Role of Inventory Management in SCM

Chapter 10 By Chandrashekeran

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Need for Inventory Management

Fulfills the objectives and challenges of COST AND RESPONSIVENESS Inventory OFFERS various models and SKUs Pressure on inventory is higher for made to stock rather than made to engineer or made to stock Jewellery, fashion etc.
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Inventory Management
Inventory management is the planning and controlling of inventories in order to meet the competitive priorities of the organization.
Effective inventory management is essential for realizing the full potential of any value chain.

Inventory management requires information about expected demands (SKU), amounts on hand (Qty) and amounts on order (EOQ) and price for every item stocked at all locations.
The appropriate timing and size of the reorder quantities must also be determined.
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Inventory within supply chain network

Suppliers Subcontracting Direct site
ProductionRaw material Work in process Finished good

Factory Wareho use

Customer

Distribution channel or retailer

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Inventory Basics
Inventory is created when the receipt of materials, parts, or finished goods exceeds their disbursement. (HIGH) Inventory is depleted or replenished when their disbursement exceeds their receipt.(LOW) An inventory managers job is to balance the advantages and disadvantages of both low and high inventories.
Both have associated cost characteristics.
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Importance of inventory
Customer service and product availability Example- Manufacturer of food flavors Production, purchase and transportation economy Price discount, transportation economy Hedge against price changes. Price of seeds Hedge against uncertainties in demand and lead time Hedge against strikes, fires, calamities and mismatch between demand and supply
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Types of Inventory
Raw Material- Purchased but not processed Ensures Material availability for production Reduces supplier variability in quality, quantity and time Work in Process- Reduces cycle time (time to make a product) Finished Goods- Reduces mismatch between demand and supply Maintenance/ Overhauling/ Repair- Items consumed in a production but not a part of end product. Lubricants 2007 Pearson Education

Classification of Inventory
Cycle Inventory: Average inventory of lot or batch size.
Average cycle inventory = 2 Where Q= Lot or batch size, d= Demand per time Lot Sizing: Lot size refers to quantity that a supply chain either produces or orders at a given time. Cycle inventory takes advantages of economies of scale but each stages maintains cycle inventory which increases cost.
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Classification of Inventory
Safety Stock Inventory: Surplus inventory that a company holds to protect against uncertainties in demand, lead time and supply changes. Reduces lost sales Seasonal inventory- Meets the volatility of demand and supply. Pipeline Inventory: Inventory moving from point to point in the materials flow system. Includes orders that have been placed but not served. Pipeline inventory = DL = dL , L= Lead time
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Estimating Inventory Levels

Example 12.1
A plant makes monthly shipments of electric drills to a wholesaler in average lot sizes of 280 drills. The wholesalers average demand is 70 drills a week. Lead time is 3 weeks. The wholesaler must pay for the inventory from the moment the plant makes a shipment. If the wholesaler is willing to increase its purchase quantity to 350 units, the plant will guarantee a lead time of 2 weeks. What is the effect on cycle and pipeline inventories? 280 Average cycle inventory = Q = = 140 drills 2 2

Pipeline inventory = DL = dL = 70(3) = 210 drills

Under new proposal, the average lot size becomes 350 and lead time of 2 weeks. Average demand remains at 70 drills a week.
350 Average cycle inventory = Q = = 175 drills 2 2 Pipeline inventory = DL = dL = 70(2) = 140 drills

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Pressures for Low Inventories

Inventory holding cost is the sum of the cost of capital and the variable costs of keeping items on hand, such as storage and handling, taxes, insurance, and shrinkage.
Cost of Capital is the opportunity cost of investing in an asset relative to the expected return on assets of similar risk. Storage and Handling arise from moving in and out of a storage facility plus the rental cost and/or opportunity cost of that space. Taxes, Insurance, and Shrinkage: More taxes are paid and insurance costs are higher if end-of-the-year inventories are high. Shrinkage comes from theft, obsolescence and deterioration.
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 Ordering Cost: The cost of preparing a purchase order for a supplier or a production order for the shop. Setup Cost: The cost involved in changing over a machine to produce a different item. Labor and Equipment: Creating more inventory can increase workforce productivity and facility utilization. Transportation Costs: Costs can be reduced. Quantity Discount: A drop in the price per unit when an order is sufficiently large.

