LOS 8
Inventory Management:
Certainty Approach
Learning Outcome Statement (LOS)
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define inventory and inventory management
understand why we need to carry inventory
how to control inventory
understand the basic economic order quantity
(EOQ) model
discuss
the
development
in
inventory
management
define costs in inventory systems
Introduction
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"Inventory" to many small business owners is one of the more
visible and tangible aspects of doing business. Raw materials,
goods in process and finished goods all represent various
forms of inventory.
In a literal sense, inventory refers to stocks of anything
necessary to do business. These stocks represent a large
portion of the business investment and must be well managed
in order to maximize profits.
In fact, many small businesses cannot absorb the types of
losses arising from poor inventory management. Unless
inventories are controlled, they are unreliable, inefficient and
costly.
Inventory Management
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The management of inventory is unlike the management of
any other assets and liabilities in that this type of assets are
physical rather than purely financial in nature.
The management of inventory is one of the oldest concerns of
management science.
The challenge here is to formulate strategies for the ordering
and holding of inventory that will be the most advantageous to
the firm. But because of uncertainties regarding the various
parameters that are estimated in making these decisions, there
is risk associated with these strategies.
Inventory Management
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Successful inventory management involves balancing the costs
of inventory with the benefits of inventory. This fine line
between keeping too much inventory and not enough is not
the manager's only concern. Others include:
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Maintaining a wide assortment of stock - but not spreading
the rapidly moving ones too thin;
Increasing inventory turnover - but not sacrificing the
service level;
Keeping stock low - but not sacrificing service or
performance.
Obtaining lower prices by making volume purchases - but
not ending up with slow-moving inventory; and
Having an adequate inventory on hand - but not getting
caught with obsolete items.
Effective Inventory Management
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A system to keep track of inventory
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A reliable forecast of demand
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Knowledge of lead times
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Reasonable estimates of holding costs, ordering costs,
shortage costs
Inventory classification system
Inventory Management
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Two approaches are used in addressing this risk. One of them
is “certainty approach” discussed in this LOS.
In this approach, a strategy is first formulated to deal with the
expected values of these inventory parameters, under the
unrealistic assumptions that these parameters are certain.
Then, a hedging strategy is formulated to address the
uncertainties in these parameters.
This is called the “certainty approach” not because the
parameters are certain, but because they are treated as
certain in the first phase of policy making.
Why Carry Inventory?
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The reasons why the firm wants to carry inventory depends on
what types of inventory it basically holds: raw materials, workin-process or finished goods.
Raw Materials
1.
2.
3.
4.
Having an available stock of raw materials makes production
scheduling easier.
Keeping raw materials may help to avoid price changes for
these goods.
Keeping extra raw materials may help to hedge against supply
shortage.
Keeping additional raw materials may help to take advantage
of quantity discount.
Why Carry Inventory?
Work-in-Process
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In manufacturing firms, a certain amount of work-in-process
inventory occurs as products move from one production
process to the next.
A major reason that firms keep work-in-process inventory
beyond a minimum level is to buffer production.
Buffering is a part of the planning process and allows flexibility
and economies that would not otherwise occur.
Why Carry Inventory?
Finished Goods
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One reason to keep finished goods inventory is to provide
immediate service.
A second reason for keeping finished goods inventory is to
stabilize production.
The Purchasing Plan
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One of the most important aspects of inventory control is to
have the items in stock at the moment they are needed.
For retailers, planning ahead is very crucial. Since they offer
new items for sale months before the actual calendar date for
the beginning of the new season, it is imperative that buying
plans be formulated early enough to allow for intelligent
buying without any last minute panic purchases.
Part of your purchasing plan must include accounting for the
depletion of the inventory. Before a decision can be made as to
the level of inventory to order, you must determine how long
the inventory you have in stock will last.
Controlling the Inventory
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To maintain an in-stock position of wanted items and to
dispose of unwanted items, it is necessary to establish
adequate controls over inventory on order and inventory in
stock.
There are several proven methods for inventory control. They
are listed below, from simplest to most complex.
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Visual control enables the manager to examine the
inventory visually to determine if additional inventory is
required.
Controlling the Inventory
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Tickler control enables the manager to physically count a
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Click sheet control enables the manager to record the item
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Stub control (used by retailers) enables the manager to
small portion of the inventory each day so that each
segment of the inventory is counted every so many days on
a regular basis.
as it is used on a sheet of paper. Such information is then
used for reorder purposes.
retain a portion of the price ticket when the item is sold.
The manager can then use the stub to record the item that
was sold.
Controlling the Inventory
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As a business grows, it may find a need for a more
sophisticated and technical form of inventory control.
Today, the use of computer systems to control inventory is far
more feasible than ever before.
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Point-of-sale terminals relay information on each item used
or sold. The manager receives information printouts at
regular intervals for review and action.
