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Chapter 9-Inventory Fundamentals

IM417 Manufacturing Resources AnalysisSoutheast Missouri State University

Compiled by Bart WeihlSpring 2001

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Inventory Fundamentals

Inventory– Materials and supplies that a business or institution

carries either for sale or to provide inputs or supplies to the production process

– Represents between 20 to 60% of assets

– http:www/inventoryops.com

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Inventory Fundamentals

Aggregate Inventory Management– Managing inventories according to their

classification rather than at the individual item level.

– Generally involves: Flow and kinds of inventory needed Supply and demand patterns Functions that inventories perform Objectives of inventory management Costs associated with inventories

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Inventory Fundamentals

Item Inventory Management– The organization must establish some decision rules

about inventory items for overall direction.

– Rules include: Which inventory items are most important How individual items are to be controlled How much to order at one time When to place an order

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Inventory Fundamentals

Inventory and the Flow of Material– Raw materials

Purchased items received which have not entered the production process

– Work-in-process Raw materials that have entered the manufacturing

process and are being worked on or waiting to be worked on

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Inventory Fundamentals

Inventory and the Flow of Material– Finished Goods

Finished products of the production process that are ready to be sold as completed items.

– Distribution inventories Finished goods located in the distribution system

– Maintenance, Repair, and Operational Supplies (MRO)

Items used in production that do not become part of the product

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Inventory Fundamentals

Supply and Demand Patterns– Demand for many products is not constant enough

to set up a flow system

– Many products are made in lots or batches

– Work moves in lots from one workstation or process to another as determined by the routings

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Inventory Fundamentals

Function of Inventories– In batch manufacturing, the basic purpose of

inventories is to decouple supply and demand

– Inventory serves as a buffer between: Supply and demand Customer demand and finished goods Operations Suppliers and queues

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Inventory Fundamentals

Function of Inventories– Anticipation inventory

Inventory built up in anticipation of future demand

– Fluctuation Inventory Inventory held to cover random unpredictable fluctuations

in supply and demand or lead time

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Inventory Fundamentals

Function of Inventories– Lot-size Inventory

Also called cycle stock Items purchased or manufactured in quantities greater

than immediately needed. Allows the firm to take advantage of quantity discounts and

to reduce shipping, clerical, and setup costs

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Inventory Fundamentals

Function of Inventories– Transportation Inventory

Also called pipeline or movement inventories Inventory in transit because of the time to move goods

from one location to another

– MROs Used to support general operations and maintenance, but

do not become part of the product

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Example: Transportation Inventory

Q: A company is using a carrier to deliver goods to a major customer. The annual demand is $5,000,000, and the average transit time is 8 days. Another carrier promises to deliver in 6 days. What is the reduction in transit inventory?

A: Average annual inventory in transit (I) = tA/365

Where t = transit time in days (8 - 6 = 2 days)

A = annual demand ($5,000,000)

I = (2 X $5,000,000) / 365

I = $27,397.26

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Inventory Fundamentals

Inventory Management– Responsible for planning and controlling inventory

from raw material to customer.

– Objectives: Maximize customer service Low-cost plant operations Minimum inventory investment

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Inventory Fundamentals

Customer Service– The ability of a company to satisfy the needs of

customers.

– The availability of items needed

– Inventories help to maximize customer service by protecting against uncertainty

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Inventory Fundamentals

Operating Efficiency– Inventory helps manufacturing to be more

productive by: Allowing operations with different rates of production to

operate separately. Assist with production planning and production leveling

through lower costs. Allowing for longer production runs Allowing the purchase of larger quantities

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Inventory Fundamentals

Operating Efficiency– Inventory investment must be balanced with:

Customer service Cost of changing production levels Cost of placing orders Transportation costs

– If inventory is carried there must be a benefit that exceeds the costs of carrying that inventory.

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Inventory Fundamentals

Inventory Costs– Item Cost

Price paid plus other direct costs associated with getting the time into the plant

– Carrying Costs All the expenses incurred by the firm because of the volume of

inventory carried.– Capital costs– Storage costs– Risk costs

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Inventory and Bottom-Line Profits

Excess inventory* has a negative impact on cash flow. Carrying costs include warehousing, racking, shelving,

interest costs and insurance premiums (typically represents 8% to 14% of inventory costs).

Reduction in inventory can apply 10% to the bottom line. Slow moving, or obsolete, inventory reduces profits with

financial reserves and possible write-offs.

