02a Inventory Management (1)

Inventory Management

(Part – I)

1 Sasadhar Bera, IIM Ranchi

Outline

2 Sasadhar Bera, IIM Ranchi

Basic Inventory Concepts

Types of Inventory

Inventory Costs

Classification of Inventory Planning Techniques

Classification of Inventory System

Characteristics of Inventory System

Basic Inventory Concepts

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Sasadhar Bera, IIM Ranchi

What is Inventory ?

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Inventory is a stock of items kept by an organization to meet internal or external customer demand. Internal customers are inside the organization such as machine operator waiting for a part or partially completed product to work on. External customers are outside the organization – for example, customers for grocery products, retail items, and cars. Managing inventories is one of the most important functions of operations management in both manufacturing and service organizations.

Few Examples of Inventory

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i. Department stores or grocery stores carry inventories of all the retail products they sell.

ii. A nursery has inventory of different plants, trees and flowers.

iii. A rental car agency has inventory of cars.

iv. A football team maintains inventory of items such as food, clothing, medical supplies and personal hygiene products.

v. A small pizza business must maintain inventory of dough, toppings, sauce, and cheese as well as supplies such as boxes, napkins, and so on.

Inventory in Manufacturing Firm

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In a manufacturing firm, inventory can take the following form:

i. Raw materials – Purchased material, component parts and subassemblies

ii. Work-in-progress (WIP) – Partially completed parts waiting to be worked on

iii. Finished goods – Ready to be sold items held at factory or central warehouse or distribution centers

iv. Transit inventory - Items being transported

v. Maintenance, repair and operational supplies – Include tools, spare parts, lubricants etc. These items do not become part of the product.

Role of Inventory in Value Chain

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Inventory before, during and after production

Inventory Management

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Inventory managers are responsible for planning and controlling inventory before, during and after production to support operation and meet customer demand. As the level of inventory increases to provide better customer service, inventory cost increases, whereas lost sales and loss of customers decreases. However, maintaining large stock of inventory is costly and wasteful. The approach to inventory management is to maintain a level of inventory that reflects a compromise between inventory costs and customer service.

Types of Inventory

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Types of Inventory

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Inventories can be classified according to the function they perform. The categories are given below. i. Cycle inventory ii. Safety stock inventory iii. Work-in-process inventory iv. Finished goods inventory v. Pipeline inventory vi. Anticipation inventory vii. Decoupling stock viii. Dead stock

Types of Inventory (Contd.)

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i. Cycle inventory(also called lot size inventory): Items purchased or manufactured in batches, may be greater than needed immediately. Cycle inventory may take advantage of economies of scale from quantity discounts, volume shipments, or the allocation of manufacturing setup costs over many units.

ii. Safety stock inventory maintained as a safeguard against uncertainties of demand and supply. It is an additional amount that is kept over and above the average amount required to meet demand.

iii. Work-in-process (WIP) inventory consists of partially finished products in various stages of completion that are waiting further processing. For example, a pizza restaurant might prepare a batch of pizzas with only cheese and sauce and add other toppings when orders are placed.


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iv. Finished goods inventory: Ready to be sold items held at factory or central warehouse or distribution centers.

v. Pipeline inventory: Inventory that has been in transit mode (either a semifinished or finished product) between factories, warehouses or retail outlets, is not physically available to the user or customer. Pipeline inventory may be reduced by transporting goods by air rather than the sea or rail.

vi. Anticipation inventory: Stock accumulated in advance due to seasonal peak demand or demand due to special event that does not occur on a regular basis.

Seasonal stock: Garments demand during festival seasons; refrigerators and air conditioners exhibit peak demand during summer season.


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Speculation stock: A firm may carry certain amount of stock to take care of certain events like labour strike or transport strike.

vii. Decoupling stock: It is applicable to supply chain operations. The entire supply chain is usually divided into various decision making units. It is not uncommon for an organizations to hold large inventories at organizational as well as departmental boundaries. Supply chain integration plays important role in this regard to reduce decoupling inventory significantly.

viii. Dead stock: Dead stock essentially includes items that have become obsolete because of changes in customer style, technological development in design.

