chapter 11: strategic leadership chapter 10 inventory management

Chapter 11: Strategic Leadership

Chapter 10

Inventory management


Overview

Functions Types Costs

PLANNINGOptimum

levels

CONTROLMaintain

appropriate levels

MODELS


Outcomes

• Understand why businesses keep stock

• Differentiate between the various types of inventory

• Identify inventory-ordering costs and inventory-carrying costs

• Determine a suitable carrying cost percentage

• Set optimum inventory levels

• Perform effective inventory control


• Geographical specialisation– Location economies

– Consolidation

– Economic specialisation

• Decoupling– WIP

– Economic lot sizes greater than demand

– Large shipments at lower transport costs

– Lower cost of purchasing

Functions of inventories


• Balancing supply and demand

– Seasonal production, but year-round consumption

– Seasonal consumption: provide for peaks

• Buffer uncertainties

– Demand uncertainty

– Lead-time uncertainty

• Prevent cost of stockout

Functions of inventories (continued)


Types of inventory

• Based on position in supply chain:– Raw material

– Work-in-process (WIP)

– Packaging material

– Finished goods

• Based on purpose:– Cycle stock

– Transit inventory

– Safety stock

– Speculative stock


Important inventory concepts• Availability

– Definition

– Measurements

• Average inventory

– half order quantity + safety stock

• Inventory turnover


Average inventory and order quantity


Inventory costs

• Ordering costs• Carrying costs


Inventory-ordering costs

• Consist of:– Administration costs– Handling costs

• Depend on where stock is replenished– Outside supplier– Restocking own field warehouse


Carrying-cost percentage

• Used to calculate carrying costs• Expressed as annual % value• Applied to average inventory• ICC = average inventory x %

Example: R1 000 000 x 20% = R200 000

• Assign factor to each cost element


Determine carrying-cost percentageCost element Determinants Exam-

ple

Capital investment - Prime interest rate- Return on investment 17%

Insurance - Direct levy based on risk or exposure- % of insurance costs on average inventory value- Preventative measures

2%

Obsolescence - Problematic to quantify- Deterioration of product while stored- Difference in price

0,5%

Damage Net amount after claims 0,5%

Shrinkage Direct loss related to inventory storage 1%

Storage Space - Allocated to specific products- Type of warehouse

5%

Total 26%


Setting optimum inventory levels

• How much to order– Simple EOQ– EOQ extensions

• When to order– Reorder point

• Safety stock


Simple EOQ: the concept

• Trade-off between ordering and carrying costs

• Remember:– Average inventory = half order size

• Therefore, high OQ results in:– high average inventory and– high carrying costs

• Graph• Formula


Simple EOQ: trade-off


Simple EOQ: formula

EOQ =

Where P = ordering costs ($ per order)

D = annual demand or sales volume in units

C = carrying-cost percentage

V = cost or value per unit

2 P D / C V


EOQ adjustments

• Volume transport rates• Quantity discounts• Production lot size• Multiple-item purchases• Limited capital• Own transport• Unitisation


Determining order point

• When to order• Expressed in SKU units or days of

supply• Formula:

R = D x T + SSWhere R = reorder point in units

D = average daily demand

T = average lead time SS = safety stock


Target-level replenishment

• Fixed order interval• Short interval periodic review• Order quantities vary• Quantity to meet target level• Review period added to lead time

to arrive at targeted reorder point (ROP)


Target-level replenishment (continued)

• TSL = D (T + P) + SS

Where D = average daily demand

T = average lead time

P = review period (days)

SS = safety stock

• Now order to reach target

• Q = TSL - I –

Where Q = quantity to be ordered

TSL = target level

I = inventory status

= quantity on order

Qo

Qo


Demand uncertainty

• Safety stock added to base inventory

• Average inventory = half order quantity + SS

• Normal distribution

• Only consider when demand is greater than 50% in normal distribution

• Calculate:– Mean

– Standard deviation


Normal distribution theory


Normal distribution theory (continued)


Demand uncertainty

• Mean– Average of all values in series– Formula:

μ = ∑ xi /n

• Standard deviation– Formula:

√ (1/n x ∑ (xi-μ)2


Lead-time uncertainty

• Lead time a combination of:– Order communication time– Processing time– Transport time

• Calculation:– Same as demand uncertainty (i.e.

calculate standard deviation)


Combined standard deviation

Formula:

s = √ TSs2 + D2 St

2

Where s = combined standard deviation

T = average lead time

Ss= sales standard deviation D = average sales

St = lead time standard deviation


Fill rate

• Normal distribution theory gives indication of probability of stockout.

