1. Chapter 9- Inventory Fundamentals
IM417 Manufacturing Resources Analysis
Southeast Missouri State University
Compiled by Bart Weihl
Spring 2001

2. Inventory Fundamentals
Materials and supplies that a business or institution carries either for sale or to provide inputs or supplies to the production process
Represents between 20 to 60% of assets

3. Inventory Fundamentals
Aggregate Inventory Management
Managing inventories according to their classification rather than at the individual item level.
Generally involves:
Flow and kinds of inventory needed
Supply and demand patterns
Functions that inventories perform
Objectives of inventory management
Costs associated with inventories

4. Inventory Fundamentals
Item Inventory Management
The organization must establish some decision rules about inventory items for overall direction.
Rules include:
Which inventory items are most important
How individual items are to be controlled
How much to order at one time
When to place an order

5. Inventory Fundamentals
Inventory and the Flow of Material
Raw materials
Purchased items received which have not entered the production process
Work-in-process
Raw materials that have entered the manufacturing process and are being worked on or waiting to be worked on

6. Inventory Fundamentals
Inventory and the Flow of Material
Finished Goods
Finished products of the production process that are ready to be sold as completed items.
Distribution inventories
Finished goods located in the distribution system
Maintenance, Repair, and Operational Supplies (MRO)
Items used in production that do not become part of the product

7. Inventory Fundamentals
Supply and Demand Patterns
Demand for many products is not constant enough to set up a flow system
Many products are made in lots or batches
Work moves in lots from one workstation or process to another as determined by the routings

8. Inventory Fundamentals
Function of Inventories
In batch manufacturing, the basic purpose of inventories is to decouple supply and demand
Inventory serves as a buffer between:
Supply and demand
Customer demand and finished goods
Operations
Suppliers and queues

9. Inventory Fundamentals
Function of Inventories
Anticipation inventory
Inventory built up in anticipation of future demand
Fluctuation Inventory
Inventory held to cover random unpredictable fluctuations in supply and demand or lead time

10. Inventory Fundamentals
Function of Inventories
Lot-size Inventory
Also called cycle stock
Items purchased or manufactured in quantities greater than immediately needed.
Allows the firm to take advantage of quantity discounts and to reduce shipping, clerical, and setup costs

11. Inventory Fundamentals
Function of Inventories
Transportation Inventory
Also called pipeline or movement inventories
Inventory in transit because of the time to move goods from one location to another
MROs
Used to support general operations and maintenance, but do not become part of the product

12. Example: Transportation Inventory
Q: A company is using a carrier to deliver goods to a major customer. The annual demand is $5,000,000, and the average transit time is 8 days. Another carrier promises to deliver in 6 days. What is the reduction in transit inventory?
A: Average annual inventory in transit (I) = tA/365
Where t = transit time in days (8 - 6 = 2 days)
A = annual demand ($5,000,000)
I = (2 X $5,000,000) / 365
I = $27,397.26

13. Inventory Fundamentals
Inventory Management
Responsible for planning and controlling inventory from raw material to customer.
Objectives:
Maximize customer service
Low-cost plant operations
Minimum inventory investment

14. Inventory Fundamentals
Customer Service
The ability of a company to satisfy the needs of customers.
The availability of items needed
Inventories help to maximize customer service by protecting against uncertainty

15. Inventory Fundamentals
Operating Efficiency
Inventory helps manufacturing to be more productive by:
Allowing operations with different rates of production to operate separately.
Assist with production planning and production leveling through lower costs.
Allowing for longer production runs
Allowing the purchase of larger quantities

16. Inventory Fundamentals
Operating Efficiency
Inventory investment must be balanced with:
Customer service
Cost of changing production levels
Cost of placing orders
Transportation costs
If inventory is carried there must be a benefit that exceeds the costs of carrying that inventory.

17. Inventory Fundamentals
Inventory Costs
Item Cost
Price paid plus other direct costs associated with getting the time into the plant
Carrying Costs
All the expenses incurred by the firm because of the volume of inventory carried.
Capital costs
Storage costs
Risk costs

18. Inventory and Bottom-Line Profits
Excess inventory* has a negative impact on cash flow.
Carrying costs include warehousing, racking, shelving, interest costs and insurance premiums (typically represents 8% to 14% of inventory costs).
Reduction in inventory can apply 10% to the bottom line.
Slow moving, or obsolete, inventory reduces profits with financial reserves and possible write-offs.
*Excess Inventory: On-hand balances in excess of the amount
needed to support demand

