Operations Management

BBA
Academic Year 2021-22

Dr. Hasanuzzaman
Assistant Professor
Operations & Information Technology
ICFAI Business School Hyderabad
 Inventory

■ It is the useable but Ideal

resources such as men, machine,
money, material etc.
■ When resources involved is a
material, the inventory is called
stock
 Inventory - Objective

■ Maintain the level of customer

service
– To have the right goods, in
sufficient quantities, in the
right place, at the right time.
■ Minimize the costs of ordering
and carrying inventories.
 Inventory - Functions
■ To meet anticipated customer demand
■ To smooth production requirements
– Seasonal Inventory
■ To decouple operations
– Buffer Inventory
■ To protect against stockouts.
■ To take advantage of order cycles
■ To hedge against price increases
■ To permit operations
– Little’s Law
■ To take advantage of quantity discounts
 Inventory – Tracking System
■ Periodic Inventory System
■ Perpetual Inventory System
■ Two-bin System
■ Universal Product Code
– Bar code
■ Point of Sale System
■ RFID System
 Periodic Inventory System
■ Physical count of items in inventory made at periodic intervals
– Weekly
– Monthly
 Perpetual Inventory System
■ System that keeps track of removals from inventory continuously, thus monitoring
current levels of each item.
 Two-bin System
■ Two containers of inventory; reorder when the first is empty.
 Universal Product Code
■ Other way known as bar code
■ Bar code printed on a label that has information about the item to which it is attached
 Point of Sale System
■ Record items at time of sale
 RFID System
■ RFID stands for Radio Frequency Identification
■ Used to keep track of inventory in certain applications.
 Inventory Classifications
■ Lot-Size (or cycle) inventory
■ Pipeline (or transit) inventory
■ Safety (or buffer) inventory
■ Seasonal inventory
■ Decoupling inventory
 Lot-Size (or cycle) Inventory
■ It is the inventory necessary to meet the average demand during the successive
replenishments.
■ The amount of such inventory depends upon
– The production lot size,
– Economical shipment quantities,
– Warehouse space available,
– Replenishment lead time,
– Price-quantity discount schedules, and
– Inventory carrying cost, etc.
 Pipeline (or transit) Inventory
■ Since the movement of item cannot be instantaneous, optimal inventory level is required
for shipment of inventory items to distribution centres and customers from production
centres. Such an inventory is called a pipeline inventory.
■ This is because as it consists of materials actually being worked on or moving between
work centres.
■ Hence, for satisfying demand without delay, it is essential to keep extra stock of inventory
items at various work places to meet the demand while the supply is in transit.
■ The amounts of pipeline inventory depend on the time required for shipment and the
nature of the demand
 Safety (or buffer) Inventory
■ It is the specific level of extra stock of inventory that is maintained for protection against
uncertainties of demand and the lead time necessary for delivery of goods.
■ Despite the principle of just-in-time as well as expected customer service needs, the
demand and lead time both, in general, are random variables with known probability
distribution. Thus to avoid unpredictable shortage with a high penalty cost, additional
stock of inventory items is maintained in addition to the regular stock.
■ The level of additional stock is determined by desirable trade-off between protection
against demand and supply uncertainties and the level of investment in additional stock.
Such additional stock is known as buffer stock as it provides buffer or a safety margin
against future uncertainty.
 Seasonal Inventory
■ Inventory is also needed for items whose sales depend on seasonal pattern of demand
and whose production (or supply) is not uniform, i.e. it varies with time.
– These include fashion items, agriculture products, children’s toys, calendars, etc.
■ In these cases the manufacturer faces peak demand where the production facility is
unable to meet the demand on a period-by-period basis.
■ Thus seasonal (or anticipated) inventories are built-up in advance or are procured during
the period of low demand (provided items are not perishable) to be used during the peak
demand period.
■ If items are to be produced, then to reduce the strain of peak demand periods upon
production facilities, the production of such items may be continued during the low
demand period.
■ However, the amount of inventories to be either procured or produced to meet
unexpected demand should be determined by balancing the holding (or carrying) and
shortage (if any) costs of seasonal inventories.
 Decoupling Inventory
■ If various manufacturing processes (stages) operate successively, then in the case of the
breakdown of one, or due to any disturbance at some stage, the entire system could be
affected.
■ This kind of interdependence is not only costly but also disruptive for the entire system.
■ Thus stocking points of inventory are created between adjacent stages of production to
achieve a certain degree of independence among stages of production.
■ The decoupling inventories may be classified into four groups
– Raw materials and component parts
– Work-in Process Inventory
– Finished Goods Inventory
– Spare Parts Inventory
 Inventory Cost Components
■ Purchase Cost
■ Inventory Carrying or Stock Holding Costs
■ Procurement Cost (for bought outs) or Set up Cost (for made ins)
■ Shortage Cost (due to disservice to the customers)
 Purchase Cost

