INVENTORY MANAGEMENT & BULLWHIP EFFECT

 To provide an understanding and appreciation of inventory management as a critical supply

chain component
 To study the financial impact of inventory
 To provide an overall understanding of the various costs involved in maintaining and carrying
inventory
 To craft common inventory control management techniques to improve supply chain
management of organizations
 To study the bullwhip effect and its effects on inventory

1. Inventory – A Critical Supply Chain Component

The inventory requirements of a firm are directly linked to the facility network and the desired level
of customer service. Theoretically, a firm could stock every item sold in every facility dedicated to
servicing each customer. Few business operations can afford such a luxurious inventory commitment
because the risk and total cost are prohibitive. The objective in inventory strategy is to achieve desired
customer service with the minimum inventory commitment. Excessive inventories may compensate
for deficiencies in basic design of a supply chain system but will ultimately result in higher-than-
necessary total logistics cost.

Supply chain strategies should be designed to maintain the lowest possible financial investment in
inventory. The basic goal is to achieve maximum inventory turn while satisfying service commitments.
A sound inventory strategy is based on a combination of five aspects of selective deployment:

 Core customer segmentation

 Product profitability

 Transportation integration

 Time-based performance

 Competitive performance

Every enterprise that sells to a variety of different customers confronts uneven opportunity. Some
customers are highly profitable and have outstanding growth potential; others do not. The profitability
of a customer's business depends upon the products purchased, volume, price, value-added services
required, and supplemental activities necessary to develop and maintain an ongoing relationship.
Because highly profitable customers constitute the core market of every enterprise, inventory strate-
gies need to focus on them. The key to effective logistical segmentation rests in the inventory priorities
dedicated to support core customers.

Most enterprises experience a substantial variance in the volume and profitability across product
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lines. If no restrictions are applied, a firm may find that less than 20 percent of all products marketed
account for more than 80 percent of total profit. While the so-called 80/20 rule or Pareto principle is
common in business, management must avoid such outcomes by implementing inventory strategies
based on fine-line product classification. A realistic assessment of the incremental value added by
stocking low-profit or low-volume products is essential to avoiding excessive cost. For obvious
reasons, an enterprise wants to offer high availability and consistent delivery of its most profitable
products. High-level support of less profitable items, however, may be necessary to provide full-line
service to core customers. The trap to avoid is high service performance on less profitable items that
are typically purchased by fringe or non-core customers. Therefore, product line profitability must be
considered when developing a selective inventory policy.

The product stocking plan at a specific facility has a direct impact upon transportation performance.
Most transportation rates are based on the volume and size of specific shipments. Thus, it may be
sound strategy to stock a sufficient range or assortment of products at a warehouse to be able to
arrange consolidated shipments. The corresponding savings in transportation may more than offset
the increased cost of holding the inventory.

A firm's degree of commitment to deliver products rapidly to meet a customer's inventory

requirement is a major competitive factor. If products and materials can be delivered quickly, it may
not be necessary for customers to maintain large inventories. Likewise, if retail stores can be
replenished rapidly, less safety stock is required. The alternative to stockpiling and holding safety stock
is to receive exact and timely inventory replenishment. While such time-based programs reduce
customer inventory to absolute minimums, the savings must be balanced against other supply chain
costs incurred as a result of the time-sensitive logistical process.

Finally, inventory strategies cannot be created in a competitive vacuum. A firm is typically more
desirable to do business with, than competitors, if it can promise and perform rapid and consistent
delivery. Therefore, it may be necessary to position inventory in a specific warehouse to gain
competitive advantage even if such commitment increases total cost. Selective inventory deployment
policies may be essential to gain a customer service advantage or to neutralize a strength that a
competitor currently enjoys.

2. Inventory Flow

The operational management of logistics is concerned with movement and storage of materials and
finished products. Logistical operations start with the initial shipment of a material or component part
from a supplier and are finalized when a manufactured or processed product is delivered to a
customer.

From the initial purchase of a material or component, the logistics process adds value by moving
inventory when and where needed. Providing all goes well, materials and components gain value at
each step of their transformation into finished inventory. In other words, an individual part has greater
value after it is incorporated into a machine than it had as a part. Likewise, the machine has greater
value once it is delivered to a customer.

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To support manufacturing, work-in-process inventory must be properly positioned. The cost of each
component and its movement becomes part of the value-added process. Figure 3-1 illustrates the
function of inventory in an organization supply chain and /or value chain process to meet business
objectives.

Figure 3-1: Inventory – A Critical Supply Chain Integration Component

Inventory management is concerned with information required to implement the supply chain plan.
Using combination of human resources and information technology, inventory is deployed and then
managed to satisfy planned requirements. The work of inventory management is to make sure that
the overall supply chain system has appropriate resources to perform as planned.

Inventory decisions are high risk and high impact for supply chain management. Inventory committed
to support future sales drives a number of anticipatory supply chain activities. Without a proper
inventory assortment lost sales and customer dissatisfaction may occur. Likewise, inventory planning
is critical to manufacturing. Material or component shortages can shut down a manufacturing line or
force modification of a production schedule, which creates added cost and potential finished goods
shortages. Just as shortages can disrupt planned marketing and manufacturing operations, inventory
overstocks also create operating problems. Overstocks increase cost and reduce profitability as a
result of added warehousing, working capital, insurance, taxes, and obsolescence. Management of
inventory resources requires an understanding of the principles, cost, impact, and dynamics.

3. Inventory Functionality and Principles

Inventory policy formation requires understanding the role of inventory in a manufacturing and
logistics environment. To understand the importance of inventory decisions, consider the magnitude
of assets committed by a typical enterprise. Table 3-1 presents sales, net profit, and inventory
investment for select consumer and industrial goods manufacturers and merchandisers. The table
illustrates the significant percentage of assets that are inventory related. Because inventory is a

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significant cost center, the reduction of a firm's inventory commitment by a few percentage points
can result in dramatic profit improvement.

Attention to inventory management has significantly decreased inventory required to support Gross
Domestic Product (GDP). These reductions have been achieved during a period when new product
proliferation has been widespread. Figure 3-2 illustrates overall performance in inventory to sales
ratio.

Inventory management is risky, and risk varies depending upon a firm's position in the distribution
channel. The typical measures of inventory commitment are time duration, depth, and width of
commitment.

