Inventory ManageMent

Ma Tăng Minh Hưởng

Inventory
Inventory refers to stocks of goods and materials that are maintained
for many purposes, the most common being to satisfy normal demand
patterns. In production and selling processes, inventories serve as
cushions to accommodate the fact that items arrive in one pattern and
are used in another pattern.
Inventory management is a key component in logistics and supply
chain management, in part because inventory decisions are often a
starting point, or driver, for other business activities, such as
warehousing, transportation, and materials handling. Moreover,
different organizational functions can have different inventory
management objectives.
Inventory
Organizations strive for the proper balance (i.e., right amount) of
inventory, but achieving the proper balance can be quite difficult
because of the trade-offs between inventory carrying cost and stockout
cost.
It is important to note here that inventory carries its greatest cost after
value has been added through manufacturing and processing. Finished
goods inventories are, therefore, much more expensive to hold than
raw materials or work in progress. Carrying costs for inventories can be
significant, and the return on investment to a firm for the funds it has
tied up in inventory should be as high as the return it can obtain from
other, equally risky uses of the same funds.
INVENTORY CLASSIFICATIONS
Cycle, or base, stock refers to inventory that is needed to satisfy normal
demand during the course of an order cycle. With respect to the egg
example at the beginning of this chapter, one dozen (12) eggs represents
the cycle stock—we use one egg per day, and we buy eggs every 12 days.
Safety, or buffer, stock refers to inventory that is held in addition to cycle
stock to guard against uncertainty in demand or lead time. For example,
uncertainty in demand could come from the fact that you occasionally
decide to make a three-egg omelet as opposed to eating one egg per day.
As an example of lead-time uncertainty, you may sometimes buy eggs
every 14 days, rather than every 12 days. In both cases, a few extra eggs
would ensure that you won’t run out of eggs.
INVENTORY CLASSIFICATIONS
 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. Pipeline inventory is represented here by
eggs that are in transit between a chicken farm
and, say, a food wholesaler’s distribution center
or between the retail store and your kitchen
 Speculative stock refers to inventory that is held
for several reasons, including seasonal demand,
projected price increases, and potential
shortages of product. For example, the fact that
eggs are associated with Easter (e.g., Easter egg
rolls, colored eggs) tends to cause an increase in
demand for them prior to the Easter holiday.
INVENTORY CLASSIFICATIONS
Although inventory generally exists
to satisfy demand, in some
situations inventory is carried to
stimulate demand, also known as
psychic stock. This type of
inventory is associated with retail
stores, and the general idea is that
customer purchases are stimulated
by inventory that they can see.1 This
concept helps explain, in part, why
some retailers stock huge amounts
of certain merchandise.
INVENTORY COSTS
The data in Table 8.1 offer insights
about the absolute and relative
magnitude of inventory costs in the
United States between 2010 and
2014. From an absolute perspective,
Table 8.1 indicates that the value of
business inventory ranged between
$2.1 trillion and $2.5 trillion between
2010 and 2014. In relative terms,
inventory costs between 2010 and
2014 represent approximately one-
third of total logistics costs
Inventory Carrying Costs
A prominent concern involves the costs associated with holding
inventory, which are referred to as inventory carrying (holding) costs.
In general, inventory carrying costs are expressed in percentage terms,
and this percentage is multiplied by the inventory’s value. The
resulting number represents the dollar value associated with holding
the particular inventory. As an example, referring to Table 8.1, when the
value of business inventory in 2010, $2064 billion, is multiplied by the
carrying cost in 2010, 19.2%, the relevant carrying costs are $396 billion.
Inventory Carrying Costs
Not surprisingly, an increase or decrease in the carrying cost percentage
will affect the relevant inventory expense. Generally speaking, companies
prefer to carry lower inventory as the carrying cost percentage increases,
in part because there is greater risk (e.g., obsolescence) to holding the
inventory. As a result, the determination of a carrying cost percentage
should be quite important for many companies. However, the reality is
that many companies don’t know their actual inventory carrying costs.
