Chapter 4Inventory in the Logistics System

Inventory is everywhere

S1

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S3

Sn

W/H Plant W/H

DC1

DC2

DC3

DCn

R

R

R

R

R

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Plant/Mfg

Inventory, Inventory, Inventory, …

• “Inventory, inventory, inventory….I am sick and tired of hearing complaints about our inventory levels and the costs associated with carrying inventory,” muttered the COO.

• That’s why you have to understand:– What is the role of inventory?– What are the important trade-offs in the management of

inventory?– What are the relevant inventory costs?– Can the supply chain help control inventory?

Importance of Inventory

• Inventory - “Double-Edged Sword”

Importance of Inventory• Inventory - “Double-Edged Sword”

• As companies struggle to reduce investment in fixed assets that accommodate inventory (plants, warehouses, etc.), the significance of inventory as an asset has increased.

• Changes in inventory affect return on assets (ROA), an important internal and external metric.

• Ultimate challenge is to balance ____ and ______ as well as _______ and _____________.

• Think of inventory turns as a measure of how well ________ ______________ in the market and how well _____________ ______________.

Importance of Inventory to U.S. Economy

• Inventory in the Economy has decreased.

• As a percentage of the GDP, from 1985 to 2000, inventory levels have decreased from 5.4% to about 3.8%.

• However, the absolute dollar value of inventory continues to rise.

Year Ending

GDP ($ trillion)

Inventory ($ billion)

Inv. as a % of GDP

1985 4.23 847 5.4%

1990 5.80 1,041 4.9%

1991 5.99 1,030 4.3%

1992 6.32 1,043 3.8%

1993 6.64 1,076 3.6%

1994 7.05 1,127 3.8%

1995 7.40 1,211 4.1%

1996 7.81 1,240 3.9%

1997 8.32 1,280 3.8%

1998 8.79 1,323 3.7%

1999 9.30 1,379 3.6%

2000 9.96 1,485 3.8%

Source: Robert V. Delaney, “State of Logistics Report,” presented on June 4, 2001 at the National Press Club in Washington, D.C.

Factors Affecting Expenditures on Inventory• Improvements in “inventory velocity” prevent

inventories from sitting idle.– Inventory turnover potential is __ to ___ times/year.

• From traditional build-to-forecast manufacturing models to ____JIT__________ manufacturing.

• Product proliferation– Depth & breath of product lines trending up.– Results in actual inventories.

• Interest rates/cost of capital• Acquisition of higher-value, lower-weight

products will result in carrying costs.

Importance of Inventory of Different Products and Industries

Company

Current Sales

($ billion)

Total Assets

($ billion)

Average Inventory ($ billion)

Inv. as a % of Total Assets

Manufacturing

Ford Motor $118.1 262.8 6.7 2.5% General Electric 62.1 304.0 5.9 1.9% Philip Morris 72.1 54.9 9.0 16.4% Sony 6.8 6.4 1.0 15.6%

Wholesalers and Retailers

Bergen Brunswig 5.7 3.0 1.60 53.0% Fleming Co. 16.5 4.0 1.05 26.2% K-Mart 32.2 13.6 3.50 25.7% The Limited 4.2 4.3 1.00 23.3% Kroger 26 6.3 1.81 28.7%

Functional Types of Inventory• Cycle stocks (batching economies)

– It results from __________________ through acquisition, production, and/or transportation in order to meet demand under conditions of certainty.

– Accumulation of inventory will be sold over some period of time through normal business operations.

– ___________, ________________, and ________________ causes accumulation of cycle stock.

• In-process stock (Goods-In-Process, WIP, In-Transit)– Time-related trade-offs should be evaluated.– For accounting purposes, it may be calculated as cycle stock.

• Dead stock– It is obsolete on a total firm or at just one stock-keeping

location.– It needs to be transshipped or marked down and sold.

Functional Types of Inventory• Seasonal stock

– Necessary due to seasonality of either inbound or outbound flows of products that should be accumulated before sales

• Speculative (Anticipatory) stock– Increased prices and/or decreased may cause speculative

stock.– shortage of supplies due to orders may prompt more than

normal level of inventory.– Risk assessment is important in these cases– It is very possible when the firm uses ______ supply

lines.

• Promotional stock– Sales and deals should be coordinated among different

functions of a firm

The Impact of Inventory on Other Functional Areas

• Marketing uses inventory to provide strong customer service.

• Manufacturing uses inventory to schedule longer production runs.

• Finance wants inventory turnover ratios to be kept high so that risk of inventory loss is reduced and rate of return on assets kept competitively high.

In Summary, why firms accumulate inventory?

• “Ideally inventory will maximize cash flow.” • However, most companies have to accumulate

some level of inventory for– Meeting sudden demand

– Satisfying the markets needs

– Strategic policy

• in consideration of – trade-offs discount vs. savings vs. inventory level.

– and vendor (inbound inventory) and/or employee (outbound inventory) relationships.

Inventory-Related Costs

CarryingCosts

Order/SetupCosts

Inventory Carrying Costs

Capital Costs

– Expressed as percentage of product value

– Based on value of average inventory

– rate is most appropriate • =minimum rate of return on new investments

– Observations• Interest rates not entirely valid

• Industry averages misleading

• Most companies calculate incorrectly

• Rule of thumb of 25% can be very misleading

• Range of percentages found in textbooks can justify nearly any inventory policy

Inventory Carrying Costs

Storage Space Cost– Consider only variable portion

– Will differ between public and private warehousing

Inventory Service Cost

Inventory Risk Cost– Deterioration

– Obsolescence

– Damage

– Pilferage and theft

(Continued)

Calculating Carrying Cost

Identify Item Value– FIFO (higher inventory valuation when prices

are rising - and vice-versa)– LIFO (lower inventory valuation when prices

are rising - and vice-versa)– Average Cost

#1

$5

#2

$10

#3

$15

#4

$20

Measure Carrying Cost Components

Example:

Capital Cost 20%

Storage Space 8%

Inv. Service 4%

Inv. Risk 6%

38%

Multiply Percent by Value

Example:Value = $50 per item

Inventory Carrying Cost= ($50) x ( )= $19.00 per item/per year

Calculating Carrying Cost(Continued)

Order/Setup Costs• Order costs

– MIS costs for inventory stock level tracking.– Preparing and processing purchase orders and receiving

reports.– _____________________________________.

