Section J: Aggregate Inventory Management

Question 1

Inventory

Answer 1

inventory

Those stocks or items used to support production (raw materials and work-in-process items), supporting activities (maintenance, repair, and operating supplies), and customer service (finished goods and spare parts).

Demand for inventory may be dependent or independent. Inventory functions are anticipation, hedge, cycle (lot size), fluctuation (safety, buffer, or reserve), transportation (pipeline), and service parts.

Question 2

Inventory Management

Answer 2

inventory management

The branch of business management concerned with planning and controlling inventories.

Question 3

What two levels does Inventory Management take place?

Answer 3

Inventory management takes place at two levels: aggregate and item.

Question 4

Aggregate inventory management

Answer 4

Aggregate inventory management is part of long-term planning, for example, strategic planning, manufacturing business planning, S&OP, and production planning.

It is concerned with overall categories of inventory in the aggregate based on their financial value, such as the value of all raw materials.

Aggregate inventory management studies how inventory flows through production, how it is used to balance supply with demand, and the functions that it is used to perform.

Question 5

What are the three key objectives of aggregate inventory management?

Answer 5

three key objectives of aggregate inventory management

• Minimize inventory investment
• Meet targeted level of customer service
• Maximize manufacturing efficiency.

Question 6

What are the benefits/consequences of minimizing inventory?

Answer 6

• finance & purchasing may have an incentive to push for minimum inventory levels, depending on performance measures.
• suppliers may be required to keep higher inventories to make up for short inventory onhand

Question 7

level of service

Answer 7

level of service

A measure (usually expressed as a percentage) of satisfying demand through inventory or by the current production schedule in time to satisfy the customers’ requested delivery dates and quantities.

In a make-to-stock environment, level of service is sometimes calculated as the percentage of orders picked complete from stock upon receipt of the customer order, the percentage of line items picked complete, or the percentage of total dollar demand picked complete.

In make-to-order and design-to-order environments, level of service is the percentage of times the customer-requested or acknowledged date was met by shipping complete product quantities.

Question 8

on-time schedule performance

Answer 8

on-time schedule performance

A measure (percentage) of meeting the customer’s originally negotiated delivery request date.

Performance can be expressed as a percentage based on the number of orders, line items, or dollar value shipped on time.

Question 9

stockout percentage (Complement to Service level)

Answer 9

stockout percentage

A measure of the effectiveness with which a company responds to actual demand or requirements.

The stockout percentage can be a comparison of total orders containing a stockout to total orders, or of line items incurring stockouts to total line items ordered during a period.

The idea is that safety stock protects against uncertainty in supply or demand, and uncertainty caused by forecasting error. Safety

Question 10

Manufacturing efficiency

Answer 10

Manufacturing efficiency is about managing the flow of materials into, through, and out of the production process. Materials

Question 11

One way to manufacture efficiency is by decoupling inventory. What is decoupling inventory?

Answer 11

decoupling inventory

An amount of inventory maintained between entities in a manufacturing or distribution network to create independence between processes or entities.

The objective of decoupling inventory is to disconnect the rate of use from the rate of supply of the item.

Inventory can decouple supply from demand at the supply chain level by, for example, allowing raw materials to be pulled from inventory rather than relying on order lead times or maintaining inventories of finished goods rather than producing based on actual orders.

Question 12

Another way to manufacture efficiency is to have long production runs. What does this do?

Answer 12

Another way to increase manufacturing efficiency is to have long production runs with few changeovers, which results in higher levels of inventory since more units of a particular type will need to be made than are in demand right away.

However, a tradeoff is that long runs can harm customer service because some units will need to wait to be produced and so lead times will be longer for some customers.

Question 13

A third way to manufacture efficiency is to purchase raw materials and components in large lots. How does this help?

Answer 13

Finally, if purchasing buys raw materials and components in large lots, it decreases ordering costs (fewer orders need to be processed), cost per unit

Question 14

The types of inventory

Answer 14

• Raw material
• Work in process (WIP)
• Finished goods inventory
• Distribution inventory
• Maintenance, repair, and operating (MRO) supplies

Question 15

Raw Material

Answer 15

Raw material : Purchased items or extracted materials that are converted via the manufacturing process into components and products.

