Inventory Management Concepts. 4/15/2004 Ithaca 1

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1 Inventory Management Concepts 4/15/2004 Ithaca 1 1

2 Learning Objectives Understand the basic concepts of inventory management and how to apply them to setting and maintaining desired customer service levels Understand why warehousing is important in the logistics system and the decision factors that contribute to service and cost outcomes 4/15/2004 Ithaca 2 2

3 Baseline Purchasing Material Control Production Sales Distribution Functional Integration Materials Management Manufacturing Management Distribution Internal Integration Materials Management Manufacturing Management Distribution External Integration Suppliers Internal Supply Chain Customers 4/15/2004 Ithaca 3 In essence Logistics management seeks to create a single plan with which to manage all business processes rather than the traditional situation in which each part of the business had a different plan. Supply Chain Management seeks to extend this alignment and process beyond the boundaries of the organisation The question we must seek to answer as part of strategic development is, how much of this needs to be controlled through ownership? 3

4 Why Hold Inventory? Enable firm to achieve economies of scale Balances supply and demand Enables specialisation in manufacturing Provide protection from uncertainties in demand & order cycle Acts as a buffer between critical interfaces in the channel of distribution 4/15/2004 Ithaca 4 Why do firms hold inventories? Economies of scale can make savings from unit price reduction when purchases are made in volume (what is the trade-off when this is done? What other savings might accrue from deciding to make such a transaction (single transactional cost, transport savings etc.) manufacturers can make products in long run production, saving on setup and changeover times what is the trade-off when this is done? Balance supply & demand seasonality means that production must sometimes be in advance of demand then held against that demand what are some examples of such a situation (chocolates for Valentine s Day, Christmas toy production, Easter Eggs) alternately raw materials may only be available at a particular time of year what are some examples of this situation (dairy, canned fruit & vegetables) what are the type of savings this can generate (labour force, asset utilisation) Specialisation finished goods produced by one organisation are mixed or bundled with FG of another organisation to fill customer orders for example Whirlpool has established focused factories that only make one type of good (washing machines, refrigerators, dryers are each made at a different place and consolidated at warehouses Protection from uncertainty why might variability occur in demand (promotions, specials) why might variability occur in supply? (strikes, seasonality, capacity) Inventory as a buffer did anyone see the news during the week about the car factories having to stand people down because a component manufacturer was on strike? Why did that happen? Inventory can be held as a buffer in a number of places in the supply chain supplier/procurement; procurement/production; production/marketing; marketing/distribution; distribution/intermediary; intermediary/consumer 4

5 Relationship Between Inventory and Service Inventory Investment in $1,000's NOW Service Percentage 4/15/2004 Ithaca 5 5

6 Inventory Pipeline Raw & In-Process Finished Goods In-TransitPlant Vendor to Whse Process Mfg. Plant. Whse Mfr. In- Transit to DCs Field Whse Pick Load & In-Transit to Customer Custmr 4/15/2004 Ithaca 6 Inventories can be classified based on the reasons for which they are held: Cycle stock resulting from replenishment of inventory sold or used in production such as in this slide where the rate of sales and lead time for replenishment is held to be constant In-transit inventory what might this be, how should it be treated? (same as cycle inventory) Safety or buffer stock held against variability in demand and supply what role would forecasting of demand have to play in determining how much stock should be held? What role should prediction of supply in terms of capacity (production, transport and storage) have in determining the level of buffer stock? How could the level of safety stock be kept at a minimum? Speculative stock volume purchases (trade-offs such as Carter Holt Harvey holding 2 years of paper stock what might the cost of that be?; forecast price increases; expected materials shortage or strike Seasonal stock Dead stock what might dead stock be? (expired, obsolete, end of lifecycle complete decline of product) Why does it exist? (production of wrong item lack of accurate forecasts, lack of sales & marketing effort) How could it be dealt with? (sell at lower price, give-away, waste, re-cycle) 6

7 The Effect of Reorder Quantity on Average Inventory Investment with Constant Demand and Lead Time Inventory 400 Order placed Order arrival Order placed Order arrival Order placed Days /15/2004 Ithaca 7 So, if demand and lead-time are constant as depicted in this slide, why is any safety stock required? 7

