Inventory ManagementInventory Management

Kusdhianto Setiawan, SE, SiviløkonomKusdhianto Setiawan, SE, Siviløkonom

Gadjah Mada UniversityGadjah Mada University

Inventory: The Shift from cost control Inventory: The Shift from cost control area to cost reduction areaarea to cost reduction area

The objective of inventory management has been to keep enough The objective of inventory management has been to keep enough inventory to meet customer demand and also be cost-effective. inventory to meet customer demand and also be cost-effective. However, inventory has not always been perceived as an area to However, inventory has not always been perceived as an area to control cost. Companies maintained "generous" inventory levels to control cost. Companies maintained "generous" inventory levels to meet long-term customer demand because there were fewer meet long-term customer demand because there were fewer competitors and products in a generally sheltered market competitors and products in a generally sheltered market environment. environment. In the current international business environment with more In the current international business environment with more competitors and highly diverse markets, in which new products and competitors and highly diverse markets, in which new products and new product features are rapidly and continually introduced, the cost new product features are rapidly and continually introduced, the cost of inventory has increased due in part to quicker product of inventory has increased due in part to quicker product obsolescence. At the same time, companies are continuously obsolescence. At the same time, companies are continuously seeking to lower costs so they can provide a better product at a seeking to lower costs so they can provide a better product at a "lower" price. Inventory is an obvious candidate for cost reduction. "lower" price. Inventory is an obvious candidate for cost reduction.

The high cost of inventory has motivated companies to focus on The high cost of inventory has motivated companies to focus on efficient supply chain management and quality management by: efficient supply chain management and quality management by: – reducing uncertainty at various points along the supply chain. In form of reducing uncertainty at various points along the supply chain. In form of

reducing variations in delivery times, uncertain production schedules reducing variations in delivery times, uncertain production schedules caused by late deliveries or large numbers of defects that require higher caused by late deliveries or large numbers of defects that require higher levels of production or service than what should be necessary, large levels of production or service than what should be necessary, large fluctuations in customer demand, or poor forecasts of customer fluctuations in customer demand, or poor forecasts of customer demand. demand.

In a continuous replenishment system of inventory management, In a continuous replenishment system of inventory management, products or services are moved from one stage in the supply chain products or services are moved from one stage in the supply chain to the next according to a system of constant communication to the next according to a system of constant communication between customers and suppliers. between customers and suppliers. Items are replaced as they are diminished without maintaining larger Items are replaced as they are diminished without maintaining larger buffer stocks of inventory at each stage to compensate for late buffer stocks of inventory at each stage to compensate for late deliveries, inefficient service, poor quality, or uncertain demand. deliveries, inefficient service, poor quality, or uncertain demand.

Inventory: The Shift from cost Inventory: The Shift from cost control area to cost reduction areacontrol area to cost reduction area

Does Inventory Management is Still Does Inventory Management is Still Needed?Needed?

Adherents of quality management believe that inventory Adherents of quality management believe that inventory should be minimized. However, this works should be minimized. However, this works primarily for primarily for a production or manufacturing process.a production or manufacturing process.

For the retailerFor the retailer who sells finished goods directly to the who sells finished goods directly to the consumer consumer or the supplieror the supplier who sells parts or materials to who sells parts or materials to the manufacturer, the manufacturer, inventory is a necessityinventory is a necessity. Few shoe . Few shoe stores, discount stores, or department stores can stay in stores, discount stores, or department stores can stay in business with only one or two items on their shelves or business with only one or two items on their shelves or racks. For these operations the traditional inventory racks. For these operations the traditional inventory decisions of how much to order and when to order decisions of how much to order and when to order continue to be important. In addition, the traditional continue to be important. In addition, the traditional approaches to inventory management are still widely approaches to inventory management are still widely used by most companies. used by most companies.

The Elements of Inventory The Elements of Inventory ManagementManagement

InventoryInventory is a stock of items kept by an organization to is a stock of items kept by an organization to meet internal or external customer demand. Virtually meet internal or external customer demand. Virtually every type of organization maintains some form of every type of organization maintains some form of inventory. inventory. Besides the finished goods, inventory could be in the Besides the finished goods, inventory could be in the forms of:forms of:– Raw materials Raw materials – Purchased parts and supplies Purchased parts and supplies – Labor Labor – In-process (partially completed) products In-process (partially completed) products – Component parts Component parts – Working capital Working capital – Tools, machinery, and equipment Tools, machinery, and equipment

The Role of Inventory in Supply The Role of Inventory in Supply Chain Management Chain Management

