Chapter 5

Inventory Management and Transportation

At the end of the chapter the students shall be able to:

 Discuss the nature of inventory;

 Identify the materials that are usually found in the list of inventories;
 Give the functions of inventory management;
 Discuss the determinants if inventory cost;
 Give the determinants of economic order quantity;
 Enumerate the factors in ordering schedule and the development of safety
stocks;
 Give the different models for material ordering system;
 Discuss how to manage inventory in relation to sales volume; and
 Identify the different transportation methods used in the supply chain.

THE NATURE OF INVENTORY

Inventory in materials management systems is the stock or store of goods in the shelf or
in the warehouse. The stock of goods or materials is dependent on the kind of operation that the
company engaged in a manufacturing firm will have different materials and component parts
that will be needed in the production of its product. It needs also to stock some spare parts for
machine maintenance, tools for its operation requirements, and finished goods ready for
shipment to its customers.

Inventories are vital parts of any organization that manufactures products for its target
customer. In view of the importance of inventory in its production system, management of the
purchasing department must be aware of its stocks that are available for use at the time when it
is needed. The investment in the stock inventory is tremendous and this must be managed
effectively.

The following are peculiar items found in the inventory of a manufacturing organization:

1. Raw materials and purchase parts

Raw materials are those supplied by the supplier and this will go into the production
line for further processing into finished products. These are inputs in the manufacturing
process to service the demand of clients and customers. The stocks are stored in shelf
or bins ready for processing.

2. Stocks in production process or work in progress

 Stocks that are already in the production is still part of the manufacturing inventory.
These are materials in carts or storage containers and now on production line ready for
processing or these are parts or components attached to the main product.

3. Finished goods for delivery or in transit

Finished goods still form part of the corporate stocks. These are those in the
warehouse or storage area awaiting shipment or delivery to the target customers. They
are still stocks until received by the buyer.

4. Replacement parts, tools and other supplies

Manufacturing plants need to have a ready stock of replacement parts for its
operating machines in order to prevent long hours of break time. Machines have
operating time limits and it requires maintenance and repair. Supplies in inventory are
those that are used in the daily operation.

THE FUNCTIONS OF INVENTORY MANAGEMENT

The objective of inventory management is to achieve satisfactory level of stock to

service customer demand. The management of the purchasing department must assure the
operating units that there are available materials when it is needed and to maintain a level of
inventory at reasonable bounds.

The following are the functions of inventory management:

1. To supply production requirement

Production or operating units needed materials that are of high quality or based in
product specifications. These materials must be available at the supply chain when they
are needed for the production of goods or component parts. Any delay would mean
stoppage of production, which will add to product cost.

2. To meet customer demand

The projected demand of the customer must be met by production as determined by
the marketing department. The projected customer demand must be supplied with the
necessary production input that is dependent on the available materials in stock at the
plant site. The purpose of inventory is to see it that stocks are available when they are
needed.

3. To protect against stock out of materials

The stock out of materials in the supply chain will result in the disruption of
manufacturing operation. Stock outs are caused by the improper monitoring of stock
level and poor coordination of the supplier. The development of good supply
management relations will avoid stock outs.

4. To decouple production operation

The demand analysis of the customer needs and wants should be studied carefully.
This should answer seasonal demands or the maintenance of buffer stocks in time of
company shot down or periodic maintenance checks. Customers’ demand could not be
 taken setting down as they are the lifeblood of the firm’s existence. Firms must have
buffer stocks in the warehouse to eliminate the source of disruption and therefore gently
decreases the need for decoupling operation.

1. Take advantage of the just- in- time delivery

The development of better supply management relations is a great step towards the
just- in- time delivery of materials in the production system. The oversupply and the
undersupply in the warehouse could be avoided if there could be greater coordination
and cooperation in materials delivery.

2. Take advantage of material price increase

With greater coordination with the supplier under the supply management relation
program, the purchasers could take advantage of large volume order in anticipation of
price increase as dictated by the global economy. This would allow volume discounts
and therefore sustain price index in the competitive market.

