Business Logistics Chapter 7

Inventory

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 finished product inventory allows a company to fill customer orders immediately Maintaining adequate materials inventory 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.

Inventory Deployment Planning Approaches Across Multiple Locations

Two planning approaches to coordinate inventory requirements across multiple locations in the supply chain Fair Share Allocation :determines a fair share % of the available supply which is then allocated to each competing demand. - Provides each distribution facility with an equitable distribution of available inventory Requirements Planning :integrates across the supply chain taking into consideration unique requirements: 1. Materials Requirements Planning (MRP): is driven by the Master Production Schedule 2. Distribution Requirements Planning : (DRP) is driven by customer demand

Inventory Management

Who are your key customers? Manufacturers (internal/external), Wholesalers, Distributors, Retailers, Consumers ─ What level of service do they required? Does it differ by customer? ─ What is important to them? ─ What value do they create? ─ What risks do they take? How do the inventory decisions you make: ─ Impact service levels to your customers? ─ Impact the total cost to serve?

1) ABC Classification allows different inventory management techniques to be applied to different segments of the inventory in order to increase revenue and decrease costs 2) Fair Share Allocation integrates across the supply chain taking into consideration unique requirements . 3) VMI arrangements transfer the responsible for managing the inventory located at a customer's facility back to the vendor/manufacturer of that inventory 4) A quantitative decision model based on the trade-off between the annual ordering costs and the annual carrying costs is called 5) Which of the following inventory types is characterized as "inventory bought to hedge a currency exchange or to take advantage of a discount"? 6) Which one of the following is NOT a valid reason to hold inventory? 7) Which Inventory Metric measures how much it costs a company to store inventory over a given period of time? 8) Companies using a make-to-order manufacturing strategy typically maintain safety stock for independent demand items. 9) "Days of Supply" is the term used to describe the level of inventory which triggers an action to replenish the inventory for an item. It is typically calculated as the demand during the replenishment lead time plus safety stock. 10) Inventory Carrying Cost is the expense associated with maintaining inventory

1) TRUE 2) False 3) True 4) Economic Order Quantity (EOQ) 5) Strategic Stock 6) Efficient utilization of warehouse space 7) Inventory Carrying Cost 8) False 9) False 10 ) True

Inventory

Consequentially, excess inventory weakens a business' competitiveness by increasing operating cost and decreasing margin. All of these reasons are why inventory, especially excess inventory, is often considered evil.

Safety Stock for Independent Demand Uncertainty

Add safety stock to base inventory to protect against a potential stockout when demand uncertainty exists, i.e., demand exceeds forecast Safety stock determinations are not intended to eliminate all stockouts — just the majority of them. Planning safety stock requires three steps: 1. Determine the likelihood of a stockout using a probability distribution, i.e., forecast accuracy/error 2. Estimate the demand during a potential stockout period 3. Establish the desired level of stockout protection, i.e., the desired service level

Inventory Metrics (continued)

Inventory Days of Supply - The number of days it would take to run out of supply if it was not replenished. Inventory On Hand // Average Daily Usage Average Daily SCM seeks to minimize inventory days of supply in order to reduce the risks of excess and obsolete inventory. Excess inventory tends to tie up operational cash flow, so there is a financial benefits to minimizing this metric. Days of Supply (DOS) - The most common KPI used by managers in measuring the efficiency in supply chain. Average Inventory // Monthly Demand Monthly Demand xx 30 It is calculated by dividing the average inventory on hand (as value) by the average monthly demand (as value) and then multiplying it by thirty, when measuring on a monthly basis.

Inventory Ordering Cost Components

Ordering Costs - are incurred each time an order is placed *Order preparation costs Order transportation costs Order receipt processing costs Material handling costs Total cost is driven by inventory planning decisions which establish when and how much to order inventory Ordering Cost Components Purchase Cost + Ordering Cost + Holding Cost = Total

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

Safety Stock to Plan for Uncertainty

Demand Uncertainty — when and how much product will our customers order? Supply Uncertainty — how long will it take to replenish inventory with our customers? Variations must be considered in each area to make effective inventory planning decisions Planning for both demand and supply uncertainty requires combining two demand and supply uncertainty requires combining two independent variables as the joint impact of the probability of both demand and independent variables as the joint impact of the probability of both demand and supply variations must be determined supply variations must be determined. The method for determining this is to combine standard deviations using a convolution formula. The calculations for the convolution formula are beyond the scope of this course but you should understand that there is a method for addressing this situation.