Rather, many companies simply assign carrying costs as 25% of the value
of their inventory—and this 25% figure has been used since the mid-
1950s.2 Table 8.1 suggests that U.S. inventory carrying costs since 2010
consistently have been between 19% and 20%.
Inventory Carrying Costs
Inventory shrinkage
 Inventory shrinkage is another
component of inventory carrying cost
and refers to the fact that more items
are recorded entering than leaving
warehousing or retailing facilities.
Theft—both by employees and
customers accounts for a majority of
inventory shrinkage. Moreover, despite
tremendous advances in technology,
administrative error, such as inaccurate
inventory counts when receiving
shipments, continues to account for
approximately 10% of inventory
shrinkage
storage costs, Handling costs
Another component of inventory carrying costs, storage costs, refers to
those costs associated with occupying space in a plant, storeroom, or
warehousing facility. Some products have very specialized storage
requirements; ice cream, for example, must be stored at a temperature
below –20 degrees Fahrenheit. You should recognize that specialized
storage requirements, such as refrigeration, result in higher storage costs.
Handling costs, another component of inventory carrying costs, involve
the costs of employing staff to receive, store, retrieve, and move
inventory. Note that specialized storage requirements may also increase
handling costs; a refrigerated warehouse requires workers to wear gloves,
head coverings, and coats to protect them from the cold temperatures
Insurance costs, taxes, interest
Insurance costs, which insure inventory against fire, flood, theft, and other
perils, are another component of inventory carrying costs. Insurance costs are
not uniform across products; diamonds, for example, are more costly to
insure than shampoo.
Taxes represent yet another component of inventory carrying costs, and they
are calculated on the basis of the inventory on hand on a particular date;
considerable effort is made to have that day’s inventory be as low as possible.
Finally, interest costs take into account the money that is required to
maintain the investment in inventory. In the United States, the prime rate of
interest has traditionally provided a convenient starting point when
estimating the interest charges associated with maintaining inventory.
Others
Some inventory items have other types of carrying costs because of
their specialized nature. Pets and livestock, for example, must be
watered and fed. Tropical fish must be fed and have oxygen added to
the water in which they are kept. Another cost, although it is generally
excluded from carrying cost, is opportunity cost—the cost of taking a
position in the wrong materials. This can be an issue for those
companies that engage in speculative inventory. Opportunity costs are
also incurred by firms that hold too much inventory in reserve for
customer demand.
Trade-Off Between Carrying and Ordering Costs
The trade-off that exists between carrying and ordering costs is that
they respond in opposite ways to the number of orders or size of
orders. That is, an increase in the number of orders leads to higher
order costs and lower carrying costs.
Ordering cost can be calculated by multiplying the number of orders
per year times the ordering cost per order. Because of the assumption of
an even outward flow of goods, inventory carrying costs are applied to
one-half of the order size, a figure that represents the average
inventory. Average inventory is multiplied by the carrying costs of the
inventory (expressed as a percentage of the dollar value).
Trade-Off Between Carrying and Ordering Costs
Stockout Costs
If avoiding oversupply were the only problem associated with
inventories, the solution would be relatively simple: Store fewer items.
However, not having enough items can be as bad as, and sometimes
worse than, having too many items. Such costs can accrue during
stockouts, when customers demand items that aren’t immediately
available.
Stockout costs, or estimating the costs or penalties 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.
Stockout Costs
Consider the following customer responses to a particular stockout situation. How
should they be evaluated?
1. The customer says, “I’ll be back,” and this proves to be so.
2. The customer says, “Call me when it’s in.”
3. The customer buys a substitute product that yields a higher profit for the seller.
4. The customer buys a substitute product that yields a lower profit for the seller.
5. The customer places an order for the item that is out of stock (a back order) and
asks to have the item delivered when it arrives.
6. The customer goes to a competitor only for this purchase.
7. The customer goes to a competitor for this and all future purchases.
Stockout Costs
To illustrate the calculation of stockout costs, assume for simplicity’s
sake that customer responses to a stockout can be placed into three
categories: delayed sale (brand loyalty), lost sale (switches and comes
back), and lost customer. Assume further that, over time, of 300
customers who experienced a stockout, 10 percent delayed the sale, 25
percent switched and came back, but the remaining 65 percent were
lost for good (see Table 8.3).
