LECTURE 7

Managing
Inventory in the
Supply Chain
Major Types of
Inventory and
Reasons for Carrying
Them
Types of Inventory and Rationales
1 Procurement (purchase
6 Cycle
discounts), production (long
production run), and
Anticipato stocks transportation (freight rate
ry stocks (Batching 1 2 discounts)
Demand- and supply-side
(Risk economie uncertainties
5 hedging) s)
Inventory costs associated with
Seasonal Safety
3 goods in motion during
stocks stocks transportation time period.
(Seasonali (Uncertaint
ty)
Work-in- Time/In-
y)
2 4 Inventory costs associated with
goods in process during
Process Transit
4 stocks (Mode
manufacture or assembly of a
complex product.
(schedulin choices) 5 Seasonality in raw materials
g&
production
3 supply (e.g. production,
transportation), in demand for
techniques finished product, or in both
) 6 Inventory hold in anticipation
that an unusual event (e.g.
strikes, significant price increase,
extreme weather)

3
 Batching economies (1)
 In the procurement area, it is not unusual for a
seller to have a schedule of prices that reflects
the quantity purchased
 In other words, larger purchased volumes result in
lower prices per unit and vice versa
 Purchase discounts are also prevalent for personal
consump- tion items: for example, buying a
package of 12 rolls of paper towels at Migros
would result in a lower price per roll than if the 12
rolls were bought separately
 When the larger package is purchased, cycle
stock is created - what is not consumed
immediately will have to be stored.
4
 Batching economies (2)
 A related discount situation occurs with
transportation services
 Transportation firms usually offer rate or price
discounts for shipping larger quantities
 In the motor carrier industry, a common example is
the lower rate or price per kg for shipping truckload
quantities versus less-than-truckload quantities
 The motor carrier saves money in pick-up, handling,
and delivery costs with the truckload shipment, and
these are reflected in a lower rate or price to the
shipper - the larger shipment quantities to justify
the discount have the same effect as the purchase
quantities—that is, cycle stocks.

5
 Batching economies (3)
 The third batching economy is associated with
production
 Many organizations feel that their production costs
per unit are substantially lower when they have long
production runs of the same product
 Long production runs decrease the number of
changeovers to a production line but increase the
amount of cycle stock that must be stored until sold
 Traditionally, organizations rationalized long
productions runs to lower unit costs without really
evaluating the resulting inventory carrying costs,
which can be high for finished goods
 There is also a related concern about obsolescence
of finished goods when high inventories are kept
6
 Safety stocks (1)
 All organizations are faced with uncertainty
 On the demand or customer side, there is
usually uncertainty in how much customers will
buy and when they will buy it
 Forecasting demand is a common approach to
resolving demand uncertainty, but it is never
completely accurate
 On the supply side, there might be uncertainty
about obtaining what is needed from suppliers
and how long it will take for the fulfillment of the
order
 Uncertainty can also arise from transportation
providers in terms of receiving reliable delivery
7
 Safety stocks (2)
 The net result of uncertainty is usually the
same: organizations accumulate safety stock to
buffer themselves against stockouts
 The challenge and analysis are different for
safety stock than for cycle stock; safety stock is
much more complex and challenging to manage
because it is redundant inventory
 Organizations today are taking a more
proactive approach to reducing uncertainty by
using the power of information to help reduce
the need for safety stocks (e.g. Walmart)

8
Time-in-transit and Work-in-process stocks
 The time associated with transportation (e.g., supplier
to manufacturing plant) and with the manufacture or
assembly of a complex product (e.g., automobile)
means that even while goods are in motion, an
inventory cost is associated with the time period
 The longer the time period, the higher the cost
 The time period for in-transit inventory and work-in-
process (WIP) inventory should be evaluated in terms
of the appropriate tradeoffs
 The various transportation modes available for
shipping freight have different transit time lengths,
transit time variability, and damage rates -the rates or
prices charged by carriers in the different modes
reflect these differences in service
9
Time-in-transit and Work-in-process stocks (cont.)

