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Operations

Management
Inventory Management
Chapter 12

12-1 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
What is Inventory?
Stock of materials
Stored capacity
© 1995
Corel Corp.

© 1984-1994 T/Maker Co. © 1984-1994 T/Maker Co.


© 1995 Corel Corp.

12-2 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Types of Inventory

 Raw material
 Work-in-progress
 Maintenance / repair / operating supplies
 Finished goods

12-3 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
The Material Flow Cycle

12-4 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
The Functions of Inventory

 To ”decouple” or separate various parts of the


production process
 To provide a stock of goods that will provide a
selection for customers
 To take advantage of quantity discounts
 To hedge against inflation and upward price
changes

12-5 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Disadvantages of Inventory
 Higher costs
 Interest or opportunity costs
 Holding (or carrying) costs – storage, handling, taxes,
insurance, shrinkage
 Ordering (or setup) costs
 Risk of deterioration or obsolescence
 Hides production problems
 Yield / scrap variations
 Unscheduled downtime

Total cost = 20% - 40% of inventory value / year


12-6 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Pressures on inventory

Pressure for lower inventory


•Inventory investment
•Inventory holding cost

Pressure for higher inventory


•Customer service
•Other costs related to inventory

12-7 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Different Views of Inventory

Demand Type Types of Inventory


Independent Cycle
Dependent Pipeline
Safety Stock
Anticipation
Annual $ Volume
Process stage A
Raw Material B
Work in Process C
Finished Goods
Other
Maintenance / Repair
Operating Supplies

12-8 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
How Is Inventory Created?
 Cycle Inventory – result of lot size
Q+0
Average cycle inventory =
2

 Pipeline Inventory – in transit


Pipeline inventory = DL = dL

 Safety Stock
 Anticipation Inventory Types of Inventory
Cycle
Pipeline
Safety Stock
Anticipation

12-9 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Calculations
We use 70 hypodermic needles a week.
We buy them in lots of 280. It takes three
weeks for order handling and shipment.

Cycle inventory = Q/2


= 280/2
= 140 needles

Pipeline inventory = DL = dL
= (70 needles/week)(3 weeks)
= 210 drills

12-10
Inventory Worksheets
© 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Reduction Tactics

 Cycle inventory Reduce lot size

 Pipeline inventory Reduce lead time

 Safety Stock Reduce uncertainties

 Anticipation inventory Various

12-11 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
ABC Analysis
 Divides on-hand inventory into three classes on
the basis of annual dollar volume – A, B, and C
 $ volume = Annual demand x Unit cost
 Policies based on ABC analysis
 Develop class A suppliers more
 Maintain tighter physical control of A items
 Forecast A items more carefully

Annual $ Volume
A
B
C
12-12 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
ABC Analysis

% Annual $ Usage Class % $ Vol % Items


A 80 20
100
B 15 30
80 C 5 50
60
40
A
B
20 C
0
0 50 100
% of Inventory Items
12-13 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Models for
Independent Demand
 Fixed order-quantity models
Help answer the
 Economic order quantity inventory planning
 Production order quantity questions!
 Quantity discount

 Probabilistic models
 Fixed order-period models
© 1984-1994
T/Maker Co.

12-14 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
EOQ – Economic Order Quantity

 Objective:
minimize (ordering cost + holding cost)

 Assumptions:
 Known and constant demand
 Known and constant lead time
 Instantaneous receipt of material
 No quantity discounts
 Only ordering / setup cost and holding cost
 No stockouts

12-15 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Usage Over Time

Usage Rate
Q
Inventory Level

Average
Q
2
Cycle
Inventory

0
Time

12-16 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
EOQ Model
How Much to Order?
Annual Cost

Minimum
total cost

Ordering (Setup) Cost

Optimal Order quantity (Q)


Order Quantity (Q*)
12-17 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Why Holding Costs Increase
More units must be stored if more are ordered

Purchase Order Purchase Order


Description Qty. Description Qty.
Microwave 1 Microwave 1000

Order quantity
12-18 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Why Ordering Costs Decrease
Cost is spread over more units
Example: You need 1000 microwave ovens

1 Order (Postage $ 0.33) 1000 Orders (Postage $330)

Purchase Order PurchaseOrder


Purchase Order
Description
PurchaseOrder
OrderQty.
Description
Purchase
Qty. Description Qty.Qty.
Microwave 1000 Description
Microwave Qty. 11
Description
Microwave
Microwave
Microwave 11

Order quantity
12-19 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
EOQ Model – When to Order

Inventory Level

Q*

Average
Cycle
Reorder Inventory
Point
(ROP)

Time
Lead Time

12-20 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
EOQ Model Equations
Optimal Order Quantity 2 ×D ×S
= Q* =
H
Expected Number of Orders =N = D
Q*
Working Days / Year
Expected Time Between Orders =T =
N
D
d = D = Demand per year
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d × L
d = Demand per day
L = Lead time in days
12-21 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Models for
Independent Demand
 Fixed order-quantity models
Help answer the
 Economic order quantity inventory planning
 Production order quantity questions!
 Quantity discount

 Probabilistic models
 Fixed order-period models
© 1984-1994
T/Maker Co.

