INVENTORY MANAGEMENT

HOW-TO MANUAL Version 2.3
Erwin Opalla Ottobrunn July 2008

July 2008

TABLE OF CONTENT
Chapter A B C D E F G Subject Financial Background and Implication of Inventory Management Basics of Forecasting Misleading Inventory Turns Practical Application of Inventory Management Problems with Minimum Order Quantities Lot Sizing Models Safety Stock Calculation

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MEASURE YOUR BUSINESS

“When you can measure what you are speaking about and express it in numbers, you know something about it; but when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.”
By Lord Kalvin

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CHAPTER A
FINANCIAL BACKGROUND AND IMPLICATION OF INVENTORY MANAGEMENT

July 2008

FINANCIAL BASICS OF INVENTORY
Many companies try to reduce cost and increase cash flow by tighter control and management of inventory, reducing for example excess inventory. “Excess inventory is any quantity much larger than needed, desired, or required!” But many companies are unaware of the amount of excess and obsolete inventory. Excess inventory is all inventory that does not have true demand (orders) or anticipated demand (forecasted orders). The sales force is usually concerned with the most current goods that produce the highest margins. So over time excess and obsolete inventory build up, tie up cash which is not available any longer for future investments. The next slides should explain some basic financial concepts in relation to inventory management. The main purpose of any manufacturing company is to make a profit. So the understanding of the underlying financials is crucial for anyone being involved in inventory management.
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INVENTORY THOUGHTS Inventory is an investment. c) insurance. Its sole purpose is to generate income. b) workers to handle and transport the goods. In this case auditors request that money is set aside in the form of obsolescence reserve for obsolete. more than 1 year-of-supply for example. may not be longer worth its original cost. Buying excess inventory has immediately a negative impact on cash flow. product development or advertising. Inventory is classified as a current asset on the balance sheet. Excess inventory results in unnecessary capital investment in the form of a) warehouses stocking the excess. shrinkage etc. just like the money spent for capital equipment. damages. Too much inventory. which means it is expected to be consumed or converted to cash in less than a year. page 6 / July 2008 . Excess inventory is something not producing any return for the company. slow-moving and/or excess inventory. The resulting obsolescence expense hits immediately the profit line.

Production Large lot sizes. Low unit cost. Purchasing Large lot sizes. We are out of space. FOCUS High availability of ALL goods.CONFLICTING INVENTORY OBJECTIVES AREA Marketing / Sales TYPICAL RESPONSE We need all products from our sales catalog in our warehouse available at all times to beat competition. High inventory levels affect negatively our liquidity. (Adopted from Tersine: Principles of Inventory and Materials Management) page 7 / July 2008 . We need another warehouse to stock all the goods. Low total inventory carrying cost. Finance Warehousing Less space and low holding cost. Where do we get the funds from to pay for this high level of inventory? The levels should be lower. We can reduce our unit cost if we buy larger quantities using quantity discounts. Low unit cost. reducing our unit cost and avoiding manufacturing variances. Inventory is too low! If we can produce in larger lot sizes our set-up cost will go down.

RETURN-ON-ASSETS July 2008 .

2. For example. Price. Quality. but at lower prices affecting negatively their profitability.INDICATORS OF SUCCESS Being competitive and making profit in today’s business environment is crucial for the survival of manufacturing companies. to get the same revenue as a year ago most companies face the dilemma to sell more products. Lead time Lead time Quality Price Today customers expect goods with a high quality at low cost in shortest lead-time. what strategy should be chosen to stay competitive and profitable? page 9 / July 2008 . There are at least three indicators of being successful: 1. from a volume point of view. 3. The question is.

ROA = Net Profit After Tax Total Assets = Profit Margin × Total Asset Turns = Net Profit After Tax Sales × Sales Total Assets page 10 / July 2008 .STRATEGIC APPROACH The DuPont Corporation was the first major company recognizing the importance of looking at both Profit Margin and Total Asset Turns in assessing the performance of an organization. For this reason the Return-on-Asset ratio (Net Profit After Tax / Total Assets) was broken down into the Profit Margin and Total Assets Turns. This breakdown provides a lot of insight for management on how to improve the profitability of a company.

In the past managers focused on the margin earned and have ignored the turnover of assets.STRATEGIC APPROACH The owner or stockholder invests money in a company to get a return in the form of a profit. But excessive funds tied up in assets can reduce profitability as well as excessive expenses. or close down the company and invest in a different one. because of higher return. If the profit is too low the investor might decide putting his money in a bank. but it could be high for wrong reasons if total assets were financed with too much debt! page 11 / July 2008 . Return-on-Equity represents the profitability of funds invested by the owners and should be as high as possible.

198.281 Return on Assets 9.000 ÷ Sales $4.7% $198.760 page 12 / July 2008 .000 $4.400 Sales Total Asset Turnover 1.0% × Inventory $632.MODIFIED DUPONT FORMULA Sales Gross Profit $1.000 Current Assets Accounts Receivables $405.580 Other Current Assets $320.000 Return on Equity 20.212.600 Net Profit Total Equity $964.471.740 $1.500 Taxes $102.212.000 COGS $2.358.100 Interest $82.212.400 Operating Expenses Total Expenses $1.600 $1.5% Equity Multiplier 2.030 Net Profit Margin 4.273.089.740.000 Legend: * Net Profit Margin = Net Profit / Sales * Total Asset Turnover = Sales / Total Assets * Return-on-Assets = Net Profit / Total Assets or Net Profit Margin x Total Asset Turnover * Equity Multiplier = Total Assets / Total Equity * Return-on-Equity = Net Profit / Total Equity Return-on-Assets * Equity Multiplier ÷ Total Assets $2.9 $4.160 + Fixed Assets $840.

because of more competition.00 9. turns improved from 2 to 6. yielding the same returnon-investment of 18%. the margin dropped from 9% to 3%.60 4. A weak margin can be offset by a strong turnover and vice versa. In this example.00 3. Margin and turnover complement each other.50 6.MARGIN VIA TURNOVER Different turnover-marginrelations yield the same ROA. Margin 9% 8% 7% 6% 5% 4% 3% 2% X X X X X X X X X Turnover 2.25 2. But because of better “Asset Management”.00 = = = = = = = = = ROA 18% 18% 18% 18% 18% 18% 18% 18% Profit Margin 9% 18% 3% 2 6 Asset Turns page 13 / July 2008 .00 2.57 3.

get rid of unneeded fixed assets. sales price or some combination while maintaining or improving the margin on sales Decrease all kind of expenses.g. improve collection of accounts receivable. freight. admin. traveling. reduce the inventory level. Reduce the amount of total assets employed.g. ROA = Net Profit After Tax Total Assets = Profit Margin × Total Asset Turns Net Profit After Tax Sales = × Sales Total Assets page 14 / July 2008 . e.DUPONT FORMULA DETAILS Actions to improve ROA (Return-on-Assets): a) b) c) Increase sales by increasing volume. e.

0933 × 2.1429 = 0.09 × 2 = 0.ROA (RETURN-ON-ASSET) EXAMPLE For this example.000 140.000 = × 300.000 300.1999 = 20% page 15 / July 2008 .18 = 18% After Inventory Reduction ROA = Net Profit After Tax Sales × Sales Total Assets 28.000 = × 300.000 = 0. both margin and turnover were increased by getting rid of redundant inventories.000 = 0. reducing so the inventory holding charge and therefore increasing the net profit without increasing sales! Before Inventory Reduction ROA = Net Profit After Tax Sales × Sales Total Assets 27.000 150.000 300.

CASH CONVERSION CYCLE July 2008 .

INVENTORY & CASH CONVERSION CYCLE The Operating Cycle (OC) is the time between purchasing materials from suppliers and receiving cash from customers after sold as finished products. OPERATING CYCLE (OC) OPERATING CYCLE (OC) Cash Inflow Inventory shipped Inventory (DOH) Inventory received Receivables (DSO) Payables (DPO) Cash Outflow Cash Conversion Cycle (CCC) Cash Conversion Cycle (CCC) page 17 / July 2008 .

also called Cash Gap. is the time between paying cash to suppliers for inventory received and collecting cash from customers from sale as finished product. CCC = DOH + DSO --DPO CCC = DOH + DSO DPO • DOH is Days Inventory On-Hand. average collection period • DPO is Days Payable Outstanding. average payment period When DPO is smaller than DSO the company would act like a bank! page 18 / July 2008 .INVENTORY & CASH CONVERSION CYCLE The Cash Conversion Cycle (CCC). average age of inventory • DSO is Days Sale Outstanding.

Low inventory improves profit and frees up needed capital for investments. page 19 / July 2008 . The Days Inventory On-Hand (DOH) should be as low as possible.MANAGING THE CASH CONVERSION CYCLE The basic strategy to manage the Cash Conversion Cycle (CCC) is as follows: 1. Turn over inventory as quickly as possible but avoid stock outs that might result in loss of sales. b) Inventory held for too long can become spoiled or obsolete resulting in an additional obsolescence reserve hitting the EBIT line on the profit & loss statement as an expense. There are two reasons for this: a) Investors do not like to see a lot of cash tied up in inventory.

MANAGING THE CASH CONVERSION CYCLE 2. A high number represents really an interest-free loan from its suppliers. A low Days Sales Outstanding (DSO) means that the company collects its outstanding receivables quickly. Pay Accounts Payable as late as possible without damaging credit rating and take advantage of any discount offered. The Days Payable Outstanding (DPO) should be as high as possible. This figure should be as low as possible. 3. which means that it is not giving interest free loans to its customers for long periods of time. page 20 / July 2008 . Collect Accounts Receivables as quickly as possible into real cash. as long as they are paid under stated terms.

CASH CONVERSION CYCLE REDUCTION OPERATING CYCLE 150 DAYS 1 Inventory 70 days Payables 40 days Receivables 80 days Cash Conversion Cycle 110 days Inventory reduction Inventory 50 days Receivables 80 days Cash Conversion Cycle 90 days 2 Payables 40 days OPERATING CYCLE 130 DAYS Receivables reduction Inventory 50 days Receivables 70 days Cash Conversion Cycle 80 days 3 Payables 40 days OPERATING CYCLE 120 DAYS page 21 / July 2008 .

CASH CONVERSION CYCLE FORMULAS 1. Days Inventory On-Hand (DOH) DOH = Inventory / Daily COGS = Inventory / ( COGS / 360 ) 3. Days Payable Outstanding (DPO) DPO = A/C Payables / Daily COGS = A/C Payables / ( COGS / 360 ) page 22 / July 2008 .DPO 2. Days Sales Outstanding (DSO) DSO = A/C Receivables / Daily Sales = A/C Receivables / ( Sales / 360 ) 4. Cash Conversion Cycle (CCC) CCC = DOH + DSO .

000 $102.400 $77.000 $632.710 $525.160 Current Liabilities A/C Payables Accrued Expenses Income Tax Notes Payable Total Current Liabilites Long-Term Debt $269.000 $964.198.000 INCOME STATEMENT Sales Cost-of-Goods Sold Gross-Profit Operating Expenses Net-Operating Income Interest Expense $4.000 $500.000 $218.500 $82.800 ($78.030 Earnings Before Income Tax Income Tax Expense Net Profit $2.358.220) $840.740 $243.200 $300.030 $198.600 $1.000 $405.SAMPLE CALCULATION PROFIT & CASH BALANCE SHEET Current Assets Cash A/C Receivables Inventory Prepaid Expenses Total Current Assets Fixed Assets Land Building Machines Depreciation Total Fixed Assets Total Assets $200.390 $10.089.740.000 $198.212.740 For illustration purposes the cash conversion cycle will be calculated on the next slide.120 $130.760 $1.471.580 $2.000 $709. page 23 / July 2008 .100 $382.000 Stockholder's Equity Capital/Stock Retained Earnings Total Stockholder's Equity Total Liabilites & Equity $766.400 $1.500 $300.198.000 $2.

page 24 / July 2008 . To free-up cash this number must be reduced.SAMPLE CALCULATION PROFIT & CASH CONT. In this example 83 days represents the average length of time a dollar is tied up in current assets.

CHAPTER B BASICS OF FORECASTING July 2008 .

George W. The focus of this forecasting section is to highlight some general characteristics of good forecasts. Forecasts are more accurate for groups of items. Forecasts are more accurate for shorter periods of time. Production and Inventory Control Applications page 26 / July 2008 . Forecasts should include an estimate of error.FORECASTING INTRODUCTION A detailed discussion of forecasting methods is beyond the scope of this presentation. Plossl. The interested reader should refer to standard text books available from different authors. Forecasts will always be wrong.

There was no usage and no forecast! Sales to Ottobrunn (Order point) Ottobrunn to Shannon (Supplier) Shannon to Ottobrunn Ottobrunn to Sales Sales to Ottobrunn Logistics Ottobrunn Operations Shannon Product Management Can my customer have 10 pcs of product XXX? Can you supply 10 pcs of product XXX? No stock. supplier. Shannon. impossible to make 10 pcs. You can’t be serious.FORECASTING DILEMMA A “normal” discussion which was forwarded to me in Jan07. how the hell will we make our target! No usage and no forecast means no inventory! What do you expect? Why is the factory empty. how the hell will we make our target? The business is in the toilet. let’s move everything to India. page 27 / July 2008 . has not shipped a product XXX in the last 12 months. you have to buy 250 pcs or nothing because no further usage in Ottobrunn. Sorry. absolute minimum we could make are 250 pcs.

FORECASTING APPROACHES “You Can Never Plan the Future from the Past” by Sir Edmund Burke “I Know No Way of Judging the Future but by the Past” by Patrick Henry page 28 / July 2008 .

Without forecasting raw materials and/or components have be ordered after receiving orders resulting in long lead times and maybe lost customers! page 29 / July 2008 . Turn-around orders will come in which must be forecasted to satisfy customer expectations of short lead times.WHY TO FORECAST DEMAND Backlog Forecast Demand Actual Orders 2 to 4 weeks Time Normally the backlog is for the near future.

Level Strategy A production planning method that maintains a stable production rate while varying inventory levels to meet demand. 11th Edition page 30 / July 2008 .MANUFACTURING STRATEGIES Q Forecast Q Forecast Production T Production T Chase Strategy A production planning method that maintains a stable inventory level while varying production to meet demand. APICS Dictionary.

e. page 31 / July 2008 . which could be forecasted in well understood business scenarios.g. Better approach might be discrete forecasting (=future demand for known products will repeat) or tender management.REGULAR VIS IRREGULAR DEMAND Regular Demand Demand Demand Irregular Demand D Time Time Items with regular demand can be statistically forecasted compared to Items with irregular demand. promotion–driven demand or intermittent demand (=large portion of zero values).

5 NL = MAD / Mean Legend: • ZDP is Zero-Demand Periods • NL is Noise Level • MAD is mean absolute deviation • Mean is arithmetic mean page 32 / July 2008 .HOW TO DETECT IRREGULAR DEMAND Irregular demand consists of either both or one of the following two components: Sporadic Demand Zero Demand Periods ZDP > 0.4 ZDP = Zero Periods / Total Periods High Fluctuating Demand Noise Level NL > 0.

370 Average Absolute Demand Deviation 364 18 364 52 364 23 364 14 364 42 364 0 364 11 364 26 364 28 364 21 364 8 364 1 244 Noise Level MAD = 244 / 12 = 20.370 / 12 = 364 NL = MAD / Mean NL = 20.5 so we have not a time series with high fluctuating demand. so the time series has not a sporadic demand and the Noise Level is not greater than 0.3 Mean = 4.3 / 364 = 0.06 Zero Demand Periods ZDP = Zero Periods / Total Periods ZDP = 0 / 12 = 0 Zero-Demand-Periods are not greater 0. This item is a proper candidate for statistical forecasting! page 33 / July 2008 .4.IRREGULAR DEMAND CALCULATION Month JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TTL Past Demand 346 312 387 350 406 364 353 338 392 385 372 365 4.

g.INDEPENDENT VIS DEPENDENT DEMAND Parent Item Parent Item Independent Demand Assembly A Component 1 Component 3 Component 1 Component 2 Items with independent demand (outside of the control of a company. Dependent Demand page 34 / July 2008 . Demand for items with dependent demand can be calculated from demand from their parent items and is not forecasted. e. customer orders) can and should be forecasted.

Frame Orders DEPENDENT DEMAND Parent Items. Work-in-process (WIP) Calculated from BOMs Planning Method EOQ with ROP and Safety Stock. Customer Backlog. Spare Parts Statistical and Discrete Forecasts. Assemblies Raw Materials. ROP is Reorder-Point.INDEPENDENT VIS DEPENDENT DEMAND PLANNING APPROACH CATEGORY Demand Source Material Type Demand Estimation INDEPENDENT DEMAND External & Internal Customers Finished Goods. Components. BOM is Bill-of-Material page 35 / July 2008 . Forward Planning Material Requirements Planning (MRP) Items can have independent (customer order) and dependent (component for parent item) demand! Legend: •EOQ is Economic Order Quantity.

In practice it happens very often that items have independent and dependent demand. dependent demand. independent demand. based on the marketplace • Demand is random.DEMAND CHARACTERISTICS Independent demand inventory is sometimes called ‘sales inventory’ and dependent demand inventory ‘manufacturing inventory’. The independent portion must then be forecasted and the dependent portion must be calculated! Sales Inventories1 • External. relatively continuous • Demand must be forecasted • Safety stock used to attain target service level --------------------1) Finish-Goods-Inventory Manufacturing Inventories • Internal. based on production schedule • Demand is lumpy and discontinuous • Demand can be calculated • Little or no safety stock needed to ensure a 100% service level page 36 / July 2008 .

