Terms-Chapter 14 (Independent Demand Inventory)

Distribution (as in distribution inventory)

(1) In the logistics context, management of the movement of materials from the supplier to the customer; also called physical distribution. (2) In the statistics context, a description of the range of values that a random variable can attain and information about the probability of each of these values. In the logistics context, distribution involves many related disciples, such as transportation, warehousing, inventory control, material handling, and the information and communication systems to support these activities.

Independent demand

(1) The demand from external customers rather than a higher-level assembly or companyrun stocking location. (2) Demand that must be forecasted rather than planned because it cannot be planned based on the plans for other items under the organization's control. Examples of independent demand include consumer demand for a retailer, customer orders arriving at a distributor warehouse, and demand for an end item for a manufacturing firm. Internal demand for a component that goes into an end item is considered dependent demand because this demand is planned based on the production plan for the end item.

Newsvendor model

A mathematical model that solves the newsvendor problem, which is an important problem where the decision maker must decide how much to purchase given the probability distribution of demand, the cost of under-buying one unit, and the cost of over-buying one unit; formerly called the newsboy model or the newsboy problem.

Service level

A measure of the degree to which a firm meets customer requirements. Service level is often measured differently for make to stock (MTS) and respond to order (RTO) products. It is possible, however, to define a general service level metric for both MTS and RTO. The following three sections describe these three types of service level metrics. Service level metrics for make to stock (MTS) products - Retailers, distributors, and manufacturers that make and or sell products from inventory (from stock) need a service level measure that reflects the availability of inventory for customers. For make to stock (MTS) products, the service level is usually measured as a fill rate metric. The unit fill rate is the percentage of units filled immediately from stock; the line fill rate is the percentage of lines filled immediately from stock; and the order fill rate is the percentage of orders filled immediately from stock. The terms "fill rate" and "service level" are often used synonymously in many make to stock firms.

ABC classification

A method for prioritizing items in an inventory system, where A-items are considered the most important; also called ABC analysis, ABC stratification, distribution by value, 80-20 rule, and Pareto analysis. The ABC classification is usually implemented based on the annual dollar volume, which is the product of the annual unit sales and unit cost (the annual cost of goods sold). High annual volume items are classified as Aitems and low annual dollar volume items are classified as C-items. Based on Pareto's Law, the ABC classification system demands more careful management of A-items where these items are ordered more often, counted more often, located closer to the door, and forecasted more carefully.

Vender managed inventory (VMI)

A supplier-customer relationship where the vendor assumes responsibility for managing the replenishment of stock; also known as supplier-managed inventory (SMI). In a traditional supplier-customer relationship, a customer evaluates its own inventory position and sends an order to a supplier (vendor) when it has a need for a replenishment order. With VMI, the supplier not only supplies goods, but also provides inventory management services. The supplier-customer agreement usually makes the supplier responsible for maintaining the customer's inventory levels. For VMI to work, the supplier needs to have access to the customer's inventory data. Examples of VMI in practice for many years include: Supermarkets and vending machines have used this concept for decades. Frito-Lay's route salespeople stock the shelves for their retail customers to keep the product fresh and the paperwork simple. Much fresh produce moves into convenience shops in the same way. For more than 20 years, Hopson Oil, a home heating oil supplier, has automatically scheduled deliveries for fuel oil based on consumption forecasts for each customer. In this way, it keeps its order-taking costs down and keeps the process simple for customers.

Continuous review

A system for managing an inventory that compares the inventory position (on-hand plus on-order less allocated) with the reorder point for every transaction and places a replenishment order when the position is less than the reorder point.

Perpetual inventory system

An inventory control system that keeps accurate inventory records at all times. In a perpetual inventory system, records and balances are updated with every receipt, withdrawal, and inventory balance correction. These systems often provide real-time visibility of inventory position (inventory on-hand and inventory on-order). In contrast, an inventory system could update inventory records periodically. However, with modern computers it makes little sense to use a periodic updating system.

Reorder point

An inventory management policy that orders more inventory when the inventory position hits a critical level called the reorder point; also called an order point system.

