Instructors’ Manual

Supply Chain Management

Text and Cases

Second Edition

Janat Shah
Indian Institute of Management Bangalore

Copyright © 2016 Pearson India Education Services Pvt. Ltd

 Chapter 4

Inventory Management

Learning Objectives
After reading this chapter, you will be able to answer following questions:
Why do firms carry inventory? What are the various types of inventory carried by an
organization?
What are the components of cost which get affected by inventory decisions?
How can firm reduce inventory in the organization?
How do firms determine the optimum level of cycle in chain?

How do firms decide required level of safety stock in chain?

Introduction (Slides 2–4)

Teaching Note: Initiate the discussion using the opening vignette on Shopper’s Stop. Use Slide 4
to show the wide difference in performance across firms in same industry. Using Slides 3 and 43
(backup slide), focus on India’s performance on this front in the last 15 years. To demonstrate
that improving performance on inventory is not easy, use Slides 44 and 45, which show that
performance on this front has not improved in USA. On the aggregate front, India’s inventory
turns are lower than that of US firms but the gap is narrowing. This is remarkable performance
given the infrastructure problems in India.
Raise the question: Can one manage 300,000 SKUs by gut feeling? Using the example of
APR, argue for a structured approach. Emphasize that the inventory for 300,000 items can not be
managed by gut feeling.
Using the examples of Infosys and IBM (caselets), relate buffer capacity (bench strength)
in services to safety stock in manufacturing. Apart from the PowerPoint slides, you may use the
accompanying Excel file in the classroom for demonstrating various inventory models discussed
in the chapter.

Types of Inventory (Slides 5–9)

Teaching Note: Understanding drivers of inventory helps a firm in designing a structured
approach for inventory management. Pose the provocative question: Why does a firm need
inventory? To start the discussion, take case of a neighbourhood retailer and explain the various
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 Chapter Four: Inventory Management

types of inventory. The classification of inventory used in SCM is different from the one used in
accounting. In accounting, inventory is classified as RM (raw material), WIP (work in progress)
and FG (finished goods). In SCM, the focus is on the drivers of inventory. This distinction needs
to be explained to the students. Then summarize by stating that focus of discussion would be on
cycle stock, safety stock, pipeline inventory and seasonal stock. Pipeline inventory is quite simple
to explain and understand so the bulk of the discussion is on cycle stock and safety stock. This
chapter does introduce the basic approach for seasonal stock determination but for details
students should be asked to refer to book by Silver and Peterson.
In my view the discussion of both types of review systems—continuous and periodic— can lead
to unwarranted confusion in students. Therefore, it is better to just focus on continuous review
models discussed in the main chapter.
Cycle Inventory
Safety Stock
Decoupling Stocks
Anticipation Inventory
Seasonal Stock
Speculation Stock
Pipeline Inventory (Slide
9) Dead Stock
Teaching Note: The risk involved in speculation stock should be emphasized. Speculation stock
should be a part of the risk management strategy of firm. It is not strictly a supply chain decision.

Inventory-related Costs (Slide 10)

Ordering Costs
Inventory-carrying
Costs Stockout Costs
Lost Sales Cost
Backorder Cost

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 Chapter Four: Inventory Management

Managing Cycle Stock

Cycle stock Inventory model (Slides 11–16)

Teaching Note: Sensitivity analysis of optimum q is not discussed in book but is
worth emphasising. Use the excel model to demonstrate same.
If you want, you may also discuss the quantity discount case, not discussed in the book. Backup
Slide 46 discusses the logic used in cases involving quantity discount situations. Refer to Silver
and Peterson for details of this model.

Insights from Cycle-stock Inventory Model

Teaching Note: To discuss the drivers of cycle stock, focus on the following:
Fast-moving versus slow-moving products: Lux versus Dove, Subhiksha versus Shopper’s Stop
Importance of Volume (D) (large retailer versus small retailer): Subhiksha versus Shopper’s
Stop (Shopper’s Stop with 300,000 SKUs has many more slow-moving items)
Importance of scale: Higher D would have higher inventory turn
Focus on reduction in ordering cost/setup cost – Toyota example (setup time reduction), GE
example (reducing ordering cost using IT)

Managing Safety Stock (Slides 17–31)

Teaching Note: Fill rate as service level has not been discussed in main chapter as the discussion
of fill rate as well as cycle service level can lead to unwarranted confusion in students.
Capturing Uncertainty
Impact of Service Level on Safety Stock

Safety Stock Inventory Model

Teaching Note: Slide 20 shows the relationship between cycle service level and safety factor. But
it may be good idea to demonstrate the use of NORMALDIST () and Norminv () functions.
It may be a good idea to introduce uncertainty in demand first (Slide 22) in SS model and
introduce both demand and supply uncertainty at a later stage. Do not discuss the derivation of
the formula. Those who are interested in understanding these details should be asked to refer to
the book by Silver and Peterson.
Slides 23-26 discusses concept of fill rate.

