Chapter 9: Inventory Management Flashcards
Inventory management
The planning and controlling of inventories to meet the competitive priorities of the organization
Lot sizing
A main part of inventory management
The determination of how frequently and in what quantity to order inventory
Lot size
The quantity of an inventory item that management either buys from a supplier or manufactures via internal processes
Level of inventory is determined by
Difference between input flow rate and output flow rate (latter both to customers and to scrap)
Pressures that incentivize small inventories
- cost of capital
- storage and holding costs
- taxes, insurance, and shrinkage
Inventory holding cost
Aka inventory carrying cost
Cost of capital for inventory + variable cost of keeping items on hand (storage, handling, taxes etc…)
Generally stated as % of inventory value
Cost of capital (for inventory)
Opportunity cost of investing in inventory relative to the expected return on assets of similar risk
Generally weighted average cost of capital
Usually the largest component of inventory holding cost
Storage and handling Inventory holding costs
Incurred when a firm could use the storage space and labor productively in some other way
Forms of shrinkage
Pilferage
Obsolescence
Deterioration
If these rates are high a large inventory may be unwise
Pressures that incentivize holding large inventories
- customer service
- ordering cost
- setup cost
- labor and equipment utilization
- transportation cost
- payments to suppliers
Ordering cost
The cost of preparing a purchase order for a supplier or production order for manufacturing
Same regardless of order size so cost efficient to do large orders
Technologies may reduce these costs
Setup cost
Cost involved in changing over a machine or workspace to produce a different item
Again, incentivizes larger production runs for fewer changeovers
Technologies may increase flexibility and lower setup costs
How can holding large inventory increase labor productivity and facility utilization?
- fewer number of set ups (which decrease overall utilization)
- reduced cost of rescheduling production due to lack of inventory
- stabilizes output rate for cyclical or seasonal items
Quantity discount
Drop in price per unit when order is sufficiently large
What relationship does inventory have with working capital?
Because inventory is financed by working capital, increasing inventory increases the need for working capital
Accounting inventory categories
Raw materials (RM)
Work-in-process (WIP)
Finished goods (FG)
Independent demand items
Items for which demand is influenced by market conditions and is not related to the inventory decisions for any other item held in stock or produced
Finished goods
(Wholesale and retail merchandise, service support inventory, product and replacement part distribution, maintenance repair and operating supplies
MRO supplies
Maintenance, repair, and operating supplies
Items that do not become part of the final service or product
Estimating demand for independent demand items
Forecasting
Dependent demand items
Items whose required quantity varies with the production of other items held in the firms inventory. (Are required as components)
Raw materials
Work in process
Demand is calculated, not forecasted
Operational inventory categories
Cycle
Safety stock
Anticipation
Pipeline
Identified conceptually, not physically
Cycle inventory
The portion of total inventory that varies directly with lot size
Given:
- lot size varies directly with elapsed time between orders
- the longer between orders the larger the cycle inventory must be
Inventory at it’s highest at the beginning of the interval (when new lot arrives) and lowest at the end (just before new lot arrives)
Calculating average cycle inventory
= cycle inventory maximum / 2
(Because minimum is approximately 0 just before new lot arrives)
Formula only exact when demand is constant and uniform
Scrap losses may cause estimating errors
Safety stock inventory
Surplus inventory that a company holds to protect against uncertainties in demand, lead time, and supply changes
Anticipation inventlry
Inventory used to absorb uneven rates of demand or supply
Often used when there are predictable, seasonal demand patterns (stockpiling during low demand to be ready for high demand)
Pipeline inventory
Inventory that is created when an order for an item is issued but not yet received
Because firm needs enough inventory on hand plus in transit to cover lead times for the order
Longer lead times or higher demand create more pipeline inventory
Average pipeline inventory between two stocking points
= average demand during lead time = average demand for the item per period * number of periods in the items lead item (time to move between two points)
Note: d (demand) and L (lead time) may not be constant, especially if lot size changes (changes lead time)
Primary inventory reduction lever
Tactic that must be used if inventory is to be reduced
Secondary inventory reduction lever
A tactic that reduces the penalty cost of applying the primary lever and the need for having inventory in the first place
Inventory reduction tactics: cycle inventory
Primary: reduce lot sizes of items moving in the supply chain (may increase set up costs or ordering costs)
Secondary (to manage setup and ordering costs)
- streamline ordering method
- increasing repeatability to eliminate need for changeovers
Repeatability and how to increase it
The degree to which the same work can be done again
Increases via: high product demand, use of specialization, devoting resources exclusive to a product, using same parts in many products, use of flexible automation, use of one-worker multiple-machines set up, via group technology
Results of increased repeatability
May justify new set up methods, reduced transportation costs, allow for quantity discounts
Inventory reduction tactics: safety stock inventory
Primary: place orders closer to time needed (problem if there are any uncertainties)
Secondary levers to address uncertainties:
- improve demand forecasts
- cut lead times of purchased or produced items (local suppliers)
- reduce supply uncertainties (fuller collaboration with suppliers, reduce scrap/rework, preventive maintenance)
- increase reliance on equipment and labor buffers (capacity cushions and cross-trained workers)
Inventory reduction tactics: anticipation inventory
Primary lever: matching demand and production.
