Inventory

Management
SESSIONS- 8,9&10

DR. SASWATI
IIFT (KOLKATA)
 CONTENT STRUCTURE
Intriduction

Types of Inventory, Inventory Related Costs

Managing Cycle stock, Safety Stock & Seasonal

Stock

Analyzing Impact Of Supply Chain Redesign on the

Inventory

Managing Inventory For Short-Life Cycle Products

Multiple Item, Multiple Location Inventory

Management
 Why do firms
carry inventory?
What are the
various types of
inventory
carried by an
organization?
How do firms What are the
decide on the components of
cost that are
level of safety affected by
stock in inventory
chain? decisions?

How do firm’s
How can a firm
determine
reduce
optimum level
inventory in the
of cycle stock in
organization?
chain?
Introduction
Why Is Inventory Important?
Distribution and inventory (logistics) costs are
quite substantial
Total U.S. Manufacturing Inventories ($m):
 1992-01-31: $m 808,773
 1996-08-31: $m 1,000,774
 2006-05-31: $m 1,324,108
Inventory-Sales Ratio (U.S. Manufacturers):
 1992-01-01: 1.56
 2006-05-01: 1.25
Why Is Inventory Important?
 GM’s production and distribution network
 20,000 supplier plants
 133 parts plants
 31 assembly plants
 11,000 dealers

 Freight transportation costs: $4.1 billion (60% for material

shipments)

 GM inventory valued at $7.4 billion (70%WIP; Rest Finished

Vehicles)

 Decision tool to reduce:

 combined corporate cost of inventory and transportation.

 26% annual cost reduction by adjusting:
 Shipment sizes (inventory policy)
 Routes (transportation strategy)
Why Is Inventory Required?
 Uncertainty in customer demand
 Shorter product lifecycles
 More competing products

 Uncertainty in supplies
 Quality/Quantity/Costs/Delivery Times
 Delivery lead times
 Incentives for larger shipments
Holding the right amount at
the right time is difficult!
 Dell Computer’s was sharply off in its forecast of
demand, resulting in inventory write-downs
 1993 stock plunge

 Liz Claiborne’s higher-than-anticipated excess

inventories
 1993 unexpected earnings decline,

 IBM’s ineffective inventory management

 1994 shortages in the ThinkPad line

 Cisco’s declining sales

 2001 $ 2.25B excess inventory charge
Inventory Management-
Demand Forecasts
 Uncertain demand makes demand
forecast critical for inventory related
decisions:

 What to order?
 When to order?
 How much is the optimal order quantity?

 Approach includes a set of techniques

 INVENTORY POLICY!!
Reasons for Inventories
 Improve customer service
 Economies of purchasing
 Economies of production
 Transportation savings
 Hedge against future
 Unplanned shocks (labor strikes, natural
disasters, surges in demand, etc.)
 To maintain independence of supply chain
Goals:
Reduce Cost, Improve Service
 By effectively managing inventory:
 Xerox eliminated $700 million inventory from
its supply chain
 Wal-Mart became the largest retail company
utilizing efficient inventory management
 GM has reduced parts inventory and
transportation costs by 26% annually
 Reliance Industries, Tata motors, Maruti,
Pantaloon, Big Bazar
Definition
 Inventory refers to any owned or financially
controlled raw material, works in process,
and/or finished good or service held in
anticipation of a sale but not yet sold.

 Also include all those items and goods that

indirectly contribute to production processes
such as stores and consumables items.

 All these will have a financial impact on the

income statement and the balance sheet of the
company.
Inventory across supply
chain Network
Performance of Indian Oil and Bharat Petroleum has deteriorated over last decade.

Performance of Reliance, Hindustan Lever, Tata Motors, Larsen & Toubro and Maruti Udyog Ltd has shown
considerable improvement.
 Food Chemical Textile Machinery Transport Consum Metal Constru
and Equipment er Goods and ction
agro metal Metetial
based product s
Product s
Worst 0.9 1.8 1.3 O,9 1.2 1.6 1.5 1.8

Avera 5.5 5.6 6.3 6 7.9 6.9 13.7 4

ge
Best 21.2 17.1 25.9 26.5 22.9 27.6 93.7 8.5

Bottom 10% & Top 10% of the firms have been removed as outliers
Source: Prowess, CMIE,2013

 Best performers work with 10-20 times higher inventory

turnover ratios compared to worst performers.
 Shows there is a significant potential for reduction in
inventory across industries
Zero-based inventory approach is a bottoms-up approach.