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 Managerial Levers for Reducing Safety Stock (Slide 31)
Teaching Note: To initiate the discussion on the drivers of SS, pose the question: Among the
three drivers—Mean LT, SD of Demand and SD of LT—which is more important and which is

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 Chapter Four: Inventory Management

less important? The intuitive answer is going to be that all three drivers are likely to be of equal
importance. So it is likely to come as a surprise when student finds that 50% reduction in mean
LT or SD of D has only a marginal impact on safety stock while 50% reduction in SD of LT
reduces SS significantly. This should help students in understanding the role of supplier
reliability. Emphasise the relationship between managerial actions and the parameters of the SS
model. For example, by choosing appropriate suppliers, firms can influence Men LT as well as
SD of LT. By focusing on forecast improvement, efforts firm can reduce SD of demand.

Managing Seasonal Stock (Slides 32–33)

Teaching Note: This section introduces the basic approach for seasonal stock determination but
for details students should be asked to refer to book by Silver and Peterson.

Planning for Seasonal Demand

Teaching Note: Refer to the example in the accompanying Excel sheet.

Analysing the Impact of Supply Chain Redesign on the Inventory (Slides

34–38)

Centralization versus Decentralization: (Slides 34–38)

Teaching Note: This part of the material may also be used in Chapter 5 while discussing e-
retailers. Discuss what kinds of firms are likely to benefit from centralization. As shown in the e-
retailer case, firms with high value density and higher demand uncertainty are likely to derive
higher benefit from centralisation. E-retailing is an excellent example of centralisation because
stocks are kept centrally. While normal retail situation stocks are close to customers in
decentralised form.

Slide 38 introduces ideas of supply chain reconfiguration, discussed extensively in Chapter 10.

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 Chapter Four: Inventory Management

Multiple-item, Multiple-location Inventory Management (Slides 39–

41) Selective Inventory Control techniques
Teaching Note: While discussing this topic, refer to the examples of Shopper’s Stop (300,000
SKUs) and Titan (3000 SKUs). You should also use the Cummins India caselet to demonstrate
effective use of selective inventory control techniques.

ABC Classification (40–41)

Teaching Note: When students work on Kurlon case, they should be encouraged to carry out an
ABC analysis.

Summary (Slides 42-43)

Indian firms find that a significant amount of money is locked up in inventory. Organizations
should use the concept of zero-based inventory planning to improve their performance on the
inventory front.
The decision maker controls inventory by deciding two critical questions: How much to order
and when to order
Based on the demand characteristics, supply characteristics, cost structure and desired service
level firm can decide optimum level of inventory.
In long run, the firm should try and influence some relevant parameters so that it can reduce
inventory-related costs, improve inventory turnover ratio and simultaneously improve customer
service.
The company can carry out an ABC analysis and target its effort on A-category items so as to
improve supply chain performance.
Teaching Note: Slide 42 is an excellent way of linking various types of inventory and the areas
where a firm can focus on to improve inventory performance.

Discussion Questions
1. What is the relationship between service levels and inventory levels?
Solution: Refer figure 4.6. Relationship between safety stock level (measured in terms of K * SD)
and service level is not linear For example when value of K is increased from zero to 1, service
level improves by 34.5% and further improvement in k by 1 unit would increase service level by
14% and still further improvement in K would increase service level by 3.4%. At some point
increasing safety stock does not result in corresponding level of improvement in service level.

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 Chapter Four: Inventory Management

2. Why does the inventory in a system increase with an increase in stock points in the system?
Solution: Refer to discussion on centralisation and decentralisation. When we reduce stock points
we are able to observe the effect of risk pooling. Safety stock reduces because of relatively lower
uncertainty faced by system with lower number stock points because of risk pooling effect. When
one increases stock points one would observe opposite effect. One observes thumb rule of that
increase in number of stock points by n would result in increase in inventory by square root of n.

3. What factors should a manger consider while deciding service levels?

Solution: Trade-off between stock out costs and inventory carrying costs. At relatively higher
value of stockout costs one would maintain higher level of service. Refer to discussion on
computing inventory related cost.

4. The sales turn over for Subhiksha retail in Bangalore has doubled in last two years. What is
the impact of this on the inventory turn for the firm?
Solution: Refer to the optimal ordering quantity formula. For a demand level of D, one would
have a corresponding order quantity of Q* resulting in an average inventory of Q*/2. This results
in inventory turns of D/Q*. When sales doubles, D would double and Q* would increase by 1.41
(square root of 2). Consequently, D would double but the average inventory would increase by
1.41 times and the inventory turn should increase by 1.41. In general, inventory turn should
increase with increase in sales. Inventory in system is scale intensive.

