Supply Chain Management - Chapter 2 Yesmine Chalgham

Part 1: Inventory Management

What is Inventory?

● Inventory includes all the goods and materials a business holds for the purpose of
resale, production, or operational needs.

Inventory represents one of the most significant assets for many companies, often making up as much as 50%
of the total invested capital.
→ The goal is to maintain enough inventory to meet customer demand promptly (ensuring good customer
service) without over-investing in inventory (minimizing holding costs).

What are the Functions of Inventory?

Let’s walk through the functions of inventory using a real-world example involving a coffee shop chain,
"BrewHouse Café," to illustrate how inventory functions play out in practice.

1. Decoupling Production Processes: Inventory helps separate stages of production,

allowing each step to continue smoothly without being dependent on others.
BrewHouse Café maintains a supply of roasted coffee beans in each café. This allows baristas to
continue making coffee, even if there’s a delay in deliveries from their roasting supplier.

2. Demand Fluctuation Management: It helps companies handle fluctuations in

demand by maintaining a stock of goods that ensures availability and selection for
customers.
BrewHouse Café expects higher customer turnout on weekends and around holidays. To manage this,
the café stocks up on additional milk, syrups, cups, and other supplies ahead of time, ensuring that
customers won’t face shortages during these busy periods.

3. Quantity Discounts: By holding larger quantities, businesses can take advantage of

discounts for bulk purchasing, which reduces overall costs.
By ordering a large quantity at once, BrewHouse Café receives a 10% discount, reducing their
per-pound cost.

4. Inflation Hedging: Inventory acts as a hedge against inflation, allowing businesses

to avoid future price increases by holding goods purchased at lower costs.
BrewHouse Café knows that coffee prices tend to rise during certain seasons due to supply issues. To
avoid sudden cost increases, they purchase and store extra coffee beans (a shelf-stable alternative) in
their inventory. This stock helps them maintain consistent pricing and avoid passing the cost increase
to customers.

What are the Types of Inventory?

Raw Materials: Basic materials that will Maintenance, Repair, and Operating
be used in production. (MRO) Supplies: Items needed to
maintain the equipment and support
Example: Tesla keeps an inventory of raw materials like aluminum
for car frames and lithium for batteries, essential for EV manufacturing processes.
manufacturing.
Example: Tesla stocks maintenance tools, robotic arm
components, and cleaning supplies to ensure production runs
Work-in-Process (WIP): Undergone smoothly and machinery stays in top condition.
some change but not completed. A
function of cycle time for a product. Finished Goods: Fully manufactured
Example: Tesla’s Fremont factory has EVs on the assembly line
with installed battery packs but waiting for software installation,
vehicles ready for sale and delivery to
representing WIP inventory. customers.

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Material Flow Cycle

The Material Flow Cycle in inventory management refers to the steps a product goes
through from raw material to finished goods.

Why Inventory Management is important? (Amazon Case Study)

Amazon started as a “virtual” retailer without physical inventory,

relying on third-party fulfillment. However, rapid growth pushed
Amazon to become a leader in inventory management, using
advanced strategies to optimize operations.

Amazon’s inventory and order fulfillment process

Order Assignment: When a customer places an order, Amazon’s system automatically assigns it to the closest distribution
center that has the product in stock. This reduces the shipping distance and speeds up delivery.

Guided Product Picking: At the distribution center, a worker receives instructions to pick the ordered items. Indicator lights
on specific shelves light up to show exactly where each product is located. The worker uses a handheld scanner to scan the
barcodes on the items, verifying they are picking the correct products.

Conveyor Belt Transportation: After items are picked and scanned, they are placed in crates on a conveyor belt, which
transports them to the packing area. Along the way, automated barcode scanners on the conveyor belt re-scan the items
multiple times to ensure accuracy and track each item’s location.

Centralized Packing and Labeling: In the packing area, items are boxed and labeled with a new barcode, which consolidates
the order information. If gift-wrapping is requested, it’s done manually at this stage.

Shipping Preparation: The packed boxes are weighed, sealed, and labeled with delivery information. They’re then loaded
onto trucks for delivery, aiming to reach the customer within a week.

Amazon's innovative approach to inventory management allows it to handle massive order

volumes with high efficiency and low error rates. By continuously improving processes,
Amazon has set a benchmark in the industry, showing how advanced technology and
strategic organization can create an effective, customer-centered supply chain.

