Inventory Management

Learning Objectives

• Why do firms carry inventory? What are the various types of

inventory carried out by an organization?
• What are the components of cost which get affected by inventory
decisions?
• How can firm reduce inventory in the organization?
• How do firms determine the optimum level of cycle in chain?
• How do firms decide required level of safety stock in chain?
 Sector-wise Inventory Performance

10

9 1991 1996 2001 2006

8

7
inventory turnover ratio

0
chemical textile machinery non metallic mineral transport metal and metal food and beverages
products
years
 Sector-wise Performance on
Inventory Turnover Ratio in India
Types of Inventory

• Cycle Stock : Economies of scale

• Safety Stock
• Anticipation Stock
• Seasonal Stock
• Speculative Stock
• Pipeline Inventory
• Dead stock
 Drivers of Inventory
Type of Inventory Driver ( Logic)

Cycle Stock Economies of Scale

Safety Stock Uncertainty in demand & Supply

Seasonal stock Mismatch between demand and supply rate

Speculation Stock Uncertainty in price of material

Pipeline Stock Lead-time in production/transportation process

Dead Stock Judgmental error/ Change in economic or

technological environment
Inventory Management: Key
Decisions

• How much to order?

• When to order?
• Where to hold inventory?
• When to review?
• Continuous review systems ( Fixed order quantity)
• Periodic review systems
Inventory in Chain

• Supply chain consists of series of stock points connected by

processes ( conversion processes and transportation
processes)
• Each stock point has demand process and supply process
• Inventory at stock point : cycle stock, safety stock, seasonal
stock
• Inventory within conversion and transportation processes:
pipeline inventory
Pipeline Inventory

• Inventory within conversion and transportation processes:

Pipeline Inventory
• Pipeline Inventory = PLT * D
- PLT = Pipeline Lead-time; D = average demand
Illustration :
LT -Shipment by air = 7 days
LT- Shipment by sea = 45 days
Average demand = 100/day
Pipeline Inventory ( Shipment by air) = 700 units
Pipeline Inventory ( Shipment by Sea = 4500 units
 Inventory Management:
Relevant Cost
• Ordering cost/setup cost
• Inventory carrying cost
• Cost of shortage
• Lost sales
• Backlogging cost
• Service level as proxy for cost of shortage
• Purchase cost ( value addition cost) of Item
• Not relevant if cost of item is not function of order quantity (No Quantity
discount case)
Cycle-stock Inventory

Fixed Order Quality Model ( Cont. Review Model)

Q=Order Quantity, Reorder point= L*d
Average cycle stock = Q/2
Optimal Order Quantity
Trade-offs
Inventory Models: Cycle
Stock

__________
Q =2AD/i C
A = Ordering Cost / Cost of setup
D = Annual Demand
i = Inventory carry cost
C = cost of item
Q= Optimum order quantity
Optimum Order Quantity
Daily Demand = 100
Working days in year=300
Ordering cost = 256 Rs.
Cost of item = 30 Rs.
Inventory-carrying cost = 0.2 Rs./Rs./Year
Supplier LT = 15 Days
Optimum order Qty. =
_______________________
 (2*256*100*300/(30*0.20 ) = 1600

Average cycle stock= 0.5* 1600 = 800 units

Reorder point= 15*100 =1500
 Total Cost versus Q

15000
Total Cost

10000
Series1
5000
0
0 1000 2000 3000 4000
Q

Optimum order quantity=Q*= 1600

 Sensitivity Analysis
Q/Q* Q Tc
0.5 800 12000
0.75 1200 10000
0.9 1440 9653.333
1 1600 9600
1.1 1760 9643.636
1.25 2000 9840
1.5 2400 10400
1.75 2800 11142.86
2 3200 12000
Safety Stock

R= reorder point
Distribution of Demand During Lead Time

Safety Stock
Ordering Policy in Case of
Demand and Supply
Uncertainty

Order quantity = Q* = Optimum order quantity

Reorder point= D * L + K Lead Time Demand
K = Safety factor
Safety stock= K Lead Time Demand
Impact of Safety Factor on
Service Level

Safety factor (K) Service level

0 0.500
0.5 0.690
1.0 0.841
1.5 0.933
2.0 0.977
2.5 0.994
3.0 0.998
Impact of Service Level On Safety Stock
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
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
Inventory Profile at Stock
Point:
Cycle Stock + Safety Stock

Inventory

Average Cycle Inventory

Inventory
Safety Inventory

Time
Basic Demand and Lead-time
Data

Demand Data
d1 d2 d 3 d4 d5 d6 d7 d8 d 9 d10
Demand 115 95 150 125 28 90 93 115 93 96
Lead-time data
L1 L2 L3 L4 L5 L6 L7 L8 L 9 L10
Lead- 12 15 4 21 18 11 12 18 19 20
time
Inventory Management
Cycle and Safety Stock

Daily Demand: Mean = 100 , SD = 30

Ordering cost = 256 Rs.
Cost of item = 30 Rs.
Inventory-carrying cost = 0.2 Rs./Rs./Year
Supplier Performance
Mean = 15 Days , SD = 5
Service Level = 98%
Impact of Change in Demand and
Supply Parameters

Average Standard Average Standard Safety Safety Remark

Demand deviation lead- deviation stock stock in
of demand time of lead- - units days of
time inventory
100 30 15 5 1026 10.3 Base case

