MGMT 346 Chapter 20 Inventory Management

All Firms Keep a Supply of Inventory for the Following Reasons

*1) Maintain Independence of Operations* - supply of materials at a work center allows that center flexibility in operations - independence of workstations is desirable on assembly line, time it takes to do identical operations will naturally vary from one unit to the next - having a cushion of several parts is desired bc shorter performance times can compensate for longer performance times *2) To Meet Variation in Product Demand* - if demand of product is known precisely, it may be possible to produce the product to exactly meet the demand - if demand is not completely known, a safety or buffer stock must be maintained to absorb variation *3) To Allow Flexibility in Production Scheduling* - stock of inventory relieves the pressure on the production system to get the goods out - causes longer lead times, which permit production planning for smoother flow and lower-cost operation *4) To Provide a Safeguard for Variation in Raw Material Delivery Time* - when material is ordered from a vendor, delay can occur for a variety of reasons: (1) normal variation in shipping time, (2) shortage of material at vendor plant, (3) unexpected strike at vendors plant/shipping co, (4) lost order, (5) shipment of incorrect or defective material *5) To take Advantage of Economic Purchase Order Size* - cost to place an order: (1) labor, (2) phone calls, (3) typing (4) postage, etc - large each order is, the fewer orders that need to be written - shipping costs favor larger orders (larger the shipment, the lower the per-unit cost) *6) Many Other Domain-Specific Reasons* - inventory is costly and large amount are undesirable - long cycle times are caused by large amount of inventory

Multiperiod Inventory Systems

*1. Fixed-Order Quantity Model* - called economic order quantity, EOQ and Q-model) - inventory control model where the amount requisitioned is fixed and actual ordering is triggered by inventory dropping to a specified level of inventory - *are event triggered* - initiates an order when the event of reaching a specified reorder level occurs - event may take place at any time, depending on demand for item - requires that inventory remaining be continually monitored - *perpetual system* that requires an update record every time a withdrawal from inventory or addition is made - attempts to determine the specific point (R) at which an order will be placed and size of that order (Q) - R is always a specified number of units, whereas the order of size Q is placed where inventory available reaches R *2. Fixed-Time Period Models* - called periodic system, periodic review system, fixed-order interval system, P-Model) - an inventory control model that specifies inventory is ordered at the end of predetermined time period - interval of time between orders is fixed and order quantity varies - *are "time" triggered* - initiates an order at the end of a predetermined time period - counting takes place only at the review period - decision to place an order is made after the stock has been counted or reviewed - inventory is counted only at particular times (such as every week or every month) - *is desirable when (1) vendors make routine visits to customers and take orders for their complete line of products, (2) when buyers want to combine orders to save transportation costs, (3) firms that want to facilitate planning inventory count - generate order quantities that vary from period to period, depending on usage rates - *requires higher level of safety stock than fixed-order quantity systems - assume that inventory is counted only at the time specified for review *both multi period inventory system* - are designed to ensure that an item will be available on an ongoing basis throughout the year - items will be ordered multiple times through the year where logic in system dictates actual quantity ordered and timing of order

Inventory Costs (Costs Associated with Inventory Management)

*1. Holding (or carrying) costs* - *includes* the costs for storage facilities, handling, insurance, pilferage, breakage, obsolescence, depreciation taxes, and opportunity cost of capital - *high holding costs* tend to favor (1) low inventory levels and (2) frequent replenishment *2. Setup (or production change) costs* - *to make product involves* (1) obtaining necessary materials, (2) arranging specific equipment setups, (3) filling out the required papers, (4) appropriately charing time and materials, (5) moving out the previous stock of material - *goal of JIT system* is to reduce setup costs to permit smaller lot sizes *3. Ordering costs* - refers to managerial and clerical costs to prepare purchase or production order - *includes* all the details such as counting items and calculating order quantities - includes costs associated with maintaining the system needed to track orders *4. Shortage costs* - when stock of an item is depleted, an order for that item must either wait until stock is replenished or be canceled - *stockout* occurs when the demand is not met and the order is canceled (running out of inventory) - *backorder* is when the order is held and filled at a later date when inventory for item is replenished

