PRODUCTION MANAGEMENT

What is Production Management?

The overall procedures of manufacturing management systems (production management)
basically comprise two phases:

1. Strategic Production Management: this deals with strategic production issues existing

between the production system and external environment and makes macroscopic decisions

so as to adapt the production system adequately to the environment, usually in the long term.

The main problems to be solved in this field are as follows:

 Establishing production objectives-the most basic of the decision-making activity in

manufacturing. It is concerned with the outputs to be produced. Production planning

plays an important role in this decision.

 Planning production resources- production resources required to produce specified

commodities, which are determined by the product planning function, include money,

facilities and equipment, materials, and personnel.

 Determining the requirements, planning for their acquisitions from the external

environment, and optimum allocation to the various divisions of the manufacturing

system for economic production is appropriately made. This is called Resource

Planning.

2. Operational (or tactical) production management: this deals with operational production

problems of the manufacturing system and makes optimal microscopic decisions, commonly

in the short term, for effective production activities to be performed under the policy derived

from the strategic production planning.

This operational production management procedure consists of the following five stages:
 i. Aggregate production planning – determines kinds of product items and the

quantities in specified time periods.

ii. Production process planning – determines the production process (or process routes)

by which resources are effectively transformed into finished products, together with

appropriate layout of these facilities for executing the determined sequence of

production processes. This function will also interact with the product design

function to function to ensure ease of manufacture of the product.

iii. Production scheduling – determines an implementation plan for the time schedule

for every job contained in the process route adopted; that is, when, with what

machine, and who does what operation?

iv. Production implementation – executes actual production operations according to the

time schedule.

v. Production control – whenever actual production progress and process and deviate

from the production standards (plans and schedules) set at the planning stages 1, 2

and 3, such deviations are measured and modifications are made.

THE PROCEDURAL ASPECTS OF A MANUFACTURING SYSTEM

EXTERNAL

INFORMATION

STRATEGIC PRODUCTION
PLANNING

STRATEGIC PLAN
INFORMATION

PRODUCTION
DEMAND AGGREGATE
ORDER PRODUCTION TECHNICAL
INFORMATIO PLANNING INFORMATION
N
PRODUCTION PRODUCTION
PLAN PLANNING
INFORMATIO PROCESS
N
PRODUCTION
PRODUCTION PROCESS
PLANNING INFORMATION

PRODUCTION
SCHEDULE
INFORMATION

PRODUCTION
IMPLEMENTATION
(IN PLANT)

PRODUCTION
RESULTS
DATA

PRODUCTION
CONTROL PRODUCTION
INFORMATION CONTROL
Strategic Planning

Tasks:
 What is strategic planning?

 What is the difference between strategic planning and long-range planning?

 Participants present their current methods of planning in each section/function.

The primary tasks of strategic management are to understand the environment, define
organizational goals, identify options, make and implement decisions, and evaluate actual
performance. Thus, strategic planning aims to exploit the new and different opportunities of
tomorrow, in contrast to long-range planning, which tries to optimize for tomorrow the
trends of today.

Traditional long-range planning in its most elementary form is based on the concept that
planning consists of at least four key steps--monitoring, forecasting, goal setting, and
implementing--that are intended to answer these questions:
(1) Where is the organization now?

(2) Where is it going?

(3) Where does it want to go? and

(4) What does it have to do to change where it is going to get to where it wants to go?

Performing these activities is a continuing process that, for example, produces a one-year
operating plan and a five- or ten-year long-range plan every year. The long-range planning
cycle begins by monitoring selected trends of interest to the organization, forecasting the
expected future of those trends (usually based upon extrapolation from historical data using
regression analysis or a similar technique), defining the desired future by setting
organizational goals in the context of the expected future, developing and implementing
specific policies and actions designed to reduce the difference between the expected future
and the desired future, and monitoring the effects of these actions and policies on the
selected trends.

Major Business Problem Areas

Business Managers
 Strategic thinkers
  True operations managers

Shortcomings

 A developed strategy cannot be implemented because there is a gap between strategic

and operational issues.

 There is a strategy vacuum as too much emphasis is placed on operational

considerations.

