Inventory Management Concepts. 4/15/2004 Ithaca 1

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Inventory Management

Concepts

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Learning Objectives

• Understand the basic concepts of inventory management

and how to apply them to setting and maintaining desired

customer service levels

• Understand why warehousing is important in the logistics

system and the decision factors that contribute to service

and cost outcomes

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Purchasing MaterialControl Production Sales Distribution

Baseline

Materials Management Manufacturing Management Distribution

Functional

Integration

Materials Management Manufacturing Management Distribution

Internal

Integration

External

Integration

Customers Internal Supply Chain Suppliers

In essence Logistics management seeks to create a single plan with which to manage all business processes – rather than the traditional situation in which each part of the business had a different plan. Supply Chain

Management seeks to extend this alignment and process beyond the boundaries of the organisation

The question we must seek to answer as part of strategic development is, how much of this needs to be controlled through ownership?

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Why Hold Inventory?

• Enable firm to achieve economies of scale

• Balances supply and demand

• Enables specialisation in manufacturing

• Provide protection from uncertainties in demand & order

cycle

• Acts as a buffer between critical interfaces in the channel

of distribution

Why do firms hold inventories?

•Economies of scale – can make savings from unit price reduction when purchases are made in volume (what is the trade-off when this is done? What other savings might accrue from deciding to make such a transaction (single transactional cost, transport savings etc.) – manufacturers can make products in long run production, saving on set-up and changeover times – what is the trade-off when this is done?

•Balance supply & demand – seasonality means that production must sometimes be in advance of demand then held against that demand – what are some examples of such a situation (chocolates for Valentine’s Day, Christmas toy production, Easter Eggs)

alternately raw materials may only be available at a particular time of year – what are some examples of this situation (dairy, canned fruit & vegetables) – what are the type of savings this can generate (labour force, asset utilisation)

•Specialisation – finished goods produced by one organisation are mixed or bundled with FG of another organisation to fill customer orders – for example Whirlpool has

established focused factories that only make one type of good (washing machines, refrigerators, dryers are each made at a different place and consolidated at warehouses •Protection from uncertainty – why might variability occur in demand (promotions, specials) why might variability occur in supply? (strikes, seasonality, capacity) •Inventory as a buffer – did anyone see the news during the week about the car factories having to stand people down because a component manufacturer was on

strike? Why did that happen? Inventory can be held as a buffer in a number of places in the supply chain – supplier/procurement; procurement/production;

production/marketing; marketing/distribution; distribution/intermediary; intermediary/consumer

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Relationship Between Inventory and Service

NOW

Inventory Inventory Investment Investment in in $1,000's $1,000's 100 100 200 200 300 300 400 400 500 500 600 600 Service Percentage Service Percentage 75 75 8080 8585 9090 9595 97.5 97.5100 100

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Inventory Pipeline

Raw & In

Raw & In--ProcessProcess Finished GoodsFinished Goods

VendorIn-Transitto Mfr.

Plant

WhseProcessMfg. Plant.Whse Transit In-to DCs

Field

Whse Pick &Load In-Transitto

CustmrCustomer

Inventories can be classified based on the reasons for which they are held: •Cycle stock – resulting from replenishment of inventory sold or used in production – such as in this slide where the rate of sales and lead time for replenishment is held to be constant

•In-transit inventory – what might this be, how should it be treated? (same as cycle inventory)

•Safety or buffer stock – held against variability in demand and supply – what role would forecasting of demand have to play in determining how much stock should be held? What role should prediction of supply in terms of capacity (production, transport and storage) have in determining the level of buffer stock? How could the level of safety stock be kept at a minimum? •Speculative stock – volume purchases (trade-offs such as Carter Holt Harvey holding 2 years of paper stock – what might the cost of that be?; forecast price increases; expected materials shortage or strike

•Seasonal stock

•Dead stock – what might dead stock be? (expired, obsolete, end of life-cycle – complete decline of product) Why does it exist? (production of wrong item – lack of accurate forecasts, lack of sales & marketing effort) How could it be dealt with? (sell at lower price, give-away, waste, re-cycle)

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The Effect of Reorder Quantity on Average Inventory

Investment with Constant Demand and Lead Time

Days 10 20 30 40 50 60 0 200 Inventory 400 Order arrival Order arrival Order placed Order placed Order placed

So, if demand and lead-time are constant as depicted in this slide, why is any safety stock required?