Examples of Service and Manufacturing Applications Single-Period Inventory Models are useful for

*1. Overbooking of Airline Flights* - is common for customers to cancel flight reservations for a variety of reasons - *the cost of underestimating* the number of cancellations is revenue lost due to an empty seat on flight - *the cost of overestimating* cancellations is the award (such as free flights or cash payments) given to customers unable to board *2. Ordering of Fashion Items* - problem is that often only a single order can be placed for entire season - is often caused by long lead times and limited life of merchandise - *cost of underestimating* demand is lost profit due to sales not made - *cost of overestimating* demand is cost that results when it is discounted *3. Any Type of One-Time Order* - ordering T-shirts for a sporting event or printing maps that become obsolete after a certain time period

NOTE

*easiest time for stock to be counted* is when there is no activity in the stockroom or the production floor - meaning on weekends or during the second and third shift when facility is less busy *recommended accuracy level by experts between physical inventory and records is*: - +-0.2% for A items, +-1% for B items, +-5% for C items

NOTE

*manual systems such as simple two-bin logic depend on* - human posting of the transactions to replenish inventory - relatively expensive compared to using a computer to automatically detect when an item needs to be ordered - *Integration* relates to how connected system are *Risk of Obsolescence* - *if an item is used infrequently or only for a very specific purpose*, there is considerable risk in using inventory control logic that does not rack specific source of demand - *if items are sensitive to technical obsolescence*, (computer memory chips or processors) they need to be managed carefully based on actual need to reduce risk of getting stuck with inventory outdated

Inventory Management (Softchalk)

*two basic purposes of inventory analysis* - are to (1) determine the quantity of inventory items to order and (2) when to order them *GOAL OF MANAGING INVENTORY* - is to have the right amount of inventory available at the right time and to minimize the annual total cost of managing it *TO MANAGE INVENTORY EFFECTIVELY* - operations managers must provide the organizational structure and operating policies for maintaining and controlling the goods to be stocked

NOTE

- *Retail Inventory* is for immediate sale to customers - *Service Inventory* refers to the tangible goods to be sold and the supplies necessary to administer the service - *Warehouse Inventory* refers to finished goods inventory in a distribution center

Multiple-Period Systems (softchalk)

- *exist* for items that are purchased periodically and inventory needs to be kept in stock to meet demand - *are designed* to ensure that an item will be available on an ongoing basis throughout the year. - *two types*: (1) *fixed-order quantity models* (also called economic order, EOQ, perpetual system, continuous system, and Q-model) (2) *fixed-period (time) models* (also referred to as the periodic system, period review system, fixed-order interval system, and P-model).

NOTE (softchalk)

- *holding safety stock is very expensive because those items are carried "in case" you need them*. They may not be sold and keeping them on hand increases the average level of inventory and the annual holding cost - *think of inventory as money sitting on the shelf, floor, stockroom, forklift etc*, if you have it around, it is costing you money.

Safety Stock

- *in the majority of cases demand is not constant*, it rather varies from day to day resulting in a safety stock being maintained to provide some level of protection against stockouts - safety stock inventory levels are determined by the probability of stock out at a given desired service level *Safety Stock*: - amount of inventory carried in addition to the expected demand - amount of safety stock depends on the service level desired - in moral distribution this would represent the mean - determined based on many different criteria - *common approach* is for a company to state that a certain number of weeks of supply needs to be kept in safety stock

Price-Break Model (softchalk)

- *often called the quantity discount model*, is used when the purchase price of an item is lowered because the customer orders a larger quantity from the supplier - *is an attractive offer unless* you do not have space available to store the larger order or the additional cost of storing it becomes prohibitive - *If a larger quantity is ordered,* there will be fewer orders placed and the purchase cost will be less because of the discount. - *larger order quantity means* that the average inventory will increase and so will the annual holding cost. - *ordering a larger quantity makes sense only if the* savings on the annual ordering cost and purchase costs are enough to offset the increased annual holding cost. - *optimal order quantity* is the one that yields the least annual total cost

