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Advances in Supply Chain

Management
Chapter 2a: Advancements in Inventory
Management

Lec 5 : Learning Objectives

Distinguish dependent from independent demand inventories

Describe the four basic types of inventories & their functions
Understand the costs of inventory & inventory turnovers
Understand ABC classification, ABC inventory matrix & cycle
counting
Know RFID & how it can be used in inventory management
Understand the EOQ model & its underlying assumptions
Understand the Quantity Discounts & the EMQ Models & their
relationships with the basic EOQ model
Understand & able to distinguish among the various statistical ROP
models
Describe the continuous review & periodic review systems

SUMMARY of Last Lecture

key performance measures are presented in detail in order to understand

the excellence a supply chain achieves. The focus was on the importance
of the integration of partners for the overall performance of the supply
chain. For the optimization of inventory, the main principle of inventory
management has to be considered: The objective is to balance the costs
arising from holding inventories and the benets of it. Furthermore, this
trade-off has to be handled for each separate component. In the coming
lectures, we will show how APS can support this critical task of
inventory management.
The focus of the present lecture is to present different concepts and
models, evolved over the period of time, that can be used inventory
management.

LAYOUT

Introduction
Dependent and Independent Demand of inventory
Concepts and Tools of Inventory Management
ABC Inventory Analysis System
RFID
Inventory Models
The continuous and periodic review system

Introduction (inventory management)

Inventory can be one of the most expensive assets of an organization
Inventory may account for more than 10% of total revenue or 20% of total
assets
Management must reduce inventory levels yet avoid stock outs and other
problems
Matching Demand and Supply
Suppliers must accurately forecast demand so they can produce & deliver
the right quantities at the right time at the right cost
Suppliers must find ways to better match supply & demand to achieve
optimal levels of cost, quality, & customer service to enable them to
compete with other supply chains
Problems that affect product & delivery will have ramifications
throughout the chain
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Dependent and Independent Demand

Inventory management models
Generally classified as dependent demand and independent demand
models

Dependent Demand
Describes the internal demand for parts based on the demand of the
final product in which the parts are used. Subassemblies,
components, & raw materials are examples of dependent demand items.

Independent Demand
The demand for final products & has a demand pattern affected by
trends, seasonal patterns, & general market conditions. Demand for tooth
paste, plasma TV, cars are example of independent demand.

Concepts and Tools of Inventory Management

Functions and Basic Types of Inventory
The primary functions of inventory are to
Buffer from uncertainty in the marketplace &
Decouple dependencies in the supply chain (e.g., safety stock)
Four broad categories of inventories (already discussed in detail in the last
lecture)
Raw materials- unprocessed purchase inputs.
Work-in-process (WIP)- partially processed materials not yet
ready for sales.
Finished goods- products ready for shipment.
Maintenance, repair & operating (MRO)- materials used in
production (e.g., cleaners & brooms).
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Contd.
Inventory Costs The cost of holding goods in stock. Expressed usually as a
percentage of the inventory value, it includes capital, warehousing,
depreciation, insurance, taxation, obsolescence and shrinkage costs.
In other words, Total Inventory Cost is the sum of the carrying cost and the
ordering cost of inventory
Total Inventory Cost Formula
TIC = C (Q/2) + F (D/Q)
Where,

C=Carrying cost per unit per year

Q=Quantity of each order
F=Fixed cost per order
D=Demand in units per year

Direct costs- directly traceable to unit produced (e.g., labor)