8 Stockholding Policy: A Function of Inventory Characteristics Inventory Holding Surge Flow Inventory Wave Flow Inventory Base Flow Inventory Fad Products Seasonal Fashion Products Core Business Products Inventory Demand Types Time 4/15/2004 Ithaca 8 Source: Gattorna JL & Walters DW, Managing the Supply Chain: A Strategic Perspective, MacMillan, London 1996, pp Base Flow Predictable high flow rates Minimum (zero) stocks. Direct deliveries from suppliers. Wave Flow Slow moving flow rates. High criticality. Perishable. Peaks are relatively predictable. Minimise stockholdings, building them only during peak demand period. Direct delivery from supplier where possible. Surge Flow (1) High criticality. Low value. Long lead-time. Small physical size. Hold high level of stock thereby allowing safety stock for delivery lead-time and demand fluctuations. Surge Flow (2) Low criticality. High value. Bulky physical characteristics. Peaks are relatively predictable. Minimise stockholdings, building them only during peak demand period. Direct delivery from supplier where possible. 8

9 Low Risk Profile Inventory Holding Surge Flow Inventory Wave Flow Inventory Base Flow Inventory Time 4/15/2004 Ithaca 9 Source: Gattorna JL & Walters DW, Managing the Supply Chain: A Strategic Perspective, MacMillan, London 1996, pp The important issue for businesses is that they must classify their inventory in a way that reflects customer demand in their markets. These patterns of demand are are usually accompanied by differential levels of margins reflecting the risk involved in their stockholding. If we consider variations even within the same industry sector a low risk profile might apply to a retailer selling clothes to older (say age 55-70) men, a fairly predictable group - while a high risk profile would be more appropriate for a retailer selling clothes to a target market of people in their late teens (16-20). In terms of what we spoke of last week base flow would equate with cycle stock, wave flow with seasonal stock and surge flow with speculative stock. The challenge for the channel intermediaries is to decide upon the demand characteristics of the target customer group and develop a merchandising/inventory mix that will obtain the required level of profitability and cash flow while satisfying customer service levels. 9

10 High Risk Profile Inventory Holding Surge Flow Inventory Wave Flow Inventory Base Flow Inventory Time 4/15/2004 Ithaca 10 Source: Gattorna JL & Walters DW, Managing the Supply Chain: A Strategic Perspective, MacMillan, London 1996, pp

11 The Bullwhip Effect Analysis: Babies Nappies Suppliers Factories Distribution Retail Parents Babies 4/15/2004 Ithaca 11 Dr Hau L. Lee - Lausanne The bullwhip effect is one outcome of planning for infinite capacity as ERP does delays caused by a lack of either information or inventory at any stage in the process send signals that there is a shortage in work-inprogress or finished goods of a particular type. This leads to production order generation to make up the supposed shortfall and, as the line of information and./or inventory holding extends, the problem is exacerbated. So, if a mother buys extra packs of babies nappies because the supermarket has put them on special, the retailer might be sending incorrect messages to the distributor that demand has increased when in fact the increase in demand has been artificially created and will be followed by a drop in demand when the price goes up again. In the meantime the factories have responded to the incorrect information about demand they have received and begun to make more packs of babies nappies leading to excessive inventory holdings of babies nappies. This problem can occur at any point in the system and reverberate throughout the entire supply chain for lack of accurate information

12 Assumptions of the Simple EOQ Model Continuous, constant, and known rate of demand Constant and known replenishment cycle or lead time Constant purchase price that is independent of the order quantity or time Constant transportation cost that is independent of the order quantity or time Satisfaction of all demand (no stock-outs are permitted) No inventory in transit Only one item in inventory, or at least no interaction among items Infinite planning horizon No limit on capital availability 4/15/2004 Ithaca 12 Many organisations use a method known as Economic Order Quantity (EOQ) to determine when and how much they will order of a product. This methodology is based on these assumptions. From your experience, reading and learning to date, do you think these assumptions are reasonable? 12

