Unit 2 Management of Conversion System Chapter 10: Inventory Management Lesson 29 - Inventory Management – Basic EOQ model Learning Objectives

After reading this lesson you would be able to understand Importance of inventory management Different types of inventory Classifying different types of inventory Optimal ordering quantity Good Morning students, today we are going to introduce the concept of what is known as Inventory Management. We will explore various approaches to Inventory Management and focuses on its importance as an indispensable tool in Production and operations management. Well dear students, all of us, I guess has a fair bit of an idea about what inventory is all about. I don’t know about your answer, but as far as I am concerned, this class has an abundant inventory of, what you call the skill set and talent i.e. the human capital.

Please allow me to focus on the job at hand in a better and organized manner. Inventory management Inventory management is an important concern for all managers. Inventory is created when the receipt of materials, parts, or finished goods exceeds their disbursement. It is depleted when their disbursement exceeds their receipt. Inventory can serve important functions that add flexibility to the operations of a firm. Well, what about the uses of inventory? Any answers around here? Inventory-uses Six uses of inventory are: 1. To provide a stock of goods to meet anticipated demand by customers. 2. To decouple production from distribution. For example, if product demand is high only during the summer, a firm may build up stock during the winter and thus avoid the costs of shortages and stockouts in the summer. Similarly, if a firm’s supplies fluctuate, extra raw materials of inventory may be needed to “decouple” production processes. 3. To take advantage of quantity discounts, since purchases in larger quantities can substantially reduce the cost of goods. 4. To hedge against inflation and price changes.

5. To protect against shortages that can occur due to weather, supplier shortages, quality problems, or improper deliveries. “Safety stocks”, namely, extra goods on hand, can reduce the risk of stockouts. 6. To permit operations to continue smoothly with the use of “work-in-process” inventory. This is because it takes time to make goods and because a pipeline of inventories are stocked throughout the process. Let us now try to find dome basis for proper categorization of inventory. Types of inventory There are four types of inventories generally a firm maintains. These are:(1) raw material inventory, (2) work-in-process inventory, (3) maintenance/repair/operating supply (MRO) inventory, and (4) finished goods inventory. Raw material inventory has been purchased, but not processed. The items can be used to separate suppliers from the production process. Work-in-process (WIP) inventory has undergone some change but is not completed. WIP exists because

of the time it takes for a product to be made (called cycle time). Reducing the cycle time reduces inventory. MROs are inventories devoted to maintenance/repair/operating supplies. They exist because the need and timing for maintenance and repair of some equipment are unknown. Finished goods inventory is completed and awaiting shipment. Finished goods may be inventoried because customer demands for a given time period may be unknown. We are now going to look at Inventory management again with a much broader perspective. Inventory managementOperations managers establish systems for managing inventory. First step is to classify inventory items. Thousands of items are held in inventory by a typical organization, but only a small percentage of need management’s closest attention and tightest control. ABC analysis is the process of dividing items into three classes according to their value (rupee usage) so that managers can focus on items that have the highest value. This method is the equivalent of creating a Pareto chart except that it is applied to inventory rather than quality. The Pareto principle states that there are a “critical few and trivial many”. The idea is to focus resources on the few critical inventory parts and

not the many trivial ones. Figure 10.1 shows, class A items typically represent only about 20 percent of the items but account for 80 percent of the rupee usage. Class B items account for another 30 percent of the items but only 15 percent of the rupee usage. Finally, 50 percent of the items fall in class C, representing a mere 5 percent of the rupee usage.

Fig Graphic representation of ABC analysis The goal of ABC analysis is :to identify the inventory levels of class A items and enable management to control them tightly by using the levels as discussed. To determine annual rupee volume for ABC analysis,

we measure the annual demand of each inventory item times the cost per unit. Dear friends, let us examine our conceptual understanding now. With the help of an example, let us understand how the ABC analysis is done. Example 10.1 The maintenance department for a small manufacturing firm has responsibility for maintaining an inventory of spare parts for the machinery it services. The parts inventory, unit cost, and annual usage are as follows. Part 1 2 3 4 5 6 7 8 9 Unit Cost (Rs) 60 350 30 80 30 20 10 320 510 Annual Usage 90 40 130 60 100 180 170 50 60




