INVENTORY MANAGEMENT

R VASUDEVAN K NAGARAJAN DAKSHINAMURTHY

Inventory Definition

What is inventory? Stock of items kept to meet future demand

Tangible Nature of Inventory

All Organisation keep inventories Inventories includes of o Raw materials o Work In progress o Finished goods o Consumables & tools o MRO Spares

Traditional Thinking is - Inventory is required to future demand. - Accounting principle treat Inventory as an Asset which adds value to the company

Inventory Management
Purpose of inventory management - how many units to order - when to order Inventory not necessarily be as physical stock Purpose of Inventory Management is to have access to stock as and when they need it

INVENTORY & PRICE BEHAVIOUR

Price does not follow simple demand supply curve in Inventory Economy Asymmetry in Price behavior due to Inventory During Stock-out Prices respond more strongly to demand shocks During Excess Stock Price respond less strongly to demand shock

Price response to demand shocks are greater during high level of economic activities than at low level
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WHY HOLDING INVENTORY !!

Transaction motive Display & Demonstration purpose To meet Sudden Demands & reduce delivery lag Precautionary motive Fear of Stock Outs & Loosing Goodwill Inventory on RM & FG to ensure smooth production and meeting fluctuating sales demand RM Inventory acts like Hedging (getting protected from future Price fluctuations) WIP Inventory helps to schedule production properly Safety stock to address uncertainty in supply & demand
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Precautionary motive takes maximum attention in Inventory study

WHY HOLDING INVENTORY !!

Uncertainty in supply & demand Speculative motive Based on Speculation maintaining Profit making Inventory Flabby Inventory Inefficient Management of Working Capital

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INVENTORY BEHAVIOR
Firm Production dependent on Inventory presence High Inventory Lower Price Low Production Low Opening Inventory Economic Conditions Recession High Inventory Low Production Sales met by drawing Inventory & Low Production Volume High Growth Increase Production Higher Withdrawal from Inventory Meeting Sales Target

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INVENTORY BEHAVIOR
Typical Indian Industry Inventory/Total asset was 6.83% in 1997-98 to 4.81% in 2005~06 due to Technological Growth Efficient Inventory Management System Inventory / Current Asset = 27% (Average)
Current Situation on different industries (based on Balance sheet as on 31/03/2010 source :moneycontrol.com)
TML (Mfg) (in crs) Total Assets Total Current assets Inventory Inventory Ratio / Current asset Inventory / Total Asset 31591.35 7080.77 2935.59 41.4% 9.2% TCS (Software) 15152 3551.39 6.78 1.77% 0.04% Tata Chemicals State Trading corp (Process ) (Trading) 7221.58 1817.75 611.19 33.6% 8.46% 3053.80 7346.66 567.01 7.7% 18.56%

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MARKET IMPERFECTION
Market Imperfection Productive-Distribution System integrated backward to Input sources and Forwardly to an efficient market Plant Operations run smoothly & Flexibly in response to demand & supply IDEAL SYSTEM Neither Productive system not market is perfect This imperfections create fluctuations & shocks in various dimensions to Productive & Distribution system

Firms maintains Inventory that acts as Buffer and absorbs all shocks insulating Operations & Distribution system to function smoothly
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TYPES OF ORGANISATION HOLDING INVENTORY

What Type of Inventories held by different Organizations? Retailers: last node of productivedistribution system Holds variety of goods from different competing manufacturers Low value addition to Goods Suffers problem of Qty holding and regularity of supplies Wholesalers: Receives large qty of Goods from manufacturers for distributing to retailers Labeling & Repackaging are little value addition to Goods Suffers Problem of associated Product demand & Supply variation
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TYPES OF ORGANISATION HOLDING INVENTORY

Manufacturers: Hold all three types of Inventories, RM, WIP & FG Inventory problems are pretty complex due to complexity in Product, Process & Distribution

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COST ASSOCIATED WITH INVENTORY

Purchase or Acquisition Cost
Direct FG Net Purchase Cost + Freight + Insurance + Loading & Unloading etc. In-house Manufactured Part Unit Production cost inclusive of OHs

Ordering or Set-up Cost

Cost associated for writing & Placing order + Vendor Follow-up Cost + Receiving & Inspection Cost + other costs associated till taking the product to stores Set up cost Preparing shop order, scheduling work, Pre-production inspection Order Cost does not vary with qty but No. of orders placed
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COST ASSOCIATED WITH INVENTORY

