Test 2
PART 3 DELIVER
Chapter 13: inventory management
432-467
INTRODUCTION
The dilemma of inventory management:
‘In spite of the cost and the other disadvantages associated with holding stocks, they
do facilitate the smoothing of supply and demand.’
In fact they only exist because supply and demand are not exactly in harmony with each
other.
WHAT IS INVENTORY?
Inventory: the accumulations (opeenstapeling) of materials, customers or information as
they flow through processes or networks
- Physical inventory: (sometimes called ‘stock’) the accumulation of physical
materials such as components, parts, finished goods or physical
(paper) information records.
- Queues: accumulations of customers, physical as in a queuing line or people in
an airport departure lounge, or waiting for service at the end of phone
lines.
- Databases: stores for accumulations of digital information, such as medical
records or insurance details.
Managing these accumulations is what we call ‘inventory management’. And it is important.
It is about the organization of the data, its storage, security and retrieval (access and search).
, All processes, operations and supply networks have inventories
Most things that flow do so in an uneven way. Inventories are often the result of uneven
flows. If there is a difference between the timing or the rate of supply and demand at any
point in a process or network then accumulations will occur. A common analogy is the water
tank.
If an operation or process can match supply and demand rates, it will also succeed in
reducing its inventory levels. But most organizations must cope with unequal supply and
demand, at least at some points in their supply chain.
There is a complication when using this ‘water flow’ analogy to represent flows and
accumulations (inventories) of information. Inventories of information can either be stored
- because of uneven flow, in the same way as materials and people
- or, because the operation needs to use the info to process something in the future
E.g. an internet provider needs customer details to register a new customer in their
system, which details might be stored in order to provide these people later on with
targeted promotional activities. The inventory of information has turned from a
transformed resource into a transforming resource, because it is being used to trans-
form other information rather than being transformed itself.
WHY SHOULD THERE BE ANY INVENTORY?
There are plenty of reasons to avoid accumulating inventory where possible. The figure
identifies some of these, particularly those concerned with: cost, space, quality and
operational/ organizational issues.
, So why have inventory?
Inventories provide many advantages for both operations and their customers. The task of
operations management is to allow inventory to accumulate only when its benefits outweigh
its disadvantages.
“Inventory is being used as ‘insurance’ against unpredictable events.”
Some benefits of physical inventory, queues, and databases:
- Physical inventory is an insurance against uncertainty – Inventory can act as a buffer
against unexpected fluctuations in supply and demand.
- Physical inventory can counteract a lack of flexibility – Where a wide range of
customer options is offered, stock will be needed to ensure supply when it is
engaged on other activities.
- Physical inventory allows operations to take advantage of short-term opportunities
– e.g. when the supplier has a good deal, you rather fill your inventory than not take
advantage of the deal
- Physical inventory can be used to anticipate future demands – This type of
inventory is called anticipation inventory and is most commonly used when demand
fluctuations are large but relatively predictable.
- Physical inventory can reduce overall costs – Costs of inventory are lower compared
to the savings you obtain via bulk buying.
- Physical inventory can increase in value – Sometimes the items held as inventory
can increase in value and so become an investment (fine wines e.g.).
- Physical inventory fills the processing ‘pipeline’ – ‘Pipeline’ inventory exists because
transformed resources cannot be moved instantaneously between the point of
supply and the point of demand.
(When a retail store places an order, its supplier will ‘allocate’ the stock to the retail
store in its own warehouse, pack it, load it onto its truck, transport it to its destination
and unload it into the retailer’s inventory. From the time that stock is allocated (and
therefore it is unavailable to any other customer) to the time it becomes available for
the retail store, it is pipeline inventory. Especially in geographically dispersed supply
networks, pipeline inventory can be substantial.)
- Queues of customers help balance capacity and demand – This is especially useful if
the main service resource is expensive, for example doctors, consultants, lawyers or
expensive equipment such as CAT scans. By creating a queue of customers, the
service always has customers to process.
- Queues of customers enable prioritization
- Queuing gives customers time to chose – Time spent in a queue gives customers
time to decide what products/services they require, fast food e.g.
- Queues enable efficient use of resources – By allowing queues to form, customers
can be batched together to make efficient use of operational resources, elevator e.g.
