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Chapter 12 The Material Flow Cycle

Inventory Management

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The Material Flow Cycle Inventory System

Defined
Wait Move Queue Setup Run
Input
Other
Time Time Time Time Time Output
• Inventory any idle goods or materials that are
held for future use, and can include: raw
Cycle Time
materials, component parts, work-in-process,
1 Run time: Job is at machine and being worked on finished products, and supplies.
2 Setup time: Job is at the work station, and the work
station is being "setup." • An inventory system is the set of policies and
3 Queue time: Job is where it should be, but is not being controls that monitor levels of inventory and
processed because other work precedes it. determines what levels should be maintained,
4 Move time: The time a job spends in transit
when stock should be replenished, and how
5 Wait time: When one process is finished, but the job is
waiting to be moved to the next work area. large orders should be.
6 Other: "Just-in-case" inventory.
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Inventory Basics Purposes of Inventory

• Inventory is created when the receipt of
materials, parts, or finished goods
exceeds their disbursement.
• Inventory is depleted when their
disbursement exceeds their receipt.
• An inventory manager’s job is to balance
the advantages and disadvantages of
both low and high inventories.
– Both have associated cost characteristics.
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1. To provide a safeguard for variation in
raw material delivery time
2. To maintain independence of operations
3. To allow flexibility in production
scheduling
4. To meet variation in product demand
5. To take advantage of economic
purchase-order size

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Inventory Costs Opposing Views of Inventory

• Cost of the items:
– Considered when quantity discounts are offered, but in most
cases it is constant • Why We Want to Hold Inventories
• Holding (or carrying) costs • Why We DO Not Want to Hold Inventories
– Costs for storage, handling, insurance, obsolescence,
p
depreciation,, taxes,, tied up
p capital,
p , etc
• Setup (or production change) costs
– Costs for arranging specific equipment setups, etc
• Ordering costs
– Costs of placing an order, etc
• Shortage costs
– Costs of canceling an order, lost goodwill/orders, late
penalties, etc ٧ ٨

Why We Want to Hold Why We Do Not Want to Hold

Inventories
• Customer Service: Reduces the potential for
stockouts and backorders.
• Ordering Cost: The cost of preparing a purchase
order for a supplier or a production order for the
shop.
• Setup Cost: The cost involved in changing over a
machine to produce a different item.
• Labor and Equipment: Creating more inventory
can increase workforce productivity and facility
utilization.
• Transportation Costs: Costs can be reduced.
• Quantity Discount: A drop in the price per unit
when an order is sufficiently large.
Inventories
• Inventory holding cost all the expenses incurred
because inventory is carried, and it is the sum of
the cost of capital and the variable costs of keeping
items on hand, such as storage and handling,
taxes, insurance, and shrinkage.
– Cost of Capital is the opportunity cost of investing in an
asset relative to the expected return on assets of similar
risk.
– Storage and Handling arise from moving in and out of a
storage facility plus the rental cost and/or opportunity cost
of that space.
– Taxes, Insurance, and Shrinkage: More taxes are paid
and insurance costs are higher if end-of-the-year
inventories are high. Shrinkage comes from theft,
obsolescence and deterioration.
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Inventory Holding Costs

(Approximate Ranges) Ordering Costs
Cost as a
Category % of Inventory Value • Ordering costs are incurred because of
Housing costs (building rent,
depreciation, operating cost, taxes,
6% the work involved in placing purchase
(3 - 10%)
insurance) orders with vendors or organizing for
3%
Material handling costs (equipment,
(1 - 3.5%)
3 5%)
production within a p
p plant such as:
lease or depreciation, power,
operating cost) 3% – Supplies
(3 - 5%)
Labor cost from extra handling – Forms
11%
Investment costs (borrowing costs, (6 - 24%) – Order processing
taxes, and insurance on inventory)
3% – Clerical support
Pilferage, scrap, and obsolescence
(2 - 5%)
26%
– Etc.
Overall carrying cost
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Setup Costs Inventory Problems

• Number of items:
• Setup costs are incurred at the work – One or many
station for preparing the machine and • Nature of demand:
equipment for production such as: – Independent or dependant; deterministic or stochastic;
static or dynamic.
– Clean-up
Cl costs
t • Number of time periods in planning horizon:
– Re-tooling costs – one or many.
– Adjustment costs • Lead time:
– Etc. – deterministic or stochastic
• Stockouts:
– Backorders or lost sales.
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Three Fundamental Inventory Identifying Critical Inventory

Decisions Items
¾How to monitor • Thousands of items are held in inventory
Inventory? by a typical organization, but only a small
% of them deserves management’s
¾How Much Should
closest attention and tightest control.
control
Be Ordered?
• ABC Classification: The process of
¾When Should dividing items into three classes,
Orders be Placed? according to their dollar usage, so that
managers can focus on items that have
the highest dollar value.
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Classifying Items as ABC ABC Classification

Class % $ Vol % Items 100 — Class B

Class C

A 80 20 90 —
% Annual $ Usage

100 Class A
B 15 30
Percentage of dollar value

80 —
80
C 5 50 70 —

60 60 —

40
A 50 —

B 40 —
20 C 30 —
0 20 —

0 50 100 10 —

% of Inventory Items 0—
10 20 30 40 50 60 70 80 90 100
١٧ Percentage of items ١٨

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Inventory Accuracy and Cycle Counting

Inventory control systems: Defined
• Continuous review system: Inventory • Inventory accuracy refers to how well the
position is continuously monitored e.g. inventory records agree with physical count
– Optical scanning • Cycle Counting is a physical inventory-
– Two bin system taking technique in which inventory is
• Periodic review system: the inventory counted on a frequent basis rather than
once or twice a year.
position is checked only at fixed intervals
of time. – Used often with ABC classification
– A items counted most often (e.g.,
daily)
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Techniques for Controlling

