MANAGING INVENTORY

Inventory is any asset held for future use or sale. The unique business model that Rent the Runway has cannot
be implemented without highly effective inventory management systems. For example, decisions about the
number of dresses that will comprise Rent the Runway's seasonal rental inventory must be made shortly after
preseason fashion shows, which are several months in advance of the rental season. The firm runs the risk of
having too many, not enough, or the wrong styles. Wrong decisions can impact profitability significantly. The
availability of inventory can also affect the company's reputation and customer retention, and failing to rent to a
customer because the rental unit was damaged by a previous customer can result in a challenging customer
service encounter. Managing inventories must also be coordinated with other aspects of its operations and
supply chain.

Many manufacturing firms maintain large amounts inventory: this is costly and wasteful. The old concept of
keeping warehouses and stockrooms filled to capacity with inventory has been replaced with the idea of
producing finished goods as late as possible prior to shipment to the customer. Better information technology
and applications of analytics have allowed dramatic reductions in inventory.

  The expenses associated with financing and maintaining inventories are a substantial part of the y cost of
doing business (ie, cost of goods sold). Managers are faced with the dual challenges of maintaining  sufficient
inventories to meet demand while at the same time incurring the lowest possible cost.

 Inventory management involves planning, coordinating, and controlling the acquisition, storage, handling,
movement, distribution, and possible sale of raw materials, component parts and subassemblies, supplies and
tools, replacement parts, and other assets that are needed to meet customer wants and needs.

Understanding Inventory

Generally, inventories are physical goods used in operations and include raw materials, parts, subassemblies,
supplies, tools, equipment or maintenance, and repair items.

One of the difficulties of inventory management is that every function in an organization generally views
inventory objectives differently. Marketing and operations prefer high inventory levels to provide the best
possible customer service and process efficiency, whereas financial personnel seek to minimize inventory
investment and thus would prefer small inventories.

9-1a Key Definitions and Concepts

Many different types of inventories are maintained throughout the value chain--before, during and after
production to support operations and meet customer demands (see Exhibit 9.1). Raw materials, component
parts, subassemblies, and supplies are inputs to manufacturing and service delivery processes. Work-in-
process (WIP) inventory consists of partially finished products in various stages of completion that are
awaiting further processing. Finished-goods inventory is completed products ready for distribution or sale to
customers. Finished goods might be stored in a warehouse or at the point of sale in retail stores.

 To reduce the risk associated with not having enough inventory firms often maintain additional stock beyond
their normal estimates Safety stock inventory is an additional amount that is kept over and above the average
amount required to meet demand.

 9-1b Managing Inventories in Global Supply Chains

Today's global supply chains present significant challenges to inventory management. The components and
materials used in nearly any product are often purchased from suppliers across the done and shipped through
complex supply chains. This is more important for perishable goods. For example, a common cheeseburger at a
fast- food restaurant my consist of wheat glutten from Poland, preservatives from the Netherlands, tomatoes
from Latin America lettuce from Mexico or New Zealand, mustard seeds from Canada vinegar from Tale garlic
powder from Australia, and ground beef from more than 50 cows from several countries.  Information
technology (IT) support Technology such as radio-frequency identification (RFID) chips can increase inventory
accuracy to better than 98 percent-much containers with thousands of products and materials, hundreds of
supplies and me orders and shippers, an accurate information system is essential Enterprise Resource Planning
(ERP) systems.

 The purchasing or procurement function is responsible for acquiring component parts, tools, and other items
required from outside suppliers. In the past firm focused primarily on low-price acquisition. Today , however,
purchasing must focus global  sourcing and total system cost; ensure quality delivery ;  performance and
technical support and seek new suppliers and products, as well as be able to evaluate their potential to the
company.

Many firms (as well as consumers) subscribe to environmentally preferable purchasing (EPP), often referred
to as green purchasing, which is the affirmative  selection and acquisition of products and services that most
effectively minimize negative environmental impacts on life cycle of manufacturing transportation use and
recycling or disposal. Examples  of environmentally preferable characteristics include products and services
that conserve energy and water, and minimize generation of waste and releases of pollutants; products made
from recycled materials and that can be reduced or recycled.

9-10 Inventory Management Decisions and Costs

Inventory managers deal with two fundamental decisions:

1. When to order items from a supplier or when to initiate production runs if the firm makes its own items.
2. How much to order or produce each time a supplier or production order is placed.
3. Inventory management is all about making trade-offs among the costs associated with these decisions.
4. Inventory costs can be classified into four major categories:
5. Ordering or setup costs.
6. Inventory-holding costs.
7. Shortage costs.
8. Unit cost of the SKUs.

Ordering costs or setup costs are incurred as a result of the work involved in placing orders with suppliers or
configuring tools, equipment, and machines within a factory to produce an item. Order and setup costs do not
depend on the number of items purchased or manufactured, but rather on the number of orders placed.           
Inventory-holding or inventory-carrying costs are the expenses associated with carrying inventory. Holding
costs are typically defined as a percentage of the dollar value of inventory per unit of time (generally one year).
They include costs associated with maintaining storage facilities , such as gas and electricity, taxes, insurance,
and labor and equipment necessary to handle, move, and retrieve inventory items, plus the opportunity cost of
capital represented by holding inventory , normally for one year . However, from an accounting perspective, it
is difficult to precisely allocate such costs to an individual stock-keeping unit (SKU). Essentially, holding costs
reflect the opportunity cost associated with using the funds invested in inventory for alternative uses and
investments.

