Chapter 6: Managing Inventory Flows in the Supply Chain 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). 9/7/2012 BA 331 Inventory 2 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. 9/7/2012 BA 331 Inventory 3 • Understand how companies can evaluate the effectiveness of their inventory management techniques. • Appreciate the importance and value of inventory visibility to increasing supply chain effectiveness.Learning Objectives • Understand how inventory items (stock-keeping units) can be designed to maximize the efficiency of managing inventory. 4 9/7/2012 BA 331 Inventory . inventory. • 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? 9/7/2012 BA 331 Inventory 5 .I am sick and tired of hearing complaints about our inventory levels and the costs associated with carrying inventory. inventory….Logistics Profile: Micros and More • “Inventory.” muttered the COO. 9/7/2012 BA 331 Inventory 6 . • Ultimate challenge is to balance supply and demand for inventory.). warehouses.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. an important internal and external metric. • Changes in inventory affect return on assets (ROA). etc. inventory levels have decreased from 5. – As a percentage of the GDP. 9/7/2012 BA 331 Inventory 7 . from 1985 to 2000.8% – Examine Table 6-1.Inventory in the Economy • Inventory in the Economy has decreased.4% to about 3. Table 6-1: Macro Inventory Cost in Relation to U.S. Gross Domestic Product 9/7/2012 BA 331 Inventory 8 . On the Line: Inventory Turns • Think of inventory turns as a measure of how well a company’s products are doing in the market and how well its inventory is managed. 9/7/2012 BA 331 Inventory 9 . • “Ideally. zero inventory will maximize cash flow. • Increasing emphasis on fully integrated supply chain means inventories barely spend any time sitting idle.” • Inventory turnover potential is 30 to 40 times/year. • There is a continuing move away from traditional build-to-forecast manufacturing models to more flexible build-to-demand systems. Inventory in the Firm: Rationale for Inventory • Product Line Proliferation – Depth & breath of product lines trending up. • Inventory carrying costs of $332 billion approach 35 percent of total logistics costs for companies. 9/7/2012 BA 331 Inventory 10 . – Results in larger inventories. • Examine Table 6-2 Total Logistics Costs1999. 1999 9/7/2012 BA 331 Inventory 11 .Table 6-2 Total Logistics Costs --. Inventory in the Firm: Batching Economies/Cycle Stocks • Price discounts – Result in trade-offs between large purchases qualifying for quantity discounts and costs of storing inventory. 9/7/2012 BA 331 Inventory 12 . so supplies are stockpiled. storage costs are often less than savings from buying in bulk. – Because physical supply inventory is often raw materials. – Lower freight rates are often reflected in lower consumer prices. – Largest shipments may qualify for even lower multiple truckload. carload or trainload rates. 9/7/2012 BA 331 Inventory 13 .Inventory in the Firm: Batching Economies/Cycle Stocks • Transportation rate discounts – Large quantities often result in carload freight rates. 9/7/2012 BA 331 Inventory 14 .Inventory in the Firm: Batching Economies/Cycle Stocks • Production economics favor long production runs. – Results in cycle stock that must be stored. – Cycle stocks can be beneficial as long as the appropriate analysis is done to cost justify the inventory. Sawtooth Models 600 Units 400 1/2Q 200 20 9/7/2012 40 60 BA 331 Inventory Time 15 . Mathematical Formulation • Total Annual Cost = Annual Inventory Carrying Cost + Annual Ordering Cost • Letting TAC = Annual Total Cost ($) 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: 9/7/2012 2 RA Q VW BA 331 Inventory 16 . 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 Q 2 RA VW 2(600)4 (240)(0.800 48 = 17 9/7/2012 .20) 100 BA 331 Inventory 4 . 