Advantages of Cycle Counting Service Inventory Include:
• Eliminates shutdown and interruption of • Good personnel selection, training, and
production necessary for annual physical discipline
inventories
• Tight control of incoming shipments
• Eliminates annual inventoryy adjustments
j
• Effective
Effecti e control of all goods leaving
lea ing the
• Provides trained personnel to audit the
accuracy of inventory facility
• Allows the cause of errors to be identified
and remedial action to be taken
• Maintains accurate inventory records
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Inventory Models EOQ Assumptions

• Fixed order-quantity models
– Economic order quantity
– Production order quantity
– Quantity discount
• Probabilistic models
• Fixed order-period models
© 1984-1994
T/Maker Co.
Help answer the • Known and constant demand
inventory planning
questions! • Known and constant lead time
• Instantaneous receipt of material
• No quantity discounts
• Only order (setup) cost and holding cost
• No stockouts

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EOQ Model
Inventory Usage Over Time How Much to Order?
Annual Cost
Order quantity = Q Usage Rate
(maximum Average
inventory level) Inventory
(Q*/2)
Inventory Leevel

Minimum
total cost

Order (Setup) Cost Curve

Minimum
inventory 0 Optimal Order quantity
Time Order Quantity (Q*)

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Why Holding Costs Increase Why Order Costs Decrease

Cost is spread over more units
• More units must be stored if more are
ordered Example: You need 1000 microwave ovens
1 Order (Postage $ 0.33) 1000 Orders (Postage $330)

Purchase Order PurchaseOrder

Purchase Order
Purchase Order Purchase Order Description
Purchase
Description
Purchase OrderQty.
Order
Qty. Description Qty.
Description Qty.
Microwave Qty.
Description Qty. Description Qty. Microwave 1000 Description
Microwave
Microwave 11
Microwave 1 Microwave 1000 Microwave 11
Order quantity Order quantity Order quantity

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EOQ Model
Deriving an EOQ
When To Order
1. Develop an expression for setup or Inventory Level
ordering costs Optimal Average
Order Inventory
2. Develop an expression for holding cost (Q*/2)
Quantity
3 Set setup
3. set p cost equal
eq al to holding cost (Q*)

4. Solve the resulting equation for the best Reorder

order quantity Point
(ROP)

Time
Lead Time

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EOQ Model Equations The Reorder Point (ROP) Curve

2 ×D ×S Q*
Optimal Order Quantity = Q* =
H Slope = units/day = d
D
Expected Number of Orders =N =

Inventory leveel (units)

Q*
Expected Time Between Orders W ki D
Working Days / Year
Y ROP
=T =
N (Units)
D D = Demand per year
d =
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d × L d = Demand per day Time (days)
L = Lead time in days Lead time = L

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Production Order Quantity EOQ POQ Model

Model When To Order
• Answers how much to order and when to Both production
order and usage take Usage only takes
Maximum place
place
• Allows partial receipt of material inventory
level
– Other EOQ
Q assumptions
p apply
pp y
Inventory Level

• Suited for production environment

– Material produced, used immediately
– Provides production lot size
• Lower holding cost than EOQ model
Time

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POQ Model Inventory Levels POQ Model Inventory Levels

Inventory Level
Inventory Level
Level
Inventory level with no demand

Production portion of cycle

Production Max. Inventory
Portion of Cycle Q·(11- d/p)
Q·(
Q*
Q
Demand portion of cycle with no
supply

Supply Supply
Time Time
Supply Supply Demand portion of cycle
Begins Ends Begins Ends with no supply

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POQ Model Equations Quantity Discount Model

• Answers how much to order &
= Q* = 2*D*S
Optimal Order Quantity when to order
( )
p d
H* 1 -
p • Allows quantity discounts
– Reduced price when item is purchased in
Maximum inventory level = Q* ( 1 -
d
p ) larger quantities
D D = Demand per year – Other EOQ assumptions apply
Setup Cost = * S
Q S = Setup cost • Trade-off is between lower price &
H = Holding cost
Holding Cost = 0.5 * H * Q
( )
1-
d
p
d = Demand per day
p = Production per day
increased holding cost

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Quantity Discount Schedule Probabilistic Models

Discount Discount Discount (%) Discount • Answer how much & when to order
Number Quantity Price (P) • Allow demand to vary
1 0 to 999 No discount $5.00 – Follows normal distribution
2 1,000 to 4 $4.80 – Other EOQ assumptions apply
1,999 • Consider service level & safety stock
3 2,000 5 $4.75 – Service level = 1 - Probability of stockout
and over
– Higher service level means more safety stock
• More safety stock means higher ROP

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Probabilistic Models
When to Order? Fixed Period Model
Service
Inventory Level
Frequency
Level P(Stockout)
• Answers how much to order
Optimal • Orders placed at fixed intervals
Order
X
– Inventory brought up to target amount
Quantity SS – Amount ordered varies
ROP
Reorder
Point
• No continuous inventory count
(ROP) – Possibility of stockout between
Safety Stock (SS)
intervals
Place Receive Time • Useful when vendors visit routinely
order Lead Time order – Example: P&G representative calls
٤١ every 2 weeks ٤٢

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Inventory Level in a Fixed Fixed Period Model

Period System When to Order?
Various amounts (Qi) are ordered at regular time intervals Inventory Level Target maximum
(p) based on the quantity necessary to bring inventory up
to target maximum
Target maximum
Q1 Q2 Q4
On--Hand Inventory

Q3

p p p
On

Time
Period Period Period
Time
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