This chapter discusses the importance of managing inventory flows throughout the supply chain. It covers the reasons companies hold inventory, including batching economies, uncertainty/safety stocks, and seasonality. It also discusses the major costs of inventory, including carrying costs, order/setup costs, and stockout costs. The chapter introduces ABC analysis for classifying inventory items and explains how inventory visibility throughout the supply chain can benefit companies. It provides methods for evaluating inventory management effectiveness, such as calculating inventory turnover ratios.

1. Chapter 6:
Managing Inventory Flows in the
Supply Chain

2. Learning Objectives - After reading this
chapter, you should be able to do the following:
 Understand the importance of coordinated
flows of inventory through supply chains.
 Understand the impact of effective inventory
management upon the return on assets
(ROA) for a company.
 Appreciate the role and importance of
inventory in the economy and why inventory
levels have declined relative to Gross
Domestic Product (GDP).

3. Learning Objectives
 Understand the major reasons for carrying
inventory.
 Explain the role of inventory to major
functional areas in the company.
 Discuss the major types of inventory-related
costs and their relationships to inventory
decisions.

4. Learning Objectives
 Understand how inventory items (stock-
keeping units) can be designed to maximize
the efficiency of managing inventory.
 Appreciate the importance and value of
inventory visibility to increasing supply chain
effectiveness.
 Understand how companies can evaluate the
effectiveness of their inventory management
techniques.

5. Logistics Profile:
Micros and More
 “Inventory, inventory, inventory….I am sick and
tired of hearing complaints about our inventory
levels and the costs associated with carrying
inventory,” muttered the COO.
 What is the role of inventory?
 What are the important trade-offs in the
management of inventory?
 What are the relevant inventory costs?
 Can the supply chain help control inventory?

6. Management of Inventory Flows
in the Supply Chain: Introduction
 Inventory as an asset has taken on increased
significance as companies struggle to reduce
investment in fixed assets that accommodate
inventory (plants, warehouses, etc.).
 Changes in inventory affect return on assets
(ROA), an important internal and external
metric.
 Ultimate challenge is to balance supply and
demand for inventory.

7. Inventory in the Economy
 Inventory in the Economy has decreased.
 As a percentage of the GDP, from 1985 to
2000, inventory levels have decreased
from 5.4% to about 3.8%
 Examine Table 6-1.

8. Table 6-1: Macro Inventory Cost in
Relation to U.S. Gross Domestic Product

9. On the Line:
Inventory Turns
 Think of inventory turns as a measure of how well a
company’s products are doing in the market and how
well its inventory is managed.
 There is a continuing move away from traditional build-
to-forecast manufacturing models to more flexible
build-to-demand systems.
 Increasing emphasis on fully integrated supply chain
means inventories barely spend any time sitting idle.
 “Ideally, zero inventory will maximize cash flow.”
 Inventory turnover potential is 30 to 40 times/year.

10. Inventory in the Firm:
Rationale for Inventory
 Product Line Proliferation
 Depth & breath of product lines trending up.
 Results in larger inventories.
 Examine Table 6-2 Total Logistics Costs-1999.
 Inventory carrying costs of $332 billion
approach 35 percent of total logistics costs for
companies.

11. Table 6-2
Total Logistics Costs --- 1999

12. Inventory in the Firm:
Batching Economies/Cycle Stocks
 Price discounts
 Result in trade-offs between large
purchases qualifying for quantity discounts
and costs of storing inventory.
 Because physical supply inventory is often
raw materials, storage costs are often less
than savings from buying in bulk, so
supplies are stockpiled.

13. Inventory in the Firm:
Batching Economies/Cycle Stocks
 Transportation rate discounts
 Large quantities often result in carload
freight rates.
 Largest shipments may qualify for even
lower multiple truckload, carload or
trainload rates.
 Lower freight rates are often reflected in
lower consumer prices.

14. Inventory in the Firm:
Batching Economies/Cycle Stocks
 Production economics favor long production
runs.
 Results in cycle stock that must be stored.
 Cycle stocks can be beneficial as long as
the appropriate analysis is done to cost
justify the inventory.

15. Inventory in the Firm:
Uncertainty/Safety Stocks
 Reasons for uncertainty are commonplace.
 Net results are the same: companies
accumulate safety stock to buffer
themselves against uncertainty.
 Safety stock more challenging and
complex to manage for many firms.

