Inventory fundamental powerpoint

Supply Chain Management

Inventory
Fundamentals

Inventory Fundamentals

• Inventory = material + supply
• For sale
• Input or supply to the production process
• Substantial part of total assets
•20% to 60% of total assets on balance sheet •
When used value is converted into cash •
Improve cash flow and return on investment
(ROI)


• Cost for carrying inventories
- Increase operation cost
- Decrease profit
• Inventory management is responsible for
- Planning inventory from raw material to
customer
- Controlling inventory from raw material to
customer


1. Inventory results from production: finished
goods
2. Inventory support production: raw material
work in process (WIP), etc.
1 and 2 must be coordinated
Inventory must be considered at each of the
planning level
- Production planning: over all - Master
production schedule: end items - Material
requirement planning: components & raw
material


Aggregate inventory management
• Deals with managing inventory according to their
classification
- Raw material
- Work in process (WIP
- Finished good
• Function of different inventories - not individual
item level
• Financially oriented - cost and benefits of
carrying different classifications of inventories


Involves
1. Flow and kind of inventory needed
2. Supply and demand pattern 3.
Functions that inventories perform 4.
Objective of inventory management 5.
Cost associated with inventory


Item inventory management
• Item level, not aggregate
• Management establishes decision rule
about inventory item
• Rules
- 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


Factors affecting inventory
management decision
1. Types of inventory based on the flow of
material
2. Supply and demand pattern 3.
Function performed by inventory 4.
Objective of inventory management 5.
Inventory cost


1. Inventory and flow of material:
• Raw material
• Purchased item not processed yet
• Supplier material
• Components •
Sub-assemblies
• Work in process (WIP)
• Raw material has been processed but not
finished

Supplier Supplier Supplier

Raw material/ Purchased part/
Material

Work in process (WIP)

Finished goods

Warehouse Warehouse Warehouse

Customer Demand Customer Demand Customer Demand


Inventory & flow of material-Continues
• Finished goods
• Ready to be sold as completed items
• Factory storage
• Warehouse
• Distribution centers
• Distribution inventories
• Finished goods in the distribution system


• MRO supplies used in production that
do not become part of the products
such as hand tools, spare parts, die,
drill bit, etc.
• Maintenance
• Repair
• Operational


• Classification depends on production
environment
For example tire
• Tire is finished goods for tire manufacturer
• Tire is raw material for car manufacturer


2. Supply and demand pattern
• If supply meet demand - no inventory •
Demand must be predictable, stable and
relatively constant over a long time period -
zero inventory
• Produce goods on a line - flow basis -
matching production with demand - no
inventory
Raw material Work center Customer
Zero Zero


2. Supply and demand pattern-continues •
Large demand to justify setting up flow
system
• Demand is instable - varies
• Lots or batch manufacturing
• Workstations are organized by function •
Work flow from workstation to workstation in lot •
Inventory build up in
• Raw material
• Work in process (WIP) •
Finished goods


3. Functions performed by inventory :
• Decouple supply and demand •
Buffer between supply and demand •
Buffer between finished goods and
customer demand
• Buffer between finished goods and
component availability


3. Functions performed by inventory -
continue
• Requirement for an operation and the
output from the preceding operation •
Parts and material to begin production and
supplies of material


3. Functions performed by inventory -
continue
Classification of inventory by function:
a) Anticipation inventory:
• Build up in anticipation of future demand •
Example: before peak selling season, promotion
program, vacation, shut down, etc. • To help
level production
• To reduce cost of changing production rate


Classification of inventory by function -
continues
b) Fluctuation inventory (Safety stock):
• Inventory is held to cover random,
unpredictable fluctuation in supply and
demand or in lead time
• If demand or lead time is greater than
forecast, a stock out occurs
• Safety stock is carried to protect stock out


continues
2. Fluctuation inventory (Safety stock):
• Prevent disruption in manufacturing or
deliveries to customer
Safety stock - buffer stock - reserve stock


continues
3. Lot size inventory:
•

Lot size inventory - cycle inventory
• Portion of inventory that depletes gradually as
customer order received
• Replenish cyclically when suppliers order are
received


continues
4. Transportation inventory:
Transportation inventory - Pipeline inventory
- movement inventory
• Time needed to move goods from one
location to another location
• Example: supplier to manufacturer; plant
to distribution centers, etc.


