Chapter 6

Report
Chapter 6:
Managing Inventory Flows in the
Supply Chain
Logistics Profile:
Micros and More


“Inventory, inventory, inventory….I am sick and
tired of hearing complaints about our inventory
levels and the costs associated with carrying
inventory,” muttered the COO.
What so important is this statement?
Chapter 6
Management of Business Logistics, 7th Ed.
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Micros and More


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Inventory has a direct impact to company’s
performance.
Management seeks Inventory management
and control as a key business logistics activity
Thus, it is useful to understand the
importance of inventory from a broad,
macroeconomic prospective
We need to gain understanding of:
Chapter 6
Management of Business Logistics, 7th Ed.
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Micros and More
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What is the role of inventory?
What are the important trade-offs in the
management of inventory?
What are the relevant inventory costs?
Can the supply chain help control inventory?
Solutions to these questions is important,
because:
Chapter 6
Management of Business Logistics, 7th Ed.
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Management of Inventory Flows
in the Supply Chain: Introduction



Inventory as an asset has taken on increased
significance as companies struggle to reduce
investment in fixed assets that accommodate
inventory (plants, warehouses, etc.).
Changes in inventory affect return on assets
(ROA), an important internal and external
metric.
Ultimate challenge is to balance supply and
demand for inventory.
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Management of Business Logistics, 7th Ed.
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Example: Inventory in the
Economy

Inventory in the Economy has decreased.
 As a percentage of the GDP, from 1985 to
2000, inventory levels have decreased from
5.4% to about 3.8%
 Examine Table 6-1.
Chapter 6
Management of Business Logistics, 7th Ed.
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Table 6-1: Macro Inventory Cost in
Relation to U.S. Gross Domestic Product
Chapter 6
Management of Business Logistics, 7th Ed.
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On the Line:
Inventory Turns
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Think of inventory turns as a measure of how well a
company’s products are doing in the market and how
well its inventory is managed.
There is a continuing move away from traditional
build-to-forecast manufacturing models to more
flexible build-to-demand systems.
Increasing emphasis on fully integrated supply chain
means inventories barely spend any time sitting idle.
“Ideally, zero inventory will maximize cash flow.”
Inventory turnover potential is 30 to 40 times/year.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Rationale for Inventory

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Product Line Proliferation
 Depth & breath of product lines trending up.
 Results in larger inventories.
Examine Table 6-2 Total Logistics Costs-1999.
Inventory carrying costs of $332 billion
approach 35 percent of total logistics costs
for companies.
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Management of Business Logistics, 7th Ed.
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Table 6-2
Total Logistics Costs --- 1999
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:

Three types of inventory:
1. Physical supply inventories
2. Physical distribution inventories
3. Functional inventory
We will discuss each of them next!
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1. Physical supply inventories


Use to support a firm’s processing,
manufacturing, or assembly functions
Reasons for accumulating materials:
a. Purchase economics
b. Transportation savings
c. Safety stock
d. Speculative purchase
e. Seasonal supply, and
f. Source maintenances
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Management of Business Logistics, 7th Ed.
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a. Purchase economics


Purchase inventory in large quantities and
receiving a price discount
The saving from the discount may exceed the
storage cost
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Management of Business Logistics, 7th Ed.
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b. Transportation savings

Can be realized when shipping in large
quantities and receiving carload/truckload
discounts
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Management of Business Logistics, 7th Ed.
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c. Safety stock


Is kept to prevent an emergency production
shut down
The amount held depends upon the
probability of delayed delivery and upon the
volume of raw materials the firm utilizes
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d. Speculative purchase

It uses to purchase or hedge against future
price increases, changing political policies,
delayed deliveries, rising or falling interest
rates, or currency fluctuations.

