[CHAPTER 7] Inventory Management and Service Levels

Inventory Carrying Cost Components => Obsolescence

deterioration of product during storage, and shelf-life ex. food and Pharma sell-by dates

the EOQ calculation will be impacted by volume economies of scale such as: => Individual Item Purchase Price Discounts

discounts for ordering larger quantities; if the volume discounts is sufficient to offset the added cost from carrying additional inventory, then ordering a larger volume may be desirable

Safety Stock Bell Curve Diagram

safety stock covers for actual demand exceeding forecasted demand but only up to a point

3 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

Independent Demand

the demand for the final product; demand pattern affected by trends, seasonal patterns & market conditions => forcasted demand: potential need for safety stock ex. automobile

Common Measures of Service Level => Performance Cycle (lead time)

the elapsed time between release of a purchase order by the buyer to the receipt of shipment

Constraints on the Practical Use of EOQ => Transportation

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

3 Ways to Calculate Safety Stock => 3. Statistical Calculations

the mathematical approach, using the mathematical theories of probability, imposes order and regularity on aggregate of more or less distinct elements => different statistical calculations are available and they provide better results than fixed and time-based safety stock calculations

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

Constraints on the Practical Use of EOQ => Storage Capacity

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

Constraints on the Practical Use of EOQ => Obsolescence

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

3 Approaches to introduce safety stock into Dependent Demand situations if necessary

1. Add Safety Time 2. Increase the replenishment order 3. Utilize statistical techniques

3 Steps Required for Planning Safety Stock

1. Determine the likelihood of a stockout using a probability distribution, (ex. forecast accuracy/error) 2. Estimate the demand during a potential stockout period 3. Establish the desired level of stockout protection, (ex. the desired service level)

6 Benefits of a Segmentation Strategy such as ABC

1. End of Life Management 2. Supplier Negotiation 3. Inventory Optimization 4. Strategic Pricing 5. Resource Allocation 6. Customer Service Levels

3 Ways to Calculate Safety Stock

1. Fixed Safety Stock Quantity 2. Time-based Calculation 3. Statistical Calculations

in addition to an ABC segmentation, companies using Lean Inventory Management to further control inventory may also opt to implement a VED Analysis which attempts to classify the items used into 3 broad categories based on their criticality for the company

1. Vital 2. Essential 3. Desirable

Inventory Ordering Cost Components

Order Preparation costs Order Transportation costs Order Receipt processing costs Material Handling coasts

Inventory Carrying Cost Components

Cost of Capital Taxes Insurance Obsolescence Storage

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 (MRP)

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

2 Planning Approaches to Coordinate Inventory Requirements across multiple locations int he supply chain:

Fair Share Allocation Requirements Planning

3 Inventory Management Practices

I. Product/Market Classification II. Segmentation Strategy III. Policies and Parameters

Inventory management models are generally classified as:

Independent Demand Dependent Demand

the EOQ calculation will be impacted by volume economies of scale such as:

Individual Item Purchase Price Discounts Multiple-Item Purchase Price Discounts Transportation Freight-Rate Discounts

Constraints on the Practical Use of EOQ

Limited Capital Storage Capacity Transportation Obsolescence Production Lot Size Unitization

Questions in Inventory Management => Who are your key customers?

Manufacturers (internal/external), Wholesalers, Distributors, Retailers, Consumers => what level of service do they require? does it differ by customer? => what is important to them? => what value do they create? => what risks do they take?

Common Measures of Service Level

Performance Cycle Order Fill Case Fill Rate Line Fill Rate

2 Approaches to Counting Inventory to maintain accurate inventory records:

Perpetual Inventory System Periodic Inventory System

Limitations to Inventory Deployment Planning Approaches

Requires accurate and coordinated forecasts for each warehouse Requires consistent and reliable product movement between warehouse facilities Subject to frequent rescheduling because of production breakdowns or delivery delays