• Setup Costs– Incurred when production changes over from one

product to another.• Order costs and carrying costs respond in _______

ways to increases in volume.• This reinforces the logisticians need to be able to

separate costs by how they behave in relation to changes in volume.

• Assistance from managerial accountants is available for cost-volume-profit analysis

Order / Setup CostAnnualCost ($)

Size of Order (units)

Note: Order / setup cost reflects:• Fixed costs (e.g., information and communications technology)• Variable costs (e.g., reviewing stock levels, order processing/

preparation expense, etc.)

A Summary Example of Inventory and Cost Information

© 2003, Coyle, Bardi, and Langley.

Saving Inventory Dollarsby Increasing Inventory Turns

Inventory Turns

Average Inventory

Carrying Cost at 30%

Carrying Cost Savings

1 $200,000 $60,000 ---- 2 100,000 30,000 $30,000 3 66,667 4 50,000 15,000 5,000 5 40,000 12,000 3,000 6 33,333 10,000 2,000 7 28,571 8,571 1,429 8 25,000 7,500 1,071 9 22,222 6,667 833

10 20,000 6,000 667

Saving Inventory Dollarsby Increasing Inventory Turns

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

0 1 2 3 4 5 6 7 8 9 10

Inventory Carrying Cost

Inventory Turns

Inventory Stockout Cost

• Cost of not having product available when a customer wants it.

• Includes ____________ costs (special order).• Losing one item profit by substituting a competing

firm’s product.• Losing a customer permanently if customer finds

they prefer the substituted product and/or company.• Possible to handle this by adding safety stock.• In a manufacturing firm, a stockout may result in

lost hours of production until the item is restocked.

Example: Inventory Calculations• Inventory Carrying Cost

= Dollar value of inventory x percentage carrying cost

• ExampleIf dollar value of inv. = $50.00And carrying cost = 22% of product valueThen Inventory Carrying Cost

==

Example: Inventory Calculations

• Inventory Turnover =

• Example: K-Mart

1992 Sales = $38.8 billion

1992 Avg. Inv. = $8.8 billion

Inventory Turnover =

(Continued)

SalesAverage Inventory

$38.8 billion $8.8 billion

= turns/year

Example: Inventory Calculations

• Average Day’s Inventory on Hand

• Example: K-Mart (cont.)

1992 Sales = $38.8 billion

1992 Avg. Inv. = $8.8 billion

Avg. Day’s IOH =

(Continued)

Avg. Inv.Sales

$8.8$38.8

= Days

= x 365

x 365

ABC Analysis

• Pareto’s Rule (80-20 Rule)– Based on a nineteenth century mathematician’s

observation that many situations were dominated by a very few elements.

– Conversely, most elements had very little influence in most situations.

– Separates the “trivial many” from the “vital few”.

• 80-20 Rule– _________________________________________

_________________________________________.– 20% of sales will come from 80% of the inventory

SKUs.– Not all customers equal nor all SKUs in inventory

management.

ABC Inventory Classification

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100

0 10 20 30 40 50 60 70 80 90 100

Percentage of Items

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Inventory Visibility

• The ability of the firm to ______________ ____________________ requires:– Tracking and tracing inventory SKUs for all

inbound and outbound orders.– Providing summary and detailed reports of

shipments, orders, products, transportation equipment, location, and trade lane activity.

– Notification of failures in inventory flow.

Benefits of Inventory Visibility

• _____________________________• _____________________________• Improved vendor relations and cost• _____________________________• _____________________________• Improved response time and service recovery• Improved performance metrics

Effectiveness of a Company’s Approach to Inventory Management

• Are customers satisfied with the current level of customer service?– If standards have been set in consultation with the customer, this

question can be answered objectively.• How frequently does backordering and/or expediting occur?

– If records of these events are kept, the answer to this question can point out the need for a modification or adoption of new inventory strategies.

• Is the company calculating an Inventory Turnover ratio for each product SKU?– This ratio can provide good information on whether the inventory is

being effectively and efficiently managed. • How does inventory level behave as sales rise or fall?

– From sales records, the firm can determine if inventory levels rise as much as sales, less than sales, or stay about the same regardless of sales levels.

Symptoms of Poor Inventory Management

• Increasing back-order status

• increasing dollar investments in inventory with back-orders remaining constant

• High customer turnover rate

• Increasing number of orders being canceled

• Periodic lack of sufficient storage space

• Wide variance in inventory turnover among distribution centers and among major inventory items

• deteriorating relationships with middlemen as typified by dealer cancellations and declining orders

• Inventories rising faster than sales

• Customers not satisfied

• Inventory turnover too low

New Developments in Inventory Management

• Shifting Inventory Positioning– From retailers to distributors

– From distributors to manufacturers and suppliers

– Out of the system whenever possible

• Accelerating use of point-of-sale (POS) and real-time information to make inventory replenishment decisions; company processes for order processing and inventory management are being integrated

• New providers of inventory services– Wholesalers in support of retailers

– 3rd party/contract logistics suppliers

– Other supplier firms in complementary businesses