Shortage or stockout costs are costs associated with inventory being unavailable when needed to meet
demand. These costs can reflect backorders, lost sales, or service interruptions for external customers, or costs
associated with interruptions to manufacturing and assembly lines for internal customers. Unit cost is the price
paid for purchased goods or the internal cost of producing them. In most situations, the unit cost is a "sunk
cost" because the total purchase cost is not affected by the order quantity. However, the unit cost of SKUs is an
important purchasing consideration when quantity discounts are offered; it may be more economical to purchase
large quantities at a lower unit cost to reduce the other cost categories and thus minimize total costs.

9-2 Inventory Characteristics

  Number of Items Most firms maintain inventories for a large number of items, often at multiple locations. To
manage and control these inventories, each item is often assigned a unique identifier, called a stock-keeping
unit, or SKU. A stock-keeping unit (SKU) is a single item or asset stored at a particular location. For
example, each color and size of a man's dress shirt at a department store and each type of milk (whole, 2
percent, skim) at a grocery store would be a different SKU.

Nature of Demand can be classified as independent or dependent, constant or uncertain, and dynamic or static.
Independent demand is demand for an SKU that is unrelated to the demand for other SKUs and needs to be
forecasted. This type of demand is directly related to customer (market) demand. Inventories of finished goods
such as toothpaste and electric fans have independent demand characteristics.

 SKUs are said to have dependent demand if their demand is directly related to the demand of other SKUs and
can be calculated without needing to be forecasted. For example, a chandelier may consist of frame and six
lightbulb sockets.

 Demand can either be constant over some period of time (or assumed to be constant), or we can assume that it
is uncertain. Sometimes we might simply assume that demand is constant in order to make our models easier to
solve and analyze, perhaps by using historical averages or statistical point estimates of forecasts.

Demand, whether deterministic or stochastic, may also fluctuate or remain stable over time. Stable demand is
usually called static demand, and demand that varies over time is referred to as dynamic demand. For
example, the demand for milk might range from 90 to 110 gallons per day, every day of the year.

Number and Duration of Time Periods In some cases, the selling season is relatively short, and any leftover
items cannot be physically or economically stored until the next season. For example, Christmas trees that have
been cut cannot be stored until the following year; similarly, other items such as seasonal fashions are sold at a
loss simply because there is no storage space or it is uneconomical to keep them for the next year.

Lead TIme The lead time is the time between placement of an order and its receipt. Lead time is affected by
transportation carriers, buyer order frequency and size, and supplier production schedules, and may be
determine or stochastic.

Stockouts A stockout is the inability to satisfy the demand for an item. When stockouts occur, the item is either
back-ordered or a sale is lost. A backorder occurs when a customer is willing to wait for the item; a lost sale
occurs when the customer is unwilling to wait and purchases the item elsewhere. Backorders result in additional
cost for transportation.

9-3 ABC Inventory Analysis

One useful method for defining inventory value is ABC analysis. It is an application of the Pareto principle,
named after an Italian economist who studied the distribution of wealth in Milan during the 1800s. He found
that a “vital few” controlled a high percentage of the wealth.  ABC analysis consists of categorizing inventory
items or SKUs into three groups according to their total annual dollar usage: 1. "A" items account for a large
dollar value but a relatively small percentage of total items.

2."C"items account for a small dollar value but a large percentage of total items.
 3. "B" items are between A and C.

Typically, A items comprise 60 to 80 percent of the total dollar usage but only 10 to 30 percent of the items,
whereas C items account for 5 to 15 percent of the total dollar value and about 50 percent of the items. There is
no specific rule on where to make the division between A, B, and C items; the percentages used here simply
serve as a guideline. Total dol- lar usage or value is computed by multiplying item usage (volume) times the
item's dollar value (unit cost). Therefore, an A item could have a low volume but high unit eost, or a high
volume and low unit cost.

ABC analysis gives managers useful information to identify the best methods to control each category of
inventory. Class A items require close control by operations managers. Class C items need not be as closely
controlled and can be managed using automated computer systems. Class B items are somewhere in the middle.

9-4 Managing Fixed-Quantity Inventory Systems

 In a fixed-quantity system (FQS), the order quantity or lot size is fixed; that is, the same amount O, is
ordered every time. The order quantity (Q) can be any quantity of product, such as a box, pallet, or container, as
determined by the vendor or shipping standards. A more appropriate way to manage an FQS is to continuously
monitor the inventory level and place orders when the level reaches some "critical" value. The process of
triggering an order is based on the inventory position. Inventory position (IP) is defined as the on-hand
quantity (OH) plus any orders placed but which have not arrived (called scheduled receipts, SR), minus any
backorders (BO), or

IP = OH (On-Hand) + SR (Schedule Receipt) – BO (Backorders)

 When the inventory position falls at or below a certain value, r, called the reorder point. a new order is placed.
The reorder point is the value of the inventory position that triggers a new order.

In Exhibit 9.6, we see that the time between orders is also constant in the deterministic and static case, and
therefore the ordering cycle repeats itself exactly. Here the TBO is constant because there is no uncertainty and
average demand is assumed to be constant and continuous.

