7 – Inventory Management

Introduction

From the standpoint of logistics operations, inventory decisions are high-risk and high-impact. A commitment to a specific inventory assortment and subsequent shipping to a market or region in anticipation of future sales determine various logistics tasks. Marketing may experience a loss of revenue and decreased consumer satisfaction if inventory is not adequately stocked. Similarly, inventory planning is essential in manufacturing. Raw material shortages can cause a manufacturing line to be shut down or a production plan to be altered, resulting in additional costs and the possibility of completed goods shortages. Overstocked stocks cause problems in the same way that shortages can disrupt planned marketing and manufacturing processes. Overstocks raise costs and impair profitability by requiring more warehousing, working capital, deterioration, insurance, taxes, and obsolescence.

7.1 Definitions and Functionality

Once an order is placed, the optimal inventory process entails manufacturing a product to a customer’s specifications. This is known as a make-to-order procedure, typical of customised equipment. A system like this does not necessitate raw materials or finished goods stocks in anticipation of future sales.

7.1.1 Geographical Specialization

Inventory has one purpose: it allows particular operating units to specialise geographically. Because of the requirements for production elements such as power, materials, water, and labour, the most cost-effective location for manufacturing is generally far from large markets.

For example, tyres, batteries, transmissions, and springs are essential components in automotive assembly.

The technology and knowledge required to manufacture each component are generally situated close to the material sources to save on transportation costs. This technique results in a geographic separation of production, allowing each automotive component to be produced economically. On the other hand, geographic separation necessitates internal inventory transfer to integrate components into the final assembly fully.

Geographical separation needs inventories to generate market assortments. Manufactured commodities from diverse locations are collected in a single warehouse and blended to form a mixed-product cargo.

Geographic isolation allows an enterprise’s manufacturing and distribution units to specialise economically. When geographical specialisation is used, inventory is brought to the logistical system through materials, semi-finished items or components, and finished goods. Every place necessitates a basic inventory. Furthermore, in-transit inventories are required to connect manufacturing and distribution. Although difficult to quantify, the efficiencies realised through local specialisation are expected to outweigh increased inventory and transit costs.

7.1.2 Decoupling

Decoupling, a second inventory function, maximises operating efficiency within a single manufacturing facility by hoarding work-in-process between production operations. Decoupling processes enable each product to be created and supplied in larger, more cost-effective lot sizes than the market wants. Warehouse inventory created beforehand allows for large-quantity shipments to customers at the lowest possible freight cost. In terms of marketing, decoupling allows products made over time to be sold as a collection. Thus, decoupling tends to “buffer,” or cushion, the enterprise’s operations against unpredictability.

7.1.3 Balancing Supply and Demand 

A third inventory function, balance, is concerned with the amount of time that has passed between consumption and manufacturing. Inventory balancing reconciles supply availability with demand.

Example: Seasonal production and year-round consumption are two prominent examples of balancing. One such product is orange juice. Antifreeze is another example of year-round production with seasonal demand. Inventory balancing connects industrial economics to fluctuations in consumption.

7.1.4 Buffers Uncertainties 

The safety stock or buffer stock function concerns short-term variations in demand or replenishment. The size of safety stockpiles is determined with considerable inventory planning. The majority of overstocks result from poor planning.

The demand for safety stock stems from uncertainties about future sales and inventory replenishment. When there is uncertainty, it is vital to protect the inventory position. In some ways, safety stock planning is analogous to purchasing insurance.

A safety stock guards against two kinds of uncertainty. The first category is demand that exceeds expectations during the performance cycle. The second sort of uncertainty involves delays in the length of the performance cycle itself. A customer request for more or fewer units than planned is an example of demand uncertainty. A delay in order reception, order processing, or transportation causes the performance cycle length uncertainty.

As a result, we can state, or rather deduce, that:

1. Geographic specialisation, decoupling, balancing supply and demand, and buffering uncertainties with safety stock are the four roles of inventory.
2. Inventory policy comprises recommendations for what to buy or create, when to act, and in what quantity. It also covers inventory positioning and placement decisions at facilities and distribution centres. For example, some businesses may postpone inventory positioning by keeping supplies at the factory.
3. The second inventory policy component is a plan for inventory management.
4. The service level is a management-specified aim. It specifies the performance goals that the inventory function must be able to meet.
5. Order cycle time, case fill rate, line fill rate, order fill rate, or any combination of the above can be used to determine the service level.
6. The performance cycle is the time that elapses between a client issuing a purchase order and receiving the associated shipment.
7. Cycle, safety stock, and transit inventory components are included in average inventories.
8. Cycle inventory, also known as base stock, is the portion of average inventory that results from replenishment. Stock is at its peak at the start of a performance cycle. Customers request to “draw off” supplies daily until the stock level approaches zero.
9. A replenishment order is placed so that stock arrives before it runs out. The replenishment order must be initiated during the performance-cycle period when the available inventory exceeds customer demand. The order quantity is the amount ordered for replenishment.
10. Base stock is the average inventory kept due to the order process.
11. Another word for this type of inventory that is widely used is lot-size stock.
12. Transit inventory is inventory moving or waiting to be moved in vehicles. This subset of overall inventory is known as transit or pipeline inventory.
13. From the standpoint of logistics management, transit inventory provides two sources of complexity in the supply chain. First, even if it is inaccessible or used, transit inventory represents tangible assets that must be paid for. Second, there has traditionally been high uncertainty connected with transit inventory since shippers could not identify where a transport vehicle was situated or when it was expected to arrive.
14. The stock retained to protect against the impact of uncertainty on each facility is the second component of average inventory. This category of inventory is known as safety stock. When uncertainty has resulted in higher-than-expected demand or longer-than-expected performance-cycle times, safety stock inventory is used only at the end of replenishment cycles.

