Session SixSession SixInventory FundamentalsInventory Fundamentals

6-1a

Course OutlineSession 1: Introduction to Supply Chain

Management.Session 2: Forecasting.Session 3: Master Planning.Session 4: Material Requirements Planning.Session 5: Capacity Management & Production

Activity Control.Session 6: Inventory Fundamentals.Session 7: Inventory Management.Session 8: Physical Distribution.Session 9: Quality Management and Purchasing.Session 10: Just-in-Time Manufacturing.

Objectives of Session

Present to participants the fundamentals of inventory including the classification of inventory, objectives and functions of inventory management, costs of inventory, classification and control of various inventory items and simple financial statements

6-2a

Session 6 Outcomes

After completing this session participants should be able to: State the importance of good inventory management.

Classify inventory based on flow of material Describe the functions inventories perform. Discuss the objectives of inventory management

6-2b

Session 6 Outcomes (cont.)

Define all the costs that are relevant to

inventory decisions. Read and develop simple financial statements Define and interpret simple inventory turns

ratio Conduct ABC analysis and suggest inventory

control for each class.

6-3

What is Inventory

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

6-4

Aggregate Inventory Management• Deals with managing according to

its classification as: raw materials, work in process, and finished goods inventory as groups

Finance orientedInvolves

Flow and kind of inventory neededSupply and demand patternsFunctions inventory performObjectives of inventory managementCosts associated with inventory

6-5

Item Inventory Management

Management must establish decision rules about

individual inventory items:Importance of inventory itemsHow they are to be controlledHow much to order at one timeWhen to place an order

6-6a

Inventory and the Flow of Materials

Supplierraw

material

Supplier SupplierCompone

nts MRO

Work in processFinished

goodsWarehous

eWarehous

eWarehous

eCustomerCustomerCustomer

6-6b

Inventory Types

Inventory can be classified into the following:

Raw materialWork in processFinished goodsDistributionMaintenance, repair, & operating supplies

(MRO)

6-7a

Reasons for Carrying Inventory

The only good reason for carrying inventory beyond current needs is if it costs less to carry it than not.

Inventory allows the company to operate with different production rates and batch sizes throughout the supply production, and distribution systems.

6-7b

Reasons for Carrying Inventory

Decouples

Demand from supplyCustomer demands from finished

goodsFinished goods from

component availability

Output of one operation from output of preceding operation

Materials to begin from suppliers of production materials

6-8

Functions of Inventory

Anticipation:anticipate future demandFluctuation: cover fluctuation in supply or

demand (safety stock)Lot size: purchase more than neededTransportation: cover material movement

timeHedge: protect against price

fluctuation

6-9

Inventory Objectives

Best customer serviceLow-cost plant operationMinimum inventory investment

6-10

Basic Problem

Balance cost of carrying inventory with costs of not carrying inventoryCustomer serviceChanging production levelsPlacing orders

Sum of the cost of carrying inventory and the cost of not carrying inventory should be as low as possible

6-11

Inventory Costs

Item costsCarrying costsOrdering costsStock-out costsCapacity-related costs

6-12

Item costs

Cost of item and all costs to get item into the plant

ProductTransportationCustoms dutiesInsuranceDirect material, direct labor, and

factory overhead

6-13

Carrying Costs

Carrying costs can be broken down into three categories:Capital costs Money tied up in inventoryStorage costsSpace, personnel, and

equipmentRisk costs Obsolescence, damage,

pilferage, insurance, and deterioration

These costs increase with the amount of inventory carried

6-14a

Problem 6.1

Given the following percentage costs of carrying inventory, calculate the annual cost if the average inventory is $1,000,000. capital costs are 6%, storage costs are 9% of the average inventory value, and risk costs are 10%.

6-14b

Problem 6.1

Total costs of carrying inventory= 6% + 9% + 10% = 25%

Annual carrying cost= 0.25 1,000,000 = $250,000

6-15

Ordering Costs

Costs of placing and order with the factory or

outside supplier

Costs includeProduction controlSetup and teardownLost capacityPurchase order

6-16a

Problem 6.2

Given the following data, calculate the average

cost of placing one order.

