Banking Operations Management (BOM)
Part II
Topic: Inventory Models
BOM By
D r. M a h a s w e t a D a s S a h a
Assistant Professor
National Institute of Bank
Management (NIBM), Pune
Table of Contents
• Inventory Fundamentals
• ABC Inventory Control
• Order Quantities
• EOQ
Inventory fundamentals
• In controlling inventory, four questions must be answered:
• What is the importance of the inventory item?
• How are they to be controlled?
• How much should be ordered at one time?
• When should an order be placed?
• The ABC inventory classification system answers the first two questions by determining the
importance of items and thus allowing different levels of control based on the relative importance
of items.
• Most companies carry a large number of items in stock.
• To have better control at a reasonable cost, it is helpful to classify the items according to their
importance.
• Usually this is based on annual INR/dollar usage, but other criteria may be used.
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Inventory fundamentals
• The ABC principle is based on the observation that a small number of items often dominate the
results achieved in any situation.
• This observation was first made by an Italian economist, Vilfredo Pareto, and is called Pareto’s law.
• As applied to inventories, it is usually found that the relationship between the percentage of items and
the percentage of annual INR/dollar usage follows a pattern in which three groups can be defined:
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ABC Analysis
• Steps in Making an ABC Analysis
• 1. Establish the item characteristics that influence the results of inventory management. This is usually
annual INR/dollar usage but may be other criteria.
• 2. Classify items into groups based on the established criteria.
• 3. Apply a degree of control in proportion to the importance of the group.
• The factors affecting the importance of an item include annual INR/dollar usage, unit cost, and scarcity
of material. For simplicity, only annual INR/dollar usage is used in this text.
• The procedure for classifying by annual dollar usage is as follows:
• 1. Determine the annual usage for each item/monetary product.
• 2. Multiply the annual usage of each item by its cost to get its total annual INR/dollar usage.
• 3. List the items according to their annual INR/dollar usage.
• 4. Calculate the cumulative INR/annual dollar usage and the cumulative percentage of items.
• 5. Examine the annual usage distribution and group the items into A, B, and C groups based
on percentage of annual usage.
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ABC Analysis-Problem
• A company has a line of ten items/monetary
products.
• The usage and unit cost are shown in the following
table, along with the annual dollar usage.
• The latter is obtained by multiplying the unit usage
by the unit cost.
• a. Calculate the annual dollar usage for each
item.
• b. List the items according to their annual
dollar usage.
• c. Calculate the cumulative annual dollar usage
and the cumulative percentage of items.
• d. Group items into an A, B, C classification.
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ABC Analysis-Problem
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Inventory fundamentals
• Control Based on ABC Classification
• Using the ABC approach, there are two general rules to follow:
• Have plenty of low-value items. C items represent about 50% of the items but account for only about
5% percent of the total inventory value. Carrying extra stock of C items adds little to the total value of
the inventory.
• C items are really only important if there is a shortage of one of them—when they become extremely
important—so a supply should always be on hand. For example, order a year’s supply at a time and carry
plenty of safety stock. That way there is only once a year when a stockout is even possible.
• Use the money and control effort saved to reduce the inventory of high-value items. A items
represent about 20% of the items and account for about 80% of the value. They are extremely important
and deserve the tightest control and the most frequent review.
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ABC Analysis-Solution
• Different controls used with different carry safety stock.
classifications might be the following:
• A items: high priority. Tight control including
complete accurate records, regular and frequent
review by management, frequent review of demand
forecasts, and close follow-up and expediting to
reduce lead time.
• B items: medium priority. Normal controls with
good records, regular attention, and normal
processing.
• C items: lowest priority. Simplest possible
controls—make sure there are plenty. Simple or
no records; perhaps use a two-bin system or
periodic review system. Order large quantities and
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Order Quantities
• The objectives of inventory management are to provide the required level of customer service and
to reduce the sum of all costs involved.
• To achieve these objectives, two basic questions must be answered:
• How much should be ordered at one time?
• When should an order be placed?
• Management must establish decision rules to answer these questions so inventory management personnel
know when to order and how much.