7.2 Inventory Costs

Inventory is the critical cost source in the supply chain and the foundation for improving customer service and increasing customer happiness.

Example: While high inventory at retail shops may help make goods more accessible to customers and increase sales, it will also increase costs and reduce profitability.

These two main challenges must be overcome to optimise the organisation’s inventory.

Excess inventory costs the industry money in terms of capital, obsolescence, and maintaining products in the supply chain. However, having the appropriate inventory to meet client demands is crucial. Inventory management concerns two issues: not running out of stock and not having too much.

Inventory is essentially a reserve system that prevents stockouts. However, as crucial as it is to avoid such a stockout, you also don’t want to keep too many goods on hand because holding expenses can quickly add up. So, how do you strike a balance between the two, and how much is enough? More importantly, when should you reorder to avoid a stockout? One can discover the solution by obtaining and using pertinent inventory models in decision-making.

The heart of inventory decisions is identifying expenses and optimising those costs concerning the organization’s operations. Stock levels and inventory expenses in production must be controlled because inventory is a necessary but idle resource.

Cost of Inventory with Time

The overall inventory is additive in nature. A series of incremental operations converts raw ingredients into finished commodities. Regardless of the operational method, all production costs incurred within a specific period for tasks or items produced are assigned to inventory. These processes also increase the price of the organization’s inventory, which rises with time.

Total Inventory Costs

7.2.1 Average Inventory

The average inventory is half the batch size plus safety stock.

Average inventory = (Order quantity + Safety stock)/2

The assumption is that at any moment, the cycle stock (stock expected to be used excluding safety stock) is half the recipient amount, i.e. it is halfway between the receiving quantity and zero left. This has the practical effect of cutting order quantity and average cycle stock in half. Inventory decreases when a part is made in smaller batches.

7.2.2 Holding costs or carrying costs

The mere fact that an item is kept in stock costs money. These are the actual expenses of inventory storage. These expenses are known as inventory holding costs or carrying costs. This broad category comprises

Storage and handling cost: This is usually around 6%. The company’s total cost is projected to be 3 percent per month or 3 percent per year of the value of inventory held.

Insurance: Insurance accounts for a percentage of the inventory costs. Companies often ensure the material since it is better to be safe than sorry. In most cases, it comes to 1%.

Pilferage and spoilage: This can range from 2% to 5%, depending on the industry and the type of inventory handled.

Obsolescence and Degradation: are items that are either unfit to sell or sitting in storage awaiting the appropriate application. They are usually around 1% of the inventory carrying cost.

Opportunity Cost: The opportunity cost of Capital is the cost of establishing the warehousing facility. This is calculated using the “Lost Opportunity Cost” rather than the interest rate.

There are also some extra charges, which may include depreciation and taxes, among other things.

These costs rise in direct proportion to the volume of inventory. If the holding costs are significant, the organisation should carry less inventory and refill the stock regularly.

Though a straight line shows holding costs, there are certain constant and variable inventory storage costs. This means that some expenses will not change regardless of whether inventory levels increase or decrease, while others depend on inventory levels held.

The capital and operating costs of the warehouse, including people, are fixed, but the interest costs of capital held in inventory, etc., are variable.

7.2.3 Ordering Costs

What is the actual cost of placing and processing a purchase order? The entire cost comprises the costs of purchasing, receiving, incoming inspection, and accounts payable. Each of these departments operates to meet the constant demand for material. We arrive at a simple calculation to compute the average cost per order as follows:

Avg. Cost per Order = Total Budget/Number of Orders Placed Per Year

Although it costs money to keep inventory, it also costs money to replenish inventory through purchase or manufacturing cycles.

Inventory Ordering Costs are costs spent during the purchasing cycle, referred to as procurement or inventory ordering costs. Ordering expenses contain two components:

(a) one that is relatively fixed and

(b) another that varies.

The cost of replenishment is a significant component of inventory costs. If an organisation orders a part or raw material from an outside source three times per year instead of six times per year, the expenses that change are the variable costs, and the fixed costs are unlikely to alter.

