Ch. 4 - Inventory Management

Why is inventory considered an asset?

Inventory represents value and is usually one of the company's largest assets, requiring careful management as an essential business requirement.

Why can inventory be a liability?

Carrying too much inventory ties up capital, requires storage space (which costs money), incurs costs for security/insurance/taxes, and may become unusable due to expiration, obsolescence, damage, or spoilage.

What is inventory?

The quantities of goods and materials that are held in stock, including all materials used to support production, finished products needed to provide customer service, and other supplies needed to run a business.

Why is inventory management important?

Adequate inventory allows companies to fill customer orders immediately and support manufacturing operations while avoiding delays. Poor management leads to dissatisfied customers, lost sales and revenue, and higher costs.

What are the two main types of inventory that companies maintain?

1) Finished product inventory - allows a company to fill customer orders immediately. 2) Materials inventory - allows a company to support manufacturing operations and the production plan while avoiding delays.

What are the four main categories of inventory?

1) Raw Materials, 2) Work-in-Process (WIP), 3) Finished Goods, 4) Maintenance, Repair and Operating (MRO) supplies.

What are Raw Materials?

Purchased items or extracted materials that are converted via the manufacturing process into components and products.

What is Work-in-Process (WIP) inventory?

Goods in various stages of completion throughout the plant, spanning from raw material released for initial processing up to fully processed material awaiting final inspection and acceptance as finished goods.

Why is WIP often called the "black hole" of inventory?

Due to the range of potential stages of completion and the fact that materials in WIP may be in a state of continuous transformation, companies may not have very good or very timely visibility into this part of their inventory.

What are Finished Goods?

Items on which all manufacturing operations, including final testing, have been completed. These products are available for sale and/or shipment to the customer.

What are MRO (Maintenance, Repair and Operating) supplies?

Items used in support of general operations and maintenance such as maintenance supplies, spare parts, and consumables used in the manufacturing process and supporting operations. Materials needed to run the manufacturing operation and the business but do not end up as part of the finished product.

What is Service Inventory?

Activities carried out in advance of the customer's arrival.

Can service companies maintain inventory of services?

No, companies in the service industry do not maintain inventory of services since services are basically produced and consumed immediately upon demand.

What are "facilitating goods" in the service industry?

Items that are used to help facilitate the service being provided (e.g., for restaurants: food, tableware, and other elements of the dining operation).

What are the four main functions of inventory (reasons to hold inventory)?

1) To Meet Customer Demand (cycle stock), 2) To Buffer Against Uncertainty in Demand and/or Supply (safety stock), 3) To Decouple Supply from Demand (strategic stock), 4) To Decouple Dependencies in the Supply Chain (strategic stock).

What does "decouple" mean in inventory management?

To separate or make independent (e.g., separating operations in a process or separating supply pattern from demand pattern).

What are the three levels of internal inventory?

1) Cycle Stock, 2) Safety Stock, 3) Strategic Stock.

What is Cycle Stock?

Inventory that a company builds to satisfy its immediate demand. Cycle stock depletes gradually as customer orders are received and is replenished cyclically when supply orders are received.

What is Safety Stock (Buffer Stock)?

Inventory that is above and beyond what is actually needed to meet anticipated demand. A quantity of stock planned to be in inventory to protect against fluctuations in demand or supply.

What is Strategic Stock?

Additional inventory beyond cycle and safety stock, generally used for a very specific purpose or future event, and for a defined period of time. Also called anticipation stock, build stock, or seasonal stock.

What are reasons a company may carry strategic stock?

To hedge currency fluctuations, take advantage of a price discount, protect against a short-term disruptive event in supply, take advantage of a business opportunity, or for life cycle changes (seasonal demand, new product launch, transition protection).

What is Pipeline Inventory?

Inventory in the transportation network and distribution system. Inventory that is already out in the market being held by wholesalers, distributors, retailers, and even consumers. Ownership has been transferred to trading partners.

What is Obsolete Inventory?

Inventory items that have met the obsolescence criteria established by the company. Stock that is expired, damaged, or no longer needed.

Why is it important to dispose of obsolete inventory?

Unusable inventory takes up space and costs money to maintain, so it may be better to absorb the loss as soon as an item has met the obsolescence criteria rather than delay and continue to lose money on storage and related fees.

In the pharmaceutical example, where is safety stock maintained for Active Ingredients and why?

Safety stock is maintained centrally for Active Ingredients due to long production lead time, to provide maximum flexibility, and as a result of batch/campaign size.

In the pharmaceutical example, where is safety stock maintained for Finished Goods and why?

Safety stock is maintained at Finished Goods in geographically dispersed locations to respond rapidly to increases in customer demand, located close to end customers.

