Chapter 8

Quantity and Inventory

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Key Questions
Addressed in Chapter 8

How much to acquire?

When to acquire?

How to manage inventory

effectively?

But First, The Quiz

Password: Q3
15 minutes
8 Questions

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Factors Complicating
Quantity Decisions

Forecasts

Purchase decisions made a long time before

actual requirements are known
Rely on forecasts of future demand, lead
times, prices, and other costs
Forecasts are rarely, if ever, perfect

Costs
Costs associated with placing orders, holding
inventory, running out of materials, and
having a service unavailable when needed

Factors Complicating
Quantity Decisions

Availability

Desired quantities may be unavailable without

paying a higher price or delivery charge

Price-Volume Relationship
Reduced prices for larger quantities versus
carrying costs

Shortages
May cause serious disruptions

Time-Based Strategies
Reduce process setup and cycle time
reduce costs
get to market faster

Coordinate the flow of resources

eliminate process/system waste
ensure on-time or just-in-time arrival in
economically sized batches

Forecasts and Uncertainty

Overage
Costs

Shortage
Costs

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Forecasting Dilemmas
Where should responsibility for
forecasting future usage lie?
Should the supply management group
be allowed to second-guess sales,
production, or user forecasts?
Should other supply chain members be
involved in a collaborative forecasting
effort?

Forecasting Dilemmas
If the forecast is wrong, who bears the risks?
Should suppliers be held responsible for meeting
forecasts or actual requirements?
Should the supply manager be held responsible
for meeting forecasts or actual requirements?
When should responsibilities for dealing with
results of inaccurate forecasts be outlined in the
contract?
What role does negotiation play in resolving
these issues?

Forecasting Techniques:
Quantitative

Use past data to predict the future

Causal models
Identify leading indicators
Purchasing Managers Index (PMI)

Develop linear or multiple regression models

Time series forecasting

Assumes sales follow a repetitive pattern
over time

Collaborative Planning,
Forecasting, and
Links sales
and marketing processes to
Replenishment
supply chain planning and execution
processes among trading partners to:
improve forecasts and service
reduce cost
develop effective replenishment plans
increase product availability
increase sales
reduce inventories
deliver higher service levels

Types of Demand
Dependent or derived demand:
item is part of a larger component or
product, and its use is dependent on the
production schedule for the larger
component

Independent demand:
usage is determined directly by
customer orders, independent of
production scheduling decisions

Classic Trade-off
When determining lot sizes in which
to make or buy cycle inventories:
the costs of carrying extra inventory
versus
the costs of purchasing or making more
frequently

Objective: minimize total annual

costs

Fixed Order Quantity System:

Cycle Stock, Safety Stock and
Lead Time
INVENTORY

cycl
e
stock
(Q)

ROP
Safety
Stock
TIME
lead time (L)
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Fixed-Quantity: The EOQ

Model
EOQ

Try example on
pp. 207 (may be
on test)

2 RS
KC

where:
R = annual demand
S = set-up or order cost per
order
C = delivered purchase cost
K = carrying cost percentage
therefore:
KC = unit holding cost

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Economic Order Quantity

Model
Annual Cost ($)

CTmi
n
total cost

carrying costs

ordering costs

EOQ

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Safety Stock
Held because of uncertainty in supply
and/or demand
Trade-off: cost of stocking out versus cost of
holding inventory
Levels can be calculated using statistical
techniques
e.g., take into account standard deviation of
demand
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Forecasting Techniques:
Qualitative

Gather opinions and use with judgment to

forecast
Market forecasts: estimates of sales staff
Top down forecast
The Delphi technique: a formal approach

Lack the rigor of quantitative techniques, but

are not necessarily any less accurate
Knowledgeable people with intimate market
knowledge have a feel that is hard to define
but that gives good forecasting results

Fixed Time Period Systems

Inventory on-hand counted at
specific time intervals and
replenished to a desired level
Only the passage of time triggers
reorder

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Fixed Time Period System:

Cycle Stock, Safety Stock and
Lead Time
INVENTORY
Q

Safety
Stock
lead
time

review
period

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TIME

20

Which System is Better?

