Supply chain Management

Planning & Managing Inventories in a Supply Chain: managing economies of scale, cycle inventory,
and managing uncertainty safety inventory optimal level of product availability

Managing Economies of Scale: Producing or purchasing in large lots allows a stage of supply chain to
exploit economies of scale and lower cost. These economies of scale result due to fixed costs associated
with ordering and transportation, quantity discounts on buying larger lots, and short-term discounts
or trade promotions.

Cyclic inventory: If purchasing is done in large lots and consumption is done in smaller lots, when the
order is received there is a sharp increase in stock or inventory. This inventory or stock gets depleted
as consumption takes place gradually and once again a big lot may be ordered and received. Thus the
cycle repeats and the average inventory held by a firm during each cycle is termed cycle inventory.

Inventory: Inventory is the items or materials which are to be kept in stock to meet the operational and
maintenance requirements

Inventory Management: Inventory Management is the function responsible for co-ordination,

planning, sourcing, purchasing, moving, storing and controlling inventories in an optimum manner,
so as to provide predetermined services to the customers at a minimum cost

Types of Inventories : By conditions during processing Inventories may be classified as

Raw Materials : These are Iron ore for steel, grain for flour, wood for furniture, raw cotton yarn for
cloth and materials used to make the components of the finished product.

Components : Parts of sub-assemblies ready to go into the final assembly of the product.

Work in Progress : Materials of components being worked on or waiting between operations in the
factory.

Finished Product : Finished items carried in inventory in a make of stock plant or finished goods ready
to ship to a customer against an order in a make to order plant.

Inventory Control-Terminology:

a. Demand: it is the number of items (products) required per unit of time. The demand may be either
deterministic or probabilistic in nature.

b. Order cycle: The time period between two successive orders is called order cycle.

c. Lead time: The length of time between placing an order and receipt of items is called lead time.

d. Safety stock: It is also called buffer stock or minimum stock. It is the stock or inventory needed to
account for delays in materials supply and to account for sudden increase in demand due to rush
orders.

e. Inventory turnover: If the company maintains inventories equal to 3 months consumption. It means
that inventory turnover is 4 times a year, i.e. the entire inventory is used up and replaced 4 times a year.

f. Re-order level (ROL): It is the point at which the replenishment action is initiated. When the stock
level reached R.O.L., the order is placed for the item.
g. Re-order quantity: This is the quantity of material (items) to be ordered at the re-order level.
Normally this quantity equals the economic order quantity.

Cost Associated with Inventory: a company’s inventory policy affects the following costs

a. Purchase (or production) cost: The value of an item is its unit purchasing (production) cost. This cost
becomes significant when availing the price discounts. This cost is expressed as Rs. /unit

b. Capital cost: the amount invested in an item, (capital cost) is an amount of capital not available for
other purchases. If the money were invested somewhere else, a return on the investment is expected.
A charge to inventory expenses is made to account for this unreceived return. The amount of the charge
reflects the percentage return expected from other investment.

c. Ordering cost: It is also known by the name procurement cost or replenishment cost or acquisition
cost. Cost of ordering is the amount of money expended to get an item into inventory. This takes into
account all the costs incurred from calling the quotation to the point at which the items are taken to
stock. The salaries and wages of permanent employees involved in purchase function and control of
inventory, purchasing, incoming inspection, accounting for purchase orders constitute the major part
of the fixed costs. The cost of placing an order varies from one organization to another. They are
generally classified under the following heads:

(i) Purchasing: The clerical and administrative cost associated with the purchasing, the cost of
requisitioning material, placing the order, follow-up, receiving and evaluating quotations.

(ii) Inspection: The cost of checking material after they are received by the supplier for quantity
and quality and maintaining records of the receipts.

(iii) Accounting: The cost of checking supply against each order, making payments and
maintaining records of purchases.

d. Transportation costs: The expenses involved in moving products or assets to a different place, which
are often passed on to consumers. For example, a business would generally incur a transportation cost
if it needs to bring its products to retailers in order to have them offered for sale to consumers. Transport
costs have significant impacts on the structure of economic activities as well as on international trade.

e. Inventory carrying costs (Holding cost): These are the costs associated with holding a given level of
inventory on hand and this cost vary in direct proportion to the amount of holding and period of
holding the stock in stores. The holding costs include.

(i) Storage costs (rent, heating, lighting, etc.)

(ii) Handling costs: Costs associated with moving the items such as cost of labor, equipment for
handling.

(iii) Depreciation, taxes and insurance.

(iv) Costs on record keeping.

(v) Product deterioration and obsolescence.

(vi) Spoilage, breakage, pilferage and loss due to perishable nature.

 f. Shortage cost: When there is a demand for the product and the item needed is not in stock, then we
incur a shortage cost or cost associated with stock out. The shortage costs include:

(i) Backorder costs.

(ii) Loss of future sales.

(iii)Loss of customer goodwill.

(iv)Extra cost associated with urgent, small quantity ordering costs.