The department manager wants to classify the inventory parts according to the ABC system in order to determine which stocks of parts should most closely be monitored The first step is to rank the items according to their total value and also compute each item’s percentage value and quantity. Part Total Value (Rs) 9 8 2 1 4 3 6 5 10 7 30,600 16,000 14,000 5,400 4,800 3,900 3,600 3,000 2,400 1,700 85,400 35.9 18.7 16.4 6.3 5.6 4.6 4.2 3.5 2.8 2.0 6.0 5.0 4.0 9.0 6.0 10.0 18.0 13.0 12.0 17.0 6.0 11.0 15.0 24.0 30.0 40.0 58.0 71.0 83.0 100.0 % Value % Quantity % Cumulative

Making an intuitive judgment, it appeared that the first three items form a group with the highest value, the next three items form a second group, and the last four items constitute a group. Thus, the ABC classification for these items is as follows. Class A B C Items 9, 8, 2 1, 4, 3 6, 5, 10, 7 % Value 71.0 16.5 12.5 % Quantity 15.0 25.0 60.0

Criteria other than annual dollar volume can determine item classification. For instance, anticipated engineering changes, delivery problems, quality problems, or high unit cost may dictate upgrading items to a higher classification. The advantage of dividing inventory items into classes allows policies and controls to be established for each class. Can anyone tell the class what factors influence the choice of this form of analysis? O.K.Let me help you with this one. Policies that may be based on ABC analysis include the following:

1. The purchasing resources expended on supplier development should be much higher for individual A items than for C items. 2. A items, as opposed to B and C items, should have tighter physical inventory control. 3. Forecasting A items may warrant more care than forecasting other items. Dear friends, at this juncture, let me tell you that the management of service inventories needs some special considerations. Although we tend to think of services as not having inventory, that is not the case. For instance, extensive inventory is held in wholesale and retail businesses, making inventory management crucial. In the food service business, for example, control of inventory can make the difference between success and failure. Moreover, inventory that is in transit or idle in a warehouse is lost value. Similarly, inventory which is damaged or stolen prior to sale is a loss. The impact on profitability is substantial, consequently inventory accuracy and control is critical. The applicable techniques include:

1. Good personnel selection, training, and discipline. These are never easy, but very necessary in food service, wholesale, and retail operations where employees have access to directly consumable merchandise. 2. Tight control of incoming shipments. This is being addressed by many firms through the use of bar-code systems that read every incoming shipment and automatically check the tallies against the purchase order. When properly designed, these systems are very hard to defeat. 3. Effective control of all goods leaving the facility. This is done with bar codes or items being shipped, personnel stationed at the exits and in potentially high-loss areas. We will now examine a variety of inventory models and the costs associated with them. Let us begin. Inventory models Inventory control models assume that demand for an item is independent of, or dependent on, the demand for other items. For example, the demand for refrigerators is independent of the

demand for toaster ovens. However, the demand for toaster oven components is dependent on the production requirements of toaster ovens. Here we will concentrate on managing independent demand items. Holding, ordering, and setup costs Holding costs are the costs associated with holding or carrying inventory over time. Therefore, holding costs also include costs related to storage, such as insurance, extra staffing, and interest payments. Table 10.1 shows the kinds of costs that need to be evaluated to determine holding costs. Table 10.1 Determining inventory holding costs Category Housing costs, such as building rent, depreciation, operating cost, taxes, insurance Material handling costs, including equipment, lease or depreciation, power, operating cost 3% (1 – 3.5%) Cost as a percent of inventory value 6% (3 – 10%)

Labour cost from extra handling Investment costs, such as borrowing costs, taxes, and insurance on inventory Scrap and obsolescence Overall carrying cost

3% (3 – 5%) 11% (6 – 24%) 3% (2 – 5%) 26%

Ordering cost Ordering cost includes costs of supplies, forms, order processing, clerical support, and so forth. When orders are being manufactured, ordering costs also exist, but they are known as setup costs. Setup cost is the cost to prepare a machine or process for manufacturing an order. In many environments setup cost is highly correlated with setup time. Setup usually requires a substantial amount of work prior to an operation actually being accomplished at the work center.

