Week 6

Course Structure
Introduction to OTM;
Managing the Overview
Transformation Process
Process Types; Advanced Recognizing

Operations Technologies;
DAO2703 OTM
Process Flows the Plant
Aggregate
Week 6
Production Planning Planning for
the Plant;
Inventory Material Require- Operations PP&C Cycle
Management ments Planning Scheduling
Inventory Management I Just-In-Time Theory of Improving the
Systems Constraints Plant
Strategic
Operations Strategic
Considerations
Supply Chain
Management
© Copyright National University of Singapore. All Rights Reserved. © Copyright National University of Singapore. All Rights Reserved.
© Copyright National University of Singapore. All Rights Reserved.
Inventory Management: Why? Inventory Management: Why?

Most organizations have three MAJOR objectives
To maximize customer service level
To have efficient low-cost operations
To minimize investment in inventory
An inventory is a stock or store of goods (presently idle) which
has future economic value
Raw materials and purchased parts
Partially completed goods, called work-in-process (WIP)
Finished-goods inventories (manufacturing firms) or merchandise (retail
stores)
Maintenance, repairs, and operations (MRO) inventory
Goods-in-transit to warehouses, distributors, or customers (pipeline https://www.census.gov/mtis/historic_releases.html
inventory) ➢ 32.5% held by manufacturing sector

➢ 29.8% held by retail sector
© Copyright National University of Singapore. All Rights Reserved. ➢ 37.7% held by wholesaler sector
Functions/Purposes of Inventory Cons of Inventory

Manage production Higher costs
To permit operations Ordering (or setup) cost
To smooth production requirements Holding (or carrying) cost
To decouple operations Difficult to control
Manage demand Determining optimal amounts
To meet anticipated customer demand Record keeping
To protect against shortages Storage and maintenance
Control costs Handling inventory is a non-value-added activity
To take advantage of order/production cycles Reduces cash availability
To hedge against inflation
To take advantage of quantity discounts
Product might become obsolete
Hides production problems
ABC Analysis
Observation: 20% of units account for 80% of total inventory
costs
Idea: Manage most important (costly) inventory items most
closely
Application: First analysis to undertake when addressing
inventories
Class A Items: 15%-20% of the total inventory items and
represent 70%-80% of the total dollar usage (high annual dollar
value)
Intensive control
Constant management attention
Critical factor in controlling inventory costs
Sophisticated forecasting necessary
ABC Analysis ABC Analysis

Class B Items: 30% of the total inventory items and represent Example 1: 10 Inventory Items from Silicon Chips, Inc.
15%-25% of the total dollar usage (medium annual dollar value) Item # % of number Annual Unit Cost Annual $ Value % of Annual Class
of items Volume $ Value
Moderate control
10286 1,000 $90.00 $90,000 38.8% A
Computer control whenever possible 20% 72%
11526 500 154.00 77,000 33.2% A
Management by exception
12760 1,550 17.00 26,350 11.3% B
Class C Items: 50%-55% of the total inventory items and 10867 30% 350 42.86 15,001 6.4% 23% B
represent 5% of the total dollar usage (low annual dollar value) 10500 1,000 12.50 12,500 5.4% B
Minimal control/simple techniques 12572 600 14.17 8,502 3.7% C
Minimize transactions costs 14075 2,000 0.60 1,200 0.5% C
Simple manual control whenever possible 01036 50% 100 8.50 850 0.4% 5% C
01307 1,200 0.42 504 0.2% C
10572 250 0.60 150 0.1% C
8,550 $232,057 100.0%
ABC Analysis Managing Inventories

Example 1: 10 Inventory Items from Silicon Chips, Inc. Inventory Systems: set of policies & controls
Establish amount of inventory where the total inventory costs is minimized
100
Class % $ Value % Items Monitor inventory levels
A 72 20 Determine when to replenish inventories
80 A Items
Calculate order/production quantities
B 23 30
Types of Demand
% Annual $ Usage
C 5 50
60 Dependent vs. Independent
Independent: end product sold to customer
40 Dependent: component used in end product
B Items Deterministic vs. Stochastic
20 Deterministic: demands known with certainty
C Items Stochastic: demands are uncertain
Static (Stationary) vs. Variable
0
20 40 60 80 100 Static: expected demand does not change over time
% of Inventory Items
Variable: expected demand changes over time
Inventory Costs Basic Economic Order Quantity (EOQ)
Total Cost (TC) is the sum of the following four types of cost How much of a given item to order every time that the item is
computed over a specific time period order?
Purchasing/manufacturing cost
Assumptions:
Ordering/setup cost
1. Annual demand is known and evenly spread throughout the year so
Holding/carrying cost that the demand rate is (reasonably) constant
Shortage/stock-out/backorder cost 2. No shortages/stockouts are allowed
TC = Purchase cost + Ordering cost + Holding cost + Shortage cost 3. Lead time is known and constant
over a specific time period 4. One-batch delivery (instantaneous delivery)
Purchase cost per period = demand per period × cost per unit 5. There are no quantity discounts
Ordering cost per period = number of orders per period × cost per order 6. All other costs remain unchanged (constant)
Holding cost per period = average stock × carrying cost per unit per period 7. The order quantity can be a fraction
Shortage cost per period = average shortage × shortage cost per unit per
period
Inventory Usage Over Time Inventory Usage Over Time