 Finally, WIP inventories are associated with

manufacturing
 Significant amounts of inventory can be accumulated in
manufacturing facilities, particularly in assembly
operations such as automobiles and computers
 The length of time WIP inventory sits in a manufacturing
facility waiting to be included in a particular product
should be carefully evaluated in relationship to
scheduling techniques and the actual manufacturing
or assembly technology
 Similar to the transportation example earlier, if an
investment in technology reduces the amount of time WIP
sits in the facility, a cost reduction could accrue to the
manufacturer
 As always, a tradeoff analysis of the costs needs to be 10
 Seasonal Stocks (1)
• Seasonality can occur in the supply of raw materials,
in the demand for finished product, or in both
• Organizations that are faced with seasonality issues
are constantly challenged when determining how much
inventory to accumulate
• Organizations that process agriculture products
are a good example of supply seasonality - while
the supply of the raw material is available during
only one part of the year, demand is stable
throughout the year
• Therefore, the finished product usually has to be
stored until it is sold - that is, when the raw
material is available, it needs to be converted to
finished product
• This scenario often involves high storage costs
11
 Seasonal Stocks (2)
 Sometimes seasonality can affect transportation,
particularly if domestic water transportation is used
 Rivers and lakes can freeze during the winter, which
might interrupt the shipment of basic raw materials and
cause organizations to accumulate raw materials before
the freeze to avoid interruption
 Another example would be the seasonality of the
construction industry in the United States and its impact
on the availability of flatbed tractor trailers
 Although construction takes place in many areas of the United
States year round, the northern states experience a slowdown in
construction activity during the winter months
 As spring approaches in the north, construction activity
increases dramatically. The peak springtime construction season
places a heavy demand on a fixed capacity of flatbed trailers to
move construction supplies
12
 Anticipatory Stocks
 A fifth reason to hold inventory arises when an
organization anticipates that an unusual event
might occur that will negatively impact its
source of supply
 Examples of these events would include strikes,
significant raw materials or finished goods price
increase, a major shortage of supply because of
political unrest or weather, and so on
 In such situations, organizations might accumulate
inventory to hedge against the risk associated with
the unusual event
 Again, an analysis should be undertaken to assess
the risk, probability, and cost of inventory
13
The Importance of Inventory in Other
Functional Areas
Objectives of the finance area might obviously conflict with
marketing and manufacturing objectives. A more subtle
conflict sometimes arises between marketing and
manufacturing as the long production runs can cause
shortages of some products needed by marketing.

Marketing Manufacturing Finance

In favor of holding In favor of long In favor of low
sufficient, or extra, production runs of a inventories to
inventory to ensure single product with increase inventory
product availability to minimal changeovers to turns, reduce
meet customer needs and lower labor and machine liabilities and assets,
new product offerings for costs per unit, resulting in and increase cash
continued market high inventory levels of flow to the
growth. the product. organization.

14
Inventory Costs
Overview

 Inventory costs are important for three

reasons
 First, inventory costs represent a significant
component of logistics costs in many
organizations
 Second, the inventory levels that an
organization maintains at nodes in its logistics
network will affect the level of service the
organization can offer its customers
 Third, cost tradeoff decisions in logistics
frequently depend on and ultimately impact
inventory carrying costs.
16
 Inventory Costs
Major Types of Costs
Emphasize of inventory cost analysis should be
placed on the variable components of these
costs. Ordering and Setup
Inventory Carrying Cost
Inventory carrying costs incurred Cost
by inventory at rest and waiting to Ordering cost refers to expense
be used. Four major components: of placing an order, excluding the
Capital cost, Storage space cost, cost of the product itself. Setup
Inventory service cost, and cost refers to the expense of
Inventory risk cost. changing/modifying a
Invento production/assembly process to
facilitate
In-transitline changeovers.
Inventory
ry Costs
Expected Stockout Cost
Carrying Cost
The cost associated with not Generally, carrying inventory in
having a product/materials transit costs less than in
available to meet warehouses. But, in-transit
customer/production demand. inventory carrying cost becomes
Most organizations hold safety especially important on global
stock or buffer stock, to minimize moves since both distance & time
the possibility of a stockout and increase.
costs of lost sales.
17
Inventory Carrying (Holding) Costs
 Inventory carrying costs are those that are incurred
by inventory at rest and waiting to be used
 From a finished goods inventory perspective, inventory
carrying costs represent those costs associated with
manufacturing and moving inventory from a plant to a
distribution center to await an order
 There are four major components of inventory carrying
cost:
 capital cost
 storage space cost
 inventory service cost
 inventory risk cost