Costs are incurred in maintaining and updating the information system, developing vendors, and evaluating vendor skills. Ordering costs include all the specifics, such as counting things and determining order quantities. Ordering costs include the price of maintaining the system used to track orders. This covers phone calls, typing, shipping, and so forth.

The fixed costs of procurement or order placement are substantially more than the variable costs of placing orders.

7.2.4 Setup (or Production Change) cost

Ordering expenses are incurred during the purchasing cycle, whereas set-up costs are payable during the manufacturing cycle. As a result, the inventory ordering costs accurately represent the set-up cost. These two expenses are thought to be mutually exclusive.

Similar expenses for manufactured goods are known as Setup Costs. In the case of subassemblies or finished items that may be manufactured in-house, the expenses associated with turning over equipment from producing one item to producing another are sometimes referred to as setup costs.

This comprises all costs unrelated to the order quantity (the costs incurred to prepare the order paperwork, process and track the order operations, set up the machine, and conduct the first inspection). This overall ordering/processing cost is finally passed on to the items.

Set-up expenses indicate the costs of collecting the necessary materials, organising specific equipment setups, filling out the relevant paperwork, appropriately billing time and materials, and transferring out the previous stock of materials used in manufacturing each product.

7.2.5 Shortage or Stock-out Costs

No industrial plant can afford to maintain enough inventory to meet every demand. At some point, stock-outs occur. Stock-outs result in a missed sale or, if the consumer is willing to wait, a backorder. A lost sale represents the risk of losing the business to competition. Furthermore, back orders incur additional costs, such as extra paperwork, the time spent dealing with this paperwork, a system to handle the back orders, extra delivery notes and invoices, and additional packing and shipping charges.

When an item’s stock is low, an order for that item must either wait until the stock is restored or be cancelled. There is a trade-off between carrying enough stock to meet demand and the costs associated with stockouts. Stock-out or shortage costs are incurred when an item runs out of stock.

Understanding the cost of a stockout is crucial to adopting any inventory model. Unless these expenses are known, the organisation cannot balance the costs (and risk) of retaining inventory with the loss of profits when an item is out of stock.

For a retailer, the costs include the lost revenues from the immediate order due to cancellations and the long-run costs if stockouts diminish the possibility of future sales. For a manufacturer, this consists of both production and capacity loss. Furthermore, the result may be a loss of product sales and, ultimately, a loss of customers.

Suppose the unsatisfied commodity demand can be supplied later (backorder situation). In that case, the cost of back orders is believed to change directly with the shortage quantity (in rupee value) and the cost associated with the additional time required to complete the backorder (‘/’/year).

However, if the unfulfilled demand is lost, the cost of shortages is considered to vary directly with the shortage amount (‘/unit shortage). When this is compared to the total cost of inventory, the price falls as inventory increases because this cost is stable, mainly due to the value of the inventory.

Frequently, the estimated shortfall cost is little more than a guess. However, a range of such prices is usually possible.

7.3 Planning Inventory

This section discusses the essential characteristics and techniques for inventory planning. The debate focuses on three issues: when, how much, and inventory control processes.

7.3.1 Determining the Order Point (When Should I Order?)

The reorder point determines when a re-supply shipment should be launched. Depending on the item and distribution centre, the reorder point can be specified in units or days of supply.

This discussion focuses on selecting reorder points under demand and performance-cycle certainty conditions. The certainty criteria indicate that future demands and performance-cycle lengths are known.

R = D × T

where,

R = reorder point in units

D = average daily demand

T = average performance-cycle length

Assume a daily demand of 10 units and a performance cycle of 20 days to demonstrate this computation. In this scenario, 10 units per day x 20 days = 200 units.

Reorder point formulations mean the re-supply shipment will arrive just as the last unit is dispatched to a client. This strategy is adequate as long as the demand and performance cycles are predictable. When there is uncertainty in either demand or performance cycle length, an inventory buffer is required to compensate for the uncertainty.

When this buffer stock is required under unpredictable conditions, the reorder point formula is R = D T + SS.

Where R is the ordering point in units.

D = average daily demand T = average performance-cycle length

SS is an abbreviation for safety or buffer stock in units.

7.3.2 Determining Lot Size (How Much?)

The lot sizing idea balances the expense of inventory maintenance against the cost of ordering. The key to understanding the relationship is to recall that the average inventory equals one-half of the order quantity. As a result, the higher the order quantity, the higher the average inventory and, as a result, the higher the annual maintenance cost. However, the higher the order amount, the fewer orders required every planning period and, as a result, the lower the total ordering cost. Lot quantity formulations identify the precise amounts at which the annual combined cost of ordering and maintenance is lowest for a particular sales volume.

Economic Order Quantity

The Economic Order Quantity (EOQ) is the replenishment order quantity that minimises inventory upkeep and ordering costs. It is identified assuming demand and costs are broadly consistent throughout the year.