Examples: fuels for airlines, commodity for
estate developers
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Management of Business Logistics, 7th Ed.
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e. Seasonal supply,

May be accumulated to meet demand
throughout the year, because the items may
be only available at certain times of the
years, or preferred transportation means may
be unavailable
 Examples: goods for x’mas, air tickets for
high traveling seasons
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Management of Business Logistics, 7th Ed.
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f. Supply source maintenances

Certain supply sources may not be able to
furnish the quantities demanded at one time,
so to maintain the supply source, business is
given the supplier to keep it operating
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2. Physical distribution inventories
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
Consist of finished goods awaiting shipping to
customers
Reasons include:
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Transportation saving – low cost if shipment in carload/truckload
Production saving – high prod gives lower per unit cost
Seasonal demand – high capacity to meet peak seasonal demand
Customer service – improve customer service or reduce lost sales costs
Stable employment – attend not to lose skilled labor
Goods for resale – to meet timely customer needs and satisfaction
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Management of Business Logistics, 7th Ed.
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3. Functional inventory

Seven principal functions:
a.
Cycle stock – firm regularly consumes during normal business activity
b.
Goods in process – necessary to manufacturing goods, or in transit
c.
Safety stock – uncertainties in demand, lead time length/out of stock
d.
Seasonal stock – advance of the season when needed
e.
Promotional stock – response to market promotion
f.
Speculative stock – protect stocks needed for
g.
“dead” stock – no value or waist to be disposed of
production/manufacturing
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Inventory in the Firm:
Batching Economies/Cycle Stocks

A. Price discounts
 Result in trade-offs between large
purchases qualifying for quantity discounts
and costs of storing inventory.
 Because physical supply inventory is often
raw materials, storage costs are often less
than savings from buying in bulk, so
supplies are stockpiled.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Batching Economies/Cycle Stocks

B. Transportation rate discounts
 Large quantities often result in carload
freight rates.
 Largest shipments may qualify for even
lower multiple truckload, carload or
trainload rates.
 Lower freight rates are often reflected in
lower consumer prices.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Batching Economies/Cycle Stocks

Production economics favor long production
runs.
 Results in cycle stock that must be stored.
 Cycle stocks can be beneficial as long as
the appropriate analysis is done to cost
justify the inventory.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Uncertainty/Safety Stocks

Reasons for uncertainty are commonplace.
 Net results are the same: companies
accumulate safety stock to buffer
themselves against uncertainty.
 Safety stock more challenging and complex
to manage for many firms.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Uncertainty/Safety Stocks

Impact of information on uncertainty
 Trade-off analysis appropriate to assess
risk and measure inventory cost.
 Information technology can be used in the
supply chain to reduce inventory.
 Collaborative planning and forecasting
requirements (CPFR) is an example.
 Bar coding, EDI, the Internet have enabled
companies to reduce uncertainty.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm: Time/In-
Transit and Work-In-Process Stocks


Time-related trade-offs from using slower to
faster transport modes
 Faster modes cost more but may save a
larger amount in inventory carrying costs.
Work-In-Process inventory should be
examined for possible trade-offs especially in
the production of high value goods.
 Scheduling and actual production times can
be closely examined to reduce inventory.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Seasonal Stocks
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Seasonality can occur on the inbound and/or
outbound side of the firm’s logistics systems.
Perishable supply in agricultural products or
seasonal-related transportation problems.
Seasonal demand compressing selling
seasons in some industries results in smaller
plants producing for stock.
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Management of Business Logistics, 7th Ed.
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Inventory in the Firm:
Anticipatory Stocks
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In some cases, companies anticipate that
some forecasted event will negatively impact
the production cycle.
For example, labor strikes, shortage of
supplies due to weather or political event, or
significant price increases may prompt the
firm to build inventory levels higher than
normal.
Risk assessment is important in these cases.
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Management of Business Logistics, 7th Ed.
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
How each functional unit views their
prospective of inventory?
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Management of Business Logistics, 7th Ed.
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The Importance of Inventory in
Other Functional Areas
1.
2.
3.
Marketing uses inventory to provide strong
customer service.
Manufacturing uses inventory to schedule
longer production runs.
Finance wants inventory turnover ratios to
be kept high so that risk of inventory loss is
reduced and rate of return on assets kept
competitively high.
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Management of Business Logistics, 7th Ed.
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

