Inventory Management FIN 340 Prof. David S. Allen Northern Arizona University
Types of Inventory • Raw materials inventory: • Factors of production that will be used in a later stage of production or assembly. • Work-in-progress inventory: • Partially assembled or completed goods. • Finished goods inventory: • Items ready for distribution or sale.
Types of Inventory • Independent items: Have demand unrelated to the requirements for other items, e.g. finished goods. • Independent items lend themselves to analysis by quantitative techniques. • Dependent items: Derive their demand from the need for other items or finished products, e.g. raw materials or work-in-progress. • The demand for the end product is used to infer demand for its components, subcomponents, and raw materials, This is combined with the existing inventory balances to establish a net requirement.
Benefits of Holding Inventory For finished goods, most marketing analyses suggest that product availability is the most important factor in customer satisfaction. The ability to order in larger lot sizes can create economies of scale in pricing, handling, and setups. In manufacturing, inventory decouples supply and demand. It makes possible longer production runs and more flexibility in the manufacturing process. Inventory also can enhance firm liquidity. In periods of high cash flows, the firm can invest excess cash in building up inventory. When cash flows are lower, the firm can sell off excess inventory without replacing it in order to generate cash.
Costs of Holding Inventory • Ordering costs: The fixed and variable costs resulting from the placement and processing of an order. • These include freight, labor, and handling charges. They are generally assumed to be proportional to the number of orders placed. In a production setting, these correspond to setup costs, i.e. the costs associated with delays and costs in resetting machinery to accommodate a different item.
Costs of Holding Inventory • Carrying costs: • Cost of capital • Storage costs • Deterioration and obsolescence costs • Insurance costs • Handling costs • Carrying costs are usually assumed to be proportional to the average inventory level. They are often split into financing costs (the first item above) and holding costs (all others above).
Factors Influencing Inventory Management • Effective inventory management is complicated by a number of factors: • Uncertainty: The inability to perfectly anticipate supply and demand. • Problems with cost and benefit assessments: Costs and benefits are difficult to quantify. • Variety in product: Perishability, value, demand, and interaction with other products are difficult to model. • Constraints: Limitations on financing, storage, and supply can lead to suboptimal decisions.
Inventory Management Systems Early inventory management focused on quantitative approaches to determining optimal order sizes, such of EOQ. This was followed by techniques that focused more on order timing, such as materials requirements planning (MRP). These two focuses have had varying degrees of success. More recently, the focus has been on "stockless" or just-in-time (JIT) systems, which emphasize minimal inventory levels.
Inventory Management Systems An important reason for holding inventory is the inability of the company to synchronize delivery with demand. The traditional western inventory system is thus a "just-in-case" type. Large safety stocks are held to cover the uncertainty of demand because of long and variable lead time or because of lumpiness in the production process. Much of the inventory management revolves around what to do because of this lead time.
Inventory Management Systems Just-in-time is a philosophy for managing inventory that seeks to identify and eliminate waste and bottlenecks in the supply chain. By holding little or no inventory, problems become apparent, and demand a solution.
Just-in-Time JIT requires at least eight factors to be effective: short distances between buyer and supplier dependable quality small supplier network dependable transportation manufacturing flexibility small lot sizes effective receiving and materials-handling facilities strong management commitment
The EOQ Inventory Model Two costs associated with inventory: Carrying costs Ordering costs Carrying costs increase as inventory levels increase. However, ordering costs decline as the inventory level increases. The firm attempts to minimize the total cost. Total inventory cost = carrying cost + ordering cost
The EOQ Inventory Model Note that the EOQ model applies to individual inventory items, not aggregate inventory.
The EOQ Inventory Model S = annual demand for item in units Q = number of items per order So, average inventory = Q/2 C = carrying cost as proportion of inventory value P = price (i.e. cost) per unit The total annual carrying cost is then: TCC = (C)(P)(Q/2) F = fixed cost to place an order N = number of orders placed per year So, total annual ordering cost is: TOC = F(S/Q)
The EOQ Inventory Model Total Inventory CostTIC = TCC + TOC = (C)(P)(Q/2) + (F)(S/Q) So, as the order quantity Q increases, the first term increases, but the second term decreases.
The EOQ Inventory Model To find the cost-minimizing order quantity, Q*, we apply calculus to the TIC equation: TIC = (C)(P)(Q/2) + (F)(S/Q) Solving, we find: Q* = [2FS/(CP)]1/2 A consequence of this equation is that Q* increases with the square root of annual sales, S. So, the firm’s inventory turnover is assumed to increase as sales increase.
EOQ With Safety Stocks Safety stocks are used to: Meet demand in the event that it is larger than expected. Meet demand if new orders take longer to receive than expected.
EOQ With Safety Stocks With safety stocks, the average inventory is higher than without them: Avg. inventory = Q*/2 + safety stock
EOQ With Quantity Discounts If the firm’s suppliers offer a discount for larger orders (larger than Q*), the firm will need to compare the reduction in purchase price with the additional TIC from holding a larger than optimal quantity: Reduction in purchase price + TIC discount quantity – TIC optimal quantity= net savings from taking the discount Let Q’ = discount quantity, D = discount percent Net savings from taking the discount= (D)(P)(S)-(Q’ / 2)(C)(P)(1-D) + (F)(S/Q’) +(Q* / 2)(C)(P)+ (F)(S/Q*)