Source: Oliver Wight Co.DILEMMA OF PLANNING/FORECASTING MRPII Business Planning Disconnection Line Production Planning Demand Management RCCP Planning Master Scheduling Detailed MRP & CRP Plant&Supplier Scheduling Execution There is no direct link between a sales forecast in dollar by product line and a discrete product number in unit-of-measure used for manufacturing and/or procurement. page 37 / July 2008 .

LINKING OF FUNCTIONS CONTROLLING LOGISTICS Business Planning • • • • Yearly Sales Dollars Plant StdHours OpIncome. ROCA etc • Resources Production Planning = Sales and Operations Planning Production Planning • • • • Master Scheduling • Weekly • Discrete Products • StdHours per Key Resource • Driving MRP Monthly Product Families UOM RCCP page 38 / July 2008 .

Top-down is a better choice if some items have very noisy history or the emphasis is on forecasting at the group level. SmartForecasts Version 6 User’s Guide. each product item is forecasted independently and the total group forecast is obtained by summing the item forecast. Group Item A B C Source: Smart Software. and then the total group forecast is distributed down proportionally among the individual items.. Group Item A B C In Top-Down forecasting. the group history is created and forecasted first.BOTTOM-UP VIS TOP-DOWN FORECASTING In Bottom-Up forecasting. Most appropriate when item histories are stable and the emphasis is on the trends and seasonal patterns of the individual items. Page 51 page 39 / July 2008 . Inc.

page 40 / July 2008 .TOP-DOWN DOLLARS TO UOM SALES DOLLAR PRODUCT LINE TO PART NUMBER MANUFACTURING Unit-of-Measure One way to convert sales dollars into manufacturing unit of measures is using average unit costs or price per aggregate unit.

000 = $ 367 / unit Projected Sales in Unit-of-Measure for XYZ = 12.645.TOP-DOWN CONVERSION Projected Sales for Product-Line XYZ = $ 4. page 41 / July 2008 .657 units Conversion to unit-of-measure done via AVERAGE cost or price per unit.

000 ea PART 1 = 30% ( 300 ea ) PART 2 = 50% ( 500 ea ) PART 3 = 20% ( 200 ea ) PART 1 = 30% ( 450 ea ) PART 2 = 50% ( 750 ea ) PART 3 = 20% ( 300 ea ) Break down into discrete parts via a constant percentage! page 42 / July 2008 .500 ea FAMILY ITEM A = 1.TOP-DOWN PLANNING BILLS Very critical are the planning percentages per part: * How often reviewed? * What parts to include? * Automatic or manual change? Sales Increase by 50% FAMILY ITEM A = 1.

BOTTOM-UP PLANNING WW SALES AND GROSS MARGIN ANALYSIS EMEA AMERICAS ASIA/PACIFIC AXICOM Entities: Ottobrunn Simel UK Reporting Lines MV Joints H/S MV Joints C/A Low Voltage H/S GAP Analysis MV J H/S Part 1 Part 2 Part 3 History History History History Forecast Forecast Forecast Forecast In Bottom-Up forecasting. page 43 / July 2008 . each product is forecasted independently and the total group forecast is obtained by summing the item forecast.

SELECTING KEY ITEMS FOR FORECASTING Keeping the right items in inventory assures good customer service and an appropriate inventory investment. Planners should concentrate on the few important items instead of the many trivial ones. page 44 / July 2008 . But not all items in inventory have the same importance.

it must be understood that each forecast consists of two key components: Science component. which describes the forecasting method.g. which includes the marketing and/or sales adjustment.DOING FORECASTING RIGHT Doing forecasting right. e. singleexponential smoothing and Art component. page 45 / July 2008 .

g. Determine which items to forecast. use computer software. e. Automatic selection of forecasting model. Determine the forecast frequency. e. Determine the forecast horizon. load into MRP. e. page 46 / July 2008 .g. Validate results. Plot and clean historical data. Implement results and make decisions. sales forecast.g detect outliers or adjust missing data. e. daily. quarterly or yearly. weekly or monthly.g. monthly. e. all or key items. adjust results where necessary. Make forecasts.g.g. e.STEPS IN FORECASTING Determine the objective of the forecast.

FORECASTIG ERROR OVER TIME Future period Time at forecasting Positive Error Negative Error To minimize the forecast error . a monthly forecasting approach should be chosen! page 47 / July 2008 .

page 48 / July 2008 . JUL AUG AUG SEP SEP SEP OCT OCT OCT OCT NOV NOV NOV NOV DEC DEC DEC DEC JAN JAN JAN FEB FEB MAR The Planning horizon should cover at least the next six months. If monthly forecasts are placed. the planning lead time is 4 weeks although the total lead time (from placing an order till goods received in the warehouse) might be 12 weeks.ROLLING MONTHLY FORECAST Planning Horizon Rolling 6 Months Current Month + 1 Mth + 2 Mth etc.

Gross-Forecast by Month 2.FORECAST BREAKDOWN TO MRP GROSS-FORECAST MTH JAN DAYS 20 PLAN 20000 FEB 19 19000 MAR 24 24000 APR 20 20000 1 2 NET-FORECAST WEEK Product A Product B .. Product X TOTAL 14 750 15 300 16 17 500 200 5000 5000 600 5000 5000 MRP SCHEDULE WEEK 17 500 Product A SUB ITEM RAW PUR 1.. MRP Schedule WEEK 16 WEEK 15 WEEK 14 500 500 500 3 page 49 / July 2008 . Net-Forecast by Week 3..

8 hours page 50 / July 2008 .FORECAST ORDERS FROM MRP TO CRP Part A Fiscal Period Planned Order 1 100 Planned orders based on forecasted demand 2 3 4 5 6 7 200 300 8 Workcenter 4: Detailed Load Routing WC 4 Cutting H-Coating J-Coating Inspection Set-up (min) 18 24 ----Run-Time (min) 0.5 0.0 Load Hours 250 150 Load 50 1 2 3 4 5 6 7 8 Capacity Period 6 7 15 5 158 185 Manufacturing hours part A Manufacturing hours part B Manufacturing hours part C Planned hours for other parts Workcenter Summary Report Period Workcenter 4 Workcenter 5 Workcenter 6 1 2 3 4 5 6 185 7 Workcenter 4: Load Profile MRP is Material Requirements Planning and CRP is Capacity Requirements Planning 1) Cutting: 18’ + 0.2 0.4 1.5 * 300 = 168’ = 2h48’ 48’/60’=x/100 x=(48/60)*100=80 2.4 0.8 7.8 Total (100h) 2.8 1) 2.0 0.

710 7% 21% 45% 27% 100% Legend: * Only competency 13005.000 >$12.200 AND <=$12.080 116.427 293.200 AND <=$12.SHOULD ALL ITEMS BE FORECASTED? Sales pro Year Parts % Trade Sales (000) 6.000 10% 37% 7% <= $1.000 WORLDWIDE 15.188 248.137 145.305 547.000 3% 45% >$12.000 > $120.000 AND <= $120.875 6.000 18% 21% >$1.200 >$1.202 % Order Lines % <= $1.738 13.200 1% 42% 0% 10% 20% Parts 30% Trade Sales 40% Order Lines 50% 41% 48% X Y Z A B C $5.691 255.000 AND <= $120.168 61. CLP installation service exluded 27% > $120.143K Inventory 60% page 51 / July 2008 .916 617.819 1.048 37.480 42% 37% 18% 3% 100% 1% 10% 41% 48% 100% 38.

FORECAST SIMULATION SmartForecast Item Master Items to forecast Forecasted Demand AMAPS Simulation Bill of Material Process & Routing No Yes Implement Purchase Orders MRP Production Orders Hours Results Okay Separate AMAPS MRP simulation run from production environment Time page 52 / July 2008 .

SAMPLE PROCEDURE 502K016 5/8 M2 EXRM 1213 EPKJ-5210 SMOE815 EPKT -1212 Planning Horizon Rolling 6 Months Current Month + 1 Mth + 2 Mth etc.000 Daily/Weekly/Monthly * Items per MAMA table * Inventory value * Safety stock value * Planning parameters Ottobrunn ABC/XYZ Planned Items ~ 3. JUL AUG AUG SEP SEP SEP OCT OCT OCT OCT NOV NOV NOV NOV DEC DEC DEC DEC JAN JAN JAN FEB FEB MAR T MW Yearly sold items ~ 17.700 MAMA Tables FG SS EE RA ZZ = = = = = Forecast and safety stock Only safety stock Forecast 10-digit kits EE Frames not included in FG & SS Items using combination of above TED Weekly/Monthly * Lead time (=Median) * Early and on time page 53 / July 2008 .

PARETO OR ABC ANALYSIS Pareto Analysis. In Inventory Management ABC Analysis is the more common term. For slow moving items with a low usage value simple control is applied. Close control is important for fast moving items with a high usage value. is a method to classify data according to their importance. He discovered that 80% of the wealth in Italy was held by only 20% of the population. hence called 80/20 rule. It was invented by Vilfredo Pareto (1848-1923). Separate the Important Few from the Trivial Many! This method is frequently used in inventory management to group items according to their yearly usage value. also called 80/20 rule or ABC analysis. page 54 / July 2008 . an Italian economist and sociologist.

Will the past repeat? XYZ analysis is a dynamic method and complements ABC analysis. In inventory management we are more concerned about the future. describing historical data and represents the value component. Focusing on A-Items (high yearly usage value) as forecasts for coming periods could be wrong because values might be completely overstated. It represents the time component.XYZ ANALYSIS ABC analysis alone can generate very misleading results. ABC analysis is a static method. How often was an item used and how good can it be forecasted? page 55 / July 2008 .

static .ABC / XYZ BASICS ABC / XYZ A X High Usage Value High Forecastability Y High Usage Value Medium Forecastability Z High Usage Value Low Forecastability B Medium Usage Value High Forecastability Medium Usage Value Medium Forecastability Medium Usage Value Low Forecastability C Low Usage Value High Forecastability Low Usage Value Medium Forecastability Low Usage Value Low Forecastability ABC analysis – value component.alone gives misleading results. It must be complemented by a XYZ analysis – time component. dynamic! page 56 / July 2008 .

12 times 6 to 10 times 0 to 5 times $% A X A #% Y Z Make-to-order. Discrete Forecasting Make-To Order. Tender Management.ABC / XYZ OVERVIEW XYZ is TIME Component Q XYZ T ABC is VALUE Component ABC Class Frequency X Y Z 11. cumulative lead time B C Class Usage Items A B C 80% 15% 5% 20% 30% 50% Reorder-Point page 57 / July 2008 .

Divide the standard deviation by the arithmetic mean getting the coefficient of variance. It is assumed that ABC is known and can be applied. x= ∑x i =1 n i n Calculate the arithmetic mean.ABC / XYZ CALCULATION The steps for determining XYZ are simple and are described below. Classify your items into ABC and XYZ. Calculate the standard deviation. see next slide for rules of thumb. 1 n 2 s= ∑( xi − x) n −1 i=1 s cv = x page 58 / July 2008 .

• XYZ (exact method) X: CV <= 40% Y: CV > 40% and <= 80% Z: CV > 80% • XYZ (based on frequency) X: FREQ 11.ABC / XYZ RULES OF THUMB • ABC A: 80% of usage value and 20% of items. 12 Y: FREQ 6 to 10 Z: FREQ 0 to 5 The frequency is an integer value counting how often there was a usage greater than zero in the active periods. C: 5% of usage value and 50% of items. B: 15% of usage value and 30% of items. Max 12 and min 0! page 59 / July 2008 .

080.00% =IF([FREQ]<=5.152.IF([FREQ]<=10.47% A 10 Y AY 1.">0") 0 0.53% 7.782 1.ABC / XYZ WITH MS EXCEL I USAGE-USD % Cum% ABC FREQ XYZ CLASS 1.00% 100."Y".00% 100.00% A 11 X AX 986.00% 100.00% 2.00% A 11 X AX 1.438."Z".83% A 9 Y AY 1.00% 100.287.40% A 11 X AX 972.40% 8.931 1.563 1."X")) C 0 Z CZ 0 0.00% C 0 Z CZ 0 0.00% C 2 Z CZ 0 0.560 1.83% 3.64% 5.090 1.00% C 0 Z CZ 70.129 From column [Cum%]: A-items 0 to 80% B-items >80% to 95% C-items >95% Legend: * [Usage] refers to usage range page 60 / July 2008 .38% 9.252 2.00% 100.78% A 11 X AX =COUNTIF([Usage].412.00% C 2 Z CZ 0 0.

00% Cum% ABC FREQ XYZ CLASS 2.40% 1.438. 3. 4.83% A 9 Y AY 5. Calculate USAGE-USD per item.931 972.129 % 2.090 1.152.00% C 0 Z CZ 100.129.83% 1.00% C 0 Z CZ 1. From column [Cum%] determine ABC in column [ABC].00% 0. at bottom of column.00% A 11 X AX 8. 2. >80% to 95% B-items and balance C-items. 5. Divide each item’s USAGE-USD by Total Usage Value in column [%].ABC / XYZ WITH MS EXCEL II USAGE-USD 1.00% 0.38% 0.00% C 0 Z CZ 100.412.080. Add cumulative percentages in column [Cum%]. here $70.00% 0.782 1.252 1.00% 1. Rule-of-thumb: 80% of cumulative percentage A-items.563 0 0 0 0 0 70.47% A 10 Y AY 7.438.560 986.g. “>0”)! page 61 / July 2008 . 6.00% A 11 X AX 3.40% A 11 X AX 9.64% 1.00% C 2 Z CZ 100.00% C 2 Z CZ 100. Sort USAGE-USD by descending value and add Total Usage Value. e.00% 0. Calculate the frequency (How often was the monthly usage greater than Zero?) per item in column [FREQ] with forumula: =Countif([Usage-Range].53% 1.78% A 11 X AX 100. YTD usage quantity multiplied by unit costs.287.

83% A 9 Y AY 5.252 1. Determine CLASS category in column [CLASS] with formula: =[ABC] & [XYZ] 9.00% 1.412.152.83% 1.00% A 11 X AX 8.00% A 11 X AX 3.00% C 2 Z CZ 100.”X”)) 8.00% C 0 Z CZ 100. Calculate XYZ category in Column [XYZ] with a nested if-formula.129 % 2.00% 0. page 62 / July 2008 . =If([XYZ]<=5.”Y”.931 972.64% 1.090 1.438.40% 1.782 1.560 986.00% C 0 Z CZ 7.00% 0.080.00% Cum% ABC FREQ XYZ CLASS 2. Prepare ABC / XYZ analysis overview.53% 1.38% 0.00% 0.40% A 11 X AX 9.287.78% A 11 X AX 100.”Z”.47% A 10 Y AY 7.563 0 0 0 0 0 70.00% 0.00% C 2 Z CZ 100.ABC / XYZ WITH MS EXCEL III USAGE-USD 1.00% C 0 Z CZ 100.If([XYZ]<=10.

37% 10.00% 19.60% 16.30% 100.61% 748.50% 19.619 1.72% 166.590 2.61% 101.564.115 137.689 56.143 18.520 0 173 6.654 3.00% 5.45% 15.80% 32.307 0 Y 134 4.942.013 38.726.948.687 178.187.045.99% 2.246 30.564 0 31 1.95% 172.952.74% 100.721 B ABC C Usage Obsolescence Reserve Total Items Total Items% Total Usage Total Usage% Total Inventory Total Inv% Total Res25% Total Res100% Items Inventory page 63 / July 2008 .849 70.056 0 75 2.390.670 1.843 0 199 7.925 1.35% 19.236 1.011 53.74% 10.34% 33.129 1.147.292 5.764.116 881 Z Grand Total 93 296 3.57% 70.917.628 19.095 0 0 313 517 11.298 4.194.34% 22.24% 98.916 1.27% 3.739 7.529 50.083.20% 100.00% 954.74% 7.029.752.796 2.513 0.577 10.749 0.60% 45.499.01% 1.86% 26.29% 1.757 75.99% 8.ABC / XYZ EXCEL RESULTS XYZ ABC A Data Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% X 69 2.247.558 0.35% 18.75% 5.12% 667.687 0 175 6.26% 2.592 27.108 38.227.108 28.775 16.50% 3.813 368.13% 135.06% 34.583 3.35% 31.880 3.514.881 27.944 60.389 14.872 8.076 2.325.311.00% 238.596.51% 2.915 27.79% 50.88% 80.87% 4.88% 331.22% 621.948 13.754 881 506 18.53% 28.01% 1.840 1.326.188.47% 79.925 38.868.945.003 0.252 3.11% 1.475.139 9.700 9.226.958 44.

short lead times. BZ CX. economic order quantity can be applied No forecasting and safety stock. AY. order quantity LFL (lot-for-lot).ABC/XYZ INVENTORY POLICY RULES AX. make-to-order policy. BX Statistically forecasted. make-to-order policy. make-to-stock or assemble-to-order policy. make-to-stock policy. safety stock policy should be used Can be statistically forecasted. safety stock policy should be used only. long lead times No forecasting due to low usage and/or sales value. cumulative lead times BY AZ. CY CZ page 64 / July 2008 . medium lead times Tender management or discrete forecasting if applicable.

Version 6.PRACTICAL FORECAST EXAMPLE • • • • The next slides show detailed steps converting historical sales data into forecasts. Inc. Commercial Edition. Microsoft Access is used to change vertical historical data into horizontal time periods. Cognos Query is used to extract historical sales data from TED (Tyco Electronics Data Warehouse). from Smart Software. MRP screens are shown as well. Software used for forecasting SmartForecasts for Windows. page 65 / July 2008 .

Save into a comma separated file! page 66 / July 2008 .COGNOS QUERY Data & Filter The query data contain all fields of interest and the filter definition downloads only selected historical data records from TED.

Current month forecast values will NOT be loaded into AMAPS! page 67 / July 2008 .HISTORY AND FORECASTS 36 months historical values 12 months forecasted with Smart Forecast for Windows History Current AMAPS MRP relevant months with forecast values always total forecasted months minus current month.

