Inventory Management

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• 1. Explain the terms inventory and inventory management.
• 2. Determination of investment in inventory.
• 3. Costs in inventory.
• 4. Calculate the optimal order quantity (EOQ / Economic Order Quantity)
• 5. Inventory control system using ABC method, just in time, & computer control system.

Inventory management

• The firm’s financial manager must arrange the firm’s inventory policy and ensure the firm’s overall profitability.
• Therefore, the role of the inventory manager is to balance the costs and benefits associated with inventory.
• Because excessive inventory uses cash, efficient management of inventory increases firm value.

An inventory is a stock or store of goods. Firms typically stock hundreds or even thousands of items in inventory, ranging from small things such as pencils, paper clips, screws, nuts, and bolts to large items such as machines, trucks, construction equipment, and airplanes.

independent-demand items, that is, items that are ready to be sold or used

dependent-demand items, which are components of finished products, rather than the finished products themselves

Types of inventories

Raw materials

To make the final product

purchasing and production executives

Work-in process

Intermediate stage of production

production executives

Finished goods

Goods ready to sale

production and marketing executives

Types of inventories

• Raw materials are materials and components that are inputs in making the final product.

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• Work-in process, also called stock-in-process, refers to goods in the intermediate stages of production.

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• Finished goods consist of final products that are ready for sale. While manufacturing firms generally hold all the three types of inventories, distribution firms hold mostly finished goods.

Inventory management

• Inventories represent the second largest asset category for manufacturing companies, next only to plant and equipment.

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• The proportion of inventories to total assets generally varies between 15 and 30%.

Inventory management

• Decisions relating to inventories are taken primarily by executives in production, purchasing, and marketing departments.
• Raw material policies are shaped by purchasing and production executives
• Work-in-process inventory is influenced by the decisions of production executives
• Finished goods inventory policy is evolved by production and marketing executives
• Yet, as inventory management has important financial implications, the financial manager has the responsibility to ensure that inventories are properly monitored and controlled.

Objectives of Inventory management

REQUIREMENTS FOR EFFECTIVE INVENTORY MANAGEMENT

• The level of customer service
• Costs of ordering and carrying inventories

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• Timing and size of orders
• customer satisfaction
• Optimize inventory turnover

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• A system to keep track of the inventory on hand and on order.
• A reliable forecast of demand →includes an indication of possible forecast error.
• Knowledge of lead times and lead time variability
• Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
• A classification system for inventory items.

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Benefits of Holding Inventory

• A firm needs its inventory to operate for several reasons.
• First, inventory helps minimize the risk that the firm will not be able to obtain an input it needs for production.
• If a firm holds too little inventory (or stock-outs), it will lead to lost sales. Disappointed customers may switch to one of the firm’s competitors.
• Second, firms may hold inventory because factors such as seasonality in demand mean that customer purchases do not perfectly match the most efficient production cycle.

THE NATURE AND IMPORTANCE OF INVENTORIES

• Raw materials and purchased parts.
• Partially completed goods, called 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).

• To meet anticipated customer demand: anticipation stocks → satisfy expected (i.e., average ) demand
• To smooth production requirements: seasonal inventories
• To decouple operations
• To reduce the risk of stockouts: safety stocks → variabilities in demand and lead time
• To take advantage of order cycles.: in economic lot sizes → periodic orders or order cycles
• To hedge against price increases.
• To permit operations: . Little's Law: pipeline inventories

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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: (also known as a 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. When the amount on hand reaches a predetermined minimum, a fixed quantity, Q, is ordered. An obvious advantage of this system is the control provided by the continuous monitoring of inventory withdrawals.
• Two-bin system: A very elementary system, uses two containers for inventory. Items are withdrawn from the first bin until its contents are exhausted. It is then time to reorder. Sometimes an order card is placed at the bottom of the first bin. The second bin contains enough stock to satisfy expected demand until the order is filled, plus an extra cushion of stock that will reduce the chance of a stockout if the order is late or if usage is greater than expected.
• Universal product code (UPC): computerized checkout systems using a laser scanning device that reads a universal product code (UPC) , or bar code, printed on an item tag or on packaging

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Inventory Counting Systems (contd.)

Costs of Inventory

• Point-of-sale (POS) systems: Electronically record actual sales. Knowledge of actual sales can greatly enhance forecasting and inventory management: By relaying information about actual demand in real time, these systems enable management to make any necessary changes to restocking decisions.

Radio frequency identification (RFID) tags are also used to keep track of inventory in certain applications

Ordering costs

e.g. expediting, transport

Carrying (holding) costs

e.g. storage, insurance, taxes

Shortage costs

e.g. safety stock

Ordering costs

Carrying costs

• Ordering costs relating to purchased items would include expenses on the following: requisitioning, preparation of purchase order, expediting, transport, and receiving and placing in storage.
• Ordering costs pertaining to items manufactured in the company would include expenses on the following: requisitioning, set-up, and receiving and placing in storage.