!"#$ℎ&'( $)'* (#",(('/"./*) = (!#/$( ,(# "./*) × (3(4&.5 ,(# "./* */4()

■ When price-break or quantity discounts are available for bulk purchase above a specified
quantity, the unit price becomes smaller as the size of order, Q, exceeds a specified
quantity level.
■ In such cases the purchase cost become variable and depends on the size of the order.
In this case purchase cost is given by

!"#$ℎ&'( $)'* = !#/$( ,(# "./* 6ℎ(. )#5(# '/7( /' 8 × 3(4&.5 ,(# "./* */4( (D)
 Carrying Cost
■ Cost Components
– Cost of Capital
– Cost of People
– Cost of Space
– Cost of Power
– Cost of Special Facilities – air conditioning, chiller, dust free environment
– Cost of Pilferage
– Cost of Obsolescence

!"##$%&' ()*+
= (!)*+ ). ("##$%&' )&/ 0&%+ ). "& %+/1 %& +ℎ/ %&3/&+)#$ .)# " '%3/& 4/&'+ℎ ). +%1/, 0*0"44$ )&/ $/"#)
× (83/#"'/ &019/# ). 0&%+* ). "& %+/1 ("##%/: %& +ℎ/ %&3/&+)#$ .)# " '%3/& 4/&'+ℎ ). +%1/)
 Ordering (or set-up) Cost
■ Cost Components
– Cost of people
– Cost of stationary
– Cost of communication – telephone, fax
– Cost of follow up– travel, fax
– Cost of transportation
– Cost of inspection and counting
– Cost of rework or rejects
■ When an item is produced ‘in-house’, ordering cost is referred as set-up cost, which includes
both paperwork costs and the physical preparation costs.
■ Ordering (or set-up) cost is independent of the size of the order (or production), rather it
varies with the number of orders placed during a given period of time. Thus, if a large number
of orders are placed, more money will be required for procuring the items.
■ Ordering cost can be calculated as given below:

!"#$"%&' ()*+ = (.)*+ /$" )"#$" )" /$" *$+ 0/) × (3045$" )6 )"#$"* )" *$+ 0/* /78($# %& +ℎ$ /78&&%&' /$"%)#*)
 Shortage Cost
■ Shortage (or stock out) and customer-service cost (Rupees/unit/year)
– Loss of customer goodwill
– Cost of loosing a customer
– Loss of profit associated with not delivering the product.
Two scenario
■ The supply of items is awaited by the customers, i.e. the items are back ordered:
– In this case there is no loss of sale but the nature and magnitude of the back ordering
cost is not exactly known.
– The back ordering cost usually has only one fixed component the extra paper work and
managerial expenses incurred in processing the order.
■ Customer is not ready to wait
– This situation may lead to a loss of customer goodwill and therefore causes loss of sale.
– The loss of goodwill is expected to increase in proportion to the length of the delay.
– Such decline in goodwill might be reflected in the loss of future business.
■ Usually shortage cost are given high preference to minimize the occurrence of shortage in
planning stage of inventory.
 Shortage Cost
■ One of the frequently used measures for inventory shortage costs is the level of
customer service achieved on meeting the product demand, i.e. percentage of demand
that is met from inventory upon demand. Shortage cost in a planning period may be
calculated as given below:

;ℎ)#+"'/ ()*+ = (!)*+ ). 9/%&' *ℎ)#+ )&/ 0&%+ ). "& %+/1) × (83/#"'/ &019/# ). 0&%+* *ℎ)#+)

■ The average number of units short in a planning period is determined by using the
following relationship

<%&%101 ;ℎ)#+"'/ + <">%101 ;ℎ)#+"'/

83/#"'/ &019/# ). 0&%+* *ℎ)#+ = ×{A/#%): ). ;ℎ)#+"'/}
2
 Total Inventory Cost
■ If a unit of an item depends on the quantity purchase, i.e. price discounts are available,
then we should formulate an inventory policy what takes into consideration the purchase
cost of the items also held in stock.
■ The total inventory cost (TC) is then given by

C)+"4 %&3/&+)#$ ()*+ = A0#(ℎ"*/ ()*+ + D#:/#%&' ()*+ + !"##$%&' ()*+ + ;ℎ)#+"'/ ()*+

■ When price discounts are not offered, the purchase cost remains constant and is
independent of the quantity purchased.
■ The total variable inventory cost (TVC) is then given by

