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Original Title: Inventory Control : operations management

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Inventory Control

Chapter 17

Inventory System Defined

Inventory Costs

Independent vs. Dependent Demand

Single-Period Inventory Model

Multi-Period Inventory Models: Basic

Fixed-Order Quantity Models

Multi-Period Inventory Models: Basic

Fixed-Time Period Model

Miscellaneous Systems and Issues

OBJECTIVES

17-3

Inventory System

Inventory is the stock of any item or

resource used in an organization and

can include: raw materials, finished

products, component parts, supplies,

and work-in-process

An inventory system is the set of

policies and controls that monitor levels

of inventory and determines what levels

should be maintained, when stock

should be replenished, and how large

orders should be

17-4

Purposes of Inventory

1. To maintain independence of

operations

2. To meet variation in product demand

3. To allow flexibility in production

scheduling

4. To provide a safeguard for variation in

raw material delivery time

5. To take advantage of economic

purchase-order size

17-5

Inventory Costs

Holding (or carrying) costs

Costs for storage, handling,

insurance, etc

Setup (or production change) costs

Costs for arranging specific

equipment setups, etc

Ordering costs

Costs of someone placing an order,

etc

Shortage costs

Costs of canceling an order, etc

17-6

E(1

)

Independent vs. Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Dependent

Demand

(Derived demand

items for

component

parts,

subassemblies,

raw materials,

etc)

Finished

product

Component parts

17-7

Inventory Systems

Single-Period Inventory Model

One time purchasing decision (Example:

vendor selling t-shirts at a football game)

Seeks to balance the costs of inventory

overstock and under stock

Multi-Period Inventory Models

Fixed-Order Quantity Models

Event triggered (Example: running out of

stock)

Fixed-Time Period Models

Time triggered (Example: Monthly sales

call by sales representative)

17-8

Single-Period Inventory Model

u o

u

C C

C

P

estimated under demand of unit per Cost C

estimated over demand of unit per Cost C

: Where

u

o

P

This model states that we

should continue to increase

the size of the inventory so

long as the probability of

selling the last unit added is

equal to or greater than the

ratio of: Cu/Co+Cu

17-9

Single Period Model Example

Our college basketball team is playing in a

tournament game this weekend. Based

on our past experience we sell on average

2,400 shirts with a standard deviation of

350. We make $10 on every shirt we sell

at the game, but lose $5 on every shirt not

sold. How many shirts should we make

for the game?

C

u

=$10 and C

o

= $5; P $10 / ($10 + $5) = .667

Z

.667

= .432 (use NORMSDIST(.667) or Appendix E)

therefore we need 2,400 + .432(350) = 2,551 shirts

17-10

Multi-Period Models:

Fixed-Order Quantity Model Model Assumptions (Part 1)

Demand for the product is constant

and uniform throughout the period

Lead time (time from ordering to

receipt) is constant

Price per unit of product is constant

17-11

Multi-Period Models:

Fixed-Order Quantity Model Model Assumptions (Part 2)

Inventory holding cost is based

on average inventory

Ordering or setup costs are

constant

All demands for the product will

be satisfied (No back orders are

allowed)

17-12

Basic Fixed-Order Quantity Model and Reorder Point Behavior

R = Reorder point

Q = Economic order quantity

L = Lead time

L

L

Q Q Q

R

Time

Number

of units

on hand

1. You receive an order quantity Q.

2. Your start using

them up over time.

3. When you reach down to

a level of inventory of R,

you place your next Q

sized order.

4. The cycle then repeats.

17-13

Cost Minimization Goal

Ordering Costs

Holding

Costs

Order Quantity (Q)

C

O

S

T

Annual Cost of

Items (DC)

Total Cost

Q

OPT

By adding the item, holding, and ordering costs

together, we determine the total cost curve, which in

turn is used to find the Q

opt

inventory order point that

minimizes total costs

17-14

Basic Fixed-Order Quantity (EOQ) Model Formula

H

2

Q

+ S

Q

D

+ DC = TC

Total

Annual =

Cost

Annual

Purchase

Cost

Annual

Ordering

Cost

Annual

Holding

Cost

+ +

TC=Total annual

cost

D =Demand

C =Cost per unit

Q =Order quantity

S =Cost of placing

an order or setup

cost

R =Reorder point

L =Lead time

H=Annual holding

and storage cost

per unit of inventory

17-15

Deriving the EOQ

Using calculus, we take the first derivative of

the total cost function with respect to Q, and

set the derivative (slope) equal to zero,

solving for the optimized (cost minimized)

value of Q

opt

Q =

2DS

H

=

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost

OPT

Reorder point, R = d L

_

d = average daily demand (constant)

L = Lead time (constant)

_

We also need a

reorder point to

tell us when to

place an order

17-16

EOQ Example (1) Problem Data

Annual Demand = 1,000 units

Days per year considered in average

daily demand = 365

Cost to place an order = $10

Holding cost per unit per year = $2.50

Lead time = 7 days

Cost per unit = $15

Given the information below, what are the EOQ and

reorder point?