Periodic review

An order-timing rule used for planning inventories; also known as a fixed-time period model, periodic system, fixed-order interval system, and P-model. A periodic review system evaluates the inventory position every P time periods and considers placing an order. Unlike a reorder point system that triggers an order when the inventory position falls below the reorder point, a periodic review system only considers placing orders at the end of a predetermined time period, the review period (P). The graph below shows the periodic review system through two review periods.

Dependent demand

Demand that is derived from higher-level plans and therefore should be planned rather than forecasted. In a manufacturing firm, dependent demand is calculated (not forecasted) from the production plan of higherlevel items in the bill of material (BOM). End item demand is usually forecasted. A production plan (aggregate production plan) and a Master Production Schedule (MPS) are created in light of this forecast. These plans are rarely identical to the forecast because of the need to build inventory, draw down inventory, or level the production rate. This dependent demand should almost never be forecasted. It is common for some items to have both dependent and independent demand. For example, a part may be used in an assembly and has dependent demand. However, this same part might also have independent demand as a service part.

Inventory management

Inventory management involves planning and control of all types of inventories. Inventory management involves forecasting demand, placing purchase and manufacturing orders, and filling sales orders. Inventory management requires two decisions that must be made frequently: when to order, and how much to order. A less frequent inventory management decision is deciding if an item should be stocked. If an item is not stocked, the firm must make, assemble, or buy the item in response to customer demand. Inventory managers may be responsible for all types of inventory: • Raw materials/purchased components inventory - Purchased materials from outside suppliers. • In-transit inventory - Inventory shipped, but not yet received. • Work-in-process inventory (WIP) - Products started in manufacturing, but not yet complete. • Manufactured components/subassemblies - Parts and subassemblies built and then stored in inventory until needed for higher-level products or assemblies. • Finished goods inventory - Products that are complete, but not yet shipped to a customer. • Supplies/consumables inventory - Supplies needed for the manufacturing process, but do not become a part of any product (e.g., cleaning supplies for a machine). These are often called Maintenance, Repair, & Operating Supplies (MRO) items. (Note: MRO has many similar names, including "Maintenance, Repair, and Operations" and "Maintenance, Repair, and Overhaul.") • Scrap inventory - Defective products that will be reworked, recycled, or scrapped. • Consignment inventory - Products owned by one party, but held by another party until sale. Inventory control systems must determine when to order (order timing) and how much to order (order quantity). Order timing can be based on a reorder point (R) or a fixed schedule (every P time periods). Order quantity can be a fixed quantity Q (possibly the EOQ) or a variable quantity based on an order-up-to level (T). With an order-up-to (base stock) policy, the order quantity is set to T - I, where I is the inventory position.

Lotsizing methods

Techniques for determining the quantity to order on a purchase or manufacturing order. The basic lotsizing methods (algorithms) include the following: • Fixed lotsize - A constant quantity is ordered every time. Note that multiples of the fixed lotsize may be required if the net requirements exceed the fixed lotsize. • Economic Order Quantity (EOQ) - The EOQ is a special case of a fixed lotsize. Again, multiples of the fixed lotsize may be required if the net requirements exceed the EOQ. • Period order quantity - The lotsize is set equal to a fixed number of periods of net requirements (e.g., a 4 week supply). • Lot-for-lot (discrete lotsize) - The lotsize is set to what is needed for the next period. Lot-for-lot is a special case of the period order quantity, where the number of periods is one. • Dynamic lotsizing procedures - These procedures are similar to the period order quantity in that they define the lotsize in terms of the number of periods of net requirements that will be added to define the lotsize. However, the number of periods used in the lotsize can change for each order. The procedures attempt to find the optimal (minimum cost) lotsizes for the net requirements over the planning horizon. Examples of dynamic lotsizing procedures include Least Unit Cost, Least Period Cost, Least Total Cost (also called Part Period Balancing), and Wagner-Whitin. Most ERP systems, such as SAP or Oracle, also allow for order size modifiers that are used to adjust order sizes. Modifiers are of three types: the minimum order size (either quantity or days supply), the maximum order size (either quantity or days supply), and multiples of a user-defined quantity. The multiples approach is appropriate when the lotsizes are constrained by delivery, packaging, or shipping units. For example, if the package size is 100 units per carton and the unit of measure is "each" (one unit), the order size has to be a multiple of 100 units. Many firms, such as retailers and distributors, often buy many products from a single supplier. Many items can be ordered on one order and therefore can share the ordering cost. This is called joint replenishment. See the joint replenishment entry for discussion on this issue.