5. While computing the ordering cost, one is suppose to consider only the fixed component of the
ordering cost. Why?
Solution: Ordering cost as defined in inventory literature does not depend on order quantity. So
any part of variable cost in ordering should be included in cost of item (c). Let us take an example
where firm has estimated that cost of order (does not include cost of item) is Rest. 100 + 20*Q
where Q is order quantity. In such a case, rest. 100 is the cost of ordering and Rest. 20 should be
added to the value of c (unit cost of item). Item cost is revised as c+20.

6. What is the impact of inventory centralization on various supply chain performance measures?
Solution: Centralisation would reduce inventory in system (Both cycle and safety stock) but
would increase led-time to customer or would result in higher cost of secondary transportation
(Transportation involving movement from stock point to customer).
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 Chapter Four: Inventory Management

7. A global software service firm, operating in seven geographical locations, has five lines of
business (LOB) and employs 100,000 people. The firm traditionally has been managing human
resources independently, that is, each LOB in each geographic region manages its resources
independently. Now it wants to explore the possibility of using a common pool of resources
across geographical regions for all LOBs. The firm wants to quantify benefits of this idea of this
common resource pool. Suggest a methodology for quantifying these benefits.
Solution: Centralisation of resources would result in lower bench. Firm keeps bench (Refer to
caselet on Infosys and IBM) because they face demand uncertainty and not having people on
bench would translate in to potential lost opportunity. As we know that when we pool resource
level of demand uncertain reduces because of risk pooling. So currently firm maintains bench at
7*5 that is equivalent to inventory at 35 stock points. By centralising human resources, bench is
kept centrally and with a result total size of bench should come down by square root of 35 that is
by about 6 times. By estimating cost to company of an employee one can value the potential
savings.
Exercises
1) A regional warehouse purchases hand tools from various suppliers and then distributes them
on demand to retailers in the region. The warehouse operates five days per week, 52 weeks per
year. The following data are estimated for one product, namely the 1-inch drill:
Average daily demand = 100 drills
Standard deviation of daily demand = 30 drills
Supplier lead time = 3 days
Holding cost = Rs 9.40 per unit per
year Ordering cost = Rs 35 per order
Service level = 98%
Design an inventory system for this product
0.5
Solution: Order qty = (2*260*100*35/9.4) = 440 SS =
2)0.5
2.05* (3*30 = 107
Reorder point = 3*100 + 107 = 407
The finance department has instructed the warehouse to reduce the investment in average
inventory by half. What are the options available to warehouse manger.
Solution: Currently average inventory (in units) = 0.5*440+ 107 = 327 units.
By reducing ordering cost by 4 times cycle stock would come down by half. Similarly by
reducing demand uncertainty by 4 times that is by improving forecast accuracy is SD of demand

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 Chapter Four: Inventory Management

can be brought down by 4 times ss would also come down by half. So warehouse manger can
work on combination of these approaches.

2) Akaga Corporation distributes video game terminals throughout India. The marketing manger
estimates the demand for next year to be 500 units per month. The base price of video game
terminal is Rs 500 and cost of placing an order is Rs. 5000. The estimated holding cost is 20% of
the base price per unit per year. The video game terminals are imported from suppliers from
Japan and the delivery lead time is 1 month.
Design an inventory policy for Akaga Corporation.
0.5
Solution: Order quantity = (2*500*12 5000/ (500*0.2)) = 775
units Reorder point = 1 *500 = 500 units
If the supplier insisted on a minimum batch size of 1200 for any order, what should be the
inventory system? What is the implication of this minimum batch size to Akaga Corporation?
Solution: Optimum order quantity = 1200, reorder point = 500
Total annual cost (inventory and ordering) can be worked out for both order sizes and one can
work out the additional cost which firm would have to pay because of the additional restriction.

Akaga realized that monthly demand is not going to be constant and is likely to have mean
demand of 500 with standard deviation of 100 units. And the marketing manger wants to ensure a
98% service level. Work out the safety stock (SS) requirement under both situations (both with
and without the batch size constraint).
Solution: SS does not depend on the Q value. So, both would have identical values of SS.
Given K = 2, SD of demand = 100 and LT = 1,
2 0.5
SS = 2 * (1*100 ) =200

The marketing manger had some difficulty in explaining the concept of 98% service level to his
top management team, so he decided to make the following promise to the top management. He
promised the top management that the inventory policy would work towards a target level of two
instances of stockout in a year. Design an inventory policy for the situations a) and b).
a) No minimum batch size constraint.
b) Minimum batch size of 1200.
Solution: Based on value of Q (775 or 1200), one would know the number of cycles in a year.

