inventory fundamental powerpoint

Supply Chain Management

InventoryFundamentals

Inventory Fundamentals

• Inventory = material + supply • For sale

• Input or supply to the production process • Substantial part of total assets

•20% to 60% of total assets on balance sheet • When used value is converted into cash • Improve cash flow and return on investment (ROI)


• Cost for carrying inventories - Increase operation cost

- Decrease profit

• Inventory management is responsible for

- Planning inventory from raw material to customer

- Controlling inventory from raw material to customer


1. Inventory results from production: finished goods

2. Inventory support production: raw material work in process (WIP), etc.

1 and 2 must be coordinated Inventory must be considered at each of the

planning level - Production planning: over all - Master production schedule: end items - Material requirement planning: components & raw material


Aggregate inventory management • Deals with managing inventory according to their

classification - Raw material

- Work in process (WIP - Finished good

• Function of different inventories - not individual item level

• Financially oriented - cost and benefits of carrying different classifications of inventories


Involves

1. Flow and kind of inventory needed 2. Supply and demand pattern 3. Functions that inventories perform 4. Objective of inventory management 5. Cost associated with inventory


Item inventory management • Item level, not aggregate

• Management establishes decision rule about inventory item

• Rules

- 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


Factors affecting inventory management decision

1. Types of inventory based on the flow of material

2. Supply and demand pattern 3. Function performed by inventory 4. Objective of inventory management 5. Inventory cost


1. Inventory and flow of material: • Raw material

• Purchased item not processed yet • Supplier material

• Components • Sub-assemblies

• Work in process (WIP) • Raw material has been processed but not

finished


Supplier Supplier Supplier

Raw material/ Purchased part/ Material

Work in process (WIP)

Finished goods

Warehouse Warehouse Warehouse

Customer Demand Customer Demand Customer Demand


Inventory & flow of material-Continues • Finished goods

• Ready to be sold as completed items • Factory storage

• Warehouse

• Distribution centers

• Distribution inventories • Finished goods in the distribution system


Inventory & flow of material-Continues

• MRO supplies used in production that do not become part of the products such as hand tools, spare parts, die, drill bit, etc.

• Maintenance • Repair

• Operational


Inventory & flow of material-Continues

• Classification depends on production environment

For example tire

• Tire is finished goods for tire manufacturer • Tire is raw material for car manufacturer


2. Supply and demand pattern

• If supply meet demand - no inventory • Demand must be predictable, stable and relatively constant over a long time period - zero inventory

• Produce goods on a line - flow basis - matching production with demand - no inventory

Raw material Work center Customer Zero Zero


2. Supply and demand pattern-continues • Large demand to justify setting up flow system

• Demand is instable - varies • Lots or batch manufacturing • Workstations are organized by function • Work flow from workstation to workstation in lot • Inventory build up in

• Raw material • Work in process (WIP) • Finished goods


3. Functions performed by inventory :

• Decouple supply and demand • Buffer between supply and demand • Buffer between finished goods and customer demand

• Buffer between finished goods and component availability


3. Functions performed by inventory - continue

• Requirement for an operation and the output from the preceding operation • Parts and material to begin production and supplies of material


3. Functions performed by inventory - continue

Classification of inventory by function: a) Anticipation inventory:

• Build up in anticipation of future demand • Example: before peak selling season, promotion program, vacation, shut down, etc. • To help level production

• To reduce cost of changing production rate


Classification of inventory by function - continues

b) Fluctuation inventory (Safety stock):

• Inventory is held to cover random, unpredictable fluctuation in supply and demand or in lead time

• If demand or lead time is greater than forecast, a stock out occurs

• Safety stock is carried to protect stock out



2. Fluctuation inventory (Safety stock):

• Prevent disruption in manufacturing or deliveries to customer

Safety stock - buffer stock - reserve stock



3. Lot size inventory: • Items purchased or manufacturing in quantities

greater the needed

Lot size inventory - cycle inventory

• Portion of inventory that depletes gradually as customer order received

• Replenish cyclically when suppliers order are received



4. Transportation inventory:

Transportation inventory - Pipeline inventory - movement inventory

• Time needed to move goods from one location to another location

• Example: supplier to manufacturer; plant to distribution centers, etc.



