Dependent demand inventory never needs to hold hedge inventory

image1

Paul A. Souders/Corbis

Chapter

eleven

Chapter Outline

Introduction

11.1 The Role of Inventory

11.2 Periodic Review Systems

11.3 Continuous Review Systems

11.4 Single-Period Inventory Systems

11.5 Inventory in the Supply Chain Chapter Summary

Managing Inventory throughout the Supply Chain

Chapter ObjeCtives

By the end of this chapter, you will be able to:

· Describe the various roles of inventory, including the different types of inventory and inventory drivers, and distinguish between independent demand and dependent demand inventory.

· Calculate the restocking level for a periodic review system.

· Calculate the economic order quantity (EOQ) and reorder point (ROP) for a continuous review system, and determine the best order quantity when volume discounts are available.

· Calculate the target service level and target stocking point for a single-period inventory system.

· Describe how inventory decisions affect other areas of the supply chain. In particular, describe the bullwhip effect, inventory positioning issues, and the impacts of transportation, packaging, and material handling considerations.

326

image5.jpg CHAPTER 11 • Managing Inventory throughout the Supply Chain  327

Inventory Management at Amazon.com

Baumgarten/VARIO IMAGES/SIPA/Newscom

Employees pick items off the shelves at an Amazon.com warehouse in Leipzig, Germany.

WHEN they first started appearing in the late 1990s, Web- based “e-tailers” such as Amazon.com hoped to replace the “bricks” of traditional retailing with the

“clicks” of online ordering. Rather than opening dozens or even hundreds of stores filled with expensive inventory, an e-tailer could run a single virtual store that served cus-tomers around the globe. Their business model suggested that inventory could be kept at a few key sites, chosen to ­minimize costs and facilitate quick delivery to custom-ers. In theory, e-tailers were highly “scalable” businesses that could add new customers with little or no additional ­investment in inventory or facilities. (Traditional retailers usually need to add stores to gain significant increases in their customer base.)

But how has this actually played out for Amazon over the years? Table 11.1 contains sales and inventory figures, pulled from the company’s annual reports, for Amazon for the years 1997 through 2012. The first column reports net sales for each calendar year, and the second column contains the amount of inventory on hand at the end of the year. The third column shows inventory turns, which is calculated as (net sales/ending inventory). Retailers generally want higher inventory turns, which indicate that they can support the same level of sales with less inventory. Inventory turns is of-ten thought of as a key measure of asset productivity.

Looking at Amazon’s performance over the years ­provides some interesting insights. Consider Figure 11.1. In late 1999, Amazon learned that managing inventory can be challenging even for e-tailers. That was the year the com-pany expanded into new product lines, such as electron-ics and housewares, with which it had little experience.

Table 11.1  Amazon.com Financial Results, 1997–2012

Inventory

Net Sales

($Millions)

Inventory

Year

($Millions)

(Dec. 31)

Turns

1997

$148

$9

16.4

1998

$610

$30

20.3

1999

$1,640

$221

7.4

2000

$2,762

$175

15.8

2001

$3,122

$143

21.8

2002

$3,933

$202

19.5

2003

$5,264

$294

17.9

2004

$6,921

$480

14.4

2005

$8,490

$566

15.0

2006

$10,711

$877

12.2

2007

$14,835

$1,200

12.4

2008

$19,166

$1,399

13.7

2009

$24,509

$2,171

11.3

2010

$34,204

$3,202

10.7

2011

$48,077

$4,992

9.6

2012

$61,093

$6,031

10.1

Amazon’s purchasing managers were faced with the ques-tion of how many of these items to hold in inventory. Too little, and they risked losing orders and alienating custom-ers; too much, and they could lock up the company’s re-sources in unsold products. Only later, when sales for the 1999 holiday season fell flat and Amazon’s inventory levels skyrocketed did the purchasing managers realize they had overstocked. In fact, as the figures show, by the end of 1999,

image6.jpg image7.jpg 328  PART IV • Planning and Controlling Operations and Supply Chains

image8.jpg

Inventory Turns at Amazon.com, 1997–2009

25.0

20.0

15.0

10.0

5.0

0.0

1999

2001

2003

2005

2007

2009

2011

2013

1997

Figure 11.1  Inventory Turns at Amazon.com, 1997–2009

Amazon’s inventory­ turnover ratio was 7.4—worse than that of the typical brick-and-mortar retailer at the time.

