Financial Impact of Inventory

1
CHAPTER 5 Financial Impact of Inventory
2
Selected Financial Data for Manufacturers,
Wholesalers, and Retailers for 1997 (Millions)
3
Cost Trade-offs in Marketing and Logistics
4
Components of Inventory Carrying Costs

• Capital
• Inventory service
• Storage space
• Inventory risk

5
Inventory Management

• Inventories are stocks of goods and materials
  that are maintained to satisfy normal demand
  patterns
• Inventory management
• Decisions drive other logistics activities
• Different functional areas have different
  inventory objectives
• Inventory costs are important to consider
• Inventory turnover

6
Inventory-Related Costs

• Inventory carrying (holding) costs
• Obsolescence
• Inventory shrinkage
• Storage costs
• Handling costs
• Insurance costs
• Taxes
• Interest charges
• Opportunity cost
• Stockouts

7
Goals of inventory management
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When to Order

• Fixed order quantity system
• Fixed order interval system
• Reorder point (ROP)
• ROP DD x RC under certainty
• ROP (DD x RC) SS under uncertainty
• Where DD daily demand
• RC length of replenishment cycle
• SS safety stock

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How Much to Reorder

• Economic order quantity (EOQ) in dollars
• EOQ v2AB/C
• Where
• 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 ()

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How Much to Reorder

• Economic order quantity (EOQ) in units
• EOQ v2AO/IC
• Where
• EOQ the most economic order size, in units
• A annual demand, in units
• O administrative costs per order of
  placing the order
• C carrying costs of the inventory ()
• I dollar value of the inventory, per
  unit

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Determining EOQ by Use of a Graph
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Cost Trade-offs Required to Determine the Most
Economic Order Quantity
6-7
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Inventory Flows

• Safety stock can prevent against two problem
  areas
• Increased rate of demand
• Longer-than-normal replenishment
• When fixed order quantity system like EOQ is
  used, time between orders may vary
• When reorder point is reached, fixed order
  quantity is ordered

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Contemporary Approaches to Managing Inventory

• ABC Analysis
• Just-in Time (JIT) Approach
• Vendor-Managed Inventory (VMI)
• Inventory Tracking
• Min-Max

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Inventory Management Special Concerns

• Defining stock-keeping units (SKUs)
• Dead inventory
• Deals
• Substitute items
• Complementary items
• Informal arrangements outside the distribution
  channel
• Repair/replacement parts
• Reverse logistics

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Inventory Positions in the Manufacturers
Logistics System
Finished goodsinventoryin field
Finished goodsinventoryat plant
Rawmaterialsinventory
In-processinventory
Assumptions A one-time increase (decrease) in
finished goods inventory results in a one-time
increase (decrease) in raw materials purchased.
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Normative Model of Inventory Carrying Cost Method
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(No Transcript)
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Inventory Turns

• What is it?
• How is it calculated?
• Why is it important?
• What about inventory days of sales on hand?

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Inventory Management

• Inventory management
• Inventory costs are important to consider
• Inventory turnover cost of goods sold divided by
  average inventory at cost
• cost of goods sold inventory turnover
• average inventory
• 200,000 inventory is sold 4 times per
  year
• 50,000
• Compare with competitors or benchmarked companies

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Inventory Management

• Low inventory turnover high inventory carrying
  costs, little (or no) stockout costs
• High inventory turnover low inventory carrying
  costs, high stockout costs
• Managing the tradeoff is important to maintain
  service levels

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Questions on Chap 5
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CHAPTER 6 Inventory Management
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Inventory Policy Decisions
Every management mistake ends up in
inventory.
Michael C. Bergerac
Former Chief Executive

Revlon, Inc.
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What are Inventories?

• Finished product held for sale
• Goods in warehouses
• Work in process
• Goods in transit
• Staff hired to meet service needs
• Any owned or financially controlled raw
  material, work in process, and/or finished good
  or service held in anticipation of a sale but
  not yet sold
• An addiction to cure ills

CR (2004) Prentice Hall, Inc.
26
Where are Inventories?
9-4
CR (2004) Prentice Hall, Inc.
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Purposes of Inventory

• Enables the firm to achieve economies of scale
• Balances supply and demand
• Enables specialization in manufacturing
• Provides protection from uncertainties in demand
  and order cycle
• Acts as a buffer between critical interfaces
  within the supply chain
• Cover up inefficiencies in operations
• Smooth variances in customer demand

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Reasons for Inventories

• Improve customer service
• Provides immediacy in product availability
• Encourage production, purchase, and
  transportation economies
• Allows for long production runs
• Takes advantage of price-quantity discounts
• Allows for transport economies from larger
  shipment sizes
• Act as a hedge against price changes
• Allows purchasing to take place under most
  favorable price terms
• Protect against uncertainties in demand and lead
  times
• Provides a measure of safety to keep operations
  running when demand levels and lead times
  cannot be known for sure
• Act as a hedge against contingencies
• Buffers against such events as strikes, fires,
  and disruptions in supply

CR (2004) Prentice Hall, Inc.
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Reasons Against Inventories

• They consume capital resources that might be put
  to better use elsewhere in the firm
• They too often mask quality problems that would
  more immediately be solved without their presence
• They divert managements attention away from
  careful planning and control of the supply and
  distribution channels by promoting an insular
  attitude about channel management

CR (2004) Prentice Hall, Inc.
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Types of Inventories

• Pipeline
• Inventories in transit
• Speculative
• Goods purchased in anticipation of price
  increases
• Regular/Cyclical/Seasonal
• Inventories held to meet normal operating needs
• Safety
• Extra stocks held in anticipation of demand and
  lead time uncertainties
• Excess inventory
• Obsolete/Dead Stock/Dormant
• Inventories that are of little or no value due to
  being out of date, spoiled, damaged, etc.

