Inventory Policy Decisions

1. Inventory Policy Decisions Chapter 9 CR (2004) Prentice Hall, Inc.

2. Inventory Strategy Inventory Strategy • • Forecasting Forecasting Transport Strategy Transport Strategy Inventory decisions Inventory decisions • • • • Transport fundamentals Transport fundamentals • • Purchasing and supply Purchasing and supply • • Transport decisions Transport decisions Customer Customer scheduling decisions scheduling decisions service goals service goals • • Storage fundamentals Storage fundamentals • • The product The product • • Storage decisions Storage decisions ORGANIZING ORGANIZING PLANNING PLANNING CONTROLLING CONTROLLING • • Logistics service Logistics service • • Ord Ord . proc. & info. sys. . proc. & info. sys. Location Strategy Location Strategy • • Location decisions Location decisions • • The network planning process The network planning process Inventory Decisions in Strategy CR (2004) Prentice Hall, Inc.

3. Inventory in the Economy • Inventory in the Economy has decreased. • As a percentage of the GDP, from 1985 to 2000, inventory levels have decreased from 5.4% to about 3.8% • Examine Table 6-1.

4. Table 6-1: Macro Inventory Cost in Relation to U.S. Gross Domestic Product

5. Inventory Costs: Why are they so important? • First, inventory costs are a significant portion of total logistics costs for many firms. • Second, inventory levels affect customer service levels.

6. Table 6-2Total Logistics Costs --- 1999

7. Management of Inventory Flows in the Supply Chain: Introduction • Inventory as an asset has taken on increased significance as companies struggle to reduce investment in fixed assets that accommodate inventory (plants, warehouses, etc.). • Changes in inventory affect return on assets (ROA), an important internal and external metric. • “Ideally, zero inventory will maximize cash flow.”

8. What are Inventories? • Finished product held for sale • Goods in warehouses • Work in process • Goods in transit • Any owned or financially controlled raw material, work in process, and/or finished good or service held in anticipation of a sale but not yet sold CR (2004) Prentice Hall, Inc.

9. Finished goods Customers Material Inbound Production Outbound warehousing sources transportation transportation Receiving Production materials Inventories in-process Shipping Finished goods Inventory locations Where are Inventories? 9-4 CR (2004) Prentice Hall, Inc.

10. Reasons Against Inventories • They consume capital resources that might be put to better use elsewhere in the firm • They too often mask quality problems that would more immediately be solved without their presence • They divert management’s attention away from careful planning and control of the supply and distribution channels by promoting an insular attitude about channel management CR (2004) Prentice Hall, Inc.

11. Reasons for Inventories • Purchase economy • Transport economy • Production savings • Safety stocks • Seasonal stocks • Speculative purchase • Improve customer service

12. Types of Inventories • Pipeline • Inventories in transit • Speculative • Goods purchased in anticipation of price increases • Regular/Cyclical/Seasonal • Inventories held to meet normal operating needs • Safety • Extra stocks held in anticipation of demand and lead time uncertainties • Obsolete/Dead Stock • Inventories that are of little or no value due to being out of date, spoiled, damaged, etc.

13. Inventory Management Philosophies • Pull • Draws inventory into the stocking location • Each stocking location is considered independent • Maximizes local control of inventories • Push • Allocates production to stocking locations based on overall demand • Encourages economies of scale in production • Just-in-time • Attempts to synchronize stock flows so as to just meet demand as it occurs • Minimizes the need for inventory CR (2004) Prentice Hall, Inc.

14. PUSH- Allocate supply to each PULL - Replenish inventory with warehouse based on the forecast order sizes based on specific needs for each warehouse of each warehouse Demand forecast Warehouse #1 Q 1 A 1 Demand A Q 2 2 forecast Plant Warehouse #2 A 3 Q 3 A = Allocation quantity to each warehouse Demand Q = Requested replenishment quantity forecast by each warehouse Warehouse #3 Pull vs. Push Inventory Philosophies 9-11 CR (2004) Prentice Hall, Inc.

15. Inventory Costs: Inventory Carrying Cost • Capital Cost • Opportunity cost associated with investing in inventory, or any asset. • What is the implicit value of having capital tied up in inventory, instead of some other worthwhile project? • Minimum ROI expected from any asset. • Debate on inventory valuation at fully allocated or variable costs only.

16. Inventory Costs: Inventory Carrying Cost • Storage Space Cost • Handling costs, rents, utilities. • Logistics develops a cost formula for storage space costs based on cost behaviors. • Public space mostly variable. • Private space a mix of fixed and variable.

