The Definitive Guide to Inventory Management

8/17/2019 The Definitive Guide to Inventory Management

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Contents

Chapter 1 Introduction to Inventory

What Is Inventory?The Role of Inventory in Supply Chain Management

Why Inventory Is Such an Important Metric for Supply Chain Management

Overview of the Book

n!notes

Chapter 2 Inventory Management Fundamentals

Types of Inventory

Inventory Costs

n!notes

Chapter 3 Inventory Control

"ncertainty in Inventory #rocesses

Inventory Replenishment #rocesses

$eman! $uring %ea! Time

&pecte! "nits Out #er Replenishment Cycle

Total 'nnual Cost as a (unction of Or!er )uantity

)uantity $iscounts

n!notes

Chapter 4 The Link Beteen Inventory Management and Forecasting

"ncertainty in $eman! an! (orecasting

Time Series Metho!s

Causal Mo!els

n!notes

Chapter ! "iscrete #vent $imulation o% Inventory &rocesses

"n!erstan! the Inventory Replenishment #rocess

Ran!omness in $eman!

Inventory Simulation in &cel

n!notes

Chapter ' (dditional Inventory Management &rocesses and Concepts

Multi*Item Inventory Management

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Multi*chelon Inventory Management

The +ewsven!or Mo!el

Censore! $istri,utions

'BC Inventory Classification

Material Re-uirements #lanning$istri,ution Re-uirements #lanning

'ggregate Inventory Control. Inventory Throughput (unctions

Storage of Inventory

Inventory Recor! Management

Implementation Challenges an! Challenging the Incum,ent #rocess

n!notes

Chapter ) Managing $upply Chain Inventory Flos

Component Risk #oolingBullwhip

Inventory #ostponement

Merge*in*Transit

/en!or Manage! Inventory

Consignment

Reverse Consignment

Colla,orative #lanning0 (orecasting0 an! Replenishment

#ush /ersus #ullChannel Separation

Inventory #lacement Optimi1ation

The 2lo,al Supply Chain Impact

Retail an! Consumer #ro!ucts Inventory Management

n!notes

Chapter * Inventory &er%ormance Measurement

Tra!e*Off 'nalysis

Types of Measures3*/ Mo!el

Measurement Systems an! (rameworks

Management ,y &ception

Measurement $ash,oar!s

n!notes

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1. Introduction to Inventory

In 4une 5678 the Council of Supply Chain Management #rofessionals 9CSCM#:

release! its annual State of %ogistics Report; The !ocument consists of several keylogistics*relate! tren!s an! !ata analyses that provi!e the rea!er with a snapshotof the emerging issues in the !iscipline an! a source for ,enchmarking supply

chain activities of a firm; One of the primary aspects of the report was the!iscussion of inventory tren!s; 'ccor!ing to the report0 inventories in the retail0 wholesale0 an! manufacturing sectors all rose in 5675; Interestingly0 retail

inventories increase! ,y owever0 inventory is one of the most interesting0 intriguing0 an! misun!erstoo!

,usiness phenomena; 't the root of this misun!erstan!ing are the variousperspectives on what inventory represents; Thus0 the ne&t sections present thepre!ominant !efinitional perspectives on inventory;

The GAAP Perspective

'ccor!ing to 2enerally 'ccepte! 'ccounting #rinciples 92''#:0 the primaryframework for financial accounting stan!ar!s0 inventory is a current asset; In

particular0 inventory represents @tangi,le personal property which are hel! for sale

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in the or!inary course of ,usinessA are in process of pro!uction for such saleA or0are to ,e currently consume! in the pro!uction; In other wor!s0 inventory 9in the

form of @work*in*process0 @raw materials0 or @finishe! goo!s: is an asset ,ecauseit represents property that is likely to ,e converte! to revenue0 as the ultimate goalof inventory is to facilitate sales for an organi1ation; Thus0 'ccounting 767 woul!

in!icate that inventory is properly accounte! for on financial statements ,y ,eingreporte! in !ollar value terms as a current asset on the ,alance sheet;

Several years ago0 an un!ergra!uate stu!ent aske! one of the authors an insightful-uestion; @If inventory is an asset0 then why are so many firms engaging ininventory re!uction initiativesD? This -uestion un!erscores the intriguing nature

of inventory; es0 accor!ing to 2''#0 it is an asset0 as it represents potentialrevenues; >owever0 themanagement of inventory ren!ers it an asset that comes with a price tag; Thus0 inventory management is why inventory is such an

interesting ,usiness phenomenon; ItDs the art of managing an asset that is often viewe! as a lia,ility even though it is an asset; /arious measures of inventory in thesupply chain are perhaps the most salient metrics for the efficiency an!

effectiveness of the supply chain;

The Supply Chain Management Efficiency Perspective

One of the primary goals of supply chain management is to ensure that operations

within an! across firms in a supply chain are efficient; In many cases0 the means toensure efficiencies is in inventoryA more specifically0 in inventory reductions;Consi!ering this0 inventory is often viewe! as a lia,ility to efficient supply chain

management; While supply chain managers recogni1e the necessity of inventory0

the unwritten 9an! in many cases0 written: rule is to keep inventory at a ,areminimum; This goal gave rise to many of the popular supply chain management

frameworks that are u,i-uitous to!ay. =ust*in*time inventory managementA leaninventoryA an! even colla,oration initiatives like colla,orative planning0forecasting0 an! replenishment 9C#(R:; Overall0 these strategic initiatives were all

!evelope! with the goal of streamlining inventories across the supply chain an!keeping inventory investment as low as possi,le;

The concept of inventory investment is0 perhaps0 the un!erlying reason why supply

chain managers attempt to keep inventories low; The cost investment associate!

with having inventories can ,e high; These costs are a!!resse! in much more !etaillater in the ,ook0 ,ut suffice it to say0 for now0 that these costs inclu!e the cash

outlay re-uire! to actually purchase the inventory0 the costs of hol!ing theinventories 9which inclu!es the cost of having investe! in inventories instea! ofsomething else:0 an! the costs associate! with managing the inventory;

Consi!ering this0 the managerial approach of keeping inventories as low as possi,leis not necessarily ,ecause itDs inventory0 per se0 ,ut ,ecause itDs moneyEmoney tie!up in something that costs even more money as it sits i!le; In a!!ition0 metrics


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such as return on assets are affecte! ,y inventory since inventory is in the assetcategory on the ,alance sheet;

The Risk Management Perspective

#erhaps another interesting answer to the @what is inventory? -uestion is the riskmanagement perspective; 'n interesting shift occurre! recently regar!inginventory; Though most firms still attempt to keep inventories as low as possi,le ,ecause of the costs associate! with hol!ing an! managing it0 there has ,een a

growing emphasis on the costs of not having or effectively managinginventories;5 In other wor!s0 inventory has ,een increasingly viewe! from a riskmanagement perspective0 where the costs an! impacts of stockouts0 misse! service

opportunities0 an! unforeseen supply chain interruptions have ,ecome a primary!ecision*!river for firms; This has resulte! in firms ,ecoming much more favora,leto concepts 9!iscusse! in much more !etail later in the ,ook: such as safety stock;

Their rationale has ,een the sentiment0 @we canDt affor! to not have safety stockinventoryF Because of this0 inventory has interestingly ,ecome a means ofmanaging risks;

In general0 there appears to ,e much more sensitivity to the risk of potential supply chain !isruptions;8 In many cases0 these !isruptions are the result of someuncertainty involve! in managing supply chain processes; Sometimes the

uncertainty is ,ecause of poor information availa,ilityA sometimes it is associate! with uncertainty in supplier lea! timesA sometimes it is uncertainty in e&ecution ofspecific tasks in various supply chain processes; In any case0 uncertainty is the

primary culprit involve! in supply chain !isruptions; One way that many firms

have chosen to !eal with such uncertainties is to he!ge against them with inventory investment; 'lthough this philosophy is cause for much !e,ate0 the reality is that

many ,usinesses engage in this practice for various reasons an!0 therefore0 viewinventory as a means of managing an! mitigating risks;