19. Example: Carrying Costs
Q: A bakery carries an average inventory of $15,000. If they estimate the cost of capital is 10%, storage costs are 5%, and the risk costs are 8%, what does it cost per year to carry this inventory?
A: Total cost of carrying inventory = 10% + 5% + 8%
= 23%
Annual cost of carrying inventory = 0.23 X $15,000
= $3,450

20. Inventory Fundamentals
Inventory Costs
Ordering Costs
Costs associated with placing an order either with the factory or a supplier.
Cost of placing an order does not depend on quantity ordered.
Annual ordering costs depend on the number of orders placed per year.
Ordering costs would include:
Production control costs
Setup and teardown costs
Lost capacity cost
Purchase order cost

21. Example: Ordering Costs
Q: Annual purchasing salaries are $85,000, operating expenses for the purchasing department are $35,000, and inspecting and receiving costs are $30/order. If the purchasing department places 12,000 orders/year, what is the average cost of ordering? What is the annual cost of ordering?
A: Average ordering cost = (fixed costs / number of orders) + variable cost
= (($85,000 + $35,000) / 12,000) + $30
= $40
Annual ordering cost = (Average ordering cost)(number of orders)
= ($40)(12,000)
= $480,000

22. Inventory Fundamentals
Inventory Costs
Stockout Costs
Stockouts occur when demand during leadtime exceeds the forecast.
Could include back-order costs, lost sales and customers
Capacity Associated Costs
Costs associated with changing the level of output
Overtime, hiring, training, shifts, layoffs…..etc

23. Inventory Fundamentals
Financial Performance Measures
Inventory Turns Ratio:
Inventory Turns = Annual COGS/Avg. Inventory $
Widely used as a measure of inventory performance
Lumps all inventory together thereby hiding obsolete and slow movers
Between 1977 and 1997, typical US high-tech manufacturer nearly doubled its inventory performance – from 2.4 to 4.8 turns/year*
*1998 PRTM study

24. Example: Inventory Turns
Q: What will be the inventory turns if the annual cost of goods sold is $32 million a year and the average inventory is $8 million?
A: Inventory turns = annual cost of goods sold / average inventory in $
= $32,000,000 / $8,000,000
= 4
Q: What would be the reduction in inventory if inventory turns were increased to 8 times per year? If the carrying costs for inventory is 25%, what are the projected savings?
A: Average Inventory= annual cost of goods sold / inventory turns
= 32,000,000 / 8
= $4,000,000
Reduction in inventory = $8,000,000 - $4,000,000 = $4,000,000
Savings = Inventory reduction X 25% = $4,000,000 X 0.25 = $1,000,000

25. Inventory Fundamentals
ABC Inventory Control
A scheme where inventory is classified by level of importance in terms of annual sales dollars.
Based on Pareto’s Law:
A items: 20% of items accounts for 80% of usage
B items: 30% of items account for 15% of usage
C items: 50% of items account for 5% of usage

26. Inventory Fundamentals
ABC Analysis
Establish item characteristics
Usually annual dollar usage
Classify items into groups based on criteria
Apply control appropriate to classification

27. Inventory Fundamentals
Control Based on ABC Classification
Have plenty of low-value items
Use the money and control effort saved to reduce the inventory of high-value items
A items get the tightest control and attention
B items get normal controls
C items get simple controls

28. Inventory Quality Ration (IQR)
Developed by materials managers from 35 companies.
Collectively reduced inventories by $500M in two years.
Implementation typically reduces inventories of manufacturing and distribution companies by an average of 25%.

29. Inventory Quality Ration (IQR)
A true dollar-based performance measure includes:
Establishing inventory classes (based on $ Rqmts.)
Setting target inventory levels
Measuring the dollars invested in inventory
Establishing specific inventory objectives
Analyzing the data
Continuously improve

30. IQR Logic and Methodology
Use ABC-type classifications using
Future dollar requirements
Past dollar usage
Current balances on hand
Establish a rule or target balance for each item
Group inventory
Active (A)
Excess (E)
Slow moving (SM)
No moving (NM)
Future Requirements
Recent Past Usage
Neither

31. IQR and its Effects IQR = =
Perfect condition (i.e., no excess, slow moving or no moving inventories), the IQR = 100%
Average IQR = 30% – 45% range
A1 + A2
Active $
A1 + A2 + E1 + E2 + SM + NM
Total $

32. For Next Week. . .
Do Problems:
9.1
9.3
9.5
9.7
9.14
9.16