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Chapter 6: Inventory Management

Topic Overview

Importance of inventory in the economy and the firm

Major types of inventory and reasons for carrying them

Major types of costs associated with inventory

Approaches to managing inventory

Inventory classification

Appreciate the role and importance of inventory in the economy.

List the major reasons for carrying inventory.

Discuss the major types of inventory, their costs, and their relationships to inventory decisions.

Understand the fundamental differences among approaches to managing inventory.

Describe the rationale and logic behind the economic order quantity (EOQ) approach to inventory decision-
making, and be able to solve some problems of a simple nature.

Understand alternative approaches to managing inventory—just in time (JIT), materials requirement planning
(MRP), distribution requirements planning (DRP), and vendor-managed inventory (VMI).

Explain how inventory items can be classified.

Know how inventory will vary as the number of stocking points changes.

Make needed adjustments to the basic EOQ approach to respond to several special types of applications.

INVENTORY COSTS AS A PERCENT OF GDP

The influence of information technology during the late 1990s and its impact on inventories was reflected in the U.S.
economy’s ability to grow dramatically while holding inflation in check.

With information technology advances escalating in the early twenty-first century, organizations are still implementing
programs to take inventories out of the supply chain.

The major cost tradeoff in logistics is between transportation and inventory.

However, the cost of fuel today, coupled with capacity constraints in the transportation industry, has escalated the
costs of transportation, and it will be interesting to see if the traditional tradeoffs between transportation and
inventory costs will remain the same in this new environment.
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Inventory in the firm

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This slide gives the break-up of inventory in the organization

The highest cost is transportation followed by the carrying cost

In transportation, motor carriers take a higher portion.

Reasons for Inventory

Inventory plays a dual role in organizations and it impacts the cost of goods sold as well as supporting order fulfillment
(customer service).

Consumer-packaged goods (CPG) firms and the wholesalers and retailers that are a part of their distribution channels
face a special challenge in keeping inventories at acceptable levels because of the difficulty of forecasting demand and
increasing expectations from customers concerning product availability.

The point is that managing inventory is a critical factor for success in many organizations. Many organizations have
responded to this challenge—as indicated by the macro data presented in the previous section—and have reduced
inventory levels while maintaining appropriate customer service levels. Their ability to achieve the twin goals of lower
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inventory (efficiency) and acceptable customer service levels (effectiveness) is based on a number of factors.
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Batching Economies or Cycle Stocks
Batching economies or cycle stocks usually arise from three sources—procurement, production, and/or
transportation. Scale economies are often associated with all three, which can result in the accumulation of inventory
that will not be used or sold immediately.

This means that some cycle stock or inventory will be used up or sold over some period of time.

Larger purchased volumes result in lower prices per unit and vice versa. Transportation firms usually offer rate/price
discounts for shipping larger quantities. Note that purchase economies and transportation economies are
complementary.

The third batching economy is associated with production. Many organizations feel that their production costs per unit
are substantially lower when they have long production runs of the same product.

Uncertainty and Safety Stocks

All organizations are faced with uncertainty. On the demand or customer side, there is usually uncertainty in how
much customers will buy and when they will buy it. On the supply side, there might be uncertainty about obtaining
what is needed from suppliers and how long it will take for the fulfillment of the order.

Tradeoff analysis is appropriate and can be accomplished using the appropriate tools to assess the risk and measure
the inventory cost. Setting safety stock levels for an organization is both an art and a science.

Time/In-Transit and Work-in-Process Stocks

The time associated with transportation (e.g., supplier to manufacturing plant) and with the manufacture or assembly
of a complex product means that even while goods are in motion, an inventory cost is associated with the time period.
The longer the transport time period, the higher the cost.

The time period for in-transit inventory and work-in-process (WIP) inventory should be evaluated in terms of the
appropriate tradeoffs. The various transportation modes available for shipping freight have different transit time
lengths, transit time variability, and damage rates.