After 1999, Amazon seemed to learn its lesson. Inven-tory turns rose to nearly 22 in 2001, but have fallen steadily ever since, to 10.1 turns for 2012, even as Amazon’s sales have risen sharply. But why? The decline in inventory turns over the past decade is due in large part to a shift in Amazon’s­ business strategy. Instead of trying to build com-petitive advantage based on low-cost books (Amazon’s original business model), the company now seeks to provide

customers with convenient shopping and fast delivery for a wide range of products. Such a strategy requires more in-ventory to support the same level of sales.

So today, how does Amazon compare to its brick-and-mortar competitors? Amazon handily beats traditional book retailer Barnes & Noble, whose inventory turns for 2013 were just 4.6. Yet Best Buy, which sells computers, phones, video games, and appliances, generated 6.9 inventory turns in 2013—not bad, especially considering all the retail stores Best Buy must support.

image9.jpg

Introduction

Inventory

According to APICS, “those stocks or items used to sup-port production (raw materials and work-in-process items), supporting activities (mainte-nance, repair, and operating supplies) and customer service (finished goods and spare parts).”

APICS defines inventory as “those stocks or items used to support production (raw materials and work-in-process items), supporting activities (maintenance, repair, and operating supplies) and customer service (finished goods and spare parts) .”1 In this chapter, we discuss the critical role of inventory—why it is necessary, what purposes it serves, and how it is controlled.

As Amazon’s experience suggests, inventory management is still an important function, even in the Internet age. In fact, many managers seem to have a love–hate relationship with inventory. Michael Dell talks about inventory velocity—the speed at which components move through Dell Computer’s operations—as a key measure of his company’s performance.2 In his mind, the less inventory the company has sitting in the warehouse, the better. Victor Fung of the Hong Kong-based trading firm Li & Fung, goes so far as to say, “Inventory is the root of all evil.”3

Yet look what happened to the price of gasoline in the United States during the spring of 2007. It skyrocketed, primarily because refineries were shut down for maintenance and suppliers were caught with inadequate reserves. And if you have ever visited a store only to find that your favorite product is sold out, you might think the lack of inventory is the root of all evil. The fact is, inventory is both a valuable resource and a potential source of waste.

image10.jpg

1Definition of Inventory in J. H. Blackstone, ed., APICS Dictionary, 14th ed. (Chicago, IL: APICS, 2013). Reprinted by

permission.

2J. Magretta, “The Power of Virtual Integration: An Interview with Dell Computer’s Michael Dell,” Harvard Business

Review 76, no. 2 (March–April 1998): 72–84.

3J. Magretta, “Fast, Global, and Entrepreneurial: Supply Chain Management, Hong Kong Style,” Harvard Business Review

76, no. 5 (September–October 1998): 102–109.

image11.jpg image12.jpg CHAPTER 11 • Managing Inventory throughout the Supply Chain  329

11.1 The Role of Inventory

image13.jpg

Consider WolfByte Computers, a fictional manufacturer of laptops, tablets and e-readers. Fig- HYPERLINK \l "page346" ure 11.2 shows the supply chain for WolfByte’s laptop computers. WolfByte assembles the laptops from components purchased from companies throughout the world, three of which are shown in the figure. Supplier 1 provides the displays, Supplier 2 manufactures the hard drives, and Sup-plier 3 produces the keyboards.

