Inventory Management (PPT Contents)

Inventory Management Provides Competitive Advantage at

Amazon.com
Normal Operating Cycle of Amazon.com
1. You order three items, and a computer in Seattle takes charge.
2. The “flow meister” in Coffeyville receives your order.
3. Rows of red lights show which products are ordered.
4. Your items are put into crates on moving belts.
5. All three items converge in a chute and then inside a box.
6. Any gifts you’ve chosen are wrapped by hand.
7. The box is packed, taped, weighed, and labeled before leaving the warehouse in a truck.
8. Your order arrives at your doorstep.

Learning Objectives
 LO1 Define the term inventory.
 LO2 List the different types of inventory.
 LO3 Describe the main functions of inventories.
 LO4 Discuss the main requirements for effective management.
 LO5 Explain periodic and perpetual review systems.
 LO6 Describe the costs that are relevant for inventory management.
 LO7 Describe the A-B-C approach and explain how it is useful.
 LO8 Describe the basic EOQ model and its assumptions and solve typical problems.
 LO9 Describe the economic production quantity model and solve typical problems.
 LO10 Describe the quantity discount model and solve typical problems.
 LO11 Describe reorder point models and solve typical problems.
 LO12 Describe situations in which the fixed-order-interval model is appropriate and
solve typical problems.
 LO13 Describe situations in which the single-period model is appropriate and solve
typical problems.

Introduction: Define the term Inventory

An inventory is a stock or store of goods. Firms typically stock hundreds or even
thousands of items in inventory, ranging from small things to large items. Naturally, many of
the items a firm carries in inventory relate to the kind of business it engages in. Inventory is one
of the most expensive assets of many companies, representing as much as 50% of total invested
capital.
The Nature and Importance of Inventories
To get a sense of the significance of inventories, consider the following:
- Some very large firms have tremendous amounts of inventory.
- Inventory decisions in service organizations can be especially critical.
- The major source of revenues for retail and wholesale businesses is the sale of
merchandise (inventory).

Different Kinds of Inventory

 Raw materials and purchased parts.
 Work-in-process (WIP).
 Finished-goods inventories (manufacturing firms) or merchandise (retail stores).
 Tools and supplies.
 Maintenance and repairs (MRO) inventory.
 Goods-in-transit to warehouses, distributors, or customers (pipeline inventory)

Functions of Inventory
Inventories serve a number of functions. Among the most important are the following.
1. To meet anticipated customer demand.
2. To smooth production requirements.
3. To decouple operations.
4. To reduce the risk of stockouts.
5. To take advantage of order cycles.
6. To hedge against price increases.
7. To permit operations.
8. To take advantage of quantity discounts.

Objective of Inventory Management

 To maintain optimum inventory level to maximize the profitability and reduce the cost.
 To meet the seasonal demand of the products.
 To plan when to purchase and where to purchase.
 To avoid both overstock and understock of inventory
 To run production process efficient.
 To analyze and classify the inventory on basis of volume and value.
Requirements for Effective Inventory Management
Management has two basic functions concerning inventory. One is to establish a
system to keep track of items in inventory, and the other is to make decisions about how
much and when to order. To be effective, management must have the following:
1. A system to keep track of the inventory on hand and on order.
2. A reliable forecast of demand that includes an indication of possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
5. A classification system for inventory items.

A system to keep track of the inventory on hand and on order.

Inventory Counting Systems
- Periodic System - a physical count of items in inventory is made at periodic, fixed
intervals (e.g., weekly, monthly) in order to decide how much to order of each item.
- Perpetual Inventory System (aka continuous review system) - keeps track of
removals from inventory on a continuous basis, so the system can provide
information on the current level of inventory for each item.
- Two–bin System, a very elementary system, uses two containers for inventory.
- Universal Product Code (UPC), or bar code, printed on an item tag or on
packaging. A typical grocery product code is illustrated here:

- Point-of-sale (POS) Systems electronically record actual sales.

A reliable forecast of demand that includes an indication of possible forecast error.

Knowledge of lead times and lead time variability.
Demand Forecasts and Lead-Time Information
Managers need to know the extent to which demand and lead time (the time between submitting
an order and receiving it) might vary; the greater the potential variability, the greater the need for
additional stock to reduce the risk of a shortage between deliveries.
Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
Inventory Costs
Four basic costs are associated with inventories:
- Purchase cost is the amount paid to a vendor or supplier to buy the inventory. It is
typically the largest of all inventory costs.

- Holding, or carrying costs relate to physically having items in storage. Costs include
interest, insurance, taxes (in some states), depreciation, obsolescence, deterioration,
spoilage, pillerage, breakage, tracking, picking, and warehousing costs (heat, light,
rent, workers, equipment. security).
- Ordering costs are the costs of ordering and receiving inventory. They are the costs
that occur with the actual placement of an order.
o When a firm produces its own inventory instead of ordering it from a
supplier, machine setup costs are analogous to ordering costs; that is, they
are expressed as a fixed charge per production run, regardless of the size of
the run.
- Shortage costs result when demand exceeds the supply of inventory on hand. These
costs can include the opportunity cost of not making a sale, loss of customer
goodwill, late charges, backorder costs, and similar costs.

