Uncertainty Demand

Chapter 7:
Inventory Decision Making
Learning Objectives
After reading this chapter, you should be able to do the following:

Understand the fundamental differences among approaches to managing inventory. Appreciate the rationale and logic behind the Economic Order Quantity (EOQ) approach to inventory decision making, and be able to solve some problems of a relatively straightforward nature. Understand alternative approaches to managing inventory --- JIT, MRP, and DRP.
Management of Business Logistics, 7th Ed. 2
Chapter 7
Learning Objectives
Realize how variability in demand and order cycle length affects inventory decision making. Know how inventory will vary as the number of stocking points decreases or increases. Recognize the contemporary interest in and relevance of time-based approaches to inventory management.
Chapter 7
Learning Objectives
Make needed adjustments to the basic EOQ approach to respond to several special types of applications.
Chapter 7
Management of Business Logistics, 7th Ed.
Fundamental Approaches to Managing Inventory
Basic issues are simplehow much to order and when to order. Additional issues arewhere to store inventory and what items to order. Traditionally, conflicts were usually presentas customer service levels increased, investment in inventory also increased. Recent emphasis is on increasing customer service and reducing inventory investment.
Chapter 7
Fundamental Approaches to Managing Inventory
Four factors might permit this apparent paradox, that is, the firm can achieve higher levels of customer service without actually increasing inventory: More responsive order processing Ability to strategically manage logistics data More capable and reliable transportation Improvements in the location of inventory
Chapter 7
Relationship between Inventory and Customer Service Level

Figure 7-1
Chapter 7
Key Differences among Approaches to Managing Inventory
Dependent versus Independent Demand Dependent demand is directly related to the demand for another product. Independent demand is unrelated to the demand for another product. For many manufacturing processes, demand is dependent. For many end-use items, demand is independent.
Chapter 7
Of the inventory management processes in this chapter, JIT, MRP and MRPII are generally associated with items having dependent demand. Alternatively, DRP and the EOQ models are generally associated with items exhibiting independent demand.
Chapter 7
Pull versus Push Pull approach is a reactive system, relying on customer demand to pull product through a logistics system. MacDonalds is an example. Push approach is a proactive system, and uses inventory replenishment to anticipate future demand. Catering businesses are examples of push systems.
Chapter 7
Pull versus Push Pull systems respond quickly to sudden or abrupt changes in demand, involve one-way communications, and apply more to independent demand situations. Push systems use an orderly and disciplined master plan for inventory management, and apply more to dependent demand situations.
Chapter 7
On the Line:
American Cancer Society
ACS constructed a world class automated order fulfillment center in Atlanta. Order cycle time was reduced to five business days. Centralized storage reduced waste and obsolescence of educational materials. Centralized shipment reduced freight rates. The new center saved $8 million in the first year alone.
Chapter 7 Management of Business Logistics, 7th Ed. 12
Fixed Order Quantity Approach (Condition of Certainty): Inventory Cycles
In this example, each cycle starts with 4,000 units: Demand is constant at the rate of 800 units per day. When inventory falls below 1,500 units, an order is placed for an additional 4,000 units. After 5 days the inventory is completely used. Just as the 4,000th unit is sold, the next order of 4,000 units arrives and a new cycle begins.
Fixed Order Quantity Model under the Condition of Certainty

Figure 7-2
Chapter 7
14
Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model
Simple EOQ Model Assumptions

Chapter 7
Continuous, constant, known and infinite rate of demand on one item of inventory. A constant and known replenishment time. Satisfaction of all demand. Constant cost, independent of order quantity or time. No inventory in transit costs. No limits on capital availability.
Simple EOQ Model Variables

R = annual rate of demand Q = quantity ordered (lot size in units) A = order or setup cost V = value or cost of one unit in dollars W = carrying cost per dollar value in percent S = VW = annual storage cost in $/unit per year t = time in days TAC = total annual costs in dollars per year
Chapter 7
Figure 7-3
Inventory Carrying Cost
Chapter 7
17
Figure 7-4
Order or Setup Cost
Chapter 7
18
Figure 7-5
Inventory Costs
Chapter 7
19

TAC = QVW + AR 2 Q or TAC = QS + AR 2 Q
First term is the average carrying cost Second term is order or setup costs per year
Chapter 7
20
Figure 7-6
Sawtooth Model
Chapter 7
21

TAC = QVW + AR 2 Q or TAC = QS + AR 2 Q
Solving for Q gives the following expressions:
Q=
2 RA
or Q = VW or S
2RA
VW
or Q =
2RA
S
22
Chapter 7

