Inventory Definition

A stock of items held to meet future demand It is a tangible property (i) Held for the sale in the ordinary course of business (ii) In the process of production for such sale or (iii) To be consumed in the process of production of goods or services for sale

Types of Inventory
Inputs
Raw Materials Purchased parts Maintenance and Repair Materials

Outputs
Process

Finished Goods Scrap and Waste

(in warehouses, or in transit)

In Process
Partially Completed Products and (often on the factory Subassemblies floor)

Types of Inventory

Work in process
Vendors

Raw Materials Work in process

Work in process

Finished Customer goods

Water Tank Analogy for Inventory

Inventory Level Supply Rate

Inventory Level

Buffers Demand Rate from Supply Rate

Demand Rate

Independent and Dependent Demand Inventory

Independent demand
items demanded by external customers (Kitchen Tables)

Dependent demand
items used to produce final products (table top, legs, hardware, paint, etc.) Demand determined once we know the type and number of final products

Reasons To Hold Inventory

Meet variations in customer demand:
Meet unexpected demand Smooth seasonal or cyclical demand

Pricing related:
Temporary price discounts Hedge against price increases Take advantage of quantity discounts

Process & supply surprises

Internal upsets in parts of or our own processes External delays in incoming goods

Transit

Reasons To NOT Hold Inventory

Carrying cost
Financially calculable

Takes up valuable factory space

Especially for in-process inventory

Inventory Hides Problems

Bad Design

Lengthy Setups
Inefficient Layout

Poor Quality Machine Breakdown Unreliable Supplier

To Expose Problems: Reduce Inventory Levels

Bad Design Lengthy Setups Inefficient Layout Poor Quality Machine Breakdown Unreliable Supplier

Remove Sources of Problems and Repeat the Process

Poor Quality

Lengthy Setups

Bad Design

Inefficient Layout

Machine Breakdown

Unreliable Supplier

Inventory Cost Structures

Ordering (or setup) cost Carrying (or holding) cost:
Cost of capital Cost of storage Cost of obsolescence, deterioration, and loss

Stock out cost Item costs, shipping costs and other cost subject to volume discounts

Typical Inventory Carrying Costs

Housing cost: Building rent or depreciation Building operating cost Taxes on building Insurance Material handling costs: Equipment, lease, or depreciation Power Equipment operating cost Manpower cost from extra handling and supervision Investment costs: Borrowing costs Taxes on inventory Insurance on inventory Pilferage, scrap, and obsolescence Overall carrying cost

Costs as % of Inventory Value 6% (3% - 10%)

3% (1% - 4%)

3% (3% - 5%) 10% (6% - 24%)

5% (2% - 10%) (15% - 50%)

Inventory Management Systems

Functions of Inventory Management
Track inventory How much to order When to order

Prioritization Inventory Management Approach

EOQ Continuous / Periodic

ABC Prioritization
Based on Pareto concept (80/20 rule) and total usage in dollars of each item.
Classification of items as A, B, or C often based on $ volume. Purpose: set priorities for management attention.

ABC Prioritization
A items: 20% of items, 80% of dollars B items: 30 % of items, 15% of dollars C items: 50 % of items, 5% of dollars Three classes is arbitrary; could be any number. Percents are approximate. Danger: dollar use may not reflect importance of any given item!

ABC Analysis Example

100
90 Class A 80 70 60 50 40

+Class B

+Class C

Percentage of dollar value

30
20 10 0 10 20 30 40 50 60 70 80 90 100

Percentage of items

ABC Chart For Previous Slide

45.0% 40.0% 35.0% 120.0% 100.0%

Percent Usage

30.0% 25.0%

80.0% 60.0%

20.0% 15.0% 10.0% 20.0% 5.0% 0.0% 3 6 9 2 4 1 10 8 5 7 0.0% 40.0%

Item No. Percentage of Total Dollar Usage Cumulative Percentage

Cumulative % Usage

Inventory Management Approaches

A-items
Track carefully (e.g. continuous review) Sophisticated forecasting to assure correct levels

C-items
Track less frequently (e.g. periodic review) Accept risks of too much or too little (depending on the item)

Economic Order Quantity (EOQ) Model

Demand rate D is constant, recurring, and known Amount in inventory is known at all times Ordering (setup) cost S per order is fixed Lead time L is constant and known. Unit cost C is constant (no quantity discounts) Annual carrying cost is i time the average $ value of the inventory No stockouts allowed. Material is ordered or produced in a lot or batch and the lot is received all at once

EOQ Lot Size Choice

There is a trade-off between lot size and inventory level.
Frequent orders (small lot size): higher ordering cost and lower holding cost. Fewer orders (large lot size): lower ordering cost and higher holding cost.

EOQ Inventory Order Cycle

Demand rate Inventory Level Order qty, Q

ave = Q/2 Reorder point, R 0

As Q increases, average inventory level increases, but number of orders placed decreases

Lead time Order Order Placed Received

Lead Time time Order Order Placed Received

Answer to Inventory Management Questions for EOQ Model

Keeping track of inventory
Implied that we track continuously

How much to order?

Solve for when the derivative of total cost with respect to Q = 0: -SD/Q^2 + iC/2 = 0 Q = sqrt ( 2SD/iC)

When to order?
Order when inventory falls to the Reorder Point-level R so we will just sell the last item as the new order comes in: R = DL

Re-order Point Example

Demand = 10,000 yds/year Lead time = L = 10 days

When inventory falls to R, we order so as not to run out before the new order comes in. R=?

Re-order Point Example

Demand = 10,000 yds/year Daily demand = 10,000 / 365 = 27.4 yds/day Lead time = L = 10 days

R = D*L = (27.4)(10) = 274 yds (usually can neglect issues of working days vs weekends, etc.)
Dont forget to convert to consistent time units!

EOQ Summary
How much to order?
Q = sqrt(2DS/iC)

When to order?
R = DL

EOQ Exercise
Now you do it See Excel Spreadsheet: Excel_Inv_Examples.xls, EOQ tab Compute the values of R and Q and compare to the simulation Next see what happens when you have volume discounts (EOQ w Discount Tab)

EOQ Example
Unit Cost C Holding cost factor i Ordering cost S Demand rate D Lead time L Solutions: Re-order point R Q = sqrt(2SD/(iC)) $0.45 /unit 25% /year $15.00 /order 10000 units/year 0.0192 year

units (rounded) units (rounded)