3. To provide continuous supply into the pipeline

Pipeline inventories are those on production floor, in transit to customer, semi-
finished items in the warehouse and finished goods ready for shipment. With continuous
availability of stocks, the pipeline inventory will be able to sustain customer demand for
the product. Stocks out on customer demand is avoided and sustained operation will be
in place.

DETERMINANTS OF INVENTORY COST

Inventories are used to satisfy demand requirement of the production department. It is

crucial to have reliable estimates of the total stocks available for processing. Too much
inventory is cost investment that does not earn profit unless the finished product has been
delivered to the customer.

On the other hand, shortage in material stock is lost in operating demand and will cause
stoppage of operation that will result to more losses. Purchasing and inventory management
must go hand in hand to determine the acceptable level of inventory. Managers of the
supply management must know the extent of demand and lead time delivery so as not to
create over stocking or understocking of materials.

The three basic costs associated with inventory are:

1. Holding or carrying cost

The stocks in the warehouse are idle money put in materials which are needed in
production. We call it ‘holding cost’ as these materials in processing are still investments
until they are processed and finally delivered and paid by the customer.

We pay insurance cost while materials are in the warehouse or storage to guard
against damages due to fire or other unforeseen events. Inventory of goods are charged
taxes as they are considered as corporate sheets.
 As we hold these materials in inventory, some are damaged and may not be fit for
production processing. Some materials may become obsolete due to changing market
demand or the arrival of more suitable quality materials.

The holding or carrying cost could be minimized if inventory management is properly

monitored. The inventory management system must develop better linkages with
supplier so that minimum inventory is carried in the warehouse. This could be done
through improved supply management relations and just- in- time delivery system.

2. Ordering cost
The salaries and wages paid for those in charge of purchasing, canvassing and
receiving of the materials, and maintaining them in storage are part of the ordering cost.
Transportation expenses in the inspection of the materials at the supplier plant site are
cost associated with ordering the materials.

When materials arrive at the factory or the warehouse, it needs inspection, checking
of quality, counting and indexing, and transpiring the same in the storage which are the
manpower cost associated with ordering. The equipment used in handling the materials
and the storage facilities are part of the ordering and storage costs.

3. Shortage cost
Shortage cost is the result when the demand for the product exceeds the supply
inventory at hand. It is considered as production cost due to availability of the needed
materials for processing. This is also called opportunity cost for not meeting customer
demand which could have been earned profit for the organization.

Since the processing of the products covers a lot of material inputs, any shortage in
one particular item that is needed before a product could be finished is considered as
shortage cost. This will cost production stoppage and the cost estimate becomes more
subjective which may run into thousands of pesos as this will also cover idle manpower
cost.

Based on the above discussions, the role of inventory management in the

organization is too crucial to be taken setting down. Improved inventory management
system must be put in place in order to avoid the above discussed cist in material
handling.

THE DETERMINATION OF ECONOMIC ORDER QUANTITY

Manufacturing organization or any processing company engaged in the production of

goods to satisfy consumer demand must place periodic order of the necessary materials. The
need for the purchase of such materials calls for some design regarding the number of units of a
particular material. How much to order and what to order, and the time of delivery are crucial
decisions that are faced by those in the procurement units.

All decisions to purchase materials involve cost such as ordering cost, storage cost,
investment cost and other associated cost related to material inventory. Ordering more
materials would give the firm quantity discount. On the other hand, it requires more investment
in stocks. Stocks that could not be turned immediately into cash are investment in money
resources. It will take time before it could be processed and sold to the ultimate consumer.

While ordering more materials would avoid the possibility of stock- outs that will cause
disruption of production schedules and lost customer orders, we have to balance the cost
involved with the other cost that is associated with more materials in inventory. The balancing
process requires careful analysis of the production schedules, the market demand and the
availability of material inputs that would be necessary to meet those demands.