WIP inventories are associated with manufacturing. The length of time WIP inventory sits in a manufacturing facility
waiting to be included in a particular product should be carefully evaluated in relationship to scheduling techniques
and the actual manufacturing/assembly technology.

Seasonal Stocks
Seasonality can occur in the supply of raw materials, in the demand for finished products, or in both. Organizations
that are faced with seasonality issues are constantly challenged when determining how much inventory to
accumulate. While the supply of the raw material is available during only one part of the year, demand is stable
throughout the year. This scenario many times is faced with high storage costs and/or high obsolescence costs and
sometimes seasonality can impact transportation as well.

Anticipatory Stocks
A fifth reason to hold inventory arises when an organization anticipates that an unusual event might occur that will
negatively impact its source of supply. Examples of these events would include strikes, significant raw materials or
finished goods price increases, and a major shortage of supply because of political unrest or weather.

Summary of Inventory Accumulation

Most organizations will accumulate some level of inventory for very good reasons. In many instances, the inventory
cost might be more than offset by savings in other areas. The basic principle is that decisions to accumulate inventory
need to be evaluated using a tradeoff framework. In addition to the other reasons discussed, there are other reasons
for accumulating inventory such as maintaining suppliers or employees.

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Inventory in other functions

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Logistics interfaces with an organization’s other functional areas, such as marketing and manufacturing. The interface
is usually more prominent in the inventory area. As background for analyzing the importance of inventory in the
logistics system, several aspects of how logistics relates to other functional business areas concerning inventory must
be discussed.

Marketing - The primary mission of marketing is to identify, create, and help satisfy demand for an organization’s
products/services. Marketing tends to have a favorable view on holding sufficient and/or extra inventory to ensure
product availability to meet customer needs.

Manufacturing - In many organizations, manufacturing operations are measured by how efficiently they can
produce each unit of output. This situation typically means that manufacturing operations tend to be optimized
when they have long production runs of a single product while minimizing the number of changeovers. These long
production runs will result in high inventory levels but low labor and machine costs per unit.

Finance – Inventories impact both the income statement and balance sheet of an organization. Inventories create
both an asset and liability on the balance sheet as well as a cash flow impact on the income statement. As such,
finance usually looks favorably at low inventories to increase inventory turns, reduce liabilities and assets, and
increase cash flow to the organization.

Proper inventory management and control affects customers, suppliers, and an organization’s functional areas.
Despite the many possible advantages to holding inventory in a logistics system, the costs of holding this inventory are
a major expense. So, in making decisions about inventory levels, an organization needs to assess the tradeoffs
between costs and the resulting service.

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Inventory costs
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Inventory costs are important for three reasons. First, inventory costs represent a significant component of logistics
costs in many organizations. Second, the inventory levels that an organization maintains at nodes in its logistics
network will affect the level of service the organization can offer its customers. Third, cost tradeoff decisions in logistics
frequently depend on and ultimately impact inventory carrying costs.

Inventory Carrying Costs

Inventory carrying costs are those that are incurred by inventory at rest and waiting to be used. From a finished goods
inventory perspective, inventory carrying costs represent those costs associated with manufacturing and moving
inventory from a plant to a distribution center to await an order. There are four major components of inventory
carrying cost: capital cost, storage space cost, inventory service cost, and inventory risk cost.

Capital Costs - Sometimes called the interest or opportunity cost, capital cost focuses on the cost of capital tied up
in inventory and the resulting lost opportunity from not investing that capital elsewhere. One calculation method
is the hurdle rate, the minimum rate of return on new investments. Another way of calculating capital cost is for
an organization to use its weighted average cost of capital (WACC). WACC is the weighted average percent of debt
service of all external sources of funding, including both equity and debt. The inventory valuation method used is
critical to accurately determining capital cost and is subsequently critical to determining overall inventory carrying
cost.

The commonly accepted accounting practice of valuing inventory at fully allocated manufacturing cost is unacceptable
in inventory decision-making because raising or lowering inventory levels financially affects only the variable portion of
inventory value and not the fixed portion of the allocated cost.