In the pharmaceutical example, where is safety stock NOT maintained and why?

Safety stock is NOT maintained at Dosage Forms due to long term stability concerns and expiry concerns.

How does safety stock help decouple the supply chain?

By maintaining safety stock at strategic points, cumulative lead time can be dramatically reduced. For example, in pharmaceuticals, safety stock at Active Ingredients and Finished Goods reduces cumulative lead time from 15 months to 2 months.

What is inventory management?

The function of planning and controlling inventories.

What is the goal of inventory management?

To help a company be more profitable by lowering the cost of goods sold and/or by increasing sales.

What are the two competing considerations in effective inventory management?

1) Reducing the amount of inventory held in stock, while 2) Ensuring there is enough inventory to satisfy customer demand.

What are Direct costs in inventory?

Costs directly traceable to unit produced (e.g., materials, labor).

What are Indirect costs in inventory?

Costs that cannot be traced directly to the unit produced (e.g., overhead, MRO items, buildings, equipment).

What are Variable costs in inventory?

Costs dependent on the unit volume produced that vary with output level (e.g., materials, labor, utility power).

What are Fixed (Sunk) costs in inventory?

Costs independent of the unit volume produced (e.g., buildings, equipment, rent, allocated overhead costs).

What are Carrying costs?

Costs for physically having inventory on-site and for maintaining the infrastructure needed to store the inventory and to secure and insure it over time.

What are Order costs?

Labor costs associated with placing an order for inventory and the cost of receiving the order.

What are examples of Order Costs?

Order preparation costs, order transportation costs, order receipt processing costs, material handling costs.

What are examples of Carrying Costs?

Cost of capital, taxes on inventory, insurance, obsolescence (deterioration during storage, shelf-life), and storage (facility expense related to holding rather than handling).

What are the hidden costs of having too much inventory?

Financial resources tied up in inventory; underlying problems being hidden rather than exposed and solved (including quality problems not being immediately identified); no incentive for process improvements.

What are the hidden costs of having too little inventory?

Production disruptions creating need for expediting and additional costs; longer delivery replenishment lead times; reduced responsiveness; lost revenue.

What is Absolute Inventory Value?

The value of the inventory at either its cost or its market value. Generally found on the balance sheet.

What is Inventory Turnover?

The number of times that an inventory cycles, or "turns over," during the year.

What is the formula for Inventory Turnover Ratio?

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory @ Cost

Is higher or lower inventory turnover better?

Higher is better - the more turns, the better.

What are the three fundamental questions for setting target inventory levels?

1) When to review inventory? 2) When to order inventory? 3) How much inventory to order?

What is a Periodic Review System?

Inventory levels are reviewed at a set frequency (e.g., weekly, monthly). At the time of review, if stock levels are below the pre-determined level (reorder point), an order for replenishment is placed.

What are the advantages of a Periodic Review System?

Reduces the time spent analyzing inventory; less expensive to implement and operate than a Continuous Review System.

What are the disadvantages of a Periodic Review System?

Can be difficult to determine the best review/reordering intervals; can make inventory accounting less accurate; greater risk of inventory dropping well below reorder point between reviews, therefore greater potential need for safety stock.

What is a Continuous Review System?

Inventory levels are continuously reviewed. As soon as inventory falls below a pre-determined level (reorder point), a replenishment order is automatically triggered.

What are the advantages of a Continuous Review System?

Allows for real-time updates of inventory, making it easier to know when to replenish; facilitates accurate accounting since the system can generate real-time costs of goods sold; potentially requires less safety stock because inventory is constantly monitored.

What is the disadvantage of a Continuous Review System?

Cost of implementation - generally requires an automated system. The hardware and software necessary to run the system can be expensive to purchase, install, and maintain.

What is the Reorder Point (ROP)?

The lowest inventory level at which a new order must be placed to avoid a stockout.

What is the formula for Reorder Point (ROP) without safety stock?

ROP = Demand during Lead Time (dL) = d × L, where d = demand rate and L = lead time.

What is the formula for Reorder Point (ROP) with safety stock?

ROP = (D × LT) + SS, where D = demand, LT = lead time, and SS = safety stock.

What is a Fixed-Time Period System?

Inventory is checked in fixed time periods against a target inventory level. If inventory is less than target, a quantity necessary to bring inventory back up to the target level is ordered. The amount of inventory ordered varies from period to period.

What is the order quantity formula for Fixed-Time Period System?

Q = R - IP, where Q = order quantity, R = target inventory level, IP = inventory position.

What is a Fixed-Order Quantity System?

A continuous inventory review system in which the same order quantity is used from order to order. When the inventory position drops to a predetermined reorder point, a predetermined fixed order quantity is placed. The time between orders varies.