Holding Cost Contains two parts
Cost of Physical carrying of Inventories Financial cost of funds engaged in Inventories Proportional to the Inventory holding

Stock-out Cost
Implicit cost of lost sales due to Supplies shortage Include Back order cost, lost profit & Cost of loosing Goodwill Difficult to place monetary value

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INVENTORY VALUATION & METHODS

Valuation of Inventory affects COGS & hence Profit / Loss of the Enterprise. Leads to Higher Tax payment & Lesser Dividend payment

Valuation Methods:
FIFO (First in First Out) LIFO (Last in Fast Out)

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INVENTORY VALUATION & METHODS

Average Cost
Simple Average Weighted Average Moving Average

Specific Identification Other methods accepted by Accounting Standard

Base Stock Adjusted Selling Price Standard Cost

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INVENTORY VALUATION & METHODS

Method of Inventory Valuation affects P&L Example
For a company A, let us assume the following :
Month January February March Total Monthly Inventory Purchases* Units Purchased Cost/piece 1,000 10 1,000 12 1,000 15 3,000 Total Value 10,000 12,000 15,000
- Source: investopedia.com

Beginning Inventory = 1,000 units purchased at $8 each (a total of 4,000 units)

Income Statement (simplified): January-March* Item LIFO FIFO Sales = 3,000 units @ $20 each $60,000 $60,000 Beginning Inventory Purchases Ending Inventory (appears on B/S) *See calculation below COGS Expenses Net Income 8,000 37,000 8,000 $37,000 10,000 $13,000 8,000 37,000 15,000 $30,000 10,000 $20,000

The income statement will be:

Average $60,000 8,000 37,000 11,250 $33,750 10,000 $16,250

*Note: All calculations assume that there are 1,000 units left for ending inventory: (4,000 units - 3,000 units sold = 1,000 units left)

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INVENTORY VALUATION & METHODS

Method of Inventory Valuation affects P&L Example
- Source: investopedia.com

Basic valuation Beginning inventory + purchase during the period ending inventory = COGS FIFO Ending 1,000 units X 15 each = 15,000 Inventory Cost = Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory. LIFO Ending 1,000 units X 8 each = 8,000 Inventory Cost = Remember that the last units in are sold first; therefore, we leave the oldest units for ending inventory. Average Cost Ending Inventory = [(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = 11.25 per unit 1,000 units X 11.25 each = $11,250

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GOAL OF INVENTORY MANAGEMENT

Inventory Management is the integral part of Material Requirement Planning (MRP) whose goals are Minimize investment in inventory Ensure smooth and efficient operation of the plant Maximize Customer Service & Satisfaction In a firm no single department can work in isolation to achieve the above goals Modern system assigns this job to a specialised Material manager
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INVENTORY STRATEGIES
Integrate Inventory functions to Corporate Strategy of Business organization Top management perspective Inventory should be managed to realize competitive business strategy Integrates suppliers in to business & runs through consumers in a manner that involves material flow & two-way information flow. Forecasting, Order processing, Production planning, machine scheduling, vendor engagement, etc handles in integrated manner Michael Porters ways to achieve competitive strategy
Cost Leadership Strategy Differentiation Strategy Focus Strategy
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INVENTORY STRATEGIES

Cost Leadership Strategy

Produce Standard Products with no special Features Goods for Mass Consumption (e.g., Hardware) Product Demand is stable Competition is High Market & Consumers very price sensitive Stock-out cost is high
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INVENTORY STRATEGIES

Cost Leadership Strategy

Inventory Strategy-MAKE TO STOCK
Wait-time for customers are very short Part manufactured (lower OH or Purchased in discount) & Stored in large Qty

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INVENTORY STRATEGIES Differentiation Strategy

Enterprise Unique in Industry (E.g., Apple) Charge premium price for unique value addition Differentiation could be Product, selling location (unique retailer atmosphere), delivery types, etc Achieve higher market share by cutting premium price Need to invest in R&D for sustaining strategy

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INVENTORY STRATEGIES Differentiation Strategy

Enterprise Unique in Industry (E.g., Apple) Charge premium price for unique value addition Differentiation could be Product, selling location (unique retailer atmosphere), delivery types, etc Achieve higher market share by cutting premium price Need to invest in R&D for sustaining strategy