In Exhibit 9.6, we see that the inventory position jumps by Q when the order is placed. With the highly variable
demand rate, the TBo varies, whereas Q is constant

EXHIBIT 9.5 Summary of Fixed Quantity System (FQS)

Managerial Decisions                                                           Order Quantity (Q) and Reorder Point ( r )

Ordering decision rule                    A new order is triggered whenever the inventory position for the item drops
to or past the recorder  point. The size of each order is Q units .
Key Characteristics                             The order quantity orders (TBO) is constant when the  demand rate is
stable. The TBO can vary when demand is  variable.

9-4a The EOQ Model

 The economic order quantity (EOC) model is a classic economic model developed in the early 1900s that
minimizes the total cost , which is the sum of the inventory holding cost and the ordering cost. Several key
assumptions underlie the quantitative model we will develop:

 Only a single item (SKU) is considered.

 The entire order quantity (Q) arrives in the inventory at one time.
 Only two types of costs are relevant--order/setup and inventory-holding costs.
 No stockouts are allowed.
 The demand for the item is constant and continuous over time.
 Lead time is constant.

 Under the assumptions of the model, the cycle inventory pattern is shown in Exhibit 9.8 Suppose that we begin
with Q units in inventory. Because units are assumed to be withdrawn at a constant rate, the inventory level falls
in a linear fashion until it hits zero. Because no stockouts are allowed, a new order can be planned to arrive
when the inventory falls to zero, at this point, the inventory is replenished back up to. This cycle keeps
repeating. This regular pattern allows us to compute the total cost as a function of the order quantity, Q.

Cycle inventory (also called order or lot size inventory) is inventory that results from purchasing or
producing in larger lots than are needed for immediate consumption or sale. From the constant demand
assumption, the average cycle inventory can be easily computed as the average of the maximum and minimum
inventory levels:

Average cycle inventory = (Maximum inventory + Minimum inventory)/2

  = (Q + 0)/2 = Q/2

If the average inventory during each cycle is Q/2, then the average inventory level over any number of cycles is
also Q/2.

The inventory-holding cost can be calculated by multiplying the average inventory by the cost of holding one
item in inventory for the stated period (see Equation 9.5). The period of time selected for the model is up to the
user, it can be a day, week, month, or year. However because the inventory-holding costs for many industries
and businesses are expressed as an annual percentage or rate, most inventory models are developed on an
annual cost basis (see Equation 9.4). Let

I = annual inventory-holding charge expressed as a percent of unit cost

C = unit cost of the inventory item or SKU

I includes two types of costs -cost of capital (money) plus any inventory-handling and storage costs, both
expressed as a percentage of the item cost. The cost of storing one unit in inventory for the year, denoted by Ch,
is given by Ch = (I)( C )

 Thus, the general equation for annual inventory-holding cost is

Annual inventory-holding cost= (Average inventory)(Annual holding cost per unit)= QCh

The second component of the total cost is the ordering cost. Because the inventory holding cost is expressed on
an annual basis, we need to express ordering cost as an annual cost also. Letting D denote the annual demand
for the product, we know that by ordering Q items each time we order, we have place D/Q orders per year. If Co
is the cost of placing one order, the general expression  for the annual ordering cost is shown in Equation 9.5.

Annual ordering cost= (Number of ordering per year)(Cost per order)= Co

Thus, the total annual cost is the sum of the inventory-holding cost given by Equation 9.4 plus the order or setup
cost given by Equation 9.5 TC= QCh + Co

The next step is to find the order quantity. Q, that minimize the total cost expressed in Equation 9.6. by using
different calculus, we can show that the quantity that minimizes the total cost, denoted by Qo is referred to as the
economic order quantity, or EOQ.  Q=

Finally, we need to determine when to place an order for Qo units. The recorder point, r, depended on the lead
time and the demand rate. Because we assume that demand is constant in the ECQ model, the recorder point is
found by  multiplying the fixed demand rate, d (units/day, unit/month, etc.), by the length of the lead time. L (in
the same units, e.g. days or months). Note that it is easy to convert the annual demand D (in units/year) to a
demand rate, d, having the same time units as the lead time.

r = Lead time demand

      = (demand rate) (lead time)

  = (d) (L) 

Because the ECQ model depends only on the order quantity, fixed costs associated with any ordering or
inventory holding are irrelevant (in accounting language, these are sunk costs). therefore, only variable costs of
ordering and inventory holding are required for the model.

9-4b Safety Stock and Uncertain Demand in a Fixed-Order-Quantity System       Stockouts occur whenever
the lead-time demand exceeds the recorder point. When  demand is uncertain using EOQ based only on the
average demand will result in a high probability of a stockout. One way to reduce the risk is to increase the
recorder point by adding additional stock called safety stock to the average lead time demand. Safety stock is
additional, planned  on-hand inventory that acts as a buffer to reduce the risk of a stockout.