Where R = 3600 units V = $100; W = 25%; S (or VW)= $25; A = $200 per order Q=
2 RA
VW or S
or
Q=
2RA
VW
or
Q=
2RA
S
2*3600*$200 2*3600*$200
$100*25%
Q = 240 units
Chapter 7
$25
Q = 240 units
23
Figure 7-7
Sawtooth Models
Chapter 7
24
Table 7-1
Total Costs for Various EOQ Amounts
Chapter 7
25
Figure 7-8 Graphical Representation of
the EOQ Example
Chapter 7
26
Fixed Order Quantity Approach (Condition of Certainty)
Summary and Evaluation of the Fixed Order Quantity Approach:

EOQ is a popular inventory model. EOQ doesnt handle multiple locations as well as a single location. EOQ doesnt do well when demand is not constant. Minor adjustments can be made to the basic model. Newer techniques will ultimately take the place of EOQ.
Fixed Order Quantity Approach (Condition of Uncertainty)
Uncertainty is a more normal condition. Demand is often affected by exogenous factors---weather, forgetfulness, etc. Lead times often vary regardless of carrier intentions. Examine out Figure 7-9. Note the variability in lead times and demand.
Chapter 7
Figure 7-9 Fixed Order Quantity Model
under Conditions of Uncertainty
Chapter 7
29
Reorder Point A Special Note With uncertainty of demand, the reorder point becomes the average daily demand during lead time plus the safety stock. Examine Figure 7-9 again.
Chapter 7
30
Uncertainty of Demand Affects Simple EOQ Model Assumptions:

a constant and known replenishment time. constant cost/price, independent of order quantity or time. no inventory in transit costs. one item and no interaction among the inventory items. infinite planning horizon. no limit on capital availability.
Chapter 7
Table 7-2 Probability Distribution
of Demand during Lead Time

Demand 100 units 110 120 130 140 Probability 0.01 0.06 0.24 0.38 0.24
150
160
Chapter 7
0.06
0.01
Table 7-3 Possible Units of Inventory
Short or in Excess during Lead Time with Various Reorder Points

Actual Demand 100 100 0 110 -10 120 -20 130 -30 140 -40 150 -50 160 -60
Chapter 7
110 10
0 -10 -20 -30 -40 -50
Reorder Points 120 130 140 20 30 40 10 20 30 0 10 20 -10 0 10 -20 -10 0 -30 -20 -10 -40 -30 -20
150 50
160 60
40 30 20 10 0 -10
50 40 30 20 10 0
33
Table 7-3 Possible Units of Inventory
Short or in Excess during Lead Time with Various Reorder Points

Actual Demand Probability
Reorder Points 100 0.0 -0.6 110 0.1 0 120 0.2 0.6 130 0.3 1.2 140 0.4 1.8 150 0.5 2.4 160 0.6 3.0
100 110
0.01 0.06
120
130
0.24
0.38
-4.8
-11.4
-2.4
-7.6
0
-3.8
2.4
0
4.8
3.8
7.2
7.6
9.6
11.4
140
150
0.24
0.06
-9.6
-3.0
-7.2
-2.4
-4.8
-1.8
-2.4
-1.2
th
0
-0.6
2.4
0
4.8
0.6
160 7 0.01 Chapter
-0.6 -0.5 of Business Logistics, 7 -0.2 -0.4 -0.3 Ed. Management
-0.1
34
Table 7-4 Calculation of Lowest-Cost Reorder Point Dmnd (e) (VW) (g) G=gw GR/Q TAC 100 0.0 0 30 $300 110 0.1 $2.50 20.1 $201 120 0.8 $20 10.8 $108 130 3.9 $97.50 3.9 $39 $585 140 10.8 150 20.1 160 30.0
$270 $502.50 $750 0.8 $8 $120 0.1 $1 $15 0.0 $0 $0
$4500 $3015 $1620
$4500 $3018 $1640 $682.50 $390 $517.50 $750

Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model

Where R = 3600 units V = $100; W = 25%; A = $200 per order; G = 8 Q=
2 R(A + G)
VW
2 * 3600 * ($200 + 8)
$100 * 25%
Q = approximately 242 units
Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model

Where R = 3600 units V = $100; W = 25%; A = $200 per order; G = 8; Q = 242; e = 10.8
TAC = QVW + AR + eVW + GR 2 Q Q TAC = (242*$100*25%) + (200*3600) + (10.8*$100*25%) + (8*3600) 2 242 242 TAC = TAC = $3025 + $2975 + $270 + $119
$6389 (New value for TAC when uncertainty introduced)

