Chapter 8

Quantity and Inventory

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 Key Questions
Addressed in Chapter 8
• How much to acquire?

• When to acquire?

• How to inventory effectively?

 Quantity and Timing Issues
Factors Complicating Quantity Decisions
• Forecasts
– Managers must make purchase decisions made a long
time before actual requirements are known
– They must rely on forecasts of future demand, lead
times, prices, and other costs
– Forecasts are rarely, if ever, perfect

• Costs
– Costs associated with placing orders, holding inventory,
running out of materials, and having a service
unavailable when needed
 Factors Complicating Quantity Decisions

• Availability
– Desired quantities may be unavailable without paying a
higher price or delivery charge

• Price-Volume Relationship
– Reduced prices for larger quantities versus carrying
costs

• Shortages
– May cause serious disruptions
Quantity and Delivery

 Quantity and delivery go hand in hand. Order less,

deliver more frequently; order more, deliver less
frequently.
 Every supplier performance evaluation scheme includes
quantity and delivery as standard evaluation criteria.
 To ensure timely delivery, recognition needs to be given
to the times required to complete each of the steps in
the acquisition process.
 The ability to compress these times by doing them in
parallel, by eliminating time-consuming and nonvalue-
adding activities, by doing steps faster, and by
eliminating delays can provide significant benefits.

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 Time-Based Strategies
The time-based strategies that are of importance in the quantity decision are ones that
relate directly to the flow of materials and services, inventories (raw material, work-in-
process, and finished goods), and related information and decisions. Competitive
advantage accrues to organizations that can:

• Reduce process setup and cycle time

– reduce costs
– get to market faster

• Coordinate the flow of resources

– eliminate process/system waste
– ensure on-time or just-in-time arrival in
economically sized batches
 Long lead times can occur in:
 The design and development process
 The material acquisition to distribution of finished goods process
 Administrative support cycles (e.g., accounts payable, purchase order
development/release cycle).
Some of the causes of long lead times are:
 Waiting and procrastination
 Poorly engineered designs
 The accumulation of batches prior to movement
 Inefficient and long physical flows with backtracking, and poor communication.
Long lead times can impact decisions about how much to buy. Compressed cycle times
and coordination of material and information flows can result in materials arriving just-
on time (e.g., when they were scheduled to arrive) or just-in-time (just prior to actual
use or need).
The causes for poor material flow coordination are:
Late, early, or no deliveries; low fill rate; material defects; scrap; uneven batch sizes; long
lead times; production schedule changes; downtime; long setup/changeover times;
infrequent updates of MRP systems; forecasts; and on-hand inventory accounting
systems.

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Forecasts and Uncertainty

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 Forecasting Dilemmas
The problem is how to plan to meet the needs of the future, which requires answers
to questions such as:
• Where should responsibility for forecasting future usage lie?
– Should the supply management group be allowed to second-
guess sales, production, or user forecasts?
– Should other supply chain members be involved in a
collaborative forecasting effort?

In many organizations, the need for raw materials, services, parts, and
subassemblies is usually derived from a sales forecast, which is the
responsibility of marketing. In some service organizations and public
agencies, the supply function often must both make forecasts and acquire
items. In resale, the buyer may have to assess the expected sales volume
(including volumes at reduced prices for seasonal goods), as well as make
purchase commitments recognizing seasons.
 Forecasting Dilemmas
• If the forecast is wrong, who bears the risks?
– Should suppliers be held responsible for meeting forecasts or
actual requirements?
– Should the supply manager be held responsible for meeting
forecasts or actual requirements?
– When should responsibilities for dealing with results of
inaccurate forecasts be outlined in the contract?
– What role does negotiation play in resolving these issues?
The real problem with forecasts is their unreliability.
To a supplier, a substantial variation from forecast may appear as a
procurement ploy. If demand falls below forecast, the supplier may suspect
that the original forecast was an attempt to obtain a favorable price or other
concessions. Should demand exceed forecast, supplier costs may well increase
because of overtime, rush buying, and changed production schedules.
Purchasers need to share forecast uncertainty regularly with suppliers so that
their quotations may take uncertainty into account. Such sharing is obviously
impossible if buyers themselves are not aware of the uncertainty and its
potential impact on the supplier.
 Forecasting Techniques:
Quantitative
• Use past data to predict the future