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Stockholding Policy:

A Function of Inventory Characteristics

Source: Gattorna JL & Walters DW, Managing the Supply Chain: A Strategic Perspective,MacMillan, London 1996, pp.132-13

Base Flow Inventory

Core

Business

Products

Wave Flow Inventory

Seasonal

Fashion

Products

Surge Flow Inventory

“

Fad”

Products

Inventory Demand Types

Inventory

Holding

Time

Base Flow

Predictable high flow rates

Minimum (zero) stocks. Direct deliveries from suppliers. Wave Flow

Slow moving flow rates. High criticality. Perishable. Peaks are relatively predictable.

Minimise stockholdings, building them only during peak demand period. Direct delivery from supplier where possible.

Surge Flow (1)

High criticality. Low value. Long lead-time. Small physical size.

Hold high level of stock thereby allowing safety stock for delivery lead-time and demand fluctuations.

Surge Flow (2)

Low criticality. High value. Bulky physical characteristics. Peaks are relatively predictable.

Minimise stockholdings, building them only during peak demand period. Direct delivery from supplier where possible.

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Low Risk Profile

Base Flow Inventory

Wave Flow Inventory

Inventory

Holding

Time

Surge Flow Inventory

The important issue for businesses is that they must classify their inventory in a way that reflects customer demand in their markets. These patterns of demand are are usually accompanied by differential levels of margins

reflecting the risk involved in their stockholding.

If we consider variations even within the same industry sector – a low risk profile might apply to a retailer selling clothes to older (say age 55-70) men, a fairly predictable group - while a high risk profile would be more

appropriate for a retailer selling clothes to a target market of people in their late teens (16-20).

In terms of what we spoke of last week – base flow would equate with cycle stock, wave flow with seasonal stock and surge flow with speculative stock. The challenge for the channel intermediaries is to decide upon the demand characteristics of the target customer group and develop a

merchandising/inventory mix that will obtain the required level of profitability and cash flow while satisfying customer service levels.

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High Risk Profile

Base Flow Inventory

Wave Flow Inventory

Inventory

Holding

Time

Surge Flow Inventory

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The “Bullwhip” Effect

Analysis:

Babies Nappies

Dr Hau L. Lee - Lausanne

Babies

Parents

Retail

Distribution

Suppliers

Factories

The bullwhip effect is one outcome of planning for infinite capacity – as ERP does – delays caused by a lack of either information or inventory at any stage in the process send signals that there is a shortage in work-in-progress or finished goods of a particular type. This leads to production order generation to make up the supposed shortfall – and, as the line of information and./or inventory holding extends, the problem is exacerbated. So, if a mother buys extra packs of babies nappies because the

supermarket has put them on special, the retailer might be sending

incorrect messages to the distributor that demand has increased – when in fact the increase in demand has been artificially created and will be followed by a drop in demand when the price goes up again. In the meantime the factories have responded to the incorrect information about demand they have received and begun to make more packs of babies nappies – leading to excessive inventory holdings of babies nappies. This problem can occur at any point in the system and reverberate throughout the entire supply chain for lack of accurate information.

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Assumptions of the Simple EOQ Model

• Continuous, constant, and known rate of demand

• Constant and known replenishment cycle or lead time

• Constant purchase price that is independent of the order quantity or time

• Constant transportation cost that is independent of the order quantity or time

• Satisfaction of all demand (no stock-outs are permitted)

• No inventory in transit

• Only one item in inventory, or at least no interaction among items

• Infinite planning horizon

• No limit on capital availability

Many organisations use a method known as Economic Order Quantity (EOQ) to determine when and how much they will order of a product. This

methodology is based on these assumptions.

From your experience, reading and learning to date, do you think these assumptions are reasonable?

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A – Inventory Level in a

Push System

B – Inventory Level in a

Pull System

Volatile Demand Inaccurate Forecasts Unreliable Suppliers Bottlenecks Quality Problems

JIT suggests that, wherever possible, no activity should take place in a system until there is a need for it – nothing made, no components ordered – until there is a downstream

requirement – a pull concept where demand at the end of the pipeline pulls products towards the market – and behind that, the flow of components is determined by the same demand. Traditionally a push system has operated where products are manufactured in anticipation of demand and positioned in the supply chain as buffers.