Storage Space Cost – This includes handling costs associated with moving products into and out of inventory, as
well as storage costs such as rent, heating, and lighting. Storage space costs are relevant to the extent that they
either increase or decrease as inventory levels rise or fall.

Inventory service cost - This includes insurance and taxes.

Inventory risk cost – This is the final major component of inventory carrying cost and reflects the very real
possibility that inventory dollar value might decline for reasons beyond an organization’s control.

Ordering and Setup Cost

A second cost affecting total inventory cost is the ordering cost or setup cost.

Ordering Cost - This refers to the expense of placing an order and does not include the cost of the product itself.

Setup cost – This refers more specifically to the expense of changing or modifying a production or assembly
process to facilitate line changeovers.

Nature of ordering and setup costs - The costs associated with ordering inventory have both fixed and variable
components. Separating the fixed and variable portions of order/setup cost is essential. When calculating annual

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ordering costs, organizations usually start with the cost or charge associated with each individual order or setup.
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Future Perspective - Although an accurate, comprehensive statement of inventory cost must include the portion
related to ordering and setup activities, the magnitude of these costs is likely to decrease in the future. Considering the
move to highly automated systems for order management and order processing and the streamlining of inventory
receiving practices, the variable cost of handling individual orders is certain to decrease significantly. In organizations
where vendor-managed inventory (VMI) programs are being utilized, the concept of placing orders itself loses
significance, and therefore the concept of ordering cost loses relevance.

Carrying Cost versus Order Cost

Order cost and carrying cost respond in opposite ways to changes in the number of orders or size of individual orders.
Total cost also responds to changes in order size.

Expected Stockout Cost

Stockout cost is the cost associated with not having a product available to meet demand and several consequences
might occur. First, the customer might be willing to wait and accept a later shipment (back order). Second, the
customer might decide to purchase a competitor’s product in this instance, resulting in a direct loss of profit and
revenue for the supplier. Third, the customer might decide to permanently switch to a competitor’s product. Stock-out
costs can be difficult to determine because of the uncertainty of future consequences that might occur. Stockouts will
occur because of the uncertainties in both demand and lead time.

Safety Stock - Determining safety stock levels and the related inventory carrying costs might be relatively
straightforward, but not so for determining the cost of a lost sale. Likewise, determining the cost of a production
shutdown due to a lack of raw materials is also a challenge.

Cost of Lost Sales - Determining safety stock levels and the related inventory carrying costs might be relatively
straightforward, but not so for determining the cost of a lost sale. Likewise, determining the cost of a production
shutdown due to a lack of raw materials is also a challenge.

In-Transit Inventory Carrying Cost

Another inventory-carrying cost that many organizations ignore is that of carrying inventory in transit. Someone will
own the inventory while it is in transit and will incur the resulting carrying costs. In-transit inventory carrying cost
becomes especially important on global moves since both distance and time from the shipping location increase.

Determining the Cost of In-transit Inventory -First, the capital cost of carrying inventory in transit generally equals
that of carrying inventory in a warehouse. If the organization owns the inventory in transit, the capital cost will be
the same.

Second, storage space cost generally will not be relevant to inventory in transit since the transportation service
provider typically includes equipment (space) and necessary loading and handling costs within its overall
transportation price.

Third, while taxes generally are not relevant to inventory service costs, the need for insurance requires special analysis.

Fourth, obsolescence or deterioration costs are lesser risks for inventory in transit because the transportation service
typically takes only a short time. Also, the fact that inventory is moving to the next node in the supply chain assumes
that there is a demand for that inventory, lessening the probability that it will not be sold.

Generally, carrying inventory in transit usually costs less than carrying inventory in the warehouse. However, an
organization seeking to determine actual cost differences more accurately should examine the details of each
inventory cost in depth.

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Ordering vs Carrying costs

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This image gives information on ordering and carrying costs, with the size of the order.

As the lot size increases, the order cost comes down and the carrying cost goes up.

Total cost gives the visualization of the combined cost.

There is a point at which the total cost is minimum and this point/lot is known as economic order quantity.

