SMG OM 323 Study Guide - Final Guide: Universal Product Code, Radio-Frequency Identification, Inventory Turnover
30 Apr 2018
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OM323 Final Study Guide
OM12: Inventory Management (chapter 13 550-565, 568-572)
Inventory: a stock or store of goods e.g pats i a fato, podut o a etaile’s sheles, ustoes o hold, …
Independent-demand items: items that are ready to be sold or used
Return on Investment (ROI): Profit after tax/ total assets
• Because inventories may represent a significant portion of total assets ,a reduction of inventories can result in a signifincant
increase in ROI, although that benefit has to be weighed aigainst a possible risk of a decrease in customer service
• The ratio of uncentories to sales in the manufactuing, wholesale, and retail sectors is 1 measure that is used to gauge the health
of the U.S economy
Inventory decisions: how many buy each time, space limitation,
storage capability, perishable?
Different kinds of inventories:
• Raw material and purchased parts
• Partially completed goods (WIP)
• Finished goods inventories (manufacturing firms) or
merchandise (retail stores)
• Tools and supplies
• Maintenance and repairs (MRO) inventory
Why hold inventory
• Cycle stock: to achieve economies of scale
o Fixed costs of each ordering
o Quantity discounts
• Safety stock: deal with uncertainty
o In supply of raw materials
o In demand of finished goods
• Pre-build stock: to smooth capacity requirements
• Speculative stock: to hedge against possible price increases in the near future
• Pipeline stock: to keep supply lines full
Functions of inventory
1. To meet anticipated customer demand. Refereed to anticipation stocks because held to satisfy expected demand
2. To smooth production requirements. Firm experiences seasonal patterns in demand often build up inventories during preseason
periods to meet overly high requirements during seasonal periods (seasonal inventories) e.g sell fresh fruits, greeting cards
3. To decouple operations. Use buffers of raw materials to insulate production from disruptons in deliveries from suppliers, and FG
inventory to buffer sales operations from manufacturing disruptions. Careful analysis can reveal both points where buffers would
be most useful and points where they would merely increase costs without adding value
4. To redue the risk of stockouts. Delayed deliveries and unexpected increases in demand increase the risk of shortage. (weather,
supplier stockouts, delieies of og ateials, ualit poles,…
a. Rrisk of shortages can be reduced by holding safety stocks- stocks in excess of expected demand to compensate for
variabilities in demand and lead time
5. To take advantage of order cycles: to minimize purchasing and inventory costs, buys in quantities that exceed immediate
requirements, storing some or all of the purchased amount for later use. Eobomical to produce in large rather than small qty. The
excess output must be stored for later use.
a. Inventory storage enables firm to buy and prouce in economic lot sizes without haing to try to match purchases or
production with demand requirements in the short run. Results in periodic orders or order cycles
6. to hedge against price increases: suspect price increase, purchase larger than normal amt to beat the increase
7. to permit operations: There will be WIP inventory. Intermediate stocking of goods- RM, semifinished items, FG at production
sites, goods stored in warehouses-leads to pipeline inventories throughout a production-distribution system
a. little’s law: quantifying pipeline inventory.
i. Avaerage amount of inventory in a system=average demand rate*average time unit in the system
ii. E.g units in system for an avg of 10 days, the demand rate is 5 units per day, average inventory is 50 units
5 units/day*10 days=50 units
8. To take advantage of quantity discounts
Objective of Inventory management: achieve satisfaction levels of customer service while keeping inventory costs within reasonable
bounds (decisions: when to order and how much to order)
• Understocking leads to missed deliveries, lost sales, dissatisfied customers, and production bottlenecks
• Overstocking unnecessarily takes up space and ties up funds that might me more productive elsewhere
• Inventory turnover: ratio of annual COGS/average inventory investment
o How many times a year the inventory is sold. The higher the ratio, the beter, because more efficient use of inventories
o The higher the proft margin, the lower the acceptable number of inventory turns, and vice versa (high end)
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▪ Supermakrket (low profit margin), high turnover rate
o Product that takes a long time to manufacture, or sell, will have a low turnover rate
• Days of inventory on hand- number that indicates the expected n.o days of sales that can be suplied from existing inventory (high
n.o of days might imply excess invetory, while low might imply a risk of running out of stock)
Requirements for effective inventory management
1) a system to keep track of the inventory on hand and on order
2) a reliable forecast of demand that includes an indication of possible forecast errors
3) knowledge of lead times and lead time variability
4) reasonable estimates of inventory holding costs, ordering costs, and shortage costs
5) A clarification system for inventory items
1) Inventory counting system
a. Periodic system: physical count of items in inventory made at periodic intervals (weekly, monthly) to decide how much
to order prior to he next delivery period
i. Advantage: Order for many items occur at the same time
ii. Distadvantage: lack of control between reviews, need to protect against shortage between review periods by
carrying extra stock
b. Perpetual system: keeps track of removals from inventory continuously, thus monitoring current level of each item.