– Causal models
• Identify leading indicators
• Develop linear or multiple regression models

– Time series forecasting

• Assumes sales follow a repetitive pattern over time
 Forecasting Techniques:
Qualitative
• Gather opinions and use with judgment to forecast
– Market forecasts: estimates of sales staff
– Top down forecast
– The Delphi technique: a formal approach
• Lack the rigor of quantitative techniques, but are
not necessarily any less accurate
• Knowledgeable people with intimate market
knowledge have a “feel” that is hard to define but
that gives good forecasting results
 Collaborative Planning,
Forecasting, and Replenishment
• Links sales and marketing processes to supply chain
planning and execution processes among trading
partners to:
– improve forecasts and service
– reduce cost
– develop effective replenishment plans
– increase product availability
– increase sales
– reduce inventories
– deliver higher service levels
 DETERMINING ORDER QUANTITIES AND
INVENTORY LEVELS
Types of Demand
• Dependent or derived demand:
– item is part of a larger component or product, and
its use is dependent on the production schedule
for the larger component
– example: demand for bottles and caps for a drink

• Independent demand:
– usage is determined directly by customer orders,
independent of production scheduling decisions
– example: demand for an energy drink
 Classic Trade-off

• When determining lot sizes in which to make

or buy cycle inventories:
– the costs of carrying extra inventory
versus
– the costs of purchasing or making more frequently

• Objective: minimize total annual costs

 Fixed Order Quantity System

• Perpetual inventory system

• Event triggered: Initiates order when stock
depleted to a specific level.
– Reorder point

• Inventory replaced in fixed amounts

– Economic order quantities

• Issues: visual signals, IT applications

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Fixed-Quantity: The EOQ Model

2 RS
EOQ 
KC where:

R = annual demand
S = set-up or order cost per
order
C = delivered purchase cost
K = carrying cost percentage

therefore:

KC = unit holding cost

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 Economic Order Quantity Model

CTmi
Annual Cost ($)

n
total cost

carrying costs

ordering costs

EOQ

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 Fixed Order Quantity System
Fixed order quantity system
Higher maintenance costs
Every transaction logged
Inventory controlled precisely

cycle
stock
ROP

ROP = L × d TIME
lead time (L)

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Example 1:
Total annual requirements (R) = 50,000 units
Ordering cost (S) = L.E 150
Unit price (C)= L.E1
Carrying Costs ( K)= 30%
The supplier offers 15% discount if the order size is 50,000 unit. Do you
accept this offer?
The solution:

2 RS = 2 x 50,000 x 150
EOQ  0.3x 1
= 7,071 units
KC
RS QKC
TC = RC + +
Q 2
50,000 x 150 7071 x 0.3 x 1
= 50,000 x 1 + 7071
+
2
= 50,000 + 1,060.66 + 1,060.65 = L.E 52,121.3
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In case of Discount:
x 150 + 50,000 x 0.3 x 0.85
TC = 50,000 x 0.85 + 50,000
50,000 2
= 42,500 + 150 + 6,375
= L.E 49,025

Since L.E 49,025 < L.E 52,121.3 Accept the

Discount offered by the Supplier.

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Example 2:
If total annual demand is 1,000 units, the unit price is L.E 10, ordering
cost is L.E. 50, holding cost is 25%. The supplier offers 2% discount if the
buyer order for 1,000 units or more. Under these conditions, should the
buyer accept the discount offer?
The solution:

2 RS 2 x 1,000x 50
EOQ  0.25x 10
= 200 units
KC
Requirements costs = RC , Ordering Costs = RS
Q
Carrying costs = QKC
2
RS + QKC
TC = RC +
Q 2
1,000 x 50 200 x 0.25 x 10
= 1,000 x 10 + 200
+
2
= 10,000 + 250 + 250 = L.E 10,500
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In case of Discount:
1,000 x 50 1,000 x 0.25 x 9.8
TC = 1,000 x 9.8 + 1,000
+
2
= 9,800 + 50 + 1,225
= L.E 11,075

Since L.E 11,075 > L.E 10,500 The buyer

should reject the discount offer.