- Databases provide efficient multi-level access – Databases are relatively cheap ways
of storing information and providing many people with access, although there may
be restrictions or different levels of access.
, - Databases of information allow single data capture – There is no need to capture
data at every transaction with a customer or supplier, though checks may be
required.
- Databases of information speed the process – Amazon, for example, stores, if you
agree, your delivery address and credit card information so that purchases can be
made with a single click, making it fast and easy for the customer.
Reducing physical inventory
For the remainder of this chapter we will focus on physical inventory. The table identifies
some of the ways in which physical inventory may be reduced.
The effect of inventory on return on assets
One can summarize the effects on the financial performance of an operation by looking at
how some of the factors of inventory management impact ‘return on assets’, a key financial
performance measure.
- Inventory governs the operation’s ability to supply its customers à The absence of
inventory means that customers are not satisfied with the possibility of reduced
revenue.
- Inventory may become obsolete as alternatives become available, or could be
damaged, deteriorate or simply get lost à This increases costs and reduces revenue
- Inventory incurs storage costs à leasing space, maintaining appropriate conditions
- Inventory involves administrative and insurance costs à Every time a delivery is
ordered, time and costs are incurred.
- Inventory ties up money, in the form of working capital à which is therefore
unavailable for other uses, such as reducing borrowings or making investments in
productive fixed assets
- Inventory contracts with suppliers can dictate the timing of when suppliers need to
be paid à If they require paying before the operation receives payment from its
customers (as is normal), the difference between the amount the operation owes
, suppliers and the amount suppliers owe the operation adds to working capital
requirements.
Working capital of inventory: There will probably be a lag between paying our
suppliers and receiving payment from our customers.
During this time we will have to fund the costs of
inventory.
Day-to-day inventory decisions
Wherever inventory accumulates, operations need to manage the day-to-day tasks of man-
aging inventory. In managing the system, operations managers are involved in three major
types of decision:
1. How much to order – Every time a replenishment order is placed, how big should it
be (sometimes called the volume decision)?
2. When to order – At what point in time, or at what level of stock, should the
replenishment order be placed (sometimes called the timing decision)?
3. How to control the system – What procedures and routines should be installed to
help make these decisions? Should different priorities be allocated to different stock
items? How should stock information be stored?
1. HOW MUCH TO ORDER? THE VOLUME DECISION
Two extremes for doing your groceries:
- Go every day, and only buy what is necessary – reduces costs since you only buy
what you need + allows you to be flexible
- Go once a month and buy everything you think you’ll need – reduces time to visit
every day, however, not so flexible
Somewhere between these two extremes the perfect ‘buying strategy’ can be found. The
same principles apply in commercial order-quantity decisions as in this domestic situation.
Inventory costs
In making a decision on how much to purchase, operations managers must try to identify the
costs which will be affected by their decision.
,Decrease as order size is increased:
1. Cost of placing the order – These include preparing the order, communicating with
suppliers, arranging for delivery, making payment and maintaining internal records of
the transaction
2. Price discount costs – suppliers offer discounts for large quantities and cost penalties
for small orders
3. Stockout costs – both penalties and opportunity loss
Increase as order size is increased:
4. Working capital costs – After receiving a replenishment order, the supplier will
demand payment and it takes some time before the customer pays for the goods.
The costs associated with it are the interest we pay the bank for borrowing it, or the
opportunity costs of not investing it elsewhere.
5. Storage costs – These are the costs associated with physically storing the goods.
6. Obsolescence costs – When we order large quantities, this usually results in stocked
items spending a long time stored in inventory. This increases the risk that the items
might either become obsolete or deteriorate with age
7. Operating inefficiency costs – According to just-in-time philosophies, high inventory
levels prevent us seeing the full extent of problems within the operation.
It is worth noting that it may not be the same organization that incurs the costs. You can for
instance make a deal with a supplier that you’ll eventually buy a certain amount of goods,
but you only pay for them when you use them. Until you use them they remain the property
of the supplier, and so till then you don’t have any costs for them.
