Supply Chain Management: 2014

What is an Inventory System

Purposes of Inventory
Inventory Management in a Supply Chain

Dr. RAVI SHANKAR

Professor
Department of Management Studies
Indian Institute of Technology Delhi
Hauz Khas, New Delhi 110 016, India

Inventory is defined as the stock of any item or

resource used in an organization.
An Inventory System is made up of a set of
policies and controls designed to monitor the
levels of inventoryy and designed
g
to answer
the following questions:

Phone: +91-11-26596421 (O); 2659-1991(H); (0)-+91-9811033937 (m)

Fax: (+66)-(2) 5246020

Email: r.s.research@gmail.com, ravi1@dms.iitd.ac.in

http://web.iitd.ac.in/~ravi1

2/7/20142

1. To maintain independence of operations

2. To meet variation in product demand
3. To allow flexibility in production scheduling
4. To provide a safeguard for variation in raw
material delivery time

What levels should be maintained?

When stock should be replenished? and
How large orders should be? i.e. what is the
optimal size of the order?

5. To take advantage of economic purchaseorder size

Lecture 1 480 1

Inventory issues
Demand
Constant vs. variable
deterministic vs. stochastic

Lead time
Review time
Continuous vs. periodic

Excess demand
Backorders,
Backorders lost sales

Inventory change
Perish, obsolescence

ABC Inventory Management

ABC Inventory Management

Inventory
Decisions:
When, What, and
how many to order

Based on Pareto concept (80/20 rule)

and total usage in Rs. of each item.
Classification of items as A, B, or C
based on usage.
Purpose is to set priorities on effort
used to manage different SKUs, i.e. to
allocate scarce management
resources.

A items: 20% of SKUs, 80% of Rs. Value

B items: 30 % of SKUs, 15% of Rs. Value
C items: 50 % of SKUs, 5% of Rs. Value
Three classes is arbitrary; could be any number
number.
Percents are approximate.
Danger: Rs. Value may not reflect importance of
any given SKU!

SKU: Stock Keeping Unit

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Lecture 1 480 2

Example of SKU list for 10 items

Unit Cost
Rs.

1.50

Rupees Usage
Rs.

Percentage of
Total Rupees
Usage

45.0%

35.0%

5,000

7,500

2.9%

1,500

8.00

12,000

4.7%

10,000

10.50

105,000

41.2%

6 000
6,000

2 00
2.00

12 000
12,000

4 7%
4.7%

100.0%

80.0%
60.0%

20 0%
20.0%
15.0%

7,500

0.50

3,750

1.5%

6,000

13.60

81,600

32.0%

10.0%

5,000

0.75

3,750

1.5%

5.0%

4,500

1.25

5,625

2.2%

0.0%

7,000

2.50

17,500

6.9%

10

3,000

2.00

6,000

2.4%
7100.0%

25.0%

Rs. 254,725

30.0%

Total

120.0%

40.0%

40.0%
20.0%
0.0%
3

10

Item No.
Cumulative Percentage

Cumulattive % Usage

Annual Usage in
Units

Perce
ent Usage

Item

ABC Application: IMPLICATION IN A

SUPPLY CHAIN?

ABC Chart for SKU List

Policies based on the ABC:

Develop links with A suppliers more;

Get tighter control of A items;

Forecast A more carefully.

Applications

Jewelry Store
Dining Restaurant
Outdoor Retailer
Large Department Store
9

Lecture 1 480 3

Basic inventory elements

Carrying cost, Cc

- to study methods to deal with

Include facility operating costs, record

keeping, interest, etc.

Category

Ordering cost, Co

Include p
purchase orders, shipping,
pp g handling,
g
inspection, etc.

