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IBS3002 Logistics & International Trade
Chapter 4
Inventory management

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Contemporary logistics, Murphy (2015)

Topic areas
 Inventory
 Classifying inventory
 Inventory costs
 Inventory decisions
 Inventory flow patterns
 Inventory management
 Contemporary approaches to managing inventory

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Inventory
 Inventory: stocks of goods and materials that are maintained for many purposes,
the most common being to satisfy normal demand patterns
 Inventory management: is a systematic approach to sourcing, storing, and selling
inventory—both raw materials (components) and finished goods (products).
 Inventory management is a key component in logistics & SCM because its

decisions are a driver for other business activities

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Inventory
 Management must reduce inventory levels yet avoid stockouts and other problems
 Important of inventory in other organizational functions:
 Marketing – more inventory for higher customer service
 Manufacturing – more inventory to schedule longer productions runs
 Finance – less inventory to keep inventory turnover ratios high (reduce risk
inventory loss) and to keep Return on Assets (ROA) high (increase
competitiveness)

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Inventory classifications
 Cycle (base) stock: inventory that is needed to satisfy normal demand during the
course of an order cycle
 Safety (buffer) stock: inventory that is held in addition to cycle stock to guard against
uncertainty in demand or lead time
 Pipeline (in-transit) stock: inventory that is en route between various fixed facilities
in a logistics system (plant, warehouse, store…)

 Speculative stock: inventory that is held for several reasons, including seasonal
demand, projected price increases and potential shortages of product


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Inventory classifications
 Cycle (base) stock: inventory that is needed to satisfy normal demand during the
course of an order cycle
 Safety (buffer) stock: inventory that is held in addition to cycle stock to guard against
uncertainty in demand or lead time
 Pipeline (in-transit) stock: inventory that is en route between various fixed facilities
in a logistics system (plant, warehouse, store…)
 Speculative stock: inventory that is held for several reasons, including seasonal
demand, projected price increases and potential shortages of product

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Inventory costs
 Inventory costs are important:
- Represent a significant component of costs in many organizations
- Inventory levels kept affect the level of service the organization can offer its
customers
- Cost tradeoff decisions in logistics depend on and ultimately impact inventory
carrying costs
 Inventory costs include:
- Carrying costs
- Ordering costs

- Stockout costs
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Inventory costs
 Carrying costs:
 Carrying costs refer to the costs associated with holding inventory
 Inventory costs are expressed in percentage terms & this percentage is multiplied
by the inventory’s value
 Components of inventory carrying costs:
- Obsolescence costs

- Taxes

- Inventory shrinkage

- Interest costs

- Storage costs
- Handling costs
- Insurance costs

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Inventory costs
 Carrying costs:

 Obsolescence cots: are incurred when an item in inventory becomes obsolete before
it is sold or used (i.e. perishable products-meat, milk…)
 Inventory shrinkage: is the excess amount of inventory listed in the accounting
records, but which no longer exists in the actual inventory (i.e. damage, loss, theft..)
 Storage costs: costs associated with occupying space in a plant, storeroom, or
warehousing facility
 Handling costs: costs of employing staff to receive, store, retrieve, move inventory
 Insurance costs: insure inventory against fire, flood, theft, other perils…
 Interest costs: money required to maintain the investment in inventory
 Taxes

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Inventory costs
 Ordering costs:
 Ordering costs refer to the costs associated with ordering inventory, including order
costs and setup costs
 Order costs: the costs of receiving an order. They include:
+ The transaction costs associated with making an international purchase:
international wire transfers, letters of credit, and bank fees.
+ The document costs, such as certificates of origin, import license, customs
brokerage fees.
+ The time spent, as all international purchases take more time than domestic
purchases.
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Inventory costs
 Ordering costs:
 Setup costs: are those necessary to modify production processes to make the
products necessary to satisfy particular orders. They include:
+ The process-change costs associated with switching from making one type of
part to making another type of part. Different raw materials, different settings,
different speed.
+ The time involved in making the change, from employees’ costs to production
downtime costs.

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Inventory costs

An offset printing machine incurs a
setup cost when production changes
from one job to another.

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Inventory costs
 Stockout costs:
 Stockout costs (shortage costs) are costs caused by product shortages on the shelf.
 They may be an effect of wrong forecasting, supplier-retailer communication and/or

logistics management.
 It involves an understanding of a customer’s reaction to a company being out of
stock when a customer wants to buy an item
 There are 3 types of customer response to a stockout:
+ delayed sale (brand loyalty)
+ lost sale (switches and comes back)
+ lost customer
=> cost of stockout

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Inventory costs
 Trade-off between Carrying & Ordering costs:
• The trade-off that exists between carrying and ordering costs is that they respond in
opposite ways to the number of orders or size of orders
• An increase in the number of orders leads to higher order costs & lower carrying
costs

 Trade-off between Carrying & Stockout costs:
• The trade-off between carrying and stockout costs is that both move in opposite
directions – higher inventory levels (higher inventory carrying costs) result in lower
chances of a stockout (lower stockout costs)
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Inventory costs


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Lead time
 The lead time is the period between the moment an order is placed and the time at
which it arrives.