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 9/7/2012 BA 331 Inventory 18 Reorder Point (when to order) The Goal is to have a shipment of EOQ units to arrive as the BalanceOn-Hand > 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 9/7/2012 BA 331 Inventory 19 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) 9/7/2012 BA 331 Inventory 20 Related Concepts • “Two-bin” system • “Min-max” system – demand may occur in larger increments than with the traditional EOQ approach 9/7/2012 BA 331 Inventory 21 . 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 9/7/2012 BA 331 Inventory 22 . uncertainty periods balance out Inventory Level (Units) Qm ROP Safety Stock 9/7/2012 BA 331 Inventory Time 23 .Inventory Model Under Conditions of Uncertainty • EOQ is still the amount ordered each time • Assumes that over time. Explanation of Graph • Demand rate changes slope – Varying demand during cycle can make line non linear • Lead time changes – Reorder point to receipt 9/7/2012 BA 331 Inventory 24 . it results in higher safety stock levels 9/7/2012 BA 331 Inventory 25 .Fixed Order Interval • Involves ordering of inventory at fixed or regular intervals • Amount order depends on how much is onhand at the time of ordering (NOT EOQ) • Implications: – Does not require close surveillance of inventory levels – Inventory monitoring less expensive – Over time. 000 Units $2.000 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 Time (weeks) 9/7/2012 BA 331 Inventory 26 .000 $1.Fixed Interval Modal $4.000 $3. – Safety stock more challenging and complex to manage for many firms. 9/7/2012 BA 331 Inventory 27 .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. Inventory in the Firm: Uncertainty/Safety Stocks • Impact of information on uncertainty – Trade-off analysis appropriate to assess risk and measure inventory cost. 9/7/2012 BA 331 Inventory 28 . the Internet have enabled companies to reduce uncertainty. EDI. – Collaborative planning and forecasting requirements (CPFR) is an example. – Bar coding. – Information technology can be used in the supply chain to reduce inventory. – Scheduling and actual production times can be closely examined to reduce inventory.Inventory in the Firm: Time/InTransit 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. 9/7/2012 BA 331 Inventory 29 . • Work-In-Process inventory should be examined for possible trade-offs especially in the production of high value goods. 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. compressed time horizons Real-time information by SKU Seamless logistics network Partnership relationships throughout the supply chain Commitment to Quality • What were results? 9/7/2012 BA 331 Inventory 30 . – – – – – shorter. Time horizons Information Logistics Supplier/ Manufacturer relationships Basic Elements of QR Manufacturing operations Philosophical/ Cultural change 9/7/2012 BA 331 Inventory 31 . QR Profit Sources Faster Order Placement Shorter Lead Times Rapid Reaction to Demand More Reliable Lead Times Fast Response to Sales Trends Higher Sales Lower Markdowns 9/7/2012 BA 331 Inventory Reduced Cycle Stock Reduced Safety Stock Lower Markdowns Higher Sales Greater Profitability Reduced Total Channel Costs 32 . + 33 .R. BA 331 Inventory Q.Time Savings from QR 80 70 60 50 40 30 20 10 0 Present 9/7/2012 66 46 Retail Apparel Textile Fiber 21 Q.R. paperless information flow Supplier Distributor Retail Store Consumer Household Smooth. Efficient Consumer Response: Enhancing Consumer Value in the Grocery Industry 9/7/2012 BA 331 Inventory 34 . continual product flow matched to consumption Source: Kurt Salmon Associates. Inc. accurate.Efficient Consumer Response (ECR) Timely. less costly supply chain – Improved asset utilization 9/7/2012 BA 331 Inventory 35 . in-stock performance. and prices – Leaner. assortments.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 . more responsive. faster.products. ECR Impact on Dry Grocery Chain Current Dry Good Chain P a c k i n g Suppler Warehouse 38 days Distributor Warehouse 40 days 104 days Retail Store 26 days C o n s u m e r P u r c h a s e ECR Dry Good Chain L i n e Suppler Distributor Warehouse Warehouse 27 days 12 days 61 days BA 331 Inventory Retail Store 22 days 9/7/2012 36 . 