18
Capital Cost

 Sometimes called the interest or opportunity

cost, this cost type focuses on the cost of capital
tied up in inventory and the resulting lost
opportunity from investing that capital elsewhere
 For example, all organizations borrow money from
external sources to fund operations
 This money might be in the form of equity (from stock
issues) or debt (borrowing from banks)
 In either case, borrowed money has a cost associated
with it For equity, it is dividends; for debt, it is interest
payments
 In either case, an organization incurs a cost for
borrowing money.
19
Capital Cost (cont.)

 If an organization decides to use this money to

buy raw materials, build manufacturing plants,
and hire labor to produce finished products for
storage, then this inventory carries this
“borrowed money” cost while sitting waiting to
be sold
 As such, capital tied up in inventory still
requires dividend or interest payments to the
funding source
 The opportunity cost of this inventory is the
return on capital the organization might
have realized if it had invested in another
opportunity rather than in raw materials,
20
Capital Cost (cont.)

 The capital cost is frequently the largest

component of inventory carrying cost
 An organization usually expresses it as a
percentage of the dollar value of the
inventory held in a particular time
period
 For example, a capital cost expressed as 20
percent of a product’s value of $100 equals a
capital cost of $20 ($100 × 20%) per year

21
Storage Space Cost

 Storage space cost includes handling

costs associated with moving products into
and out of inventory as well as storage costs
such as rent, heating, and lighting
 Such costs might vary considerably from
one circumstance to the next
 For example, organizations often unload raw
materials from rail cars and store them
outside, whereas finished goods typically
require covered and more sophisticated
storage facilities

22
Storage Space Cost (cont.)

 Storage space costs are relevant to the extent that they

either increase or decrease as inventory levels rise or fall
 Thus, organizations should include variable, rather than
fixed, expenses when estimating storge space costs
 This can be illustrated by contrasting the use of public
warehousing versus private warehousing
 When an organization uses public warehousing, almost all
handling and storage costs vary directly with the level of
stored inventory.
 As a result, these variable costs are relevant to decisions
regarding inventory
 When an organization uses private warehousing,
however, many storage space costs (such as depreciation
on the building) are fixed and are not relevant to
inventory carrying costs
23
Inventory Service Cost
 Another component of inventory carrying cost
includes insurance and taxes
 Depending on the product value and type, the
risk of loss or damage might require high
insurance premiums
 Also, some jurisdictions impose a tax on
inventory value, sometimes on a monthly basis
 High inventory levels resulting in high tax costs can
be significant in determining specific locations where
organizations store products
 Insurance and taxes might vary considerably
from product to product, and organizations
must consider this when calculating inventory
carrying costs. 24
Inventory Risk Cost

 The final major component of inventory carrying

cost reflects the very real possibility that
inventory value might decline for reasons
beyond an organization’s control
 For example, goods held in storage for long periods
of time might become obsolete and thus decrease in
value
 This situation is commonly found in the computer and
electronics industries.
 Also, fashion apparel might rapidly deteriorate in
value once the selling season is over
 This situation also occurs with fresh fruits and
vegetables when quality deteriorates or the price falls
over time
25
Inventory Risk Cost (cont.)