Table 3-1: Selected Data for Consumer and Industrial Goods Manufacturers and Merchandisers (US$
Millions)

For a manufacturer, inventory risk is long term. The manufacturer's inventory commitment starts with
raw material and component parts, includes work-in-process, and ends with finished goods. In
addition, finished goods are often positioned in warehouses in anticipation of customer demand. In
some situations, manufacturers are required to consign inventory to customer facilities. In effect, this
practice shifts all inventory risk to the manufacturer. Although a manufacturer typically has a narrower
product line than a retailer or wholesaler, the manufacturer's inventory commitment is deep and of
long duration.

A wholesaler purchases large quantities from manufacturers and sells smaller quantities to retailers.
The economic justification of a wholesaler is the capability to provide retail customers with assorted
merchandise from different manufacturers in specific quantities. When products are seasonal, the
wholesaler may be required to take an inventory position far in advance of the selling season, thus
increasing depth and duration of risk. One of the greatest challenges of wholesaling is product-line
expansion to the point where the width of inventory risk approaches that of the retailer while depth
and duration of risk remain characteristic of traditional wholesaling. In recent years, retail clientele
have also forced a substantial increase in depth and duration by shifting inventory responsibility back
to wholesalers.

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For a retailer, inventory management is about buying and selling velocity. The retailer purchases a
wide variety of products and assumes a substantial risk in the marketing process. Retailer inventory
risk can be viewed as wide but not deep. Due to the high cost of store location, retailers place prime
emphasis on inventory turnover and direct product profitability. Inventory turnover is a measure of
inventory velocity and is calculated as the ratio of annual sales divided by average inventory.

Although retailers assume a position of risk on a variety of products, their position on anyone product
is not deep. Risk is spread across more than 30,000 stock keeping units (SKUs) in a typical supermarket.
A discount store offering general merchandise and food often exceeds 25,000 SKUs. A full-line
department store may have as many as 50,000 SKUs. Faced with this width of inventory, retailers
attempt to reduce risk by pressing manufacturers and wholesalers to assume greater and greater
inventory responsibility. Pushing inventory back up the channel has resulted in retailer demand for
fast delivery of mixed-product shipments from wholesalers and. manufacturers. Specialty retailers, in
contrast to mass merchandisers, normally experience less width of inventory risk as a result of
handling narrower assortments; however, they must assume greater risk with respect to depth and
duration of inventory holding.

Figure 3-2: Inventories to Sales Ratio

If a business plans to operate at more than one level of the distribution channel, it must be prepared
to assume related inventory risk. For example, the food chain that operates a regional warehouse
assumes risk related to the wholesaler operation over and above the normal retail operations. To the
extent that an enterprise becomes vertically integrated, inventory must be managed at all levels of
the supply chain.

4. Inventory Functionality

From an inventory perspective, the ideal situation would be a response capability to manufacture
products to customer specification. At various points in early chapters, the practicality of becoming
fully response-based has been discussed in terms of the total costs and timeliness of customer
support. While a zero-inventory manufacturing/ distribution system is typically not attainable, it is
important to remember that each dollar invested in inventory is a trade-off with an alternative use of
assets that may provide a better return.
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Inventory is a major asset that should provide return for the capital invested. The return on inventory
investments is the marginal profit on sales that would not occur without inventory. Accounting experts
have long recognized that measuring the true cost and benefits of inventory on the corporate profit-
and-loss is difficult. Lack of measurement sophistication makes it difficult to evaluate the trade-offs
among service levels, operating efficiencies, and inventory levels. While aggregate inventory levels
have decreased, many enterprises still carry an average inventory that exceeds their basic
requirements. This generalization can be understood better through a review of the four prime
functions of inventory. Below summarizes inventory functionality:

4.1 Geographical Specialization

Allows geographical positioning across multiple manufacturing and distributive units of an enterprise.
Inventory maintained at different locations and stages of the value-creation process allows
specialization.

4.2 Decoupling

Allows economy of scale within a single facility and permits each process to operate at maximum
efficiency rather than having the speed of the entire process constrained by the slowest.

4.3 Supply /Demand Balancing

Accommodates elapsed time between inventory availability (manufacturing, growing, or extraction)

and consumption.

4.4 Buffering Uncertainty

Accommodates uncertainty related to demand in excess of forecast or unexpected delays in order

receipt and order processing on delivery and is typically referred to as safety stock.

The above four functions require inventory investment to achieve managerial operating objectives.
While lean logistics has made significant progress in reducing overall supply chain inventory, inventory
properly deployed can create value and reduce total cost. Given a specific manufacturing/ marketing
strategy, inventories planned and committed to operations can only be reduced to a level consistent
with performing the four inventory functions. All inventories exceeding the minimum level are excess
commitments.

At the minimum level, inventory invested to achieve geographical specialization and decoupling can
only be modified by changes in facility location and operational processes of the enterprise. The
minimum level of inventory required to balance supply and demand depends on the difficult task of
estimating seasonal requirements. With accumulated experience over a number of seasonal periods,
the inventory required to achieve marginal sales during periods of high demand can be projected fairly
well. A seasonal inventory plan can be formulated based upon this experience.

Inventories committed to safety stocks represent the greatest potential for improved logistical
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performance. These commitments are operational in nature and can be adjusted rapidly in the event
of an error or policy change. A variety of techniques are available to assist management in planning
safety stock commitments. The focus in the balance of this chapter is on a thorough analysis of safety
stock relationships and policy formulation.

5. Inventory-Related Definitions

When formulating inventory management policy, specific inventory relationships must be considered.
A firm must use these relationships to determine the optimum inventory policy with respect to when
and how much to order. The inventory policy essentially determines inventory performance. The two
key indicators of inventory performance are service level and average inventory.

Inventory policy consists of guidelines concerning what to purchase or manufacture, when to take
action, and in what quantity. It also includes decisions regarding geographical inventory positioning.
For example, some firms may decide to postpone inventory positioning by maintaining stock at the
plant. Other firms may use a more speculative policy by electing to position more products in local
markets or regional warehouses to have product closer to the market. The development of sound
inventory policy is the most difficult issue within overall inventory management.

A second aspect of policy concerns inventory management practice. One approach is to independently
manage inventory at each stocking facility. At the other extreme is central inventory management of
all stocking locations. Centralized inventory management requires effective communication and
coordination. The increased availability of affordable information technology and integrated planning
systems are allowing more firms to move toward centralized inventory planning.