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INVENTORY STRATEGIES
Differentiation Strategy Inventory Strategy-MAKE TO STOCK or ASSEMBLE TO ORDER
Products are maintained in semi-knocked down condition Suitable for products differentiated with optional features Product differentiation done regionally based on customer requirements of particular region Customer wait time is longer than make to stock

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INVENTORY STRATEGIES
Focus Strategy Focus on narrow competitive scope within an Industry Enterprise choose a segment or group of segments in Industry and tailor its strategy to serve them Focus could be taking cost advantage or Product differentiation in the selected segment

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INVENTORY STRATEGIES
Focus Strategy
Inventory Strategy-VARIES WITH FOCUS For Cost Focus, Make to Stock is the ideal option Focused differentiation in custom based product may follow make to order or engineer to order In both cases production will not start till receives order Consultancy element is greater Customer wait time is longer in engineer to order than make to order

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Types of Demand:
Dependent
Demand for items used to produce final products Tires stored at a Goodyear plant are an example of a dependent demand item

Independent
Demand for items used by external customers Cars, appliances, computers, and houses are examples of independent demand inventory

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TECHNIQUES OF INVENTORY MANAGEMENT

Classification - ABC analysis EOQ Quantity Discounts All Unit Discount Incremental Discount Present Value Approach Ordering Intervals Fixed Order System Periodic Order System
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ABC Classification
Class A 5 15 % of units 70 80 % of value Class B 30 % of units 15 % of value Class C 50 60 % of units 5 10 % of value

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ABC Classification: Example

PART 1 2 3 4 5 6 7 8 9 10
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UNIT COST $ 60 350 30 80 30 20 10 320 510 20

ANNUAL USAGE 90 40 130 60 100 180 170 50 60 120

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ABC Classification: Example (cont.)

TOTAL PART VALUE % OF TOTAL % OF TOTAL UNIT COSTQUANTITY % CUMMULATIVE ANNUAL USAGE VALUE

PART

9 8 2 1 4 3 6 5 10 7

$30,600 1 16,000 2 14,000 3 5,400 4 4,800 5 3,900 3,600 6 CLASS 3,000 7 2,400 A 8 1,700 B 9 C $85,400

10

35.9 6.0 $ 60 18.7 5.0 350 16.4 4.0 30 6.3 9.0 80 5.6 6.0 30 4.6 10.0 % OF TOTAL 4.2 18.0 20 VALUE ITEMS 3.5 13.0 10 12.0 9, 8,2.8 2 71.0 320 17.0 1, 4,2.0 3 16.5 510 6, 5, 10, 7 12.5

20

6.0 90 11.0 40 A 15.0 130 24.0 60 30.0 B 100 40.0 % OF TOTAL 58.0 180QUANTITY 71.0 170 C 83.0 50 15.0 100.0 25.0 60 60.0 120

Example 10.1

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Economic Order Quantity (EOQ) Models

EOQ optimal order quantity that will minimize total inventory costs

Basic EOQ model Production quantity model

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Assumptions of Basic EOQ Model

Demand is known with certainty and is constant over time No shortages are allowed Lead time for the receipt of orders is constant Order quantity is received all at once

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Inventory Order Cycle

Order quantity, Q

Reorder point, R

Inventory Level

Demand rate

Lead time Order Order placed receipt

12-35

Lead time Order Order placed receipt

Time

EOQ Cost Model

Co - cost of placing order Cc - annual per-unit carrying cost D - annual demand Q - order quantity Co D Q CcQ 2 CcQ 2

Annual ordering cost = Annual carrying cost = Total cost = CoD Q +

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EOQ Cost Model

Deriving Qopt TC = Co D Q + CcQ 2

Proving equality of costs at optimal point Co D Q

2

CoD C TC = + c Q Q2 2 0= Qopt = C0 D Q2 + Cc 2

CcQ 2 2CoD Cc 2CoD Cc

Q =

2CoD Cc
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Qopt =

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EOQ Cost Model (cont.)