The Process of Strategy Development

SOME DEFINITIONS OF COMPETITIVENESS

Governments
* A positive balance of trade
Economists Identification of trends
in global competition and constraints acting upon
* Low unit of labour cost adjusted for exchange rates
the organisation
Industry
* Ability to compete in world markets

Measure of Competitiveness

 Productivity:

 value of output produced by a unit of labour or capital

Formulation of a
 Value: business strategy

 depends on the quality and features of the product and the efficiency with which

E they are produced

P Lower Differentiation
cost Formulation
O t
C of aligned operations
Cost
rke
S strategies Differentiator
leader
ma
d
E Competitive Strategies
oa
V Br
Source of competitive advantage
I t
T ke
Cost
I ar
Differentiation
focusFormulation of
T m
focus
operational
E ow
policies
P rr
M Na
O
 Process Choice
Variety
JOB
(Purpose-Built
Machine Tools)

Volume
BATCH
(Engineering)

LINE
(Cars)

Product Life Cycle

100%
Sales(units) Start-up Growth Maturity Decline

Time
 TOTAL PRODUCTION TIME
TRANSPORT, IDLE AND WAITING
TIME
0 5 100
% % %

PRODUCTIVE SET-UP
TIME TIME

0 40
% %
TOTAL MACHINING TIME
 Past Present Future
Sales
(units)

Time

AGGREGATE PLANNING

Learning Objective:

To take the first steps in translating forecasts for demand into a production plan.

Aggregate Planning: Attempts to match the supply of and demand for a product or service
by determining the appropriate quantities and timing of inputs, transformation, and outputs.
Decisions made on production, staffing, and inventory and backorder levels.

Characteristics of aggregate planning:

* Considers a "planning horizon" from about 3 to 18 months, with periodic updating;

* Looks at aggregate product demand, stated in common terms;

* Looks at aggregate resource quantities, stated in common terms;

* Possible to influence both supply and demand by adjusting production rates,

workforce levels, inventory levels, etc., but facilities cannot be expanded.

Production Plan (manufacturing aggregate plan):

A managerial statement of the period-by-period (time-phased) production rates, work force

levels, and inventory investment, given customer requirements and capacity limitations.

Staffing Plan (service aggregate plan):

A managerial statement of the period-by-period staff sizes and labour-related capacities,

given customer requirements and capacity limitations.

Objectives of Aggregate Planning

Objective of aggregate planning frequently is to minimize total cost over the planning
horizon.
Other objectives should be considered:

* maximize customer service

* minimize inventory investment

* minimize changes in workforce levels

* minimize changes in production rates

* maximize utilization of plant and equipment

Aggregate Planning Strategies

Active strategy:

* Attempts to handle fluctuations in demand by focusing on demand

management;

* Use pricing strategies and/or advertising and promotion;

 * Develop counter-cyclical products;

* Request customers to backorder or advance-order; and

* Do not meet demand.

Passive strategy (reactive strategy):

* Attempts to handle fluctuations in demand by focusing on supply and capacity

management;

* Vary size work force size by hiring or layoffs;

* Vary utilization of labour and equipment through overtime or idle time;

* Build or draw from inventory;

* Subcontract production;

* Negotiate cooperative arrangements with other; and

* Allow backlogs, back orders, and/or stock outs.

Mixed strategy:

* Combines elements of both an active strategy and a passive (reactive)

strategy; and

* Firms will usually use some combination of the two.

Passive (reactive) Strategies in Aggregate Planning: Basic Approaches

Chase approach

Capacities (workforce levels, production schedules, output rates, etc.) are adjusted to match

demand requirements over the planning horizon.

Advantages:

* Anticipation inventory is not required, and investment in inventory is low; and

* Labour utilization is kept high.

Disadvantages:

* Expense of adjusting output rates and/or workforce levels; and

* Alienation of the workforce.

Level Approach
Capacities (workforce levels, production schedules, output rates, etc.) are kept constant over
the planning horizon.

Advantage:

* Stable output rates and workforce levels.

Disadvantages:

* Greater inventory investment is required;

* Increased overtime and idle time; and

* Resource utilization vary over time.

Aggregate Planning Methods: Intuitive Methods

Intuitive methods use management intuition, experience, and rules-of-thumb, frequently

accompanied by graphical and/or spreadsheet analysis.

Advantage:

* Easy to use and explain.

Disadvantage:
 * Many solutions are possible; most of which are not optimal.

Aggregate Planning Example:

Suppose you have the following forecasts for demand to meet:

Month 1 2 3 4 5 6
Deman
1000 1200 1500 1900 1800 1600
d

Relevant Costs:

Regular production cost $35/unit

Lost sales $100/unit

Inventory carrying costs $10/unit/month
Subcontracting costs $60/unit
Hiring costs $1500/worker
Firing costs $3000/worker
Beginning workforce level 20 workers
Capacity per worker 50 units/month
Initial inventory level 700 units
Closing inventory level 100 units

LEVEL PRODUCTION STRATEGY

Find the requirements for the period of the plan and produce the average amount needed per
month to meet the plan.