5.1 Service Level

The service level is the performance target specified by management. It defines inventory
performance objectives. Service level is often measured in terms of an order cycle time, case fill rate,
line fill rate, order fill rate, or any combination of these. The performance cycle is the elapsed time
between the release of a purchase order by a buyer and the receipt of the corresponding shipment.
A case fill rate defines the percent of cases or units ordered that are shipped as requested. For
example, a 95 percent case fill rate indicates that, on average, 95 cases out of 100 are filled from
available stock. The remaining 5 cases are backordered or deleted. The line fill rate is the percent of
order lines filled completely. Order fill is the percent of customer orders filled completely.

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 Figure 3-3: Inventory Cycle for Typical Product
Inventory management is a major element of logistical strategy that must be integrated to meet
service objectives. While one strategy to achieve a high service level is to increase inventory, other
alternative approaches are the use of fast transportation and collaboration with customers and service
providers to reduce uncertainty.

5.2 Average Inventory

Average inventory consists of the materials, components, work-in-process, and finished product
typically stocked in the logistical system. From a policy viewpoint target inventory levels must be
planned for each facility. Figure 3-3 illustrates the performance cycles for one item at one warehouse
location. At the maximum, the facility has in stock and during the normal performance cycle $70,000
and a minimum of $30,000. The difference between these two levels, $40,000 ($70,000 - $30,000), is
the order quantity resulting in a cycle inventory of $20,000.

Cycle inventory or base stock (also called lot size stock) is the portion of average inventory that results
from replenishment. At the beginning of a performance cycle, stock level is at a maximum. Customers
deplete inventory until the stock level reaches its minimum. Prior to the stock level reaching the
minimum, a replenishment order is initiated so that inventory will arrive before an out-of-stock occurs.
The replenishment order must be initiated when the available inventory is less than or equal to
forecasted demand during the performance cycle time. The amount ordered for replenishment is
termed the order quantity. Given this basic order formulation, average cycle inventory or base stock
equals onehalf order quantity.

The majority of inventory in the typical supply chain system is typically safety stock. Safety stock is
maintained in a logistical system to protect against demand and performance cycle uncertainty. Safety
stock inventory is used only at the end of replenishment cycles when uncertainty has caused higher
than expected demand or longer than expected performance cycle times. Thus, the average inventory
focus of logistical management is one-half order quantity plus safety stock.

5.3 Average Inventory Over Multiple Performance Cycles

In initial policy formulation, it is necessary to determine how much inventory to order at a specified
time. For purposes of illustration, assume the replenishment performance cycle is a constant 10 days
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and daily sales rate is 10 units per day. Also assume the replenishment order quantity is 200 units.

Figure 3-4: Inventory Relationship Constant Sales and Performance Cycle

Figure 3-4 illustrates these relationships. This type of chart is referred to as a sawtooth diagram
because of the series of right triangles. Since complete certainty exists with respect to usage and
performance cycle, orders are scheduled to arrive just as the last unit is sold. Thus, no safety stock is
necessary. Since the rate of sale in the example is 10 units per day and it takes 10 days to complete
inventory replenishment, a sound reorder policy might be to order 200 units every 20 days. Given
these conditions, terminology related to policy formulation can be identified.

First, the reorder point is specified as 100 units on hand. The reorder point defines when a
replenishment order is initiated. In this example, whenever the quantity on hand drops below 100, an
additional order for 200 units is placed. The result of this policy is that daily inventory level ranges
from a maximum of 200 to a minimum of zero over the performance cycle.

Second, average inventory is 100 units, since stock on hand exceeds 100 units one-half of the time, or
for 10 days, and is less than 100 units one-half of the time. In fact, average inventory is equal to one-
half the 200-unit order quantity.

Third, assuming a work year of 240 days, 12 purchases will be required during the year. Therefore,
over a period of 1 year, 200 units will be purchased 12 times for a total of 2400 units. Sales are
expected to equal 10 units per/day over 240 days for a total of 2400 units. As discussed above, average
inventory is 100 units. Thus, inventory turns will be 24 (2400 total sales/100 units of average
inventory).

In time, the sheer boredom of such routine operations would lead management to ask some questions
concerning the arrangement. What would happen if orders were placed more frequently than once
every 20 days? Why not order 100 units every 10 days? Why order as frequently as every 20 days?
Why not reorder 600 units once every 60 days? Assuming that the inventory performance cycle
remains a constant 10 days, what would be the impact of each of these alternative ordering policies
on reorder point, average base inventory, and inventory turnover?

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 Figure 3-5: Alternative Order Quantity and Average Inventory

The policy of ordering a smaller volume of 100 units every 10 days means that two orders would
always be outstanding. Thus, the reorder point would remain 100 units on hand or on order to service
average daily sales of 10 units over the 20-day inventory cycle. However, average inventory on hand
would drop to 50 units, and inventory turnover would increase to 48 times per year. The policy of
ordering 600 units every 60 days would result in an average base inventory of 300 units and a turnover
of approximately eight times per year. These alternative ordering policies are illustrated in Figure 3-5.

The figure illustrates that average inventory is a function of the reorder quantity. Smaller
replenishment order quantities do result in lower average inventory, but there are other factors such
as performance cycle uncertainty, purchasing discounts, and transportation economies that are
important when determining order quantity.

An exact order quantity policy can be determined by balancing the cost of ordering and the cost of
maintaining average inventory. The Economic Order Quantity (EOQ) model provides a specific quantity
balancing of these two critical cost components. By determining the EOQ and dividing it into annual
demand, the frequency and size of replenishment orders minimizing the total cost of cycle inventory
is identified. Prior to reviewing EOQ, it is necessary to identify costs typically associated with ordering
and maintaining inventory.

6. Inventory Carrying Cost

Inventory carrying cost is the expense associated with maintaining inventory. Inventory expense is
calculated by multiplying annual inventory carrying cost percent by average inventory value. Standard
accounting practice is to value inventory at purchase or standard manufacturing cost rather than at
selling price.

Assuming an annual inventory carrying cost percentage of 20 percent, the annual inventory expense
for an enterprise with $1 million in average inventory would be $200,000 (20% x $1,000,000). While
the calculation of inventory carrying expense is basic, determining the appropriate carrying cost
percent is less obvious.
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Determining carrying cost percent requires assignment of inventory-related costs. Financial accounts
relevant to inventory carrying cost percent are capital, insurance, obsolescence, storage, and taxes.
While cost of capital is typically a standard assessment, expense related to insurance, obsolescence,
storage, and taxes varies depending on the specific attributes of individual products.