Safety stock vs Service Level

For the image in this slide, the below points can be used for discussion.

As the service, level increases the safety stock increases.

Towards 100% customer service level, the stock increases rapidly

It must be noted that it is practically not possible to provide 100% service level to all customers, at all times.

Infinite inventory level must be available to provide 100% service level.

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Inventory management Approaches

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Managing inventory involved four fundamental questions:

How much should inventory be ordered?

When should inventory be ordered?

Where should inventory be held?

What specific line items should be available at specific locations?

Managing inventory involves two fundamental questions: how much to order and when to order. But now
questions regarding where inventory should be held and what specific line items should be available at specific
locations pose challenges to managers.

The current dynamic operating environment has caused organizations to examine their inventory policies as well
as their customer service policies and find the optimal solution that balances both service and cost. Many
approaches exist to identify and analyze this tradeoff. Organizations will choose the approach that serves them
the best as defined by their markets and corporate goals.

Several factors make this objective achievable: (1) “real-time” order management systems, (2) improved
technologies to manage logistics information, (3) more flexible and reliable transportation resources, and (4)
improvements in the ability to position inventories so that they will be available when and where they are needed.

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Inventory money vs service

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As seen in the previous slides, the safety stock increases as we move towards 100% service level

This means the inventory amount is also going to increase accordingly

Key factors

Differences in approaches include dependent versus independent demand, pull versus push, and system-wide versus
single-facility solutions to inventory management decisions.

Dependent Versus Independent Demand - Demand for a given inventory item is termed “independent” when such
demand is unrelated to the demand for other items. Conversely, demand is defined as “dependent” when it is
directly related or derives from, the demand for another inventory item or product. An important point to
remember is that developing inventory policies for items exhibiting independent demand requires that forecasts
be developed for these items.

The approaches to inventory management to be discussed include just-in-time (JIT), materials requirement
planning (MRP), and manufacturing resource planning (MRP II). These are usually associated with items having
dependent demand. Alternatively, DRP generally involves the movement of items having independent demand.

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The economic order quantity (EOQ) and vendor-managed inventory approaches apply to both independent and
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Pull Versus Push - The “pull” approach relies on customer orders to move product through a logistics system, while
the “push” approach uses inventory replenishment techniques in anticipation of demand to move products. A
principal attribute of pull systems is that they can respond quickly to sudden or abrupt changes in demand
because they produce to an order and have very little, if no, finished goods inventory. Pull systems usually run on
short-term forecasts, allowing them the flexibility to adapt to swings in demand.

JIT is a pull system since organizations place orders for more inventory only when the amount on hand reaches a
certain minimum level, thus “pulling” inventory through the logistics system as needed. Having established a
master production schedule, MRP develops a time-phased approach to inventory scheduling receipt.

MRP and MRP II approaches are push-based because they generate a list of required materials in order to
assemble or manufacture a specific amount of finished products DRP involves the allocation of available inventory
to meet market demands. DRP, on the outbound or physical distribution side of logistics, is also a push-based
strategy. VMI uses preset reorder points and economic order quantities along with on-hand inventory levels in
customers’ warehouses to generate replenishment orders and can be considered a push approach. Finally, the
EOQ approach is generally a pull approach,

System-Wide Versus Single-Facility Solutions - A final inventory management issue is whether the selected
approach represents a system-wide solution or whether it is specific to a single facility, such as a distribution
center. Basically, a system-wide approach plans and executes inventory decisions across multiple nodes in the
logistics system. MRP and DRP are typically system-wide approaches to managing inventory. Both approaches
plan inventory releases and receipts between multiple shipping and receiving points in the network. On the other
hand, a single-facility approach plans and executes shipments and receipts between a single shipping point and
receiving point. EOQ and JIT are normally considered single-facility solutions. Both release orders from a single
facility to a specific supplier for inventory replenishment. Usually, MRP and DRP are employed to plan system
inventory movements, and EOQ and JIT are used to execute these plans at a single-facility level. VMI can be used to
plan system-wide replenishment as well as execute replenishment on a single-facility basis.