8 18.7 16.2 3.8 Source: Food Marketing Inst. ECR.0 8. Current 9/7/2012 BA 331 Inventory ECR 37 .1 89.2 42.1 4.ECR’s Effect on Cost 100 12.1 9.7 Cost of Goods 40..2 9.0 8.3 5.8 6.4 4. 1993. • 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. 9/7/2012 BA 331 Inventory 38 .Inventory in the Firm: Seasonal Stocks • Seasonality can occur on the inbound and/or outbound side of the firm’s logistics systems. • For example. companies anticipate that some forecasted event will negatively impact the production cycle. labor strikes. • Risk assessment is important in these cases. 39 9/7/2012 BA 331 Inventory .Inventory in the Firm: Anticipatory Stocks • In some cases. or significant price increases may prompt the firm to build inventory levels higher than normal. shortage of supplies due to weather or political event. Inventory in the Firm: The Importance of Inventory in Other Functional Areas • Marketing uses inventory to provide strong customer service. • 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. 9/7/2012 BA 331 Inventory 40 . • Manufacturing uses inventory to schedule longer production runs. • Third. inventory cost trade-off decisions affect inventory carrying costs. 9/7/2012 BA 331 Inventory 41 . inventory levels affect customer service levels. inventory costs are a significant portion of total logistics costs for many firms. • Second.Inventory Costs: Why are they so important? • First. 9/7/2012 BA 331 Inventory 42 . or any asset. – Debate on inventory valuation at fully allocated or variable costs only.Inventory Costs: Inventory Carrying Cost • Capital Cost – Opportunity cost associated with investing in inventory. – What is the implicit value of having capital tied up in inventory. instead of some other worthwhile project? – Minimum ROR expected from any asset. 9/7/2012 BA 331 Inventory 43 . utilities. rents. – Logistics develops a cost formula for storage space costs based on cost behaviors. • Public space mostly variable.Inventory Costs: Inventory Carrying Cost • Storage Space Cost – Handling costs. • Private space a mix of fixed and variable. • Inventory Risk Cost – Largely beyond the control of the firm. 9/7/2012 BA 331 Inventory 44 .Inventory Costs: Inventory Carrying Cost • Inventory Service Cost – Insurance and taxes on stored goods. employee pilferage. damage. – Varies according to the value of the goods. – Due to obsolescence. theft. Table 6-3 Example of Carrying Cost Components for Computer Hard Disks Cost Capital Storage space Inventory service Inventory Total 9/7/2012 BA 331 Inventory Percentage of Product Value 12 % 2 3 8 25 % 45 . $100).g. • Step 2 .Multiply overall carrying cost (as a percentage) times the dollar value of the product (e.g.Measure each individual carrying cost component as a percentage of product value (e. • Step 3 .Inventory Costs: Calculating the Cost of Carrying Inventory • Step 1 .g. 25%).Identify the value of the item stored in inventory (e. 9/7/2012 BA 331 Inventory 46 . $100 times 25% = $25 inventory carrying cost per year. Inventory Costs: Nature of Carrying Cost • Items with basically similar carrying costs should use the same estimate of carrying cost per dollar. etc. 9/7/2012 BA 331 Inventory 47 . • There are exceptions for items that are subject to special consideration for purposes of quick obsolescence or high degree of theft. Table 6-4 Inventory and Carrying Cost Information for Computer Hard Disks 9/7/2012 BA 331 Inventory 48 . 9/7/2012 BA 331 Inventory 49 .Inventory Costs: Order/Setup Costs • Order costs – MIS costs for inventory stock level tracking. – Inspecting and preparing inventory for sale. – Preparing and processing purchase orders and receiving reports. • Setup Costs – Incurred when production changes over from one product to another. Table 6-5 Order Frequency and Order Cost for Computer Hard Disks 9/7/2012 BA 331 Inventory 50 . Inventory Costs: Carrying Cost versus Order Cost • Examine Table 6-6. 