Basics of Supply Chain Management : BSCM

Chapter 6. Inventory Fundamentals.

Main Issues :

· Understand the Classification of Inventory based on Flow of material.

· Identify the Functions of Inventories.

· Identify Costs that are relevant to Inventory Decisions.

· Understand the Costs of Ordering and Carrying Inventory.

· Understand Simple Financial Statements : Balanced Sheet and Income Statement.

· Understand The Meaning of Inventory Turns Ratio.

1. Introduction to Inventory.

□ What is Inventory ?

- Those stocks or items used to support production (raw materials and work-in-process

items), supporting activities (maintenance, repair, and operating supplies), and customer

service (finished goods and spare parts)

□ Aggregate Inventory Management.

- Aggregate inventory management is concerned with managing inventories according to

their classification and the function they perform.

- It is financially oriented and is concerned with the costs and benefits of carrying the

different classifications of inventories.

- Aggregate inventory management involves

· Flow and kind of inventory needed.

· Supply and demand patterns.

· Functions performed by inventory.

· Objectives of inventory management.

· Costs associated with inventory.

Ch.5 Inventory Fundamentals.

Ch.6 Inventory Fundamentals

□ Item Inventory Management

- Inventory is not only managed at the aggregate level but also at the item level.

- Management must establish decision rules about inventory items.

· Which individual inventory items are most important.

· How individual are to be controlled.

· How much to order at one time.

· When to place an order.

2. Aggregate Inventory Management.

□ Inventory and the Flow of Materials.

Figure 1. Inventories and the flow of materials.

- Raw Materials

· They represents any material inputs acquired by an individual company from the

outside for its use in manufacturing process.

· Natural materials (metal ores, trees, petroleum, etc.) + product from other companies.

- Work In Process

· While materials are in factory in various stages of completion, they are referred

to as work-in process inventory.

· The amount of work in process differs greatly from company, from production process.

- Finished Goods

· They are products ready to be delivered to distribution centers or ultimate users.

· They exist in various places and in different states in term of distribution points or centers.

- Distribution Inventories.

· Finished goods located in the distribution system.

- Maintenance, Repair, and Operating Supplies(MRO)

· They are hold by all company as well as just manufacturer and distribution centers.

· These types of goods are often low cost, but numerous, and include office and

janitorial supplies, spare parts, or even food for company-run cafeterias.

□ Functions of Inventory.

- Cycle inventory (Lot-size inventory)

· It is sometimes referred to as lot-size stock and results from ordering in

quantities that are in excess of current needs.

· Cycle stock applies equally to all types of inventory.

- Fluctuation inventory (Safety inventory)

· It is referred to as buffer stock.

· It is used to protect against the possibility of stockouts when demands or

supplies are subject to uncertainty.

- Pipeline inventory

· It called sometimes transportation stock that means inventory in transit.

· It is most prevalent with distribution inventories of finished goods.

· The average amount of inventory in transit :

[eqn: I ~ =~ {t A} over 365]

where  [eqn: I] is the average annual inventory in transit.

[eqn: t] is transit time in days.

[eqn: A] is annual demand,

- Anticipation Stock

· It is usually applied to inventory buildups that are produced and accumulated

based on some strategy.

· Seasonal buildup is one of the best examples of anticipation stock.

- Hedging Stock

· The term of its inventory is borrowed from financial markets to denote the higher

degree of risk involved.

· It is even called gambling stock.

· Justification of it may be based on such things as pending labor strikes in

supplier industry, predicted sharp price increases for a raw material, unsettled

governments of countries where foreign suppliers are located, etc..

- Decoupling Stock

· It is used to denote work-in-process inventories that act as buffers between

successive work operations in a factory, especially in job-shop production.

· The objective is to prevent idle time in the factory.

□ Inventory Management Objectives.

- Inventories must be coordinated to meet three conflicting objectives :

· Maximum customer service.

· Low-cost plant operation.

· Minimum inventory investment.

3. Inventory Costs.

□ Item Costs.

- For an item manufactured in-house, the cost includes direct material, direct labor, and

factory overhead.

- For a purchased item, the cost of the item + any other direct cost such as

transportation, custom duties, and insurance.