Vertical time periods are changed to horizontal ones for easier forecasting. page 68 / July 2008 .FORECAST FILTER The Crosstab query filters from historical sales data only items which should be forecasted (=Finished Goods. Quick-Ship. Off-the-shelve).

If needed sort periods in right sequence.COPY FILTERED DATA Copy query content from Microsoft Access into Smart Forecast for Windows. page 69 / July 2008 .

page 70 / July 2008 .FILL BLANKS WITH ZERO Fill blank cells with zero. Zeros are valid historical values but blanks are treated as gaps in the time series and forecasts will start at blank cells.

FORECAST TOURNAMENT 1) Configure ---> Files. Variable Labels = 6 2) Forecast tournament with Smart Forecast for Windows. Automatic selection of forecasting method 3) Forecast horizon = 12 page 71 / July 2008 .

Save forecasts results. page 72 / July 2008 . press button “Save All … “ Export final forecast into Microsoft Excel. AMAPS in Ottobrunn. Load into MRP system.BASIC FORECASTING STEPS Smart Forecast for Windows 1) 2) 3) 4) Adjust forecast as needed. review manual for more details.

page 73 / July 2008 .FORECASTS IN MRP SYSTEM Sample screen from Ottobrunn’s AMAPS Demand generated by Forecasting is identified by an order type M/S.

PERIOD ORDER QUANTITY Sample screen from Ottobrunn’s AMAPS A dynamic Order Policy is used. here POS (=Periods of Supply). page 74 / July 2008 .

SAP CLASSIFICATION OF MATERIAL July 2008 .

TYCO’S GIC SAP STOCK POLICY Z100 The following criteria are aimed for a stock material: • • • • • • • • • AX. Supply MOQ < 3 months forecast At least 1 PPQ per weeks forecast At least 12 ship lines (hits) in last 6 months The X Distribution Chain status must be E2 (released). Material must not be included on the “do not change to stock” file. GIC EMEA page 76 / July 2008 . BX At least 5 months demand in the last 6 months. demand in last 6 months. AY. At least 3 customers in last 6 months No customer greater than 75% share in last 6 months A ratio of the last 2 months demand compared to the avg. Paul McCullagh.

it is then changed to a Z100. This then allows the Xelus forecast to be active in MRP. BY Paul McCullagh. • When a new Stock material has been identified and agreed with the relevant PM it will be changed to a Z110 for an initial 3 month period. At the end of this period and if the material still meets the required criteria. • Z110 can also be used for a manual forecast provided by the PM to initiate supply for a new or strategic product. GIC EMEA page 77 / July 2008 .TYCO’S GIC SAP STOCK POLICY Z110 This is firstly a transitional MRP Group with a view to changing to Z100. Any failed materials are reviewed on a individual basis with the PM to either change to Z120 or Z200.

BZ There are 4 reasons why a material can be a Z120 : • • • • Customer Order with supporting schedule agreement for the MOQ. AZ.These are materials that do not qualify to be Stock. These materials are effectively Make to Order with a replenishment lead time as a Z200. Paul McCullagh.TYCO’S GIC SAP STOCK POLICY Z120 • A Z120 strategic material is Sales/Product Management initiated. GIC EMEA page 78 / July 2008 . A buffer stock A forecasted part for specific customers in the form of schedule agreements Agreement to sell in PPQ’s.

TYCO’S GIC SAP STOCK POLICY Z200 CZ • • • • • Back to Back ordering Logic only. No Schedule agreements No Buffer stocks. GIC EMEA page 79 / July 2008 . No EDI forecasts. Paul McCullagh. No Xelus forecasts.

INVENTORY QUALITY RATIO (IQR) July 2008 .

with no excess. The items in these groups are then stratified into typical ABC-type classifications using their future dollar requirements. items with no future requirements but with recent past usage. slow moving (SM) or no moving (NM). slow moving or no moving inventories).. E2 or E3). The balance on hand of each item is compared to the rule and the dollars of each item are categorized as either active (A1 or A2). Gary Gossard.INVENTORY QUALITY RATIO (IQR) The IQR logic divides inventory into three groups: items with future requirements. their past dollar usage. The IQR is the ratio of active inventory dollars to total inventory dollars. the IQR would be 100 percent. respectively. These are called the seven quality categories. Improving Inventory Performance and Bottom-Line Profits page 81 / July 2008 . the IQR for most companies surveyed is in the 30-45 percent range. In a theoretically perfect situation (i. excess (E1. and items with neither. A rule or target inventory level is set for each item based on its classification.e. or their current balances on hand. Using nominal target inventory levels of 412-24 weeks’ supply for A-B-C items.

24 DEF E1 B A1 ABC B A2 E2 © 1992-2004 IQR International page 82 / July 2008 .15 .5 % 4 .OVERVIEW INVENTORY QUALITY RATIO MRP / ERP NM 12 SM BOHV Data Extract E3 H AWWRV G H K 6 AWWUV R 80 .12 .

INVENTORY QUALITY RATIO IQR = Active Inventory Dollars Total Inventory Dollars IQR = A1 + A2 A1 + A2 + E1 + E2 + E3 + SM + NM Perfect IQR = 100% © 1992-2004 IQR International page 83 / July 2008 .

AVERAGE INVENTORY QUALITY RATIO Active Inventory Dollars Total Inventory Dollars A1 + A2 A1 + A2 + E1 + E2 + E3 + SM + NM IQR = IQR = 30-50% Average IQR = 30-45% © 1992-2004 IQR International 10% page 84 / July 2008 .

Slow Moving: no reqmt. balance within limits .Dynamic ABC and user-defined parameters • Develops inventory quality categories: . no use in 6 months .Active: reqmt/use.INVENTORY QUALITY RATIO LOGIC • Analyzes inventory using: .Balance on hand and unit cost .Excess: reqmt/use.Past usage and future requirements . © 1992-2004 IQR International page 85 / July 2008 . no use in 12 months • Measures overall inventory performance. balance over user’s limits .No Moving: no reqmt.

458 1.689 4.400 267 Total 372 17.667 54.965 32.4% 47.738 18 3.INVENTORY QUALITY RATIO SAMPLE Quick Look Dollars ($1000) by Purch / Manuf and Quality Category Purch Manuf P M Active 1 351 21 Active 2 16.9% © 1992-2004 IQR International page 86 / July 2008 .756 3.507 IQR Ratio 32.5% Moving Moving 1.879 385 3 0 0 Slow No Total Value 53.264 0 1.994 695 Excess Excess Excess 1 4.097 121 2 26.218 27.

ABC / XYZ CLASSIFICATION Examples July 2008 .

161 €22.552 7 (=Frequency) What quantity will be forecasted? page 88 / July 2008 .EXERCISE 1 A Description: Unit-Cost: Qty on-hand: Inventory Value: Usage Value: Months with Usage: SOME-1094-102K049-126/89 €6.800 €23.10 3.

EXERCISE 1 B

Classification = BY

page 89 / July 2008

CONCLUSION EXERCISE 1
The Arithmetic Mean is an in-appropriate tool to use as an order quantity and/or monthly forecast for items with irregular demand. In this situation the Median ( = the middle value! ) should be used instead, because it excludes extreme high and/or low values! Stock is normally available for components going into parent items. Lead times could be 2 to 3 weeks. These items are normally purchased and/or manufactured with an assemble-to-order policy.

page 90 / July 2008

EXERCISE 2 A

Description: Unit-Cost: Qty on-hand: Inventory Value: Usage Value: Months with Usage:

RICS-5043-30-1 €20.67 1,106 €22,864 €364,734 12 (=Frequency)

What quantity will be forecasted?

page 91 / July 2008

EXERCISE 2 B

Classification = AX

page 92 / July 2008

CONCLUSION EXERCISE 2
For items with regular demand, either the Arithmetic Mean or the Median could be the proper tool for calculating monthly order quantities and/or forecasts. A good practice in forecasting is, to eliminate extreme values. One method could be excluding the highest and lowest value! Stock is normally available and lead times are short and predictable. These items are purchased and/or manufactured with a make-to-stock policy.

page 93 / July 2008

146 2 (=Frequency) What quantity will be forecasted? page 94 / July 2008 .EXERCISE 3 A Description: Unit-Cost: Qty on-hand: Inventory Value: Usage Value: Months with Usage: 603W035-53/239(S5) €8.400 €12.58 1.006 €5.

EXERCISE 3 B Classification = CZ page 95 / July 2008 .

Could build stock in anticipation of a known (=discrete) potential order with a high probability. this items are purchased and manufactured with a make-to-order policy. either the Arithmetic Mean or the Median are in-proper tools for monthly order quantities and/or forecasts. In nearly all cases. Stock is normally not available and lead times are long! page 96 / July 2008 .CONCLUSION EXERCISE 3 For items with one-time or very irregular demand. These items should be treated with discrete and not with statistical forecasting.

CHAPTER C MISLEADING INVENTORY TURNS July 2008 .

Q3 Dulmison COS (cost-of-sales) was $1. page 98 / July 2008 .MISLEADING INVENTORY TURNS INTRODUCTION Adam Hinton. The next slide illustrates the unfavorable month-of-supply distribution and why inventory turns or DOH (days on-hand) were misleading.582K. annualized COS equals $4. The UK got a credit for the cost-of-sales although there was no inventory activity because of the drop-shipments. stock turns 10. wrote me an E-Mail on the 10th of July 2006 with the following content regarding the inventory performance for Dulmison UK for June 2006: “Erwin. controller UK.25.” He concluded. that inventory turns is a misleading figure because much of the Dulmison UK inventory was slow moving and most of the sales were from drop shipped projects [from Thailand]. current inventory $447K.146K.

MISLEADING INVENTORY TURNS INTRODUCTION CHART page 99 / July 2008 .

Jordan Products.625. But is there a further potential for inventory reduction? page 100 / July 2008 .4 Based on inventory turns pretty good performance.625.663 / 90 ~ $18.054 / $18.063 $450.MISLEADING INVENTORY TURNS 1A Ottobrunn. July 2004 Gross-Inv: 3 COS: Daily COS: Days: Inv Turns: $450.792.May04: 642.063 ~ 25 360 / 25 ~ 14.054 $1. Jun04: $480.663 (Jul04: $502.659.212) $1.

4 there is another inventory reduction potential of at least $74K! page 101 / July 2008 .MISLEADING INVENTORY TURNS 1B Although inventory turns were pretty high with 14.

July 2004 Gross-Inv: 3 COS: Daily COS: Days: Inv Turns: $1. Cable Accessories.882.527.663 / 90 ~ $65.221 $5.623K. Jun04: $1.MISLEADING INVENTORY TURNS 2A Shannon.922K.338K) $5.363 ~ 23 360 / 23 ~ 16 Based on inventory turns pretty good performance.663 (Jul04: $1.363 $1. But is there a further potential for inventory reduction? page 102 / July 2008 .882.May04: $2.527.221 / $65.

In fact we have a big obsolescence reserve problem of around $500K! page 103 / July 2008 .MISLEADING INVENTORY TURNS 2B Inventory turns of 16 were misleading.

CHAPTER D PRACTICAL APPLICATION OF INVENTORY MANAGEMENT July 2008 .

INVENTORY REDUCTION APPROACH Management Input 3-Years Inventory Targets: 50-Days-Reach Inventory or 7.2 WW Inventory Turns Manufacturing Sites: 4+ Turns Distribution Sites: 6 – 8 Turns Sales Inventory Sites: 12 Turns Classification of Sites Inventory Control Tools • • • • • ABC/XYZ Analysis Month-of-Supply Obs Reserve Procedure Push / Pull Strategy Inventory Ratios Sites classified as 'Distribution Inventory' must have a kitting operation and sites classified as 'Sales Inventory' have no kitting operation – only pick & pack! page 105 / July 2008 .

INVENTORY POLICY for Global Energy Published 6th February. it has become necessary to issue a further reminder and re-statement of the Inventory Policy for Global Energy Division as follows: • No supplying site is allowed to ship more than 2 MOS (months-of-supply) to ordering sites based on minimum order quantities for purchased and manufactured parts. This has to be reversed. Supplying sites producing or purchasing minimum lot sizes over 2 MOS have to keep the excess inventory if this does not affect negatively their inventory targets.5M to $3M. Urgent action is needed now. Ordering sites should refuse receipts over 2 MOS if this will hurt their inventory targets. orders have to be placed directly to supplying sites. It is mandatory to have an order before. • As of December 2007 CZ parts (no usage and no demand in the last 12 months) accounted for [3. We expect all sites and functions to fully support these measures.6%] of worldwide gross-inventory. 2008 Further to our e-mail in June 2007.2%] of our usage and [19. • No inventory build is allowed for potential projects with questionable accounts. The key objective is to cut our worldwide shipping inventory (not released due to customer inflicted reasons) by half down to $2. Tony Gatt / Joe Lane / Olaf Happe page 106 / July 2008 . Any business requirements which need to deviate from this policy will be approved by Olaf Happe on an exception basis. Energy management will consider taking appropriate disciplinary action against anyone who fails to comply with this policy. To avoid unnecessary inventory build-up in our supply-chain.

INVENTORY CYCLE I
1.Accounting View of Inventory Intercos M&P RM WIP Obsolescence Reserve Net-Inventory and DOH GIT FG COGS
ABC is VALUE Component ABC

4. ABC / XYZ Analysis Revenue Recognition
XYZ is TIME Component Q XYZ T

X A

Y

Z
Make-to-order, Tender Management, Discrete Forecasting Make-To Order, cumulative lead time

$%
A

#%

B C
Reorder-Point

3. Month-of-Supply Analysis 2. Approximated DOH

page 107 / July 2008

INVENTORY CYCLE II
1. The „Accounting View of Inventory“ splits inventory into raw material, work-inprocess, and finished goods. The focus here is „added-value“ from receiving material into the warehouse till the shipment to the customer as finished goods. For inventory control this view is not sufficient for corrective actions. 2. Calculating „Approximated DOH“ breaks down inventory into product lines and/or groups separating the good from the bad performers. The bad performers have to be broken down further. 3. A „Month-of-supply Analysis“ of inventory (=aging!) should be done to detect the scope of the problem for the bad performers. A good inventory distribution must be right-skewed. 4. Last but not least a combined „ABC/XYZ Analysis“ is needed to find the items representing the „bread-and-butter“ business also called standard products. Here we determine our inventory strategy, e.g. make-to-order or make-to-stock, safety stock, lot sizes etc.
page 108 / July 2008

Trade Sales FY 2006
XYZ ABC A Data Parts Parts % Sales Sales % Margin Margin% Parts Parts % Sales Sales % Margin Margin% Parts Parts % Sales Sales % Margin Margin% Parts Parts % Sales Sales % Margin Margin% X 2,103 5.5% 310,208,124 44.1% 148,498,509 49.2% 1,195 3.1% 18,226,298 2.6% 7,783,244 2.6% 489 1.3% 1,501,919 0.2% 552,783 0.2% 3,787 9.8% 329,936,340 46.9% 156,834,535 51.9% Y 1,526 4.0% 154,469,291 22.0% 60,404,177 20.0% 2,386 6.2% 32,236,584 4.6% 14,366,248 4.8% 2,569 6.7% 6,215,043 0.9% 2,461,219 0.8% 6,481 16.8% 192,920,919 27.4% 77,231,644 25.6% Z 1,329 3.4% 97,954,126 13.9% 35,165,566 11.6% 4,416 11.5% 55,049,545 7.8% 22,182,658 7.3% 22,519 58.4% 27,448,623 3.9% 10,568,462 3.5% 28,264 73.4% 180,452,294 25.7% 67,916,686 22.5% Grand Total 4,958 12.9% 562,631,541 80.0% 244,068,252 80.8% 7,997 20.8% 105,512,427 15.0% 44,332,150 14.7% 25,577 66.4% 35,165,586 5.0% 13,582,464 4.5% 38,532 100.0% 703,309,553 100.0% 301,982,866 100.0%

• TED trade sales of $703M in USD TBR06 in FY2006 for competency 13005 (only Energy). • We sold around 40K discrete products but around 60% of our products in class CZ generated only 3.9% of sales with only 3.5% of margin. • For our repetitive business in class AX, AY, BX, and BY we only needed ~20% items but generating ~75% of sales.

B

C

Total Total Total Total Total Total

page 109 / July 2008

Trade Sales FY 2006 – C Items

Looking at C-items from an inventory point of view it can be shown that these items account for the majority of slow-moving and/or dead-stock inventory. Most fo these items have a low inventory value but the cumulative impact goes into the millions!
page 110 / July 2008

FY2007 Inventory Reduction Approach

ADR-049 December 2006: Purchased outside Vendor Manufactured in-house Purchased within Tyco

$48,129 $33,801 $28,500

43% 31% 26%

page 111 / July 2008

Inventory turns or DOH (days on-hand) are based on Hyperion total trade COS (other and standard cost-of-sales) and are used as corporate performance measure. 4. Depending on the Interco shipments per site DOH for worldwide benchmarking might be based on total shipments – Interco and Trade shipments at cost – from TED (Tyco Electronics Data warehouse). Total cost-of-sales for Zibo is based on feedback from local controllers. 3. 5. Reported inventory represents Net-Inventory. Net-Inventory consists of raw-material plus work-in-progress plus finished goods plus goods in-transit minus obsolescence reserve. 6. 2. All reported inventory is based on Hyperion and valued in USD TBR (Tyco-BudgetRate) for FY2007.MONTHLY INVENTORY REPORTING 1. page 112 / July 2008 .