Stockout Costs
Trade-Off Between Carrying and Stockout Costs
The trade-off between carrying and stockout costs is that both move in
opposite directions— higher inventory levels (hence higher inventory
carrying costs) result in lower chances of a stockout (hence lower stockout
costs).
One way to illustrate this relationship is to look at the trade-offs between
levels of safety stock and the number of stockouts prevented, as illustrated in
Table 8.4. In this example, we assume that inventory can only be ordered in
multiples of 10 and that each unit of inventory is valued at $480 with carrying
costs of 25 percent. As a result, the incremental carrying costs of moving from
0 units of safety stock to 10 units of safety stock are (10 * $480) * .25, or $1,200.
Likewise, the incremental carrying costs of moving from 10 to 20 units of
safety stock are $1,200.
Trade-Off Between Carrying and Stockout Costs
This example also assumes that the various levels of safety stock prevent a certain
number of stockouts.
For example, holding 10 units of safety stock for an entire year allows the firm to
prevent 20 stockouts; moving from 10 units to 20 units of safety stock allows 16
additional orders to be filled. Using an average cost per stockout of $400, a safety
stock of 10 units allows the firm to prevent 20 stockouts, which saves the firm
$8,000 ($400 * 20). The savings of $8,000 is much greater than the additional
carrying costs of $1,200, so the firm wants to hold at least 10 units of safety stock.
Twenty units of safety stock result in $1,200 of additional carrying costs, whereas
the additional stockout costs avoided are $6,400 (16 * $400). According to the data
in Table 8.4, the optimum quantity of safety stock is 70 units. At this point, the cost
of 10 additional units of inventory is $1,200, and $1,200 is saved in stockout costs.
Trade-Off Between Carrying and Stockout Costs
WHEN TO ORDER AND HOW MUCH TO ORDER
A key issue with respect to inventory management involves the
determination of when product should be ordered; one could order a
fixed amount of inventory (fixed order quantity system), or orders can
be placed at fixed time intervals (fixed order interval system).
There needs to be a reorder (trigger) point (i.e., the level of inventory at
which a replenishment order is placed) for there to be an efficient fixed
order quantity system. Reorder points (ROPs) are relatively easy to
calculate, particularly under conditions of certainty; a reorder point is
equal to the average daily demand (DD) in units times the length of the
replenishment cycle (RC):
WHEN TO ORDER AND HOW MUCH TO ORDER
ROP = DD * RC
Suppose, for example, that average daily demand is 40 units, and the
replenishment cycle is 4 days. The reorder point in this example is 40 * 4, or 160
units; in other words, when the inventory level reaches 160 units, a reorder is
placed.
The reorder point under conditions of uncertainty can be calculated in a similar
manner; the only modification involves including a safety stock (SS) factor:
ROP = (DD * RC) + SS
Continuing with the previous example, suppose that the company decides to
hold 40 units of safety stock. The reorder point becomes (40 * 4) + 40, or 200
units.
Economic Order Quantity
A long-standing issue in inventory management concerns how much
inventory should be ordered at a particular time. The typical inventory
order size problem, referred to as the economic order quantity (EOQ),
deals with calculating the proper order size with respect to two costs:
the costs of carrying the inventory and the costs of ordering the
inventory. The EOQ 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. More specifically, “The economic order
quantity (EOQ) is the quantity of product that will minimize your total
costs of inventory per piece. The nature of carrying costs and ordering
costs are presented in Figure 8.1.
