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Inventory Management II: Inventory Metrics This module covers calculating demand, simple forecasting, average aggregate inventory, inventory turnover, bullwhip effect, and the impact of inventory management on financial metrics. Authors: Stu James and Robert Robicheaux © 2013 Stu James and Management by the Numbers, Inc.

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Calculating Demand Simple Forecasting Average Aggregate Inventory Value Inventory Turnover (Inventory Turns) Bullwhip or Whiplash Effect Impact of Inventory Management on Financial Metrics T OPICS C OVERED 2 Topics Covered MBTN | Management by the Numbers This MBTN Module introduces the fundamentals of inventory management including:

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C ALCULATING D EMAND 3 Calculating Demand MBTN | Management by the Numbers In Inventory Management I, we used demand in several calculations. Now lets describe how one would calculate demand itself and then cover some simple forecasting techniques using only historical demand. Lets start with how to calculate demand using information typically available to an inventory manager. Definitions Demand p = Starting Inventory p +Purchases Received p –Ending Inventory p Where p = appropriate time period (year, month, etc.) Question 1a: Siva wants to calculate last years demand for heating coils for his business. The starting inventory on Jan 1 was 35 and during the year there were 2 purchases of 250 coils each. Ending inventory on Dec 31 st was 70 units. What was demand for last year?

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C ALCULATING D EMAND 4 Calculating Demand MBTN | Management by the Numbers Answer: Demand = Starting + Purchases – Ending = * 2 – 75 = 465 There are two additional considerations when calculating demand. The first is backorders. A backorder is a customer order that has been received, but has not yet been fulfilled. Backorders can inflate or deflate demand depending on when they are fulfilled. The second consideration is to not include purchases ordered but not yet received. Lets quickly consider an example where these factors would need to be considered. Question 1b: Sivas manager, Shaila, checked the calculation and realized that a backorder of 50 units from the previous year was fulfilled early in the year and there is currently a backorder of 125 units. Also, the 2 nd order for 250 units had not yet been received and added to inventory. What is the demand when adjusted for these factors?

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C ALCULATING D EMAND 5 Calculating Demand MBTN | Management by the Numbers Answer: Demand = Starting + Purchases - Ending Since the 2 nd order had not yet been received into inventory, purchases only equals 250 units. Backorders are a little trickier. Strictly speaking, the backorder for 50 fulfilled at the beginning of the year should not be included, but we do need to include the current backorder for 125 units as that demand fell in the current year, but could not be fulfilled due to insufficient inventory. Adjusting for these factors leads to: Demand = Starting + Purchases – Ending = – = 290 Notice that this is a significant difference from Sivas original calculation. A case could also be made on the backorders that they are instead special orders and not part of normal demand, and therefore neither should be counted. This is a managerial decision.

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C ALCULATING D EMAND 6 Calculating Demand MBTN | Management by the Numbers You may also want to convert annual demand into monthly, weekly or daily demand depending on the circumstances. This is easily done as shown in the definitions below. Definitions Weekly Demand (from Annual Demand) = Annual Demand / 52 Monthly Demand (from Annual Demand) = Annual Demand / 12 Daily Demand (from Annual Demand) = Annual Demand / 365 Daily Demand (from Annual Demand) = Annual Demand / 250 (use 365 for calendar days, 250 for business days) Question 1c: What is the daily demand based on business days for the heating coils if annual demand is 290 units? Answer: Daily Demand = Annual Demand / 250 (for Business Days) = 290 / 250 = 1.16 units / day

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S IMPLE F ORECASTING 7 Simple Forecasting MBTN | Management by the Numbers Ideally, when we use demand in our calculations for things such as the appropriate amount to order, when to reorder, etc., we are actually more interested in future demand than historical demand. Though the future is usually unknown, we may be asked to use a forward looking estimate. This would be called a forecast of demand. Lets consider two simple methods of forecasting demand using historical growth – one based on percentage growth and the second based on unit growth. Note that demand could be provided in units or currency. Definitions Forecast p+1 (based on unit growth) = Demand p + Unit Growth Forecast p+1 (based on % growth) = Demand p * (1 + Growth%) Where p = appropriate time period (year, month, etc.)