17. Inventory Costs: Inventory Carrying Cost • Inventory Service Cost • Insurance and taxes on stored goods. • Varies according to the value of the goods. • Inventory Risk Cost • Largely beyond the control of the firm. • Due to obsolescence, damage, theft, employee pilferage.

18. Relevant Costs (Cont’d) • Procurement costs • Cost of preparing the order • Cost of order transmission • Cost of production setup if appropriate • Cost of materials handling or processing at the receiving dock CR (2004) Prentice Hall, Inc.

19. Relevant Costs (Cont’d) • Out-of-stock costs • Lost sales cost • Profit immediately foregone • Future profits foregone through loss of goodwill • Backorder cost • Costs of extra order handling • Additional transportation and handling costs • Possibly additional setup costs CR (2004) Prentice Hall, Inc.

20. Stockouts • Four possible outcomes from a stockout • Customers wait • Back orders • Lost sales • Lost customers

21. Expected Costs of Stockouts

22. Inventory Holding costs Customer Service , i.e., Stock Availability Inventory Management Objectives Good inventory management is a careful balancing act between stock availability and the cost of holding inventory. • Service objectives • Setting stocking levels so that there is only a specified probability of running out of stock • Cost objectives • Balancing conflicting costs to find the most economical replenishment quantities and timing CR (2004) Prentice Hall, Inc.

23. Inventory’s Conflicting Cost Patterns Total cost Minimum cost reorder quantity Cost Carrying cost Procurement cost Stockout cost Replenishment quantity 9-16 CR (2004) Prentice Hall, Inc.

24. Reorder Point Method Under Certainty for a Single Item Quantity on-hand plus on-order Inventory Level Q Reorder point, R Lead time Lead time 0 Time Order Placed Order Received Order Placed Order Received 9-22 CR (2004) Prentice Hall, Inc.

25. Reorder Point Control for a Single Item Quantity on hand Q Place order Q DDLT ROP Receive order P 0 Stockout LT LT Time 9-25 CR (2004) Prentice Hall, Inc.

26. Periodic Control for a Single Item M Q2 Q1 Quantity on hand ~ q Stock level reviewed Order received 0 Time LT LT T T T = review interval q = quantity on hand Qi = order quantity M = maximum level M - q = replenishment quantity LT = lead time 9-39

27. Min-Max Inventory Control Add increment ROPq to order size M ~ Quantity on hand Q1 Q* Q2 ROP q LT Time LT 9-54 CR (2004) Prentice Hall, Inc.

28. Classifying Inventory:ABC Analysis • Ranking system • Developed in 1951 by H. Ford Dicky of General Electric3. • Suggested that GE classify items according to relative sales volume, cash flows, lead time, or stockout cost. • Most important inventory put in Group A. • Lesser impact goods put in Groups B and C respectively.

29. Classifying Inventory:ABC Analysis • Pareto’s Rule (80-20 Rule) • Based on a nineteenth century mathematician’s observation that many situations were dominated by a very few elements. • Conversely, most elements had very little influence in most situations. • Separates the “trivial many” from the “vital few”.

30. Classifying Inventory:ABC Analysis • 80-20 Rule • 80% of sales will come from 20% of the inventory SKUs. • 20% of sales will come from 80% of the inventory SKUs. • The 80-20 Rule has been found to explain many phenomena that interest managers. • For example, 80% of sales come from 20% of customers; and vice versa.

31. Product items can be grouped according to 80-20 curve, each with different stocking policies 100 90 80 70 Aggregate Inventory Control 60 Total sales (%) 50 40 30 A items B items C items 20 10 0 0 20 40 60 80 100 Total items (%) CR (2004) Prentice Hall, Inc. 9-72

32. Risk Pooling (Cont’d) Safety stock in 1 warehouse Total inventory AIL = Regular stock + Safety stock AIL = 59.75 + 27.66 = 87.41 units In a one-warehouse channel AIL = 42.56 + 26.43 = 68.99 units Two warehouses ConclusionThere is a reduction in the average inventory level of an item as the number of stocking points in the supply channel is decreased. In this example, both regular stock and safety stock decline. 9-77 CR (2004) Prentice Hall, Inc.

33. Evaluating the Effectiveness of a Company’s Approach to Inventory Management • Are customers satisfied with the current level of customer service? • How frequently does backordering or expediting occur? • How is the inventory turns relative to industry average? • Is inventory cost as percentage of sales higher or lower than industry average?