Annual production control cost = $200,000

Average cost of setup and teardown = $200Number of orders per year = 20,000

6-16b

Problem 6.2

Annual production control cost = $200,000

Average cost of setup and teardown = $200Number of orders per year =

20,000

Average cost of placing an order 200,000 20,000

= + 200 = $210

6-17

Stock-out costs

If demand during the lead time exceeds forecast

and available inventory, we can expect a stock-

out, causingBackorder costsLost sales costsLost customer costs

6-18

Capacity-Related Costs

Cost of changing production levelsOver-time/under-timeHiringLayoffTrainingShift premiums

Can be avoided by leveling production (but may build inventory)

6-19a

Problem 6.3Next year quarterly sales forecast is 2000, 3000, 4000, and 3000. Calculate a level production plan, quarterly ending inventory, and average quarterly inventory.

Assume average quarterly inventory is the average of the quarter’s starting inventory and ending inventory. Opening and ending inventories = zero.

If inventory carrying costs are $3 per unit per quarter, what is the annual cost of carrying inventory?

6-19b

Problem 6.3 (Solution)

Q1 Q2 Q3 Q4

Sale2,00

03,00

04,00

03,00

0Production

Ending inventoryAverage inventory

Inventory costAnnual inventory carrying cost

=

6-19c

Problem 6.3 (Solution)

Q1 Q2 Q3 Q4

Sale2,00

03,00

04,00

03,00

0

Production3,00

03,00

03,00

03,00

0Ending

inventory1,00

01,00

00 0

Average inventory

5001,00

0500 0

Inventory cost1,50

03,00

01,50

00

Annual inventory carrying cost = 1500 + 3,000 + 1,500 + 0 = $6,000

6-20

Accounting Systems

Accounting systems classify activities of a company into five types of accounts

balance sheet accounts

income statement accounts

Assets Liabilities Owner’s equity

RevenuesExpenses

6-21

Balance Sheet Equation

Assets = Liabilities + Owners’ equity

Assets: Anything of valueLiabilities: Amounts owedOwners’ equity: What is left over

after liabilities are paid

6-22a

Problem 6.4

A. If the owner’s equity is $1,000 and liabilities are $800, what are the assets worth?

Assets =

6-22+

Problem 6.4

A. If the owner’s equity is $1,000 and liabilities are $800, what are the assets worth?

Assets = Liabilities + Owner’s equity= 800 + 1,000= $1,800

6-22b

Problem 6.4

B. If the assets are $1,000 and liabilities are $600, what is the owners’ equity?

Owners’ equity =

6-22b+

Problem 6.4

B. If the assets are $1,000 and liabilities are $600, what is the owners’ equity?

Owners’ equity = Assets – liabilities= 1,000 – 600 = $400

6-23

Income Statement

Income = Revenue – Expenses

Revenue:Comes form the sale of goods and servicesIncreases owners’ equity

Expenses: Costs incurred in earning revenue

Decreases owners’ equityClassified as:- Cost of goods sold (labor, material,

OH)- General and administrative expense

6-24

Income StatementRevenue $1,000,000Cost of goods sold

Direct labor $200,000Direct material 400,000Overhead 200,000

Total cost of goods sold – 800,000Gross margin (gross profit) $ 200,000General and admin. expense – 100,000Net income (profit) $ 100,000

6-25a

Problem 6.5

A. Given the following data, calculate the gross margin and net income.

Revenue = $1,500,000Direct labor = $300,000Direct material = $500,000Overhead = $400,000General & admin expenses = $150,000

6-25b

Problem 6.5

Revenue $________Cost of goods sold

Direct labor $________Direct material $________Overhead $________

Total cost of goods sold $________Gross margin (gross profit) $________General & admin expense $________Net income (profit) $________