Looking downstream, WolfByte sells its products through independent retail stores and through its own Web site. At retail stores, customers can buy a laptop off the shelf, or they can order one to be customized and shipped directly to them. On average, WolfByte takes about two days to ship a computer from its assembly plant to a retail store or a customer. Both WolfByte and the retail stores keep spare parts on hand to handle customers’ warranty claims and other service requirements.

With this background, let’s discuss the basic types of inventory and see how they fit into WolfByte’s supply chain.

Cycle stock

Components or products that are received in bulk by a downstream partner, gradually used up, and then replenished again in bulk by the upstream partner.

Safety stock

Extra inventory that a company holds to protect itself against uncertainties in either demand or replenishment time.

Inventory Types

Two of the most common types of inventory are cycle stock and safety stock. Cycle stock refers to components or products that are received in bulk by a downstream partner, gradually used up, and then replenished again in bulk by the upstream partner. For example, suppose Supplier 3 ships 20,000 keyboards at a time to WolfByte. Of course, WolfByte can’t use all those devices at once. More likely, workers pull them out of inventory as needed. Eventually, the inventory runs down, and WolfByte places another order for keyboards. When the new order arrives, the inven-tory level rises and the cycle is repeated. Figure 11.3 shows the classic sawtooth pattern associ-ated with cycle stock inventories.

Cycle stock exists at other points in WolfByte’s supply chain. Almost certainly, Suppliers 1 through 3 have cycle stocks of raw materials that they use to make components. And retailers need to keep cycle stocks of both completed computers and spare parts in order to serve their customers.

Cycle stock is often thought of as active inventory because companies are constantly using it up, and their suppliers constantly replenishing it. Safety stock, on the other hand, is extra in-ventory that companies hold to protect themselves against uncertainties in either demand levels or replenishment time. Companies do not plan on using their safety stock any more than you plan on using the spare tire in the trunk of your car; it is there just in case.

Let’s return to the keyboard example in Figure 11.3. WolfByte has timed its orders so that a new batch of keyboards comes in just as the old batch is used up. But what if Supplier 3 is late in delivering the devices? What if demand is higher than expected? If either or both these condi-tions occur, WolfByte could run out of keyboards before the next order arrives.

Imagine the resulting chaos: Assembly lines would have to shut down, customers’ orders couldn’t be filled, and WolfByte would have to notify customers, retailers, and shippers about the delays.

Figure 11.2

WolfByte Computers

Supply Chain

Supplier 1

image14.jpg

WolfByte

Computers

Supplier 2

Supplier 3

image307.jpg image2Customer Retail store

image15.jpg image16.jpg

Customer

image17.jpg image18.jpg 330  PART IV • Planning and Controlling Operations and Supply Chains

Figure 11.3

Cycle Stock at WolfByte

Computers

Anticipation inventory

Inventory that is held in antici-pation of customer demand.

Hedge inventory

According to APICS, a “form of inventory buildup to buffer against some event that may not happen. Hedge inventory planning involves specula-tion related to potential labor strikes, price increases, unset-tled governments, and events that could severely impair the company’s strategic initiatives.”

Transportation inventory

Inventory that is moving from one link in the supply chain to another.

Smoothing inventory

Inventory that is used to smooth out differences between upstream produc-tion levels and downstream demand.

Figure 11.4

Safety Stock at WolfByte

Computers

Keyboard order

Another order

20,000

received ...

received ...

level

Inventory

10,000

Inventory

And the

drawn down

process

gradually ...

repeats itself

0

Time

image19.jpg

One solution is to hold some extra inventory, or safety stock, of keyboards to protect against fluctuations in demand or replenishment time. Figure 11.4 shows what WolfByte’s inventory­ levels would look like if the company decided to hold safety stock of 1,000 keyboards. As you can see, safety stock provides valuable protection, but at the cost of higher inventory lev-els. Later in the chapter, we discuss ways of calculating appropriate safety stock levels.

