Concepts of Inventory

A number of general concepts of inventory need to be explored before we proceed.

Independent Demand. Demand from the marketplace for end-product items, such as finished goods and service parts, is driven by factors that are independent of company decisions. This type of demand usually comes from relatively uniform customer orders, received continuously but also randomly throughout any time period. Forecasts of demand for these independent-demand items are typically projections based on historical demand patterns that estimate the average usagerate,usagetrends,andthepatternofdemandvariation.Thedemandgenerallydrawsdown the inventory until the reorder point is reached, and then a replacement order is placed and received. See Figure 1

Dependent Demand. Demand in manufacturing for materials needed to make finished goods is dependent on the demand of the end-product items. These dependent-demand items are raw materials, components, and lower-level subassemblies, and they are dependent on demand for the end-product item. This type of derived demand is usually intermittent, or dependent, because demand exists only at a time when the next higher level of assembly is being made. Requirements for the lower-level material requirements are dependent on the next higher level and can be calculated based on the assembly or production of the end product. Inventory is generally planned only to meet specific production requirements. See Figure 2

Lead Time. A concept essential to inventory planning is lead time, or the time that it takes to replenish an inventory item. It is how long it takes to purchase or manufacture the item.

Lead time is composed of many elements. Purchased lead time includes the time it takes to source, order, receive, and enter items into stock. Manufacturing lead time adds the elements of setup time, running time, queue time, and move or transit time. The lead time is important in knowing when to order, so that you have the time to order and get the item.

Lead time of the product can vary based on cycle time of the process and the inventory strategy of the company to deliver the product to the market. These inventory strategies are make to stock, assemble to order, make to order, or engineer to order. See Figure 3

• Make-to-stock (MTS) strategy. The finished product is produced to stock and is in stock awaiting the customer order. This strategy produces a short customer lead time and a high

level of customer service. But it requires better customer demand planning with a higher level of finished inventory investment.

• Assemble-to-order (ATO) strategy. The important parts or subassemblies are planned in inventory but not assembled. The customer delivery lead time and customer service are good. But it requires good customer demand planning and inventory investment in components for assembly.
• Make-to-order (MTO) strategy. The finished product is produced after the customer order is received. It allows for specific customer orders. This strategy requires a longer customer lead time but less investment in inventory.
• Engineer-to-order (ETO) strategy. The product is defined, designed, planned, and produced to meet the customer’s specific requirements. This strategy requires a longer lead time but virtually no prior inventory investment.

Many companies pursue more than one of these strategies and sometimes all four at once, that is, different strategies for different product lines. Proper inventory planning strategy requires that the company has an understanding of the production lead time of each product and the competitive delivery lead time in the marketplace to implement the inventory planning strategy that will maximize customer satisfaction while minimizing inventory investment.

FINISHED-GOODS INVENTORY, INDEPENDENT-DEMAND PLANNING

Finished-goods inventories that are stocked to meet customer demand are usually found in finished-goods warehouses, distribution warehouses, stocking locations, or retail environments. These inventories characteristically include a large number of items. They are the end-item stock-keeping units (SKUs) that are stocked for the customer. Their demand generally comes from many customers and is independent of other activities. Retailers can often count the number of SKUs in the hundreds and thousands when considering different variations such as sizes and colors.

Inventory management of these items relates directly to forecast demand and the level of customer service. Failing to order what is needed, in the quantity needed, at the time needed results in stockouts, poor customer service, and potential loss of sales. Conversely, ordering too much or ordering too soon will result in excessively high inventory and extra costs.

In many companies, independent-demand inventory control is heavily biased toward customer service at the cost of high inventory. Good customer service does not necessarily have to mean high inventory. Good customer service also depends on the accuracy of the demand plan (forecast) and the cycle time to replenish inventory. Another approach to excellent customer service without high inventory is to have accurate demand forecasts and short replenishment cycle times. Remember, what we want is the right amount of the right items at the right time. Customer service is really a function of the accuracy of the forecast, the replenishment cycle time, and the inventory levels. The better the forecast, the shorter the cycle time, the better the service with lower inventories.

