• Annual cost of carrying inventory

51
Problem 6.7

• Orders placed per year 1,000
• Receiving cost per order 15
• Annual office expense 8,000
• Average inventory 500,000
• Cost of capital 10 of ave. inventory
• Cost of storage 8 of ave. inventory
• Annual cost of carrying inventory
• Ave. inventory(cost of capital cost of
  storage)
• 500,000 (0.10 0.08) 90,000

52
Problem 6.8

• An importer operates a small warehouse that has
  the following annual costs. Wages for purchasing
  are 80,000, purchasing expenses are 70,000, and
  customs brokerage is 45 per order. The estimated
  cost of financing the inventory is 10, storage
  costs are 7, and risk costs are 10. The average
  inventory is 500,000, and 10,000 orders are
  placed in a year. What are the annual ordering
  and carrying costs? What is the average ordering
  cost?

53
Problem 6.8

• Annual ordering cost
• Annual carrying cost
• Total annual cost
• Average ordering cost

54
Problem 6.8

• Annual ordering cost 80,000 70,000
• (45 ? 10,000) 600,000
• Annual carrying cost 0.27 ? 500,000 135,000
• Total annual cost 600,000 135,000
• 735,000
• Average ordering cost 600,000 ? 10,000 60

55
Problem 6.9

• Given the following data, calculate the gross
• margin and net income.
• Revenue 2,000,000
• Direct labor 200,000
• Direct material 800,000
• Overhead 600,000
• General admin expenses 200,000

56
Problem 6.9

• Revenue ________
• Cost of goods sold
• Direct labor ________
• Direct material ________
• Overhead ________
• Total cost of goods sold ________
• Gross margin (gross profit) ________
• General admin expense ________
• Net income (profit) ________

57
Problem 6.9

• Revenue 2,000,000
• Cost of goods sold
• Direct labor 200,000
• Direct material 800,000
• Overhead 600,000
• Total cost of goods sold 1,600,000
• Gross margin (gross profit) 400,000
• General admin expense 200,000
• Net income (profit) 200,000

58
Problem 6.10

• If the annual cost of goods sold is 48 million
• and the average inventory is 12 million
• What is the inventory turns ratio?
• What would be the reduction in average inventory
  if, through better materials management, the
  turns ratio were increased to six times per year?
• If the cost of carrying inventory is 25 of the
  average inventory, what is the annual savings?

59
Problem 6.10

• a. Turns Ratio
• b. Average inventory
• Reduction in inventory
• c. Annual savings

60
Problem 6.10

• a. Turns Ratio 4
• b.
• 8,000,000
• Reduction in inventory 12,000,000 8,000,00
  4,000,000
• c. Annual savings 25 ? 4,000,000 1,000,000

61
ABC Inventory Control

• For basic questions must be answered
• What is the importance of the inventory items?
• How are they to be controlled?
• How much should be ordered at one time?
• When should an order be placed?

62
Concept of ABC Inventory Control

• A small number of items will present the most
  critical values.
• ABC inventory control separates the most
  significant items from the less important.
• It is used to determine the degree and level of
  control used.

63
ABC Classification

• A items 20 of the items account for 80 of the
  total dollar usage
• B items 30 of the items account for 15 of the
  total dollar usage
• C items 50 of the items account for 5 of the
  total dollar usage

64
ABC Process

• 1. Establish the item characteristics that
  influence the results of inventory management
• Annual dollar usage
• Scarcity of material
• Quality problems

65
ABC Process

• 2. Classify items into groups based on the
  criteria established
• 3. Apply a degree of control in proportion to the
  importance of the group

66
Example of ABC Analysis
Part number Annual unit usage Unit cost () Annual usage ()
1 1,100 2 2,200
2 600 40 24,000
3 100 4 400
4 1,300 1 1,300
5 100 60 6,000
6 10 25 250
7 100 2 200
8 1,500 2 3,000
9 200 2 400
10 500 1 500
Total 38,250
67
Example ABC Analysis-cont.
Part number Annual usage Cumulative usage Cumulative usage Cumulative of items
2 24,000 24,000 63 10
5 6,000 30,000 78 20
8 3,000 33,000 86 30
1 2,200 35,200 92 40
4 1,300 36,500 95 50
10 500 37,000 97 60
3 400 37,400 98 70
9 400 37,800 99 80
6 250 38,050 99 90
7 200 38,250 100 100
68
Example ABC Analysis-cont.
Part number Annual usage Cumulative usage Cumulative usage Cumulative of items
2 24,000 24,000 63 10
5 6,000 30,000 78 20
8 3,000 33,000 86 30
1 2,200 35,200 92 40
4 1,300 36,500 95 50
10 500 37,000 97 60
3 400 37,400 98 70
9 400 37,800 99 80
6 250 38,050 99 90
7 200 38,250 100 100
69
Example ABC Analysis-cont.
A
B
C
70
Problem 6.11
Item no. Annual usage
1 13,189
2 156,127
3 334
4 8,493
5 42,749
6 5,589
7 19,562
8 241,873
9 1,962
10 10,112
Total 500,000