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Part 2: Inventory Management Techniques

1. ABC Analysis

ABC Analysis is an inventory categorization technique that helps businesses prioritize

inventory items based on their annual dollar usage.

This method divides inventory into three categories (A, B, and C) according to their
importance, allowing companies to focus resources on the most valuable items.

How ABC Analysis Works

ABC Analysis works by categorizing inventory items as follows:

1. Class A: High-value items, These items

require close monitoring, precise
forecasting, and tighter controls.
2. Class B: Medium-value items, These items
need moderate control and monitoring.
3. Class C: Low-value items, These items
require minimal oversight and are managed
in bulk to reduce handling costs.

Why ABC Analysis is Important?

ABC Analysis allows businesses to:

● Optimize Resources: Focus time and resources on managing the most valuable
items (Class A), ensuring that they are always in stock.
● Reduce Costs: Control costs by managing lower-value items (Class C) with minimal
resources.
● Improve Efficiency: Prioritize critical items for better forecasting, stock
replenishment, and supply chain management.

Example: Electronics Retailer

Consider an electronics retailer that

stocks various products, from high-end
laptops to small accessories.

● Class A: High-value items like

laptops and smartphones.
(Inspection Frequently, often
monthly or even weekly)
● Class B: Mid-range items, such
as tablets and headphones.
(Inspection Periodically, usually
quarterly.)
● Class C: Low-value items like
phone cases, chargers, and
cables. (Inspection Infrequently,
typically annually.)

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Alternative Criteria for ABC Classification:

ABC Analysis can also factor in:

● Anticipated Engineering Changes: Prioritize items with upcoming design/spec

changes.

A smartphone manufacturer is planning to release a new model with a completely redesigned charging port.
This means the current charging port parts they have in stock may soon become outdated. Therefore, they
prioritize using up the existing charging ports in the current models to avoid having leftover parts that they
can’t use once the new design is launched.

● Delivery Problems: Items with frequent delays may need higher priority.

Popular laptop accessories that often face shipping delays should be closely monitored to avoid stockouts.

● Quality Issues: Manage items with quality problems closely to avoid

dissatisfaction.

A batch of tablets with reported screen defects may require extra inspections and control to ensure quality.
High-cost items, even in small quantities, may require more control.

● High Unit Cost

Expensive, high-performance graphics cards, though low in quantity, should have tighter inventory control due
to their value.

Policies for Managing Each Class:

Companies often apply tailored strategies, especially for Class A items:

● Supplier Development: Strengthen supplier relationships for reliable supply.

● Tighter Inventory Control: Regular checks and secure storage for critical items.
● Improved Forecasting: More care in forecasting A items.

2. Record Accuracy:

Accurate inventory records are crucial for effective production and inventory management.
They allow organizations to:

● Focus on what’s needed and avoid unnecessary stock.

● Make precise decisions regarding ordering, scheduling, and shipping.
● Ensure smooth operations by preventing stockouts or overstocking.

Methods to Maintain Record Accuracy

One key method for maintaining record accuracy is Cycle Counting:

● Cycle Counting: A periodic inventory auditing process where items are counted and
records are updated regularly.

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○ Often used with ABC Analysis to determine the frequency of counts.

Advantages of Cycle Counting:

■ Eliminates the need for annual inventory shutdowns. (A retail store uses cycle
counting, so it doesn’t need to close for a full inventory check at year-end.)
■ Allows trained personnel to audit and correct inventory records
continuously. (In a warehouse, staff can identify and update stock levels weekly, keeping
records up-to-date without needing a large, disruptive audit.)
■ Identifies and corrects errors, maintaining accurate records over time. (A
grocery store’s cycle counting reveals that a certain item was miscounted, allowing them to fix
it right away and avoid potential stock issues.)

3. Control of Service Inventories:

Control of Service Inventories involves managing inventory effectively in service industries,

where inventory can include items like supplies, tools, and materials needed to deliver a
service. Effective control of these inventories can help reduce losses and improve
profitability.