C

I = t x A/ 365; I = average amount; A=annual
demand; t = transit time, days
I Cost; I t;

Reduce transit time to reduce inventory
and hence cost


continues
Example: Delivery of goods from a supplier is
in transit for ten days. If the annual
demand is 5200 units, what is the average
annual inventory in transit?
I = 10 x 5200 / 365 = 142.5 units


continues
5. Hedge inventory:
• Commodities
- Mineral
- Oil
- Grain
• Buy and wait to sell when price rises •
Buy at low cost, wait, sell on high price


continues
6. MROs inventory:
Maintenance, repair and operation / over haul
• Support general operation and
maintenance
- Spare parts -
Consumables -
Stationer


3. Objective of inventory management:
A. Maximum customer service
B. Low cost plant operation C. Minimum
inventory investment Maximum customer
service: • Ability to satisfy customer
needs • Availability of items when
needed and a measure of inventory
management effectiveness


3. Objective of inventory management-
continues
Maximum customer service: •
Customers: who they are!
• Purchaser
• Distributor •
Other plants •
Workstations


3. Objective of inventory management-
continues
Maximum customer service:
• Measurements of customer service
• % of order shipped on schedule
• % of line item shipped on schedule
• Order days out of stock
• Inventory help to maximize customer service
by protecting against uncertainties
• Carry extra inventories to meet uncertain
demand


3. Objective of inventory
management:- continues
Low cost plant operations (4 ways) I.Allow
operation with different rates of production
to operate separately and more
economically
II. Allow level production of seasonal
items - inventories build up in non-
peak sale season


3. Objective of inventory management:-
continues
Low cost plant operations (4 ways) II.Allow
level production of seasonal items -
inventories build up in non-peak sale season,
How?
Reduced overtimeReduced training cost Reduced
training cost Lower capacity requirement Reduced
subcontracting cost


continues
Low cost plant operations (4 ways)
III. Allow longer production run
• Lower setup cost
• Setup cost is fixed: one unit or 1000 units
• Increase in capacity
• less setup
• More run time
• Bottleneck operation


3. Objective of inventory
management:- continues
Low cost plant operations (4 ways) IV.
Allow to purchase in larger quantities
• Lower ordering cost
• Quantity discount


continues
Inventories cost money, they must be balanced
with
I. Customer service:
 Low inventory - high stock out  Lower level
of customer service II.Cost in changing
production level
 Excess equipment
 Overtime
 Hiring and layoff 
training


continues
Inventories cost money, they must be balanced
with
III. Cost of placing order
 Each order placed cost IV.
Transportation cost
 Small quantity cost more per unit

Therefore, carry inventory if it cost less
than not to carry


Inventory costs:
1. Item cost
• landed price
• purchase cost
• cost to get it in plant
• transportation
• custom duties
• insurance
2. Carrying cost
3. Ordering cost
4. Stock out cost
5. Capacity associated costs


Inventory costs:
1. Item cost
2. Carrying cost
• Cost of carrying volume of inventory
• Capital cost
• Storage cost
• Space
• Labor
• equipment
• Risk cost
• Obsolescence: model change, out dated
• Damage: in handling
• Pilferage: lost, misplace, stray, stolen
3. Ordering cost
4. Stock out cost


Inventory costs:
1. Item cost
2. Carrying cost
3. Ordering cost
• Associated with placing an order with a factory or supplier
• Independent of quantity order
• Depends on number of orders placed in a year
• Production control cost
* Setup time *Production loss
* Tear down at the end of run
• Lost capacity cost
* Incurred when an order is placed
* Order preparation * Expediting
* Follow-up * Receiving
* Authorizing payment * Receiving and paying invoice


Inventory costs:
1. Item cost
2. Carrying cost
3. Ordering cost: Example
A company carry an average annual
inventory of $2,000,000. If they estimate
the cost of capital is 10%. Storage costs
are 7% and risk costs are 6%. What does
it cost per year to carry this inventory?