12-22 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
POQ – Production Order Quantity
 Answers how much to order and when to order
 Allows partial receipt of material
 Other EOQ assumptions apply
 Suited for production environment
 Material produced, used immediately
 Provides production lot size

 Lower holding cost than EOQ model

12-23 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
EOQ POQ Model

Both production
and usage take Usage only takes
Maximum place
place
inventory
level
Inventory Level

Time

12-24 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Models for
Independent Demand
 Fixed order-quantity models
Help answer the
 Economic order quantity inventory planning
 Production order quantity questions!
 Quantity discount

 Probabilistic models
 Fixed order-period models
© 1984-1994
T/Maker Co.

12-25 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Quantity Discount Model
 Answers how much to order & when to order
 Allows quantity discounts
 Other EOQ assumptions apply
 Trade-off is between lower price & increased holding cost

Discount Discount Discount Discount


Number Quantity (%) Price (P)
1 0 to 999 No discount $ 5.00
2 1,000 to 1,999 4 $ 4.80
3 2,000 and over 5 $ 4.75

12-26 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Quantity Discount – How Much to Order

12-27 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Models for
Independent Demand
 Fixed order-quantity models
Help answer the
 Economic order quantity inventory planning
 Production order quantity questions!
 Quantity discount

 Probabilistic models
 Fixed order-period models
© 1984-1994
T/Maker Co.

12-28 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Probabilistic Models
Service
Level P(Stockout)

Frequency
 Answer how much &
when to order X

 Allow demand to vary


 Other EOQ assumptions apply
 Consider service level & safety stock
 Service level = 1 – Probability of stockout
 Higher service level means more safety stock
 More safety stock means higher ROP

12-29 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Probabilistic Models - When to Order?
Service
Level P(Stockout)

Frequency
Inventory Level

X
SS
Reorder
ROP
Point
(ROP)

Safety Stock (SS)


Lead Time Time
Place Receive
order order

12-30 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Models for
Independent Demand
 Fixed order-quantity models
Help answer the
 Economic order quantity inventory planning
 Production order quantity questions!
 Quantity discount

 Probabilistic models
 Fixed order-period models
© 1984-1994
T/Maker Co.

12-31 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Fixed Period (P) Systems
 Answers how much to order
 Orders placed at fixed intervals
 Inventory brought up to target amount
 Amount ordered varies
 No continuous inventory count
 Possibility of stockout between intervals
 Useful when vendors visit routinely
 Example: Office Max representative calls every week

12-32 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory in a Fixed Period System
Various amounts (Qi) are ordered at regular time
intervals (p) based on the quantity necessary to
bring inventory up to target maximum

Target maximum
Q1 Q2 Q4
Q3
On-Hand Inventory

p p p

Time
12-33 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Comparison of Q and P Systems
 Continuous Review System (Q)
A system designed to track the remaining inventory
of an item each time a withdrawal is made, to
determine whether it is time to replenish

 Periodic Review System (P)


A system in which an item’s inventory position is
reviewed periodically rather than continuously

12-34 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Comparison of Q and P Systems
 Continuous Review System (Q)
 Individual review frequencies
 Possible quantity discounts
 Lower, less-expensive safety stocks

 Periodic Review System (P)


 Convenient to administer
 Orders may be combined
 Inventory position only required at review

12-35 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Inventory Measures
Average inventory = $2 million
Cost of goods sold = $10 million
52 business weeks per year

Average inventory value


Weeks of supply =
Weekly sales (at cost)
$2 million
= = 10.4 weeks
($10 million)/(52 weeks)

Annual sales (at cost)


Inventory turns =
Average inventory value
$10 million
= $2 million = 5 turns/year
12-36 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458
Summary
 Functions of inventory –
Inventory enables value creation for many processes
 Costs of inventory
 Different views of inventory
 Inventory reduction tactics
 ABC and EOQ are traditional tools used to manage
inventory – still used in many circumstances
 Continuous review system (Q) for high-value parts;
Periodic review system (P) for some low value parts
 Weeks of Supply and inventory turns are widely-used
measures of inventory
12-37 © 2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458