First determine the average requirements per month:

Avg. requirements = total requirements - opening inv. + closing inv.

number of periods

Avg. requirements = (9000 - 700 + 100)/6 = 1400 units/period

STEPS:

1. Enter the production data

2. Determine hire/fire to get to production level desired

3. Update inventory levels

 4. Does the inventory run out - If it does recalculate average production needed and go

to step 1

5. Calculate totals for each category

6. Calculate costs

LEVEL STRATEGY
Period 1 2 3 4 5 6 Total
Req. 1000 1200 1500 1900 1800 1600 9000
Prod.
Inv.(700)
Hire
Fire
Sub.

Costs:
1. Regular production costs:

2. Inventory carrying costs:

3. Hiring Costs:

TOTAL COSTS: _________

CHASE STRATEGY

* Produce exactly what is required every period.

* Hire and fire to adjust monthly production to monthly requirements.

* The first and last period production levels are adjusted to account for

opening inventory and closing inventory requirements.

Period 1 2 3 4 5 6 Total
Req. 1000 1200 1500 1900 1800 1600 9000
Prod.
 Inv.(700)
Hire
Fire
Sub.
Costs:

1. Regular production costs:

2. Inventory carrying costs:

3. Hiring Costs:

4. Firing Costs:

TOTAL COSTS : _____________

Intuitive (Mixed) Strategy

- Trial and Error to find a good solution;

- Use Excel to model the problem and test the impact of different solutions

Build the model using proper structure with key variables at the top and a summary of key
results immediately below.

Finding Optimal Solutions Using Linear Programming

Aggregate planning problems can be solved optimally using linear programming (LP). Given
the constraints on requirements, production capabilities, allowed workforce changes,
overtime and subcontracting limits plus all relevant costs LP will find an optimal solution to
the problem which minimizes total costs.

Capacity Planning Systems

Medium-term (aggregate) planning e.g. a weekly/monthly plan or schedule tries to match

demand with capacity as such the units of measurement for both needs to be defined. For
demand these might be:
* Volumes to be shipped by day/week etc; and

* Number and type of customers to be served etc.

If we are making one product e.g. strawberry jam tarts, demand can be measured as gross or
Tonnes output/week or production hours required per week (given a standard quantity of
production per hour).

For capacity we need to know

* Machine and vehicle capacity, staff skills and hours, and material/component

stock availability.

A bakery of mixers, ovens, preparation tables, packaging machines etc. has a design capacity
to produce tarts at a given rate and to a maximum capacity (working flat out 24 hours a day,
each week and all year) - assuming you have the staff who can withstand the stress.

Complexity (Output/Capacity Relationships)

Output/Capacity Relationships must be managed in a multi-product situation. Each product

may make different time/process demands. Do we have the ability to properly co-ordinate all
operations to meet existing orders let alone squeeze in a new order with its knock on effect
on the rest? Will managerial breakdown result? Sales staff may wish the company to accept
the order. Operations staff despair at the pressure.

If the order/product mix and processes are stable, a multi-product firm may
* Assume that the overall mix (aggregate demand) for the product is roughly

constant; and

* On this basis we can draw up our aggregate plan (our manufacturing resources

plan) on the basis of "total" figures.

Master Production Schedules

* Start with anticipated demand for individual products over the planning

horizon - up to the due date of the plan.

 * Map expected demand against available capacity

* Identify over/under-capacity problems.

* Take action to amend the schedule or adjust capacity.

* When actual orders roll in they can be compared against plan and the MPS (a

continuous rolling plan) up-dated.

With our overall estimate, accommodation of slight, short-term variations in the

product mix is akin to fine-tuning. The overview and aggregate allocations
provide predictability and ease in seeing where the gaps are.

Data for manufacturing resources planning

There is need for process time and availability data in order to allocate capacity across our
planned products and required processes. Plant capacity depends on:

* required times for each operation/process on each product;

* machine speeds, set up times and availabilities; and

* Work patterns and operator availabilities e.g. a 40-hr week plus controlled

overtime per operator or shift working possibilities.

You can be swamped with data and not see the wood for trees.
Aggregate planning systems must be workable and user friendly for those who refer to
them. If users find that the plans are inaccurate or make too many assumptions - then they
come to disbelieve the plans and ignore the figures. Chaos beckons.

A heuristic for planners is to

* Group products e.g. by the similarly of demands made on equipment, staff, facilities;

and

* Use larger units, e.g. weekly outputs rather than daily.

A Gross of Vans
A van may have three engine types, four levels of trim and eight paint options i.e. 96
permutations for customers. Yet in assembly - equipment needs (provided we have
equipment flexibility) and staff skill requirements are similar. Demand can be aggregated
into a plan for 96. Data on engine supply, paint availability and trim stocks requirements
however is required in more detail.

Bills of Materials

With standard products, information from the product specification is used with production
data to provide a bill of materials. This is an essential record in scheduling production of
specific quantities of the product and the components that make it up.