Starts with zero level of inventory & for all identified

drivers of inventory, an analytical exercise is carried out to
determine appropriate level of inventory required for each
of the identified driver.

Though a detailed analysis is carried out for only a few

critical items/products, the exercise helps a firm ↓

• in setting broad targets for inventory turnover ratio

• to understand various drivers that force firms to
maintain the current level of inventory
Three general classes of costs are
important for inventory-related
decisions
• Ordering cost
• Inventory carrying cost
• Stock-out cost
 Includes all fixed costs (components of costs that do not vary with the
size of the order) associated with placing an order.
 Main components of ordering cost :
 Administration costs involved in placing the order
Preparing purchase order will involve documentation, getting
necessary approval and other formalities.
Electronic ordering can reduce the time required by buyer ► reduce
this component of cost.

 Transportation cost
A fixed transportation cost is n incurred regardless of size of order.

 Receiving cost
Refers to the cost incurred on account of administrative work that has
to be undertaken on receiving order.
E.g., at the time of receipt, receiver will have to prepare goods receipt
note, update inventory records, and make necessary checks against
respective purchase order.
 • Financing cost
• Inventory represents assets and working capital of a
Captures all firm.
actual & • Can be estimated as cost of borrowing.
opportunity • Represents cost of opportunity as funds can be
deployed for alternative use.
costs that are
• Directly proportional with value of item
incurred
because of • Storage and handling cost
• Charges that company incurs because of storage of
holding inventory
inventory. • Function of size of item, not the value
Main • Not relevant while calculating pipeline inventory
components • Inventory Risk
of carrying • Cost associated with deterioration, obsolescence,
cost: shrinkage, theft or damage.
• Depends on nature of the item,
• E.g., fashion goods, perishable goods and high-
technology products are likely to have much higher
risks.
Inventory-carrying cost (ICC) is calculated at the firm level
in terms of rupees per rupee of inventory per year.

For two different types of components with varying risk or

difference in size/ value ratio of items,firm may have
different inventory carrying cost for different category,.

For any item, inventory-carrying cost per unit per year is

calculated by multiplying ICC by value of the item
Stock-out cost captures
economical
consequences of
running out of stock.

• Customer is willing to wait and items are

back-ordered
Two possible scenarios
• Customer places in order but cannot be
filled from inventory

Two kinds of stock-out • Backorder cost

costs: • Lost sales costs

These costs are

intangible and
therefore difficult to
measure.
 A measure that captures chances of stock-out situation.

Essentially on items for which stock-out costs are relatively low,

company fixes customer service levels at a lower level.

A target of 100 percent service level requires that inventory system

meets all customer demand from inventory.

Service level targets ranging from 90 to 99 percent are commonly

used in industry.

Instead of minimizing total system costs, inventory system is

expected to minimize ordering cost plus inventory cost subject to
meeting targeted service level.
 Divided into
various categories.

• Cycle stock
• Safety stock
Six main • Pipeline stock ►(process/ transport
categories of time) X (usage rate of the item)
inventories • Decoupling stock
• Anticipation inventory (Seasonal and
Speculation)
• Dead stock
 Cycle Stock
inventory Model.
Because of economies of scale involved in production
and transportations, firms produce and transport
goods in batches.

Apart from economic considerations, quality

considerations may force firms to produce in large batches.

Inventory resulting from production or purchase in batches is

called cycle stock, since the lots are produced or purchased in
cyclical lots.

More frequently less frequently

Firms have and incurring
and incurring
a choice of large ordering significant
ordering costs or inventory cost.
A decision maker managing inventory point has • how much to order
to make two critical decisions • when to order

A retailer having a demand 100 units/day, operates 300 days a year.

