Inventory Management

Learning Outcomes
• Describe the aim of inventory management

• Understand the impact of inventory on financial performance

• Identify how to use different inventory performance measures

• Understand the two ‘burning’ questions for all inventory systems:

- Volume Decision: How much to order? (EOQ approach)
- Timing Decision: When to order? (Reorder Points & Safety Stocks)

• Describe the advantages & disadvantages of Just In Time (JIT) Delivery

 The aim of inventory management
According to Lysons and Farrington (2006), there are four main aims of
inventory management:

(1). Provide both internal and external customers with the required
service levels in terms of quantity and order fill rate.

(2). Ascertain present and future requirements for all types of inventory
to avoid overstocking while avoiding ‘bottlenecks’ in production.

(3). Keep costs to a minimum by variety reduction, economical lot sizes

and analysis of costs incurred in obtaining and carrying
inventories.

(4). Provide upstream and downstream inventory visibility in the supply

chain.
 Inventory Illustration
Input
process Input flow of materials
(rate of supply from input processes)

Inventory level
Inventory

Scrap flow
Output Output flow of materials
process
(rate of demand from output processes)

Inventory compensates for differences in timing

between the supply and demand
 Why hold inventory? reducing warehouse
Some examples…. attractive
handling costs

exchange rates

variation in demand
for finished goods
reduced unit production
RAW freight costs flexibility
MATERIALS enables
uncertainty of operations to be price
lead times uncoupled discounts
(maintenance) display of
suppliers discounts
for large orders WORK IN products
PROGRESS favourable
units unable to be
supplied on demand exchange rates
production rates
anticipated future are uneven FINISHED
price rises improves
delivery speed GOODS
production
disruptions Speculation:
anticipated price VALUE
smoothing increases
production flows variation in
ADDED
customer demand
Why companies avoid holding inventory?
• Inventory ties up money (e.g. working capital)

• Inventory incurs storage costs

• Inventory may become obsolete

• Inventory can be damaged or deteriorate

• Inventory could be lost

• Inventory might be hazardous

• Inventory uses space that could be used to add value

• Inventory involves administrative and insurance costs

 Impact of inventory
on financial performance
Total revenue:
• Increasing the percent of on-time deliveries to customers will increase
total revenue because satisfied customers will buy more services and
products.
• Increasing the percent of on-time deliveries from suppliers has the effect
of reducing the costs of inventories, which has implications for the cost
of goods sold and contribution margins.

Cost of goods sold:

• Being able to buy materials at a better price and process, or transform
them more efficiently, will improve the firm’s cost of goods sold, and
ultimately net income.
• Improvements will also have an effect on contribution margin.

Operating expenses:
• Designing a supply chain with minimal capital investment can reduce
depreciation charges.
 Impact of inventory
on financial performance
Cash flow:
• Cash-to-cash is the time lag between paying for services and materials
needed to produce a service or product and receiving payment for it.
• The shorter the time lag, the better the cash flow position of the firm
because it needs less working capital.
• The goal is to have a negative cash-to-cash situation, which is possible
when the customer pays for service or product before the firm has to pay
for the resources and materials needed to produce it.

Working capital:
• Money used to finance ongoing operations.
• Decreasing weeks of supply or increasing inventory turns reduces the
working capital needed to finance inventories.

Return on assets:
• Techniques for reducing inventory, transportation, and operating costs
related to resource usage and scheduling are discussed in the chapters
to follow.
 Linking inventory costs
to financial performance
inventory driven costs

price product obsolescence component

protection return devaluation

traditional
Return On revenues expenses inventory
Net Assets costs
(RONA) working capital
fixed assets
requirement

days days days

receivables inventory payables
outstanding outstanding outstanding

Callioni et al (2005) Inventory Driven Costs, Harvard Business Review

 Inventory Performance Measures
Lead times: time taken to supply a requirement from the time a need is
ascertained to the time the need is satisfied.

Service levels: actual service level attained in a given period: i.e…

= Number of times the item is provided on demand.
Number of times the item has been demanded.

Rate of stock turn: number of times that a stock item has been sold and replaced
in a given period; i.e…
= sales or issues
average inventory (at selling price)

Stockouts: e.g. stockouts as a percentage of the total stock population during a

given period.