To determine the appropriate reorder point, we first need to know the probability distribution of the lead-time
demand, which we often assume to be normally distributed. The appropriate reorder point depends on the risk
that management wants to take of incurring a stockout. A service level is the desired probability of not having a
stockout during a lead-time period. For example, a 95 percent service level means that the probability of a
stockout during the lead time is 0.05. Choosing a service level is a management policy decision. When demand
is uncertain, then the reorder point is the average demand during the lead time, plus the additional safety stock.
The average demand during the lead time is found by multiplying the average demand per unit of time by the
length of the lead time expressed in the same time units. When a normal probability distribution provides a
good approximation of lead-time demand, the general expression for reorder point is

R = µL + zơL

Where µL = average demand during the lead time

ơL= standard deviation of demand during the lead time

z= the number of standard deviations necessary to

Achive the acceptable service level

The term “zơL” represents the amount of safety stock.

EXAMPLE 9.2

The sale of a popular mouthwash at Mekle Pharmacies over the past 6 months have averaged 2000 per month,
which is the current order quantity. Merkle’s cost is $12.00 per case. The company estimates its cost of capital
to be 12 percent. Insurance, taxes, breakage, handling, and pilferage are estimated to be approximately 6 percent
of item cost. Thus, the annual inventory-holding costs are estimated to be 18 percent of item cost. Because the
cost of one case is $12.00, the cost of holding one case in inventory for one year, using Equation 11.4, is Ch =
(IC) = 0.18= $2.16 per case per year. The cost of placing an order is estimated to be $38.00 per order regardless
of the quantity requested in the order. Form this information, we have

D= 24,000 cases per year.

Co=  $38 per order

I= 18 percent

C= $12.00 per case.

Ch= IC= $2.16

Thus, the minimum cost economic order quantity as given by Equation 9.7 is

EOQ= = 919 cases rounded to a whole number

For the data based in this problem, the total cost model based on Equation 9.6 id

TC= Q ($2.16) + ($38.00)

= $1.08Q + 912,000/Q

For the EOQ is 919, the total cost is calculated to be

(1.08)(919) + (24,000/919)($38.00) =$1,984.90

We can compare this total cost using EOQ with the current purchasing policy of Q= 2,000. The total annual
cost of the current order policy is
TC= 1.08(2000) + 912, 000/2,000

= $2, 616.00

Thus, the EOQ analysis has resulted in a $2,616.00 - $1,984.90 = $631. 10 savings, or 24.1 percent cost
reduction. Notice also that the total ordering cost ($992) for the EOQ. In general, this will always be the for the
EOQ Model template, which finds the EOQ and optimal costs, and charts the cost functions. You can see the
curve is relatively flat around the minimum total cost solution. The Sensitivity Analysis section allows you to
compare the EOQ with any other order quantity.

In many cases, we do not know the mean and standard deviation of demand during the lead time, but only for
some other length of time such as a day or week. Suppose that µt and ơt are the mean and standard deviation of
demand for some time interval t, and that the lead time L is expressed in the same units (days, weeks, etc.). If
the distributions of demand for result to find µL and ơL based on µt and ơt as follows:

µL = µt L

ơL=   ơt √L

9-5 Managing Fixed-Period Inventory Systems

 An alternative to a fixed-order-quantity system is a fixed-period system (FPS)-sometimes called a periodic

review system-in which the inventory position is checked only at fixed intervals of time, T, rather than on a
continuous basis. At the time of review, an order is placed for sufficient stock to bring the inventory position up
to a predetermined maximum inventory level, M, sometimes called the replenishment level, or "order-up-to"
level.

 There are two principal decisions in an FPS:

1. The time interval between reviews.

2. The replenishment level.

We can set the length of the review period judgmentally based on the importance of the item or the convenience
of review. For example, management might select to review noncritical SKUS every month and more critical
SKUs every week. We can also incorporate economics using the EOQ model.

The EOQ model provides the best "economic time interval" for establishing an optimal policy for an FPS
system under the model assumptions. This is given by     T = Q/D

 whereQo is the economic order quantity. The optimal replenishment level without any safety stock is computed
by M= d(T+L)
Where d= average demand per time period (days, weeks, months, etc.) , L is the lead time in the same time
units, and M is the demand during the lead time plus review period. When demand is stochastic, mangers can
add appropriate safety stock to the optimal replenishment level to ensure a target service level.

A summary of fixed-period system is given in Exhibit 9.11 Exhibit 9.12 shows the system operation
graphically. In Exhibit 9.12, at the same time of the first review, a rather large amount of inventory (IP) is in
stock, so the order quantity (Q) is relatively small. Demand during the lead time was small, and when the order
arrived, a large amount of inventory was still available. At the third review cycle, the stock level is much closer
to zero because the demand rate has increase. Thus, the order quantity is much larger. During the lead time,
demand was high and some stockouts occurred. Note that when an order is place at time T, it does not arrive
until time T + L. Thus, in using an FPS, managers must cover the risk of a stockout over the time period T+L,
and therefore, must carry more inventory.

To add safety stock to the replenishment level (M) in an FPS, we can use the same statistical principles as with
the FQS. We must compute safety stock over the period T+L, so the replenishment level is computed as
follows:

M= µT+L + zơT+L

µT+L = µt(T+L)

ơT+L= ơt

The choice of which system to use FQS or FPS depends on a variety of factors, such as how many total SKU’s
the firm must monitor, whether computer or manual systems are used, availability of technology and human
resources, the nature of the ABC profile, and the strategic focus of the organization, such as customer service or
cost minimization.

