Chapter 5: Managing Inventory for Satisfying

Customer Demand
Section I: Managing Inventory to Satisfy
Customer Demand
 Inventory Management

• Inventory constitutes the stock levels of raw, packaging material and other
input material such as standard spares and also the finished goods as well
as work in progress carried in the business to service the demand in the
market.
• More often than not, the inventory in a business is disproportionately
higher than the required or optimal level resulting in very high working
capital locked up in the business impacting the performance of the
organization itself.
 Inventory Management Goal

• Inventories represent the largest single investment in assets as current

assets for many manufacturers, wholesalers and retailers.
• Inventory investment represents over 20% of the total assets of
manufacturers and more than 50% of the total assets of wholesalers and
retailers.
• One goal in operations is to keep the level of inventory in the supply chain
as low as possible and to free up funds for other productive purposes.
 Why Do We Need Inventory?

• Improves customer service

• Provides immediacy in product availability
• Encourages production, purchase and transportation economies
• Allows for long production runs
• Takes advantage of price-quantity discounts
• Allows for transport economies from larger shipment sizes
• Acts as a hedge against price changes
• Allows purchasing to take place under most favourable price terms
• Protects against uncertainties in demand and lead times
 Inventory Impacts Business Performance

• Inventory blocks capital in the form of working asset. It is, therefore, a cost
to the business and hence impacts the performance of the business.
• The best way to run a business is without having any inventory and, if
possible, on ‘made to order’ basis or as just-in-time inventory to be
delivered which is produced against a confirmed customer order.
• In some business categories in B2B model, this may be possible.
 Types of Inventory

• Raw material inventories

• Packaging material inventories
• Work-in-process inventories
• Spare part inventories
• Finished goods inventories
o Movement inventories
o Lot size inventories
o Anticipation inventories
o Fluctuation inventories
o Physical inventories
o Transit inventories
 Components of Inventory Decisions

• Cycle inventory
• Safety inventory
• Seasonal inventory
• Level of product availability
 Inventory Cost Management

• Purchase cost
• Ordering cost
• Holding cost
• Storage cost
 Inventory Control

• Inventory control is the process of managing materials’ inventory of right

quality and quantity to be made available as and when required at least
cost without facing any stock-out situation resulting in loss of either
production or sales.
• The desired level of inventory can neither be high nor be low because a
high level of inventory will lead to an increase in carrying cost, while a low
level of inventory will lead to an increase in ordering cost.
 Effective Inventory Management

• Inventory management means the methods that are used for organizing,
holding and replenishing stock. The main purpose of inventory
management is minimizing differences between customers’ demand and
availability of items.
• These differences are caused by three factors: customers’ demand
fluctuations, suppliers’ delivery time fluctuations and inventory control
accuracy.
 Inventory Transaction

• Normal stock receipt: from previously issued purchase orders and

transfers
• Unexpected stock receipts: the stuff that just shows up on receiving stock
• Requisitions: a request for material to be consumed within a company
• Emergency requisitions
• Sales
 Stock-Keeping Unit

• The inventory control is made by a stock-keeping unit (SKU). An SKU is an

individual product that differs from other products in some way, and
inventories are kept SKU-wise.
• The difference could be in size, colour, brand, model, package function or
some other relevant characteristic such as flavour and fragrance or a
combination of these.
• Each SKU has its own unique identification code (product code) in the
inventory accounting system and it is counted and stored separately from
other items.
 Bullwhip Effect

• Manufacturers like to produce in large lot sizes because it is more cost-

effective to do so. The problem, however, is that producing in large lots
does not allow for flexibility in terms of product mix. It also adds to the
inventory which a business may not require immediately.
• The downside is that ordering/producing large lots can result in large
inventories of products that are currently not in demand while being out
of stock for items that are in demand.
 Causes That Lead to the Bullwhip Effect

• Demand forecasting
• Lead time
• Batch ordering
• Price fluctuation
• Inflated orders
Distributors’ Orders to the Manufacturers
Consumer Offtake at Retail Sales Point
Manufacturers’ Orders to the
Suppliers/Vendors
 Reducing Impact of Bullwhip Effect

• Reducing variability
• Reducing lead time
• Strategic partnerships
 Business Response to Stock-Out

• Back-ordering
• Substitution
• Lost sales
 Replenishment of Inventory

• Periodic or fixed interval review system

• Reorder point system
• Time-phased order point (TPOP) system
 Periodic or Fixed Interval Review System

• The periodic review system is very widely practised in the industry by

taking the inventory details once in a fixed predetermined time interval to
decide the ordering quantity. This time interval for review is determined
based on the company’s past practice as well as experience and lead time
for ordering of long delivery items.
 Reorder Point System

• The point triggers when reordering has to be done taking the information
related to stock level as well as other input regarding any delay in
receiving the stock than the normal lead time as well if there is any excess
consumption arising out of unusual demand. At this point, procurement is
initiated. The recorder point is actually average daily consumption
multiplied by the lead time of procurement plus the safety stock.
Reorder Point for Inventory
 Time-phased Order Point System