Fixed order quantity system
Higher maintenance costs
Every transaction logged
Inventory controlled precisely

Fixed time period

Minimal record keeping
Higher average inventories to protect against
stock-outs
Higher stock-out rates
Different order quantities for each cycle
Ability to batch orders to suppliers
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Materials Requirement
Planning (MRP)

Designed for push or forecast-driven systems

Based on a master production schedule:
Creates schedules identifying the specific parts and
materials required to produce end items
Determines exact numbers needed
Determines the dates when orders for those
materials should be released, based on lead times

Get the right materials

to the right place at the right time.

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Key Inputs to MRP

Master production schedule:
when do we need it

Inventory record:
what do we have and what do we need

Bill of material (BOM):

what do we need to make one end
product
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Four Basic MRP Lot Sizing

Rules

Lot-for-lot (L4L)

Economic order quantity (EOQ)

Least-total-cost (LTC)
Least-unit-cost (LUC)

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MRP Implications for

Supply

Accurate records for quantities, lead

times, bills of material, and specifications
Tight control of inventory
Cooperation from suppliers for on-time
delivery, proper quantities and batch
sizes, exacting quality (zero defects)
May need to re-evaluate existing contracts

Long-term planning horizon

Less slack in the system
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Demand Driven MRP

Driven by customer demand and
supply chain modeling
Five key components:
strategic inventory positioning
buffer profile and levels
dynamic adjustments
demand driven planning
visible collaborative execution
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Capacity Requirements
Planning (CRP) Systems

Capacity = amount of work in a set

amount of time
CRP translates MRP material plan into

required human and machine resources by

workstation and time bucket
compares required resources to availability
if insufficient capacity, either capacity or the
master production schedule is adjusted
feedback loop to the master production
schedule; closed-loop MRP

Enterprise Resource
Planning (ERP) Systems

Software that integrates business systems and

processes to combine and analyze information
Links customer orders through fulfillment
processes
Requires:
highly accurate information, abandoning rules of
thumb, and using common data

Results:
reduced inventory levels, higher service coverage,
ready access to high-quality information, ability to
replan quickly in response to unforeseen problems

Why Inventory?
To provide and maintain good customer
service.
To smooth the flow of goods through the
production process
To provide protection against the
uncertainties of supply and demand
To obtain a reasonable utilization of
people and equipment

Forms and Functions of

Inventory
Functions of
Inventories
Transit or pipeline
inventories
Cycle inventories
Buffer or uncertainty
inventories or safety
stock
Anticipation or
certainty inventories
Decoupling inventories

Forms of
Inventories
Raw materials,
purchased parts
and packaging
Work-in-process
(WIP)
Finished goods
MRO items

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TYPE

Transit or
Pipeline
Cycle
Buffer or
Safety

Anticipation

Decoupling

Inventory:
Types, Functions,
Objectives

FUNCTION
It takes time to move products (transit time,
handling time, delays)

OBJECTIVE
Balance in-transit inventory costs against
cost of reducing delays

Demand pattern does not equal supply

pattern (goods produced in lot sizes)

Balance cost of ordering (or setup) and cost

of carrying inventory

Demand pattern varies. Customer service

levels must be maintained.

Balance cost of carrying extra inventory

against cost of stocking out

Variations in demand relative to productive

capacity or significant cost advantages to
holding supply in anticipation of demand

Balance inventory costs against production

costs, transportation costs, purchase
discounts, and costs of avoiding price
changes

Distribution and production efficiency

gained from independence between stages
of production and distribution

Balance efficiency of production distribution activities against costs

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Examples of Inventory
Functions

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Inventory Forms and

Functions
WHY

ELIMINATE REASON BY

FUNCTION
Transit

move speed/distance

make moves faster/shorter

Cycle

make/use batch

Buffer

cope with variability

reduce onetime batch

costs
reduce variability

Anticipation

smooth peak
demand
reduce dependence

increase volume
flexibility
coordinate/schedule

Decoupling

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Cost of Inventories
Basic elements are:
capital costs
inventory service costs
storage space costs
inventory risk costs

Annual Inventory Carrying

Cost

(carrying cost per year) = (average inventory

value) x (inventory carrying cost as a % of
inventory value)
Average inventory value = (average inventory in
units) x (material unit cost)
Detailed
CC = Q/2 x C x I, where
explanation on pp.
219 (may be on
CC = carrying cost per year
test)
Q = order or delivery quantity in units
C = delivered unit cost of the material
I = inventory carrying cost as % of inventory
value

