ISL455U-SUPPLY CHAIN MANAGEMENT
Chapter 5: Inventory Management in Supply Chains
What is Inventory?
Inventory management is one of the important part of supply chain management. Coordination of inventory policies of the suppliers, manufacturers and distributors, is very crucial since material flow and cost minimization must be achieved and demand of the customers must be met in the supply chain. Inventory can be defined as a stock or item used to support production, supporting activities and customer service. Based on this definition raw materials, spare parts, finished goods, operating supplies can be considered as inventory.
Companies stock inventory because of several reasons:
• to protect against fluctuations and uncertainties in demand • to protect against uncertainties in supply • to satisfy seasonal demand • economies of scale in procurement in other words to decrease the cost of buying from suppliers
There are four types of inventory:
1. Raw material stocks: They are used as inputs of the production of final products. For example, cocoa is a raw material for chocolate production. 2. Semi-finished product stocks: These are the substances that are being processed or waiting to be processed. These stocks are also called work- in-process (WIP) stock. 3. Finished product stocks: These are the completed products waiting for shipment to be sent to the customer. Companies may keep these products in stocks against demand uncertainties. 4. Consumables: These materials are not used directly in the production process. Cleaning and hygiene products, paper and envelopes are examples. 5. Service, maintenance, replacement parts and spare parts.
Cycle Inventory arises from procurement, production and transportation. It is held primarily to take advantage of economies of scale in the supply chain and reduce the costs. The quantity of cycle inventory is calculated as the average amount of inventory used to satisfy demand between orders or between the production cycles. Companies generally produce or purchase in large lots to get the advantage of economies of scale in the production, transportation, or purchasing process. When cycle inventory is low, the order costs will increase due to the frequency of the order. Otherwise, the cost will increase due to the high amount of inventory. Therefore, in the supply chain how often orders must be given and their lot sizes are important questions. Determining the seasonal stocks is an important decision also. This stock is held to meet the demand that will occur during the season before the season begins.
Inventory Costs
Inventory, affects not only the production performance of companies but it also effects businesses financially. In addition to the costs of being out of stock or holding excess stock, the costs such as quality control, warehouse personnel, etc. also rise. There are four basic classes of inventory costs as: purchasing, ordering, carrying inventory and out of stock.
Purchase costs is the unit or batch cost paid to suppliers when purchasing raw materials and materials of a product to be produced. Sometimes a company produces related materials instead of buying it. In this case production costs occur instead of purchase costs. When the supplier is a foreign company it may be difficult to calculate the value of the inventory because of different currencies used in transactions.
Ordering costs include the costs of ordering and obtaining the products. Examples of ordering costs are; expenditures for doing paperwork such as conducting market research, collecting offers, processing orders, determining the amount of inventory required, preparing invoices, transportation costs, controlling goods in terms of quality and quantity, and moving goods to the buffer stock area In case of international orders transportation costs become more important due to risks of inventory depreciation and loss of inventory depending on the type of transportation and length of periods.
Inventory holding costs are the cost of physically keeping inventory items in stock. There are four main inventory holding costs as; capital (like the opportunity cost of money allocated to the inventory), inventory service (like insurance and taxes), storage space (like heating, cooling, lighting, renting, and security expenses) and inventory risk costs (like obsolescence or value decrease due to the aging of technology, damage, shrinkage, relocation costs).
Other type of inventory costs is stockout costs that arise when demand is greater than the current inventory. If the current inventory level cannot meet the demand, either orders will be met at a later date or lost sales will occur. Customers’ waiting for products will be dissatisfied.