1 year 1 year
Average Inventory Level

Q
Average Inventory Level
Q Q
2
Q
2
0 Many orders produce a low average inventory level Time 0 Few orders produce a high average inventory level Time
The Inventory Cycle Cost Elements of the EOQ Model

Profile of Inventory Level Over Time
Purchase cost is ignored since it does not vary with lot size and
Q Usage
demand is known (assumption 5)
Quantity rate We need to consider 2 costs: ordering/setup and holding costs
on hand
Ordering/setup cost: Holding cost:
Time needed to prepare a Warehouse space
purchase order Interest on tied-up money
Reorder
point Receiving and inspection Obsolescence, breakage,
Order forms spoilage, deterioration
Telephone calls Taxes
Time
Receive Place Receive Place Receive Authorization Insurance
order order order order order Vendor’s fixed charge Pilferage
Worker’s compensation costs
Lead time
Basic EOQ Model Basic EOQ Model
TC = (Purchase + Ordering + Holding + Shortage) costs per period dTC DS H H DS
=0− 2 + +0 = − 2
DS QH DS QH dQ Q 2 2 Q
TC = DP + + + 0 where TIC = + + Shortage cost
Q 2 Q 2 dTC H DS
Notations: Setting = 0 yields =
dQ 2 Q2
D: demand per time period
2DS
Q: order quantity Q* = and TIC * = 2 DSH
P: purchase cost per unit H
S: ordering or setup cost for each order
Notes:
H: holding cost per unit per period; H = h × P where h denotes the holding
charge per period (stated as a percentage of unit cost) Purchasing cost is not affected by order quantity, Q
TIC: (ordering + holding + shortage) costs per period Ordering cost = holding cost when Q = Q*
TC: purchasing cost per period (DP) + TIC Number of optimal orders per period, N* = D/Q*
Time between optimal orders, T * = Q*/D
How Much to Order? Robustness of the EOQ Model

In reality, the order quantity, Q is an approximate value of Q*
Annual Cost
Q D If the order quantity, Q1 = 0.5Q*, then

TIC = H + S
2 Q DS Q1 H DS 0.5Q* H
Q TICQ1 = + = + = 1.25TIC *
H Q1 2 0.5Q* 2
2 50% decrease in Q* → 25% increase in TIC
If the order quantity, Q2 = 2Q*, then
DS Q2 H DS 2Q* H
D TICQ2 = + = + = 1.25TIC *
S Q2 2 2Q* 2
Q
100% increase in Q* → 25% increase in TIC
2DS Order Quantity, Q
Q =
*
H © Copyright National University of Singapore. All Rights Reserved.
Basic EOQ Model Economic Production Quantity (EPQ)

Example 2:
D = 10,000 units/year There are times when firms may receive their inventories over a
P = $50 per unit period of time instead of instantaneous delivery
S = $24 per order Assumption 4 of the basic EOQ is now “receipt of material over time”
h = 2% of the purchase cost per unit per month EPQ is applicable under two situations:
2 DS 2  10,000  24 Inventory builds up over a period of time after an order has been placed
Q* = = = 200 units/order Units are produced (at a rate, p) and used/sold simultaneously (at a
H 0.02  50  12
rate, u), p > u
TIC * = 2 DSH = 2  10,000  24  12 = $2, 400/year
Especially suited for a production environment, also called the
TC * = PD + TIC * = $ (10,000  50 ) /year + $2, 400/year = $502, 400/year Production Order Quantity (POQ)
D 10,000 units/year
N* = * = = 50 orders/year Like EOQ, answers how much and when to order
Q 200 units/order
* 1 1 Lower (effective) holding cost than the EOQ since average
T = *= = 0.02 years/order inventory is lower
N 50 orders/year
The Inventory Cycle for EPQ Economic Production Quantity (EPQ)
Q
Additional notations:
Production Usage only Production Usage only Production
and usage and usage and usage
p: production rate per time period
Qp u: usage rate per time period
Cumulative
tp: run time (length of the production run)
production tc: cycle time (time between setups of consecutive runs)
Imax Imax: maximum inventory level
Qp Qp
Q p = pt p  t p = , tc =
p u
Qp
Amount I max = pt p − ut p = ( p − u ) t p = Q p − u
on hand p
I max Q p  u
tp Time Average inventory = = 1 − 
tc
2 2  p
Economic Production Quantity (EPQ) EPQ Model

