ECE 2507 LOGISTICS & SYSTEM ANALYSIS IN TRANSPORTATION DKUT 2017

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TRANSPORTATION INVENTORY AND PRODUCTION COSTS INTERRELATIONSHIPS.

Inventories are materials and supplies that a business or institution carries either for sale or to
provide inputs or supplies to the production process. All businesses and institutions require
inventories. Often they are a substantial part of total assets.
Inventory management is responsible for planning and controlling inventory from the raw material
stage to the customer. Since inventory either results from production or supports it, the two cannot
be managed separately and, therefore, must be coordinated. Inventory must be considered at each of
the planning levels and is thus part of production planning, master production scheduling, and
material requirements planning. Production planning is concerned with overall inventory, master
planning with end items, and material requirements planning with component parts and raw
material.
The scope of inventory management concerns the fine lines between replenishment lead time,
carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory
visibility, future inventory price forecasting, physical inventory, available physical space for
inventory, quality management, replenishment, returns and defective goods, and demand
forecasting. Balancing these competing requirements leads to optimal inventory levels, which is an
on-going process as the business needs shift and react to the wider environment.

Inventory and the Flow of Materials

There are many ways to classify inventories. One often-used classification is related to the flow of
materials into, through, and out of a manufacturing organization, as shown in the figure below:
• Raw materials. These are purchased items received which have not entered the production
process. They include purchased materials, component parts, and subassemblies.
• Work-in-process (WIP). Raw materials that have entered the manufacturing process and are
being worked on or waiting to be worked on.
• Finished goods. The finished products of the production process that are ready to be sold as
completed items. They may be held at a factory or central warehouse or at various points in
the distribution system.
• Distribution inventories. Finished goods located in the distribution system.
• Maintenance, repair, and operational supplies (MROs). Items used in production that do not
become part of the product. These include hand tools, spare parts, lubricants, and cleaning
supplies.
Classification of an item into a particular inventory depends on the production environment. For
instance, sheet steel or tires are finished goods to the supplier but are raw materials and
component parts to the car manufacturer.

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Functions of Inventory
Inventory only exist because there is a difference in the timing or rate of supply and demand. For
example, if you had a product that was immediately demanded when you received it, there would be
no need to store it, therefore no inventory. As such, when the rate of supply exceeds the rate of
demand, inventory increases; when the rate of demand exceeds the rate of supply, inventory
decreases.
In batch manufacturing, the basic purpose of inventories is to decouple supply and demand.
Inventory serves as a buffer between:
o Supply and demand.
o Customer demand and finished goods.
o Finished goods and component availability.
o Requirements for an operation and the output from the preceding operation.
o Parts and materials to begin production and the suppliers of materials.
Based on this, inventories can be classified according to the function they perform.

i. Anticipation Inventory: Anticipation inventories are built up in anticipation of future

demand. For example, they are created ahead of a peak selling season, a promotion program,

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vacation shutdown, or possibly the threat of a strike. They are built up to help level
production and to reduce the costs of changing production rates.
ii. Fluctuation Inventory (Safety Stock): Fluctuation inventory is held to cover random
unpredictable fluctuations in supply and demand or lead time. If demand or lead time is
greater than forecast, a stockout will occur. Safety stock is carried to protect against this
possibility. Its purpose is to prevent disruptions in manufacturing or deliveries to customers.
Safety stock is also called buffer stock or reserve stock.
Effect of shipment delays
Transit times vary in a random fashion. Each mode and carrier is characterized by a
distribution of delivery times

Regular on-time delivery

Delivery pattern with a single delay

Errattic delivery pattern

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Avoiding a stock-out using buffer stock

iii. Lot-Size Inventory: Items purchased or manufactured in quantities greater than needed
immediately create lot-size inventories. This is to take advantage of quantity discounts, to
reduce shipping, clerical, and setup costs, and in cases where it is impossible to make or
purchase items at the same rate they will be used or sold. Lot-size inventory is sometimes
called cycle stock. It is the portion of inventory that depletes gradually as customers’ orders
come in and is replenished cyclically when suppliers’ orders are received.