There are four other common types of inventory: anticipation, hedge, transportation, and smoothing. Anticipation inventory, as the name implies, is inventory that is held in anticipation of customer demand. Anticipation inventory allows instant availability of items when custom-ers want them. Hedge inventory, according to APICS, is “a form of inventory buildup to buffer against some event that may not happen. Hedge inventory planning involves speculation related to potential labor strikes, price increases, unsettled governments, and events that could severely impair the company’s strategic initiatives.”4 In this sense, hedge inventories can be thought of as a special form of safety stock. WolfByte has stockpiled a hedge inventory of two months’ worth of hard drives because managers have heard that Supplier 2 may experience a temporary shut-down over the next two months.

Transportation inventory represents inventory that is “in the pipeline,” moving from one link in the supply chain to another. When the physical distance between supply chain partners is long, transportation inventory can represent a considerable investment. Suppose, for example, that Supplier 2 is located in South Korea, and WolfByte is located in Texas. Hard drives may take several weeks to travel the entire distance between the two companies. As a result, multiple orders could be in the pipeline on any particular day. One shipment of hard drives might be sitting on the docks in Kimhae, South Korea; two others might be halfway across the Pacific; a fourth might be found on Route I-10, just outside Phoenix, Arizona. In fact, the transportation inventory of hard drives alone might dwarf the total cycle and safety stock inventories in the rest of the supply chain.

Finally, smoothing inventory is used to smooth out differences between upstream pro-duction levels and downstream demand. Suppose management has determined that WolfByte’s assembly plant is most productive when it produces 3,000 laptops a day. Unfortunately, demand from retailers and customers will almost certainly vary from day to day. As a result, WolfByte’s

Keyboard order

Another

21,000

received ...

order received ...

level

11,000

Inventory

Inventory

And the

drawn down

process

gradually...

repeats itself

1000

Safety stock of 1,000 keyboards

image20.jpg

Time

image21.jpg

4Definition of Hedge Inventory in J. H. Blackstone, ed., APICS Dictionary, 14th ed. (Chicago, IL: APICS, 2013). Reprinted­ by permission.

image22.jpg

Figure 11.5

Smoothing Inventories at

WolfByte Computers

CHAPTER 11 • Managing Inventory throughout the Supply Chain  331

image23.jpg

4,000

systems

3,000

Demand

Computer

2,000

Production

Inventory

1,000

0

1

2

3

4

5

6

7

8

9

Day

image24.jpg

managers may decide to produce a constant 3,000 laptops per day, building up finished goods inventory during periods of slow demand and drawing it down during periods of high demand. (Figure 11.5 illustrates this approach.) Smoothing inventories allow individual links in the sup-ply chain to stabilize their production at the most efficient level and to avoid the costs and head-aches associated with constantly changing workforce levels and/or production rates. If you think you may have heard of this idea before, you have: It’s part of the rationale for following a level production strategy in developing a sales and operations plan (see Chapter 10).

Inventory drivers

Business conditions that force companies to hold inventory.

Supply uncertainty

The risk of interruptions in the flow of components from upstream suppliers.

Inventory Drivers

From this discussion, we can see that inventory is a useful resource. However, companies don’t 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. Likewise, the space used to store inventory can often be put to more productive use. Inventory also poses a significant risk of obsolescence, particularly in supply chains with short product life cycles. Consider what happens when Intel announces the next generation of processor chips. Would you want to be stuck hold-ing the old-generation chips when the new ones hit the market?

Finally, inventory is too often used to hide problems that management really should resolve. In this sense, inventory can serve as a kind of painkiller, treating the symptom without solving the underlying problem. Consider our discussion of safety stock. Suppose WolfByte’s managers decide to hold additional safety stock of hard drives because of quality problems they have been experi-encing with units received from Supplier 2. While the safety stock may buffer WolfByte from these quality problems, it does so at a cost. A better solution might be to improve the quality of incoming units, thereby reducing both quality-related costs and the need for additional safety stock.