Customer service = forecast accuracy + cycle time + inventory levels

Order Point Systems

For many years, historical data had been relied on to develop demand patterns, set order points, and determine order quantities. These basic techniques involve setting reorder points for each inventory item (this reorder point depends on the replenishment cycle time), then when stock diminishes to the reorder point, placing an order for a specified order quantity.

Setting of the reorder point is influenced by four factors: (1) the demand rate, (2) the amount of uncertainty in the demand rate, (3) the lead time required to obtain replenishment inventory, and (4) management’s policies regarding acceptable inventory shortages and customer service.

Reorder point = demand during lead time + safety stock

When there is no uncertainty in either demand rate or lead time for an item, determination of the reorder point is fairly straightforward. For example, if the demand rate for an item is exactly five units per day, and the replenishment lead time is exactly 1 day, the reorder point or trigger to launch the replenishment order is five units.

Yet, constant demand rates and fixed replenishment lead times are rare in actual operations. Variations occur, not only from fluctuations in customer demand, but in replenishment lead times because of supply uncertainty. To provide protection when there is uncertainty in demand or replenishment time, the reorder point needs to be increased beyond the average demand during lead time to maintain some level of safety stock. But, remember, the objective is to have accurate forecasts with short lead times and reduced variability. This will result in lower inventories and higher-level customer service.

Order Rules

Setting of inventory levels, order points, and order quantities is central to inventory planning and management for finished goods. These are stated in order rules. This process begins with forecasting average usage or demand. The order point is set at the demand during lead time. The safety stock is determined by the variability during lead time. The order quantity is determined by the economics of production or supply.

Once these order rules are determined, the inventory management process focuses on reviewing the available stock levels against the order point. Reviewing must be done frequently because of the constant rate of depletion of stock. Some items may be checked as frequently as every issue. This is particularly true with computer systems that make this possible. Real-time data can then be reviewed as frequently as appropriate to the business—a McDonald’s store uses its point-of-sale (POS) inventory system to review inventory at least daily and usually every hour. Orders to replenish inventory items from central distribution or a nearby supplier can be launched daily or even several times a day in times of heightened demand or unanticipated traffic. However, the management goal is to forecast usage accurately so that the store can run on its regular shipment until the next scheduled shipment from the central warehouse or some other source of supply.

Order rules and order points should be reviewed and recalculated on a regular basis. Computers now make it easy to analyze rates of usage and recalculate order points and order quantities frequently to keep pace with changes in customer demand, replenishment cycle time, and other changes in the consumer environment.

There are several types of order rules and many variations of each, because any given situation or class of inventory may require different types of order rules involving differences in inventory levels and total inventory costs. The order rules most commonly applied in the distribution and retail environment are based on fixed order quantities and fixed order cycles or intervals.

Fixed Order Quantity. In some systems, the order point establishes when to order the inventory. When the stock on hand falls to the reorder point, the inventory planner places a reorder. How much to order is prescribed by a predetermined economic order quantity (EOQ). The EOQ is calculated as the quantity that will result in the lowest total costs of acquiring, producing, or carrying the item. Thus, the order quantity is fixed and the time interval between orders may vary, depending on the rate of usage.

A good example of fixed order quantity inventory management can be seen in the maintenance of service parts at an auto dealer. When stock of a particular part, such as a gasket, reaches the reorder point for that item, it automatically orders an EOQ from the distribution center. The inventory control system may be as simple as a two-bin system. When one bin is depleted, the order is issued for replenishment inventory.

The advantage of the fixed order quantity for managing inventory is that it is flexible. Orders can be issued any time. When the order point is reached, an order is generated. Thus, the order cycle may vary, but the order quantity does not. The nature of some businesses may also require that they develop separate order points and order quantities on items for different times of the year because of different (seasonal) usage rates.

Fixed Order Cycle. In some distribution systems, ordering takes place at a fixed interval or cycle. When this rule is used, items are ordered at regular fixed cycles, such as every week. The specified interval indicates when to order. How much to order is determined by subtracting the stock on hand to determine an order amount to meet an established or target inventory level. In this case, the order quantity may vary, but the order review cycle is fixed.