Secondary levers to even out customer demand:
- add new products with different demand cycles
- provide off season promotional campaigns
- offer seasonal pricing plans
Inventory reduction tactics: pipeline inventory
Primary lever: reduce lead time
Secondary levers to help cut lead time:
- source from more responsive suppliers and reliable carriers, improve information sharing
- change Q (lot size) when lead time is dependent on lot size
Questions for each item of inventory
1) what degree of control should be imposed?
2) how much to order?
3) when to order?
ABC analysis
The process of dividing SKUs into three classes, according to their dollar usage, so that managers can focus on items that have the highest dollar value
Class A = highest dollar value, requires close control
Class B = mid range dollar usage, moderate control
Class C = lowest dollar usage, only loose control necessary
Determining SKU Dollar usage
Annual demand rate x cost of SKU = dollar usage
Finding classes for ABC analysis
Plot all SKUs on a chart and look for natural changes in the slope. Dividing lines between classes are inexact
Inventory treatment of class A skus
Review frequently - need to maintain high turnover so lot size should be reduced if possible
Inventory treatment of class B skus
Safety stocks can help provide cost effective coverage
Cycle counting
An inventory control methid whereby storeroom personnel physically count a small percentage of the total number of items each day, correcting errors as they are found
Inventory holding cost
Sum of the cost of capital and the variable costs of keeping items on hand (storage and handling, taxes, insurance, shrinkage)
Ordering cost
Cost of preparing a purchase order for a supplier or a productions order for the shop
Setup cost
Cost of changing over a machine to produce a different item
Cycle inventory
That portion of total inventory that varies directly with lot size
Economic order quantity
EOQ
The lot size that minimizes total annual cycle-inventory holding and ordering costs
Assumptions used in determining EOQ
- demand rate for the item is constant and known with certainty
- no restraints are placed on the size of each lot
- only relevant costs are inventory holding costs and fixed costs per lot for ordering or setup
- decisions for one item can be made independently of other items (not considering advantage from combining orders from same supplier)
- lead time is constant and known with certainty, and amount received = amount ordered and receipt is all at once
When to NOT use EOQ
- using make to order strategy and customer wants entire order at once
- order size is constrained by capacity limitations
When to use modified EOQ
- if significant quantity discounts exist
- if replenishment is not instantaneous (items must be used or sold as completed without waiting for entire lot)
When to use EOQ
- company uses a make to stock strategy and item has stable demand
- carrying costs per unit and setup and ordering costs are known and relatively stable
Annual holding cost for calculating EOQ
= average cycle inventory* unit holding cost
(Average cycle inventory = lot size / 2)
Annual ordering cost for calculating EOQ
= (number of orders/year)* (ordering or setup cost)
Average number of orders per year = annual demand / lot size
Total annual cycle - inventory cost for calculating EOQ
= annual holding cost + annual ordering or setup cost
= (Lot size/2)unit holding cost for a year + (annual demand/lot size) cost of ordering or setting up one lot
Can be graphed with lot size as independent variable and annual cost as dependent variable
Best lot size aka EOQ
If graph annual holding cost, annual ordering cost, and total annual cycle inventory cost with lot size as independent variable and annual cost as dependent variable best lot size will be:
Lowest point on total annual cycle inventory cost line, which should be where annual holding cost = annual ordering cost
EOQ formula
= √((2*annual demand * set up or order cost)/holding cost for one unit for a year)
If annual holding cost is greater than annual ordering cost
Lot size is too large
Time between orders
TBO
Average time elapsed between receiving (or placing) replenishment orders of Q units for a particular lot size
Expressed as a fraction of a year
Formula for time between orders
Lot size/ annual demand
Fraction is portion of a year (multiply by 12 to get % of a month, by 52 to get weeks, by 365 to get days)
Sensitivity analysis
A technique for systematically changing crucial parameters to determine the effects of a change
In EOQ can change demand, various costs
Advantages of reducing setup time and costs
Makes small lot production more economical and allows for use of lean systems where less inventory is held
Continuous review system
Aka Q system, aka Reorder point system (ROP), aka fixed order quantity system
A system designed to track the remaining inventory of a sku each time a withdrawal is made to determine whether it is time to reorder
Inventory position
IP
Measurement of a SKU’s ability to satisfy future demand
Scheduled receipts
SR
Orders that have been placed and not yet received (aka open orders)
Inventory position equation
= on-hand inventory + scheduled receipts - backorders
Reorder point
R
The predetermined minimum level that an inventory position must reach before a predetermined quantity Q of the SKU is ordered
Time between orders in an continuous review system
Varies
Order quantity in a continuous review system
Fixed
Reorder point when demand and lead time are constant
R= total demand during lead time
No safety stock needed if somehow the supplier always ships total quantities that arrive on time
Reorder point when demand is variable
Means time between orders will also be variable (TBO)
Orders done when IP falls below R (must consider full inventory position, not just what is on hand)
Safety stock may reduce stockouts/backorders
Reorder point with safety stock
= (average demand)*(constant lead time) + safety stock
Determining level of safety stock
Usually a management decision based on customer service levels desires and tolerance for backorders vs inventory holding costs
Service level
Aka cycle service level
The desired probability of not running out of stock in any one ordering cycle (beginning at time an order is place and ending with the arrival of the stock)
Protection interval
The period over which safety stock must protect the user from running out of stock
For continuous system protection interval = lead time
Probability of running short during the protection interval
100 - service level
Steps to arrive at a reorder point
1) choose appropriate service level policy
2) determine the distribution of demand lead time
3) determine the safety stock and reorder point levels
Distribution of demand during lead time
Need to know mean and standard deviation.
