Chapter 7: Inventory Management

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

Inventory Carrying Cost Policy

Final carrying cost percent used by a firm is a managerial policy Inventory carrying cost is an imputed cost. It doesn't appear in the financial statement. Companies determine the cost of capital they want to use which is typically the return they expect on investments

Pull (Make-to-Order)

Producing stock in response to actual demand Responds to actual customer demand to pull the product through the distribution channel

Push (Make-to-Stock)

Producing stock on the basis of anticipated demand. Proactively allocates inventory on the basis of forecasted demand and product availability

Policies and Parameters

must be defined at a detailed level e.g., data requirements, software applications, performance objectives, and decision guidelines

Carrying Cost

is the expense associated with maintaining inventory

Limited Capital

The model may generate an order quantity which the company does not have sufficient available funds to purchase at one time

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

Safety Time (i.e. Safety Lead Time)

is ordering an item earlier than necessary based on the lead time, to ensure timely arrival

Safety Stock Decouples the Supply Chain (Pharmaceutical Example)

- Cumulative lead time without safety stock = 15 months - Cumulative lead time with safety stock to decouple AI and FG lead times = 2 months

Demand Uncertainty

Add safety stock to base inventory to protect against stockout when demand uncertainty exists, i.e., demand exceeds forecast Planning safety stock requires three steps: Determine the likelihood of a stockout using a probability distribution, i.e., forecast accuracy/error Estimate demand during a stockout period Decide on a policy concerning the desired level of stockout protection, i.e., desired Service Level

Independent Demand

The demand for the final product. Has a demand pattern affected by trends, seasonal patterns, & general market conditions. Forecasted Demand Example: Pick-up Truck

Transportation

The item being ordered and transported may require specialized or dedicated transportation, impacting the quantity per order

Storage Capacity

The model may generate an order quantity which the company does not have sufficient storage capacity to handle at one time

Unitization

The supplier may require the company to order an item in full pack, case, or pallet configurations

Production Lot Size

The supplier may require the company to order an item in full production lot sizes

Reorder Point

defines when a replenishment order is initiated

Product/Market Classification

groups products, markets, or customers with similar characteristics to facilitate inventory management e.g., classify by sales, profit contribution, inventory value, usage rate or item category

Fill Rate

represents the magnitude of a backorder or stockout. Can be case fill rate, line fill rate, etc.

Inventory Outcomes/Metrics

Customer Service Level - measured as "fill rate" We discussed Perfect Order in Chapter 3. Common Metrics for Inventory: Units - the number of units available Dollars - the amount of dollars tied up in inventory Weeks of Supply - (avg. on-hand inventory) / (avg. weekly usage) Inventory Turns - (cost of good sold) / (avg. inventory value) Inventory Carrying Cost - (discussed with EOQ) Every unit/dollar of inventory that you can reduce drops right to the bottom line as pure savings

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

Safety Stock to Plan for Uncertainty

What are the 2 types of uncertainty we are trying to account for with safety stock? Demand Uncertainty — when and how much product will our customers order? Supply (Performance Cycle) Uncertainty — how long will it take to replenish inventory with our customers? Variations must be considered in both areas to make effective inventory planning decisions

Calculating Safety Stock

Probability theory enables the calculation of safety stock for a target service level Service level is equal to 100% minus 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 than 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 (demand exceeds forecast) error!

Inventory Policy

Who are your key customers/stakeholders? Manufacturers (internal/external), Wholesalers, Distributors, Retailers, Consumers Level of service required (does it differ by customer) What is important to them? What value do they create? What risks do they take? Inventory positioning / ABC classification How do the inventory decisions you make impact service levels to your customers, "total costs" to serve?

Maintenance, Repair & Operating (MRO) Supplies

These are 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 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.

Why Hold Inventory?

To Meet Customer Demand (cycle stock): Immediately fill customer orders Deploy the product / material near where it will be used 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 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 To Decouple Dependencies in the Supply Chain: Separating operations in a process Smoothing production and reducing peak period capacity needs

Assumptions of Reactive (Pull) Inventory Logic

All customers, market areas, and products contribute equally to profits Infinite capacity exists at the production facility Infinite inventory availability at the supply location Supply cycle time can be predicted and cycle lengths are independent Customer demand patterns are relatively stable and consistent Each distribution warehouse's timing and quantity of replenishment orders are determined independently of all other sites, including the supply source Supply cycle length cannot be correlated with demand

ABC System

An ABC system classifies inventory based the degree of importance: Steps: Determine annual usage or sales for each item. Determine % of total usage or sales that each item represents. Rank items from highest to lowest %. Classify items into groups: A: Highest Value B: Moderate Value C: Least Valuable A method to determine which inventories should be counted & 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

Dependent Demand Replenishment

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

Dependent Demand

Describes the internal demand for parts based on the demand of the final product in which the parts are used. Determined / Calculated Demand 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: Pick-up Truck Engine

Determining How Much to Order

Economic Order Quantity - A quantitative decision model based on the trade-off between the annual ordering costs and the annual inventory holding costs Generally used as a baseline for further modification before determining the actual quantity to order

Practical Considerations of EOQ (Volume Economies of Scale)

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

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 Total Cost = Purchase Cost + Ordering Cost + Holding Cost

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) 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) is a modified QR that eliminates the need for replenishment orders Profile 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)

Categories of Inventory

There are four main 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

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

Inventory Carrying Cost Components

Inventory Carrying Cost is the expense associated with maintaining inventory Annual inventory carrying cost percent times average inventory value 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

Inventory Control Using Reactive Approaches

Inventory control defines how often inventory levels are reviewed to determine when and how much to order Periodic Review monitors inventory status of an item at regular intervals such as weekly or monthly Perpetual Review continuously monitors inventory levels to determine inventory replenishment needs

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.

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

Service Level

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 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 your service level vary by customer? . . . by product?

Safety Stock with Combined Uncertainty

Planning for both demand and supply uncertainty requires combining two independent variables The joint impact of the probability of both demand and supply variation must be determined Direct method is to combine standard deviations using a convolution formula The calculations are beyond the scope of this course but you should understand that the concept exists and there is a method for addressing this situation.

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

Obsolescence

The model may generate an order quantity which would create spoilage or obsolescence

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

Safety Stock in Dependent Demand Situations

Three approaches to introduce safety stock into dependent demand situations if necessary Put safety time into the requirements plan e.g., order a component earlier than needed to assure timely arrival Increase the replenishment order by a quantity specified by some estimate of expected plan error, i.e., over-planning / top-level demand e.g. assume plan error will not exceed 5 percent Utilize statistical techniques to set safety stocks directly for a component rather than to the item of top-level demand

Inventory Deployment Planning Approaches

Two planning approaches to coordinate inventory requirements across multiple locations in the supply chain Fair Share Allocation provides each distribution facility with an equitable distribution of available inventory Limited ability to manage multistage inventories Requirements Planning integrates across the supply chain taking into consideration unique requirements Materials Requirements Planning (MRP) is driven by a production schedule Distribution Requirements Planning (DRP) is driven by supply chain demand

Time Buckets

are discrete increments of time used to facilitate planning activities

Segmentation Strategy

definition specifies all aspects of inventory management process for each segment of inventory e.g., service objectives, forecasting method, management technique, and review cycle

Demand Uncertainty

involves the variation in sales during the lead time necessary to replenish inventory

Supply (or performance cycle) Uncertainty

involves variation in the time and/or quantity necessary to replenish inventory

Inventory Control

is the managerial procedure for implementing an inventory policy