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 Chapter Four: Inventory Management

Situation (a): Number of cycles in a year when Q is 775 = 500*12/775 = 7.74. So, in thee years,
one would have 23.22 cycles. So the expected service level = 1 − (2/23.22) = 0.9123 or 91.23%.
At this service level, one can get the value of K from Table 4.3 and calculate the required SS.

Situation B can be worked out accordingly.

3) e-Growth Software Services is doing a manpower planning exercise for the first two quarters
of the next financial year. HRD requires six months to get software professionals. The company
incurs a cost of $5000 for every software engineer employed with the organization. The company
usually charges $20,000 per software employee for all the projects which are taken up by
organization. The marketing team is of the view that the actual demand for software engineers in
the next six months is likely to be uncertain. Most probably the requirement would be for 500
engineers but the actual demand may be quite off the mark. The worst-case scenario would
involve the actual demand being as low as 60% of projected numbers, while the best-case
scenario would involve actual demand being as high as 140% of the projected numbers.
How many software engineers should the organization plan for? Discuss the limitations of your
approach.
Solution: SD of demand = (Demand for best-case – Demand for worst case)/6
Now given cost of stockout and cost of overstocking one can work out SS (people on bench)
using short life cycle model

Limitation of approach cost of overstocking should also involve likely morale problem with
people on bench. This need to be factored in when one is dealing with human beings.

4) You are in charge of Anusmaran (reunion event for your college) at Chennai. Although large
attendance is expected, you will not know until the evening of the event exactly how many people
would attend. Your understanding with the caterer is that you will have to communicate him, one
week before the event, the number of dinners that would be served at the event. The price for
these dinners will be Rs 400 each. If fewer people show up than the committed number, you are
still required to pay for the committed number. If more people attend than your committed
number, they will be served at a cost of Rs 600 each. Your judgment about the number attending
can be described by normal distribution with a mean of 200 people and standard deviation of 80.

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 Chapter Four: Inventory Management

Suppose the entire cost of dinner is being borne by alumni association. What kind of number will
you commit to the caterer?
Solution: Work out cost of overstocking and cost of under stocking and using inventory model for
short life cycle product
Suppose the event is organized by your college and college wants to use this event for raising
funds and each person attending the event is charged Rs 500. What kind number you would
commit to caterer. You can assume that likely number of people attending the event does not
change based on this pricing policy.
Solution: Cost of overstocking and cost of under stocking remains same so decision is same as in
previous case.
How would your answer change (for part a) and b)) if the caterer does not provide any
flexibility? He will serve exactly committed number of dinners, so in case more people attend
than your committed number, some people will have to go hungry (may be you would prioritize
participants based on batch (older batches will get dinner first) or you will give tokens to people
on first cum first served basis.
Solution: One can generate interesting debate about cost of stock out in such a situation.
Cost of stock out is likely to be very high so work with very high service level (about 99%).

5) Foodworld, a grocery store carries a particular brand of tea which has a daily demand of 20
units and a standard deviation of 5 units. Its current supplier sells tea to Foodworld at Rs 50 per
unit but requires two weeks lead time. Foodworld has an alternate supplier who is willing to
supply at Rs 49.50 per unit but require s3 weeks of lead time and insists on a minimum order size
of 500 units per order. The company has an ordering cost of Rs 200 per order and inventory-
carrying cost of 25%. The management at Foodworld is of the view that a target level of one
stockout in two years time is acceptable for grocery items. Which supplier should the company
choose?
Solution: Calculate the total annual cost [cost of item + cost of ordering + inventory carrying cost
(cycle + safety stock)]. Select the supplier with the lowest total cost.
Now, the required service level can be worked out using the approach suggested in Exercise 2.

6) Bangalore hospital orders its antibiotics every four weeks when a sales person visits from one
of the pharmaceutical companies. Zombacycline which cost Rs 25 per capsule is one of its most
prescribed antibiotics, with an average daily demand of 50 capsules. The standard deviation of
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 Chapter Four: Inventory Management

daily demand, derived from examining prescriptions filled over the past six months, was found to
be 15 capsules. It takes two weeks for the order to arrive. Bangalore Hospital would like 99 per
cent of all demand from prescriptions to be satisfied from stock. The cost to place an order is Rs
1000 and holding costs are 20% of the purchase price. The sales person has just arrived and
there are currently 1000 capsules in stock.
How many capsules should be ordered? (Hint: refer Appendix 4A)
Bangalore hospital has just hired a consultant who has suggested that instead of ordering at the
time of a sales person’s visit, the company should monitor its stocks regularly and place an order
whenever they feel appropriate. Devise an optimal ordering policy based on the consultant’s
suggestion. What would be the cost savings if Bangalore Hospital follows the policy suggested by
the consultant?
Solution: Suggest cost of both approaches (continuous review systems and periodic review
systems). Period view system is explained in the appendix.

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