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Sometimes penalties involved; if customer is

internal, work delays could result

10

Cost (and Range) as a

Percent of Inventory
Value

Housing costs (including rent or depreciation,

operating costs, taxes, insurance)

6% (3 - 10%)

Material handling costs (equipment lease or

depreciation power
depreciation,
power, operating cost)

3% (1 - 3.5%)

Labor cost

Shortage (stock out) cost, Cs

Inventory

Carrying Costs

Investment costs (borrowing costs, taxes, and

insurance on inventory)
Pilferage, space, and obsolescence
Overall carrying cost

3% (3 - 5%)
11% (6 - 24%)
3% (2 - 5%)

how much stock of items should be kept

on hands that would meet customer
demand
Objectives are to determine:
a) how much to order, and
b) when to order

26%

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12

Lecture 1 480 4

Inventory models

Basic model

Profile of Inventory Level Over Time

The basic model is known as:

Economic Order Quantity (EOQ) Models

Here, we study the following two different models:

1. Basic model

Q
Objective is to determine the optimal order size that
will minimize total inventory costs

2. Model with re-order points

Usage
rate

Quantity
on hand

Reorder
point

How the objective is being achieved?

Receive
order

Place
order

Receive
order

Place
order

Receive
order

Lead time
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Lecture 1 480 5

Profile of Frequent Orders

IMPLICATION IN A SUPPLY CHAIN?

The Basic EOQ Model

Basic EOQ models

The optimal order size, Q,

Three models to be discussed:

1
2
3.

is to minimize the sum of carrying costs and ordering costs.

Assumptions and Restrictions:

- Demand is known with certainty and is relatively constant over time.
- No shortages are allowed.
- Lead time for the receipt of orders is constant. (will consider later)
- The order quantity is received all at once and instantaneously.

Basic EOQ model

EOQ model without instantaneous
receipt
EOQ model with shortages.

How to determine
the optimal value
Q* ?

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17

(c) Dr. Ravi Shankar, AIT (2008)

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Lecture 1 480 6

The Basic EOQ Model

Determine of Q

Cost Relationships for Basic EOQ

(Constant Demand, No Shortages)

We assumed that, we will only keep half the inventory over a year then

We try to

The total carry cost/yr = Cc x (Q/2).

Find the total cost that need to spend for keeping

inventory on hands
= total ordering + stock on hands
Determine its optimal solution by finding its first
derivative with respect to Q

Then , Total cost =

Total order cost = Co x (D/Q)

TC = C D +C Q
Q
2
o

Finding optimal Q*
Total
Cost

min

Ordering
Cost

Q*

Q = 2C D
C
c

19

(c) Dr. Ravi Shankar, AIT (2008)

Order Quantity (how much)

EOQ balances carrying

costs and ordering
costs in this model.

2/7/201419

Carrying
Cost

TC = C D +C Q
Q
2

How to get these values?

1. Find out the total carrying cost
2. Find out the total ordering cost
3. Total cost = (1) + (2)
4.
Equate (1) and (2) and Find Q*

20

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Lecture 1 480 7

The Basic EOQ Model

Total annual inventory cost is sum of ordering and carrying cost:

To order inventory
To keep inventory

TC = C D + C Q
2
Q
o

Numerical Illustration

Robustness of EOQ model

IMPLICATION IN A SUPPLY CHAIN?

Model parameters
: Cc = Rs.1.50, Co = Rs.300, D =10,000 kg

Optimal order size: Q*= 2CoD = 2(300)(10,000) = 2,000Kg

Cc
(1.50)

Very Flat Curve - Good!!

Total annual inventory cost: (TCmin) = Co D +Cc Q* = (300)10,000+(1.50) (2,000) = Rs.3,000

2
2,000
2
Q*

Total
Cost

TC

Number- of -orders- per- year: D =10,000= 5

Q* 2,000
Q*-Q

Order- cycle- time= 365days= 365= 73Days-of - store- inventory

5
D/ Q*

Q*

Q*+Q

Order Quantity

Would have to mis-specify Q* by quite a bit

before total annual inventory costs would
change significantly.