9-6 Single-Period Inventory Model

The single-period inventory model applies to inv9-6 Single-Period Inventory Model The single-period
inventory model applies to inventory situations in which one order is placed for a good in anticipation of a
future selling season where demand is uncertain. At the end of the period the product has either sold out, or
there is a surplus of unsold items to sell for a salvage value. Single-period models are used in situations
involving seasonal or perishable items that cannot be carried in inventory and sold in future periods

The newsvendor problem can be solved using a technique called marginal economic analysis, which compares
the cost or loss of not ordering one additional item. the costs are defined as

Cs= the cost per item of overestimating demand this cost represents the loss of ordering one additional item and
finding that it cannot be sold.

Cu= the cost per item of underestimating demand; this cost represents the opportunity loss of not ordering one
additional item and finding that it could have been sold.

The optimal order quantity is the value of Qo that satisfies Equation 9.17.

                   Cu

         P(demand ≤Qo) =  Cu + Cs

This formula can be used for any probability distribution of demand, such as uniform or a normal distribution.

NOTE:  You may use QM for Windows to check your manual answers.

SUPPLY CHAIN MANAGEMENT

Supply chain management (SCM) is the management of all activities that facilitate the fulfillment of a
customer order for a manufactured good to achieve customer satisfaction at reasonable cost. To stay
competitive, “retailers need to know where things are at all times so they can redirect shipments, rebalance
inventories and respond to new demands on the fly.

Managing Supply Chains

Managing a supply chain requires numerous operational activities, including working closely with suppliers,
purchasing, transportation, inventory management, managing risks that may disrupt the supply chain, measuring
supply chain management is called logistics. Logistics is the management of transportation activities and the
flow of materials within a supply chain to ensure adequate customer service at reasonable cost. The logistics
function is responsible for selecting transportation carriers; managing company-owned fleets of vehicles,
distribution centers, and warehouses: controlling efficient interplant movement of materials and goods within
the supply chain; and ensuring that goods are delivered to customers.

10-1a The SCOR Model

The Supply Chain Operations Reference (SCOR) model is a framework for understanding the scope of
supply chain management (SCM) that is based on five basic functions involved in managing a supply chain:
plan, source, make, deliver, and return. (see the box on the SCOR model), which are the key processes that
create value to customers.

 A supply chain is an integrated system of processes that requires much coordination and collaboration among
its various players. Every company is part of a long chain (in fact, many long chains) of customers and
suppliers. Each company is a customer to its suppliers and a supplier to its customers, so it does not make sense
to think of a company as only one or the other.

The SCOR Model

The Supply Chain Operations Reference (SCOR) model is a framework for understanding the scope of supply
chain management (SCM) that is based on five basic functions involved in managing a supply chain: plan,
source, make, deliver, and return.

1. Plan - Developing a strategy that balances resources with requirements and establishes and
communicates plans for the entire supply chain. This includes management policies and aligning the
supply chain plan with financial plans.
2. Source - Procuring goods and services to meet planned or actual demand. This includes identifying and
selecting suppliers, scheduling deliveries, authorizing payments, and managing inventory.
3. Make - Transforming goods and services to a finished state to meet demand. This includes production
scheduling, managing work-in-process, manufacturing, testing, packaging, and product release.
 4. Deliver - Managing orders, transportation, and distribution to provide the goods and services. This
entails all order management activities from processing customer orders to routing shipments, managing
goods at distribution centers, and invoicing the customer.
5. Return - Processing customer returns; providing maintenance, repair , and overhaul; and dealing with
excess goods. This includes return authorization, receiving, verification, disposition, and replacement or
credit

10-1b Sourcing and Purchasing

Suppliers are vital to supply chains, because they provide the materials and components needed for production
to ultimately meet customer demand. If these are not delivered on time, in the proper quantity, and with the
right level of quality, the entire supply chain could break down. For manufacturing, one of the first questions
that supply chain managers must ask is where to obtain ("source") raw materials, manufactured components,
and subassemblies. For services, sourcing options might include employment agencies, equipment maintenance
and repair companies, information systems providers, third-party logistic firms, engineering services, health
care services, and retirement providers. The best companies link sourcing decisions to their business strategy,
use business analytics tools, and focus on the total cost of ownership," not simply the cost of purchasing.

Purchasing (procurement) is the function responsible for acquiring raw materials, component parts, tools,
services, and other items required from external suppliers. Purchasing can have a significant impact on total
supply chain costs.

The principal goal of purchasing is to support its key internal customers. Thus, purchasing must do much more
than simply buy according to the quoted line-item purchase prices. Purchasing must ensure quality, delivery
performance, low cost, and technical support. Moreover, purchasing must continually seek new suppliers and
products, and be able to evaluate their strategic, market, and economic potential to the company.

The responsibilities of a purchasing department include learning the material needs of contracts, selecting
transportation modes and mix, ensuring delivery, expediting, authorizing payments, and monitoring cost,
quality, and delivery performance by supplier" worldwide Accordingly, purchasing agents must maintain good
relations and communications with other internal departments , such as accounting and finance, where budgets
are prepared, product design and engineering, where material specifications are set; production, where timely
delivery is essential, and the legal department, where contracts are reviewed. Likewise, purchasing must
maintain good relationships with external suppliers, third-party logistic providers, and all types of transportation
services.