'nother popular variation of the risk management perspective is investing ininventory as a means of he!ging against currency an! price fluctuations; /en!orsoften offer short*term volume !iscounts0 the prices of many raw materials are ,ase! on market value0 an! purchasing from glo,al suppliers involves currency

e&change rates; To he!ge against these potential fluctuations an! changes0 many

firms opt to invest in inventory as a means of locking in prices an! currency valuations; $oing this ultimately prevents them from ,eing suscepti,le to the risk

of inventory costs going a,ove ,u!getary an! capital constraints;

The Balanced Perspective

's all the prece!ing !efinitional perspectives suggest0 inventory has a variety of

meanings an! sym,olic roles within supply chains; This un!erstan!ing is perhaps

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the most important an! fun!amental starting point for effective inventorymanagement; Inventory is an asset0 ,ut an asset that firms !onDt want too much of;

et not having @too much coul! put the firm at risk of potential supply chain!isruptions an! unforeseen e&treme costs; 's such0 the key to effective inventorymanagement is ,alanceEmaintaining a!e-uate inventories to ensure smooth

pro!uction an! merchan!ising flows while simultaneously minimi1ing inventoryinvestment to ensure firm financial performance; This ,alance is often referre! toas optimal;

The -uest for optimal inventory levels is not an easy un!ertaking; It involves aninterweaving of several analytical metho!s an! techni-ues; Moreover0 several

interconnecte! !ecisions must ,e ma!e to maintain optimal flows an! seamlesse&change of inventories along the supply chain; These issues are the focus of this ,ook an! are !iscusse! in much !etail in the forthcoming chapters;

T> RO% O( I+/+TOR I+ S"##% C>'I+M'+'2M+T

Managing customer an! ven!or relationships is a critical aspect of managingsupply chains; In many cases0 the colla,orative relationship concept has ,een

consi!ere! the essence of supply chain management; >owever0 a closere&amination of supply chain relationships0 particularly those involving pro!uctflows0 reveals that the heart of these relationships is inventory movement an!

storage; Much of the activity involve! in managing relationships is ,ase! on thepurchase0 transfer0 or management of inventory; 's such0 inventory plays a criticalrole in supply chains ,ecause it is a salient focus of supply chains;

#erhaps the most fun!amental role that inventory plays in supply chains is that offacilitating the ,alancing of !eman! an! supply; To effectively manage the forwar!

an! reverse flows in the supply chain0 firms have to !eal with upstream suppliere&changes an! !ownstream customer !eman!s; This puts an organi1ation in theposition of trying to strike a ,alance ,etween fulfilling the !eman!s of customers0

which is often !ifficult to forecast with precision or accuracy0 an! maintaininga!e-uate supply of materials an! goo!s; This ,alance is often achieve! throughinventory;

(or e&ample0 a growing tren! is the implementation of sales an! operationsplanning 9SGO#: processes;3 The fun!amental purpose of SGO# is to ,ring the!eman! management functions of the firm 9for e&ample0 sales forecasting0

marketing: together with the operations functions of the firm 9for e&ample0manufacturing0 supply chain0 logistics0 procurement: an! level strategic plans; Thisoften involves e&tensive !iscussions a,out the firmDs on*han! inventory0 in*transit

inventory0 an! work*in*process; Such !iscussions allow the sales an! marketinggroup to a!e-uately plan for the forthcoming time hori1on ,y gaining a realistic

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picture of the inventory levels availa,le for sale; '!!itionally0 the operations groupsare a,le to get up!ate! an! !irect sales forecasting information0 which can assist in

planning for future inventory nee!s; Such information may very well result in shiftsin manufacturing plans or alterations to procurement nee!s ,ecause of thestrategic !ecision to focus on specific units of inventory instea! of others in the

near future;

'nother e&ample of ,alancing through inventory is the use of point*of*saleH 9#OS:

!ata for perpetual inventory management in the retail in!ustry; (or many retailers0every @,eep of a cash register upon scanning of an itemDs ,ar co!e !uring checkouttriggers a series of messages that another unit of inventory has ,een sol!; This

information is not only tracke! ,y the retailer ,ut is also share! with upstream ven!ors; 's items are !eplete! from inventory0 in some cases0 ,oth the retailer an! ven!or work colla,oratively to !etermine when reor!ering is necessary to replenish

the !eplete! inventory0 especially at the !istri,ution center level; This is a ,alancing of supply an! !eman! ,ecause !eman! information is tracke! to!etermine when to ,est place replenishment or!ers ,ase! on the time re-uire! to

get the inventory to the store location; In essence0 inventory !ecisions are use! toeffectively time when supply inflows are nee!e! to han!le !eman! outflows;

W> I+/+TOR IS S"C> '+ IM#ORT'+T MTRIC (OR

S"##% C>'I+ M'+'2M+T

's initiatives like SGO# illustrate0 inventory can ,e a vital part of managing supplychains; Because of this0 the status of a firmDs inventory is often use! as a litmus testfor the overall @health of its supply chain management processes an! !ecision*

making; (or e&ample0 consi!er the firm that has e&cessive amounts of inventory inthe form of safety stock; Such high safety stock is in!ee! a pro,lem in an! of itself ,ecause of the costs of hol!ing this inventory an! the opportunity costs of having

working capital tie! up in assets that arenDt ,eing converte! to sales; The largerissue here0 however0 is that this safety stock situation is likely a symptom of somesort of ineffective supply chain management !ecision*making; #erhaps !eman!

forecasting is constantly an! significantly inaccurate0 may,e supplier lea! times areunnecessarily long0 perhaps firm operations are la!en with ,ottlenecks an!inefficient inventory han!ling0 or may,e transportation carriers are not provi!ing

-uality service in the form of !elivering inventory !amage*free an! on*time; These

are ,ut a few e&amples of supply chain management ineffectiveness that oftenmanifest in the form of either e&tensive levels of stagnant inventory or consistent

out*of*stocks; >ence0 inventory is an important supply chain measurement tool ,ecause it is likely one of the first signs that some root cause9s: is causing supplychain inefficiencies;

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This has resulte! in in!ustry analysts0 supply chain consultants an! researchers0an! even Wall Street paying close attention to inventory metrics to glean insights

a,out supply chain performance tren!s an! changes; Measures such as inventoryturns0 !ays of inventory0 an! cash*to*cash cycle have ,ecome popular0 as they areall in!icators of how well a firmDs supply chain is ,eing manage!; These inventory

measures tell us0 for e&ample0 how -uickly inventory is moving through the supplychain0 how likely the firm can han!le the fulfillment of customer !eman!s0 how thefirmDs li-ui!ity is impacte! ,y its investment in inventory0 an! may even signal how

effectively supplier relationships are ,eing manage!;

O/R/IW O( T> BOO

Consi!ering that inventory management is clearly a fun!amental aspect of supplychain management0 this ,ook has ,een !evelope! to outline the concepts an!

techni-ues at the heart of effective inventory !ecision*making; 's we esta,lishe! in

this chapter0 inventory management is a far*reaching an! e&pansive su,=ect;Because of this0 we canDt make claims that this ,ook will ,e e&haustive0 ,y any

means; >owever0 we have carefully piece! together what we consi!er to ,e the keyframeworks an! approaches to assist the rea!er in ,etter un!erstan!ing the @what0 why0 how0 an! ,y what means of inventory management !ecision*making;