iv. Transportation Inventory: Goods in transit are merchandise and other types of inventory that
have left the shipping dock of the seller, but not yet reached the receiving dock of the buyer.
It is also known as pipeline inventory. pipeline inventory exists because material cannot be
transported instantaneously between the point of supply and the point of demand. The
average annual transit inventory is computed as:

365
Where: I = average annual inventory in transit
T = average transit time in days
A = annual deamand
Notice that the transit inventory does not depend upon the shipment size but on the transit time and
the annual demand. The only way to reduce the inventory in transit, and its cost, is to reduce the
transit time.

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Example:
Delivery of goods from a supplier takes an average of 10 days. If the annual demand is 5200 units,
what is the average annual inventory in transit?
Solution:
10 ∗ 5200
= .
365
The problem can be solved in the same way using monetary values instead of units
v. Hedge Inventory: Some products such as minerals and commodities, for example, grains or
animal products, are traded on a worldwide market. The price for these products fluctuates
according to world supply and demand. If buyers expect prices to rise, they can purchase
hedge inventory when prices are low.
vi. Maintenance, Repair, and Operating Supplies (MRO): MROs are items used to support
general operations and maintenance but which do not become directly part of a product.
They include maintenance supplies, spare parts, and consumables such as cleaning
compounds, lubricants, pencils, and erasers.
Objectives Of Inventory Management
A firm wishing to maximize profit will have at least the following objectives:
• Maximum customer service. In broad terms, customer service is the ability of a company to
satisfy the needs of customers. In inventory management, the term is used to describe the
availability of items when needed and is a measure of inventory management effectiveness.
The customer can be a purchaser, a distributor, another plant in the organization, or the
workstation where the next operation is to be performed. Inventories help to maximize
customer service by protecting against uncertainty. If we could forecast exactly what
customers want and when, we could plan to meet demand with no uncertainty.
• Low-cost plant operation.: Inventories allow operations with different rates of production to
operate separately and more economically. If two or more operations in a sequence have
different rates of output and are to be operated efficiently, inventories must build up
between them.
• Minimum inventory investment: If inventory is carried, there has to be a benefit that exceeds
the costs of carrying that inventory. The only good reason for carrying inventory beyond
current needs is if it costs less to carry it than not. This being so, we should turn our
attention to the costs associated with inventory.

Although inventory plays an important role in any operation, there are also some disadvantages
associated with them, including:
i. It ties up money
ii. Incurs storage costs (leasing etc)
iii. May become obsolete as alternatives become available
iv. Can be damaged or deteriorate
v. Could be lost or expensive to retrieve
vi. Uses space that could be used to add value
vii. Incurs administrative and insurance costs

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Inventory Costs
The following costs are used for inventory management decisions:
• Item cost.
• Carrying costs.
• Ordering costs.
• Stockout costs.
• Capacity-associated costs.
a. Item Cost
Item cost is the price paid for a purchased item, which consists of the cost of the item and any other
direct costs associated in getting the item into the plant. These could include such things as
transportation, custom duties, and insurance. The inclusive cost is often called the landed price. For
an item manufactured in-house, the cost includes direct material, direct labor, and factory overhead.
These costs can usually be obtained from either purchasing or accounting.
b. Carrying Costs
Carrying costs include all expenses incurred by the firm because of the volume of inventory carried.
As inventory increases, so do these costs. They can be broken down into three categories:
i. Capital costs. Money invested in inventory is not available for other uses and as such
represents a lost opportunity cost. The minimum cost would be the interest lost by not
investing the money at the prevailing interest rate, and it may be much higher depending on
investment opportunities for the firm.
ii. Storage costs. Storing inventory requires space, workers and equipment. As inventory
increases, so do these costs.
iii. Risk costs. The risks in carrying inventory are:
• Obsolescence; loss of product value resulting from a model or style change or technological
development.
• Damage; inventory damaged while being held or moved.
• Pilferage; goods lost, strayed, or stolen.
• Deterioration; inventory that rots or dissipates in storage or whose shelf life is limited.
What does it cost to carry inventory? Actual figures vary from industry to industry and company to
company. Capital costs may vary depending upon interest rates, the credit rating of the firm, and the
opportunities the firm may have for investment. Storage costs vary with location and type of storage
needed. Risk costs can be very low or can be close to 100% of the value of the item for perishable
goods. The carrying cost is usually defined as a percentage of the dollar value of inventory per unit
of time (usually one year). Textbooks tend to use a figure of 20―30% in manufacturing industries.
This is realistic in many cases but not with all products. For example, the possibility of obsolescence
with fad or fashion items is high, and the cost of carrying such items is greater. Calculating the cost
to carry (or hold) a particular item in inventory involves three steps:
Step 1, determine the value of the item stored in inventory.
Step 2, determine the cost of each individual carrying cost component to determine the total
direct costs consumed by the item while being held in inventory.

