role of inventory in the supply chain 1224840859246394 8

7/29/2019 Role of Inventory in the Supply Chain 1224840859246394 8

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Role of Inventory in theSupply Chain

Overstocking: Amount available

exceeds demand

Liquidation, Obsolescence, Holding

Understocking: Demand exceeds

amount available

Lost margin and future sales

Goal: Matching supply and demand


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Understanding Inventory

The inventory policy is affected by:

Demand Characteristics

Lead Time

Number of Products Objectives

Service level

Minimize costs

Cost Structure


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Cost Structure

Order costs

Fixed

Variable

Holding Costs

Insurance

Maintenance and Handling

Taxes

Opportunity Costs

Obsolescence


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EOQ: A View of Inventory*

Time

Inventory

Order

Size

Note:

No Stockouts

Order when no inventory

Order Size determines policy

Avg. Inventory


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EOQ:Total Cost*

0

20

40

60

80

100

120

140

160

0 500 1000 1500

Order Quantity

Cost

Total Cost

Order Cost

Holding Cost


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EOQ: Calculating TotalCost*

Purchase Cost Constant

Holding Cost: (Avg. Inven) * (HoldingCost)

Ordering (Setup Cost):Number of Orders * Order Cost

Goal: Find the Order Quantity thatMinimizes These Costs:


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Fixed costs: Optimal Lot Size and

Reorder Interval (EOQ)

R: Annual demandS: Setup or Order

Cost

C: Cost per unit

h: Holding cost peryear as afraction ofproduct cost

H: Holding cost perunit per year

Q: Lot Size

T: Reorder intervalRHST

HRSQ

hCH

2

2


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Example

Demand, R = 12,000 computersper year

Unit cost, C = $500

Holding cost, h = 0.2Fixed cost, S = $4,000/order

Q = 980 computersCycle inventory = Q/2 = 490

Flow time = Q/2R = 0.49 month

Reorder interval, T = 0.98 month


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EOQ: Another Example

Book Store Mug Sales

Demand is constant, at 20 units a week

Fixed order cost of $12.00, no lead time

Holding cost of 25% of inventory valueannually

Mugs cost $1.00, sell for $5.00

QuestionHow many, when to order?


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EOQ: ImportantObservations*

Tradeoffbetween set-up costs andholding costs when determining orderquantity. In fact, we order so that these

costs are equal per unit time Total Cost is not particularly sensitive

to the optimal order quantity

Order Quantity 50% 80% 90% 100% 110% 120% 150% 200%

Cost Increase 125% 103% 101% 100% 101% 102% 108% 125%


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The Effect ofDemand Uncertainty

Most companies treat the world as if it werepredictable:

Production and inventory planning are based onforecasts of demand made far in advance of the selling

season Companies are aware of demand uncertainty when they

create a forecast, but they design their planning processas if the forecast truly represents reality

Recent technological advances have increasedthe level of demand uncertainty:

Short product life cycles

Increasing product variety


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Example: SnowTime Sporting Goods

Fashion items have short life cycles,high variety of competitors

SnowTime Sporting Goods

New designs are completed One production opportunity

Based on past sales, knowledge of theindustry, and economic conditions, the

marketing department has a probabilisticforecast

The forecast averages about 13,000, butthere is a chance that demand will be

greater or less than this.


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SnowTime DemandScenarios

Demand Scenarios

0%

5%

10%

15%

20%

25%30%

8000

1000

0

1200

0

1400

0

1600

0

1800

0

Sales

Probability


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SnowTime Costs

Production cost per unit (C): $80

Selling price per unit (S): $125

Salvage value per unit (V): $20

Fixed production cost (F): $100,000 Q is production quantity, D demand

Profit =Revenue - Variable Cost - Fixed Cost+ Salvage


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SnowTime Scenarios

Scenario One:

Suppose you make 12,000 jackets anddemand ends up being 13,000 jackets.

Profit = 125(12,000) - 80(12,000) - 100,000= $440,000

Scenario Two:

Suppose you make 12,000 jackets anddemand ends up being 11,000 jackets.

Profit = 125(11,000) - 80(12,000) - 100,000

+ 20(1000) = $ 335,000


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SnowTime Best Solution

Find order quantity that maximizesweighted average profit.

Question: Will this quantity be lessthan, equal to, or greater thanaverage demand?


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(s, S) Policies

For some starting inventory levels, it is better tonot start production

If we start, we always produce to the same level

Thus, we use an (s,S) policy. If the inventorylevel is below s, we produce up to S.

s is the reorder point, and S is the order-up-tolevel

The difference between the two levels is drivenby the fixed costs associated with ordering,transportation, or manufacturing


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Notation

AVG = average daily demand

STD = standard deviation of daily demand

LT = replenishment lead time in days

h = holding cost of one unit for one day SL = service level (for example, 95%). This

implies that the probability of stocking out is100%-SL (for example, 5%)

Also, the Inventory Position at any time is theactual inventory plus items already ordered, butnot yet delivered.


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Analysis

The reorder point has two components:

To account for average demand during lead time:LTAVG

To account for deviations from average (we call this

safety stock)z STD LT

where z is chosen from statistical tables to ensure thatthe probability of stockouts during leadtime is100%-SL.


