1. CHAPTER 7 INVENTORY MANAGEMENT
Principles of Supply Chain Management: A Balanced Approach
Prepared by Daniel A. Glaser-Segura, PhD

2. © 2009 South-Western, a division of Cengage Learning
Learning Objectives
You should be able to:
Distinguish dependent from independent demand inventories.
Describe the four basic types of inventories & their functions.
Understand the costs of inventory & inventory turnovers.
Understand ABC classification, ABC inventory matrix & cycle counting.
© 2009 South-Western, a division of Cengage Learning

3. Learning Objectives (Cont.)
Know RFID & how it can be used in inventory management.
Understand the EOQ model & its underlying assumptions.
Understand the Quantity Discounts & the EMQ Models & their relationships with the basic EOQ model.
Understand & able to distinguish among the various statistical ROP models.
Describe the continuous review & periodic review systems.
© 2009 South-Western, a division of Cengage Learning

4. © 2009 South-Western, a division of Cengage Learning
Chapter Seven Outline
Dependent Demand & Independent Demand
Concepts & Tools of Inventory Management
The Functions & Basic Types of Inventory
Inventory Costs
Inventory Investment
The ABC Inventory Control System
Radio Frequency Identification
© 2009 South-Western, a division of Cengage Learning

5. Chapter Seven Outline (Cont.)
Inventory Models
The Economic Order Quantity Model The Quantity Discount Model
The Economic Manufacturing Quantity Model
The Statistical Reorder Point
The Continuous Review System versus the Periodic Review System
The Continuous Review System
The Periodic Review System
© 2009 South-Western, a division of Cengage Learning

6. © 2009 South-Western, a division of Cengage Learning
Introduction
Inventory can be one of the most expensive assets of an organization
Inventory may account for more than 10% of total revenue or 20% of total assets
Management must reduce inventory levels yet avoid stockouts and other problems
This chapter will discuss:
Dependent & independent demand
Tools for managing inventory
Basic types of inventories
Various inventory management approaches
© 2009 South-Western, a division of Cengage Learning

7. Matching Supply & Demand
Suppliers must accurately forecast demand so they can produce & deliver the right quantities at the right time at the right cost.
Suppliers must find ways to better match supply & demand to achieve optimal levels of cost, quality, & customer service to enable them to compete with other supply chains.
Problems that affect product & delivery will have ramifications throughout the chain.
© 2009 South-Western, a division of Cengage Learning

8. Dependent & Independent Demand
Inventory management models are generally classified as dependent demand and independent demand models.
Dependent Demand
Describes the internal demand for parts based on the demand of the final product in which the parts are used. Subassemblies, components, & raw materials are examples of dependent demand items.
Independent Demand
The demand for final products & has a demand pattern affected by trends, seasonal patterns, & general market conditions.
© 2009 South-Western, a division of Cengage Learning

9. Concepts and Tools of Inventory Management
Functions and Basic Types of Inventory
The primary functions of inventory are to:
Buffer uncertainty in the marketplace &
Decouple dependencies in the supply chain (e.g., safety stock)
Four broad categories of inventories
Raw materials- unprocessed purchase inputs.
Work-in-process (WIP)- partially processed materials not yet ready for sales.
Finished goods- products ready for shipment.
Maintenance, repair & operating (MRO)- materials used in production (e.g., cleaners & brooms).
© 2009 South-Western, a division of Cengage Learning

10. Concepts and Tools of Inventory Management (Cont.)
Inventory Costs
Direct costs- directly traceable to unit produced (e.g., labor)
Indirect costs- cannot be traced directly to the unit produced (e.g., overhead)
Fixed costs- independent of the output quantity (e.g, buildings, equipment, & plant security)
Variable costs- vary with output level (e.g., materials)
Order costs- direct variable costs for making an order. In mfg, setup costs are related to machine setups
Holding or carrying costs- incurred for holding inventory in storage
© 2009 South-Western, a division of Cengage Learning

11. Concepts and Tools of Inventory Management (Cont.)
Inventory Investment
Firms should diligently measure inventory investment to ensure that it does not adversely affect competitiveness. Measures include:
Absolute value of inventory (found on balance sheet)
Inventory turnover or turnover ratio- how many times inventory “turns” in an accounting period. Faster is better!
Cost of Revenue
Average Inventory
Inventory Turnover Ratio =
© 2009 South-Western, a division of Cengage Learning