NOTE

- A quick way to find the exact number of standard deviations needed for a given probability of stocking out is with the NORMSINV(probability) function on Microsoft Excel - *Optimal Stocking Level* using marginal analysis, occurs at the point where the expected benefits derived from carrying the next unit are less than the expected costs for that unit Co = Cost per unit of demand overestimated Cu = Cost per unit of demand underestimated *expected marginal cost equation* p(Co) < (1-P)Cu - p = the cumulative probability that the unit will not be sold - (1-p) = the probability of the unit being sold bc one or the other must occur (unit is sold or unit is not sold) - states that we should increase the size of the order so long as the probability of selling what we order is equal to or less than the ratio Cu/(Co+Cu)

Which of the following is NOT a good reason to hold inventory?

- As needed to improve company cash flow GOOD REASONS to hold inventory include: - to build a bank of finished goods to protect customers from a potential strike at your plant - To buy ahead in anticipation of significant raw material price increases - As needed to shift from one raw material supplier to another

Example of Dependent vs Independent Demand

- If an car company plans on producing 50 cars per day, then it will need 2,000 wheels and tires (plus spares). - *dependent* is the number of wheels, tires, engines, transmissions, which is dependent on the production level and is not derived separately - *independent* is the demand for cars, it comes from many sources external to car firm and is not part of other products (unrelated) (vans, trucks)

Because this simple model assumes constant demand and lead time, neither _______ stock nor ________ cost is necessary

- Safety - Stockout

Inventory Turn

- a measure of the expected number of times inventory is replaced over a year - is a key measure that relates to company performance - *important for managers to realize that* how they run items using inventory control logic relates directly to the financial performance of the firm *formula* Inventory Turns = (Cost of Goods Sold)/(Average Inventory Value)

Cycle Counting

- a physical inventory-taking technique in which inventory is counted on a frequent basis rather than once or twice a year - depends on the available personnel - *key to effective cycle counting* lies in deciding which items are to be counted, when, and by whom

ABC Inventory Classfication

- a scheme that divides inventory into dollar volume categories that map into strategies appropriate for the categories - if annual usage of items in inventory is listed by dollar volume, a small number of items account for a large dollar volume and a large number of items account for a small dollar volume - *objective* is to try to separate the important from the unimportant - *purpose of classifying items into groups* is to establish the appropriate "degree of control" over each item - *three grouping of inventory items* (1) high dollar volume (A) - top 15% of items (2) moderate dollar volume (B) - next 35% of items (3) low dollar volume (C) - last 50% of items *dollar volume* is a measure of the importance - an item low in cost but high in volume can be more important than a high-cost item with low volume

Inventory

- all the money that the system has invested in purchasing thing sit intends to sell - is the stock of any item or resource used in an organization - refers to any "tangible" goods and the "supplies" necessary to administer the service

Inventory Position

- amount on-hand plus on-order minus backordered quantity - when inventory has been allocated for special purposes, inventory position is reduced by these allocated amounts

Reorder Point (R)

- an order is placed when inventory drops to this level

Single-Period (Newsperson) Problem

- answers the questions of how much to order when an item is purchased only one time and it is expected that it will be used and then not reordered *example* - consider the problem that a newsperson has in deciding how many newspapers to put in sales stand outside a hotel lobby each morning - if the person does not put enough papers, some customers will not be able to purchase a paper and news person will lose profit - if the person puts to many papers, they will have paid for papers that were not sold during the day, lowering profit of the day - *think about single-period* as how much risk we are willing to take for running out of inventory

Probability Approach to Determining Safety Stock

- assume that the demand over a period of time is normally distributed with a mean and standard deviation - *this approach considers* only the probability of running out of stock, not "how many units" we are short - *to determine the probability of stocking out over time* plot a normal distribution of the expected demand and where the amount we have on hand lies on curve - *common for companies using the probability approach* to set the probability of not stocking out at 95%

ABC Approach (softchalk)

- classifies inventory items according to some measure of importance, usually annual dollar usage or value and then allocates control efforts accordingly. - *three classes of items are used:* A (very important), B (moderately important), and C (least important). - *A items should be monitored closely using a perpetual system*, while *B and C items* only need to be monitored periodically. - Because of their higher level of importance, compared to C items, B items may be monitored using shorter review periods than C items.