Question 16

Work in process (WIP)

Answer 16

Work in process (WIP) : A good or goods in various stages of completion throughout the plant, including all material from raw material that has been released for initial processing up to completely processed material awaiting final inspection and acceptance as finished goods inventory. Many accounting systems also include the value of semifinished stock and components in this category.

Question 17

Finished goods inventory

Answer 17

Finished goods inventory : Those items on which all manufacturing operations, including final test, have been completed. These products are available for shipment to the customer as either end items or repair parts.

Question 18

Distribution inventory

Answer 18

Distribution inventory : Inventory, usually spare parts and finished goods, located in the distribution system (e.g., in warehouses or in transit between warehouses and the consumer).

Question 19

Maintenance, repair, and operating (MRO) supplies

Answer 19

Maintenance, repair, and operating (MRO) supplies : Items used in support of general operations and maintenance such as maintenance supplies, spare parts, and consumables used in the manufacturing process and supporting operations.

Question 20

Functions of Inventory

Answer 20

• Safety stock
• Decoupling inventory
• Buffer
• Anticipation inventory
• Lot-size inventory
• Transportation inventory
• Hedge inventory

Question 21

-Lot-size inventory

Answer 21

Lot-size inventory : Inventory that results whenever quantity price discounts, shipping costs, setup costs, or similar considerations make it more economical to purchase or produce in larger lots than are needed for immediate purposes.

Cycle stock : One of the two main conceptual components of any item inventory, the cycle stock is the most active component. The cycle stock depletes gradually as customer orders are received and is replenished cyclically when supplier orders are received. The other conceptual component of the item inventory is the safety stock, which is a cushion of protection against uncertainty in the demand or in the replenishment lead time.

Question 22

-Transportation inventory

Answer 22

Transportation inventory : Inventory that is in transit between locations.

Transit inventory : Inventory in transit between manufacturing and stocking locations.

Pipeline stock : Inventory in the transportation network and the distribution system, including the flow through intermediate stocking points. The flow time through the pipeline has a major effect on the amount of inventory required in the pipeline. Time factors involve order transmission, order processing, scheduling, shipping, transportation, receiving, stocking, review time, and so forth.

In-transit inventory : Material moving between two or more locations, usually separated geographically; for example, finished goods being shipped from a plant to a distribution center.

Question 23

-Hedge inventory

Answer 23

Hedging is a way of locking in prices for something now to reduce uncertainty in case the price is too high later. This can be done with financial products such as futures, or it can be done by buying inventory sooner than it is needed when prices are low. When the latter is done, it is called hedge inventory.

A form of inventory buildup to buffer against some event that may not happen. Hedge inventory planning involves speculation related to potential labor strikes, price increases, unsettled governments, and events that could severely impair a company’s strategic initiatives. Risk and consequences are unusually high, and top management approval is often required.

Question 24

What are the following inventory costs?

Answer 24

The following are common inventory costs:

• Item costs
• Carrying costs
• Ordering costs
• Stockout costs
• Capacity-related costs

Question 25

-Item costs

Answer 25

Item costs are the purchase price plus other direct costs required to get the units to where they need to be,

Question 26

-Carrying costs

Answer 26

The cost of holding inventory, usually defined as a percentage of the dollar value of inventory per unit of time (generally one year).

Carrying cost depends mainly on the cost of capital invested as well as costs of maintaining the inventory such as taxes and insurance, obsolescence, spoilage, and space occupied.

Such costs vary from 10 percent to 35 percent annually, depending on type of industry.

Carrying cost is ultimately a policy variable reflecting the opportunity cost of alternative uses for funds invested in inventory.

• Capital costs
• Storage costs
• Risk costs

Question 27

-Ordering costs

Answer 27

The costs that increase as the number of orders placed increases. Used in calculating order quantities. Includes costs related to the clerical work of preparing, releasing, monitoring, and receiving orders; the physical handling of goods; inspections; and setup costs, as applicable.