Chapter 50 @Inventory Management (un!amentals0 ,uil!s on the !efinitional!iscussion in this chapter an! provi!es foun!ational insights into the keyterminology an! concepts involve! in inventory management; Chapter 5 highlights

the !ifferent types of inventory an! the various cost !rivers an! cost categoriesassociate! with these inventories; Because there is often confusion in !iscussions

a,out inventory that is a result of lack of terminology0 we carefully an! thoroughlyconsi!er many !ifferent an! overlapping inventory concepts; ' thoroughun!erstan!ing of Chapter 5 facilitates your un!erstan!ing of the remain!er of the ,ook;

Chapter 80 @Inventory Control0 takes the inventory management !iscussion further ,y focusing on the analyses use! to make well*informe! inventory

!ecisions; Chapter 8 presents frameworks that assist in !etermining wheninventory shoul! ,e or!ere!0 how much shoul! ,e or!ere!0 an! ultimately how theinventory or!ere! shoul! ,e manage! an! accounte! for; The chapter conclu!es

with some e&amples of managerial issues that firms have face! when implementingseveral of these inventory approaches; This portion of the chapter was !evelope! tohelp conte&tuali1e the analysis techni-ues ,y sharing certain roa!,locks0 pro,lems0

an! uni-ue successes that some firms have reali1e! when putting these theoreticalconcepts to practice;

Chapter 30 @The %ink Between Inventory Management an! (orecasting0 looks at

forecasting within the conte&t of inventory management; It is really impossi,le to

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even e&amine inventory management without thoroughly !iscussing forecastingan! how it relates to inventory !ecisions; ou nee! to know how many units you

are e&pecting to sell if you want to or!er an appropriate -uantity at the appropriatetime; In a!!ition0 the error in forecasts also contains useful information0 ,ecause itis an in!icator of how much uncertainty there is in !eman!;

Chapter H0 @$iscrete vent Simulation of Inventory #rocesses0 !escri,es a tool thatis useful for analy1ing inventory processes0 the effects of forecasting metho!s on

inventory processes0 an! how e&ecution failures affect the performance of theinventory systemEnamely0 !iscrete event simulation; $iscrete event simulation isuse! to stu!y a wi!e variety of processes an! systems0 ,ut we are !iscussing its use

only within the conte&t of forecasting an! inventory management; (urthermore0many software packages are specifically !esigne! for !iscrete event simulation0 ,ut we e&plain how to con!uct !iscrete event simulation in Microsoft &cel;

#rior to Chapter J0 we primarily look at inventory management from theperspective of an in!ivi!ual stock*keeping unit 9S":0 ,ut in Chapter J0@ '!!itional Inventory Management #rocesses an! Concepts0 we consi!er

inventory management with multiple S"s; One must clearly un!erstan!inventory management an! theory from the single S" perspective to ,e a,le tofully un!erstan! multi*item inventory management since many of the concepts

from single item inventory management are use! in the !iscussion of multi*iteminventory management; In a!!ition0 up to Chapter J0 we only !iscuss singleechelon inventory management0 ,ut in Chapter J we e&ten! the !iscussion to

inclu!e multi*echelon inventory management; Many other relate! concepts are!iscusse! in Chapter J0 inclu!ing !istri,ution re-uirements planning0 which is

certainly a multi*echelon concept;

Chapter K0 @Managing Supply Chain Inventory (lows0 looks at a num,er of topicsrelate! to overall management of the flow of inventory0 inclu!ing who owns theinventory0 who makes !ecisions a,out when an! how much to or!er0 where the

pro!uct flows vis*L*vis where the marketing transactions occur0 an! other relate!topics; We also look at -uestions a,out where inventory shoul! ,e hel! an! howor!ers can cause a!!itional uncertainty in !eman! as they move up the supply

chain;

'lthough performance measurement is !iscusse! ,oth !irectly an! in!irectly

throughout Chapters 5 through K0 Chapter


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+$+OTS

1+ $augherty0 #atricia 4;0 Matthew B; Myers0 an! Cha! W; 'utry; @'utomaticReplenishment #rograms. 'n mpirical &amination; ournal of Business

!ogistics 56;5 97NNN:. J8*


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2. Inventory Management Fundamentals

T#S O( I+/+TOR

There are many !ifferent types of stock or inventory an! many !ifferent ways ofclassifying them; In this ,ook we spen! more time talking a,out the !ifferent typesof stock than most ,ooks on inventory management0 an! we classify them in more ways than most ,ooks classify them; ou will also notice that many of the!efinitions overlap; We !o this ,ecause how you shoul! manage the stock !epen!s

heavily on the type of stock0 what it is use! for0 how it is affecte! ,y antece!ents0an! what it affects; There is no nee! to ,e laconic on !efining stock an! no nee! to worry a,out too much overlap; It is more important to come up with the smallest

set of items in the classification that gets the =o, !one well; That is what we !o inthis ,ook; In managing inventory it is crucial to communicate clearly on what youare talking a,out; The authors have ha! many !iscussions a,out inventory an!

inventory management with ,oth practitioners an! aca!emics0 an! they havefoun! that many times one of the challenges is that people are !iscussing !ifferentaspects of inventory management without reali1ing it; We emphasi1e this ,ecause it

might ,e tempting to gloss over the following !iscussion0 not !igging in !eeply an!thinking things through0 ,ut we ,elieve this woul! ,e a mistake;

's we mentione!0 you will notice overlaps in our classification system; (ore&ample0 one of the items in our classification scheme is retail ,ackroom stock9RBS:0 an! another item is safety stock 9SS:; Well0 RBS may very well inclu!e SS;

>owever0 theoretical an! practical !ifferences make it ,eneficial to keep them

separate!0 while at the same timerecogni1ing the overlap; Since communicationa,out inventory management within companies an! ,etween companies is a

persistent pro,lem0 we nee! a complete voca,ulary with precision to improve thesituation; Throughout this ,ook we refer to these !efinitions an! classifications soit is worthwhile to spen! plenty of time in this section;

We often hear of pro=ects to re!uce inventory0 an! many times they are successful; We rarely hear careful specificity regar!ing which types of stock were re!uce!0 yetit has a huge impact on the short*term an! long*term implications of the stock

re!uction;

This is even a pro,lem0 as we will see0 with those who have a cursory un!erstan!ing

of the terms; (or e&ample0 some erroneously ,elieve that as long as safety stock isnot re!uce!0 service levels will remain unchange!; 2enerally this is a fallacy that isa result of a narrow view of service; If the !efinition of service is the fre-uency with

which we run out of stock !uring the protection perio!0 such as the lea! time0 thenthat is true; If it is the total amount of !eman! fulfille! from inventory0 then it is wrong; Re!ucing cycle stock hurts service level as we learn later in the chapter;


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'nother !ifferentiating factor a,out our classification an! our !efinitions thatmake them more useful is that we !efine them from ,oth a forwar! looking

perspective an! a historical perspective; We actually !o this throughout the entire ,ook; In most inventory management ,ooks the !efinitions of inventory areforwar! looking only; Take0 for e&ample0 safety stock; The forwar! looking

!efinition lea!s to a mathematical formulation to estimate how much inventory isre-uire! to achieve a !esire! @service level0 whereas the historical perspectiveestimates how much safety stock we actually ha! over time;7 It woul! ,e great if we

coul! specify a service level0 calculate a re-uire! safety stock0 an! then later look ,ack at the !ata an! fin! that our historical safety stock was the same as ourforwar! looking safety stock; (or technical reasons0 many times that !oes not

happen; Therefore0 we propose an empirical approach to setting some of theseinventory levels;