(v) Loss of profit contribution by lost sales revenue. The unsatisfied demand can be satisfied at a
later stage (by means of back orders) or unfulfilled demand is lost completely (no back ordering,
the shortage costs become proportional to only the shortage quantity).

Inventory Cost Relationships: There are two major costs associated with inventory. Procurement cost
(ordering cost) and inventory carrying cost. Annual procurement cost varies with the number of orders.
This implies that the procurement cost will be high, if the item is procured frequently in small lots. The
procurement cost is expressed as Rs. /Order. The annual inventory carrying cost (Product of average
inventory X Carrying cost) is directly proportional to the quantity in stock. The inventory carrying cost
decreases, if the quantity to be ordered per order is small. The two costs are diametrically opposite to
each other. The right quantity to be
ordered is one that strikes a balance
between the two opposing costs. This
quantity is referred to as “Economic
order quantity” (EOQ).

One basic problem of inventory

management is to find out the order
quantity so that it is most economical
from overall operational point of view.
Here that problem lies in minimizing the
two conflicting costs, i.e. ordering cost
and inventory carrying cost. Inventory
models help to find out the order
quantity which minimizes the total costs (sum of ordering costs and inventory carrying costs).

Objectives of Inventory Control

• To reduce financial investment in Inventories, through proper Inventory balances.

• To facilitate production operations
• To avoid losses of Inventory obsolescence
• To minimise total ordering cost and total carrying cost
• To improve customer service
• To follow government policies with regard to inventories

Inventory Models: Basically the types of inventory policies relating to replenishment of inventory as
under
Deterministic Models:

Fixed Quantity System:

1. Economic Order Quantity with Instantaneous Stock Replenishment (Basic Inventory Model)
Assumptions
(i) Demand is deterministic, constant and it is known.
(ii) Stock replenishment is instantaneous (lead time is zero)
(iii) Price of the materials is fixed (quantity discounts are not allowed)
(iv) Ordering cost does not vary with order quantity.

Basic inventory model Let D be the annual demand (units per year)
2. Economic Order Quantity when stock replenishment is non-instantaneous (Production Model)
: This model is applicable when inventory
continuously builds up over a period of time
after placing an order or when the units are
manufactured and used (or sold) at a
constant rate. Because this model is
especially suitable for the manufacturing
environment where there is a simultaneous
production and consumption, it is called
“Production Model”.

Assumptions
(i) The item is sold or consumed at the
constant demand rate which is
known.
(ii) Set up cost is fixed and it does not change with lot size.
(iii) The increase in inventory is not instantaneous but it is gradual.
3. Inventory model with shortages
permitted.
In many practical situations, shortages or
stock outs are not permitted. So, it is must
that stocks out situations are to be
avoided. There are occasions where stock
out are economically justifiable. This
situation is observed normally when cost
per unit is very high.

4. Inventory Model with price discounts: When items are bought in large quantities, the supplier
often gives discounts. However, if the material is purchased to take advantage of discount, the
average inventory level and so the inventory carrying costs will increase. Benefits for the
purchaser from large orders are, lower cost per unit, lower shipping and transportation cost,
reduced handling cost and reduction in ordering costs due to less number of orders. These
benefits are to be compared with the increase in carrying costs. As the order size increases,
more space should be provided to stock the items. A decision is, therefore, to be taken whether
the buyer should stick to economic order quantity or increase the same to take advantage that,
at large quantities, the production costs per piece are lower (economics of scale) and, hence,
part of the savings can be passed on to the customer.
Safety Stock: The economic order quantity formula is developed based on the assumption that
the demand is known and certain and that the lead time is constant and does not vary. In actual
practical situations, there is an uncertainty with respect to both demand as well as lead time.
The total forecasted demand may be more or less than actual demand and the lead time may
vary from the estimated time. In order to minimize the effect of this uncertainty due to demand
and lead time, a firm maintains safety stock, reserve stock or buffer stock. The safety stock is
defined as “the additional stock of material to be maintained in order to meet the unanticipated
increase in demand arising out of uncontrollable factors.” Because it is difficult to predict the
 exact amount of safety stock to be maintained, by using statistical methods and simulation, it
is possible to determine the level of safety stock to be maintained.

2. Fixed Order Interval Replenishment System (P System/Periodic Ordering/Periodic Review

System):
Under this system, ordering times are fixed rather than the quantities. It can be characterised as follows
• The time interval for ordering is fixed either for a group of items or for individual items.
• The inventory carrying costs as well as fixed reorder quantity are not considered explicitly.
• Review of inventory is done at definite time intervals.
• Average consumption during review period and lead time are forecast.
Replenishment level is computed as under:
RPL = B + CD (L + R)
RPL = Replenishment Level
L = Lead time (days)
R = Review interval (days)
B = Buffer stock
CD - Average daily sales (units/day)
Order is placed after fixed period, for the quantity by which inventory level had come down from a
predetermined level or point. It is determined on the basis of requirement of materials during review
period and lead time plus safety stock.