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Example 3:
Annual Reqts. ( R ) 900 units
Price/ unit ( c ) L.E 45
Car. Cost ( K ) 25%
Ord. Cost ( S ) L.E 50/ 0rder
Lead Time ( L ) 10 Days ( assuming 250 working days). Calculate the
EOQ & reordering point ( P ).
The solution:

2 RS 2 x 900 x 50
EOQ  0.25x 45
= 89 units
KC
The reorder point ( P ) = The lead time ( L ) x daily demand
LR
P=
250

= 10 x 900 36 units
250 =
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Exercise :
Total annual requirements 8,000 units, price per unit L.E 50, carrying
cost 30%, ordering cost L.E 100 per order, annual working days 300, lead
time 10 days.
a) Calculate the EOQ & The reorder level.
b) If the supplier offers a 5% price discount for buying 8,000 or more,
do you accept this offer?

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 Safety Stock

• Held because of uncertainty in supply and/or

demand

• Trade-off: cost of stocking out versus cost of

holding inventory

• Levels can be calculated using statistical

techniques
– e.g., take into account standard deviation of demand

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 Fixed Order Quantity System:
Cycle Stock, Safety Stock and Lead Time
cycle
INVENTORY stock
(Q)

ROP

Safety
Stock
TIME
lead time (L)

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 Fixed Time Period Systems

• Inventory on-hand counted at specific time

intervals and replenished to a desired level

• Only the passage of time triggers reorder

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 Fixed Time Period System:
Cycle Stock, Safety Stock and Lead Time
INVENTORY

Safety
Stock

lead TIME
review
time period

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 Which System is Better?
• Fixed order quantity system
– Higher maintenance costs
– Every transaction logged
– Inventory controlled precisely
• Fixed time period
– Minimal record keeping
– Higher average inventories to protect against stock-outs
– Higher stock-out rates
– Different order quantities for each cycle
– Ability to batch orders to suppliers

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 Materials Requirement Planning
(MRP)
• Designed for “push” or forecast-driven systems
• Based on a master production schedule:
– Creates schedules identifying the specific parts and
materials required to produce end items
– Determines exact numbers needed
– Determines the dates when orders for those materials
should be released, based on lead times

“Get the right materials

to the right place at the right time.”
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 Key Inputs to MRP

• Master production schedule:

– when do we need it

• Inventory record:
– what do we have and what do we need

• Bill of material (BOM):

– what do we need to make one end product

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 Four Basic MRP Lot Sizing Rules

• Lot-for-lot (L4L)

• Economic order quantity (EOQ)

• Least-total-cost (LTC)

• Least-unit-cost (LUC)

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 MRP Implications for Supply

• Accurate records for quantities, lead times, bills

of material, and specifications
• Tight control of inventory
• Cooperation from suppliers for on-time delivery,
proper quantities and batch sizes, exacting
quality (zero defects)
– May need to re-evaluate existing contracts
• Long-term planning horizon
• Less “slack” in the system
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 Demand Driven MRP

• Driven by customer demand and supply chain

modeling
• Five key components:
– strategic inventory positioning
– buffer profile and levels
– dynamic adjustments
– demand driven planning
– visible collaborative execution

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 Capacity Requirements
Planning (CRP) Systems
• Capacity = amount of work in a set amount of
time
• CRP translates MRP material plan into
– required human and machine resources by
workstation and time bucket
– compares required resources to availability
– if insufficient capacity, either capacity or the master
production schedule is adjusted
– feedback loop to the master production schedule;
closed-loop MRP
 Enterprise Resource Planning
(ERP) Systems
• Software that integrates business systems and
processes to combine and analyze information
• Links customer orders through fulfillment processes
• Requires:
– highly accurate information, abandoning rules of thumb,
and using common data
• Results:
– reduced inventory levels, higher service coverage, ready
access to high-quality information, ability to replan
quickly in response to unforeseen problems
 Why Inventory?
The Functions of Inventory
• To provide and maintain good customer service.