Drivers of Inventory

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Type of Inventory Driver ( Logic)

Cycle Stock Economies of scale

Safety Stock Uncertainty in demand & Supply

Seasonal stock Mismatch between demand and supply rate

Speculation Stock Uncertainty in price of material

Pipeline Stock Lead-time in production/transportation process

Dead Stock Judgmental error/ Change in economic or technological environment

Inventory Costs

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Inventory Costs

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Three basic costs are associated with inventory: i. Ordering Costs or Costs of replenishing the inventory

ii. Inventory carrying costs

iii. Stock-out costs or Shortage costs

Ordering Costs

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Ordering costs: The costs associated with placing an order either within the factory or to a supplier. Ordering cost is independent of order size. The main components of the ordering cost include the following:

i. Administrative costs involved in placing the order. Preparing the purchase order will involve documentation, getting the necessary approval and other formalities. Electronic or online ordering can reduce the time required by the buyer and thus reduce this component of cost.

ii. Receiving cost: Administrative cost involved on receiving the order. For example, at the time of receipt, the receiver will have to prepare the goods receipt note, update inventory records, make necessary check against the respective purchase order.

Ordering Costs (Contd.)

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Ordering costs are normally expressed as dollar or Rs. per order. A significant part of the ordering cost in a purchase situation is information intensive. By using electronic or online ordering can substantially reduce ordering cost. As the size of orders increases, fewer orders are required, reducing ordering costs. In general, if order size increases, ordering costs decrease and inventory carrying costs increase. In production environment, ordering cost is set-up cost. The focus is on set-up time reduction in case of production process.

Inventory Carrying Costs

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Inventory carrying costs: The costs of holding inventory are known as inventory carrying costs. The greater the level of inventory over a period of time, the higher the carrying costs. The carrying cost increases operating cost and decreases profit. Carrying costs can include the following:

i. Financing cost: The inventory represents the assets and the working capital of a firm. Some firms consider cost of carrying inventory fund can be deployed for alternative purpose. Financing cost is directly proportional to the value of the item.

ii. Storage and handling costs: Space costs (rent, taxes, insurances) are charges for storage of inventory. Storage costs are function of size of the item. Handling costs involve material handling equipment and labour cost.

Inventory Carrying Costs (Contd.)

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iii. Inventory risk: Cost associated with deterioration, spoilage, breakage, obsolescence, and pilferage. This will depend on nature of item, for example fashion goods, perishable goods, and high technology products are likely to have much higher risk.

The usual way is to assign total carrying costs, determined by summing all the individual costs just mentioned on a per-unit basis per time period, such as a month or year. In this form, carrying costs are commonly expressed as per unit dollar amount on an annual basis. Carrying costs can range from 10 to 40% of the value of manufactured item.

Stock-out Costs or Shortage Costs

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Stock-out costs or Shortage costs: Stock-out occurs when customer demand cannot be met because of insufficient inventory. Stock-out costs are intangible or difficult to measure. There are two kinds of stock-out costs.

Lost sales cost: When customers is unwilling to wait and purchase the item elsewhere. Company loses potential sales because of non-availability of finish product. A lost sale associates with opportunity cost, which may include loss of goodwill and potential future revenue.

When demand is internal, a shortage can cause work stoppage in the production process and create delays, resulting in downtime costs and the cost of lost production (including indirect and direct production costs).

Stock-out Costs or Shortage Costs (Contd.)

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Backorder cost: Backorder cost is incurred in a situation where the customer is willing to wait for the item. Backorder results in additional cost for administrative, handling and transportation when material is to be sent to customer separately. Most of the decision maker finds it difficult to quantify exact value of shortage cost. Therefore instead of working with shortage cost, firm finds it easier to work with a target service level that the inventory system must meet. Instead of minimizing total cost in an inventory system, firms minimize ordering cost plus inventory carrying cost subject to meeting target service level.