□ Carrying Costs.

- These costs include all expenses incurred by the firm because of the volume of

inventory carried.

- They can be broken down into :

1. Capital costs : A lost opportunity cost.

2. Storage costs : Space, workers, and equipment.

3. Risk costs. : Obsolescence, damage, pilferage, and deterioration.

□ Ordering Costs.

- Ordering cost are those associated with placing an order either with the factory or a supplier.

- The cost of placing an order does not depend on the quantity ordered.

- However, the annual cost of ordering depends on the number of orders placed in a year.

· Production control costs : Issuing and closing orders, scheduling, loading,

dispatching, and expediting.

· Setup and teardown costs.

· Lost capacity cost : The time taken to set up is lost, particularly important and

costly with bottleneck work centers.

· Purchase order cost : Order preparation, follow-up, expediting, receiving,

authorizing payment, and the accounting cost of receiving and paying the invoice.

□ Stockout Costs.

- A stockout can potentially be expensive because of back-order costs, lost sales, and

possibly lost customers.

- Stockouts can be reduced by carrying extra inventory to protect against those times

when the demand during lead time is greater than forecast.

□ Capacity-Related Costs.

- When output levels must be change, they may be cost for overtime, hiring, training,

extra shifts, and layoffs.

- These costs can be avoided by leveling production, but this builds inventory in the

slack periods.

4. Financial Statements and Inventory.

□ Balance Sheet.

Figure 2. Balance Sheet.

Assets		Liabilities
Cash Accounts receivable Inventory Fixed assets	$ 100,000 $ 300,000 $ 500,000 $ 1,000,000	Note Payable Accounts Payable Long-term debt	$ 5,000 $ 20,000 $ 500,000
		Total Liabilities	$ 525,000
		Owners' Equity
		Capital Retained earnings	$ 1,000,000 $ 375,000
Total Assets	$1,900,000	Total Liabilities and Owners' Equity	$ 1,900,000

- An asset : something that has value and is expected to benefit the future operation of

the business.

- Liabilities : Obligations or amounts owed by a company.

- Owners' equity : The difference between assets and liabilities.

□ Income Statement.

Figure 3. Income Statement

Revenue		$ 1,000,000
Cost of goods sold
· Direct labor · Direct material · Factory overhead	$ 200,000 $ 400,000 $ 200,000	$ 800,000
Gross margin (profit)		$ 200,000
General and administrative expenses		$ 100,000
Net income (profit)		$ 100,000

- Income (Profit) : Revenue - Expenses.

- Revenue : The sale of goods or services.

- Expenses : The costs incurred in the process of making revenue.

- Cost of goods sold : Costs that are incurred to make the product.

- General and administrative expenses : All other costs in running a business such as

advertising, insurance, property taxes, and wages and benefits other than factory.

□ Cash Flow Analysis.

- The inflow and outflow of cash in the business over a given period of time.

- To survive, a business must have the cash available to pay its bills.

- Cash flow :

· Raw material               : Cash outflow.

· Work in process            : Cash outflow.

· Finished goods            . : Cash outflow.

· Accounts receivable paid     : Cash inflow.

□ Financial Inventory Performance Measures : Inventory Turns.

- A convenient measure of how effectively inventories are being used is the inventory turns ratios.

- The number of times that the inventory has "turn over", or has been replaced, during

that periods

· Inventory Turnover =	Annual cost of goods sold
	Average inventory in dollars

- Example 1.

What will be the inventory turns ratio if the annual cost of goods sold is $24 million

a year and the average inventory is $6 million ?

Answer)

· Inventory Turnover =	24,000,000	= 4
	6,000,000

- Example 2.

What would be the reduction in inventory if inventory turns were increased to 12

times per year ?

Answer)

· Average Inventory =	Annual cost of goods sold	=	24,000,000	= $2,000,000
	Inventory Turnover		12

.                Reduction in inventory = 6,000,000 - 2,000,000 = $ 4,000,000

5. Inventory Classification : ABC Classification.

□ ABC Inventory Analysis

- It is a very useful and relatively simple method for classifying and analyzing inventory.

- It is based on Pareto's Law that close to 80% of the value(usage dollar value) of total

inventory is represented by 20% of items.