BOM data covers:

* Raw materials and component quantities;

* Processes used, sequences and throughput capacities; and

* Standard times for each process stage (work measurement data).

BOM e.g. for a packet of 24 vitamin tablets allows machine and staff requirements, raw
material and component quantities from an order. With cost data we can then calculate the
product's standard cost.

Bill of Materials
Bottles of 500 mg tabs, 1000 bottles per batch
Standard
Process Plant Material Quantity Yield
time
Weigh Scales 4 Vitamin 65 mg
Binding
30 mg
agent

Shine agent 5 mg

Mix Blender 10
Tab
Set-up press 8
Press
Tab
Press operation 12 96%
Press
Inspecti
Inspection 1.2 95%
on slot
Pack Bottler 1.8 Plastic bottle 1 99.5%
 Foam insert 1
Plastic lid 1
Auto
Label 0.5 Label 1 99%
labeller

GIGO

Garbage in equals garbage out. A sound plan needs sound up-to-date information. The bill of
materials file must be up-dated with any changes to product specifications, processes,
standard times and yields.
The "yield" column reflects a process where there may be quality problems. A BOM must

Realistic Data, Proactively and Planning-Job Shop Relationships

Realistic Data

Capacity data must be realistic - reflecting what can actually be done - not the planner's
dreams. Well-grounded standard times are important including
* work times, relaxation allowances, sickness, training courses, absences and

holidays

* contingencies e.g. supplier difficulties, work not available from up-stream

operations and machine breakdown

* planned maintenance times/schedules

Medium-term plans and Short-term Pressures

Plans are imposed upon working facilities. The people who perform the operations usually
find short-term scheduling and re-scheduling involve more pressures than medium term
aggregate planning. In shop floor terms therefore - the proactive manager anticipates the
medium term demands in resolving immediate day to day problems. He/she keeps the longer
term in view rather than being overwhelmed by the fire-fighting behaviours of the shorter-
term panic.
 Project/job shop planning

One-off jobs/projects involve substantial uncertainty and planning depends on subjective

estimating. Some repetitive operations may enable use of measured standard times but many
tasks/times are unique to the order/project. It is usually the case that the job-shop teams have
the ability to undertake their own day-to-day planning. If operations planners do this it is
essential that they have prior experience with "the kind of job that is involved". They have to
be able to:

* research the project requirement properly consulting with the shop floor ;

* rely on the expertise and ability the team in the job shop;

* Facilitate the flexibility that people in the job shop need. It is unlikely that

neither work measurement data nor standard bills of materials are useable;

* Not irritant the job shop staff further by continually changing plans with little

or no notice or

* Harassing for work-in-progress updates.

PRODUCTION SCHEDULING

Tasks:
 What is the difference between production scheduling and production sequencing?

 Differentiate between project scheduling and production scheduling?

Production Scheduling is a function done to determine an actual (optimal or feasible)

implementation plan as to the time schedule for all jobs to be executed; that is, when, with what
machine, who does what operation? This is done after the products and the quantities to be
manufactured in specified time periods have been decided by production planning and the
production processes for those product items have been determined by production process planning.

A general description of scheduling is the allocation of resources over time to perform a

collection of tasks (Baker, 1974). “Classical” scheduling problems have been formalised into
an underlying framework referred to as scheduling theory. This approach to solving
scheduling problems is used mainly in the academic arena. Scheduling in practice however,
varies greatly between different companies and even departments, with no definitive model
of ‘real world’ scheduling available to aid manufacturing industry in its understanding of
scheduling problems. A comparison of these scheduling approaches makes the problems of
studying scheduling practice clearer (Table 1).

Table 1 Comparison of scheduling approaches

SCHEDULING THEORY SCHEDULING PRACTICE

 Scheduling approached as a relatively  Scheduling approached as a ‘complex’

‘simple’ mathematical problem real world problem

 Aims to reach an ‘optimal’ solution  Attempts to reach a solution; ‘optimal’

if possible, but often ‘satisfying’

 Uses dispatching rules  Uses heuristics or ‘rules of thumb’

 Scheduling environment normally  Scheduling environment is unstable

stable and certain and uncertain

 Solutions are provided in form of  Solutions provided in form of

formulas suggestions presented by computers

and people working together

Scheduling in industry

Therefore, it can be seen that there is a gap between scheduling theory and scheduling in
practice. In academia, the ergonomics literature is sparse and the human element is not
considered in the majority of operations research and manufacturing texts, with the result that
human factors in scheduling are not fully understood. In industry there is limited
understanding of the optimal level of human integration and potential in planning and
scheduling with the added constraints of the complexity and uncertainty of dynamic
manufacturing environments. In response, industry has increasingly made use of computer
technology in production scheduling to compensate for the lack of theoretically generated
solutions. These solutions, which attempt to automate the decision-making processes of
scheduling, include decision support systems and computer aided production and planning
systems. The overall aim of such systems was to reduce the amount of human input needed
to carry out the tasks of planning and scheduling. Scheduling occurs in many environments
including staff scheduling, transportation, and manufacturing.