When determining and accounting for direct and indirect labor costs, it is
best to begin with the direct labor costs. Direct labor costs are those costs
accumulated as a result of workers producing the product. Because this
cost is a single cost, it is easier to determine than indirect labor costs.
Various factors can go into direct labor costs, but for the most part direct
labor can be determined by multiplying the number of units produced by
the number of hours required to produce the product. The resulting figure
then is multiplied by the cost of labor per hour to determine the direct
labor cost for that product. If multiple products are produced, the cost is
determined for each product and then added together.
Indirect costs- cannot be traced directly to the unit produced (e.g., overhead)
The indirect costs associated with the manufacturing process are any costs
not directly attributable to the cost of labor. Therefore, the simplest way to
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determine the total of a company's indirect costs is to use accounting

records to determine the overall expenditures and subtract the direct labor
costs from the total cost. Since many expenses are included in these
indirect costs, it may difficult to have an accurate and up-to-date figure.
Companies often will use estimates based on the previous year's
expenditures to determine these costs.
All the costs faced by companies can be broken into two main categories:
fixed costs and variable costs.
Fixed costs- Fixed costs are costs that are independent of output. These
remain constant throughout the relevant range and are usually considered
sunk for the relevant range (not relevant to output decisions). Fixed costs
often include rent, buildings, machinery, etc.
Variable costs- Variable costs are costs that vary with output. Generally
variable costs increase at a constant rate relative to labor and capital.
Variable costs may include wages, utilities, materials used in production,
etc.
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Order costs- direct variable costs for making an order. In mfg, setup costs are
related to machine setups - Ordering costs are costs of ordering a new
batch of raw materials. These include cost of placing a purchase order,
costs of inspection of received batches, documentation costs, etc.
Ordering costs vary inversely with carrying costs. It means that the more
orders a business places with its suppliers, the higher will be the ordering
costs. However, more orders mean smaller average inventory levels and
hence lower carrying costs. It is important for a business to minimize the
sum of these costs which it does by applying the economic order quantity
model.
Holding or carrying costs- incurred for holding inventory in storage- The
associated price of storing inventory or assets that remain unsold. Holding
costs are a major component of supply chain management, since
businesses must determine how much of a product to keep in stock.

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Holding costs include an opportunity cost because money thats tied up in

inventory cant benefit the company in another way, such as an
investment in new product development. In addition, maintaining
inventory levels greater than required to support a particular level of
customer service leads to unnecessary holding costs. To lower holding
costs, you can limit the volume of inventory you store in a warehouse and
limit the time the inventory stays there. This is especially important if you
use refrigerated warehouse space, a relatively expensive type of storage.
You can also control holding costs by improving warehouse space use -selecting the right warehouse design, for example, or using proper storage
methods.

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Contd.
Inventory Investment
Firms should diligently measure inventory investment to ensure
that it does not adversely affect competitiveness. Measures
include:

Absolute value of inventory (found on balance

sheet)
Inventory turnover or turnover ratio- how many
times inventory turns in an accounting period.
More is better because its faster!
Inventory Turnover Ratio =

Cost of Revenue
Average Inventory

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ABC Inventory Control System

ABC Inventory Control System
Determines which inventories should be counted &
managed more closely than others
Groups inventory as A, B, & C Items
A items are given the highest priority with larger safety stocks. A
items, which account for approximately 20% of the total items, are
about 80% of the total inventory cost
B & C items account for the other 80% of total items & only 20% of
costs. The B items require closer management since they are
relatively more expensive (per unit), require more effort to
purchase/make, & may be more prone to obsolescence
C items have the lowest value and hence lowest priority
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Inventory Models
The Economic Order Quantity (EOQ) Model
A quantitative decision model based on the trade-off between
annual inventory holding costs & annual order costs

The EOQ model seeks to determine an optimal

order quantity, where the sum of the annual order
cost & the annual inventory holding cost is
minimized.
Order Cost is the direct variable cost associated with
placing an order.
Holding Cost or carrying cost is the cost incurred for
holding inventory in storage.
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Assumptions of the EOQ Model

Demand must be known & constant.

Delivery time is known & constant.
Replenishment is instantaneous.
Price is constant.
Holding cost is known & constant.
Ordering cost is known & constant.
Stock-outs are not allowed.