FOQ EOQ

In the fixed order quantity EOQ model, inventory is reordered when the amount on hand reaches the reorder point.
The reorder point quantity depends on the time it takes to get the new order and on the demand for the item during
this lead time.
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Fixed Order Quantity Approach (Condition of Certainty)

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The fixed order quantity model involves ordering a fixed amount of product each time reordering takes place, and
uses a minimum stock level to determine when to reorder the fixed quantity. This is called the reorder point. When the
number of units of an item in inventory reaches the reorder point, the fixed order quantity (the EOQ) is ordered.

The fixed-order quantity model is often referred to as the two-bin model. When the first bin is empty, the organization
places an order.

Both notions (trigger and bin) imply that an organization will reorder inventory when the amount on hand reaches the
reorder point.

Inventory Cycles - Figure shows the fixed order quantity model with three inventory cycles, or periods. Establishing
a reorder point provides a trigger or signal for reordering the fixed quantity. Business inventory situations base
the reorder point on lead time and the demand during lead time. The constant monitoring necessary to determine
when inventory has reached the reorder point makes the fixed order quantity model a perpetual inventory
system.

Simple EOQ Model

The following are the basic assumptions of the simple EOQ model:

1. A continuous, constant, and known rate of demand

2. A constant and known replenishment or lead time

3. All demand is satisfied

4. A constant price or cost that is independent of the order quantity (i.e., no quantity discounts)

5. No inventory in transit

6. One item of inventory or no interaction between items

7. Infinite planning horizon.

8. Unlimited capital

Fixed Order Quantity EOQ: Condition of Uncertainty

Because several factors can influence the reliability of demand (or usage rate) and lead time, the fixed order quantity
model is adjusted by reformulating the reorder point to allow for safety stock.

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Until now, the reorder point was based on the amount of inventory on hand and demand was known and constant.
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When inventory on hand reached zero, a new order was received in an economic order quantity, and stock-out costs
were not incurred. Most firms would not operate under conditions of certainty for a variety of reasons and several
factors can affect lead time. Because of all the potential factors that can influence the reliability of demand and lead
time, inventory models need to be adjusted to account for this uncertainty.

Reorder Point—A Special Note - The reorder point under the basic model is the on-hand inventory level needed to
satisfy demand during lead time. Calculating the reorder point is relatively easy since demand and lead time are
constant. Under uncertainty, an organization must reformulate the reorder point to allow for safety stock. In
effect, the reorder point becomes the average daily demand during lead time plus the safety stock.

Uncertainty of Demand - The first factor that might cause uncertainty deals with demand or usage rate. While
focusing on this variable, the following assumptions concerning EOQ still apply:

1. A constant and known replenishment or lead time

2. A constant price or cost that is independent of order quantity or time

3. No inventory in transit

4. One item of inventory or no interaction between items

5. Infinite planning horizon

6. No limit on capital availability

Additional Approaches: Just in Time (JIT)

JIT systems are designed to manage lead times and eliminate waste. Many JIT systems place a high priority on short,
consistent lead times. However, the length of the lead time is not as important as the reliability of the lead time.

The interest in reducing inventory levels along the supply chain is indicative of the importance of inventory as a cost of
doing business as for many, inventory is the first or second largest asset on the balance sheet. Firms can reduce their
costs of doing business and improve their return on investment or assets (ROI/ROA) by decreasing inventory levels as
long as service levels are met when decreasing inventories. There are several approaches to inventory management,
which will be examined: JIT, MRP, and DRP.

JIT Versus EOQ Approaches to Inventory Management – There are key ways in which the JIT philosophy differs
from customary inventory management in many organizations.

First, JIT attempts to eliminate excess inventories for both the buyer and the seller.

Second, JIT systems typically involve short production runs and require production activities to change frequently
from one product to another. This approach minimizes the economies of scale that are generated from long
production runs of a single product. It also results in higher changeover costs, assuming that the cost of each
changeover is constant. However, shorter production runs will result in lower finished goods inventory levels.
Therefore, the tradeoff here is between changeover costs and finished goods inventory levels.

