Managing Inventory Flows in the Supply Chain

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Managing Inventory Flows in the Supply Chain

• Henry C. Co
• Technology and Operations Management,
• California Polytechnic and State University
• Read Coyle, et al, Supply Chain Management A
  Logistics Perspective, Ch. 6 7 (covered in TOM
  301)

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Managing Inventory

• Decisions about supplies, inventories, production
  levels, staffing patterns, schedules, and
  distribution -operations infrastructure
• 4 Rs
• Right Material
• Right Amount
• Right Place
• Right Time.

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Tradeoffs

• Too much
• Not enough

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Too Much

• Ties up capacity and financial resources
• Inventory carrying cost, obsolescence, etc.
• To be covered later

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Not Enough

• Stockout 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.
• In a manufacturing firm, a stockout may result in
  lost hours of production until the item is
  restocked.

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• Possible to handle this by adding safety stock.

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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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Drivers
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• Approximately 16 of total assets are invested
  in inventories (1986)
• In manufacturing firms, 25 to 35 of total assets
  of typical are tied in inventories
• Materials average share in a manufacturers cost
  of goods sold
• 40 in 1945
• 50 in 1960
• gt 60 Today
• Spare parts (service parts) inventories of a
  typical manufacturer
• 5 million - 15 million

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• Consequently distribution and inventory
  (logistics) costs are quite substantial
• As a percentage of the GDP, from 1985 to 2000,
  inventory levels have decreased from 5.4 to
  about 3.8
• Inventory carrying costs of 332 billion approach
  35 percent of total logistics costs for companies.

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Macro Inventory Cost in Relation to U.S. Gross
Domestic Product
Table 6-1 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Total Logistics Costs 1999
Table 6-2 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Basic definitions

• An inventory is an accumulation of a commodity
  that will be used to satisfy some future demand.
• Inventories of the following form
• Raw material
• Components
• Semi-finished goods
• Spare parts
• Purchased products in retailing.

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Functional classification

• Cycle Inventories Produce or buy in larger
  quantities than needed.
• Economies of scale
• Quantity discounts
• Restrictions (technological, transportation,)

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• Safety Stock Provides protection against
  irregularities and uncertainties.

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• Anticipation stock Low demand in one part of the
  year build up stock for the high demand
  season

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• Hedge inventories expect changes in the
  conditions (price, strike, supply, etc.)
• Pipeline (or work-in-process) inventories goods
  in transit, between levels of a supply chain,
  between work stations.

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Service Operations

• No tangible items to purchase or inventory,
  materials management is of minor concern
• Operations that provide repair or refurbishment
  services carry inventory of replacement parts and
  supplies
• Examples
• Automobile service centers carry automotive parts
• Hospitals carry inventory of food, linens,
  medicine, and medical supplies

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Functions of Inventory

• To meet anticipated demand
• To smooth production requirements
• To decouple components of the production-distribut
  ion
• To protect against stock-outs
• To take advantage of order cycles
• To help hedge against price increases or to take
  advantage of quantity discounts

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Conflicting Needs

• Some Excuses for Holding Excess Inventory
• Inaccurate sales forecast
• Poor quality
• Unsynchronized processes
• Poor schedules
• Unreliable suppliers
• Unreliable shippers
• Poor attitudes

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• Pressures to Cut Inventory
• Interest/opportunity cost
• Storage and handling
• Property taxes
• Insurance premiums
• Shrinkage
• INVENTORIES HIDE PROBLEMS!

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Inventory in the Firm

• Batching Economies/Cycle Stocks
• Uncertainty/Safety Stocks

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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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• 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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• 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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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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• 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 Costs

• Inventory Carrying Cost
• Order/Setup Costs

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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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• 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 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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Example of Carrying Cost Components for Computer
Hard Disks
Table 6-3 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Inventory and Carrying Cost Information for
Computer Hard Disks
Table 6-4 Coyle, et al, Supply Chain
Management A Logistics Perspective
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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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Order Frequency and Order Cost for Computer Hard
Disks
Table 6-5 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Profile of Inventory Level Over Time
Q
Usage rate
Quantity on hand
Reorder point
Receive order
Place order
Place order
Receive order
Receive order
Lead time
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Profile of Frequent Orders
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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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Summary of Inventory and Cost Information
Table 6-6 Coyle, et al, Supply Chain
Management A Logistics Perspective
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The Classical EOQ Model

• The total cost curve reaches its minimum where
  the carrying and ordering costs are equal.

Ordering Costs
Order Quantity (Q)
(optimal order quantity)
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• Using calculus, we take the derivative of the
  total cost function (TC) and set the derivative
  (slope) equal to zero and solve for Q.

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When to Reorder?
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• Reorder Point R When the quantity on hand of an
  item drops to this amount, the item is reordered
• Safety Stock SS Stock that is held in excess of
  expected demand due to variable demand rate
  and/or lead time.
• Service Level - Probability that demand will not
  exceed supply during lead time.

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Continuous Review
Average Lead Time Demand
SS Safety Stock R SS
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Maximum probable demand during lead time
Quantity
Expected demand during lead time
Reorder point R
Safety stock
LT
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Reorder Point
Service level
Risk of a stock-out
probability of no stock-out
Quantity
Expected demand
Safety-stock
0
z
z-scale
R
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Inventory Visibility
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• 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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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
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• 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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• 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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• 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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• 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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Inventory Turnover, Average Inventory, and
Inventory Carrying Costs
Table 6-8 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Saving Inventory Dollars by Inventory Turns
Figure 6-3 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Past and Projected Inventory Turnover of Finished
Goods
Figure 6-4 Coyle, et al, Supply Chain
Management A Logistics Perspective
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Inventory Management Then and Now
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• Innovations in information technology and
  computer networking
• tracking customer demand
• production demand
• Electronic Data Interchange
• Efficient Consumer Response (ECR)
• Vendor Managed Inventory (VMI)
• How to utilize available information ?

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Electronic Data Interchange

• Computer to computer transmission of data
  (orders, invoices, payments, etc.)
• Fast and reliable tracking of inventory levels,
  outstanding customer orders, backorders.
• Shorter lead times for order processing, more
  reliable due-date quotation.

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Efficient Consumer Response (ECR)

• Distributors and suppliers work together so that
  information and goods can be exchanged quickly,
  efficiently and reliably
• Efficient store assortment
• Efficient replenishment
• Efficient promotion
• Efficient product introduction
• Wegmans, Spartan Stores, HP, IBM, Compaq

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• Vendor Managed Inventory (VMI)
• Supplier manages the inventory on its
  customers shelf (when and how much to order)

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Framework for Inventory Management

• Large number of items
• Large manufacturer 500,000 items
• Retailer 100,000
• Items show different characteristics
• Demand can occur in many ways
• Unit by unit, in cases, by the dozen, etc.

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• Decision making in production and inventory
  management involves dealing with large number of
  items, with very diverse characteristics and with
  external factors.
• We want to resolve
• How often the inventory status (of an item)
  should be determined ?
• When a replenishment order should be placed ?
• How large the replenishment order should be ?