Lecture 21

Inventory Fundamentals

Books• Introduction to Materials Management, Sixth Edition, J. R. Tony Arnold, P.E., CFPIM, CIRM, Fleming

College, Emeritus, Stephen N. Chapman, Ph.D., CFPIM, North Carolina State University, Lloyd M. Clive, P.E., CFPIM, Fleming College

• Operations Management for Competitive Advantage, 11th Edition, by Chase, Jacobs, and Aquilano, 2005, N.Y.: McGraw-Hill/Irwin.

• Operations Management, 11/E, Jay Heizer, Texas Lutheran University, Barry Render, Graduate School of Business, Rollins College, Prentice Hall

Objectives

• Inventory Fundamentals• Aggregate inventory management• How company use their inventory• Objectives of Inventory management• Relevant inventory cost• Inventory function• Types of inventory• Material Flow• Functions of inventory• Inventory cost• Inventory turns

Amazon.com

Amazon.com started as a “virtual” retailer – no inventory, no warehouses, no overhead; just computers taking orders to be filled by others

Growth has forced Amazon.com to become a world leader in warehousing and inventory management

Amazon.com

1. Each order is assigned by computer to the closest distribution center that has the product(s)

2. A “flow meister” at each distribution center assigns work crews

3. Lights indicate products that are to be picked and the light is reset

4. Items are placed in crates on a conveyor. Bar code scanners scan each item 15 times to virtually eliminate errors.

Amazon.com

5. Crates arrive at central point where items are boxed and labeled with new bar code

6. Gift wrapping is done by hand at 30 packages per hour

7. Completed boxes are packed, taped, weighed and labeled before leaving warehouse in a truck

8. Order arrives at customer within a week

Inventory Fundamentals • What is inventory?

– Materials and supplies that a business or institution carries either for sale or to provide inputs or supplies to the production process.

– Those stocks or items used to support production (raw materials and work-in-process items), supporting activities (maintenance, repair, and operating supplies), and customer service (finished goods and spare parts)

- APICS Dictionary

Inventory Fundamentals

• Can production be planned without managing inventory?– since inventory either results from production or supports

it, the two cannot be managed separately separately and must be coordinated• Production planning is concerned with overall inventory• Master planning is concerned with end items• Material requirements planning is concerned with

component parts and raw material

Aggregate Inventory Management

• Aggregate inventory management is concerned with managing inventories according to their classifications (raw material, work-in-process, finished goods, etc.) and the function they perform. It is financially oriented and is concerned with the costs and benefits of carrying the classifications of inventories.

Aggregate Inventory Management

• Aggregate inventory management involves

– Flow and kind of inventory needed

– Supply and demand patterns

– Functions inventory performs

– Objectives of inventory management

– Costs associated with inventory

Item Inventory Management

• Management must establish decision rules about individual

inventory items:

– Importance of inventory items

– How they are to be controlled

– How much to order at one time

– When to place an order

How Companies Use Their Inventory

1. Anticipation or seasonal inventory2. Fluctuation Inventory or Safety stock: buffer demand

fluctuations3. Lot-size or cycle stock: take advantage of quantity

discounts or purchasing efficiencies4. Transportation or Pipeline inventory5. Speculative or hedge inventory protects against some

future event, e.g. labor strike6. Maintenance, repair, and operating (MRO)

inventories

Objectives of Inventory Management

Provide desired customer service level• Customer service is the ability to satisfy customer

requirements– Percentage of orders shipped on schedule– Percentage of line items shipped on schedule– Percentage of $ volume shipped on schedule– Idle time due to material and component shortages

Inventory Objectives con’t

Provide for cost-efficient operations:– Buffer stock for smooth production flow– Maintain a level work force– Allowing longer production runs & quantity discounts

• Minimum inventory investments:– Inventory turnover– Weeks, days, or hours of supply

Customer Service Level Examples

• Percentage of Orders Shipped on Schedule– Good measure if orders have similar value. Does not capture value.– If one company represents 50% of your business but only 5% of your

orders, 95% on schedule could represent only 50% of value • Percentage of Line Items Shipped on Schedule

– Recognizes that not all orders are equal, but does not capture $ value of orders. More expensive to measure. Ok for finished goods.– A 90% service level might mean shipping 225 items out of the total 250 line

items totaled from 20 orders scheduled• Percentage Of Dollar Volume Shipped on Schedule

– Recognizes the differences in orders in terms of both line items and $ value

Inventory Investment Measures Example: The Coach Motor Home

Company has annual cost of goods sold of $10,000,000. The average

inventory value at any point in time is $384,615. Calculate inventory

turnover and weeks/days of supply.• Inventory Turnover:

• Weeks/Days of Supply:

turns inventory 26$384,615

0$10,000,00

value inventory average

sold goods ofcost annualTurnover

2weeks0/52$10,000,00

$384,615

dollarsin usage weekly average

dollarsin handon inventory averageSupply of Weeks

days 100/260$10,000,00

$384,615Supply of Days

Relevant Inventory Costs

Item Cost Includes price paid for the item plus other direct costs associated with the purchase

Holding Costs Include the variable expenses incurred by the plant related to the volume of inventory held (15-25%)

Capital Costs The higher of the cost of capital or the opportunity cost for the company

Ordering Cost

Fixed, constant dollar amount incurred for each order placed

Shortage Costs

Loss of customer goodwill, back order handling, and lost sales

Risk costs Obsolescence, damage, deterioration, theft, insurance and taxes

Storage costs Included the variable expenses for space, workers, and equipment related to the volume of inventory held

Relevant Inventory Costs

Determining Order Quantities

Lot-for-lot Order exactly what is needed

Fixed-order quantity

Specifies the number of units to order whenever an order is placed

Min-max system

Places a replenishment order when the on-hand inventory falls below the predetermined minimum level.