$efinitions of replenishment processes0 service metrics0 an! so on0 are allintertwine! with our !efinitions an! classification scheme0 ,ut you have to startsomewhere; So0 while we are !efining these items of the classification scheme0 we

focus on a few !efinitions of service0 which are !efine! in the course of !iscussiona,out the type of stock; We also nee! to !o this for a replenishment process; Thatis0 we nee! a couple of !ifferent types of replenishment processes; Regar!ing

service level measures0 we ,egin ,y using 97: protection perio! in*stock 9##IS:metric an! 95: item*level fill rate 9I%(R: metric; Regar!ing replenishmentprocesses05 we ,egin ,y using 97: the fi&e! or!er point0 fi&e! or!er -uantity

9)0RO#: process0 an! the fi&e! or!er interval0 or!er up to level 9T0O"%: process;These are helpful in !iscussing each of the !efinitions within the classificationscheme; >owever0 in Chapter 80 @Inventory Control0 we go into more !epth on

each of the service level measures as well as the replenishment processes; Ina!!ition0 later in this chapter we look at other types of measures of service as wellas other types of replenishment processes;

Before we !efine the ##IS metric0 we must !efine protection perio!; #rotectionperio!8 is the interval of time over which a stockout is possi,le; This may seem o!!since it woul! appear that you coul! stockout anytimeA however0 this is not the

case; Consi!er the 9)0RO#: process; In that process you or!er ) when theinventory position3reaches the RO#; Well0 if the RO# 60 it is not possi,le tostockout prior to reaching the RO#0 ,y !efinition; >owever0 you can stockout after

you reach the RO#; 's soon as you hit the RO#0 you place an or!er; The time ,etween when the or!er is place! an! the or!er is receive! an! availa,le for use isthe lea! time 9%:; So0 with the 9)0RO#: process the protection perio! is the lea!

time; +ow we can !efine the ##IS metric for the 9)0RO#: processEnamely0 the##IS for the 9)0RO#: process is the pro,a,ility of a stockout !uring the lea! time;

(or the 9T0O"%: process0 you only or!er when you get to the reor!er times0 which

are space! out ,y T perio!s of time; So0 suppose you are at one of the reor!er times0

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an! you calculate the !ifference ,etween the O"% an! the inventory an! or!er that-uantity; Then you wait for the lea! time to receive the or!er; ou cannot or!er

again until you reach the ne&t reor!er time; Once you place your or!er0 you canstockout anytime ,etween or!er times an! the lea! time; >ence0 for the 9T0O"%:replenishment process the protection perio! is T % an! the ##IS is the pro,a,ility

of a stockout !uring T %;

The item*level fill rate 9I%(R: is the percentage of !eman! fulfille! from on*han!

inventory; If !eman! is not fulfille! from on*han! inventory0 the !eman! is eitherlost 9lost sales: or ,ack*or!ere!;H In either case0 that is the !eman! loss at thattime; So0 the total !eman! loss over a perio! of time !ivi!e! ,y the total !eman!

over that time is the I%(R;

With all of this0 we can now ,egin to !iscuss each type of stock in our classificationscheme;

Cycle Stock

Cycle stock J is the amount of inventory ,etween replenishments; (or a 9)0RO#:

replenishment process0 the average amount of inventory ,etween replenishments is9)7:5 for !iscrete unitsK 9such as cartons of rea!y*to*eat cereal: an! )5 forcontinuous units 9such as gallons of gasoline:;


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,ottles per store U K66 ,ottles;76 The total cycle stock in the retail network is K66 ,ottles plus 3H6 ,ottles U 707H6 ,ottles;

(or a 9T0O"%: process0 it is similar; Suppose you or!er to ,ring the inventoryposition up to O"%; Suppose a !istri,ution center goes through 70666 ,ottles per

week0 an! the !istri,ution center or!ers once per week; Then in that case0 theaverage cycle stock per !istri,ution center is 70666 5 U H66 ,ottles; Suppose eachstore or!ers once per week an! each goes through J ,ottles per weekA then the

average cycle stock per store is 9J 7: 5 U 8;H;

The point of all of this is that it is relatively easy to estimate cycle stock with ,oththe 9)0RO#: an! the 9T0O"%: replenishment processes; This is nice ,ecause cycle

stock is often a large component of total inventory0 so it is a step closer toestimation of inventory re-uirements; Such estimation is easy to !o in a meeting onthe ,ack of a napkin yet few know a,out this metho!;

These metho!s are forwar! looking0 not historical; That is0 we use these metho!s toestimate what the average cycle stock is0 ,ut it might ,e !ifferent in reality; It is

easy to see why it might ,e !ifferent for the 9T0O"%: replenishment process sincethe average cycle stock is estimate! to ,e ! T 5; That is0 the actual average!eman! might turn out to ,e !ifferent from !; But why woul! it ,e !ifferent for the

9)0RO#: metho!? Well0 it coul! ,e that you run out of inventory an! lose salesevery replenishment cycle;77 Suppose you start the month with 766 units an! yourun out half way through the month; Then your average inventory in the first half of

the month is H60 ,ut the last half of the month is 1ero; So the average cycle stock!uring the month is 9H6 6: 5 U 5H; With the 9)0RO#: replenishment process

an! lost sales0 it is possi,le for the 9) 7: 5 metho! to ,e !ifferent from thehistorical calculation of cycle stock;

To reiterate0 for the 9T0O"%: metho! of estimating forwar! looking cycle stock0 ! T can ,e inaccurate if the average !eman! is !ifferent from !; That woul! not ,e

surprising; On the other han!0 for the 9)0RO#: metho!0 9) 7: 5 will ,e !ifferentif there are fre-uent an! !eep stockouts;

We now !iscuss the measurement of historical cycle stock; 's soon as the perpetual

inventory goes up as a result of receiving an or!er0 ,egin to take the average of on*han! inventory; Cease taking the average at the time ,efore the ne&t replenishmentarrives; +ow su,tract the final on*han! inventory from the average inventory to

arrive at the average cycle stock for one replenishment cycle; This continues overtime0 an! the average cycle stock for a set of replenishment cycles is the estimate ofthe historical safety stock;

(or the 9)0RO#: replenishment process0 higher levels of cycle stock can improveitem*level fill rate 9I%(R:; To un!erstan! why0 letDs take an e&treme e&ample;

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Suppose you set ) such that you or!er =ust enough for one !ay of supply; Then you will have to reor!er 8JH times !uring that year0 meaning that you will ,e e&pose! to

lea! time failures 8JH times !uring the year; On the other han!0 if you set ) suchthat you or!er enough for the entire year0 there will only ,e one time per year youare face! with the possi,ility of a lea! time failure; In the former case the num,er

of stockouts !ue to lea! time failures will ,e high compare! to the latter case;

The same woul! not necessarily ,e true for the 9T0O"%: process ,ecause you can

stockout anytime !uring T; (or the 9)0RO#: process0 you replenish0 on average0every )! perio!s of time0 ,ut if !eman! picks up0 you or!er early; Whereas withthe 9T0O"%: you might not ,e a,le to or!er early; (or e&ample0 a company might

or!er a truckloa! per week of 56 !ifferent S"s from a supplier; Or!ering one S"early ,ecause its !eman! picke! up might not ,e cost effective0 especially if theseS"s yiel! low margin in the market; In that case0 e&pe!ite! transportation might

not ,e economical; >ence0 more forwar! looking cycle stock in this replenishmentprocess may not have as much impact on I%(R as it !oes in the 9)0RO#:replenishment process;

We have focuse! on cycle stock in the conte&t of two !ifferent replenishmentprocesses0 the 9)0RO#: process an! the 9T0O"%: process0 ,ut there are many otherhy,ri! processes0 some of which we !iscuss inChapter 8; The i!eas for estimating

forwar! looking cycle stock are key in the other processes as well so we focus onthese two types of replenishment processes for now;