6-25b+

Problem 6.5Revenue $1,500,000Cost of goods sold

Direct labor $300,000Direct material $500,000Overhead $400,000

Total cost of goods sold $1,200,000

Gross margin (gross profit) $300,000General & admin expense $150,000Net income (profit) $150,000

6-25c

Problem 6.5

B. How much would profits increase if, through better materials management, material costs were reduced by $50,000?

If material costs were reduced by $50,000, income would increase by:

6-25c+

Problem 6.5

B. How much would profits increase if, through better materials management, material costs were reduced by $50,000?

If material costs were reduced by $50,000, income would increase by:

$50,000

6-26

Cash Flow Analysis

The inflow and outflow of cash in the business over a given period of time

To survive, a business must have the cash available to pay its bills

6-27

Cash Flow

Inventory state Effect on cash flow

Raw material Cash outflowWork in process Cash outflowFinished goods Cash outflowAccounts receivable paid Cash inflow

6-28

Inventory Turns

A measure of how effectively inventory is being

used

ExampleAnnual cost of goods sold =

$1,000,000Average inventory = $500,000

inventory average

sold goods ofcost annual turnsinventory

2000,500

000,000,1 turnsinventory

6-29a

Problem 6.6

If the annual cost of goods sold is $10 million

and the average inventory is $2.5 million:

a. What is the inventory turn ratio?b. What would be the reduction in average

inventory if, through better materials management, inventory turns were increased to 10 times per year?

c. If the cost of carrying inventory is 20% of the average inventory, what is the annual savings?

6-29b

Problem 6.6

a. Turns Ratio = =

b.

= $________________ Reduction in inventory =

=c. Annual savings =

$

$

ratio turns

goods ofcost annual inventory Average

6-29c

Problem 6.6

a. Turns Ratio = = 4

b.

= = $1,000,000 Reduction in inventory = 2,500,000 –

1,000,00 = $1,500,000c. Annual savings = 20% 1,500,000 =

$300,000

ratio turns

goods ofcost annual inventory Average

000,500,2$0$10,000,00

100$10,000,00

6-30

Strategic Performance Measures

Strategic performance measures relate to a company’s long-range goals

Measures includeProfitabilityMarket shareGrowthProductivity

6-31

Problem 6.7

Given the following information, calculate the

annual cost of carrying inventory.

Orders placed per year = 1,000Receiving cost per order = $15Annual office expense = $8,000Average inventory = $500,000Cost of capital = 10% of average inventory valueCost of storage = 8% of average

inventory value

6-32a

Problem 6.7Orders placed per year = 1,000Receiving cost per order = $15Annual office expense = $8,000Average inventory = $500,000Cost of capital = 10% of ave.

inventoryCost of storage = 8% of ave.

inventory

Annual cost of carrying inventory=

6-32b

Problem 6.7Orders placed per year = 1,000Receiving cost per order = $15Annual office expense = $8,000Average inventory = $500,000Cost of capital = 10% of ave. inventoryCost of storage = 8% of ave. inventory

Annual cost of carrying inventory= Ave. inventory×(cost of capital + cost of storage)= 500,000 × (0.10 + 0.08) = $90,000

6-33a

Problem 6.8An importer operates a small warehouse that has the following annual costs. Wages for purchasing are $80,000, purchasing expenses are $70,000, and customs brokerage is $45 per order. The estimated cost of financing the inventory is 10%, storage costs are 7%, and risk costs are 10%. The average inventory is $500,000, and 10,000 orders are placed in a year. What are the annual ordering and carrying costs? What is the average ordering cost?