• TPOP is a computerized management tool that plans inventory needs in a

priority-sequenced, time-phased manner to meet customer and forecast
demand as it occurs.
• This technique is at the heart of MRP and DRP systems used for the
control of manufacturing and distribution channel inventories. The main
advantage is that inventory actions are triggered by matching supply with
anticipated demand as it occurs in time.
 Inventory Position

• On-hand inventory
• Available inventory
• On-order inventory
• Inventory position
Economic Ordering Quantity
 Material Requirements Planning (MRP)

• The types of materials and the quantity that has to be purchased from
outside, taking into account current inventory levels
• The types of materials that need to be manufactured internally and in
what quantity, taking into account current inventory levels
• At what time to place these orders, either by purchasing from outside or
for manufacturing inside
 Components of MRP II

• Master production schedule

• Bill of materials
• Inventory status file
• Output of MRP
• Min-Max replenishment system
 Total Cost of Inventory

• Material cost (landed cost): It is the purchase price of product plus freight
and any other charges that are related to specific shipment including
taxes, transportation and so on or manufacturing cost in production.
• Ordering cost: It is the cost of issuing, receiving and paying a vendor. It is
associated with ordering frequency, not with the quantity ordered.
• Inventory carrying or holding cost: It is the cost of maintaining the
inventory in a warehouse before it is sold, transferred or otherwise used.
It is associated with quantity ordered, not with the ordering frequency.
 Out-of-Stock Costs

• Lost sales cost: When a customer faces an out-of-stock situation, he/she

chooses to withdraw the request for the product. Unearned profit from
given sale + possible negative effects on future sales.
• Back-order cost: When a customer decides to wait in an out-of-stock
situation. The sale is not lost, only delayed, but it incurs back-order
processing costs and additional transportation and handling costs.
 Total Cost Approach

• WACC (weighted average capital cost)—considered most objective for a

realistic cost overview
• Hurdle rate—minimal acceptable return on investment accepted by the
company
• The lowest bank loan interest rate (currently around 10–12% in India),
which can be different in other countries
• Inventory service costs—which include typically insurance and taxes on
inventory
• Storage costs—part of warehousing costs depending on inventory level
• Inventory risk costs—obsolescence, damage, pilferage and relocation costs
 Order Point System vs MRP System

Criteria Order Point System MRP system

Demand Independent Dependent
Ordering Philosophy Replenishment Need Based
Control Principle ABC Grouping All items are equally
important
Forecasting Based on Demand Based on Master Production
schedule
Purpose Satisfying customer needs Satisfying Production needs
Order size determination Economic Ordering Quantity Firm request for concrete
( EOQ) items
Design Pattern Unvaried Changing but predictable
Inventory types Finished Product, spare Work in Progress(WIP), Raw
parts Material
 Structure of Inventory Carrying Cost

• Capital cost: 82%

• Inventory serving cost: 0.75%
• (Insurance 0.25% and taxes 0.50%)
• Storage cost: 3.25%
• Inventory risk cost: 14.0%
• Total: 100%
Section II: Dealing with Demand
Uncertainty in Supply Chain
 Managing Uncertainty in Supply Chain

A higher level of inventory increases the cost of holding and other associated
problems related to a company’s performance, but the company also cannot
afford to lose sales on account of non-availability of stock. Safety inventory,
therefore, is carried in the system to satisfy the demand that exceeds the
demand forecast.
 Measuring Product Availability

There are several ways to measure the product availability. One of those
measures is product fill rate, which means the fraction of the product
demand that is satisfied from the product available in the inventory. It is the
corporation’s decision about the fill rate but in an intensely fought
competitive environment, companies aim at a very high fill rate nearing 99%.
When the Demand Is Variable but
Lead Time Constant
Reorder Point with Safety Stock
Service Level Determines the Safety Stock
 Single Period Model

Sometimes referred to as the newsboy problem, it is used to handle ordering

of perishables (fresh fruits, vegetables, seafood, cut flowers) and items that
have a limited useful life (newspapers, magazines, spare parts for specialized
equipment).
 Focuses on Two Costs: Shortage Cost
and Excess Cost
As the product is perishable and has a very limited shelf-life or useful life, if
there is excess stock then businesses lose as the unsold stock is lost. Also, if
there is shortage of stock then the loss will be arising out of loss of sales,
dissatisfied customer and customer moving to the competition.
 Impact of Uncertainties

Uncertainties in supply, process and demand are recognized to have a major

impact on the manufacturing function. Uncertainty propagates throughout
the network and leads to inefficient processing and non-value-adding
activities. The uncertainty arising out of uncertain customer orders leads to
the question: How many and how much stock that business should carry and
will the supplier deliver the requested stock on time and as per
specifications? But those who can manage the uncertainty better deliver
much superior performance.