Chapter 7
Fixed Order Quantity Approach (Condition of Uncertainty): Conclusions
Following costs will rise to cover the uncertainty: Stockout costs. Inventory carrying costs of safety stock Results may or may not be significant. In text example, TAC rose $389 or approximately 6.5%. The greater the dispersion of the probability distribution, the greater the cost disparity.
Chapter 7
Figure 7-10
Area under the Normal Curve
Chapter 7
39
Table 7-5 Reorder Point Alternatives and
Stockout Possibilities
Chapter 7
40
Fixed Order Interval Approach

A second basic approach Involves ordering at fixed intervals and varying Q depending upon the remaining stock at the time the order is placed. Less monitoring than the basic model Examine Figure 7-11. Amount ordered over each five weeks in the example varies each week.
Chapter 7
Figure 7-11 Fixed Order Interval Model
(with Safety Stock)
Chapter 7
42
Summary and Evaluation of EOQ Approaches to Inventory Management
Four basic inventory models:

Fixed quantity/fixed interval Fixed quantity/irregular interval Irregular quantity/fixed interval Irregular quantity/irregular interval
Where demand and lead time are known, basic EOQ or fixed order interval model best. If demand or lead time varies, then safety stock model should be used
Relationship to ABC analysis A items suited to a fixed quantity/irregular interval approach. C items best suited to a irregular quantity/fixed interval approach. Importance of trade-offs Familiarity with EOQ approaches assists the manager in trade-offs inherent in inventory management.
Chapter 7
New concepts JIT, MRP, MRPII, DRP, QR, and ECR also take into account a knowledge and understanding of applicable logistics trade-offs. Number of DCs The issue of inventory at multiple locations in a logistics network raises some interesting questions concerning the number of DCs, the SKUs at each, and their strategic positioning.
Chapter 7
Additional Approaches to Inventory Management
Three approaches to inventory management that have special relevance to supply chain management: JIT (Just in Time) MRP (Materials Requirements into Planning) DRP (Distribution Resource Planning)
Chapter 7
46
Time-Based Approaches to Replenishment Logistics: JIT
Definition and Components of JIT Systems - designed to manage lead times and eliminate waste. Kanban - refers to the informative signboards on carts in a Toyota system of delivering parts to the production line. Each signboard details the exact quantities and necessary time of replenishment. JIT operations - Kanban cards and light warning system communicate possible production interruptions. Fundamental concepts - JIT can substantially reduce inventory and related costs.
Chapter 7
Definition and Components of JIT Systems designed to manage lead times and eliminate waste. Goal is zero inventory, and zero defects. Similarity to the two-bin system - one bin fills demand for part, the other is used when the first is empty. Reduces lead times through requiring small and frequent replenishment.
Chapter 7
JIT is a widely used and effective strategy for managing the movement of parts, materials, semi-finished products from points of supply to production facilities. Product should arrive exactly when a firm needs it, with no tolerance for early or late deliveries. JIT systems place a high priority on short, consistent lead times.
Chapter 7
JIT versus EOQ Approaches to Inventory Management
Six major differences: First, JIT attempts to eliminate excess inventories for both buyer and seller. Second, JIT systems involve short production runs with frequent changeovers. Third, JIT minimizes waiting lines by delivering goods when and where needed.
Chapter 7
JIT versus EOQ Approaches to Inventory Management
Fourth, JIT uses short, consistent lead times to satisfy inventory needs in a timely manner. Fifth, JIT relies on high-quality incoming products and on exceptionally high-quality inbound logistics operations. Sixth, JIT requires a strong, mutual commitment between buyer and seller, emphasizing quality and win-win outcomes for both partners.
Chapter 7
Table 7-6 EOQ versus JIT Attitudes and
Behaviors
Chapter 7
52
JIT versus Traditional Inventory Management Reduces excess inventories Shorter, more frequent production runs Minimize waiting lines by delivering materials when and where needed Short, consistent lead times through proximate location Quality stressed throughout supply chain Win-win relationships necessary to a healthy supply chain
Examples of JIT Successes:
Apple Computers increase in IT from 10 weeks to 2 weeks resulted in 18-month $20 million payback on plant. GM increased production by 100%, but inventories increased by only 6%. Norfolk Southern mini-train hauls direct from one GM plant to another without switching delays. Ryder handles all inbound logistics for Saturn.
Chapter 7
Figure 7-12
The Orderly Pickup Concept
Chapter 7
55
Time-Based Approaches to Replenishment Logistics: MRP
A Materials Requirements Planning (MRP) system consists of a set of logically related procedures, decision rules, and records designed to translate a master production schedule into time-phased net inventory requirements for each component item needed to implement this schedule. MRPs re-plan net requirements based on changes in schedule, demand, etc.
Chapter 7
Goals of an MRP: Ensure the availability of materials, components, and products for planned production. Maintain lowest possible inventory level. Plan manufacturing activities, delivery schedules, and purchasing activities.
Chapter 7
Key elements of an MRP: Master production schedule Bill of materials file Inventory status file MRP program Outputs and reports
Chapter 7
58
Figure 7-13
An MRP System
Customer Orders Master Production Schedule Bill of Material File Demand Forecasts
MRP Program
Output and Reports
Inventory Status File
Chapter 7
59
Figure 7-14 Relationship of Parts to Finished Product: MRP Egg Timer Example
1 Egg Timer 2 Ends 1 Bulb 1 Gram of Sand 3 Supports
Chapter 7
60
Table 7-7 Inventory Status File:
MRP Egg Timer Example

