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LOS 8
Inventory Management: Certainty Approach
Learning Outcome Statement (LOS)
define inventory and inventory management
understand why we need to carry inventory how to control inventory understand the basic economic order
quantity (EOQ) model discuss the development in inventory
management define costs in inventory systems
Introduction
"Inventory" to many small business owners is one of the more visible and tangible aspects of doing business. Raw materials, goods in process and finished goods all represent various forms of inventory.
In a literal sense, inventory refers to stocks of anything necessary to do business. These stocks represent a large portion of the business investment and must be well managed in order to maximize profits.
In fact, many small businesses cannot absorb the types of losses arising from poor inventory management. Unless inventories are controlled, they are unreliable, inefficient and costly.
Inventory Management
The management of inventory is unlike the management of any other assets and liabilities in that this type of assets are physical rather than purely financial in nature.
The management of inventory is one of the oldest concerns of management science.
The challenge here is to formulate strategies for the ordering and holding of inventory that will be the most advantageous to the firm. But because of uncertainties regarding the various parameters that are estimated in making these decisions, there is risk associated with these strategies.
Inventory Management
Successful inventory management involves balancing the costs of inventory with the benefits of inventory. This fine line between keeping too much inventory and not enough is not the manager's only concern. Others include:
Maintaining a wide assortment of stock - but not spreading the rapidly moving ones too thin;
Increasing inventory turnover - but not sacrificing the service level;
Keeping stock low - but not sacrificing service or performance.
Obtaining lower prices by making volume purchases - but not ending up with slow-moving inventory; and
Having an adequate inventory on hand - but not getting caught with obsolete items.
A system to keep track of inventory
A reliable forecast of demand
Knowledge of lead times
Reasonable estimates of holding costs, ordering costs, shortage costs
Inventory classification system
Effective Inventory Management
Inventory Management
Two approaches are used in addressing this risk. One of them is “certainty approach” discussed in this LOS.
In this approach, a strategy is first formulated to deal with the expected values of these inventory parameters, under the unrealistic assumptions that these parameters are certain. Then, a hedging strategy is formulated to address the uncertainties in these parameters.
This is called the “certainty approach” not because the parameters are certain, but because they are treated as certain in the first phase of policy making.
Why Carry Inventory?
The reasons why the firm wants to carry inventory depends on what types of inventory it basically holds: raw materials, work-in-process or finished goods.
Raw Materials
1. Having an available stock of raw materials makes production scheduling easier.
2. Keeping raw materials may help to avoid price changes for these goods.
3. Keeping extra raw materials may help to hedge against supply shortage.
4. Keeping additional raw materials may help to take advantage of quantity discount.
Why Carry Inventory?
Work-in-Process
In manufacturing firms, a certain amount of work-in-process inventory occurs as products move from one production process to the next.
A major reason that firms keep work-in-process inventory beyond a minimum level is to buffer production.
Buffering is a part of the planning process and allows flexibility and economies that would not otherwise occur.
Why Carry Inventory?
Finished Goods
One reason to keep finished goods inventory is to provide immediate service.
A second reason for keeping finished goods inventory is to stabilize production.
The Purchasing Plan
One of the most important aspects of inventory control is to have the items in stock at the moment they are needed.
For retailers, planning ahead is very crucial. Since they offer new items for sale months before the actual calendar date for the beginning of the new season, it is imperative that buying plans be formulated early enough to allow for intelligent buying without any last minute panic purchases.
Part of your purchasing plan must include accounting for the depletion of the inventory. Before a decision can be made as to the level of inventory to order, you must determine how long the inventory you have in stock will last.
Controlling the Inventory
To maintain an in-stock position of wanted items and to dispose of unwanted items, it is necessary to establish adequate controls over inventory on order and inventory in stock.
There are several proven methods for inventory control. They are listed below, from simplest to most complex.
Visual control enables the manager to examine the inventory visually to determine if additional inventory is required.
Controlling the Inventory
Tickler control enables the manager to physically count a small portion of the inventory each day so that each segment of the inventory is counted every so many days on a regular basis.
Click sheet control enables the manager to record the item as it is used on a sheet of paper. Such information is then used for reorder purposes.
Stub control (used by retailers) enables the manager to retain a portion of the price ticket when the item is sold. The manager can then use the stub to record the item that was sold.
Controlling the Inventory
As a business grows, it may find a need for a more sophisticated and technical form of inventory control.
Today, the use of computer systems to control inventory is far more feasible than ever before.
Point-of-sale terminals relay information on each item used or sold. The manager receives information printouts at regular intervals for review and action.