Dependent Demand Items

Dependent demand inventory requirements are a function of known events that are not random Dependent demand does not require forecasting because there is no uncertainty Generally, no specific safety stock is needed to support time-phased procurement programs (e.g., MRP) No safety stock assumes: - Procurement replenishment is predictable and constant - Vendors and suppliers maintain adequate inventories to satisfy 100% of purchase requirements However, these assumptions do not always hold true . .

Order Quantity Determination: EOQ

Economic Order Quantity - A quantitative decision model based on the trade-off between the annual ordering costs and the annual carrying costs The sum of the Annual Ordering Costs Annual Ordering Costs and the and the Annual Carrying Costs Annual Carrying Costs is minimized The intersection of the Annual Ordering Costs and the Annual Inventory Carrying Cost will yield the lowest Annual Total Cost. This model involves many assumptions Generally used as a baseline for further modification before determining the actual quantity to order.

Inventory Metrics

Inventory Carrying Cost - Measures how much it costs a company to store inventory over a given period of time. The inventory carrying cost metric helps a company to understand how much profit they can make with their current inventory; it is also useful in helping suppliers determine their production cycles. Generally, carrying costs equal approximately 20 - 30% of a company's inventory value, making this metric a significant cost factor. Inventory Accuracy - The variance between perpetual inventory and physical inventory. An important metric because misleading inventory levels may make it seem that a company has more inventory than it actually does, which leads the company to sell stock that is not available which results in dissatisfied customers. Inaccurate inventory data may also obscure inventory that is actually available, which can lead to stock remaining in a warehouse and ultimately becoming obsolete.

Inventory Carrying Cost Components

Inventory Carrying Cost is the expense associated with maintaining inventory Cost Components: 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 - e.g., food and pharmaceutical sell-by dates Storage - facility expense related to product holding rather than product handling Typically expressed as a percentage of inventory

Inventory Metrics (continued)

Inventory Turnover - The number of times that a company's inventory cycles per year. Cost of Goods Sold // Average Inventory The inventory turnover ratio is a key metric for determining how efficiently a company manages its' inventory and generate sales from it. It measures the number of opportunities to earn profit that a company experiences each year from the working capital invested in inventory. A higher inventory turnover means lower inventory levels and indicates an efficient supply chain There is no specific benchmark for Inventory Turnover, however generally: Product Leaders in the Market 3 - 4 Turns per Year Wholesalers/Distributors 5 - 7 Turns per Year Operational Excellence-Oriented Organizations 8 - 9 Turns per Year Every unit/dollar of inventory that a company can reduce drops right to the bottom line as pure savings

Pipeline Inventory

Inventory in the transportation network and the distribution system. Inventory that is already out in the marketout 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. Pipeline Inventory Inventory in transit . Inventory held / owned by suppliers, or by Inventory held / owned by suppliers, or by wholesalers, distributors, retailers, and customers.

Obsolete Inventory Stock that is expired, out-of-date or no longer needed.

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.

Independent & Dependent Demand

Inventory management models are generally classified as: Independent Demand - The demand for the final product. Demand pattern affected by trends, seasonal patterns, & market conditions. Forecasted Demand-> Potential need for Safety Stock Example: Automobile Dependent Demand - Internal demand for parts and materials based on the demand for the final product in which the parts and materials are used. Calculated Demand -> Generally, no need for Safety Stock - Order quantities computed with Material Requirements Planning (MRP). - Relationship between independent and dependent demand shown in Bill of Materials (BOM). - Subassemblies, components, & raw materials are examples of dependent demand items. Example: Automobile engine

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.

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.