Off-line point-of-sale terminals relay information directly to
the supplier's computer who uses the information to ship
additional items automatically to the buyer/inventory
manager.
Controlling the Inventory
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The final method for inventory control is done by an outside
agency.
A manufacturer's representative visits the large retailer on a
scheduled basis, takes the stock count and writes the reorder.
Unwanted merchandise is removed from stock and returned to
the manufacturer through a predetermined, authorized
procedure.
Controlling the Inventory
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A principal goal for many of the methods described above is to
determine the minimum possible annual cost of ordering and
stocking each item.
Two major control values are used: (1) the order quantity, that
is, the size and frequency of orders; and (2) the reorder point,
that is, the minimum stock level at which additional quantities
are ordered.
The Economic Order Quantity (EOQ) formula is one widely
used method of computing the minimum annual cost for
ordering and stocking each item.
Objective of Inventory Control
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To achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds
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Level of customer service
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Costs of ordering and carrying inventory
Inventory turnover is the ratio of average cost of goods
sold to average inventory investment.
Inventory Counting Systems
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Periodic System – Physical count of items made at periodic
intervals
Perpetual Inventory System – A system that keeps track of
removals from inventory continuously, thus monitoring
current levels of each item
Inventory Counting Systems
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Two-Bin System – Two containers of inventory; reorder when
the first is empty.
Universal Bar Code – Bar code printed on a label that has
information about the item to which it is attached.
0
214800 232087768
ABC Classification System
Classifying inventory according to some measure of importance
and allocating control efforts accordingly.
A - very important
B - mod. important
C - least important
High
A
Annual
$ value
of items
B
C
Low
Low
High
Percentage of Items
Key Inventory Terms
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Lead time: time interval between ordering and receiving the
order
Holding (carrying) costs: cost to carry an item in inventory for
a length of time, usually a year (e.g., money invested in
inventory, storage costs, handling costs, insurance costs,
taxes, etc.)
Ordering costs: costs of ordering and receiving inventory
(e.g., cost of getting price quotations, processing purchase
order, receiving shipments, inspection, etc.)
Shortage costs: costs when demand exceeds supply
The Basic EOQ Model
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Economic order quantity (also known as the Wilson EOQ
Model or simply the EOQ Model) is a model that defines the
optimal quantity to order that minimizes total variable costs
required to order and to hold inventory.
The EOQ computation takes into account the cost of placing an
order, the annual sales rate, the unit cost, and the cost of
carrying inventory.
The model was originally developed by F. W. Harris in 1913,
though R. H. Wilson is credited for his early in-depth analysis of
the model.
The Basic EOQ Model
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Basic EOQ model is simple, but it is applicable only to those
inventory situations described by its assumptions, such as:
1.
2.
3.
4.
5.
There are only two types of costs: carrying/holding costs
and ordering costs
There is no quantity discounts
There may be lead times of any length
There is no risk
The replenishment rate is infinite
The Basic EOQ Model
Variables
Q* = optimal order quantity
C = cost per order event (not per unit)
R = monthly (annual) demand of the product
P = purchase cost per unit
F = holding cost factor; the factor of the purchase cost that is
used as the holding cost (this is usually set at 10-15%, though
circumstances can require any setting from 0 to 1)
H = holding cost per unit per month (per year) (H = PF)
The Basic EOQ Model
Total Costs
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The single item EOQ formula can be seen as the minimum
point of the following cost function:
Total cost = purchase cost + order cost + holding cost
which corresponds to:
The Basic EOQ Model
The Optimal Order Quantity
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The question in this inventory situation is how much to order;
that is, what should be the order quantity, Q?
A relatively large Q results in a high average inventory but
infrequent orders. A smaller order quantity results in lower
average inventory but more frequent orders.
The first strategy will result in higher holding cost but lower
ordering cost; the latter strategy will have the reverse effect.
The Basic EOQ Model
When to Reorder with EOQ Ordering
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Reorder Point - When the quantity on hand of an item
drops to this amount, the item is reordered
Safety Stock - Stock that is held in excess of expected
demand due to variable demand rate and/or lead time
Service Level - Probability that demand will not exceed
supply during lead time
Determinants of the Reorder Point
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The rate of demand
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The lead time
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Demand and/or lead time variability
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Stockout risk (safety stock)
The Order Point
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Rather than using a timed ordering approach, it is often
advantageous to place orders based on inventory levels. In this
way, if the usage rate is greater than expected, an order will be
placed earlier and the goods received sooner.
The triggering of orders based on inventory levels is called the
order point system, and it works well with modern methods of
inventory record keeping.
If the firm’s database of inventory levels is adjusted each time a
unit of inventory is used, then the firm’s computer can compare
inventory levels to order points and generate a list of items to be
ordered.