• To smooth the flow of goods through the

production process
• To provide protection against the uncertainties
of supply and demand
• To obtain a reasonable utilization of people and
equipment
 Forms and Functions of Inventory

Functions of Inventories Forms of Inventories

• Transit or pipeline • Raw materials,
inventories purchased parts and
• Cycle inventories packaging
• Buffer or uncertainty • Work-in-process (WIP)
inventories or safety • Finished goods
stock • MRO items
• Anticipation or certainty • Resale items
inventories
• Decoupling inventories
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 Inventory:
Types, Functions, Objectives
TYPE FUNCTION OBJECTIVE
It takes time to move products (transit time, Balance in-transit inventory costs against
Transit or handling time, delays) cost of reducing delays
Pipeline
Demand pattern does not equal supply Balance cost of ordering (or setup) and cost
Cycle
pattern (goods produced in lot sizes) of carrying inventory

Buffer or Demand pattern varies. Customer service Balance cost of carrying extra inventory
levels must be maintained. against cost of stocking out
Safety

Balance inventory costs against production

Variations in demand relative to productive costs, transportation costs, purchase
Anticipation capacity or significant cost advantages to discounts, and costs of avoiding price
holding supply in anticipation of demand changes

Distribution and production efficiency Balance efficiency of production -

Decoupling gained from independence between stages distribution activities against costs
of production and distribution

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Examples of Inventory Functions
TYPE EXAMPLE
Transit or  parts on trains, forklifts, etc.
Pipeline  paper forms being moved between departments

Cycle  a retail store that orders furniture by the truckload to save ordering and
shipping (set-up) costs
 student buys $25 of credit instead of $10 for a photocopy card to reduce
trips for extra credit

Buffer or Safety  extra shirts ordered for unanticipated demand by a retailer

 extra bottles ordered by a brewery to allow for unexpected breakage

Anticipation  air conditioners produced and stored during winter

 sandwiches assembled during the morning and stored for lunch

Decoupling  plastic moulding machine produces at 100 parts/hr, assemblers work at

50 parts/hr, parts are held in operations to balance production rates ( and
moulding is shutdown periodically).

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 Inventory Forms and Functions

FUNCTION WHY ELIMINATE REASON BY

Transit move speed/distance make moves faster/shorter

Cycle make/use batch reduce onetime batch

costs
Buffer cope with variability reduce variability

Anticipation smooth peak increase volume

demand flexibility
Decoupling reduce dependence coordinate/schedule

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 Cost of Inventories
• Basic elements are:
–capital costs
–inventory service costs
–storage space costs
–inventory risk costs
 Annual Inventory Carrying Cost
• (carrying cost per year) = (average inventory value)
x (inventory carrying cost as a % of inventory value)
• Average inventory value = (average inventory in
units) x (material unit cost)
• CC = Q/2 x C x I, where
CC = carrying cost per year
Q = order or delivery quantity in units
C = delivered unit cost of the material
I = inventory carrying cost as % of inventory value
 Inventory Costs
• Carrying, holding, or possession costs:
– include handling charges; the cost of storage facilities or
warehouse rentals; the cost of equipment to handle inventory;
storage, labor, and operating costs; insurance premiums;
breakage; pilferage; obsolescence; taxes; and investment or
opportunity costs.
• Ordering or purchase costs:
– managerial, clerical, material, telephone, mailing, fax, e-mail,
accounting, transportation, inspection, and receiving costs
associated with a purchase order
• Setup costs:
– all the purchaser and supplier’s costs of setting up a production
run, including early spoilage and low production output until
standard rates are achieved, setup, employees’ wages and
other costs, machine downtime, extra tool wear, parts (and
equipment) damaged during setup
 Inventory Costs
• Stockout costs:
– costs of not having the required parts or materials on
hand when and where needed
– Includes lost contribution on present and future lost
sales, changeover costs, substitution, rescheduling and
expediting, labor and machine idle time, lost customer
and user goodwill, penalties
• Variations in delivered costs:
– costs associated with purchasing in quantities or at
times when prices or delivery costs are higher than at
other quantities or times
ABC Classification of Purchases