Assumptions : 1) No uncertainties in demand

►every day he sells exactly 100 units.
2) Retailer has a very reliable supplier

He can procure 100 units daily from supplier and maintain zero
inventory.

► He has to place 300 such orders in a year leading to a huge ordering

cost.

Or he can order once a year incurring ordering cost just once.

But, he will end up incurring additional cost on account of huge

inventory.
 Need to trade–off between ordering cost and inventory costs.

D = annual demand of item

d =daily demand
A = fixed cost of order (cost of set-up in manufacturing environment)
C =cost per unit of item
I =inventory-carrying cost per rupee of inventory per year
Q =order size
H =inventory-carrying costs per unit per year = C x I

• Total annual cost of items = C x D irrespective of order size (Assume supplier

does not offer any quantity discounts)
• Not relevant from inventory management point of view
• Only relevant supply chain costs are cost of carrying and cost of ordering.

• Inventory in the system will behave as shown in Figure :

Inventory Re-order point
on hand

Q Q Q Q Average cycle
inventory

Time
L L L

At beginning of every cycle (just after replenishment from supplier), retailer has
stock equal to Q and same will reduce to zero by end of the cycle (just before the
next replenishment).

On an average, retailer will carry cycle inventory of Q/2 throughout the year.
►Incurring an annual inventory-carrying cost Q/2 X H.

Since annual demand is D, retailer will have D/Q such cycles in a year and in every
cycle retailer incurs an ordering cost of A resulting in total annual ordering cost of
amount A x D/Q.
As can be seen in the figure, inventory-carrying cost increases linearly with
order size Q, while the annual ordering cost decreases exponentially with
order size Q.

Total cost
Cost

Holding cost=Q/2 x H

Ordering cost=D/Q x A

Q*
Optimum order quantity size
 Optimal order quantity Q* will be at a point where total inventory-related
cost will be lowest► known as EOQ, economic order quantity:

 Optimal order quantity = Q* 2 AD / H

 Also need to specify the time of placing an order to supplier

 Assumption is that the decision maker gets his material from a reliable
supplier with a lead time of L days.

 During this lead-time period, the quantity of demand faced by the retailer
is equal to L x d.

 Need to place an order every time stock reaches at level L x d, known as

reorder point R.

 Whenever inventory reaches reorder point R, retailer has to place an order

for quantity Q*.
Economic Order Quantity-
(EOQ) Model-
The Economic Order Quantity (EOQ) Model-

A quantitative decision model based on trade-off

between annual inventory holding costs and
annual order costs.

Determines an optimal order quantity, where

sum of annual order cost and annual inventory
holding cost is minimized.
Economic Order Quantity -
(EOQ) Model-
Assumptions of the Economic Order Quantity Model
 Demand must be known & constant.
 Delivery time is known & constant.
 Replenishment is instantaneous.
 Price is constant.
 Holding cost is known & constant.
 Ordering cost is known & constant.
 Stock-outs are not allowed.
Case of retailer
Product is purchased at Rs. 30 and inventory-carrying cost is 20%.

Ordering cost for retailer is estimated to be Rs 256 per order.

Supplier takes 15 working days to supply the item at the retailer’s

warehouse.

Carrying cost per unit for retailer = H = 30 x 0.2 = Rs. 6 per unit per year

Optimal order quantity = Q * = 2 x 256 x 30000 / 6

Optimum order quantity is 1,600 and average inventory is 800 units.

So on an average retailer carries cycle stock of 8 days of demand and has an

inventory turnover of 37.5.
• If demand for a retailer shoots up by four
times, order quantity should increase by
only two, with the result the average
inventory in a system doubles and
sales/assets ratio increases two times

