Few Notes on Inventory Management

INVENTORY HIGHLIGHTS:
Inventory decisions are high-risk & high-impact from Logistics point of view. Commitment to a particular
inventory assortment and subsequent shipment to a market or region in anticipation of future sales
determine a number of logistics activities. Without proper inventory assortment, marketing may find that
sales are lost and customer satisfaction will decline. Likewise, inventory planning is critical to
manufacturing. Raw material shortages can shut down a manufacturing line or modify a production
schedule, which, in turn, introduces added expenses and potential for finished goods shortages. Just as
shortages can disrupt planned marketing and manufacturing operations, overstocked inventories also
create problems. Overstocks increase cost and reduce profitability through added warehousing, working
capital requirements, deterioration, insurance, taxes and obsolescence. On the other hand, zero inventory
is also not possible.

Under following table you will financial highlights as well as inventory data for some consumer &
industrial goods manufacturing companies at USA (all figures are in million US$) :

Company Sales Net Total Inventory Inventory

Income Assets Investment as % of
Assets
Johnson & Johnson 13,753 1,030 11,884 1,742 14.70

RJR-Nabiso 15,734 319 32,041 2,776 8.70

Dow Chemical 18,971 276 25,360 2,692 10.60

Fleming Companies 12,938 113 3,118 959 30.80

Ace Hardware 1,871 61 595 213 35.20

JC Penney 18,009 777 13,563 3,258 24.00

Dillards 4,714 236 4,107 1,106 26.90

It is quite understood from above table that if Inventory commitment can be reduced by few percentage,
a dramatic profit can be improved.

RISK OF INVENTORY:
 Holding inventory is Risky because of capital investment and potential for obsolescence. It varies
with Manufacturers, Wholesalers & Retailers
 Risk of Inventory for Manufacturer:
 Inventory risk has a long term dimension.
 Inventory commitment are in raw material, component parts, work in progress and
finished goods.
 Though manufacturer have narrow product lines than wholesaler or retailer, their
inventory commitment is relatively deep & of long duration.
 Risk of Inventory for Wholesaler:
 Risk exposure is narrower but deeper and of long duration than retailer
 Risk of Inventory for Retailer:
  Although retailers assume a position of risk on a variety of products, their position on any
one product is not deep. Rather it is spread among different items / categories.

FUNCTIONS UNDERLYING INVENTORY COMMITMENTS:

These are functions that define wither inventory investment is necessary for a specific system to execute
management’s objectives. These Four functions are:

1. Geographic Specialization:
 Sometimes requirements for factors of production like power, material, water & labor is
at considerable distance from major market.
 Eg: tire, battery, transmission & springs are significant components in automobile
assembly. Technology and expertise to produce each of these components are
traditionally located in proximity to material sources in order to minimize transportation.
This strategy leads to geographical separation of production so that each automobile
component can be produced economically. However, geographical separation requires
internal inventory requirements.
 Geographic separation also requires inventories to create market assortments. So,
different products can be stored in one common warehouse and dispatched from there.

2. Decoupling:
 This process permits each product to be manufactured and distributed in economical lot
sizes that are greater than market demands.

3. Balancing Supply and Demand:

 This reconciles supply availability with demand.
 Eg: seasonal production and year-round consumption. Like Orange juice.
 Eg: round the year production with seasonal consumption: Cold Garments

4. Buffer Uncertainties :
 Safety stock / Buffer stock concerns short range variation either demand or
replenishment.
 Considerable inventory planning is required to determine safety stock.
 Most overstocks are the result of improper planning.