- A rule of thumb in ABC is to identify the top 20% of the items as "A", the next 30%

as "B", and the bottom 50% as "C".

Figure 4. Percent of number of items

- Uses of ABC Classification

· Cycle counting frequency.

: When checking inventory record accuracy, A items should be verified more frequently.

· Engineering priorities.

: Efforts are better spent on items with high cost or usage than on items with

: very low value or usage.

· Procurement priorities.

: Purchasing activities should concentrate on the high-cost, high-usage raw materials.

· Security.

: Although absolute unit cost might be a better guideline than usage dollar                        : value, ABC analysis may be used as an indicator of which items should be                     : more closely secured in locked stockrooms to protect against inventory loss.

· Replenishment systems

: It might be more economical to control some C items with a simple two-bin

: system of replenishment, with more sophisticated methods employed for A

: and B items.

· Investment decisions.

: More care may be taken when making decisions about order quantity and

: buffer stocks about A items.

- ABC Calculations

·The primary data : a value that represents the cost of each item in inventory and

annual usage for each item.

· Procedures of calculation

1. Calculate annual usage in units for each item.

2. Multiply usage be unit cost to determine annual dollar usage.

3. Rank items by annual dollar usage from highest to lowest.

4. Assign ABC categories.

- ABC Calculations Example.

ITEM No.	Annual Demand	Unit Cost	Annual Dollar Volume	% of Annual Dollar Volume	% of Number of Item	Total % of Annual Dollar Volume	Class
0286	1000	$ 90.00	$ 90000	38.8%	20%	72%	A
1526	500	154.00	77000	33.2%
2760	1550	17.00	26350	11.4%	30%	23%	B
0867	350	42.86	15001	6.5%
0500	1000	12.50	12500	5.4%
2572	600	14.17	8502	3.7%	50%	5%	C
4075	2000	0.60	1200	0.5%
1036	100	8.50	850	0.4%
1307	1200	0.42	504	0.2%
1057	250	0.60	150	0.1%
Total	8550		$231057	100%	100%	100%

■ Performance Check

1. Which of the following statements is most accurate about inventory management ?

A. Inventories and production must be managed together.

B. Inventory is not important at the production planning level.

C. Inventories are usually insignificant on the balance sheet.

D. Inventory does not cost much to carry.

2. What is the name of materials used in the production process that do not become part of the product ?

A. Raw materials.

B. Work in process.

C. Finished goods.

D. Maintenance, repair, and operating supplies.

3. What is the name given to inventories of items that are purchased or manufactured in quantities

greater than needed immediately ?

A. Fluctuation inventory.

B. Lot size inventory.

C. Transportation inventory.

D. Scheduled receipts.

4. Which of the following company objectives are in conflict ?

A. Maximum customer service and low-cost plant operation.

B. Low-cost plant operation and cash flow.

C. Maximum inventory investment and customer service.

D. Cash flow and profitability,

5. Which of the following costs will increase if order quantity is increased ?

A. Annual cost of carrying inventory.             B. Cost of ordering.

C. Cost of manufacturing operations.             D. Cost of customer service.

6. Which of the following are costs of carrying inventory ?

A. Capital costs and production control costs.

B. Capital costs and storage costs.

C. Production control costs and purchase costs.

D. Storage costs and purchasing costs.

7. Which of the following are considered ordering costs ?

A. Production control costs.                B. Capital costs.

C. Risk costs.                            D. Obsolescence costs.

8. Which of the following equations is correct ?

A. Assets = Liabilities - Owners' equity.

B. Income = Revenue - Liabilities.

C. Owners' equity = Assets - Liabilities

D. Revenues = Cost of goods sold - General and administrative expenses.

9. If the annual cost of goods sold is $ 10 million and the average inventory is $ 2.5 million, what is the turns ratio ?

A.  7.5                             B.  0.25

C.  2.5                             D.  4

10. Which of the following costs is relevant to inventory management decisions ?

A. Run costs.                        B. Storage costs.

C. Marketing costs.                   D. New product development costs.

Solutions.

1  2  3  4  5  6  7  8  9  10

A D B A A B A C D B