The mathematical method is the most efficient for computing economic order quantity. The standard formulation for EOQ is used to do the necessary computations.

Where, 

EOQ stands for  economic order quantity (EOQ)

Co stands for cost per order.

Ci denotes the annual inventory carrying cost.

D denotes the annual sales volume in units.

U is the cost per unit.

While the EOQ model predicts the ideal replenishment quantity, it does so based on relatively stringent assumptions limiting its direct use. The following are the main assumptions of the simple EOQ model:

1. Complete satisfaction of all requests
2. Demand that is continuous, constant, and predictable
3. Consistent and predictable replenishment performance-cycle time
4. a product with a fixed price that is unaffected by the quantity or timing of the order (i.e., there are no discounts for purchase quantity or transportation price available)
5. The planning horizon is infinite.
6. There is no interaction between several inventory items.
7. There is no inventory in transit.
8. Capital availability is not restricted. However, some of these assumptions impose limits that can be avoided with computational expansions. The EOQ idea, on the other hand, emphasises the significance of the trade-offs associated with holding and acquisition costs.

EOQ Extensions

While the EOQ formulation is pretty simple, there are a few extra elements to consider in a real application. The most persistent issues are those associated with the numerous changes required to take advantage of particular buying scenarios and unitization features.

Volume adjustments, quantity discounts, other adjustments, and volume transportation prices are three common types of adjustments.

The impact of transportation costs on order quantity was not taken into account in the EOQ formulation. When things are acquired on a delivered basis, and the seller bears the expense of transportation from the point of origin to the end of inventory, such negligence may be justified. The vendor is liable for the shipping until it reaches the customer’s location. When product ownership is transferred at the point of origin, the impact of transportation rates on total cost must be considered when deciding order quantity.

Generally, the heavier the order, the cheaper the cost per pound of transportation from origin to destination. A freight-rate discount for larger goods is typical for trucks and rail and may be found in almost all transportation pricing systems. All else being equal, a firm will naturally desire to acquire in quantities that maximise transportation efficiencies. These sums might be more significant than the EOQ approach’s purchase quantity.

Rates

The impact of transportation costs on order quantity was not taken into account in the EOQ formulation. When things are acquired on a delivered basis, and the seller bears the expense of transportation from the point of origin to the end of inventory, such negligence may be justified. The vendor is liable for the shipping until it reaches the customer’s location. When product ownership is transferred at the point of origin, the impact of transportation rates on total cost must be considered when deciding order quantity.

Generally, the heavier the order, the cheaper the cost per pound of transportation from origin to destination. A freight-rate discount for larger goods is typical for trucks and rail and may be found in almost all transportation pricing systems. All else being equal, a firm will naturally desire to acquire in quantities that maximise transportation efficiencies. These amounts may be more significant than the purchase quantity indicated by the EOQ approach. Increasing order size has a dual effect on inventory costs.

The second effect is a reduction in the number of orders needed. The reduced number of orders increases the size, resulting in more excellent transportation economics.

The total cost with and without transportation savings must be calculated to complete the study. While this calculation can be performed directly by modifying the EOQ formulation, comparison yields a more illuminating result. The only extra data required is the applicable freight costs when ordering in quantities.

The impact of volume shipping rates on total procurement costs cannot be overlooked. As a result, if transportation charges are the buyer’s responsibility, every EOQ must be assessed for transportation cost sensitivity across a range of weight breaks. Finally, two aspects of inventory cost under conditions of origin buy are worth mentioning. (With an origin purchase, the buyer is responsible for freight costs and product risk while the product is en route.) First, the buyer takes the entire inventory risk at shipment. Depending on the period of needed payment, this could imply that transit inventory is included in the enterprise’s average inventory and, hence, liable to an appropriate charge. As a result, every weight break change resulting in a shipment method with a different in-transit duration should be analysed in a total-cost analysis for additional cost or savings.

Second, the transportation cost must be added to the purchase price to achieve an appropriate estimate of the worth of products held in inventory. Once the inventory is received, the amount invested in the product must be increased to cover shipping costs. The inventory carrying cost should then be calculated based on the item’s total price, including transportation.

The basic EOQ formulation may handle quantity discounts directly by calculating the total cost at any given volume-related purchase price to determine associated EOQs. Suppose the discount at any linked quantity is significant enough to offset the additional maintenance cost less the lower ordering cost. In that case, the quantity discount is a viable option. It should be noted that quantity discounts and volume transportation prices significantly impact purchasing volumes. This does not always imply the lowest total cost because it reflects a fixed cost once the decision to resupply merchandise is taken. If a private fleet is used to transport replenishment products, the firm must fill the truck regardless of the EOQ.

Another factor to consider when determining the order amount is the unitization characteristic. Many products are housed and transported in standard containers, such as cases or pallets. Because these standardised units are meant to accommodate transportation or handling vehicles, there may be substantial diseconomies when the EOQ is not a unit multiple.

