Category Archives: Inventory Systems for Independent Demand

Inventory Costs

Inventory Costs

In making any decision with respect to inventories, the following costs should be taken into consideration:

Holding or Carrying Costs Thi broad category i usually subdivided into three segments: storage costs. capital costs. and obsolescence/shrinkage cost. Storage costs include the cost of the storage facility in the form of rent or depreciation. insurance, taxes, utilities, security. and facility personnel.

Capital costs can vary, depending on the firm's financial situation. For example. if the firm has an excess of cash, then the capital co interest lost by putting the money into inventory instead of short-term notes. If the firm has an alternative project to invest in, then the capital cost is the opportunity cost of the anticipated return of that project. If the firm has to borrow funds to maintain an inventory, then the capital cost is the interest paid on these funds.

Obsolescence costs recognize that products tend to depreciate in value over time. This is especially true in high technology industries where newer and better (and often cheaper) products are constantly being introduced. In this ca ego. we also include spoilage costs associated witt: products that have a short shelf life. like pen'stable food products and some types of prescription drugs. Shrinkage costs track pilferage and breakage.

Reasons for Maintaining Inventory

Reasons for Maintaining Inventory

Organizations maintain inventories for several reasons. These include 1. To protect against uncertainty. For purposes of inventory management. We examine uncertainty in three areas. First. there uncertainty with report raw materials. which necessitates raw material inventory. Here. uncertainty pertain, both to the lead time that can vary due to unexpected delays and to (he amount of raw material received.

on process. Here work-in-process (WIP) inventories absorb the variability that exist between of the races. thereby providing independence between operations and improving efficiency. In addition. this WIP inventory can be used to the stages in a process. sect to the demand for a firm's finished products. the demand for a product were to be known precisely. then it could be possible to manufacture then it could be possible to manufacture product so that demand would be exactly met. However, more often demand is not totally known, and a safety stock of finished goods inventory is therefore maintained to absorb these variations.To support a strategic plan. As we learned in

To support a strategic plan. As we learned in the previous chapter on aggregate planning. when a firm adopts a level strategy, an inventory of finished goods i required to buffer the cyclic demand for product from the level output generated by the transformation process. Under these circumstances. when demand exceeds production. the difference i withdrawn from inventory: when demand is less than production. the difference i placed back into inventory.

To take advantage of economies of scale. Each time we place an order or do a setup to perform an operation, we incur a fixed cost, regardless of the quantity involved. Thus; the larger the quantity ordered or produced. the lower the average total cost per unit. However, as we shall see shortly. there are trade-offs to be considered in determining the proper lot size. In addition. companies often offer discounts for larger-quantity orders. as an incentive to customers to buy more than they normally would. This results in accumulations of items that otherwise would not exist. Firms offer quantity discounts for several reasons, including the need to reduce excessive stockpiles and to generate positive cash flow. In addition, there are economies of scale with respect to transportation costs, especially when products are shipped in either full trailer loads or full car load').

Definition of Inventory

Definition of Inventory

Inventory is defined as the stock of any item or resource used in an organization. An inventory management system is the set of policies and controls that monitors levels of inventory and determines (a) what levels should be maintained, (b) when stock should be replete head and (c) how large orders should be.

In a broader context. inventory can include inputs such as human. financial. energy, equipment, and physical items such as raw materials; outputs such as parts. components, and finished goods; and interim stages of the process. such as partially finished good or work-in-process (WIP). The choice of which items to include in inventory depend on the
organization. A manufacturing operation can have an inventory of personnel. machines. and working capital. as well as raw materials and finished goods. An airline can have an inventory of seats modern drugstore. an inventory of medicines, batteries. and toys: and an engineering firm. an inventory of engineering talent.

By convention. manufacturing inventory generally refers to materials that contribute to or become part of a firm's product output. In services, inventory generally refers to the tangible goods that are sold and the supplies necessary to administer the service. Customers waiting in line at a service operation also can be viewed as inventory similar to pans waiting to be processed in a factory.The basic purpose of inventory analysis in manufacturing and

The basic purpose of inventory analysis in manufacturing and stock keeping services is to specify (a) when items should be ordered and (D) how large the order should be. Recent trends have modified the simple questions of "when" and "how many." As we saw in an earlier chapter on supply chain management, many firms are tending to enter into longer-term relationships with vendors to supply their needs for perhaps the entire year. This changes the "when" and "how many to order" to "when" and "how many to deliver."

Managerial Issue

Managerial Issue

Management's view towards inventory has changed significantly over the past several years. Previously, managers perceived inventory as an asset because it appears as an asset in the firm's financial reports. However, as seen in the opening vignette, this is no longer th~ case. As we have seen, product life cycles are becoming ever shorter, increasing the likelihood of product obsolescence, as seen in the accompanying OM in Practice box. As we also have seen, excessive inventories on the manufacturing floor tend to conceal a wide variety of problems. Moreover, inventory storage costs are typically very expensive, averaging 30 to 35 percent annually of the types of inventory:

raw material Vendor-supplied items that have not had any labor added. finished goods Completed products still in the possession of the firm. work-in-process (WIP) Items that have been partially processed but are still incomplete. 604 value of the inventory-and in some cases they are much higher. For all of these reasons, managers now look at inventory as a liability to the firm, something to be reduced or eliminated wherever possible, as illustrated in the GE advertisement. Consequently, no topic in operations is more often discussed by managers or perceived to be more important by them than inventory. There is a continuous effort among managers to reduce inventories in all categories, beginning with raw materials and purchased parts, through to working process, and ultimately in finished good.

Inventory Systems for Independent Demand

Chapter Objectives

• Introduce the different types of inventories that can exist in an organization and provide a rationale for why companies maintain inventories.

• Identify the various costs associated with carrying and maintaining inventories.

• Define the classical inventory models and the conditions necessary for them to be applicable.

• Show how the economic order quantity IS calculated for each of the different inventory models.

• Introduce the single-period inventory model and the concept of yield management with respect to service operations.

• Present some of the current inventory management trends and issues that exist in companies today.

The senior executives of Alpha Numerics were having their annual retreat to review accomplishments of the past year and to discuss major policy issues for the coming year.· As was the norm, the retreat was held at a small hotel in the mountains of eastern Pennsylvania, well removed from the company's actual manufacturing facility. The first day's meeting had gone well, but in the early evening, after dinner, the subject of inventory control and the number of shortages that had occurred over the past year came up for discussion. The vice president of engineering suggested that, as <;I solution to the shortage 'problem, purchasing should order all of the projected material. requirements at the beginning of the year.

The vice president of manufacturing was so taken back by this suggestion that, to the amazement of the others in the room, he leaped .onto the conference table and shouted out, "Inventory is evil!" He turned to the president and said, "If we were to follow this suggestion, Mr. President, do you have an extra 25,000 square feet of warehouse space where we can store the material?" The president shook his head no. "And do you, Mr. Vice President of Race, have an extra $5 million to buy all this material?" The VP of finance similarly shook his head. "And are you, Mr. Vice President of Marketing, going to provide me with a perfect forecast of the products we expect to sell for the next year?" The VP of marketing said, "No, of course not. That would be impossible." And turning to the VP of engineering who had made he initial proposal, he said, "And you'll keep the same designs in the coming year without making any
changes, won't you?" The VP of engineering said, "That would be very unrealistic." All of the individuals in the room then looked up to the VP of manufacturing still standing on the conference table and said, "We see what you mean. Inventory is indeed evil!"