When the amout on hand reach a predetermined minimum, a fixed quantity is ordered.
i. Advantage: the control by continuous monitoring, fixed order quantity, management can determine an optimal
order quantity
ii. Disadvantage: added cost of recort keeping, physical counts must still be performed periodically to verify
eods possile eos, spoilage… that a edue the effetie aout of ieto
1. Two-bin system: 2 containers of inventory; reordered when the first is empty. The 2nd bin contains
enough stock to satisfy demand until the order is filled, plus an extra cushion of stock that will reduce
the chance of a stockout if the order is late or if usage is greater than expected.
a. Advantage: no need to record each withdrawal from inventory
b. Disadvantage: reorder card may not be turned in because isplaed, footte…
2. Universal product code (UPC): bar code printed on a label that has information about the item to
which it is attached (item category, manufacturer, specific item code)
a. Speed and accuracy, gives managers continuous information on inventoris, reduce need for
periodic review and order-size determinations, and improve the level of customer service by
idiatig the pie ad uatit of eah ite o the ustoe’s receipt
b. Radio frequency identification (RFID) tags are also used to keep track of inventory in certain
3. Point of sale (POS) system: electronically record actual sales. Knowledge of actual sales can enhance
forecasting and inventory managemnt- actual demand in real time- that enable make chances to
restocking decisions. Important input to effective supply chain management, make this information
available to suppliers
2) Demand forecasts and lead-time information
a. Lead time: the time between submitting an order and receiving it
b. Demand and lead time might vary, the greater potential variability, the greater the need for additional stock to reduce
the risk of a shortage between deliveries
3) Inventory costs
a. Purchase cost: the amount paid to a vendor/supplier to buy the inventory (typically largest of all inv costs)
b. Holding or carrying costs: cost to carry an item in inventory for a length of time, usually a year. Costs include interest,
insurance, taxes, depreciation, obsolescence, deterioration, spoilage, pilferage, breakage, tracking, picking, and
warehousing costs (heat, light, rent, workers, equipment, securitiy). Also include opportunity costs
c. Ordering costs: costs of ordering and receiving inventory (how much needed, preparing invoices, inspecting goods,
moving)
d. Setup osts: costs involved in preparing equipment for a job (when produce own inventory)
e. Shortage costs: when demand exceeds the supply of inventory; often unrealized profit per unit (opportunity cost)
4) Classification System: allocate control efforts according to the relative inportance of various items in inventory
a. ABC approach: classifying inventory according to some measure of importance, and allocating control efforts
accordingly. Three classes of items
i. A (very important): 10-20% of items but 60-70% annual dollar value
ii. B( moderately important)
iii. C (least important): 50-60% items, 10-15% dollar value
1. For each item, multiple annual volume by unit price to get the annual dollar value
2. Arrange annual dollar values in descending order
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3. The few (10-15%) with the highest annual dollar value are A items. The most (about 50%) with the
lowest annual dollar value are C items. Those in between (about 35%) are B items
iv. Managers may take other factors into account in making exceptions for certain items (e.g changing the
classification of B item to an A item)- risk of obsolescence, stockout, distance of a supplie…
1. Cycle counting: a physical count of items in inventory. To reduce discrepancies between the amounts
indicated by inventory records and the actual quantities of inventory on hand. Inaccurate reccords can
lead to disruptions in operations, poor customer servince, unnescessarily high inventory carrying cost
Inventory Ordering Policies
• Cycle stock: the amount of inventory needed to meet expected demand
• Safety stock: extra inventory carried to reduce the probability of a stockout due to demand and/or lead time variabilty
How much to order: Economic Order Quantity Models (EOQ)
Economic order quantity (EOQ): The optimized order quantity by minimizing the sum of certain annual costs that vary with order size and
order frequency (graphs page 562)
1) The basic economic order quantity model: fixed order size that will
minimize the sum of the annual costs of holding inventory and ordering
inventory, assume that usage rate and lead time do not vary
a. Only 1 product is invoved
b. Annual demand requirements are known*
c. Demand is spread evenly throughout the year so that the
demand rate is reasonably constant
d. Lead time is known and constant
e. Each order is received in a single delivery
f. There are no quantity discount
g. Trade-off: fixed order costs vs inventory costs
Avaerage inventory level and number of orders per year are inversely
related: as 1 increases, the other decreases
Holding/Carrying cost (H) is a linear function of Q,
direct proportion to changes in Q (warehousing, insurance, opportunity cost of investment, taxes, breakage, spoilage,
obsolescence, returns)
Annual ordering cost (S) will decrease as order size increases because for a given annual demand, the larger the order size, the
fewer the number of orders needed, inversely related to order size (purchase, inspection cost, setup, handling fees, shipping)
• Does not depend on order size-therefore called fixed cost
Total cost= annual carrying cost + annual
ordering cost
S
Q
D
H
Q
TC
+=
2
Q=order quantity in units
H= holding/carrying cost per unit per year
D= demand, usually in units per year
S= ordering cost per order
TC reaches its mimimum at the optimal order
quantity where carrying cost= ordering cost
H
DS
Q
2
0
=
Length of order cycle = Q/D
2) The economic production quantity model
3) The quantity discount model
• Quantity discounts: price reductions for larger orders
1) Will storage space be avaiable for the additional items
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