• Analyze the given data to produce an ABC
  classification based on annual dollar usage.

71
Problem 6.11
Item no. Annual usage Cum. usage Cum. usage Cum. of items Item Class











72
Problem 6.11
Item no. Annual usage Cum. usage Cum. usage Cum. of items Item Class
8 241,873 241,873 48.37 10 A
2 156,127 398,000 79.60 20 A
5 42,749 440,749 88.15 30 B
7 19,562 460,311 92.06 40 B
1 13,189 473,500 94.70 50 B
10 10,112 483,612 96.72 60 C
4 8,493 492,105 98.42 70 C
6 5,589 497,694 99.54 80 C
9 1,962 499,656 99.93 90 C
3 344 500,000 100.00 100 C
Total 500,000
73
Problem 6.11
A
B
C
74
Control Based on ABC Classification

• Two general rules to follow
• Have plenty of low-value items
• Use control effort saved to reduce the inventory
  of A items
• A items Tight control
• B items Normal control
• C items Simplest possible control

75
Inventory Control of A Items

• A items Tight control
• Complete, accurate records
• Regular, frequent review by management
• Frequent review of forecasts
• Close follow-up

76
Inventory Control of B Items

• B items Normal control
• Good records
• Normal processing

77
Inventory Control of C Items

• C items Simple control
• Make sure there are plenty
• Simple or no records
• Large order quantities

78
Problem 6.12
Item Annual Demand Unit cost
1 21,000 1
2 5,000 40
3 1,600 3
4 12,000 1
5 1,000 100
6 50 50
7 800 2
8 10,000 3
9 4,000 1
10 5,000 1

• Use the given data to classify into A, B, C
  groups based on annual dollar usage (demand).

79
Problem 6.12
Item no. Annual Demand Unit cost Annual usage Rank Class
1 21,000 1
2 5,000 40
3 1,600 3
4 12,000 1
5 1,000 100
6 50 50
7 800 2
8 10,000 3
9 4,000 1
10 5,000 1
Total
80
Problem 6.12
Item no. Annual Demand Unit cost Annual usage Rank Class
1 21,000 1 21,000 4 B
2 5,000 40 200,000 1 A
3 1,600 3 4,800 7 C
4 12,000 1 12,000 5 B
5 1,000 100 100,000 2 A
6 50 50 2,500 9 C
7 800 2 1,600 10 C
8 10,000 3 30,000 3 B
9 4,000 1 4,000 8 C
10 5,000 1 5,000 6 C
Total 380,900
81
Problem 6.12
Item no. Annual usage Cum. usage Cum. usage Cum. of items Class











82
Problem 6.12
Item no. Annual usage Cum. usage Cum. usage Cum. of items Class
2 200,000 200,000 52.5 10 A
5 100,000 300,000 78.8 20 A
8 30,000 330,000 86.6 30 B
1 21,000 351,000 92.2 40 B
4 12,000 363,000 95.3 50 B
10 5,000 368,000 96.6 60 C
3 4,800 372,800 97.9 70 C
9 4,000 376,800 98.9 80 C
6 2,500 379,300 99.6 90 C
7 1,600 380,900 100.0 100 C
380,900
83
Problem 6.12
A
B
C
84
Session 6 Outcomes

• After completing this session participants should
  be able to
• State the importance of good inventory
  management.
• Classify of inventory based on flow of material
• Describe the functions inventories perform.
• Discuss the objectives of inventory management

85
Session 6 Outcomes (cont.)

• Define all the costs that are relevant to
• inventory decisions.
• Read and develop simple financial statements
• Define and interpret simple inventory turns
  ratio
• Conduct ABC analysis and suggest inventory
• control for each class.