To answer the question on how much to order and stock can be solved by some
quantity model that are solved by some organizations. The three order models are the following:

1. The economic order quantity model

This is used to identify the order size that will minimize the annual cost of holding
inventory and the ordering cost. This is based on the assumptions that the unit price of
the item is not included in the total cost.

This model works effectively under the following conditions:

a. The firm manufactures one kind of product

b. The annual demand forecast is identified
c. There is a constant demand of the product on annual basis
d. The lead time delivery is constant
e. The supplier offers no quantity discount
f. The order is received in a single delivery

2. Instantaneous economic order model

This model assumes that the usage of materials is proportionately equal to the
delivery of materials in the production line. As the production is constantly equal to the
delivery, the material build up at the storage does not occur. When production stops
operation, the supply delivery stops. It is the process of instant replenishment.

When the company makes the product component itself, the supplier delivery is not
needed. It will not involve ordering cost. As the components are made directly into the
production line, then holding cost is minimum level. The supply ceased when production
operation stops. On the other hand, the cost of equipment maintenance of the
component production, the cost of labor involved, and the equipment wear and tear are
costs of material production. Replacement of equipment when it becomes obsolete is a
part of the material supply cost.

3. Quantity discounts
Quantity discounts are price reduction offered by suppliers for volume orders. The
more materials are offered the lesser the price. These become too tempting to order
more items but must be analyzed accordingly. The relationship of the supplier and the
buyer must be established that the payment terms must be reasonable enough to be
advantageous to both parties.
 When quantity discount is offered, the buying organization must be able to compute
between the carrying cost, storage cost and amount of capital investments. The interest
rates and other cost associated with inventory must be decoupled against the savings in
quantity discounts. When the quantity discounts exceed the other costs involved, then
the purchasing organization should grab the cost opportunity.

ORDERING SCHEDULE AND SAFETY STOCKS

The ordering of materials needed in the production line needs constant analysis and
study. This will affect the cost associated with materials inventory. When to order the
materials is called the material reorder point (MRP). The time of material delivery must be
made so that the stock level is still enough to supply production operation. The basic
concern of the purchasing manager is to have the materials on the shop floor before stocks
run out.

The following are the signal points in materials reordering process:

1. The rate of the demand based on production schedule

2. The lead time of delivery
3. The extent of demand and time variability
4. The degree of stock risk and operation costs involved
SAFETY LEVEL OF STOCK

It is necessary to carry additional inventories in stock to reduce the risk of running out
materials during the ordering lead- time. This is needed when variability is present in demand or
lead- time. This happens when production actual demand will exceed its requirement. The
reorder point is adjusted based on the safety stocks available in the warehouse. Safety stock
then is the buffer level of inventory that will sustain the supply of materials while waiting for the
arrival of replenishment.

The amount of safety stocks that is appropriate for a given situation depends on the
following:

1. The average demand rate and average lead- time.

The average demand rate is the production requirements for any given time either on
weekly or monthly bases. The average lead- time is the period by which replenishment will
arrive at the warehouse. The greater the variability in lead- time delivery, the greater the
safety stock level in inventory.

2. Demand and lead time variability.

Demand is predicted on the schedule of production. The demand projection varies
with the plant operating capability and the prevailing conditions at work. When demand is
constant, the lead time variability in the supply of materials could be determined and
therefore stock outs are avoided. When the demand varies, the time variability must also
be adjusted to avoid stock outs.

3. The demand service level.

 The demand service level is the average time by which the supplier can deliver the
goods to the production line. The longer the service period, the more safety stock should
be stored to avoid stock outs. The cost of stock outs at exceed the cost of carrying more
units in stocks hence determination of service level must be identified.

The data availability within the procurement system is within the tip of the finger with
the advent of the computerized system in materials inventory. The advanced technology in
materials handling could avoid stock outs and delay in the production process.