Third, JIT minimizes wait times by delivering materials and products when and where an organization needs them.
Automobile manufacturers, using JIT, have components and parts delivered to the assembly line when needed,
where needed, and in the exact quantity needed.

Fourth, the JIT concept uses short, consistent lead times to satisfy the need for inventory in a timely manner. This
is why many suppliers tend to locate their facilities close to their customers who are planning to use the JIT
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approach.
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Fifth, JIT-based systems rely on high-quality incoming parts and components and on exceptionally high-quality
inbound logistics systems.

Sixth, the JIT concept requires a strong, mutual commitment between the buyer and the seller, one that
emphasizes quality and seeks win-win decisions for both parties.

Just In Time (JIT)

JIT's commitment to short, consistent lead times and to minimizing or eliminating inventories is JIT principal
differentiator from the more traditional approaches.

JIT saves money on downstream inventories by placing greater reliance on improved responsiveness and
flexibility.

Successful JIT applications:

Place a high priority on efficient and dependable manufacturing processes.

Demand effective and dependable communications & information systems, and high-quality, consistent
transportation services.

Definition and Components of JIT Systems – Generally, JIT systems are designed to manage lead times and to
eliminate waste. Ideally, products should arrive exactly when an organization needs it, with no tolerance for late or
early deliveries. Many JIT systems place a high priority on short, consistent lead times. However, in a true JIT
system, the length of the lead time is not as important as the reliability of the lead time.

The JIT concept is an Americanized version of the Kanban system, which the Toyota Motor Company developed in
Japan. Kanban refers to the cards attached to carts delivering small amounts of needed components and other
materials to locations within manufacturing facilities. Each card precisely details the necessary replenishment
quantities and the exact time when the replenishment activity must take place.

Four major elements underlie the JIT concept: zero inventories; short, consistent lead times; small, frequent
replenishment quantities; and high quality, or zero defects. JIT is an operating concept based on delivering
materials in exact amounts and at the precise times that organizations need them—thus minimizing inventory
costs. JIT can improve quality, minimize waste, and completely change the way an organization performs its
logistics activities.

The underlying theme of the phrase “just-in-time” suggests that inventories should be available when an
organization needs them. Generally, just-in-time systems are designed to manage lead times and to eliminate
waste. Four major elements underlie the JIT concept: zero inventories; short, consistent lead times; small,
frequent replenishment quantities; and high quality, or zero defects.

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Material Requirement Planning-MRP

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Another inventory and scheduling approach that has gained wide acceptance is materials requirements planning. MRP
deals specifically with supplying materials and parts whose demand depends on the demand for a specific product.
Only recently have technology and information systems permitted organizations to benefit fully from MRP and to
implement such an approach.

Definition and Operation of MRP Systems - MRP begins by determining how much end products (independent
demand items) customers desire and when they are needed, then disaggregates the timing and need for
components based on the end-product demand by using the following key elements:

Master production schedule (MPS)

Bill of Materials file (BOM)

Inventory status file (ISF)

MRP program

Outputs and reports

Summary and Evaluation of MRP Systems - The MRP program develops a time-phased approach to inventory
scheduling and inventory receipt. As it generates a list of required materials to assemble or manufacture a
specified number of independent demand items, the system MRP represents a push approach. Typically, MRP
applies primarily when the demand for parts and materials depends on the demand for some specific end
product. Since actual demand is key to the establishment of production schedules, MRP systems can react quickly
to changing demand for finished products.

MRP can achieve objectives more commonly associated with the JIT-based approaches, while at times decisions made
through the pull concept do not reflect the future events for which the JIT policies are intended.

The principal advantages of most MRP-based systems include the following:

They attempt to maintain reasonable safety stock levels and to minimize or eliminate inventories whenever
possible.

They can identify process problems and potential supply chain disruptions long before they occur and take the
necessary corrective actions.