Stock-out Costs or Shortage Costs (Contd.)

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The customer service level is the ability to meet internal or external demand at a specified level of efficiency. High quality service is often perceived as always being able to meet demand, which normally requires high inventory levels and can be costly. Efficient management of the inventory system can meet demand most of the time. Target service level ranges from 90 to 99 percent. High service level is kept for the items for which shortage cost is high.

Classification of Inventory Planning Techniques

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Classification of Inventory Planning

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Most firms carry a large number of items in stock. Control of inventory is done by controlling individual items, which is called stock-keeping units (SKU). Each SKU has an identifying code.

When dealing with different SKUs, the management may not be in a position to focus attention on all SKUs. Hence inventory is managed with aggregate level according to their classification.

For example, a retail store has to manage thousands of SKUs. Not all SKUs are likely to be equal importance. Hence managers classify the SKUs so that they can pay suitable attention to different categories of SKUs.

Classification of Inventory Planning (Contd.)

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Three different classification schemes are given below:

ABC classification: SKUs are classified into three categories (A, B, and C) according to their rupees (or dollar) so that managers can focus on according to their sales value or usage value. VED classification: SKUs are based on criticality: vital (V), essential (E), and desirable (D). This classification is quite popular in maintenance management. FSN classification: SKUs are classified based on volume of usage: first moving (F), slow moving (S), and non-moving (N). This classification is quite popular in the retail industry.

ABC Classification

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ABC classification principle is based on Pareto’s law. The Pareto’s law says that a small number of SKUs account for most of the inventory value (or usage in terms of dollar). It is usually found that the relationship between the percentage of SKUs and the percentage of annual dollar value follow a pattern in which three groups can be defined:

A-category SKUs: About 15% to 20% of the SKUs account for about 70% to 80% of the dollar value.

B-category SKUs: About 25% to 30% of the SKUs account for about 10% to 15% of the dollar value.

C-category SKUs: A large percentage of total SKUs account for a small dollar value. About 50% to 55% of the SKUs account for about 5% to 10% of the dollar value.

Steps for ABC Classification

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Steps for ABC classification

i. Determine total number of SKUs .

ii. Each SKU is assigned a dollar value which is unit cost .

iii. Determine the annual dollar value for each SKU. Annual dollar value is computed by multiplying the dollar cost of one unit by the annual demand for that SKU.

iv. List the SKUs descending order according to their annual dollar value.

v. Calculate the cumulative annual dollar value and the cumulative percentage of SKUs.

vi. Examine the annual volume distribution in terms of percentage usage and groups the SKUs into A, B, and C categories based on volume distribution.

ABC Classification

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Example: ABC Classification

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1 60 90

2 350 40

3 30 130

4 80 60

5 30 100

6 20 180

7 10 170

8 320 50

9 510 60

10 20 120

PART UNIT COST ANNUAL USAGE

($) (count)

Spare parts inventory of a small manufacturing firm

Example: ABC Classification (Contd.)

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9 $30,600 35.9 6.0 6.0

8 16,000 18.7 5.0 11.0

2 14,000 16.4 4.0 15.0

1 5,400 6.3 9.0 24.0

4 4,800 5.6 6.0 30.0

3 3,900 4.6 10.0 40.0

6 3,600 4.2 18.0 58.0

5 3,000 3.5 13.0 71.0

10 2,400 2.8 12.0 83.0

7 1,700 2.0 17.0 100.0

TOTAL % OF TOTAL % OF TOTAL PART VALUE VALUE QUANTITY % CUMMULATIVE

A

B

C

$85,400

Example: ABC Classification (Contd.)

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% OF TOTAL % OF TOTAL CLASS ITEMS VALUE QUANTITY

A 9, 8, 2 71.0 15.0

B 1, 4, 3 16.5 25.0

C 6, 5, 10, 7 12.5 60.0

Managerial Decisions on ABC Classified SKUs

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A-category SKUs: Tight control including complete accurate records, regular and frequent review by management, frequent review of demand forecasts, and close follow-up and expediting to reduce lead time. B-category SKUs: Normal controls with good records, regular attention, and normal processing. C-category SKUs: Order large quantity and carry safety stock. Use two-bin system or periodic review system.