Stock cover: number of days the current stock will last if sales continue at the
anticipated rate.
Days’ stock coverage = current quantity in stock
anticipated future daily rate of usage or sales
 Inventory Measures

Average Number of Number of

Value of Value of
aggregate units of item units of item
= each unit + each unit
inventory A typically on B typically
of item A of item B
value hand on hand

Average aggregate inventory value

Weeks of supply =
Weekly sales (at cost)

Annual sales (at cost)

Inventory turnover =
Average aggregate inventory value
 Inventory Classification – By Location

SUPPLIERS OPERATION CUSTOMERS

raw materials finished goods

work-in-progress
(WIP)
• Raw materials (i.e. input inventory)
– raw materials, bought in items (assemblies & sub-assemblies)

• Work-in-progress (WIP)
– partially processed materials not yet ready for sales.

• Finished goods (i.e. output inventory)

– products ready for shipment.
 Inventory Classification – By Function
• Cycle inventory (i.e. average inventory)
– portion of total inventory that varies with lot (or order) size

• Safety stock inventory (i.e. buffer stock)

– surplus held to protect against uncertainties (demand, lead
time, supply)

• Decoupling inventory
– inventory that is used to allow processes to operative
relatively independently.

• Anticipation inventory
– surplus used to absorb uneven rates of demand /supply

• Pipeline inventory
– inventory moving from point to point in the Supply Chain
– A.k.a as open orders or scheduled receipts
 Inventory Classification – By Value
• Sort by annual dollar volume

• ABC analysis treats high dollar volume parts differently.

Class C
100 — Class B
90 —
Class A
Percentage of dollar value

80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Percentage of SKUs
 Independent Demand & Dependent Demand
Independent Demand
• Independent demand is uncertain. • Demand not related to other items.
• Dependent demand is certain. • i.e. finished goods
• (e.g. cars)
• Demand cannot be precisely forecast.

EXAMPLE:
AUTOMOTIVE SUPPLY CHAIN
Dependent Demand
Original Equipment
• Derived.
Manufacturer (OEM) • i.e. subassemblies/components.
(car factory) • (e.g. car engines / pistons)
• Demand is derived from number of
units to be produced.
1st tier suppliers
(car engine factory)

2nd tier suppliers

(engine piston factory)

Note: The distinction between independent demand & dependent demand is

fundamental to inventory management.
 Characteristics of Inventory Systems

• Demand:

- Constant versus variable

- Known or unknown

• Lead times:

- Constant versus random

- Suppliers

• Excess demand:

- Lost versus backlogged

 Inventory Decisions
• Two ‘burning’ questions for all inventory systems:

– Volume Decision: How much to order? (the order quantity)

– Timing Decision: When to order? (order placement time)

• Ways to answer these questions are:

– Heuristics: (e.g. experience, “rules of thumb”, best guess)

– Optimization Methods: (e.g. the EOQ equation approach)

– Just In Time (JIT) Delivery System (i.e. part of Lean Production)

The Volume Decision

How much to order

 Inventory Profile
• An inventory profile is a visual representation of the inventory level
over time.

• Every time an order is placed, Q items are ordered.

• Assumes that the replenishment order arrives in one batch

(instantaneously).

• Demand is steady and perfectly predictable at a rate of D units per

month.

• The average inventory = Q

2

• The time interval between deliveries = Q

D

• The frequency of deliveries = the reciprocal of the time interval = D

Q
 Basic Inventory Dynamics

order quantity
replenishment

time between orders

Inventory level

Slope = demand rate

Q

receive Time
order
 Example: Inventory Profile

Inventory level

Average inventory
=Q2

Q
D Time

Instantaneous deliveries at a rate of D per period

Q
 Two alternative inventory plans
Inventory level with different order quantities (Q)

Demand (D) = 1000 items per year

400 Plan A
Q = 400

Average inventory
for plan A = 200

Plan B Average inventory

100 Q = 100 for plan B = 50

Time
0.1 yr 0.4 yr
 Economic Order Quantity (EOQ)
• Fixed quantity is usually based on an economic order quantity (EOQ).

• EOQ mathematical model: the optimal ordering quantity for an item of stock
that minimises cost. EOQ provides optimal tradeoff between ordering and
holding cost.

• EOQ approach is useful for repetitive purchasing situations.

Use the EOQ:- Make-To-Stock (MTS) strategy

- Carrying & setup costs are known & relatively stable

Modify the EOQ: - Quantity discounts

- Replenishment not instantaneous

Don’t use the EOQ: - Make-To-Order (MTO) strategy

- Order size is constrained
 Basic Cost Relationships

Total
Cost

Holding
Cost
ACo
st
nnu
al

Ordering
Cost

Order Quantity
Order Quantity and Inventory Related Costs

• Annual holding cost rises as order quantity increases

- more cycle stock.

