Chapter 4 - Inventory Management

Inventory in the Service Industry

-Companies in the service industry do not maintain inventory of services since services are basically produced and consumed immediately upon demand -Companies can however, maintain inventory of "facilitating goods," which are those items that are used to help facilitate the service being provided -For example: - Restaurants offer dining services, but cannot inventory the actual dining service; they can only begin the dining service when the customers arrive - Restaurants can inventory the food, tableware, and other elements of the dining operation as there are facilitating goods necessary to provide the service - Restaurants can even prepare some of their meal options in advance, such as salads or desserts. They can inventory these facilitating products so they are ready to go when the customers arrive for the dining service

Disadvantages of Continuous Review System

-Cost of implementation -Generally requires an automated system -The hardware and software necessary to run the system can be expensive to purchase, install, and maintain

Carrying Costs Definition

-Costs for physically having inventory on-site and for maintaining the infrastructure needed to store the inventory and to secure and insure it over time

Other Inventory Information

-Holding some inventory may be necessary to maintain operations and ensure that products are available when customers demand them -Too much inventory ties up capital which could otherwise be used for purposes such as research and development, marketing and sales, stockholder dividends, salary increases, etc. -The more inventory a company holds, the more space is needed, and space costs money -In addition to storage costs, a company may also have to pay for security, insurance, taxes, etc. to hold inventory -Inventory can become a liability if it becomes unusable due to expiration, obsolescence, damage, or spoilage

Carrying Costs

-Incurred for holding inventory - Cost of capital - specified by senior management - Taxes - on inventory held in warehouses - Insurance - based on estimated risk or loss over time and facility characteristics - Obsolescence - deterioration of product during storage, and shelf-life - Storage - facility expense related to product holding rather than product handling

Fixed Costs (Sunk Costs) Definition

-Independent of the unit volume produced (e.g., buildings, equipment, rent, allocated overhead costs, etc.)

Pipeline Inventory

-Inventory in the transportation network and the distribution system -Inventory that is already out in the market being held by wholesalers, distributors, retailers, and even consumers -The ownership of this inventory has been transferred to the trading partners, but may still influence decisions the company makes regarding how they manage and control their internal inventory, and how much safety stock and/or strategic stock to hold

Bin System

-Inventory system that uses either one or two bins to hold a quantity of the item being inventoried - It is mainly used for small or low value items - When the inventory in the first bin has been depleted, an order is placed to refill or replace the inventory - The second bin is set up to hold enough inventory to cover demand during the replenishment lead time so as to last until the replacement order arrives

Maintenance, Repair, and Operating (MRO)

-Items used in support of general operations and maintenance such as maintenance supplies, spare parts, and consumables used in the manufacturing process and supporting operations - Materials that you need to run the manufacturing operation and the business but do not end up as part of the finished product - Some MRO items are consumed during the process of converting raw materials into finished goods, e.g., oil for the manufacturing equipment - Other MRO items are used to facilitate the manufacturing operation, e.g., cleaning suppliers, spare parts, etc. - While still other MRO items may be used to facilitate the company's administrative activities, e.g., office supplies, coffee for the break room, etc.

Advantages of Periodic Review System

-Reduces the time spent analyzing inventory -Less expensive to implement and operate than a Continuous Review System

Inventory Turnover

-The number of times that an inventory cycles, or "turns over," during the year -The more turns, the better

Inventory Turnover Ratio

Cost of Goods Sold / Average Inventory at Cost

Fixed-Order Quantity System

-A continuous inventory review system in which the same order quantity is used from order to order -When the inventory position drops to a predetermined reorder point, a predetermined fixed order quantity is placed -The time between orders (i.e., order period) varies from order to order -If the review determines that an order should be placed, then the order for a pre-defined quantity for that item is placed

Single-Period Model

-A type of inventory system in which inventory is only ordered for a one-time stocking - The objective is to maximize profits - Ex: Christmas tree lots, Newspaper stands