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EOQ Model

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Ilustration

Inventory on hand & relationships to EOQ, average inventory, lead

time, reorder point, & order cycle

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EOQ for constant Demand & Lead Time

IP

On-hand inventory

IP
Order
received

Order
received

Order
received

Order
received

Q
OH

OH

IP

Q
OH

R
Order
placed

Order
placed
L

TBO

Order
placed
L

TBO

L
TBO
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Time

Impact of lead time and uncertainty in demand

Lead time has NO impact if the demand is
deterministic and at a constant rate.
Uncertainty in the demand creates the need for
safety stock
Lead time under uncertain demand requires
even a larger safety stock!

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EOQ for Uncertain Demand and Constant Lead Time

On-hand inventory

IP

IP

Order
received

Order
received

Order
received

Order
received
Q

Q
OH

L
TBO1

Order
placed

Order
placed

Order
placed

L
TBO2

L
TBO3
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Time

The Statistical Reorder Point (ROP)

The lowest inventory level at which a new order must be placed to
avoid a stock out.
Demand and delivery lead time are never certain and require safety
stock.

The models used under uncertainty are

Statistical ROP with Probabilistic Demand and Constant Lead Time
The Statistical ROP with Constant Demand and Probabilistic Lead
Time
The Statistical ROP when Demand and Lead Time are both
Probabilistic

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Finding Safety Stock

With a normal Probability Distribution, for an 85% Cycle-Service Level
Cycle-service level = 85%

Probability of stockout
(1.0 0.85 = 0.15)

Average
Average
demand
demand
(D)
during
during
lead
time
lead time

R
z L
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Finding Safety Stock and R

Records show that the demand for dishwasher detergent during
the lead time is normally distributed, with an average of 250
boxes and L = 22. What safety stock should be carried for a 99
percent cycle-service level? What is R?
Safety stock (SS)

Reorder point

= z L
= 2.33(22) = 51.3
= 51 boxes
= DL + SS
= 250 + 51
= 301 boxes

2.33 is the number of standard

deviations, z, to the right of
average demand during the lead
time that places 99% of the area
under the curve to the left of that
point.

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 The

Continuous Review System versus The Periodic Review

System
Order quantity & ROP models assume that the physical inventory is
precisely known at every point in time
Reality shows that stock records and actual quantity are different &
requires continuous review of inventory to determine when to reorder
A Continuous Review System is costly to conduct but requires less
safety stock than the
The Periodic Review System, which reviews physical inventory at
specific points in time and requires higher level of safety stock

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Continuous Review Systems

r point

Selecting the reorder point with variable demand and

constant lead time
= Average demand during lead time
+ Safety stock
=

dL + safety stock

Where
d = average demand per week (or day or months)
L = constant lead time in weeks (or days or months)

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Demand During Lead Time

Specify mean and standard deviation
Standard deviation of demand during lead time
dLT =

d2L = d

Safety stock and reorder point

Safety stock = zdLT
where
z = number of standard deviations needed to achieve the
cycle-service level
dLT =
stand deviation of demand during lead time

Reorder point R = dL + safety stock

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Continuous Review Systems General Cost Equation

Calculating total systems costs
Total cost =

Annual cycle inventory holding cost

+ Annual ordering cost
+ Annual safety stock holding cost

Q
D
C = 2 (H) +
(S) + (H) (Safety stock)
Q

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Periodic Review System (P)

Fixed interval reorder system or periodic reorder system
Four of the original EOQ assumptions maintained

No constraints are placed on lot size

Holding and ordering costs
Independent demand
Lead times are certain

Order is placed to bring the inventory position up to the

target inventory level, T, when the predetermined time,
P, has elapsed

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Periodic Review System (P)

On-hand inventory

IP
Q1

IP

Order
received
OH

Order
received

Q2

IP
Q3

Order
received

OH

IP1
IP3

Order
placed

Order
placed

IP2

L
P

L
P

Protection interval
Figure 12.10 P System When Demand Is Uncertain
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Time

How Much to Order in a P System

EXAMPLE
A distribution center has a backorder (BO) for five 36-inch color TV sets.
No inventory is currently on hand (OH), and now is the time to review.
How many should be reordered if T = 400 and no receipts are scheduled
(SR)?
SOLUTION
IP = OH + SR BO
= 0 + 0 5 = 5 sets
T IP = 400 (5) = 405 sets
That is, 405 sets must be ordered to bring the inventory position
up to T sets.