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When to order
 Fixed order interval system: the time interval is constant, the order size may
fluctuate

-> The inventory is replenished at regular intervals, and the quantity of goods reordered changes.
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When to order
 Fixed order quantity system: the time interval may fluctuate, the order size stays
constant

-> The inventory is replenished whenever inventory level reaches a certain
point. The periodicity changes
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When to order
 Reorder point (trigger point): the level of inventory at which a replenishment order
is placed.
• The firm reorders the goods when the inventory level has reached a point that is
equal to the expected demand during the lead time.
ROP = DD x RC

- ROP: reorder point
- DD: average daily demand (unit)
- RC: replenishment cycle (day/ week/ month)
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When to order
 Example: Average daily demand is 40 units, the replenishment cycle is 4 days
The order point is 40x4=160 units
-> when the inventory level reaches 160 units, a reorder is placed
 Reorder point is used for an efficient fixed order quantity system -> require relatively
frequent monitoring of inventory levels
 Inventory levels are monitored much less frequent in fixed order interval system ->
make this system much more susceptible to stockout situations -> higher levels of
safety stock

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When to order
 Reorder point can be calculated in the other manner:
ROP = (DD x RC) + SS
SS: safety stock

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How to order
 Economic Order Quantity (EOQ):
 Economic order quantity (EOQ) is the ideal order quantity a company should
purchase to minimize inventory costs
 EOQ deals with calculating the proper order size with respect to two costs: carrying
costs & ordering costs
 EOQ determines the point at which the sum of carrying costs & ordering costs is
minimized (the point at which carrying costs equal ordering costs)
 EOQ formula was created by Ford W. Harris in 1915

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How to order


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How to order
 Economic Order Quantity (EOQ):
 The basic EOQ model is grounded in the following assumptions:
1. A continuous, constant, & known rate of demand
2. A constant & known replenishment or lead time
3. A constant purchase price that is independent of the order quantity

4. All demand is satisfied (no stockouts are allowed)
5. No inventory in transit
6. Only one item in inventory or no interaction between inventory items
7. An infinite planning horizon
8. Unlimited capital availability

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How to order

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How to order

EOQ  2 AB / C

- EOQ: the most economic order size, in dollars
- A: annual usage, in dollars
- B: administrative costs per order of placing the order
- C: carrying costs of the inventory (expressed as an annual percentage of the
inventory dollar value)

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How to order
 Example: suppose that $1000 of a particular items is used each year, the order
costs are $25 per order submitted, inventory carrying costs are 20%. EOQ in dollars

EOQ  2 x1000 x25 / 0.2  250000  500dollars
-> Therefore, EOQ is $500 order size

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How to order

EOQ  2DB / IC
- EOQ: the most economic order size, in units
- D: annual demand, in units
- B: administrative costs per order of placing the order
- C: carrying costs of the inventory (expressed as an annual percentage of the
inventory dollar value)

- I: dollar value of the inventory, per unit
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How to order
 Example: suppose that $1000 of a particular items is used each year, the product
has a cost of $5 per unit, the order costs are $25 per order submitted, inventory
carrying costs are 20%
- Annual demand: D = 1000/5 = 200 units

EOQ  2DB / IC  2 x200 x25 / 0.2 x5  10000 / 1  100units
-> Therefore, EOQ is 100 units

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How to order
The total cost calculations for several other order size:

-> The total cost is minimized at EOQ
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Inventory flows

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How to order
* Assumption:
 EOQ: 120 units
 Safety stock: 60 units
 Average demand: 30 units per day
 Order cycle: 2 days

 Beginning inventory = EOQ + safety stock = 120 + 60 = 180 units
 Reorder point = (daily demand x replenishment cycle) + safety stock
= 30x2 + 60 = 120 units

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How to order
• Safety stock can prevent against two problem areas: an increased rate of demand
and a longer-than-normal replenishment
• When a fixed order quantity system (EOQ) is used, the time between orders may
vary
• Requirement of using a fixed order quantity system: that the level of inventory must
constantly be monitored, when the reorder point is hit, the fixed order quantity is
ordered

-> use technology advances to monitor inventory constantly
-> reorder point is established electronically

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Inventory management: special concerns
 ABC Analysis of Inventory:
 ABC analysis of inventory is the classification of a group of items in decreasing
order, based on their value to the business. The A group is the most important in
terms of the value contributing to the company, whilst C items are the least valuable.
 The 80/20 rule: 80% of a company’s sales come from 20% of its products &
conversely

 Company should focus on the 20% of products that generate the 80% of sales
-> decrease inventory carrying costs