• Carrying costs include expenses on the following: interest on capital locked up in inventory, storage, insurance, and obsolescence.
• Carrying costs generally are about 25 percent of the value of inventories held.

Shortage costs

• Shortage costs arise when inventories are short of requirement for meeting the needs of production or the demand of customers.
• Inventory shortages may result in one or more of the following: high costs concomitant with 'crash' procurement, less efficient and uneconomic production schedules, and customer dissatisfaction and loss of sales.
• Measurement of shortage costs when shortage results in failure to meet customer demand is relatively difficult because the effects are both long-term and short-term and somewhat intangible in nature.
• When a firm orders large quantities, in a bid to reduce the total ordering costs, the average inventory, other things being equal, tends to be high thereby increasing the carrying costs.
• Also, when a firm carries a large safety stock to reduce shortage costs its carrying costs tend to be high. In view of such relationships, minimisation of overall costs of inventory management would require a consideration of trade-offs among these costs.

Classification System

• Allocate control efforts according to the relative importance of various items in inventory
• A-B-C approach: A (very important), B (moderately important), and C (least important)
• Measurement of shortage costs when shortage results in failure to meet customer demand is relatively difficult because the effects are both long-term and short-term and somewhat intangible in nature.
• When a firm orders large quantities, in a bid to reduce the total ordering costs, the average inventory, other things being equal, tends to be high thereby increasing the carrying costs.
• Also, when a firm carries a large safety stock to reduce shortage costs its carrying costs tend to be high. In view of such relationships, minimisation of overall costs of inventory management would require a consideration of trade-offs among these costs.

To solve an A-B-C problem, 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.

Inventory Management Techniques – THE ABC APPROACH

• The ABC approach is a simple approach to inventory management in which the basic idea is to divide inventory into three (or more) groups.
• The underlying rationale is that a small portion of inventory in terms of quantity might represent a large portion in terms of inventory value.
• For example, this situation would exist for a manufacturer that uses some relatively expensive, high-tech components and some relatively inexpensive basic materials in producing its products.

Inventory Management Techniques – THE ABC APPROACH

THE ABC APPROACH

• Figure illustrates an ABC comparison of items in terms of the percentage of inventory value represented by each group versus the percentage of items represented.
• As Figure shows, the A Group constitutes only 10 percent of inventory by item count, but it represents more than half of the value of inventory.
• The A Group items are thus monitored closely, and inventory levels are kept relatively low.
• At the other end, basic inventory items, such as nuts and bolts, also exist; but, because these are crucial and inexpensive, large quantities are ordered and kept on hand. These would be C Group items.
• The B Group is made up of in-between items.

Classification System (contd.)

Costs of Holding Inventory – GAP example

• The benefits from reducing inventory requirements can be substantial.
• In 2003, the apparel chain GAP reduced its investment in inventory significantly by reducing its inventory days outstanding by 24%.
• This change gave $344 million for other purposes.
• GAP invested some of this cash in short-term securities—primarily in U.S. government and agency securities and in bank certificates of deposits with maturities between three months and one year.
• The firm reported an increase of $1.2 million in interest income in fiscal year 2003 compared with fiscal year 2002.
• It attributed the increase to increases in the average cash balances available for investment

Costs of Holding Inventory - just-in-time inventory management

• Some firms seek to reduce their carrying costs as much as possible.
• With “just-in-time” ( JIT) inventory management, a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it.

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• This technique requires:
• 1. exceptional coordination with suppliers
• 2. predictable demand for the firm’s products
• 3. good production planning is also essential

Just-in-Time Inventory

• The approach began in Japan, and it is a fundamental part of Japanese manufacturing philosophy. The goal of JIT is to have only enough inventory to meet immediate production needs.
• The result of the JIT system is that inventories are reordered and restocked frequently. Making such a system work and avoiding shortages requires a high degree of cooperation among suppliers.
• Japanese manufacturers often have a relatively small, tightly integrated group of suppliers with whom they work closely to achieve the needed coordination.
• These suppliers are a part of a large manufacturer’s (such as Toyota’s) industrial group, or keiretsu. Each large manufacturer tends to have its own keiretsu. It also helps to have suppliers located nearby, a situation that is common in Japan.

The economic order quantity

• This classical stock management model calculates an optimum order size by balancing the costs of holding stock against the costs of ordering fresh supplies.

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• This optimal order size is the basis of a minimum cost policy.

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• The economic order quantity model assumes that, for the period under consideration (usually one year), costs and demand are constant and known with certainty.