10-1c Managing Supplier Relationships

Three principles for working with suppliers are:

1. Recognizing their strategic importance in accomplishing business objectives such as minimizing the
total cost of ownership.
2. Developing a win-win relationship through long-term partnerships rather than as adversaries.
3. Establishing trust through openness and honesty, and therefore, leading to mutual advantages.

10-1d Supply and Value Chain Integration

Supply chain integration is the process of coordinating the physical flow of materials to ensure that the right
parts are available at various stages of the supply chain, such as manufacturing and assembly plants. Some
firms, such as Walmart, manage supply chain integration themselves. Others make use of third-party system
integrators" such as Exel (www.exel.com (Links to an external site.)) to manage the process.
Value chain integration in services-where value is in the form of low prices, convenience, and access to special,
time-sensitive deals and travel packages--takes many forms. For example, third-party integrators for the leisure
and travel industry value chains include Orbitz, Expedia, Priceline, and Travelocity. They manage information
to make these value chains more efficient and create value for their customers.

 Electronic data interchange and Internet links streamline information flow between global customers and
suppliers and increase the velocity of supply chains. Many firms now use cloud- based software for managing
inventories in supply chains and synchronizing marketing and sup- ply chain functions. Trucking companies
track their trucks via global positioning system (GPS) technology as they move across the country, and many
use in-vehicle navigational systems.

10-2 Logistics

Logistics managers have the following three primary responsibilities:

1. Purchasing transportation services.

 Selecting appropriate modes of shipment and mix of specific carriers.

 Contracting with suppliers for domestic and global transportation services.
 Negotiating transportation rates, and shipping, insurance, and liability contracts.
 Managing international trade agreements, custom laws, and import/export fees .
 Using business analytics to evaluate different shipping options.

2. Managing the transportation of materials and goods through the supply chain.

 Tracing shipments in transit and expedite them when necessary.

 Coordinating shipments with airports, rail yards, and seaport docks.
 Issuing and auditing freight bills.

3. Managing inventories.

 Managing the flow of goods through warehouses, and sometimes, shipping directly to retail stores and
customers.
 Filing claims for damaged goods.

10.2a Transportation

The selection of transportation servo is a complex decision, as varied are available rail trucks, air, water and
pipeline. Transportation costs can add to 10 percent to the total cost of the product as it moves through the
supply chain

Rail transport provides a good balance between cost delivery speed,  tonnage capacity, and environmental
sustainability and is sometime immune to vehicle traffic congestion. Rail transit is generally slow and  train can
carry 10,000 tons of freight .

 Trucks are the most flexible of all transportation modes with the capability for door-to-door display and
delivery.  Perishable goods such as fruit and flowers can be quickly moved to the buyers.  Transportation costs
are higher than rail, and it is used most often for short distances and smaller shipments. Full truckload (FTL)
and less-than-full trackload (LTL) shipments are critical to making a profit on a load. A backhaul is when a
truck delivers its load and also carries freight on the return journey. Without backhaul business, the capacity
utilization of the truck is low and non-revenue producing.
International shipping relies on air and water. Air shipments have the highest transportation costs, are very fast
for long distances, but are limited in how much airplane designed. A 747 airplane designed to only carry freight
can carry up to 100 metric tons. Airfreight is most often used to trans- port high-value items such as flowers,
heart valves, seafood, electronics, and smaller manufactured parts .

 Weather can disrupt maritime shipments, and this mode requires high initial investment. They are slow, but
inexpensive from a unit cost basis. Like air, they require other modes of transportation to get to customer
locations.

 Pipelines carry water, petroleum, natural gas, and sometimes a slurry of minerals or commodities.

     Domestically, most consumer items are shipped via rail, trucks, and air. The critical factors in selecting a
transportation mode are (1) speed, (2) accessibility, (3) cost, and (4) capability. Supply chain managers often
combine these modes of transportation (called intermodal transportation) in a global supply chain such as
transporting by ship and container to a sea port, loading the containers onto a train for transport to a large,
"break bulk" warehouse, and delivering to individual retail stores by truck.

10-2b Inventory Management

Vendor-managed inventory (VMI) is where the vendor (supplier) monitors and manages inventory for the
customer.

The performance of a supply chain often suffers from a phenomenon known as the bullwhip effect, in which
inventories exhibit wild swings up and down. This had been observed across most industries and increases cost
and reduces service to customers. The bullwhip effect results from order amplification in the supply chain.
Order amplification is a phenomenon that occurs when each member of a supply chain “orders up” to buffer
its own inventory.

10-3 Risk Management in Supply Chains

Companies face a multitude of risks in managing supply chains. Risks in domestic supply chains are often
minimal; however, risks in global supply chains are much greater. These include production problems with
suppliers that result in material shortages, labor strikes, unexpected transportation delays, delays from customs
inspection or port operations, political  instability in foreign countries, natural disasters, and even terrorism.
Good supply chain managers must anticipate and mitigate these risks to ensure that the supply chain will be able
to create and deliver its goods and services worldwide. Should they occur, they must take action to deal with the
consequences and get the supply chain up and running again For example, cybersecurity intrusions can greatly
disrupt global supply chains. Supply chain managers must have backup plans, and multiple avenues of
communication to keep supply chains operating effectively.

The consequences of supply chain disruptions can be significant..

