Inventory Management

Professor Stephen R. LawrenceLeeds School of Business

University of ColoradoBoulder, CO 80309-0419

Inventory Management Outline

Inventory Management What is inventory? Why is it held? Why materials management is important Conflicting organizational objectives ABC inventory analysis Independent vs dependent demand systems

Deterministic inventory models Economic Order Quantity (EOQ)

Stochastic inventory models “Newsvendor” single-period models Independent demand multi-period models

Inventory Management

What is inventory?

Purposes of inventory?

Where Inventory is Held

INPUTS TRANSFORMATIONS OUTPUTS

Purchasing

Vendors

Receiving

Raw Materials

FGI

WIP

Shipping

Distributors

Customers

Customers

Customers

ConversionProcesses

WarehouseInventory

Why Inventories are Held

Cycle Stock inventory resulting from batch (rather than unit) ordering or

production. Safety (Buffer) Stock

buffer against uncertain demand. Anticipation Stock

accumulation in anticipation of peak demand. Pipeline (WIP) Stock

goods in transit and in-between stages of production. Decoupling Stock

inventory used to seperate decision making at different production echelons (e.g. factory and warehouse).

Why Inventory is Important

Recent inventory write-offs (2000): Cisco – $2.5 billion Agere Systems -- $270 million Micron Technology -- $260 million Vitesse Semiconductor – $50.6 million Xilinx, Nortel, Lucent, Corning, JDS Uniphase, …

Where Inventories are Held (USA): Manufacturing 40% Wholesalers 21% Retailers 20% Farm 9% Others 10%

Greater leverage with materials

Consider a company with Materials = 50% cost of sales Labor = 20% cost of sales Profit margin = 10% of sales

To raise profits by 1% Increase sales by 10%; Decrease labor costs by 5%; or Reduce material costs by 2%

Conflicting Objectives Marketing/sales

I can't keep our customers if we continue to stockout and there is not sufficient product variety. I can't sell from an empty wagon!

Production If I can produce larger lot sizes, I can reduce per unit cost and

function efficiently! Purchasing

I can reduce our per unit cost if I buy large quantities in bulk!

Finance Where am I going to get the funds to pay for inventory? The

levels should be lower! Distribution (warehousing)

I am out of space. I can't fit anything else in the building!

Relevant Inventory Costs

Costs of Holding Inventory opportunity costs of

capital; storage, handling,

insurance; obsolescence, shrinkage;

Costs of Procuring Materials per unit cost of material; ordering/setup costs; tracking costs; volume discounts;

Costs of Backlogs & Stockouts lost sales; backorder costs; lost future sales

(goodwill).

Rule of thumb Annual inventory

carrying costs are about 25-30% of the value of inventory!

ABC Analysis

Observation: 20% of SKU's account for 80% of total inventory costs (Pareto principal).

Idea: Manage most important (costly) inventory items most closely.

Use: First analysis to undertake when attacking inventories!

1.0

Fraction of Total Items

0.0 0.2 0.5

0.6

0.91.0

Fraction of $Annual Use

ABC Item Classification

Class A Items: 20% of items which account for approximately 60-80% of annual $ usage Tight control, keep inventories as low as possible; Monitor continuously (continuous review); Purchase/manufacture in small, frequent batches.

Class B Items: 30% of items which account for approximately 20-30% of annual $ usage Moderate control; Good records, monitor periodically (periodic review); Purchase/manufacture in medium size batches.

Class C Items: balance of SKU's whcich account for remaining 5-15% of annual $ usage Minimal control; Simple manual records, occasional review; Purchase/manufacture in large, infrequent batches.

ABC Example

Annual $ Annual $ Cumul $ Cumul Item Quantity Cost Usage Usage Percent Class

G2 195,000 11 2,145,000 2,145,000 39.75M3 240,000 7 1,680,000 3,825,000 70.89M1 100,000 5 500,000 4,325,000 80.15P1 80,000 6 480,000 4,805,000 89.05G1 40,000 7 280,000 5,085,000 94.24M4 16,000 8 128,000 5,213,000 96.61P2 10,000 7 70,000 5,283,000 97.91P3 5,000 9 45,000 5,328,000 98.74G3 4,000 10 40,000 5,368,000 99.48M2 2,000 14 28,000 5,396,000 100.00

-------------5,396,000

Independent Demand

Independent Demand Items Finished goods, end products purchased by

customers Raw material commodity stocks, common to many

products Demand rate and pattern determined outside of

the firm Demand is independent of demand for other

products or items We will focus on Independent Demand Items here

Dependent Demand Items

Dependent Demand Items Materials, parts, and subassemblies used in end

products Items traceable to specific end products Demand is dependent on the number of end items

manufactured To produce 100 bicycles in March, then need 200

wheels in February and 7200 spokes in January Dependent demand items are controlled using

Materials Resource Planning (MRP) systems

Independent vs Dependent Demand

Bicycle

HardwareWheelsFrame

RimHubSpokes Tire

IndependentDemand

DependentDemand

DependentDemand

Inventory Management Systems

Establish amount of inventory Monitor inventory levels Determine when to replenish inventories Calculate order or production quantities

Inventory System Design

Repetition Single-order (one-time

buy) Multiple orders

Supply source External supply (purchase) Internal supply (produce)

Certainty of demand Deterministic Stochastic

Pattern of demand Constant demand Time-varying demand Dependent demand

Knowledge of leadtime Constant (certain) Stochastic (random)

Inventory Review Continuous (perpetual) Periodic

Inventory System Taxonomy