Annual cost ($) Slope = 0 Minimum total cost Carrying Cost = CcQ 2

Total Cost

Ordering Cost = Optimal order Qopt

CoD Q

Order Quantity, Q

EOQ Example
Cc = $0.75 per yard Qopt = Qopt = 2CoD Cc
2(150)(10,000) (0.75)

Co = $150 TCmin = TCmin =

D = 10,000 yards CoD Q + CcQ 2

(150)(10,000) (0.75)(2,000) + 2,000 2

Qopt = 2,000 yards

Orders per year = D/Qopt
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TCm = $750 + $750 = $1,500 in

Order cycle time = 311 days/(D/Qopt ) = 311/5 = 62.2 store days

= 10,000/2,000 = 5 orders/year Working Capital Management

Production Quantity Model

An inventory system in which an order is received gradually, as inventory is simultaneously being depleted

AKA non-instantaneous receipt model assumption that Q is received all at once is relaxed

p - daily rate at which an order is received over time, a.k.a. production rate

d - daily rate at which inventory is demanded

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Production Quantity Model (cont.)

Inventory level Maximum inventory level Average inventory level

Q(1-d/p)

Q (1-d/p) 2

0 Order receipt period

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Begin End order order receipt receipt

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Time

Production Quantity Model: Example (cont.)

Number of production runs =

10,000 D = = 4.43 runs/year 2,256.8 Q d p = 2,256.8 1 32.2 150

Maximum inventory level = Q 1 -

= 1,772 yards

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Production Quantity Model (cont.)

p = production rate Maximum inventory level = Q Q d p d p

d = demand rate

=Q1Average inventory level =

Q d 1p 2

Qopt =

2CoD d Cc 1 - p

CoD CcQ d TC = + 1- p Q 2
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Production Quantity Model: Example

Cc = $0.75 per yard

Co = $150

D = 10,000 yards p = 150 yards per day

d = 10,000/311 = 32.2 yards per day 2CoD Qopt = Cc 1 - d p =

2(150)(10,000) 32.2 0.75 1 150 = 2,256.8 yards

Co D CcQ d TC = + 1- p Q 2 Production run =

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= $1,329

2,256.8 Q = = 15.05 days per order p 150

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Quantity Discounts

Price per unit decreases as order quantity increases

TC = where P = per unit price of the item D = annual demand
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CoD Q

CcQ 2

+ PD

Quantity Discount Model (cont.)

ORDER SIZE 0 - 99 100 199 200+ PRICE $10 8 (d1) 6 (d2)

TC = ($10 ) TC (d1 = $8 ) TC (d2 = $6 )

Inventory cost ($)

Carrying cost

Ordering cost Q(d1 ) = 100 Qopt 12-46 Q(d2 ) = 200

Quantity Discount: Example

QUANTITY 1 - 49 50 - 89 90+ Qopt = For Q = 72.5 TC = For Q = 90 TC =
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PRICE $1,400 1,100 900 2 Co D Cc CoD Qopt Co D Q =

Co = $2,500 Cc = $190 per computer D = 200 2(2500)(200) = 72.5 PCs 190

CcQopt 2 CcQ 2

+ PD = $233,784

+ PD = $194,105

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Reorder Point

Level of inventory at which a new order is placed

R = dL where d = demand rate per period L = lead time

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Reorder Point: Example

Demand = 10,000 yards/year Store open 311 days/year Daily demand = 10,000 / 311 = 32.154 yards/day Lead time = L = 10 days R = dL = (32.154)(10) = 321.54 yards
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Safety Stocks

Safety stock
buffer added to on hand inventory during lead time

Stockout
an inventory shortage

Service level
probability that the inventory available during lead time will meet demand

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Variable Demand with a Reorder Point

Inventory level

Reorder point, R

LT Time

LT

Reorder Point with a Safety Stock

Inventory level

Q
Reorder point, R

Safety Stock

0
Copyright 2006 John Wiley & Sons, Inc.

LT
12-52

LT Time

Reorder Point With Variable Demand R = dL + z

where d = average daily demand L = lead time d = the standard deviation of daily demand z = number of standard deviations corresponding to the service level probability z d L = safety stock

Reorder Point for a Service Level

Probability of meeting demand during lead time = service level

Probability of a stockout

Safety stock z dL Demand

12-54
d

L R

Reorder Point for Variable Demand

The carpet store wants a reorder point with a 95% service level and a 5% stockout probability
d = 30 yards per day L = 10 days d = 5 yards per day For a 95% service level, z = 1.65 R = dL + z
d

Safety stock = z

= 30(10) + (1.65)(5)( 10) = 326.1 yards

= (1.65)(5)( 10) = 26.1 yards

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Order Quantity for a Periodic Inventory System