Economic Order Quantity
Economic Order Quantity
The basic EOQ model is grounded in the following assumptions:
1. A continuous, constant, and known rate of demand
2. A constant and known replenishment or lead time
3. A constant purchase price that is independent of the order quantity
4. All demand is satisfied (no stockouts are allowed)
5. No inventory in transit
6. Only one item in inventory or no interaction between inventory items
7. An infinite planning horizon
8. Unlimited capital availability.
Economic Order Quantity
Mathematically, the EOQ can be calculated in two ways; one presents
the answer in dollars, the other in units. In terms of dollars, suppose
that $1,000 of a particular item is used each year, the order costs are $25
per order submitted, and inventory carrying costs are 20 percent. The
EOQ can be calculated using this formula:
Economic Order Quantity
Economic Order Quantity
Alternatively, the EOQ can be calculated in terms of the number of
units that should be ordered. Using the same information as in the
previous example, and assuming that the product has a cost of $5 per
unit, the relevant formula is
Economic Order Quantity
Economic Order Quantity
Although we’ve calculated EOQs, how do we know that the answers are
correct? Because the EOQ is the point where carrying costs equal ordering
costs, we need to calculate both of these costs (see Table 8.5). Recall that we
calculated $500 (100 units) to be the EOQ.
As shown in Table 8.5, a $500 order size means that we’ll be ordering twice
per year; the corresponding ordering costs are $50. Average inventory for a
$500 order size is $250, meaning that our carrying costs are $50. Thus, we’ve
proven that at an order size of $500, our ordering costs and carrying costs are
equal. Table 8.5 presents the total cost calculations for several other order
sizes. Note that ordering costs equal carrying costs at the EOQ and that the
total cost (i.e., sum of ordering costs and carrying costs) is minimized as well.
Economic Order Quantity
 INVENTORY FLOWS
Figure 8.2 presents an illustration
of inventory flow based on the
following assumptions: an EOQ of
120 units, safety stock of 60 units,
average demand of 30 units per
day, and a replenishment or order
cycle of 2 days. Further, the
beginning inventory is equal to the
safety stock plus the EOQ (60 + 120
= 180). Recall from earlier in this
chapter that the reorder point can
be calculated as (daily demand *
replenishment cycle) + (safety
stock), or (30 * 2) + (60) = 120 units.
 INVENTORY FLOWS
The inventory flow example
presented in Figure 8.2 illustrates
that safety stock can act as a
safeguard against two problem
areas: an increased rate of
demand and a longer-than-
normal replenishment cycle.
Exercise:
Daily demand: 50 units
Replenishment cycle: 4 days
Safety stock: 40 units
Beginning inventory: 500 units
A = Annual usage = $1000
B = Ordering costs: $25
C = carrying costs: 20%
ROP?
EOQ?
Drawing an inventory flow diagram?
ABC Analysis of Inventory
ABC analysis of inventory, which can be applied in several different
ways, recognizes that inventories are not of equal value to a firm and
that, as a result, all inventory should not be managed in the same way.
An individual firm may stock hundreds or thousands of items, and it is
a real challenge to determine the relative importance of each item.
One common rule of thumb, the 80/20 rule, is that 80 percent of a
company’s sales come from 20 percent of its products (conversely, 20
percent of sales come from 80 percent of products). From a managerial
perspective, this suggests that the primary focus should be on the 20
percent of products that generate the 80 percent of sales.
ABC Analysis of Inventory
Measures that can be used to determine ABC status include sales
volume in dollars, sales volume in units, the fastest-selling items, item
profitability, or item importance. For example, with respect to item
importance, a firm supplying medicine to hospitals might need to stock
certain items because they are critically important.
Thus, in terms of item importance, ABC might be operationalized as
follows: A items could be the ones with the highest criticality, B items
could be those with moderate criticality, and C items could have low
criticality.
Dead Inventory
Some companies have added a fourth category, D, to ABC analysis. D
stands for either “dogs” or dead inventory (dead stock), which refers to
product for which there are no sales during a 12-month period.
Companies might also attempt to sell their dead inventory to
companies that specialize in selling such items. Internet sites are
available that specialize in selling off dead stock (e.g.,
deadstockbroker.com).
Inventory Turnover
Inventory turnover refers to the number of times that inventory is sold
in a one-year period, and can be calculated by dividing the cost of
goods sold by the average inventory, where average inventory is the
sum of beginning and ending inventory divided by 2. For example,
suppose the cost of goods sold is $675,000, beginning inventory is
$200,000, and ending inventory is $250,000. The inventory turnover for
these data is:
COST OF GOODS SOLD ($675,000) ÷ AVERAGE INVENTORY
[($200,000 + $250,000) ÷ 2], or $675,000 ÷ $225,000, which equals 3.