Safety stock

The planned or actual amount of "extra" inventory used to protect against fluctuations in demand or supply; the planned or actual inventory position just before a replenishment order is received in inventory; sometimes called buffer stock, reserve stock, or inventory buffer. The business case for safety stock: Safety stock is management's primary control variable for balancing carrying cost and service levels. If the safety stock is set too high, the inventory carrying cost will be too high. If safety stock is set too low, the shortage cost will be too high. Safety stock is needed in nearly all systems to protect against uncertain demand, leadtime, and yield that affect demand, supply, or both demand and supply. Definition of safety stock: Managers often confuse safety stock with related concepts, such as an order-upto level (for determining the lotsize), a reorder point (a "minimum" inventory for triggering a new order), or the average inventory. Safety stock is the average inventory when a new order is received. It is not the minimum, maximum, or average inventory. The figure below shows the safety stock as the lowest point on each of the three order cycles. The actual safety stock over this time period is the average of these three values.

Lotsize

The quantity that is ordered; also called batch size, order size, and run length. The lotsize is called the order size for purchase orders and the lotsize, batchsize, or run length for manufacturing orders. The optimal lotsize for stationary demand is the Economic Order Quantity (EOQ).

Unit of measure

The standard method for counting an item used for inventory records and order quantities; sometimes abbreviated U/M. The unit of measure is an attribute of each item (stock keeping unit, part number, material) and is stored in the inventory master. Typical values are box, case, pallet, or each. The commonly used term "each" means that each individual item is one unit. The unit of measure can be ambiguous when a box is inside a box, which is inside another box. Typical abbreviations include case (CA or CS), pallets (PL), pounds (LB), ounces (OZ), linear feet (LF), square feet (SF), and cubic feet (CF). Information systems often need to convert the unit of measure. For example, a firm might purchase an item in pallets, stock it in cases, and sell it in "eaches" (units).

Critical ratio (see dispatching rule)

Policies used to select which job should be started next on a process; sometimes called job shop dispatching or priority rules. For example, a manager arrives at work on a Monday morning and has 20 tasks waiting on her desk. Which task should she handle first? She might take the one that is the most urgent (has the earliest due date), the longest one, or the one that has the most economic value. In a very similar way, a shop supervisor might have to select the next job for a machine using the same types of rules. The best-known dispatching rules include First-In-First-Out (FIFO), shortest processing time, earliest due date, minimum slack time, and critical ratio, which are factors of the arrival time, processing time, due date, or some combination of those factors. Other factors to consider include value, customer, and changeover cost or time. The FIFO rule may be the "fairest" rule, but does not perform well with respect to average flow time or due date performance. It can be proven that the shortest processing time rule will minimize the mean (average) flow time, but does poorly with respect to on-time delivery. MRP systems backschedule from the due date and therefore are essentially using a minimum slack rule, which has been shown to perform fairly well in a wide variety of contexts. The critical ratio (Berry and Rao 1975) for a job is equal to the time remaining until the due date divided by the work time remaining to complete the job13. A critical ratio less than one indicates the job is behind schedule, a ratio greater than one indicates the job is ahead of schedule, and a ratio of one indicates the job is on schedule. (Do not confuse the critical ratio rule with the critical ratio in the newsvendor model.) Dispatching rules are used to create a daily dispatch list for each workcenter. This is a listing of manufacturing orders in priority sequence based on the dispatching rule.

Period's supply

The "time quantity" for an inventory; also known as days on hand (DOH), days supply, days of inventory, days in inventory (DII), inventory days, inventory period, coverage period, weeks supply, and months supply. The periods supply44 is the expected time remaining before the current inventory goes to zero, assuming that the current average demand rate does not change. The periods supply metric is often preferable to the inventory turnover metric, because it is easier to understand and can easily be related to procurement and manufacturing leadtimes. Periods supply is estimated by taking the current inventory and dividing by some estimate of the current (or future) average demand. The current average demand might be a simple moving average, an exponentially smoothed average, or an exponentially smoothed average with trend. For example, a professor has 100 pounds of candy in his office and is consuming 20 pounds per day. Therefore, the professor has five-days supply. The periods supply metric and the inventory turnover metric measure essentially the same inventory performance. However, periods supply is based on the current average or forecasted demand, and inventory turnover is based on historical actual demand or cost of goods sold over a specified time period. If demand is relatively stable, one can easily be estimated from the other. The relationships between inventory turnover (T) and days on hand are T = 365/DOH and DOH = 365/T. Inventory Dollar Days (IDD) is the unit cost times DOH.

