Inventory Management in Supply Chain

Inventory Management: Key Decisions

• How much to order?

• When to order?
• Where to hold inventory?
• When to review?
– Continuous review systems ( Fixed order
quantity)- As firms have real-time inventory
management system ( Shoppers Stop)
– Periodic review systems
 Sector-wise Performance on
Inventory Turnover Ratio in India

Zero-based inventory budgeting approach

 Types of Inventory
• Cycle Stock : Economies of scale. Trade off between Ordering
and Holding cost
• Safety Stock
• Decoupling Stock- Buy, Make and Deliver functions
• Anticipation Stock
– Seasonal Stock (Plan in advance for Lean season)
– Speculative Stock (Hedging, Forward contract for eventualities)
• Pipeline Inventory- Is product of Process time or transport
time and usage rate of the item
• Dead stock- Periodically review and write-off slow moving
items or which have not moved for 6 months- Organizations
refrain from Product Rationalization as in book of accounts it
shows as a financial loss
 Drivers of Inventory
Type of Inventory Driver ( Logic)

Cycle Stock Economies of Scale

Safety Stock Uncertainty in demand & Supply

Seasonal stock Mismatch between demand and supply rate

Speculation Stock Uncertainty in price of material

Pipeline Stock Lead-time in production/transportation process

Dead Stock Judgmental error/ Change in economic or

technological environment
 Pipeline Inventory

• Inventory within conversion and transportation processes:

Pipeline Inventory
– Pipeline Inventory = PLT * D
- PLT = Pipeline Lead-time; D = average demand
Illustration :
LT -Shipment by air = 7 days
LT- Shipment by sea = 45 days
Average demand = 100/day
Pipeline Inventory ( Shipment by air) = 700 units
Pipeline Inventory ( Shipment by Sea = 4500 units
 Inventory Management: Relevant Cost
• Ordering cost/setup cost - (Placing(Electronic ordering), Transportation,
Receiving) – If it is fixed cost and does not vary with order quantity then
include in ordering cost else cost of the item (Activity Based costing)
• Inventory carrying cost (20-25%)- Financing cost, Storage and
Handling Cost, Inventory Risk
Inventory Carrying cost per unit per year= Inventory Carrying
cost*value of the item
• Cost of shortage (By Substitute products)
– Lost sales (Offer substitute products or maintain high service level))
– Backorder cost- Customer willing to wait
– Service level as proxy for cost of shortage (90-99%)
• Purchase cost ( value addition cost) of Item
– Not relevant if cost of item is not function of order quantity (No
Quantity discount case)
– Cost that varies with order size is included in the cost of the item
 Cycle-stock Inventory

Fixed Order Quality Model ( Cont. Review Model)

Q=Order Quantity, Reorder point= L*d
Average cycle stock = Q/2
Periodic review- Lead Time= Supplier Lead Time+Review period
Optimal Order Quantity Trade-offs
 Inventory Models: Cycle Stock

__________
Q =2AD/i C
A = Ordering Cost / Cost of setup
D = Annual Demand
i = Inventory carry cost
C = cost of item
Q= Optimum order quantity
Reorder Point= L*d
 Optimum Order Quantity
Daily Demand(d) = 100
Working days in year=300
Annual Demand (D)= 30000
Ordering cost = 256 Rs.
Cost of item = 30 Rs.
Inventory-carrying cost = 20%
Supplier LT = 15 Days
Optimum order Qty. =
_______________________
Ö (2*256*100*300/(30*0.20 ) = 1600

Case I
Average cycle stock= 0.5* 1600 = 800 units
So, Retailer carries cycle stock of 8 days
Reorder point= L * d= 15*100 =1500
Inventory Turnover= Demand/Average Inventory=37.5
No. of orders placed =30,000/1600=18.75 times a year
 Optimum Order Quantity (Contd..)
Case II - Changes in demand Pattern
• Demand gets 4 times i.e. 400 per day
• EOQ gets doubled =3200 units
• Cycle stock gets doubled= 1600 units
• Inventory turnover ratio will increase to 75
• Retailer carries cycle stock for 4 days
• Number of orders=30000*4/3200=37.5
Inference-
• Large retailers have a better inventory turnover ratio
• Focus has to be on decreasing ordering cost as number of
orders had got doubled
 Optimum Order Quantity (Contd..)
Case III
• Reduce Ordering cost to one-fourth
• Average inventory turns half=400
Ordering Cost=64
EOQ=√2*64*30000/6= 800
• So, if retailer wants to bring average inventory to half he
has to bring ordering cost to one-fourth
Inference:
At the same demand level, for expensive item one will order
more often and carry less inventory and for less expensive
items prefer to carry more inventory and order less often
 Sensitivity Analysis
Q/Q* Q Tc
0.5 800 12000
0.75 1200 10000
0.9 1440 9653.333
1 1600 9600
1.1 1760 9643.636
1.25 2000 9840
1.5 2400 10400
1.75 2800 11142.86
2 3200 12000
 Total Cost versus Q

