Inventory Management: Balancing Benefits and Drawbacks

Inventory Considerations

• Managing inventory is a balancing act
• The goal is to boost the benefits of having inventory while decreasing the related drawbacks
• "Good" inventory covers for operational inefficiencies and supply uncertainties
• It can lower purchase prices via quantity discounts
• It elevates customer service
• It allows for quicker response times to customers
• It makes more sales happen in certain periods
• "Evil" inventory ties up cash that could be utilized better otherwise
• It leads to promotions and price discounts to get rid of excess stock
• It can be damaged, become outdated, or get lost, and this causes financial write-offs
• Resources are consumed because of inventory

Why Inventory Is Useful

• Uncertainty or inconsistency of customer demand creates a need for inventory
• This is because of shorter production lifecycles and more competition and production capability instead of demand
• Uncertainty in supply also drives need for inventory
• This encompasses quality, quantity, cost, and delivery times
• Incentives for larger shipments and economies of scale also bolster inventory

Uncertainty in Inventory Management

• Demand forecasting is critical for inventory-related choices when demand is uncertain
• Inventory can be added to compensate for a lack of confidence in forecasts
• Over-forecasted demand leads to excess inventory
• The same principle applies to uncertainty about supply
• Less confidence in supplier performance necessitates more inventory to meet customer demand
• Three key questions when managing inventory:
  • What should be ordered?
  • When should orders be placed?
  • How much should be ordered?

Economic Order Quantity (EOQ)

• This is a lot size (Q) that minimizes the total cost
• Holding costs increase as the lot size gets bigger
• Ordering costs decrease as the lot size grows
• Must look for the point of lowest total costs
• EOQ is calculated as the square root of (2DS/H)
  • D = Annual Demand (in units)
  • S = Ordering or setup costs per lot
  • H = Holding cost per unit per year
  • C = Total annual cycle-inventory cost
• Time Between Orders (TBO) is calculated as (EOQ/D) x (12 months/year)

Sensitivity Analysis of the EOQ

• Higher demand causes a larger optimal lot size (EOQ)
• EOQ changes by the square root of D
• Increasing the setup cost increases the EOQ
• Growing the holding costs decreases the EOQ and weeks of supply
• It also decreases inventory turnover, and larger lots are justified

ABC Analysis

• This approach divides SKUs into three classes depending on their dollar usage
  • SKU = Stock-keeping unit
• This lets businesses prioritize items that have the biggest dollar impact

Key Inventory Metrics

• Fill Rate: Percentage of demand satisfied from product in inventory
• Cycle Service Level: Percentage of replenishment cycles finishing with 100% of customer demand met (probability of no stock-out when replenishing)
• Inventory Turnover: Can be calculated with two methods

Total Costs Equation

• The total costs equation can be written as TC = cD + (D/Q)S + (Q/2)h
  • Cost of one item x Annual Demand (cD)
  • Number of runs x Setup (order) cost for each setup (order) ((D/Q)S)
  • Average cycle inventory x Holding cost per unit per year ((Q/2)h)

EOQ: Sensitivity Analysis

• Total cost isn't that sensitive to order quantities
• A change in the actual order quantity Q, as a multiple b of the optimal order quantity Q**; ie, Q = bQ** doesn't impact total costs that much

• b	.5	.8	.9	1	1.1	1.2	1.5	2

• Increase in Cost | 25% | 2.5% | 0.5% | 0 | .4% | 1.6% | 8.9% | 25%

Cost Comparisons

• As an example to compare costs:
  • Monthly Demand = 1,000 units
  • Order cost per lot, S = $4,000
  • Unit cost, c = $500
  • Holding cost as a fraction of unit cost, i = 0.2
  • Annual demand, D = 1,000 x 12 = 12,000 units
• Q = 980 TC = 6,000,000 + 48,980 + 49,000 = 6,097,980
• Q = 1,200 TC = 6,000,000 + 40,000 + 60,000 = 6,100,000

Cost Reduction

• Lower overall inventory costs by aggregating orders
• Numerous people across a company independently requesting the same items
  • Should think about office supplies, maintenance parts, safety items, software
• Bundle these into a single (aggregate) order to save order costs
• Bundle these items to leverage price
• Outsource the purchasing and inventory management of some items for boosted leverage by combining purchases across firms

Aggregating Orders

• Reduced fixed costs enabled by order aggregation causes reduction of total costs
  • It makes more sense to aggregate costs

