Managing Inventory Flows in the

Supply ChainChapter 4

•Inventory as an asset has taken on increased significance as companies struggle to reduce investment in fixed assets that accommodate inventory (plants, warehouses, etc.).

•Changes in inventory affect return on assets (ROA), an important internal and external metric.

•Ultimate challenge is to balance supply and demand for inventory.

Macro Inventory Cost inRelation to U.S. Gross Domestic Product

On the Line:Inventory Turns• Think of inventory turns as a measure of how well a

company’s products are doing in the market and how well its inventory is managed.

• There is a continuing move away from traditional build-to-forecast manufacturing models to more flexible build-to-demand systems.

• “Ideally, zero inventory will maximize cash flow.”

• Inventory turnover potential is 30 to 40 times/year.

Three kinds of inventory

•Cycle inventory•Seasonal inventory•Safety inventory

Inventory in the Firm:Batching Economies/Cycle Stocks•Price discounts

▫Result in trade-offs between large purchases qualifying for quantity discounts and costs of storing inventory.

•Transportation rate discounts▫Large quantities often result in carload

freight rates.▫Lower freight rates are often reflected in

lower consumer prices.

•Production economics favor long production runs.▫Results in cycle stock that must be stored.▫Cycle stocks can be beneficial as long as

the appropriate analysis is done to cost justify the inventory.

Inventory in the Firm:Uncertainty/Safety Stocks•Net results are the same: companies

accumulate safety stock to buffer themselves against uncertainty.

•Safety stock more challenging and complex to manage for many firms.

•Impact of information on uncertainty▫Trade-off analysis appropriate to assess

risk and measure inventory cost.▫Information technology can be used in the

supply chain to reduce inventory.▫Collaborative planning and forecasting

requirements (CPFR) is an example.▫Bar coding, EDI, the Internet have enabled

companies to reduce uncertainty.

Inventory in the Firm: Time/In-Transit and Work-In-Process Stocks

• Time-related trade-offs from using slower to faster transport modes▫ Faster modes cost more but may save a

larger amount in inventory carrying costs.• Work-In-Process inventory should be

examined for possible trade-offs especially in the production of high value goods.▫ Scheduling and actual production times can

be closely examined to reduce inventory

Inventory in the Firm:Seasonal Stocks•Seasonal demand compressing selling

seasons in some industries results in smaller plants producing for stock.

Inventory in the Firm:Anticipatory Stocks•In some cases, companies anticipate that

some forecasted event will negatively impact the production cycle.

•For example, labor strikes, shortage of supplies due to weather or political event, or significant price increases may prompt the firm to build inventory levels higher than normal.

•Risk assessment is important in these cases.

Inventory in the Firm: The Importanceof Inventory in Other Functional Areas•Marketing uses inventory to provide

strong customer service.•Manufacturing uses inventory to schedule

longer production runs.•Finance wants inventory turnover ratios

to be kept high so that risk of inventory loss is reduced and rate of return on assets kept competitively high.

Inventory Costs: Why are theyso important?

•First, inventory costs are a significant portion of total logistics costs for many firms.

•Second, inventory levels affect customer service levels.

•Third, inventory cost trade-off decisions affect inventory carrying costs.

Inventory Costs:Inventory Carrying Cost•Capital Cost

▫Opportunity cost associated with investing in inventory, or any asset.

•Storage Space Cost▫Handling costs, rents, utilities.▫Logistics develops a cost formula for

storage space costs based on cost behaviors. Public space mostly variable. Private space a mix of fixed and variable.

•Inventory Service Cost▫Insurance and taxes on stored goods.▫Varies according to the value of the goods.

•Inventory Risk Cost▫Largely beyond the control of the firm.▫Due to obsolescence, damage, theft,

employee pilferage.

Example of Carrying CostComponents for Computer Hard Disks

Inventory Costs: Calculating theCost of Carrying Inventory

•Step 1 - Identify the value of the item stored in inventory (e.g. $100).

•Step 2 - Measure each individual carrying cost component as a percentage of product value (e.g. 25%).