Types of operations scheduling

  Job sequencing – determining the order of processing jobs on a machine. An

optimal job sequence is selected from among a set of “permutation schedules” or

by the “dispatching (or priority) rules” established reasonably by scheduling

simulation.

 Flow shop scheduling – scheduling for a flow shop, where the sequence of

machines according to multiple-stage manufacturing is completely identical for all

jobs to produced. This type of flow is typical for mass production.

 Job-shop scheduling-scheduling for a job shop, where the sequence of machines

differs for each job. This is typical for the case of varied production of most

jobbing types and some batch types.

Scheduling Criteria

A basic role of operations scheduling is to generate an optimal schedule. That scheduling

decision is made according to a certain measure of performance or scheduling criterion.
Important ones include:

 Maximum flow time or makespan – F max;

 Mean flow time –F;

 Maximum lateness or tardiness –Lmax or Dmax;

 Mean lateness or tardiness – L or D;

 Number of tardy jobs –m;

 Average number of work in process;

 Facility utelisation.

The last measure is maximised; others are minimised.

The flow time or production time,F for a job is the total length of time that the job spends for
processing. It is the sum of waiting time, W and processing time, t.

F = W + t

Lateness, L is the difference between the completion time, F and the due date, d.
L = F - d

Tardiness refers to positive lateness.

The total flow time or makespan, which represents a time length from the beginning of the
first operation to the end of the last operation of the last job, is then given by the maximum
of the
flow times for all the jobs.

Mean flow time is the mean time length during which all jobs remain in the workshop. The
mean flow time is closely related to inventory in the workshop. The ratio of the average work
in progress against the total number of jobs to be processed is equal to and the ratio of the
mean flow time against the makespan, this is true for static cases.

Maximum lateness and maximum tardiness are the maximum values among the Ls and Ds
respectively.
The mean lateness and tardiness are calculated by dividing the total of the lateness or total of
the tardiness by the total number of jobs.

An optimal schedule that has the minimum flow time also has the minimum mean
lateness and the minimum mean waiting time. The schedule also minimises the work in
process inventory.
Shortest processing time (SPT) Scheduling
The jobs are sequenced in order of increasing processing time.
Example
Consider the set of six jobs with the following data.
JOBS
1 2 3 4 5 6
Processing Times(ti) 21.4 5.7 16.2 8.4 9.0 11.2
Due Dates(di) 25 34 82 54 70 45
Sequence these jobs to minimise the average number of jobs in the shop and find the average
flow time.
JOBS
2 4 5 6 3 1
Processing time 5.7 8.4 9.0 11.2 16.2 21.4
Due dates(di) 34 54 70 45 82 25
Completion time(Ci) 5.7 14.1 23.1 34.3 50.5 71.9
Lateness (Ci- di) -28.3 -39.9 -46.9 -10.7 -31.5 46.9

Average Flow time=(5.7+14.1+23.1+34.3+50.5+71.9)/6=33.27

Maximum tardiness=46.9.
INVENTORY MANAGEMENT AND PRODUCTION SYSTEMS IN KPS

INVENTORY MANAGEMENT

Successful inventory management involves simultaneously balancing the costs and benefits
of inventory. In any business, one should aim to minimize holding costs. Yet, the benefit of
inventory is sales revenue and holding sufficient inventory ensures that customers can
purchase products when required. Consequently, holding too little inventory may result in the
loss of sales while holding too much inventory may result in excessive holding costs. There
are many specific reasons for holding inventory. These include:
 Holding inventory minimizes the unreliability associated with the supply of raw

materials.

 Early purchasing of raw materials can be cost effective in times of rising prices.

 Holding an appropriate level of raw materials inventory will be economical if the

costs associated with reorder and distributions are very high.

 Inventory may be held to allow flexibility in job scheduling.

 Holding an appropriate in-process will be economical if the cost of setting up the

required equipment is very high.

 In process inventory may be held so that perturbations to a sub-system’s operation

(e.g. machine failure) does not starve the other sub-systems within the

organisation.

 It is often difficult to tailor the production to meet the demand of a variable

nature. In such a case, if customer orders are to be delivered promptly then an

appropriate level of finished goods inventory must be held.

The above considerations indicate that the prime function of inventory management is to
minimize costs while creating a flow of items through the system such that actual output
matches required output at the right time and in the right quality.

Inventory management can lead to increased profits by either increasing sales through
having better stock availability, or by decreasing inventory-holding costs. Proper inventory
management includes the following:
 Keeping holding costs low while ensuring adequate supply for customers;

 Increasing inventory turnover while maintaining adequate profits;

 Keeping process material stocks as low as possible; and

 Making volume purchases to obtain discounts while avoiding excess buying.

DECISION MAKING IN INVENTORY MANAGEMENT

A number of decision problem exist in inventory management. These are as follows.

(a) Which items should be carried in stock?

(b) How much should be ordered
(c) When should an order be placed?
(d) What type of inventory system should be used?

The first question deals with decisions on making to stock, making to order and the keeping
of an item as a stock item or not. At times obsolete or "insurance" items with very little
demand are often kept in stock. One has to decide whether to keep, salvage, write off or
replenish these items.

The second question is concerned with order quantity and requires a straight forward analysis
of how much should be ordered at each time that the order quantity is reached with a view to
replenish stock.

The third question is concerned with the timing of the order. A decision rule can then be
designed based on these two questions that is questions two and three.

The last question deals with the control system needed to ensure that the right amount is
ordered, in the right quantities, being of the right quality and at the right time. Accurate
records, order triggers and information as well as material tracking is necessary at all times.
A right computer or manual system can be developed to assist in the management of the
inventory.

INVENTORY COST STRUCTURES

Many Inventory decision problems can be solved using an economic criterion, hence the
need to understand inventory cost structuring. These are as follows: -

(1) ITEM COST

 This is the cost of buying or producing one item. A discount can be given for bulk
purchases.

(2) ORDERING (OR SET UP) COST

This is the cost of ordering a batch (lot) of items. They do not depend on the number
of items ordered. It consists of the costs of typing the purchase order, expediting it,
transportation and the receiving of the order placed. When doing own products the
set up costs include cost of paperwork and the setting up production equipment for a
run. Large runs are more economic as well as bulk purchases, considering the
resulting cost per unit item. Both types of costs can be reduced.

(3) CARRYING (OR HOLDING) COST.

This is associated with the cost of keeping inventory for a period of time. It is a
charged as a percentage of keeping a given value of stock per year say. The cost is
normally made up of three components as follows:-

(a) The opportunity cost, which is the cost of capital tied up in inventory, which is not
available to earn interest or to be channelled to better investment projects. There is
associated with it the cost of forgone opportunities.

(b) The cost of obsolescence that can be caused by deterioration in the case of
perishable goods and can result in a permanent loss of income. Some items have a
higher risk of becoming obsolete (no longer required or bought by the customers).
Perishable products deteriorate over time especially food and blood. Losses can
result from pilferage and breakage resulting in more insurance costs. Some items just
go out of fashion. One can consider the results of making charcoal irons for an urban
market or the production of the old Morris Minor to compete with Toyota cars. It is
clear that companies that do not change with fashion trends will incur very heavy
costs, and will not be viable in future.

(c) The cost of storage, which includes the cost of the space required for
warehousing, insurances costs which are needed to insure the material against fire
theft and natural hazards and the cost of taxes rentals and levies associated with the
space that is being utilised.

(4) STOCKOUT COST

This reflects the economic consequences of running out of stock. If customers wait
for a late delivery, there is still the danger of loosing good will or the loss of future
business. Such an opportunity cost is associated with what is known as a stock-out
cost. Alternatively the sale can be lost due to material unavailability. Profit is lost as
well as the goodwill and future sales.
The assumption made is that ordering costs reduce as the order quantity Q is increased. This
is expected to result in less paper work, less handling and transportation costs. On the other
hand, the carrying costs are assumed to increase in proportion to the order quantity. The
rationale behind this assumption is that, a high order quantity, results in a higher average
inventory level.

It is not easy to assess these inventory costs but with persistence they can be estimated
accurately enough for decision-making purposes. Item cost and ordering cost can be
obtained from historical records. Ordering cost should include only costs which vary with
the number of orders placed and it is very difficult to separate the fixed and variable costs.
Carrying cost is difficult to obtain and financial considerations can be used to estimate it.
Cost studies and records can be used to estimate storage, deterioration, obsolescence and any
other losses. Stock-out costs are the most difficult to estimate. The estimates can be based
on assumptions of lost profits. An acceptable stock-out risk level can also be used. This is
regarded as the service level.

The basic inventory model, which was devised over 70 years ago, deals with single items of
stock. It can be used to determine the optimum inventory level and timing of replenishment
that culminates in the least cost situation. The appropriate way of illustrating the basic
inventory model is through an industrial example.

Example: A steel bridge is painted by a permanent team of four painters who work from end
to end once every year with each man in effect painting a quarter. The present paint is
effective for one year after which serious corrosion will set in if the bridge is left unpainted.
The overall annual paint usage by the four painters stands at 6000 units which are currently
ordered in 12 lots of 500 units. Each order is received beginning of a month. Every unit cost
$20 and the transportation and administration costs associated with placing an order of any
size has been estimated to be$250. It has been found that the annual holding cost is directly
proportional to the unit value of the paint and in this connection the holding cost factor has
been estimated to be 0.15. The committee responsible for the bridge is uncertain whether the
current inventory policy is optimum.
a) Establish the optimum order quantity and timing which gives a minimum costs

situation.

b) Determine the amount of savings that will be realised as a result of implementing the

optimum policy.

c) Discuss the quantitative factors that should be considered before making the final

judgment.
SOLUTION

In the figure below, Q represents the quantity of paint ordered at every replenishment point
while T is the time between replenishments.
INVENTORY

Average
Q
inventory 
2
level

Figure showing0: Inventory over time TIME

T T T T

The costs incurred can be divided into two distinct groups: holding and replenishments. The
annual holding cost can be expressed as:
Ch = f x V x (Q/2)
Where f is the holding cost factor, V represents the value of one unit of paint and Q/2 is
the average inventory level.
If the annual paint usage is represented by U then the number of replenishments required per
year is given by U/Q. The annual replenishment cost can therefore be determined via:
 Cr= (U/Q) x R
Where R represents the cost of replacing an order of any size.

The total annual cost, Ct is the summation of holding and replenishment costs and is
represented by:

Ct = Ch + Cr = {f x V x (Q/2)} + {(U/Q) x R}

For the current inventory policy the total cost is:

Ct = [0.15x20x (500/2)] + [(6000/500) x250] =$3750

TC curve
EOQ Graph
Annual
costs
Holding costs

Ordering
costs

Q* Q
Where Q* is the EOQ

The figure above shows the graphs of holding, replenishment and total costs against a range
of values for order quantity. The figure reveals that the current inventory policy does not
result in a minimum cost situation. It also indicates that the optimum value of order quantity
that gives the minimum total cost is realised when the holding and replenishing cost curves
intersect i.e. when the rate of change of the holding cost curve equals that of the
replenishment cost curve.
The rate of change of the holding cost curve is determined by the deferential of the equation
Ch = f x V x (Q/2) giving:
dCh / dQ = (f x V)/2

The rate of change of replenish mentis determined by differentiation the equation

Cr= (U/Q) x R giving:
dCr / dQ = (U x R)/Q2
Equating the rates of holding and replenishment costs results in:
(f x V)/2 = (U x R)/Q2

the optimum order quantity that results in the minimum cost situation is known as the
Economic Order Quantity or EOQ,
for the example under consideration, EOQ is given by:
EOQ = √ [(2 x 6000 x 250)/(0.15 x 20)]= 1000
If the order quantity is 1000 then the number of orders that must be placed in a year is six
(i.e. annual usage is 6000 divided by the quantity being 1000).

The total cost corresponding to the optimum policy is:

Ct = [0.15 x 20 x (1000/2)] + [(6000/1000) x 250] = $3000
Total savings = $3750 - $3000 = $750

ECONOMIC ORDER QUANTITY (EOQ)

The cost of placing a single order, or the set-up costs to produce a single batch, controls the
minimum quantity that is economical to order at one time. Set-up costs are usually based on
set-up times, during which a machine and its operators are idle (i.e. unproductive). Arguably,
if the machine would have been idle anyway, then the EOQ should be based on a different
measure of set-up costs.
Assume: a constant continuous ordering demand rate, a fixed known ordering cost
(independent of the amount ordered) given stockholding cost (cost per item per year)
Using the following symbols, the EOQ, ordering, and carrying costs can be determined.
Q = number of units per order
Q* = optimum number of units per order
D = annual demand in units for the inventory item
Oc = ordering cost for each order
Cc = carrying cost per unit per order

Developing an expression for ordering cost.

Ordering cost =

= (3)
Developing an expression for ordering cost.
Carrying cost =

= (4)

Equating (3) and (4) the optimal order quantity is obtained.

(5)

From equation (5), Q* can be deduced i.e.

But inventory carrying cost for many businesses and industries are often expressed as an
annual percentage of the unit cost or price. Hence, let be the annual inventory carrying cost
charge as a percent price. The cost of storing one unit of inventory for the year CC is given by
, where P is the unit price of an inventory item. Therefore, EOQ is expressed as

Now, expected number of orders placed during the year (N) and the expected time between
orders (T) can be determined as follows:-

Expected number of orders,

Expected time between orders,

DEMAND BEHAVIOR

Production decisions in a manufacturing supply chain are no longer driven by manual

systems based on instinct and experience. They are regulated interactions between analysts,
production managers and their collective manipulation of policies within the production
information system.