6.1 Capital Cost

The appropriate charge to place on capital invested in inventory varies widely. Review of a variety of
enterprises indicates that assessments range from the prime interest rate to as high as 25 percent.
The logic for using the prime interest rate or a specified rate pegged to the prime rate is that cash to
replace capital invested in inventory can be obtained in the money markets at that rate. Higher
managerially specified capital costs are based on expected or target return on investment for all funds
available to an enterprise. This target rate is often termed a hurdle rate. Any funds invested in
inventory lose their earning power, restrict capital availability, and limit other investment. For
example, if a firm expects a 20 percent before-tax return on invested capital, similar logic suggests
that capital tied up in inventory should be assessed or charged the same 20 percent.

Confusion often results from the fact that senior management frequently does not establish a clear-
cut capital cost policy. For logistical planning, the cost of capital must be thought out clearly since the
final rate of assessment will have a significant impact on system design and performance.

6.2 Taxes

Taxing authorities typically assess inventory held in warehouses. The tax rate and means of
assessment vary by location. The tax expense is usually a direct levy based on inventory level on a
specific day of the year or average inventory level over a period of time.

6.3 Insurance

Insurance cost is an expense based upon estimated risk or loss over time. Loss risk depends on the
product and the facility storing the product. For example, high-value products that are easily stolen
and hazardous products result in high insurance cost. Insurance cost is also impacted by facility
characteristics such as security cameras and sprinkler systems that might help reduce risk.

6.4 Obsolescence

Obsolescence cost results from deterioration of product during storage. A prime example of
obsolescence is product that ages beyond recommended sale date, such as food and pharmaceuticals.
Obsolescence also includes financial loss when a product becomes obsolete in terms of fashion or
model design. Obsolescence costs are typically estimated based on past experience concerning
markdowns, donations, or quantity destroyed. This expense is the percent of average inventory value
declared obsolete each year.

6.5 Storage

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Storage cost is facility expense related to product holding rather than product handling. Storage cost
must be allocated on the requirements of specific products since it is not related directly to inventory
value. In public or contract warehouses, storage charges are billed on an individual basis. With
privately owned facilities, the total annual depreciated expense of the warehouse must be calculated
in terms of a standard measure such as cost per day per square or cubic foot. The cost of total annual
occupancy for a given product can then be assigned by multiplying the average daily physical space
occupied by the standard cost factor for the year. This figure can then be divided by the total number
of units of merchandise processed through the facility to determine average storage cost per
merchandise unit.

Table 3-2: Inventory Carrying Cost Components

Table 3-2 illustrates the components of annual inventory carrying cost and typical range of component
costs. It should be clear that the final carrying cost percent used by a firm is determined by managerial
policy. Decisions regarding inventory carrying cost level are important because carrying cost is traded
off against other logistics cost components in system design and operating decisions.

7. Planning Inventory and Inventory Management Practices

Key parameters and procedures, namely, when to order, how much to order, and inventory control,
guide inventory planning. The when to order is determined by the demand and performance average
and variation. The how much to order is determined by the order quantity. Inventory control
determines the process for monitoring inventory status.

7.1 Determining When to Order?

As discussed earlier, the reorder point defines when a replenishment shipment should be initiated. A
reorder point can be specified in terms of units or days' supply. This discussion focuses on determining
reorder points under conditions of demand and performance cycle certainty.

The basic reorder point formula is:

R=D x T,

where
R = Reorder point in units;
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D = Average daily demand in units; and
T = Average performance cycle length in days.

To illustrate this calculation, assume demand of 20 units/day and a 10-day performance cycle. In this
case,

R =DxT
= 20 units/day x 10 days = 200 units.

An alternative form is to define reorder point in terms of days of supply. For the above example, the
days of supply reorder point is 10 days.

The use of reorder point formulations implies that the replenishment shipment will arrive as
scheduled. When uncertainty exists in either demand or performance cycle length, safety stock is
required. When safety stock is necessary to accommodate uncertainty, the reorder point formula is:

R = D x T + SS,

where
R = Reorder point in units;
D = Average daily demand in units;
T = Average performance cycle length in days; and
SS = Safety stock in units.

7.2 Determining How Much to Order

Lot sizing balances inventory carrying cost with the cost of ordering. The key to understanding the
relationship is to remember that average inventory is equal to one-half the order quantity. Therefore,
the greater the order quantity, the larger the average inventory and, consequently, the greater the
annual carrying cost. However, the larger the order quantity, the fewer orders required per planning
period and, consequently, the lower the total ordering cost. Lot quantity formulations identify the
precise quantities at which the annual combined total inventory carrying and ordering cost is lowest
for a given sales volume. Figure 3-6 illustrates the basic relationships. The point at which the sum of
ordering and carrying cost is minimized represents the lowest total cost. Simply stated, the objectives
are to identify the ordering quantity that minimizes the total inventory carrying and ordering cost.

8. Economic Order Quantity

The EOQ is the replenishment practice that minimizes the combined inventory carrying and ordering
cost. Identification of such a quantity assumes that demand and costs are relatively stable throughout
the year. Since EOQ is calculated on an individual product basis, the basic formulation does not
consider the impact of joint ordering of products.

The most efficient method for calculating EOQ is mathematical. Earlier in this chapter a policy dilemma
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regarding whether to order 100, 200, or 600 units was discussed. The answer can be found by
calculating the applicable EOQ for the situation.

Figure 3-6: Economic Order Quantity

Factors for Determining EOQ

Annual demand volume 2400 units

Unit value at cost $5.00

Inventory carrying cost percent 20% annually
Ordering cost $19.00 per order

To make the appropriate calculations, the standard formulation for EOQ is:

EOQ = 2CoD
CiU

where
EOQ = Economic order quantity;
Co = Cost per order;
Ci = Annual inventory carrying cost;
D = Annual sales volume, units; and
U = Cost per unit.

EOQ = 2 x 19 x 2400
0.20 x 5.00

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 = 91,200

= 302 (round to 300)

Total ordering cost would amount to $152 (2400/300 x $19.00), and inventory carrying cost to $150
[300/2 x (5 x .20)]. Thus, after rounding to allow ordering in multiples of 100 units, annual reordering
and inventory carrying cost have been equated.