MODELS FOR MATERIALS ORDERING

1. Fixed interval model

The fixed- order interval model is the process of ordering materials at fixed interval for
a given period say weekly or on a month base or a time frame where stock inventory is
determined to run out. This requires close monitoring of stocks as larger order is made
to avoid stock outs.

The supplier of materials would usually encourage the fixed interval mode for ease of
time delivery and determination of the amounts of stocks to be delivered. Grouping of
materials from the same supplier can reduce shipping costs. The important variable in
the time delivery is constant, the use of fixed interval model is most appropriate.

2. Fixed quantity model

This is the process of ordering materials at fixed quantity at varying intervals based
on materials consumption. Under this concept, the orders are triggered by the amount of
stock needed at a particular period. The fixed quantity model needs to monitor the lead
time delivery at a certain period before stocks run out in the production area.

The difference between the two models is primarily on time of order and the quantity
of materials that will be ordered. Fixed quantity model needs monitoring of important
components under A classification system. The fixed quantity model can be placed any
time and will be received at the plant site as lead time is available.

MANAGING INVENTORY TO SALES VOLUME

The most important component of inventory management is the knowledge of what

quantity of parts or materials to order and when to order it. Without this information, the optimal
level of materials cannot be maintained. To manage inventory to the anticipated sales volume,
purchasers must use various inputs to determine as correctly as possible the optimal inventory
amount in relation to anticipated customer demand.

1. Inventory turnover
Inventory turnover is the time it takes for the inventory to move from finished
warehouse to the point of customer acceptance and payment. The manufacturing
inventory management plan or ordering procedure should reflect the product turnover
rate. The sales volume is determined on a monthly or annual basis and this will guide
the purchasing and inventory management.
 2. The percentage of sales volume
Purchasers must consider the estimates of sales volume to determine the amount of
inventory that should be available in stock to meet the operation’s demand. To properly
calculate the expected usage, the historical data of sales should be used as benchmark
in the stock of needed materials.

3. The par stock approach

The par stock approach requires that purchaser determines the level of inventory
item that must continually to be in stock from one delivery date to the next in order to
meet the customer demand. This method should be reviewed from time to time if the
supplier delivery schedules change or there is a change in supplier.

EFFECTIVE INVENTORY MANAGEMENT

Effective inventory management is all about knowing what is on hand and what is true. It
must reflect on how much finished products were produced. The process usually involved
controlling the transfer of units. This is to prevent the inventory form becoming too high or too
low. Production operation will be in jeopardy if the transfer of units is not monitored properly.
Competent inventory management team seeks to control to cost of keeping inventory
associated with carrying cost and tax burden associated materials in stock.

Balancing inventory management is paying attention to the three key aspects:

1. Time of delivery
This refers to the supplier processing an order or delivering the same to the
production floor.

2. Processing time until goods are finished

The processing time refers to the time by which the good goes out into the production
floor until it is ready for shipment to the intended buyer.

3. The number of units required at one particular period

The number of units required for a particular item to keep production moving.
Overstocking of materials means cost.

THE ROLE OF TRANSPORTATION IN PURCHASING

The role of supply manager in the flow of information and physical supply is from the
supplier to the ultimate customer. Transportation involves facilitating the movement of raw
materials and component parts from the supplier to the manufacturing plant and then the
finished product to the ultimate customers.

In the traditional inventory system, supply management is a manufacturing activity until the
advent of the just in time delivery system. Transportation is the most costly and time consuming
component of the purchasing management. The schedule of delivery must be properly
coordinated with the transporting organization. On time receipt of the materials in the production
line and its delivery to the ultimate consumer are important factors for competitive advantage.

The transportation interface requires knowledge of transporting activities which are

necessary in decision making. The important activities related to transportation are worth
considering for analysis.

THE MODE OF TRANSPORTATION

The purchasing manager must select the most convenient and reliable mode of
transportation in the transfer of materials and component parts and the finished product. The
decision involves specific operating and cost characteristics and decision makers must weigh
the advantages and disadvantages in the choice of transportation mode.