 Any calculation of inventory risk costs should

include the costs associated with
obsolescence, damage, pilferage, and other
risks to stored products
 The extent to which inventoried items are
subject to such risks will affect the inventory
value and thus the carrying cost.

26
Example

27
ABC Inventory Classification
 All items in a company’s inventory are not equal and do not
need the same level of control
 We can apply Pareto’s law to determine the level of control
needed for individual items - Pareto’s law implies that
roughly 10 to 20 percent of a company’s inventory
items account for approximately 60 to 80 percent of
its inventory costs
 These relatively few high-dollar-volume items are classified as
A items
 Moderate-dollar-volume items, roughly 30 percent of the
items, account for about 25 to 35 percent of the company’s
inventory investment
 These are classified as B items
 Low-dollar volume items, about 50 to 60 percent of the
items, represent only 5 to 15 percent of the company’s
inventory investment and are classified as C items
28
ABC Inventory Classification (cont.)

29
ABC Inventory Classification (cont.)

 After classifying inventory items into A, B, and

C classes, we can determine the appropriate
level of inventory control
 For our most important and expensive A items,
we need very tight control, highly accurate
inventory records, and frequent or continuous
review
 A continuous review system keeps track of
an inventory item 24/7
 It tracks every inventory transaction as it occurs,
whether it is more material going into inventory or
material being withdrawn from the stockroom

30
ABC Inventory Classification (cont.)

 B items need normal control, moderately

accurate inventory records, and a reasonable
time period between reviews
 For B items, a periodic review system can be
used
 A periodic review system reviews the inventory
level of the item at regular intervals (daily,
weekly, monthly) to determine whether a
replenishment order is needed
 C items require the least amount of control
 Possible options for C items are the two-bin system
or an infrequent periodic review system

31
ABC Inventory Classification (cont.)
 A two-bin system splits an incoming replenishment
order into two separate bins
 One bin is placed on the factory floor so workers can
take what they need, while the other bin is kept in the
storeroom
 This second bin should have enough items to cover
normal demand during the replenishment lead time
 Lead time is the amount of time it takes from order
placement until the ordered item is received
 When the bin on the floor is empty, workers go to the
stockroom to request additional material
 The bin in the stockroom is released to the workers
on the floor and a replenishment order is placed.
32
Determining order quantities

 Inventory management and control are done at

the level of the individual item or stock-
keeping unit (SKU)
 An SKU is a specific item at a particular
geographic location
 For example, a pair of jeans, size 32x32, in
inventory at the plant and also eight different
warehouses, represents nine different SKUs
 A pair of the same jeans held at the same
locations but a different size (32x34) represents
nine additional SKUs
 The same style of jeans in a different color
represents additional SKUs.
33
Ordering approaches

34
Ordering approaches (cont.)

 Lot-for-lot is ordering exactly what you need

 You adjust the ordering quantity to your
ordering needs, which ensures that you will not
have leftover inventory
 You use lot-for-lot when demand is not constant
and you have information about expected
needs
 Ordering sandwiches for a business lunch
meeting is a good example of when to use lot-
for-lot
 The number of persons attending the meeting can
vary based on the meeting topic
 Since sandwiches are perishable, you do not want to
35
Ordering approaches (cont.)

 Fixed-order quantity specifies the number of

units to order each time you place an order for
a certain SKU or item
 The quantity may be arbitrary (perhaps 100
units at a time), or it may be the result of how
the item is packaged or prepared (such as 144
per box or a loaf of bread)
 The advantage of this system is that it is easily
understood; the disadvantage is that it does
not minimize inventory costs.

36
Ordering approaches (cont.)

 The min-max system involves placing an

order when the on-hand inventory falls below a
predetermined minimum level
 The quantity ordered is the difference between
the quantity available and the predetermined
maximum inventory level
 For example, if the minimum is set at 50 units, the
maximum is set at 250 units, and the quantity
available at the time of the order is 40 units, the
order quantity is 210 units (250 - 40)
 With this system, both the time between orders
and the quantity ordered can vary

37
Ordering approaches (cont.)

 Order n periods means that you determine

the order quantity by summing your company’s
requirements for the next n periods
 Suppose you have to order enough each time
you place an order to satisfy your company’s
requirements for the next three periods
 If these requirements for the next three weeks are
60, 45, and 100, your order is for 205 units
 A concern with this system is determining the
number of periods to include in the order.