Techniques for Control of Service Inventories:

1. Good Personnel Selection, Training, and Discipline: Employing trustworthy and

well-trained staff reduces the chances of errors, shrinkage, or pilferage.
○ Example: A hotel trains housekeeping staff to accurately track and record linen and cleaning
supplies to prevent shortages.
2. Tight Control on Incoming Shipments: Verifying and inspecting incoming inventory
helps catch discrepancies early.
○ Example: A restaurant checks all food deliveries carefully to ensure the correct quantity and
quality before items are added to inventory.
3. Effective Control on Goods Leaving the Facility: Tracking items as they are used
ensures accurate records and reduces loss.
○ Example: A hospital tracks the usage of medical supplies, like gloves and syringes, to prevent
unauthorized usage and maintain stock levels.

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Part 3: Inventory Models

Demand Classification:

● Independent Demand: Demand that is not related to the demand for other items. It
typically comes from external customers and is forecasted separately.

Example: Finished products like cars or laptops, where demand depends on customer purchases.

● Dependent Demand: Demand that depends on the demand for another item,
usually a component or part of a larger product.

Example: Tires for cars or processors for laptops, where demand depends on the production levels of the
finished products they go into.

Cost Types:

1. Holding Costs: The expenses of storing and maintaining inventory over time.
These include warehousing, insurance, depreciation, and potential obsolescence.
2. Ordering Costs: The costs involved in placing and receiving orders for inventory.
This includes processing, transportation, and handling fees.
3. Setup Costs: The costs of preparing equipment or processes for production runs,
often associated with manufacturing.

Part 4: Inventory Models for Independent Demand

1. Basic EOQ Model (Economic Order Quantity):

The Basic Economic Order Quantity (EOQ) Model is a formula used to determine the
optimal order quantity (Q*) that minimizes the total costs of holding and ordering
inventory. It’s based on the balance between holding costs (cost of storing inventory) and
ordering costs (cost of placing orders).

The graph illustrates the EOQ

inventory cycle: starting at a maximum
level (Q), inventory depletes at a
steady rate until it hits the reorder
point, avoiding stockouts. The average
inventory maintained is Q/2, because
inventory levels fluctuate between
maximum (Q) and minimum (0). This
average level helps balance costs.

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EOQ Model Assumptions (with context example):

At Eco Supplies Co., a small eco-friendly notebook business, the Basic EOQ Model helps
them find the best order size to minimize inventory costs. Here’s how they make it work:

1. Constant Demand: Sales are steady, so they know exactly how many notebooks
they’ll need each month.
2. Constant Lead Time: Every order from their supplier arrives in exactly five days,
allowing perfect planning.
3. Instant Replenishment: Once notebooks arrive, they’re immediately ready for
sale—no delays.
4. No Stockouts: They plan orders carefully to ensure they never run out of notebooks
for customers.
5. No Quantity Discounts: The supplier’s price per notebook stays the same, no
matter the order size.

Formula:

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Expected Number of Orders:

Units: Orders per year

Interpretation: The number of times orders need to be placed annually to

meet demand.

Expected Time Between Orders:

● Units: Days
● Interpretation: The average interval (in days) between each order, indicating how often
orders should be placed.

Total Annual Cost:

Units: Dollars per year (or local currency)

Interpretation: The combined cost of

ordering and holding inventory for the
year, minimized at the optimal order
quantity Q*

→ EOQ answers the “how much” question

2. Reorder Points (ROP):

The reorder point (ROP) tells when to order.

At the top, Q* is the Economic Order Quantity (EOQ)—the

ideal amount to order each time to minimize costs. Inventory
decreases at a steady demand rate (slope = d).

When inventory hits the Reorder Point (ROP), we place a

new order. This ensures that during the Lead Time (L)—the
time it takes for the order to arrive—we still have enough
stock to meet demand. The goal is for the new stock to arrive
just as inventory reaches zero, preventing stockouts while
keeping holding costs low.

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In other words:

Where:

Putting ROP and EOQ together in an Example!

A pharmacy sells a popular pain relief medication, which has a consistent daily demand from customers. To
avoid running out of stock, the pharmacy needs to know when to reorder this medication, ensuring that new
inventory arrives before they run out.

● Daily Demand (d): 20 units per day

● Lead Time (L): 5 days (time it takes for the supplier to deliver an order)

ROP=d*L= 20*5= 100 Units

When the pharmacy’s inventory for this medication drops to 100 units, they should place a new order. Given
the 5-day lead time, this ensures that the new stock arrives just as the inventory reaches zero, preventing
stockouts and maintaining availability for customers.