Ordering costs are incurred for purchasing and for placing orders for production at the plant.

• Production control costs
• Setup costs
• Lost capacity cost

= (fixed cost/# of orders) + variable cost

Question 28

-Stockout costs

Answer 28

The costs associated with a stockout. Those costs may include lost sales, backorder costs, expediting, and additional manufacturing and purchasing costs.

Question 29

-Capacity-related costs

Answer 29

costs generally related to increasing (or decreasing) capacity in the medium- to long-range time horizon.

Question 30

What are the 3 types of financial statements?

Answer 30

The 3 types of Financial Statements:

0the balance sheet

• the income statement
• the statement of cash flows

Question 31

balance sheet

Answer 31

balance sheet

a financial statement showing the resources owned, the debts owed, and the owner’s share of a company at a given point in time.

Question 32

assets

Answer 32

What the organization owns are called assets. Current assets are those assets that are cash or can be converted into cash quickly and include accounts receivable, while fixed assets are assets that would take longer to sell, such as property, plant, and equipment.

Question 33

liabilities

Answer 33

An accounting/financial term (balance sheet classification of accounts) representing debts or obligations owed by a company to creditors. Liabilities may have a short-term time horizon, such as accounts payable, or a longer-term obligation, such as mortgage payable or bonds payable.

Question 34

Equity

Answer 34

The sum of owner investment plus retained earnings is owners’ (or shareholders’) equity.

Question 35

owners’ equity

Answer 35

owners’ equity (also called shareholders’ equity or simply equity) as an accounting/financial term (balance sheet classification of accounts) representing the residual claim by the company’s owners or shareholders, or both, to the company’s assets less its liabilities.

Owner’s equity = asset - liability

Question 36

income statement

Answer 36

income statement as “a financial statement showing the net income for a business over a given period of time.”

Income = Revenue - Expenses

Question 37

Cost of goods sold (COGS)

Answer 37

Cost of goods sold (COGS) : An accounting classification useful for determining the amount of direct materials, direct labor, and allocated overhead associated with the products sold during a given period of time.

Question 38

Direct labor

Answer 38

Direct labor

Labor that is specifically applied to the good being manufactured or used in the performance of the service.

Question 39

Direct material

Answer 39

Direct material : Material that becomes a part of the final product in measurable quantities.

Question 40

Overhead

Answer 40

Overhead

The costs incurred in the operation of a business that cannot be directly related to the individual goods or services produced.

These costs, such as light, heat, supervision, and maintenance, are grouped in several pools (e.g., department overhead, factory overhead, general overhead) and distributed to units of goods or services by some standard allocation method such as direct labor hours, direct labor dollars, or direct materials dollars.

Question 41

Fixed overhead

Answer 41

Fixed overhead

Traditionally, all manufacturing costs—other than direct labor and direct materials—that continue even if products are not produced.

Although fixed overhead is necessary to produce the product, it cannot be directly traced to the final product.

Question 42

Gross margin

Answer 42

Gross margin

The difference between total revenue and the cost of goods sold.

Question 43

What is net income?

Answer 43

Gross profit minus operating expenses, depreciation, and interest expenses on debt results in net income (profit) before taxes.

Question 44

Examples of Operating Expenses

Answer 44

Operating expenses include:

• Selling expenses such as salespersons’ commissions or advertising
• General and administrative expenses such as executive and clerical wages and benefits
• Insurance
• Lease expenses such as for office space or vehicles

Question 45

general and administrative expenses

Answer 45

general and administrative expenses [G&A]

the category of expenses on an income statement that includes the costs of general managers, computer systems, research and development, etc.

Question 46

profit margin

Answer 46

profit margin

1) The difference between the sales and cost of goods sold for an organization, sometimes expressed as a percentage of sales.
2) In traditional accounting, the product profit margin is the product selling price minus the direct material, direct labor, and allocated overhead for the product, sometimes expressed as a percentage of selling price.