C)+"4 3"#%"94/ %&3/&+)#$ ()*+ = D#:/#%&' ()*+ + !"##$%&' ()*+ + ;ℎ)#+"'/ ()*+
 Inventory Control Problem
■ When to order?
– Lead time
■ How much to order?
– As few as possible.
■ How to safety stock should be kept?
– Important to avoid over stocking while ensuring that no stock out take place.
 Inventory Models
■ Single Period Models
■ Multiperiod Models
■ Based on current system they can be further classified
as
– P-system
– Q-system
 EOQ Model with Constant Rate of Demand
Assumptions
■ The inventory system involves one type of item or product
■ The demand is known and constant and is resupplied instantaneously
■ The inventory is replenished in single delivery for each order
■ Lead time (LT) is constant and known, i.e. replenishment is instantaneous, so that
inventory increases by Q units as soon as an order is placed.
■ Shortages are not allowed, i.e. there is always enough inventory on hand to meet the
demand.
■ Purchase price and reorder costs do not vary with the quantity ordered. That is, quantity
discount is not available.
■ Carrying cost per year (as a fraction of product cost) and ordering cost per order are
known and constant.
■ Each item is independent and money cannot be saved by substituting by other items or
grouping cost several items into a single order.
EOQ Model with Constant Rate of Demand
 EOQ Model with Constant Rate of Demand
■ In order to determine the optimal order size (Q), we need to calculate a total variable
inventory cost (TVC) for each order cycle.
■ This cost is given by

:;< = =.."&> $&##?/.@ $)'* + =.."&> )#5(#/.@ $)'*

=.."&> <&##?/.@ <)'* = =B(#&@( C.B(.*)#? D(B(> × {<&##?/.@ <)'* /F./*/G(&#

0+8
=.."&> <&##?/.@ <)'* = [ ]×<!
2

=.."&> L#5(#/.@ <)'* = M"4N(# )O L#5(# !>&$(5 ,(# G(&# × {L#5(#/.@ <)'*/ L#5(#}
"
=.."&> L#5(#/.@ <)'* = <$
#
8 3
:;< = <! + <$
2 8
 EOQ Model with Constant Rate of Demand
■ The total variable inventory
cost is minimum at a value of
Q, which appears to be at the
point where inventory carrying
and ordering costs are equal.

8 3
< = <
2 ! 8 $

23<$
8∗ =
<!

8
D(.@*ℎ )O )#5(# $?$>( =
3
The above formula for Q* is also known as the Wilson or Harris lot size formula.
 EOQ Model with Constant Rate of Demand
■ A local distributor for a national tire company expects to sell approximately 9,600 steel-
belted radial tires of a certain size and tread design next year. Annual carrying cost is
$16 per tire, and ordering cost is $75. The distributor operates 288 days a year.
– What is the EOQ?
– How many times per year does the store reorder?
– What is the length of an order cycle?
– What is the total annual cost if the EOQ quantity is ordered?
 EOQ Model with Constant Rate of Demand
■ The production department of a company requires 3,600 kg of raw material for
manufacturing a particular item per year. It has been estimated that the cost of placing
an order is Rs 36 and the cost of carrying inventory is 25 per cent of the investment in
the inventories. The price is Rs 10 per kg. Help the purchase manager to determine an
ordering policy for raw material.
 Reorder Point
■ When the quantity on hand of an item drops to this amount, the item is reordered.
■ Determinants of reorder point
– The rate of demand (usually based on a forecast).
– The lead time.
– The extent of demand and/or lead time variability.
– The degree of stockout risk acceptable to management.

QL! = 5 × D:
– d is the demand rate
– LT is the Lead Time
 Reorder Point - Example
■ Tingly takes Two-a-Day vitamins, which are delivered to his home by a routeman seven
days after an order is called in. At what point should Tingly reorder?
 Safety Stock
■ Stock that is held in excess of expected
demand due to variable demand and/or lead
time.
– Reorder point will be increased here

Q()#5(# !)/.*
= 3(4&.5 3"#/.@ D(&5 :/4(
+ {R&O(*? R*)$S}
§ Example
If expected demand during lead time is 100
units, and the desired amount of safety stock
is 10 units, the ROP would be 110 units.
 Safety Stock
§ Service Level
Probability that demand will not exceed
supply during lead time.

R(#B/$( >(B(> = 100% − R*)$S)"* #/'S

 Inventory Control Techniques
Classification Basis of Classification Purpose
To control raw material, components and work-in-
ABC
Value of consumption progress inventories in the normal course of
(Always, Better, Control)
business
HML
Unit price of the material Mainly to control purchases
(High, Medium, Low)
To review the inventories and their uses at
XYZ Value of items in storage
scheduled intervals
VED
Criticality of the component To determine the stocking levels of spare parts
(Vital, Essential, Desirable)
FSN Consumption pattern of the
To control obsolescence
(Fast, Slow, Non-moving) component
SDE
Problems faced in procurement Lead-time analysis and purchasing strategies
(Scarce, Difficult, Easy to obtain)

GOLF
(Government, Ordinary, Local, Source of the material Procurement strategies
Foreign sources)