Demand variation is a major source of uncertainty in manufacturing supply chains. A lack of

understanding in demand processing may lead to unjustifiably high inventory, excess
capacity, or overly nervous operational policies; all translate into significant capital and
costs.

Basic assumptions of Demand behavior:

□ Past repeats

□ Past trends will continue

□ Future trends can be predicted

□ Future trends are difficult to predict

Basic forecasting models

□ Moving averages
Short to
□ Exponential smoothing medium term

□ Simple regression
Medium to
Moving averages long term
Demand

100

50

10

Time
1 7 (period)
Where Ft is the forecast
Xn are individual demand levels

Exponential Smoothing

Ft = Xt -1 + (1-)Xt -2 + (1-)2Xt -3 +…………. (Eqn 1)

Ft -1= Xt -2 + (1-)Xt -3 + (1-)2Xt -4 +…………. (Eqn 2)

(Eqn 1) - (Eqn 2) = Ft - (1-) Ft –1 = Xt -1

Therefore

Ft = Xt –1 + (1-) Ft –1

Where Ft is the forecast

Ft –1 is previous forecast
 is the weighting. If  = 1the demand for tomorrow is today’s demand. MRP system
uses this forecast.

SIMPLE REGRESSION

Y=a+
Y
bX
Best fit

e(i) = Y(i) – [a + bX(i)]

X
The aim is to estimate the values of “a” and “b” that minimise the sum of squares of
deviation

Coefficient of Linear Correlation (r) = nXY – (X)(Y)

r =0 r =0

r = -1
r=1

APPROACHES TO INVENTORY CONTROL

Independent demand – A classification used in inventory control systems where the

demand for any one item has no relationship with the demand for any other item and
variations in demand occur because of random influences from the market place

Dependent demand – A classification used in inventory control where the demand for one
item has a direct mathematical relationship with the demand for another higher level or
parent component and where the demand for that item is ultimately dependent on the demand
for the higher level or parent item.

NB: Independent Demand is triggered by the behavior of stock itself and not by orders
placed for finished goods.

Currently in industry the following inventory management strategies are in use:

a) Fixed Order Quantity (two bin system)

An inventory control system where stock is reviewed continuously and, whenever the
inventory falls to a predetermined point, an order for a fixed quantity of stock is generated,
e.g. you issue photo-copier paper from two boxes, when the first box is empty, order
sufficient paper to refill the box. Meanwhile use paper from second box.
b) Fixed Re-order Interval System

Re-ordering takes place cyclically. Assess usage then re-order at fixed intervals of time to
bring back the stock to a predetermined maximum level. The advantage of cyclical ordering
is that suppliers know well in advance when orders are to be received, e.g. each week
sufficient paper is ordered to bring back the level stocked to say 5000 reams.

CHOOSING A LOT SIZE

It is obvious that when there are larger lots, the inventory on average is higher and more
inventory carrying charges are paid (carrying charges are the interest costs on capital tied up
in inventory, plus physical holding costs such as warehouse rent and warehouse workers
wages). Therefore in order to cut carrying costs, it is essential to order smaller quantities
more often. But more frequent ordering has its costs too, in factories every time there is a
need to reorder a component, there is a set up cost.

The resolution of this conflict however is a pragmatic compromise; an economically correct

lot size not so big as to incur an excessive set up cost. This compromise quantity is known as
the economic order quantity (EOQ) or economic lot size or run size. This principle was
derived around the 1915’s when Ford Harris and R.H Wilson independently derived it. It can
be derived graphically

TC curve
EOQ Graph
Annual
costs
Holding costs

Ordering
costs

Q* Q
Where Q* is the EOQ
The EOQ analysis assumes that:
a) The unit purchase price is constant. No volume discounts.

b) The usage is constant

c) Stock outs do not happen

d) Orders are fulfilled in one delivery

e) Lead time is constant

In practice demand and lead-time may vary and may result in stock outs. Use of safety or
insurance stock provides a cushion against stock-outs.

The following costs are associated with inventory:

a) Ordering and procurement costs- include acquisition, transporting, collecting, sorting

and placing items in storage. Also include managerial and clerical costs of placing an

order. Ordering costs are fixed and independent of items ordered while procurement

costs vary with the quantity of items.

b) Inventory holding costs- incurred during the storage of items e.g. operation of

warehouse, insurance, property tax etc. It includes pilferage, spoilage, and obsolescence.

Opportunity costs are an important part of holding costs being those funds invested in

inventory that might have been profitably invested elsewhere. Holding costs depend on

number of items and the duration of storage.

c) Inventory shortage costs- occur when there is demand for an item currently not in stock.

Comprises of extra paper work and managerial and clerical expenses incurred in

processing the order. It includes cost of good will lost.