The following measures of effectiveness are:

1. Speed- immediate response and on- time delivery

2. Cost- the more urgent the delivery, the higher the cost
3. Reliability- is the quality of service rendered in terms of speed
a. The use of rail or train
Railroad is one of the most convenient means of transportation and is used
extensively in foreign countries. It is less costly in the transport of products from the
supplier to the customer as it carries more volume and faster. In the Philippine
setting, this mode of transportation is not very much used due to its unreliable
operation and limited destination.

b. Trucks and containerized van

The trucking industry in the Philippines is usually composed of a large number of
for- hire and private carriers usually own by brokerage companies. The trucking
industry controls mostly the shipment of imported and export goods from the pier and
vice versa. Some trucking companies are used for local deliveries of grocery
products, fruits and vegetables.

c. Water carriers or ships

Water carriers are either used locally for the import or export of goods as the
country is composed of several islands. The roll on- roll off vessels are used to
transport export and import products. The cargo vessels are excellent mode of
transport for large quantity low value bulk products.

d. Air cargo
Air cargo is used for high value product that needed to be received on time for
the processing of important component parts. Some electronic components of high value
are shipped through cargo forwarders in small containers. The speed in delivery is the
important consideration in use of these transport systems. The integrated air cargo
companies have air service related support and handle air cargo from origin to
destination.
TRANSPORT EVALUATION

Transportation cost consists of all direct charges associated with the movement of the
product from one location to another. To determine the significance of the mode of
transportation, it is necessary to identify the total cost involved. The most important criteria to
consider for transport selection are:

1. Competitive rates
2. Customer service
3. Transport reliability
4. Pick- up and delivery service
5. Availability of handling equipment
6. Geographic coverage
7. Billing accuracy
8. Insurance coverage and damage claim
9. Electronic data interchange for effective communication
The most recent trend in the selection process is to reduce the number of carriers. The
shipper gains competitive advantage over the carriers that usually results in lower cost and
higher quality of service. After selecting the most suitable carrier, the shipper has to identify
the type of cargo, the quantity involved, and the lead- time availability. Bigger volume
shipment needs to use containerized trucks for in land transport. For high value products for
foreign consignee, the air transport is the most appropriate choice. The shipper must
consistently evaluate the performance of the carriers based on the above criteria.

FREIGHT RATE DETERMINATION

The following factors are the determinants in the freight rate charges:

1. Shipping weight per cubic meters

2. Liability for damage
3. Perishable product needs refrigeration
4. Liability for damage to other commodities
5. Dangerous cargo that is subject to explosion
6. Susceptibility to theft
7. The value of the product
8. Loading and handling difficulty
9. Excessive length or weight
10. Trade condition to port destination
11. Quantity offered as a single consignment
12. Value of service
Negotiating the rate is a management process that involves planning, analysis and
reviewing past transactions. Negotiation activities are influenced by the characteristic of
current business trends and the individual frame of mind in the negotiation table. It is further
conditioned by the environmental factors of competition and technology. Competition is the
greatest factor that influences the rate charges.

The following terms must be understood before entering into an agreement

1. Prepaid- the shipper owns or pays for the freight

2. Collect- the consignee owns or pays for the freight
3. Prepaid/ Collect- a specified portion of the freight is paid by the shipper and the
balance to be paid by the consignee.
4. Prepay and add- the shippers advanced payment of the freight and collects later
to the consignee the additional expenses.
5. F.O.B Origin- the title of the merchandise passes to the consignee at the time of
pick up. The liability of the supplier is terminated when the merchandise is picked
up by the shipping organization.
6. F.O.B Destination- the title to the merchandise passes at the time and place of
delivery. The supplier’s liability is terminated only when the buyer receives the
merchandise.
7. Bill of lading- conveys the freight terms and conditions, and this acts as the
contract for carriage and receipt for delivery of the merchandise.