The Order Point
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The order point is calculated as the expected usage during
the lead time. Assume that a firm purchases 10,000 units of a
particular product per year and the lead time is 7 days. The
usage over this time will be (7/360)(10,000) = 194 units.
When the level of inventory reaches 194 units, the firm should
place an order for the optimal quantity. Just as this order
arrives (7 days later), the firm will have run out of inventory.
The basic EOQ model with order point is easy to understand
and put into practice, but this range is limited to those
situations described by its assumptions.
Quantity
Safety Stock
Maximum probable demand
during lead time
Expected demand
during lead time
ROP
Safety stock
LT
Safety stock reduces risk of
stockout during lead time
Time
Reorder Point
The ROP based on a normal
distribution of lead time demand
Service level
Risk of
a stockout
Probability of
no stockout
Expected
demand
0
ROP
Safety
stock
z
Quantity
z-scale
Variations on the Basic EOQ Model
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Several extensions can be made to the EOQ model, including
backordering costs and multiple items. Additionally, the
economic order interval can be determined from the EOQ and
the economic production quantity model (which determines the
optimal production quantity) can be determined in a similar
fashion.
Economic Production Quantity model (also known as the
EPQ model) was developed by E. W. Taft in 1918. The
difference being that the EPQ model assumes orders are
received incrementally during the production process. The
function of this model is to balance the inventory holding cost
and the average fixed ordering cost.
Economic Production Quantity model
Variables
K = ordering cost
D = demand rate
F = holding cost
T = cycle length
P = production rate
x = D/P
Formula
Developments In Inventory
Management
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Like investment in any other assets, investment in inventory
should be carefully considered in light of the alterative
approaches to the problem at hand.
For example, holding raw materials is not the only way to avoid
price fluctuations. The firm could enter into long-term private
contracts with the producers of these raw materials. The firm
also could enter into a futures contract on the raw materials.
In recent years, two approaches have had a major impact on
inventory management: Material Requirements Planning (MRP)
and Just-In-Time (JIT and Kanban).
Their application is primarily within manufacturing but suppliers
might find new requirements placed on them and sometimes
buyers of manufactured items will experience a difference in
delivery.
Developments in Inventory
Management - MRP
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MRP is basically an information system in which sales are
converted directly into loads on the facility by sub-unit and time
period.
Materials are scheduled more closely, thereby reducing
inventories, and delivery times become shorter and more
predictable.
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Its primary use is with products composed of many components.
MRP systems are practical for smaller firms.
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The computer system is only one part of the total project which
is usually long-term, taking one to three years to develop.
Developments in Inventory
Management - JIT
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JIT is an approach which works to eliminate inventories rather
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The inventory of raw materials and work-in-process falls to that
needed in a single day.
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This is accomplished by reducing set-up times and lead times so
that small lots may be ordered.
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Suppliers may have to make several deliveries a day or move
closer to the user plants to support this plan.
than optimize them.
Costs in Inventory Systems
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Costs directly proportional to amount of inventory held
– any costs that fluctuate directly with the level of inventory,
such as the opportunity cost of inventory investment, insurance
on the inventory, storage costs of inventory, taxes on inventory
investment, etc.
Costs not directly proportional to the amount of
inventory held – costs such as spoilage and obsolescence.
Costs directly proportional to the number of orders –
costs such as machinery set-up costs, purchasing order
generating costs, check writing costs and payment order
mailing costs, and fixed costs of unloading the order, etc.
Costs in Inventory Systems
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The price per unit of inventory obtained – due to
quantity discounts and economies of scale in production, the
price per unit of goods purchased or produced for inventory
may vary with the amount ordered.
Stockout cost – occurs when immediate service is required
but inventory is unavailable.
Costs in Inventory Systems
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If the inventory is raw materials or work-in-process, the cost of
stocking out will include the cost of changing the firm’s
production plants, costs of idling or rescheduling equipment,
etc.
If the inventory is finished goods, stockout costs may include
the lost cash flow from the sale if the customer does not make
the purchase because immediate service cannot be provided.
Other Characteristics of Inventory
Situations
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Lead times – a time lag from the initiation of the production
process until the inventory starts to arrive. Lead time may
range from a few minutes to few months depending whether
the firm is producing goods for its inventory or is ordering
these goods from another firm.
Sources and levels of risk – uncertainties play a significant
role in inventory situations. Uncertainties usually involve lead
times and demand levels, but situations where other variables
are uncertain also occur.
Other Characteristics of Inventory
Situations
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Static versus dynamic problems – in a static inventory
problems, the goods have a one-period life; there can be no
carryover of goods from one period to the next. In dynamic
inventory problems, the goods have value beyond the initial
period; they do not lose their value completely over time.
Replenishment rate – for a small order, the rate of
replenishment is essentially infinite. For larger orders from
vendors, or for inventory produced within the firm, the
replenishment rate may be slower.