• Earlier , the retailer was placing orders of

1,600 units about 19 (18.75 to be exact)
times a year.
If demand increases
to 400 units per day,
retailer should be ► it is expected
ordering 3,200 units Inventory
that large retailers
per order and place turnover
have a better
about 38 (37.5 to be ratio will
exact) orders per inventory turnover
increase from
year and carry an ratio compared to
37.5 to 75.
average 1,600 units smaller players.
in stock (average 4
days of cover).
 Although, every In a mature market
decision unit cannot demand is likely to
expect demand to go be stable; thus, to
up, each decision improve inventory
unit is interested in ratio, focus has to be
improving inventory on decreasing
turnover ratio. ordering cost.
 if retailer wants to
decrease average
inventory by half, he
has to find a way of
reducing ordering
cost by four times,
►ordering cost
should be reduced
to Rs. 64.
 When dealing with
more expensive
item, firm need to
order more often
EOQ formula
and carry less
provides an insight
inventory, but if
into managing
dealing with less
different items in
expensive items
inventory system.
preferable is to
carry more
inventory and order
less often.
Famous automobile industry
study carried out by MIT Japanese suppliers
reveals that Japanese carried required a set-up time of
1.5 days of parts inventory 8 minutes compared to
compared to their American 120 minutes required by
counterparts that carried 8 American suppliers.
days of parts inventory.

A set-up time lower by 15 times on the part of Japanese suppliers (8

minutes vis-a-vis 120 minutes) resulted in reduction of parts inventory
by about 5 times (from 8 to 1.5 days).
 SAFETY Stock
inventory Model.
Maintained as a safeguard against uncertainties of demand
and supply.

Amount of inventory carried in addition to expected demand.

Unnecessary in case of an assured supply and predictable

customer demand.
Firms end up carrying a large quantity of safety stocks fearing
loss of customers due to non-availability of products.
Customer demand is difficult to control but firms may work on
supply uncertainties to bring it down gradually.
Analytical models are developed to derive optimal safety
stock.
 While determining cycle stock assumption was that demand was
constant and supplier was reliable.

Unfortunately, customers do not behave in a predictable way and

suppliers also work with some degree of unreliability.

►►all inventory points end up keeping safety stock.

In retailer example, with no Every day At end of 15

uncertainty, it is optimal to place an Supplier will
customers will days, stock
take exactly
order when stock on hand is exactly demand exactly
15 days.
on hand will
1,500 units. 100 units. be zero.

Considering uncertainty in demand ► Average daily demand is

100 units which could vary.

Similarly, supplier will take, on an average, 15 days but it could

take more time or less.
 Inventory
Re-order point
inventory
Average

Average cycle
inventory

Safety
L L L Inventory

If firm works with a reorder point of 1,500 units, 50% of time it runs
out of stock and faces a stock-out situation.

To take care of this demand and supply uncertainty, safety stock is

carried by the firm so as to reduce chances of stock-out situations.
Average inventory carried by a firm is average
cycle stock plus safety stock.

Increasing safety stock inventory reduces chances

of stock out situations.

Increasing safety stock increases inventory-

carrying cost.

A trade-off between these two is desired.

Establishing Safety
Stock Levels
Safety stock can be determined based on many
different criteria

A common approach is to simply keep a certain

number of weeks of supply

A better approach is to use probability.

• Assume demand is normally distributed
• Assume mean and standard deviation are known
• To determine probability normal distribution for expected
demand need to plot and to note where the existing amount lies
on the curve
Instructor Slides
 In most real-life situations if demand is observed for a
reasonable number of days, it is found that demand follows
a normal distribution.

 Demand distribution is captured by two parameters

 mean demand
 standard deviation of demand .

 Similarly, a supply system has two parameters

 average lead time
 standard deviation of lead time
 If demand is observed for the last n days where d1, d2…..dn represent
demand on respective days, daily demand distribution can be captured
using following expressions: 

 Average daily demand = d  d1  d 2  ....  d n  / n

  2
   2
   2

 SD of daily demand = d   d1  d    d 2  d   ...   d n  d   / n

      

 Let demand and lead-time data for past few observations are as below.
Demand data

d1 d2 d3 d4 d5 d6 d7 d8 d9 d10
Demand 115 95 150 125 28 90 93 115 93 96

Lead-time data

L1 L2 L3 L4 L5 L6 L7 L8 L9 L10
Lead time 12 15 4 21 18 11 12 18 19 20

From above data,

d = 100 units and  d = 30 units


Using lead time data , L


=15 days and L = 5.0 days
 For items or suppliers with a past history, firm can estimate
mean and standard deviation from past data.

