Introduction to Logistics & Supply

Chain Management (OMGT2085)

Topic 5

Inventory Management
Outline
• Inventory and its types

• Reasons for Holding Inventory

• Importance of Inventory in Other Areas

• Inventory Costs

• Inventory Visibility

• Fundamentals Approaches to Carrying Inventory

• Economic Order Quantity (EOQ)

• Other Approaches to Managing Inventory

• Classifying Inventory

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Inventory

• Inventory is an asset on the balance sheet and a

variable expense on the income statement.

• Inventories also have an impact on return on

investment (ROI) for the firm.

• Inventory can be one of the most expensive assets of

any organization

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Inventory

• Inventory may account for more than 10% of total

revenue or 20% of total assets

• Management must reduce inventory levels yet avoid

stock-outs and other problems

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Types of Inventories

• Raw materials and purchased parts

• Work-in-process (WIP) partially completed goods

• Finished-goods

• Maintenance, repair & operating (MRO) - materials

used in production (e.g., cleaners and brooms).

• Goods-in-transit to warehouses or customers

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Reasons for Holding Inventory

• Batching Economies / Cycle Stocks:

o Procurement: larger purchased volumes result in lower

prices per unit and vice versa.

o Production: long production runs decrease the number of

changeover to a production line but increase the amount
of cycle stock that must be stored until they are sold.

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Reasons for Holding Inventory

o Transportation: transportation firms usually offer rate/price

discounts for shipping larger quantities.

o Trade-off between truckload (TL) quantities and less-than-

truckload (LTL) quantities

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Reasons for Holding Inventory

• Uncertainty/Safety Stock:

o All organisations are faced with uncertainty.

o On the demand side, there is uncertainty in how much

customers will buy and when they will buy it.

o On the supply side, there might be uncertainty about

obtaining what is needed from suppliers and how long it will
take for the fulfilment of the order.

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Reasons for Holding Inventory

• Time/In Transit:

o The time associated with transportation means that even

while goods are in motion, an inventory cost is
associated with the time period.

o The longer the time, the higher the cost.

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Reasons for Holding Inventory

• Work-in-process Stocks

o WIP inventories, associated with manufacturing, can be

significant while the length of time the inventory sits in a
manufacturing facility waiting and should be carefully
evaluated in relationship to scheduling techniques and
the actual manufacturing/assembly technology.

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Reasons for Holding Inventory

• Seasonal Stocks

o Seasonality can occur in the supply of raw materials, in

the demand for finished product, or in both.

o Those faced with seasonality issues are constantly

challenged when determining how much inventory to
accumulate.

o Seasonality can impact transportation.

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Reasons for Holding Inventory

• Anticipatory Stocks

o This reason to hold inventory arises when an organisation

anticipates that an unusual event might occur that will
negatively impact its source of supply.

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Importance of Inventory in Other
Areas
o Finance: less inventory to keep inventory turnover ratios high
(reduce risk of inventory loss) and to keep Return On Assets
(ROA) high (increase competitiveness)

o Marketing: more inventory for higher customer service

o Manufacturing: more inventory to schedule longer production

runs

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Inventory Costs:
Why are they so important?
• First, inventory costs are a significant portion of total
logistics costs for many firms.

• Second, inventory levels affect customer service levels.

• Third, inventory cost trade-off decisions affect inventory

carrying costs.

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Inventory Costs

1. Inventory Carrying Costs

o Capital Cost (opportunity cost which is associated with

investing in inventory and not in something else)

• The ways of calculating capital cost are: Hurdle rate,

Weighted average cost of capital (WACC)

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Inventory Costs

o Storage Space Cost

• Includes handling costs as well as such costs as rent, heat,

and light

• Public space (pubic warehousing) is mostly variable

• Private space (private warehousing) is a mix of fixed and

variable

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Inventory Costs

o Inventory Service Cost

• Includes insurance and taxes

• Varies according to the value of the goods

o Inventory Risk Cost

• Reflects the possibility that inventory value might decline

for reasons beyond firm’s control such as obsolescence,
damage, theft

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Inventory Costs

2. Order Cost

• Expense of placing an order for additional inventory

o MIS costs for inventory stock level tracking

o preparing and processing purchase orders and reports

o inspecting and preparing goods prior to placing these in

inventory
o preparing and processing payment

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Inventory Costs

3. Setup Costs

• Expenses incurred each time an organization modifies

a production or assembly line to produce a different
item for inventory

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Inventory Costs

Relationship between inventory carrying cost, Order

cost and total cost

o If we decide to place small orders, then we will keep

small amounts of inventory in stock (low inventory
carrying cost ), but we will need to place more
orders (high order/setup cost )

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Inventory Costs

o If we decide to place big orders, then we will keep big

amounts of inventory in stock (high inventory carrying
cost ), but we will need to place less orders (low
order/setup cost )

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Inventory Costs

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Inventory Costs

4. Expected Stock-out Cost

• supplier’s cost for not having the product available to meet

demand

o Back order costs: customer might be willing to wait and

accept a later shipment

o losing the sale to a competitor (one time substitution)

o losing a customer for life (permanent substitution)

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Inventory Costs
o Possible way to handle expected stock-out cost is by adding
safety stock. For a manufacturer, stock-out may result in lost
hours of production until the item is restocked.