38
Economic order quantity (EOQ)

 EOQ is a continuous review system, used

to keep track of the inventory on hand
each time stock is added or withdrawn
 If the withdrawal reduces the inventory
level to the reorder point or below, you
make a replenishment order.
 Thus, EOQ tells you when to place a
replenishment order and determines the
order quantity that minimizes annual
inventory cost

39
Economic order quantity (cont.)

 Suppose you decide that your kayaking

equipment company needs to place a
replenishment order whenever the inventory
level of item K310 reaches 100 units
 Right now you have 105 units of item K310 in
inventory. You withdraw 5 K310s to satisfy a
customer order, resulting in an updated
inventory level of 100 units
 Since the inventory level has reached the
reorder point, it is time to place a
replenishment order for K310
 A key characteristic of the continuous review system
is that it keeps track of inventory as it is withdrawn
40
Economic order quantity (cont.)

The basic EOQ model makes these

assumptions:
● Demand for the product is known and
constant
• This means that we know how much the
demand is for every time period and that
this amount never changes
• For example, demand is 50 units per
week every week or 10 units per day
every day.

41
Economic order quantity (cont.)

 Lead time is known and constant

 Lead time is the amount of time it takes from
order placement until it arrives at the
manufacturing company (for example, 10 working
days between order placement and receipt of
merchandise).
 Because you know how long it takes for the
replenishment order to arrive, you can determine
when you need to place the order
 By finding the reorder point, you schedule the arrival
of the replenishment quantity just as your company’s
inventory level reaches zero
 The minimum inventory level with the basic EOQ
should be zero
42
Economic order quantity (cont.)
 Quantity discounts are not considered: the cost of all
units is the same, regardless of the quantity ordered
 Ordering and setup costs are fixed and constant: the
dollar amount to place an order is always the same,
regardless of the size of the order.
 Since the company knows demand with certainty,
the assumption is that all demand is met.
 The quantity ordered arrives at once
 Since the order is scheduled to arrive just as the
company runs out of inventory, the maximum
inventory level equals the economic order quantity

43
Economic order quantity (cont.)

44
Economic order quantity (cont.)

 Since the basic model assumes certainty about

demand and lead time, the reorder point is set
equal to demand during lead time, or
R = d*L
where R = reorder point
d = average daily demand
L = lead time in days
 For example, if average daily demand is 40 units
and lead time is five days, then the reorder
point is 200 (40 units times five days) - when the
inventory reaches 200, it is time to place an
order
45
Economic order quantity (cont.)

 Since companies are interested in the costs

associated with inventory policies, let’s
calculate the annual ordering or setup costs and
the annual holding costs associated with the
basic EOQ model
 We do not include stockout (shortage) costs
since all demand is satisfied with the basic EOQ
model

Total annual cost = annual ordering

costs + annual holding costs

46
Economic order quantity (cont.)

 We calculate annual ordering costs by

multiplying the number of orders placed
per year by the cost to place an order
 To find the number of orders placed per year,
we divide the annual demand by the quantity
ordered.
 Suppose annual demand is 10,000 units and the
company currently orders 500 units each time
 The number of orders placed per year is 20
(10,000/500)
 If the cost to place an order is $75, then the annual
ordering cost is $1500 (20 orders x $75 ordering
cost)
47
Economic order quantity (cont.)

