chapter 6:

Chapter 6:

Managing Inventory Flows in the Supply Chain

Chapter 6Management of Business Logistics, 7th

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Logistics Profile: Micros and More

“Inventory, inventory, inventory….I am sick and tired of hearing complaints about our inventory levels and the costs associated with carrying inventory,” muttered the COO.

What so important is this statement?


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Micros and More

Inventory has a direct impact to company’s performance.

Management seeks Inventory management and control as a key business logistics activity

Thus, it is useful to understand the importance of inventory from a broad, macroeconomic prospective

We need to gain understanding of:


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Micros and More

What is the role of inventory? What are the important trade-offs in the

management of inventory? What are the relevant inventory costs? Can the supply chain help control

inventory?

Solutions to these questions is important, because:


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Management of Inventory Flows in the Supply Chain: Introduction

Inventory as an asset has taken on increased significance as companies struggle to reduce investment in fixed assets that accommodate inventory (plants, warehouses, etc.).

Changes in inventory affect return on assets (ROA), an important internal and external metric.

Ultimate challenge is to balance supply and demand for inventory.


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Example: Inventory in the Economy

Inventory in the Economy has decreased. As a percentage of the GDP, from

1985 to 2000, inventory levels have decreased from 5.4% to about 3.8%

Examine Table 6-1.


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Table 6-1: Macro Inventory Cost in Relation to U.S. Gross Domestic Product


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On the Line: Inventory Turns

Think of inventory turns as a measure of how well a company’s products are doing in the market and how well its inventory is managed.

There is a continuing move away from traditional build-to-forecast manufacturing models to more flexible build-to-demand systems.

Increasing emphasis on fully integrated supply chain means inventories barely spend any time sitting idle.

“Ideally, zero inventory will maximize cash flow.” Inventory turnover potential is 30 to 40 times/year.


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Inventory in the Firm: Rationale for Inventory

Product Line Proliferation Depth & breath of product lines

trending up. Results in larger inventories.

Examine Table 6-2 Total Logistics Costs-1999.

Inventory carrying costs of $332 billion approach 35 percent of total logistics costs for companies.


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Table 6-2Total Logistics Costs --- 1999


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Inventory in the Firm:

Three types of inventory:

1. Physical supply inventories

2. Physical distribution inventories

3. Functional inventory

We will discuss each of them next!


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1. Physical supply inventories

Use to support a firm’s processing, manufacturing, or assembly functions

Reasons for accumulating materials:a. Purchase economicsb. Transportation savingsc. Safety stockd. Speculative purchasee. Seasonal supply, andf. Source maintenances


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a. Purchase economics

Purchase inventory in large quantities and receiving a price discount

The saving from the discount may exceed the storage cost


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b. Transportation savings

Can be realized when shipping in large quantities and receiving carload/truckload discounts


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c. Safety stock

Is kept to prevent an emergency production shut down

The amount held depends upon the probability of delayed delivery and upon the volume of raw materials the firm utilizes


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d. Speculative purchase

It uses to purchase or hedge against future price increases, changing political policies, delayed deliveries, rising or falling interest rates, or currency fluctuations.

Examples: fuels for airlines, commodity for estate developers


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e. Seasonal supply,

May be accumulated to meet demand throughout the year, because the items may be only available at certain times of the years, or preferred transportation means may be unavailable Examples: goods for x’mas, air

tickets for high traveling seasons


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f. Supply source maintenances

Certain supply sources may not be able to furnish the quantities demanded at one time, so to maintain the supply source, business is given the supplier to keep it operating


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2. Physical distribution inventories

Consist of finished goods awaiting shipping to customers

Reasons include: Transportation saving – low cost if shipment in

carload/truckload

Production saving – high prod gives lower per unit cost

Seasonal demand – high capacity to meet peak seasonal demand

Customer service – improve customer service or reduce lost sales costs

Stable employment – attend not to lose skilled labor

Goods for resale – to meet timely customer needs and satisfaction


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3. Functional inventory

Seven principal functions:a. Cycle stock – firm regularly consumes during normal business

activity

b. Goods in process – necessary to manufacturing goods, or in transit

c. Safety stock – uncertainties in demand, lead time length/out of stock

d. Seasonal stock – advance of the season when needed

e. Promotional stock – response to market promotion

f. Speculative stock – protect stocks needed for production/manufacturing

g. “dead” stock – no value or waist to be disposed of


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Inventory in the Firm: Batching Economies/Cycle Stocks

A. Price discounts Result in trade-offs between large

purchases qualifying for quantity discounts and costs of storing inventory.

Because physical supply inventory is often raw materials, storage costs are often less than savings from buying in bulk, so supplies are stockpiled.


