Inventory Strategy

Inventory Decisions
They are high risk and high impact
decisions
Without a proper inventory assortment
Sales may be lost and
Customer satisfaction will decline
Likewise inventory planning is critical to
manufacturing, without which
Raw material shortages can shut down
manufacturing or
Modify production scheduling
Inventory Decisions
Overstocking also creates problems
They result in
Increased cost &
Reduced profitability thru
Added warehousing
Working capital requirements
Deterioration
Insurance

Taxes &
Obsolescence
Inventory Decisions
We should attempt to study inventory from 3
perspectives

1. Inventory functionality & principles ;To

understand the basics of inventory management
1. Inventory carrying cost & its primary components
2. Definitions for common inventory terms
3. Inventory decision rules
1. Inventory tracking
2. Determining when to replenish inventory
3. Determining the amount to replenish
4. Inventory decision rules to incorporate uncertainty
Inventory Functionality & Principles
Formulating inventory policy requires an
understanding of inventorys role in manufacturing /
marketing enterprise
It involves the magnitude of assets committed in a
typical enterprise
Following table presents inventory investment in select
consumer & industrial products companies along with
other key data on
Sales
Net profits & inventory management
A significant percentage of assets for many firms
are inventory related
Data for select companies
( $ millions)
Company Sales Net Total Inventor Inventori
Income assets y es as a
investme %age of
nt assets
Johnson & 13753 1030 11884 1742 14.70
Johnson
Dow 15734 319 32041 2776 8.70
Chemicals

Kmart 37724 941 18931 8752 46.20

JC Penny 18009 777 13563 3258 24.00
Inventory types & Characteristics
Holding of inventory is risky because of 2
reasons:-
Capital investment
1. Investments for inventory cannot be used to obtain
other goods or assets that can improve the
enterprise performance
2. Funds need to be borrowed : increasing firms
interest burden
3. Potential for obsolescence
Risk of possibility of pilferage
Inventory types & Characteristics

Nature & extent of risk will depend upon

Enterprises position in the distribution channel :one
out of the below mentioned 3 positions:-
1. Manufacturing
2. Wholesale
3. Retail
Inventory types & Characteristics

1. Manufacturing
Here inventory risk has a long- term dimension
It has the following components:-
.Raw materials
.Component parts
.WIP
.Finished goods :which must be transferred to
warehouses located closest to wholesalers/
retailers
Inventory types & Characteristics
2. Wholesalers
Wholesaler risk dimension is narrower but deeper
It is of a longer duration than retailers
Wholesaler must provide assorted merchandise from
different manufacturers in smaller quantities
Wholesaler is forced to take an inventory position far in
advance of sales- thereby increasing depth & duration of risk
Expansion of product lines has increased the width of
inventory risk
Retailers have shifted the inventory responsibility back to
the wholesalers
Inventory types & Characteristics
3. Retailers
Their risk can be viewed as wide but not deep
Turnover measures inventory velocity : calculated
as the ratio of annual sales divided by average
inventory.
Discount store : offers general merchandise &
food often exceeds 25000 SKUs
Full line deptt store : may have as much as
50,000 SKUs
Retailers therefore pass on the risk to
manufacturers / wholesalers
Inventory types & Characteristics
Inventory functionality
The ideal inventory process : manufacture a
product once an order is placed
This may not be practically possible
P&L accounts can never display the true cost or
benefit of inventory investments
Most enterprises carry an average inventory that
far exceeds their basic requirements
Inventory types & Characteristics
Inventory functionality
It is therefore important to examine 4 prime functions
underlying inventory commitments:-
1. Geographical specialization
For example tires , batterries , transmissions & springs are
significant components in automobile assembly
The inventory of these must be allowed near the manufacturing
unit- away from customers
Geographical separation is also required to create
assortments
P & G uses distribution centers to combine products from
laundry, food and health care divisions
Inventory types & Characteristics
Inventory functionality
It is therefore important to examine 4 prime functions
underlying inventory commitments:-
1. Geographical specialization
For example tires , batterries, transmissions & springs are
significant components in automobile assembly
The inventory of these must be allowed near the manufacturing
unit- away from customers
Geographical separation is also required to create
assortments
P & G uses distribution centers to combine products from
laundry, food and health care divisions
Inventory types & Characteristics
2. Decoupling
This allows each product to be manufactured and distributed
in economical lot sizes that are greater in demand
This can lead to creation of buffer stocks