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S IMPLE F ORECASTING 8 Simple Forecasting MBTN | Management by the Numbers Answer: Unit Growth = 290 – 210 = 80 units % Growth = 80 / 210 = 38% Forecast (Units) = = 370 units Forecast (%) = 290 * (1 +.38) = 400 units Question 2a: Shaila asks Siva to calculate two forecasts for the heating coils, one based on % growth and one based on unit growth. We know that demand was 290 units for last year. The previous year was 210 units. Calculate the two forecasts. Sometimes, especially when an item is a subassembly, the appropriate way to forecast is to apply the forecast from the final assembly (or assemblies if an item is used in multiple products). Lets consider an example of when this would be appropriate.

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S IMPLE FORECASTING 9 Simple Forecasting MBTN | Management by the Numbers Answer: Forecast = XF1 + 2 * XF2 + Spare Parts = * = 430 units Question 2b: Shaila tells Siva that the heating coil is used as a component part in two air control systems, the XF1 and the XF2. In addition, they anticipate needing 50 units for spare parts. Marketing has provided a forecast of 180 units for the XF1 and 100 units for the XF2. The XF2 uses two heating coils in each system. What should the forecast for the heating coils be based on this new information? Insight Often marketing will have more insight into future demand patterns than could be predicted using historical demand alone. However, using past growth rates to forecast demand can also provide a quick check on forecasts provided by others. If there is a large difference, it may be worthwhile for management to check the rationale.

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B ULLWHIP E FFECT 10 Bullwhip Effect MBTN | Management by the Numbers Because demand is rarely perfectly stable, companies forecast to properly position inventory and other resources. Since forecasts are often based on statistical estimates, they are rarely perfectly accurate. As we know, due to this variability in demand and forecast error, companies carry an inventory buffer called "safety stock". Sometimes, a missed due date or stock-out may cascade downstream, affecting the supply chain. This phenomenon is know as the bullwhip effect. This is graphically depicted to the right.

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B ULLWHIP E FFECT 11 Bullwhip Effect MBTN | Management by the Numbers Proctor and Gamble (P&G) executives coined the term after studying the demand for disposable diapers. As expected, babies used diapers at a fairly steady and predictable rate, and retail sales were quite uniform. But, P&G found that each retailer based orders on a slightly exaggerated forecast, thereby distorting the information about real demand. Wholesalers' orders to the P&G diaper factory fluctuated even more. And P&Gs orders to 3M and other materials suppliers fluctuated even more. Notice how a small rise in consumer demand launched series of over adjustments through the channel. Especially look at consumer demand relative to the wholesaler and manufacturer orders.

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B ULLWHIP E FFECT 12 Bullwhip Effect MBTN | Management by the Numbers Moving up the supply chain from end-consumer to raw materials supplier, each supply chain participant has greater observed variation in demand and thus greater need for safety stock. In periods of rising demand, down-stream participants will increase their orders. In periods of falling demand, orders will fall or stop to reduce inventory. Variations are amplified as one moves upstream in the supply chain (further from the customer). This effect is especially strong in a supply chain where the suppliers have few (or only one) customer.

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K ANBAN S YSTEM 13 Kanban System MBTN | Management by the Numbers To eliminate the bullwhip effect, suppliers throughout the supply chain can coordinate their orders based on actual end-customer orders. This is especially effective where there is a single retailer buying from suppliers in the chain, as it is easier to coordinate. This approach is called Kanban, and an excellent example of its implementation would be Wal-Marts distribution system. Insight The result is near-perfect visibility of customer demand and inventory movement throughout the supply chain. Better information leads to better inventory position and lower costs throughout the supply chain. Stores transmit point-of-sale (POS) data from cash register to corporate several times a day. Information used to queue shipments from: Wal-Mart distribution center to the store The supplier to the Wal-Mart distribution center.

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A VERAGE A GGREGATE I NVENTORY V ALUE 14 Average Aggregate Inventory Value MBTN | Management by the Numbers The value of all inventory held is called the aggregate inventory value. This would also represent the value of inventory on the balance sheet. The average value of this over the course of a year would be considered the Average Aggregate Inventory Value. Definitions Avg. Agg. Inventory Value = Avg. Units Item A * Value Item A + Avg. Units Item B * Value Item B + … + Avg. Units Item Z * Value Item Z Where Avg. Unit Item A = Average inventory level in units for Item A, and Value Item A = Value (at cost) basis for Item A. Insight Manufacturing firms typically have about 25% of their assets tied up in inventory, whereas retailers have approximately 75%. These are rough estimates, and one should consider peer companies to determine best practices.