Q = d(tb + L) + z where d tb L
d

tb + L - I

z
d

= average demand rate = the fixed time between orders = lead time = standard deviation of demand

tb + L = safety stock I = inventory level

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Fixed-Period Model with Variable Demand

d = 6 bottles per day d = 1.2 bottles tb = 60 days L = 5 days I = 8 bottles z = 1.65 (for a 95% service level) Q = d(tb + L) + z
d

tb + L - I 60 + 5 - 8

= (6)(60 + 5) + (1.65)(1.2)
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= 397.96 bottles

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Planning for Uncertainty

changing lead times changing demand Uncertainty creeps in: Plug in safety stock

Safety stock - allows manager to determine the probability of stock levels - based on desired customer service levels

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Inventory Model Under Uncertainty

reorder Qm point

safety stock time

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Profit through Inventory Management

Consider 2 companies of annual sales 5 Mil & employees 85 people, All other items of the balance sheet is same if the company A has managed to reduce inventory to 500,000 and Company B is having inventory of 2.5 Mil. This additional cost of 2.0 Mil is financed by debt @ 15%. The Total cost will be as per the table below

Warehousing costs Cost element Stores: extra area rent, heating etc. Stores, equipment; trucks and racking depreciation Maintenance Stock obsolescence Plus financing charge 2 million @ 15% Total extra cost Cost ( p.a.) 500 1 000 1 000 5 000 300 000 307500

Additional cost outflow:

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Inventory Management Techniques

MRP II (Material Resource Planning) Source: Best practice in inventory : Tony Wild
Well developed technique for planning dependent demand. The concept is to have stock when needed. With dependent demand the size and time of demand is known MRP-II therefore give more control over the supply chain. The MRP approach is entirely different, based on: interdependent usage rates between stock lines acquiring stock for when it will be used.

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Inventory Management Techniques

MRP II (Material Resource Planning) Source: Best practice in inventory : Tony Wild
Customers tend to use items together, so demand is not truly independent. For example, there must be a connection between the demand for hinges and doors, paint and paint brushes, nuts and bolts, although, in general business, will become clear after a that for every 100 bolts bought by a customer, they require forty nuts of one type and twenty of another. This relationship could be consistent, because the customer's use is consistent, sometimes without identifying the reason. The demand for these items could therefore be interlinked, and could vary as their level of business changes.
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Inventory Management Techniques

It is important, therefore, for the items to be balanced in stock. Material requirements planning links in the inventory systems with the sales and financial plans of the company. It is a professional technique for a modern company and it requires adequate information, particularly:
a master schedule of planned supply to customers for each product, projected far enough ahead to permit ordering of bought-out items, raw materials and components. This 'planning horizon' must be long enough to cover the procurement lead time for bought-out items plus the total manufacturing time a well defined 'bill of materials' showing purchased items and manufactured components to identify what to make and buy lead times for the purchase or manufacture of all parts, realistic times taken accurate records of stock, work in progress and on-order parts.
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Inventory Management Techniques

Objective of JIT(Just in Time) Produce only the products the customer wants. Produce products only at the rate that the customer wants them. Produce with perfect quality Produce with minimum lead time. Produce products with only those features the customer wants.
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Inventory Management Techniques

JIT Principles (Just In Time) Create flow production one piece flow machines in order of processes small and inexpensive equipment

U cell layout, counter clockwise multi-process handling workers easy moving/standing operations standard operations defined
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Inventory Management Techniques

JIT Tactics Single Minute Exchange of Dies (SMED) Statistical Process Control Use of standard containers Doable stable schedules with adequate visibility TAKT-Time 5-S Program Kaizen Event
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Visual control Flexible workers Tools at the point of need Product redesign Group Technology Total Productive Maintenance

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Inventory Management Techniques

Push Vs. Pull Scheduling Push Scheduling traditional approach move the job on when finished problems - creates excessive inventory Pull scheduling coordinated production driven by demand (pulled through system) extensive use of visual triggers (production/withdrawal kanbans)

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Inventory Management Techniques

Embed youtube file Jit@Mcdonald

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SUMMARY Inventory Constitutes very small % of Gross Net Profit Inventory Contribution to Business fluctuation is very high Types of Inventories accounting for fluctuation are Retail inventories, Manufacturers Inventory on RM & Wholesalers Inventory. FG & WIP does not contribute much to variance

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