13 Unreliable Suppliers A Inventory Level in a Push System Inaccurate Forecasts B Inventory Level in a Pull System Volatile Demand Quality Problems Bottlenecks 4/15/2004 Ithaca 13 JIT suggests that, wherever possible, no activity should take place in a system until there is a need for it nothing made, no components ordered until there is a downstream requirement a pull concept where demand at the end of the pipeline pulls products towards the market and behind that, the flow of components is determined by the same demand. Traditionally a push system has operated where products are manufactured in anticipation of demand and positioned in the supply chain as buffers. Conventional approach to meeting customer requirements was based on some form of statistical inventory control which typically relied on re-ordering when inventory levels fell to a particular point. The re-order quantity would then be based on the expected lead-time it would take to arrive & the anticipated usage during that time, resulting in a EOQ formulation balancing the cost of holding inventory against the costs of placing replenishment orders. Weakness frequently stock levels are higher or lower than they need to be especially where the rate of demand changes thinking has been channeled into a belief that there is some optimal amount to order but it actually means we will carry excess stock on every day of the cycle except the last then, on top of that, we add safety stock In a push system there is plenty of inventory, so all the problems are hidden in JIT we are forced to confront the problems Kanban was developed to confront these issues basing demand at the lowest point in the supply chain and dealing with the bottlenecks progressively from there through reducing set-up and ordering costs at the appropriate points. JIT is an extension of the Toyota concept of Kanban both are focused on the elimination of waste. Kanban can apply to any manufacturing operation involving repetitive operations demanding that items are supplied only at the moment they are needed. JIT extends this to purchasing, manufacturing and logistics. 13

14 Strategic Lead Time OR Pipeline MANAGEMENT In-transit Regional Stock Customer Delivery Value-adding adding time Raw Material Stock Production Finished Stock Regional Stock Customer Delivery Raw Material Stock Production Finished Stock In-transit Cost-adding time 4/15/2004 Ithaca 14 Manufacturing & Procurement lead-times must be linked to the needs of the marketplace as discussed when we looked at S&OP whilst increasing the speed of response to those needs. The goals of pipeline management are: Lower costs Higher quality process More flexible process Faster response times None of these can be achieved without managing the supply chain as an entity and seeking to reduce the pipeline length and/or speed up flow through the pipeline. When examining a pipeline it is often found that there are many non-value-adding activities such as re-positioning pallets within a warehouse re-engineering is about eliminating or at least minimising these activities through process improvement and change management. The concern is to remove blockages and fractures that occur in the pipeline where inventory typically builds up and response times lengthen focusing on reducing set-up and changeover times on production lines, identify and eliminate bottlenecks, awareness and management of excess inventory, instituting sequential order processing and improving visibility throughout the pipeline 14

15 Quick Response: Substituting Information for Inventory Traditional Inventory Cost Quick Response Inventory Service Level 4/15/2004 Ithaca 15 Quick response refers to the combination of IT systems and the JIT logistics systems that combine together to get the right product in the right place at the right time Specifically this is about the advent of Electronic Data Interchange (EDI), bar coding, Electronic Point of Sale (EFTPOS) systems and laser scanners Demand is captured as close to real time as possible and as close to the consumer as possible The logistics response is then made based on that information at the nth degree Proctor & Gamble receive data directly from Wal-Mart checkouts and can plan replenishment and delivery to Wal-Mart Based on that information The result is that Wal Mart carries less inventory AND has fewer stock outs of Proctor & Gamble products P&G benefit because they get better economies in production & logistics and they have greatly increased their sales to Wal-Mart QR also reduces cumulative lead times also resulting in lower inventory levels and further reducing response times- QR has become common in the fashion industry in the US and has the potential to greatly impact the $25Bn that logistics costs that industry if adopted by everyone 15

16 Production Strategies for Quick Response RETAILER Initiate order Interface Order Transmission MANUFACTURER Remove product from shelf Inventory Depletion In-store Inventory Storage Place on shelf Retail Warehouse Storage Receive shipment & store Receive order & initiate processing Order Processing Delivery Authorise shipping Warehouse Order Manufacturer Inventory Depletion Initiate production cycle Complete production & store 4/15/2004 Ithaca 16 Production Raw Material Storage Purchase materials Flexible manufacturing systems hold the key to achieving QR this is not just about new technology such as robotics, it is primarily about the time taken to change set-up time often this is not achieved through technology but by thinking or working differently coming back to the why and questioning conventional wisdom, Benetton s new dying technique exploits this approach very well as does Fisher & Paykel s economies of scope model. One way of doing it is by postponing the production decision until the last possible moment, such as the models used by Dell and Hewlett-Packard 16