15000
Total Cost

10000
Series1
5000
0
0 1000 2000 3000 4000
Q

Optimum order quantity=Q*= 1600

 Safety stock-Capturing level of
uncertainty
• Demand distribution captured by 2 parameters: mean demand and
standard deviation of demand
• Supply system has 2 parameters: average lead time and standard deviation
of lead time

Uncertainty captured by-Mean, Standard deviation and Coefficient of

variation
(CV= SD/Mean)
CV when we want to compare 2 items with different means
New product- Range (Standard Deviation=Range/6
Range is assessment of best and worst case scenario (optimistic and
pessimistic)
Service Sector-Safety capacity in terms of human inventory (Infosys 20%
planned idle capacity)
 Impact of Service level on Safety Stock
• Service Level is the probability that all orders will be
filled from stock during the replenishment lead time
or during the reorder cycle. Also called as cycle
service level. (Supply Perspective)
• Service level is a percentage of demand filled from
stock during a given period of time. Also called as Fill
rate. (Demand Perspective)
• Safety stock is calculated keeping the target service
level and the anticipated uncertainty in demand and
supply.
 Impact of Safety Factor on
Service Level

Safety factor (K) Service level

0 0.500
0.5 0.690
1.0 0.841
1.5 0.933
2.0 0.977
2.5 0.994
3.0 0.998
Inference:
• After a level even increasing safety stock will not improve service level
• Increase Inventory Turnover Ratio, Reduce Ordering cost, Less Holding Cost, Less Cycle stock
• Stock out cost if high than high service level.
• Service level-Product mix rationalization/offering substitute product as private labels
Impact of Service Level On Safety Stock
 Illustration
• Average Daily demand=100 units
SD of daily demand=30 units
Average lead time=15 days
SD of Lead time=5 days
So, LTD=d*L= 100*15=1500 units
Lead Time Demand= 513
If SS with Retailer for 7 days= 700 units, Then Safety factor=
700/513= 1.4. Hence, Service Level is 91.6%. Keep 1539
units for 100% Service Level.
(SS=z =3*513=1539 units)
 Ordering Policy in Case of
Demand and Supply Uncertainty

Order quantity = Q* = Optimum order

quantity
Reorder point= D * L + K Lead Time Demand
K = Safety factor
Safety stock= K Lead Time Demand
(LTD= Mean Demand during replenishment cycle)
 Safety Stock: Demand Uncertainty Only

S.S = K Lead Time Demand

______
Lead Time Demand =  L D2

D = average Demand ,D = S.D. of Demand ,

L = Lead-time, K = Safety Factor

 Safety Stock : Demand and Supply
Uncertainty

S.S = K Lead Time Demand

____________
Lead Time Demand =  L D2 + D2 L2

D = average Demand ,D = S.D. of Demand ,

L = Average Lead-time, L = S.D. of Lead-time

K = Safety Factor
 Basic Demand and Lead-time Data

Demand Data
d1 d2 d3 d4 d5 d6 d7 d 8 d 9 d10
Demand 115 95 150 125 28 90 93 115 93 96
Lead-time data
L1 L2 L3 L4 L5 L6 L7 L 8 L 9 L10
Lead- 12 15 4 21 18 11 12 18 19 20
time
 Impact of Change in Demand and Supply
Parameters- Managerial levers for reducing
safety stock at 97.8% service level
Average Standard Average Standard Safety Safety Remark
Demand deviation lead- deviation stock stock in
of demand time of lead- - units days of
time inventory
100 30 15 5 1026 10.3 Base case

100 30 15 0 232 2.3 No supply

uncertainty,
100 0 15 5 1000 10 No demand
uncertainty
100 15 15 5 1006 10 Reduce demand
uncertainty
100 30 15 2.5 526 5.3 Reduce supply
uncertainty
100 30 7.5 5 1003 10 Reduction in
lead-time
 Illustration- Single Period Model
Consider the case of a music retailer who has to book in advance the
number of CDs that need to be purchased before the release of the
movie. Based on past experience, the retailer is aware that the pull, of
the demand takes place during the first two weeks of a movie release.
During this period, the retailer will not be able to get replenishment
from the manufacturer in case the demand turns out to be more than
the estimate. However, at the end of two weeks all the unsold CDs will
have to be sold at discounted price. For example, the retailer books CDs
at ₹200 each and sells them at ₹300 during the first two weeks. After
two weeks the retailer will have dispose of the unsold stock at ₹62.
Based on experience, the retailer expects that demand for this kind of
CD has a mean demand of 100 and a standard deviation of demand of
30.
 