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B. Transportation rate discounts Large quantities often result in

carload freight rates. Largest shipments may qualify for

even lower multiple truckload, carload or trainload rates.

Lower freight rates are often reflected in lower consumer prices.


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Production economics favor long production runs. Results in cycle stock that must be

stored. Cycle stocks can be beneficial as long

as the appropriate analysis is done to cost justify the inventory.


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Inventory in the Firm: Uncertainty/Safety Stocks

Reasons for uncertainty are commonplace. Net results are the same: companies

accumulate safety stock to buffer themselves against uncertainty.

Safety stock more challenging and complex to manage for many firms.


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Inventory in the Firm: Uncertainty/Safety Stocks

Impact of information on uncertainty Trade-off analysis appropriate to assess

risk and measure inventory cost. Information technology can be used in the

supply chain to reduce inventory. Collaborative planning and forecasting

requirements (CPFR) is an example. Bar coding, EDI, the Internet have enabled

companies to reduce uncertainty.


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Inventory in the Firm: Time/In-Transit and Work-In-Process Stocks

Time-related trade-offs from using slower to faster transport modes Faster modes cost more but may save a

larger amount in inventory carrying costs. Work-In-Process inventory should be

examined for possible trade-offs especially in the production of high value goods. Scheduling and actual production times

can be closely examined to reduce inventory.


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Inventory in the Firm: Seasonal Stocks

Seasonality can occur on the inbound and/or outbound side of the firm’s logistics systems.

Perishable supply in agricultural products or seasonal-related transportation problems.

Seasonal demand compressing selling seasons in some industries results in smaller plants producing for stock.


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Inventory in the Firm: Anticipatory Stocks

In some cases, companies anticipate that some forecasted event will negatively impact the production cycle.

For example, labor strikes, shortage of supplies due to weather or political event, or significant price increases may prompt the firm to build inventory levels higher than normal.

Risk assessment is important in these cases.


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How each functional unit views their prospective of inventory?


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The Importance of Inventory in Other Functional Areas

1. Marketing uses inventory to provide strong customer service.

2. Manufacturing uses inventory to schedule longer production runs.

3. Finance wants inventory turnover ratios to be kept high so that risk of inventory loss is reduced and rate of return on assets kept competitively high.


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How to balance all their views?

We thus need to examine what constitute inventory cost in the firm!


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Three reasons why for the importance of inventory cost.

1. inventory costs are a significant portion of total logistics costs for many firms.

2. inventory levels affect customer service levels.

3. inventory cost trade-off decisions affect inventory carrying costs.


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Four main Inventory or carrying Costs:

1. Capital cost2. Storage space cost3. Inventory Service Cost4. Inventory Risk Cost


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1. Capital cost

Opportunity cost associated with investing in inventory, or any asset.

What is the implicit value of having capital tied up in inventory, instead of some other worthwhile project?

Minimum ROR expected from any asset.

Debate on inventory valuation at fully allocated or variable costs only.


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2. Storage space cost

Handling costs, rents, utilities. Logistics develops a cost formula for

storage space costs based on cost behaviors.

Public space mostly variable. Private space a mix of fixed and

variable.


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3. Inventory service cost

Inventory Service Cost Insurance and taxes on stored goods. Varies according to the value of the

goods.


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4. Inventory Risk Cost

Inventory Risk Cost Largely beyond the control of the firm. Due to obsolescence, damage, theft,

employee pilferage.

Their ratio roles on a product value – see next slide


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Table 6-3 Example of Carrying Cost Components for Computer Hard Disks

Cost Percentage of Product Value

Capital 12 %

Storage space 2

Inventory service 3

Inventory 8

Total

25 %


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Inventory Costs: Calculating the Cost of Carrying Inventory

Step 1 - Identify the value of the item stored in inventory, based on policy such as FIFO, LIFO or average cost (e.g. $100).

Step 2 - Measure each individual carrying cost component as a percentage of product value (e.g. 25%).

Step 3 - Multiply overall carrying cost (as a percentage) times the dollar value of the product (e.g. $100 times 25% = $25 inventory carrying cost per year.


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Inventory Costs: Nature of Carrying Cost

Items with basically similar carrying costs should use the same estimate of carrying cost per dollar.

There are exceptions for items that are subject to special consideration for purposes of quick obsolescence or high degree of theft, etc.


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Table 6-4Inventory and Carrying Cost Information for Computer Hard Disks


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What other costs involved?

Two other costs affecting inventory are

1. Order cost – a preparation cost ordering inventory MIS costs for inventory stock level tracking. Preparing and processing purchase orders and receiving reports. Inspecting and preparing inventory for sale.