17 Efficient Consumer Response Working together to fulfil consumer wishes better, faster, and at less cost. 17

18 Efficient Consumer Response 4/15/2004 Ithaca 18 The ECR movement began in the mid-90s and was characterised by the emergence of new principles of collaborative management along the supply chain. It was understood that companies can serve consumers better, faster and at less cost by working together with trading partners. At the heart of ECR was a business environment characterised by dramatic advances in information technology, growing competition, global business structures and consumer demand focused on better choice, service, convenience, quality, freshness and safety and the increasing movements of goods across international borders. This new reality required a fundamental reconsideration of the most effective way of delivering the right products to consumers at the right price. Non-standardized operational practices and the rigid separation of the traditional roles of manufacturer and retailer threatened to block the supply chain unnecessarily and failed to exploit the synergies that came from powerful new information technologies and planning tools. ECR, QR and EFR methodologies have become common over the past 10 to 12 years and have facilitated the ability of the grocery, retail and foodservice industries to successfully implement supply chain reform. Although the full gamut of supply chain savings available has not yet been realised billions have been saved. This has occurred mostly in European applications of the ECR model and North American experience of QR both primarily due to the holistic approach which has been demonstrated to be far more effective than the exercise of market power based approach used to less effect in other sectors. Companies, which are not well prepared internally to pursue ECR, are in danger of exposing this fundamental weakness when starting to work together with their trading partners. And companies that are unable to work effectively with their trading partners will fall increasingly behind in the competition and falter in their efforts to meet changing consumer demand. 18

19 ECR Strategy 4/15/2004 Ithaca 19 Commitment to the implementation of Demand Management - with strategic plans, people & organization, and, information systems fully aligned to this commitment. The concept covers progress on the key issues of developing a clear strategy putting in place all the key supporting processes developing the appropriate measurement tools into a full scorecard developing the supporting information technology clarifying how the organization will develop trading relationships ensuring the company's organization can cope with Demand Management The concept stresses the need to develop these issues in parallel. The concept can increase costs associated with 'Manage Product Categories' but these costs are often offset by reduced costs in other sales and marketing activities and the benefits from increased demand. While the optimal organization structure will vary depending on the company's strategic intent and the specific category's role, a number of principles hold generally true: internally, demand management requires true cross-functional working, be it within manufacturers or retailers; joint demand management requires a new type of interface structure between manufacturers and retailers; and personal and category performance measures need to be re-aligned from narrow functional criteria to measures which focus on the category's profitability from an endto-end supply chain perspective. The scorecard looks at the evolution of internal and joint strategy development. 19

20 ECR - Integration 4/15/2004 Ithaca 20 The new Integrators domain in the ECR Scorecard adds truly integrating concepts to the ECR platform. Two concepts have been defined, the first one being Collaborative Planning Forecasting and Replenishment that is the ultimate Responsive Replenishment facilitator starting with specific partners. The second concept is E-Business, Business to Business that explores new ways of doing business using public standard-based networks. Open up business processes to trading partners to improve performance by information sharing. Create a public electronic marketplace for buying and selling. Create a public electronic environment for: buying and selling forecasting planning & replenishment The integrator concepts will have a major impact on the business environment because of opportunities to: develop and deliver products and services faster extend geographical reach increase process efficiency and effectiveness redefine products and services leverage information by providing more flexible infrastructures and business models. Success is driven by the identification and implementation of business opportunities, not just by using latest technology. 20

21 Collaborative Planning, Forecasting & Replenishment Once 1. Front-End Agreement Quarterly 2. Joint Business Plan Collaborative Planning Weekly, Monthly 3. Create Sales Forecast 4. Identify Exceptions 5. Resolve Expectations Collaborative Forecasting Weekly, Monthly 7. Create Sales Forecast 8. Identify Expectations 9. Resolve Expectations Collaborative Replenishment 9. Generate Order 4/15/2004 Ithaca 21 CPFR stands for Collaborative Planning, forecasting and replenishment. It is a process enabled by technology and has primarily been applied in the packaged goods industry. The evolution of CPFR over the past 15 years features changes in two areas from earlier forms of collaboration: Information improved from retailer orders to inventory information to POS data Relationship improved from orders to sharing of key business information, to shared infrastructure and joint forecasting/planning responsibility 21

22 Suggested Reading / Research What to Expect: Inventory Management Principles and Technology by Neil Jaffe, Just in Time June 2003 ECR in the American Grocery Industry by Donald Lim, RMIT VMI and Supplier Scheduling in MHD Supply Chain Solutions November / December 2000 pp by James G. Hutzel, Donald P. Belmont & Mark A Nichols Managing Supply Chain Inventory: Pitfalls and Opportunities by Hau L. Lee and Corey Billington (Sloan Management Review/Spring 1992) 4/15/2004 Ithaca 22 22

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