Operations & Production

Management

Lecture 3.1: Inventory Management

 A stock or store of goods

 Raw materials or purchased parts

 work-in-progress

 Finished goods inventories

 Merchandise

 Tools and supplies

 Replacement parts (MRO)

 Goods-in-transit between locations (Pipeline

inventory)
 To meet anticipated customer demand
 Anticipation stock
 To smooth production requirements
 Seasonal inventory
 To decouple operations
 Decoupling/buffer stock
 To protect against stock-outs
 Safety stock
 To take advantage of order cycles
 Cycle inventory
 To take advantage of quantity discounts
 To hedge against price increases
 A system to keep track of the inventory on hand and

on order.

 A reliable forecast of demand that includes an

indication of possible forecast error.

 Knowledge of lead times and lead time variability.

 Reasonable estimates of inventory holding costs,

ordering costs, and shortage costs.

 A classification system for inventory items.

 Periodic System
 Physical count of items in inventory made at periodic
intervals
 Perpetual Inventory System
 System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
 An order is placed when inventory drops to a
predetermined minimum level
 Two-bin system: Two containers of inventory; reorder
when the first is empty
 Cost of placing the order (Order Cost)

 Price discount cost

 Stock-out cost (Shortage Cost)

 Working capital cost (Purchase Cost)

 Storage cost
Carrying/ Holding Cost
 Obsolescence cost

 Operating efficiency
 Application for classifying inventory items based on the
items’ consumption values.
 Widely used for manufactured products, spare parts,
components, finished items and assembly items in
Precision Industry.
 ABC analysis is used identify which products need more
attention than others, and prioritize the inventory
management accordingly.
 Separate out products that require a lot of attention from
those that don’t.
 Go through the product list and adding each product to one
of three categories: A, B and C.
 Category A – goods that register the highest value in terms of
annual consumption.
 The top 70 to 80 percent of the yearly consumption value of the
company comes from only about 10 to 20 percent of the total
inventory items.
 Hence, it is crucial to prioritize these items; require regular
attention because their financial impact is significant but sales are
unpredictable.
 Category B – goods that fall somewhere in-between that have a
medium consumption value.
 About 30 percent of the total inventory in a company which
accounts for about 15 to 20 percent of annual consumption value.
 Category C – goods that have the lowest consumption value.
 Account for less than 5 percent of the annual consumption
value that comes from about 50 percent of the total inventory
items.
 It requires less oversight because they have a smaller financial
impact, and they’re constantly turning over.
 ABC classification helps businesses to maintain control over the
costly items which have large amounts of capital invested in
them.
 Prioritization of attention and focus helps to keep the costs in
check and under control in the supply chain system.
1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year so
that the demand rate is reasonably constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There are no quantity discounts.
  Order size: Q units

 Demand: D units

 Average inventory: Q/2

 No. of orders: D/Q

 Holding cost/unit: H

 Ordering cost/order: S
 Holding cost: Holding cost/unit * Average inventory

= HQ/2

 Ordering cost: Ordering cost/Order * No. of Orders

= SD/Q

 Total cost = Holding cost + Ordering cost

= HQ/2 + SD/Q

 EOQ = √(2DS/H

 Length of order cycle = Q/D

 A local retailer of woolen blankets expects to sell 9,600

blankets of a certain size and design next year. Annual

Carrying Cost is $16 per blankets, and Ordering Cost is
$75. The retailer operates 288 days per year. What is
the EOQ? How many times per year does the retailer
reorder blankets? What is the Total Annual Cost if the
EOQ is ordered?

 EOQ = √(2DS/H
1. Only one product is involved
2. Annual demand is known
3. The usage rate is constant
4. Usage occurs continually, but production occurs
periodically
5. The production rate is constant when production is
occurring
6. Lead time is known and constant
7. There are no quantity discounts
  Production Rate: p units

 Usage rate of inventory: u units

 Maximum inventory, Imax: Q(p-u)/p

 No. of orders: D/Q

 Holding cost/unit: H

 Setup cost/run: S
 Holding cost: Holding cost/unit * Average inventory

= (Imax/2)*H

 Setup cost: Setup cost/run * No. of runs

= SD/Q

 Total cost = Holding cost + Ordering cost

= (Imax/2)*H+ SD/Q

 EMQ/EPQ:
 A t-shirt manufacturer uses 48,000 buttons per year

for its most popular design of t-shirts. The firm makes

its own buttons, which it can produce at a rate of 800
per day. The t-shirts are manufactured uniformly over
the entire year. Carrying cost is $1 per button per year.
Setup cost for a production run of buttons is $45. The
firm operates 240 days per year. What is the EPQ?
What is the Total Annual Cost if the EPQ is ordered?
  Order size: Q units