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Inventory Management Example 1

An auto parts supplier sells Hardy-brand batteries to car dealers and auto
mechanics. The annual demand is approximately 1,200 batteries. The
supplier pays $28 for each battery and estimates that the annual
holding cost is 30 percent of the battery's value. It costs approximately
$20 to place an order (managerial and clerical costs). The supplier
currently orders 100 batteries per month.
a. Determine the ordering, holding, and total inventory costs for the
current order quantity.
b. Determine the economic order quantity (EOQ).
c. How many orders will be placed per year using the EOQ?
d. Determine the ordering, holding, and total inventory costs for the
EOQ. How has ordering cost changed? Holding cost? Total inventory
cost?
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Contd.

Solution, We are given the following information:

annual demand: D = 1200 batteries per year
item cost: c = $28 per battery
holding cost: C=H= ic = 30% of (28) = $8.40 per battery per year
order cost: F=S= $20 per order
current order quantity: Q = 100 batteries

a. The current ordering and holding costs are: TIC = C (Q/2) + F (D/Q)
= 100/2(8.40) +1200/100(20) = 420 + 240 = $660.

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Contd.

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EXAMPLE 2
Foster Drugs, Inc., handles a variety of health and beauty aid products. A
particular hair conditioner product costs Foster $2.95 per unit. The annual
holding cost rate is 20 percent. Using an EOQ model, they determined
that an order quantity of 300 units should be used. The lead time to
receive an order is one week, and the demand is normally distributed with
a mean of 150 units per week and a standard deviation of 40 units per
week.
a. What is the reorder point if the firm is willing to tolerate a 1-percent chance
of a stock out during an order cycle?
b. What safety stock and annual safety stock cost are associated with your
recommendation in part a?
c. Foster is considering making a transition to a periodic-review system in an
attempt to coordinate ordering of some of its products. The review period
would be two weeks and the delivery lead time would remain one week.
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What target inventory level would be needed to ensure the same 1-percent
risk of stockout?
d. What is the safety stock associated with your answer to part c? What is the
annual cost associated with holding this safety stock?
e. Compare your answers to parts b and d. If you were the manager of Foster
Drugs, would you choose a continuous- or periodic-review system?

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Radio Frequency Identification (RFID)

Radio Frequency Identification (RFID)
Successor to the barcode for tracking individual unit of goods. RFID
does not require direct line of sight to read a tag and information on the
tag is updatable.
RFID Tags (Transponders)

Readers

Information Infrastructure (Local/ERP Servers)

Item

Box

Hand Held Readers

Shelf Readers
Fixed Portal Readers

Database
RFID Middleware
Local / ERP Server

Pallet
Crate

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RFID
Automates the supply chain:
Materials Management goods automatically counted and logged as
they enter the supply warehouse
Manufacturing assembly instructions encoded on RFID tag provide
information to computer controlled assembly devices
Distribution Center shipment leaving DC automatically updates
ERP to trigger a replenishment order and notify customer for delivery
tracking
Retail Store no check out lines as scanners link RFID tagged goods
in shopping cart with buyers credit card

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SUMMARY
The present lecture has further analyzed the concepts and models related
to inventory management. It included basic types of inventories,
distinguished between independent and dependent demand, cost of
inventories and their turnover. Explanation of ABC classification was
also included. How RFID can be used in inventory management, EOQ
model and its underlying assumption, the relationship of quantity discount
and EMQ models with EOQ model. Further distinguished among various
statistical ROP models and described the continuous and periodic review
system of inventory management. The purpose is the optimization of
inventory: to balance the costs arising from holding inventories and the
benets of it. In the coming lectures, we will show how APS can support
this critical task of inventory management.

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