Product
Egg Timers Ends Supports Bulbs Sand
Chapter 7
Gross Req. Inventory

1 2 3 1 1 0 0 2 0 0
Net Req.
1 2 1 1 1
Lead Time
1 5 1 1 4
61
Master Schedule: MRP Egg Timer Example

Figure 7-15
Chapter 7
62
Principal advantages of MRP: Maintain reasonable safety stock. Minimize or eliminate inventories. Identification of process problems. Production schedules based on actual demand. Coordination of materials ordering. Most suitable for batch or intermittent production schedules.
Chapter 7
Principal shortcomings of MRP: Computer intensive. Difficult to make changes once operating. Ordering and transportation costs may rise. Not usually as sensitive to short-term fluctuations in demand. Frequently become quite complex. May not work exactly as intended.
Chapter 7
Time-Based Approaches to Replenishment Logistics: Distribution Resource Planning
MRP sets a master production schedule and explodes into gross and net requirements. DRP starts with customer demand and works backwards toward establishing a realistic system-wide plan for ordering the necessary finished products. Then DRP works to develop a time-phased plan for distributing product from plants and warehouses to the consumer.
Time-Based Approaches to Replenishment Logistics: Distribution Resource Planning
DRP develops a projection for each SKU and requires17: Forecast of demand for each SKU. Current inventory level for each SKU. Target safety stock. Recommended replenishment quantity. Lead time for replenishment.
Chapter 7
66
Table 7-8 DRP Table for
Chicken Noodle Soup

Month Week CN Soup Forecast Schedule Receipt 1
974 0
Columbus Distribution CenterDistribution Resource Planning

January 2
974 0
February 4
974 0
March 8
1002 0 4023 0
3
974 3800
5
989 0
6
1002 0
7
1002 3800 5025 0
9
1061 0 2962 3800
67
Current BOH=4314; Q=3800; SS=1956; LT=1
BOH-End 3340 2366 5192 4218 3229 2227
Planned Order
Chapter 7
3800
3800
Figure 7-16
Combining DRP Tables
Chapter 7
68
Inventory at Multiple Locations
The Square Root Law (SQL)

Used to reduce inventory at multiple locations. As locations increase, inventory also increases, but not in the same ratio as the growth in facilities. The square root law (SRL) states that total safety stock can be approximated by multiplying the total inventory by the square root of the number of future facilities divided by the current number of facilities.
Chapter 7
Inventory at Multiple Locations
The Square Root Law

X2= (X1) * (n2/n1) Where: n1 = number of existing facilities n2 = number of future facilities X1 = total inventory in existing facilities X2 = total inventory in future facilities
Chapter 7
70
Square Root Law Example

Current distribution 40,000 units Eight facilities shrinking to two Using the square root law:

X2 = (40,000) *
(2/8)
X2 = 20,000 units
Chapter 7
71
Table 7-9 Example Impacts of Square Root Law
on Logistics Inventories
Warehouses 1 2 3 4 5 10 15 n 1.0000 1.4142 1.7321 2.0000 2.2361 3.1623 3.8730
Total Av Inv 3,885 5,494 6,729 7,770 8,687 12,285 15,047
% Change --141% 173% 200% 224% 316% 387%
20 23 25
Chapter 7
4.4721 4.7958 5.0000
17,374 18,632 19,425
447% 480% 500%

