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Lecture 7: Inventory Analysis

• The importance of understanding inventory

• Defining inventory

• Counting and control systems in practice

• ABC classification

• Pediatric Care Center: Part I ABC analysis

• Inventory control decisions

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Inventory and Cost

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Inventory in an Economy• There are more than $1.16 trillion in US at a

given time:– 1/3 held by retailers: ¼ of which in auto industry– 1/5 by wholesalers – the remainder by manufacturers

• Inventory cost at 25% - 35% of the value is more than $350 billion per year

• For each dollar of GNP in manufacturing and trade, about $0.4 worth of inventory was held

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Inventory in a Firm

• Inventory accounts about 34% of current assets, 90% of working capital of a typical US company

• Costs of holding inventory

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Statements of Kmart and Wal-Mart

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Financial Metrics• Inventory turns

• Per dollar (marginal) inventory cost

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Formulas

inventory

sold goods ofcost turnsinventory (1)

turnsinventory

costinventory annualcost inventory unit per (2)

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Retail Inventory Turns and Margins Inventory

Gross Segment Examples Turns MarginApparel and accessory Ann Taylor, GAP 4.57 37%Catalog, Mail-order Spiegel, Land’s End 8.60 39%Department stores Sears, J. C. Penney 3.87 34%Drug & Proprietary stores Rite Aid, CVS 5.26 28%Food stores Albertsons, Safeway 10.78 26%Hobby, toy/game stores Toys R Us 2.99 35%Home furniture/equipment Bed Bath & Beyond 5.44 40%Jewelry Tiffany 1.68 42%Radio, TV, Consumer elec. Best Buy, Circuit City 4.10 31%Variety stores Kmart, Wal-Mart, Target 4.45 29%

.

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Efficiency Frontier

10% 20% 30% 40% 50%

1

2

3

4

5

6

7

8

9

10

Inventory turns

Gross margin

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• ... by 1990 Wal-Mart was already winning an important technological war that other discounters did not seem to know was on. “Wal-Mart has the most advanced inventory technology in the business and they have invested billions in it”. (New York Time, Nov. 95).

• Business

Week 1997

The Importance of Understanding Inventory

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Kmart declared bankruptcy and now been bought by Sears

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Inventory by Location• Raw materials & purchased parts (RM)• Partially completed goods, work in progress (WIP)• Finished-goods inventories (FGI, manufacturing

firms) or merchandise (retail stores) • Goods-in-transit to warehouses or customers• Replacement parts, tools, & supplies

ProcessWIP

Raw Mat. Or Purch. Parts

F. G.

outputsinputs

manufacturersupplier distributor

retailer

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TCL’s TV Supply Chain

TV Cases

AB Plastics

SCLogistics’

WarehouseTCL’s Assembly Line

SCLogistics’

Warehouse

Other Components

TVs

SC Logistics’ TrucksTCL’s Distribution

CentersTCL’s Stores

Guo Mei, Wal-MartOther Retailers

Consumers

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• Keeping inventory is costly, but it is a necessary curse for business operations

• Theoretical or pipeline inventory

• Cycle or batch inventory

• Seasonal inventory

• Decoupling inventory

• Safety inventory

• Strategic inventory

Inventory by Function

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• To achieve a target throughput rate, a minimum amount of WIP is needed

Theoretical/Pipeline Inventory

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• Fixed costs associated with batches• Quantity discounts• Trade promotions

• Economies of scale

Cycle or Batch Inventory

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• Uncertainty

– Information uncertainty

– Supply/demand uncertainty

• Buffers between operations

Safety and Decoupling Inventories

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• Seasonal variability• Level production

• Natural disasters and wars• Availability• Speculation

Seasonal and Strategic Inventories

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Good Inventory Management

• Low cost and fast turnover• Fulfillment:

- 100 percent satisfactory rate?

- percentage of demand filled on arrival

- percentage of periods without stockout

- percentage of on-time delivery• Must contribute to company’s bottom line

- IBM PC Division made profit 1st time in 97

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IBM BREAKTHROUGH IN SUPPLY CHAIN IS KEY TO OPERATIONS RESEARCH PRIZE

Fewer Unsold Computers; $750 Million+ Savings

• ILINTHICUM, MD, May 17, 1999 - IBM's success at reengineering its supply chain was a key factor in its selection as winner of the 1999 Franz Edelman Award for Achievement in Operations Research and the Management Sciences in Cincinnati earlier this month. The company's reengineering efforts resulted in over $750 million in savings in 1998, the company reports.