The Reorder Point (ROP) only tells the pharmacy when to place an order (in this case, when inventory drops
to 100 units). To determine how much to order, the pharmacy would typically use the Economic Order
Quantity (EOQ) formula or a similar inventory replenishment model.

Assume:

● Annual Demand (D) = 7,300 units (20 units per day × 365 days).
● Ordering Cost (S) = $50 per order.
● Holding Cost (H) = $2 per unit per year.

2* 7300*50
Q*= 2
= 3600= 604

Once the ROP is reached, the pharmacy orders the full EOQ quantity of 604 units. This isn’t adjusted based
on the remaining stock; instead, the EOQ is the fixed amount ordered each time to optimize costs.

Why Not Subtract the ROP from the EOQ?

The EOQ formula is designed to minimize costs by setting a consistent order quantity each time. Adjusting
the order size based on the remaining stock would disrupt this balance and could lead to higher costs. By
always ordering the EOQ, the pharmacy maintains a predictable cycle that minimizes both holding and
ordering costs.

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3. The Wilson Model with Shortage:

We assume that shortage is tolerated and satisfied when the order arrives.

The Wilson Model with Shortage (also known as the EOQ Model with Shortages) extends the basic
Economic Order Quantity (EOQ) model to account for situations where it may be acceptable to temporarily run
out of stock and fulfill backorders when new inventory arrives. This model aims to minimize total costs,
including ordering, holding, and shortage costs.

Inventory depleted over time, reaching zero

at the end of t₁. During t₂, demand
continues, but inventory is out of stock,
leading to backorders.

When the next order arrives, it covers both

the backordered amount and new
inventory, bringing the level back to M.
This cycle repeats, balancing holding costs
with the cost of shortages.

Formula:

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4. Production Order Quantity Model (POQ):

The Production Order Quantity Model, also known as the Economic Production Quantity
(EPQ) Model, is an extension of the EOQ model. It applies to situations** where inventory
is replenished gradually as items are produced, rather than all at once through an external
order. This model is particularly useful in manufacturing settings where products are
produced and consumed simultaneously.***

**Situation 1: At Tijen Water Plant, water bottles are produced continuously

in-house to meet steady demand from retailers. The production line makes 1,000
bottles per hour, while demand is 600 bottles per hour, allowing inventory to
gradually increase during each production run. When a run ends, stored inventory is
used to meet demand until it runs low, at which point Tijen restarts production,
repeating the cycle.

***Situation2 : A bakery that produces bread continuously throughout the day while customers purchase it in
real-time. The bakery can’t produce all the bread in the morning, as it would go stale; instead, it produces
bread steadily. The Production Order Quantity Model helps the bakery decide how much to bake in each run,
balancing the costs of frequent baking setups and holding freshly baked bread without having too much on
hand at once.

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This graph shows the Production

Order Quantity Model cycle:

Production Phase: Inventory builds up

as items are produced faster than
demand. This continues until
inventory reaches the maximum level.

Demand Phase: Production stops, and

inventory gradually depletes solely to
meet demand until it reaches zero.

Cycle Repeat: The process then repeats, balancing production with holding costs by producing in controlled
batches.

Formulas:

Maximum Inventory Level:

Where p is the daily production rate, t is the length of the production run in days, and d is the daily
demand rate.

Average Inventory Level:

Annual Inventory Holding Cost:

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Holding Cost per Year (Adjusted for Production):

Where Q is the total quantity

produced per cycle, d is the daily
demand rate, ppp is the daily
production rate, and H is the
holding cost per unit per year.

Setup Cost:

Where D is the annual demand and S is the

setup cost per order.

Optimal Order Quantity (EOQ with Production):

EOQ Formula Using Annual Rates:

5. Quantity Discount Model:

In the Quantity Discount Model,

reduced prices are available for
larger purchase quantities, offering
an incentive to buy in bulk.

However, there’s a trade-off:

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● Reduced Product Cost: Larger orders qualify for discounts, lowering the per-unit
purchase price.
● Increased Holding Cost: Ordering more at once means holding more inventory,
which increases storage costs, tying up capital and resources.

The goal is to find an order quantity that balances these two factors—minimizing total
costs by leveraging discounts without significantly raising holding costs.

Each curve represents the total cost

at various order quantities for a
specific discount level.

Price Breaks indicate minimum

quantities needed to qualify for
each discount.

