Lecture 7: Inventory Analysis

1
Lecture 7 Inventory Analysis

• The importance of understanding inventory
• Defining inventory
• Counting and control systems in practice
• ABC classification
• Pediatric Care Center Part I ABC analysis
• Inventory control decisions

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Inventory and Cost
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Inventory in an Economy

• There are more than 1.16 trillion in US at a
  given time
• 1/3 held by retailers ¼ of which in auto
  industry
• 1/5 by wholesalers
• the remainder by manufacturers
• Inventory cost at 25 - 35 of the value is more
  than 350 billion per year
• For each dollar of GNP in manufacturing and
  trade, about 0.4 worth of inventory was held

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Inventory in a Firm

• Inventory accounts about 34 of current assets,
  90 of working capital of a typical US company
• Costs of holding inventory

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Statements of Kmart and Wal-Mart
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Financial Metrics

• Inventory turns
• Per dollar (marginal) inventory cost

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Formulas
(1)
(2)
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Retail Inventory Turns and Margins

• Inventory Gross
• Segment Examples Turns
  Margin
• Apparel and accessory Ann Taylor, GAP
  4.57 37
• Catalog, Mail-order Spiegel, Lands End
  8.60 39
• Department stores Sears, J. C. Penney
  3.87 34
• Drug Proprietary stores Rite Aid, CVS
  5.26 28
• Food stores Albertsons, Safeway
  10.78 26
• Hobby, toy/game stores Toys R Us
  2.99 35
• Home furniture/equipment Bed Bath Beyond
  5.44 40
• Jewelry Tiffany 1.68
  42
• Radio, TV, Consumer elec. Best Buy, Circuit City
  4.10 31
• Variety stores Kmart, Wal-Mart, Target
  4.45 29 .

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Efficiency Frontier
Inventory turns
10
9
8
7
6
5
4
3
2
1
20
10
30
Gross margin
40
50
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The Importance of Understanding Inventory

• ... by 1990 Wal-Mart was already winning an
  important technological war that other
  discounters did not seem to know was on.
  Wal-Mart has the most advanced inventory
  technology in the business and they have invested
  billions in it. (New York Time, Nov. 95).
• Business
• Week 1997

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Kmart declared bankruptcy and now been bought by
Sears
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Inventory by Location

• Raw materials purchased parts (RM)
• Partially completed goods, work in progress (WIP)
• Finished-goods inventories (FGI, manufacturing
  firms) or merchandise (retail stores)
• Goods-in-transit to warehouses or customers
• Replacement parts, tools, supplies

supplier
distributor
manufacturer
retailer
Raw Mat. Or Purch. Parts
F. G.
outputs
inputs
Process WIP
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TCLs TV Supply Chain
Other Components
AB Plastics


SC Logistics Warehouse
SC Logistics Warehouse
TVs
TCLs Assembly Line
TV Cases
SC Logistics Trucks
TCLs Distribution Centers
TCLs Stores
Guo Mei, Wal-Mart Other Retailers
Consumers
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Inventory by Function

• Keeping inventory is costly, but it is a
  necessary curse for business operations
• Theoretical or pipeline inventory
• Cycle or batch inventory
• Seasonal inventory
• Decoupling inventory
• Safety inventory
• Strategic inventory

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Theoretical/Pipeline Inventory

• To achieve a target throughput rate, a minimum
  amount of WIP is needed

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Cycle or Batch Inventory

• Fixed costs associated with batches
• Quantity discounts
• Trade promotions
• Economies of scale

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Safety and Decoupling Inventories

• Uncertainty
• Information uncertainty
• Supply/demand uncertainty
• Buffers between operations

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Seasonal and Strategic Inventories

• Seasonal variability
• Level production
• Natural disasters and wars
• Availability
• Speculation

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Good Inventory Management

• Low cost and fast turnover
• Fulfillment
• - 100 percent satisfactory rate?
• - percentage of demand filled on arrival
• - percentage of periods without stockout
• - percentage of on-time delivery
• Must contribute to companys bottom line
• - IBM PC Division made profit 1st time in 97

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IBM BREAKTHROUGH IN SUPPLY CHAIN IS KEY TO
OPERATIONS RESEARCH PRIZEFewer Unsold Computers
750 Million Savings

• ILINTHICUM, MD, May 17, 1999 - IBM's success at
  reengineering its supply chain was a key factor
  in its selection as winner of the 1999 Franz
  Edelman Award for Achievement in Operations
  Research and the Management Sciences in
  Cincinnati earlier this month. The company's
  reengineering efforts resulted in over 750
  million in savings in 1998, the company reports.
• The Institute for Operations Research and the
  Management Sciences (INFORMS) presented the
  award for a study entitled Extended Enterprise
  Supply Chain Management at IBM Personal Systems
  Group and Other Divisions.