Problem 1:

Assume you have a product with the following specifications:

360 units per year = annual demand

Annual holding cost =’1.00 per unit

Order price = ‘100 per order

What is the order quantity for this product?

Solution:

EOQ   = 268.33 items

The EOQ model is based on the assumption that any absolute quantity is possible. The amount requested must be an integer value and may be influenced by packaging or other item features. The EOQ of 268 is assumed in the following problems:

Problem 2:

Given the information in Problem 1, and assuming a 300-day work year, how many orders should be completed each year? How long should it take between orders?

Solution:

N = Demand/Q = 360/268 = 1.34 orders per year

T = Working days/Expected number of orders = 300/1.34 = 224 days between orders

Problem 3:

What is the total cost for the inventory policy used in Problem 1?

Solution:

TC = Demand*Order Cost/Q + (Quantity of Items)*(Holding Cost)/2

= 360*100/268 + 268*1/2 = 134 + 134 = $268

Notice that at the EOQ, the Total Holding Cost and Total Ordering Cost are equal.

Problem 4:

Based on the material from Problems 1-3, what would the cost be if the demand was higher than estimated (i.e., 500 units instead of 360 units), but the EOQ established in Problem 3 above is used? What will be the total annual cost?

Solution:

TC = Demand*Order Cost/Q + (Quantity of Items)*(Holding Cost)/2

= (500*100)/268 + (268*1)/2 = 186.57 + 134 = $320.57

Note that while demand was underestimated by nearly 50%, annual cost increases by only 20% (320/268 = 1.20), which illustrates the degree to which the EOQ model is relatively insensitive to small errors in estimating demand.

Problem 5:

If demand for an item is 3 units per day and delivery lead time is 15 days, what should we use for a simple re-order point?

Solution:

ROP = Demand during lead-time = 3 * 15 = 45 units

Other EOQ Adjustments

Various scenarios may arise that necessitate changes to the standard EOQ. Here are several examples:

1. Quantity of production lots
2. Purchasing multiple items
3. Limited financial resources

Four. Private trucking. The production lot size refers to the most cost-effective amounts from a manufacturing standpoint. Multiple-item purchase relates to instances in which more than one product is purchased simultaneously, and quantity and transportation discounts must account for the impact of product combinations. “limited capital” refers to situations with budget constraints for overall inventory investment. Order quantities must realise the requirement to allocate the inventory investment across the product line since the product line must be met within the budget constraints.

7.3.3 Discrete Lot Sizing

Not all replenishment scenarios have uniform usage rates, like in the prior EOQ estimates. Demand for a single component tends to occur irregularly and in varying quantities in many production circumstances. The erratic nature of use requirements results from demand contingent on the production schedule. That is, the necessary assembly parts must be available during manufacturing. There is no need to keep component inventory on hand between required times if it can be obtained. Inventory servicing of contingent demand necessitates a modified technique to order quantity determination known as discrete lot sizing. The term “discrete” refers to the procurement goal of obtaining a component quantity equal to the net requirements at a particular time. Due to fluctuating component requirements, purchase amounts using discrete lot sizing will change between orders. There are numerous lot sizing techniques available. There are two options:

1. Lot-for-lot sizing
2. Period orders quantity
3. Time-series lots sizing

Lot-for-Lot Sizing

The most fundamental type of discrete ordering is to schedule purchases to cover net requirements over a specific period. The cost of ordering under lot-for-lot sizing is not taken into account. Because no ordering economies are considered, the lot-for-lot technique is purely dependent and demand-oriented in one sense. The order amount corresponds perfectly to the manufacturing or demand quantity. The basic strategy is frequently utilised when the purchased item is affordable and the requirements are minor and irregular. Lot-for-lot scaling often employs electronic order transfer and premium transportation to save processing and delivery time.

Period Order Quantity

The Period Order Quantity (POQ) technique extends the logic of the EOQ technique. Three stages are taken here to complete the component acquisition. First, the standard EOQ is calculated. Second, the EOQ quantity is divided by the estimated yearly usage to determine the order frequency.

Third, to express the order quantity in periods, the number of orders is divided by the applicable period (e.g., 52 for weeks or 12 for months).

For example, consider an EOQ of 300 and a forecast of 2,400. The POQ approach would be as follows to modify to a twelve-period year:

Orders per Year = 2400/300 = 8.00

EOQ = 300

Forecast = 2400

Orders per Year = 2400/300 = 8.00

Order Interval = 12 x 8.00 = 1.5 Months

Orders are scheduled every six weeks under the POQ application. Unless utilisation deviates from the intended quantity and necessitates a “catch-up” or “light” re-supply order, the regular order is 300 units.

The main advantage of the POQ technique is that it considers inventory-carrying costs, thereby minimising inventory carryover. The downside is that, like the basic EOQ, POQ requires consistent demand to reach its full potential.