One of the main strategy of a company is holding inventories of One of the main strategy of a company is holding inventories of finished goods to meet customer demand for a product, especially in finished goods to meet customer demand for a product, especially in a retail operation. a retail operation. Since demand is usually not known with certainty, an additional Since demand is usually not known with certainty, an additional amount of inventory, called amount of inventory, called safety, or buffer, stockssafety, or buffer, stocks, is kept on , is kept on hand to meet excess demand. hand to meet excess demand. Additional stocks of inventories are sometimes built up to meet Additional stocks of inventories are sometimes built up to meet demand that is demand that is seasonal or cyclicalseasonal or cyclical. . At the other end of the supply chain from finished goods inventory, At the other end of the supply chain from finished goods inventory, suppliers might keep large stocks of parts and material inventory suppliers might keep large stocks of parts and material inventory to to meet variations in customer demandmeet variations in customer demand. This is . This is especially true of especially true of manufacturing suppliersmanufacturing suppliers who are under pressure to meet the who are under pressure to meet the exacting demands of exacting demands of continuous replenishmentcontinuous replenishment with frequent, on- with frequent, on-time delivery of small lots. time delivery of small lots. When JIT was introduced in the automobile industry, it was reported When JIT was introduced in the automobile industry, it was reported that suppliers created a boom in the warehousing business in that suppliers created a boom in the warehousing business in Detroit, creating huge stocks of inventory to meet JIT schedules. Detroit, creating huge stocks of inventory to meet JIT schedules.

Many companies find it necessary to maintain Many companies find it necessary to maintain buffer buffer inventoriesinventories at different stages of their supply chain to at different stages of their supply chain to provide independence between stages and to avoid work provide independence between stages and to avoid work stoppages or delays. stoppages or delays. – Inventories of Inventories of raw materials and purchased partsraw materials and purchased parts are kept on are kept on

hand so that the production process will not be delayed as a hand so that the production process will not be delayed as a result of missed or late deliveries or shortages from a supplier.result of missed or late deliveries or shortages from a supplier.

– Work-in-processWork-in-process inventories are kept between stages in the inventories are kept between stages in the manufacturing process so that production can continue smoothly manufacturing process so that production can continue smoothly if there are temporary machine breakdowns or other work if there are temporary machine breakdowns or other work stoppages. stoppages.

– Similarly, a stock of Similarly, a stock of finished parts or productsfinished parts or products allows allows customer demand to be met in the event of a work stoppage or customer demand to be met in the event of a work stoppage or problem with transportation or distribution. problem with transportation or distribution.

The Role of Inventory in Supply The Role of Inventory in Supply Chain ManagementChain Management

The Role of Inventory in SCM: The Role of Inventory in SCM: Managing DemandManaging Demand

The starting point for the management of inventory is customer The starting point for the management of inventory is customer demand. Inventory exists to meet customer demand. demand. Inventory exists to meet customer demand. Customers can be inside the organization, such as a machine Customers can be inside the organization, such as a machine operator waiting for a part or partially completed product to work on. operator waiting for a part or partially completed product to work on. Customers can also be outside the organization--for example, an Customers can also be outside the organization--for example, an individual purchasing groceries or a new VCR. individual purchasing groceries or a new VCR. In either case an essential determinant of effective inventory In either case an essential determinant of effective inventory management is an accurate forecast of demand. management is an accurate forecast of demand. Type of Demand:Type of Demand:– Independent DemandIndependent Demand, , Independent demand items are final or Independent demand items are final or

finished products that are not a function of, or dependent upon, finished products that are not a function of, or dependent upon, internal production activity. Independent demand is usually internal production activity. Independent demand is usually external and, thus, is beyond the direct control of the external and, thus, is beyond the direct control of the organization. organization.

– Dependent Demand, Dependent Demand, items are typically component parts or items are typically component parts or materials used in the process of producing a final product. materials used in the process of producing a final product.

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E(1)

Independent vs. Dependent Independent vs. Dependent DemandDemand

Independent Demand(Demand not related to other items)

Dependent Demand(Derived)

The ability to meet effectively internal organizational demand or external customer demand in a timely, efficient manner is referred to as the level of customer service.A primary objective of supply chain management is to provide as high a level of customer service in terms of on-time delivery as possible. To provide level of quality customer service, the tendency is to maintain large stocks of all types of items. However, there is a cost associated with carrying items in inventory, which creates a cost trade-off between the quality level of customer service and the cost of that service. As the level of inventory increases to provide better customer service, inventory costs increase, whereas quality-related customer service costs, such as lost sales and loss of customers, decreases. The conventional approach to inventory management is to maintain a level of inventory that reflects a compromise between inventory costs and customer service. However, according to the contemporary "zero defects" philosophy of quality management, the long-term benefits of quality in terms of larger market share outweigh lower short-run production-related costs, such as inventory costs.