A classification system for inventory items.

Classification System
The A-B-C approach classifies inventory items according to some measure of importance,
usually annual dollar value (i.e., dollar value per unit multiplied by annual usage rate), and then
allocates control efforts accordingly.

3 Classes of Items
- A (very important)
o A items generally only account for about 10 to 20 percent of the number of
items in inventory but about 60 to 70 percent of the annual dollar value.
- B (moderately important)
- C (least important)
o C items might account for about 50 to 60 percent of the number of items but
only about 10 to 15 percent of the value of an inventory.
 Figure 13.1: A typical A-B-C breakdown in relative annual dollar value of
items and number of items by category
To conduct an A-B-C analysis, follow these steps:
1. For each item, multiply annual volume by unit price to get the annual dollar value.
2. Arrange annual dollar values in descending order.
3. The few (10 to 15 percent) with the highest annual dollar value are A items. The most
(about 50 percent) with the lowest annual dollar value are C items. Those in between
(about 35 percent) are B items.

Managers use the A-B-C concept in many different settings to improve operations.
- One key use occurs in customer service, where a manager can focus attention on the
most important aspects of customer service by categorizing different aspects as
very important, important, or of only minor importance.
- Another application of the A-B-C concept is as a guide to cycle counting, which is a
physical count of items in inventory.
The key questions concerning cycle counting for management are:
1. How much accuracy is needed?
2. When should cycle counting be performed?
3. Who should do it?
APICS recommends the following guidelines for inventory record accuracy:
o ± .2 percent for A items,
o ± 1 percent for B items,
o ± 5 percent for C items.
 A items are counted frequently
 B items are counted less frequently.
 C items are counted the least frequently.

Inventory Ordering Policies

Inventory ordering policies address the two basic issues of inventory management,
which are how much to order and when to order.
Inventory that is intended to meet expected demand is known as cycle stock, while
inventory that is held to reduce the probability of experiencing a stockout due to demand
and/or lead time variability is known as safety stock.
How much to order: Economic Order Quantity Models
EOQ models identify the optimal order quantity by minimizing the sum of certain annual
costs that vary with order size and order frequency. Three order size models are:
1. The basic economic order quantity model
2. The economic production quantity model
3. The quantity discount model

Basic Economic Order Quantity (EOQ) Model

It is used to identify a fixed order size that will minimize the sum of the annual costs of holding
inventory and ordering inventory.

The basic model involves a number of assumptions.

1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year so that the demand rate is reasonably
constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There is no quality discounts.
 Carrying/Holding Cost

Q
Annual Carrying Cost= H
2
Where:
Q = Order quantity in units
H = Holding (carrying) cost per unit per year

Ordering Cost

D
Annual Ordering Cost =S
Q
where
D = Demand, usually in units per year
S = Ordering cost per order
Total Cost

Q D
TC= ACC+ AOC + H+ S
2 Q

Basic Economic Order Quantity Formula

Q 0=
√ 2 DS
H
Q D
TC= H+ S
2 Q

Examples:

Economic Production Quantity (EPQ)

The assumptions of the EPQ model are similar to those of the EOQ model, except that
instead of orders received in a single delivery, units are received incrementally during
production. The assumptions are:
1. Only one product is involved
2. Annual demand is known
3. The usage rate is constant
4. Usage occurs continually, but production occurs periodically
5. The production rate is constant when production is occurring
6. Lead time is known and constant
7. There are no quantity discounts
Setup Cost
D
Annual SetupCost = S
Q

TC min=CC +SC= ( )I max

2
D
H+ S
Q

Where:
Imax = Maximum Inventory

Economic Product Quantity Formula

Q p=
√ √
2 DS
H
p
p−u
Where:
P = Production or Delivery rate
U = Usage rate
Qp
Cycle Time=
u
Qp
Runtime=
p
Qp
I max= ( p−u)
p
I max
I average=
2
Quantity Discount
Quantity discounts are price reductions for larger orders offered to customers to induce
them to buy in large quantities.

When quantity discounts are available, there are a number of questions that must be
addressed to decide whether to take advantage of a discount. These include:
1. Will storage space be available for the additional items?
2. Will obsolescence or deterioration be an issue?
3. Can we afford to tie up extra funds in inventory?

If the decision is made to take advantage of a quantity discount, the goal is to select the
order quantity that will minimize total cost, where total cost is the sum of carrying cost, order-ing
cost, and purchasing (i.e., product) cost:
When to order: Reorder Point Ordering
The goal in ordering is to place an order when the amount of inventory on hand is
sufficient to satisfy demand during the time it takes to receive that order (i.e., lead time). There
are four determinants of the reorder point quantity:
1. The rate of demand (usually based on a forecast)
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management
If demand and lead time are both constant, the reorder point is simply

When variability is present in demand or lead time, it creates the possibility that
actual demand will exceed expected (average) demand. Consequently, it becomes
necessary to carry additional inventory, called safety stock, to reduce the risk of running out of
inventory (a stockout) during lead time. The reorder point then increases by the amount of the
safety stock: