DOTE 2030
Operations Management
Inventory Control
Part III
Page 1
Various Models for Inventory Management
Discussion continued
Page 2
Notation Revisited
D = Annual demand
d = D/365 = Daily demand
L = Lead time
C = Variable cost per unit
S = Setup cost of a lot (i.e., a batch)
H = Annual holding cost per unit of inventory
H is often taken as a percentage of the cost of the item,
e.g., H = iC, where i is the percent carrying cost per year
Page 3
Fixed-Order Quantity Model with Positive Lead Time
Demand for the product is constant and uniform throughout
the planning horizon
Lead time (time from producing/ordering to receipt) is positive
Relaxed
Variable cost per unit of product is constant
for either production or order placement from supplier
Inventory holding cost is based on average inventory
All demands for the product will be satisfied
Page 4
Fixed-Order Quantity Model with Positive Lead Time
Now assume the lead time is positive
Lead time
Place an order Receive an order
1. When to order: R = demand in lead time = dL
2. How much to order: Q = Qopt, the same as before
Page 5
Example
Consider inventory control of a product:
Weekly demand is 20 units
Lead time is zero (as assumed in last lecture)
Variable cost per unit is $4
Cost of placing an order is $20
25% annual interest rate for money tied in inventory
Now, what if Lead time L = 14 days?
Page 6
Fixed-Order Quantity Model with Random Demand and
Positive Lead Time
Demand for the product is randomly distributed throughout
the planning horizon Relaxed
Lead time (time from producing/ordering to receipt) is positive
Relaxed
Variable cost per unit of product is constant
for either production or order placement from supplier
Inventory holding cost is based on average inventory
All demands for the product will be satisfied
Page 7
Fixed-Order Quantity Model with Random Demand and
Positive Lead Time
Now assume the demand is random
1. When to order: R = Average demand in lead time + Safety stock
2. How much to order: Q = Qopt, the same EOQ as before
Page 8
Establishing Safety Stock Level
Safety stock is the amount of inventory carried in
addition to average demand in lead time
Safety stock can be determined based on many
different criteria
A common approach is to simply keep a certain
number of days/weeks/months of supply
A better approach is to use probability (such as a
service level of 80% for not running out of stock)
Here we follow the approach of using probability and
assume demand is normally distributed
Page 9
Fixed–Order Quantity Model with Safety Stock
Reorder point R = Average demand in lead time + Safety stock
R dL z L
where
R = Reorder point
d = Average daily demand
L = Lead time in days
z = Number of standard derivations for a specified service level
L = Standard deviation of demand in lead time
zL = Safety stock
Page 10
Another Example
Find the economic order quantity and reorder point, given
(note that data is different from previous example)
Daily demand being Normally distributed with mean
d = 60 and standard deviation d = 7
Lead time = 6 days
Cost of placing an order S = $10 per order
Holding cost H = $0.5 per unit per year
Service level being 95% of not stocking out during the
lead time
Page 11
Inventory Management at Item Level:
ABC Classification
ABC classification is a way to determine what items in
inventory are important and thus deserves close scrutiny
Type % of items % of value Inventory mgmt effort
A ~ 20% ~ 70% Close scrutiny
B ~ 30% ~ 25% Some effort
C ~ 50% ~ 5% Minimal effort
Page 12
HP DeskJet Case: Background
DeskJet is HP’s most successful product
The manufacturing of DeskJet was located in HP’s facility
in Vancouver, where different models were completed
before delivering to DCs (distribution centers)
Supplier IC Mfg US DC Customer
European
Supplier PCAT FAT Customer
DC
Print Far East Customer
Supplier DC
Mech
Supplier
Page 13
HP DeskJet Case: Analysis
Problems in European DC
High inventories
Inventory imbalance
Causes
Uncertain market
Long lead times
Many geographical options (localization)
…
What are HP’s options?
Page 14
HP DeskJet Case: Options
Short-term options
Focus of
Rationalize safety stock by postponement this case
Long-term options
Better forecasting
More inventory
Air shipment
European factory
Uniform product for all markets
…
Page 15
HP DeskJet Case: Postponement
Various Markets:
Vancouver European
Mfg Facility DC UK
France
Traditional Italy
Practice .
Complete Complete .
products products .
manufactured stocked
Various Markets:
Vancouver European
Mfg Facility DC UK
France
Italy
Postponement .
Generic Generic .
products products .
manufactured stocked Localization:
Power supply, manual
Page 16
Localization: Power Supply
UK
France
Italy
Page 17
HP DeskJet Case: Evaluating Postponement
With postponement and thus localization at DCs,
inventories are pooled, which presumably can reduce
safety stocks while maintaining service levels
To evaluate the impact, compare total safety stock if
complete products are held in inventory (as in traditional
practice) or if generic products are held (as with
postponement)
Page 18
HP DeskJet Case: Calculation of Safety Stock
Recall the calculation of safety stock
Safety stock = zL
Use printer A in the traditional practice as an example
Service level of 98% gives z = NORMSINV(0.98) = 2.05
Monthly sample data of the product yields
Monthly average = 42, monthly standard deviation = 32
Lead time = 5 weeks = 35 days
Safety stock of printer A in the traditional practice is
Safety stock = 2.05 × 32 × √ (35/30) = 72 units
Page 19
HP DeskJet Case: Comparison of Safety Stock
Printer Monthly Ave Monthly Std Safety stock
A 42 32 72
Traditional AB 15830 5625 12477 Safety stock
Practice AU 4208 2205 4890 in total
= 20713
AA 420 204 452
AQ 2301 1168 2592
AY 307 103 229
Printer Monthly Ave Monthly Std Safety stock
Postponement Generic 23108 6244 13851
Page 20
HP DeskJet Case: Impacts of Postponement
Safety stock reduction
Traditional practice: safety stock = 20,712 units
Postponement: safety stock = 13,851 units
Other benefits
Less capital tied with inventory
Ease of freight and logistics
Local procurement of localization materials
Local presence of “manufacturing”
Customs implications
But there are costs
DC modifications to accommodate light manufacturing
Page 21