254 $11.587 $3.978 107 56 126 107 131 68 126 55 53 116 $12.243 8.023 64. USA Shannon Gevrey Wyong Axicom Canada Corp-India $138.8% page 113 / July 2008 .173 $15.911 $11.1% TOP10 Ottobrunn U.231 13.984 10.429 $15.K.261 $1.8% $4.WW Inventory by Region Jan07 $19.2% $89.908 $30.427 3.070 $13.1% $13.504 $5.

MONTHLY HYPERION INVENTORY REPORTING Monthly Hyperion inventory reporting (=accounting view!) page 114 / July 2008 .

MONTHLY INVENTORY REPORTING TOP 10 page 115 / July 2008 .

MONTHLY INVENTORY BY COMPETENCY page 116 / July 2008 .

747 9.177 1.165 1.MONTHLY INVENTORY PROJECTION FY 2007 Sep07 Act Actual Inventory FY2008 Oct07 Act Inventory Forecast Jan08 Act Inventory Plan FY 2008 Feb08 Plan Nov07 Act Dec07 Act Feb08 Fcst Mar08 Fcst Apr08 Fcst Mar08 Plan Apr08 Plan Sep08 Plan NET-INVENTORY Ottobrunn 0973 Gevrey 0436 UK All Shannon 0964 Axicom 1294 India All Saudi 0993 Dubai 1369 USA FV 1083 Canada 0392 Brazil 1300 Mexico 0399 Wyong 1147 Thailand 1148 Hong Kong 0451 Shanghai 1006 Zibo 1149 Indonesia 1143 Singapore 1.477 1.519 10.680 2.051 144.000 1.700 2.795 1.400 1.500 1.691 7.622 10.648 8.900 1.825 10.500 1.393 3.000 2.000 1.837 8.184 1.658 9.700 5.000 7.900 11.000 12.414 5.656 1.143 10.000 Fcst DOH 144.100 4.300 1.100 9.194 2.100 14.200 1.500 1.937 31.680 3.131 3.900 5.200 13.000 139.105 12. Wadhwa M.100 1. Opalla BASE TED TED TED TED TED TED HYP HYP HYP TED TED HYP HYP TED HYP HYP TED TED HYP HYP HYP 133.114 13.995 15.896 861 10.300 3.580 3.450 9.000 6.242 1. Dave H.694 11.000 4.859 2.254 5.230 5.180 2.600 11.001 99 63 75 79 126 58 156 104 66 124 32 90 59 95 114 28 97 82 53 71 141 87 145.002 31.934 8.305 2.000 3.200 1.048 11.000 100 94 Monthly inventory reduction action meetings. Leme A.400 13.900 1.000 138.700 1.230 1.519 142.356 12.230 1.500 2.379 2. Leme R. Dominguez R.259 1.014 34.732 2.557 6.000 12.294 1.574 8.647 8.111 12.740 11.800 9. Glennharto R.681 3.800 1.231 940 834 1.863 4.487 11.769 966 11.225 4.100 750 1.663 2.766 6.014 2.500 7.400 11.025 999 675 1.172 980 800 1. Kryukov E. Stenz H.226 2.000 145.611 32.467 35.732 2.000 4.501 1.977 12.000 132.250 9.800 1.113 3.750 9.014 Dul Malay ??? Rayenergo ??? Other Sites XXXX M.200 12.790 30.450 3.400 14.500 1.000 $140.350 1.211 1.200 2.200 12.200 3.536 11.200 14.200 2. Djane T.164 950 750 1.216 900 750 1. Dominguez M. Dave A.419 1.753 1.200 9.730 3.356 780 600 1.021 1.143 1.586 12.491 12.076 1.700 6.700 2.000 4.550 36.977 1.158 977 728 1.430 3.662 11.000 12.756 10.488 1.900 1.385 3.323 1.037 12.298 11.100 1.800 1.500 8.350 5.749 1. page 117 / July 2008 . MacDonnell D.851 1.827 3.333 31.200 2.490 3.883 11.798 1.588 8.666 11.100 750 1.152 3.461 1.200 1.305 12.000 10.510 35.350 11.100 14.250 3.864 8.328 12.754 1.300 2.500 5.200 10.084 4.061 3.161 2. Tan S.114 758 762 713 1.588K! 3COS = 3COS = $131.229 1.416 33.912 9.500 1.658 2.742 984 2.576 2.719 5.500 8. Wan Yusuf D.193 2.159 7.028 728 1.774 11.797 1.300 2.780 9.250 10.838 12.743 144.545 11.000 35.143 1. Kessler C.898 11.000 5.100 1.225 3. Qiu A.700 6.200 14.589 2.577 8.171 33.000 138.351 13.036 2.166 985 3. Wong H. Morris Nok J.200 2.350 5.700 6.200 3.800 1.000 Legend: * Fy2008 recost impact on inventory $2.900 5.903 11.937 10.000 11.000 4.102 12.100 750 1. Burgess R.658 867 11.194 1. Qiu H.000 1.517 81 50 59 62 94 49 128 50 70 83 50 63 74 106 137 32 73 64 50 53 60 81 136.138 1.650 1.000 5.200 3.450 3.

1. Daily Cost-of-sales = COS last three months divided by 90 Days-Reach (DOH) = Net-Inventory divided by daily cost-of-sales Inventory-Turns = 360 / Days-Reach Derivation: DOH = 360 / Turns = 360 / (COS / INV) = 360 / ((4 × 3COS) / INV) 360 × INV = = INV / (3COS / 90) 4 × 3COS INV = Daily COS page 118 / July 2008 .INVENTORY FORMULAS The following formulas are used for Inventory Days-Reach and Turns. 3. 2.

2. This ratio gives a good insight into the “aging” of inventory and highlights items where urgent review of order parameter is needed. page 119 / July 2008 .MONTH-OF-SUPPLY CALCULATION I A good starting point for analyzing manufacturing inventory is a simple month-of-supply calculation. 1. Dead-stock is all inventory with no usage in the last 12 months and no demand. 1st Demand has as well no usage in the last 12 months but for the first time demand has been recorded.

2. Divide per item the last 12-month usage by the number of active usage periods. and Qty OH = 500 pcs Month − of − Supply = QtyOH ÷ 600 = 500 ÷ 6 = 5 months Usage last 12 months Active Periods page 120 / July 2008 . Example: Usage last 12 months = 600 pcs.MONTH-OF-SUPPLY CALCULATION II The calculation is done in three steps: 1. see next slide for an example. 3. Active periods = 6. Classify the inventory in meaningful terms. Divide the current free qty on-hand by the monthly usage from point “1”.

447 + $11.652 = 43% QIP should be between 60 to 70%! page 121 / July 2008 .803 + $18.Quality of Inventory Percentage (QIP) % of Inventory < 3 MOS QIP = = (0 − 1M ) + (1 − 2M ) + (2 − 3M ) Total Gross Inventory $14.767 $104.

page 122 / July 2008 .FY 2008 Inventory Reduction Plan Quality of Inventory Percentage (QIP) The QOI percentage must be around 70%.

Approximated DOH Approximated DOH by competency will be used to detect inventory reduction potential during monthly inventory reviews. A good inventory performance is right-skewed using month-of-supply and has a QIP between 60 to 70%! page 123 / July 2008 .

274 324.145 3.951 152.973 0.122 26.560 1.446 23.153 1.482 466.01% 89 0.503.101 372 192.137 19.86% 15.947 109.930 176.189 6.00% 0 0.645 11.374.731 3-6 M 447.361 218.00% 69 0.09% 3.83% 15.758 4.700 1.200 40.62% 36.248 461.12% 20.513 9.529 100% 0.932 483.090 5.25% 31.845 16.711 41.66% 682.916 28.04% 1.164 360 2-3 M 73.320 153.459 29.685 20.482 966.256 300.692 2.085 47.451 3.492 106.212.682 30.942.020.01% 623 0.347 22.034 12-24 M 24-99 M 988.161 492 1st Demand Dead Stock Total % 62.411 6-12 M 432.476 42.688 445.63% 9.957 81.646 66.954 8.180 214.731.562 161.00% 0 0.72% 100% 69 860.11% 24.02% 257 748 0.760 12.621 3.173 9.71% 13.393 0.118 38.09% 184.261 593.20% 6.53% 190.422 37.360 620.901 0.742 114.659 14.562.685 2.233 6.157 1.848 69.295.97% 25.902 25.310 1.00% 0 0 0.305 2.357 9.983 607.146 50.973 739 1.350 111.997.393 0 0 623 89 0 0 0 932.363 1.MONTH-OF-SUPPLY APPLICATION I Competency Code 5 Bowthorpe (13155) ENERGY CABLE ACCS (13041) INSULATORS (13040) SURGE ARRESTER (13037) COMPOUNDS (13054) COPPER (13061) RAYSULATE (13039) Dulmison Insulators (13074) MATERIALS (13055) B&H Products (13150) HARNESS COMPONENTS (13048) DULMISON FITTINGS (13072) HV Products (13234) HARNESSES (13049) SINGLE WALL TUBING (13043) Utilux (13181) SUCOFIT PRODUCTS (13149) Corrosion Protection (13007) Total % 0-1 M 108. • 1st Demand are all items with Zero Usage but First Time Demand.657 23.00% 62.346 1.09% • Dead-Stock items had Zero Usage and Zero Demand and were active in the last 12 months.772 9.253 436.555 258.965 4.059 33.104 102. page 124 / July 2008 .38% 1-2 M 131.07% 9.994 13.692 228.

357 500.000 1.772 860.500.363 1.000 Target 2.000 62.997.000.000.562.500.700 1.000 1.482 0 0-1 M 1-2 M 2-3 M 3-6 M 6-12 M 12-24 M 24-99 M 1st Demand Dead Stock page 125 / July 2008 .MONTH-OF-SUPPLY APPLICATION II 2.503.000 932.189 1.560 1.153 966.374.954 682.

It's important to understand the impact of changing the obsolescence reserve.000 has an immediate income impact because our operating income will be reduced by the resulting obs expense. An increase of obs reserve from $500 to $1.TYCO’S OBSOLESCENCE RESERVE POLICY Each site has to report their obsolescence reserve. This is normally done by finance quarterly. page 126 / July 2008 .

Transactions in month 7 to 12 500 pcs minus 300 pcs is 200 pcs ObsRes is 200 pcs * 100% 3. No Transactions in the last 12 months 500 pcs minus 0 is 500 pcs Obs Res is 500 pcs * 100% page 127 / July 2008 .OBSOLESCENCE RESERVE EXAMPLE Usage per year is 300 pcs. 1. Quantity on-hand is 500 pcs. Obs Res is 200 pcs * 25% 2. Transactions in the last 6 months 500 pcs minus 300 pcs is 200 pcs.

ORDER QUANTITIES GUIDELINES Up to 2 month-of-supply Local planner/buyer Between 2 to 6 month-of-supply Local group leader. authorized by local Logistics Manager Worldwide Controller and/or Global Logistics Manager Greater than 6 months-of-supply page 128 / July 2008 .

The Approver is the local supply-chain manager being accountable for the inventory performance. The issuer has the responsibility to maintain “current” stock builds. The Issuer of the stock build is the person filling out the form. Old or completed stock builds should be closed as explained in the training. Depending on the total value (see as well approval level policy) the approver can approve/authorize the stock build if it does not violate his approval level policy. • • • • page 129 / July 2008 . It can be the same person as the requester but this depends on the decision of the local Supply-Chain-Manager granting access to this application. As the time of writing this mail we identified the following approvers The Authorizers are Geert Quaegebeur and Olaf Happe. All values must be entered in K USD! The Requester of the stock build is normally a person from sales and/or product management. If the value for the stock build is higher than his approval limit the stock build is send to EMT members for authorization. For items with regular demand a stock build is only needed if violating our inventory policy not ordering and/or producing more than 2 months-of-supply of inventory. The issuer sends the stock build to the approver with the status Initialized.STOCK BUILD APPROVAL When to Apply • Stock Builds should be used for items having irregular demand or for new product launches.

com hdave@tycoelectronics.com rmacdonnell@tycoelectronics.com dmitry.burgess@tycoelectronics.com fchazee@tycoelectronics.com agus@tycoelectronics.com marco.com troy.qiu@tycoelectronics.wadhwa@tycoelectronics.com hdave@tycoelectronics.kyrukov@tycoelectronics.wong@tycoelectronics.com heidi.com akash.com troy.com troy.com marco.pp@tycoelectronics.burgess@tycoelectronics.dominguez@tycoelectronics.burgess@tycoelectronics.com jassica.com rpleme@tycoelectronics.com mgreen@tycoelectronics.STOCK BUILD APPROVAL List of Approvers – February 2008 1147 Wyong Australia 1300 Braganza Brazil 0451 Hong Kong 1006 Shanghai China 1149 Zibo China 0436 Gevrey France 0973 Ottobrunn Germany 0464 India-Corp India 1144 India-Sys India 1143 Djakarta Indonesia 0964 Shannon Ireland 0468 Auckland New Zealand 9999 Moscow Russia 0993 Damman Saudi Arabia 1014 Singapore 1151-0862 Wohlen CH 1148 Bangkok Thailand 1369 Dubai UAE 0962 Witham UK 1441 Witham UK 1325 Aldrige UK 1083 Fuquay-Varina US 0392 Markham CA Ashley Morris Ruy Leme Jassica Wong Heidi Qiu Heidi Qiu Fabrice Chazee Michael Kessler Himanshu Dave Himanshu Dave Agus Glennharto Randal McDonnell Murray Green Dmitry Kryukov Himanshu Dave Ridhwan Tan Daniel Stenz Nutchanat Permpool Akash Wadhwa Troy Burgess Troy Burgess Troy Burgess Marco Dominguez Marco Dominguez ashley.dominguez@tycoelectronics page 130 / July 2008 .com dstenz@tycoelectronics.com hdave@tycoelectronics.com mkessler@tycoelectronics.com heidi.com ridtan@tycoelectronics.qiu@tycoelectronics.morris@tycoelectronics.com nutchanat.

asp page 131 / July 2008 .asp • You can find an overview of all requested SBAs at http://deoworld1/energy-sba-masterlist.STOCK BUILD APPROVAL Intranet Link • You can enter/request a new SBA (Stock Build Approval) at http://deoworld1/energy-sba/sba-new.

page 132 / July 2008 .STOCK BUILD APPROVAL Totals by Entity Click on Org-ID to see a list of all Stock-Builds.

TED INVENTORY AND USAGE July 2008 .

III. TED Catalog page 134 / July 2008 . measures in HTML format. TED details as above plus 12 month historical usage reports by site. Screen on-line drill down for last completed month by region. Item number. Intranet Reports Separate IWR request for competency. Worldwide items search. competency. product code.WW INVENTORY AND USAGE REPORTING Power-Cubes Level of Detail I. Total 2 year’s history. GPL. product code. Site usage report for last completed month. II. GPL.

• Availability of 12 monthly usage data. calculated obsolescence reserve. NC IRL AUS BKK Otto page 135 / July 2008 . • Link between item-numbers and competency biz codes. stock on-hand etc. Mfg/Pro. or any Legacy Systems. SAP. quantity on-hand and unit-costs from Global-Cost-System for the last 2 years. • Month-of-supply and weeks-of-supply ratios. • Total outstanding customer requirements and supplies.WW INVENTORY REPORTING SET-UP Codes TED ADR-049 Data feed • Common front-end for worldwide inventory planning and control independent from current used systems.g. AMPICS. e.

WW INVENTORY HYPERION VIA USAGE REPORT The Intranet usage report includes obsolescence reserve and represents gross inventory minus work-in-process plus manufactured & purchased components! page 136 / July 2008 .

753K $16.681K or 2% Hyperion ADR-049 Net-Inventory $86.457K GAP $1.138K Hyperion page 137 / July 2008 .112K $84.892K $1.924K $94.569K $10.GAP HYPERION TO ADR-049 S E P T EM B E R Gross-Inventory WIP excl M & P GIT Sub-Total Obs Reserve Net-Inventory 2005 ADR-049 Hyperion Hyperion $75.

All worldwide usage reports can be downloaded into Excel as comma-separated format. product code and part number. page 138 / July 2008 . GPL.IWR REPORT SELECTION Intranet web reports can be requested by competency.

To get results for all entities will enter Tyco’s product number (TCPN).IWR REPORT NUMBER 1 SELECTION With this report you can request a worldwide inventory/usage overview per discrete item number. page 139 / July 2008 . All sites will be shown having either inventory and/or usage.

entity 1151.IWR REPORT NUMBER 10 SELECTION Select inventory and usage information for ALL items per reporting organization and/or plant. page 140 / July 2008 . is selected with plant code 0862 to get results for Axicom in Wohlen. In this case TELAG.

ADR-049 RESULTS I page 141 / July 2008 .

ADR-049 RESULTS II

page 142 / July 2008

ADR-049 RESULTS III
ABC A Data Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% X 69 2.50% 19,083,592 27.11% 1,596,775 16.06% 34,564 0 31 1.12% 667,003 0.95% 172,619 1.74% 7,056 0 75 2.72% 166,513 0.24% 98,749 0.99% 8,687 0 175 6.35% 19,917,108 28.29% 1,868,143 18.79% 50,307 0 Y 134 4.86% 26,752,108 38.01% 1,948,628 19.60% 16,520 0 173 6.27% 3,952,292 5.61% 748,739 7.53% 28,843 0 199 7.22% 621,558 0.88% 331,880 3.34% 33,754 881 506 18.35% 31,325,958 44.50% 3,029,246 30.47% 79,116 881 Z Grand Total 93 296 3.37% 10.74% 10,475,689 56,311,389 14.88% 80.00% 954,298 4,499,700 9.60% 45.26% 2,011 53,095 0 0 313 517 11.35% 18.75% 5,945,577 10,564,872 8.45% 15.01% 1,326,590 2,247,948 13.34% 22.61% 101,115 137,013 38,925 38,925 1,670 1,944 60.57% 70.51% 2,726,583 3,514,654 3.87% 4.99% 2,764,252 3,194,881 27.80% 32.13% 135,687 178,129 1,187,916 1,188,796 2,076 2,757 75.30% 100.00% 19,147,849 70,390,915 27.20% 100.00% 5,045,139 9,942,529 50.74% 100.00% 238,813 368,236 1,226,840 1,227,721

B

AX, AY and BX items account for around 66% of total usage. Represent typical candidates for statistical forecasting. CZ inventory (3.9% usage) make up 28% of total gross-inventory. Calculated obsolescence for CZ inventory $1,324K. Fully reserved $1,188K.