4. Transportation inventory: I = t x A/ 365; I = average amount; A=annual

demand; t = transit time, days I Cost; I t;

Reduce transit time to reduce inventory and hence cost



4. Transportation inventory:

Example: Delivery of goods from a supplier is in transit for ten days. If the annual demand is 5200 units, what is the average annual inventory in transit?

I = 10 x 5200 / 365 = 142.5 units



5. Hedge inventory: • Commodities

- Mineral

- Oil

- Grain

• Buy and wait to sell when price rises • Buy at low cost, wait, sell on high price



6. MROs inventory:

Maintenance, repair and operation / over haul • Support general operation and

maintenance - Spare parts - Consumables - Stationer


3. Objective of inventory management: A. Maximum customer service

B. Low cost plant operation C. Minimum inventory investment Maximum customer service: • Ability to satisfy customer needs • Availability of items when needed and a measure of inventory management effectiveness


3. Objective of inventory management- continues

Maximum customer service: • Customers: who they are!

• Purchaser

• Distributor • Other plants • Workstations


3. Objective of inventory management- continues

Maximum customer service: • Measurements of customer service

• % of order shipped on schedule • % of line item shipped on schedule • Order days out of stock

• Inventory help to maximize customer service by protecting against uncertainties

• Carry extra inventories to meet uncertain demand


3. Objective of inventory management:- continues

Low cost plant operations (4 ways) I.Allow operation with different rates of production to operate separately and more economically

II. Allow level production of seasonal items - inventories build up in non- peak sale season



Low cost plant operations (4 ways) II.Allow level production of seasonal items - inventories build up in non-peak sale season, How?

Reduced overtimeReduced training cost Reduced training cost Lower capacity requirement Reduced subcontracting cost



Low cost plant operations (4 ways) III. Allow longer production run • Lower setup cost

• Setup cost is fixed: one unit or 1000 units

• Increase in capacity • less setup • More run time • Bottleneck operation



Low cost plant operations (4 ways) IV. Allow to purchase in larger quantities

• Lower ordering cost

• Quantity discount



Inventories cost money, they must be balanced with

I. Customer service: Low inventory - high stock out Lower level of customer service II.Cost in changing production level

Excess equipment Overtime

Hiring and layoff training



Inventories cost money, they must be balanced with

III. Cost of placing order Each order placed cost IV.

Transportation cost Small quantity cost more per unit

Therefore, carry inventory if it cost less than not to carry


Inventory costs: 1. Item cost

• landed price • purchase cost • cost to get it in plant

• transportation • custom duties • insurance

2. Carrying cost 3. Ordering cost 4. Stock out cost 5. Capacity associated costs


Inventory costs: 1. Item cost 2. Carrying cost

• Cost of carrying volume of inventory • Capital cost • Storage cost

• Space • Labor • equipment

• Risk cost • Obsolescence: model change, out dated • Damage: in handling • Pilferage: lost, misplace, stray, stolen

3. Ordering cost 4. Stock out cost 5. Capacity associated costs



3. Ordering cost • Associated with placing an order with a factory or supplier • Independent of quantity order • Depends on number of orders placed in a year • Production control cost

* Setup time *Production loss * Tear down at the end of run

• Lost capacity cost * Incurred when an order is placed

* Order preparation * Expediting * Follow-up * Receiving * Authorizing payment * Receiving and paying invoice



3. Ordering cost: Example

A company carry 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?


Example-continues

Total cost of carrying inventory = 10% + 7% + 6% Total cost of carrying inventory = 23% Total annual cost of carrying inventory = 23% x $2,000,000

Total annual cost of carrying inventory = 0.23 x $2,000,000

Total annual cost of carrying inventory = $460,000


Ordering cost: Example

Given the following annual costs, calculate the average cost of placing one order. Production control salaries = $60, 000 Supplies and operating expenses for production control department = $15,000 Cost of setting up work centers for an order = $120 Order placed each year = 2000


Ordering cost: Example Average cost = fixed cost/number of orders + variable cost