• Annual ordering cost falls as order quantity increases

- larger orders means fewer orders placed.

• Stock-out cost is only indirectly related to order quantity.

- timing of orders has a much greater impact.
 Cost Relationships for EOQ

Total
Cost

Holding
Cost
ACo
st
nnu
al

Ordering
Cost

Q* Order Quantity
EOQ balances holding
costs and ordering
costs
 EOQ: Assumptions

• FIVE Major Assumptions:

– Demand is known and Constant (D)

– Whole lot sizes

– Only two relevant costs

– Items are independent

– Certainty in lead time and supply

 Inventory Modeling:
How much to Order?

Annual Holding Cost (CC) = Q/2 (H)

Annual Ordering Cost (OC) = D/Q (S)

TOTAL COST: TC = Q/2 (H) + D/Q (S)

Notation
Q = Order quantity (i.e., lot size)
D = Expected demand rate
S = Order processing cost per lot
H = Holding cost per unit per year
OC = Total order processing costs per year
CC = Total holding costs per year
TC = Annual total of all relevant costs
 Economic Order Quantity
• So, What’s the Best Value of Q ?

– Recall:
TC = (D/Q) S + (Q/2) H

– TC is minimized where Q = EOQ

[Differentiating with Q= 2 D S = EOQ

respect to Q]
H

– EOQ (Economic Order Quantity) provides optimal tradeoff

between ordering and holding cost
 Example - EOQ for Copy Paper
D (i.e. Expected demand rate) = 20 reams per week
= 1040 reams per year

H (i.e. Holding cost per unit per year) = $0.60 per ream
S (i.e. Order processing cost per lot) = $30 per order

Lead Time (LT) = 9 days

Number of Days Per Year = 360 days

2 DS
EOQ =
H

= 2(1040)(30)
.60
= 322 reams
 Impact of parameter changes on the EOQ

TABLE 12.1 | SENSITIVITY ANALYSIS OF THE EOQ

Parameter EOQ Parameter EOQ Comments
Change Change

Increase in lot size is in proportion to the

Demand 2DS
H
↑ ↑ square root of D.

Weeks of supply decreases and inventory

Order/Setup
Costs
2DS
H
↓ ↓ turnover increases because the lot size
decreases.

Holding Larger lots are justified when holding

Costs
2DS
H
↓ ↑ costs decrease.
The Timing Decision

When to order
 Reorder Point Decisions
Re-order point = The point in time at which more items are ordered, usually
calculated to ensure that inventory does not run out before the next batch of
inventory arrives.

Re-order level = The level of inventory at which more items are ordered

When to reorder an item is a function of:

- The length of supplier’s lead time
- The distribution of demand during lead time (level of demand uncertainty)
- The willingness of the firm to have stock-outs
- The costs associated with holding safety stock (or buffer) stock
 The re-order point

Inventory level

Re-order level

Re-order point

Order lead time Time

 Example - EOQ for Copy Paper
• ROP = Re-Order Point

• ROP = demand during lead time = D x LT

• Where: D = demand (1040 reams per year);

LT = lead time (9 days)

• Note: D and LT must be expressed in the same time units!

• ROP = (D/360) x (LT)

• ROP = (1040/360) x (9)

• ROP = 26

• So, reorder when inventory levels reach 26 units, order 322 reams
at that point.

• However, this only applies when demand is known and certain

 Safety Stock
• If demand and/or lead time is variable (i.e. uncertain), we must add
some safety stock (SS).

• Safety Stock (SS) provides protection against stock-outs

• The higher the demand and/or lead time uncertainty, the more
safety stock we need to hold

• The more safety stock we hold, the earlier we place an order

• Therefore, we still have stock in inventory when the order arrives

– Because of variability sometimes we have higher-than-average

safety stock, and sometimes less-than-average
Inventory planning allowing for shortages

Inventory level

Time

Shortages
Safety stock(s) helps to avoid stock-outs when demand
and/or order lead times are uncertain

Re-order level (ROL)

Distribution of
Inventory level

lead-time
Q usage

d1
d2
?
S

t1 t2
Time
 Summary
EOQ and the order quantity decision

Ordering
costs

Stock-holding
costs

How much
to order?
 Summary
EOQ and the timing decision

Ordering
too late

Ordering
too early

When to
order?
 Just In Time (JIT) Delivery Systems
• The aim of JIT systems: “Just in Time (JIT) is a method of planning and
control and an operations philosophy that aims to meet demand
instantaneously with perfect quality and no waste” (Slack et al, 2007)
• JIT means producing goods and services exactly when they are needed:
not before they are needed so that they wait as inventory, nor after they are
needed so that it is the customers who have to wait.