• •

C

Total Total Total Total Total Total Total Total

???
page 143 / July 2008

ADR-049 RESULTS IV

Only competency 13005 (Energy products) is shown!

page 144 / July 2008

ADR-049 RESULTS V

page 145 / July 2008

ADR-049 RESULTS VI

page 146 / July 2008

total usage. Here the first item is dead-stock in Dubai but could be used up in the UK! page 147 / July 2008 . stock submitted etc. It shows per product line all entities carrying active parts (=usage and/or stock is greater zero!) with month-of-supply.ADR-049 RESULTS VII This is a snapshot of the results of the new worldwide web-report.

ADR-049 MONTHLY CUBE This ADR-049 cube shows only data for the current month! page 148 / July 2008 .

ADR-021 WEEKLY CUBE The ADR-021 data feeds shows weekly gross-inventory (excluding WIP & GIT) by entity. page 149 / July 2008 . Several weekly values are available.

ADR-049 FEBRUARY 2007 KEY ENERGY ENTITIES page 150 / July 2008 .

Missing sites is Rayenergo with $1. Total net-inventory as of February 2008 $145M with DOH=99! page 151 / July 2008 .ADR-049 IMPLEMENTATION STATUS February 2008 As of February 2008 nearly all Energy sites report their gross-inventory and usage via the ADR-049 data feed.8M inventory.

CHAPTER E PROBLEMS WITH MINIMUM ORDER QUANTITIES July 2008 .

The supplying site‘s answer is that the mimimum order quantity for this item is 300 pcs.MISUSE OF MINIMUM ORDER QTY’S An ordering site needs only 1 pc of an item from a supplying site. If the ordering site would accept this minimum order quantity it would have to create a reserve for the receiced quantity in excess of a yearly usage if it would follow strictly financial procedures. What is the apporach? I need one piece! You have to order 300 pcs! page 153 / July 2008 .

page 154 / July 2008 . On the purchasing side quantities are bought taking advantage of discounts leading to lower unit costs. Financially. a provison for an obs reserve must be done for all quantities in excess of a yearly demand. if followed strictly. but at the same time the quantity ordered represents much more than the yearly demand. Set-up time is regarded as a fixed element which is not modifiable. Advocats of mimimum order quantities normally claim that it doesn't make sense setting up a machine in order to produce only a few meters or pieces because the set-up time would be much greater than the run-time.PROBLEM OF MINIMUM ORDER QTY’S The typical purpose of a minimum manufacturing or purchase order quantity is to find an optimal level between set-up or order costs and inventory carrying costs.

ordering sites have to procure minimum order qtys although their customer demand is much lower. This system results as well in slow-moving and/or obsolete inventory at ordering sites and leads to irregular demand at supplying sites although demand could be stable at source. This approach 'optimizes' the supplying site but sup-optimizes the worldwide supply chain.CURRENT PUSH SYSTEM Target Turns ----------TE Supplying Site MFG INV C/O 0 0 0 0 0 500 500 0 500 0 500 0 0 0 0 TE Regional Hub P/O INV C/O 0 0 5 500 0 5 500 0 5 0 500 5 0 495 0 Customer P/O INV 5 0 5 0 5 0 5 0 0 5 1 2 3 4 5 Customer places order Hub places min order qty Supplying Site produces min order qty Supplying site delivers min order qty Hub ships to end customer Legend: P/O C/O MFG INV Purchase order Customer Order Manufacturing order Inventory In our existing push system. page 155 / July 2008 .

.. Ordering Site N ...200 pcs MinOrdQty: 500 pcs Inv Turns: 2. Legend: MinOrdQty = EOQ etc. page 156 / July 2008 ...4 Ordering Site 1 Regional/Territory Yearly Demand: 120 pcs MinOrdQty: 500 pcs Inv Turns: 0.24 Ordering Site 2 .EXAMPLE DATA PUSH SYSTEM Supplying Site Worldwide Yearly Demand: 1.

Legend: * ROP is Reorder-Point * EOQ is Economic-Order-Quantity page 157 / July 2008 .PUSH SYSTEM AND IRREGULAR DEMAND Ordering Site ROP ROP ROP Time Supply Site EOQ EOQ EOQ Time Although the demand at the ordering site is quite regular demand at the supply site is showing an irregular demand pattern because of min order qtys.

200 pcs 300 pcs 4 Ordering Site 1 Regional/Territory Yearly Demand: 120 pcs MinOrdQty: 10 pcs Target Turns: 12 Ordering Site 2 . Ordering Site N ..... Legend: MinOrdQty = WW Demand / Target Turns page 158 / July 2008 ...EXAMPLE DATA PULL SYSTEM Supplying Site Worldwide Yearly Demand: MinOrdQty: Target Turns: 1.

page 159 / July 2008 . This approach avoids slow-moving and/or obsolete inventory at ordering and supplying sites. tries to optimize the worldwide supply chain. Capacity is better utilized. Remnants of min order qtys remain at supplying sites. Minimum order quantities at both. pull system.FUTURE PULL SYSTEM Target Turns Customer places order --Hub places min order qty based on target turn 12 Supplying Site produces min order qty 4 Supplying site delivers purchase order 4 Hub ships to end customer 12 TE Supplying Site MFG INV C/O 0 0 0 0 0 10 300 0 10 0 290 0 0 290 0 TE Regional Hub P/O INV C/O 0 0 5 10 0 5 10 0 5 0 10 5 0 5 0 Customer P/O INV 5 0 5 0 5 0 5 0 0 5 1 2 3 4 5 Legend: P/O C/O MFG INV Purchase order Customer Order Manufacturing order Inventory The new modified supply chain. the supplying and ordering site. are set-up in relation to inventory target turns.

• If the yearly (=worldwide) usage is 500 pc and the minimum order quantity is 100 pc then the resulting inventory turns would be 500/100=5! • No minimum order quantity should be greater than the yearly (=worldwide) usage because the excess has to be put into obsolescence reserve. • If the yearly (=regional) usage is 120 pc and the target inventory turns are 4 the order quantity should be equal to 30 pc. • Ordering sites have only visibility about their regional demand. page 160 / July 2008 . • Supplying sites have worldwide visibility about total demand.PUSH / PULL FUNDAMENTALS Supplying Site • Each minimum order quantity must be evaluated in relation to the yearly (=worldwide) usage. • No minimum order quantity should be greater than the yearly (=regional) usage because the excess has to be put into obsolescence reserve. Ordering Site • Each order quantity must be evaluated in relation to their yearly (=regional) usage.

INVENTORY CONSOLIDATION July 2008 .

It makes more sense to stock the fast-moving items decentralized near customers and slow-moving items at central warehouses. page 162 / July 2008 .g. going from 5 warehouses to 1. e. This law was proved mathematically by D. H. Maister in his 1975 article “Centralization of Inventories and The Square Root Law” in the International Journal of Physical Distribution.CENTRALIZATION OF INVENTORY It is not a good inventory strategy to have the same stock of inventory at different warehouses just in case for a future possible sale. The formula used is known as the Square Root Law of Inventory. Offering the same lead time for the whole product portfolio is also too costly as described in the previous section because normally minimum order quantities are pushed to ordering sites for slow-moving parts. The approximated savings for centralization can be approximated by the same approach used for warehouse consolidation.

THE SQUARE ROOT LAW OF INVENTORY The square root law of inventory states that the total inventory can be approximated by multiplying the total inventory by the square root of future warehouses divided by the current number of warehouses. I New Notation: WhseNew = I Old × WhseOld INew is centralized inventory in one or several locations IOld is total de-centralized inventory WhseNew is number of new centralized warehouses WhseOld is number of de-centralized warehouses page 163 / July 2008 . This formula can be used if an equal amount of inventory is kept in each warehouse and inventory control at each warehouse is based on EOQ principles.

16M The total new inventory in 2 warehouses will be $3.THE SQUARE ROOT LAW OF INVENTORY Multiple Warehouses Example Example: * $5M total inventory in de-centralized warehouses * Total number of de-centralized warehouses is 5 * Total number of centralized warehouses is 2 I New Whse New = I Old × Whse Old 2 = $5M × 5 = $3.16M or 37% less inventory! page 164 / July 2008 .

He covers on pages 447 to 449 the square root formula for one single warehouse. I New = I Old × = I Old × = I Old × = Whse New Whse Old 1 Whse Old Whse Old 1 × Whse Old Whse Old Take care that in the simplified version of this formula the average inventory is now used instead of the total inventory! To get the average inventory you have to divide the total inventory by the number of existing warehouses. Ballou. page 165 / July 2008 . Prentice Hall. 3rd Edition.THE SQUARE ROOT LAW OF INVENTORY Single Warehouses Derivation The square root formula1) can be simplified if consolidation of inventory is done into one single warehouse. “Business Logistics Management”. I Old × Whse Old Whse Old = I Average × Whse Old 1) See Ronald H. 1992.

236M or 55% less inventory! page 166 / July 2008 .THE SQUARE ROOT LAW OF INVENTORY Single Warehouses Example Example: * $5M total inventory in de-centralized warehouses * Total number of de-centralized warehouses is 5 * Total number of centralized warehouses is 1 I New = I Average × Whse Old = $1M × 5 = $1M × 2. The total new inventory in ONE warehouse will be $2.236 = $2.236M At first the total inventory of $5M in 5 warehouses has to be divided by the total number of warehouses to get the average inventory of $1M per warehouse.

If we relax this assumption the inventory impact for centralization of warehouses has to be modified.CONSOLIDATION OF INVENTORY Non Average Inventory The previous examples were applicable if average inventory per warehouse was nearly equal. We now have to apply basic statistics for joint (independent) random variables. The variance of the sum of several independent random variables is equal to the sum of variances of the individual items! For two random independent variables the variance and standard deviation can be calculated as: Variance: 2 2 2 σ X +Y = σ X + σ Y Standard Deviation: 2 2 σ X +Y = σ X + σ Y page 167 / July 2008 .

Assume a lead time of 6 weeks. z − score = NORMSINV(P ) = NORMSINV(95% ) = 1.CONSOLIDATION OF INVENTORY Non Average Inventory – Example I What is the reduction on safety stock if inventory is centralized.000 600 MY 1.000 SP 3. The table below shows the base data.1). Demand distribution is normal N(0.500 HK 1. a) Using Microsoft-Excel we get the z-score.000 2.000 ID 500 300 page 168 / July 2008 .000 1. The service level should be 95%.500 1.65 b) Weekly data from decentralized warehouses: Country Code Average Demand Standard Deviation TH 2.

250.000 + 90.042 MY = 1.042 SP = 1.65 × 2.65 ×1.700.65 ×1.104 HK = 1.903 ≈ 45.000.000 2 + 2.000 2 + 300 2 σ 2 = 1.000 + 1.950 × 6 = 11.65 × 2.000 σ = 8.000 + 6.500 2 + 600 2 + 1.000.000 × 6 = 4.65 × 300 × 6 = 4.000 σ = 2.000 + 360.CONSOLIDATION OF INVENTORY Non Average Inventory – Example II c) Decentralized safety stock d) Centralized Standard Deviation 2 2 2 2 2 σ 2 = σ TH + σ SP + σ HK + σ MY + σ ID S/S = z × σ × LT TH = 1.000 σ 2 = 8.042 ID = 1.4% page 169 / July 2008 .500 × 6 = 10.923 Old Safety Stock = 21.042 Total Safety Stock is 21.923 Reduction = 9.700.826 New Safety Stock = 11.950 e) Centralized Safety Stock f) Safety Stock Reduction S/S = z × σ × LT = 1.826 σ 2 = 1.000 × 6 = 4.65 × 600 × 6 = 2.

CENTRALIZATION OF WAREHOUSES Benchmarking page 170 / July 2008 .

CHAPTER F LOT SIZING MODELS July 2008 .

11th Edition). work in process. month. week etc. The objective is to minimize total variable cost of a cost function over a specified time period. e. The cost function may be represented by Total Inventory Purchasing Setup Holding Shortage Transportation = + + + + Cost Cost Cost Cost Cost Cost page 172 / July 2008 . a year.INVENTORY CONTROL Basics Inventory Control comprises all activities and techniques of maintaining the desired levels of items.g. or finished goods (APICS Dictionary. whether raw material.

Ordering costs are salaries and expenses of processing and order and setup (changeover) costs are for start-up scrap. spoilage. 11th Edition. Shortage costs is the marginal profit that is lost when a customer orders an item that is not available. calibration.INVENTORY COSTS Definition • • Purchasing / Manufacturing costs represent the actual price of the item. downtime etc. Holding costs is the cost of holding inventory. It includes finance costs and costs maintaining the inventory as taxes. insurance. obsolescence. Transportation cost is caused by inventory that is in transit between locations. • • • APICS Dictionary. 2005 page 173 / July 2008 . and space occupied. usually defined as a percentage of the dollar value of inventory per unit of time (generally one year). Setup / Ordering costs occur regardless of the of the quantity ordered.

C. It is crucial to understand time units. e. Wiley.g. and Inventory Control. If I(t) is the inventory at time t. 1974 page 174 / July 2008 .T) is defined as Inventory I(t) 1 T I = ∫ I(t )dt T 0 If h is the holding cost for one unit of time. the average inventory over a period (0.T) is h x AvgInv.INVENTORY COSTS Holding Cost and Average Inventory Johnson1) described that inventory holding costs is assumed to be proportional to average inventory. Operations Research in Production Planning. Scheduling. does h refer to one unit of time or to the total period T! Time T The average inventory is now the shaded area under the inventory curve divided by T. D. Johnson. then the average holding cost over the interval (0.A. Montgomery. The total holding inventory cost is of course T x h x AvgInv. 1) L.

INVENTORY COSTS Example 1 Calculate with h=3 a) Total inventory.800 Inv Cost = Avg Inv × h × T Year = 600 × 3 × 12 = 21. b) Average inventory.200 Avg Total Inv = Inv T = 7.600 page 175 / July 2008 .200/12 = 600 Inv Cost = Avg Inv × h Unit Time = 600 × 3 = 1. The average holding cost per unit of time is then h=i*c and total holding cost H=h*T! 1.200 0 Avg Inv 12 T Total 1 = × 1. and d) Total inventory cost for period T (here 1 year!) Q Total (=Area) Inventory The holding cost per unit of time h is normally calculated by multiplying the inventory carrying rate in percent by the product unit cost. c) Holding cost per unit of time.200 × 6 = 7.200 × 12 Inv 2 = 1.

INVENTORY COSTS Example 2 Calculate with h=3 a) Total inventory.600 Avg Total Inv Inv T 3. c) Holding cost per unit of time. b) Average inventory. and d) Total inventory cost for period T (here 1 year!) Q 600 0 3 6 9 12 T Total 1 = 4 × × 600 × 3 Inv 2 = 4 × 900 = 3.800 page 176 / July 2008 .600 = 12 = 300 = Inv Cost = Avg Inv × h Unit Time = 300 × 3 = 900 Inv Cost = Avg Inv × h × T Year = 300 × 3 × 12 = 10.

200 + 3.800 Inv Cost = Avg Inv × h × T Year = 600 × 3 × 12 = 21.600 + 600 + 1.400 900 600 1 1 1 1 = × 800 × 3 + × 2.400 × 3 + × 600 × 2 + × 900 × 4 Inv 2 2 2 2 = 1.INVENTORY COSTS Example 3 Calculate with h=3 a) Total inventory. c) Holding cost per unit of time.800 = 7. and d) Total inventory cost for period T (here 1 year!) Total Q 2.200 800 0 3 6 8 12 T Avg Total Inv Inv T 7. b) Average inventory.600 page 177 / July 2008 .200 = 12 = 600 = Inv Cost = Avg Inv × h Unit Time = 600 × 3 = 1.

INVENTORY CONTROL Quantity and Timing Rules have to be defined of 1. When an order should be placed? Two standard systems are in use 1. or Order Point System 2. page 178 / July 2008 . Fixed-Time Period System or Periodic Review System. Fixed Order Quantity. Continuous Review. How much of an inventory item has to be ordered? 2.

s. q t. S t. S Notation: q is Fixed-Order Quantity s is Reorder-Point S is Fixed order up inventory level t is Fixed review period page 179 / July 2008 . q t. S t. s s. q s.INVENTORY SYSTEMS Overview Inventory Systems Order Point Order Cycle Combined Review Period variable fixed fixed Order Quantity ( fixed ) (variable) Triggered by s t t. s.