Time-Series Lots Sizing

Time-series lot sizing primarily aims to consolidate requirements over multiple periods to arrive at procurement logic. The time-series technique is dynamic because the order quantity is changed to suit current requirement estimates. In contrast, basic EOQ is static because once the order quantity is computed, it remains unaltered for the duration of the demand-planning horizon.

The fundamentals of dynamic lot sizing are that requirements are articulated in shifting amounts throughout time rather than in consumption rates per day or week, as is typical of the basic EOQ. Fixed order amounts are replaced with a lot sizing system that can compute an efficient order given fluctuating and intermittent usage in the presence of significant usage variability. Three such strategies are commonly discussed in the literature and are briefly addressed here: least unit cost, least overall cost, and part period balance.

Least Unit Cost

It aims to discover the lowest cost per SKU requirement over several periods. Beginning with the initial period’s net requirements, each subsequent period’s per unit requirements are analysed to obtain a combined amount for a certain number of periods with the lowest unit cost. The least-unit-cost technique analyses purchasing requirements regarding the number of weeks of supply available in the future.

The first week takes into account one week’s supply. After that, the study considers adding a second week. The unit cost (including quantity discounts, ordering cost, inventory carrying cost, and transportation cost) is calculated for each choice.

While the average unit cost will decrease when more periods are added due to the discount, ordering, and shipping expenses, the inventory-carrying cost will increase due to the additional inventory. As a result, under the least-unit-cost technique, order volumes and frequency will fluctuate significantly. While this method overcomes the static aspects of EOQ and POQ, the technique may cause unit costs to vary considerably between periods.

Least total cost

The least-total-cost strategy seeks the amount with the lowest overall cost throughout multiple periods. In this view, the goal of the least overall cost, balancing ordering and carrying, is comparable to that of EOQ. The essential distinction is changing the order interval to achieve the lowest total cost. The computation is based on the economic portion period, a ratio of ordering to carrying cost (CdCi). The financial part period specifies the quantity of a specific component that, if held in inventory for one period, would result in a carrying cost equal to the ordering cost. The least-total-cost technique chooses order sizes and intervals closest to the economic part-period calculation. As a result, order sizes remain reasonably constant; nonetheless, significant variances in elapsed time between order places occur. The least-total-cost technique overcomes the failure of the least-unit-cost technique to account for trade-offs during the entire planning period.

Part-period Scheduling

Part-period balancing is a variant of the least-total-cost technique that includes a particular adjustment routine known as look-ahead look-back.

The essential advantage of this feature is that it extends the planning horizon beyond more than one ordering point when computing order quantities to account for use peaks and valleys. When a forward or backward examination of more than one order requirement suggests that changes to the economic period may be favourable, adjustments are made in order time or quantity. Typically, the look-ahead feature is tested first to see if more time results in an approximation of the part-period economic amount. When look-ahead leaves the lot size unchanged, look-back is usually used. In this context, look-back indicates that a future order that would ordinarily be scheduled for delivery during the fourth period under the economic part-period rule should be advanced if early delivery would reduce total cost. Incorporating the look-ahead/look-back feature has the net effect of transforming the application of the economic component period concept into a simultaneous examination of various periods.

7.4 Managing Uncertainty

Global optimization is more challenging because supply chains must be developed for and operated in uncertain contexts, sometimes posing tremendous risks to the business. This is due to several variables, including:

1. Matching supply and demand is a significant challenge:

• In October 1997, Boeing Aircraft disclosed a $2.6 billion write-down owing to “raw material shortages, internal and supplier part shortages, and productivity inefficiencies.”
• “Second-quarter revenues at US Surgical Corporation fell 25%, resulting in a $22 million loss.” The sales and earnings shortfall is related to higher-than-expected stockpiles on hospital shelves.”
• “EMC Corp. said it missed its revenue projection of $2.66 billion for the second quarter of 2006 by roughly $100 million, owing to higher-than-expected orders for the new DMX-3 systems over the DMX-2, resulting in an inventory problem.”
• “There are so many ways inventory can enter our system that keeping it under control is a constant problem” [Johnnie Dobbs, Wal-Mart Supply Chain and Logistics Executive].
• “Intel, the world’s largest chipmaker, announced a 38% drop in quarterly earnings Wednesday, blaming intense competition from Advanced Micro Devices and a general slowdown in the personal computer industry, which caused inventories to rise.”

This challenge derives from the fact that producers must commit to precise production levels months before demand is met. These advance agreements include significant financial and supply concerns.

2. Inventory and back-order levels vary significantly across the supply chain, while customer demand for specific products does not. In a typical supply chain, distributor orders to the manufacturing facility fluctuate significantly more than underlying retailer demand.

3. Forecasting does not resolve the issue. Indeed, we will argue that the first forecasting premise is that “forecasts are always inaccurate.” As a result, even with the most sophisticated forecasting tools, predicting the precise demand for a single item is difficult.

4. Uncertainty is not limited to demand. Delivery lead times, manufacturing yields, transit periods, and component availability can all substantially impact the supply chain.