To benefit from the most economical purchase arrangement, orders should be placed in the quantity
of 300 units rather than 100, 200, or 600. Thus, over the year, eight orders would be placed and
average base inventory would be 150 units. Referring back to Figure 10-5, the impact of ordering in
quantities of 300 rather than 200 can be observed. An EOQ of 300 implies that additional inventory in
the form of base stock has been introduced into the system. Average inventory has been increased
from 100 to ISO units on hand.

While the EOQ model determines the optimal replenishment quantity, it does require some rather
stringent assumptions. The major assumptions of the simple EOQ model are:

 All demand is satisfied

 Rate of demand is continuous, constant, and known

 Replenishment performance cycle time is constant and known

 There is a constant price of product that is independent of order quantity or time

 There is an infinite planning horizon

 There is no interaction between multiple items of inventory

 No inventory is in transit

 No limit is placed on capital availability.

The constraints imposed by some of these assumptions can be overcome through computational
extensions; however, the EOQ concept illustrates the importance of the trade-offs associated with
inventory carrying and replenishment ordering cost.

Relationships involving the inventory performance cycle, inventory cost, and economic order
formulations are useful for guiding inventory planning. First, the EOQ is found at the point where
annualized order cost and inventory carrying cost are equal. Second, average base inventory equals
one-half order quantity. Third, the value of the inventory unit, all other things being equal, will have a

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direct relationship with replenishment order frequency. In effect, the higher the product value, the
more frequently it will be ordered.

9. Safety Stock

9.1 Role of Safety Stock

No matter how hard a firm tries to meet customers’ requirements in terms of quantity and delivery,
there are forces at work which will result in the firm falling short. Besides customers’ demands, other
forces at play include shipping delay, quality issues, discrepancies at inbound area, pilferage amongst
others. While excess stocks is a major concern, here, we will focus on the shortages, i.e. when demand
exceeds quantity on hand.
100%

Target Service
Level

Current target Goal target

No of demands
which can be
satisfied out of
total demands
for the same
period

0%
Demand per period 100%

Figure 3-7: Service Level

Safety stocks can be referred to stocks that would be used if there is an unusual peak demand. This
definition implies that during normal demand, safety stocks will be dormant, waiting to be used when
demand surges. Implicit in this definition is that this will be a permanent layer of stocks, adding to the
increased inventory costs.

In Figure 3-7, customer service is defined as number of orders which can be satisfied out of the total
demands for a specified period. A large increase in meeting demands will result in a small increment
in service level. Supply chain managers often have to weigh the balance of increasing service level
versus the increase in inventory level. In spite of such attempts, shortages are not uncommon.

There are two types of shortages:

 Out-of-stock Situation

This is planned. An example is when there is no demand, the stock is set to zero; or, a the stock may
be zero until a customer demands it.

 Stock-out Situation

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This is unplanned and any zero stock is undesirable. This condition can heightened customer
dissatisfaction.

In order to minimize stock-outs, organizations do consider safety stocks as an option. The choice of
safety stocks will depend on:

 Company’s customer service philosophy

 Customer service level eg no of stock-outs per period

 Stock investment

 Cost of stock-out versus cost of non-stock-out.

Shortages in organizations are emotional issues. As every shortage is monitored, therefore if supply
chain managers do not differentiate the types of inventory which created the shortages, the blame
game can be pretty nasty. In supply chains, it is more cost effective if Class C parts are bought in bulk
to offset shortage costs, leaving the organization to focus on Class A and B items.

9.2 Safety Stock Techniques

There are generally three methods of computing safety stocks:

 Statistical Method

The level is computed using statistics, based on the historical demand. It uses deviation of forecast
and actual demand.

Safety stock = Z + σ * √LT

Where Z = service level, σ = standard deviation, LT = lead-time

 Fixed Method

The level is fixed, ignoring the usage rate.

 Time Method

The level is determined by looking at the future demand of items.

9.3 Safety Stocks & PLC

For industrial products, the PLS is relatively long and therefore, safety stocks are less of an issue than
FMCG or electronic product with shorter PLC. How should supply chain managers handle this?

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 Further reduce
SS to lower
obsolescence
risk
Carry SS to
minimize
stock-out

Carry sufficient SS
- Support production
- EC

Volume
Reduce SS
- CS level
- LT
- Product mix

Introduction Growth Maturity Decline

Time

Figure 3-8: Managing SS During PLC

10. Product Classification

Inventory control is the managerial procedure for implementing an inventory policy. The
accountability aspect of control measures units on hand at a specific location and tracks additions and
deletions. Accountability and tracking can be performed on a manual or computerized basis.

An integrated inventory management strategy defines the policies and process used to determine
where to place inventory, when to initiate replenishment shipments, and how much to allocate. The
strategy development process employs three steps to classify products and markets, define segment
strategies, and operationalize policies and parameters.

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 Annual Percent
Product Sales Total Accumulated Classification
Identification (in 000s) Sales Sales (%) Products (%) Category
1 45,000 30.0 30.0 5 A
2 35,000 23.3 53.3 10 A
3 25,000 16.7 70.0 15 A
4 15,000 10.0 80.0 20 A
5 8,000 5.3 85.3 25 B
6 5,000 3.3 88.6 30 B
7 4,000 2.7 91.3 35 B
8 3,000 2.0 93.3 40 B
9 2,000 1.3 94.6 45 B
10 1,000 0.7 95.3 50 B
11 1,000 0.7 96.0 55 C
12 1,000 0.7 96.7 60 C
13 1,000 0.7 97.4 65 C
14 750 0.5 97.9 70 C
15 750 0.5 98.4 75 C
16 750 0.5 98.9 80 C
17 500 0.3 99.2 85 C
18 500 0.3 99.5 90 C
19 500 0.3 99.8 95 C
20 250 0.2 100.0 100 C
$150,000

Table 3-3: Product Classification (Sales) – ABC Classification

The objective of product/market classification is to focus and refine inventory management efforts.
Product/market classification, which is also called fine-line or ABC classification, groups products,
markets, or customers with similar characteristics to facilitate inventory management. The
classification process recognizes that not all products and markets have the same characteristics or
degree of importance. Sound inventory management requires that classification be consistent with
enterprise strategy and service objectives.