Example-continues
Total cost of carrying inventory = 10% + 7% + 6%
Total cost of carrying inventory = 23% Total
annual cost of carrying inventory = 23% x
$2,000,000
Total annual cost of carrying inventory = 0.23 x
$2,000,000
Total annual cost of carrying inventory = $460,000


Ordering cost: Example
Given the following annual costs, calculate
the average cost of placing one order.
Production control salaries = $60, 000
Supplies and operating expenses for
production control department = $15,000
Cost of setting up work centers for an order =
$120
Order placed each year = 2000


Ordering cost: Example
Average cost = fixed cost/number of orders + variable cost
Average cost = ($60, 000 + $15,000 )/2000 + $120
Average cost = $37.50 + $120 = $157.50


Inventory costs:
1. Item cost
2. Carrying cost
3. Ordering cost
4. Stock out cost
• If demand during the lead time exceeds forecast we
expect a stock out
 Back order cost
 Lost sale
 Lost customer


Inventory costs:
1. Item cost
2. Carrying cost
3. Ordering cost
4. Stock out cost
• When output level is changed, following cost may
incur
i. Overtime v. Training
ii. Hiring vi. Extra shift
iii. Leveling production vii. Laying off
iv. Carrying inventory


Quarter Quarter Quarter Quarter
1 2 3 4 Total

Forecast demand 2,000 3,000 6,000 5,000 16,000

Production 4,000 4,000 4,000 4,000 16,000

Ending inventory 0 2,000 3,000 1,000 0 -
Average
inventory 1,000 2,500 2,000 500 -

Inventory cost ($) $ 3,000 $ 7,500 $ 6,000 $1,500 $18,000


1. Capacity associated costs: Example A
company makes and sells a seasonal product.
Based on a sales forecast of 2000, 3000, 6000 and
5000 per quarter, calculate a level production plan,
quarterly ending inventory and average quarterly
inventory.
If inventory carrying costs are $3 per unit per
quarter, what is the annual cost of carrying
inventory? Opening and ending inventories are
zero.


Financial statement and inventory:
• Balance sheet
Assets = Liabilities + Owner’s equity
• Income statement
Income = Revenue - Expenses
• Cash - flow analysis
- Cash requires
• To purchase raw material
• Pay for production cost -
Labor
- overhead


Financial statement and inventory:
Example:
a) If the owner’s equity is $1,000 and liabilities
are $800, what are the assets
b) If the assets $1,000 and liabilities are $600,
what is the owner’s equity?
a) Assets = Liabilities + Owner’s equity
Assets = $800 + $1,000 = $ 1,800)
Owner’s equity = Assets - Liabilities
Owner’s equity = $1,000 - $600 = $400


Financial statement and inventory: continues
Cash in - cash out > 0; self-finance
• Income statement
Cash in - cash out < 0; borrow
Example:
Given the following data, calculate the gross
margin and the net income.
How much would profit increase if, through better
material management, material costs are
reduced by $50,000?

Example: continues
Revenue $1,500,000
Direct labor $300,000
Direct material $500,000 Notice, net income
Factory overhead $400,000
General and admin. (profit) of 33%
Expenses $150,000

Revenue $1,500,000 Revenue $1,500,000
Cost of goods sold Cost of goods sold
Direct labor $300,000 Direct labor $300,000
Direct material $500,000 Direct material $450,000
Factory overhead $400,000 $1,200,000 Factory overhead $400,000 $1,150,000
Gross margin $300,000 Gross margin $350,000
General and admin. General and admin.
Expenses $150,000 Expenses $150,000
Net income (profit) $150,000 Net income (profit) $200,000
33%


Financial inventory performance measures: •
Inventory - money tied up
1. Total inventory investment
2. Inventory turn ratio
3. Days of supply


Financial inventory performance measures:
continues
Inventory turn ratio = Annual cost of goods sold
/ average inventory in $
- Higher is better
If annual cost of goods sold is $1 million and
average inventory is $500,000, then Inventory
turn ratio = $1,000,000/$500,000 = 2


Inventory turn ratio - continues
Example: a) What will be the inventory turn
ratio if the annual cost of goods sold is
$24 million a year and the average
inventory is $6 million?
Answer:
Inventory turn ratio = Annual cost of goods sold / average
inventory in $
Inventory turn ratio = $24 million/$6 million = 4


Example: b) What would be the reduction in
inventory if inventory turn ratio is
increased to 12 times per year?
Answer:
average inventory in $ = Annual cost of goods sold /
Inventory turn ratio
average inventory = $24 million/ 12 =$2 million Reduction
in inventory = $6 million - $ 2 million = $4 million


Example: c) If cost of carrying inventory is
25% of the average inventory, what will
be the savings?
Answer:
Reduction in inventory = $6 million - $ 2 million = $4 million
Saving = $4 million x 25% = $4 million x 0.25 = $1 million