A good example of fixed order cycle inventory management can be seen in the stocking of bread to retail outlets. Each retail site is visited by the bread distributor’s representative on a predetermined schedule. The representative checks the loaves on the shelf, removes any outdated stock, and adds to what remains the quantity required to bring it to the desired inventory level. The replenishment quantity may vary from order to order (depending on the usage), but the interval at which the representative revisits, checks, and brings up the stock is fixed.

Fixed order cycle inventory management is most useful in situations where there are a large number of items that are ordered and delivered at one time, and there are no significant economies from ordering individual items in larger quantities.

Order point continues to be used in many companies for managing independent-demand finished-goods items, service parts, supplies, and stable-usage items. While it may be executed manually, many companies now track finished-goods sales and inventories on computers, aided in the retail and warehouse environment by POS terminals, scanners, or bar-code readers for real-time data capture. The computers track on-hand inventory at all sales locations and provide automatic reorder messages to trigger replenishment orders and the proper distribution of inventory throughout the entire distribution system or supply chain.

DEPENDENT-DEMAND INVENTORY PLANNING

For many years, the same order point method was utilized for managing both independent demand finished-goods and dependent-demand raw-materials inventories. There were a number of problems, however, with using order point for these dependent-demand items. First, the approach is not oriented to future demand. It’s based on historical usage. Second, and most important, it does not recognize the dependent-demand relationship. The lower-level components and raw materials are not needed in inventory until they are required for the next higher level. Their demand is dependent on the higher-level parent. With the advent of computers, we are now able to plan more effectively and calculate dependent-demand inventories based on these dependent relationships.

The Closed-Loop Inventory Planning System

First came computer-based material requirements planning (MRP) in the 1960s and 1970s. This shifted emphasis from order points and launching orders when an item appeared to be running out to scheduling and priority planning based on due dates for finished products and due dates for components and raw materials.

Next came manufacturing resource planning (MRP II) in the 1970s and 1980s.This expanded the scope of planning and control to encompass all functions of the company, including sales, manufacturing, engineering, purchasing, and production. This enabled management to integrate long-term, medium-term, and short-term planning into a total-company closed-loop inventory planning system.

Then came enterprise resource planning (ERP) in the 1990s, which expanded the scope of planning and control to the entire enterprise. The current computer systems have migrated to the ERP model.

The closed-loop system translates top management planning into a business plan, sales plan, and production plan for finished goods into rates of production that must be established and produced by operations management to meet customer demand. This is the what, how much, and when of the rates of finished products or finished goods by month that are needed for the company. See Figure 4

The next step is the heart of the computer-based inventory planning system. Operations management planning develops the master schedule of what, how much and when, which is the weekly detail statement of the mix of products to be produced, and then this schedule is

exploded into the detail materials plan and capacity plan. Material planning is a time-phased priority planning system to schedule material to meet requirements. Capacity planning provides detail capacity requirements of labor and equipment to produce the product.

In the computer-based inventory planning system, these activities are supported by information in a database, which includes bills of material, inventory status, and routings. The bill of materials specifies the parts or materials needed to produce the final product. Routings specify the process or the operations in production. And the inventory status includes the on hand quantity and location of the items in raw material, work in process, and finished goods that are available to produce the product.

Operations management execution is the final step, which develops daily schedules of inventory and production for purchasing and manufacturing. Purchasing then purchases the materials and parts required to support the inventory plan, and manufacturing moves the raw materials and subassemblies through the production process to meet daily schedules and produce the final product to meet the inventory plan. Performance measurement provides the monitoring device to review and communicate that all functions are performing to plans and to meet customer demand.

A computer-based closed-loop inventory planning system can provide much better planning and control of dependent-demand inventories. The computer takes over the multistep task of calculating requirements for all the parts through the bills of material, maintaining inventory record status, and projecting material and capacity requirements to produce the product.

