Inventory Management

4
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

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
llustration :
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 9653.3333
1 1600 9600
1.1 1760 9643.6364
1.25 2000 9840
1.5 2400 10400
1.75 2800 11142.857
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 d 2 d3 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

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
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 stock system –1 stock
points point
Cycle stock/stock 800 3200

point = Q*/2
Safety Stock per 232 928

stock point
Total Inv. in units (232+800)  16 928+3200

for the system = 16512 = 4128
Total Inv. carrying 16512  6 4128  6

cost = 99072 = 24768
Incremental 300100160.
Transportation 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
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20
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/SelectTable.asp?Benchmark=P#S
0
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

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4

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

9 1991 1996 2001 2006

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

• How much to order?

• Ordering cost/setup cost

Fixed Order Quality Model ( Cont. Review Model)

Average cycle stock= 0.5* 1600 = 800 units

Optimum order quantity=Q*= 1600

Order quantity = Q* = Optimum order quantity

Safety factor (K) Service level

S.S = K Lead Time Demand

L = Lead-time, K = Safety Factor

S.S = K Lead Time Demand

Average Cycle Inventory

Daily Demand: Mean = 100 , SD = 30

100 30 15 0 232 2.3 No supply

• Capacity versus inventory tradeoff in seasonal

Production 9000 9000 9000 9000

Inv. C. Cst 3000 6000 9000 0

Production 8000 8000 8000 12000

Hiring Cost 0 0 0 48000

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

Demand distribution at each region ( 16 regions)

Cycle stock/stock 800 3200

Safety Stock per 232 928

Total Inv. in units (232+800)  16 928+3200

Total Inv. carrying 16512  6 4128  6

Balancing cost of under-stocking versus cost of overstocking

Class Percentage of Percentage of

items Total sales Value

Cycle Stock Economies of Scale Reduce ordering/setup cost

Speculation Stock Uncertainty in price of material Risk management

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

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

Year Manufacturer Wholesaler Retailer

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

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

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