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Inventory Models
EOQ Model Production Order Quantity Model Quantity Discount Model

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BASIC EOQ Model

Cycle inventory

Q= EOQ Economic Order Quantity R= Reorder Level L= Lead time

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Economic Order Quantity

Economic Order Quantity (EOQ) is the lot size that minimizes total annual inventory holding and ordering costs. Assumptions of EOQ
1. The demand rate is constant and known with certainty. 2. There are no constraints on lot size. 3. The only relevant costs are holding costs and ordering/setup costs. 4. Decisions for items can be made independently of other items. 5. Lead time is constant and known with certainty.
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 Annual set up/ ordering cost=D.S/Q Annual Holding cost=Q.H/2 At EOQ, Annual set up cost= Annual holding cost Reorder level=d.L Time between order=(Order size/ annual demand) x time fraction/year

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Total Annual Cycle-Inventory Costs

Q = lot size; C = total annual cycle-inventory cost H = holding cost per unit; D = annual demand S = ordering or setup costs per lot

Annual cost (dollars)

Total cost =

Q D (H) + (S) 2 Q

Holding cost =

Q (H) 2

Ordering cost =

D (S) Q

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Lot Size (Q)

Costing out a Lot Sizing Policy

Example 12.2
Museum of Natural History Gift Shop: Bird feeder sales are 18 units per week, and the supplier charges $60 per unit. The cost of placing an order (S) with the supplier is $45. Annual holding cost (H) is 25% of a feeders value, based on operations 52 weeks per year. Management chose a 390-unit lot size (Q) so that new orders could be placed less frequently. What is the annual cycle-inventory cost (C) of the current policy of using a 390-unit lot size?
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Costing out a Lot Sizing Policy

Example 12.2
Museum of Natural History Gift Shop: What is the annual cycle-inventory cost (C) of the current policy of using a 390-unit lot size?
D = (18 /week)(52 weeks) = 936 units H = 0.25 ($60/unit) = $15

C=

Q D 936 390 (H ) + (S) = (15) + (45) 2 Q 390 2

C = $2925 + $108 = $3033

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Lot Sizing at the Museum of Natural History Gift Shop

Current cost
3000

Annual cost (dollars)

Total cost
2000

Holding cost
1000

Lowest cost
0 | 50 | 100 | 150 | 200

Ordering cost

| 250

| 300

| 350

| 400

Q (EOQ) 2007 Pearson Best Education

Lot Size (Q)

Current Q

EOQ POLICY
Bird Feeders:
EOQ = 2DS H D = annual demand S = ordering or setup costs per lot H = holding costs per unit EOQ = 2(936)45 = 74.94 or 75 units 15 75 936 (15) + (45) 2 75

D = 936 units H = $15 S = $45 C= Q D (H ) + (S) 2 Q

C=

C = $1,124.10
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 ABC Cycle Ltd. A manufacturer of sports bikes, has an annual demand of 240,000 units in a year. On an average, delivery of an order takes seven working days. What is the reorder level?

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Application 12.1

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Application 12.1

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Application 12.2

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Application 12.2
continued

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Solved Problem 3
EOQ, is 75 units when annual demand, D, is 936 units/year, setup cost, S, is $45, and holding cost, H, is $15/unit/year. If we mistakenly estimate inventory holding cost to be $30/unit/year, what is the new order quantity, Q, if D = 936 units/year, S = $45, and H = $30/unit/year? What is the change in order quantity, expressed as a percentage of the EOQ (75 units)?
The new order quantity is

The change in percentage is

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Problem: Best Buy

Demand for deskpro computer at Best Buy is 1000 units per month. Best buy incurs a fixed order placement cost of $4000 each time an order is placed. Each component costs Best Buy $500 and the retailer has a holding cost of 20%. Calculate the optimal order size and cycle inventory cost. If management chose a 900-unit lot size (Q) so that new orders could be placed less frequently, What is the annual cycleinventory cost (C) of the current policy of using a 900-unit lot size?

Show these two situation in cost diagram. If delivery of an order takes place in each month, calculate reorder level. What is the Time Between Orders (TBO) expressed in months.
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Dominick Supermarket
Dominick Supermarket sells nut flakes. Demand for nut flakes is 1000 boxes per week. Dominicks has a holding cost of 25% and incurs $200 for each replenishment order. Calculate the cycle inventory cost. If the ordering cost decreases to $150 then calculate the % change of cycle inventory cost.

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