Average cost = ($60, 000 + $15,000 )/2000 + $120 Average cost = $37.50 + $120 = $157.50


Inventory costs: 1. Item cost 2. Carrying cost 3. Ordering cost

4. Stock out cost • If demand during the lead time exceeds forecast we

expect a stock out Back order cost Lost sale Lost customer

5. Capacity associated costs


Inventory costs: 1. Item cost 2. Carrying cost 3. Ordering cost 4. Stock out cost

5. Capacity associated costs • When output level is changed, following cost may

incur i. Overtime v. Training ii. Hiring vi. Extra shift iii. Leveling production vii. Laying off iv. Carrying inventory


Quarter Quarter Quarter Quarter 1 2 3 4 Total

Forecast demand 2,000 3,000 6,000 5,000 16,000

Production 4,000 4,000 4,000 4,000 16,000

Ending inventory 0 2,000 3,000 1,000 0 -

Average inventory 1,000 2,500 2,000 500 -

Inventory cost ($) $ 3,000 $ 7,500 $ 6,000 $1,500 $18,000


1. Capacity associated costs: 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.


Financial statement and inventory: • Balance sheet Assets = Liabilities + Owner’s equity • Income statement Income = Revenue - Expenses • Cash - flow analysis

- Cash requires • To purchase raw material • Pay for production cost - Labor

- overhead


Financial statement and inventory: Example: a) If the owner’s equity is $1,000 and liabilities

are $800, what are the assets b) If the assets $1,000 and liabilities are $600,

what is the owner’s equity? a) Assets = Liabilities + Owner’s equity Assets = $800 + $1,000 = $ 1,800) Owner’s equity = Assets - Liabilities Owner’s equity = $1,000 - $600 = $400


Financial statement and inventory: continues Cash in - cash out > 0; self-finance • Income statement

Cash in - cash out < 0; borrow Example: Given the following data, calculate the gross

margin and the net income. How much would profit increase if, through better

material management, material costs are reduced by $50,000?

Inventory Fundamentals Example: continues

Revenue $1,500,000

Direct labor $300,000

Direct material $500,000 Notice, net income Factory overhead $400,000

General and admin. (profit) of 33% Expenses $150,000

Revenue $1,500,000 Revenue $1,500,000

Cost of goods sold Cost of goods sold

Direct labor $300,000 Direct labor $300,000

Direct material $500,000 Direct material $450,000

Factory overhead $400,000 $1,200,000 Factory overhead $400,000 $1,150,000

Gross margin $300,000 Gross margin $350,000

General and admin. General and admin. Expenses $150,000 Expenses $150,000

Net income (profit) $150,000 Net income (profit) $200,000

33%


Financial inventory performance measures: • Inventory - money tied up

1. Total inventory investment 2. Inventory turn ratio

3. Days of supply


Financial inventory performance measures: continues

Inventory turn ratio = Annual cost of goods sold / average inventory in $

- Higher is better

If annual cost of goods sold is $1 million and average inventory is $500,000, then Inventory turn ratio = $1,000,000/$500,000 = 2


Inventory turn ratio - continues

Example: a) What will be the inventory turn ratio if the annual cost of goods sold is $24 million a year and the average inventory is $6 million?

Answer: Inventory turn ratio = Annual cost of goods sold / average

inventory in $

Inventory turn ratio = $24 million/$6 million = 4



Example: b) What would be the reduction in inventory if inventory turn ratio is

increased to 12 times per year? Answer: average inventory in $ = Annual cost of goods sold /

Inventory turn ratio

average inventory = $24 million/ 12 =$2 million Reduction in inventory = $6 million - $ 2 million = $4 million



Example: c) If cost of carrying inventory is 25% of the average inventory, what will be the savings?