Service Inventory

-Activities carried out in advance of the customer's arrival

Measuring Inventory Performance

-Common metrics for inventory: - Units - the number of units available - Dollars - the amount of dollars tied up in inventory - Weeks of Supply - (average on-hand inventory) / (average weekly usage) - Inventory Turns - (cost of goods sold) / (average inventory value) -Every unit/dollar of inventory that you can reduce drops right to the bottom line as pure savings

Continuous Review System

-Inventory levels are continuously reviewed - As soon as inventory falls below a pre-determined level (i.e., a reorder point), a replenishment order automatically is triggered

Periodic Review System

-Inventory levels are reviewed at a set frequency, e.g., weekly, monthly - At the time of review, if the stock levels are below the predetermined level (i.e., a reorder point), an order for replenishment is placed, otherwise no action is taken

Inventory Control Tools

-Many exist in today's market -Those that incorporate barcode tracking or RFID tagging generally offer the most flexibility and ease of use - Linear Barcode - 2D Barcode - Radio Frequency Identification (RFID)

Two Models for Determining When to Review Inventory

-Periodic Review System -Continuous Review System

Maintenance, Repair, and Operating (MRO) Supplies

-The materials that you need to run the manufacturing operation and the business, but do not end up as part of the finished product - MRO inventory is separate from production inventory, but it is just as important - Frequently these items are expensed at the time they are purchased, and there may be a separate function, group, or individual who plans and orders these MRO items, from those who plan and order production items

Assumptions of a Fixed-Order Quantity System

-A constant demand (d) rate, i.e., not erratic, seasonal, etc. -Inventory position (IP) is reduced (i.e., consumed/used) by a rate of (d) -Replenishment order placed when reorder point (ROP) is reached -When inventory is received, (IP) increases by the order quantity (Q) -(Q) computed using the economic order quantity (EOQ) model -Lead time (L), i.e., the time between placing an order and receiving delivery of the order, is known and constant -Inventory position (IP) is reviewed on continual basis

Economic Order Quantity (EOQ) Model

-A fixed-order quantity model -A quantitative decision model based on the trade-off between annual inventory order costs and annual inventory carrying costs -Where the sum of the annual order costs and the annual inventory carrying costs is minimized - Order Costs are costs that are incurred each time an order is placed - Carrying Costs are costs that are incurred for holding inventory in storage EOQ = sq rt (2 x order cost x annual demand volume / annual carrying cost % x unit cost_

Work-in-Process

-A good or goods in various stages of completion throughout the plant, spanning from raw material that has been released for initial processing up to fully processed material awaiting final inspection and acceptance as finished goods - Due to the range of potential stages of completion, and the fact that materials in WIP may be in a state of continuous transformation, many companies view WIP as the "black hole" of inventory as they may not have very good or very timely visibility into this part of their inventory - Best practice generally suggests minimizing the amount of WIP inventory in the manufacturing area since too much WIP may clutter up the physical space and impede the process flow

Inventory Introduction

-A key decision in any product-based supply chain is how much inventory to keep on hand - Inventory is usually one of the company's largest assets, so careful management of that asset is an essential business requirement - Maintaining adequate finished product inventory allows a company to fill customer orders immediately - Maintaining adequate materials inventory allows a company to support manufacturing operations and the production plan while avoiding delays - Failing to manage inventory adequately can lead to significant issues and inefficiencies throughout the supply chain, including dissatisfied customers, lost sales and revenue, and higher costs

Base Stock Level System

-A type of inventory system that issues an order whenever a withdrawal is made from inventory - Replenishment order quantity is equal to the quantity withdrawn from inventory - This will maintain the inventory at a base stock level - Used primarily for very expensive items, e.g., airplane engine - A form of just-in-time

Other Types of Inventory Systems

-ABC System -Bin System -Base Stock Level System -"Single-Period" Inventory Model