CLASSIFICATION OF INVENTORY:
There are different types of classification of inventory available for considerations. These are mainly:

ABC Analysis:
 The materials are divided into a number of categories for adopting a selective approach for
materials control. It is generally seen that in manufacturing concerns, a small percentage of
items contribute large percentage of value of consumption and large percentage of items of
material contribute a small percentage of value.
 In between these two limits there are some items which have almost equal percentage of value
of materials. Under A-B-C analysis, the materials are divided into three categories viz. A’, ‘B’ and
‘C’. Past experience has shown that almost 10% of the items contribute to 70% of value of
consumption and this category is called A’ category.
 About 20% of items contribute about 20% of value of consumption and this is known as ‘B’
category materials. Category ‘C’ covers about 70% of items of materials which contribute only
10% of value of consumption. There may be some variations in different organizations and an
adjustment can be made in these percentages
XYZ Classification:
 While the ABC analysis is based on the assumption on value, XYZ analysis is based on the value
of inventory undertaken during the closing of annual accounts. X items are those having
high value, Y items are those whose inventory values are medium and Z items are those whose
inventory values are low.
 The percentages are similar to ABC analysis. This analysis helps find items with heavy stock.

HML Classification:
 The HML classification is similar to the ABC classification, except for the fact that instead of
consumption values of items, their unit values are considered. Items are classified on the basis of
their unit values into:
o H = High value items.
o M = Medium value items.
o L = Low value items.
 This type of analysis is useful for keeping control over materials consumption at the departmental
level. For example, gold, which is a high value item, will be classified as H and coal, which is a
low value item, will be classified as L.

VED Analysis:
 In this analysis, the items are classified on the basis of their criticality to the production process
or other services. In the VED classification of materials:
o V = Vital items
o E = Essential items
o D = Desirable items
 Vital items are stocked in adequate number to ensure smooth and risk free operation of plant. In
other words, without such items the production process would come to a standstill.
 Essential items are those whose stock-out would adversely affect the efficiency of the production
system. Although the production system would not stop for want to these items, yet their non-
availability might cause temporary losses in, or dislocation of production.
 The D or desirable class of items are those which are required but do not immediately cause a
loss of production.
 The VED analysis is done in respect of spare parts. However, this VED classification can also be
done in the case of critical raw materials, which are difficult to obtain.

FNS Analysis:
 FSN stands for fast moving, slow moving and non-moving. Here, classification is based on
the pattern of issues from stores and is useful in controlling obsolescence.
 To carry out an FSN analysis, the date of receipt or the last date of issue, whichever is later, is
taken to determine the number of months, which have lapsed since the last transaction. The
items are usually grouped in periods of 12 months.
 FSN analysis is helpful in identifying active items which need to be reviewed regularly and surplus
items which have to be examined further. Non-moving items may be examined further and their
disposal can be considered.

SOS Classification:
 Raw materials, especially agricultural inputs are generally classified by the seasonal, off-
seasonal systems since the prices during the season would generally be lower.
 The seasonal items which are available only for a limited period should be procured and stocked
for meeting the needs of the full year. The prices of the seasonal items which are available
throughout the year are generally less during the harvest season.
  The quantity required of such items should, therefore, be determined after comparing the cost
savings on account of lower prices, if purchased during season, with the higher cost of carrying
inventories if purchased throughout the year.
 A Buying and stocking strategy for seasonal items depend on a large number of factors and more
and more sophistication is taken place in this sphere and operational techniques are used to
obtain optimum results.

SDE Classification:
 Under this analysis, ‘S’ stands for scarce items which are in short supply, ‘D’ refers to the
difficult items meaning the items that might be available in the indigenous market but cannot
procured easily while ‘E’ represents easily available items, may be from the local market.

GOLF Classification:
 The letter stands for Government, Ordinary, Local and Foreign.
 There are mainly imported items which are canalized through the State Trading Corporation
(STC), Minerals and Metals Trading Corporation, etc. Indian Drugs and Pharmaceutical Ltd (IDPL),
Mica trading corporation etc. These are special procedures of inventory control which may not
applicable to ordinary items as they require special procedures.

MNG Classification:
 The grouping of inventory items in this analysis takes place as:
o M- Moving items – The items which are consumed from time to time are normally
referred to as moving items.
o N- Non moving items – These items which are not and consumed in last one year are
covered under this group.
o G- Ghost items – This group refers to such items which neither have been received nor
issued during the year. The balance of such items shown in stock registers of the
organization will be nil, both at the beginning and at the end of the previous financial
year.