ORDER-POINT SYSTEMS s,q and s,S
Stock Stock

s, q

s, S S
q1 q2 q3

q2 q1

s

s

t1

t2

t3

Time

t1

t2

t3

Time

q1 = q2 = qn and t1<> t2 <> t3 <> tn Inventory position checked continuously. At or below s (=reorder-point) constant quantity will be ordered.

q1 <> q2 <> qn and t1<> t2 <> t3 <> tn Inventory position checked continuously. At or below s (=reorder-point) variable quantity to fill target inventory S will be ordered.
page 180 / July 2008

ORDER-CYCLE SYSTEMS t,q and t,S
Stock Stock

t, q

t, S S
q2 q1 q3

q1 q2

q3

t1

t2

t3

Time

t1

t2

t3

Time

q1 = q2 = qn and t1= t2 = t3 = tn At constant intervals t a constant quantity q will be ordered. Irregular demand leads to strong fluctuating inventory.

q1 <> q2 <> qn and t1= t2 = t3 = tn Same as t,p policy but variable quantity q will be ordered to fill target inventory level S.

page 181 / July 2008

COMBINED SYSTEMS t,s,q and t,s,S
Stock Stock

t, s, q
q2 q1

t, s, S S
q1 q1

s

s

t1

t2

t3

Time

t1

t2

t3

Time

q1 = q2 = qn and t1= t2 = t3 = tn Similar to t,q policy but reorder point s is used to place order quantity q.

q1 <> q2 <> qn and t1= t2 = t3 = tn Similar to t,s,q policy. Inventory position is checked at constant intervals. Depending on s inventory filled up to target level S.
page 182 / July 2008

NOTATION
D d c Demand rate in units per year. Demand rate in units per period, e.g. week, month. Unit production or purchasing cost not including setup or inventory carrying costs in dollar per unit. K Constant setup (ordering) cost to produce (purchase) a batch in dollars. h t, j Q EOQ Holding cost per unit per time. Time indexes Lot size in units. Economic Order Quantity

page 183 / July 2008

CLASSIFICATION OF LOT SIZING MODELS Deterministic via Probabilistic
Lot Sizing Models

Deterministic

Probabilistic
Single Period or News Boy model Reorder-Point Models Periodic Review Models

Static Lot Sizing
• • • • • Economic Order Quantity EOQ Economic Production Quantity EPQ EOQ with Shortage Resource Constraints Fixed Order Quantity

Dynamic Lot Sizing
Simple

• • • • • Fixed Period Period Order Quantity Lot for Lot

Optimum

Wagner-Whitin

Heuristic

• • • •

Silver- Meal Least Unit Cost Part Period Balancing Groff

Some lot size models will be described on the next slides.

page 184 / July 2008

g. because demand is uncertain and not constant. Static / Fixed order quantities (demand rates are fixed at all times) remain the same each time they are ordered unless the factors used in determining the quantity change. There is no uncertainty. not regular or continuous. The advantage in using them is that there will be no remnants from one order cycle to the next as with fixed or economic order quantities.CHARACTERISTICS OF LOT SIZES • For Deterministic lot sizes demand is constant and known. Heuristic models achieve a low-cost solution which is not necessarily optimal. e. Dynamic (Discrete) lot sizing models change with each order because they deal with lumpy demand (known but allowed to vary over time!). • • • page 185 / July 2008 . Normal or Poisson. Probabilistic (Stochastic) lot sizes can only be described by probability distribution.

2. It is calculated by dividing the “Variance of demand per period” by the “Square of average demand per period”. If VC < 0.2. If VC ≥ 0.VARIABILITY COEFFICIENT Formula Dynamic lot sizes should be used if the variability of demand exceeds some threshold value. use the Silver-Meal heuristic. use a simple EOQ with average demand as demand estimate. see Peterson-Silver (1979). “A useful measure of the variability of a demand pattern is the variability coefficient VC”. page 186 / July 2008 . N × ∑ D2 j j=1 N VC = ⎛ ⎞ ⎜∑Dj ⎟ ⎜ ⎟ ⎝ j=1 ⎠ N 2 −1 1. 2.

page 187 / July 2008 .2.400 = −1 28. use the Silver-Meal heuristic instead of the EOQ.23 VC ≥ 0.900 = 0.900 −1 170 2 35.VARIABILITY COEFFICIENT Example t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 VC = N×∑D j=1 N 2 j VC = −1 ⎞ ⎛ ⎜∑Dj ⎟ ⎟ ⎜ ⎝ j=1 ⎠ N 2 6 × 5.

ECONOMIC ORDER QUANTITY Trail-and-Error Approach One order per year results in lowest ordering but highest inventory costs! D= K= c= i= h= 2.700 $50 $10 30% $3 units per year per order unit cost carrying charge per unit per year page 188 / July 2008 .

Incremental increase in inventory carrying cost (regarded as a loss!) is then ⎛ Q + ΔQ Q ⎞ ICInv = ⎜ − ⎟× h 2⎠ ⎝ 2 ⎛ Q + ΔQ − Q ⎞ =⎜ ⎟× h 2 ⎝ ⎠ ⎛ ΔQ ⎞ =⎜ ⎟× h ⎝ 2 ⎠ page 189 / July 2008 . The incremental gain in set-up reduction can be calculated as D ⎞ ⎛D ICSet − Up = ⎜ − ⎟ ⎜ Q Q + ΔQ ⎟ × K ⎠ ⎝ ⎛ D(Q + ΔQ ) − DQ ⎞ =⎜ ⎜ Q(Q + ΔQ ) ⎟ × K ⎟ ⎝ ⎠ ⎛ DQ + D × ΔQ − DQ ⎞ ⎟× K =⎜ ⎜ ⎟ Q(Q + ΔQ ) ⎝ ⎠ ⎛ ΔQ ⎞ ⎛ D ⎞ =⎜ ⎜ Q + ΔQ ⎟ × ⎜ Q ⎟ × K ⎟ ⎜ ⎟ ⎝ ⎠ ⎝ ⎠ Inventory carrying charge is a function of average inventory Q/2.ECONOMIC ORDER QUANTITY Incremental Analysis Larger order quantities result in less set-up cost. Producing or ordering once per year results in lowest ordering costs but is offset by additional inventory carrying costs.

page 190 / July 2008 .ECONOMIC ORDER QUANTITY Cost Elements Analysis At the optimal order quantity the absolute values for setup and inventory (holding) cost of the first derivative (= slope of total cost curve) are equal to average order and inventory (holding) cost.

ECONOMIC ORDER QUANTITY Slope of total cost Cost Total Cost Total 1st Derivative EOQ Qty At the optimal order quantity the absolute values for setup and inventory (holding) cost of the first derivative (= slope of total cost curve) are equal to average order and inventory (holding) cost. page 191 / July 2008 .

3.ECONOMIC ORDER QUANTITY Assumptions The simplest. 6. see picture below. There is no discount. and most widely used order quantity was developed 1913 by F. oldest. Ordering or setup cost are constant and can be expressed as K+c*q No backorders are allowed. W. 2. Demand Inventory -d d Time Time page 192 / July 2008 . Inventory holding costs are based on average inventory. Harris. This formula is applicable if all decision parameters are known with certainty: 1. 5. Demand is known and constant per period. 4. Lead time is instantaneous or zero. All demand will be satisfied. Unit price is constant.

page 193 / July 2008 . As inventory reaches t a new order of q is received immediately (lead time is zero) and will be consumed in the next cycle and so forth.ECONOMIC ORDER QUANTITY Basic Sawtooth Model Qty Cycle length: t=q/d -d q 0 t 2t Time At time zero an order quantity of q arrives and will be consumed during t with d units per unit of time.

ECONOMIC ORDER QUANTITY Costs per Cycle / Unit of Time 1. Inventory per cycle 1 IC = × q × t 2 1 q = ×q× 2 d q2 = 2d t = q/d 2. Holding cost per cycle q2 H = h× 2d h × q2 = 2d 3. Total cost per unit of time h × q2 C = K + c×q + divided by t 2d K c × q h × q2 = + + t = q/d t t t × 2d d q = K× + c×d + × h q 2 page 194 / July 2008 . Total cost per cycle TC = Order Cost + Holding Cost h × q2 = K + c×q + 2d 4.

• Because the second derivative of C is positive we reached a minimum. Economic Order Quantity (EOQ) dC K×d h =− 2 + dq q 2 d 2C 2 × d × K = > 0 Minimum! dq 2 q3 2× K ×d q* = h page 195 / July 2008 . • Note as well that q does not depend on the purchase/unit cost because they are constant for each quantity.ECONOMIC ORDER QUANTITY Derivation of EOQ 5. 6. Minimal cost with respect to q q d C = K × + c×d + × h q 2 dC K×d h =− 2 + =0 dq q 2 q* = 2× K ×d h • Take the first derivative of C with respect to q and set it equal to zero.

Optimal cycle length q = d×t q∗ t = d 2× K × d h t∗ = d 2× K × d 1 t∗ = × 2 h d ∗ t∗ = 2× K h×d page 196 / July 2008 .ECONOMIC ORDER QUANTITY Optimal Cycle Length 7.

ECONOMIC ORDER QUANTITY Minimum Cost per Unit of Time 8. Minimum cost per unit of time d q C = K × + c×d + × h q 2 d q∗ C = K × ∗ + c×d + × h q 2 ∗ q ∗ = 2 × K × d/h C∗ = C∗ = K×d 2 × K × d/h h × 2 × K × d/h × + c×d + 2 2 × K × d/h 2 × K × d/h K × d × 2 × K × d/h h × 2 × K × d/h + c×d + 2 × K × d/h 2 h × 2 × K × d/h h × 2 × K × d/h C∗ = + c×d + 2 2 1 h2 1 h2 C = × 2× K × d × + × 2× K ×d × + c×d 2 h 2 h 1 1 C∗ = × 2 × K × d × h + × 2 × K × d × h + c × d 2 2 ∗ C∗ = 2 × K × d × h + c × d page 197 / July 2008 .

Sensitivity Analysis d q K× + ×h C q 2 = ∗ d q∗ C K× ∗ + ×h q 2 d q K× + ×h q 2 = 2Kdh d×K q×h = + q × 2Kdh 2 × 2Kdh = d × K × 2Kdh + q × 2Kdh × 2Kdh 2Kdh q + 2 × q × h 2 × q∗ 1 2Kdh q × + 2 2q h 2 × q∗ q 2Kdh 2× h2 For this analysis we can skip the factor c * d (=total purchasing or manufacturing cost per cycle). because it is independent of the lot size q! = = C 1 ⎛ q∗ q ⎞ = ×⎜ + ∗ ⎟ ∗ C 2 ⎜q q ⎟ ⎝ ⎠ 1 q∗ 1 q = × + × ∗ 2 q 2 q page 198 / July 2008 .ECONOMIC ORDER QUANTITY Sensitivity Analysis 9.

K = $50 per order.EOQ D = 2.8 weeks ≈ 6 weeks page 199 / July 2008 .30 per unit per year Calculate the optimal quantity q.000 = $27. 2× K × d q = h * 2× K t = h×d ∗ C∗ = 2 × K × d × h + c × d = 2 × 50 × 2. and total cost. c = $10 unit cost.700 3 = 300 pcs = = 2 × 50 3 × 2.700 = 0.700 units per year.ECONOMIC ORDER QUANTITY Example . h = $3 = c * i = $10 * 0.700 = 810. i = 30% carrying charge per year.000 + 27.111 years × 52 weeks/year = 5. cycle time t.900 per year 2 × 50 × 2.700 × 3 + 10 × 2.

30 ⎞ = ×⎜ + ⎟ 2 ⎝ 1.ECONOMIC ORDER QUANTITY Example . page 200 / July 2008 .30 ) 2 = 1.0643 ≈ 6.4% Although the deviation (plus/minus) of the order quantity compared to the EOQ is quite big the cost impact is much lower.5% Minus 30% C 1 ⎛ q∗ q ⎞ = ×⎜ + ⎟ C∗ 2 ⎜ q q ∗ ⎟ ⎝ ⎠ 1 ⎛ 1 0.0346 ≈ 3.70 ⎞ = ×⎜ + ⎟ 2 ⎝ 0.70 ) 2 = 1.7692 + 1.70 1 ⎠ 1 = × (1.4286 + 0. Due to the flatness of the total cost curve around the EOQ it is more cost effective to produce bigger lot sizes than smaller ones.Sensitivity What cost impact does it have if the actual purchased/manufactured quantity is 30% higher or 30% lower than the EOQ (Economic Order Quantity)? Plus 30% C 1 ⎛ q∗ q ⎞ = ×⎜ + ⎟ C∗ 2 ⎜ q q ∗ ⎟ ⎝ ⎠ 1 ⎛ 1 1.30 1 ⎠ 1 = × (0.

page 201 / July 2008 . The maximum inventory level is reduced by the factor (p-d) during production cycle t1.ECONOMIC PRODUCTION QUANTITY Inventory over Time Qty q = p × t1 ⇒ t1 = q q = t×d ⇒ t = q Inv max = (p − d )× t1 d p Invmax q p-d -d = (p − d )× q p ⎛ d⎞ = ⎜1 − ⎟ × q ⎜ p⎟ ⎝ ⎠ Inv max = d × t 2 ⇒ t 2 = Inv max d t1 t2 t 2t Time For this model inventory builds up during the production cycle t1 but is consumed by d.

Holding cost per cycle 1 ⎛ d ⎞ q2 H = ⎜1 − ⎟ × h 2⎜ p⎟ d ⎝ ⎠ 1 ⎛ d ⎞ q 2h = ⎜1 − ⎟ 2⎜ p⎟ d ⎝ ⎠ 4. Inventory per cycle 1 IC = × Inv max × t t = q/d 2 q 1 ⎛ d⎞ = × ⎜1 . Total cost per unit of time 1 ⎛ d ⎞ q 2h TC = K + c × q + ⎜1 − ⎟ 2⎜ p⎟ d ⎠ ⎝ K c × q 1 ⎛ d ⎞ q2 × h C= + + ⎜1 − ⎟ t t 2 ⎜ p ⎟ d×t ⎠ ⎝ d 1⎛ d⎞ C = K × + c × d + ⎜1 − ⎟ × q × h q 2⎜ p⎟ ⎠ ⎝ divide by t t = q/d 3.ECONOMIC PRODUCTION QUANTITY Costs per Cycle / Unit of Time 1. Total cost per cycle TC = Order Cost + Holding Cost 1 ⎛ d ⎞ q 2h = K + c × q + ⎜1 − ⎟ 2⎜ p⎟ d ⎠ ⎝ page 202 / July 2008 .⎟ × q × ⎜ p⎟ d 2 ⎝ ⎠ 1 ⎛ d ⎞ q2 = ⎜1 − ⎟ 2⎜ p⎟ d ⎝ ⎠ 2.

⎟ × h ⎜ p⎟ ⎝ ⎠ * dC K×d 1 ⎛ d ⎞ = . Minimal cost with respect to q 1⎛ d⎞ q C = K × + c × d + ⎜1 − ⎟ × q × h 2⎜ p⎟ d ⎝ ⎠ dC K×d 1 ⎛ d ⎞ = − 2 + ⎜1 − ⎟ × h = 0 dq q 2⎜ p⎟ ⎝ ⎠ K×d 1 ⎛ d ⎞ = ⎜1 − ⎟ × h q2 2⎜ p⎟ ⎝ ⎠ K×d q2 = 1⎛ d⎞ ⎜1 − ⎟ × h 2⎜ p⎟ ⎝ ⎠ q2 = 2× K ×d ⎛ d⎞ ⎜1 − ⎟ × h ⎜ p⎟ ⎝ ⎠ • Take the first derivative of C with respect to q and set it equal to zero. Economic Production Quantity (EPQ) 2× K × d q = ⎛ d⎞ ⎜1 .2 + × ⎜1 − ⎟ × h dq q 2 ⎜ p⎟ ⎝ ⎠ d 2C 2 × d × K = > 0 Minimum! dq 2 q3 page 203 / July 2008 . 6. • Note as well that q does not depend on the purchase/unit cost because they are constant for each quantity. • Because the second derivative of C is positive we reached a minimum.ECONOMIC PRODUCTION QUANTITY Derivation of EPQ 5.

Optimal cycle length t* t ∗ = q ∗ /d q∗ = 2×d× K (1 − d/p )× h 2× d × K (1 − d/p )× h = d 2×d× K = (1 − d/p )× h × d 2 t∗ = 2× K (1 − d/p )× h × d Keep in mind that the production period t1 = q / p (time to produce the lot size) is different to the (production) cycle time t = q / d (time between production runs)! page 204 / July 2008 .ECONOMIC PRODUCTION QUANTITY Optimal Cycle Length 7.

Minimum cost per unit of time C∗ = = d 1 × K + (1 − d/p )× q ∗ × h + c × d ∗ q 2 d×K 1 + (1 − d/p )× 2 2× d × K (1 − d/p )× h d×K× q∗ = 2× d × K (1 − d/p )× h 2×d × K × h + c×d (1 − d/p )× h 2×d × K × h + c×d (1 − d/p )× h = = = (1 − d/p )× h 2×d× K + 1 (1 − d/p )× 2 2 × d × K × (1 − d/p )× h + c×d 2dK × (1 − d/p )× h (1 − d/p )× h × d × K × (1 − d/p )× h 2× d × K + + c×d 2 2dK × (1 − d/p )× h 2 × d × K × (1 − d/p )× h ⎛ d⎞ C∗ = 2 × d × K × h × ⎜1 − ⎟ + c × d ⎜ p⎟ ⎝ ⎠ 22 × d 2 × K 2 × h 2 = × 2× d × K × h (1 − d/p )2 (1 − d/p ) + c×d page 205 / July 2008 .ECONOMIC PRODUCTION QUANTITY Minimum Cost per Unit of Time 8.

10 per meter/year. Each setup requires cleaning of the equipment and inspection and calibration costs $25 per run.25 per meter and inventory holding cost is estimated as 40% annually. p=8.1 = 2.000 ⎞ ⎜1 − ⎟ × 0.000 ⎠ Production time is 0.25 years or 3 months.000/8. c=$0.000 ⎛ 4.000 meters. The cost to produce the tubing is $0.000=0.25) Cycle time is 0.000 meters per year.25. (t1=q/p=2.000 0. The production capacity is 8. d=4.000/4. h=i x c = 40% x $0.ECONOMIC PRODUCTION QUANTITY Example A heat-shrink tube has a yearly usage of 4.000 = page 206 / July 2008 .5 years or 6 months.000=0.25 = $0.5) = 200. (t=q/d=2. What should be the optimum production size? K=$25 /order.000 meters per year q* = 2× K ×d ⎛ d⎞ ⎜1 .000 meters per year.10 ⎝ 8.5 × 0.⎟ × h ⎜ p⎟ ⎝ ⎠ 2 × 25 × 4.

