Inventory vs. Material Costs
Inventory vs. Material Costs
Quickly decide whether the relative costs justify any further analysis
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Inventory Primer
People often refer to three types of inventory: pipeline inventory, cycle stock inventory, and safety stock inventory.
- Pipeline is the inventory that you’re responsible for (if any) over the lead time. It is sometimes called inbound inventory.
- Cycle stock is the inventory used to satisfy average customer demand in-between supplier deliveries. It is sometimes called working inventory.
- Safety stock inventory is used to “insure” against demand and supply uncertainty. It is sometimes called buffer inventory.
Inventory levels are determined by three main factors: customer behavior, supplier performance, and operating policies.
| Customer Driven Factors | Supplier Driven Factors | Policy Driven Factors |
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Eliminating All the Inventory
Say you’ve got a design idea that will reduce inventory levels. How much is it worth? Well, as an absolute upper limit on its value, imagine that it could eliminate all inventory! This is the most that you would be willing to pay to pursue an idea.
- If the idea costs more than the savings, it probably won’t pay for itself
- If the idea costs less than the savings, you should do a little more analysis by using the next set of calculators (commonality or supplier selection)
How would you eliminate all inventory? By eliminating pipeline and cycle stock and safety stock inventory. How would you eliminate each? Here are some examples.
- Pipeline inventory: don’t take ownership of the components until you get them, or use suppliers with zero lead times
- Cycle stock inventory: use suppliers with true “just-in-time” deliveries (essentially an infinite delivery frequency)
- Safety stock inventory: no forecast errors and no lead time uncertainty, or zero lead times and continuous inventory review, or 50% target service levels
See below for a more detailed description of all the parameters used in this calculator.
To use the calculator, simply change one or more of the blue numbers and then click the Calculate button.
| Inventory Carrying Costs | ||
| Annual holding cost (h) | (%) | |
| Inventory cost (c) | ($/unit) | |
| Pipeline Inventory | ||
| Responsible for pipeline? | ||
| Cycle Stock | ||
| Delivery frequency (f) | (times per week) | |
| Safety Stock | ||
| Target service level (SL) | ||
| Forecast error (fe) | (%) | |
| Lead time (L) | (weeks) | |
| Lead time uncertainty (lu) | (%) | |
| Review period (R) | (weeks) | |
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| What is the total cost of holding safety stock and cycle stock inventory? | ||
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Inventory cost |
($/unit/WOS) | |
| Pipeline Inventory (P) | (WOS) | |
| Cycle stock (CS) | (WOS) | |
| Safety stock (SS) | (WOS) | |
| Total inventory | (WOS) | |
| Inventory cost | ($/unit) | |
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Do the relative costs justify further analysis?
If you were able to decrease inventory to zero, it might be worth spending as much as $/unit more in material costs. For a material cost savings of $/unit, you could afford to carry an additional WOS of inventory.
This may allow you to increase your service levels to % or more. |
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Note: These calculators were created to facilitate rapid analysis of DFSC decisions. Although these calculators make simplifying assumptions, they have proved useful in practice. For complex trade-offs of additional cost factors or for especially important decisions, you may want to perform a more detailed analysis.
Inventory Parameters:
- Demand: Mean demand or consumption at an inventory stockpile (units/week).
- Forecast error (fe): Standard deviation of the difference between forecasted and actual customer orders, divided by the mean demand. This ratio is sometimes also called coefficient of variation (CoV).
- Lead time (L): Mean lead time to replenish product into an inventory stockpile (weeks).
- Pipeline inventory: The inventory that you’re responsible for (if any) from the time you place an order to the time you receive the components.
- Generally, if you pay for the components when you place the order, you are responsible for pipeline inventory. If you pay when you receive the order, you are not. Of course, payment terms and return policies complicate this distinction.
- Lead time uncertainty (lu): Standard deviation of replenishment lead time divided by the mean lead time.
- Component yield (y): Probability that a component is not defective or unusable when it arrives from a supplier.
- Target service level (SL): The desired percentage of demand periods where there are no stock-outs. It is sometimes called availability rate. Depending on the target service level, safety stock is scaled up or down by a factor “k.”
- Delivery frequency (f): The frequency of replenishment deliveries from suppliers (times/week). In some cases, suppliers may be upstream assembly processes.
- Review period (R): The period of time in-between physical review of inventory stockpiles (weeks). It is assumed that replenishment orders are placed after each inventory review. For continuous review systems, R is zero.
- Inventory cost (c): The current cost of the inventory, including material costs and any incremental value-add ($/unit).
- Annual inventory holding cost (h): Expressed as a percentage of inventory cost, the annual inventory holding cost typically includes financing, storage, devaluation, and scrap.
- Inventory weeks of supply: Inventory units divided by the mean weekly demand (WOS).