16. Inventory in the Firm:
Uncertainty/Safety Stocks
 Impact of information on uncertainty
 Trade-off analysis appropriate to assess
risk and measure inventory cost.
 Information technology can be used in the
supply chain to reduce inventory.
 Collaborative planning and forecasting
requirements (CPFR) is an example.
 Bar coding, EDI, the Internet have enabled
companies to reduce uncertainty.

17. Inventory in the Firm: Time/In-Transit
and Work-In-Process Stocks
 Time-related trade-offs from using slower to
faster transport modes
 Faster modes cost more but may save a
larger amount in inventory carrying costs.
 Work-In-Process inventory should be
examined for possible trade-offs especially in
the production of high value goods.
 Scheduling and actual production times
can be closely examined to reduce
inventory.

18. Inventory in the Firm:
Seasonal Stocks
 Seasonality can occur on the inbound and/or
outbound side of the firm’s logistics systems.
 Perishable supply in agricultural products or
seasonal-related transportation problems.
 Seasonal demand compressing selling
seasons in some industries results in smaller
plants producing for stock.

19. Inventory in the Firm:
Anticipatory Stocks
 In some cases, companies anticipate that
some forecasted event will negatively impact
the production cycle.
 For example, labor strikes, shortage of
supplies due to weather or political event, or
significant price increases may prompt the
firm to build inventory levels higher than
normal.
 Risk assessment is important in these cases.

20. Inventory in the Firm: The Importance
of Inventory in Other Functional Areas
 Marketing uses inventory to provide strong
customer service.
 Manufacturing uses inventory to schedule
longer production runs.
 Finance wants inventory turnover ratios to be
kept high so that risk of inventory loss is
reduced and rate of return on assets kept
competitively high.

21. Inventory Costs: Why are they
so important?
 First, inventory costs are a significant portion
of total logistics costs for many firms.
 Second, inventory levels affect customer
service levels.
 Third, inventory cost trade-off decisions affect
inventory carrying costs.

22. Inventory Costs:
Inventory Carrying Cost
 Capital Cost
 Opportunity cost associated with investing
in inventory, or any asset.
 What is the implicit value of having capital
tied up in inventory, instead of some other
worthwhile project?
 Minimum ROR expected from any asset.
 Debate on inventory valuation at fully
allocated or variable costs only.

23. Inventory Costs:
Inventory Carrying Cost
 Storage Space Cost
 Handling costs, rents, utilities.
 Logistics develops a cost formula for
storage space costs based on cost
behaviors.

Public space mostly variable.

Private space a mix of fixed and
variable.

24. Inventory Costs:
Inventory Carrying Cost
 Inventory Service Cost
 Insurance and taxes on stored goods.
 Varies according to the value of the goods.
 Inventory Risk Cost
 Largely beyond the control of the firm.
 Due to obsolescence, damage, theft,
employee pilferage.

25. Table 6-3 Example of Carrying Cost
Components for Computer Hard Disks
Cost Percentage of Product Value
Capital 12 %
Storage space 2
Inventory service 3
Inventory 8
Total 25 %

26. Inventory Costs: Calculating the
Cost of Carrying Inventory
 Step 1 - Identify the value of the item stored
in inventory (e.g. $100).
 Step 2 - Measure each individual carrying
cost component as a percentage of product
value (e.g. 25%).
 Step 3 - Multiply overall carrying cost (as a
percentage) times the dollar value of the
product (e.g. $100 times 25% = $25 inventory
carrying cost per year.

27. Inventory Costs:
Nature of Carrying Cost
 Items with basically similar carrying costs
should use the same estimate of carrying
cost per dollar.
 There are exceptions for items that are
subject to special consideration for purposes
of quick obsolescence or high degree of theft,
etc.

28. Table 6-4
Inventory and Carrying Cost Information
for Computer Hard Disks

29. Inventory Costs:
Order/Setup Costs
 Order costs
 MIS costs for inventory stock level tracking.
 Preparing and processing purchase orders
and receiving reports.
 Inspecting and preparing inventory for sale.
 Setup Costs
 Incurred when production changes over
from one product to another.

30. Table 6-5 Order Frequency and
Order Cost for Computer Hard Disks

31. Inventory Costs:
Carrying Cost versus Order Cost
 Examine Table 6-6.
 Order costs and carrying costs respond in
opposite ways to increases in volume.
 This reinforces the logisticians need to be
able to separate costs by how they behave in
relation to changes in volume.
 Assistance from managerial accountants is
available for cost-volume-profit analysis.