Independent Demand

- demands for these items are unrelated to each other, or to activities that can be predicted with certainty - demand for various items are unrelated to each other - is demand that comes from sources external to the firm and not related to other products - are items purchased from a vendor - *required quantities* are computed based on a firm's sales and market research departments

Fixed-Order Quantity Model with Safety Stock

- fixed-order quantity system perpetually monitors the inventory level and places a new order when stock reaches some level, R - *danger of stockout i this model occurs* during the lead time, between the time an order is placed and time it is received - *an order is placed* when inventory position drops to the reorder point, R - *during the lead time, L*, a range of demands is possible which is determined by either an analysis of past demand data or from an estimate - *key difference between a fixed-order quantity model where demand is known and one where demand is uncertain*, is in computing the reorder point, the order quantity is the SAME in both

NOTE

- in both the fixed-order quantity model and fixed-time period model for safety stock, assume that when going through an order cycle half the time we need to use safety stock and half the time we do not - on average we expect the safety stock to be on hand

Villefredo Pareto

- in the 19th century found in a study of the distribution of wealth in Milan, that 20% of people controlled 80% of the wealth *Pareto Principle* - "few having the greatest importance, and the many having little importance" - *true in everyday life* that most of our decisions are relatively unimportant, but few shape our future - *true in inventory system* where a few items account for the bulk of our investments - means that 20% of the items account for 80% of the total inventory cost

Distribution Inventory

- inventory is classified as in-transit, meaning that it is being moved in the system, and warehouse, which is inventory in a warehouse or distribution center

Fixed-Time Period Method (softchalk)

- inventory is counted only at particular times, such as every week or every month - Another name for this model would be the P (for period) model. - *generates* a different order quantity each time an order is placed at specified intervals - we will solve for q, rather than Q - *is unique in that the average demand and safety stock must* cover both the time between orders as well as the lead time - *order amount is reduced* by the amount of inventory that is on hand and/or on order.

NOTE

- inventory records usually differ from the actual physical count - *inventory accuracy* refers to how well the two agree, how well the information records and physical count agree - *use of barcodes and RFID tags* are important ways to keeping a firm's inventory records accurate and up-to-date, through minimizing errors caused by inputting wrong numbers in the system

Customer Order Decoupling Point

- is a point where the inventory is positioned to allow processes or entities in the supply chain to operate independently - *selection of decoupling point* is a strategic decision that determines customer lead times and impacts inventory investment - *close the point is to the customer* the quicker the customer can be served - *trade-off* is where quicker response to customer demand comes at the expense of greater inventory investment (bc finished goods inventory is more expensive than raw material inventory) - *single decoupling point in a supply chain is* UNREALISTIC

Transaction Cost

- is dependent on the level of integration and automation incorporated in the system

Single-Period Model (softchalk)

- is for "one-off" events that happen one time and do not reoccur on a regular basis - In this situation you will not be ordering the exact same inventory item repeatedly because the item is perishable and will become obsolete after the event occurs - *describes this as the classic "newsperson" problem* because the task is to determine how many current editions of newspapers or magazines should be ordered, knowing that they will become obsolete once the next issue is published - *applications in service and manufacturing such as* (1) overbooking of airline flights and hotel rooms, and (2) ordering fashion items in a single order - *calculates a service level* based on the costs of over- and underestimating demand. - *service level measures* the performance of inventory replenishment policies and quantifies the probability of not stocking out during the lead time - *risk of a stock out is 100% minus the service level* (1 - the service level) - Holding only enough inventory to cover average demand results in a 50% service level. - *to increase the service level it is necessary to carry safety stock* - High service levels, i.e., 90%, 95%, or 98%, require greater amounts of safety stock.