Safety Stock

(orwar! looking safety stock 75 is the e&pecte! num,er of units on han! when thereplenishment arrives an! is availa,le for use; >istorical safety stock is the average

amount of inventory on han! when the replenishment arrives an! is availa,le foruse; >istorical safety stock an! forwar! looking safety stock can !iffer ,ecause 97:the assume! replenishment process in the safety stock calculation is !ifferent from

the actual replenishment process0 95: the assume! !istri,ution of !eman! is!ifferent from the actual !istri,ution or the !eman! is nonstationary0 98: the actuallea! time !istri,ution !iffers from the actual lea! time !istri,ution0 if it even e&ists0or 93: other types of e&ecution errors e&ist that are not accounte! for in the forwar!

looking safety stock calculation; We a!!ress each of these in turn;

>istorical safety stock an! forwar! looking safety stock can !iffer ,ecause the

assume! replenishment process is !ifferent from the actual replenishment process;If the 9)0RO#: or 9T0O"%: replenishment processes are use!0 it is easy to fin!calculations of safety stock in the literature; >owever0 it is rare to fin! such pure

processes in practices; (or e&ample0 to implement the 9)0RO#: process0 all of theS"s you are or!ering woul! have to ,e or!ere! whenever they hit their reor!erpoint 9RO#:; If transportation costs are low enough relative to inventory costs0 this

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might ,e possi,le; (or e&ample0 suppose you are or!ering an e&pensive component0so e&pensive that even air carriage is a small fraction of the inventory carrying cost;

In that case0 it might make sense to or!er each S" ,y air each time the RO# is hit;But for most S"s0 you really nee! to or!er several S"s at the same time !ue tothe fact that they all nee! to go on the same pallet or truckloa! or carloa!; This

soun!s like a 9T0O"%: process0 where you coul! set T so that you go throughenough !eman! on average where you can or!er several S"s at the same time;>owever0 this also has a strong assumption; That is0 each time you or!er0 you must

or!er up to O"%; The pro,lem is that you might nee! to only or!er in multiples ofsome num,er0 such as case packs or truckloa!s; That is0 using a strict 9T0O"%:process0 you might nee! to or!er a pack an! a half to ,ring the inventory position

up to O"%0 ,ut you then might have to or!er two as a minimum or!er -uantityfrom the supplier; Similarly0 what if several S"s run out ,efore T units of time0then if the cost of a stockout is high enough0 an emergency or!er will ,e place!; If

that is possi,le0 the forwar! looking safety stock calculations ,ase! on the 9T0O"%:replenishment process will not ,e accurate0 ,ecause emergency or!ers are not apart of the 9T0O"%: process; In a!!ition to this situation0 suppose you or!er all of

the S"s using a 9T0O"%: process0 an! you are only at J6 percent of a fulltruckloa!; It might ,e optimal to or!er more of some pro!ucts to fill the truck upthe rest of the way0 increasing transportation utili1ation; If this is possi,le0 then

this is not a true 9T0O"%: process ,ut a hy,ri!0 an! safety stock calculations ,ase!on the 9T0O"%: process will ,e inaccurate;

>istorical safety stock an! forwar! looking safety stock can !iffer ,ecause theassume! !istri,ution of !eman! is !ifferent from the actual !istri,ution or the!eman! is nonstationary; ven with the tra!itional 9)0RO#: an! 9T0O"%:

replenishment processes0 many of the forwar! looking safety stock calculations are ,ase! on a limite! num,er of !eman! !istri,utions0 inclu!ing the normal0#oisson078 %aplace073 an! empirical !istri,utions; In reality0 there are many times were we actually face a mi&ture of !istri,utions; (or e&ample0 in retail0 the

!istri,ution of !eman! is !ifferent for !ifferent !ays of the weekA theprepon!erance of shopping occurs on the weeken!; ven more pro,lematic0 thema=ority of S"s in retail face nonstationary !eman!; (or simplicity we can

assume that this means that their mean an!or stan!ar! !eviation change overtime;

>istorical safety stock an! forwar! looking safety stock can !iffer ,ecause theactual lea! time !istri,ution !iffers from the assume! lea! time !istri,ution; %ea!time is the time ,etween when the or!er is place! an! when the inventory is

availa,le for use; It is not =ust the transportation time; Many times errors are ma!ein calculating safety stock ,y using transportation time to represent lea! time; %ea!time can also inclu!e or!er placement time0 or!er picking0 staging0 loa!ing0

transportation0 receiving0 put away0 an! so on; In a!!ition0 sometimes the stan!ar!!eviation of transit time is use! in place of the stan!ar! !eviation of lea! time;

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&ecution errors in all the steps in the lea! time can contri,ute to the stan!ar!!eviation of lea! time;

ou might won!er why you woul! want to calculate ,oth forwar! looking an!historical safety stocks; The reason for this is that it can allow you to a!=ust your

forwar! looking safety stock to fit reality0 an! it can help you i!entify whether this!ifference is the reason for stockouts or e&cess inventory; mpirical estimates ofthe relationship ,etween causes of safety stock an! actual level of safety stock can

,e estimate! to set future safety stock levels more accurately; One ,enefit to this isthat you !o not have to !erive the e&act analytical mo!el0 which might very well ,eimpossi,le;

's we have alrea!y !iscusse!0 ,oth safety stock an! cycle stock can ,e use! to !eal with stockouts; In many te&t,ooks0 it is often purporte! that safety stock alone isuse! to a!!ress uncertainty in supply an! !eman!; This is simply not true; (or any

given target %ine Item (ill Rate 9%I(R: you can a!=ust safety stock0 cycle stock0 or ,oth to hit the target; +ow0 for the ##IS metric in the 9)0RO#: process0 only safetystock can affect it ,y !efinition; (or this uni-ue situation0 ##IS is the pro,a,ility of

,eing in stock !uring the lea! time; >owever0 even for this process0 the %I(R can ,ea!=uste! either through cycle stock or safety stock; >aving more varia,les to use fora!=usting this is ,etter than having fewer varia,les;

One might won!er why it even matters to !ifferentiate ,etween cycle stock an!safety stock; In fact0 some te&t,ooks !onDt even use the two terms; Well there are

many reasons to want to manage them in !ifferent ways; (or e&ample0 in ,rick an!mortar retail esta,lishments0 having less than a certain amount of inventory on the

shelf !oesnDt look attractive; Safety stock can ,e use! to a!!ress this issue; Ina!!ition0 in some cases0 a certain amount of cycle stock is necessary; (or e&ample0suppose transportation costs !ramatically outweigh inventory costs; In that case itmight ,e that inventory is or!ere! in truckloa! or carloa! -uantitiesA ,oth %I(Ran! ##IS must ,e manage! through safety stock;

"n&Transit Stock

In*transit stock 7H is inventory that is not ,eing store! for later use or sale ,ut is en

route to an inventory hol!ing no!e;7J The most o,vious in*transit stock is inventory

that is in a transportation unit0 such as on a truck0 train0 ship0 or airplane;>owever0 =ust ,ecause it is in a transportation unit !oes not mean that it is in*

transit stock; (or e&ample0 if inventory is hel! in a truck trailer for sale !irectlyfrom the truck trailer0 it is not in*transit stockA the truck trailer is actually aninventory hol!ing no!e; Similarly0 if you look at inventory in a !istri,ution center0

some of it is in a no!e an! some of it is in*transit stock; If the inventory is ,eingcross !ocke! through the !istri,ution center0 it is in transit; Similarly0 if you seeinventory in the ,ackroom of the store0 awaiting stocking to the shelves0 it is in