 Demand: D units

 Price: P/unit

 Average inventory: Q/2

 No. of orders: D/Q

 Holding cost/unit: H

 Ordering cost/order: S
 Holding cost: Holding cost/unit * Average inventory

= HQ/2

 Ordering cost: Ordering cost/unit * No. of Orders

= SD/Q

 Total cost = Holding cost + Ordering cost + Purchasing

cost

= HQ/2 + SD/Q + PD
 A shirt manufacturer uses 4,000 labels a year. Labels

are priced as follows: 1 to 499, 90 cents each; 500 to

999, 85 cents each; and 1,000 or more, 80 cents each. It
costs approximately $30 to prepare an order and
receive it, and carrying costs are 40 percent of
purchase price per unit on an annual basis. Determine
the optimal order quantity and the total annual cost.
 A key to reducing lot size is the reduction of the fixed
cost incurred per lot.
 One major source of fixed costs is transportation.

 In several companies, the products sold are divided into

families or groups, with each group managed
independently by a separate product manager.
 Results in separate orders and deliveries for each product
family, increasing the overall cycle inventory.
 Aggregating orders and deliveries across product families
is an effective mechanism to lower cycle inventories.
 Another way is to have a single delivery coming from multiple
suppliers, allowing fixed transportation cost to be spread
across multiple suppliers; or to have a single truck delivering
to multiple retailers, allowing fixed transportation cost to be
spread across multiple retailers.
 Firms that import product to the United States from Asia
have aggregated their shipments across suppliers, often by
building hubs in Asia that all suppliers deliver to, allowing
them to maintain transportation economies of scale while
getting smaller and more frequent deliveries from each
supplier.
 The goal in ordering is to place an order when the amount
of inventory on hand is sufficient to satisfy demand
during the time it takes to receive that order (lead time).
 There are four determinants of the reorder point quantity:
1. The rate of demand (usually based on a forecast)
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stock-out risk acceptable to management
 If demand and lead time are both stable, the reorder point
is Demand Rate * Lead Time
 What if the demand/lead time is not stable?

 Need to keep safety inventory

 The appropriate level of safety inventory is determined

by the following two factors:

• The uncertainty of both demand and supply
• The desired level of product availability

 ROP = Expected Demand During Lead Time + Safety

Stock
When To Order: ROP
 Service level: probability that the inventory available
during lead time will meet demand
 Depends on:
 Shortage cost – the unrealized profit per unit. That is,
shortage cost = Revenue per unit − Cost per unit
 Excess cost – related to items left over at the end of the
period. In effect, excess cost is the difference between
purchase cost and salvage value. That is,
excess cost = Original cost per unit − Salvage value per unit
 If there is cost associated with disposing of excess items, the
salvage will be negative and will therefore increase the excess
cost per unit.
 The service level is the probability that demand will not exceed
the stocking level, and computation of the service level is the
key to determining the optimal stocking level, So, Service level
= Cs/(Cs+ Ce)
where Cs = Shortage cost per unit, Ce = Excess cost per unit
 If actual demand exceeds So, there is a shortage; if demand is
less than So, there is an excess.
 Just in time (JIT) is a technique to increase production efficiency
and decrease waste by receiving goods only as they are needed in
the production process, thereby reducing inventory costs.

 In other words, JIT inventory refers to an inventory management

system with objectives of having inventory readily available to
meet demand, but not to a point of excess where you must
stockpile extra products.

 In Precision Industry, materials are purchased and units are

produced only as needed to meet actual customer demand.
 Just-in-time inventory management helps you to manage
cash flow.
 This approach to managing inventory is an essential
element in the philosophy of lean manufacturing, which is
based on using information and strategy to run a business
as efficiently as possible.
 Before implementing JIT, companies need to conduct
thorough research into customer buying habits, seasonal
demand, and source for reliable suppliers and channels of
transportation to minimize risks and screw-ups.