The Role of Inventory in SCM: The Role of Inventory in SCM: Managing Quality?Managing Quality?

Carrying costsCarrying costs are the costs of holding items in inventory. are the costs of holding items in inventory. – the greater level of inventory over a period of time, the higher the the greater level of inventory over a period of time, the higher the

carrying costs. carrying costs. – include the cost of losing the use of funds tied up in inventory; include the cost of losing the use of funds tied up in inventory;

direct storage costs such as rent, heating, cooling, lighting, direct storage costs such as rent, heating, cooling, lighting, security, refrigeration, record keeping, and transportation; interest security, refrigeration, record keeping, and transportation; interest on loans used to purchase inventory; depreciation; obsolescence on loans used to purchase inventory; depreciation; obsolescence as markets for products in inventory diminish; product deterioration as markets for products in inventory diminish; product deterioration and spoilage; breakage; taxes; and pilferage. and spoilage; breakage; taxes; and pilferage.

– Carrying costs are normally specified in one of two ways.Carrying costs are normally specified in one of two ways.assigning total carrying costs, determined by summing all the assigning total carrying costs, determined by summing all the individual costs just mentioned, on a per-unit basis per time period, individual costs just mentioned, on a per-unit basis per time period, such as a month or year. In this form, carrying costs are commonly such as a month or year. In this form, carrying costs are commonly expressed as a per-unit dollar amount on an annual basis; for expressed as a per-unit dollar amount on an annual basis; for example, $10 per unit per year. example, $10 per unit per year. expressed as a percentage of the value of an item or as a percentage expressed as a percentage of the value of an item or as a percentage of average inventory value. It is generally estimated that carrying costs of average inventory value. It is generally estimated that carrying costs range from 10 to 40 percent of the value of a manufactured item. range from 10 to 40 percent of the value of a manufactured item.

The Role of Inventory in SCM:The Role of Inventory in SCM:Reducing or Removing Inventory Cost?Reducing or Removing Inventory Cost?

Ordering costsOrdering costs are the costs associated with are the costs associated with replenishing the stock of inventory being held. replenishing the stock of inventory being held. – normally expressed as a dollar amount per order and are normally expressed as a dollar amount per order and are

independent of the order size. independent of the order size. – as the number of orders increases, the ordering cost increases. as the number of orders increases, the ordering cost increases. – Costs incurred each time an order is made can include Costs incurred each time an order is made can include

requisition and purchase orders, transportation and shipping, requisition and purchase orders, transportation and shipping, receiving, inspection, handling and storage, and accounting and receiving, inspection, handling and storage, and accounting and auditing costs. auditing costs.

– Ordering costs generally react inversely to carrying costs. As the Ordering costs generally react inversely to carrying costs. As the size of orders increases, fewer orders are required, reducing size of orders increases, fewer orders are required, reducing ordering costs. However, ordering larger amounts results in ordering costs. However, ordering larger amounts results in higher inventory levels and higher carrying costs. In general, as higher inventory levels and higher carrying costs. In general, as the order size increases, ordering costs decrease and carrying the order size increases, ordering costs decrease and carrying costs increase. costs increase.

The Role of Inventory in SCM:The Role of Inventory in SCM:Reducing or Removing Inventory Cost?Reducing or Removing Inventory Cost?

Shortage costs,Shortage costs, also referred to as also referred to as stockout costs,stockout costs, occur when customer occur when customer demand cannot be met because of insufficient inventory. demand cannot be met because of insufficient inventory. If these shortages result in a If these shortages result in a permanent loss of salespermanent loss of sales, shortage costs include , shortage costs include the the loss of profitsloss of profits. Shortages can also cause . Shortages can also cause customer dissatisfaction customer dissatisfaction and a and a loss of goodwill that can result in a permanent loss of customers and loss of goodwill that can result in a permanent loss of customers and future salesfuture sales. In some instances, the inability to meet customer demand or . In some instances, the inability to meet customer demand or lateness in meeting demand results in penalties in the form of lateness in meeting demand results in penalties in the form of price discounts price discounts or rebatesor rebates. When demand is internal, a shortage can cause work stoppages in . When demand is internal, a shortage can cause work stoppages in the production process and create delays, resulting in the production process and create delays, resulting in downtime costs downtime costs and the and the cost of lost production (including indirect and direct production costs). cost of lost production (including indirect and direct production costs). Costs resulting from lost sales because demand cannot be met are more difficult Costs resulting from lost sales because demand cannot be met are more difficult to determine than carrying or ordering costs. Therefore, to determine than carrying or ordering costs. Therefore, shortage costs are shortage costs are frequently subjective estimates and some times an educated guessfrequently subjective estimates and some times an educated guess. . Shortage costs have an inverse relationship to carrying costs--as the amount of Shortage costs have an inverse relationship to carrying costs--as the amount of inventory on hand increases, the carrying cost increases, whereas shortage inventory on hand increases, the carrying cost increases, whereas shortage costs decrease. costs decrease. The objective of inventory management is to employ an inventory control system The objective of inventory management is to employ an inventory control system that will indicate how much should be ordered and when orders should take place that will indicate how much should be ordered and when orders should take place so that the sum of the three inventory costs just described will be minimized. so that the sum of the three inventory costs just described will be minimized.