 When dealing with a new item or a new supplier, firm can

subjectively assess uncertainty.

 E.g., using decision maker’s assessment of optimistic (best-

case scenario) & pessimistic estimate (worst-case scenario)
& using range value (diff between optimistic & pessimistic
estimate) Standard deviation can be estimated as Range /6

 In general, standard deviation is estimated using either past

data or subjective assessments.
Difficult to directly measure stock-out costs.

Firms have resorted to specifying target service of various categories of

items.

A service level of 100% means that there will never be a stock-out

situation and all demands are served from stock.

Two popular ways in which services levels are expressed:

• Service level is the probability that all orders will be filled from
stock during replenishment lead time or during recorder cycle (also
known as cycle service level).
• Service level is a percentage of demand filled from stock during a
given period of time, for example, a year- Known as FILL RATE.
Number
of units
on hand Average demand
during lead time

O
R

Range of demand

Safety stock
O
Stockout

After the reorder is placed, demand during

the lead time may be higher than expected,
consuming some (or all) of the safety stock
There could be very little of actual demand before replenishment, resulting in excess
stock at time of replenishment.

Demand during replenishment cycle may be quite high ► even a reasonable amount
of safety stock may not be enough to avoid stock-out situation.

This Uncertainty of demand during lead time is because of uncertainty in actual

demand (demand may be higher or lower than average) or uncertainty in supply
{actual lead time being higher or lower than average lead time) or a combination of
both.

If there was no uncertainty in demand or supply, firm prefers reorder level

to be at a value such that inventory at the time of replenishment is exactly
zero.
 Safety stock inventory is calculated WRT target service level and
anticipated uncertainty in demand and supply.
 For typical inventory situation, stock-out is likely to take place only
during the reorder cycle.

 Once the replenishment of items takes place, till the reorder point is
reached, there is no possibility of stock-out.
 Firm is exposed to a stock-out only before arrival of order and after
placement of the order.

 To take care of this uncertainty, firms need to retain safety stock,

Safety stock = K LTD Reorder point R = LTD + Safety stock = LTD + K LTD

where LTD is mean demand during replenishment cycle,  LTD is

standard deviation of demand during lead time and K is the safety
factor.
  
LTD  L d
where 
 LTD  L 2
d d 
2 2
L

L & ƠL are mean and standard deviation of lead time

and d & Ơd are mean and standard deviation of

the demand
d


•
 Retailer faces uncertainty in demand as well as
supplier front.

Average daily demand = 100units,

SD of daily demand=30 units

Average lead time =15 days,

SD of lead time = 5 days
LTD=100 x 15=1500

 LTD  15302   1002  52   13500  250000  513.3  513

 Given desired service level, value of k can be determined from this table, because in most real-life
systems, demand during lead time follows a normal distribution.
Similarly using knowledge about quantity of safety stock held by a firm, value of safety factor(K)
can be determined rom safety stock formula and estimate service level using the data in this table.
K Service level K Service K Service K Service
(%) level(%) Level (%) Level(%)
-3.0 0.13 -1.4 8.1 0.1 54 1.6 94.5
-2.9 0.19 -1.3 9.7 0.2 57.9 1.7 95.5
-2.8 0.26 -1.2 11.5 0.3 61.8 1.8 96.4
-2.7 0.35 -1.1 13.6 0.4 65.5 1.9 97.1
-2.6 0.47 -1.0 15.9 0.5 69.2 2.0 97.7
-2.5 0.62 -0.9 18.4 0.6 72.5 2.1 98.2
-2.4 0.8 -0.8 21.2 0.7 75.5 2.2 98.6
-2.2 1.1 -0.7 24.5 0.8 78.8 2.3 98.9
-2.2 1.4 -0.6 27.5 0.9 81.6 2.4 99.2
-2.1 1.8 -0.5 30.8 1.0 84.1 2.5 99.38
-2.0 2.3 -0.4 34.5 1.1 86.4 2.6 99.53