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Step 3, divide the total costs calculated in Step 2 by the value of the item determined in Step
1.
Example
Given the following costs for Item 1, calculate the annual percentage inventory carrying cost for the
item
Production cost = 600
Internal transport = 30
Labour = 10 per unit received plus 1 per unit per month
Space = 0.5 per square metre per month. Item 1 requires 6 sq. Metres
Insurance = KSh 2 per unit per year
Borrowing interest = 10%
Taxes = Sh1 per Sh 100 value
Loss and damage = 3.0% per year
Obsolescence =1% per year
Solution
Inventory Carrying Costs for Item 1
Cost Category Computation Annual cost
Production cost 600
Internal transport 30
Labour Ksh 10 per unit received plus Ksh. 1 22
per unit per month x 12 months
Space KSh. 0.5/sm/month x 6m2 x 12 36
months
Insurance KSh 2 per unit per year 2
Borrowing interest 10% x 600 60
Taxes KSh. 1 per KSh 100 value 6
Loss and damage 3% x 600 18
Obsolescence 1% x 600 6
Total Inventory carryng cost Sum of all inventory costs 180
% inventory cost 180/600 % 30%

Example
A company carries an average annual inventory of $2,000,000. If they estimate the cost of capital is
10%, storage costs are 7%, and risk costs are 6%, what does it cost per year to carry this inventory?
Solution
Total cost of carrying inventory = 10% + 7% + 6% = 23%
Annual cost of carrying inventory = 0.23 x $2,000,000 = $460,000

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c. Ordering Costs
Ordering costs are those associated with placing an order either with the factory or a supplier. The
cost of placing an order does not depend upon the quantity ordered. Whether a lot of 10 or 100 is
ordered, the costs associated with placing the order are essentially the same. However, the annual
cost of ordering depends upon the number of orders placed in a year.
Ordering costs in a factory include the following:
• Production control costs. The annual cost and effort expended in production control depend
on the number of orders placed, not on the quantity ordered. The fewer orders per year, the
less cost. The costs incurred are those of issuing and closing orders, scheduling, loading,
dispatching, and expediting.
• Setup and teardown costs. Every time an order is issued, work centers have to set up to run
the order and tear down the setup at the end of the run. These costs do not depend upon the
quantity ordered but on the number of orders placed per year.
• Lost capacity cost. Every time an order is placed at a work center, the time taken to set up is
lost as productive output time. This represents a loss of capacity and is directly related to the
number of orders placed. It is particularly important and costly with bottleneck work
centers.
• Purchase order cost. Every time a purchase order is placed, costs are incurred to place the
order. These costs include order preparation, follow-up, expediting, receiving, authorizing
payment, and the accounting cost of receiving and paying the invoice. The annual cost of
ordering depends upon the number of orders placed.
The annual cost of ordering depends upon the number of orders placed in a year. This can be
reduced by ordering more at one time, resulting in the placing of fewer orders. However, this drives
up the inventory level and the annual cost of carrying inventory.