Question 47

Product Cost

Answer 47

Cost allocated by some method to the products being produced. Initially recorded in asset (inventory) accounts, product costs become an expense (cost of sales) when the product is sold.

Question 48

cash flow

Answer 48

cash flow

The net flow of dollars into or out of the proposed project. The algebraic sum, in any time period, of all cash receipts, expenses, and investments. Also called cash proceeds or cash generated.

Question 49

One simple way to measure the performance of inventory is to measure the unit cost. Define.

Answer 49

unit cost

Total labor, material, and overhead cost for one unit of production (e.g., one part, one gallon, one pound).

Question 50

value added

Answer 50

value added

1) In accounting, the addition of direct labor, direct material, and allocated overhead assigned at an operation. It is the cost roll-up as a part goes through a manufacturing process to finished inventory.
2) In current manufacturing terms, the actual increase of utility from the viewpoint of the customer as a part is transformed from raw material to finished inventory; the contribution made by an operation or a plant to the final usefulness and value of a product, as seen by the customer.

The objective is to eliminate all non-value-added activities in producing and providing a good or service.

Question 51

velocity

Answer 51

velocity

1) The rate of change of an item with respect to time.
2) In supply chain management, a term used to indicate the relative speed of all transactions, collectively, within a supply chain community.

A maximum velocity is most desirable because it indicates higher asset turnover for stockholders and faster order-to-delivery response for customers.

Velocity measures include inventory turnover and days of supply.

Question 52

inventory turnover (also called inventory turns)

Answer 52

inventory turnover (also called inventory turns)

The number of times that an inventory cycles, or “turns over,” during the year.

A frequently used method to compute inventory turnover is to divide the annual cost of sales by the average inventory level.

For example, an annual cost of sales of $21 million divided by an average inventory of $3 million means that inventory turned over seven times.

Question 53

average inventory , which the Dictionary defines as One-half the average lot size plus the safety stock, when demand and lot sizes are expected to be relatively uniform over time. The average can be calculated as an average of several inventory observations taken over several historical time periods; for example, 12-month ending inventories may be averaged. When demand and lot sizes are not uniform, the stock level versus time can be graphed to determine the average.

Answer 53

average inventory

One-half the average lot size plus the safety stock, when demand and lot sizes are expected to be relatively uniform over time.

The average can be calculated as an average of several inventory observations taken over several historical time periods; for example, 12-month ending inventories may be averaged.

When demand and lot sizes are not uniform, the stock level versus time can be graphed to determine the average.

Question 54

Average Inventory (calculation)

Answer 54

average inventory = (period 1 + period 2)/2

Question 55

Inventory Turnover (calculation)

Answer 55

Inventory Turnover = Annual COGS/average inventory

Question 56

days of supply

Answer 56

days of supply

1) Inventory-on-hand metric converted from units to how long the units will last.

For example, if there are 2,000 units on hand and the company is using 200 per day, then there are 10 days of supply.

2) A financial measure of the value of all inventory in the supply chain divided by the average daily cost of goods sold rate.

Question 57

generally accepted accounting principles (GAAP),

Answer 57

generally accepted accounting principles (GAAP),

accounting practices that conform to conventions, rules, and procedures that are generally accepted by the accounting profession.

Question 58

GAAP allows 3 methods of accounting to value inventory.

Answer 58

GAAP allows three methods of accounting for the value of inventory:

• first-in, first-out (FIFO)
• last-in, first-out (LIFO)
• average cost

Question 59

FIFO

Answer 59

With the FIFO method, the first unit put into inventory is the first unit removed from the ERP system’s inventory records when a sale occurs. The oldest items are sold first.

Question 60

LIFO

Answer 60

With LIFO, the last unit put into inventory is the first removed from the ERP inventory records when there is a sale, and the newest items are sold first.

Question 61

Average cost (Weighted average cost)

Answer 61

The average cost, also called the weighted average cost, is the average of all costs paid for or internally invested in inventory for COGS and balance sheet inventory valuation. It is basically an average of the oldest and newest costs, so the valuation falls somewhere between FIFO and LIFO. Because it is an average, it does not reflect actual prices paid whether prices are rising or falling.

