Inventory Management

Outline

► The Importance of Inventory

► Managing Inventory
► Inventory Models
 Inventory Management

The objective of inventory

management is to strike a balance
between inventory investment and
customer service
 Importance of Inventory
▶ One of the most expensive assets of
many companies representing as
much as 50% of total invested capital
▶ Operations managers must balance
inventory investment and customer
service
 Functions of Inventory
1. To provide a selection of goods for
anticipated demand and to separate
the firm from fluctuations in demand
2. To decouple or separate various
parts of the production process
3. To take advantage of quantity
discounts
4. To hedge against inflation
 Types of Inventory
▶ Raw material
▶ Purchased but not processed
▶ Work-in-process (WIP)
▶ Undergone some change but not completed
▶ A function of cycle time for a product
▶ Maintenance/repair/operating (MRO)
▶ Necessary to keep machinery and processes
productive
▶ Finished goods
▶ Completed product awaiting shipment
 The Material Flow Cycle

Cycle time

95% 5%

InputWait for Wait to Move Wait in queue Setup Run Output

inspection be moved time for operator time time
 Managing Inventory

1. How inventory items can be classified

(ABC analysis)
2. How accurate inventory records can
be maintained
 ABC Analysis
▶ Divides inventory into three classes
based on annual dollar volume
▶ Class A - high annual dollar volume
▶ Class B - medium annual dollar volume
▶ Class C - low annual dollar volume
▶ Used to establish policies that focus on
the few critical parts and not the many
trivial ones
 ABC Analysis
ABC Calculation

(1) (2) (3) (4) (5) (6) (7)

PERCENT PERCENT
OF OF
ITEM NUMBER ANNUAL ANNUAL ANNUAL
STOCK OF ITEMS VOLUME UNIT DOLLAR DOLLAR
NUMBER STOCKED (UNITS) x COST = VOLUME VOLUME CLASS

#10286 20% 1,000 $ 90.00 $ 90,000 38.8% 72 A

#11526 500 154.00 77,000 33.2% % A

#12760 1,550 17.00 26,350 11.3% 23 B

%
#10867 30% 350 42.86 15,001 6.4% B

#10500 1,000 12.50 12,500 5.4% B

#12572 600 $ 14.17 $ 8,502 3.7% 5% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

Percentage of annual dollar usage ABC Analysis
A Items
80
–
70
–
60
–
50 B Items
– C Items
40 | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
–
30 Percentage of inventory items
–
20
 ABC Analysis
▶ Other criteria than annual dollar volume
may be used
▶ High shortage or holding cost
▶ Anticipated engineering changes
▶ Delivery problems
▶ Quality problems
 ABC Analysis
▶ Policies employed may include
1. More emphasis on supplier development for
A items
2. Tighter physical inventory control for A items
3. More care in forecasting A items
 Record Accuracy
► Accurate records are a critical
ingredient in production and
inventory systems
► Periodic systems require regular
checks of inventory
► Two-bin system
► Perpetual inventory tracks receipts
and subtractions on a continuing basis
► May be semi-automated
 Record Accuracy

► Incoming and outgoing

record keeping must be
accurate
► Stockrooms should be secure
► Necessary to make precise decisions
about ordering, scheduling, and
shipping
 Cycle Counting
▶ Items are counted and records updated
on a periodic basis
▶ Often used with ABC analysis
▶ Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified
and corrected
5. Maintains accurate inventory records
 Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C
items
Policy is to count A items every month (20 working days), B
items every quarter (60 days), and C items every six months
(120 days)
CYCLE
ITEM COUNTING NUMBER OF ITEMS
CLASS QUANTITY POLICY COUNTED PER DAY
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day

C 2,750 Every 6 months 2,750/120 = 23/day

77/day
 Inventory Models
▶ Independent demand - the demand for
item is independent of the demand for
any other item in inventory
▶ Dependent demand - the demand for
item is dependent upon the demand for
some other item in the inventory
 Inventory Models
▶ Holding costs - the costs of holding or
“carrying” inventory over time
▶ Ordering costs - the costs of placing an
order and receiving goods
▶ Setup costs - cost to prepare a machine
or process for manufacturing an order
▶ May be highly correlated with setup time
 Holding Costs
Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 -
operating costs, taxes, insurance) 10%)
Material handling costs (equipment lease or 3% (1 -
depreciation, power, operating cost) 3.5%)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 -
insurance on inventory) 24%)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change
like PCs and cell phones)
Overall carrying cost 26%
 Holding Costs
Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 -
operating costs, taxes, insurance) 10%)
Material handling costs (equipment lease or 3% (1 -
depreciation, power, operating cost) 3.5%)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 -
insurance on inventory) 24%)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change
like PCs and cell phones)
Overall carrying cost 26%
 Inventory Models for
Independent Demand
Need to determine when and
how much to order