Basic Distinction Between Two Multiple-Period System (Softchalk)

- is that *fixed-order quantity models* are "event triggered" and *fixed-period models* are "time triggered." - *To use a fixed-quantity model*, inventory is monitored perpetually or continuously, and an order is placed for a predetermined fixed-quantity (Q) whenever stock falls to a predetermined reorder point (R). - *reorder point is the simplest of situations*; both the demand and the lead time are constant which results in no safety stock being held.

Inventory System

- is the set of policies and controls that monitor levels of inventory and determine (1) what levels should be maintained, (2) when stock should be replenished, (3) how large orders should be

Basic Purpose of Inventory Analysis

- no matter manufacturing, distribution, retail, or service the purpose of inventory analysis is to specify: 1) when items should be ordered 2) how large the order should be

Inventory Control System

- provides the organizational structure and operating policies for maintaining and controlling goods to be stocked - is responsible for (1) ordering and receiving of goods: (2) timing the order placement and (3) keeping track of what has been ordered, how much, and from whom - must follow up to answer question such as: (1) Has supplier received the order? (2) Has the order been shipped? (3) Are the dates correct? (4) Are the procedure established for reordering or returning undesirable merchandise?

Manufacturing Inventory

- refers to items that contribute to or become part of a firm's products output - *classified* into (1) raw materials, (2) finished products, (3) component parts, (4) supplies, and (5) work-in-process

Sawtooth Effect

- relates to Q and R and shows that when inventory position drops to point R, a reorder is placed

Price-Break Model

- the model is useful for finding the order quantity of an item when the price of the item varies with the order size. - suggest that the selling price of an item varies with the order size - *practical consideration in price-break problems* is price reduction from volume purchases frequently makes it seemingly economical to order amounts larger than the Qopt - *to determine optimal quantity of any item to order*, solve for the economic order quantity for each price and at the point of price change

Dependent Demand

- the need for an item is a direct result of the need for some other item; usually an item of which it is a part of (higher-level item) - when the demand for the item can be predicted with accuracy due to a schedule or specific activities - *required quantities* are computed based on the # needed of higher-level item produced

Optimal Order Quantity (Qopt)

- the order size minimizes total annual cost - total cost is minimal at the point where the slope of the curve is zero - *total annual cost equation* (annual purchase cost + annual ordering cost + annual holding cost)

Deriving the Optimal Order Quantity are Based on the Following Characteristics

- these assumptions are unrealistic, but represent a starting point 1) Demand for the product is constant and uniform throughout the period 2) Lead time (time from placing an ordering to receiving the item) is constant 3) Price per unit of product is constant 4) Inventory holding cost is based on average inventory 5) Ordering or setup costs are constant 6) All demand for the product will be satisfied (no backorders are allowed)

Three Models of Supply Chain Inventories (Make-to-Stock Environment)

- these models are *directed at the customer* - *characterize demand by using a probability distribution* and maintain stock so risk associated with stockout is magned - *retail store inventory* and *warehouse inventory* are in the upper echelons of supply chain in which supply points closer to the customer and stock usually is kept that an item can be delivered quickly when a customer needs - *raw materials* and *manufacturing plant inventory* are in the lower echelon of supply chain and can be managed to take advantage of planning and synchronization that are needed to efficiently operate supply chain *1) Single-Period Model* - is used when we are making a one-time purchase of an item (such as purchasing T-shirts to sell at sporting events) - helps in situations where a company is trying to produce the optimal quantity of inventory for a single event minimizing overproduction costs and potential lost revenues. - retail store inventory and warehouse inventory *2) Fixed-Order Quantity Model* - is used when we want to maintain an item "in-stock" and when we resupply the item, a certain number of unit must be ordered each time - inventory for the item is monitored until it gets down to a level where risk of stocking is great enough that we are compelled to order *3) Fixed-Time Period Model* - similar to the fixed-order quantity model - is used when item should be in-stock and ready to use - item is ordered at certain intervals of time (ex: every friday morning - is convenient when a group of items is ordered together

