Inventory Management

 

12.	Inventory Management
	Inventory is the stock of items kept by an organisation to meet internal or external customer demand (Russell and Taylor, 2009). The type of inventory management system employed is determined by the nature of the demand for the goods and services on the organisation. Demand can be classified into two categories; dependent and independent.
	12.1.	Dependent Demand
		A dependent demand item has a demand which is relatively predictable because it is dependent on other factors. Thus a dependent demand item can be classified has having a demand that can be calculated as the quantity of the item needed to produce a scheduled quantity of an assembly that uses that item.
	12.2.	Independent Demand
		Independent demand is when demand is not directly related to the demand for any other inventory item. Usually this demand comes from customers outside the company and so is not as predictable as dependent demand. Because of the unknown future requirements of customers, forecasting is used to predict the level of demand. A safety stock if then calculated to cover expected forecast error. Independent demand items can be finished goods or spare parts used for after sales service.
	12.3.	Types of Inventory Generally inventory is classified as either raw materials, work-in-progress (WIP) or finished goods. The proportion between these inventory types will vary but it is estimated that generally 30% are raw materials, 40% are work in progress and 30% finished goods. The location of inventory can be used to define the inventory type and its characteristics. There are various definitions of inventory types including the following :
		-	Buffer/Safety This is used to compensate for the uncertainties inherent in the timing or rate of supply and demand between two operational stages.
		-	Cycle If it is required to produce multiple products from one operation in batches, there is a need to produce enough to keep a supply while the other batches are being produced.
		-	Anticipation This includes producing to stock to anticipate a increase in demand due to seasonal factors. Also speculative policies such as buying in bulk to take advantage of price discounts may also increase inventory levels.
		-	Pipeline/Movement This is the inventory needed to compensate for the lack of stock while material is being transported between stages. e.g. the time taken in distribution from the warehouse to a retail outlet.
	12.4.	Inventory Decisions The main concern of inventory management is the trade-off between the cost of not having an item in stock against the cost of holding and ordering the inventory. A stock-out can either be to an internal customer in which case a loss of production output may occur, or to an external customer when a drop in customer service level will result. In order to achieve a balance between inventory availability and cost the following inventory management aspects must be addressed of volume - how much to order and timing - when to order.
	12.5.	The Economic Order Quantity (EOQ) Model The Economic Order Quantity (EOQ) calculates the inventory order volume which minimises the sum of the annual costs of holding inventory and the annual costs of ordering inventory. The model makes a number of assumptions  including :
		-	Stable or Constant Demand
		-	Fixed and identifiable ordering cost
		-	The cost of holding inventory varies in a linear fashion to the number of items held
		-	The item cost does not vary with the order size
		-	Delivery lead time does not vary
		-	No quantity discounts are available
		-	Annual demand exists
	These assumptions have led to criticisms of the use of EOQ in practice. The assumption of one delivery per order, and then the use of that stock over time increases inventory levels and goes against a JIT approach. Also annual demand will not exist for products with a life-cycle of less than a year. However the EOQ approach still has a role in inventory management in the right circumstances and if its limitations are recognised Using the EOQ each order is assumed to be of Q units and is withdrawn at a constant rate over time until the quantity in stock is just sufficient to satisfy the demand during the order lead time (the time between placing an order and receiving the delivery). At this time an order for Q units is placed with the supplier. Assuming that the usage rate and lead time are constant the order will arrive when the stock level is at zero, thus eliminating excess stock or stock-outs. The order quantity must be set at a level which is not too small, leading to many orders and thus high order costs and not too large leading to high average levels of inventory and thus high holding costs. The annual holding cost is the average number of items in stock multiplied by the cost to hold an item for a year. If the amount in stock decreases at a constant rate from Q to 0 then the average in stock is Q/2.
	12.6.	The Re-Order Point (ROP) Model The EOQ model tells us how much to order, but not when to order. The Reorder point model identifies the time to order when the stock level drops to a predetermined amount. This amount will usually include a quantity of stock to cover for the delay between order and delivery (the delivery lead time) and an element of stock to reduce the risk of running out of stock when levels are low (the safety stock). The previous economic order quantity model provides a batch size that is then depleted and replenished in a continuous cycle within the organisation. Thus the EOQ in effect provides a batch size which the organisation can work to. However this assumes that demand rates and delivery times are fixed so that the stock can be replenished at the exact time stocks are exhausted. Realistically though both the demand rate for the product and the delivery lead-time will vary and thus the risk of a stock-out is high. The cost of not having a item in stock when the customer requests it can obviously be costly both in terms of the potential loss of sales and the loss of customer goodwill leading to further loss of business.
		12.6.1.		Safety Stock and Service Level Safety stock is used in order to prevent a stock-out occurring. It provides an extra level of inventory above that needed to meet predicted demand, to cope with variations in demand over a time period. The level of safety stock used, if any, will vary for each inventory cycle, but an average stock level above that needed to meet demand will be calculated. To calculate the safety stock level a number of factors should be taken into account including : -       cost due to stock-out -       cost of holding safety stock -       variability in rate of demand -       variability in delivery lead time It is important to note that there is no stock-out risk between the maximum inventory level and the reorder level. The risk occurs due to variability in the rate of demand and due to variability in the delivery lead time between the reorder point and zero stock level. The reorder level can of course be estimated by a rule of thumb, such as when stocks are at twice the expected level of demand during the delivery lead time. However to consider the probability of stock-out, cost of inventory and cost of stock-out the idea of a service level is used. The service level is a measure of the level of service, or how sure, the organisation is that it can supply inventory from stock. This can be expressed as the probability that the inventory on hand during the lead time is sufficient to meet expected demand (e.g. a service level of 90% means that there is a 0.90 probability that demand will be met during the lead time period, and the probability that a stock-out will occur is 10%. The service level set is dependent on a number of factors such as stockholding costs for the extra safety stock and the loss of sales if demand cannot be met.
	12.7.	The ABC Inventory Classification System Normally a mix of fixed-order-interval and fixed order quantity inventory systems are used within an organisation. When there are many inventory items involved this raises the issue of deciding which particular inventory system should be used for a particular item. The ABC classification system sorts inventory items into groups depending on the amount of annual expenditure they incur. This will depend on both the estimated number of items used annually multiplied by the unit cost. To instigate a ABC system a table is produced listing the items in expenditure order (with largest expenditure at the top), and showing the percentage of total expenditure and cumulative percentage of the total expenditure for each item. By reading the cumulative percentage figure it is usually found, following Pareto’s Law, that 10-20% of the items account for 60-80% of annual expenditure. These items are called A items and need to be controlled closely to reduce overall expenditure. This often implies a fixed quantity system with perpetual inventory checks or a fixed-interval system employing a small time interval between review periods. It may also require a more strategic approach to management of these items which may translate into closer buyer-supplier relationships. The B items account for the next 20-30% of items and usually account for a similar percentage of total expenditure. These items require fewer inventory level reviews than A items. A fixed order interval system with a minimum order level may be appropriate here. Finally C items represent the remaining 50-70% of items but only account for less than 25% of total expenditure. Here much less rigorous inventory control methods can be used, as the cost of inventory tracking will outweigh the cost of holding additional stock. It is important to recognise that overall expenditure may not be the only appropriate basis on which to classify items. Other factors include the importance of a component part on the overall product, the variability in delivery time, the loss of value through deterioration and the disruption caused to the production process if a stock-out occurs.