Quantity Discounts

• Pricing schedules specify quantity break points to have a reduced purchase price because of volume
  • The prices are based off quantity
• An order has to measure at least so large as qj but smaller than qj+1; hence each unit has an average unit cost cj
• Unit cost mostly decreases as quantity increases
• The target of a lot size decision is to minimize the sum of material, order, and holding costs
• Step 1: Evaluate the optimal lot size for each price cj, so 0 is ≤ j to < ∞
• Qj stands for the square root of (2DS) / (icj)
• Step 2: Choose the order quantity Qj
  • Price must < qj ≤ qj+1
  • Qj < qj
  • Qj ≥ qj+1 ignore in this case as it is being considered for Qj+1
• Case 1: Set Q*=Qj Case 2: there is a discount is not possible for a lot size of Qj = qj to qualify for the discounted price of cj Step 3: Calculate the total annual cost if Qj units are acquired when ordering
  • TCj =(D /Qj)S + (Qj/2)icj + Dcj Step 4: Then to select the Qj** with the lowest total cost TCj

Quantity Discounts: Example

• Order Quantity and Unit Price are directly correlated
• 0-4,999: $3.00
• 5,000-9,999: $2.96
• 10,000 or more: $2.92
• q0 = 0, q1 = 5,000, q2 = 10,000
• c0 = $3.00, c1 = $2.96, c2 = $2.92
• D = 120,000/year, S = $100/lot, i = 0.2
• Then a formula can be generated
• Q0 = the square root of (2120,000$100) / ($3.00*0.02) = 6,324
• Q1 = the square root of (2120,000$100) / ($2.96*0.02) = 6,367
• Q2 = the square root of (2120,000$100) / ($2.92*0.02) = 6,410
• Ignore i = 0 as Q0 = 6,324 > q1 = 5,000 this allows this calculation For i = 1, 2 Q1 = Q1 = 6,367 Q2 = q2 = 10,000 TC1 = Dc1 + (D/Q1)S+(Q1/2)ic1= 358,969: TC = $354,520 Lowest total cost is for price level 2 Order 10,000 bottles per lot at $2.92 per bottle

Summary Of Quantity Discounts.

• Quantity discounts offer overall savings and help coordinate a supply chain
• They may cause increases in cycle inventory but an increase in net income
• Quantity Discounts also need to sell to the accountability of the inventory metric
• A look at risks associated also helps determine cost

Inventory Metrics

• Fill rate is a metric of satisfied demand from product in inventory To understand why the inventory is at its existing levels there are questions to ask yourself.

Safety Inventory

Demand is not level and always predictable

• The higher the inventory the higher levels of proudct availability and customer satisfaction

Replenishment is typically not instantaneous

• Addressing uncertainty of demand during "lead time" helps

Variables

• D = Average demand per unit time
• D= Standard deviation of demand per unit time
• L = lead time = time between when an order is placed and when it is received
• Cv = Coefficient of variation = (std. Dev)/ mean the size of uncertainty relative to demand

Safety Stock models will be known

• Demand will be known during this lead time DL Safety level until order arrives = SS = DL as well

For Satisfying demand with a 95% confidence level, determine how many standard deviation of demand should we carry as safety inventory.

Inventory Policies For Uncertainty

Continuous review

• Inventory is typically reviewed continiously

Periodic Review

• Inventory is reviewed at regular intervals

What will increase Inventory Results?

When Fill rate is much higher than CSL with the same replenishment policy. Change the lot size of safety stock

Why Are the 2 Types of Inventory Review Needed and In Their Places?

Continuous Review is calculated to determine when to reorder inventory.

• It has less safety stock

Periodic Inventory is used for Establishing Target inventory Level

• It has a defined frequency

Echelon Inventory

• Echelons or stages and level in the supply chain are also referred to as "echelon"
  • Echelon Inventory means what the inventory equals at any stage of the echelon. Each stage or level of the supply chain is referred to as an echelon"

Bullwhip Effect

• The Bullwhip effect is the amplification of variability as it goes further up the supply chain
• it is commonly caused by batch ordering
• When there is a large order, followed by several periods of no orders then the large order is followed on again
• Retailers can often attempt to stock up for future use Inflated Orders happen typically when there are inflated shortage periods
• It happens when there are inflated retailers and distributors that expect products in short supply