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transit until it gets to the shelves; On the other han!0 if inventory is hel! in the ,ackroom of a store until the shelf nee!s to ,e restocke!0 it is not in*transit

inventoryA the ,ackroom of the store is an inventory hol!ing no!e; In general0anytime inventory is @in the lea! time07K it is in*transit stock;

(or precision of !iscussion0 we refer to in*transit stock that is ,eing transporte!as in&transport stock; In*transit stock that is ,eing cross !ocke!0 stage!0 picke!0put away0 an! so on0 we refer to as in&non&transport stock; So0 in*transit stock has

in*transport an! in*non*transport stock; We nee! to make this !istinction ,ecausethese may have !ifferent costs0 as we !iscuss later in this chapter;

It is also important to !istinguish which portion of in*transit stock is actually ,eing

move! ,y a common carrier; The reason for this is that after a common carrier isten!ere! freight0 the lia,ility for the inventory shifts to the carrier in many cases; When this is the case0 the cost of hol!ing the inventory is lower !uring the time it is

in transit ,ecause the lia,ility portion of the inventory carrying cost is remove!;

The forwar! looking e&pecte! amount of in*transit stock is relatively easy to

estimate; It is the e&pecte! lea! time in !ays !ivi!e! ,y 8JH !ays07


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Increases in any of the components of lea! time not only increase in*transit stock0 ,ut also increase the amount of safety stock an!or cycle stock re-uire!; (or this

reason0 using the comparison of forwar! looking an! historical in*transit stock can ,e particularly valua,le; It is a way of keeping check on the accuracy of the lea!time estimates;

When ocean carriage is use!0 the in*transit stock naturally is much higher than when air carriage is use!; (or ocean carriage0 most likely the prepon!erance of the

lea! time is the transit time0 whereas in air carriage0 that might not ,e thesituation; Imagine a pro!uct that is or!ere! from Tokyo0 4apan0 for use in %ongBeach0 California0 an! that lea! time minus transportation time is 7 !ay; Suppose

ocean carriage is 75 !ays an! air carriage is 7 !ay; In this highly styli1e! e&ample0estimating in*transit stock simply from transportation time is possi,ly accepta,lefor ocean carriage0 ,ut for air carriage it is in error ,y a factor of 5; >owever0 if you

are simply comparing the two0 with all else ,eing e-ual0 you can estimate thechange in in*transit stock =ust using the !ifference in transportation time; Back tothe e&ample of the pro!uct moving from Tokyo0 4apan0 to %ong Beach0 California.

If a switch from ocean to air was ,eing consi!ere!0 it woul! result in a N5 percentre!uction in in*transit stock 975*7:75; Similarly0 if the switch ,eing consi!ere! isfrom air to ocean0 the increase in in*transit stock woul! ,e 77*fol!; In general0 if

any component of lea! time is consi!ere! for a change0 only the relative change inthat component is nee!e! to estimate the relative change in in*transit stock; This isconvenient ,ut must ,e weighe! carefully in light of the change in total cost; (or

e&ample0 if in*transit stock is a small percentage of total inventory costs0 a N5percent re!uction0 as !iscusse! earlier0 may seem more impressive than it willactually ,e on total inventory;

Promotional Stock

There are two categories of promotional stock. a promote! S" that iscontinuously in the assortment0 an! a promote! S" that is not carrie!

continuously; (or the former0 there are many !ifferent types of promotions.temporary price re!uctions0 promotional !isplays0 ,uy one get one free0 ,onuspacks0 coupons0 samplings0 signage0 e&tra inventory in the store0 an! many others;

Many times these are use! in com,ination with one another; (or e&ample0 atemporary price re!uction might ,e couple! with a promotional !isplay an! e&tra

inventory;

The goal of promotions is to increase !eman!; >owever0 the change in -uantitysol! at any given location is !ifficult to forecast0 making it !ifficult to know howmuch a!!itional inventory is re-uire!0 if any; (or pro!ucts that are slow movers0

where you sell one every couple of weeks0 a promotion might result in selling oneper !ay an! perhaps not re-uire e&tra inventory to support the increase! !eman!;


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#emonstration Stock

Inventory hel! for the purposes of !emonstration or !isplay is calle!

!emonstration stock; If it cannot ,e sol!0 even if out of stock of the item0 it istechnically not a part of safety stock; On the other han!0 if it can ,e sol! in the case

of an out of stock0 it really is a part of safety stock; In that case0 the safety stock isactually higher than the planne! safety stock0 an! ,oth the I%(R an! the ##IS areactually higher than planne!; In that case0 it might ,e ,etter =ust to view!emonstration stock as a part of safety stock for cost an! service calculations;

>owever0 if !emonstration stock goes out of !ate or !eteriorates in some way0 it isnot really a part of safety stock;

Retail Backroom Stock

Retail ,ackroom stock 7N is inventory locate! in the storage or ,ackroom of a retailstore; Retail ,ackroom stock may actually ,e in*transit stock0 safety stock0 or cyclestock or a com,ination of safety stock an! cycle stock;

Before we e&plain this further0 first note that an inventory hol!ing no!e is aphysical location from which or!ers are place! an! receive!; If inventory is or!ere!from +o!e ' an! from +o!e B0 ,ut it travels from +o!e B through +o!e C0 an!

then on to +o!e '0 then +o!es ' an! B are inventory hol!ing no!es an! +o!e C isnot; +o!e C might ,e a cross !ock or it might ,e a retail ,ackroom;

If inventory from the shelves is not replenishe! from the ,ackroom0 then the ,ackroom is not an inventory hol!ing no!e ,ut simply a staging area0 an!0 hence0

the inventory is in*transit stock; If inventory is planne! to ,e hel! in the ,ackroom0the retail shelves are replenishe! from the ,ackroom0 an! the ,ackroom isreplenishe! from the !istri,ution center 9$C: or supplier0 the inventory in the ,ackroom is a com,ination of cycle stock an! safety stock;

Consi!er the situation where the ,ackroom is not an inventory hol!ing no!e ,ut areplenishment arrives; It goes to the stock shelves0 ,ut some of the units !onDt fit onthe shelf; Then the units go to the ,ackroom until the shelf has more space; This is

a pro,lematic situation ,ecause there may not ,e formal triggers to replenish theshelf when it gets too low; Technology may eventually solve this pro,lem0 ,ut

coor!inating shelf capacity an! ,ackroom capacity is not an easy task; It isimportant for operational e&cellence to ,e a,le to specify what types of inventoryare where an! why they are there; That is why we are going into !etail to provi!e voca,ulary for !iscussion of these issues;

If store safety stock is set to shelf capacity0 then on average0 no units that arrive tothe shelf from an or!er will fit on the shelf; Recall that safety stock is the e&pecte!

num,er of units of inventory availa,le =ust ,efore the replenishment arrives;

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Consi!er a continuous review 9)0RO#: system; If shelf capacity is e-ual to RO# )0 then units will always fit on the shelf when an or!er arrives; Consi!er the

situation where an or!er is place! an! !eman! goes to 1ero; Then when the unitsarrive at the shelf0 there are still RO# units since that is what it was when the or!er was place!; Since the or!er is ) units0 the total num,er of units that will ,e on the

shelf will ,e ) RO#; The pro,lem with this is that there will on average ,e 9RO#V safety stock: units of empty shelf space; (or a 9T0O"%: process0 if shelf capacity isset to O"%0 it is =ust like setting shelf capacity to RO# ); Both of these situations

result in waste! shelf space; On the other han!0 when items have to go to the ,ackroom ,ecause they !onDt fit0 that !rives e&tra la,or costs; Shelf space costsmust ,e weighe! against la,or costs among other things in setting shelf capacity;

