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).
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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 Costs1999. Inventory carrying costs of $332 billion approach 35 percent of total logistics costs for companies.
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Table 6-2 Total 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

600

Units

400 1/2Q 200

20
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60
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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

2 RA VW

2(600)4 (240)(0.20)
100
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=
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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 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

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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 Under Conditions of Uncertainty

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

Inventory Level (Units) Qm

ROP

Safety Stock
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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 onhand 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

$4,000 $3,000 Units $2,000 $1,000

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 Time (weeks)
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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/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.

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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Time horizons

Information

Logistics

Supplier/ Manufacturer relationships

Basic Elements of QR
Manufacturing operations Philosophical/ Cultural change

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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
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Reduced Cycle Stock

Reduced Safety Stock Lower Markdowns Higher Sales Greater Profitability Reduced Total Channel Costs
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Time Savings from QR

80 70 60 50 40 30 20 10 0 Present
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Retail Apparel Textile Fiber

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Q.R.
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Efficient Consumer Response (ECR)

Timely, accurate, paperless information flow

Supplier

Distributor

Retail Store

Consumer Household

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

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

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Retail Store 22 days

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ECRs Effect on Cost

100
12.1

89.2
9.8

18.3

5.0
8.1 4.1 9.7

16.4

4.8
6.2 3.0 8.2

42.7

Cost of Goods

40.8

Source: Food Marketing Inst., ECR, 1993.

Current
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ECR
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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
Cost Capital Storage space Inventory service Inventory Total
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Percentage of Product Value 12 % 2 3 8 25 %

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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 6-4 Inventory 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 Inventory: ABC 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 Inventory: ABC 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 Inventory: ABC 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 64.

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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

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