Classification can be based on a variety of measures. The most common are sales, profit contribution,
inventory value, usage rate, and nature of the item. The typical classification process sequences
products or markets so that entries with similar characteristics are grouped together. Table 3-3
illustrates product classification using sales. The products are classified in descending order by sales
volume so that the high-volume products are listed first, followed by slower movers. Classification by
sales volume is one of the oldest methods used to establish selective policies or strategies. For most
marketing or logistics applications, a small percentage of the entities account for a large percentage
of the volume. This operationalization is often called the 80/20 rule or Pareto's law. The 80/20 rule,
which is based on widespread observations, states that for a typical enterprise 80 percent of the sales
volume is typically accounted for by 20 percent of the products. A corollary to the rule is that 80
percent of enterprise sales are accounted for by 20 percent of the customers. The reverse perspective
of the rule would state that the remaining 20 percent of sales are obtained from 80 percent of the
products, customers, etc. In general terms, the 80/20 rule implies that a majority of sales results from
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a relatively few products or customers.

Once items are classified or grouped, it is common to label each category with a character or
description. High-volume, fast-moving products are often described as "A" items. The moderate
volume items are termed the "B" items, and the low-volume or slow movers are known as "Cs." These
character labels indicate why this process is often termed ABC analysis. While fine-line classification
often uses three categories, some firms use four or five categories to further refine classifications.
Grouping of similar products facilitates management efforts to establish focused inventory strategies
for specific product segments. For example, high-volume or fast-moving products are typically
targeted for higher service levels. This often requires that fast-moving items have relatively more
safety stock. Conversely, to reduce overall inventory levels, slower-moving items may be allowed
relatively less safety stock, resulting in lower service levels.

In special situations, classification systems may be based on multiple factors. For example, item gross
margin and importance to customers can be weighted to develop a combined index instead of simply
using sales volume. The weighted rank would then group items that have similar profitability and
importance characteristics. The inventory policy, including safety stock levels, is then established using
the weighted rank.

11. Lead-time Issues of Inventory

Superior cost, quality, delivery, and technological performance do not guarantee success for a supply
chain. Organizations must also be able to compete on the basis of time. This does not mean that cost,
quality, delivery, and technology considerations are no longer important; they are critically important.
However, individual organizations and supply chains must be competitive in these areas and be able
to get their products and services to their customers faster than the competition.

Increasingly, organizations are realizing that they are competing on the basis of time. In fact, reducing
the time required to provide the end customer with products or services is one of the major forces
leading organizations to participate in supply chain management initiatives. Adopting an integrated
supply chain management approach provides the means to make significant reductions in the cycle
time required to move materials among supply chain members and to the end customer. Several
authors have shown time to be a highly effective area in which to focus overall improvement efforts
within an organization. The opportunity for improvement appears to be even greater in an inter-
organizational supply chain environment. This time-sensitive environment presents new challenges
and opportunities for the individual organizations and their supply chains. This section introduces the
concept of cycle time, presents common causes of "long" cycle times, discusses an approach for
making cycle time improvements, and presents several critical success factors that should be
considered as part of the cycle time reduction initiatives.

11.1 Cycle Time Overview

Cycle time is the total elapsed time required to complete a business process. All too often only a small
percentage (e.g., three to five percent) of the total elapsed time required to complete a process has
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anything to do with "real work.” The rest of the time is typically devoted to a wide range of counterpro-
ductive, time-consuming activities and events. IdentifYing, improving, and/or eliminating these time-
consuming activities represent one of the major SCM opportunity areas. However, cycle time
reduction is not just about completing a process quickly (ie., speed for the sake of speed); it is
concerned with completing the given process effectively. By focusing on key processes, supply chain
member organizations can significantly improve cycle time performance, improvements that can
provide a source of competitive advantage for the supply chain.

11.2 Causes of Long Cycle Times

A number of causes of long process cycle times can be found in a supply chain environment. In
examining supply chain processes, typically one or more of the following causes will be present. 12
Several common causes of long process cycle times and key issues that should be addressed when
these situations are encountered include, but are not limited to, the following:

 Waiting

In many multi-step processes, significantly more time is devoted to waiting between processed steps
than is spent in all of the processing steps combined! Where are the longest waits occurring in the
process? What are the causes of these delays? What actions can be taken to reduce or eliminate the
time spent waiting? Does the organization or supply chain need additional capacity in terms of
facilities, equipment, or personnel?

 Non-Value-Added Activities

The key processes found in many supply chains have existed for many years. When examining supply
chain processes, it is worthwhile to determine the value that is being added by the overall process and
individual process activities. It is not uncommon to find processes or activities within a process that
were essential at one time, but that now add little or no value. Is this process necessary? Do all
activities in the process add value? Activities that do not add value should be eliminated. If the process
activity is adding value, is it being conducted in the best possible way given current practices and
available technologies? For example, does the organization conduct quality inspections of purchased
materials upon receipt, or does it utilize high-performing suppliers that certify that the materials they
ship meet all specifications?

 Serial versus Parallel Operations

Many supply chain process activities are conducted serially (i.e., first complete activity 1, then
complete activity 2, and so on through activity N). Are there opportunities in the process for activities
to take place in a parallel (ie., simultaneous) manner as opposed to the currently used serial or
sequential fashion? For example, within a manufacturing organization in the supply chain, are new
products and the processes that will be used to manufacture these products developed concurrently,
or is the product designed and then thrown "over the wall" to the manufacturing group? Are the
manufacturing organization's key supplier and customer partners in the supply chain involved early in
the new-product development process?
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 Repeating Process Activities

A significant cause of poor supply chain cycle time performance is having to repeat process steps due
to product or service quality problems. There are few situations that can increase product cycle times
(in terms of both average cycle times and variability) more than this condition. Are parts of the process
repeated owing to an inability to get it right the first time? What are the causes of these problems?
What actions are necessary to resolve these problems?

 Batching

Batching occurs when some quantity of materials or orders is accumulated at one step in the process
or organization in the supply chain before it is released to the next process step or supply chain
member organization. What is the rationale for batching? Make certain that the rationale is economic
rather than "that's how we have always done it." For example, a firm might wish to take advantage of
lower transportation rates by batching orders to create larger shipment quantities. In such
circumstances, however, the firm should periodically revisit the economics of the situation to ensure
that the savings associated with the batch approach are worth the additional time required.