Order n periods

Order quantity is determined by total demand for the item for the next n periods

Functions of Inventory

1. To decouple or separate various parts of the production process

2. To decouple the firm from fluctuations in demand and provide a stock of goods that will provide a selection for customers

3. To take advantage of quantity discounts

4. To hedge against inflation

Types of Inventory

Raw material Purchased but not processed

Work-in-process Undergone some change but not completed A function of cycle time for a product

Maintenance/repair/operating (MRO) Necessary to keep machinery and processes

productive

Finished goods Completed product awaiting shipment

The Material Flow Cycle

Input Wait for Wait to Move Wait in queue Setup Run Outputinspection be moved time for operator time time

Cycle time

95% 5%

Inventory Management

How inventory items can be classified How accurate inventory records can

be maintained

Inventory and the Flow of Materials

• Inventory can be classified according to the following flow:– Raw material– Work-in-process (WIP)– Raw and In-Process (RIP)– Finished goods– Distribution– Maintenance, repair, and operating supplies (MRO)

Inventory and the Flow of Materials

• Raw materials - purchased materials, component parts, and subassemblies.

• Work-in-process (WIP) - materials that have entered the manufacturing process and are being worked on or waiting to be worked on.

• Raw and in-process (RIP) - raw materials or work-in-process, a term used in JIT to account for shipments to point-of-use.

Inventory and the Flow of Materials

• Finished goods - finished products of the production process that are ready to be sold as completed items.

• Distribution inventories - finished goods located in the distribution system.

• Maintenance, repair, and operational supplies (MROs) - items used in production that do not become part of the product.

Functions of Inventories

• Inventory serves as a buffer between:– supply and demand– customer demand and finished goods– finished goods and component availability– requirements for an operation and the output from the

preceding operation– parts and materials to begin production and the supplies of

materials

Functions of Inventories

• Purposes of inventory– Anticipation inventory - to anticipate future demand – built up to help level production and to reduce costs of

changing production rates– Examples:

• created ahead of a peak selling season, a promotion program, vacation shutdown, or possibly a strike

Functions of Inventories

• Purposes of inventory (continued)– Fluctuation inventory - to cover random fluctuations in

supply and demand or lead time (commonly called safety stock)

– Purpose - to prevent disruptions in manufacturing or deliveries to customers

Functions of Inventories

• Purposes of inventory (continued)– Lot-size inventory - to purchase or manufacture in

quantities greater than needed immediately– Purpose - to take advantage of quantity discounts, to

reduce shipping, clerical, and setup costs, and in cases where it is impossible to make or purchase items at the same rate they will be used or sold

Functions of Inventories

• Purposes of inventory (continued)– Transportation inventory - to cover the time

needed to move goods from one location to another (sometimes called pipeline inventory)

– Hedge inventory - to protect against price fluctuations

Inventory Objectives

• Inventories must be coordinated to meet three conflicting objectives:

– Maximize customer service

– Low-cost plant operation

– Minimum inventory investment

Inventory Costs

• Costs used for inventory management decisions– Item costs

– Carrying costs

– Ordering costs

– Stockout costs

– Capacity-related costs

Inventory Costs

• Item costs– Item costs include the cost of the item and all costs

to get the item into the facility:• product

• transportation

• customs duties

• insurance

• direct material, direct labor, and factory overhead

Inventory Carrying Costs

• Carrying costs– Carrying cost include all costs caused by the amount of

inventory carried. Three categories used are:• Capital costs

– money tied up in inventory• Storage costs

– space, personnel, and equipment• Risk costs

– Obsolescence, damage, pilferage, insurance, and deterioration

Inventory Carrying Costs

• The annual carrying costs depend on the average inventory carried. The more that is ordered at one time, the higher the average inventory.

• The annual cost of carrying inventory can be decreased by ordering less at one time.

Inventory Ordering Costs

• Ordering costs - include the costs of placing an order with a factory or outside supplier.– Categories included in ordering cost are:

• Production control costs• Setup and teardown costs• Lost capacity costs

– Every time an order is placed on a work center, the time taken to set up is lost as productive output time. It is particularity important with bottleneck operations.

• Purchase order costs

Inventory Ordering Costs

• The annual ordering cost depends on the number of orders placed in a year

• The annual cost of ordering can be reduced by decreasing the cost of placing an order and by reducing the number of orders placed

• The number of orders per year can be reduced by ordering more at any one time

Inventory Costs

• Stockout costs– If demand during lead time exceeds the forecast

and available inventory, we can expect a stockout. Possible costs of a stockout include:• Backorder costs• Lost sales costs• Lost customer costs

Inventory Costs

• Capacity-related costs– These costs are those of changing production

levels. They include:• Overtime / slack time• Hiring• Layoff• Training• Shift premiums

Inventory Turns

• Inventory turns: a measure of how effectively inventories are being used. The ratio of Annual Cost of Goods Sold divided by average inventory in dollars

Inventory Turns Example

Example from Page 238What will be the inventory turns ratio if the annual

cost of goods sold is $24 million and the average inventory is $6 million?

Inventory turns = Annual COGS / Avg. inv. $ = $24 million / $6 million = 4

Inventory Turns Example

What would be the reduction in inventory if inventory turns were increased to 12?

Avg. inv. $ = Annual COGS / Inventory Turns= $24 million / 12 = $2 million

Reduction = $6 million - $2 million = $4 million

If the carrying cost is 25%, what will the savings be?Savings = $4 million X 25% = $1 million!

End of Lecture 21