6-33b

Problem 6.8

Annual ordering cost =

Annual carrying cost =

Total annual cost =

Average ordering cost =

6-33c

Problem 6.8

Annual ordering cost = 80,000 + 70,000 + (45 10,000) = $600,000

Annual carrying cost = 0.27 500,000 = $135,000

Total annual cost = 600,000 + 135,000 = $735,000

Average ordering cost = 600,000 10,000 = $60

6-34a

Problem 6.9

Given the following data, calculate the gross margin and net income.Revenue = $2,000,000Direct labor = $200,000Direct material = $800,000Overhead = $600,000General & admin expenses = $200,000

6-34b

Problem 6.9

Revenue $________Cost of goods sold

Direct labor $________Direct material $________Overhead $________

Total cost of goods sold $________Gross margin (gross profit) $________General & admin expense $________Net income (profit) $________

6-34c

Problem 6.9

Revenue $2,000,000Cost of goods sold

Direct labor $200,000Direct material $800,000Overhead $600,000

Total cost of goods sold $1,600,000Gross margin (gross profit) $ 400,000General & admin expense $ 200,000Net income (profit) $ 200,000

6-35a

Problem 6.10

If the annual cost of goods sold is $48 million

and the average inventory is $12 million:a. What is the inventory turns ratio?b. What would be the reduction in average

inventory if, through better materials management, the turns ratio were increased to six times per year?

c. If the cost of carrying inventory is 25% of the average inventory, what is the annual savings?

6-35b

Problem 6.10

a. Turns Ratio =

b. Average inventory =

Reduction in inventory =

c. Annual savings =

6-35c

Problem 6.10

a. Turns Ratio = = 4

b.

= = $8,000,000 Reduction in inventory = 12,000,000 –

8,000,00 = $4,000,000

c. Annual savings = 25% 4,000,000 = $1,000,000

ratio turns

goods ofcost annual inventory Average

000,000,12$0$48,000,00

60$48,000,00

6-36a

ABC Inventory Control

For basic questions must be answered:

What is the importance of the inventory items?

How are they to be controlled?How much should be ordered at one

time?When should an order be placed?

6-36b

Concept of ABC Inventory Control

A small number of items will present the most critical values.

ABC inventory control separates the most significant items from the less important.

It is used to determine the degree and level of control used.

6-37

ABC Classification

A items20% of the items account for 80% of the total dollar usage

B items30% of the items account for 15% of the total dollar usage

C items50% of the items account for 5% of the total dollar usage

6-38

ABC Process

1. Establish the item characteristics that influence the results of inventory management

Annual dollar usageScarcity of materialQuality problems

6-39

ABC Process

2. Classify items into groups based on the criteria established

3. Apply a degree of control in proportion to the importance of the group

6-40

Example of ABC AnalysisPart number

Annual unit usage

Unit cost ($)

Annual usage ($)

1 1,100 2 2,2002 600 40 24,0003 100 4 4004 1,300 1 1,3005 100 60 6,0006 10 25 2507 100 2 2008 1,500 2 3,0009 200 2 40010 500 1 500

Total $38,250

6-41a

Example ABC Analysis-cont.Part

numberAnnual $

usageCumulat

ive $ usage

Cumulative % $ usage

Cumulative % of items

2 24,000 24,000 63 105 6,000 30,000 78 208 3,000 33,000 86 301 2,200 35,200 92 404 1,300 36,500 95 5010 500 37,000 97 603 400 37,400 98 709 400 37,800 99 806 250 38,050 99 907 200 38,250 100 100

6-41b

Example ABC Analysis-cont.Part

numberAnnual $

usageCumulat

ive $ usage

Cumulative % $ usage

Cumulative % of items

2 24,000 24,000 63 105 6,000 30,000 78 208 3,000 33,000 86 301 2,200 35,200 92 404 1,300 36,500 95 5010 500 37,000 97 603 400 37,400 98 709 400 37,800 99 806 250 38,050 99 907 200 38,250 100 100

6-41c

Example ABC Analysis-cont.Pareto (ABC) Chart

0

20

40

60

80

100

0 20 40 60 80 100

% no. of items

% a

nn

ual

usa

ge

A B C

6-42a

Problem 6.11

Analyze the given data to produce an ABC classification based on annual dollar usage.

Item no.

Annual $ usage

1 13,1892 156,1273 3344 8,4935 42,7496 5,5897 19,5628 241,8739 1,96210 10,112

Total 500,000

6-42b

Problem 6.11Item

no.