Risk management involves identifying risks that can occur, determining the impact on the firm and its
customers, and identifying steps to migrate the risks.

10-4Supply Chains in E-Commerce

E-commerce has greatly influenced the design and management of supply chains. There are many types of
supply chains other than business to customer (B2C). Other major e-commerce relationships and supply chain
structures include B2B-business to business; C2C-customer to customer; G2C-government to customer; G2G-
government to government; and G2B-government to business.

10.5 Measuring Supply Chain Performance

  Delivery reliability is often measured by perfect order fulfillment. A perfect order is defined as one that
is delivered meeting all customer requirements such as delivery date condition of goods, accuracy of
items and correct invoice.
 Responsiveness is often measured by order fulfillment lead time or by perfect delivery fulfillment.
Customers today expect rapid fulfillment of orders and having promised delivery dates met.
 Customer-related measures focus on the ability of the supply chain to meet customer wants and needs.
Customer satisfaction is often measured by a variety of attributes on a perception scale that might range
from "Extremely Dissatisfied" to "Extremely Satisfied.
 Supply chain efficiency measures include average inventory value and inventory tun- over Average
inventory value tells managers how much of the firm's assets are tied up in inventory Inventory turnover
(IT) is the ratio of the cost of goods sold divided by the average inventory value Inventory turnover is
computed using the following formula:

Inventory tumover (IT) = Cost of goods sold Average inventory value

 If a manufacturer has a cost of goods sold of $10,600,000 and an average inventoryvalue of $3,600,000, then
inventory turnover is computed to be $10,600,000/$3,600.000 = 2.94 times per year. Note that inventory
turnover can be computed over any time period such as months, quarters, or years. The cost of goods sold is the
cost to produce the goods and services and normally does not include selling, general, administrative research
engineering, and development expenses.

 Sustainability measures show how supply chain performance affects the environment. These might
include recycle versus original product manufacturing costs, water discharge quality, carbon dioxide
emissions, and energy reductions. The goal is a carbon-neutral supply chain.
 Financial measures show how supply chain performance affects the bottom line. These might include
total supply chain costs, costs of processing return and warranties, and the cash-to=cash conversion
cycle.

By tracking such measures and using the results to better control and improve supply chain performance key
organizational financial measures such as return on assets, cost of good sold, revenue, and cash floe can be
affected. For example, a reduction in average inventory value will improve return on assets; improved supplier
performance can reduce  lead times can have a positive impact on cash flow. Thus, senior managers should
recognize the value of good supply chain design and management and provide resources to improve it.

10-5a Total Supply Chain Costs

 Perhaps the most important financial measure for supply chain performance in Exhibit 10.6 of procurement, but
also costs of transportation, tariffs and fees, inventory, and management oversight. Tariffs and fees may be
imposed by a country involved in the creation and delivery of the product along the supply chain and can add to
the cost of outsourcing globally .

 Supply chain managers seek to optimize the total system cost; this usually involves analytic modeling and
analysis. We may calculate total supply chain costs using the following:

Total supply chain cost (TSCC)= Procurement cost + Oversight  cost

+ Transportation cost + Order Cycle

Inventory cost + Pipeline inventory cost

TSCC= P D + OD  + C1D + Co (D/C) + (1/2)QCh + dLCh

By complaining terms, we may express this as

TSCC = D(P + O + Ct) + Co(D/Q)

+ (1/2) QCh + dLCh

where

P = Unit Cost D Unit price of procurement

O = Management oversight costs per per unit

Ct = Cost for transportation including import and export tariffs and fees

D = Annual demand forecast (units)

Q = Order quantity (units)

Co= Order cost per order

Ch – Annual inventory holding cost per unit

L = Lead time (days)

d – Average daily demand (units/day)

In this formula , PD represents the total annual cost of procuring the item, 0ºD is the total annual cost of
management oversight, and CtD is the total annual transporta- tion cost including tariffs and fees. From Chapter
9, we saw that the annual order cost is expressed in Equation 9.5 as C. (D/Q), and the annual inventory holding
costs from Equation 9.4 is (1/2) Q°Ch. Finally, the average annual pipeline inventory cost = (d'L) C. Pipeline
inventory is inventory that has been ordered but is in transit. Note that dºL is the average number of units in
transit; thus, (d'L) Ch is the average annual holding cost for this inventory. For example, suppose that a
computer manufacturer orders an average of 10,000 keyboards each week and it takes four weeks to ship from a
factory in Asia to the United States. The average daily demand is 10,000/7, and the lead time is 28 days;
therefore, the pipeline inventory is (10,000/7)(28) = 40,000 units. Although pipeline inventory is not physi-
cally available to the user or customer, it must be accounted for to plan production and future replenishment
orders.

Consider the following situation. A global sourcing manager for Delta Automotive wants to compute the total
supply chain costs for different order sizes for an automobile part purchased from three different global
suppliers. The data for this problem is shown in Exhibit 10.7, and the annual demand D = 400,000 units. The
supplier prices and transportation costs are predicated on an order quantity of 40,000 units (note that this is not
the EOQ). Unit price discounts are given for larger order quantities that reflect economies of scale. Which
supplier and order quantity provides the lowest total supply chain cost? We may assume that parts are
transported from Mexico to the United States by truck, and by a combination of ships and trucks from Japan and
China, and 250 work- ing days per year.