VED Classification

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VED classification: SKUs are based on criticality: vital (V), essential (E), and desirable (D). Based on VED classification, one can fix different service levels for different SKUs. Of course, a firm prefers to work with a very high service level for V-category spare SKUs. D-category SKUs have lower level of service requirements.

FSN Classification

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FSN classification: SKUs are classified based on volume of usage: first moving (F), slow moving (S), and non-moving (N). Fast-moving SKUs are usually stocked in a decentralized fashion while slow-moving SKUs are stocked centrally. Non-moving SKUs are candidates for disposal and the firm will like to make sure that non-moving SKUs do not take up a significant share of inventory investment. This classification is quite popular in the retail industry.


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An inventory system is the set of policies and controls that monitor level of inventory and determines what level of inventory should be maintained, how much to order and when to place order. There are two basic types of inventory system: i. Continuous review system or fixed-order-quantity

system or Q system

ii. Periodic review system or fixed-time-period system or P system

Continuous Review Inventory System

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In continuous review system inventory level for every item is continuously monitored. Whenever the inventory on hand decreases to a predetermined level, referred to as the reorder point, a new order is placed to replenish the stock of inventory. The order size is fixed amount whenever the order is placed. The order size that minimizes the total inventory cost is called economic order quantity. However, maintaining a continual record of the amount of inventory on hand can also be costly. Many firms use bar code systems and handheld laser scanner to determine inventory materials, supplies, equipment, in-process parts, and finished goods.

Periodic Review Inventory System

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In a periodic review system, the inventory is checked and reordering is done only at a specified time interval – weekly, biweekly, monthly or some other time interval. Once the inventory in stock is determined after specified time interval, an order is placed for an amount that will bring back to a desired inventory level. Hence for periodic review system order quantity is variable amount. An example of periodic review system is a college or university book store. Textbooks are normally ordered according to periodic system (semester), wherein a count of textbooks in stock is done after the first few weeks of a semester.

Characteristics of Inventory System

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Characteristic of Inventory System

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One of the first steps in analyzing an inventory problem should be to describe the essential characteristics of the environment and inventory system. This is very useful when we develop quantitative models for making good inventory decisions. We will define few terms related to inventory management.

Characteristic of Inventory System (Contd.)

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Number of items: Most firms carry a large number of items in stock. Control of inventory is done by controlling individual items, which is called stock-keeping units (SKU). Each SKU has an identifying code and is held in inventory at a particular location. For example, two blue shirts in the same inventory but of different sizes or styles would be two different SKUs. The same shirt in two different inventories would be two different SKUs.

Inventory Order Cycle

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Order cycle: Time interval between receipt of two successive orders.

Demand rate

Time Lead time

Lead time

Order placed

Order placed

Order receipt

Order receipt

Inven

tory

Level

Reorder point, R

Order quantity, Q

0

Average

inventory

Q

2

order cycle


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Order size or Lot size: When purchasing from a supplier, we usually call order size as order quantity. In case of production of items within the organization order size is called lot size.

Economic Order Quantity (EOQ): The order size for which total inventory cost is minimum is known as EOQ. A calculation is made which considers demand rate, ordering cost, holding cost, lead time, and service level.

Lead time: It is length of time between placing an order and its receipt for actual use.

Reorder point (R): Reorder point indicates a stock level. when inventory drops to that level or below, ordered should be triggered or placed.


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Time horizon: This define planning period over which inventory is to be controlled. The planning period may be finite or infinite. Depending on planning period demand can be forecast reliably. Inventory planning in a firm is generally done on annual basis. Inventory position: It measures the SKU’s ability to satisfy customer demand. Inventory position = On-hand inventory + schedule receipts - Backorders


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Service Level: Service level indirectly measure the chances of stock-out situation. Target service level ranges from 90 to 99 percent. High service level is kept for the items for which stock- out cost is high. There are two popular ways of measuring the service level:

Cycle service level: It is a probability that customer demand will be filled from stock during lead time.