32. Table 6-6 Summary of Inventory
and Cost Information

33. Figure 6-1
Inventory Costs

34. Inventory Costs:
Expected Stockout Cost
 Cost of not having product available when a
customer wants it.
 Includes backorder costs (special order).
 Losing one item profit by substituting a
competing firm’s product.
 Losing a customer permanently if customer
finds they prefer the substituted product and/or
company.

35. Inventory Costs:
Expected Stockout Cost
 Possible to handle this by adding safety stock.
 In a manufacturing firm, a stockout may result
in lost hours of production until the item is
restocked.

36. Inventory Costs:
Inventory in Transit Carrying Cost
 Any product inbound to the firm using F.O.B.
origin should be counted.
 Any product outbound from the firm using
F.O.B. destination should be counted.
 In transit carrying cost is generally less than
for regular inventory because some cost
components are not present.
 No storage costs, no taxes, and reduced
risk of obsolescence.

37. Classifying Inventory:
ABC Analysis
 Ranking system
 Developed in 1951 by H. Ford Dicky of
General Electric3
.
 Suggested that GE classify items
according to relative sales volume, cash
flows, lead time, or stockout cost.
 Most important inventory put in Group A.
 Lesser impact goods put in Groups B and
C respectively.

38. Classifying Inventory:
ABC Analysis
 Pareto’s Rule (80-20 Rule)
 Based on a nineteenth century
mathematician’s observation that many
situations were dominated by a very few
elements.
 Conversely, most elements had very little
influence in most situations.
 Separates the “trivial many” from the “vital
few”.

39. Classifying Inventory:
ABC Analysis
 80-20 Rule
 80% of sales will come from 20% of the
inventory SKUs.
 20% of sales will come from 80% of the
inventory SKUs.
 The 80-20 Rule has been found to explain
many phenomena that interest managers.
 For example, 80% of sales come from 20%
of customers; and vice versa.

40. Figure 6-2
ABC Inventory Analysis

41. Table 6-7 ABC Analysis for Big
Orange Products, Inc.

42. Inventory Visibility
 The ability of the firm to “see” inventory on a
real-time basis throughout the supply chain
system requires:
 Tracking and tracing inventory SKUs for all
inbound and outbound orders.
 Providing summary and detailed reports of
shipments, orders, products, transportation
equipment, location, and trade lane activity.
 Notification of failures in inventory flow.

43. Inventory Visibility:
General Benefits
 Improved customer service
 Decreased cost-of-sales
 Improved vendor relations and cost
 Increased Return on Assets
 Improved cash flow
 Improved response time and service
recovery
 Improved performance metrics

44. Evaluating the Effectiveness of a
Company’s Approach to Inventory
Management
 Are customers satisfied with the current
level of customer service?
 If standards have been set in consultation
with the customer, this question can be
answered objectively.

45. Evaluating the Effectiveness of a
Company’s Approach to Inventory
Management
 How frequently does backordering and/or
expediting occur?
 If records of these events are kept, the
answer to this question can point out the
need for a modification or adoption of new
inventory strategies.

46. Evaluating the Effectiveness of a
Company’s Approach to Inventory
Management
 Is the company calculating an Inventory
Turnover ratio for each product SKU?
 This ratio can provide good information on
whether the inventory is being effectively
and efficiently managed.
 Examine Table 6-8, Figure 6-3 and
Figure 6-4.

47. Evaluating the Effectiveness of a
Company’s Approach to Inventory
Management
 How does inventory level behave as sales rise
or fall?
 From sales records, the firm can determine
if inventory levels rise as much as sales,
less than sales, or stay about the same
regardless of sales levels.

48. Table 6-8 The Relationship among
Inventory Turnover, Average Inventory,
and Inventory Carrying Costs

49. Figure 6-3 Saving Inventory
Dollars by Inventory Turns

50. Figure 6-4 Past and Projected
Inventory Turnover of Finished Goods

51. Chapter 6:
Summary and Review Questions
Students should review their knowledge of the chapter
by checking out the Summary and Study Questions
for Chapter 6.
This is the last slide for Chapter 6

52. End of Chapter 6 Slides
Managing Inventory Flows in
the Supply Chain