•Step 3 - Multiply overall carrying cost (as a percentage) times the dollar value of the product (e.g. $100 times 25% = $25 inventory carrying cost per year.

Inventory Costs:Nature of Carrying Cost•Items with basically similar carrying costs

should use the same estimate of carrying cost per dollar.

•There are exceptions for items that are subject to special consideration for purposes of quick obsolescence or high degree of theft, etc.

Inventory and Carrying Cost Information for Computer Hard

Disks

Inventory Costs:Order/Setup Costs•Order costs

▫Costs for inventory stock level tracking.▫Preparing and processing purchase orders

and receiving reports.▫Inspecting and preparing inventory for

sale.•Setup Costs

▫Incurred when production changes over from one product to another.

Order Frequency andOrder Cost for Computer Hard

Disks

Inventory Costs:Carrying Cost versus Order Cost•Order costs and carrying costs respond in

opposite ways to increases in volume.•This reinforces the logisticians need to be

able to separate costs by how they behave in relation to changes in volume.

•Assistance from managerial accountants is available for cost-volume-profit analysis.

Summary of Inventory and Cost Information

Inventory Costs

Inventory Costs:Expected Stockout Cost•Cost of not having product available when

a customer wants it.•Includes backorder costs (special order).•Losing one item profit by substituting a

competing firm’s product.•Losing a customer permanently if

customer finds they prefer the substituted product and/or company.

•Possible to handle this by adding safety stock.

•In a manufacturing firm, a stockout may result in lost hours of production until the item is restocked.

Inventory Costs:Inventory in Transit Carrying Cost•Any product inbound to the firm using

F.O.B. origin should be counted.•Any product outbound from the firm using

F.O.B. destination should be counted.•In transit carrying cost is generally less

than for regular inventory because some cost components are not present.▫No storage costs, no taxes, and reduced

risk of obsolescence.

Classifying Inventory:ABC Analysis•Ranking system

▫Developed in 1951 by H. Ford Dicky of General Electric.

▫Suggested that GE classify items according to relative sales volume, cash flows, lead time, or stockout cost.

▫Most important inventory put in Group A.▫Lesser impact goods put in Groups B and C

respectively.

•Pareto’s Rule (80-20 Rule)▫Based on a nineteenth century

mathematician’s observation that many situations were dominated by a very few elements.

▫Conversely, most elements had very little influence in most situations.

▫Separates the “trivial many” from the “vital few”.

•80-20 Rule▫80% of sales will come from 20% of the

inventory SKUs.▫20% of sales will come from 80% of the

inventory SKUs.•The 80-20 Rule has been found to explain

many phenomena that interest managers.▫For example, 80% of sales come from 20%

of customers; and vice versa.

ABC Inventory Analysis

ABC Analysis for Big Orange Products, Inc.

Inventory Visibility• The ability of the firm to “see” inventory on a

real-time basis throughout the supply chain system requires:▫ Tracking and tracing inventory SKUs for all

inbound and outbound orders.▫ Providing summary and detailed reports of

shipments, orders, products, transportation equipment, location, and trade lane activity.

▫ Notification of failures in inventory flow.

Inventory Visibility:General Benefits•Improved customer service•Decreased cost-of-sales•Improved vendor relations and cost•Increased Return on Assets•Improved cash flow•Improved response time and service

recovery•Improved performance metrics

Evaluating the Effectiveness of a Company’s

Approach to Inventory Management•Are customers satisfied with the current

level of customer service?▫If standards have been set in

consultationwith the customer, this question can be answered objectively.

•How frequently does backordering and/or expediting occur?▫If records of these events are kept, the

answer to this question can point out the need for a modification or adoption of new inventory strategies.

•Is the company calculating an Inventory Turnover ratio for each product SKU?▫This ratio can provide good information on

whether the inventory is being effectively and efficiently managed.

•How does inventory level behave as sales rise or fall?▫From sales records, the firm can determine

if inventory levels rise as much as sales, less than sales, or stay about the same regardless of sales levels.

The Relationship amongInventory Turnover, Average Inventory,

and Inventory Carrying Costs