Inventory models for independent demand Here we will introduce three inventory models that address two important questions: when to order and How much to order. These independent demand models are: 1. Basic economic order quantity (EOQ) model 2. Production order quantity model 3. Quantity discount model

Figure 29.1 Inventory usage over time The basic economic order quantity model The economic order quantity (EOQ) is one of the oldest and most commonly known inventory control techniques. This technique is relatively easy to use but is based on several assumptions:

1. Demand is known and constant 2. Lead time, that is, the time between the placement of the order and the receipt of the order, is known and constant 3. Receipt of inventory is instantaneous. In other words, the inventory from an order arrives in one batch, at one time 4. Quantity discounts are not possible 5. The only variable costs are the cost of setting up or placing an order (setup cost) and the cost of holding or storing inventory over time (holding or carrying cost) 6. Stockouts (shortages) can be completely avoided if orders are placed at the right time Figure 29.1 shows the inventory usage over time under these assumptions. Q represents the amount that is ordered. If this amount is 500 dresses, all 500 dresses arrive at one time (when an order is received). Thus, the inventory level jumps from 0 to 500 dresses. In general, an inventory level increases from 0 to Q units when an order arrives. Because demand is constant over time, inventory drops at a uniform rate over time. When the inventory level reaches 0 the new order is placed and received, and the inventory level again jumps to Q units. This process continues indefinitely over time.

The objective of most inventory models is to minimize the total costs. Under the assumptions considered, the significant costs are the setup (or ordering) cost and the holding (or carrying) cost. All other costs, such as the cost of the inventory itself, are constant. Thus, if we minimize the sum of the setup and holding costs, we will also be minimizing the total costs. Figure 10.2 illustrates total cost as a function of order quantity, Q. The optimal order size, Q*, will be the quantity that minimizes the total costs. As the quantity ordered increases, the total number of orders placed per year will decrease. Thus, as the quantity ordered increases, the annual setup or ordering cost will decrease. But as the order quantity increases, the holding cost will increase due to larger average inventories that are maintained. The optimal order quantity occurred at the point where the ordering cost curve and the carrying cost curve intersected. With the EOQ model, the optimal order quantity will occur at a point where the total setup cost is equal to the total holding cost. The necessary steps in developing the model are: 1. Develop an expression for setup or ordering cost 2. Develop an expression for holding cost 3. Set setup cost equal to holding cost 4. Solve the equation for the best order quantity

Using the following variables we can determine setup and holding costs and solve for Q*: Q = Number of pieces per order Q* = Optimum number of pieces per order (EOQ) D = Annual demand in units for the inventory item S = Setup or ordering cost for each order H = Holding or carrying cost per unit per year 1. Annual setup cost = Number of orders placed per year x Setup or order cost per each order) x Setup or order cost per order = (D / Q) S 2. Annual holding cost = Average inventory level x Holding cost per unit per year = (Order quantity / 2) Holding cost per unit per year = (Q / 2) H 3. Optimal order quantity is found when annual setup cost equals annual holding cost, namely, order = (Annual demand / Number of units in

(D/Q) S = (Q/2) H 4. To solve for Q*, simply cross-multiply terms and isolate Q on the left of the equal sign. 2DS = Q2H Q2 = (2DS/H) Q* = √(2DS)/H The total annual inventory cost is the sum of the setup and holding costs: Total annual cost = setup cost + Holding cost In terms of variables the total cost TC can be expressed as: TC = (D/Q) S + (Q/2) H Wee friends, this calls for an example. Example 10.2 Electronic Village stocks and sells a particular brand of personal computer. It costs the store Rs450 each time it places an order with the manufacturer for the personal computers. The annual cost of carrying the PCs in inventory is Rs170. The store

manager estimates that annual demand for the PCs will be 1200 units. Determine the optimal order quantity and the total minimum inventory cost. Solution: D = 1200 personal computer H = Rs170 S = Rs450 Q* = √(2DS)/H = √(2 (450)(1200) / 170) = 79.7 personal computers TC = (D/Q) S + (Q/2) H = 450 (1200/79.7) + 170 (79.7/2) = Rs13,549.91 Moving over to Reorder points then. Reorder points Once we have decided how much to order, now we will look at the second inventory question, when to order. The time between the placement and receipt of an order, called the lead time or delivery time, can be as short as a few hours to as long

as months. Thus, when-to-order decision is usually expressed in terms of a reorder point, the inventory level at which an order should be placed. The reorder point (ROP) is given as: ROP = (Demand per day) x (Lead time for a new order in days) =dxL This equation for ROP assumes that demand is uniform and constant. When this is not the case, extra stock, often called safety stock, should be added. The demand per day, d, is found by dividing the annual demand, D, by the number of working days in a year: d = D / (Number of working days in a year) We will take an example to demonstrate how to calculate reorder point. Example 10.3 The I-75 Discount Carpet Store is open 311 days per year. If annual demand is 10,000 yards of Super Shag Carpet and the