3. Balancing supply & demand

Inventory stock piling allows mass consumption or mass
manufacturing of products irrespective of seasonality.
The balancing function requires investment in seasonal
stocks that can be fully liquidated within the season
Inventory types & Characteristics
4. Buffer uncertainties
The safety stock or buffer stock function concerns short
range variation in either demand or replishment
Safety stocks protects in 2 ways:-
Uncertainty of handling demand in excess of forecast during a
performance cycle
Uncertainty of delays in performance cycle
 Inventory related definitions
1. Inventory Policy
It broadly consists of 2 things:-
1. The guidelines concerning what to purchase
or manufacture : Make or Buy
decisions. Additionally, decisions
regarding positioning of inventory at plants
and distribution centers
2. Inventory management strategy :
Central control vs. managing inventory
independently at each distribution center
 Inventory related definitions
2. Service Level
1. Service level is a target specified by
management
For example,
.. order placed by a customer is 80 units of
product A + 20 units of product B
.. If the firm can produce only 75 units of
Product A + 20 units of Product B, the case fill
would be 95%
.. In this example the order could not be
completely filled , so resulting order fill would
 Inventory related definitions
3. Average Inventory
It consists of the following:-
Materials
Components
WIP
Finished goods stocked at logistical facilities
 Inventory related definitions
Average inventory also includes:-
Cycle Inventory: Also called Base stock is the
portion of average inventory that results from
replenishment stocks
Safety stock : Is used only at the end of
replenishment cyclesto meet higher than
expected demand or meet uncertainties caused
by longer than expected performance cycle time
Transit inventory
Inventory carrying cost
Capital
Cost

Taxes

Insuranc
e

Obsolescence
 Inventory carrying cost
(%age)

Element Average Ranges

Capital cost 15 8-40

Taxes 1 0.5 to 2

Insurance .05 0-2

Obsolescence 1.20 0.5 to 2

Storage 2 0-4

Total 19.25 9-50

 Factors for determining EOQ

Annual demand volume 2400 units

Unit value at cost Rs.5

Inventory carrying cost 20% annually

percentage
Ordering cost Rs.19 per order
 Economic order quantity
EOQ is the replenishment order quantity that
minimizes the combined cost of inventory
maintenance + ordering
It has to be calculated on a individual product
basis
EOQ = 2C0D
CiU
EOQ = 2x19x2400
.20x5.00
=91,200=302 (rounded to 300)
 Economic order quantity
Total ordering cost would amount to : Rs.152 ( 2400/300
x Rs.19 ) and
Maintenance cost would be : Rs. 150 [ 300/2 x (5 x 0.20)].
Therefore after rounding to allow ordering in multiples of
100 units , annual reordering and maintenance cost have
been equated.
Over the year 8 orders would be placed at an average
inventory base of 150 units.
An EOQ of 300 implies that an additional inventory in the
form of base stock has been introduced in the system.
Average inventory has been increased from 100 to 150
units at hand
 Economic order quantity
Total
Most
Cost
economic
al no. of
orders Ordering
Cost

Total
Rupees

Maintenance
Cost

No of orders per year

 Economic order quantity
The major assumptions of the simple EOQ model
are:-
Satisfaction of all demand
Continuous , constant and known rate of demand
Constant and known replenishment performance cycle
time
Constant price of product irrespective of order quantity
/ time
Infinite planning horizon
No inventory in transit
No limit on capital availability
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