100 30 15 0 232 2.3 No supply

uncertainty,
100 0 15 5 1000 10 No demand
uncertainty
100 15 15 5 1006 10 Reduce demand
uncertainty
100 30 15 2.5 526 5.3 Reduce supply
uncertainty
100 30 7.5 5 1003 10 Reduction in
lead-time
Managing Seasonal Stock

• Capacity versus inventory tradeoff in seasonal demand//supply

situation
• Two basic approaches in aggregate planning ( Sales and operations
Planning)
• Chase Option : Produce as per demand
• Level Option:
• Mix apparoches
Illustration: Managing Seasonal Stock

Q1 Q2 Q3 Q4
Demand 8000 8000 8000 12000

Level option

Production 9000 9000 9000 9000

Hiring Cost 0 0 0 0

Inv. C. Cst 3000 6000 9000 0

Chase option

Production 8000 8000 8000 12000

Hiring Cost 0 0 0 48000

Inv. C. Cst 0 0 0 0

Cost: level option= 18,000 Chase option= 48000

Centralized Versus
Decentralized Systems
• Inventory
• Safety Stock
• Cycle stock
• Service Level
• Overhead Costs
• Customer Lead Time
• Transportation Cost
Centralized Versus
Decentralized Systems:
Illustration

Demand distribution at each region ( 16 regions)

Daily Demand: Mean = 100 , SD = 30
Ordering cost = 256 Rs.
Cost of item = 30 Rs.
Inventory Carrying cost = 0.2 Rs./Rs./Year
Plant Lead time:= 15 Days ( No supply Uncertainty)
Transportation:
Decentralized- Rs. 1 per unit
Centralized case: - 10% higher
 
Decentralised Centralised
system –16 system –1
stock points stock point

Cycle 800 3200

stock/stock
point = Q*/2

Safety Stock 232 928

per stock point

Total Inv. in (232+800)  928+3200

units for the 16 = 4128
system = 16512

Total Inv. 16512  6 4128  6

carrying cost = 99072 = 24768

 
Incremental 30010016
Transportation 0.1
cost =48,000
Centralization

• Physical centralization
• Decentralized inventory & centralization of information
• Specialization at each stock point
• Mix of Centralization & decentralization
Impact of Inventory Pooling

• Centralization of inventory
• Product substitution
• Component commonality
• Postponement
Inventory for Short life-cycle
Products: Single Period
Model

Balancing cost of under-stocking versus cost of

overstocking
CU = Cost of under-stocking
CO = Cost of overstocking
Optimum service level = (CU *100/ (CU + CO )
Optimum Order size= Mean demand
+ K * Std. Dev. Demand
K= optimum service level
Optimum Order for a New
Music CD

CD purchase price = Rs. 200

CD sales price = Rs. 300
CD sales price after first weeks = Rs. 62.
Demand: Average 100 and Standard Deviation 30
- What is optimum order quantity
- If manufacturer offers buyback scheme , would your
decision change?
- Cost of administering return- Rs. 53
Selective Inventory Control
techniques

• ABC classification
• FSN Classification
• VED Classification
 ABC Classification

Class Percentage of Percentage of

items Total sales Value

A 5-15 55-75

B 20-30 20-30

C 55-75 5-15
ABC Classification: Kurlon Case

39
 Improving Inventory Turns
Type of Inventory Driver ( Logic) Improvement focus

Cycle Stock Economies of Scale Reduce ordering/setup cost

Safety Stock Uncertainty in demand & Supply Reduce demand & supply
uncertainty & Reduce LT, supply
chain redeisgn

Seasonal stock Mismatch between demand and supply Reduce Seasonality in demand,
rate Create flexible capacity

Speculation Stock Uncertainty in price of material Risk management

Pipeline Stock Lead-time in production/transportation Reduce Lead Time

process

Dead Stock Judgmental error/ Change in economic Anticipate changes in demand

or technological environment structure
 Summary
• Indian firms find that a significant amount of money is locked up in the
inventory. Organizations should use the concept of zero-based inventory
planning to improve their performance on the inventory front.
• The decision maker controls inventory by deciding two critical questions:
How much to order and When to order
• Based on the demand characteristics, supply characteristics, cost structure
and desired service level firm can decide optimum level of inventory.
• In long run the firm should try and influence some relevant parameters so
that it can reduce inventory-related costs, improve inventory turnover ratio
and simultaneously improve customer service.
• The company can carry out an ABC analysis and target its effort on A
category items so as to improve supply chain performance.
Backup Slides
 INVENTORY TURNOVER RATIO for
MANUFACTURING INDUSTRY
7.00
inventory turnover ratio

6.00
5.00
4.00
3.00
2.00
1.00
0.00

YEAR
 Inventory Turns in US
economy

Year Manufacturer Wholesaler Retailer

2001
8.57 8.89 7.95
1991
7.50 8.89 8.28

http://www.bea.gov/national/nipaweb/NIPA_Underlying/SelectTabl
e.asp?Benchmark=P#S0
Inventory Turnover
performance in US Retail *

• Study looked at 311 publicly listed retailers for years 1987-

2000
• Overall trend in inventory turns is downward slopping
during 1987-2000
• time trend is negative for 176 firms
• time trend is positive for 135 firms

* Guar, Fisher & Ananth Raman- Management Science. February,2005 51(2)

181-194
EOQ Model: Quantity
Discount Case

Minimize Total Cost : Annual purchase cost ( D *c) + Annual

ordering cost+ Annual Inv. Carrying cost
- Calculate optimal Q* for each price category
- Determine optimal feasible Q for each price category
- Compare total cost across all the price categories