• Percentage, not indication of availability levels.

• Fill rate gives indication of magnitude of stockout rather than probability.

• Fill rate = desired customer service objective.

• Fill rate = percentage of units out of stock relative to demand.


Fill rate and order size

• Fill rate influenced by:– Probability of stockout– Replenishment order size

• The larger the order quantity, the lower the magnitude of potential stockouts.

• Example: 20-day period– OQ sufficient for 10 days, stockouts

can occur twice– OQ sufficient for 20 days, stock-outs

will occur once


Fill rate formula

• Formula for SL:

SL = 1-[(s/EOQ) x f(k)]Where f(k) = function of right tail

Or f(k) = (1-SL) x (Q/s)s = combined standard

deviation


Safety stock for given fill rate• Formula for SS:First calculate f(k)

SS = k x sWhere k = safety factor for corresponding

f(k) s = combined standard deviation

k can also be calculated:k = SS/s


Calculating safety stock: example• Information

– EOQ = 300– S = 13– Desired FL = 99%

• SolutionFirst calculate f(k)f(k) = (1-0,99) x (300/13)

= 0,01 x 23,08= 0,2308

k = 0,4 (corresponding factor for f(k) of 0,2308)

SS = 0,4 x 13= 5,2 units


Calculating fill rate: example• Information

– EOQ = 200– s = 13 – SS = 8

• First calculate kk = 8/13 = 0,6154Therefore f(k) = 0,16 (roughly)

• Fill rateSL = 1-[(s/OQ) x f(k)]

= 1-[(13/200) x 0,16]= 1-[0,0650 x 0,16]= 1-0,0104= 0,99 or 99%


Logistics requirements planning (LRP)


Procedure for LRP

• Plan weekly• Start with independent demand• Demand forecasting• Calculate how long stocks will last• Deduct safety stock• Add stock in transit• Calculate date when safety stock is

reached


Procedure for LRP (continued)

• Calculate date of shipment (allow lead time)

• Plan production• Calculate delivery date of materials• Calculate shipment allowing for lead

time


Just in time (JIT): approach• We have items when they are needed and none when they are not needed.

• Demand for one item triggers demand for another.


Conventional vs JIT systems

• Push system• Satisfied with

status quo• Fixed lead time• Product range is

a sales issue• Stock in case of

demand• Convenient

purchase batch size

• Pull system• Continuous

improvement• Reducing lead time• Product range reduc-

tion: inventory issue• Purchase to meet

demand• Buy single or small

quantities


JIT application possibilities

• Typical features of ideal company:– Narrow product range

– Manufacturer

– High volume

– Stable market

– Influential

– Good quality management

– Local suppliers of goods and services

– Dependent and reliable suppliers

– Fast-cycle processes

– Personal commitment


JIT requirements

• Short lead time• Long-term agreements• Close co-operation• Local suppliers• Customers must smooth forecasts• Good estimate of long-term demand• Frequent deliveries


Collaborative inventory initiatives

• Collaborative planning, forecasting and replenishment (CPFR)

• Quick response (QR)• Vendor-managed inventory (VMI)• Profile replenishment (PR)


Pareto analysis

Pareto principle:– Villefredo Pareto: 18th century– 20% of people control 80% of wealth– True in everyday life– 80% of effect is provided by 20% of

cause


ABC analysis using Pareto

• Purpose– Facilitate control

– Minimise effort

– Provide service with least cost and effort

• Procedure– Rank items/lines according to annual turnover

– Annual turnover = annual usage x unit costs

• Classification– A = 10% of lines giving 65% turnover

– B = 20% of lines giving 25% turnover

– C = 70% of lines giving 10% of turnover


80

ABC analysis based on the Pareto principle


Different service levels for inventory categories

CLASS TURNOVER VALUE (%)

LOS

(%)

WEIGHTED LOS (%)

A 66,8 98 65,5

B 23,2 90 20,9

C 10 85 8,5

OVERALL SERVICE LEVEL 94,9


Stock cover

• Time in which stock will run out• Tool for measuring total inventory• Monitor performance of each item• Formula:

current stock x 52 forecast usage

• Result: weeks in hand

SC =


Stock turnover

• Measures inventory management effectiveness

• Formula:

Stock turnover =

Value of annual usageValue of stock in store

• Shows number of times that stock will be used up during the year


Setting stock targets

• Based on ABC• ‘A’ class: tighter control and lower

stock cover• Target for each class• Acceptable ranges:

– A 1 to 4 weeks– B 2 to 8 weeks– C 3 to 20 weeks

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