Inventory Models
Inventory models are used to determine the most suitable inventory amount to be ordered or produced. These models may be static or dynamic. Static models are the models that have a constant demand over time. In dynamic models, demand varies over time. One of the static inventory models is Economic Order Quantity Model (EOQ) which provides a guideline for managers to use when ordering items from their suppliers It is the simplest model used to determine a fixed order quantity that minimizes the total of annual purchase, ordering, and inventory handling costs. If there is a lead time in the ordering process in other words if a certain time passes between the ordering time and the arrival time of products,
the orders must be placed before the inventory level drops to zero. Based on this model lead time and demand rate must be considered to determine the reordering point. So that products will arrive to the system exactly when the inventory drops to zero. The best order quantity is at the point where the inventory carrying cost is equal to the ordering cost. Annual total inventory cost is calculated as the sum of the annual purchase cost, annual ordering cost and annual inventory holding cost.
Some companies prefer to produce instead of ordering from suppliers. In this case Economic Production Quantity Model (EPQ) is used to determine a fixed production quantity that minimizes the sum of production set-up costs, production costs and inventory holding costs. According to this model optimal production amount to be determined is the production volume of each lot. Because the production is made in batches.
Based on this model annual total cost is calculated as the sum of the annual set-up cost, annual production cost and annual inventory holding cost.
Reorder Point Model (ROP) is used to determine the stock level that the order needs to be renewed. This model is based on ordering a certain amount of predefined orders in order to minimize the total inventory cost when the stock amount is reduced to a certain level. The amount of re-ordering includes the demand for the duration of the supply and the amount of safety stock to avoid stock outs. The value that corresponds to this amount is the point of reordering.
Multi-Echelon Inventory Management
If we think about the inventory management of a big supermarket chain it is obvious that there is a need for many products in many locations. If the manufacturer supplying products to this supermarket is out of stock supermarket will be effected from this situation. In cases like this there are multiple stages with multiple locations (facilities) at each stage in the supply chain. The inventory models at multiple locations are called multi-echelon inventory models.
The goal of a multi-echelon system is to decrease total costs by coordinating orders across the supply chain. In a multi-echelon supply chain, each stage represents a process, such as the procurement, manufacturing or transportation of items. Each stage is a potential location for holding the stock of the item processed at this stage. In each stage supply, production or transportation of the products are interrelated.
The echelon inventory represents the inventory between a stage in the supply chain and the final customer. To make it more clear we can give the example of echelon inventory at the warehouse. It will be equal to sum of the inventory at the warehouse, all inventory in transit to and in the stocks of the retailers.
The multi-echelon inventory can be used also within the same firm. When the inventory is stored at more than one geographic location, for example in different factories of firm, one must be accountable for supplying inventory when an order is placed.
Materials requirements planning means controlling what item is purchased and in what quantities and also controlling the timing of its arrival through computerized systems. MRP is a very complex system that is used in multi-echelon inventory control. In order to use this system all data about raw materials, semi-finished products, set-up costs, inventory costs must be known.
Additional Approaches to Inventory
There are some other approaches available for inventory management. These approaches are; Just-In-Time Inventory System (JIT), Distribution Requirement Planning (DPR), Vendor-Managed Inventory (VMI).
In Just-in- Time System the required items are received at the time they are needed. So this approach decreases the waste and inventory costs by receiving the items just when they’re needed. JIT not only provides the right inventory, at the right amount, at the right time, but also in the right place. Using JIT provides some benefits to companies that can be summarized as the following:
• reduction of stock outs • reduction of inventory levels (zero inventory) • reduction of material handling equipment • reduction of time frames between delivery and production (short lead times) • improvement of quality (with zero defect)
Distribution Requirement Planning (DRP) is an extension of manufacturing requirement planning and it is used to minimize the shortage of products in the distribution location. It also reduces ordering cost, transportation cost and inventory cost. According to DRP product demand at the final distribution point determines demand at intermediate distribution centers.
Vendor-Managed Inventory (VMI) systems requires a partnership with suppliers since the management of inventory is left to the reliable suppliers in this system. This means a kind of partnership with the supplier. The supplier produces and sends the orders and also responsible for managing consignment stocks. Payment for the products is made to the supplier after the products are being sold. The advantages of this system are as follows:
• suppliers can better respond to customers’ inventory needs, so, customer satisfaction is provided. • the imbalance and uncertainty in customer orders decreases. • the need for safety stock is reduced or eliminated.