The primary functions of inventory are:
Buffering against uncertainty in the marketplace
Decoupling dependencies in the supply chain
Balancing demand and supply
Geography (Where used)
raw materials, work-in-process, finished goods, and maintenance, repair, and operations (MRO) (Stocked internally)
Cycle Stock (aka base stock)
\ is inventory to satisfy actual or projected demand in the next immediate time
is inventory held for the purpose of buffering against variations or uncertainty in demand or supply.
Anticipation (Speculative) / Strategic Inventory
is to hedge a currency exchange, take advantage of a discount, protect against a major short-term disruptive event in supply, take advantage of a major business opportunity for sales, provide for life cycle changes; seasonal, launch, bridging, etc.
represents the inventory being held by third parties outside the firm in the "downstream" external supply channel.
Maintenance, Repair, and Operations (MRO)
are items that are needed by the firm to operate the business and/or produce products but do not end up as part of the final product.
Other Important Inventory Related Definitions
Inventory Control is the managerial procedure for implementing an inventory policy
Demand Uncertainty involves the variation in sales during the lead time necessary to replenish inventory
Supply (or performance cycle) Uncertainty involves variation in the time and/or quantity necessary to replenish inventory.
Time Buckets are discrete increments of time used to facilitate planning activities
Reorder Point defines when a replenishment order is initiated.
Carrying Cost is the expense associated with maintaining inventory.
Safety Time is ordering an item earlier than necessary based on the lead time, to assure timely arrival.
Fill Rate represents the magnitude of a backorder or stockout. Can be case fill rate, line fill rate, etc.
Who are your key customers/stakeholders?
Manufacturers (internal/external), Wholesalers, Distributors, Retailers, Consumers
Level of service required (does it differ by customer)
What is important to them?
What value do they create?
What risks do they take?
Service Level is
a performance target specified by management and defines inventory performance objectives
Generally, the higher the service level target, the higher the amount of inventory you will need to assure the target is achieved.
e.g. 90% of orders filled complete in 3 order cycle days
Common measures of service level include:
Performance Cycle - the elapsed time between release of a purchase order by the buyer to the receipt of shipment
Case Fill Rate - the percent of cases ordered that are shipped as requested
Line Fill Rate - the percent of order lines (items) that were filled completely as requested
Order Fill - the percent of customer orders filled completely as requested
Determining How Much to Order
Economic Order Quantity - A quantitative decision model based on the trade-off between the annual ordering costs and the annual inventory holding costs
Where the sum of the annual ordering costs and the annual inventory holding costs is minimized
SQRT of (2XCost per orderXAnnual sales volume/Inventory carry cost*Cost p/unit)
Inventory Ordering Cost Components
Ordering Costs - are incurred each time an order is placed
Order preparation costs
Order transportation costs
Order receipt processing costs
Material handling costs
Total Cost = Purchase Cost + Ordering Cost + Holding Cost
Total cost is driven by inventory planning decisions which establish when and how much to order
Inventory Carrying Cost Components
-Cost of capital - specified by senior management
-Taxes - on inventory held in warehouses
-Insurance - based on estimated risk or loss over time and facility characteristics
-Obsolescence - deterioration of product during storage, and shelf-life
e.g., food and pharmaceutical sell-by dates
-Storage - facility expense related to product holding rather than product handling
is the expense associated with maintaining inventory
Annual inventory carrying cost percent times average inventory value
Inventory Carrying Cost Policy
Inventory carrying cost is an
imputed cost. It doesn't appear in the financial statement. Companies
determine the cost of capital they want to use which is typically the
return they expect on investments.
Final carrying cost percent used by a firm is a managerial policy
EOQ Model Assumptions
All demand is satisfied. Stock-outs are not allowed.
Rate of demand is continuous, constant and known
Replenishment lead time is constant and known
Unit price of product is constant and independent of order quantity or time
Holding/Carrying cost is known and constant.
Ordering cost is known and constant
An infinite planning horizon exists
No interaction between multiple items of inventory
No in transit inventory time
No limit is placed on capital availability
Typical Adjustments to EOQ
-Volume Transportation Rates offer a freight-rate discount for larger shipments
-Quantity discounts offer a lower per unit cost when larger quantities are purchased
-Ordering in full production lot sizes (due to vendor requirement, quality, etc.)
-Multiple-item purchase (may generate a volume discount or other benefit)
-Limited capital - may not be able to afford to buy the EOQ quantity at one time
-Dedicated trucking (due to security reasons, cross contamination concerns, etc.)
What are the 2 types of uncertainty we are trying to account for with safety stock?
1.)Demand Uncertainty — when and how much product will our customers order?
2.)Supply (Performance Cycle) Uncertainty — how long will it take to replenish inventory with our customers?
Variations must be considered in both areas to make effective inventory planning decisions
Planning safety stock requires three steps:
1. Determine the likelihood of stockout using a probability distribution, i.e., forecast accuracy/error
2. Estimate demand during a stockout period
3. Decide on a policy concerning the desired level of stockout protection, i.e., desired Service Level
Calculating Safety Stock
Service level is equal to 100% minus probability % of stockout
e.g., a service level of 99% results in a stockout probability of 1%
The most common probability distribution for demand is the normal distribution, i.e., "bell curve"
From analysis of historical demand data the safety stock required to ensure a stockout only 1% of the time is possible
A one-tailed normal distribution is used because only demand that is greater than the forecast can create a stockout.
Is the forecast error bias on the over-forecast or under-forecast side of the
When is safety stock needed
Safety stock is only needed for under-forecast (demand exceeds forecast) error!