ABC-XYZ ANALYSIS:
 When it comes to inventory management, the ABC Analysis is a good tool to:
 Identify the products we should review and spend most of our time on (demand planning
reviews/meetings, emails…)
 Set Service Rate targets, that
determine safety stock levels.

 For setting Service Rate Targets, there

are 2 classic mistakes made by companies:
 Setting high Safety stock on A codes, to
protect top sellers
 Setting low Safety Stock on A codes,
because sales volume is high, so they
seem more predictable

 We have the opposite issues for C items:

 Setting high safety stock on C codes because these items are unpredictable
 Setting low safety stock on C codes because we don’t want to hedge low selling items
 Both statements are incorrect because it all depends on the uncertainty of demand.

 To better estimate service rates and

safety stock targets, we need to add
another dimension: XYZ categories

 Products have different levels of demand

uncertainty.
 Stable products such as toilet paper
(X items)
 Volatility products, such as umbrellas
– only during rainy periods (Z items).

 Probably better forecast quality is

possible for X items than on the Z items.
 Other products are in-between.

ABC-XYZ Analysis in Inventory Management:

The main idea of the ABC XYZ analysis is
to combine ABC and XYZ categories
across two dimensions: we end up with a
matrix of 9 categories

We can classify items around 4 extremes:

AX: High sales volumes, stable

AZ: High sales volumes, very volatile
CX: Low sales volumes, stable
CZ: Low sales volumes, very volatile

Inventory Management Policy with ABC-XYZ Analysis:

To use effectively the ABC XYZ matrix, we need to define an Inventory Management
Policy: setting service level and safety stock targets. Roughly speaking, for better service level,
we need higher safety stock.

Example: we can choose to hold more inventory for the A category, as A items are the major
drivers of business, and we want to maximize the service level for those products.
For AX items, we can afford to hold less safety stock than AZ items, as we have better visibility
over the demand.

The same logic applies to B items.

 Regarding C codes, we can decide to hold low inventory for both CX and CZ categories, for
two reasons:

 CX items have a low impact on the

business, so we can afford to set a
lower service level. Also, they are
stable, so we require even less safety
stock.

 CZ items are very volatile. We can

think we need therefore a bit more
safety stock, but by experience we
know that most of the time It is not
worth it: because they are both low-
selling items and very unpredictable,
CZ items are often a source of high
stock levels and unnecessary
headaches.

 CZ items represent a big part of the total sleeping inventory of most companies. It might be
wise to set lower service levels for this category.

Example of Inventory Management with ABC-XYZ Analysis:

% of Standard Coefficient Uncertainty

MONTH 1 2 3 4 5 6 7 8 9 10 11 12 Total ABC
total Deviation Variation XYZ

Item 1 280 260 290 272 300 304 292 276 300 292 268 268 3,402 28% A 14.1 5% X

Item 2 408 204 550 80 360 84 276 132 600 120 360 312 3,486 57% A 167.3 58% Z

Item 3 120 168 150 148 120 160 100 156 148 120 170 164 1,724 72% B 22.0 15% Y

Item 4 86 76 74 156 112 80 86 120 102 152 84 134 1,262 82% B 28.2 27% Z

Item 5 60 57 66 68 71 69 77 73 77 61 69 66 814 89% B 6.1 9% X

Item 6 50 38 40 14 60 42 56 54 46 46 48 46 540 93% C 11.2 25% Y
Item 7 36 54 40 20 30 14 42 22 28 50 50 40 426 97% C 12.3 35% Z
Item 8 22 28 18 19 22 25 21 21 21 23 25 19 264 99% C 2.8 13% Y

Item 9 10 9 5 8 10 5 3 5 2 5 1 7 70 100% C 2.8 48% Z

Item 10 4 5 5 6 2 2 2 5 0 6 3 3 43 100% C 1.8 51% Z
12,030

 Standard Deviation is calculated for 12 months above.