Off-line point-of-sale terminals relay information directly to the supplier's computer who uses the information to ship additional items automatically to the buyer/inventory manager.
Controlling the Inventory
The final method for inventory control is done by an outside agency.
A manufacturer's representative visits the large retailer on a scheduled basis, takes the stock count and writes the reorder.
Unwanted merchandise is removed from stock and returned to the manufacturer through a predetermined, authorized procedure.
Controlling the Inventory
A principal goal for many of the methods described above is to determine the minimum possible annual cost of ordering and stocking each item.
Two major control values are used: (1) the order quantity, that is, the size and frequency of orders; and (2) the reorder point, that is, the minimum stock level at which additional quantities are ordered.
The Economic Order Quantity (EOQ) formula is one widely used method of computing the minimum annual cost for ordering and stocking each item.
Objective of Inventory Control
To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds
Level of customer service
Costs of ordering and carrying inventory
Inventory turnover is the ratio of average cost of goods sold to average inventory investment.
Inventory Counting Systems
Periodic System – Physical count of items made at periodic intervals
Perpetual Inventory System – A system that keeps track of removals from inventory continuously, thus monitoring current levels of each item
Inventory Counting Systems
Two-Bin System – Two containers of inventory; reorder when the first is empty.
Universal Bar Code – Bar code printed on a label that hasinformation about the item to which it is attached.
0
214800 232087768
ABC Classification System
Classifying inventory according to some measure of importance and allocating control efforts accordingly.
AA - very importantBB - mod. importantCC - least important
Annual $ value of items
AA
BB
CC
High
Low
Low HighPercentage of Items
Lead time: time interval between ordering and receiving the order
Holding (carrying) costs: cost to carry an item in inventory for a length of time, usually a year (e.g., money invested in inventory, storage costs, handling costs, insurance costs, taxes, etc.)
Ordering costs: costs of ordering and receiving inventory (e.g., cost of getting price quotations, processing purchase order, receiving shipments, inspection, etc.)
Shortage costs: costs when demand exceeds supply
Key Inventory Terms
The Basic EOQ Model
Economic order quantity (also known as the Wilson EOQ Model or simply the EOQ Model) is a model that defines the optimal quantity to order that minimizes total variable costs required to order and to hold inventory.
The EOQ computation takes into account the cost of placing an order, the annual sales rate, the unit cost, and the cost of carrying inventory.
The model was originally developed by F. W. Harris in 1913, though R. H. Wilson is credited for his early in-depth analysis of the model.
The Basic EOQ Model
Basic EOQ model is simple, but it is applicable only to those inventory situations described by its assumptions, such as:
1. There are only two types of costs: carrying/holding costs and ordering costs
2. There is no quantity discounts 3. There may be lead times of any length 4. There is no risk5. The replenishment rate is infinite
The Basic EOQ Model
Variables
Q* = optimal order quantity C = cost per order event (not per unit) R = monthly (annual) demand of the product P = purchase cost per unit F = holding cost factor; the factor of the purchase cost that is used as the holding cost (this is usually set at 10-15%, though circumstances can require any setting from 0 to 1) H = holding cost per unit per month (per year) (H = PF)
The Basic EOQ Model
Total Costs
The single item EOQ formula can be seen as the minimum point of the following cost function:
Total cost = purchase cost + order cost + holding cost
which corresponds to:
The Basic EOQ Model
The Optimal Order Quantity
The question in this inventory situation is how much to order; that is, what should be the order quantity, Q?
A relatively large Q results in a high average inventory but infrequent orders. A smaller order quantity results in lower average inventory but more frequent orders.
The first strategy will result in higher holding cost but lower ordering cost; the latter strategy will have the reverse effect.
The Basic EOQ Model
When to Reorder with EOQ Ordering
Reorder Point - When the quantity on hand of an item drops to this amount, the item is reordered
Safety Stock - Stock that is held in excess of expected demand due to variable demand rate and/or lead time
Service Level - Probability that demand will not exceed supply during lead time
Determinants of the Reorder Point
The rate of demand
The lead time
Demand and/or lead time variability
Stockout risk (safety stock)
The Order Point
Rather than using a timed ordering approach, it is often advantageous to place orders based on inventory levels. In this way, if the usage rate is greater than expected, an order will be placed earlier and the goods received sooner.
The triggering of orders based on inventory levels is called the order point system, and it works well with modern methods of inventory record keeping.
If the firm’s database of inventory levels is adjusted each time a unit of inventory is used, then the firm’s computer can compare inventory levels to order points and generate a list of items to be ordered.