Exhibit 10.8 show the calculation of total supply chain costs for each supplier for the 40,000-unit order quantity
in a spreadsheet (available in the Data Workbook). We see that the Mexican supplier has the lowest cost. If the
model is evaluated for the discounted prices and a 100,000-unit order quantity, you will find that the total cost is
less for all three suppliers; however, you will see that the Chinese supplier now has the lowest total cost.
The Mexican supplier offers only a 2.6 percent discount in unit price [($7.60 - $7.40)/87.60) when Q = 40,000
versus Q = 100,000. However, despite the fact that the unit transportation cost is much higher, the Chinese
supplier offers a 15.7 percent procurement discount [($7.00 - $5.90)/$7.00] for Q = 100,000. Based strictly on
minimizing total supply chain costs, Delta Automotive should outsource to the Chinese supplier with Q =
100,000 units. Delta Automotive saves $78,100 ($3,568,200 - $3,490,100). In practice, the final decision would
consider not only total supply chain costs but also the risks noted in Exhibits 10.3 and 10.4.

10-5b The Cash-to-Cash Conversion Cycle

One of the more useful financial metrics for evaluating supply chain performance is the cash- to-cash
conversion cycle, which identifies cash flows from the time costs are incurred (such as raw material inventory)
to when it is paid (accounts receivable). The cycle is computed as inventory days' supply (IDS) plus accounts
receivable days' supply (ARDS) minus accounts payable days' supply (APDS). The following formulas are used
(see Example 10.1 for an application):

Inventory days’ supply (IDS)= Average total inventory/Cost of goods sold per day      Cost of goods sold per
day (CGS/D) +

Cost of goods sold value/Operating days per year

ARDS = Accounts receivable value/Revenue per day

APDS= Accounts payable value/ Revenue per day

Revenue per day (R/D) =Total revenue/Operating days per year

FInally, the cash-to-cash conversion cycle is computed as:

Cash-to-cash conversion

Cycle= IDS + ARDS - APDS

10.5c Supplier Evaluation and Certification

Evaluating and measuring supplier performance plays an important role in supply chain management.

Many companies also use some type of supplier certification process. These processes are designed to rate and
certify suppliers certification process. These processes are designed to rate and certify suppliers who provide
quality materials in a cost-effective and timely manner. For example, the Pharmaceutical Manufacturers
Association defines a certified supplier as one that, after extensive investigation, is found to supply material of
such quality that routine testing on each lot received is unnecessary. Certification provides recognition for high-
quality suppliers, which motivates them to improve continuously and attract more business.

10.6 SUSTAINABILITY IN SUPPLY CHAINS

In the past, supply chain performance was focused on cost, time, and quality performance. Today, sustainability
is one of the key goals of supply chains

10-6a Green Sustainable Supply Chains

A green sustainable supply chain is one that uses environmentally friendly inputs and transforms these inputs
through change agents—whose byproducts can improve or be recycled within the existing environment.  
10-6b Manufactured Goods Recovery and Reverse Logistics

 Many companies are developing options to recover manufactured goods that may be dis- carded or otherwise
unusable. This is often called manufactured goods recovery, and consists of one or more of the following:

 Reuse or resell the equipment and its various component parts directly to customers once the original
manufactured good is discarded.
 Repair a manufactured good by replacing broken parts so it operates as required.
 Refurbish a manufactured good by updating its looks and/or components for example, cleaning,
painting, or perhaps replacing parts that are near failure. Products may have scratches, dents, or other
forms of “cosmetic damage” that do not affect the performance of the unit.
 Remanufacturer a good by completely disassembling it and repairing or replacing worn out or obsolete
components and modules. Honda, for example, remanufactures vehicle steering mechanism controls for
sale as dealer-authorized replacement parts with the same warranty as new parts.
 Cannibalize parts for use and repair of other equipment of the same kind, such as automobiles,
locomotives, and airplanes.
 Recycle goods by disassembling them and selling the parts scrap materials to other suppliers.
 Incineration of landfill disposal of goods that are not economical to repair, refurbish, remanufacture, or
recycle.

For products that are of high enough value, it is normally more cost-effective to remanufacture or refurbish the
product, and convert damaged inventory into saleable goods, thus recapturing value on products that would
otherwise be lost in disposition.

Reverse logistics refers to managing the flow of finished goods, materials, or components that may be unusable
or discarded through the supply chain from customers toward either suppliers, distributors, or manufacturers
for the purpose of reuse, resale, or disposal.

Reverse logistics includes the following activities:

 Logistics: authorizing returns, receiving, sorting, testing, refurbishing, cannibalizing, repairing,

remanufacturing, recycling, restocking, reshipping, and disposing of materials.
 Marketing/sales: remarketing and selling the recovered good for reuse or resale to wholesalers and
retailers.
 Accounting/finance: approving warranty repairs, tracking reverse logistic revenue and costs, billing, and
paying appropriate suppliers and third-party vendors.
 Call center service: managing service center calls all along the supply chain to coordinate work
activities such as collecting items from many diverse sources for recovery operations.
 Legal/regulatory compliance: constantly monitoring compliance with local, state, federal, and country
laws, import and export regulations including environmental, and service contract commitments.