ACHIEVING ACCURATE INVENTORY

Accurate inventory records are very important for a company’s inventory management. They are important for many reasons:

• They verify the physical inventory as an asset in determining the value of a company.
• Customer orders for products can be accurately quoted and shipped from inventory.
• Realistic production schedules can be developed and met because people can count on having the necessary parts and materials available in inventory when needed.
• Production delays caused by unexpected shortages of critical materials can be eliminated and the need for costly, last-minute rush orders can be reduced.
• Inventory levels can be reduced because “safety” stocks held to compensate for unexpected shortages or incorrect balance information are not needed.
• Improved production efficiency, product quality, productivity, and customer service can result.

Effective inventory control depends upon accurate and timely inventory information. A key measurement of inventory control is inventory record accuracy.

Measuring inventory accuracy is a two-step process. First, the inventory items are physically counted. Next, the count is compared with the balances shown on the inventory records. When the counts match the balances shown on the inventory records exactly or within predetermined tolerance ranges, the inventory is accurate. Inventory accuracy of at least 95 percent is generally considered mandatory for effective inventory planning and control.

Inventory Transaction Processing System (TPS)

An inventory transaction processing system is required to track the movement, location, quantity, and status of materials and parts as they physically move through the production process. The transaction processing system relies on people, processes, procedures, and computers to accurately account for the physical transfer of materials within the production process.

Inventory transaction systems should be simple and transparent and should reflect reality. A blueprint or layout of the facility is a handy starting point for identifying material flows and inventory control points. Inventory control points are anyplace where materials are transferred, such as the receiving dock, controlled stockroom areas, and the shipping dock. As material passes through an inventory control point, it should be documented and recorded by a transaction to maintain accurate inventory information.

Transaction information should include identification of the part number being moved, quantity, its location, and the material’s status. For example, when an item is received into the warehouse, a transaction should be recorded specifying the part number of the item and how many are being received into that stock location.

Controlled stockrooms can be helpful in improving inventory accuracy defined by physical barriers such as fences or by psychological barriers such as lines painted on the floor, signs on the walls, or other markings. Employees in each controlled stockroom are responsible for recording the appropriate transaction information any time materials move in or out of the area. The inventory accuracy of each controlled stockroom area should be measured, and performance results posted in each area for accountability.

Transaction recording can be facilitated through the use of bar coding, scanners, and optical character readers. This enhances both the accuracy and timeliness of the data capture. Paper forms may still be necessary under some circumstances, however. The following are guidelines for designing paper transaction forms:

• Develop simple single-use forms. To minimize errors, a different form or paper color should be provided for each transaction type.
• Make directions and field titles simple and easy to understand.
• Minimize the amount of writing necessary to complete the forms. Preprint as much information as possible.
• Organize the fields on the forms so that they can be completed in order as stockroom personnel receive or issue materials.
• Make forms computer-scannable or clearly arrange the fields to match the computer system’s input screens to facilitate accurate data entry.

To ensure that the inventory transaction system is up to date, transactions should be processedonatimelybasis.TimelyTPSisimportantforaccurateinventoryrecordsandforaudit reconciliation.Mostinventorytransactionsystemsgenerateatransactionaudittrailforreconciling the inventory and identifying and correcting errors. The paper transaction documents completed by employees as materials move through the production process serve as a valuable, physical audit trail. These documents can be maintained in a file for reference whenever discrepancies are detected in the computerized records.

Transaction history reports can be generated detailing all transaction activity affecting on hand balances. Reports by part number and location are also useful for identifying and correcting errors. Remember, the objective is to maintain accurate inventories, not to generate transactions and documents. Value added—not cost added. Less is more.

A number of methods can be used to verify the inventory. The two most frequently used procedures are the annual physical inventory and cycle counting.

Annual Physical Inventory (API)

Traditionally, manufacturers closed their plants for a number of days to physically count and verify their inventories. Discrepancies between the dollar value of materials counted on hand and of inventory on the books were reconciled. The books were adjusted as necessary. The purpose of the annual inventory was to ensure that the company’s books were accurate for accounting and tax purposes. The primary emphasis of this approach was on total dollar value of the inventory.

Today’s competitive manufacturing environment requires a much different and higher degree of inventory accuracy. Managers require correct inventory information by item at all times to ensure the quality of their planning, scheduling, and control decisions. Inventory information that is reliable only once a year and only by total dollar value is of little use for modern production and distribution planning.