Question 62

Job costing

Answer 62

Job costing

A cost accounting system in which costs are assigned to specific jobs. This system can be used with either actual or standard costs in the manufacturing of distinguishable units or lots of products.

Question 63

Standard costs

Answer 63

Standard costs

The target costs of an operation, process, or product including direct material, direct labor, and overhead charges.

Question 64

Variance

Answer 64

Variance

1) The difference between the expected (budgeted or planned) value and the actual.
2) In statistics, a measurement of dispersion of data.

Question 65

Lean Accounting Methods..

backflush

Answer 65

Lean Accounting Methods..
backflush

A method of inventory bookkeeping where the book (computer) inventory of components is automatically reduced by the computer after completion of activity on the component’s upper-level parent item based on what should have been used as specified on the bill of material and allocation records.

This approach has the disadvantage of a built-in differential between the book record and what is physically in stock.

Rather than recording each raw material and each WIP transaction, lean systems (and also some conventional MPC environments) backflush.

Question 66

stock keeping unit (SKU)

Answer 66

stock keeping unit (SKU)

1) An inventory item.

For example, a shirt in six colors and five sizes represents 30 different SKUs.

2) In a distribution system, an item at a particular geographic location.

For example, one product stocked at the plant and at six different distribution centers would represent seven SKUs.

Question 67

wall-to-wall inventory

Answer 67

wall-to-wall inventory

An inventory management technique in which material enters a plant and is processed through the plant into finished goods without ever having entered a formal stock area.

Question 68

safety lead time

Answer 68

safety lead time

An element of time added to normal lead time to protect against fluctuations in lead time so that an order can be completed before its real need date.

When used, the MRP system, in offsetting for lead time, will plan both order release and order completion for earlier dates than it would otherwise.

Safety lead time is often preferred over safety stock for items that are only sporadically in demand, because it reduces uncertainty without resulting in more units that may not sell for a long time.

Question 69

Factors to consider for Safety Stock…

Describe demand variability during the lead time.

Answer 69

Demand variability during the lead time.

When demand variability is high, forecast error rates will be high, and higher amounts of safety stock will be needed to provide a targeted customer service level.

Question 70

Factors to consider for Safety Stock…

Targeted customer service level.

Answer 70

Targeted customer service level.

The customer service ratio (fill rate) can be specified as part of the organization’s strategy, and safety stocks will be calculated to meet this level. One way the customer service ratio might be expressed is as the acceptable number of stockouts per period, which is related to order frequency.

Question 71

Factors to consider for Safety Stock…

Order frequency.

Answer 71

Order frequency.

When orders are less frequent, they must also be in higher quantities to meet a given demand level. The only time a stockout can occur is when inventory is about to be reordered, because this is when the inventory will be running low. Thus, less frequent orders result in fewer chances of stockouts (but higher carrying costs).

Question 72

Factors to consider for Safety Stock…

Duration of the lead time.

Answer 72

Duration of the lead time.

When resupply takes longer, there is more chance for demand variability to become an issue and, thus, more safety stock is needed.

Reducing lead times reduces safety stock requirements. If the lead time were zero, there would be no need for safety stock, since resupply would be instantaneous.

The manufacturing environment will also affect lead time duration. For example, a make-to-order organization may or may not need safety stocks of raw materials depending on customer lead time expectations versus the lead time required to order these materials, produce, and ship (they won’t have finished good safety stocks because these are made to order).

Question 73

Safety Stock Calculation

Answer 73

Safety Stock = SD (or MAD in units) x Appropriate service factor for SD or MAD

Question 74

Orders per Period Calculation

Answer 74

Orders per Period = Period Demand / Order Quantity

Question 75

Customer Service Level Calculation

Answer 75

Customer Service Level = (Orders per period - Stockout chances per period)/Orders per period

Question 76

New Safety Stock Calculation

Answer 76

New Safety Stock = Old Safety Stock x SQRT (New Lead time/Old lead time)