17-17

EOQ Example (1) Solution

Q =

2DS

H

=

2(1,000 )(10)

2.50

= 89.443 units or

OPT

90 units

d =

1,000 units / year

365 days / year

= 2.74 units / day

Reorder point, R = d L = 2.74units / day (7days) = 19.18 or

_

20 units

In summary, you place an optimal order of 90 units. In

the course of using the units to meet demand, when

you only have 20 units left, place the next order of 90

units.

17-18

EOQ Example (2) Problem Data

Annual Demand = 10,000 units

Days per year considered in average daily

demand = 365

Cost to place an order = $10

Holding cost per unit per year = 10% of cost

per unit

Lead time = 10 days

Cost per unit = $15

Determine the economic order quantity

and the reorder point given the following

17-19

EOQ Example (2) Solution

Q =

2DS

H

=

2(10,000 )(10)

1.50

= 365.148 units, or

OPT

366 units

d =

10,000 units / year

365 days / year

= 27.397 units / day

R = d L = 27.397 units / day (10 days) = 273.97 or

_

274 units

Place an order for 366 units. When in the course of

using the inventory you are left with only 274 units,

place the next order of 366 units.

17-20

Fixed-Time Period Model with Safety Stock Formula

order) on items (includes level inventory current = I

time lead and review over the demand of deviation standard =

y probabilit service specified a for deviations standard of number the = z

demand daily average forecast = d

days in time lead = L

reviews between days of number the = T

ordered be to quantitiy = q

: Where

I - Z + L) + (T d = q

L + T

L + T

17-21

Multi-Period Models: Fixed-Time Period Model:

Determining the Value of s

T+L

T+L d

i 1

T+L

d

T+L d

2

=

Since each day is independent and is constant,

= (T+ L)

i

2

sequence of random events

equals the square root of the

sum of the variances

17-22

Example of the Fixed-Time Period Model

Average daily demand for a product is

20 units. The review period is 30 days,

and lead time is 10 days. Management

has set a policy of satisfying 96 percent

of demand from items in stock. At the

beginning of the review period there are

200 units in inventory. The daily

demand standard deviation is 4 units.

Given the information below, how many units

should be ordered?

17-23

Example of the Fixed-Time Period Model: Solution (Part 1)

T+ L d

2

2

= (T + L) = 30 + 10 4 = 25.298

The value for z is found by using the Excel

NORMSINV function, or as we will do here, using

Appendix D. By adding 0.5 to all the values in

Appendix D and finding the value in the table that

comes closest to the service probability, the z

value can be read by adding the column heading

label to the row label.

So, by adding 0.5 to the value from Appendix D of 0.4599,

we have a probability of 0.9599, which is given by a z = 1.75

17-24

Example of the Fixed-Time Period Model: Solution (Part 2)

or 644.272, = 200 - 44.272 800 = q

200 - 298) (1.75)(25. + 10) + 20(30 = q

I - Z + L) + (T d = q

L + T

units 645

you should place an order of 645 units at

this review period

17-25

Price-Break Model Formula

Cost Holding Annual

Cost) Setup or der Demand)(Or 2(Annual

=

iC

2DS

= Q

OPT

Based on the same assumptions as the EOQ model,

the price-break model has a similar Q

opt

formula:

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since C changes for each price-break, the formula

above will have to be used with each price-break cost

value

17-26

Price-Break Example Problem Data

(Part 1)

A company has a chance to reduce their inventory

ordering costs by placing larger quantity orders using

the price-break order quantity schedule below. What

should their optimal order quantity be if this company

purchases this single inventory item with an e-mail

ordering cost of $4, a carrying cost rate of 2% of the

inventory cost of the item, and an annual demand of

10,000 units?

Order Quantity(units) Price/unit($)

0 to 2,499 $1.20

2,500 to 3,999 1.00

4,000 or more .98

17-27

Price-Break Example Solution (Part 2)

units 1,826 =

0.02(1.20)

4) 2(10,000)(

=

iC

2DS

= Q

OPT

Annual Demand (D)= 10,000 units

Cost to place an order (S)= $4

First, plug data into formula for each price-break value of C

units 2,000 =

0.02(1.00)

4) 2(10,000)(

=

iC

2DS

= Q

OPT

units 2,020 =

0.02(0.98)

4) 2(10,000)(

=

iC

2DS

= Q

OPT

Carrying cost % of total cost (i)= 2%

Cost per unit (C) = $1.20, $1.00, $0.98

Interval from 0 to 2499, the

Q

opt

value is feasible

Interval from 2500-3999, the

Q

opt

value is not feasible

Interval from 4000 & more, the

Q

opt

value is not feasible

Next, determine if the computed Q

opt

values are feasible or not

17-28

Price-Break Example Solution (Part 3)

Since the feasible solution occurred in the first price-

break, it means that all the other true Q

opt

values occur

at the beginnings of each price-break interval. Why?

