Managing Inventory Flows in the Supply Chain

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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).

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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.

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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.

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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?

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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.

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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.

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Table 6-1 Macro Inventory Cost in Relation to
U.S. Gross Domestic Product
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On the Line Inventory Turns

• Think of inventory turns as a measure of how well
  a companys 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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Inventory in the Firm Batching Economies/Cycle
Stocks

• 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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Inventory in the Firm Batching Economies/Cycle
Stocks

• 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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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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Inventory in the Firm Seasonal Stocks

• Seasonality can occur on the inbound and/or
  outbound side of the firms 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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Inventory Costs Inventory Carrying Cost

• 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 Costs Inventory Carrying Cost

• 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
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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 firms 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 InventoryABC 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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Classifying InventoryABC Analysis

• Paretos Rule (80-20 Rule)
• Based on a nineteenth century mathematicians
  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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Classifying InventoryABC Analysis

• 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 Companys
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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Evaluating the Effectiveness of a Companys
Approach to Inventory Management

• 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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Evaluating the Effectiveness of a Companys
Approach to Inventory Management

• 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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Evaluating the Effectiveness of a Companys
Approach to Inventory Management

• 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