Wednesday, November 30, 2011

Inventory Management - Part II

In the last session we had learnt about Inventory related cost. In the internet a user has posted a query on the Inventory related cost. The site details are given below.

Now let us solve the query to understand the Inventory related cost working.

Q. How to Calculate ordering cost and inventory carrying cost in this example given below:

Purchasing department expenses Rs 200,000
Stores Personnel expenses Rs 200,000
Obsolescence Rs 60,000
Hire charges of warehouse Rs 140,000
Material handling in stores Rs 160,000
Cost of Bill Payment Rs 100,000
Insurance Charges 1%
Interest Charges 18%
Order Placed per year 5000
Average total inventory Rs. 200 lakhs

Inventory Carrying Cost

Stores Personnel expenses
Hire charges of warehouse
Material Handling in stores
Cost of Bill Payment

Inventory carrying rate = Total / Average total Inventory value
Ie Inventory carrying Rate = (6,60,000 / 200,00,000)*100 = 3.3%


Inventory carrying rate worked out = 3.3%
Insurance Charges                               = 1.0%
Interest charges                                   = 18.0%

Total Inventory carrying rate             = 22.3%

Inventory Carrying Cost = Total Inventory carrying rate (%) X Average Total Inventory Value
       = 22.3% X 20000000
       = (22.3/100)X20000000
       = Rs. 44,60,000

Ordering Cost

Purchase Department expenses = Rs. 200000
Order Placed per year = 5000 Nos

Ordering cost (in terms of one order) = Purchase Department expenses / No of order placed per year
     = 200000/5000
     = Rs.40

Inventory Management - Part I

Due to readers request, I am writing articles on Inventory Management  from the perspective of Supply Chain Management.  In the next few sessions, we will cover the followings on Inventory Management.

®     What is Inventory  & Types of Inventory

      ®     Inventory Related Cost

®     Selective Inventory Control method  (ABC / FSN / VED Analysis)

®     Terms used in Inventory and their  calculation methodology  (Cycle Inventory, Lot Size,  Economic Order Quantity (EOQ), Reorder Level (ROL), Safety Stocks etc)

®     Financial Terms related to Inventory management(Inventory Turn over Ratio, Working capital etc) for effective Inventory management and control

What is Inventory and Types of Inventory

Inventory  means the goods and services that businesses hold in stock, which are idle resources, to meet future demand.   The business keep the inventory which are idle resources for various reason like to meet the demand fluctuation /,  variation, Economy of Scale, Price discount etc.  For example you may require 500g of Surf Excel pack on monthly basis.  But HLL company is promoting 1 Kg Surf Excel with 30% extra, ie., 1300g Surf Excel at the rate of 1 Kg.  You indent to buy 1Kg Surf Excel with 30% Extra  for economy.    You fully aware of the fact that Surf Excel (1300g) inventory will last for next 2-1/2 months , but still you are planning to keep the inventory because of cost benefit.

There are  different  types of inventory. They are

Ø  Raw Materials and components. This usually consists of the essential items needed to create or make a finished product.  Example Mother board for a computer

Ø  WIP, or work in progress inventory in sub assemblies. This refers to items that are partially completed, but are not the entire finished product. Example Body of a Maruti Swift is WIP and when the same is fitted with Engine, Wheel and other components then it become finished product.

Ø  Finished goods. These are the final products that are ready to be purchased by consumers.

Please note that most people think of the finished goods like car as being part of an inventory stock, but the parts like tyre, tube, engine etc  that create them are held accountable in inventory as well.

Category of Inventory / Stock

Ø  Cycle Inventory that builds up in the supply chain because  company  either produces or purchases materials in lots or batch that are larger than those demanded by the customer.

Ø  Pipeline Inventory  which are In Process or Transit Stock.  The concept is similar to that of water pipeline where the water will flow in the tap only when the pipeline is filled with water.  If pipeline is lengthy, you require more water to get filled in the pipeline and it will take time to get water in the tap.  Similarly when a manufacturing process is lengthy you require more inventory to be filled in the sub assembly lines and it will take time to get the final product.  It is the process design and hence one cannot do anything in controlling the pipeline inventory, provided the top management is willing to redesign the manufacturing process which involves capital expenditure.

Ø  Safety Inventory to meet the uncertainties in Demand/Sales, Supply/Production and Lead time.

Ø  Seasonal Inventory.  Certain raw materials can be available only during some season.    For example Coca Cola company produces MAAZA mango drink.  Mango fruits are available in India only during summer season (April – July).  Hence the company will procure quality Mango during this season and manufacture mango drink to make available in all season.    

Inventory Related Cost

Ø  Inventory carrying cost -  This is the cost a business incurs over a certain period of time, to hold and store its inventory.  Carrying cost of inventory is often described as a percentage of the inventory value.  Carrying costs include storage costs, maintenance , Handling, insurance and other less tangible expenses, such as opportunity costs and losses due to theft. 

Even though calculating Inventory carrying cost is related to Finance, we can understand the same through simple illustration.

Amount (Rs.)/ Year
Warehouse Rent or Storage Cost for keeping inventory   
Administrative Expenses include maintenance
Obsolescence / Outdated
Breakage / Damage
Pilferage / Theft

Please note that obsolescence is common feature in Electronic Industry due to technology change or upgrade.  If you keep mobile stocks  in your warehouse for more than two year then you cannot sell those model in market  as it become outdated.

Divide the cost (Rs. 42500) which we have calculated above by Average Inventory value.  We will see how to calculate Average Inventory value in later session.  Let us assume the average inventory value is Rs. 5 Lac then the percentage is calculated as  Rs.42500/500000 which is 8.5%. 