Strategic Stock

-Additional inventory beyond cycle and safety stock, generally used for a very specific purpose or future event, and for a defined period of time -A company may decide to carry strategic stock to: - Hedge currency fluctuations - Take advantage of a price discount - Protect against a short-term disruptive event in supply - Take advantage of a business opportunity - For life cycle changes: seasonal demand, new product launch, transition protection -Also called anticipation stock, build stock, or seasonal stock

Advantages of Continuous Review System

-Allows for real-time updates of inventory, which can make it easier to know when to replenish -Facilitates accurate accounting, since the inventory system can generate real-time cost of goods sold -Potentially requires less safety stock because inventory is constantly monitored, and replenishment actions are taken more quickly

Disadvantages of Periodic Review System

-Can be difficult to determine the best review/reordering intervals -It also can make inventory accounting less accurate -Since items are only reviewed periodically, there is a greater risk of inventory dropping well below the reorder point between reviews and, therefore, a greater potential need for safety stock

Indirect Costs Definition

-Cannot be traced directly to the unit produced (e.g., overhead; MRO items, buildings, equipment, etc.)

Assumptions of the EOQ Model

-The model must be calculated for one product at a time -The demand must be constant throughout the year -The delivery replenishment lead time does not fluctuate -Replenishment is instantaneous -The purchase price (i.e., unit cost) is constant and no discounts or price breaks are factored into the model -Carrying cost is known and constant -Order cost is known and constant

Inventory

-The quantities of goods and materials that are held in stock - Includes all of the raw materials and work-in-process items used to support production, all of the finished products needed to provide customer service, and all of the other materials and suppliers needed to run a business, i.e., maintenance, repair, and operating supplies - Inventory can be one of the largest and most important assets of an organization - However, too much inventory can also be a significant liability

How Much to Order?

-The two common inventory ordering system categories are: 1. Fixed-Time Period System 2. Fixed-Order Quantity System

Absolute Inventory Value

-The value of the inventory at either its cost or its market value -Generally found on the balance sheet

Inventory Stock Levels

-There are three levels of internal inventory which may be held by companies to: 1. Meet customer demand 2. Buffer against uncertainty in demand and/or supply 3. Decouple supply from demand 4. Decouple dependencies in the supply chain -There may also be inventory which is held external to the company by downstream supply chain trading partners -Internal Inventory - Obsolete inventory --> stock that is expired, out-of-date or no longer needed *Strategic stock *Safety stock *Cycle stock -External Inventory - Pipeline inventory - Inventory in transit - Inventory held/owned by suppliers, or by wholesalers, distributors, retailers, and customers

Finished Goods

-Those items in which all manufacturing operations, including final testing, have been completed. These products are available for sale and/or shipment to the customer - From a cost perspective, finished goods are usually worth much more than raw materials or WIP since all of the material, labor, and overhead costs are fully applied to finished goods - The amount of finished goods inventory that a company decides to maintain is a strategic decision: - Make-to-Order - Make-to-Stock

Inventory Policy - Set Target Inventory Levels

-To set target inventory levels for all products and materials, you need to address these 3 fundamental questions: 1. When to review inventory? 2. When to order inventory? 3. How much inventory to order?

Make-to-Stock

-Where product is produced prior to receipt of a customer order -A forecast and demand plan are created and the finished goods are produced and held in inventory until a customer order is received -Significant amounts of finished goods inventory can sometimes be maintained

Make-to-Order

-Where the finished goods are not produced until a customer order is received, and the raw materials may not even be ordered from the supplier(s) in advance -Little to no finished goods inventory is maintained

ABC System

-Classifies inventory based on the degree of importance: -Steps: 1. Determine annual usage or sales for each item 2. Determine % of total usage or sales that each item represents 3. Rank items from highest to lowest % 4. Classify items into groups: A: Highest Value B: Moderate Value C: Least Valuable -A method to determine which inventories should be counted and managed more closely than others -Groups inventory as A, B, or C based on a set criterion - A items are given the highest priority. "80/20 rule" Generally, A items account for approximately 20% of the total number of items, but about 80% of the total inventory cost - B & C items account for the other 80% of the total number of items, but only 20% of total inventory cost - 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 the lowest priority

Inventory Investment

-Common measures include: - Absolute Inventory Value - Inventory Turnover

Variable Costs Definition

-Dependent on the unit volume produced vary with output level (e.g., materials, labor, utility power, etc.)