Customer Service Level Metrics

Perfect Order Measurement - The percentage of orders that are error-free. A Perfect Order is delivered complete, on time, at the right location, in perfect condition, with complete and accurate documentation Fill RateFill Rate - The percentage of a customer's order that is filled on the first shipment. This can be represented as the percentage of items, SKUs or order value that is included with the first shipment. Fill rate can be important to customer satisfaction and has implications for transportation efficiency.

Calculating Safety Stock

Probability theory enables the calculation of safety stock for a target service level Service level is equal to 100% minus the probability % of stockout - e.g., a service level of 99% results in a stockout probability of 1% The most common probability distribution for demand is the normal distribution, i.e., "bell curve" - From analysis of historical demand data the safety stock required to ensure a stockout only 1% of the time is possible - A one-tailed normal distribution is used because only demand that is greater only demand that is greater than the forecast can create a stockoutthan the forecast can create a stockout - Is the forecast error bias on the over-forecast or under-forecast side of the bell curve? Safety stock is only needed for under-forecast error (demand exceeds forecast)

Collaborative Inventory Replenishment Programs

Replenishment Programs are designed to streamline the flow of goods within the supply chain -Intent is to reduce reliance on forecasting and position inventory using actual demand on a just-in-time basis Quick Response: (QR)Quick Response (QR) is a technology-driven cooperative effort between retailers and suppliers to improve inventory velocity while matching supply to consumer buying patterns Vendor Managed Inventory :(VMI)Vendor Managed Inventory (VMI) is a modified QR that eliminates the need for replenishment orders Profile Replenishment :(PRProfile Replenishment (PR) ) extends QR and VMI by giving suppliers the right to anticipate future requirements according to their knowledge of a product category (JIT II)

Review Frequency & Reorder Point Formulas

Review Frequency: Defines how often inventory levels are reviewed Periodic Review: : monitor inventory status of an item at regular intervals such as weekly or monthly ROP = (D X (T + P/2)) + SS where: ROP = Reorder Point D = Average Daily Demand T = Average Lead Time in Days P = Review Period in Days SS = Safety Stock Perpetual Review: : monitor inventory status of an item continuously ROP = (D X T) + SS where ROP = Reorder Point D = Average Daily Demand T = Average Lead Time in Days SS = Safety Stock ROP = Demand during lead time + safety stock Reorder Point: Defines when a replenishment order is initiated. Both methods compare the item's on-hand and on-order inventory to the Reorder Point. If the total is ≤ Reorder Point, then a replenishment order is initiated

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.

Service Level

Service Level is a performance target specified by management and defines inventory performance objectives Generally, the higher the service level target, the higher the amount of inventory you will need to assure the target is achieved. - e.g., 90% of orders filled complete in 3 order cycle days Common measures of service level include: Performance Cycle- the elapsed time between release of a purchase order by the buyer to the receipt of shipment (i.e., lead time)(i.e., lead time) Order Fill - the percent of customer orders filled completely as requested Case Fill Rate - the percent of cases ordered that are shipped as requested Line Fill Rate - the percent of order lines (items) that were filled completely as requested Does service level vary by customer? . . . by product?

Volume Economies of Scale

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 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 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.

Inventory Carrying Cost Policy

The carrying cost percent used by a firm is a managerial managerial policypolicy. It is typically around 24% (i.e., ≈2% per month) Inventory carrying cost is an imputed cost. It doesn't appear in the financial statement. Companies also determine the cost of capital they want to use which is typically the return they expect on investments.

Practical use of EOQ

The experienced supply chain practitioner will check each application of EOQ to be sure that it is valid for the practical situation at hand. In the real world, EOQ is generally used as a baseline. With a thorough understanding of EOQ, the technique can be used to yield some benefits by its modification based on experience » Supply chain practitioners will frequently apply overrides due to variability in the assumptions previously outlined.