72
Four Directions for Replenishment Logistics

Figure 7-17
Chapter 7
73
Time-Based Approaches to Replenishment Logistics: Quick Response (QR)
Structure of QR Shorter, compressed time horizons. Real-time information available by SKU. Seamless, integrated logistics networks with rapid transportation, cross-docking and effective store receipt and distribution systems.
Chapter 7
74
Time-Based Approaches to Replenishment Logistics: Quick Response (QR)
Structure of QR Partnership relationships present among supply chain members. Redesign of manufacturing processes to reduce lot sizes, changeover times and enhanced flexibility. Commitment to TQM.
Chapter 7
75
Figure 7-18
Basic Elements of Quick Response (QR)
Chapter 7
76
Time-Based Approaches to Replenishment Logistics: Efficient Consumer Response (ECR)
Structure of ECR
Grocery industry estimates U.S. savings at approximately $30 billion. Ultimate goal is a responsive, consumer-driven system in which distributors and suppliers work together as business allies to maximize consumer satisfaction and minimize cost. Accurate information and high-quality products flow through a paperless system between manufacturing and check-out counter with minimum degradation or interruption
Chapter 7
Figure 7-19 Efficient Consumer
Response: Broad Operating Capabilities Tailored to Each Unique Partner
Chapter 7
78
Chapter 7: Summary and Review Questions

Students should review their knowledge of the chapter by checking out the Summary and Study Questions for Chapter 7. This is the last slide for Chapter 7
Figure A7-1 Sawtooth Model Modified for
Inventory in Transit
Chapter 7
80
Figure A7-2 EOQ Costs Considering
Volume Transportation Rate
Chapter 7
81
Table 7A-1 Annual Savings, Annual Cost,
and Net Savings by Various Quantities Using Incentive Rates
Chapter 7
82
Figure A7-3 Net Savings Function for
Incentive Rate
Chapter 7
83
End of Chapter 7 and 7A Slides

Inventory Decision Making

Uncertainty Demand

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Chapter 7:

Inventory Decision Making

After reading this chapter, you should be able to do the following:

Management of Business Logistics, 7th Ed.

Fundamental Approaches to Managing Inventory

Fundamental Approaches to Managing Inventory

Relationship between Inventory and Customer Service Level

Management of Business Logistics, 7th Ed.

Key Differences among Approaches to Managing Inventory

Key Differences among Approaches to Managing Inventory

Management of Business Logistics, 7th Ed.

Key Differences among Approaches to Managing Inventory

Key Differences among Approaches to Managing Inventory

American Cancer Society

Fixed Order Quantity Approach (Condition of Certainty): Inventory Cycles

Fixed Order Quantity Model under the Condition of Certainty

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model

Simple EOQ Model Assumptions

Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model

Simple EOQ Model Variables

Inventory Carrying Cost

Management of Business Logistics, 7th Ed.

Order or Setup Cost

Management of Business Logistics, 7th Ed.

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model

Management of Business Logistics, 7th Ed.

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model

Solving for Q gives the following expressions:

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model

Management of Business Logistics, 7th Ed.

Management of Business Logistics, 7th Ed.

Total Costs for Various EOQ Amounts

Management of Business Logistics, 7th Ed.

Figure 7-8 Graphical Representation of

the EOQ Example

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Certainty)

Summary and Evaluation of the Fixed Order Quantity Approach:

Fixed Order Quantity Approach (Condition of Uncertainty)

Figure 7-9 Fixed Order Quantity Model

under Conditions of Uncertainty

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Uncertainty)

Management of Business Logistics, 7th Ed.

Fixed Order Quantity Approach (Condition of Uncertainty)

Uncertainty of Demand Affects Simple EOQ Model Assumptions:

Table 7-2 Probability Distribution

of Demand during Lead Time

Table 7-3 Possible Units of Inventory

Short or in Excess during Lead Time with Various Reorder Points

0 -10 -20 -30 -40 -50

Management of Business Logistics, 7th Ed.

Table 7-3 Possible Units of Inventory

Short or in Excess during Lead Time with Various Reorder Points

160 7 0.01 Chapter

-0.6 -0.5 of Business Logistics, 7 -0.2 -0.4 -0.3 Ed. Management

$270 $502.50 $750 0.8 $8 $120 0.1 $1 $15 0.0 $0 $0

$4500 $3015 $1620

$4500 $3018 $1640 $682.50 $390 $517.50 $750

Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model