Formula for Calculating Safety Stock
K X sqrt(Lead time X dc) X 1.25 MAD
K= Customer service level
Lead time = time to replenish goods
DC=Number of distribution centers where there's safety stock
MAD = Mean absolute deviation of the monthly demand(past 12 months)
Safety Stock with Combined Uncertainty
Planning for both demand and supply uncertainty requires combining two independent variables
The joint impact of the probability of both demand and supply variation must be determined
Direct method is to combine standard deviations using a convolution formula
-The calculations are beyond the scope of this course
but you should understand that the concept exists and
there is a method for addressing this situation.
Inventory control defines how often inventory levels are reviewed to determine when and how much to order
Periodic Review monitors inventory status of an item at regular intervals such as weekly or monthly
Perpetual Review continuously monitors inventory levels to determine inventory replenishment needs
Periodic review =
ROP = D(T + P/2) + SS
D=Average daily demand
T = Average performance cycle length
P = reveiw period in days
SS = safety stock
PERPETUAL DOESN'T USE P VARIABLE
Perpetual review =
D X T + SS
D=Average daily demand
T = Average performance cycle length
SS = safety stock
- The demand for the final
product. Has a demand pattern affected by trends, seasonal patterns,
& general market conditions.
Example: Pick-up Truck
- Describes the internal demand for parts based on the demand of the final product in which the parts are used.
Determined / Calculated Demand
Order quantities computed with Material Requirements Planning (MRP).
Relationship between independent and dependent demand shown in Bill of Materials (BOM).
Subassemblies, components, & raw materials are examples of dependent demand items.
Example: Pick-up Truck Engine
Dependent Demand Replenishment
Dependent demand inventory requirements are a function of known events that are not random
Dependent demand does not require forecasting because there is no uncertainty
Generally, no specific safety stock is needed to support time-phased procurement programs (e.g., MRP)
No safety stock assumes
-Procurement replenishment is predictable and constant
-Vendors and suppliers maintain adequate inventories to satisfy 100% of purchase requirements
Three approaches to introduce safety stock into dependent demand situations if necessary
1.) Put safety time into the requirements plan
2.)Increase the replenishment order by a quantity specified by some estimate of expected plan error, i.e., over-planning / top-level demand
3.) set safety stocks directly for a component rather than to the item of top-level demand
Approaches to implementing inventory management policies:
Anticipatory / Planning (or push)
Approach proactively allocates inventory on the basis of forecasted
demand and product availability
Responsive / Reactive (or pull) Approach responds to actual customer demand to pull the product through the distribution channel
Hybrid approach uses a combination of push and pull
Assumptions of Reactive (Pull) Inventory Logic
All customers, market areas, and products contribute equally to profits
Infinite capacity exists at the production facility
Infinite inventory availability at the supply location
Supply cycle time can be predicted and cycle lengths are independent
Customer demand patterns are relatively stable and consistent
Each distribution warehouse's timing and quantity of replenishment orders are determined independently of all other sites, including the supply source
Supply cycle length cannot be correlated with demand
Fair Share Allocation
provides each distribution facility with an equitable distribution of available inventory
Limited ability to manage multistage inventories
DS=AQ+Sum Inventory for each whse /sum of daily demand for each whose
Amount allocated = (DS * D) - I
DS = Common days supply for warehouse inventories
AQ = Inventory units to be allocated from plant warehouse = 500
Ij = Inventory in units for warehouse J
Dj = Daily demand for warehouse J
integrates across the supply chain taking into consideration unique requirements
Materials Requirements Planning (MRP) is driven by a production schedule
Distribution Requirements Planning (DRP) is driven by supply chain demand
Collaborative Inventory Replenishment Programs
are designed to streamline the flow of goods within the supply chain
Intent is to reduce reliance on forecasting and position inventory using actual demand on a just-in-time basis
Quick Response (QR)
is a technology-driven cooperative effort between retailers and suppliers to improve inventory velocity while matching supply to consumer buying patterns
Profile Replenishment (PR)
extends QR and VMI by giving suppliers the right to anticipate future requirements according to their knowledge of a product category (JIT II)
Vendor Managed Inventory detail (VMI)
VMI arrangements transfer the
responsible for managing the inventory located at a customer's facility
back to the vendor/manufacturer of that inventory.
-Places replenishment orders
-Arranges the display
-Typically owns inventory until purchased
-Is required to work closely with customer
Common Metrics for Inventory:
Customer Service Level - measured as "fill rate"
Units - the number of units available
Dollars - the amount of dollars tied up in inventory
Weeks of Supply - (avg. on-hand inventory) / (avg. weekly usage)
Inventory Turns - (cost of good sold) / (avg. inventory value)
Inventory Carrying Cost - (discussed with EOQ)
groups products, markets, or customers with similar characteristics to facilitate inventory management
e.g., classify by sales, profit contribution, inventory value, usage rate or item category
Segment Strategy definition
specifies all aspects of inventory management process for each segment of inventory
e.g., service objectives, forecasting method, management technique, and review cycle
Policies and Parameters
must be defined at a detailed level
e.g., data requirements, software applications, performance objectives, and decision guidelines
An ABC System classifies inventory based the degree of importance:
1.) Determine annual usage or sales for each item.
2.) Determine % of total usage or sales that each item represents.
3.) Rank items from highest to lowest %.
4.) Classify items into groups:
A: Highest Value
B: Moderate Value
C: Least Valuable
A items are
given the highest priority. "80/20 rule" Generally, A items account for approximately 20% of the total number of items, but about 80% of the total inventory cost.
B & C items
account for the other 80% of the total number of items, but only 20% of total inventory cost.
B items require closer management since they are relatively more expensive (per unit), require more effort to purchase / make, & may be more prone to obsolescence.
C items have the lowest value, and hence the lowest priority