Production schedules are based on actual demand as well as on forecasts of independent demand items.

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MRP
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An MRP system is designed to translate a master production schedule into time-phased net inventory requirements
and the planned coverage of such requirements for each component item needed to implement this schedule.

Additional advantage points

Base production schedules on actual demand and forecasts of independent demand items.

Coordinate materials ordering across multiple points in a firm’s logistics network.

Suitable for batch, intermittent assembly, or project processes.

Additional shortcoming

Not as sensitive to short-term fluctuations in demand as order point approaches

Frequently becomes quite complex and sometimes does not work exactly as intended.

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Distribution Requirements Planning (DRP)

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DRP systems accomplish for outbound shipments what MRP accomplishes for inbound shipments.

DRP determines replenishment schedules between a firm’s manufacturing facilities and its distribution centers.

DRP is usually coupled with MRP systems to manage the flow and timing of both inbound materials and outbound
finished goods.

Distribution requirements planning is a widely used and potentially powerful technique for outbound logistics systems
to help determine the appropriate level of inventory to be held to meet both cost and service objectives. DRP
determines replenishment schedules between an organization’s manufacturing facilities and its distribution centers.
DRP is usually coupled with MRP systems in an attempt to manage the flow and timing of both inbound materials and
outbound finished goods. The underlying rationale for DRP is to more accurately forecast demand and to explode that
information back for use in developing production schedules.

DRP develops a projection for each SKU and requires the following:

Forecast of demand for each SKU

Current inventory level of the SKU (balance on hand, BOH)

Target safety stock

Recommended replenishment quantity

Lead time for replenishment

Summary and Evaluation of DRP - A DRP system can accomplish for outbound shipments what MRP accomplishes for
inbound shipments and is an example of a push approach and can be used for both single-facility and system-wide
applications. The key to a successful DRP approach is having accurate demand forecasts by SKU by distribution center.

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VMI (Vendor Managed Inventory)

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A relatively new inventory management technique, vendor-managed inventory, manages inventories outside an
organization’s logistics network or is a technique to manage its inventories held in its customer’s distribution centers.
The basic principles underlying the concept of VMI are relatively simple. First, the supplier and its customer agree on
which products are to be managed using VMI in the customer’s distribution centers. Second, an agreement is made on
reorder points and economic order quantities for each of these products. Third, as these products are shipped from
the customer’s distribution center, the customer notifies the supplier, by SKU, of the volumes shipped on a real-time
basis. This notification is also called “pull” data.

VMI was traditionally used for independent demand items between suppliers and Retailers and can be used for both
independent and dependent demand items. Many organizations are now using VMI in conjunction with CPFR to
manage system-wide inventories. Remember that CPFR is a concept that allows suppliers and their customers to
mutually agree upon system-wide demand for products. A major benefit of VMI is the knowledge gained by the
supplier of real-time inventory levels of its products at its customer locations.

The use of VMI to manage inventories is not affected by which organization owns those inventories. Some customers
have been investigating the use of what can be called almost consignment inventory as the supplier manages and
owns the inventory in the customer’s distribution until that inventory is pulled for shipment.

Inventory Classification

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Multiple product lines and inventory control require organizations to focus on more important inventory items and to
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utilize more sophisticated and effective approaches to inventory management. Inventory classification is usually the
first step toward efficient inventory management.

ABC Classification

This classification technique assigns inventory items to one of three groups according to the relative impact or value of
the items that make up the group. A items are considered to be the most important, with B items being of lesser
importance, and C items being the least important. Important to remember here is that the criteria used to evaluate
an item will determine the group to which it is assigned.

Pareto’s Law, or the “80–20 Rule,” is based on the principle that a relatively small percentage of a population might
account for a large percentage of the overall impact or value. This rule has been found to exist in many practical
situations.

ABC classification is relatively simple. The first step is to select some criteria, such as revenue, for developing the
ranking. The next step is to rank items in descending order of importance according to this criterion and to calculate
actual and cumulative total revenue percentages for each item. This calculation will allow the items to be grouped into
the ABC categories.