How to balance all their views?
We thus need to examine what constitute
inventory cost in the firm!
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Management of Business Logistics, 7th Ed.
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Three reasons why for the
importance of inventory cost.
1.
2.
3.
inventory costs are a significant portion of
total logistics costs for many firms.
inventory levels affect customer service
levels.
inventory cost trade-off decisions affect
inventory carrying costs.
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Management of Business Logistics, 7th Ed.
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Four main Inventory or carrying
Costs:
1.
2.
3.
4.
Capital cost
Storage space cost
Inventory Service Cost
Inventory Risk Cost
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Management of Business Logistics, 7th Ed.
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1. Capital cost
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Opportunity cost associated with investing
in inventory, or any asset.
What is the implicit value of having capital
tied up in inventory, instead of some other
worthwhile project?
Minimum ROR expected from any asset.
Debate on inventory valuation at fully
allocated or variable costs only.
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Management of Business Logistics, 7th Ed.
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2. Storage space cost
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
Handling costs, rents, utilities.
Logistics develops a cost formula for
storage space costs based on cost
behaviors.
 Public space mostly variable.
 Private space a mix of fixed and
variable.
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Management of Business Logistics, 7th Ed.
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3. Inventory service cost

Inventory Service Cost
 Insurance and taxes on stored goods.
 Varies according to the value of the goods.
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4. Inventory Risk Cost

Inventory Risk Cost
 Largely beyond the control of the firm.
 Due to obsolescence, damage, theft,
employee pilferage.
Their ratio roles on a product value – see next
slide
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Management of Business Logistics, 7th Ed.
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Table 6-3 Example of Carrying Cost
Components for Computer Hard Disks
Cost
Percentage of Product Value
Capital
12 %
Storage space
2
Inventory service
3
Inventory
8
Total
Chapter 6
25 %
Management of Business Logistics, 7th Ed.
38
Inventory Costs: Calculating the
Cost of Carrying Inventory
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Step 1 - Identify the value of the item stored
in inventory, based on policy such as FIFO,
LIFO or average cost (e.g. $100).
Step 2 - Measure each individual carrying cost
component as a percentage of product value
(e.g. 25%).
Step 3 - Multiply overall carrying cost (as a
percentage) times the dollar value of the
product (e.g. $100 times 25% = $25
inventory carrying cost per year.
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Management of Business Logistics, 7th Ed.
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Inventory Costs:
Nature of Carrying Cost
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
Items with basically similar carrying costs
should use the same estimate of carrying cost
per dollar.
There are exceptions for items that are
subject to special consideration for purposes
of quick obsolescence or high degree of theft,
etc.
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Management of Business Logistics, 7th Ed.
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Table 6-4
Inventory and Carrying Cost Information
for Computer Hard Disks
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Management of Business Logistics, 7th Ed.
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What other costs involved?
Two other costs affecting inventory are
Order cost –
1.
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4.
MIS costs for inventory stock level tracking.
Preparing and processing purchase orders and receiving reports.
Inspecting and preparing inventory for sale.
Set up cost
2.
3.
a preparation cost ordering inventory
Incurred when production changes over from one product to another.
Stockout cost
In-transit carrying cost
Example of ordering cost – see next slide
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Management of Business Logistics, 7th Ed.
42
Table 6-5 Order Frequency and
Order Cost for Computer Hard Disks
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Management of Business Logistics, 7th Ed.
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Inventory Costs:
Carrying Cost versus Order Cost
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Examine Table 6-6.
Order costs and carrying costs respond in
opposite ways to increases in volume.
This reinforces the logisticians need to be
able to separate costs by how they behave in
relation to changes in volume.
Assistance from managerial accountants is
available for cost-volume-profit analysis.
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Management of Business Logistics, 7th Ed.
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Summary of Inventory
and Cost Information
Table 6-6
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Management of Business Logistics, 7th Ed.
45
Figure 6-1
Inventory Costs
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Management of Business Logistics, 7th Ed.
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3. Stockout Cost
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
Cost of not having product available when a
customer wants it.
Consequences:
1.
Includes backorder costs (special order).
2.
Losing one item profit by substituting a
competing firm’s product.
3.
Losing a customer permanently if customer
finds they prefer the substituted product
and/or company.
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How to handle it?
Expected Stockout Cost


Possible to handle this by adding safety stock.
In a manufacturing firm, a stockout may result
in lost hours of production until the item is
restocked.
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Management of Business Logistics, 7th Ed.
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4. Inventory in Transit Carrying
Cost
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Any product inbound to the firm using F.O.B.
(free on Board) origin should be counted.
Any product outbound from the firm using
F.O.B. destination should be counted.
In transit carrying cost is generally less than
for regular inventory because some cost
components are not present.
 No storage costs, no taxes, and reduced
risk of obsolescence.
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Management of Business Logistics, 7th Ed.
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Classifying Inventory
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
The first step of inventory management is to
adopting Inventory classification
Two approaches:
1.
ABC analysis – only discuss this here
2.
Critical Value Analysis
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Management of Business Logistics, 7th Ed.
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1. ABC Analysis