Figure The EOQ cost model

Try to get this value

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Lecture 1 480 8

Model with re-order points

The reorder point is the inventory level at which a new order is placed.
Order must be made while there is enough stock in place to cover demand during lead time.
Formulation: R = dL, where d = demand rate per time period, L = lead time

What happens to Reorder

level when

To cope up with uncertainty of

demand during lead time

Then R = dL = (10,000/311)(10) = 321.54

Working days/yr

Inventory level depletes at slower or faster rate

during lead time.
This
Thi iis due
d to the
h ffact that
h d
demand
d iis uncertain
i
during the lead time

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(c) Dr. Ravi Shankar, AIT (2008)

Keep
p safety
y stock as a safeguard
g
or hedge
g
against stock-out scenarios.

25

Lecture 1 480 9

How to decide Safety Stock?

Numerical Illustration

Find Reorder point and safety

stock for service level of 95%

R = d L + (Zd L )

d =30Kg per day, L =10 days, = 5 Kg per day

d

S f t stock
Safety
t k

For 95% service- level, Z =1.65

R= dL+Z L =30 (10 )+(1.65) (5) ( 10) =300+26.1=326 .1Kg
d

Safety stock: 26.1 Kg.

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(c) Dr. Ravi Shankar, AIT (2008)

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Lecture 1 480 10

CASE STUDY IN A TUTORIAL MODE

A TUTORIAL ON RISK POOLING

Dr. RAVI SHANKAR

Professor
Department of Management Studies
Indian Institute of Technology Delhi
Hauz Khas, New Delhi 110 016, India
Phone: +91-11-26596421 (O); 2659-1991(H); (0)-+91-9811033937 (m)
Fax: (+91)-(11) 26862620

Email: r.s.research@gmail.com
http://web.iitd.ac.in/~ravi1

RISK POOLING
Risk pooling is an important
concept in supply chain
management. The idea of risk
pooling
p
g is executed by
ya
centralized distribution system
which caters to the requirements
of all the markets in a given
region instead of separate
warehouse allocated for different
markets.

Risk Pooling
Consider these two systems:

Warehouse One

Market One

Warehouse Two

Market Two

Supplier

Market One
Supplier

Warehouse
Market Two

Lecture 1 480 11

Centralized Systems

DISTRIBUTOR

Decentralized System

Factory

Central
warehouse

DISTRIBUTOR

Market one

Warehouse

Warehouses

Market two

Retailers
Retailers

Lecture 1 480 12

Factory

Factory

Factory: ABC
Central
warehouse
Pathumthani Warehouse

Market One

Prachin Buri Warehouse

Market Two

ABC Chiang Rai

Centralised
warehouse at
Ayutthaya

Decentralized Warehouses

Market two

Warehouse 2
Warehouse 1

Market one

ABC Chiang
Rai

Central
warehouse:
Ayutthaya

Market Pathumthani
Market
One

Market Prachin
Buri
Market
Two

Lecture 1 480 13

TERMINOLOGY

HISTORICAL DEMAND DATA

WEEK

Pathumthani

68(-17)

37(+14)

45(+6)

58(-7)

16(+35)

32(+19)

72(-21)

80(-29)

Prachin Buri

87(-27)

62(-3)

55(+4)

67(-8)

12(+47)

42(+17)

69(-10)

81(-22)

TOTAL

155(-45)

99(+11)

100(+10)

125(-15)

28(+82)

74(+36)

141(-31)

161(-51)

Average

51
59

Market one
One

ABC company
Prachin Buri Warehouse

ABC company

Central
warehouse
(Ayutthaya)

Market
Market Two
two

Market
Market One
one

AVERAGE WEEKLY DE
EMAND

110
Pathumthani Warehouse

PRODUCT A
100
90
80
70
60
50
40
30
20
10
0

DEMAND Pathumthani
DEMAND Prachin Buri

Two
Market two

D: Average daily demand faced by the distributor.

d: standard deviation of the daily demand faced by
the distributor.
L: Replenishment lead time from the supplier to the
distributor in days
p cost)) incurred every
y time the
Co: Fixed cost ((set up
warehouse places an order, it includes
transportation cost.
Cc: Cost of holding one unit of the product in the
inventory for one day at the warehouse.
: Service level -the probability of not stocking out
during lead time.