For discount level 2, the EOQ Q*

initially falls below the minimum
required quantity, so it’s adjusted to
the minimum at point b.

The goal is to select the order

quantity with the lowest total cost
that meets discount requirements.

Example:
Suppose a company needs 10,000 units of a part annually. The setup cost per order is $50, and the holding cost
per unit per year is $2. The supplier offers the following quantity discounts:

● 1-499 units: $10 per unit

● 500-999 units: $9.50 per unit
● 1000+ units: $9 per unit

The goal is to find the optimal order quantity Q* that minimizes the total cost, taking into account the
discounts.

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Steps in analyzing a quantity discount

Step 1: For Each Discount, Calculate Q*

Step 2: Check Feasibility for Each Discount

Step 3: Compute the Total Cost for Each Q* or Adjusted Value:

.......

Step 4: Select the Q* that Gives the Lowest Total Cost

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Part 5: Probabilistic Models and Safety Stock

1. Probabilistic models and safety stock:

Probabilistic Models and Safety Stock are used in inventory management when demand is
uncertain.

Purpose: They help maintain a desired service level and prevent stockouts by using safety
stock.

The reorder point (ROP) = 50 units,

Stockout cost = $40 per frame

Carrying cost = $5 per frame per year

Q =6 orders per year.

Safety Stock Additional Holding Cost Stockout Cost Total Cost

20 units (20)×(5)=100 $0 $100

10 units (10)×(5)=50 (10)×(0.1)×(40)×(6)=240 $290

0 units $0 (10)×(0.2)×(40)×(6)+(20)×(0.1)×(40)×(6)=960 $960

According to the demand distribution, the highest level of demand expected during the lead time is 70 units,
with a low probability of 0.1. The reorder point (ROP) is set at 50 units. By adding 20 units of safety stock, the
total inventory available at the time of reorder becomes 50 + 20 = 70 units.

By adding 10 units of safety stock, the total inventory available at the time of reorder becomes 50 + 10 = 60
units. So there is a risk of 10 units stockout.

If there is a 10% probability of being short 10 units at a certain safety stock level, and the stockout cost per unit
is $40 with 6 orders per year, then:

Stockout Cost=(10)×(0.1)×(40)×(6)=240

By adding 0 units of safety stock, the total inventory available at the time of reorder becomes 50 units. So
there is a risk of 10 units stockout with probability 0.2 and 20 units stockout with probability 0.1.

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Probabilistic Demand:

The graph shows how the Reorder Point

(ROP) of 366.5 units is determined by
adding the expected demand during lead
time (350 units) to a safety stock buffer
(16.5 units). This safety stock accounts for
demand variability, ensuring enough
inventory is available even if demand
spikes during the lead time. When
inventory hits the ROP, a new order is
placed to prevent stockouts.

Probabilistic Demand:

Service Level and Safety

Stock: For a 95% service level,
we set safety stock to cover
demand fluctuations, ensuring
no stockouts 95% of the time.

Example:

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Other Probabilistic Models:

Model Reorder Point (ROP) Formula Example

Variable Demand,
Constant Lead Time

Variable Lead Time,

Constant Demand

Both Demand and A combination of the above models, used when both
Lead Time Variable demand and lead time vary.

2. Fixed-Period (P) Systems for periodic ordering

In a Fixed-Period (P) System, we review inventory and place orders at regular, fixed
intervals, such as weekly or monthly. At the end of each period, we check how much
inventory we have left and decide how much to order to bring the inventory up to a
predetermined target level, which we call the "maximum" or "target level" (T).

This graph illustrates how inventory is managed in a

Fixed-Period (P) System:

● Inventory Level (Y-axis): Shows the amount

of stock on hand over time.
● Target Maximum (T): The inventory level we
aim to reach after each order.
● Time (X-axis): Divided into fixed periods (P),
marking when inventory is reviewed and replenished.
● Order Quantities (Q1, Q2, Q3, Q4):
Represent the amounts ordered at the end of each

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period to bring inventory back up to the target maximum.

● Inventory Pattern: Inventory depletes over each period due to usage or sales, then jumps back up
after each order.

Example:

Risk of Stockouts: Because we’re only checking inventory at specific intervals, there’s a
chance we might run out of stock between periods. To avoid this, we may need extra safety
stock.

Useful for Routine Inventory: This system works well in settings where we have
predictable demand and can afford to count inventory only at fixed intervals.

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