EOQ with Shortage Basics Qty Inventory/ cycle M q t = q/d t1 = M/d t 2 = t − t1 q M − d d q−M = d m =q−M = -d Backorders/ cycle m t1 t t2 m Time In this scenario backorders are now allowed (=no lost sales!) but a shortage cost s must be paid proportional to the waiting time t2 till the order can be delivered. page 207 / July 2008 .

m =q−M 2 d 1 q−M = × (q − M )× ×s 2 d (q − M )2 × s = 2d 3.EOQ with Shortage Cycle Costs 1. Shortage cost per cycle BC = m× t2 q−M ×s t2 = . Inventory cost per cycle IC = M × t1 ×h 2 M M = × ×h 2 d M2 = ×h 2d t1 = M/d 2. Total cost per cycle TC = Order Cost + Holding Cost + Shortage Cost h × M 2 s × (q − M ) = K + cq + + 2d 2d 2 page 208 / July 2008 .

Total cost per unit of time C= TC t = q/d t 2 d cqd h × M 2 × d s × (q − M ) × d = K+ + + q q 2dq 2dq d h × M 2 s × (q − M ) = K + cd + + q 2q 2q 2 d h × M 2 + s × q 2 − 2Mq + M 2 = K + cd + q 2q ( ) M 2 (h + s ) sq d + − sM C = K + cd + 2q 2 q d h × M 2 sq 2 2Mqs M 2s = K + cd + + − + q 2q 2q 2q 2q d h × M 2 + s × M 2 sq = K + cd + + − Ms q 2q 2 page 209 / July 2008 .EOQ with Shortage Total Cost per Unit of Time 4.

Modifying M-term for q derivation s ×q h +s M s = q h +s M= M2 s2 = q 2 (h + s )2 page 210 / July 2008 . Partial derivation for M C= ∂C = ∂M s= M= M 2 (h + s ) sq d + − sM K + cd + 2q 2 q 2 × M × (h + s ) −s = 0 2q 2 × M × (h + s ) 2q s ×q h+s 6.EOQ with Shortage Partial Derivation of M 5.

EOQ with Shortage Partial Derivation of q 7. Partial derivation for q d M 2 (h + s ) sq C = K + cd + + − sM q 2q 2 d × K M 2 (h + s ) s ∂C =− 2 − + =0 q 2q 2 2 ∂q d × K s s 2 × (h + s ) = − q2 2 2 × (h + s )2 2× d × K s2 =s− q2 h +s 2 × d × K s × (h + s ) − s 2 = q2 h +s 2 × d × K sh + s 2 − s 2 = q2 h+s h+s q 2 = 2dK × sh 2dK h + s q2 = × h s page 211 / July 2008 M2 s2 = q 2 (h + s )2 q∗ = 2× d × K h +s × h s .

Solution for M M= s ×q h+s q= 2dK h +s × h s 1/2 s 2dK (h + s ) = × × h+s h s1/2 2dK (h + s ) = 1/2 × × s h h +s s = 1/2 M∗ = 2× d × K s × h h +s 2dK 1/2 1 ×s × h (h + s )1/2 M is the up-to inventory level after receiving the order quantity.EOQ with Shortage Solution for M 8. page 212 / July 2008 .

EOQ with Shortage Cycle Length 9. Optimal Cycle Length t∗ = q∗ d 2× d × K h+s × h s = d 2× d × K h+s = × 2 h×d s t∗ = 2× K h +s × h×d s page 213 / July 2008 .

EOQ with Shortage Maximum Shortage Quantity 10. Maximum Shortage Quantity m∗ = q ∗ − M ∗ = = = = = = 2dK h + s 2dK s − h s h h +s 2dK h 2dK h (h + s )× (h + s ) − 2dK s × s (h + s )× s s × (h + s ) h (h + s )2 − 2dK s2 (h + s )× s s × (h + s ) h Multiply the 1st square root by (h+s)/(h+s) and the 2nd square root by s/s and simplify further! 2dK 2 × ⎡ (h + s ) − s 2 ⎤ ⎥ ⎣ ⎦ h × s × (h + s ) ⎢ 2dK × [(h + s ) − s] h × s × (h + s ) 2dK ×h h × s × (h + s ) m∗ = 2× d × K h × s h +s 2dK h2 = s h × (h + s ) Because m represents backorders it is actually a negative value! page 214 / July 2008 .

Maximal Shortage Time q ∗ −M ∗ Θ= d ⎛ 2×d× K h ⎞ ⎟ /d =⎜ ⎜ s h+s ⎟ ⎝ ⎠ = = 2×d× K h s × d2 h +s 2× K h d×s h + s 12. 1996) recommends to use the maximal shortage time Θ instead. Springer-Verlag.und Operations Management. Shortage Cost Derivation 2× K h d×s h + s 2× K × h Θ2 = d × s × (h + s ) 2× K × h s × (h + s ) = d × Θ2 2× K × h 0 = s2 + s × h − d × Θ2 Θ= page 215 / July 2008 .EOQ with Shortage Maximal Shortage Time Because of the difficulties to calculate shortage costs Neumann (Produktions. This shortage time determines how many days a customer must wait till goods are delivered. 11.

EOQ with Shortage Shortage Cost The shortage cost is now the positive part of the quadratic equation! s2 + s × h − 2× K × h =0 2 d×Θ 2 h ⎛ h ⎞ 2× h × K s=− + ⎜ ⎟ + 2 d × Θ2 ⎝2⎠ Note: The standard quadratic equation in normal form is shown on the right p=h and q=-2hK/dΘ2 x 2 + px + q = 0 x1.2 p ⎛p⎞ = − ± ⎜ ⎟ −q 2 ⎝2⎠ 2 page 216 / July 2008 .

Order cost are $200 and the unit-cost is $30.25 = 50 Optimal order quantity q is 50 units per order. h=$1 /unit/day . Daily usage d=5 units (1. K=$200 /order. 1996. Produktions.5 + 0. Example taken from Neumann.25 + 20 =4 Shortage cost s is$4 per unit per day. In order not to loose this customer management decided that in case of shortage the maximum waiting time is 2 days.Yearly usage with 250 working days is 1. Θ=2 days.000 × 1.EOQ with Shortage Example I We deliver to a key account customer a special type of HV connectors. Holding cost is $1 /unit/day.000 units.250/250) 1. Springer page 217 / July 2008 . c=$30. 2 2 q∗ = = 2×d × K h +s × h s 2 × 5 × 200 1+ 4 × 1 4 = 2. Shortage Cost s: 2.und Operations Management. Optimal Order quantity q: h ⎛ h ⎞ 2× h × K s=− + ⎜ ⎟ + 2 d × Θ2 ⎝2⎠ 1 ⎛ 1 ⎞ 2 ×1× 200 =− + ⎜ ⎟ + 2 5 × 22 ⎝2⎠ = −0.

A new order should be placed if backorders reach minus m* = 10.EOQ with Shortage Example II 3. page 218 / July 2008 .8 = 40 = 500 × 0. Optimal Order Point m: M∗ = = 2× d × K s × h h+s 2 × 5 × 200 4 × 1 1+ 4 m∗ = = 2×d× K h × s h+s 2 × 5 × 200 1 × 4 1+ 4 = 2.2 = 10 Optimal up-to inventory level M* = 40 units. Optimal Inventory Level M: 4.000 × 0.

If the lead time would be for example 7 days the reorder-point would be m* + LT x d = -10 + 7 x 5 = 25 units.EOQ with Shortage Example III 5. a new order for 50 units should be placed filling inventory up to 40 units. Optimal Cycle Length t: t∗ = = 2× K h +s × h×d s 2 × 200 1+ 4 × 1× 5 4 = 80 × 1. page 219 / July 2008 . after reaching (minus) 10 units backorders.25 = 10 Each 10 days. More details for reorder points will follow in later sessions.

LOT SIZING TOURNAMENT July 2008 .

Demand Inventory -D D Time Time page 221 / July 2008 . 3. 4. EOQ = = 2 × Demand × OrderCost Holding Cost 2× D× K h 1. Holding cost is based on average inventory. 6. Optimal results can only be reached if following assumptions are met. Ordering cost is constant. no discounts. Cost per unit is constant. 2. 5. Item demand is constant. No shortages are allowed. Lead time is constant.ECONOMIC QRDER QUANTITY (EOQ) The most popular order quantities in practice is the ‘Economic Order Quantity’ or EOQ because of its simplicity.

EOQ Example t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 EOQ = 2× D× K h K=$50.3 ~ 29 EOQ = 2 × 29 × 50 = 53. h=$1/unit/period Average Demand d = 40+20+10+30+50+20 = 170 / 6 = 28.85 ≈ 54 1 2 20 54 48 38 8 3 10 4 30 5 50 54 12 6 20 54 46 t/j dj EOQ End Inv 1 40 54 14 For holding costs only ending inventory is considered! page 222 / July 2008 .

EOQ Example Results 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 54 54 54 54 Lot Q(1) Q(2) Q(5) Q(6) Total Cost Qty 54 54 54 54 Setup 50 50 50 50 200 Holding 14 94 12 46 166 Cost 64 144 62 96 366 page 223 / July 2008 .

.SILVER-MEAL HEURISTIC (SM) This method is quite similar to the least unit cost approach. C(1) = K C(2) = K + hd 2 2 K + hd 2 + 2hd 3 C(3) = 3 K + hd 2 + 2hd 3 + . but instead of minimizing the unit cost for a lot it minimizes the cost per period over the number of periods the lot will cover. Start calculation again at period j. page 224 / July 2008 . + (j − 1)hd j C(j) = j If Cj ≥ Cj-1 stop and set lot Q = d1+d2+d3+…+dj-1..

SILVER-MEAL Example t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 Cj ≥ Cj-1 Stop! K=$50. h=$1/unit/period t=1. j=4: C(4) = (50+0*1*40+1*1*20+2*1*10+3*1*30)/4 = 45 C(4) ≥ C(3) . Q(1) = d1+d2+d3 = 70 t=4. j=1: C(1) = (50+0*1*40)/1 = 50 t=2. j=1: C(1) = (50+0*1*50)/1 = 50 t=6. STOP! STOP! STOP! page 225 / July 2008 . j=3: C(3) = (50+0*1*40+1*1*20+2*1*10)/3 = 30 t=4. j=2: C(2) = (50+0*1*40+1*1*20)/2 = 35 t=3. j=2: C(2) = (50+0*1*50+1*1*20)/2 = 35 Q(5) = d5+d6 = 70 End of horizon. j=1: C(1) = (50+0*1*30)/1 = 50 t=5. Q(4) = d4 = 30 t=5. j=2: C(2) = (50+0*1*30+1*1*50)/2 = 50 C(2) ≥ C(1).

SILVER-MEAL Example Results 100 90 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 30 70 70 Lot Q(1) Q(4) Q(5) Qty 70 30 70 Setup 50 50 50 150 Holding 40 0 20 60 Cost 90 50 70 210 Total Cost page 226 / July 2008 .

C(1) = C(2) = C(3) = C(j) = K d1 K + hd 2 d1 + d 2 K + hd 2 + 2hd 3 d1 + d 2 + d 3 K + hd 2 + 2hd 3 + . + d j If Cj ≥ Cj-1 stop and set lot Q = d1+d2+d3+…+dj-1. page 227 / July 2008 ..LEAST UNIT COST (LUC) This method is similar to the Silver-Meal method but instead of dividing the cost over j periods it is divided by the total number of units d1+d2+d3+…+dj. Start calculation again at period j.. + (j − 1)hd j d1 + d 2 + d 3 + ...

17 t=3. j=1: C(1) = (50+0*1*50)/50 = 1 t=6.LEAST-UNIT COST (LUC) Example t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 Cj ≥ Cj-1 Stop! K=$50. Q(5) = d5 = 50 Q(6) = d6 = 20 End of horizon! STOP! STOP! STOP! page 228 / July 2008 . Q(1) = d1+d2 = 60 t=3. j=3: C(3) = (50+0*1*40+1*1*20+2*1*10)/70 = 1. h=$1/unit/period t=1.25 t=2. j=1: C(1) = (50+0*1*10)/10 = 5 t=4. Q(3) = d3+d4 = 40 t=5. j=2: C(2) = (50+0*1*40+1*1*20)/60 = 1. j=1: C(1) = (50+0*1*40)/40 = 1. j=2: C(2) = (50+0*1*50+1*1*20)/70 = 1 C(2) ≥ C(1). j=3: C(3) = (50+0*1*10+1*1*30+2*1*50)/90 = 2 C(3) ≥ C(2). j=2: C(2) = (50+0*1*10+1*1*30)/40 = 2 t=5.29 C(3) ≥ C(2) .

LEAST-UNIT COST (LUC) Example Results 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 20 40 50 60 Lot Q(1) Q(3) Q(5) Q(6) Qty 60 40 50 20 Setup 50 50 50 50 200 Holding 20 30 0 0 50 Cost 70 80 50 50 250 Total Cost page 229 / July 2008 .

sometimes called the Least Total Cost (LTC) method . It’s derived from the fact that for the economic order quantity the set-up cost is equal to the holding cost for that lot size! h ∑ d ( j − 1) ≈ K j=1 j j K ∑ d j ( j − 1) ≈ h j=1 j ∑ d ( j − 1) j=1 j j is called part-periods! For each step compare holding cost with set-up cost. page 230 / July 2008 .PART PERIOD BALANCING (PPB) This method. chooses a lot size which makes the holding and set-up costs as nearly equal as possible.

j=1: $1*0*40 = 0 < K t=2. j=2: $1*0*40+$1*1*20 = 20 < K t=3. j=4: $1*0*40+$1*1*20+$1*2*10+$1*3*30 = 130 > K STOP! 40 is closer to K=50 than 130! Q(1) = d1+d2+d3 = 70 t=4.PART PERIOD BALANCING (PPB) Example t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 h ∑ d j (t − 1) ≈ K j=1 j K=$50. j=1: $1*0*30 = 0 < K t=5. j=3: $1*0*40+$1*1*20+$1*2*10 = 40 < K t=4. j=2: $1*0*30+$1*1*50 = 50 = K STOP! 50 is equal to K=50! Q(4) = d4+d5 = 80 Q(6) = d6 = 20 End of horizon! page 231 / July 2008 . h=$1/unit/period t=1.

PART PERIOD BALANCING (PPB) Example Results 100 90 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 20 70 80 Lot Q(1) Q(4) Q(6) Qty 70 80 20 Setup 50 50 50 150 Holding 40 50 0 90 Cost 90 100 50 240 Total Cost page 232 / July 2008 .

h=$1/unit/period ΔK = K K − j j +1 K(j + 1) − Kj Kj + K − Kj = = j(j + 1) j(j + 1) K = j(j + 1) ΔK = 100 100 − 4 4 +1 = 25 − 20 = 5 or K j(j + 1) 100 100 = = =5 4(4 + 1) 4 × 5 = page 233 / July 2008 . The incremental reduction of set-up or order cost per period can be shown by comparing average costs per period.GROFF HEURISTIC I It is based on the feature of the economic order quantity that at the optimal lot size the incremental reduction of set-up costs per period equals the incremental increase of holding costs per period. Example: K=$100.

GROFF HEURISTIC II The lot size is increased by the requirement of another period till the increased holding costs equals roughly the decreased set up cost. h × d j+1 2 Increased holding cost h × d j+1 2 ≈ K j × ( j + 1) K j × ( j + 1) Decreased set up cost h × d j+1 2 > K ⇒ STOP! j × ( j + 1) If in period j the incremental increase of holding costs is greater than the incremental decrease of set-up costs then choose order qty Q as d1+d2…+dj-1! page 234 / July 2008 .

j=1: ($1*30)/2 = 15 < $50/(1*[1+1]) = 25 t=3.33 t=1. j=1: ($1*20)/2 = 10 < $50/(1*[1+1]) = 25 Q(5) = d5+d6= 70 End of horizon! STOP! STOP! STOP! page 235 / July 2008 . j=1: ($1*50)/2 = 25 > $50/(1*[1+1]) = 25 t=4.17 Q(1) = d1+d2 = 60 t=3. j=3: ($1*30)/2 = 15 > $50/(3*[3+1]) = 4. j=1: ($1*20)/2 = 10 < $50/(1*[1+1]) = 25 t=1.33 Q(4) = d4 = 30 t=5.33 Q(3) = d3 = 10 t=4.GROFF HEURISTIC Example t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 h × d j+1 2 > K ⇒ STOP! j × ( j + 1) K=$50. h=$1/unit/period t=1. j=2: ($1*50)/2 = 25 > $50/(2*[2+1]) = 8. j=2: ($1*20)/2 = 10 > $50/(2*[2+1]) = 8. j=2: ($1*10)/2 = 5 < $50/(2*[2+1]) = 8.

GROFF HEURISTIC Example Results 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 10 30 70 60 Lot Q(1) Q(3) Q(4) Q(5) Qty 60 10 30 70 Setup 50 50 50 50 200 Holding 20 0 0 20 40 Cost 70 50 50 70 240 Total Cost page 236 / July 2008 .

e.WAGNER-WHITIN This method analyzes all possible combinations to find the optimal lot sizes.g. from 2 to 1 is defined as zero! Wagner-Whitin is included because it is common to use it for benchmarking! page 237 / July 2008 . For example it is possible to produce lot-for-lot or produce 1 lot for period 1 and a second lot in period 2 covering requirements from period 2 to period 6. 1 2 3 4 5 6 To start with a matrix is calculated showing the cost impact of all different lot sizes. c τj = K + h × t = τ +1 ∑ (t − τ )× d j t Be aware that a sum from a higher index to a smaller.