 To have a good estimation of the items’ demand uncertainty, we can use the coefficient of
variation (CV). It is simply the standard deviation divided by the average values of 12
months here.

 We can apply the formula over the past 12 months to have a monthly coefficient of
variation.

 The more unstable your series is, the higher your standard deviation will be.

 For item 1, we get a 5% coefficient of variation vs 58% for item 2 which is consistent

 Graph for CV of item 1 & 2:

 Then, we need to define coefficients of variation thresholds to classify items in XYZ

categories. Here, we assumed:
 CV < 10%: X code
 10% < CV < 25%: Y code
 CV > 25%: Z code

 From above ABC-XYZ analysis, we

get following table of selection of
items:

 Of course, those threshold values are

arbitrary, and should be adjusted
according to the data (if you have
almost no X items for example).

 Set the thresholds based on the business specifies: Identify clear patterns and group your
items accordingly.
Application of ABC-XYZ Analysis:
 Excellent supply chain managment tool:
 Marketing / Sales
 Finance
 Production
 Suppliers / Customers

 Good Crisis Management Tool

Case Study of Application of ABC-XYZ Analysis:

Your CFO comes to your desk telling you to “cancel all orders because there is no more cash”.
Or telling you the opposite, urging you to “double all orders” because you sell surgical masks
and plan to make +100% in times of pandemic

Having your products well categorized is key to taking action quickly in those situations. In the
first situation, you could convince your anxious CFO to save at least your most strategic
products:

Following table can be plotted from the ABC-XYZ Analysis:

INVENTORY CONTROL:
 It is a mechanical process to implement Inventory Policy. The accountability aspect of control
measures units on hand at a specific location and tracks additions and deletions to the base
quantity. Accountability and tracking can be performed by manual or computerized techniques.
The primary differentials are speed, accuracy and cost.

 Inventory management depends on how often inventory levels are reviewed & compared w.r.t.
inventory parameters.

 There are 2 types of inventory control procedures :

o Perpetual Review
o Periodic Review
o Modified Control System

 Let us consider one example to under both these methods:

Average daily demand 20 units

Performance cycle 10 days
Order quantity 200 units

Perpetual Review Method:

 Reviews inventory status daily to determine replenishment needs.

 This review process is implemented through a
Reorder Point and Order Qty. considering following Where,
formula : ROP : Reorder Point in units
ROP = D x T + SS D : Av. Daily demand in units
T : Av. Performance cycle length in days
SS : Safety or buffer stock in units
 So, considering the example above we get,
ROP = 20 X 10 + 0 = 200 units

 Perpetual review compares sum of On-Hand & On-Order Inventory to the items reorder point.
 On hand represent Qty. that physically resides in particular distribution facility
 On order represent Qty. that have been ordered from suppliers
 If, On-hand + On-order qty. < Reorder point,
Where,
Replenishment order is placed. That means :
I : Inventory on hand
If, I + Q0 ≤ ROP, then order Q Q0 : Inventory on order from supplier
Q : Order quantity
 So, as per example, 200 units will be ordered only
when sum of on-hand and on-order inventory is
less than 200 units

 Since reorder point equals the order qty, the previous replenishment shipment would arrive just
as the next replenishment is initiated. Hence concept of Average Inventory is essential.

 The Average Inventor, I’ = Q/2 + SS = 200/2 + 0 = 100 units

Periodic Review Method:

  Reviews inventory status of an item at regular intervals such as Weekly or Monthly.
 Basic Reorder Point must be adjusted to consider extended intervals between reviews. Following
formula is used to determine Reordering Point:
Where,
P is review period in days.
ROP = D(T + P/2) + SS Rest all abbreviations are the same as
previous.
 Since inventory status counts are completed only
at a specific time, any item could fall below the desired reorder point prior to the review period.
 So, assumption is made that inventory will fall below ideal reorder status prior to periodic count
approx. Half of the review time.
 Considering review period of 7 days :

ROP = 20 (10 + 7/2) + 0 = 270 units

• So, Average Inventory formulation for periodic review :

I’ = Q/2 + (P x D/2) + SS = 200/2 + (7 x 20)/ 2 + 0 = 100 units

Modified Control System:

 This is a fixed-order-interval system that provides for short-interval periodic review.