The accuracy of inventory balance information determined by an API is often questionable, even on the day that the inventory is completed. Because the annual inventory occurs only once a year, it is taken by numerous employees who are generally untrained in inventory taking. Counting and identification errors are likely to result, and the API has always been suspect. Despite the massive effort involved and loss of production time while the plant is shut down, the major problem with the API is that no ongoing problem-solving and accuracy improvements are likely to result. The API does not promote an ongoing process of continuous improvement and keeping the inventory accurate throughout the entire year.

Cycle Counting

In place of the API, today’s companies use a process called cycle counting, a proven method that helps maintain inventory accuracy over time. Cycle counting relies on continuous counts, or audits of the inventory, on a regular basis throughout the year. These counts are compared with the balances shown on the computerized inventory records. Any discrepancies are analyzed immediately to determine what caused the errors, and steps are taken to fix the error and prevent it from occurring again.

Inventory record accuracy =number of records correct × 100 number of inventory items

Examples of accuracy tolerances for inventory items classified using the ABC method are shown in table below. Inventory records showing on-hand balances that match the physical count or fall within the tolerance range are considered accurate. Notice that 0 percent tolerance is allowed for high-dollar-value items (class A). The wider tolerance range for class C items, 5 percent, reflects both their lower dollar value and the fact that weigh counting is routinely used instead of physical counting to determine both actual and transaction quantities for these items.

Inventory accuracy can also be measured by comparing the dollar value of inventory on hand, as shown by the inventory records, with the dollar value of the physical inventory. However, this measurement is not particularly useful for efficient manufacturing and improving inventory accuracy. As shown in the last column of table below, inventory accuracy measured in dollars produces a higher level of rate accuracy than count accuracy. For inventory control purposes, the count accuracy of on-hand balance by item by location is the important measurement, much more so than the dollar accuracy of the financial statements.

                          Examples of Accuracy Tolerances for Inventory Items Classified by the ABC Method

Control		Count analysis			Dollar analysis
Value	Parts	Within #	Count	On hand	Variance	Accuracy
class        Tolerance	counted	limit	accuracy	(in dollars)	(in dollars)	(in dollars)
A                    0%	50	49	98%	7500	75	99%
B                    2%	75	72	96%	2000	(100)	95%
C                    5%	100	93	93%	500	(50)	90%
Total	225	214	95%	10,000	(75)	99%

LOGISTICS AND DISTRIBUTION

Remember, take care of the piece count accuracy, and the dollar accuracy will take care of itself.

Benefits of cycle counting in contrast to an API include

• Efficient use of trained personnel
• Regular error detection and correction
• Minimal loss of production time
• Improved inventory accuracy
• Reduced inventory levels
• Better productivity
• Improved customer service

Control Group Method

Before implementing a full-scale cycle counting program for all inventory, it is a good idea to select a small sample control group of items for daily counting and reconciliation to prove the process and identify any problems. For example, a group of about 50 items, ranging in volume, price, and size from large to small, may be counted and reconciled. Differences between the counts and the balances shown on the computerized inventory records should be identified and corrected on a daily basis for this control group.

ABC method. This method maximizes dollar inventory accuracy while minimizing the effort and cost required for counting. Items are categorized as class A, B, or C, based on their dollar value. Class A items are counted most frequently, perhaps monthly, because they are usually about 10 percent of all inventory items that account for 60 to 75 percent of the total dollar value of inventory. Class B items are counted somewhat less often, perhaps quarterly. Class B items account for 20 percent of inventory items but comprise 20 percent of the inventory’s total dollar value. Class C items are counted least often, perhaps only once or twice per year. Class C consists of the low-dollar-value items that make up the remaining 70 percent of the total inventory items.

Reorder method. The reorder selection method is designed to minimize the number of items that must be counted with each count .Using this technique, inventory items are counted whenever a reorder is issued, and the inventory is usually at the lowest level requiring the counting of the fewest number of items. Another advantage of this method is that when a quantity discrepancy is identified, there may still be time to prevent a stockout.