-1.9 2.9 -0.3 38.2 1.2 88.5 2.7 99.65

-1.8 3.6 -0.2 42.1 1.3 90.3 2.8 99.75
-1.7 4.5 -0.1 46 1.4 91.9 2.9 99.81
-1.6 5.5 0.0 50 1.5 93.3 3.0 99.87
-1.5 6.7

For a given value of K, Excel function NORMDIST(K,0,1,1) can be used to get the value of service level in
fraction terms. E.g., NORMALDIST (2,0,1,1)=0.097725.Similarly, for given service levels in percentage
terms, the excel function NORMINV(s/100,0,1) can be used to get a value of K. E.g., NORMINV
 If firm holds safety stock equal to one SD (K=1), it could provide a
service level equal to 84.1%, so chances of a stock-out in a cycle is
equal to 15.9%.
Relationship between K and service level is not linear.
• Value of K is increased from 0 to 1, service
level improves by 34.1%
Relation between • Further improvement of K by 1 unit will
Service level and K increase service level by 13.6%
• Further improvement in K will increase
service level by 2.2%
Beyond a level, increase in safety stock does not result in a
corresponding level of improvement in service level.

If retailer specifies a service level of 97.7%, stock-out situations result

in ~ 2 cycles during 100 such recorder cycles, which will result in K=2.

If retailer has 7 days of • Service Factor K = 700/513 = 1.36 ~ 1.4

inventory as safety stock, • Value of the service level for K=1.4 is 91.6
i.e. inventory ~ 700 units percent.
• Following figure shows how safety stock required by a retailer will vary with changes in
service levels.
• Marginal increase in safety stock increases as service levels rise.
• Increasing of safety stock from 600 – 800 ►significant increase in service level (~6%).
• But increasing SS from 1200 -1400 ►little improvement in service levels (less than 1%).
• 100 Highlights importance of selecting suitable service levels.

98
Service Level

96

94

92

90

88

86

84

82
400 600 800 1000 1200 1400 1600 1800
Inventory Level
 Reduction in demand uncertainty, SD of demand captures forecast
error. This error can be mitigated
 either by better forecasting or
 by entering into contracts with some customers for assured stable
demand.

 Reduction in supplier lead time Retailer can work with supplier and
find ways and means of reducing supplier lead time. Retailer may also
reduce internal processing time or use a faster mode of transport.

 Reduction in supply uncertainty Again retailer can work with supplier

for reducing uncertainty in supplier lead time, which may involve use of
more reliable modes of transport. Retailer may have to track the supplier
on the reliability of delivery. So when choosing a supplier this criterion
should get top priority.
Safety Stock : Demand and Supply
Uncertainty
S.S = K Lead Time Demand
____________
Lead Time Demand =  L D2 + d2 L2

d = average Demand ,D = S.D. of

Demand ,
L = Average Lead-time, L = S.D. of
Lead-time
K = Safety Factor
Safety Stock: Demand Uncertainty
Only
S.S = K Lead Time Demand
______
Lead Time Demand =  L D2

d = average Demand ,D = S.D. of

Demand ,
L = Lead-time, K = Safety Factor
Average SD of Average SD of Safety Safety Remark
demand demand lead lead stock stock in
time time units days of
inventory
100 30 15 5 1,026 10.3 Base case
100 30 15 0 232 2.3 No supply
uncertainty
100 0 15 5 1,000 10 No demand
uncertainty
100 15 15 5 1,006 10 Reduce
demand
uncertainty
100 30 15 2.5 526 5.3 Reduce
supply
uncertainty
100 30 7.5 5 1,003 10 Reduction
in lead time
Various Improvement
scenarios are in forecast
shown and accuracy and This kind of
Reduction in analysis has
required safety supplier reduction in
stock level that average lead important
uncertainty implications in
retailer will will provide time do not
have to seem to have terms of
highest payoffs. prioritization
maintain to much impact
work with 97.8 on required of efforts on the
percent service safety stock part of retailer.
level is level.
determined.