 In this case Target Replenishment Level (TGT) is defined. Following formula is used to determine
TGT:

TGT = D(T + P) + SS
Where,
And
TGT : Replenishment level
D : Av. Daily demand in units
Q = TGT – I – Q0 T : Av. Performance cycle length in days
P : Review period in days
 Considering a review period of 5 days (i.e. P = 5 SS : Safety or buffer stock in units
days) : I : Inventory status at review time
Q : Order quantity
Q0 : Quantity on order
TGT = 20(10 + 5) + 0 = 300 units

 Since replenishment cycle is longer than the review period, it is necessary to consider
outstanding orders.
 Assuming there is one outstanding order for 100 units at the time of the review and current
inventory is 50 units :

Q = 300 – 50 – 100 = 150 units

• So, Average Inventory formulation :

I’ = DP/2 + SS = (20 x 5)/ 2+ 0 = 50 units

Inventory Systems under different Factors:
Under different factors, the procedures adopted by different inventory systems differ. Following table
may summarize it:

Factor Periodic Inventory System Perpetual Inventory System

Basis of ascertaining inventory By actual physical count On the basis of records
Calculation of inventory Directly by applying the method Closing Inventory = opening
of valuation of inventories inventory+ purchases –cost of
goods sold
Calculation of cost of goods sold Cost of goods sold = opening Directly calculated by applying
inventory + purchases – closing the method of valuation of
inventory inventories
Lost Goods Cost of goods sold includes Cost of closing inventory includes
cost of lost goods (if any) cost of lost goods (if any)

Few Notes on Perpetual Inventory Management:

 This system track sold and stocked inventory in real-time, updating your accounting system
whenever a sale is made, new inventory has arrived, or inventory is used.

 All of this information is sent to a central hub that authorized employees can access at any time.

 The advantages of this system include the ability to manage multiple locations quickly, more
informed forecasting, and proactively monitoring inventory turnover.

 Wall Mart uses this system

METHODS OF INVENTORY VALUATION:

 An inventory valuation allows a company to provide momentary value for items that make up its
inventory.
 There are following three method by which valuation is determined. These are explained below:

o First In First Out (FIFO) Method.

o Last In First Out (LIFO) Method.
o Weighted Average Cost/price Method.

First In First Out (FIFO) Method:

• Based on the assumption that the goods that are received first are issued first.
• For purpose of assigning costs and not exactly for purpose of physical flow of goods.
• Goods sold, thus, consist of earliest lots and are valued at the price paid for such lots.
• The ending inventory consists of latest lots and is valued at the price paid for such lots.
• Balance sheet shows ending inventory costs as per approx. market price.

• Let us enumerate this process with the help of an example / question:

• QUESTION – ABC Ltd. Provides you with the following information :

• 1.1.2021 Opening Stock 100 units @ Re 1.
• 2.1.2021 Purchased 400 units @ Rs 1.50.
 • 3.1.2021 Issued 450 units.
• 4.1.2021 Purchase 500 units @ Re 2.06.
• 5.1.2021 issued 300 units.
• REQUIRED : Compute the value of inventory and cost of goods sold as on 5.1.2021
assuming following :
• Perpetual system; and
• Periodic system under FIFO method.

1. Stock Ledger under FIFO Method

DATE RECEIPTS ISSUES BALANCE

Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
1/1/2021 - - - - - - 100 1.00 100
2/1/2021 400 1.50 600 - - - 100 1.00 100
400 1.50 600
3/1/2021 - - - 100 1.00 100 50 1.50 75
350 1.50 525
4/1/2021 500 2.06 1030 - - - 50 1.50 75
500 2.06 1030
5/1/2021 - - - 50 1.50 75 250 2.06 515
250 2.06 515
 2. Calculations:

a. By PERPETUAL System: b. by PERIODIC System:

b.