The interaction of shelf capacity0 or!er -uantity0 safety stock0 lea! time0 an! others!etermines how often units must go to the ,ackroom;

Replenished Retail Shelf Stock

Replenishe! retail shelf stock 56 is inventory that is on the shelf an! consists of ,othcycle an! safety stock; It is to ,e !istinguishe! from promotional stock that might

also ,e on the shelf; arlier we !iscusse! promotional stockEthe e&tra stock in thestore to fulfill e&tra !eman! !ue to a promotion; Consi!er a situation where apromotional !isplay is put in the store in an area !ifferent from the regular shelf

location an! that no other promotion is use! in com,ination with the promotion!isplay; If ,ar co!es are use! at point*of*sale57 9#OS: an! the items on thepromotional !isplay have a !ifferent co!e than the replenishe! retail shelf stock0

confusion may occur; (or e&ample0 people who woul! have normally purchase!from the shelf may purchase off the promotional !isplay; It might make the

promotion look more successful than it actually is; Consi!er a promotion thatinvolves a ,onus pack an! that there are also replenishe! retail shelf stock in thestore; The ,onus pack may have a !ifferent ,ar co!e0 making it appear as thoughthe !eman! for the replenishe! item is lower; This coul! make the forecast for theitem go lower0 causing out of stocks in the future; This is an important point. There

is a !ifference ,etween inventory categories an! !eman!; (rom the consumerDsperspective0 the ,onus pack an! the non,onus pack might essentially ,e the same;So0 for inventory management0 we nee! to classify things one way0 an! for !eman!

management we might nee! to classify them another way;

Seasonal Stock

Seasonal stock is inventory hel! for a portion of the yearA it may ,e replenishe!

!uring the season or it may not ,e; Seasonal stock is usually purchase! ,ase! on asingle or!er0 even if it is replenishe!; The news ven!or mo!el is an approach tocalculating the or!er -uantity; If not enough seasonal stock is purchase!0 sales an!

profit are lost; If too much is purchase!0 mark!owns ,ecome necessary0 re!ucingthe ROI; The news ven!or mo!el attempts to ,alance these costs;

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Replenished Multiple !ocation "mpulse Stock

In many retail stores0 certain items are foun! in multiple locations; (or e&ample0

can!y ,ars are often at multiple checkstan!s in the grocery store an! also in thecan!y aisle; Items can potentially ,e out of stock at many locations an! still recor!

!aily sales if they are in stock in other locations within the store; eeping all of thelocations stocke! is a store e&ecution challenge; Many of these items are impulseitems0 meaning that people !onDt come to the store planning on purchasing them ,ut !eci!e to purchase them when they see them on the shelf; This inventory may

,e a com,ination of cycle stock an! safety stock for the store as a whole0 ,ut in thein!ivi!ual locations0 the inventory can ,e !ifficult to plan an! manage well; Manytimes the specific locations the inventory is hel! in changes over time0 with the

e&ception of where its continual location is in the main part of the store;

Ra' Material Stock

Raw material stock is inventory hel! for pro!uction; (or e&ample0 to make ,rea!0

grain must ,e hel!; Running out of stock of raw material inventory can ,ee&pensive ,ecause it can cause the entire pro!uction line to shut !own; 'lso0 rawmaterial inventory is relatively less e&pensive than finishe! goo!s inventory0 so

hol!ing more of it can easily ,e argue!;

Suppose a ,rea! manufacturer keeps intro!ucing new types of ,rea!0 an! everytime a new ,rea! S" is intro!uce!0 a new specification of grain is create!0 to the

point that eventually there are 766 !ifferent grains for 766 !ifferent S"s; If it woul! ,e possi,le to have 76 grains an! still ,e a,le to pro!uce the 766 !ifferent

S"s0 the total amount of inventory re-uire! coul! ,e greatly re!uce!;

(ork in Process Stock

Work in process stock is inventory in the process of ,eing transforme! into the

finishe! pro!uct; It is sometimes ,uilt up ,etween workstations so that the entireline !oesnDt have to shut !own if one machine ,reaks !own; >owever0 when thereis more stock in ,etween workstations0 the fee!,ack loop ,etween the workstations

is longer; 4ust*in*time 94IT:55came to the "nite! States through the change inperception of 4apanese pro!ucts ,eing sol! here; The reputation of 4apanese an!

Chinese goo!s transforme! from one of low -uality in terms of pro!uct failures or ,reak!owns in the late 7NJ6s an! early 7NK6s to one of high -uality in the late7NK6s an! early 7N


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Suppose that %inDs !rill press is unrelia,le0 ,ut he !rills a lot of ,locks an! pro!uces56 !ays of supply; $ays of supply 9$OS: are inventory !ivi!e! ,y forecast per !ay;

(or e&ample0 766 units of inventory are pro!uce!0 an! the forecast is H units per!ay; This woul! e-ual 56 !ays of supply 9$OS U 766 units H units!ay U 56 !ays:;

But %inDs !rill ,reaks !own; %in thinks that the !rill press was !rilling the correctsi1e holes ,efore the ,reak!own; >owever0 4im says that the holes are not the rightsi1e an! asks %in what is wrong; %in has no i!ea ,ecause it has ,een almost 56 !ays

since the !rill press ,roke !own0 an! 56 !aysD material has ,een waste! ,ecause ofthe ,it pro,lem;

+ow letDs change the scenario ,y removing the entire inventory; The !rill press is

working0 ,ut the !rill ,it has not ,een change! in -uite a while; 4im approaches %in with the same concern. The pegs !o not fit in the holes; %in respon!s ,y changingthe !rill ,it imme!iately; This illustrates the key i!ea ,ehin! 4IT. creating shorter

fee!,ack loops0 which !rive learning to improve -uality; The i!ea is that asinventory increases it lengthens the fee!,ack loop an! hi!es pro,lems that coul! ,e occurring in processes from manufacturing to sale;

There is a pro,lem with coupling the initial scenario an! the secon! scenario; If theinventory is !eplete! or eliminate!0 an! nothing has ,een !one to improve or

replace the !rill ,it0 when the !rill press ,reaks !own0 it causes 4im to not ,e a,leto work0 an! he must wait; The lack of an inventory cushion when the !rill press ,reaks !own is more of a !etriment in this scenario than carrying some inventory

an! the costs associate! with it to allow for the !rill to ,e fi&e! an! resumepro!uction; To re!uce inventory0 checks must ,e in place to make sure the !rill

press is relia,le;

)inished Goods Stock

(inishe! goo!s stock is inventory in its final form after pro!uction; It can inclu!e ,oth cycle stock an! safety stock; $ue to the a!!e! value0 finishe! goo!s stock is

more e&pensive to hol! than work in process stock0 which is more e&pensive to hol!than raw materials stock; 'lso0 once the finishe! goo!s inventory is pro!uce! it can!eteriorate0 spoil0 ,ecome o,solete0 get !amage!0 or ,e stolen; 'll of this can

happen with any inventory0 ,ut0 for e&ample0 it is more likely that a car might ,e

stolen than sheet metal; (or a pro!ucer0 there is also the -uestion as to where tohol! finishe! goo!s stock. at the factory0 a !istri,ution center0 several !istri,ution

centers0 customer !istri,ution centers0 or some com,ination; When or!eringpro!uct from a supplier0 the or!er often arrives at one time0 whereas the or!erfrom your pro!uction facility ,uil!s up over time; Therefore the optimal or!er

-uantity is !ifferent from the optimal pro!uction -uantity;


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the replenishment process? What costs !o I incur if I have too much or too littleinventory?

