Contemporary Logistics
Eleventh Edition
Chapter 8
Inventory
Management
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Learning Objectives
• To learn about the ways that inventory can be classified
• To discuss inventory costs and the trade-offs that exist
among them
• To identify when to order an how much to order, with a
particular emphasis on the economic order quantity
• To differentiate the various inventory flow patterns
• To discuss special concerns with inventory management
• To identify several contemporary approaches to managing
inventory
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Inventory Management Key Terms
(1 of 3)
• ABC analysis of inventory
• Back order
• Complementary products
• Cycle (base) stock
• Dead inventory (dead stock)
• Economic order quantity (EOQ)
• Fixed order interval system
• Fixed order quantity system
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Inventory Management Key Terms
(2 of 3)
• Inventory
• Inventory carrying (holding) costs
• Inventory shrinkage
• Inventory turnover
• Just-in-time (JIT) approach
• Lean manufacturing (lean)
• Ordering costs
• Pipeline (in-transit) stock
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Inventory Management Key Terms
(3 of 3)
• Psychic stock
• Reorder (trigger) point (ROP)
• Safety (buffer) stock
• Service parts logistics
• Speculative stock
• Stockout costs
• Substitute products
• Vendor-managed inventory (VMI)
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Inventory Management (1 of 3)
• Inventory refers to stocks of goods and materials that
are maintained for many purposes, the most common
being to satisfy normal demand patterns.
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Inventory Management (2 of 3)
• Inventory management
• Inventory decisions drive other business activities like:
• Warehousing
• Transportation
• Materials handling
• Objectives can differ for different functional areas of an
organization
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Inventory Management (3 of 3)
• Inventory management
• Must consider inventory costs
• Carrying costs
• Ordering costs
• Stockout costs
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Inventory Classifications (1 of 2)
• Cycle or base stock refers to inventory that is
needed to satisfy normal demand during the course of
an order cycle.
• Safety or buffer stock refers to inventory that is held
in addition to cycle stock to guard against uncertainty
in demand or lead time.
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Inventory Classifications (2 of 2)
• Pipeline or in-transit stock is inventory that is en
route between various fixed facilities in a logistics
system such as a plant, warehouse, or store.
• Speculative stock refers to inventory that is held for
several reasons, including seasonal demand,
projected price increases, and potential shortages of a
product.
• Psychic stock is inventory carried to stimulate
demand (retail).
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Inventory Costs (1 of 13)
• Inventory costs in the twenty-first century represent
approximately one-third of total logistics costs.
• Inventory cost should factor into an organization’s
inventory management policy.
• Inventory costs include:
• Carrying cost
• Ordering cost
• Stockout cost
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Inventory Costs (2 of 13)
• Inventory carrying (holding) costs
• the costs associated with holding inventory.
• In general expressed in percentage terms and this
percentage is multiplied by the inventory’s value
• Resulting number represents dollar value associated
with holding the particular inventory
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Inventory Costs (3 of 13)
TABLE 8.1 Magnitude of Inventory Costs
Year Value of Inventory Inventory Total Logistics Inventory as a
Business Carrying Cost Carrying Cost Cost ($ billion) Percentage of
Inventory ($ (%) ($ billion) Total Logistics
billion) Cost
2006 1,859 24.0 446 1,305 34.2
2007 2,015 24.1 485 1,394 34.8
2008 1,963 21.4 420 1,344 31.3
2009 1,833 19.3 353 1,101 32.1
2010 2,018 19.2 387 1,204 32.1
2011 2,182 19.1 478 1,287 32.1
2012 2,269 19.1 434 1,331 32.6
Source: 24th Annual State of Logistics Report, 2013, prepared by Rosalyn Wilson for the
Council of Supply Chain Management Professionals ([Link]).
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Inventory Costs (4 of 13)
TABLE 8.2 Components of Inventory Carrying Cost
Obsolescence costs
Inventory shrinkage
Storage costs
Handling costs
Insurance costs
Taxes
Interest costs
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Inventory Costs (5 of 13)
• Ordering costs refer to those costs associated with
ordering inventory, such as order costs and setup
costs.
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Inventory Costs (6 of 13)
• Examples of order costs include:
• Costs of receiving an order (wages)
• Conducting a credit check
• Verifying inventory availability
• Entering orders into the system
• Preparing invoices
• Receiving payment
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Inventory Costs (7 of 13)
• Trade-Off between Carrying and Ordering Costs
• Costs respond in opposite ways to the number of
orders or size of orders
• An increase in the number of orders leads to higher
order costs but lower carrying costs
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Inventory Costs (8 of 13)
• Calculations:
• Ordering = # of orders per year x ordering cost per
order Cost
• Carrying = average inventory x carrying cost per unit
Cost
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Inventory Costs (9 of 13)
• Stockout costs
• an estimated cost or penalty for a stockout
• involve an understanding of a customer’s reaction to a
company being out of stock when a customer wants to
buy an item
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Inventory Costs (10 of 13)
TABLE 8.3 Determination of the Average Cost of a Stockout
Alternative Loss Probability Average Cost
1. Brand-loyal customer $00.00 .10 $00.00
2. Switches and comes back 37.00 .25 9.25
3. Lost customer 1,200.00 .65 780.00
Average cost of a stockout Empty 1.00 $789.25
Note: These are hypothetical figures for illustration.
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Inventory Costs (11 of 13)
• General Rules Regarding Stockout Costs
• The higher the average cost of a stockout, the better it is for
the company to hold some amount of inventory (safety
stock) to protect against stockouts.