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

3 Ways to Calculate Safety Stock => 2. Time-based Calculation

Time-based safety stock level is used to calculate the stock required over a fixed period => with the cycle stock, usually a percentage or a week's average sales is added => when items are slow moving, there are drawbacks as there is no connection to lead-time => can result in a large amount of unnecessary capital tied up in safety stock, which becomes excess stock sitting in warehouse

2 Planning Approaches to Coordinate Inventory Requirements across multiple locations int he 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

[DRP] Distribution Requirements Planning

a time-phased finished goods inventory replenishment plan in a distribution network; the function of determining the need to replenish inventory at branch warehouses => DRP is a logical extension of the MRP system and ties physical distribution the manufacturing planning and control system

2 Planning Approaches to Coordinate Inventory Requirements across multiple locations int he supply chain => 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

6 Benefits of a Segmentation Strategy such as ABC => 3. Inventory Optimization

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

6 Benefits of a Segmentation Strategy such as ABC => 6. Customer Service Levels

allows planners to set customer service levels based on the product classification, which improves overall supply chain performance by carrying less safety stock => customer service level is set by product and depends on multiple factors such as the item cost, demand, and margin

Inventory Carrying Cost Components => Insurance

based on estimated risk or loss over time and facility characteristics

ABC classification allows different inventory management techniques to

be applied to different segments of the inventory to increase revenue and decrease costs => A items are given the highest priority (80/20 rule); generally, A items are approximately 20% of the total number of items, but about 80% of the total inventory cost => B&C items are the other 80% of the total number of items, but only 20% of the total inventory cost

Segmentation Strategy => ABC Classification A: highest value B: moderate value C: least valuable

classifies inventory based on the degree of importance 1. determine annual usage or sales for each item 2. determine % of the total that each item represents 3. rank items from highest to lowest % 4. classify items into groups

ABC Classification => 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

Planning for both demand and supply uncertainty requires

combining two independent variables as the joint impact of the probability of both demand and supply variations must be determined

3 Ways to Calculate Safety Stock => 1. Fixed Safety Stock Quantity

companies can set a fixed level of safety stock for their goods => number may be based on the judgement of the operations manager or on assumed stock level calculations => often set on an aggregated level and not on the individual item => this method may lead to high inventory costs or stock-outs since demand is not always constant or similar for all the items int eh group for which the aggregation is done

6 Benefits of a Segmentation Strategy such as ABC => 2. Supplier Negotiation

company can prioritize and focus on negotiating with suppliers of the class A category items since they represent 70-80% of the money spent => negotiation needs to be win-win; 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 Management Practices => III. Policies and Parameters

defined at the detail level ex. data requirements, software applications, performance objectives, and decision guidelines

Reorder Point

defines when a replenishment order is initiated

safety stock determinations are not intended to

eliminate all stock outs, just the majority of them

Finished Goods Inventory Deployment is determining where to stock each item and

evaluating alternative deployment and fulfillment strategies from a total network, logistics, and cost to serve perspective => must factor in transportation, distribution, and inventory dynamics in a single holistic approach => model and evaluate slow-mover stocking consolidation, postponement and delayed differentiation, hub and spoke fulfillment, and other advanced stocking strategies => quantify the business benefits of adoption before you make operational changes

3 Approaches to introduce safety stock into Dependent Demand situations if necessary => 2. Increase the replenishment order by a quantity specified by some estimate of expected plan error

ex. over-planning/top-level demand (frequently used if there is a history of quantity issues) ex. order an additional 5%

Practical use of EOQ

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

Inventory Carrying Cost Components => Storage

facility expense related to product holding rather than product handling

3 Inventory Management Practices => I. Product/Market Classification

groups products, markets, or customers with similar characteristics together to facilitate inventory management ex. classify by sales, profit contribution, inventory value, usage rate or item category. ABC classification system

ABC Classification => C items

have the lowest value, and hence the lowest priority

6 Benefits of a Segmentation Strategy such as ABC => 4. Strategic Pricing

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

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

Review Frequency defines

how often inventory levels are reviewed => both methods compare the item's on-hand and on-order inventory to the Reorder Point; if the total <= reorder point, then a replenishment order is initiated

the EOQ calculation will be impacted by volume economies of scale such as: => 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

Questions in Inventory Management => How do they inventory decisions you make:

impact service levels to your customers? impact the total cost to serve?