Last In First Out (LIFO) Method:

 Based on assumption that goods that are received last are issued first.
 Assumption made for purposes of assigning costs and not for actual physical flow of goods.
 Flows of goods and costs may not coincide.
 Goods sold, thus, consist of the latest lots and are valued at the price paid for such lots.
 The ending inventory consists of the earliest lots and is valued as such.
 Balance sheet has an inventory costs at old prices.

 WHY USED?
o U.S. is the only country that allows LIFO because it adheres to Generally Accepted
Accounting Principles (GAAP), rather than the International Financial Reporting Standards
(IFRS), the accounting rules followed in the European Union (EU), Japan, Russia, Canada,
India, and many other countries.

o Virtually any industry that faces rising costs can benefit from using LIFO cost accounting.

 CRITICISM OF LIFO:
o Opponents of LIFO say that it distorts inventory figures on the balance sheet in times of
high inflation. They also point out that LIFO gives its users an unfair tax break because it
can lower Net Income, and subsequently, lower the taxes a firm faces.

 Let us enumerate this process with the help of an example / question:

o QUESTION) – ABC Ltd. Provides you with the following information :

 1.1.2021 Opening Stock 100 units @ Re 1.
 2.1.2021 Purchased 400 units @ Rs 1.50.
 3.1.2021 Issued 450 units.
 4.1.2021 Purchase 500 units @ Re 2.06.
 5.1.2021 issued 300 units.
 o REQUIRED : Compute the value of inventory and cost of goods sold as on 5.1.2021
assuming following :
 Perpetual system; and
 Periodic system under LIFO method.

1. Stock Ledger under LIFO Method

DATE RECEIPTS ISSUES BALANCE

Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
1/1/2021 - - - - - - 100 1.00 100
2/1/2021 400 1.50 600 - - - 100 1.00 100
400 1.50 600
3/1/2021 - - - 400 1.50 600 50 1.00 50
50 1.00 50
4/1/2021 500 2.06 1030 - - - 50 1.00 50
500 2.06 1030
5/1/2021 - - - 300 2.06 618 50 1.00 50
200 2.06 412

2. Calculations:

a. By PERPETUAL System: b. by PERIODIC System:

b.

Difference in Results between FIFO & LIFO Methods:

PARTICULAR Unit FIFO LIFO

Opening Inventory Rs. 100 100

Closing Inventory Rs. 515 462
Cost of Goods Sold Rs. 1,215 1,268
Weighted Average Price Method:
 Based on the assumption that each issue of goods consists of a due proportion of the earlier lots
and is valued at weighted average price.
 Weighted average price is calculated by dividing the total cost of goods in stock by the total
quantity of goods in stock.
 This weighted price is used for pricing the issues until a new lot is received when a new weighted
average price would be calculated.
 This method evens out the effect of widely varying prices of different lots that make up stocks.

 Example :

Units available Units sold Per unit TOTAL

cost COST in
₹
Opening inventory 100 -- 2.10 210

Sale -- 75 -- --

Purchase 150 -- 2.80 420

Sale -- 100 -- --

Purchase 50 -- 3.00 150

Total 300 175 780

 The weighted-average cost per unit is ₹780/300 = ₹2.60

 Ending inventory is 125 units (300 – 175) at ₹2.60 = ₹325
 Cost of goods sold (i.e. 175 units at ₹2.60) = ₹455.

PLANNING APPROACH CO-ORDINATE REQUIREMENTS ACROSS

MULTIPLE LOCATIONS IN THE SUPPLY CHAIN:
Inventory planning methods use a common information base to coordinate inventory requiremnts across
multiple locations or stages in the value added chain. Planning activities may occur at the plant
warehouse level to coordinate inventory allocation and delivery to multiple distribution centers. Planning
my also occur to coordinate inventory requirements across multiple channel partners such as
manufacturing and retailers.