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Inventory Costs

5. In-transit Inventory Carrying Cost

• Someone will own the inventory while it is in transit and

will incur the resulting carrying cost.

• In-transit carrying cost is generally less than regular

inventory carrying cost because some cost components
are not present

• No storage costs, no taxes & reduced risk of

obsolescence

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Inventory Visibility

• Ability of a firm to “see” inventory on a real-time basis

throughout the supply chain system which requires:

o Tracking & tracing inventory Stock Keeping Units (SKUs) for all
inbound & outbound orders

o Providing summary and detailed reports of shipments, orders,

products, transportation equipment, location & trade lane
activity

o Notification of failures in inventory flow

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Inventory Visibility

• General benefits:
o Improved customer service

o Decreased cost of lost sales

o Improved vendor relations and cost for purchasing

o Increased return on assets (ROA)

o Improved cash flow

o Improved response time & service recovery

o Improved performance metrics

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Fundamental Approaches for
Carrying Inventory
• Basic issues

o how much to order

o when to order

o where to store inventory

o what items to order

• Traditionally, as customer service levels increased, investment in

inventory also increased

• Recent emphasis: increase customer service & reduce investment

in inventory
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Fundamental Approaches for
Carrying Inventory
• PARADOX: How can a firm achieve higher customer service levels
without increasing inventory?

o Utilizing more responsive order processing

o Ability to strategically manage logistics data

o More capable & reliable transportation

o Improvements in the location of inventory

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Fundamental Approaches for
Carrying Inventory
• Dependent vs Independent Demand

o Dependent demand is directly related to the demand for

another inventory item or product (e.g. computer chip)
o Independent demand is unrelated to the demand for
other items (e.g. computer, mobile phone)

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Fundamental Approaches for
Carrying Inventory
• Pull vs Push
o Pull approach is a “reactive” system - relies on customer
demand to “pull” product through a logistics system, e.g.
Burger King
o Push approach is a “proactive” system. - uses inventory
replenishment to anticipate future demand, e.g. catering
business; Nokia

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Fundamental Approaches for
Carrying Inventory
o Pull systems respond quickly to sudden changes in
demand
o Involve one-way communication
o Short term forecast – allowing flexibility to respond to
demand
o Apply more to independent demand situations

o Push systems use orderly/disciplined master plans for

inventory management
o Long term forecast – allowing for scale of economies in
manufacturing
o Apply more to dependent demand situations

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Economic Order Quantity (EOQ)

• Fixed order quantity model involves ordering a fixed

amount of product each time reordering takes place to
identify the optimal order quantity that minimizes the
sum of certain annual costs that vary with order size.

Annual Annual
Total Annual cost = carrying + ordering
cost cost
1 R
TAC = QS + A
2 Q

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Economic Order Quantity (EOQ)

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Economic Order Quantity (EOQ)

• Determining Q can be accomplished by differentiating

the TAC function with respect to Q

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Economic Order Quantity (EOQ)
EOQ Example

• Nittany Fans of Lewistown, Pennsylvania, USA, is a distributor of industrial

fans used in plants, warehouses, and other industrial facilities. Its market
area covers most of Pennsylvania, eastern Ohio, and New Jersey.
 Annual demand: 36,000 fans
R
 Fan value (price): $4000 each
V
 Inventory carrying cost rate (annual): 25%
W
 Cost per order to replenish inventory: $200
A
What should the economic order quantity be for Nittany Fans?

Q = 120, TAC=120,000

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Economic Order Quantity (EOQ)

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 Economic Order Quantity (EOQ)

Number of times inventory is sold or used in a time period such as a year.

The number of days it will take a company to sell its entire inventory.

A lead time (LT) is the amount of time between the initiation and
completion of a process.