What are the two main variables to calculate in a Fixed-Order Quantity System?

1) Reorder Point (ROP), 2) Order Quantity (Q).

What is the Economic Order Quantity (EOQ) Model?

A quantitative decision model based on the trade-off between annual inventory order costs and annual inventory carrying costs, where the sum of the annual order costs and the annual inventory carrying costs is minimized.

What is the EOQ formula?

EOQ = √(2 × Order Cost × Annual Demand Volume) / (Annual Carrying Cost % × Unit Cost)

What are the assumptions of the EOQ Model?

The model must be calculated for one product at a time; demand must be constant throughout the year; delivery replenishment lead time does not fluctuate; replenishment is instantaneous; purchase price is constant (no discounts); carrying cost is known and constant; order cost is known and constant.

Do EOQ assumptions hold true in the real world?

No, in the "real world" these assumptions do not hold true over time. Supply Chain Managers must make adjustments to the basic EOQ.

What volume economies of scale impact EOQ?

Individual Item Purchase Price Discounts (discounts for ordering larger quantities), Multiple-Item Purchase Price Discounts (volume discount based on total volume across all items), and Transportation Freight-Rate Discounts (lower per unit costs from ordering larger quantities).

What are constraints on the practical use of EOQ?

Limited Capital (insufficient funds to purchase), Storage Capacity (insufficient space), Transportation (specialized/dedicated requirements), Obsolescence (spoilage concerns), Production Lot Size (supplier requirements for full lot sizes), and Unitization (supplier requirements for full pack/case/pallet configurations).

How is EOQ typically used in practice?

EOQ is generally only used as a baseline. Supply chain managers make adjustments to the EOQ based on their judgment due to constraints and assumptions.

What is an ABC System?

An inventory system that classifies inventory based on the degree of importance: A (Highest Value - ~20% of items, ~80% of sales), B (Moderate Value), C (Least Valuable - ~60-80% of items, ~10% of sales).

How do you classify items in an ABC System?

1) Determine annual usage or sales for each item. 2) Determine % of total usage or sales that each item represents. 3) Rank items from highest to lowest %. 4) Classify items into groups A, B, or C.

What is a Bin System?

An inventory system that uses either one or two bins to hold a quantity of the item being inventoried. Mainly used for small or low value items. When inventory in the first bin is depleted, an order is placed to refill. The second bin holds enough inventory to cover demand during replenishment lead time.

What is a Base Stock Level System?

A type of inventory system that issues an order whenever a withdrawal is made from inventory. Replenishment order quantity equals the quantity withdrawn. Used primarily for very expensive items (e.g., airplane engine). A form of just-in-time.

What is a "Single-Period" Inventory Model?

A type of inventory system in which inventory is only ordered for a one-time stocking. The objective is to maximize profits. Examples: Christmas tree lots and newspaper stands.

What are Linear (1D) Barcodes?

A series of alternating bars and spaces printed or stamped on parts, containers, labels, or other media, representing encoded information that can be read by electronic readers. They are one-dimensional, can only be read horizontally, and can hold a maximum of 85 characters.

What are 2D Barcodes?

A graphical image that stores information both horizontally and vertically. 2D Barcodes can store over 7,000 characters.

What is a barcode reader?

An electronic device that can read barcodes and transmit the data to a computer. These might be handheld cordless devices, corded devices that attach directly to a PC's USB port, or computers with integrated laser scanners.

What is RFID (Radio Frequency Identification)?

Successor to the barcode for tracking individual units of goods. RFID does not require direct line of sight to read a tag, and the information on the tag is updatable.

What are the components of an RFID system?

RFID Tags (Transponders) attached to items/boxes/pallets, Readers (hand held, shelf, or fixed portal readers), and Information Infrastructure (RFID Middleware on Local/ERP Servers with Database).

How does RFID automate Materials Management?

Goods are automatically counted and logged as they enter the supply warehouse.

How does RFID automate Manufacturing?

Assembly instructions encoded on RFID tags provide information to computer controlled assembly devices.

How does RFID automate Distribution Centers?

Shipments leaving DC automatically update ERP to trigger a replenishment order and notify customer for delivery tracking.

How does RFID automate Retail Stores?

No checkout lines as scanners link RFID tagged goods in shopping cart with buyer's credit card.

What are common metrics for measuring inventory performance?

Units (number of units available), Dollars (amount of dollars tied up in inventory), Weeks of Supply (avg. on-hand inventory / avg. weekly usage), Inventory Turns (cost of goods sold / avg. inventory value).

What is the financial impact of reducing inventory?

Every unit/dollar of inventory that you can reduce drops right to the bottom line as pure savings.