 Excessive Controls

How much time is spent and potentially wasted following the rules and regulations governing
processes within and among supply chain member organizations? A common internal example of this
situation is seen in purchase order (PO) processing. How many signatures are needed for a PO? How
many of these signatures are merely being "rubber stamped"? We do not mean to imply that all
controls should be abandoned. However, organizations would be well served to periodically review
the controls it uses to govern both internal and external supply chain processes, and determine if the
level of control provided is worth the associated cost. A periodic cost/benefit analysis for
intraorganizational and interorganizational controls as they apply to the supply chain is likely to be
time well spent. Many organizations discover that their rules and regulations serve only to increase
their response time to internal and external customers, and that many of these control mechanisms
are more of a burden than a benefit.

 Lack of Synchronization in Materials Movement

Are materials being moved across the supply chain in the most effective manner? Are product
movements across the supply chain managed so as to ensure that the right quantity of the right
product is getting to the right location at the right time? Or are materials arriving at the customer's
location too early, causing additional storage and materials handling activities, or too late, disrupting
the customer's operations and in so doing damaging the supplier's reputation?

 Ambiguous Goals and Objectives

Do all supply chain member organizations clearly understand the overall supply chain goals and
objectives? Do all supply chain members understand what their organization must contribute for the

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overall supply chain to be successful?

 Poorly Designed Procedures and Forms

Do the procedures and forms associated with a specific process lead to the efficient completion of the
process? Or do they significantly increase the time required to complete the process by creating more
work while adding little value?

 Outdated Technology

Are the supply chain member organizations making the best use of available technology? How is key
information communicated across the supply chain? For example, are purchase orders transmitted
from the buying organization to the supplying organization by fax, EDI, the Internet, or are they
mailed? Are warehousing operations within the supply chain utilizing a high level of automation or are
they primarily manual operations?

 Lack of Information

The cycle time for supply chain decision making is often lengthy owing to the time needed to gain
access to the information required to make decisions. It should be recognized that the required
information may originate within the decision-maker's organization or in one or more of the other
supply chain member organizations. Do decision makers have the information they need, when they
need it, and in the desired format? How much time is being spent identifying, collecting, and
manipulating the information required to make a decision versus making the actual decision?

 Poor Communication

Intra-organizational and inter-organizational communication are critical to overall supply chain

performance. Have the necessary lines of communication been established across the supply chain
member organizations? Do managers within supply chain organizations know whom to contact in
other functional areas within their own organization, as well as in the other supply chain organizations,
if there are problems? A list of key contacts in different organizations across the chain is a very simple
but valuable problem-solving resource.

 Limited Coordination

Coordinating supply chain processes is another important factor in determining supply chain
performance. Do all parties involved in a given process have a clear understanding of their respective
roles and associated responsibilities? Are the inter-organizational processes effectively coordinated?
Are there formal rules of engagement to ensure that the desired level of coordination is maintained?

 Limited Cooperation

Are all supply chain member organizations truly committed to the supply chain management
initiative? If not, it is time to reevaluate the membership of those organizations that lack the required

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level of commitment. Cycle time and overall supply chain performance hinges on the cooperative
efforts of the member organizations. Do all organizations have the appropriate cooperative
philosophy?

 Lack of/Ineffective Training

Proper training reduces the time for people to become proficient in their jobs and also can lead to
ongoing improvements. Have all people involved in supply chain processes and activities received
adequate training for their specific jobs? Are there ongoing training opportunities for employees that
focus on supply chain performance improvement in general and cycle time reduction in specific?

Lead-time issues can lead to problems in supply chains. One of these effects is the bull whip effect.

11.3 Case Studies – Lead-time

Many companies have spent enormous amounts of money to decrease the lead times within their
organizations, only to discover that their customers never saw much benefit because of long shipping
times. These same companies are now concentrating intensively on the logistics systems that link
them to their customers. Since logistics systems often interface directly with the customer, they can
have considerable impact on overall customer satisfaction.

Consider the experience of Ford Motor Company, which had to radically re-engineer their entire
system of delivering vehicles to dealerships. Why was this necessary? Quite simply, customer
expectations exceeded the performance of Ford's old logistics system. Ford dealers would often
complain that consumers were "spoiled" by their experience with package delivery companies such
as Federal Express, which allowed them to track packages. Dealers, however, couldn't tell customers
when a vehicle would arrive at a dealership! Until recently, once a vehicle left Ford's factory, a dealer
didn't know where it was until it arrived at the lot. Many consumers, unwilling to wait to find out
whether the car they wanted was on its way, simply went elsewhere for a car.'6 In February 2000,
however, Ford struck a deal with UPS. Under the agreement, UPS uses its advanced logistics
capabilities to track Ford's vehicle shipments, so that dealers can find the exact location of a particular
vehicle by logging onto the UPS website. The system is a major improvement in the way Ford does
business.

In studying the existing supply chain processes and attempting to reduce cycle time, organizations
(such as Ford) may realize that the entire logistics system has major flaws. In such cases, the entire
supply chain may need to be re-designed or "re-engineered”.

Changes in government regulations and policies also may create the need for changes in supply chain
strategy. In Europe, for example, the deregulation of European Community (EC) economic, financial,
and operational barriers have meant that companies have to rethink their logistics strategies. The
single market environment allows greater flexibility in supplier sourcing and customer deliveries.
Many companies are re-engineering and rationalizing their logistical networks to take advantage of
the reduction in, or elimination of, numerous artificial barriers that previously affected logistics
decisions.

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In addition to regulations, organizations must recognize the cultural differences found in many
countries where they do business. One group of logistics researchers notes that. "Seemingly small
cultural differences among Asian countries are only an indication of the complexity of the task of
managing logistics within the region." Performance standards may vary from region to region or by
organization. Therefore, global supply chains require a detailed understanding of a foreign supply
chain partners' capabilities as well as regional performance standards and regional infrastructure.
Managers attempting to create global supply chains must be sensitive to specific local conditions and
modify their strategies accordingly.

As organizations embark on various initiatives to manage supply chains, they need to recognize that
these efforts provide an opportunity to do much more than merely align their current logistical
processes with those of their supply chain partners. SCM provides a platform to make significant
improvements in logistical performance across the supply chain. These improvements may be the
result of changes in roles of the supply chain member organizations. Organizations that ignore this re-
engineering opportunity will likely make only incremental improvements.