12. Concepts and Tools of Inventory Management (Cont.)
ABC Inventory Control System
Determines which inventories should be counted & managed more closely than others
Groups inventory as A, B, & C Items
A items are given the highest priority with larger safety stocks. A items, which account for approximately 20 % of the total items, are about 80 % of the total inventory cost
B & C account for the other 80% of total items & only 20% of costs. The B items require closer management since they are relatively more expensive (per unit), require more effort to purchase/make, & may be more prone to obsolescence
C items have the lowest priority
© 2009 South-Western, a division of Cengage Learning

13. Concepts and Tools of Inventory Management (Cont.)
The ABC Inventory Matrix (Fig. 7.1)
© 2009 South-Western, a division of Cengage Learning

14. Concepts and Tools of Inventory Management (Cont.)
Radio Frequency Identification (RFID)
Successor to the barcode for tracking individual unit of goods. RFID does not require direct line of sight to read a tag and information on the tag is updatable.
(See Fig. 7.4)
© 2009 South-Western, a division of Cengage Learning

15. © 2009 South-Western, a division of Cengage Learning
Inventory Models
The Economic Order Quantity (EOQ) Model
A quantitative decision model based on the trade-off between annual inventory holding costs & annual order costs.
The EOQ model seeks to determine an optimal order quantity, where the sum of the annual order cost & the annual inventory holding cost is minimized.
Order Cost is the direct variable cost associated with placing an order.
Holding Cost or carrying cost is the cost incurred for holding inventory in storage.
© 2009 South-Western, a division of Cengage Learning

16. Inventory Models (Cont.)
Assumptions of the EOQ Model
Demand must be known & constant.
Delivery time is known & constant.
Replenishment is instantaneous.
Price is constant.
Holding cost is known & constant.
Ordering cost is known & constant.
Stock-outs are not allowed.
© 2009 South-Western, a division of Cengage Learning

17. Inventory Models (Cont.)
EOQ Model (Fig. 7.5)
© 2009 South-Western, a division of Cengage Learning

18. Inventory Models (Cont.)
Physical inventory & relationships of EOQ, average inventory, lead time, reorder point, & order cycle (Fig. 7.6)
© 2009 South-Western, a division of Cengage Learning

19. Inventory Models (Cont.)
The Quantity Discount Model or price-break model
Relaxes the constant price assumption by allowing purchase quantity discounts.
Considers the tradeoff between purchasing in large quantity to take advantage of the price discount and issuing fewer orders, against holding higher inventory.
Due to the step-wise shape of the total inventory cost curve, the optimal order quantity lies on either one of the feasible EOQs or at the price break point.
© 2009 South-Western, a division of Cengage Learning

20. Inventory Models (Cont.)
Quantity Discount Model (Fig. 7.7)
© 2009 South-Western, a division of Cengage Learning

21. Inventory Models (Cont.)
The Economic Manufacturing Quantity Model or Production Order Quantity Model
Relaxes the instantaneous replenishment assumption by allowing usage during production or partial delivery.
The EMQ model is especially appropriate for a manufacturing environment with simultaneous manufacture and consumption
Inventory builds up gradually during the production period rather than at once as in the EOQ model.
© 2009 South-Western, a division of Cengage Learning

22. Inventory Models (Cont.)
The EMQ Model (Fig. 7.9)
© 2009 South-Western, a division of Cengage Learning

23. Inventory Models (Cont.)
The Statistical Reorder Point (ROP)
The lowest inventory level at which a new order must be placed to avoid a stockout.
Demand and delivery lead time are never certain and require safety stock.
The models used under uncertainty are:
Statistical ROP with Probabilistic Demand and Constant Lead Time
The Statistical ROP with Constant Demand and Probabilistic Lead Time
The Statistical ROP when Demand and Lead Time are both Probabilistic
© 2009 South-Western, a division of Cengage Learning

24. Inventory Models (Cont.)
The Continuous Review System versus The Periodic Review System
Order quantity & ROP models assume that the physical inventory is precisely known at every point in time
Reality shows that stock records and actual quantity are different & requires continuous review of inventory to determine when to reorder
A Continuous Review System is costly to conduct but requires less safety stock than the
The Periodic Review System, which reviews physical inventory at specific points in time and requires higher level of safety stock
© 2009 South-Western, a division of Cengage Learning