• The Institute for Operations Research and the Management Sciences (INFORMS®) presented the award for a study entitled “Extended Enterprise Supply Chain Management at IBM Personal Systems Group and Other Divisions.”

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Inventory Counting and Control Systems• Periodic System

Physical count of items made at periodic intervals

• Perpetual Inventory SystemSystem that keeps track of removals from inventory continuously, thus monitoringcurrent levels of each item

• Two-Bin (Kanban) SystemTwo containers, reorder when the first is empty

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Harbin Turbines Co. has 300,000 SKUs

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ABC Classification SystemWhat should management focus on?

Classify inventory according to some measure of importance and allocating control efforts accordingly.

A - very importantB - moderately

importantC - least important

Annual value of items

AA

BB

CC

High

Low

Few Many Number of Items

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Item Annual Unit Dollar % of total units used cost usage dollar usage

1 5,000 $1.50 $7,500 2.92 1,500 8.00 12,000 4.73 10,000 10.50 105,000 41.24 6,000 2.00 12,000 4.75 7,500 .50 3,750 1.56 6,000 13.60 81,600 32.07 5,000 .75 3,750 1.58 4,500 1.25 5,625 2.29 7,000 2.50 17,500 6.910 3,000 2.00 6,000 2.4

Total $254,725 100.0

Example 1: Annual Usage of Items by Dollar Value

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0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

3 6 9 2 4 1 10 8 5 7

Item No.

Pe

rce

nt

Usa

ge

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

Cu

mu

lati

ve %

Usa

ge

Percentage of Total Dollar Usage Cumulative Percentage

Example 1: Percentage Usage by Dollar Value

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Example 1: ABC Classification

Class Item % of total % of total

numbers items dollar usage

A 3, 6 20 73.2

B 2,4,9 30 16.3

C 1,5,7,8,10 50 10.5

Total 100 100.0

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ABC Analysis for a Pediatric Care Center

• The importance of inventory cost

• Difference between different items

• Outcome of ABC analysis– A items:– B items– C items

• How to manage different classes of items?

Injectable medical supplies

Non-injectable medical suppliesOffice supplies

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Example 2 Motorola Hong Kong• Motorola Hong Kong’s IC packaging

operation uses a molding material at a rate of 90 kg per day. Every Friday, the material manager, Mr. Chan, checks the inventory, and places an order if needed.

• It takes the supplier 3 full working days to deliver the molding material to Motorola.

• The material is very expensive, so keeping large inventory is costly

• The ordering and shipping cost is also high

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Questions

• How much should Chan order?

• To solve the problem

–What costs should be considered?

–What should be the decision variable?

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More Information• The material costs $50/kg, storage costs

$5/kg/year, and the interest rate is 15%• Ordering and shipping cost is $600 for up to

2000 kg• Motorola and the supplier work Monday to

Saturday for 8 hours/day and the no. of production days in a year is 300

• Order is placed in the afternoon and delivery arrives in the morning of the 4th working day

• Consumption of the material is at a constant rate from Monday to Saturday

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Preparation for Solutions• Let Q be the order quantity• The annual demand rate R = 27000• The number of orders = 27000/Q• The ordering cost per order S = 600• The annual holding cost per unit

H = 5 + 50 x 0.15 = $12.5/kg/year • The average inventory level = Q/2• Total annual cost

TC(Q)= cR + S R/Q + H Q/2

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Q

Q/2

4 8 12

Average inventory level

0

R

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Alternative Solutions• Total annual controllable cost,

TCC(Q)=(R/Q)S +H(Q/2)

• TCC(1080) = 15000 + 6750 = $21750

• TCC(1620) = 10000 +10125 = $20125

• TCC(2160) = 7500 + 13500 = $21000

• What should be your advice?

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Observation

• A fixed ordering and shipping cost

• A cost for holding inventory

• Cannot eliminate either cost, but can change the total by having different order quantities

• Observation:

Order quantity affect total operation cost

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Questions

• With a larger order quantity:– Per unit ordering cost becomes smaller– Average inventory level becomes higher

• What is the economics of this phenomenon?• What is the optimal order quantity?

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Inventory Control Decisions

• What are the important decisions to be made in inventory management?

• Two major decisions:

– How much should we order?

– When should we order?

• Consider the following question

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Q

Q/2

Q/3

Q/6

4 8 12

Average inventory level

0

How should we trade-off?

R

R

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Today’s Takeaways• Inventory plays important roles in production

and business operations, but it can be very costly

• Five functions of inventory, the basic reasons for holding inventory

• ABC analysis (80-20 rule, Pareto chart)• Production or purchasing order decisions

determine the inventory cost• Equations (1) and (2)