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Nature of Demand

• Perpetual demand
• Continues well into the foreseeable future
• Seasonal demand
• Varies with regular peaks and valleys throughout
  the year
• Lumpy demand
• Highly variable (3? ? Mean)
• Regular demand
• Not highly variable (3? lt Mean)
• Terminating demand
• Demand goes to 0 in foreseeable future
• Derived demand
• Demand is determined from the demand of another
  item of which it is a part

Accurately forecasting demand is singly the most
important factor in good inventory management
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Inventory Management Philosophies

• Pull
• Draws inventory into the stocking location
• Each stocking location is considered independent
• Maximizes local control of inventories
• Push
• Allocates production to stocking locations based
  on overall demand
• Encourages economies of scale in production
• Just-in-time
• Attempts to synchronize stock flows so as to just
  meet demand as it occurs
• Minimizes the need for inventory

CR (2004) Prentice Hall, Inc.
33
Inventory Management Philosophies (Contd)

• Supply-Driven
• Supply quantities and timing are unknown
• All supply must be accepted and processed
• Inventories are controlled through demand
• Aggregate Control
• Classification of items
• Groups items according to their sales level
  based on the 80-20 principle
• Allows different control policies for 3 or more
  broad product groups

CR (2004) Prentice Hall, Inc.
34
Costs Relevant to Inventory Management

• Carrying costs
• Cost for holding the inventory over time
• The primary cost is the cost of money tied up in
  inventory, but also includes obsolescence,
  insurance, personal property taxes, and
  storage costs
• Typically, costs range from the cost of short
  term capital to about 40/year. The average is
  about 25/year of the item value in inventory.

CR (2004) Prentice Hall, Inc.
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Virtual Inventories

• Stockouts are filled from other stocking
  locations in the distribution network
• Customers assigned to a primary stocking
  location
• Backup locations are usually determined by
  zoning rules
• Expectation is that lower system-wide
  inventories can be achieved while maintaining or
  improving stock availability levels
• Total distribution costs should be lower to
  support the cross filling of customer demand
• Warehouse in a warehouse concept

CR (2004) Prentice Hall, Inc.
36
Safety Stock in 2 Locations

• Meaning of safety stock
• Safety stock depends on
• Demand dispersion (variance is proportional to
  (demand)
• Fill rate

Observation
A system of multiple stocking locations will
carry its minimum safety stock when demand is
balanced among them
9-89
CR (2004) Prentice Hall, Inc.
37
Square Root Law of Inventory Consolidation

• The amount of inventory (regular stock) at
  multiple stocking points can be estimated by the
  square root law when
• Inventory control at each point is based on EOQ
  principles
• There is an equal amount on inventory at each
  point
• The square root law is

where IT amount of inventory at one
location Ii amount of inventory at each of n
locations n number of stocking points
9-97
CR (2004) Prentice Hall, Inc.
38
Square Root Law (Contd)
Example Suppose that there is 1,000,000 of
inventory at 3 stocking points for a total of
3,000,000. If it were all consolidated into 1
location, we can expect
If we wish to consolidate from 3 to 2 warehouses,
the level of inventory in each warehouse would be
For a total system inventory of n x I 2 x
1,224,745 2,449,490.
9-98
CR (2004) Prentice Hall, Inc.
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a
6-3 a
The Effect of Reorder Quantity on Average
Inventory Investment with Constant Demand and
Lead Time
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b
6-3 b
The Effect of Reorder Quantity on Average
Inventory Investment with Constant Demand and
Shortened Lead Time
41
c
6-3 c
The Effect of Reorder Quantity on Average
Inventory Investment with Constant Demand and
Lenghtened Lead Time
42
Symptoms of Poor Inventory
6-8

• Increasing numbers of back orders
• Increasing dollar investment in inventory with
  back orders remaining constant.
• High customer turnover rate.
• Increasing number of orders being canceled.
• Periodic lack of sufficient storage space.
• Wide variance in inventory turnover among
  distribution centers and major inventory items.

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ABC Analysis

• Paretos Law meaningful few and trivial many
• 80/20 based on Paretos analysis 80 percent of
  the wealth was in 20 percent of the peoples
  hands in inventory management usually 20
  percent of your items account for 80 percent of
  your inventory dollars

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ABC Analysis

• Volume
• Dollar value
• Annual Dollar Value
• Customers

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Inventory Using ABC

• A items inventory monthly
• B items quarterly
• C items annually or as needed

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Summary

• EOQ purpose
• Inventory Turns
• Types of inventory
• Purpose of inventory
• Safety stock
• Lead times and average inventory

47
Next Class

• Mid Term Exam posted
• Chapters 7,8