Annual $ usage

Cum. $ usage

Cum. % $ usage

Cum. % of items

Item Clas

s

6-42b+

Problem 6.11Item

no.

Annual $ usage

Cum. $ usage

Cum. % $ usage

Cum. % of items

Item Clas

s

8 241,873

241,873 48.37 10 A

2 156,127

398,000 79.60 20 A

5 42,749 440,749 88.15 30 B

7 19,562 460,311 92.06 40 B

1 13,189 473,500 94.70 50 B

10 10,112 483,612 96.72 60 C

4 8,493 492,105 98.42 70 C

6 5,589 497,694 99.54 80 C

9 1,962 499,656 99.93 90 C

3 344 500,000 100.00 100 C

Total

$500,000

6-42c

Problem 6.11Pareto (ABC) Chart

0

20

40

60

80

100

0 20 40 60 80 100

% no. of items

% a

nn

ual

usa

ge

A B C

6-43

Control Based on ABC ClassificationTwo general rules to followHave plenty of low-value itemsUse control effort saved to reduce

the inventory of A items

A items: Tight controlB items: Normal controlC items: Simplest possible control

6-44

Inventory Control of A Items

A items: Tight control

Complete, accurate recordsRegular, frequent review by

managementFrequent review of forecastsClose follow-up

6-45

Inventory Control of B Items

B items: Normal control

Good recordsNormal processing

6-46

Inventory Control of C Items

C items: Simple control

Make sure there are plentySimple or no recordsLarge order quantities

6-47a

Problem 6.12

Use the given data to classify into A, B, C groups based on annual dollar usage (demand).

ItemAnnua

l Dema

nd

Unit cost $

1 21,000 12 5,000 403 1,600 34 12,000 15 1,000 1006 50 507 800 28 10,000 39 4,000 110 5,000 1

6-47b

Problem 6.12Item no.

Annual Deman

dUnit

cost $Annual $ usage Rank Clas

s

1 21,000 12 5,000 403 1,600 34 12,000 15 1,000 1006 50 507 800 28 10,000 39 4,000 110 5,000 1

Total

6-47b+

Problem 6.12Item no.

Annual Deman

dUnit

cost $Annual $ usage Rank Clas

s

1 21,000 1 21,000 4 B2 5,000 40 200,00

0 1 A3 1,600 3 4,800 7 C4 12,000 1 12,000 5 B5 1,000 100 100,00

0 2 A6 50 50 2,500 9 C7 800 2 1,600 10 C8 10,000 3 30,000 3 B9 4,000 1 4,000 8 C10 5,000 1 5,000 6 C

Total

380,900

6-47c

Problem 6.12Item

no.

Annual $ usage

Cum. $ usage

Cum. % $ usage

Cum. % of items

Class

6-47c+

Problem 6.12Item

no.

Annual $ usage

Cum. $ usage

Cum. % $ usage

Cum. % of items

Class

2 200,000

200,000 52.5 10 A

5 100,000

300,000 78.8 20 A

8 30,000 330,000 86.6 30 B

1 21,000 351,000 92.2 40 B

4 12,000 363,000 95.3 50 B

10 5,000 368,000 96.6 60 C

3 4,800 372,800 97.9 70 C

9 4,000 376,800 98.9 80 C

6 2,500 379,300 99.6 90 C

7 1,600 380,900 100.0 100 C

380,900

6-47d

Problem 6.12

Pareto (ABC) Chart

0

20

40

60

80

100

0 20 40 60 80 100

% no. of items

% a

nn

ual

usa

ge

A B C

6-2a

Session 6 Outcomes

After completing this session participants should be able to: State the importance of good inventory management.

Classify of inventory based on flow of material Describe the functions inventories perform. Discuss the objectives of inventory management

6-2b

Session 6 Outcomes (cont.)

Define all the costs that are relevant to

inventory decisions. Read and develop simple financial statements Define and interpret simple inventory turns

ratio Conduct ABC analysis and suggest inventory

control for each class.