Inventory position/stock position

The amount of inventory available to fill future orders; defined as on-hand plus on-order minus allocated and minus backordered inventory quantities; also called stock position. On-hand inventory is the material that is physically located in the plant or warehouse. On-order inventory includes the materials that have been ordered but not yet received. Allocated inventory and backorders have been promised to customers or other orders and therefore are not available for use. Many textbooks and training programs simplify the definition to just on-hand plus on-order.

Purchasing

The business function (department) responsible for selecting suppliers, negotiating contracts, and ensuring the reliable supply of materials; also known as procurement, supply management, supplier management, supplier development, strategic sourcing, and buying. The goals of a purchasing organization are usually defined in terms of on-time delivery, quality, and cost. Some purchasing organizations, particularly in the larger firms, also get involved helping their suppliers improve their performance. The sourcing, supplier scorecard, and spend analysis entries have much more information on this topic. Purchasing practices in the U.S. are constrained by a number of important laws. Bribery, kickbacks, price fixing, and GATT rules are important issues for purchasing managers. See the antitrust law and GATT entries for more details.

Cycle stock

The inventory due to lotsize quantities greater than one; also called the lotsize inventory. Cycle stock follows a "saw tooth" pattern (see the reorder point entry for an example). For instantaneous replenishment and constant average demand, the average cycle stock is Q/2, where Q is the fixed order quantity. Organizations can reduce cycle stock by reducing lotsizes and lotsizes can be reduced economically by reducing the order (setup) cost. The setup time reduction methods entry provides a methodology for reducing setup cost.

Carrying cost

The marginal cost per period for holding one unit of inventory (typically a year). The carrying cost is usually calculated as the average inventory investment times the carrying charge. For example, if the annual carrying charge is 25% and the average inventory is $100,000, the carrying cost is $25,000 per year. Many firms incorrectly use the end-of-year inventory in this calculation, which is fine if the end-ofyear inventory is close to the average inventory during the year. However, it is quite common for firms to have a "hockey stick" sales and shipment pattern where the end-of-year inventory is significantly less than the average inventory during the year. Technically, this type of average is called a "time-integrated average" and can be estimated fairly accurately by averaging the inventory at a number of points during the year.

Inventory turnover

The number of times that the inventory is replaced during a time period (usually a year). The standard accounting measure for inventory turnover is the cost of goods sold divided by the average inventory investment. For example, if a firm has an annual cost of goods sold of $10 million and an average inventory investment of $5 million, the firm has two turns per year. Inventory turnover (T) can also be defined as 52d/I, where d is the average demand in units per week and I is the average inventory in units. If the current inventory investment is close to the average and the historical rate of consumption is close to the current rate of consumption, the inverse of the inventory turnover ratio for any inventory is approximately the periods supply. The inverse of the inventory turnover ratio for work-in-process inventory (WIP) is an estimate of the dollar-weighted cycle time for a product. Some students confuse inventory turnover with other turnover measures. Employee turnover is the number of times that employees are replaced during a period (usually a year). Outside of the U.S., turnover usually means sales or revenue. Hill and Zhang (2010) identified six "fallacies" regarding inventory turnover: the ratio fallacy, the end-ofperiod inventory fallacy, the different numerator/denominator units fallacy, the different demand fallacy, the industry average fallacy, and the common turnover (days supply) fallacy.

Economic order quantity (EOQ)

The optimal order quantity (batch size or lotsize) that minimizes the sum of the carrying and ordering costs. If the order quantity is too large, the firm incurs too much carrying cost; if the order quantity is too small, the firm incurs too much ordering (setup) cost. The EOQ model can help managers make the trade-off between ordering too much and ordering too little (Harris 1913, 1915; Wilson 1934). The EOQ finds the Fixed Order Quantity that minimizes the sum of the ordering and carrying costs.