Determine minimum cost per period τ\t 1 2 3 4 5 6 1 50 70 90 180 380 480 2 3 4 5 6 50 60 120 270 350 50 80 180 240 50 100 140 50 70 50 τ\t 1 2 3 4 5 6 ft 1 50 2 3 4 5 6 70 90 180 380 480 100 110 170 320 400 120 150 250 310 140 190 230 190 210 240 50 70 90 140 190 210 For example. h=$1/unit/period 1.WAGNER-WHITIN Example I t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 c τj = K + h × t = τ +1 ∑ (t − τ )× d j t K=$50. in period 3 add minimum cost of $70 from period 2 and in period 5 add minimum cost of $140 from period 4. page 238 / July 2008 . Calculate cost matrix 2.

Q(5) = d5+d6 = 70 page 239 / July 2008 . Derive optimal order quantities τ\t 1 2 3 4 5 6 ft 1 50 2 3 4 5 6 70 90 180 380 480 100 110 170 320 400 120 150 250 310 140 190 230 190 210 240 Start 50 70 90 140 190 210 Q(1) = d1+d2+d3 = 70. Q(4) = d4 = 30.WAGNER-WHITIN Example II t/j dj 1 40 2 20 3 10 4 30 5 50 6 20 c τj = K + h × t = τ +1 ∑ (t − τ ) × d j t K=$50. h=$1/unit/period 3.

WAGNER-WHITIN Example Results 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 30 70 70 Lot Q(1) Q(4) Q(5) Qty 70 30 70 Setup 50 50 50 150 Holding 40 0 20 60 Cost 90 50 70 210 Total Cost page 240 / July 2008 .

Q(3)=10. Q(4)=30. although tedious to calculate. Q(6)=20 Q(1)=60. Q(5)=50. It is obvious as well from this simulation that the EOQ should not be used for time-varying demand. Q(5)=70 Q(1)=60. Q(6)=20 Q(1)=Q(2)=Q(5)=Q(6)=54 Setup 150 150 200 150 200 200 Holding 60 60 40 90 50 166 Cost 210 210 240 240 250 366 Comparing the different dynamic lot sizing methods with each other and with the EOQ the worked-out examples match with different simulations in textbooks. Q(4)=30. followed by Silver-Meal. shows normally the lowest costs. page 241 / July 2008 . Q(4)=80. Q(5)=70 Q(1)=70.LOT SIZE Benchmarking Method Wagner-Whitin Silver-Meal Groff Part-Period Least-Unit EOQ Qty Q(1)=70. Q(5)=70 Q(1)=70. Q(4)=30. Wagner-Whitin. Here both methods generate the same costs! For time-varying demand Silver-Meal and Groff are normally used. Q(3)=40.

CHAPTER G SAFETY STOCK CALCULATION July 2008 .

Running out of stock has a very negative impact on customer service: Loss of goodwill. The objective is to balance the additional costs of holding safety stock with the expected cost of shortages.REASONS FOR SAFETY STOCK One of the biggest problems in inventory management is random variability in the demand rate and/or lead time because it is unpredictable. To absorb shortages companies maintain safety stock. expected demand during lead time to reduce the risk of stock outs because of random variation of either lead time and/or demand. Obtaining accurate shortage costs is very difficult. special set-up costs in manufacturing etc. expediting costs from vendors. Two major forms of safety stock are common: cycle-service level and unit-service level. Safety stock is all inventory held in excess of average. page 243 / July 2008 . Therefore management accepts a reasonable service level in the form of safety stock. Both will be covered in detail.

e. demand rate or usage per period.DETERMINISTIC INVENTORY SYSTEMS Quantity In a deterministic inventory system all parameters are predictable. lead time.g. no shortages etc. No safety stock is needed! Order Quantity Demand Rate Time Lead Time page 244 / July 2008 .

PROBABILISTIC INVENTORY SYSTEMS 50 100 150 Relative Frequency Distribution Order Quantity ROP 200 250 300 % Safety Stock Time Stock out Lead Time page 245 / July 2008 .

150 950 750 550 350 150 -50 -250 =Avg Projected Inventory 300 250 200 150 100 50 0 -50 Average Forecast Error 0 1 2 3 4 5 6 7 8 9 10 <Avg >Avg Avg Fcst < Fcst > Fcst page 246 / July 2008 .000 1 100 900 100 900 0 1.000 0 1.000 2 100 800 150 750 200 800 3 100 700 50 700 150 650 4 100 600 200 500 50 600 5 100 500 0 500 250 350 6 100 400 120 380 50 300 7 100 300 0 380 150 150 8 100 200 50 330 200 -50 9 100 100 50 280 150 -200 10 100 0 70 210 50 -250 AVG 100 79 120 1.000 0 1.PROBABILISTIC INVENTORY SIMULATION Period Demand INV Avg Demand INV <Avg Demand INV >Avg 0 0 1.

should determine the amount of safety stock. “Two weeks of Supply”. not the average rate. e. demand during leadtime is ‘normally distributed’. But the variability of supply and demand. page 247 / July 2008 .SAFETY STOCK DEFINITION In deterministic inventory models the reorder point is equal to lead time demand or ROP = d * LT. Both methods will be described on the next slides.g. demand will be greater than the mean 50% and less than the mean 50% of the time. One popular method relates safety stock to “usage rates or time supply”. however. To provide for a service level greater than 50% a safety stock must be added. see the picture on the right. If.

which reflects the desired service level. there is room for improvement because a “time supply” calculation could be misleading. Safety Stock = Std Deviation * z-score page 248 / July 2008 . both with an average monthly usage of 1. If safety stock is based on “time supply”. safety stock is a function of a safety factor. The safety stock is set on “time supply” with 250 pcs ( = one week! ). A and B. e. one monthly usage as safety stock. Let’s consider two items.000 pcs a month. Item A has a standard deviation of 100 pcs and B of 300 pcs. Statistically.g. and the variability of the forecast error during lead-time.SAFETY STOCK BASICS I How safety stock is calculated is important to discover excess inventory.65) and demand during lead-time is normally distributed. the service level should be 95% (is equal to a z-score of 1.

SAFETY STOCK BASICS II Monthly usage 2 weeks-of-supply Standard deviation 500 Statistical safety stock 600 Part A 1.000 250 100 165 Part B 1.000 250 300 495 495 StatisticalSafetyStock = StdDev × z − score 400 300 200 100 300 250 165 100 250 0 Part A 2 weeks-of-supply Standard deviation Part B Statistical safety stock For part A we would carry too much safety stock of 85 pcs (250 minus 165) and for part B too less safety stock minus 245 pcs (250 minus 495) for a target service level of 95%. page 249 / July 2008 .

If done properly.250 “Statistical” Safety Stock Actual Usage 1.SAFETY STOCK BASICS III With the statistically calculated safety stock we not only avoid excess inventory. 1. The figure below illustrates the statistical approach for item A. we can shift inventory from items with low variable demand to items with higher variable demand with the same investment.000 Time page 250 / July 2008 . this could increase service and decrease investment.

33 Safety Stock Increase 0.0% Desired Service Level page 251 / July 2008 .28 1. The figure below shows the relation between desired service level and inventory investment.28)/1.41 1. To increase the service level from 90% to 96% by only 6%.75 2.75-1.0% 10.2% 21.7% 60.06 2.9% 82.56 1.9% 36.7%!!! 90% Percent Increase S/S Investme 80% 70% 60% 50% 40% 30% 20% 10% 0% 90% 92% 94% 96% 98% 99% Compared to 90% Service Level 90% 92% 94% 96% 98% 99% Z-Factor 1.28 = 36. Increasing safety stock in a way to achieve a 100% service level has disastrous results on the cash-flow of a company. the incremental investment in safety stock will be (1.SAFETY STOCK INVESTMENT There is a trade-off between desired customer service level and inventory investment.

64 2.84 1.1) 90% 95% 99% Service Level Z-Score: = NORMSINV(P).1) page 252 / July 2008 .00 0.28 1. N(0. N(0.33 100 Service level SL 50% 80% 90% 95% 99% Order Qty Safety stock 0 84 128 164 233 200 Avg Q 100 100 100 100 100 Average Inv 100 184 228 264 333 Service Level --50% to 80% 80% to 90% 90% to 95% 95% to 99% --30% 10% 5% 4% Inv Inc --84% 24% 16% 26% AvgInv = Q + z ×σ 2 Q = + z × MAD ×1.25 2 Q = + MAD × SF 2 350 300 333 264 228 184 100 Average Inventory 250 200 150 100 50 0 50% 80% Service Level SL in %: = NORMSDIST(z).SAFETY STOCK INVESTMENT EXAMPLE StdDev z-score 0.

DETERMINING SAFETY STOCK LEVELS In practice there are two common methods how to calculate a safety stock for providing a desired customer service level. They are a) The ‘cycle service level’ and b) The ‘unit service level’. The ‘cycle service level’ determines the probability of not running out of inventory during an order cycle. page 253 / July 2008 . The ‘unit service level’ would be 97 % because only 25 units were backordered. Because of the simpler calculation the cycle service level is very popular. Cycle 1 2 3 4 5 6 Demand 100 120 80 150 170 140 760 Backorder 20 5 25 In this example the ‘cycle service level’ would be 67 % because there was a stockout during two cycles. The ‘unit service level or fill-rate’ determines the amount of stock which can be immediately satisfied.

g.g received orders can be completely filled from available stock. 100 short of 1. • Percentage of demand that are filled without incurring any stock-out. • Applied when the likelihood of a stockout in percent and not its magnitude in pieces is important for the company. page 254 / July 2008 . • Represents an event oriented ratio. e. • Applied when the percentage of unsatisfied demand should be under control. • Probability of not incurring a stockout during an inventory cycle.CYCLE-SERVICE-LEVEL VIA UNIT-SERVICELEVEL Cycle-Service-Level • Also called alpha or Type I service level. Unit-Service-Level • Also called beta or Type II service level. • Represents a quantity oriented ratio. e.000 ordered means 90% service level.

00% 75.13% 85. Mean absolute deviation page 255 / July 2008 .65 2.25 0.04 1.00 2.72% 98.56 Legend: SS Z S SF LT FP MAD Safety stock Z-score from standard normal distribution table Standard deviation during lead-time Safety factor lead-time in weeks.60 1. months etc.00 0.28 1.00% 94.00% 84.25 1. months etc.05 1.00 0.05 Safety Factor SF = Z x 1.00 1.00% Value Z 0.84 1.60 2.00 2.00% 80.00% 97.30 1.06 2.84 1.00% 90.67 0.52% 95.25 × MAD × LT / FP SS = MAD × SF × LT / FP Table of Safety Factors: Service Level 50. Forecast period in weeks.50 2.CYCLE SERVICE LEVEL I For a ‘cycle service level’ the safety stock is calculated as depicted below: SS = Z × S × LT / FP SS = Z × 1.

CYCLE SERVICE LEVEL II Month JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TTL Past Demand 346 312 387 350 406 364 353 338 392 385 372 365 4. FP = 4 weeks Service Level = 95% Average Demand = 4.06 × 4/ 4 SS = 42 page 256 / July 2008 .3× 2.370 / 12 ~ 364 MAD = 244 / 12 = 20.370 Average Absolute Demand Deviation 364 18 364 52 364 23 364 14 364 42 364 0 364 11 364 26 364 28 364 21 364 8 364 1 244 LT = 4 weeks.3 SS = MAD×SF× LT/ FP SS = 20.

25 = 1.06 LT 4 FP 4 S/S 42 S/S = Safety Factor SF * Mean Absolute Deviation MAD *SQRT(Lead Time LT / Forecast Period FP) page 257 / July 2008 .25 = 2.3 2.06 MAD SF=95% 20.CYCLE SERVICE LEVEL WITH MS EXCEL Jan-04 346 Feb-04 312 Mar-04 387 Apr-04 May-04 350 406 Jun-04 364 Jul-04 353 Aug-04 338 Sep-04 392 Oct-04 385 Nov-04 372 Dec-04 365 MAD = AVEDEV(Usage Jan04 to Dec04) SF = z score * 1.65 * 1.

see sample data below: Demand/ Month 12 13 14 15 16 17 18 19 Probability 0.20 0.05 0.05 Probability of Demand 0.15 0. but doesn’t answer how many units will be short.10 0.00 12 13 14 15 16 17 18 19 Monthly Demand Order Cost = $25 Carrying Rate = 25% per year Item Cost = $30 Holding Cost = $7.10 0.EXPECTED NUMBERS SHORT I The ‘cycle service level’ only considers the probability of running out of stock.50 per unit per year EOQ = 2 × Yearly Demand × Order Cost / Holding Cost EOQ = 2 × 15 × 12 × 25 / 7. Let’s assume that demand per month was estimated with the following probabilities.15 0.50 EOQ = 35 units page 258 / July 2008 .05 0.15 0.20 0.25 0.10 0.20 0.

E(Short) = (18-17) x 0.EXPECTED NUMBERS SHORT II Expected monthly demand is.0.0% Expected Numbers Short D MAX D = ROP + 1 ∑ P ( D ) × ( D − ROP ) ROP = 15.0.15 + 15 x 0.E(Short)/Q = 1 .05 0.20 + (17-15) x 0.15 Service Level = 1 .10 + 18 x 0.15 / 35 = 1 .05 = 0.05 + (19-15) x 0. page 259 / July 2008 .E(Short)/Q = 1 .6% It is very tedious to calculate the ‘expected numbers short’ for a discrete distribution.9% 100.9% 99.05 + 19 x 0.75 Service Level = 1 .9% ROP = 17.15 + 14 x 0. E(Short) = (16-15) x 0.35 0.00 Service Level 97.75 / 35 = 1 .15 0.05 = 15 ROP 15 16 17 18 19 SS 0 1 2 3 4 P(D)=ROP 0.20 + 16 x 0.004 = 0.10 + (18-15) x 0.6% 99.0.996 = 99.05 0.05 Numbers Short 0.75 0.0% 99.20 0.20 + 17 x 0. SS = 2.0.979 = 97. see previous slide: 12 x 0.10 0.021 = 0.20 0.10 + 13 x 0. SS = 0.05 = 0.05 + (19-17) x 0.

Because the table in the attachment is based on a standard deviation of one. Brown.103. If Q is the order quantity there would be D/Q orders per year. If demand during lead time is normally distributed the expected numbers short for an average of zero and a standard deviation of one can be taken from a table. pp 95 . page 260 / July 2008 . where D is the annual demand. see the attachment and R.UNIT SERVICE LEVEL I It’s more convenient to approximate a discrete distribution with a continuous distribution to simplify the safety stock and reorder point calculations.G. If the unit-service level is P then there would be a shortage of (1-P) x D units. Decision Rules for Inventory Management. E(z) must be multiplied by the standard deviation during lead time to get the expected numbers short per order.

UNIT SERVICE LEVEL II Percentage Annual Number short Number of × = × short demand per order orders per year (1 − P ) × D = E (z ) × σ LT × D Q (1 − P ) × Q E (z ) = σ LT page 261 / July 2008 .

000 / 200 ) then the total shortage per year is 50 units. Standard deviation during lead time = 25 and lead time LT = 15 days Determine the reorder point.50 ) / 1. d= 1.000 = 95 % page 262 / July 2008 .UNIT SERVICE LEVEL III Example: Annual demand D = 1.000 units.95)× 200 = 0.4 = (1 − 0. The service level is SL = ( 1. Service Level P needed = 95%.4 E (z ) = 25 σ LT σ LT × E (z ) = (1 − P )× Q 10 = 10 25 × 0.4 ⇒ z = 0 ROP = 4 ×15 + 0 × 25 = 60 The shortage per order is 10 and there are 5 orders per year ( 1.000 .000 units / year = 4 units / day 250 days / year Shortage per order ROP = d × LT + z × σ LT = 4 ×15 + z × 25 (1 − P )× Q = (1 − 0.95)× 200 E (z ) = 0. Q = 200 units.

1429 0.9005 2.40 -1.2668 0.7011 2.0085 1.00 -1.10 0.3037 2.90 -0.5020 2.80 0. 1998 page 263 / July 2008 .00 E(z) 0.0367 0.9110 1.0561 0.20 2.4367 1.10 -1.0293 z 0.30 1.40 0.0833 1.3455 1.0085 0.6015 2.0027 0.1065 2.60 0.20 -2.0111 0.80 1.UNIT SERVICE LEVEL IV E(z) 2.70 0.50 2.80 2.30 -1.1004 0.0011 0.50 -0.7183 1.0020 0.2304 0.0005 z 1.60 -2.9202 0.60 -0.10 0.00 -0.6304 0.0833 0.10 2.30 -2.4509 0.0065 0.60 1.6232 1.70 -1.20 -1.00 1.3069 0.1202 0. Applied Management Science.90 -2.40 1.0004 0.5668 0.70 -2.1686 1.0037 0.90 z = Number of standard deviations of safety stock E(z) = Expected number of units short for Source: John A.10 1.70 -0.80 -2.30 2.50 E(z) 1.7687 0.50 E(z) 0.80 -0.8429 0.0455 0.70 2.20 -0.90 2.6978 0.50 0.10 -2.60 -1.0183 0.0008 0.0686 0.30 -0.0015 0.2049 2.8008 2.5069 0.1978 0.40 -2. Pasternack.8143 1.80 -1.3989 z -1.0232 0.90 1.70 1.50 -2.90 -1. Lawrence & Barry A.20 0.40 -0.2561 1.0049 0.3509 0.4027 2.00 2.30 0.5293 z -2.40 2.60 2.20 1.1687 0.0143 0.

THE END Thanks for your attention! page 264 / July 2008 .

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