Conventional approach to meeting customer requirements was based on some form of

statistical inventory control which typically relied on re-ordering when inventory levels fell to a particular point. The re-order quantity would then be based on the expected lead-time it would take to arrive & the anticipated usage during that time, resulting in a EOQ formulation balancing the cost of holding inventory against the costs of placing replenishment orders. Weakness – frequently stock levels are higher or lower than they need to be especially where the rate of demand changes – thinking has been channeled into a belief that there is some optimal amount to order – but it actually means we will carry excess stock on every day of the cycle except the last – then, on top of that, we add safety stock

In a push system there is plenty of inventory, so all the problems are hidden – in JIT we are forced to confront the problems – Kanban was developed to confront these issues – basing demand at the lowest point in the supply chain and dealing with the bottlenecks progressively from there through reducing set-up and ordering costs at the appropriate points.

JIT is an extension of the Toyota concept of Kanban – both are focused on the elimination of waste. Kanban can apply to any manufacturing operation involving repetitive operations – demanding that items are supplied only at the moment they are needed. JIT extends this to purchasing, manufacturing and logistics.

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Strategic Lead Time

–

OR Pipeline

MANAGEMENT

Cost

-

adding time

Value

--

adding tim

e

adding tim

e

Raw Raw Material Material Stock Stock In In--transittransit Regional Regional Stock Stock Customer Customer Delivery Delivery Raw Raw Material Material Stock Stock Production Production Finished Finished Stock

Stock InIn--transittransit

Regional Regional Stock Stock Customer Customer Delivery Delivery Production Production Finished Finished Stock Stock

Manufacturing & Procurement lead-times must be linked to the needs of the marketplace as discussed when we looked at S&OP whilst increasing the speed of response to those needs.

The goals of pipeline management are: •Lower costs

•Higher quality process •More flexible process •Faster response times

None of these can be achieved without managing the supply chain as an entity and seeking to reduce the pipeline length and/or speed up flow through the pipeline. When examining a pipeline it is often found that there are many non-value-adding activities such as re-positioning pallets within a warehouse – re-engineering is about eliminating or at least minimising these activities through process

improvement and change management.

The concern is to remove blockages and fractures that occur in the pipeline where inventory typically builds up and response times lengthen – focusing on reducing set-up and changeover times on production lines, identify and eliminate

bottlenecks, awareness and management of excess inventory, instituting sequential order processing and improving visibility throughout the pipeline

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Service Level

Cost

Traditional

Inventory

Quick Response

Inventory

Quick Response:

Substituting Information for Inventory

Quick response refers to the combination of IT systems and the JIT logistics systems that combine together to get the right product in the right place at the right time

Specifically this is about the advent of Electronic Data Interchange (EDI), bar coding , Electronic Point of Sale (EFTPOS) systems and laser scanners Demand is captured as close to real time as possible – and as close to the consumer as possible

The logistics response is then made based on that information – at the nth degree Proctor & Gamble receive data directly from Wal-Mart checkouts and can plan replenishment and delivery to Wal-Mart Based on that information The result is that Wal Mart carries less inventory AND has fewer stock outs of Proctor & Gamble products –

P&G benefit because they get better economies in production & logistics – and they have greatly increased their sales to Wal-Mart

QR also reduces cumulative lead times – also resulting in lower inventory levels and further reducing response

times-QR has become common in the fashion industry in the US – and has the potential to greatly impact the $25Bn that logistics costs that industry if adopted by everyone

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Production Strategies for Quick Response

Receive shipment & store Place on shelf Remove product from shelf Initiate order Receive order & initiate

processing Authorise shipping Order Processing In-store Inventory Storage Inventory Depletion Retail Warehouse Storage Delivery Interface Order Transmission Purchase materials Initiate production cycle Complete production & store Raw Material Storage Manufacturer Inventory Depletion Production Warehouse Order MANUFACTURER MANUFACTURER RETAILER RETAILER

Flexible manufacturing systems hold the key to achieving QR – this is not just about new technology such as robotics, it is primarily about the time taken to change – set-up time – often this is not achieved through

technology but by thinking or working differently – coming back to the why and questioning conventional wisdom, Benetton’s new dying technique exploits this approach very well – as does Fisher & Paykel’s economies of scope model.

One way of doing it is by postponing the production decision until the last possible moment, such as the models used by Dell and Hewlett-Packard

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Efficient Consumer Response

“Working together to fulfil

consumer wishes better, faster,

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Efficient Consumer Response

The ECR movement began in the mid-90s and was characterised by the emergence of new principles of collaborative management along the supply chain. It was understood that companies can serve consumers better, faster and at less cost by working together with trading partners.