Two planning approaches are:

 Fair share allocation provides each distribution facility with an equitable distribution of
available inventory. Limited ability to manage multistage inventories.
  Requirements planning integrates across the supply chain taking into consideration unique
requirements
 Materials requirements planning (MRP) is driven by a production schedule
 Distribution requirements planning (DRP) is driven by supply chain demand

Fare Share Allocation Method:

 This is a simplified inventory management planning method that provides each distribution facility
with an equitable or “fair share” of available inventory from a common source such as a plant
warehouse.

 The diagram here shows the network structure, current inventory level and daily requirements
for three distribution centers served by a common plant warehouse.

 Under this technique the inventory planner determines the amount of inventory that can be
allocated to each distribution center from the available inventory at the plant warehouse.

 For example, assume that it is desirable to retain 100 units at the plant warehouse; therefore,
500 units are available for allocation.

 The calculation to determine the common days’ supply is:

Where,
DS : Common day’s supply for distribution center inventories
Aj : inventory units to be allocated from plant warehouse
Ij ; inventory in units for distribution center j
Dj : daily demand for distribution center j

 So, DS = [500 + (50 + 100 + 75)] / (10 + 50 + 15) = 9.67 days

 So the fair share allocation dictates that each distribution center should be brought up to 9.67
days of stock.

 The amount to be allocated to each distribution center is determined by formula:

Aj = (DS – Ij / Dj) x Dj
 Calculation of amount to be allocated to each distribution center :
o A1 = (9.67 - 50/10) x 10 = 46.7 units ≈ 47 units
o A2 = (9.67 - 100/50) x 50 = 383.5 units ≈ 383 units
 o A3 = (9.67 - 75/15) x 15 = 70.05 units ≈ 70 units

 Hence Allocation of 500 available units from plant :

o Warehouse 1 = 47
o Warehouse 2 = 383
o Warehouse 3 = 70

 This system leads to designing “Inventory Echelon” System.

 While fare share allocation coordinates inventory levels across multiple sites, it does not consider
site specific factors such as differences in performance cycle time, economic order quantity or
safety stock requirements.
 Hence fare share methods are limited in their ability to manage multistage inventories.

Multi Echelon Inventory Optimization:

What is Multi Echelon Inventory Optimization?

For a large enterprise such as Nike and Oracle, managing inventory can be a challenging task with
thousands of products located in thousands of locations all over the world. The challenge magnifies when
locations are placed in different tiers or echelons of the enterprise’s distribution channel.

Multi-echelon inventory optimization offers a solution to help companies optimize inventory levels
throughout their distribution networks. This type of supply chain planning successfully combines
inventory optimization (how much stock to keep at each distribution level) with multi-echelon planning
(deciding where to keep inventory at each distribution level). In multi-echelon inventory optimization,
companies can strategically manage their inventory across all echelons of their supply chain. It treats
inventory optimization from a comprehensive or globalized perspective, helping successfully optimize
inventory throughout the supply chain. This helps mitigate such issues as being able to optimize levels of
stock at your upstream distribution points, while failing to meet the needs of downstream locations or
vice versa. Enterprises that have been integrating this method of supply chain planning into their
inventory optimization have enjoyed many benefits as a result.

What Are the Benefits of Multi-Echelon Inventory Optimization?

1) Boost in Cost-Efficiency
Without a strong inventory optimization strategy, companies may try to just keep more stock throughout
their supply chain, so they are prepared to meet consumer demand with enough stock ready at any one
distribution point. Sounds good, right? Well, unfortunately this approach is uneconomical, as well as
unprofitable because it can lead to inventory excess, with too much capital tied up in stock that won’t
move quickly enough. Multi-echelon inventory optimization helps companies make better use of their
capital, investing in optimal levels of stock that will move more fluidly throughout the supply chain.