Ordering Costs are

incurred EACH TIME an order is placed

Dependent Demand

internal demand for parts and materials based on the demand for the final product in which the parts and materials used => calculated demand: generally, no need for safety stock => order quantities computed with MRP => relationship between independent and department demand shown in BOM => subassemblies, components, & raw materials are examples of dependent demand items ex. automobile engine

Total Cost is driven by

inventory planning decisions which establish when and how much to order Purchase Cost + Ordering Cost + Holding Cost => Total Cost

Inventory Carrying Cost

is the expense associated with maintaining inventory

the carrying cost percent used by a firm is a managerial policy

it is typically around 24% (around 2% per month)

3 broad categories based on criticality for the company to control inventory => Essential

items whose stock-out cost is very high

3 broad categories based on criticality for the company to control inventory => Desirable

items whose stock-out or shortage causes only a minor disruption for a short duration in the production schedule; cost incurred is very nominal

3 broad categories based on criticality for the company to control inventory => Vital

items without which the production activities or any other activity of the company, would stop, or at least be drastically affected

ABC Analysis => B items

less tightly controlled good records regular review

Positioning of products is important for

minimizing the number of moves and the amount of time spent loading transportation vehicles => becomes even more important when customers are only accepting delivery within a specific time window => traditionally customer order use to be fulfilled completely from a single location, now customer orders can be split and fulfilled from different locations creating additional complexity => an inefficient paring of items and locations might result in a waste of money and resources

Review Frequency => Periodic Review

monitor inventory status of an item at regular intervals such as weekly or monthly

Review Frequency => Perpetual Review

monitor inventory status of an item continuously

Inventory Carrying Cost Components => Taxes

on inventory held in warehouse

the EOQ calculation will be impacted by volume economies of scale such as: => 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

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

No safety stock assumes:

procurement replenishment is predictable and constant vendors and suppliers maintain adequate inventories to satisfy 100% of purchase requirements => but these assumptions do not always hold true

3 Approaches to introduce safety stock into Dependent Demand situations if necessary => 3. Utilize statistical techniques to set safety stocks directly for a component

rather than to the item of top-level demand

6 Benefits of a Segmentation Strategy such as ABC => 5. Resource Allocation

resource allocation is a continuous process requiring periodic tracking of class A items => if class A item is no longer desired by the customers or has lower demand, the item can be moved to a lower classification

ABC Analysis => C items

simplest controls possible minmal records large inventories periodic review and reorder

Inventory Carrying Cost Components => Cost of Capital

specified by senior management

3 Inventory Management Practices => II. Segmentation Strategy

specifies all aspects of inventory management for each segment of inventory ex. service objectives, forecasting method, management technique, and review cycle by segment

Calculating Safety Stock => Service level = 100% minus the probability % of stockout ex. service level of 99% results in a stockout probability of 1%

the most common probability distribution for demand is the Normal Distribution (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 => safety stock is only needed for under-forecast error (when actual demand>forecasted demand)

Common Measures of Service Level => Case Fill Rate

the percent of cases ordered that are shipped as requested

Common Measures of Service Level => Order Fill

the percent of customer orders filled completely as requested

Common Measures of Service Level => Line Fill Rate

the percent of order lines (items) that were filled completely as requested

in the EOQ,

the sum of the annual ordering costs and the 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 => generally used as a baseline for further modification before determining the actual quantity to order

Constraints on the Practical Use of EOQ => Unitization

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

Constraints on the Practical Use of EOQ => Production Lot Size

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

Calculating Safety Stock => Considerations

there are numerous other deterministic safety stock formulas company will have to determine which is the most appropriate for their products many 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

the method for determining safety stock uncertainty is

to combine standard deviations using a convolution formula => method for addressing the situation; don't need to know the calculations for this course

ABC Analysis => A items

very tight control complete and accurate records frequent review via EOQ model

Demand Uncertainty

when and how much product will our customer order?

6 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