Answer: Reduction in inventory = $6 million - $ 2 million = $4 million Saving = $4 million x 25% = $4 million x 0.25 = $1 million


Financial inventory performance measures: continues

Days of supply = Inventory on hand / average daily usage

- Lower is better Example: Inventory on hand is 9,000 units and

annual usage is 48,000 units, there are 240 days per year

average daily usage = 48,000/240 = 200 units Days of supply = 9000 / 200 = 45 days


Methods of evaluating inventory: (4) 1. FIFO

- In rising prices, replacement is at higher prices than assumed cost

- Does not reflect current price

- Replacement is understated in rising price - Replacement is overstated in falling price

2. LIFO

3. Average cost 4. Standard cost



2. LIFO

- In rising prices, replacement is at current prices - Reflect current price

- Replacement is current in rising price - Replacement is current in falling price

3. Average cost

4. Standard cost



2. LIFO

3. Average cost

- An average of all the prices paid for the article - Reflect average price

- Replacement is average in rising price - Replacement is average in falling price

4. Standard cost



2. LIFO

3. Average cost 4. Standard cost

- Cost is determined before production begins - Cost = direct material + direct labor + overhead - Any difference between the standard cost and actual cost is stated as variance


ABC Inventory Control: • Controlling individual items

- What is the importance of inventory item? - How are they to be controlled?

- How much should be ordered at one time? - When should an order be placed?


ABC inventory classification system - Importance of an SKU - inventory item

• $ value • scarcity

- Level of control Pareto principle - 80-20 rule 1. A - 20% of items; 80% of $ value 2. B - 30% of items; 15% of $ value 3. C - 50% of items; 5% of $ value


Steps in making an ABC analysis: (3) 1. Establish item characteristics

- $ value

- scarcity

2. Classify items into groups

3. Apply a degree of control in proportion to importance


Procedure for classifying by annual $ values: (5 steps)

1. Determine annual usage 2. Multiply annual usage by its cost; total annual $

usage

3. List items according to their annual $ usage 4. Calculate the cumulative annual $ usage and

cumulative percentage of the items 5. Examine the annual usage distribution and group

the items into A, B and C groups based on annual percentage usage


ABC Analysis: Example

A company manufactures a line of ten items. Their usage and unit costs are shown in the following table along with the annual usage. a.Calculate the annual usage of each items b. List the items according to their annual $ usage

c. Calculate the cumulative annual dollar usage and the cumulative percent of items

d. Group items into A, B and C classification


Example - continues (table) Part Number Unit usage Unit cost $

1 1,100 2

2 600 40

3 100 4

4 1,300 1

5 100 60

6 10 25

7 100 2

8 1,500 2

9 200 2

10 500 1

Total 5,510

Inventory Fundamentals Example - continues (Answer a))

Part Number Unit usage Unit cost $ Annual $ usage

1 1,100 2 $2,200

2 600 40 $24,000

3 100 4 $400

4 1,300 1 $1,300

5 100 60 $6,000

6 10 25 $250

7 100 2 $200

8 1,500 2 $3,000

9 200 2 $400

10 500 1 $500

Total 5,510 $38,250


Example - continues (Answer b), c) and d))

Inventory Fundamentals Example - continues (Answer b), c) and d))

Part Unit Unit Annual $ Cumulative Cumulative Cumulativ Class

Number usage cost $ usage $ usage % $ usage e % items

2 600 40 $24,000 $24,000 62.75% 10.0% A

5 100 60 $6,000 $30,000 78.43% 20.0% A

8 1,500 2 $3,000 $33,000 86.27% 30.0% B

1 1,100 2 $2,200 $35,200 92.03% 40.0% B

4 1,300 1 $1,300 $36,500 95.42% 50.0% B

10 500 1 $500 $37,000 96.73% 60.0% C

3 100 4 $400 $37,400 97.78% 70.0% C

9 200 2 $400 $37,800 98.82% 80.0% C

6 10 25 $250 $38,050 99.48% 90.0% C

7 100 2 $200 $38,250 100.00% 100.0% C


Control based on ABC classification: (2 rules) 1. Have plenty of low $ value items

- C items - 50% items - 5% cost - Keep safety stock - Order annually

2. Use the money and control effort to reduce the inventory of high value items - A items - 20% items - 80% cost - Deserve the tightest control - Frequent review


Different Controls:

• A - items: High priority - Tightest control

- Complete accurate record - Regular and frequent review - Frequent review of demand

- Close follow up and expediting to reduce lead time


• B - items: Medium priority - Normal control

- Good record - Regular attention - Normal processing

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