- how demand during lead times is distributed
- how lead times are distributed
If small variation then safety stock can be small, if large variation safety stock must be larger
Average demand during lead time
Assuming lead time is constant and average demand for each period is identical and independent of other demands
= Average demand * lead time
Standard deviation of distribution during lead time
= standard deviation for one period * square root of # of periods in lead time
Assumptions when determining safety stock
Normally distributed demand during lead time (so can easily calculate probability of stock out for particular reorder point based on average demand)
Probability of a stockout using normal distribution
Area to the right of the reorder point. (Area below reorder point= likelihood of having stock = service level policy)
Safety stock equation
= z (number of standard deviations needed to achieve the cycle-service level) * σ (standard deviation during lead time))
85% service level z = 1.04
Assumptions when demand and lead time are both variable
- demand distribution and lead time are measured in same time units
- demand and lead time are independent variables
Standard deviation of demand during lead time when demand and lead time are variable
= square root of ((average lead time * variance of demand) + (average demand squared * variance of lead time))
Demand period and lead time must be same periods
More conservative z value
Higher z value
Systems based on the continuous review (Q) system
- two bin system
- base stock system
Visual system
A system that allows employees to place orders when inventory visibly reaches a certain marker
Used with low value skus that have a steady demand. Overstocking common but inventory holding cost low
Two- bin system
A visual system version of the continuous review (Q) system in which a SKU’s inventory is stored at two different locations
1st bin used first. When empty, an order needs to be placed but second bin provides stock until replenishment arrives
Normal level of second bin at reorder point r
Base stock system
An inventory control system that issues a replenishment order (Q) each time a withdrawal is made for the same amount of the withdrawal
One for one replacement policy
Base stock level = reorder point
Used to minimize cycle inventory (more orders placed but each order smaller)
Appropriate for more expensive items
Total costs of a continuous review system
= annual cycle-inventory holding costs + annual ordering costs + annual safety stock holding costs
= (Lot size/2)* annual holding cost for one unit + (annual demand/lot size)* cost of ordering one lot + (annual holding cost for one unit* safety stock)
Advantages of the continuous review (Q) sustem
- review frequency for each SKU may be individualized (can reduce total holding and ordering costs)
- fixed lot sizes may result in quantity discounts
- low levels of safety stock required
Periodic review (P) system
A system in which an item’s inventory position is reviewed periodically rather than continuously
Establishes routine that may simplify delivery scheduling since a new order is always placed at the end of each review. Time between orders is fixed but lot size changes (each time ordered to bring up to target inventory (T))
Order quantity in a periodic review system
= Target inventory - inventory position
Inventory levels under P vs Q systems
Generally to gain benefit of periodic ordering (avoiding constant monitoring) a p system requires more inventory than a Q system for the same level of of protection against backorder and stockouts
Ways to select time between reviews for a periodic review system
- convenient interval
- average time between orders for the economic order quantity
- annual demand / lot size
Target inventory when demand is variable and lead time is constant
T must be large enough to have inventory position last through the next review/lead time
T= average demand * (period + lead time) + safety stock
Protection interval under periodic review system
= period + lead time
Because orders are placed at fixed intervals
Safety stock required for periodic review inventory system
Again assuming normal probability distribution
Z = cycle service level (1- probability of stock out)
= Z* standard deviation of distribution of demand during the protection interval
standard deviation of distribution of demand during the protection interval = standard deviation of demand * square root of (P+ L)
Total P system costs
Same as Q system
= (Lot size/2)* annual holding cost for one unit + (annual demand/lot size)* cost of ordering one lot + (annual holding cost for one unit* safety stock)
Where lot size = average demand * periods between orders
Advantages of P system
- administrative convenience (orders at fixed intervals). Standardized pick up and delivery
- orders for multiple items from same supplier made on a single purchase order
- IP only needs to be known when review is made
Perpetual inventory system
System of inventory control in which the inventory records are always current
Inventory systems based on the p system
Single-bin system
Optional replenishment system
Single bin system
A system of inventory control in which a maximum level is marked on the storage shelf or bin and the inventory is brought up to that mark periodically
Optional replenishment system
Aka: optional review. Min-max, or (s, S) system
System used to review the inventory position at fixed time intervals and, if position has dropped to (or below) a predetermined level, to place a variable sized order to cover expected needs
Orders not automatically placed unless inventory has dropped to predetermined minimum (reorder point R)