*Excess Inventory: On-hand balances in excess of the amount needed to support demand

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Example: Carrying Costs

Q: A bakery carries an average inventory of $15,000. If they estimate the cost of capital is 10%, storage costs are 5%, and the risk costs are 8%, what does it cost per year to carry this inventory?

A: Total cost of carrying inventory = 10% + 5% + 8%

= 23%

Annual cost of carrying inventory = 0.23 X $15,000

= $3,450

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Inventory Fundamentals

Inventory Costs– Ordering Costs

Costs associated with placing an order either with the factory or a supplier.

Cost of placing an order does not depend on quantity ordered. Annual ordering costs depend on the number of orders placed per

year. Ordering costs would include:

– Production control costs– Setup and teardown costs– Lost capacity cost– Purchase order cost

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Example: Ordering Costs

Q: Annual purchasing salaries are $85,000, operating expenses for the purchasing department are $35,000, and inspecting and receiving costs are $30/order. If the purchasing department places 12,000 orders/year, what is the average cost of ordering? What is the annual cost of ordering?

A: Average ordering cost = (fixed costs / number of orders) + variable cost

= (($85,000 + $35,000) / 12,000) + $30

= $40

Annual ordering cost = (Average ordering cost)(number of orders)

= ($40)(12,000)

= $480,000

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Inventory Fundamentals

Inventory Costs– Stockout Costs

Stockouts occur when demand during leadtime exceeds the forecast.

Could include back-order costs, lost sales and customers

– Capacity Associated Costs Costs associated with changing the level of output

– Overtime, hiring, training, shifts, layoffs…..etc

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Inventory Fundamentals

Financial Performance Measures– Inventory Turns Ratio:

– Inventory Turns = Annual COGS/Avg. Inventory $

– Widely used as a measure of inventory performance– Lumps all inventory together thereby hiding obsolete and slow

movers– Between 1977 and 1997, typical US high-tech manufacturer nearly

doubled its inventory performance – from 2.4 to 4.8 turns/year*

– *1998 PRTM study http://www.prtm.com

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Example: Inventory Turns

Q: What will be the inventory turns if the annual cost of goods sold is $32 million a year and the average inventory is $8 million?A: Inventory turns = annual cost of goods sold / average inventory in $

= $32,000,000 / $8,000,000 = 4

Q: What would be the reduction in inventory if inventory turns were increased to 8 times per year? If the carrying costs for inventory is 25%, what are the projected savings?

A: Average Inventory= annual cost of goods sold / inventory turns

= 32,000,000 / 8

= $4,000,000

Reduction in inventory = $8,000,000 - $4,000,000 = $4,000,000

Savings = Inventory reduction X 25% = $4,000,000 X 0.25 = $1,000,000

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Inventory Fundamentals

ABC Inventory Control– A scheme where inventory is classified by level of

importance in terms of annual sales dollars.

– Based on Pareto’s Law: A items: 20% of items accounts for 80% of usage B items: 30% of items account for 15% of usage C items: 50% of items account for 5% of usage

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Inventory Fundamentals

ABC Analysis– Establish item characteristics

Usually annual dollar usage

– Classify items into groups based on criteria

– Apply control appropriate to classification

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Inventory Fundamentals

Control Based on ABC Classification– Have plenty of low-value items

– Use the money and control effort saved to reduce the inventory of high-value items

A items get the tightest control and attention B items get normal controls C items get simple controls

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Inventory Quality Ration (IQR)

Developed by materials managers from 35 companies.

Collectively reduced inventories by $500M in two years.

Implementation typically reduces inventories of manufacturing and distribution companies by an average of 25%.

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Inventory Quality Ration (IQR)

A true dollar-based performance measure includes:– Establishing inventory classes (based on $ Rqmts.)– Setting target inventory levels– Measuring the dollars invested in inventory– Establishing specific inventory objectives– Analyzing the data– Continuously improve

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IQR Logic and Methodology

Use ABC-type classifications using– Future dollar requirements– Past dollar usage– Current balances on hand

Establish a rule or target balance for each item Group inventory

– Active (A)– Excess (E)– Slow moving (SM)– No moving (NM)

Future Requirements

Recent Past UsageNeither

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IQR and its Effects

IQR = =

Perfect condition (i.e., no excess, slow moving or no moving inventories), the IQR = 100%

Average IQR = 30% – 45% range

A1 + A2

A1 + A2 + E1 + E2 + SM + NM

Active $

Total $

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For Next Week. . .

Do Problems: 9.1 9.3 9.5 9.7 9.14 9.16