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W EEKS OF S UPPLY AND I NVENTORY T URNOVER 15 Weeks of Supply and Inventory Turnover MBTN | Management by the Numbers Two measures that managers use to judge performance of inventory management are Weeks of Supply (or potentially, days) and Inventory Turnover. Both measures describe inventory levels relative to sales at cost and incorporate the element of time. Definitions Weeks of Supply = Inventory Turnover = Average Aggregate Inventory Weekly Sales (at Cost) Annual Sales (at Cost) Average Aggregate Inventory Value Insight As weeks of supply decreases, fewer assets are tied up in inventory. As inventory turnover increases, fewer assets are tied up in inventory. These two measures move together, but in opposite directions.

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A VERAGE A GGREGATE I NVENTORY V ALUE 16 Average Aggregate Inventory Value MBTN | Management by the Numbers Question 3a: A business analyzes its inventoried items and finds the following average inventory levels and associated unit costs. What is the average aggregate inventory value for the company? Item Average Inventory (Units) Unit CostAverage Inventory Value 144C 2,500 $ $ 217, B 1,250 $ $ 150, XY5,000 $ 5.00 $ 25, Q2,000 $ $ 20, I 150 $ $ 7, UFO31,000 $ 5.00 $ 5, T 125 $ $ 1, Y 11,000 $ 0.10 $ 1, ROF3250 $ 2.00 $ C400 $ 1.25 $

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A VERAGE A GGREGATE I NVENTORY V ALUE 17 Average Aggregate Inventory Value MBTN | Management by the Numbers Item Average Inventory (Units) Unit CostAverage Inventory Value 144C 2,500 $ $ 217, B 1,250 $ $ 150, XY5,000 $ 5.00 $ 25, Q2,000 $ $ 20, I 150 $ $ 7, UFO31,000 $ 5.00 $ 5, T 125 $ $ 1, Y 11,000 $ 0.10 $ 1, ROF3250 $ 2.00 $ C400 $ 1.25 $ Answer: First multiply the average inventory levels for the year by the unit costs as shown below. Then sum the average inventory value for all the parts. The total of the average inventory values is $428,600.00, which therefore is the average aggregate inventory value.

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W EEKS S UPPLY AND I NVENTORY T URNOVER 18 Weeks Supply and Inventory Turnover MBTN | Management by the Numbers Question 3b: Given that the average aggregate inventory value is $428,600, what is the weeks supply and inventory turns for the company if the weekly sales at costs are $55,000 and the annual revenues are $11.44 million? The accounting department tells us that COGS are 25% of sales. Answer: Weeks Supply = AAIV / Weekly Sales (at Cost) = $428,600 / $55,000 = 7.79 weeks Annual Sales (at cost) = $11,440,000 *.25 = $2,860,000 - or – = 52 weeks * $55,000 = $2,860,000 Inventory Turnover = Annual Sales / AAIV = $2,860,000 / $428,600 = 6.67 Turns Insight Quick check: Weeks supply * inventory turns must equal 52. Does it?

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H OW I NVENTORY I MPACTS F INANCIAL M EASURES 19 How Inventory Impacts Financial Measures MBTN | Management by the Numbers Lets take a quick look at how inventory management impacts key financial measures: Return on Assets – By reducing inventory levels, total assets will decrease, thereby increasing ROA. If inventory management costs can be reduced, ROA will also increase. However, management must not sacrifice customer service levels that may impact satisfaction or sales. Working Capital – Reducing weeks supply or increasing inventory turns will improve working capital. Note that reducing lead times also improves this metric. Cash Flow – Reducing the amount of time between when a company purchases an item and when the company sells the end- product or service improves cash flow as well.

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Please see MBTN Inventory Management modules 1, 3 and 4 that cover other important concepts related to this module. I NVENTORY M ANAGEMENT – F URTHER R EFERENCE 20 Inventory Management - Further Reference MBTN | Management by the Numbers

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