5. Cost-cutting initiatives such as lean manufacturing, outsourcing, and offshoring considerably enhance hazards.

Consider an automobile company whose parts suppliers are located in Canada and Mexico. Parts can be delivered to assembly factories “just in time” based on defined manufacturing schedules with less uncertainty in transportation and a reliable supply schedule.

However, in the event of an unforeseeable tragedy, such as the September 11 terrorist attacks, port strikes, or weather-related calamities, adherence to this type of approach may result in the stoppage of production lines due to a lack of parts. Outsourcing and offshoring, on the other hand, suggest that supply chains are more geographically varied, and as a result, natural and man-made disasters can have a massive impact.

Hurricane Katrina wreaked havoc on New Orleans and the Gulf Coast on August 29, 2005. The hurricane significantly impacted Proctor & Gamble coffee manufacturing, with brands like Folgers sourcing more than half of their supply from New Orleans. Six months later, a P&G official told the New York Times that there were “still holes on the shelf” where P&G’s brands should have been.

A port strike on the West Coast in 2002 shut down ports from Seattle to San Diego. Economists believe the strike cost the economy up to $1 billion daily since stores could not stock, fruits and vegetables decayed, and companies were forced to close due to a lack of parts.

A massive earthquake hit Taiwan in September 1999. Initially, 80% of the island’s power was lost. Supply disruptions hurt companies such as Hewlett-Packard and Dell, which rely on Taiwanese manufacturers for various components.

Following the January 26, 2001, earthquake in the Indian state of Gujarat, fabric shipments from India were delayed, affecting numerous U.S. garment manufacturers.

Although uncertainty and risk cannot be eliminated, we will look at several examples that show how product design, network modelling, information technology, procurement, and inventory strategies can reduce risks by minimising uncertainty and building flexibility and redundancy in the supply chain.

7.5 Policies for Inventory Management

Inventory is a concern for business owners and managers because it is often the second-greatest cost in a firm after payroll. Policies and procedures assist businesses in actively managing the many items in their facilities. While conventional inventory management policies and procedures exist, owners and managers have some leeway in developing business standards.

Inventory management is the process of implementing an inventory policy. In the reactive or pull inventory strategy, customer demand pulls products through the distribution channel. An alternate viewpoint is a planning method that allocates inventory proactively based on projected demand and product availability. A third, or hybrid, reasoning employs a mix of push and pull.

7.5.1 Inventory Control

Inventory control is the managerial method for implementing an inventory policy. The accountability part of control counts the number of units on hand at a given place and tracks additions and removals. Accountability and tracking can be done manually or automatically. Inventory control specifies how frequently inventory levels are checked to determine when and how much to order. It can be done on a continuous or periodic basis.

7.5.2 Reactive Methods

As the name implies, a reactive or pull inventory system responds to a channel member’s inventory demands by drawing the product through the distribution channel. Replenishment shipments are launched when warehouse stock levels fall below a predefined minimum or order point. Some lot-sizing formula usually decides the amount ordered, but it could be a variable quantity determined by current stock levels and a predetermined maximum level.

7.5.3 Planning Methods

Inventory planning strategies use a shared database to coordinate inventory requirements across various locations or stages of the supply chain. Inventory allocation and delivery to different destinations may necessitate planning actions at the plant warehouse level. Coordinating inventory requirements among different channel partners, such as manufacturers and retailers, may also occur.

Applications of the Advanced Planning and Scheduling (APS) system planning method: While APS technologies automate the process, logistics managers must understand the underlying logic and assumptions. Fair Share Allocation and Distribution Requirements Planning are two inventory planning strategies (DRP).

Fair share allocation is a simplified inventory management planning strategy that allocates an equal or “fair share” of available inventory from a common source, such as a plant warehouse, to each distribution outlet.

DRP (Distribution Requirements Planning): DRP is a more complex planning approach that considers numerous distribution stages and their distinct characteristics. It is a logical extension of Manufacturing Requirements Planning (MRP); however, there is one key distinction between the two methodologies. MRP is based on a production schedule defined and controlled by management policy. DRP, on the other hand, is influenced by client demand.

As a result, although MRP typically operates in a dependent demand environment, DRP operates in an independent demand environment where variable consumer demand dictates inventory requirements. MRP manages inventory by coordinating the scheduling and integration of materials into finished goods. Once finished goods are received at the plant warehouse, DRP assumes coordination responsibilities.

7.5.4 Collaborative Inventory Planning 

Replenishment initiatives are intended to improve the flow of commodities through the distribution system. There are various collaborative replenishment approaches based on the common denominator of swiftly renewing inventory based on actual sales experience. The goal is to move away from projects when and where inventory will need to be positioned to satisfy consumer or end-user demand and instead allow suppliers to respond to demand on a just-in-time basis. Effective collaborative replenishment systems necessitate substantial cooperation and information exchange among partners in the distribution channel. Quick response, continuous replenishment, vendor-managed inventory, and profile replenishment are all examples of automatic replenishment techniques.