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Inventory Counting and Control Systems

• Periodic System
• Physical count of items made at periodic
  intervals
• Perpetual Inventory System
• System that keeps track of removals from
  inventory continuously, thus monitoringcurrent
  levels of each item
• Two-Bin (Kanban) System
• Two containers, reorder when the first is empty

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Harbin Turbines Co. has 300,000 SKUs
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ABC Classification System

• What should management focus on?
• Classify inventory according to some measure of
  importance and allocating control efforts
  accordingly.
• A - very important
• B - moderately
• important
• C - least important

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• Example 1 Annual Usage of Items by Dollar Value

Item Annual Unit
Dollar of total
units used cost
usage dollar usage 1
5,000 1.50 7,500
2.9 2
1,500 8.00 12,000
4.7 3
10,000 10.50 105,000
41.2 4
6,000 2.00 12,000
4.7 5
7,500 .50
3,750 1.5 6
6,000 13.60
81,600 32.0 7
5,000 .75
3,750 1.5 8
4,500 1.25
5,625 2.2 9
7,000 2.50
17,500 6.9 10
3,000 2.00
6,000 2.4 Total

254,725 100.0
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Example 1 Percentage Usage by Dollar Value
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Example 1 ABC Classification

• Class Item of total
  of total
• numbers items
  dollar usage
• A 3, 6 20
  73.2
• B 2,4,9 30
  16.3
• C 1,5,7,8,10 50
  10.5
• Total 100
  100.0

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ABC Analysis for a Pediatric Care Center

• The importance of inventory cost
• Difference between different items
• Outcome of ABC analysis
• A items
• B items
• C items
• How to manage different classes of items?

Injectable medical supplies
Non-injectable medical supplies
Office supplies
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Example 2 Motorola Hong Kong

• Motorola Hong Kongs IC packaging operation uses
  a molding material at a rate of 90 kg per day.
  Every Friday, the material manager, Mr. Chan,
  checks the inventory, and places an order if
  needed.
• It takes the supplier 3 full working days to
  deliver the molding material to Motorola.
• The material is very expensive, so keeping large
  inventory is costly
• The ordering and shipping cost is also high

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Questions

• How much should Chan order?
• To solve the problem
• What costs should be considered?
• What should be the decision variable?

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More Information

• The material costs 50/kg, storage costs
  5/kg/year, and the interest rate is 15
• Ordering and shipping cost is 600 for up to 2000
  kg
• Motorola and the supplier work Monday to Saturday
  for 8 hours/day and the no. of production days in
  a year is 300
• Order is placed in the afternoon and delivery
  arrives in the morning of the 4th working day
• Consumption of the material is at a constant rate
  from Monday to Saturday

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Preparation for Solutions

• Let Q be the order quantity
• The annual demand rate R 27000
• The number of orders 27000/Q
• The ordering cost per order S 600
• The annual holding cost per unit
• H 5 50 x 0.15 12.5/kg/year
• The average inventory level Q/2
• Total annual cost
• TC(Q) cR S R/Q H Q/2

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Q
R
Average inventory level
Q/2
4
8
12
0
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Alternative Solutions

• Total annual controllable cost,
• TCC(Q)(R/Q)S H(Q/2)
• TCC(1080) 15000 6750 21750
• TCC(1620) 10000 10125 20125
• TCC(2160) 7500 13500 21000
• What should be your advice?

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Observation

• A fixed ordering and shipping cost
• A cost for holding inventory
• Cannot eliminate either cost, but can change the
  total by having different order quantities
• Observation

Order quantity affect total operation cost
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Questions

• With a larger order quantity
• Per unit ordering cost becomes smaller
• Average inventory level becomes higher
• What is the economics of this phenomenon?
• What is the optimal order quantity?

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Inventory Control Decisions

• What are the important decisions to be made in
  inventory management?
• Two major decisions
• How much should we order?
• When should we order?
• Consider the following question

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How should we trade-off?
Q
R
Average inventory level
Q/2
Q/3
R
Q/6
4
8
12
0
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Todays Takeaways

• Inventory plays important roles in production and
  business operations, but it can be very costly
• Five functions of inventory, the basic reasons
  for holding inventory
• ABC analysis (80-20 rule, Pareto chart)
• Production or purchasing order decisions
  determine the inventory cost
• Equations (1) and (2)