Quadrant Model

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This is typically used to classify raw materials, parts, or components for a manufacturing firm, the quadrant model can
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also be used to classify finished goods inventories using value and risk to the firm as the criteria. Value is measured as
the value contribution to profit; risk is the negative impact of not having the product available when it is needed.

Inventory Evaluation

LIFO

FIFO

Averages

Standard

#1 – FIFO – FIFO inventory stands for first in first out. It simply means that the goods should be sold in the order
they were purchased. Good produce should be sold first, and this is the order in which the cost of goods sold and
inventory should be calculated.

#2 – LIFO – LIFO inventory stands for Last in First out and is conceptually opposite to FIFO. Simply put, the goods
purchased recently should be sold first while the goods purchased first should be sold last.

#3 – Weighted average – Weighted average inventory calculation, as the name suggests, calculates the weighted
average of the whole inventory irrespective of the order in which it was placed.

Summary

Principal types of inventory are cycle stock, work-in-process, inventory in transit, safety stock, seasonal stock, and
anticipatory stock.

Principal types of inventory costs are inventory carrying, ordering and setup, expected stock out, and in-transit
inventory.

Four major components of inventory carrying costs are Capital cost, Storage space cost, Inventory service cost, and
Inventory risk cost.

Choosing an appropriate inventory model considers three key differences: Independent vs. dependent demand,
Push vs. pull distribution system, and system-wide vs. specific facility decisions.

Inventory as a percent of overall business activity continues to decline. Explanatory factors include greater
expertise in managing inventory, innovations in information technology, greater competitiveness in markets for
transportation services, and emphasis on reducing cost through the elimination of non-value-adding activities.

As product lines proliferate and the number of SKUs increases, the cost of carrying inventory becomes a
significant expense of doing business.

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There are a number of principal reasons for carrying inventories. Types of inventory include cycle stock, work-in-
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process, and inventory in transit, safety stock, seasonal stock, and anticipatory stock.
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Principal types of inventory cost are inventory carrying cost, ordering and setup cost, expected stock out cost, and
in-transit inventory carrying cost.

Inventory carrying cost is composed of capital cost, storage space cost, inventory service cost, and inventory risk
cost. There are precise methods to calculate each of these costs.

Choosing the appropriate inventory model or technique should include an analysis of key differences that affect
the inventory decision. These differences are determined by the following questions: (1) Is the demand for the
item independent or dependent? (2) Is the distribution system based on a push or pull approach? (3) Do the
inventory decisions apply to one facility or to multiple facilities?

Two basic forms of the EOQ model are the fixed quantity model and the fixed interval model. The former is the
most widely used.

JIT model aims to minimize inventory levels, emphasizing frequent deliveries of smaller quantities and alliances
with suppliers or customers.

MRP and DRP are typically used in conjunction to manage the flow and timing of both inbound materials and
outbound finished goods.

VMI is used to manage a firm’s inventories in its customers’ distribution centers.

Inventory classification is the vital initial step toward efficient inventory management.

Traditionally, inventory managers focused on two important questions to improve efficiency, namely, how much to
reorder from suppliers and when to reorder.

The two aforementioned questions were frequently answered using the EOQ model, trading inventory carrying
cost against ordering costs, and then calculating a reorder point based on demand or usage rates.

The two basic forms of the EOQ model are the fixed quantity model and the fixed interval model. The former is the
most widely used. Essentially, the relevant costs are analyzed (traded off), and an optimum quantity is decided.
This reorder quantity will remain fixed unless costs change, but the intervals between orders will vary depending
on demand.

The basic EOQ model can be varied or adapted to focus more specifically on decisions that are impacted by
inventory-related costs, such as shipment quantities where price discounts are involved.

Just-in-time inventory management captured the attention of many U.S. organizations during the 1970s, especially
the automobile industry. As the name implies, the basic goal is to minimize inventory levels with an emphasis on
frequent deliveries of smaller quantities and alliances with suppliers or customers. To be most effective, JIT should
also include quality management.

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