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Chapter 9 Managing Inventory in the Supply Chain

Learning Objectives
After reading this chapter, you should be able to do the
Appreciate the role and importance of inventory in the economy.
List the major reasons for carrying inventory.
Discuss the major types of inventory, their costs, and their
relationships to inventory decisions.
Understand the fundamental differences among approaches to
managing inventory.
Describe the rationale and logic behind the economic order
quantity (EOQ) approach to inventory decision making, and be
able to solve some problems of a simple nature.
Learning Objectives (cont.)
After reading this chapter, you should be able to do the
Understand alternative approaches to managing inventoryjust-
in-time (JIT), materials requirement planning (MRP), distribution
requirements planning (DRP), and vendor-managed inventory
Explain how inventory items can be classified.
Know how inventory will vary as the number of stocking points
Make needed adjustments to the basic EOQ approach to
respond to several special types of applications.


Inventory is an asset on the balance sheet and a variable expense on
the income statement.

Inventories also have an impact on return on investment (ROI) for the

Inventories also have an impact on return on investment (ROI) for an
GDP versus Inventory

Nominal GDP grew by 127.2 percent between 1990 and 2006.

The value of inventory increased by 78.4 percent during the
same time period.

Inventory costs as a percent of GDP declined from 17.9 percent
in 1990 to 14.1 percent in 2006.

The absolute value of inventory increased during this time
period, but it decreased as a percentage of GDP.
Batching economies or cycle stocks

arises from three sources




Scale economies are often associated with all three, which
can result in the accumulation of inventory that will not be
used or sold immediately
Uncertainty/Safety Stocks

All organizations are faced with uncertainty.

On the demand side, there is usually uncertainty in how much
customers will buy and when they will buy it.

On the supply side, there might be uncertainty about obtaining
what is needed from suppliers and how long it will take for the
fulfillment of the order.
Time/In-Transit and Work-in-Process Stocks

The time associated with transportation means that even while goods
are in motion, an inventory cost is associated with the time period. The
longer the time, the higher the cost.

WIP inventories, associated with manufacturing, can be significant while
the length of time the inventory sits in a manufacturing facility waiting
and should be carefully evaluated in relationship to scheduling
techniques and the actual manufacturing/assembly technology.
Seasonal Stocks

Seasonality can occur in the supply of raw materials, in the
demand for finished product, or in both.
Those faced with seasonality issues are constantly challenged
when determining how much inventory to accumulate.
Seasonality can impact transportation.

Anticipatory Stocks
A fifth reason to hold inventory arises when an organization
anticipates that an unusual event might occur that will negatively
impact its source of supply.
The Importance of Inventory in Other Functional Areas

Logistics interfaces with an organizations other functional areas



Inventory Costs
Inventory Carrying Costs
Capital Cost (interest or opportunity cost)

cost of capital tied up in inventory and the resulting lost
opportunity from investing that capital elsewhere

hurdle rate

weighted average cost of capital (WACC).
Storage Space Cost
includes handling costs associated with moving products into
and out of inventory, as well as such costs as rent, heat, and
Can be variable
Inventory Service Cost
includes insurance and taxes
Inventory Risk Cost
reflects the possibility that inventory value might decline for
reasons beyond firms control

Calculating the Cost of Carrying Inventory

Calculating the cost to carry (or hold) a particular item in
inventory involves three steps.
First, determine the value of the item stored in inventory.

Second, determine the cost of each individual carrying cost
component to determine the total direct costs consumed by the item
while being held in inventory.

Third, divide the total costs calculated in Step 2 by the value of the
item determined in Step 1.
Nature of Carrying Cost
Ordering Cost or Setup Cost
refers to the expense of placing an order for additional inventory,
not including product cost
Order Cost
Cost of placing order which may have both fixed and variable
Setup Costs
expenses incurred each time an organization modifies a production
or assembly line to produce a different item for inventory
Expected Stockout Cost
several consequences might occur:

Back order, which results in the vendor incurring incremental
variable costs associated with processing and making the extra

Customer might decide to purchase a competitors product resulting
in a direct loss for the supplier.

Customer might decide to permanently switch to a competitors
product with loss of income.
Safety Stock
Cost calculation Formula

In-Transit Inventory Carrying Cost

Owner of product while it is in transit will incur
resulting carrying costs.

In-transit inventory carrying cost becomes especially
important on global moves since both distance and
time from the shipping location both increase.

Owner should consider its delivery time part of its
inventory carrying cost.

Determining the Cost of In-Transit Inventories

The capital cost of carrying inventory in transit generally equals carrying

storage space cost not relevant to inventory in transit

insurance needs requires special analysis

obsolescence or deterioration costs are lesser risks for inventory in

Dependent versus Independent Demand

independent when such demand is unrelated to the demand for other

dependent when it is directly related, or derives from, the demand for
another inventory item or product

Pull versus Push
The pull approach relies on customer orders to move product through
a logistics system, while the push approach uses inventory
replenishment techniques in anticipation of demand to move products.
Principle Approaches -Techniques for Inventory

Fixed order quantity model involves ordering a fixed amount of
product each time reordering takes place