2. Set up cost Incurred when production changes over from one product to another.

3. Stockout cost4. In-transit carrying cost

Example of ordering cost – see next slide


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Table 6-5 Order Frequency and Order Cost for Computer Hard Disks


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Inventory Costs: Carrying Cost versus Order Cost

Examine Table 6-6. Order costs and carrying costs respond in

opposite ways to increases in volume. This reinforces the logisticians need to be

able to separate costs by how they behave in relation to changes in volume.

Assistance from managerial accountants is available for cost-volume-profit analysis.


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Table 6-6 Summary of Inventory and Cost Information


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Figure 6-1 Inventory Costs


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3. Stockout Cost

Cost of not having product available when a customer wants it.

Consequences:1. Includes backorder costs (special

order).2. Losing one item profit by substituting

a competing firm’s product.3. Losing a customer permanently if

customer finds they prefer the substituted product and/or company.


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How to handle it? Expected Stockout Cost

Possible to handle this by adding safety stock.

In a manufacturing firm, a stockout may result in lost hours of production until the item is restocked.


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4. Inventory in Transit Carrying Cost

Any product inbound to the firm using F.O.B. (free on Board) origin should be counted.

Any product outbound from the firm using F.O.B. destination should be counted.

In transit carrying cost is generally less than for regular inventory because some cost components are not present. No storage costs, no taxes, and

reduced risk of obsolescence.


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Classifying Inventory

The first step of inventory management is to adopting Inventory classification

Two approaches:1. ABC analysis – only discuss this here

2. Critical Value Analysis


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1. ABC Analysis Ranking system

Developed in 1951 by H. Ford Dicky of General Electric3.

Suggested that GE classify items according to relative sales volume, cash flows, lead time, or stockout cost.

Most important inventory put in Group A.

Lesser impact goods put in Groups B and C respectively.


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1. ABC Analysis Pareto’s Rule (80-20 Rule)

Based on a nineteenth century mathematician’s observation that many situations were dominated by a very few elements.

Conversely, most elements had very little influence in most situations.

Separates the “trivial many” from the “vital few”.


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1. ABC Analysis 80-20 Rule

80% of sales will come from 20% of the inventory SKUs (stock keep units)

20% of sales will come from 80% of the inventory SKUs.

The 80-20 Rule has been found to explain many phenomena that interest managers. For example, 80% of sales come from

20% of customers; and vice versa.


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Figure 6-2 ABC Inventory Analysis


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Table 6-7 ABC Analysis for Big Orange Products, Inc.


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Evaluating the Effectiveness of a Company’s Approach to Inventory Management

Four main questions address to this querry:

1. Are customers satisfied with the current level of customer service? If standards have been set in

consultation with the customer, this question can be answered objectively.

Customer loyalty, order cancellation are some questions to ask


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2. How frequently does backordering and/or expediting occur? If records of these events are kept,

the answer to this question can point out the need for a modification or adoption of new inventory strategies.


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3. Is the company calculating an Inventory Turnover ratio for each product SKU? This ratio can provide good

information on whether the inventory is being effectively and efficiently managed.

Examine Table 6-8, Figure 6-3 and Figure 6-4.


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4. How does inventory level behave as sales rise or fall? From sales records, the firm can

determine if inventory levels rise as much as sales, less than sales, or stay about the same regardless of sales levels.


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What is the most important element to render inventory management to be efficient and effective?


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Inventory Visibility The ability of the firm to “see” inventory

on a real-time basis throughout the supply chain system requires:

1. Tracking and tracing inventory SKUs for all inbound and outbound orders.

2. Providing summary and detailed reports of shipments, orders, products, transportation equipment, location, and trade lane activity.

3. Notification of failures in inventory flow.


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Inventory Visibility: General Benefits

1. Improved customer service2. Decreased cost-of-sales3. Improved vendor relations and cost4. Increased Return on Assets5. Improved cash flow6. Improved response time and service

recovery7. Improved performance metrics


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Table 6-8 The Relationship among Inventory Turnover, Average Inventory, and Inventory Carrying Costs


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Figure 6-3 Saving Inventory Dollars by Inventory Turns


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Figure 6-4 Past and Projected Inventory Turnover of Finished Goods

Chapter 6: Summary and Review Questions

Students should review their knowledge of the chapter by checking out the Summary and

Study Questions for Chapter 6.

This is the last slide for Chapter 6

End of Chapter 6 Slides

Managing Inventory Flows in the Supply Chain

chapter 6:

Documents

inventory management

inventory levels

inventory plants

importance of inventory

role of inventory

types of inventory

relevant inventory costs

management of inventory