 Inventory for Short life-cycle Products: Single
Period Model-Selling Season
(Fashionable and Perishable goods)
• Reactive assessment
• Speculative assessment
Balancing cost of under-stocking versus cost of overstocking
CU = Cost of under-stocking
CO = Cost of overstocking
Optimum service level = (CU *100/ (CU + CO )
Optimum Order size= Mean demand
+ K * Std. Dev. Demand
K= optimum service level
 Optimum Order for a New Music CD
CD purchase price = Rs. 200
CD sales price = Rs. 300
CD sales price after first weeks = Rs. 62.
Demand: Average 100 and Standard Deviation 30

- What is optimum order quantity (SL=42.1,K=-0.2)=94

- If manufacturer offers buyback scheme , would your
decision change? =112
If cost of administering return- Rs. 53 (SL=65.4,K=0.4)
 Price-Break Model Formula
Based on the same assumptions as the EOQ model, the price-
break model has a similar Qopt formula. It differs because unit
prize change with order size.

2DS 2(Annual Demand)(Order or Setup Cost)

Q OPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since “C” changes for each price-break, the formula

above will have to be used with each price-break cost
value
 Price-Break Example

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 Price-Break Example
First, plug data into formula for each price-break value of “C”
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DS 2(10,000)( 4)

Qopt value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)( 4)
Qopt value is not feasible Q OPT = = = 2,000 units
iC 0.02(1.00)
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Qopt value is not feasible Q OPT = = = 2,020 units
iC 0.02(0.98)
 Price-Break Example

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 Kanban
• Kanban
– display card in Japanese
– a sign, card, or label, that communicates what is
needed and when.
Double sided racks
 The Kanban System
The information on the Kanban will often include:
• Component part number and identification.
• Storage location.
• Container size (if the material is stored in a container).
• Work center (or supplier) of origin.
 The Kanban System
How does it work?

WITHDRAWAL CARD
Two-card Kanban system.
Production kanban (authorizing production)
Withdrawal kanban (authorizing the movement of the identified
material).

At the start of the process there is no movement, since all the cards
are attached to full containers or bins.
 The Kanban System
Example : The bottom of a printer body goes through three
steps: molding, trimming, and detailing. The table below provides
the annual fixed cost, cost per load, and maximum transport size
for three handling options. Choose the container size and
technology. The system will produce 200,000 printers per year.
Annual inventory holding cost is $2 per unit of WIP.

Option Annual cost Cost / trip Max. Lot size

Manual Carry $27,000 $0.15 2
Push Cart $28,000 $0.16 20
Forklift $50,000 $0.90 500
 The Kanban System
Solution:
The best container size for each technology:

2c2ij  Di 2c2 ij  200,000

n 
*
ij   447.21 c2ij
hi 2
Plugging c2ij, we have:

Option The best container size nij

Manual Carry 300
Push Cart 310
Forklift 735
 The Kanban System
In all 3 cases, we are constrained by the maximum lot size.
Thus, we compare the cost using these feasible load size as
follows:

Manual: (3)( 200,000)

$27,000  $0.15   $72,000
2

Push cart: (3)( 200,000)

$28,000  $0.16   $32,800
20

(3)( 200,000)
Forklift: $50,000  $0.90   $51,000
500

The obvious choice is to use a push cart with containers of size

20 pieces.
 Centralized Versus Decentralized Systems
• Inventory
– Safety Stock
– Cycle stock
• Service Level
• Overhead Costs
• Customer Lead Time
• Transportation Cost
dc= d1+d2+d3….+dn
σdc= √ σ2d1+ σ2d2+…. σ 2dn
SD of demand at centralized stock point is 4 times
Centralized Versus Decentralized Systems:
Illustration
Demand distribution at each region ( 16 regional stock points)
Daily Demand: Mean = 100 , SD = 30
Ordering cost = 256 Rs.
Cost of item = 30 Rs.
Inventory Carrying cost = 6 Rs.
Service level=97.7 percent
Plant Lead time:= 15 Days ( No supply Uncertainty)
Number of days in year=300
Transportation:
Decentralized- Rs. 1 per unit
Centralized case: - 10% higher
  Decentralised system – Centralised system –1
16 stock points stock point

Cycle stock/stock point 800 3200

= Q*/2

Safety Stock per stock 232 928

point

Total Inv. in units for the (232+800)  16 928+3200

system = 16512 = 4128

Total Inv. carrying cost 16512  6 4128  6

= 99072 = 24768

Incremental   300100160.1
Transportation cost =48,000