Inventory profiles
An inventory profile is a visual representation of the inventory level over time. Figure 13.5
shows a simplified inventory profile for one particular stock item in a retail operation. Every
time an order is placed, Q items are ordered. The replenishment order arrives in one batch
instantaneously. Demand for the item is then steady and perfectly predictable at a rate of D
units per month. When demand has depleted the stock of the items entirely, another order
of Q items instantaneously arrives, and so on. Under these circumstances:
𝑄
𝑇ℎ𝑒 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
2
𝑄
𝑇ℎ𝑒 𝑡𝑖𝑚𝑒 𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑖𝑒𝑠 =
𝐷
𝐷
𝑇ℎ𝑒 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 𝑜𝑓 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑖𝑒𝑠 = 𝑡ℎ𝑒 𝑟𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙 𝑜𝑓 𝑡ℎ𝑒 𝑡𝑖𝑚𝑒 𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 =
𝑄
, The economic order quantity (EOQ) formula
The most common approach to deciding how much of any particular item to order when
stock needs replenishing is called the economic order quantity (EOQ) approach. This
approach attempts to find the best balance between the advantages and disadvantages of
holding stock.
To minimize the total cost of stocking an item we first need to find the optimal order
quantity and insert this into the total cost formula. Qo is the minimum cost order quantity.
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠 + 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡𝑠
𝐶@ 𝑄 𝐶A 𝐷
𝐶? = +
2 𝑄
Where:
- Ct = total cost
- Ch = holding cost/unit
- Co = ordering cost
- Q = quantity
2𝐶A 𝐷
𝑄A = 𝐸𝑂𝑄 = D
𝐶@
As we would expect with low values of Q, holding costs are low but the costs of placing
orders are high because orders have to be placed very frequently. As Q increases, the
holding costs increase but the costs of placing orders decrease. Initially the decrease in
ordering costs is greater than the increase in holding costs and the total cost falls. After a
point, however, the decrease in ordering costs slows, whereas the increase in holding costs
remains constant and the total cost starts to increase.
EFG H
𝑇𝑖𝑚𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑜𝑟𝑑𝑒𝑟𝑠 = H
𝑂𝑟𝑑𝑒𝑟 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 = EFG
Examination of the graphical representation of the total cost curve in Figure 13.7 shows that,
although there is a single value of Q which minimizes total costs, any relatively small
deviation from the EOQ will not increase total costs significantly. In other words, costs will
be near optimum provided a value of Q is chosen that is reasonably close to the EOQ.
, Gradual replacement – the economic batch quantity (EBQ) model
Although the simple inventory profile above made some simplifying assumptions, it is
broadly applicable in most situations where each complete replacement order arrives at one
point in time. In many cases, however, replenishment occurs over a time period rather than
in one lot.
Provided the rate at which parts are being made and put into the inventory (P) is higher than
the rate at which demand is depleting the inventory (D) then the size of the inventory will
increase. The resulting profile:
Such a profile is typical for cycle inventories supplied by batch processes, where items are
produced internally and intermittently. For this reason the minimum cost batch quantity for
this profile is called the economic batch quantity (EBQ). It is also sometimes known as the
economic manufacturing quantity (EMQ), or the production order quantity (POQ).
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠 + 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡𝑠
𝐶@ 𝑄(𝑃 − 𝐷) 𝐶A 𝐷
𝐶? = +
2𝑃 𝑄
Where:
- P = rate at which parts are being made
- D = rate at which demand is depleting the inventory
2𝐶A 𝐷
𝑄A = 𝐸𝐵𝑄 =
N 𝐷
𝐶@ O1 − Q𝑃 RS
Responding to the criticisms of EOQ
In order to keep EOQ-type models relatively straightforward, it was necessary to make
assumptions. These concerned such things as the stability of demand, the existence of a
fixed and identifiable ordering cost, that the cost of stock holding can be expressed by a
linear function, shortage costs which were identifiable, and so on. While these assumptions
are rarely strictly true, most of them can approximate to reality. Furthermore, the shape of
the total cost curve has a relatively flat optimum point, which means that small errors will
not significantly affect the total cost of a near-optimum order quantity.
However, at times the assumptions pose limitations to the models. E.g. the assumption of
steady demand is untrue for a wide range of the operation’s inventory problems.