WEEK

Lecture 1 480 14

Average demand during lead time =LD.

This ensures that if a distributor places an order the system has

enough inventory to cover expected demand during lead time.

Safety stock = z d

Order quantity (Q): It is the number of items ordered

each time places an order that minimizes the average
total cost per unit of time distributor.

This is the amount of inventory distributor needs to keep

to meet deviations from average demand during lead time.

TC

z: Sa
Safety
ety factor
acto which
c is
sc
chosen
ose from
o statistical
stat st ca
table to ensure that probability of stock out is
exactly (1-)
Reorder level (s) = average demand during lead
time + safety stock
s = LD + z d L

Q =

Whenever the inventory level drops below reorder level the

distributor should place new order to raise its inventory.

= C D +C Q
Q
2

Average inventory = Q/2 + z d

min

Coefficient of variation = ((d ) / DL

2C D
C
o

Order-up-to level (S): Since there is variability in

demand the distributor places an order for Q items
whenever inventory is below reorder level (s).

S= Q + s

Lecture 1 480 15

CASE STUDY OF RISK POOLING

Let us illustrate this with an example of a Chiang Rai
based company ABC that produces certain type of
products and distributes them in the South
Thailand region .
The current distribution system partitions S-Thailand
region into two markets each of which has a
warehouse.
warehouse
1. One warehouse is located in Prachin Buri
2. Another one located in Pathumthani.
Alternative strategy of centralized distribution system
replaces two warehouses by a single warehouse
located between the two cities in Ayutthaya that
will serve all customer orders in both markets

ASSUMPTIONS
Manufacturing facility has sufficient
capacity to satisfy any warehouse demand
Lead time for delivery to each warehouse is
about one week and is assumed to be
constant.
t t
Delivery time does not change significantly
if we adopt a centralized distribution
system.
Service level of 95% that is the probability of
stocking out is 5% is maintained.

DATA ANALYSIS
Now with analysis of weekly demand
for two different products, product A
and product B produced by ABC
company for last 8 weeks in both
market zones we will be able to
decide which distribution strategy
will be more efficient and cost
effective.

Lecture 1 480 16

HISTORICAL DEMAND DATA FOR PRODUCT-A

WEEK

HISTORICAL DEMAND DATA FOR PRODUCT-B

WEEK

68

37

45

58

16

32

72

80

Pathumthani

Prachine Buri

87

62

55

67

12

42

69

81

Prachine Buri

TOTAL

155

99

100

125

28

74

141

161

TOTAL

PRODUCT-B
DEMAND Pathumthani

100
90
80
70
60
50
40
30
20
10
0

DEMAND Pathumthani
DEMAND Prachine Buri

WEEK

AVERAGE DEMAND

AVERAGE WEEKLY DE
EMAND

Pathumthani

PRODUCT-A

ANALYSIS OF HISTORICAL DATA

PRODUCT

AVERAGE
DEMAND

STANDARD
DEVIATION

COEFFICIENT
OF
VARIATION

Pathumthani

Pathumthani

51

20.70

0.41

1.38

1.41

1.02

Prachin Buri

59.38

22.23

0.32

DEMAND Prachine Buri

4.5
4
3.5
3
2.5
2
1.5
1
0.5
0

Prachin Buri

CENTRAL

110.38

39.14

0.35

2.38

1.99

0.84

Warehouse

CENTRAL
Warehouse
1

WEEK

Lecture 1 480 17

SAMPLE CALCULATIONS
FOR PRODUCT-A IN PATHUMTHANI
WAREHOUSE
1. Average demand = (68+37+45+58+16+32+72+80)/8=51

GENERALIZATIONS

Average demand for Product-A is much higher than

Product-B, which is a slow moving product.

Both standard deviation (absolute) and coefficient of

variation (relative to average demand) are measure
of variability of demand, but we find that STD for
Product-A is higher
g
but coefficient of variation of
Product-B is higher.