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 (i.e., running out of stock) due to demand and/or lead time variability is known as safety stock .

The economic order quantity

Inventory Cycle

Basic Economic Order Quantity (EOQ) Model

Annual carrying cost is computed by multiplying the average amount of inventory on hand by the cost to carry one unit for one year, even though any given unit would not necessarily be held for a year.

The average inventory is simply half of the order quantity: The amount on hand decreases steadily from Q units to 0, for an average of ( Q + 0)/2, or Q /2.

The number of orders per year will be D/Q, where D is Annual demand and Q is Order size.

Basic Economic Order Quantity (EOQ) Model

• The minimum total cost occurs when holding costs and ordering costs are equal, i.e., the economic order minimises the sum of holding costs and ordering costs quantity, i.e. the order quantity which

An expression for the optimal order quantity, , can be obtained using calculus

Basic Economic Order Quantity (EOQ) Model

Economic Production Quantity (EPQ)

periodically produce such items in batches, or lots, instead of producing continually.

The batch mode is widely used in production. Even in assembly operations, portions of the work are done in batches. The reason for this is that in certain instances, the capacity to produce a part exceeds the part's usage or demand rate. As long as production continues, inventory will continue to grow. In such instances, it makes sense to periodically produce such items in batches, or lots, instead of producing continually.

EPQ

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.

EPQ (contd.)

Economic run/production quantity is given as:

Quantity Discounts

Quantity discounts are price reductions for larger orders offered to customers to induce them to buy in large quantities.

Inclusion of unit price in the total-cost computation in that case would merely increase the total cost by the amount P times D. A graph of total annual purchase cost versus quantity would be a horizontal line. Hence, including purchasing costs would merely raise the total-cost curve by the same amount ( PD ) at every point. That would not change the EOQ.

Note that no one curve applies to the entire range of quantities; each curve applies to only a portion of the range. (See Figure 13.8 .) Hence, the applicable or feasible total cost is initially on the curve with the highest unit price and then drops down, curve by curve, at the price breaks, which are the minimum quantities needed to obtain the discounts. Thus, in Table 13.2 , the price breaks for gauze strips are at 45 and 70 boxes. The result is a total-cost curve with steps at the price breaks.

Quantity Discounts

Quantity Discounts

Quantity Discounts

REORDER POINT ORDERING

The reorder point occurs when the quantity on hand drops to a predetermined amount in perpetual inventory monitoring

REORDER POINT ORDERING

The customer service level increases as the risk of stockout decreases. Order cycle service level can be defined as the probability that demand will not exceed supply during lead time (i.e., that the amount of stock on hand will be sufficient to meet demand). Hence, a service level of 95 percent implies a probability of 95 percent that demand will not exceed supply during lead time. An equivalent statement that demand will be satisfied in 95 percent of such instances does not mean that 95 percent of demand will be satisfied. The risk of a stockout is the complement of service level; a customer service level of 95 percent implies a stockout risk of 5 percent.

Service level = 100 percent - Stockout risk

REORDER POINT ORDERING

REORDER POINT ORDERING

REORDER POINT ORDERING

FIXED-ORDER INTERVAL MODEL

The fixed-order-interval (FOI) model is used when orders must be placed at fixed time intervals (weekly, twice a month, etc.): The timing of orders is set.

Reasons for Using the Fixed-Order-Interval

Model In some cases, a supplier's policy might encourage orders at fixed intervals. Even when that is not the case, grouping orders for items from the same supplier can produce savings in shipping costs. Furthermore, some situations do not readily lend themselves to continuous monitoring of inventory levels.

FIXED-ORDER INTERVAL MODEL

THE SINGLE-PERIOD MODEL

The single-period model (sometimes referred to as the newsboy problem ) is used to handle ordering of perishables (fresh fruits, vegetables, seafood, cut flowers) and items that have a limited useful life (newspapers, magazines, spare parts for specialized equipment). The period for spare parts is the life of the equipment, assuming that the parts cannot be used for other equipment.

Shortage cost

Excess cost

Continuous Stocking Levels

THE SINGLE-PERIOD MODEL

THE SINGLE-PERIOD MODEL

Discrete Stocking Levels

THE SINGLE-PERIOD MODEL

THE SINGLE-PERIOD MODEL

THE SINGLE-PERIOD MODEL

THE SINGLE-PERIOD MODEL

OPERATIONS STRATEGY

Record keeping.

Variation reduction

Lean operation

Supply chain management

The economic order quantity model - American version

The economic order quantity model - Indian version

• For determining the EOQ formula we shall use the following symbols:
• U = annual usage/demand
• Q = quantity ordered
• F = cost per order
• C = percent carrying cost
• P = price per unit
• TC = total costs of ordering and carrying

Example