Free-count method. Using the free-count method, stockroom personnel count inventory items whenever they are servicing the inventory at a location, such as when a replenishment lot is received or when pulling the last item from a location—thus, a “free” count.

Zone-count method. This is cycle counting by location or zone. On a rotating basis, each zone’s contents are counted. This method is used because zones keep the counting concentrated in one area. Also, inventory accuracy accountability is usually assigned by area. This is probably the best method.

Other methods. In addition to dollar value, some companies may use classification criteria such as how critical an item is to the finished product, length of procurement lead time, or amount of storage space required.

Items should also be counted whenever an error condition has been identified or a problem exists. For example, if the computerized inventory records show a negative balance on hand for a particular item or a quantity on hand without a valid stockroom location, the actual inventory status should be investigated and the records corrected.

^{INVENTORY MANAGEMENT AND CONTROL}

Process of Continuous Improvement

The objective is to fix the problems that are causing the discrepancies—which involves far more than just adjusting the numbers to bring them into balance. Once the problems are resolved, the records will begin to stay accurate on an ongoing basis.

Once inventory accuracy of at least 95 percent is consistently maintained for the small sample control group, then a full-scale cycle counting program can be launched that encompasses all the inventory. Various criteria can be used to select and schedule the inventory items that will be counted. These criteria include the ABC selection method, the reorder selection method, free counting, zone counting, and others.

Measuring Performance

Inventory accuracy is a measurement of performance indicating the accuracy of inventory balances on hand. Actual inventory should be compared with the balances shown on the inventory records at least once per year by physically counting the items. The measurement is expressed as the percentage of correct record balances. Correct on-hand balances are those that match, within pre-established tolerance ranges, the actual number of items on hand.

INVENTORY MANAGEMENT AND ANALYSIS

Inventory management and analysis are an important part of the management function. Timely inventory analysis enables managers to identify and control inventory investment problems. By monitoring and controlling inventory investment levels, turnover rates, lead times, and days of stock, many companies can significantly reduce their inventory investment and their total inventory investment costs.

Inventory Flow Model

Modeling has been used for analysis in many areas of management, and it is also an important tool for inventory management and analysis. Inventory models can be used to plan inventory levels and to highlight problem areas, such as inventory buildups or inventory imbalances. The purpose of the inventory flow model is to model the present inventory against the inventory flow rates to detect problems with the inventory. The information needed to construct the model is material, labor and overhead costs as a percentage of cost of sales, the annual volume, and the present inventory levels. This information is used to model each category of the present inventory—raw materials, work in process, and finished goods—and to establish inventory targets for each category and for the total inventory. See Fig. 10.5.8.

• Materials cost.   As a percentage of cost of sales, figure generally 50 to 60 percent.
• Labor cost.        As a percentage of cost of sales, figure generally 5 to 10 percent.
• Overhead cost.   As a percentage of cost of sales, figure generally 30 to 45 percent.
• Cost of sales dollar volume.        The annual total dollar volume in cost of sales (COS) divided by 12 gives the monthly total volume in COS rate, and that divided by 20 gives the daily COS rate.
• Flow percentage. The flow percentage for raw materials (RM) is the percent that RM is of the total cost of goods. In the example, 50 percent. The flow percent for finished goods is 100 percent. The flow percent for work-in-process is the RM flow rate plus one-half the difference between the RM rate and the finished goods (FG) rate, or 50 percent plus ¹⁄2 of 100 minus 50 percent = 75 percent.
• Flow rates per day. Divide the flow percentage for each category into the total flow rate per day to determine the dollar flow rate per day for each category.

Literatures :

Herbert W. Davis – Maynard’s Industrial Engineering Handbook (1992).

Jenkins, C. H., Complete Guide to Modern Warehouse Management, Prentice-Hall, Old Tappan, NJ, 1990.
(book)
Mulcahy, David E., Warehouse Distribution and Operations Handbook, McGraw-Hill, New York, 1994.
(book)
Tompkins, J. A., and J. D. Smith, The Warehouse Management Handbook, Tompkins Associates, Inc.,
Raleigh, NC, 1988. (book)

Home