There is urgent need for logistics to re-engineer such that "new approaches to business partnerships,
dramatic innovations in technology, and reinvented supply chain strategies all result in new logistical
expectations, none of which are attainable through mild-mannered, incremental tweaks to an existing
process." Whirlpool and Hewlett-Packard are among those companies that have successfully re-
engineered their logistics functions. At Whirlpool the re-engineering process relies on computer
systems and third-party partners that enable the company to fill orders within 24 hours. The Hewlett-
Packard re-engineering process takes the form of an improved delivery strategy, which was
formulated and prototyped to meet the needs of the company.

The Council of Logistics Management suggests that companies consider the following issues when
working to improve their supply chains:

 Help customers become more knowledgeable about logistics.

 Eliminate any logistics activities that do not add customer value.

 Remove the barriers among the members of the supply chain to improve customer focus, make
better and faster decisions, improve supply chain efficiency, and achieve sustainability.

 Manage partnerships with third parties.

Organizations are recognizing that their current logistical processes and practices may not be the best
approach within the context of an interorganizational supply chain. Although organizations recognize
the danger of functional or departmental sub-optimization within the context of a single organization,
this logic must now be applied to the supply chain to avoid "sub-optimizing" performance at the
organizational level. This means that the level of analysis for the re-engineering effort is the entire
supply chain, and it is this larger system that the member organizations must attempt to optimize.

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Although internal corporate process improvements can lead to significant performance gains,
managers and academicians alike have realized that reengineering must extend beyond the
organization to include other members of the supply chain. This outward-focused approach to re-
engineering not only aligns corporate actions with the customer's desire for on-time provision of
goods and services, but in most cases can also significantly improve profitability. One study, for
example, found that supply chain re-engineering can boost profits by 150 percent to 250 percent and
can reduce order cycle time by up to 70 percent.29 Supply chain process improvements also may
significantly reduce the cost of doing business for supply chain members, particularly in the areas of
administration, inventory control, warehouse management, and transportation. Grocery industry
managers, for example, believed they could cut $30 billion – 10 percent of total operating budgets –
via supply chain re-engineering.

Firms such as Dow Chemical, SC Johnson Wax, National Semiconductor, Merle Norman, Levi Strauss,
and Xerox are but a few of the growing list of organizations to reap the vast benefits of total supply
chain re-engineering. The main obstacles keeping others from realizing similar benefits are top
management's limited understanding of the process, a general resistance to change, the persistence
of rigid department-based organizational structures, and lack of a customer perspective.

The cost of not re-engineering can be high. For example, Compaq Computer estimated that it lost
between $500 million and $1 billion in sales in the first 10 months of 1994 because its products were
not available when and where customers wanted them.

12. Bullwhip Effect

One of the main challenges in supply chains is dealing with variability, which seems to occur if one
does not monitor and control it. It is a known fact that for all metrics, they vary around an average
value. If the variations swing wildly, then supply chain managers need to manage these and minimize
them as the greater the variability the more difficult and expensive is to run the chain.

Supply chains are vulnerable to variabilities because of the sequence and interdependence of activities
across the entire supply chains. A delay, no matter how small, will cascade down the chain and creating
havoc in inbound, storage, production and finally shipment and delivery.

So far, we have covered inventory which is used to cope with variability. Inventory acts as buffer, line
balancer and protection against supply variability. Even with inventory, variability is manifested in
many forms. These include but not limited to the following.

 Quality issues

 Delivery issues

 Forecasting issues

 Demand issues

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The flow of inventory is often down the chain, from suppliers to end users. Supply variability is this
case is amplified down the chain. Demand variability can also be amplified up the chain.

Demand variability increases as one moves up the supply chain away from the retail customer. This
observation holds across most industries. The result is increased cost and poorer service. Sources of
variability can be demand variability, quality problems, strikes, plant shutdowns and many others.
Variability with time delays in the transmission of information up the chain and time delays in the
manufacturing and shipment down the chain create the bullwhip effect.

Supplier Supplier Manufacturer Wholesaler Distributor Retailer

Demand for raw Demand for

materials finished goods

Figure 3-7: Bullwhip Effect

Figure 3-7 demonstrates that a small variation in demand at the retailer causes this variation to be
amplified up the supply chain. A small change in finished goods is experienced quite differently at the
supplier’s end. There is a big swing for raw materials.

Some of the causes of bullwhip effect are:

 Overreaction to backlogs

 Neglecting to order in an attempt to reduce inventory

 No communication up and down the supply chain

 No co-ordination up and down the supply chain

 Delay in information and material flows

 Order batching

 Shortage gaming

 Demand forecast (adding another layer of buffer to the demand estimates)

Some of the strategies to minimize the bullwhip effect are:

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 Order Batching

Using EDI to capture real demand. Random peak demand is countered by more frequent small orders.
And smaller orders have smaller variance. When a downstream entity orders more often, it will not
see a reduction in its own demand variance. This is not critical. What is more critical is that the
upstream entity sees a reduction in demand variance.

 Demand Signalling
Lack of demand visibility can be addressed by either EDI or ePOS. Another method is the use of VMI.
There is only one point of control of inventory demand and hence demand variability can be
minimized.

 Shortage Gaming

Unrestricted ordering is not allowed. Entities can reserve a fixed quantity per year and then specify
ordering quantities per order, as long as the total quantity at the end of the year is equal to the
reserved quantity. For this system to work, information must be shared with all upstream partners in
the supply chain.

 Delivery Synchronization

There ought to be agreement at the start of the lead-time and quantity.

 Fluctuating Prices

Often, when there is speculation, material prices will swing upwards. Contracts need to be negotiated
upfront in order to stabilize the supply chains without the purchasing department constantly haggling
prices. The end result could see a speculative build-up of inventory in the supply chain. Speculations
have the characteristics of feeding itself. Retailers in attempts to secure inventory will increase
demand further fueling the virtual accumulation of inventory.

13. Conclusion
The flow of inventory in supply chains is critical to the efficiency of supply chains. While inventory is
an important component, it carries risks in terms of costs. Costs is revealed in many forms such as
capital costs, carrying costs, obsolescence costs, transportation costs, delayed costs and shortage
costs. On one hand, inventory is kept as supply is subject to variability and demand can be erratic. The
challenge is therefore to maintain a balance between supply and demand. Keeping too much stocks
while is comforting decreases the efficiency of supply chains. Having a low inventory can be
devastating to customer service level. Firms attempt to address the bullwhip effect by different
strategies via EDI, JIT delivery and others including safety stocks. However, safety stocks are not a
perfect answer either. While it provides protection when there is peak demand, they are a permanent
feature if supply chain managers do not take steps to monitor and control them.

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