lead time to receive an order is 10 days, determine the reorder point for carpet. Solution: r = dL = (10,000/ 311) 10 = 321.54 Thus, when the inventory level falls to approximately 321 yards of carpet, a new order is placed. Notice that the reorder point is not related to the optimal order quantity or any of the inventory costs. Friends, the next model lined up for today’s discussion is:Production order quantity model In the EOQ inventory model, we assumed that the entire inventory order was received at one time. There are times, however, when the firm may receive its inventory over a period of time. Such cases require a different model, one that does not require the instantaneous receipt assumption. This model is applicable when inventory continuously flows or builds up over a period of time after an order has been placed or when units are produced and sold simultaneously. Under these circumstances, we take into account the daily production (or inventory flow)

rate and the daily demand rate. Figure 29.2 shows inventory levels as a function of time.

Figure 29.2 Inventory levels over time for the production model Because this model is especially suitable for the production environment, it is commonly called the production order quantity model. It is useful when inventory continuously builds up over time and the traditional economic order quantity assumptions are valid. We derive this model by setting ordering or setup costs equal to holding costs and solving for Q*. Using the following symbols, we can determine the expression for annual inventory holding cost for the production run model: Q = Number of pieces per order H = Holding cost per unit per year

p = Daily production rate d = Daily demand rate, or usage rate t = Length of the production run in days 1. Annual inventory holding cost = (Average inventory level) x (Holding cost per unit per year) = (Average inventory level) x H 2. Average inventory level = (Maximum inventory level) /2 3. Maximum inventory level = (Total produced during the production run) – (Total used during the production run) = pt – dt But Q = total produced = pt, and thus t = Q/p. Therefore, Maximum inventory level = p(Q/p) – d(Q/p) = Q – (d / p) Q = Q (1 – d / p) 4. Annual inventory holding cost (or simply holding cost) = (Maximum inventory level / 2) H = (Q / 2) ( 1 – (d / p) ) H

Using the expression for holding cost above and the expression for setup cost developed in the basic EOQ model, we solve for the optimal number of pieces per order by equating setup cost and holding cost: Setup cost = (D / Q) S Holding cost = (1/2) HQ (1 – (d / p) ) Set ordering cost equal to holding cost to obtain Q*p: (D / Q) S = (1/2) HQ(1 – (d / p)) Q2 = 2DS / (H (1 – (d / p)) Q*p = √ 2DS / (H (1 – (d / p)) We can use the above equation, Q*p, to solve for the optimum order or production quantity when inventory is consumed as it is produced. We will take an example to see how to use it.

Example 10.4 We now assume that I-75 Outlet Store has its own manufacturing facility in which it produces Super Shag carpet. We further assume that the ordering cost is the cost of setting up the production process to make Super Shag carpet. Estimated annual demand is 10,000 meters of carpet, and annual carrying cost is Rs0.75 per meter. The manufacturing facility operates the same days the store is open (i.e., 311 days) and produces 150 meters of the carpet per day. Determine the optimal order size, total inventory cost, the length of time to receive an order, the number of orders per year, and the maximum inventory level. Solution: S = Rs150 H = Rs0.75 D = 10,000 meters d = 10,000 / 311 = 32.2 meters per day p = 150 meters per day The optimal order size is determined as follows: Q* = √ 2DS / (H (1 – (d / p)) = √(2 (150) (10,000) / (0.75 (1 – (32.2 / 150) ) ) ) = 2,256.8 meters

This value is substituted into the following formula to determine total minimum annual inventory cost: TC min = (D / Q) S + (D / 2) H ( 1 – d / p) = ( (150)(10,000) / 2,256.8) + (0.75 (2,256.8) / 2) (1 – 32.2/150) ) = Rs1,329 The length of time to receive an order for this type of manufacturing operation is commonly called the length of the production run. It is computed as follows: Production run length = Q/p = 2,256.8 / 150 = 15.05 days per order The number of orders per year is actually the number of production runs that will be made: Number of production runs (from orders) = D/Q = 10,000 / 2,256.8 = 4.43 runs per year Finally, the maximum inventory level is Maximum inventory level = Q (1 – d / p)

= 2,256.8 (1 – 32.2 / 150) = 1,772 meters. With that, we have come to the end of today’s discussions. I hope it has been an enriching and satisfying experience. Points to ponder

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