Ranking system
 Developed in 1951 by H. Ford Dicky of
General Electric3.
 Suggested that GE classify items according
to relative sales volume, cash flows, lead
time, or stockout cost.
 Most important inventory put in Group A.
 Lesser impact goods put in Groups B and C
respectively.
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Management of Business Logistics, 7th Ed.
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1. ABC Analysis

Pareto’s Rule (80-20 Rule)
 Based on a nineteenth century
mathematician’s observation that many
situations were dominated by a very few
elements.
 Conversely, most elements had very little
influence in most situations.
 Separates the “trivial many” from the
“vital few”.
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Management of Business Logistics, 7th Ed.
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1. ABC Analysis


80-20 Rule
 80% of sales will come from 20% of the
inventory SKUs (stock keep units)
 20% of sales will come from 80% of the
inventory SKUs.
The 80-20 Rule has been found to explain
many phenomena that interest managers.
 For example, 80% of sales come from 20%
of customers; and vice versa.
Chapter 6
Management of Business Logistics, 7th Ed.
53
Figure 6-2
ABC Inventory Analysis
Chapter 6
Management of Business Logistics, 7th Ed.
54
ABC Analysis for Big
Orange Products, Inc.
Table 6-7
Chapter 6
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Evaluating the Effectiveness of a Company’s
Approach to Inventory Management

Four main questions address to this querry:
1. Are customers satisfied with the current
level of customer service?
 If standards have been set in consultation
with the customer, this question can be
answered objectively.
 Customer loyalty, order cancellation are
some questions to ask
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Evaluating the Effectiveness of a Company’s
Approach to Inventory Management
2. How frequently does backordering and/or
expediting occur?
 If records of these events are kept, the
answer to this question can point out the
need for a modification or adoption of
new inventory strategies.
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57
Evaluating the Effectiveness of a Company’s
Approach to Inventory Management
3. Is the company calculating an Inventory
Turnover ratio for each product SKU?
 This ratio can provide good information on
whether the inventory is being effectively
and efficiently managed.
 Examine Table 6-8, Figure 6-3 and
Figure 6-4.
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Management of Business Logistics, 7th Ed.
58
Evaluating the Effectiveness of a Company’s
Approach to Inventory Management
4. How does inventory level behave as sales rise
or fall?
 From sales records, the firm can determine
if inventory levels rise as much as sales, less
than sales, or stay about the same
regardless of sales levels.
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Management of Business Logistics, 7th Ed.
59

What is the most important element to render
inventory management to be efficient and
effective?
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Management of Business Logistics, 7th Ed.
60
Inventory Visibility

The ability of the firm to “see” inventory on a
real-time basis throughout the supply chain
system requires:
1.
Tracking and tracing inventory SKUs for all
inbound and outbound orders.
2.
Providing summary and detailed reports of
shipments, orders, products,
transportation equipment, location, and
trade lane activity.
3.
Notification of failures in inventory flow.
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Management of Business Logistics, 7th Ed.
61
Inventory Visibility:
General Benefits
1.
2.
3.
4.
5.
6.
7.
Improved customer service
Decreased cost-of-sales
Improved vendor relations and cost
Increased Return on Assets
Improved cash flow
Improved response time and service
recovery
Improved performance metrics
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Management of Business Logistics, 7th Ed.
62
The Relationship among
Inventory Turnover, Average Inventory,
and Inventory Carrying Costs
Table 6-8
Chapter 6
Management of Business Logistics, 7th Ed.
63
Saving Inventory
Dollars by Inventory Turns
Figure 6-3
Chapter 6
Management of Business Logistics, 7th Ed.
64
Past and Projected
Inventory Turnover of Finished Goods
Figure 6-4
Chapter 6
Management of Business Logistics, 7th Ed.
65
Chapter 6:
Summary and Review Questions
Students should review their knowledge of the
chapter by checking out the Summary and Study
Questions for Chapter 6.
This is the last slide for Chapter 6
End of Chapter 6 Slides
Managing Inventory Flows in
the Supply Chain

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