Fill rate: It is a percentage of customer orders that could be filled from stock during a given period of time (quarter or year). Typically an organization will specify a service level of 95 percent, suggesting that it will meet 95 percent of demand from stock, but will not meet the remaining 5 percent of demand.


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Demand patterns: It indicate how demand size x units consumed over time t. There are several way to withdraw x units.

i. The entire x units may be withdrawn at the beginning of the period – infinite demand

ii. The entire x units may be withdrawn at the end of the period.

iii. Withdrawn may be uniformly throughout the period. Class of demand is represented by:

Amount of inventory at time T: Q(T) = S – x (T/t)1/n S: Amount of inventory at T = 0 (beginning) x: demand in the time period t n: demand pattern index.


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Types of demand pattern


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Replenishment patterns: How the ordered item is added to the stock determines replenishment pattern. t/ is replenishment period.

Cycle Counting

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Cycle counting is a repetitive physical counting of inventory throughout the year. It ensures that all items are counted and higher value items (A-category) are counted more frequently than lower-value items (B and C categories). The benefits of cycle counting are:

i. Errors can be detected on timely basis and causes can be investigated and corrected.

ii. A high level of inventory accuracy can be achieved.

iii. Can have a correct statement of assets throughout the year.

Perishable Item

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A perishable item either deteriorates or become obsolete after a certain period. For example fruit, milk, cheese, and medicine have a limited life in shelf. Cricket match or concert tickets have no value after the game or performance. Similarly, hotel room cannot generate revenue if they are not rented. Inventories of perishable items must be handled differently from non-perishable items.


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Multi-stage inventories: When inventory is stocked at more than one stage in the sequential production process, they are called multi-stage inventories.


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An inventory system consists of several stocking point rather than one. In some cases these stocking points are organized such that one point acts as a supply sources for some other points. This type of operation may repeat at different level so that a demand point may become a new supply point. This situation is usually referred to as a multi-echelon system. For example, the factory supplies the products to warehouse, and the warehouse supplies the retailer. Retailer supplies to customer. Each level is called echelon. Multi-echelon inventory system includes products stocked at the various levels in the distribution system.


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Multi-echelon supply system

Financial Inventory Performance Measures

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Inventory turnover ratio: From financial point of view, inventory is an asset and represents money that tied up and cannot be used for other purposes. The inventory turnover ratio is a common measure of the performance indicator in material and inventory management. The inventory turnover ratio is calculated by Cost of Goods Sold (COGS) over a period (financial quarter or annually) in the numerator and average aggregate inventory value over that period in denominator. Inventory turnover ratio = RupeesininventoryAverage

SoldGoodsofCostAnnual

Financial Inventory Performance Measures (Contd.)

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Calculation of average inventory can be complicated and is a subject for cost accounting. The higher value of inventory turnover ratio indicates company can generate more revenue from less inventory holding and therefore increase profits. Sometimes “days of supply” is used as a measure of financial inventory performance measure. “days of supply” is calculated as follows: Days of supply = usagedailyAverage

handinInventory

References

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i. Operations Management: Processes and Supply Chains, Krajewski, Ritzman, Malhotra, and Srivastava, 9th edition, Pearson publication.

ii. Inventory Control and Management, Donald Waters, 2nd edition, Wiley student edition.

iii. Supply Chain Management: Text and Cases, Janat Shah, Pearson publication.

iv. Operations Management, Russell and Taylor, 7th edition, International student edition.

v. Operations Management: Concepts, Techniques, and Applications, Evans and Collier, Cengage learning India edition.

vi. Introduction to Material Management, Arnold, Chapman, and Clive, 6th edition, Pearson publication.

02a Inventory Management (1)

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