Inventory Costs
Ordering or purchase costs:
managerial, clerical, material, telephone, mailing,
fax, e-mail, accounting, transportation, inspection,
and receiving costs associated with a purchase
order

Setup costs:
all the purchaser and suppliers costs of setting up
a production run, including early spoilage and low
production output until standard rates are
achieved, setup, employees wages and other
costs, machine downtime, extra tool wear, parts
(and equipment) damaged during setup

Inventory Costs
Stockout costs:
costs of not having the required parts or materials
on hand when and where needed
Includes lost contribution on present and future lost
sales, changeover costs, substitution, rescheduling
and expediting, labor and machine idle time, lost
customer and user goodwill, penalties

Variations in delivered costs:

costs associated with purchasing in quantities or at
times when prices or delivery costs are higher than
at other quantities or times

ABC Classification of
Purchases
Class

Percentage of Total
Items Purchased

Percentage of Total
Purchase Dollars

10

70-80

10-20

10-15

70-80

10-20

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Example of ABC Analysis

Number of
Items

Percentage
of Items

1,095

10.0%

2,168

19.9

7,660

70.1

10,923

100%

Annual
Purchase Value

Percentage
Annual Purchase
Volume

$21,600,000

Class

71.1%

5,900,000

19.4

2,900,000

9.5

$30,400,000

100%

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Category

Purchase Value is a
Combination of
Price
and
Quantity
Unit Value
Annual Volume
Annual Value

high

high

high

medium

high

high

low

very high

high

high

low

medium

medium

medium

medium

low

high

medium

medium

low

low

low

medium

low

low

low

low

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ABC Classification of
Inventory

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Vendor- or SupplierManaged Inventory

Also called systems contracting or stockless
(VMI/SMI)
buying

Merges ordering and inventory functions

Relies on periodic billing procedures
Nonpurchasing personnel issue order releases
Employs special catalogs
Requires suppliers to maintain minimum
inventory
Normally does not specify volume
Improves inventory turnover rates

Lean Thinking and Lean

Supply

A management philosophy focused on

creating value for the customer while
eliminating waste or nonvalue-adding
activities:

Overproduction
Waiting, time in queue
Transportation
Nonvalue-adding processes
Inventory
Motion
Costs of quality: scrap, rework, and inspection

What is JIT?
Providing the exact quantity needed
at the precise moment it is required
Requires capabilities of:
short production lead times
economical small batch production
flexible resources (labor, material and
equipment)
exacting quality
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What is JIT?
JIT production systems strive to eliminate
waste
inefficient set-up procedures, inventories
focus on all aspects of the production system:
human resources, supply, technology, and
inventories

Nothing will be produced until it is needed

when a unit is sold, the system pulls a replacement
unit from the last position in the system
this process continues throughout the system

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Kanban
Kanban means sign or instruction card in
Japanese
A number of visual methods can be used

Authority to produce come from downstream

operations
Kanban cards represent the number of
containers used in the system
Dictates the lot size production levels and inventory

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JIT Imposed Supplier

Activities

Frequent deliveries
Small lot sizes
Exacting quality

Long-term relationships/contracts
Reduced number of suppliers

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JIT Implications for Supply

Reduction in number of suppliers
Reduction in supplier lead time
Improvement in supplier quality
Improvement in supplier delivery
Increased inventory turnover
Inventory reduction in total dollars

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Managing Supply Chain

Inventories

Impacts customer service, working capital,

profitability
What inventory and where in the supply chain
IT for compatibility and to manage information flows
Operational design of physical flow of
goods/services--production and fulfillment, lead
times, quality, lot sizes
Confidentiality issues
Share actual consumer demand with suppliers for
production planning, to avoid bullwhip effect, reduce
costs

Dimensions of Services
Degree of tangibility
Direction of the service
Production of the service
Nature of demand
Degree of standardized
Skills required

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Determining Quantity
of Services

Forecasting aggregate demand for services

often more unreliable than for goods
Multiple contacts: users, specifiers, order
placers, and supplier relationship managers
Multiple contracts at varying prices and terms
with the same supplier

Organizationwide consumption management

is impossible under these conditions
Difficult for suppliers to determine capacity
requirements and project utilization rates