 We calculate annual holding costs by

multiplying the average inventory level by the
annual holding cost per unit
 The average inventory is equal to the maximum
inventory plus the minimum inventory divided
by 2
 In the EOQ model, the maximum inventory is Q
and the minimum is zero - therefore, the
average inventory level is Q /2
 For example, if the order quantity is 500 units, the
holding cost is $6 per unit per year, and the annual
holding cost is $1500 (500 units/2 x $6 per unit)

48
Economic order quantity (cont.)

 Sometimes the holding cost is given as a

percentage, such as 20 percent of the
item price
 In this case, we multiply the item price
by the percentage to determine the
annual unit holding costs
 For example, if the holding cost is 20 percent
of the item price and the item price is $30,
then the annual holding cost is $6 per unit
($30 item price x 20 percent holding cost)

49
Economic order quantity (cont.)

50
Economic order quantity (cont.)

51
Economic order quantity (cont.)

52
Economic order quantity-exercise

53
 Quantity discount model

 The basic EOQ model assumes that no quantity

discounts are available
 In real life, however, quantity discounts are often
available, so we need to modify the basic model for
these situations
 Quantity discounts are price incentives to encourage
a company to buy in larger quantities
 For example, a supplier charges your company $7.50
per kg if your company’s order is less than 500 kg
 If your order is for 500 to 999 kg, the price per kg is
$6.90
 On orders of 1000 kg or more, the supplier charges
$6.20 per kg
54
 Quantity discount model (cont.)

 Whenever the price per unit is not fixed but varies

based on the size of your order, the total annual cost
formula for any inventory policy used must include
the cost of material

55
 Quantity discount model (cont.)

 Jeannette’s Steak House currently orders 200 pounds

of single-portion filet mignons at a time (a two week
supply). The annual demand for the filets is 5200
pounds. The ordering cost is estimated at $50. The
annual holding cost is 30 percent of the unit price.
Jeannette pays $7.50 per pound for the steaks.
Therefore, the annual holding cost rate is $2.25 ($7.50
x 0.30). What are the annual total costs?

56
 Quantity discount model (cont.)

 Jeannette’s supplier has offered the following

price incentives
 If Jeannette places an order for 500 or more pounds,
the cost per pound is $6.90
 For orders of 1000 pounds or more, the supplier will
charge Jeannette $6.20 per pound
 For orders of less than 500 pounds, Jeannette would
continue to pay $7.50 per pound
 Now there are three possible prices based on the size
of the order
 Let’s look at how Jeannette can determine the best
policy for her business.

57
Quantity discount model (cont.)

58
 Quantity discount model (cont.)

 The Quantity Discount Procedure

 The first step is to calculate the order quantity using
the basic EOQ model and the cheapest price available
 In our example, Jeannette’s cheapest price is $6.20 per
pound. Therefore, the annual holding cost is $1.86 (that
is, $6.20 x 0.30), and the EOQ is

59
 Quantity discount model (cont.)

 Now determine whether the order quantity is feasible

 If Jeannette orders 528.74 pounds, the supplier will
charge her $6.90 per pound rather than the $6.20 she
used in calculating the order quantity
 Therefore, this is an infeasible quantity
 Since the order quantity is infeasible, we calculate the
order quantity using the next higher price, $6.90 per
pound.

60
 Quantity discount model (cont.)

 If Jeannette orders 501 pounds, the supplier charges

her $6.90 per pound, which is the same as the price
we used in calculating the order quantity
 Therefore, this is a feasible order quantity
 Once Jeannette finds the feasible quantity, she
calculates the total annual costs for this order
quantity.

61
 Quantity discount model (cont.)

 Jeannette compares the total annual cost of this

feasible order quantity with the total annual cost of
the minimum order quantities necessary to qualify
for any prices lower than the price at which she
found the feasible solution
 For example, to qualify for a price of $6.20 per
pound, Jeannette must order a minimum of 1000
pounds at a time. The total annual cost of ordering
1000 pounds at a time is

62
Quantity discount model (cont.)

63
Quantity discount model - exercise

64
Quantity discount model - exercise

65
 Relevant videos

 Warehouse management
 [Link]

 KPIs for inventory management

 [Link]

66