The Role of Inventory in SCM:The Role of Inventory in SCM:Reducing or Removing Inventory Cost?Reducing or Removing Inventory Cost?

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Classifying Inventory ModelsClassifying Inventory Models

Fixed-Order Quantity ModelsFixed-Order Quantity Models– Event triggeredEvent triggered

Fixed-Time Period Models Fixed-Time Period Models – Time triggered Time triggered

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Fixed-Order Quantity ModelsFixed-Order Quantity ModelsAssumptionsAssumptions

Demand for the product is constant and Demand for the product is constant and uniform throughout the perioduniform throughout the period

Lead time (time from ordering to receipt) is Lead time (time from ordering to receipt) is constantconstant

Price per unit of product is constant Price per unit of product is constant

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Fixed-Order Quantity ModelsFixed-Order Quantity ModelsAssumptionsAssumptions

Inventory holding cost is based on Inventory holding cost is based on average inventoryaverage inventory

Ordering or setup costs are constantOrdering or setup costs are constant

All demands for the product will be All demands for the product will be satisfied (No back orders are allowed) satisfied (No back orders are allowed)

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EOQ Model--Basic Fixed-EOQ Model--Basic Fixed-Order Quantity ModelOrder Quantity Model

R = Reorder pointQ = Economic order quantityL = Lead time

L L

Q QQ

R

Time

Numberof unitson hand

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Cost Minimization GoalCost Minimization Goal

Ordering Costs

HoldingCosts

QOPT

Order Quantity (Q)

COST

Annual Cost ofItems (DC)

Total Cost

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Basic Fixed-Order Basic Fixed-Order Quantity ModelQuantity Model

TC = DC + D

Q S +

Q

2 H

Total Annual Cost =Annual

PurchaseCost

AnnualOrdering

Cost

AnnualHolding

Cost+ +

TC Total annual costD DemandC Cost per unitQ Order quantityS Cost of placing an order or setup costR Reorder pointL Lead timeH Annual holding and storage cost per unit of inventory

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Deriving the EOQDeriving the EOQ

Using calculus, we take the derivative of Using calculus, we take the derivative of the total cost function and set the the total cost function and set the derivative (slope) equal to zero derivative (slope) equal to zero

Q = 2DS

H =

2(Annual D em and)(Order or Setup Cost)

Annual Holding CostOPT

Reorder point, R = d L_

d = average daily demand (constant)

L = Lead time (constant)

_

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EOQ ExampleEOQ Example

Annual Demand = 1,000 unitsDays per year considered in average daily demand = 365Cost to place an order = $10Holding cost per unit per year = $2.50Lead time = 7 daysCost per unit = $15

Determine the economic order quantity and the reorder point.

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SolutionSolution

Q = 2DS

H =

2(1,000 )(10)

2.50 = 89.443 units or OPT 90 units

Why do we round up?

d = 1,000 units / year

365 days / year = 2.74 units / day

Reorder point, R = d L = 2.74units / day (7days) = 19.18 or _

20 units

When the inventory level reaches 20, order 90 units.

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In-Class ExerciseIn-Class Exercise

Annual Demand = 10,000 unitsDays per year considered in average daily demand = 365Cost to place an order = $10Holding cost per unit per year = 10% of cost per unitLead time = 10 daysCost per unit = $15

Determine the economic order quantity and the reorder point.

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SolutionSolution

Q =2DS

H=

2(10,000 )(10)

1.50= 365.148 units, or OPT 366 units

d =10,000 units / year

365 days / year= 27.397 units / day

R = d L = 27.397 units / day (10 days) = 273.97 or _

274 units

When the inventory level reaches 274, order 366 units.

Fixed-Time Period ModelFixed-Time Period Model

stockin inventory I

stocksafety

demand ofdeviation standard

timelead L

ordersbetween timefixed thet

rate demand average d

quantity sizeorder

)(

d

b

Ltz

Q

ILtzLtdQ

bd

bdb