Managing Inventory Flows in the Supply Chain

1
Chapter 6

• Managing Inventory Flows in the Supply Chain

2
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).

3
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.

4
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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Sawtooth Models
Units
1/2Q
20
40
60
Time
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Mathematical Formulation

• Total Annual Cost Annual Inventory Carrying
  Cost Annual Ordering Cost
• Letting TAC Annual Total Cost ()
• R Annual demand (units)
• A Cost of placing a single order ()
• V Value of one unit of inventory ()
• W Inventory carrying cost as a of product
  value
• Q EOQ
• Then TAC 1/2 QVW A (R/Q)
• and the EOQ that minimizes the TAC is

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Example of EOQ

• R Annual demand 600 units
• A Order cost 4/order
• V Product value 240/unit
• W inventory carrying cost 20 0.20

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Example of TAC

• R Annual demand 600 units
• A Order cost 4/order
• V Product value 240/unit
• W inventory carrying cost 20 0.20
• Then
• TAC 1/2 QVW A (R/Q)
• 1/2 (10) (240) (0.20) (4) (600/10)
• 240 240
• 480

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Reorder Point (when to order)

• The Goal is to have a shipment of EOQ units to
  arrive as the Balance-On-Hand gt 0
• Reorder Point (ROP)
• minimum amount of inventory to last during the
  replenishment or lead time
• Lead time length (in days) X Demand per day
  (in units per day)
• Continuing Example (Assume 300 days per year)
• Lead time length 12 days
• Then Demand per day 600 / 300
• 2 units/day
• ROP ( 12 days) ( 2 units/day)
• ROP 24 units
• Additional exercises to do at home CBL, pp. 230,
  7 and 8

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EOQ Review

• Perhaps the most well-know, traditional approach
  to managing inventory
• computes an optimum value for the economic
  order quantity (EOQ) based on a trade-off of two
  types of cost
• Inventory carrying cost
• Ordering cost or setup cost
• Replenishment orders placed when
  inventory-on-hand reaches a pre-determined ROP
• currently declining in popularity and frequency
  of use
• Too much emphasis on carrying inventory
• Not very useful for systems with multiple
  distribution centers
• Greater emphasis today on approaches which
  synchronize delivery of shipments with timing
  of actual need (e.g., JIT)

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Related Concepts

• Two-bin system
• Min-max system
• demand may occur in larger increments than with
  the traditional EOQ approach

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EOQ in Condition of Uncertainty

• Uncertainty variation in demand and/or lead
  time
• Requires holding of safety stock inventory
• Policy Cost of carrying safety stock should be
  balanced with expected cost of stockouts
• Average inventory 1/2 EOQ Safety Stock

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Inventory Model UnderConditions of Uncertainty

• EOQ is still the amount ordered each time
• Assumes that over time, uncertainty periods
  balance out

Inventory Level (Units)
ROP
Time
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Explanation of Graph

• Demand rate changes slope
• Varying demand during cycle can make line non
  linear
• Lead time changes
• Reorder point to receipt

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Fixed Order Interval

• Involves ordering of inventory at fixed or
  regular intervals
• Amount order depends on how much is on-hand at
  the time of ordering (NOT EOQ)
• Implications
• Does not require close surveillance of inventory
  levels
• Inventory monitoring less expensive
• Over time, it results in higher safety stock
  levels

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Fixed Interval Modal
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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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Quick Response (QR)

• How did it evolve?
• QR is a method of maximizing the efficiency of
  the supply chain by reducing inventory investment
  where partners commit to meet specific service
  performance criteria.
• shorter, compressed time horizons
• Real-time information by SKU
• Seamless logistics network
• Partnership relationships throughout the supply
  chain
• Commitment to Quality
• What were results?

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Basic Elementsof QR
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QR Profit Sources
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Time Savings from QR
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Efficient Consumer Response (ECR)
Timely, accurate, paperless information flow
Consumer Household
Supplier
Distributor
Retail Store
Smooth, continual product flow matched to
consumption
Source Kurt Salmon Associates, Inc. Efficient
Consumer Response Enhancing Consumer Value in
the Grocery Industry
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ECR

• Components
• Category management (Managing product groups as
  strategic business units)
• Integrated electronic data interchange (EDI)
• Activity-Based Costing (ABC)
• Continuous replenishment programs
• Flow-through cross-dock replenishment
• Benefits
• Better - products, assortments, in-stock
  performance, and prices
• Leaner, faster, more responsive, less costly
  supply chain
• Improved asset utilization

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ECR Impact on Dry Grocery Chain
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ECRs Effect on Cost
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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
51
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.

66
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