0 1826 2500 4000 Order Quantity

Total

annual

costs

So the candidates

for the price-

breaks are 1826,

2500, and 4000

units

Because the total annual cost function is

a u shaped function

17-29

Price-Break Example Solution (Part 4)

iC

2

Q

+ S

Q

D

+ DC = TC

Next, we plug the true Q

opt

values into the total cost

annual cost function to determine the total cost under

each price-break

TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)

= $12,043.82

TC(2500-3999)= $10,041

TC(4000&more)= $9,949.20

Finally, we select the least costly Q

opt

, which is this

problem occurs in the 4000 & more interval. In summary,

our optimal order quantity is 4000 units

17-30

Maximum Inventory Level, M

Miscellaneous Systems:

Optional Replenishment System

M

Actual Inventory Level, I

q = M - I

I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

17-31

Miscellaneous Systems:

Bin Systems

Two-Bin System

Full Empty

Order One Bin of

Inventory

One-Bin System

Periodic Check

Order Enough to

Refill Bin

17-32

ABC Classification System

Items kept in inventory are not of equal

importance in terms of:

dollars invested

profit potential

sales or usage volume

stock-out penalties

0

30

60

30

60

A

B

C

% of

$ Value

% of

Use

So, identify inventory items based on percentage of total

dollar value, where A items are roughly top 15 %, B

items as next 35 %, and the lower 65% are the C items

17-33

Inventory Accuracy and Cycle Counting

Inventory accuracy refers to

how well the inventory

records agree with physical

count

Cycle Counting is a physical

inventory-taking technique in

which inventory is counted on

a frequent basis rather than

once or twice a year

17-34

Question Bowl

Which of the following is a reason why

firms keep a supply of inventory?

a. To maintain independence of

operations

b. To meet variation in product demand

c. To allow flexibility in production

scheduling

d. To take advantage of economic

purchase order size

e. All of the above

Answer: e. All of the above (Also can include to provide

a safeguard for variation in raw material delivery

time.)

17-35

Question Bowl

An Inventory System should

include policies that are related

to which of the following?

a. How large inventory purchase

orders should be

b. Monitoring levels of inventory

c. Stating when stock should be

replenished

d. All of the above

e. None of the above

Answer: d. All of the above

17-36

Question Bowl

Which of the following is an

Inventory Cost item that is

related to the managerial and

clerical costs to prepare a

purchase or production

order?

a. Holding costs

b. Setup costs

c. Carrying costs

d. Shortage costs

e. None of the above

Answer: e. None of the

above (Correct answer

is Ordering Costs.)

17-37

Question Bowl

Which of the following is

considered a Independent

Demand inventory item?

a. Bolts to a automobile

manufacturer

b. Timber to a home builder

c. Windows to a home builder

d. Containers of milk to a grocery

store

e. None of the above

Answer: d. Containers of milk to a grocery store

17-38

Question Bowl

If you are marketing a more

expensive independent demand

inventory item, which inventory

model should you use?

a. Fixed-time period model

b. Fixed-order quantity model

c. Periodic system

d. Periodic review system

e. P-model

Answer: b. Fixed-order quantity model

17-39

Question Bowl

If the annual demand for an

inventory item is 5,000 units,

the ordering costs are $100 per

order, and the cost of holding a

unit is stock for a year is $10,

which of the following is

approximately the Q

opt

?

a. 5,000 units

b. $5,000

c. 500 units

d. 316 units

e. None of the above

Answer: d. 316

units

(Sqrt[(2x1000x10

0)/10=316.2277)

17-40

Question Bowl

The basic logic behind the ABC

Classification system for inventory

management is which of the

following?

a. Two-bin logic

b. One-bin logic

c. Pareto principle

d. All of the above

e. None of the above

Answer: c. Pareto principle

17-41

Question Bowl

A physical inventory-taking

technique in which inventory is

counted frequently rather than

once or twice a year is which of

the following?

a. Cycle counting

b. Mathematical programming

c. Pareto principle

d. ABC classification

e. Stockkeeping unit (SKU)

Answer: a. Cycle counting

17-42

End of Chapter 17

17-43

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