• Characteristics of JIT include:

- Delivery of parts to meet production;
- Production to meet customer demands;
- Means of production control;
- JIT forms part of the Toyota Production System (Lean Production).

• Western firms tend to produce large quantities of products - just in case –

using EOQ to determine purchase quantity and batch size.
• Their Japanese counterparts produce small quantities just in time (JIT).
Example: JIT in the automotive industry

Source: Cachon and Olivares (2010) Management Science

 Just In Time (JIT) Delivery
• Achieve production outcomes using minimal inventories
(e.g. raw materials, WIP, finished goods)

• Parts “pulled” to the next workstation on a "just in time” basis.

• JIT emphasizes:
– Reduction of waste
– Continuous improvement
– Synchronization of material flows within the organization
– Channel integration
– Extending partnerships in the supply chain

• JIT   lean production

• JIT  pull demand system (e.g. pull-led supply chain)
• JIT operates with very little “fat” (i.e. inventory)
 The impact of JIT on operating performance
• JIT is more than just inventory management, it is a new way of production, and
forms part of the LEAN PHILOSOPHY.

• JIT improves operating efficiency and creates a smooth flow of materials.

• It can improve production visibility and total productive maintenance (TPM).

• A JIT approach can lower set up times, and create throughput time improvements.

• Reduces risk of quality defects, and stoppages in the production line.

• JIT can increase the responsiveness of the firm, and the wider supply chain.

• JIT reduces the risk of technological obsolescence and perishability.

• JIT can increase the efficiency of cash flow.

• Soon after implementing JIT, firms experience an increase in the cash they have.

• JIT can improve Return On Equity (ROE).

 JIT material flow

Traditional approach
buffer buffer
inventory inventory
stage A stage B stage C

traditional approach: - buffer inventory used to separate stages

JIT approach
orders orders

stage A stage B stage C

deliveries deliveries

JIT approach: - deliveries are made on request

 Streamlined Production
• Traditional approach causes stagnant ponds of inventory to form.
• JIT approach causes a smooth ‘streamlined’ flow of material.

Traditional approach
production process
(stream of water)

suppliers
customers
buffer inventory
JIT approach (stagnant ponds) material
(water in
stream)
suppliers
orders
materials
customers
 Minimizing waste:
quality at the source
• Close similarities between JIT and Total Quality Management(TQM)

• Goal of TQM is quality improvement in all aspects of the firm’s activities.

• JIT focuses on eliminating waste (e.g. waiting times, transportation, idle

inventory, waste of motion, and quality defects), so it cannot work without an
explicit focus on quality improvement.

• In other words, JIT cannot work in isolation from quality management.

• In relation to quality, JIT emphasises the importance of:

- Worker responsibility
- Line-stopping empowerment
- Fail-safe methods
- Automated inspection
- Measure Statistical Quality Control (SQC)
 Kanban Card System
• Kanban: Japanese word for card (e.g. a card, flag, verbal signal)

• ‘Pulls’ material through the process, plant and supply chain

• Receipt of a card triggers movement, production, or supply of one unit.

• Used often with fixed-size containers

• Add or remove containers to change production rate

 Design flow process:
reduce lot sizes

Delivering smaller quantities more often can reduce inventory levels

inventory
levels

time

inventory
levels

time
 Some cautions about JIT
• JIT systems are unsuitable for situations with complex product structures
and complex flow-path routings

• Supply chain disruptions and risk

• Inventory stockout risk

• JIT requires frequent deliveries

(i.e. infrastructure may not be set-up for this! )

• “Green” issues

• Delivery windows – minutes

 Conclusions

• The aim of inventory management

• Impact of inventory on financial performance

• Inventory performance measures

• Two ‘burning’ questions for all inventory systems:

- Volume Decision: How much to order? (EOQ approach)
- Timing Decision: When to order? (Reorder Points & Safety Stocks)

• Just In Time (JIT) Delivery Systems