'nswering these -uestions shoul! ,egin with a consi!eration of costs; If I have 7 wrappe! up in inventory0 the costs associate! with it are calle! opportunity costsE

what I woul! make if it were not in inventory; ach !ollar in inventory coul! ,euse! for other things; Opportunity costs coul! cause loss ,y not re!ucing !e,t or ,y not investing in other important actions;

There are several ways to figure the real cost of opportunity costs; One simplee-uation is the following. Weighte! average cost of capital U cost of !e,t the costof e-uity; But the e-uation leaves out the calculation of the ,est return that coul!

,e o,taine! ,y investment in something other than inventory; >owever0 it is!ifficult to calculate;

$ecision*makers must e&ercise care when inclu!ing storage costs in inventory;They shoul! not inclu!e storage costs in calculations if the costs are fi&e!0 unlessthey are ,eing charge! ,ase! on how much inventory they have; Suppose you have

a $C that is a million s-uare feet an! you are going to keep it0 even though you only use KH percent of it; The inventory varies ,etween H6 percent an!


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'll these inventory hol!ing costs com,ine! are represente! as a percentage of the value of the inventory for a year0 h; %et c ,e the unit value of the inventory; So the

cost of carrying one unit of inventory for one year is > U hc;

"nventory "nvestment* Cost* and +aluation

Inventory is an asset; Inventory on the ,alance sheet is liste! as an asset an! is asnapshot of the value of the inventory at one point in time; The cost of inventory isnot liste! on financial statements; We alrea!y !iscusse! the cost of inventory; The

cost of inventory is often represente! ,y an inventory hol!ing cost factor0 h0 an! is ,ase! on all of the !rivers of inventory hol!ing cost inclu!ing the ones !iscusse!previously; To calculate the inventory hol!ing cost0 you multiply the value of the

inventory ,y the inventory hol!ing cost factor; To calculate the value of theinventory0 you take the value per unit times the num,er of units of inventory; 's inthe ,alance sheet0 you sometimes want to know the value of the inventory at a point

in time; 't other times0 you want to know the value of average inventory over sometime in the past or the e&pecte! value of inventory in the future;

In accounting0 three well known metho!s of !etermining the value of inventory

inclu!e first*in0 first*out 9(I(O:0 last*in0 first*out 9%I(O:0 an! average cost; (or(I(O0 the cost of the first units in are assigne! to the first units outA for %I(O0 thecost of the last units in are assigne! to the first units outA an! for average cost0 the

cost of the average unit is assigne! to each unit out; There is also the issue of usingstan!ar! costs or actual costs; Stan!ar! costs are use! in accounting for simplifyingthings so that they !onDt have to use a !ifferent cost for each S"; But when we are

making inventory !ecisions an! analy1ing inventory performance0 we want to use

the actual cost of a pro!uct;

One issue associate! with calculation of the current value of inventory is knowinghow much inventory you actually have; ven for an in!ivi!ual S" it can ,e!ifficult to know how much inventory is on han!; Research shows that inventory

can ,e off significantly; Inventory hol!ing no!es often have a perpetual inventorysystem that keeps track of on*han! inventory; It a!!s units receive! an! su,tractsunits sol! or use!; 'gain0 research shows that perpetual inventory systems oftenhave significant errors;

rrors in perpetual inventory result in errors in the calculation of the value of on*han! inventory0 the estimate of average inventory over some time interval0 an! the

timing an! -uantity of or!ers; (or e&ample0 a 9)0RO#: system places or!ers whenthe inventory position reaches RO#; The inventory position is e-ual to on han! an!on or!er minus ,ack*or!ers0 so if the on han! is wrong0 the inventory position will

,e off; (or the 9T0O"%: process0 you or!er the !ifference ,etween O"% an!inventory position; Clearly0 with either of these processes0 errors in perpetual


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inventory can result in either e&cess inventory 9more than we think we have: orstockouts;

One important concept to remem,er is that there is a !ifference ,etween inventory value an! inventory cost; Sometimes people confuse a 7 million inventory

re!uction as a 7 million inventory cost re!uction; If inventory is re!uce! ,y 7million0 the cost re!uction must ,e calculate! ,y multiplying the re!uction ,y theinventory hol!ing cost factor;

In a 9)0RO#: inventory system5H the e&pecte! cycle stock is )50 so the e&pecte!cycle stock hol!ing cost is 9)5:hc; The amount of safety stock in a 9)0RO#: systemis 9RO# V $$%T: where $$%T is e&pecte! !eman! !uring the lea! time so the

e&pecte! cost of hol!ing safety stock is 9RO# V $$%T:hc;

)i,ed and +aria$le -rdering Costs

Or!ering costs are another category of cost associate! with inventory that we!iscuss in this ,ook; There are two salient categories of or!ering costs0namely0 varia$le ordering costs an! fi,ed ordering costs; /aria,le or!ering costs

are a cost per unit0 whereas fi&e! or!ering costs are a cost per or!er; (or e&ample0the price per unit of inventory or!ere! woul! ,e a varia,le or!ering cost0 whereasthe cost of a truckloa! of pro!uct that was or!ere! woul! ,e a fi&e! or!ering cost0 if

truckloa! motor carriage is the mo!e; >owever0 if it were shippe! ,y less thantruckloa! 9%T%: motor carriage0 then it woul! ,e a varia,le or!ering cost ,ecause%T% rates are given in terms that !epen! on how many units are

transporte!;5J Other costs associate! with fi&e! or!ering costs inclu!e a!!itional

costs !ue to placing or!ers0 receiving or!ers0 paying invoices0 an! reconcilinginvoice match errors; Throughout the ,ook0 where it is o,vious ,ase! on the

conte&t0 we =ust refer to fi&e! or!ering costs as or!ering costs; The most commontype of varia,le or!ering cost we !iscuss is the cost per unit0 c0 which in many of the!iscussions is the cost ,eing pai! for the item; >owever0 there are some costs per

unit an! some costs per or!er0 such as transportation costs0 that we ela,orate ontheir effect on inventory !ecisions;

Cost of an -ut&of&Stock

It is costly to have inventory0 ,ut it is also costly to not have it;5K

Customer service isa varia,le we talk a,out in inventory management0 ,ut it has a narrow meaning;Imagine a customer is looking for kum-uats at a grocery store; Many peopleconsi!er goo! customer service to mean that0 upon entering a store0 the customer

is aske! ,y a smiling0 neatly !resse! employee what she is looking for an! !irectsher to the kum-uats; The kin! of customer service we consi!er is to ask what is thepro,a,ility that in this case the grocer will have kum-uats in stock0 given they carry

kum-uats; 2enerally0 the higher the average inventory of kum-uats the grocer has0

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the greater the pro,a,ility that the retailer will have them in stock0 which translatesinto higher customer service in this concept; But when the item is not in stock0

what is the cost of lost sales?

Suppose your spouse tells you to go to the store to go get some Similac ,a,y

formula late in the evening; ou !eci!e to also pick up few other things you nee! while you are out; 'fter putting a few things in the grocery ,asket you arrive at the ,a,y formula section to notice that the store is completely out of the ,ran! you

were sent to get; Because you !o not want to go through the checkout stan!s of thisretailer an! the other store where you have to go for the formula0 you !eci!e toleave your items there an! go to another store0 one that might have the ,ran! you

want; ou !rive to another grocery store0 which !oes have the item on the shelves0an! purchase it along with the other items you nee!;

This scenario translates into an even greater cost to the first retailer than the

margin it lost0 ,ecause you were going to purchase more items other than theformula; The items you !i! not purchase at the first store are inclu!e! in the actuallost sales cost;

The cost for the stockout was not =ust the profit margin of the Similac; So supposethe first retailer sells the formula fo

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The Definitive Guide to Inventory Management