Example 3:
DS Q p  u D = 600,000 pounds/year, P = $3.50 per pound, S = $1,500 per setup,
TC = DP + + 1 −  H
Qp 2  p p = 10,000 pounds/day, h = 12% of the purchase cost per pound per year
Assuming that there are 250 working days in a year.
dTC DS H  u H  u  DS 2 DS 2  600,000  1,500
=0− 2 + 1 −  = 1 −  − 2 Q*p = = = 75,093.92 pounds/batch  75,094 pounds/batch
dQ p Qp 2  p 2  p  Qp H 1− u
p ( )
0.12  3.50  1 − 2,400
10,000 ( )
2 DSH (1 −
p) 10,000 )
= 2  600,000  1,500  0.42  (1 − 2, 400
2 DS
Q*p = u
( )
*
TIC = = $23,969.98/year
H 1− u
p TC * = PD + TIC * = $ ( 600,000  3.50 ) /year + $23,969.98/year = $2,123,969.98/year
D 600,000 pounds/year
( )
N* = * = = 8 batches/year
TIC * = 2 DSH 1 − u Q p 75,094 pounds/batch
p 1 1
T* = * = = 0.125 years/batch = 31.25 days/batch
N 8 batches/year
EOQ With Quantity Discount All-Units Quantity Discount

Quantity discounts appear everywhere; many companies either Assumption 6 of the basic EOQ is now “purchase cost per unit
offer or receive quantity discounts for at least some of the changes with order quantity”
products that they sell or purchase The higher the order quantity, the lower will be the cost per unit
Types of quantity discounts: There will be several values of P, for various ranges of quantity
All-Units Discounts Incremental Discount
per order
C
C A Quantity Discount Schedule
Price Range Quantity Ordered Price Per Unit, P
Initial price 1 – 119 $100
Discount price 1 120 – 1,499 $98
Discount price 2 1,500 or more $96
Q1 Q2 Q Q1 Q2 Q
All-Units Quantity Discount All-Units Quantity Discount
Solution Procedure:
1. Beginning with the lowest purchase price, calculate the EOQ
for each price level until a feasible EOQ is found. It is feasible
if it lies in the range corresponding to its price.
2. If the first feasible EOQ found is for the lowest purchase price
level, this quantity is the best lot size. Otherwise, calculate
the total cost (purchasing plus inventory holding plus setup)
for the first feasible EOQ and for the larger price break
quantity at each lower price level. The quantity with the
lowest cost is optimal.
All-Units Quantity Discount All-Units Quantity Discount

Example 4: Example 4:
D = 4,800 units/year
S = $60 per order 2  4,800  60
*
Q$26.50 = = 294.86 units/order ( Infeasible to order 295 units at the $26.50/unit )
h = 25% of the purchase cost per unit per year 0.25  26.50
Price Range Quantity Ordered Price Per Unit, P

2  4,800  60
P1 1 – 99 $32.50 *
Q$27 = = 292.12 units/order ( Infeasible to order 293 units at the $27/unit )
0.25  27
P2 100 – 279 $30.00
P3 280 – 499 $28.00
2  4,800  60
P4 500 – 1,999 $27.00 *
Q$28 = = 286.85 units/order ( Feasible to order 287 units at the $28/unit )
0.25  28
P5 2,000 or more $26.50
All-Units Quantity Discount

Example 4:
*
DS HQP3   4,800  60 
TC287 = PD + + = $  28  4,800 +  
QP*3 2   286.85 
 0.25  28   
+    286.85  /year = $136, 407.98/year
 2   
  4,800  60   0.25  27   
TC500 = $  27  4,800 +   +    500   = $131,863.50/year
  500   2   
  4,800  60   0.25  26.50   

TC2,000 = $  26.50  4,800 +   +    2,000   = $133,969/year
  2,000   2   

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Course Structure

Process Types; Advanced Recognizing

Inventory Management: Why? Inventory Management: Why?

inventory) ➢ 32.5% held by manufacturing sector

Functions/Purposes of Inventory Cons of Inventory

ABC Analysis ABC Analysis

Minimize transactions costs 14075 2,000 0.60 1,200 0.5% C

ABC Analysis Managing Inventories

Inventory Usage Over Time Inventory Usage Over Time

Average Inventory Level

Average Inventory Level

The Inventory Cycle Cost Elements of the EOQ Model

How Much to Order? Robustness of the EOQ Model

Q D If the order quantity, Q1 = 0.5Q*, then

Basic EOQ Model Economic Production Quantity (EPQ)

Economic Production Quantity (EPQ) EPQ Model

EOQ With Quantity Discount All-Units Quantity Discount

All-Units Quantity Discount All-Units Quantity Discount

Price Range Quantity Ordered Price Per Unit, P

All-Units Quantity Discount

  4,800  60   0.25  26.50   

© Copyright National University of Singapore. All Rights Reserved.

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