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Example

The distributor has historically observed weeklydemand of:

AVG = 44.6 ; STD = 32.1Replenishment lead time is 2 weeks, and desired

service level SL = 97% Average demand during lead time is:

44.6 2 = 89.2

Safety Stock is:

1.88 32.1 2 = 85.3

Reorder point is thus 175, or about 3.9 weeks ofsupply at warehouse and in the pipeline


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Model Two:Fixed Costs*

In addition to previous costs, a fixed cost K ispaid every time an order is placed.

We have seen that this motivates an (s,S) policy,where reorder point and order quantity aredifferent.

The reorder point will be the same as theprevious model, in order to meet meet theservice requirement:

s = LTAVG + z AVG L What about the order up to level?


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Model Two:The Order-Up-To Level*

We have used the EOQ model to balance fixed,variable costs:

Q=(2 K AVG)/h If there was no variability in demand, we would

order Q when inventory level was at LT AVG.Why?

There is variability, so we need safety stockz AVG * LT

The total order-up-to level is:S=max{Q, [LT AVG+ z AVG * LT]}


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Model Two: Example*

Consider the previous example, but with thefollowing additional info:

fixed cost of $4500 when an order is placed

$250 product cost

holding cost 18% of product

Weekly holding cost:h = (.18 250) / 52 = 0.87

Order quantity

Q=(2 4500 44.6 / 0.87 = 679 Order-up-to level:

s + Q = 85 + 679 = 765


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What to Make?

Question: Will this quantity beless than, equal to, or greater thanaverage demand?

Average demand is 13,100 Look at marginal cost Vs. marginal

profit

if extra jacket sold, profit is 125-80 =45

if not sold, cost is 80-20 = 60

So we will make less than average


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SnowTime Expected Profit

Expected Profit

$0

$100,000

$200,000

$300,000

$400,000

8000 12000 16000 20000

Order Quantity

Profit


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SnowTime Expected Profit

Expected Profit

$0

$100,000

$200,000

$300,000

$400,000

8000 12000 16000 20000

Order Quantity

Profit


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SnowTime:Important Observations

Tradeoff between ordering enough tomeet demand and ordering too much

Several quantities have the same average

profit Average profit does not tell the whole

story

Question: 9000 and 16000 unitslead to about the same averageprofit, so which do we prefer?


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Key Points from this Model The optimal order quantity is not

necessarily equal to average forecastdemand

The optimal quantity depends on the

relationship between marginal profitand marginal cost

As order quantity increases, averageprofit first increases and then decreases

As production quantity increases, riskincreases. In other words, theprobability of large gains andof large

losses increases


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Initial Inventory

Suppose that one of the jacket designs isa model produced last year.

Some inventory is left from last year

Assume the same demand pattern asbefore

If only old inventory is sold, no setup cost

Question: If there are 7000 unitsremaining, what should SnowTime do?What should they do if there are 10,000

remaining?


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Initial Inventory and Profit

0

100000

200000

300000

400000

500000

5000

6500

8000

9500

1100

0

1250

0

1400

0

1550

0

Production Quantity

Profit


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Periodic Review Policy

Each review echelon, inventoryposition is raised to the base-stocklevel.

The base-stock level includes twocomponents:

Average demand during r+L days (the

time until the next order arrives):(r+L)*AVG

Safety stock during that time:

z*STD*r+L


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Inventory Management: BestPractice

Periodic inventory review policy(59%)

Tight management of usage rates,lead times and safety stock (46%)

ABC approach (37%)

Reduced safety stock levels (34%)

Shift more inventory, or inventoryownership, to suppliers (31%)

Quantitative approaches (33%)


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Inventory Management: BestPractice

Periodic inventory reviews

Tight management of usage rates,lead times and safety stock

ABC approach

Reduced safety stock levels

Shift more inventory, or inventoryownership, to suppliers

Quantitative approaches

Ch I I t


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Changes In InventoryTurnover

Inventory turnover ratio =annual sales/avg. inventory

level

Inventory turns increased by 30%from 1995 to 1998

Inventory turns increased by 27%

from 1998 to 2000 Overall the increase is from 8.0 turns

per year to over 13 per year over afive year period ending in year 2000.


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Industry UpperQuartile

Median LowerQuartile

Dairy Products 34.4 19.3 9.2

Electronic Component 9.8 5.7 3.7

Electronic Computers 9.4 5.3 3.5

Books: publishing 9.8 2.4 1.3

Household audio &video equipment

6.2 3.4 2.3

Household electricalappliances

8.0 5.0 3.8

Industrial chemical 10.3 6.6 4.4

Inventory Turnover Ratio

F t th t D i R d ti


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Factors that Drive Reductionin Inventory

Top management emphasis on inventoryreduction (19%)

Reduce the Number of SKUs in the

warehouse (10%) Improved forecasting (7%)

Use of sophisticated inventory

management software (6%) Coordination among supply chain

members (6%)

Other


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Factors that Drive Inventory TurnsIncrease

Better software for inventory management(16.2%)

Reduced lead time (15%)

Improved forecasting (10.7%) Application of SCM principals (9.6%)

More attention to inventory management

(6.6%) Reduction in SKU (5.1%)

Others

role of inventory in the supply chain 1224840859246394 8

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