Direct Costs Definition

-Directly traceable to unit produced (e.g., materials, labor, etc.)

Hidden Costs of Inventory

-Having too much or too little inventory on hand can sometimes build hidden costs that create risk for a company -Having too much inventory can result in effects like: - Financial resources tied up in inventory - Underlying problems being hidden rather than being exposed and solved, including quality problems not being immediately identified - No incentive for process improvements -Having too little inventory can result in effects like: - Production disruptions creating the need for expediting and additional costs - Longer delivery replenishment lead times - Reduced responsiveness - Lost revenue

Barcodes

-Help businesses track products and stock levels for inventory management - Linear (1D) Bar Codes are "a series of alternating bars and spaces printed or stamped on parts, containers, labels, or other media, representing encoded information that can be read by electronic readers - Linear bar codes do have some limitations: they are one-dimensional, can only be read horizontally, and can only hold a maximum of 85 characters - 2D Bar Codes are a graphical image that stores information both horizontally and vertically - 2D Barcodes can store over 7,000 characters, allowing transmission of almost two paragraphs of information - A barcode reader (or barcode scanner) is an electronic device that can read barcodes and transmit the data to a computer - These might be handheld cordless devices, corded devices that attach directly to a PC's USB port, or computers with integrated laser scanners

Inventory Order Costs

-Incurred each time an order is placed - Order preparation costs - Order transportation costs - Order receipt processing costs - Material handling costs

Fixed-Time Period System

-Inventory is checked in fixed time periods against a target inventory level -If the inventory is less than target, a quantity necessary to bring inventory back up to the target level is ordered -The amount of inventory ordered will potentially vary from period to period based on the remaining inventory at each time interval checked -The order quantity is the difference between the on-hand stock on review day, and the predetermined target inventory level *Q = R - IP where: - Q = order quantity - R = target inventory level - IP = inventory position -The order quantity in this system will differ from one order to another depending on the on-hand quantity on the day of the review - A target inventory level (R) is established - Inventory levels are checked/reviewed in fixed time periods (T) - If (IP) < (R) then (Q) is ordered and (R) is restored when each new order is received

Inventory Management

-The function of planning and controlling inventories - The goal of inventory management is to help a company be more profitable by lowering the cost of goods and/or by increasing sales - In an effort to achieve this stated goal, effective inventory management balances two competing considerations: - Reducing the amount of inventory held in stock, while - Ensuring there is enough inventory to satisfy customer demand -What is the right amount of inventory? - The answer to that is, "It depends" - It depends on the supply chain strategy and set-up, the type of product(s), customers' expectations, customer service objectives, product shelf life, etc.

Obsolete Inventory

-Inventory items that have met the obsolescence criteria established by the company -Obsolete inventory is stock that is expired, damaged, or no longer needed -Obsolete inventory will never be used or sold at full value - Writing obsolete inventory off of the books and disposing of it may be a difficult decision to make as all or part of the obsolete product's value may be lost and it may reduce a company's profit - Unusable inventory takes up space and costs money to maintain, so it may be better to absorb the loss as soon as an item has met the obsolescence criteria rather than delay and continue to lose money on storage and related fees - There may be a cost associated with the actual disposal of the inventory - Some companies may donate this inventory to a non-profit organization if it has any remaining value, which not only helps the non-profit but also avoids disposal costs and may result in a tax benefit for the company