For centralized distribution average demand is

simply the sum of the demand faced by each of
existing warehouse

However the variability of demand as measured by

or COV faced by central warehouse is lower than
that faced by the two existing ones.

2. Standard deviation of demand =

(68 51)2 + (51 37) 2 .............. + (80 51) 2

= 20.7
8
3. Coefficient of variation = 20.7/51 = 0.41

NUMERICAL VALUES
Safety factor (Z) =1.65
Fixed cost for both the products (Co)
= Rs 3500
Inventory holding cost (Cc)
= Rs 18.5 per unit per week.
Cost of transportation from warehouse to
a customer
Current distribution system = Rs 50 per
product
Centralized distribution system = Rs 60 per
product.

Lecture 1 480 18

SAMPLE CALCULATIONS
FOR PRODUCT-A IN PATHUMTHANI WAREHOUSE

INVENTORY LEVELS

4. Safety stock =1.65 20.7

PRODUCT

AVERAGE
DEMAND
DURING
LEAD TIME

SAFETY
STOCK
(SS)

REORDER
POINT
(s)

ORDER
QUANTITY
(Q)

ORDER
UPTO
LEVEL
(S)

AVERAGE
INVENTORY

1 = 34.16

5. Reorder point = 51 + 34.16 = 85.16

6 O
6.
Order
d quantity
tit =

2 3500 51
18.5

51

34.16

85

139

224

104

Pathumthani

B
A

1.38
59.38

2.33
36.68

4
96

23
150

27
246

14
112

7. Order up to level = 139 +85 = 224

CENTRALIZED
W/H

B
A

1
1.65
110.38 64.58

3
175

19
204

22
379

11
167

8. Average inventory = 139/2 +34.16 = 103.66

CENTRALIZED
W/H

30

36

18

Prachine Buri

2.38

3.28

REDUCTION IN AVERAGE INVENTORY

PRODUCT A = (104 + 112 167) 100 = 22.7%

(104 + 112)

= 139

Pathumthani

Prachine Buri

PERCENT REDUCTION IN INVENTORY

PRODUCT B =

(14 + 11 18)
100
(14 + 11)

= 28%

Lecture 1 480 19

ANALYSIS AT DIFFERENT
SERVICE LEVELS

PERCENT REDUCTION IN AVERAGE INVENTORY

91

92

1.29 1.34 1.41

93

1.48

94

95

1.56 1.65

96

1.75

97

98

1.88 2.05

99

99.9

2.33 3.08

PRODUCT-A

24

23.7

23.4

23.1

23

22.7

22.3

21.8

21.7

21.2

19.5

PRODUCT-B

27.12

27.07

27.0

26.94

26.89

26.82

26.72

26.59

26.44

26.2

25.65

91

92

93

94

95

96

97

98

99

30
25
20
15
10
5
0

PRODUCT-A

Comment on the Following Generalizations:

99.9

PERCENTAGE REDUCTION IN
AVERAGE INVENTORY AT DIFFERENT SERVICE LEVELS
INVENTORY

SERV 90
ICE
LEVE
L (%)

90

% REDUCTION IN AVG
G

When average inventory for different level of

service is calculated corresponding to
varying value of z it was found that there
exists a trade-off between service level and
reduction in inventory through risk pooling.
pooling

SERVICE
LEVEL
(%)

If a supply chain goes for higher level of service it

has to compromise with the percent reduction in the
inventory level and vice versa.

T provide
To
id high
hi h service
i level
l
l service
i level
l
l has
h to
t
maintain high inventory too.

Percent reduction in inventory decreases with

increase in service level.

PRODUCT-B

90

93
96
SERVICE LEVEL

99

Lecture 1 480 20

IDEAL SITUATION
This works best for:

High coefficient of variation, which

reduces required safety stock.
Negatively correlated demand as in
such a case the high demand from
one customer will be offset by low
demand from another

Lecture 1 480 21