The Order Point
The order point is calculated as the expected usage during the lead time. Assume that a firm purchases 10,000 units of a particular product per year and the lead time is 7 days. The usage over this time will be (7/360)(10,000) = 194 units.
When the level of inventory reaches 194 units, the firm should place an order for the optimal quantity. Just as this order arrives (7 days later), the firm will have run out of inventory.
The basic EOQ model with order point is easy to understand and put into practice, but this range is limited to those situations described by its assumptions.
Safety Stock
LT Time
Expected demandduring lead time
Maximum probable demandduring lead time
ROP
Qu
an
tity
Safety stock
Safety stock reduces risk ofstockout during lead time
Reorder Point
ROP
Risk ofa stockout
Service level
Probability ofno stockout
Expecteddemand Safety
stock0 z
Quantity
z-scale
The ROP based on a normaldistribution of lead time demand
Variations on the Basic EOQ Model
Several extensions can be made to the EOQ model, including backordering costs and multiple items. Additionally, the economic order interval can be determined from the EOQ and the economic production quantity model (which determines the optimal production quantity) can be determined in a similar fashion.
Economic Production Quantity model (also known as the EPQ model) was developed by E. W. Taft in 1918. The difference being that the EPQ model assumes orders are received incrementally during the production process. The function of this model is to balance the inventory holding cost and the average fixed ordering cost.
Economic Production Quantity model
Variables
K = ordering cost D = demand rate F = holding cost T = cycle length P = production rate x = D/P
Formula
Developments In Inventory Management
Like investment in any other assets, investment in inventory should be carefully considered in light of the alterative approaches to the problem at hand.
For example, holding raw materials is not the only way to avoid price fluctuations. The firm could enter into long-term private contracts with the producers of these raw materials. The firm also could enter into a futures contract on the raw materials.
In recent years, two approaches have had a major impact on inventory management: Material Requirements Planning (MRP) and Just-In-Time (JIT and Kanban).
Their application is primarily within manufacturing but suppliers might find new requirements placed on them and sometimes buyers of manufactured items will experience a difference in delivery.
Developments in Inventory Management - MRP
MRP is basically an information system in which sales are converted directly into loads on the facility by sub-unit and time period.
Materials are scheduled more closely, thereby reducing inventories, and delivery times become shorter and more predictable.
Its primary use is with products composed of many components. MRP systems are practical for smaller firms.
The computer system is only one part of the total project which is usually long-term, taking one to three years to develop.
Developments in Inventory Management - JIT
JIT is an approach which works to eliminate inventories rather than optimize them.
The inventory of raw materials and work-in-process falls to that needed in a single day.
This is accomplished by reducing set-up times and lead times so that small lots may be ordered.
Suppliers may have to make several deliveries a day or move closer to the user plants to support this plan.
Costs in Inventory Systems
Costs directly proportional to amount of inventory held – any costs that fluctuate directly with the level of inventory, such as the opportunity cost of inventory investment, insurance on the inventory, storage costs of inventory, taxes on inventory investment, etc.
Costs not directly proportional to the amount of inventory held – costs such as spoilage and obsolescence.
Costs directly proportional to the number of orders – costs such as machinery set-up costs, purchasing order generating costs, check writing costs and payment order mailing costs, and fixed costs of unloading the order, etc.
Costs in Inventory Systems
The price per unit of inventory obtained – due to quantity discounts and economies of scale in production, the price per unit of goods purchased or produced for inventory may vary with the amount ordered.
Stockout cost – occurs when immediate service is required but inventory is unavailable.
Costs in Inventory Systems
If the inventory is raw materials or work-in-process, the cost of stocking out will include the cost of changing the firm’s production plants, costs of idling or rescheduling equipment, etc.
If the inventory is finished goods, stockout costs may include the lost cash flow from the sale if the customer does not make the purchase because immediate service cannot be provided.
Other Characteristics of Inventory Situations
Lead times – a time lag from the initiation of the production process until the inventory starts to arrive. Lead time may range from a few minutes to few months depending whether the firm is producing goods for its inventory or is ordering these goods from another firm.
Sources and levels of risk – uncertainties play a significant role in inventory situations. Uncertainties usually involve lead times and demand levels, but situations where other variables are uncertain also occur.
Other Characteristics of Inventory Situations
Static versus dynamic problems – in a static inventory problems, the goods have a one-period life; there can be no carryover of goods from one period to the next. In dynamic inventory problems, the goods have value beyond the initial period; they do not lose their value completely over time.
Replenishment rate – for a small order, the rate of replenishment is essentially infinite. For larger orders from vendors, or for inventory produced within the firm, the replenishment rate may be slower.