Cycle Stock

-Inventory that a company builds to satisfy its' immediate demand -Cycle stock depletes gradually as customer orders are received, and is replenished cyclically when supply orders are received -The amount of cycle stock that a company holds is dependent on actual demand in the immediate time period, supply replenishment lead time and order quantities

Order Costs Definition

-Labor costs associated with placing an order for inventory and the cost of receiving the order

Constraints on the Practical Use of EOQ

-Limited Capital: The model may generate an order quantity which the company does not have sufficient available funds to purchase at one time -Storage Capacity: The model may generate an order quantity which the company does not have sufficient storage capacity to handle at one time -Transportation: The item being ordered and transported may require specialized or dedicated transportation, impacting the quantity per order -Obsolescence: The model may generate an order quantity which would create spoilage or obsolescence -Production Lot Size: The supplier may require the company to order an item in full production lot sizes -Unitization: The supplier may require the company to order an item in full pack, case, or pallet configurations -Because of these constraints and assumptions, the EOQ is generally only used as a baseline -Supply chain managers make adjustments to the EOQ based on their judgement

Raw Materials

-Purchased items or extracted materials that are converted via the manufacturing process into components and products - Every company that produces a product generally starts with some type of raw material, component part or starting material - There are strategies around the question of how much raw material a company should hold in inventory - Buy from a supplier and have it delivered to the operation just in time for when it is needed - Buy and hold a larger quantity for strategic reasons -Companies might be willing to increase costs by storing excess raw material inventory if they fear there may be a potential shortage of the material or if they suspect that there is an upcoming price increase and want to buy at the current lower price

Categories of Inventory

-Raw materials -Work-in-Process (WIP), sometimes called Work-in-Progress -Finished goods -Maintenance, repair, and operating (MRO) supplies -Individual items within each of these inventory categories can be current or obsolete

Two Main Variables to Calculate of a Fixed-Order Quantity System

-Reorder Point (ROP) -Order Quantity (Q)

Safety Stock

-Safety stock, also known as "buffer stock," is inventory that is above and beyond what is actually needed to meet anticipated demand -A quantity of stock planned to be in inventory to protect against fluctuations in demand or supply -Companies operating in a make-to-stock environment will generally maintain some amount of safety stock whether based on a management decision, or based on a safety stock determination formula

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 the information on the tag is updatable -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

Volume Economies of Scale Impact EOQ

-The EOQ calculation will be impacted by volume economies of scale such as the following: - Individual Item Purchase Price Discounts - Discounts for ordering larger quantities. If the volume discount is sufficient to offset the added cost from carrying additional inventory, then ordering a larger volume may be desirable - Multiple-Item Purchase Price Discounts - If you purchase a combination of items from a supplier you may be able to take advantage of a volume discount based on the total volume across all the items purchased rather than just an individual item's volume - Transportation Freight-Rate Discounts - Ordering a larger quantity may mean that you can take advantage of Transportation Freight-Rate Discounts which will lower the per unit costs

When to Order Inventory?

-The lowest inventory level at which a new order must be placed to avoid a stockout is known as the Reorder Point (ROP) - The ROP is set at a level that provides enough inventory so demand is covered during the lead time (L) needed to replenish inventory - ROP = Demand during Lead Time (dL)

Functions of Inventory

1. To meet customer demand (cycle stock): - Immediately fill customer orders - Deploy the product/material near where it will be used 2. To buffer against uncertainty in demand and/or supply (safety stock): - Uncertainty in demand: sales or usage above expectations - Uncertainty in supply: shortages, delays, disruptions 3. To decouple supply from demand (strategic stock): - Supply pattern is different from demand pattern: - Achieve economies of scale in purchasing; take advantage of volume price breaks/discounts - Speculative buying in anticipation of a price increase - Economical order size, lot size, production output - Seasonal products/demands 4. To decouple dependencies in the supply chain: - Separating operations in a process - Smoothing production and reducing peak period capacity needs