Financial inventory performance measures:
continues
Days of supply = Inventory on hand / average
daily usage
- Lower is better
Example: Inventory on hand is 9,000 units and
annual usage is 48,000 units, there are 240
days per year
average daily usage = 48,000/240 = 200 units
Days of supply = 9000 / 200 = 45 days


Methods of evaluating inventory: (4)
1. FIFO
- In rising prices, replacement is at higher prices
than assumed cost
- Does not reflect current price
- Replacement is understated in rising price -
Replacement is overstated in falling price
2. LIFO
3. Average cost
4. Standard cost


1. FIFO
2. LIFO
- In rising prices, replacement is at current prices -
Reflect current price
- Replacement is current in rising price -
Replacement is current in falling price
3. Average cost
4. Standard cost


1. FIFO
2. LIFO
3. Average cost
- An average of all the prices paid for the article -
Reflect average price
- Replacement is average in rising price -
Replacement is average in falling price
4. Standard cost


1. FIFO
2. LIFO
3. Average cost
4. Standard cost
- Cost is determined before production begins -
Cost = direct material + direct labor + overhead -
Any difference between the standard cost and
actual cost is stated as variance


ABC Inventory Control: •
Controlling individual items
- What is the importance of inventory item? -
How are they to be controlled?
- How much should be ordered at one time? -
When should an order be placed?


ABC inventory classification system
- Importance of an SKU - inventory item
• $ value
• scarcity
- Level of control
Pareto principle - 80-20 rule
1. A - 20% of items; 80% of $ value
2. B - 30% of items; 15% of $ value
3. C - 50% of items; 5% of $ value


Steps in making an ABC analysis: (3)
1. Establish item characteristics
- $ value
- scarcity
2. Classify items into groups
3. Apply a degree of control in proportion to
importance


Procedure for classifying by annual $ values:
(5 steps)
1. Determine annual usage
2. Multiply annual usage by its cost; total annual $
usage
3. List items according to their annual $ usage
4. Calculate the cumulative annual $ usage and
cumulative percentage of the items
5. Examine the annual usage distribution and group
the items into A, B and C groups based on annual
percentage usage


ABC Analysis: Example
A company manufactures a line of ten items. Their
usage and unit costs are shown in the following
table along with the annual usage.
a.Calculate the annual usage of each items
b. List the items according to their annual $ usage

c. Calculate the cumulative annual dollar usage
and the cumulative percent of items
d. Group items into A, B and C classification

Example - continues (table)
Part Number Unit usage Unit cost $
1 1,100 2
2 600 40
3 100 4
4 1,300 1
5 100 60
6 10 25
7 100 2
8 1,500 2
9 200 2
10 500 1
Total 5,510

Example - continues (Answer a))
Part Number Unit usage Unit cost $ Annual $ usage
1 1,100 2 $2,200
2 600 40 $24,000
3 100 4 $400
4 1,300 1 $1,300
5 100 60 $6,000
6 10 25 $250
7 100 2 $200
8 1,500 2 $3,000
9 200 2 $400
10 500 1 $500
Total 5,510 $38,250

Example - continues (Answer b), c) and d))

Example - continues (Answer b), c) and d))

Part Unit Unit Annual $ Cumulative Cumulative Cumulativ
Class
Number usage cost $ usage $ usage % $ usage e % items

2 600 40 $24,000 $24,000 62.75% 10.0% A

5 100 60 $6,000 $30,000 78.43% 20.0% A

8 1,500 2 $3,000 $33,000 86.27% 30.0% B

1 1,100 2 $2,200 $35,200 92.03% 40.0% B

4 1,300 1 $1,300 $36,500 95.42% 50.0% B

10 500 1 $500 $37,000 96.73% 60.0% C

3 100 4 $400 $37,400 97.78% 70.0% C

9 200 2 $400 $37,800 98.82% 80.0% C

6 10 25 $250 $38,050 99.48% 90.0% C

7 100 2 $200 $38,250 100.00% 100.0% C


Control based on ABC classification: (2 rules)
1. Have plenty of low $ value items
- C items
- 50% items
- 5% cost
- Keep safety stock -
Order annually
2. Use the money and control effort to reduce the
inventory of high value items
- A items
- 20% items
- 80% cost
- Deserve the tightest control -
Frequent review


Different Controls:
• A - items: High priority
- Tightest control
- Complete accurate record -
Regular and frequent review -
Frequent review of demand
- Close follow up and expediting to reduce
lead time


• B - items: Medium priority
- Normal control
- Good record -
Regular attention -
Normal processing

Inventory fundamental powerpoint

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