Chapter 11: Managing Inventory through the Supply Chain

Inventory those stocks or items used to support production (raw materials, and work-inprogress items), supporting activities (maintenance, repair, and operating supplies) and
customer service (finished goods and spare parts.)
1.1 The Role of Inventory
Cycle stock components or products that are received in bulk by a downstream
partner, and then replenished again in bulk by the upstream partner.
Cycle stock is thought of as active inventory because companies are constantly using
it up, and their suppliers are constantly replenishing it.
Safety stock extra inventory that a company holds to protect itself against
uncertainties in either demand or replenishment time.
Companies dont plan on using safety stock, it is there just in case.
Anticipation inventory inventory that is held in anticipation of customer demand.
Allows instant availability of items when customers want them.
Hedge stock a form of inventory build up to buffer against some event that may not
happen. Hedge inventory planning involves speculation related to potential labour
strikes, price increases, unsettled governments, and events that could severely impair
the companys strategic initiatives.
Hedge inventories can be thought of as a special kind of safety stock.
Transportation inventory inventory that is moving from one link in the supply
chain to another.
When physical distance between supply chain partners is long, transportation
inventory can represent a considerable investment.
Smoothing inventory inventory that is used to smooth out differences between
upstream production levels and downstream demands.
Companies dont want to hold more inventory than necessary.
Inventory ties up space and capital; a dollar invested in inventory is a dollar that
cannot be used somewhere else.
Inventory also poses a significant risk of obsolescence, particularly in supply chains
with short product life cycles.
Inventory is too often used to hide problems that management should really resolve.
Inventory drivers business conditions that force companies to hold inventory.
To the extent that organisations can manage and control the drivers of inventories,
they can reduce the supply chains need for inventory.
Supply uncertainty the risk of interruptions in the flow of components from
upstream suppliers.
Demand uncertainty the risk of significant and unpredictable fluctuations in
downstream demand.
In dealing with demand uncertainty in supply and demand, the trick is to determine
what types of uncertainty can be reduced and then focus on reducing them.
Another common inventory driver is the mismatch between demand and the most
efficient production or shipment volumes.
On an organisational scale, mismatch between demand and efficient production or
shipment volumes are the main volume drivers.

Managers often alter their business processes to reduce production or shipment

volumes, thereby reducing the mismatch with the demand and resulting need for cycle
stocks.
Mismatches between overall demand levels and production capacity can force
companies to hold smoothing inventories.
Managers can reduce smoothing inventories by varying their capacity to better match
demand or by smoothing demand to better match capacity.
Whenever the customers maximum waiting time is shorter than the supply chains
lead time, companies must have transportation and anticipation inventories to ensure
that the product will be available when the customer wants it.
Independent demand inventory inventory items whose demand levels are beyond
a companys complete control.
Dependent demand inventory inventory items whose demand levels are tied
directly to a companys planned production of another item.
Because the required quantities and timing of dependent demand inventory items can
be predicted with great accuracy, they are under a companys complete control.

11.2 Periodic Review Systems

Periodic review system an inventory system that is used to manage independent

demand inventory. The inventory level for an item is checked at regular intervals and
restocked to some predetermined level.
Q=RI
Q Order quantity
R Restocking level
I Inventory level at the time of review
As the downward-sloping line, shows the inventory starts out full and then slowly
drains down as units pulled from it. The line will only be straight if demand is
constant. The inventory is replenished, and the process begins again. INSERT
FIGURE ON PG349.
A periodic review system nicely illustrates the use of both cycle stock and safety
stock.
Replenishing inventory every two weeks, rather than daily or even hourly, the
organisation spreads the cyclical cost of restocking across more units.
Increasing the restocking level effectively increases safety stock: the higher level, the
less likely the organisation is to run out of inventory before the next replenishment
period.
Because inventory is checked only at regular intervals, the company could run out of
an item before the inventory is replenished.
A periodic review system is best suited to items for which periodic restocking is
economical and the cost of a high restocking level and a large safety stock is not
prohibitive.

Restocking level (R) should be high enough to meet all but the most extreme demand
levels during the reorder period (RP) and the time it takes for the order to come in (L)
R= RP+ L + Z RP +L
RP +L = average demand during the reorder period and reorder lead time
RP+ L = standard deviation of demand during the reorder period and reorder lead
time
Z = number of standard deviations above the average demand (higher z values
increase the restocking level, thereby lowering the probability of a stockout.)

By setting R a certain number of standard deviations above the average, a firm can
establish a service level.
Service level a term used to indicate the amount of demand to be met under
conditions of demand and supply uncertainty.

11.3 Continuous review systems

Continuous review system an inventory system used to manage independent

demand inventory. The inventory level for an item is constantly monitored, and when
the reorder point is reached, am order is released.
Key features of a continuous review system:
1. Inventory levels are monitored constantly and a replenishment order is
issued only when a pre-established reorder point has been reached.
2. The size if a replenishment order is typically based on the trade-off
between holding costs and reordering costs.
3. The reorder point is based on both demand and supply considerations, as
well as on how much safety stock managers would want to hold.
Assume the variables that underlie the system are constant:
1. The inventory item were interested in has a constant demand period, d.
There is no variability in demand from one period to the next. Demand for
the year is D.
2. L is the lead time, or number of periods that must pass before a
replenishment order arrives. L is constant.
3. H is the cost of holding a single unit in inventory for a year. It includes the
cost of the space needed to store the unit, the cost of potential
obsolescence, and the opportunity cost of tying up the organisations funds
in inventory. H is known and fixed.
4. S is the cost of placing an order, regardless of the order quantity. S is also
known and fixed.
5. P, the price of each unit, is fixed.
The fluctuations in the inventory levels for an item will look like the diagram below:
Inventory levels start out at Q, the order quantity, and decrease at a constant rate, d.

Because this is a continuous review system, the next order is reordered at order point,
labelled ROP, is reached.
We should reorder when the inventory level reaches the point where there are just
enough units left to meet requirements until the next order arrives:
ROP = dL

The inventory level in the model goes from Q to 0 over and over again, the inventory
level is Q/2.

Total holding and ordering cost for the year = total yearly holding cost + total yearly
ordering cost

( Q2 ) H +( QD ) S

Yearly holding cost is calculated by taking the average inventory level (Q/2) and
multiplying it by the per-unit holding cost.
Yearly ordering cost is calculated by calculating the number of times we order per
year (D/Q) and multiplying it by the fixed ordering costs.

Economic order quantity (EOQ) the order quantity that minimises annual holding
and ordering costs for an item.

This special order quantity is found by setting yearly holding costs equal to yearly
ordering costs and solving for Q:

( Q2 ) H =( DQ ) S

Q = order quantity
H = annual holding cost per unit

Q 2=

2 DS
H

D = annual demand
S = ordering cost

Q=

2 DS
=EOQ
H

EOQ has some limitations:

1. Holding costs (H) and ordering costs (S) cannot always be estimated precisely. So
orders quantities can be off a little and still yield total costs that are close to the
minimum.
2. It does not take into account volume discounts, which can be particularly
important if suppliers offer steep discounts to encourage customers to order in
large quantities.
The EOQ is a good starting point for understanding the impact of order quantities on
inventory-related costs.
The EOQ tells managers how much to order but not when to order.
When either lead time or demand or both varies, a better solution is to set the
reorder point higher than ROP = Dl, Specifically:

ROP = d L + SS

SS = safety stock
We start with an inventory level of Q plus the safety stock (Q + SS)

When we reach the new reorder point of d L + SS , an order is released.

During the first