SOS Procurement/holding strategies for seasonal

Nature of supplies
(Seasonal, Off-Seasonal) items
 ABC Classification
■ The ABC analysis consists of separating the inventory items into three groups: A, B and C,
according to their annual cost volume consumption (unit cost × annual consumption).
■ Although the break points between these groups vary according to individual business
conditions, a common breakdown might be as follows
Category (or group) Percentage of the Item Percentage of the Total Annual Value of the Inventories
(Rs)
A 10-20 60-70
B 20-30 20-25
C 50-60 10-15

■ This type of classification is also known as the principle of law of Vital Few and Trival
Many.
■ The ABC analysis facilitates analysis of yearly consumption value of items in the store to
identify the vital few items that are generally referred to as A category items.
 ABC Classification
■ Carrying out the ABC analysis of the store items helps in identifying the few items that are vital
from the financial point of view and require careful watch, scrutiny and follow-up. The
application of ABC analysis extends overall of the aspects of materials management like
purchasing, inventory control, value analysis, etc.
■ The procedure of ABC analysis
■ Step 1: Obtain data on the annual usage (or consumption) in units and unit cost of each inventory
item. Multiply the annual usage in units and the value of each item to get annual value for each of
these items:
!""#$% &$%#' = )"*+ ,-.+ × !""#$% ,-".#01+*-"
■ Step 2: Arrange these inventory items in a decreasing order of their value computed in Step 1.
■ Step 3: Express the annual value of each item as percentage of the total value of all items. Also
compute the cumulative percentage of annual consumption rupees spent.
■ Step 4: Obtain the percentage value for each of the items. That is, if there are 50 items involved in
classification, then each item would represent 100/50 = 2 per cent of the total items. Also cumulate
these percentage values.
■ Step 5: Draw a graph between cumulative percentage of items (on x-axis) and cumulative annual
percentage of usage value (on y-axis), and mark cut-off points.
ABC Classification
ABC Classification - Example
ABC Classification – Example Solution
ABC Classification – Example Solution
 Cycle Counting
■ A physical count of items in inventory.
– Application of the A-B-C concept
■ The purpose of cycle counting is to
– Reduce discrepancies between the amounts indicated by inventory records and the
actual quantities of inventory on hand
■ The key questions concerning cycle counting for management are
– How much accuracy is needed?
– When should cycle counting be performed?
– Who should do it?
■ APICS recommends the following guidelines for inventory record accuracy
– 0.2 percent for A items,
– 1 percent for B items, and
– 5 percent for C items.
■ A items are counted frequently, B items are counted less frequently, and C items are counted
the least frequently.
 Single Period Model
■ Model for ordering of perishables and other items with limited useful lives.
■ Goal
– To minimize the long-run excess and shortage costs
■ Shortage cost
– Generally, the unrealized prof it per unit.

!ℎ#$%&'( )#*% = ,(-(./( 0($ /.1% − )#*% 0($ /.1%

■ Excess cost
– Difference between purchase cost and salvage value of items left over at the end of a period.

345(** )#*% = 6$'1.&7 )#*% 0($ 8.1% − !&7-&'( 9&7/( 0($ /.1%
■ Service Level
– The probability that demand will not exceed the stocking level

)"
!! =
)" + )#
 Single Period Model
■ Stocking Level
– Continuous - Normal Distribution
■ Demand for petroleum, liquids, and gases tends to vary over some continuous scale
– Discrete – Poisson Distribution
■ Demand for tractors, cars, and computers is expressed in terms of the number of units
demanded and lends itself to the description by a discrete distribution.
Single Period Model – Continuous Stocking Level
■ Sweet cider is delivered weekly to Cindy’s Cider Bar. Demand varies uniformly between
300 liters and 500 liters per week. Cindy pays 20 cents per liter for the cider and
charges 80 cents per liter for it. Unsold cider has no salvage value and cannot be carried
over into the next week due to spoilage. Find the optimal stocking level and its stockout
risk for that quantity.
Single Period Model – Discrete Stocking Level
 Discrete Stocking Level - Example
■ Historical records on the use of spare parts for several large hydraulic presses are to serve as an estimate of
usage for spares of a newly installed press. Stockout costs involve downtime expenses and special ordering
costs. These average $4,200 per unit short. Spares cost $800 each, and unused parts have zero salvage.
Determine the optimal stocking level.
 Discrete Stocking Level - Solution
■ Historical records on the use of spare parts for several large hydraulic presses are to serve as an estimate of
usage for spares of a newly installed press. Stockout costs involve downtime expenses and special ordering
costs. These average $4,200 per unit short. Spares cost $800 each, and unused parts have zero salvage.
Determine the optimal stocking level.
 Discrete Stocking Level – Solution through Decision Table

■ The lowest expected cost is $1,060, which occurs for a stocking level of two units, so two is the optimal
stocking level, which agrees with the ratio approach.