Assumptions of the EOQ Model

The model must be calculated for one product at a time. The demand must be known and constant throughout the year. The delivery replenishment lead time is known and does not fluctuate. Replenishment is instantaneous. — There is no delay in the replenishment of the stock, and the order is delivered in the quantity that was demanded, i.e. in one whole delivery. 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. Stockouts are not allowed

Categories of Inventory

There are four main categories of inventory: Raw Materials (RM) Work-in-Process (WIP) sometimes called Work-in-Progress Finished Goods (FG) Maintenance, Repair and Operating supplies (MRO) Raw Materials-> Work in Process->Finished Goods Maintenance, Repair, and Operating Individual items within each of these inventory categories can be current or obsolete

Calculating Safety Stock - Considerations

There are numerous other deterministic safety stock formulas than those that are covered here. Some models can be quite complex. A company will have to determine which of the many formulas is the most appropriate for their products. Many companies calculate safety stock based on demand uncertainty alone, and rely on that to at least partially cover for supply uncertainty as well. » If an item has a known supply uncertainty, an additional quantity of safety stock may be added to compensate.

Inventory Stock Levels

There are three levels of internal inventory which may be held by companies to: Meet customer demand Buffer against uncertainty in demand and/or supply Decouple supply from demand 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:: Strategic Stock Safety Stock Cycle Stock Pipeline Inventory-> *Inventory in transit. * Inventory held / owned by suppliers, or by wholesalers, distributors, retailers, and customers. <-- External inventory Obsolete Inventory Stock that is expired, out-of-date or no longer needed.

Maintenance, Repair & Operating (MRO) supplies

These are materials that you need to run the manufacturing run the manufacturing operation and the business 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 supplies, 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. 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.

Segmentation Strategy: ABC Classification (continued)

This allows different inventory management techniques to be applied to different segments of the inventory in order to increase revenue and decrease costs. A items items are given the highest priority. "80/20 rule80/20 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

Safety Stock in Dependent Demand Situations

Three approaches to introduce safety stock into dependent demand situations if necessary 1. Add Safety Time into the requirements plan. - Safety Time (aka, Safety Lead Time) is ordering an item earlier than necessary based on the lead time, to ensure timely arrival. 2. Increase the replenishment order by a quantity specified by some estimate of expected plan error, i.e., over-planning / top-level demand. (Frequently used if there is a history of quality issues.) - e.g. order an additional 5% 3. Utilize statistical techniques to set safety stocks directly for a component rather than to the item of top-level demand

Vendor Managed Inventory (VMI)

VMI arrangements transfer the responsible for managing the inventory located at a customer's facility back to the vendor/manufacturer of that inventory. The vendor/manufacturer: Stocks inventory Places replenishment orders Arranges the display Typically owns inventory until purchased Is required to work closely with customer

Benefits of a Segmentation Strategy such as ABC

1. End of Life Management ::With the ABC analysis, inventory planners can forecast the declining demand and manage the stock levels accordingly; reducing inventory levels to minimize carrying costs and avoid obsolescence. 2. Supplier Negotiation::The company can prioritize and focus on negotiating with suppliers of the class A category items since they represent 70% - 80% of the money spent. The negotiation needs to be win-win. The supplier needs to make a reasonable profit from the deal while helping the company get the desired quality product and services at the lowest price. 3. Inventory Optimization::ABC analysis allows inventory planners to organize high priority items aligned to customer requirement. Inventory levels can be set to satisfy to high demand items while also carrying low stock for undesirable items. 4. Strategic Pricing::ABC analysis helps in setting the prices strategically for products which bring more value to the company. Prices for highly desirable products can be increased which will have a significant impact on profits. 5. Resource Allocation::Resource allocation is a continuous process requiring periodic tracking of class A items. If a class A item is no longer desired by the customers or has lower demand, the item can to be moved to a lower classification. 6. Customer Service Levels::ABC analysis allows planners to set customer service levels based on the product classification, which improves the overall supply chain performance by carrying less safety stock.The customer service level is set by product and depends on multiple factors such as the item cost, demand, and margin.

Functions of Inventory - Why hold 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/demand 4. To Decouple Dependencies in the Supply Chain (strategic stock):: Separating operations in a process Smoothing production and reducing peak period capacity needs