With these concerns in mind, let’s turn our attention to inventory drivers—business condi-tions that force companies to hold inventory. Table 11.2 summarizes the ways in which various inventory drivers affect different types of inventory. To the extent that organizations can manage and control the drivers of inventories, they can reduce the supply chain’s need for inventory.

In managing inventory, organizations face uncertainty throughout the supply chain. On the upstream (supplier) end, they face supply uncertainty, or the risk of interruptions in the

Table 11.2 

Inventory Drivers and

Their Impact

Inventory Driver

Impact

Uncertainty in supply or demand

Safety stock, hedge inventory

Mismatch between a downstream partner’s demand and the most

efficient production or shipment volumes for an upstream partner

Cycle stock

Mismatch between downstream demand levels and upstream

production capacity

Smoothing inventory

Mismatch between timing of customer demand and supply

Anticipation inventory

chain lead times

Transportation inventory

image25.jpg

image26.jpg image27.jpg 332  PART IV • Planning and Controlling Operations and Supply Chains

Demand uncertainty

The risk of significant and unpredictable fluctuations in downstream demand.

flow of components they need for their internal operations. In assessing supply uncertainty, managers need to answer questions such as these:

· How consistent is the quality of the goods being purchased?

· How reliable are the supplier’s delivery estimates?

· Are the goods subject to unexpected price increases or shortages?

Problems in any of these areas can drive up supply uncertainty, forcing an organization to hold safety stock or hedging inventories.

On the downstream (customer) side, organizations face demand uncertainty, or the risk of significant and unpredictable fluctuations in the demand for their products. For example, many suppliers of automobile components complain that the big automobile manufacturers’ forecasts are unreliable and that order sizes are always changing, often at the last minute. Under such conditions, suppliers are forced to hold extra safety stock to meet unexpected jumps in de-mand or changes in order size.

In dealing with uncertainty in supply and demand, the trick is to determine what types of uncertainty can be reduced and then to focus on reducing them. For example, poor quality is a source of supply uncertainty that can be substantially reduced or even eliminated through business process or quality improvement programs, such as those we discussed in Chapters 4 and 5. On the other hand, forecasting may help to reduce demand uncertainty, but it can never completely eliminate it.

Another common inventory driver is the mismatch between demand and the most efficient production or shipment volumes. Let’s start with a simple example—facial tissue. When you blow your nose, how many tissues do you use? Most people would say 1, yet tissues typically come in boxes of 200 or more. Clearly, a mismatch exists between the number of tissues you need at any one time and the number you need to purchase. The reason, of course, is that packaging, shipping, and selling facial tissues one at a time would be highly inefficient, especially because the cost of holding a cycle stock of facial tissues is trivial. On an organizational scale, mismatches between demand and efficient production or shipment volumes are the main drivers of cycle stocks. As we will see later in this chapter, managers can often alter their business processes to reduce produc-tion or shipment volumes, thereby reducing the mismatch with demand and the resulting need for cycle stocks.

Likewise, mismatches between overall demand levels and production capacity can force companies to hold smoothing inventories (Figure 11.5). Of course, managers can reduce smooth-ing inventories by varying their capacity to better match demand or by smoothing demand to better match capacity. As we saw in Chapter 10, both strategies have pros and cons.

The last inventory driver we will discuss is a mismatch between the timing of the cus-tomer’s demand and the supply chain’s lead time. When you go to the grocery store, you expect to find fresh produce ready to buy; your expected waiting time is zero. But produce can come from almost anywhere in the world, depending on the season. To make sure that bananas and lettuce will be ready and waiting for you at your local store, someone has to initiate their move-ment through the supply chain days or even weeks ahead of time and determine how much anticipation inventory to hold. Whenever the customer’s maximum waiting time is shorter than the supply chain’s lead time, companies must have transportation and anticipation inventories to ensure that the product will be available when the customer wants it.