7.5.5 Adaptive Logic

A mixed inventory management system can help solve issues when utilising either a reactive or a planning strategy. The circumstances that favour using a reactive system in one instance may alter over time to favour using an inventory planning system. Thus, the perfect solution is an adaptive inventory management system that contains components of both types of logic and enables different tactics to be employed with specific customer or product segments. The rationale for an adaptive system is that client demand must be represented as independent in most cases; however, demand can be treated as dependent in other supply chain collaborations. As a result, an interface exists between independent and dependent demand at specific points and times along the supply chain. Because dependent demand settings lessen system demand uncertainty, the closer that interface is to the final client, the lower the amount of overall system inventory.

A significant consumer campaign, for example, may lead demand to behave like dependent demand even at the consumer level because a significant demand spike can be expected from knowledge of the promotion schedule.

7.6 Inventory Management Techniques

An integrated inventory management plan describes the policies and processes used to determine where inventory should be placed, when replenishment shipments should begin, and how much to assign. The strategy development process uses three steps to identify products and markets, design segment strategies, and operationalize regulations and parameters.

7.6.1 Product/Market Segmentation

Product market classification aims to focus and fine-tune inventory management operations. Product/market classification, or fine-line or ABC classification, unites items, markets, or customers with similar qualities to make inventory management more effortless. The classification process acknowledges that not all items and marketplaces have the same features or relevance. A sound inventory management system necessitates classification that is compatible with the corporate strategy and service objectives.

A multitude of criteria can be used to classify anything. Sales profit contribution, inventory value, usage rate, and item kind are the most prevalent. The typical classification procedure logically arranges items or markets, grouping entries with comparable qualities. The products are arranged in descending order by sales volume, with the most popular items appearing first, followed by slower sellers. One of the oldest approaches for establishing selective policies or strategies is classification based on sales volume. A small fraction of entities account for a significant percentage of the volume in most marketing or logistical applications. This operationalization is commonly called the 80/20 rule or Pareto’s law. According to the 80/20 rule, based on extensive observations, 20% of the goods account for 80% of the sales volume for a typical firm. A corollary to the concept is that 20 percent of customers account for 80 percent of company revenue. According to the rule’s inverse, the remaining 20% of sales are obtained from 80% of the products, consumers, and so on. In general, the 80/20 rule means that a small number of items or consumers generates the most sales.

Once things have been categorised or grouped, assigning a character or description to each category is usual practice. High-volume, fast-moving products are sometimes referred to as “A” items. The intermediate-volume goods are called “Bs,” while the low-volume or slow movers are called “Cs.” These character labels explain why this procedure is sometimes called ABC analysis. While three categories are commonly used for fine-line categorization, some organisations utilise four or five to enhance classifications further. Grouping comparable products makes it easier for management to develop focused inventory plans for specific categories.

High-volume or fast-moving products, for example, are often targeted for greater service levels. This frequently necessitates a higher level of safety stock.

Slower-moving items, on the other hand, may be given less safety stock to reduce total inventory levels, resulting in poorer service levels.

7.6.2 Definition of Segment Strategy

The next stage is to develop an integrated inventory plan for each product/market group or segment. The integrated strategy specifies all components of the inventory management process, such as service objectives, forecasting methods, management techniques, and review cycles.

The knowledge that product segments have varying degrees of value in attaining the corporate objective is critical to developing selected management strategies.

7.6.3 Implement Policies and Parameters

The final step in developing a targeted inventory management strategy is to define comprehensive procedures and parameters. Data needs, software applications, performance objectives, and decision standards are all described in the procedures. The parameters define values such as review period length, service objectives, inventory carrying cost %, order quantities, and reorder points. The combination of parameters determines or can be used to calculate the amounts required to make inventory management decisions. Following the implementation of the methods and parameters, the environment and performance characteristics must be monitored regularly. Continuous monitoring is necessary to guarantee that the inventory management system accomplishes the expected goals and that the customer and product environments do not change significantly.

For example, as demand for a given product increases, inventory process monitoring should recognise the requirement and possibly recommend a move from a reactive to an inventory planning system.

REVIEW QUESTIONS:

1. Define Decoupling in the context of supply chain management.
2. Define Buffer Uncertainty and its role in managing supply chain risks.
3. Explain how the Cost of Inventory varies over time.
4. Discuss the concept of Total Inventory Costs and its components.
5. Define Holding (or Carrying) Costs and their significance in inventory management.
6. Differentiate between Fixed and Variable Ordering Costs in inventory management.
7. Assess whether ordering costs are incurred in the purchase cycle, providing a rationale for your answer.
8. Briefly overview Planning Inventory and its importance in supply chain management.
9. Highlight the factors that contribute to managing uncertainty in inventory management.
10. Discuss various Inventory Management Policies and their implications for supply chain operations.