Simple EOQ Model
The following are the basic assumptions of the simple EOQ model:
1. A continuous, constant, and known rate of demand
2. A constant and known replenishment or lead time
3. All demand is satisfied
4. A constant price or cost that is independent of the order quantity
(i.e., no quantity discounts)
5. No inventory in transit
6. One item of inventory or no interaction between items
7. Infinite planning horizon
8. Unlimited capital
The EOQ model can be developed in standard mathematical form,
using the following variables:
Determining Q can be accomplished by differentiating the
TAC function with respect to Q, as shown in Formula 9-5
Total cost model formulas:

The Just-in-Time Approach

Four major elements

zero inventories

short, consistent lead times

small, frequent replenishment quantities

high quality, or zero defects
Materials Requirements Planning:

deals specifically with supplying materials and component parts
whose demand depends on the demand for a specific end

consists of a set of logically related procedures, decision rules,
and records designed to translate a master production schedule
into time-phased net inventory requirements and the planned
coverage of such requirements for each component item needed
to implement this plan
MRP system uses the following elements:

Master production schedule (MPS)

Bill of materials file (BOM)

Inventory status file (ISF)

MRP program

Outputs and reports
Distribution Requirements Planning:
Purpose is to more accurately forecast demand and to explode
that information back to develop production schedules.
Firm can minimize inbound inventory in conjunction with
production schedules.
Outbound (finished goods) inventory is minimized
DRP develops a projection for each SKU requiring the following:
Forecast of demand for each SKU
Current inventory level of the SKU (balance on hand, BOH)
Target safety stock
Recommended replenishment quantity
Lead time for replenishment

Vendor-Managed Inventory
The basic principles:
The supplier and its customer agree on which products are to
be managed using in the customers distribution centers.
An agreement is made on reorder points and economic order
quantities for each of these products.
As these products are shipped from the customers
distribution center, the customer notifies the supplier, by
SKU, of the volumes shipped on a real-time basis.
This notification is also called pull data
ABC Analysis:
Assigns inventory items to one of three groups according to the
relative impact or value of the items

A items are considered to be the most important

B items being of lesser importance

C items being the least important

Paretos Law, or the 8020 Rule

many situations were dominated by a relatively few vital elements
Inventory at Multiple LocationsThe Square-Root Rule:
The square-root rule states that total safety stock inventories in a
future number of facilities can be approximated by multiplying the
total amount of inventory in existing facilities by the square root of
the number of future facilities divided by the number of existing
Inventory as a percent of overall business activity continues to decline. Explanatory
factors include greater expertise in managing inventory, innovations in information
technology, greater competitiveness in markets for transportation services, and
emphasis on reducing cost through the elimination of non-value-adding activities.

As product lines proliferate and the number of SKUs increases, the cost of carrying
inventory becomes a significant expense of doing business.

There are a number of principle reasons for carrying inventories. Types of inventory
include cycle stock, work-in-process, inventory in transit, safety stock, seasonal
stock, and anticipatory stock.

Principle types of inventory cost are inventory carrying cost, order/setup cost,
expected stockout cost, and in-transit inventory carrying cost.

Inventory carrying cost is composed of capital cost, storage space cost, inventory
service cost, and inventory risk cost. There are precise methods to calculate each of
these costs.

Choosing the appropriate inventory model or technique should include an analysis of
key differences that affect the inventory decision. These differences are determined
by the following questions: (1) Is the demand for the item independent or dependent?
(2) Is the distribution system based upon a push or pull approach? (3) Do the
inventory decisions apply to one facility or to multiple facilities?

Summary (cont.)

Traditionally, inventory managers focused on two important questions to improve
efficiency, namely, how much to reorder from suppliers and when to reorder.

The two aforementioned questions were frequently answered using the EOQ model,
trading inventory carrying cost against ordering costs, and then calculating a reorder
point based on demand or usage rates.

The two basic forms of the EOQ model are the fixed quantity model and the fixed
interval model. The former is the most widely used. Essentially, the relevant costs are
analyzed (traded off), and an optimum quantity is decided. This reorder quantity will
remain fixed unless costs change, but the intervals between orders will vary
depending on demand.

The basic EOQ model can be varied or adapted to focus more specifically on
decisions that are impacted by inventory-related costs, such as shipment quantities
where price discounts are involved.

Just-in-time inventory management captured the attention of many U.S. organizations
during the 1970s, especially the automobile industry. As the name implies, the basic
goal is to minimize inventory levels with an emphasis on frequent deliveries of smaller
quantities and alliances with suppliers or customers. To be most effective, JIT should
also include quality management

Summary (cont.)

Materials requirements planning and distribution requirements planning are typically
used in conjunction with each other. In addition, a master production schedule is
utilized to help balance demand and supply of inventory. DRP is used on the
outbound side of a logistics system. Demand forecasts of individual SKUs are
developed to drive the DRP model. Then, an MPS schedule is developed to meet the
scheduled demand replenishment requirements.

VMI is used to manage an organizations inventories in its customers distribution
centers. Using pull data, suppliers monitor inventory levels and create orders to ship
product to bring inventory levels up to an economic order quantity in the customers
distribution centers.

ABC analysis is a useful tool to improve the effectiveness of inventory management.
Another useful tool is the quadrant model.

When organizations are adding warehouses to their logistics networks, a frequently
asked question is, How much additional inventory will be required? The square root
rule is a technique that can be used to help answer this question.