2) Improvement in Customer Service

Without successfully optimizing their inventory levels, enterprises may end up forecasting too low,
resulting in inventory deficits. This means that they could potentially be out of a certain product a
customer wants or needs by the time inventory has moved downstream to the consumer. And, of course,
this would hurt their customer service levels as they are not sufficiently meeting consumer demand.
When companies utilize multi-echelon inventory optimization, they can successfully forecast enough
levels of stock throughout their supply network — meeting consumer needs and keeping customers
happy.
3) Better Management of Supply or Market Volatility
If companies fail to optimize their inventory levels, they may not be prepared for sudden changes in
market demand or supply. With multi-echelon inventory optimization, companies achieve more optimal
levels of stock throughout their supply chain. Having enough stock at any point throughout their
distribution networks boosts an enterprise’s agility, helping them more quickly and strategically respond
to market and supply volatility.

4) Better Management of Lead Times

Without a strategic approach to inventory optimization, enterprises handicap their ability to manage
fluctuating lead times. Since suppliers’ estimates of lead times are not always accurate, sudden changes
in lead times can arise, leading to stock shortages, excess stocks, etc. Multi-echelon inventory
optimization helps companies maintain enough levels of stock throughout the supply chain network, so
they can quickly adapt and respond to lead changes as they come up.

5) Improved Return on Investment

Without a successful inventory optimization strategy in place, enterprises may invest too much capital in
stock that is not moving fast enough through their supply chain. Multi-echelon inventory optimization
allows companies to manage more optimal levels of inventory — so without too little or too much
inventory, they can successfully meet consumer demand. This means better profits, and better returns on
investments.

Single vs. Multi Echelon Inventory System:

Broadly, there are two types of inventory systems: - the single-echelon (or, single-tier) inventory
system and the multi-echelon (or, multi-tier) inventory system.

Single-Echelon Inventory System:

A single-echelon inventory system is one
wherein a single Distribution Center (DC) acts as
a central repository between the supplier of the
inventory and the customer-facing outlets.
In a single-echelon network, an individual
material-location combination is not affected by
any other material or location. If a business was
selling products from a single location, then it
would be categorized as a single-echelon
system. The DC is under the control of a single
enterprise.

Multi-Echelon Inventory System:

A multi-echelon inventory system is one that
relies heavily on layers of suppliers distributed
across multiple distribution centers and that is
based on outsourced manufacturing. In such
a system, new inventory shipments are first
stored at a central or regional distribution center
(RDC). These central facilities are the internal
suppliers to the customer-facing outlets, also
called forward distribution centers (DCs). For
example, Nike’s distribution network consists of
7 RDCs and more than 300,000 DCs; and these DCs serve end customers. Here, the DC and RDC
both are under the control of a single enterprise – Nike, Inc.
Types of Multi Echelon Systems:

Integrated planning approach for raw materials, work-in-process, and

finished goods:
 Distribution Requirements Planning (DRP) is a more sophisticated planning approach that
considers multiple distribution stages and the characteristics of each stage. DRP is the logical
extension of manufacturing requirements planning (MRP), although there is one fundamental
difference between the two techniques.

 MRP is determined by a production schedule that is defined and controlled by the enterprise. On
the other hand, DRP is guided by customer demand, which is not controllable by the enterprise.

 So, while MRP generally operates in a dependent demand situation, DRP operates in an
independent environment where uncertain customer demand determines inventory requirements.

 The figure below illustrates the conceptual design of a combined DRP/MRP system that integrates
finished goods, work-in-progress and materials planning. DRP coordinates inventory levels, plans
inventory movement and reschedules inventory between levels (if requird).
EMERGING TRENDS IN INVENTORY MANAGEMENT:
 Entering into long term contracts at a fixed price to reduce uncertainties.
 Just-in-time.
 Kanbans – Japanese technique (Only produce when demand comes).
 Internet based ordering systems.
 Supply chain management.
 Vendor development.
 Investment in plant and machinery.