Inventory Turnover
Low turnover indicates that a company is taking longer to sell its
inventory, perhaps because of product obsolescence or pricing
problems
High turnover may signal low inventory levels, which can increase the
chance of product stockouts.
The inventory turnover concept provides an excellent example of trade-
offs involving multiple organizational functions such as finance,
logistics, and marketing.
Complementary and Substitute Products
Complementary products are defined as inventories that can be used or
distributed together, such as razor blades and razors. These products
may only intensify the pressures on retailers or wholesalers concerned
with inventory maintenance.
Substitute products refer to products that can fill the same need or
want as another product. The substitutability can occur at a specific
product level (e.g., one brand of cola is viewed as a substitute for
another brand of cola), or it can occur across product classes (e.g.,
potatoes may be viewed as a substitute for rice).
Lean Manufacturing
Broadly speaking, lean manufacturing (also referred to as lean) focuses
on the elimination of waste and the increase in speed and flow. The
lean manufacturing approach identifies seven major sources of waste,
one of which is inventory.
Just-in-time (JIT) is one of the best known lean inventory practices. We
will take a closer look at JIT in the paragraphs that follow. From an
inventory perspective, the Just-in-time (JIT) approach seeks to minimize
inventory by reducing (if not eliminating) safety stock, as well as by
having the required amount of materials arrive at the production
location at the exact time that they are needed.
Lean Manufacturing
Man-made natural disasters, the
August 2015 explosion at China’s
Port of Tianjin caused
tremendous supply chain
disruptions— lost inventories,
delayed shipments, rerouted
shipments—that are antithetical
to the lean philosophy.
Service Parts Logistics
Service parts logistics involves designing a network of facilities to stock service
parts, deciding upon inventory ordering policies, stocking the required parts,
and transporting parts from stocking facilities to customers. Long viewed as an
afterthought or—even worse—as a nuisance, service parts logistics has gained
greater attention and appreciation in recent years.
One reason for this is that the customer expectations associated with service
parts logistics continue to increase, particularly in the automotive industry
where the maximum customer wait time for repair or replacement parts is one
day.
Another reason for increased emphasis on service parts logistics is that tepid
worldwide economic conditions result in some organizations repairing, rather
than replacing, aging or defective equipment.
Vendor-Managed Inventory
In traditional inventory management, the size and timing of
replenishment orders are the responsibility of the party using the
inventory, such as a distributor or a retailer. Under vendor-managed
inventory (VMI), by contrast, the size and timing of replenishment
orders are the responsibility of the manufacturer.
Operationally, VMI allows manufacturers to have access to a
distributor’s or retailer’s sales and inventory data, and this access is
accomplished electronically by electronic data interchange (EDI) or the
Internet
1
 To calculate the Economic Order Quantity (EOQ), we need to use the following formula:
 EOQ = √(2DS/H)
 Where:
 D = Annual demand for nails (in kegs)
 B = Cost per order
 H = Holding cost per keg per year = IC
 From the given information in the question, we know that:
 D = 2,000 kegs per year B = $60 per order H = $1 per keg per year
 Substituting these values in the formula, we get:
 EOQ = √(2 x 2,000 x 60 / 1) ≈ 245.1
 Therefore, Low should order approximately 245 kegs of nails at one time to minimize the total
cost of ordering and holding inventory.
1
 To calculate the Economic Order Quantity (EOQ), we need to use the following formula:
 EOQ = √(2DS/H)
 Where:
 D = Annual demand for nails (in kegs)
 B = Cost per order
 H = Holding cost per keg per year = IC
 From the given information in the question, we know that:
 D = 2,000 kegs per year B = $60 per order H = $1 per keg per year
 Substituting these values in the formula, we get:
 EOQ = √(2 x 2,000 x 60 / 1) ≈ 245.1
 Therefore, Low should order approximately 245 kegs of nails at one time to minimize the total
cost of ordering and holding inventory.