With 8.5% you need to add opportunity cost, insurance and taxes in terms of percentages.  The opportunity cost is the expected reasonable  return or interest rate, if you invested  the money elsewhere. It could be fixed deposit in bank or government bond etc.  Let us assume opportunity cost or return is 6.5%.

Since you are keeping Inventory at godown you may insure the stocks .  In such cases you should include the insurance rate .  Let us assume insurance rate is 3%

Taxes is 4% (assumption).  Hence the inventory carrying rate works out to be 22% ie., 8.5+6.5+3+4. 

Now we can calculate Inventory carrying cost by multiplying average inventory value X Inventory carrying rate.  Average inventory value  is Rs. 500000 and Inventory carrying rate is 22% or 0.22.  Multiplying both we will get Rs. 1,10,000 as inventory carry cost.

Ø  Material Cost is derived by multiplying Annual Demand with Cost per unit.  For example Cadbury India expects 10 Lac units of Bournvita 500g bottle to be sold in the Market for the given year.  Each 500g bottle cost say Rs. 2/- and the material cost of 500g bottle is Rs. 20 Lac.

Ø  Ordering Cost is the total expenses incurred in placing one order.  The cost includes

v  cost of preparing a purchase order (clerical work of preparing, releasing, monitoring, and receiving orders) ie purchase department expenses in a year

v  Inbound logistics cost (Transportation charges and loading and unloading charges). 

v  Material Inspection cost

Ø  Shortage Cost is due to loss of sales.  Loss of sales occur when demand is more than supply.  Loss of sales include lost sales value and loss of good will (which is arbitrary in nature).  Hence we will not focus on shortage cost in our further discussion.

In the next session we will discuss about Selective Inventory control method like ABC , VED, FSN Analysis.

Friday, August 12, 2011

Logistics - Warehouse Management (Facility Design) - Part IV

In this session, we are focusing our attention to compute the storage space requirement of Finished Goods warehouse, which is slightly technical in nature. I am trying to explain the computation methodology in a lucid way so that even non technical people can understand the concepts clearly.

Once we understand this concept through simple example then we can explore more complex concept like Warehouse Layout Design in our subsequent session. Let us take GSK (Glaxosmithkline) Products (Horlicks, Boost and Junior Horlicks) to decide about warehouse storage space requirement. The data and example given below are hypothetical and not represent the actual GSK process.

Assumptions / basic input are given below

• GSK products are sold in cases/carton boxes only from their respective sales depot / warehouse to various distributors.
• Monthly sales pattern are more or less constant and volume of each products are given in cases as below
         o Horlicks           – 1500 cases / month
         o Boost               - 1100 cases / month
         o Junior Horlicks – 800 cases / month

• Carton / Case Size for each product is given below

From the above assumption / input, the SCM manager now need to compute the godown / warehouse approximate space or area requirement in terms of SQFT.

To facilitate blog readers to comprehend the concept easily, we give below the image of carton box with length, width and height.

Now we will get into calculation mode. The godown spaces/area requirements are expressed in SQFT (Square Feet). The area is getting calculated by multiplying Length and Width.

Carton box size are measured in Millie meter or centimeter or meter according to industry practice. In our example the carton box size are expressed in Millie meter (MM). Since you want to compute the godown area (Length x width) requirement in SQFT, we need to measure the area of each carton box basis its length(mm) and width(mm) and convert them into SQFT. For example each Horlicks carton box is having 420mm in length and 288mm in width. Hence area of each Horlicks carton box 120960 Square mm (length x width). If you convert 120960 Sq mm to Sq feet, you will get 1.3020 Sqft area. It means each Horlicks carton box occupy 1.3020 Sqft area. Now the question is how to convert Square millimeter to Square feet ? The users may use the site to do all area conversion work.

We have learnt that each Horlicks carton box occupy 1.3020 Sqft area. Now we need to consider the height of Horlicks carton box (531 mm which is 1.7421 feet) to decide how many carton boxes can be stacked on each other vertically. Manually operated godown can store carton boxes vertically up to 6 ft (182 cm) height so that workers can lift the carton box without much strain basis weight. Since each Horlicks carton box occupy 1.7421 feet height, they can store maximum of 4 carton boxes vertically.

In layman language, 1.3020 Sqft area can accomodate 4 cases of Horlicks vertically. In order to compute the area requirement of 1500 cases of Horlicks, we need to multiply 1.3020 with (1500/4) as we are going to store 4 cases of Horlicks on each other vertically. We require 488 Sqft area to store 1500 cases of Horlicks alone.  Similarly for Boost and Junior Horlicks also the products are stacked 4 cases on each other vertically. Hence stacking or storing norms plays important role in deciding warehouse space calculation.

Basis the above computation methodology, we have calculated the SQFT area requirement for each product and the same give below as table.

Incase if the warehouse operation is carried out through automation (using forklift) then company can decided to stack 10 cases on each other vertically in a steel rack using pallets and hence the SQFT area requirement will come down. But one must remember the other costs like Fork lift, steel rack, pallet, and aisle (passage area) for fork lift movement and reserve area for fork lift and pallets will go up.  Hence Facility design (Warehouse designing) should be done with utmost care after careful consideration of various cost involved.

So far, whatever we have learnt in Warehouse facility design is tip of the iceberg. We have not considered area requirement for aisles (passage area) for handling equipment movements, reserve area for keeping handling equipment, pallets  etc. In the next session we will explore more structured concepts in Facility layout design.