Percentage of Total Percentage of Total

Class
Items Purchased Purchase Dollars

A 10 70-80

B 10-20 10-15

C 70-80 10-20

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 Example of ABC Analysis

Number of Percentage Percentage

Annual
Annual Purchase Class
Items of Items Purchase Value
Volume

1,095 10.0% $21,600,000 71.1% A

2,168 19.9 5,900,000 19.4 B

7,660 70.1 2,900,000 9.5 C

10,923 100% $30,400,000 100%

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 Purchase Value is a Combination of
Price and Quantity
Category Unit Value Annual Volume Annual Value
A high high high
A medium high high
A low very high high
B high low medium
B medium medium medium
B low high medium
C medium low low
C low medium low
C low low low

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ABC Classification of Inventory

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 Vendor- or Supplier-Managed
Inventory (VMI/SMI)
• Also called systems contracting or stockless buying
• Merges ordering and inventory functions
• Relies on periodic billing procedures
• Nonpurchasing personnel issue order releases
• Employs special catalogs
• Requires suppliers to maintain minimum inventory
• Normally does not specify volume
• Improves inventory turnover rates
 Lean Thinking and Lean Supply
• A management philosophy focused on creating
value for the customer while eliminating waste or
nonvalue-adding activities:
– Overproduction
– Waiting, time in queue
– Transportation
– Nonvalue-adding processes
– Inventory
– Motion
– Costs of quality: scrap, rework, and inspection
 What is JIT?

• Providing the exact quantity needed at the

precise moment it is required

• Requires capabilities of:

– short production lead times
– economical small batch production
– flexible resources (labor, material and equipment)
– exacting quality

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 What is JIT?

• JIT production systems strive to eliminate waste

– inefficient set-up procedures, inventories
– focus on all aspects of the production system: human
resources, supply, technology, and inventories

• Nothing will be produced until it is needed

– when a unit is sold, the system pulls a replacement
unit from the last position in the system
– this process continues throughout the system

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 Kanban
• Kanban means “sign” or “instruction card” in
Japanese
– A number of visual methods can be used

• Authority to produce come from downstream

operations

• Kanban cards represent the number of containers

used in the system
– Dictates the lot size production levels and inventory
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 JIT Imposed Supplier Activities

• Frequent deliveries

• Small lot sizes

• Exacting quality

• Long-term relationships/contracts

• Reduced number of suppliers

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 JIT Implications for Supply

• Reduction in number of suppliers

• Reduction in supplier lead time
• Improvement in supplier quality
• Improvement in supplier delivery
• Increased inventory turnover
• Inventory reduction in total dollars

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 Managing Supply Chain
Inventories
 Impacts customer service, working capital, profitability
 What inventory and where in the supply chain
 IT for compatibility and to manage information flows
 Operational design of physical flow of goods/services--
production and fulfillment, lead times, quality, lot sizes
 Confidentiality issues
 Share actual consumer demand with suppliers for
production planning, to avoid bullwhip effect, reduce
costs
 Dimensions of Services

• Degree of tangibility
• Direction of the service
• Production of the service
• Nature of demand
• Degree of standardized
• Skills required

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 Determining Quantity
of Services
• Forecasting aggregate demand for services often
more unreliable than for goods
– Multiple contacts: users, specifiers, order placers, and
supplier relationship managers
– Multiple contracts at varying prices and terms with the
same supplier
• Organizationwide consumption management is
impossible under these conditions
• Difficult for suppliers to determine capacity
requirements and project utilization rates