At the heart of ECR was a business environment characterised by dramatic advances in information technology, growing competition, global business structures and consumer demand focused on better choice, service, convenience, quality, freshness and safety and the increasing movements of goods across international borders.

This new reality required a fundamental reconsideration of the most effective way of delivering the right products to consumers at the right price. Non-standardized operational practices and the rigid separation of the traditional roles of manufacturer and retailer threatened to block the supply chain unnecessarily and failed to exploit the synergies that came from powerful new information technologies and planning tools.

ECR, QR and EFR methodologies have become common over the past 10 to 12 years and have facilitated the ability of the grocery, retail and foodservice industries to successfully implement supply chain reform.

Although the full gamut of supply chain savings available has not yet been realised – billions have been saved. This has occurred mostly in European applications of the ECR model and North American experience of QR – both primarily due to the holistic approach – which has been demonstrated to be far more effective than the exercise of market power based approach used to less effect in other sectors.

Companies, which are not well prepared internally to pursue ECR, are in danger of exposing this fundamental weakness when starting to work together with their trading partners. And companies that are unable to work effectively with their trading partners will fall increasingly behind in the competition and falter in their efforts to meet changing consumer demand.

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ECR Strategy

http://www.globalscorecard.net/guide_to_ECR/D01.asp

Commitment to the implementation of Demand Management - with strategic plans, people & organization, and, information systems fully aligned to this commitment. The concept covers progress on the key issues of

•developing a clear strategy

•putting in place all the key supporting processes

•developing the appropriate measurement tools into a full scorecard •developing the supportinginformation technology

•clarifying how the organization will develop trading relationships

•ensuring the company's organization can cope with Demand Management •The concept stresses the need to develop these issues in parallel.

The concept can increase costs associated with 'Manage Product Categories' but these costs are often offset by reduced costs in other sales and marketing activities and the benefits from increased demand.

While the optimal organization structure will vary depending on the company's strategic intent and the specific category's role, a number of principles hold generally true:

•internally, demand management requires true cross-functional working, be it within manufacturers or retailers;

•joint demand management requires a new type of interface structure between manufacturers and retailers; and

•personal and category performance measures need to be re-aligned from narrow functional criteria to measures which focus on the category's profitability from an end-to-end supply chain perspective.

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ECR

-

Integration

http://www.globalscorecard.net/guide_to_ECR/D01.asp

The new Integrators domain in the ECR Scorecard adds truly integrating concepts to the ECR platform. Two concepts have been defined, the first one being Collaborative Planning Forecasting and Replenishment that is the ultimate Responsive Replenishment facilitator starting with specific partners. The second concept is E-Business, Business to Business that explores new ways of doing business using public standard-based networks.

Open up business processes to trading partners to improve performance by information sharing.

Create a public electronic marketplace for buying and selling. Create a public electronic environment for:

buying and selling forecasting

planning & replenishment

The integrator concepts will have a major impact on the business environment because of opportunities to:

develop and deliver products and services faster extend geographical reach

increase process efficiency and effectiveness redefine products and services

leverage information by providing more flexible infrastructures and business models. Success is driven by the identification and implementation of business opportunities, not just by using latest technology.

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Collaborative Planning, Forecasting & Replenishment

Weekly, Weekly,

Monthly Monthly

7. Create Sales Forecast 8. Identify Expectations 9. Resolve Expectations Once Once Quarterly Quarterly 1. Front-End Agreement 2. Joint Business Plan

Collaborative Planning

9. Generate Order

Collaborative Replenishment

Weekly, Weekly, Monthly Monthly

3. Create Sales Forecast 4. Identify Exceptions 5. Resolve Expectations

Collaborative Forecasting

CPFR stands for Collaborative Planning, forecasting and replenishment. It is a process enabled by technology and has primarily been applied in the packaged goods industry. The evolution of CPFR over the past 15 years features changes in two areas from earlier forms of collaboration:

•Information – improved from retailer orders to inventory information to POS data

•Relationship – improved from orders to sharing of key business information, to shared infrastructure and joint forecasting/planning responsibility

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James G. Hutzel, Donald P. Belmont & Mark A Nichols

•

“Managing Supply Chain Inventory: Pitfalls and

Opportunities” by Hau L. Lee and Corey Billington (Sloan

Management Review/Spring 1992)

Inventory Management Concepts. 4/15/2004 Ithaca 1