• The higher the probability of a delayed sale, the lower the
average stockout costs and the lower the inventory that
needs to be held by a company.
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Inventory Costs (12 of 13)
• Trade-Off between Carrying and Stockout Costs
• Costs move in opposite directions
• Higher inventory levels (higher carrying costs) result in
lower chances of a stockout (lower stockout costs)
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Inventory Costs (13 of 13)
TABLE 8.4 Determination of Safety Stock Level
Number of Additional 25% Annual Total Value of Additional Stockout
Units of Safety Stock Carrying Incremental Orders Costs
Safety Stock ($480 per Unit) Cost Safety Stock Filled Avoided
10 $4,800 $1,200 $1,200 20 $8,000.00
20 9,600 2,400 1,200 16 6,400.00
30 14,400 3,600 1,200 12 4,800.00
40 19,200 4,800 1,200 8 3,200.00
50 24,000 6,000 1,200 6 2,400.00
60 28,800 7,200 1,200 4 1,600.00
70 33,600 8,400 1,200 3 1,200.00
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When to Order (1 of 3)
• Key issue involves when product should be ordered
• Can order a fixed amount of inventory (fixed order
quantity system)
• Or orders can be placed at fixed time intervals (fixed
order interval system)
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When to Order (2 of 3)
• Reorder (trigger) point (ROP)
• Level of inventory at which a replenishment order is
placed
• Necessary for efficient fixed order quantity system
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When to Order (3 of 3)
• Reorder Point (ROP) calculations:
• ROP = DD x RC under certainty
• ROP = (DD x RC) + SS under uncertainty
• Where DD = daily demand
• RC = length of replenishment cycle
• SS = safety stock
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How Much to Order (1 of 5)
• Economic order quantity (EOQ)
• Deals with calculating the proper order size with
respect to two costs
• Costs of carrying the inventory
• Costs of ordering the inventory
• Determines the point at which the sum of carrying costs
and ordering costs is minimized, or the point at which
carrying costs equal ordering costs
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How Much to Order (2 of 5)
• Economic order quantity (EOQ) in dollars
• Where:
• EOQ = the most economic order size, in dollars
• A = annual usage, in dollars
• B = administrative costs per order of placing the order
• C = carrying costs of the inventory (%)
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How Much to Order (3 of 5)
• Economic order quantity (EOQ) in units
• Where:
• EOQ = the most economic order size, in units
• A = annual demand, in units
• B = administrative costs per order of placing the order
• C = carrying costs of the inventory (%)
• I = dollar value of the inventory, per unit
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How Much to Order (4 of 5)
FIGURE 8.1 Determining EOQ by Use of a Graph
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How Much to Order (5 of 5)
TABLE 8.5 EOQ Cost Calculations
Number of Order Size Ordering Carrying Cost Total Cost (sum of Ordering
Orders Per Year ($) Cost ($) ($) and Carrying Cost) ($)
1 1,000 25 100 125
2 500 50 50 100
3 333 75 33 108
4 250 100 25 125
5 200 125 20 145
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Inventory Flows (1 of 2)
FIGURE 8.2 Inventory Flow Diagram
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Inventory Flows (2 of 2)
• Safety stock can prevent against two problem areas
• Increased rate of demand
• Longer-than-normal replenishment
• When fixed order quantity system like EOQ is used,
time between orders may vary
• When reorder point is reached, fixed order quantity is
ordered
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Inventory Management: Special
Concerns (1 of 3)
• ABC Analysis of Inventory
• recognizes that inventories are not of equal value to a firm
• as such all inventory should not be managed in the same
way
• Dead inventory (dead stock)
• is a fourth category, D, to ABC analysis where D stands
for either “dogs” or dead inventory (dead stock)
• refers to product for which there is no sales during a 12
month period.
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Inventory Management: Special
Concerns (2 of 3)
• Inventory Turnover
• number of times that inventory is sold in a one-year
period. (Compare with competitors or benchmarked
companies
• Complementary Products
• inventories that can be used or distributed together, i.e.
razor blades and razors.
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Inventory Management: Special
Concerns (3 of 3)
• Substitute Products
• products that can fill the same need or want as another
product.
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Contemporary Approaches to
Managing Inventory (1 of 5)
• Lean Manufacturing
• Focuses on the elimination of waste and the increase of
speed and flow
• Identifies seven major sources of waste including
inventory
• Just-in-time (JIT) is one of the best known lean inventory
practices
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Contemporary Approaches to
Managing Inventory (2 of 5)
• Lean Manufacturing
• Just-in-time (JIT)
• Seeks to minimize inventory by reducing (or eliminating) safety
stock while having the required amount of materials arrive at the
production location at the exact time they are needed
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Contemporary Approaches to
Managing Inventory (3 of 5)
• Service Parts Logistics
• Involves designing a network of facilities to stock service
parts:
• Deciding upon inventory ordering policies
• Stocking the required parts
• Transporting parts from stocking facilities to customers
Source: Mehmet Ferhat Candas and Erhat Kutanoglu, “Benefits of Considering Inventory in Service Parts
Logistics Network
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Contemporary Approaches to
Managing Inventory (4 of 5)
• Vendor-Managed Inventory (VMI)
• Size and timing of replenishment orders are the
responsibility of the manufacturer
• Allows manufacturers to have access to a distributor’s or
retailer’s sales and inventory data
• Benefits include reduced inventories, fewer stockouts and
improved customer retention
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Contemporary Approaches to Managing Inventory (5 of 5)
FIGURE 8.4 Advertisement from a Parts Bank Service
Source: Courtesy of Associated Distribution Logistics (ADL).
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