1. Basic economic order quantity

(EOQ) model
2. Production order quantity model
3. Quantity discount model
 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering)
and holding
6. Stockouts can be completely avoided
 Inventory Usage Over Time

Total order received

Average
Order Usage rate inventory
quantity = Q on hand
Inventory level

(maximum Q
inventory
level) 2

Minimum
inventory 0
Tim
e
 Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)

Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (order)
cost

Optimal order Order quantity

quantity (Q*)
 Minimizing Costs
▶ By minimizing the sum of setup (or
ordering) and holding costs, total costs
are minimized
▶ Optimal order size Q* will minimize total
cost
▶ A reduction in either cost reduces the
total cost
▶ Optimal order quantity occurs when
holding cost and setup cost are equal
 Minimizing Costs
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

= Number of units in each order cost per order
 Minimizing Costs
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2
 Minimizing Costs
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual

setup cost equals annual holding cost
Solving for Q*
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
 An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand
number of = N = =
orders Order quantity

1,000
N= = 5 orders per
year 200
 An EOQ Example
Determine optimal time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected Number of working days per year

time between = T =
orders Expected number of orders

250
T= = 50 days between orders
5
 An EOQ Example
Determine the total annual cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

 The EOQ Model
When including actual cost of material P

Total annual cost = Setup cost + Holding cost + Product cost

 An EOQ Example
Determine optimal number of needles
Only to
2%order
less than
D = 1,000 units 1,500
Q* = 200
unitsunits the total cost of
S = $10 per order N = 5 orders/year $125 when the
H = $.50 per unit per year T = 50 days
order quantity was
200
 Reorder Points
▶ EOQ answers the “how much” question
▶ The reorder point (ROP) tells “when” to order
▶ Lead time (L) is the time between placing and
receiving an order

Demand Lead time for a new

ROP = per day order in days

=dxL

d D
= Number of working days in a year
 Reorder Point Curve
Q*
Resupply takes place as order arrives
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days, may take 4

D
d
Number of working days in a year
=
= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units
 Production Order Quantity Model
1. Used when inventory builds up over
a period of time after an order is
placed
2. Used when units are produced and
sold simultaneously
Part of inventory cycle during which
Inventory level

production (and usage) is taking place

Demand part of cycle with
no production (only usage)
Maximum
inventory

t Time
Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual = (Average inventory level) x Holding cost

inventory per unit per year
holding cost
Annual = (Maximum inventory level)/2
inventory level

Maximum = Total produced during – Total used during

inventory level the production run the production run

= pt – dt
Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum = Total produced during – Total used during

inventory level the production run the production run

= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
=p –d =Q 1–
inventory level p p p

Maximum inventory level Q d

Holding cost = (H ) = 1– H
2 2 p
Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days
Production Order Quantity
Example
D =1,000 units p = 8 units per day
S = $10 d = 4 units per day
H =$0.50 per unit per year
Production Order Quantity Model
Note:
D 1,000
d = 4 = Number of days the plant is in operation =
250

When annual data are used the equation becomes

 Quantity Discount Models
▶ Reduced prices are often available when larger
quantities are purchased
▶ Trade-off is between reduced product cost and
increased holding cost

A Quantity Discount Schedule

DISCOUNT DISCOUNT
NUMBER DISCOUNT QUANTITY DISCOUNT (%) 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
 Quantity Discount Models
Total annual cost = Setup cost + Holding cost + Product cost

where Q = Quantity ordered P = Price per unit

D = Annual demand in units H = Holding cost per unit per year
S = Ordering or setup cost per order

Because unit price varies, holding cost ( H ) is

expressed as a percent ( I ) of unit price (P)
 Quantity Discount Models
Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the lowest possible quantity to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total cost
Quantity Discount Models
Total cost curve for discount 2
Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a and
must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,00 2,00
0 0 Order quantity
 Quantity Discount Example
Calculate Q* for every discount

2(5,000)(49)
Q 1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q 2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q 3* = = 718 cars/order
(.2)(4.75)
 Quantity Discount Example
Calculate Q* for every discount

2(5,000)(49)
Q 1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q 2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q 3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
 Quantity Discount Example
Total Cost Computations for Wohl’s Discount Store
ANNUAL ANNUAL ANNUAL
DISCOUNT UNIT ORDER PRODUCT ORDERING HOLDING
NUMBER PRICE QUANTITY COST COST COST TOTAL

1 $5.00 700 $25,000 $350 $350

$25,700

2 $4.80 1,000 $24,000 $245 $480

$24,725

3 $4.75 2,000 $23.750 $950

$122.50 $24,822.50
Choose the price and quantity that gives the
lowest total cost
Buy 1,000 units at $4.80 per unit