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Inventory management: special concerns
 ABC Analysis of Inventory:

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Inventory management: special concerns
 ABC Analysis of Inventory:

 Measures to determine ABC status: sales volume in dollars, sales volume in units,
the fastest-selling items, item profitability & item importance
 Group A usually represents 10-20% by number of items and accounts for 50-80% of
dollar volume
 Group C contains 60-70% of the items but only accounts for 10-30% of the dollar
volume
 Group B has more items than group C but less than group A, with the value is
higher than group C but far less than group A in volume

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Inventory management: special concerns
 ABC Analysis of Inventory:
 The determination of what percentage of items should be classified as A, B, C may
have effect on the efficiencies of inventory
-> too high or too low a percentage of A items may reduce the potential
efficiencies to be gained from the classification technique
 ABC analysis can determine stocking patterns in warehousing facilities
 ABC analysis could be used to determine how frequently inventory gets monitored

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Inventory management: special concerns
 ABC Analysis of Inventory:
 A items might be checked daily (increasingly, hourly)

 B items weekly
 C items monthly

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Inventory management: special concerns
 Dead Inventory:
 Dead inventory (dead stock) refers to a product for which there is no sales during a
12-month period
 Dead inventory increases inventory carrying costs, takes up space in warehousing
facilities
-> need to have structured process for managing
 How to deal with dead stock?
-> drastic price reductions
bunching it with more attractive products,
use deadstock broker, donations…
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Inventory management: special concerns
 Inventory Turnover:
 Inventory turnover: the number of times that inventory is sold in a one-year period
 Inventory turnover can be calculated:
Inventory turnover = the cost of goods sold / the average inventory
The average inventory = (beginning inventory + ending inventory) / 2


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Inventory management: special concerns
 Inventory Turnover:
 Inventory turnover measures how fast a company sells inventory & compare it to
competitors or industry averages
-> organization’s competitiveness & efficiency
 A low turnover: weak sales, overstocking
 A high turnover: strong sales, low level of inventories
 Inventory turnover related to trade-offs involving organizational functions:
marketing (price) – finance (profit) – logistics (inventory turnover)

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Inventory management: special concerns
 Inventory Turnover:
 How to increase inventory turnover?
-> reducing average inventory
-> how to reducing average inventory?
-> ABC analysis & Dead inventory

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Inventory management: special concerns
 Complementary
products:

and

Substitute

 Complementary goods are products
which are consumed and distributed
together (i.e. razor blades and razors)
-> pressure on retailers/wholesalers
involving inventory maintenance
-> need to consider the amount of
inventory to be carried because
complementary products is necessary
to support the sale of its complement
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Inventory management: special concerns
 Complementary and Substitute products:
 Substitute goods refer to products that can fill the same need or want as another
product
- The substitutability can occur at a specific product level (i.e. Coca-Cola &
Pepsi) or across product classes (i.e. potatoes & rice)
- Implications for stockout costs and the maintaining of
size of safety stock


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Contemporary issues with managing inventory
 Lean Manufacturing (Lean)
 Lean manufacturing is the methodology that
focuses on the elimination of waste and the
increase of speed and flow
 The idea of lean manufacturing was first
championed by the model “The Toyota Way”
(Toyota Production System) in the 1930 at
Toyota - Japan
 It was officially called “Lean” in the book “The
Machine that Changed the World” in the
1990s
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Contemporary issues with managing inventory
 Lean Manufacturing (Lean)
 Lean thinking aims to identify and remove wastes from work processes
 Waste is any action or step in a process that does not add value to the customer. In
other words, waste is any process that the customer does not want to pay for.
 7 major sources of waste – TIMWOOD
 TIMWOOD - Transportation, Inventory,
Motion,

Waiting,
Overproduction,
Overprocessing and Defects

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Contemporary issues with managing inventory
 Just-in-time (JIT)
 JIT approach seeks to minimize inventory by reducing (if not eliminating) safety
stock, and by having the required amount of materials arrive at the production
location at the exact time that they are needed
 JIT inventory management focuses on minimizing inventory and increasing
efficiency in logistics
 JIT emphasizes minimal inventory levels, low (no) safety stock & defective materials
 Trucking is an important mode of transportation in
the JIT approach to meet some requirements from
JIT system: smaller orders, more frequent
shipments, closer supplier location
 The aim of JIT: encompass movement of materials
and component parts from supplier to producer

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Contemporary issues with managing inventory


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Contemporary issues with managing inventory
 ECR & QR
 Efficient consumer response (ECR) and Quick response (QR) tend to focus on
product movement from manufacturer to retailer
 ECR is associated with the grocery and beverage industries
 QR is associated with the apparel industry

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Contemporary issues with managing inventory
 Service Part Logistics
 Service parts logistics involves designing a network of facilities to stock service
parts, deciding upon inventory ordering policies, stocking the required parts, and
transporting parts from stocking facilities to customers

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