Trade-off Between Order Cost and Inventory Carrying Cost

Smaller shipments result in low inventory costs and high transport costs while larger shipments
result in high inventory costs and low shipment costs

Example
A company uses 100 units of material per week. The cost of making one order is KSh. 200. Each unit
of the material is valued at KSh. 100 and an inventory carrying cost of 25% of the value of material
in stock. Determine the optimum order period
Assume: Average inventory = (Beginning Inventory + Ending inventory) /2

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Solution
Order No. of Average Total Total annual Total
Period orders inventory annual inventory cost
(weeks) per year (units) order costs carrying Cost (KSh)
1 52 50 10,400 1250 11,650
2 26 100 5,200 2500 7700
4 13 200 2600 5000 7600
13 4 650 800 16,250 17,050
26 2 1300 400 32,500 32,900
52 1 2600 200 65,000 65,200

d. Stockout Costs
If demand during the lead time exceeds forecast, we can expect a stockout. A stockout can
potentially be expensive because of back-order costs, lost sales, and possibly lost customers.
Stockouts can be reduced by carrying extra inventory to protect against those times when the
demand during lead time is greater than forecast.
g. Capacity-Associated Costs
When output levels must be changed, there may be costs for overtime, hiring, training, extra shifts,
and layoffs. These capacity-associated costs can be avoided by leveling production, that is, by
producing items in slack periods for sale in peak periods. However, this builds inventory in the slack
periods.

Example
A company makes and sells a seasonal product. Based on a sales forecast of 2000, 3000, 6000, and
5000 per quarter, calculate a level production plan, quarterly ending inventory, and average
quarterly inventory.
If inventory carrying costs are $3 per unit per quarter, what is the annual cost of carrying
inventory? Opening and ending inventories are zero.

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Summary of Inventory Costs Interrelationships

JUST-IN-TIME APPROACH
Just-in-time inventory strategy can be referred as a production strategy which is employed to
increase the level of efficiency and reduce waste by receiving goods only in the form they are
required in the production process, thus reducing the inventory costs. This method calls for the
producers to be capable of forecasting demand accurately.
This inventory supply system indicates a shift away from the conventional “just in case” strategy
which involves the producers to carry large inventories in case higher demand had to be
congregated.
A good example would be a car manufacturer that operates with very low inventory levels, relying
on their supply chain to deliver the parts they need to build cars. The parts needed to manufacture
the cars do not arrive before nor after they are needed, rather they arrive just as they are needed.

Benefits of Just-in-time Inventory systems

The main benefits associated with the just in time inventory strategy include:
i. Reduced set up time: Reducing the setup time enables the company to lessen or eliminate
inventory for “changeover” time.
ii. Improvement in the flow of goods from warehouse to shelves: Individual or small lot sizes
lessen the lot delay inventories, thus simplifying inventory flow and management.
iii. Efficient use of employees with multiple skills: Featuring employees skilled to work on
distinctive parts of the process enable companies to move workers where they are required.
iv. Synchronization of demand with production scheduling and work hour consistency: If there
is no demand for a product or service at a time, it is not produced. This saves the money of
the company, either by not having to pay overtime to the workers or by having them
concentrate on their work or participate in training.

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v. Higher emphasis on supplier relationships: A firm without inventory does not want to have a
supply system problem which creates a part shortage. This makes supplier relationships
highly important.
vi. Coming in of supplies at regular intervals all through the production day: Supply is
coordinated with the demand and the optimal amount of inventory held at any time. When
parts move directly from the truck to the assembly point, the need for storage facility is
reduced. Storing excess inventory can cost a lot of money, and reducing the amount of
inventory on hand can reduce the carrying costs as well.
vii. Less Waste: When companies use the traditional method of inventory management and
control, they can end up with pallets of unsold items that simply go to waste. The company
many need to slash prices on that unsold inventory just to get rid of it, which can reduce the
perceived value of the firm's other products.

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