Two Step Procedure for Price-Break Model

- uses these steps when the holding cost is based on a percentage of unit price (when only looking at a subset of the price-break quantities) *Step 1*: Sort the prices from lowest to highest (right to left) - beginning with the lowest price, calculate the economic order quantity for each price level unit a feasible economic order quantity is found - *feasible* means that the quantity is in the correct corresponding range for that price *Step 2*: - *If the first feasible economic order quantity is for the lowest price*, this quantity is best and you are finished - *If not,* calculate the total cost for the first feasible economic order quantity and calculate the total cost at each price break lower than the price associated with the first feasible economic order quantity - This is lowest order quantity at which you can take advantage of price break (optimal Q is one with lowest cost)

Fixed-Order Quantity and Fixed-Time Period Differences

1. Q-Model (Fixed-Order Quantity Model) - *order quantity*: Q-constant (same amount ordered each time) - *when to place order*: R- when the inventory position drops to the reorder level - *record keeping*: each time a withdrawal or addition is made - *size of inventory*: less than fixed-time period model - *time to maintain*: higher due to perpetual record keeping - *type of items*: higher-priced, critical, or important items 2. P-Model (Fixed-Time Period Model) - *order quantity*: p-variable (varies each time order is placed) - *when to place order*: T- when the review period arrives - *record keeping*: counted only at review period - *size of inventory*: larger than fixed-order quantity model - *time to maintain*: efficient, because multiple items can be ordered at the same time - *type of items*: typically used with lower-cost items ADDITIONAL NOTES: - *fixed-time period model has a larger average inventory* bc it must protect against stockout during the review period (T) - *fixed-order quantity model favors more expensive items* bc average inventory is lower - *fixed-order quantity model is more appropriate for important items (critical repair parts)* bc there is closer monitoring and quicker response to potential stock out - *fixed-order quantity model* requires more time to maintain* bc every addition or withdrawal is logged

Computers can be Programmed to Produce a Cycle Count

1. When the record shows a low or zero balance on hand (easier to count fewer items) 2. When the record shows a positive balance but a backorder was written (indicating a discrepancy) 3. After some specified level of activity 4. To signal a review based on the importance of the item (as in the ABC system)

True or false: Inventory is not an issue for services because services do not carry inventory.

FALSE

Campbell's Soup makes product for Kroger and other grocery stores based on sales to the final consumer. This inventory management environment is characterized as ________ demand. Multiple choice question.

Independent

Inventory-Control System Design Matrix (Framework Describing Inventory Control Logic)

Manual Two Bin: - High Independent Demand - High Transaction Costs - High Obsolete Inventory (Risk) Reorder Point/Equal Order Period: - in the middle of Independent and Dependent Demand - in the middle of High and Low Transaction Costs - in the middle of High and Low Obsolete Inventory Risk Material Requirements Planning: - almost Dependent Demand - almost Low Transaction Costs - almost Low Obsolete Inventory (Risk) Rate-Based Synchronous Planning: - Dependent Demand - Low Transaction Costs - Low Obsolete Inventory (Risk)

Because of favorable pricing in the short-term, a company is looking at ordering a larger-than-needed optimal quantity of an item, and keeping the excess in inventory. Which model is the company likely performing to arrive at this decision?

Price Break

Match the characteristics of the Q- and P-models based on size of inventory.

Q-model = smaller inventory size P-model = larger inventory size

Southern Printing Corp. produces high-end booklets for university graduations listing all the participating students at a given university. What inventory model would Southern use to optimize the amount of booklet inventory produced for each graduation?

Single-Period

True or false: One purpose of holding inventory is to meet variation of product demand.

TRUE

The two critical components of ALL reorder point calculation scenarios are:

average daily demand and lead time in days

Many firms are tending to enter into longer-term relationships with vendors to supply their needs for perhaps the entire year. This changes the "how many to order" to "how many to ______ "

deliver