9/7/2012 BA 331 Inventory 51 . • 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. Table 6-6 Summary of Inventory and Cost Information 9/7/2012 BA 331 Inventory 52 . Figure 6-1 Inventory Costs 9/7/2012 BA 331 Inventory 53 . Inventory Costs: Expected Stockout Cost • Cost of not having product available when a customer wants it. • Includes backorder costs (special order). • Losing a customer permanently if customer finds they prefer the substituted product and/or company. 9/7/2012 BA 331 Inventory 54 . • Losing one item profit by substituting a competing firm’s product. 9/7/2012 BA 331 Inventory 55 . a stockout may result in lost hours of production until the item is restocked.Inventory Costs: Expected Stockout Cost • Possible to handle this by adding safety stock. • In a manufacturing firm. O. 9/7/2012 BA 331 Inventory 56 . – No storage costs. no taxes.Inventory Costs: Inventory in Transit Carrying Cost • Any product inbound to the firm using F. • In transit carrying cost is generally less than for regular inventory because some cost components are not present.O. and reduced risk of obsolescence.B. destination should be counted. • Any product outbound from the firm using F.B. origin should be counted. Ford Dicky of General Electric3. – Most important inventory put in Group A.Classifying Inventory: ABC Analysis • Ranking system – Developed in 1951 by H. lead time. 9/7/2012 BA 331 Inventory 57 . or stockout cost. cash flows. – Suggested that GE classify items according to relative sales volume. – Lesser impact goods put in Groups B and C respectively. Classifying Inventory: ABC Analysis • Pareto’s Rule (80-20 Rule) – Based on a nineteenth century mathematician’s observation that many situations were dominated by a very few elements. most elements had very little influence in most situations. – Separates the “trivial many” from the “vital few”. – Conversely. 9/7/2012 BA 331 Inventory 58 . – 20% of sales will come from 80% of the inventory SKUs. and vice versa. 9/7/2012 BA 331 Inventory 59 . – For example. • The 80-20 Rule has been found to explain many phenomena that interest managers.Classifying Inventory: ABC Analysis • 80-20 Rule – 80% of sales will come from 20% of the inventory SKUs. 80% of sales come from 20% of customers. Figure 6-2 ABC Inventory Analysis 9/7/2012 BA 331 Inventory 60 . Inc.Table 6-7 ABC Analysis for Big Orange Products. 9/7/2012 BA 331 Inventory 61 . location. products. transportation equipment. – Notification of failures in inventory flow. – Providing summary and detailed reports of shipments.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. 9/7/2012 BA 331 Inventory 62 . and trade lane activity. orders. 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 9/7/2012 BA 331 Inventory 63 . Evaluating the Effectiveness of a Company’s Approach to Inventory Management • Are customers satisfied with the current level of customer service? – If standards have been set in consultation with the customer. 9/7/2012 BA 331 Inventory 64 . this question can be answered objectively. the answer to this question can point out the need for a modification or adoption of new inventory strategies.Evaluating the Effectiveness of a Company’s Approach to Inventory Management • How frequently does backordering and/or expediting occur? – If records of these events are kept. 9/7/2012 BA 331 Inventory 65 . Figure 6-3 and Figure 64. 9/7/2012 BA 331 Inventory 66 .Evaluating the Effectiveness of a Company’s 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. or stay about the same regardless of sales levels. less than sales.Evaluating the Effectiveness of a Company’s 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. 9/7/2012 BA 331 Inventory 67 . Table 6-8 The Relationship among Inventory Turnover. and Inventory Carrying Costs 9/7/2012 BA 331 Inventory 68 . Average Inventory. Figure 6-3 Saving Inventory Dollars by Inventory Turns 9/7/2012 BA 331 Inventory 69 . Figure 6-4 Past and Projected Inventory Turnover of Finished Goods 9/7/2012 BA 331 Inventory 70 .
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