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Class Exercise

Attempt the following cases from Canvas:

1. Shop & Go - Dr Thanh

2. Shop & Go - Cornetto

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Other Approaches to Managing
Inventory
• Just in Time (JIT) Approach

o Four major elements

 Zero inventories

 Short, consistent lead times

 Small, frequent replenishment quantities

 High quality, or zero defects

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Other Approaches to Managing
Inventory
Advantages of JIT (Just-in-time)
o reduces excess inventories for both buyer & seller

o minimizes waiting lines by delivering materials/finished goods

when & where they are needed
o uses short, consistent lead times from proximate locations

o stresses high quality throughout the supply chain

o requires win-win relationships & partnerships for a healthy

supply chain
o involves shorter, more frequent production runs allowing the
company to be more lean, responsive, agile, and flexible

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Other Approaches to Managing
Inventory
• Materials Requirements Planning (MRP)

o Deals specifically with supplying materials and component

parts whose demand depends on the demand for a specific
end product

o Consists of a set of logically related procedures, decision rules,

and records designed to translate a master production
schedule into time-phased net inventory requirements and the
planned coverage of such requirements for each component
item needed to implement this plan

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Other Approaches to Managing
Inventory
o computerized information system developed specifically to aid
in managing and scheduling materials needed to produce a
forecasted quantity of a specific finished good

o consists on a set of logically related procedures, decision rules

& records designed to translate (explode) a master
production schedule (MPS) into time-phased net inventory
requirements for each component item

o the plan will tell us what, how much, and when specific
components parts are required

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Other Approaches to Managing
Inventory
• Materials Requirements Planning (MRP)

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Other Approaches to Managing
Inventory
• MRP System uses:

o Master production schedule (MPS): shows the details

exactly what independent demand items an organization must
produce and when they are needed.

o Bill of materials file (BOM): specifies the exact amount of raw

materials, components, and/or subassemblies needed to
produce and independent demand item.

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Other Approaches to Managing
Inventory
o Inventory status file (ISF): maintains inventory records so that the
organization may subtract the amount on hand from the gross
requirements, thus identifying the net requirements at any time.

o MRP program: based on the independent item need specified in

the MPS and on information from the BOM, MRP disaggregate the
end product demand into gross requirements for individual parts or
materials. Then it calculates net requirements based on ISF
information, and places orders for the inputs.

o Outputs and reports

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Other Approaches to Managing
Inventory
Advantages of MRP

o maintains reasonable safety stock

o minimizes inventories

o identifies process problems

o formulates production schedules based on actual demand

o coordinates materials ordering across multiple points

o most suitable for batch or intermittent production schedules

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Other Approaches to Managing
Inventory
• Distribution Requirements Planning (DRP)
o Purpose is to more accurately forecast demand
o Firm can minimise inbound inventory in conjunction with
production schedules.
o Outbound (finished goods) inventory is minimised
o DRP develops a projection for each SKU requiring the
following:
• Forecast of demand for each SKU
• Current inventory level of the SKU
• Target safety stock
• Recommended replenishment quantity
• Lead time for replenishment

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Other Approaches to Managing
Inventory
• Vendor-Managed Inventory (VMI)
o The supplier and its customer agree on which products
are to be managed using in the customer’s distribution
centres.
o An agreement is made on reorder points and economic
order quantities for each of these products.

https://www.youtube.com/watch?v=iV735Fe8Fus

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Other Approaches to Managing
Inventory
QR (Quick Response Manufacturing)
o helps to respond quickly to customers’ needs by rapidly
designing and manufacturing products customized to their
requirements*
o shorter, compressed time horizons
o real-time information available by SKU
o integrated logistics networks with rapid transportation
o strong partnership relationships needed among supply chain
members
o redesign of manufacturing processes to reduce lot sizes,
changeover times & enhanced flexibility
o commitment to TQM

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Other Approaches to Managing
Inventory
ECR (Efficient Consumer Response)
o Developed by grocery manufacturers to bring greater value to
grocery customers

o Goal is a responsive, consumer-driven system in which

distributors & suppliers work together as business allies to
maximize consumer satisfaction & minimize cost

o Accurate information & high-quality products flow in a paperless

system between manufacturing and check-out counter with
minimum degradation or interruption

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Other Approaches to Managing
Inventory
One supply chain – many different inventory management
techniques

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Classifying Inventory

ABC Analysis

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Classifying Inventory
Assigns inventory items to one of three groups according to the
relative impact or value of the items:
Ö A items are considered to be the most important
Ö B items being of lesser importance
Ö C items being the least important

Pareto’s Rule (80-20 Rule):

√ 80% of sales will come from 20% of the inventory SKUs
√ 20% of sales will come from 80% of the inventory SKUs
√ explains many phenomena that interest managers to make
better decisions about the inventory
√ e.g. 80% of sales come from 20% of customers

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Classifying Inventory

Quadrant Model (Item Importance Procurement Matrix)

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Reflective Discussion

• Discuss how the ABC analysis can be applied

to real cases in your life to improve your
productivity.

Clue: Think about your student workload vs other commitments

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