• The assumptions on which the EOQ is based are as follows:
• Demand is relatively constant and is known.
• The item is produced or purchased in lots or batches and not continuously.
• Order preparation costs and inventory-carrying costs are constant and known.
• Replacement occurs all at once.
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EOQ
• Under the assumptions given, the quantity of an item in inventory decreases at a uniform rate.
• Suppose for a particular item that the order quantity is 200 units and the usage rate is 100 units a week.
Figure 10.1 shows how inventory would behave.
• The vertical lines represent stock arriving all at once as the stock on hand reaches zero.
• The quantity of units in inventory then increases instantaneously by Q, the quantity ordered.
• This is an accurate representation of the arrival of purchased parts or manufactured parts where all parts
are received at once. From the preceding,
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EOQ-Relevant Costs
• Relevant costs.
• Annual cost of placing orders.
• Annual cost of carrying inventory.
• As the order quantity increases, the average
inventory and the annual cost of carrying inventory
increase, but the number of orders per year and the
ordering cost decrease.
• It is a bit like a seesaw where one cost can be
reduced only at the expense of increasing the
other.
• The trick is to find the particular order quantity
in which the total cost of carrying inventory
and the cost of ordering will be a minimum.
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Problem
• The annual demand is 10,000 units, the ordering cost is $30 per order, the carrying cost is 20%, and the
unit cost is $15. The order quantity is 600 units.
• Calculate: a. Annual ordering cost b. Annual carrying cost c. Total annual cost
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EOQ
• There is an order quantity in which the sum of the ordering costs and carrying costs is a minimum.
• This EOQ occurs when the cost of ordering equals the cost of carrying.
• The total cost varies little for a wide range of lot sizes about EOQ.
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EOQ
• The EOQ occurred at an order quantity in which the ordering costs equal the carrying costs. If these two
costs are equal, the following formula can be derived:
The EOQ formula has four variables. The EOQ will increase as the annual demand (A) and the cost of ordering
(S) increase, and it will decrease as the cost of carrying inventory (i) and the unit cost (c) increase.
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EOQ-Monetary unit lot-size model
• the EOQ occurred at an order quantity in which the ordering costs equal the carrying costs. If these two
costs are equal, the following formula can be derived:
• There are several modifications that can be made to the basic EOQ model to fit particular circumstances.
One of them which is often used is the monetary unit lot-size model.
• Monetary Unit Lot Size: The EOQ can be calculated in monetary units rather than physical units.
• The same EOQ formula given in the preceding section can be used, but the annual usage changes
from units to dollars.
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Problem
• An item has an annual demand of $5000, preparation costs of $20 per order, and a carrying cost of 20%.
What is the EOQ in dollars?
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Exercise
• Apply the ‘Inventory model’ concepts to the banking processes and prepare a presentation.
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Order Quantities
• The objectives of inventory management are to provide the required level of customer service and to
reduce the sum of all costs involved. To achieve these objectives, two basic questions must be answered:
• How much should be ordered at one time?
• When should an order be placed?
• Management must establish decision rules to answer these questions so inventory management personnel
know when to order and how much.
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PLANNING
INDEPENDENT DEMAND SYSTEM
DEPENDENT DEMAND SYSTEM
Dependent and independent demand
• Independent demand
• Dependent demand
• When to place a replacement order?
• If stock is not reordered soon enough, there will be a stock out and potential loss in customer service.
• However stock ordered earlier than needed will create extra inventory. The problem then is how to
balance the costs of carrying extra inventory against the costs of a stock out.
• No matter what the items are, some rules for reordering are needed and can be as simple as order
when needed, order every month, or order when stock falls to a predetermined level.
Dependent and independent demand
• In industry there are many inventories that involve a large investment and where stock out costs
are high. Controlling these inventories requires effective reorder systems.
These basic systems are used to determine when to order :
• Order point system
• Periodic review system
• Material requirement planning (MRP)
• The first two are for independent demand items, the last for dependent demand items.
Independent demand system
Order point system
• When the quantity of an item on hand in inventory falls to a predetermined level, called an order
point, an order is placed.
• Using this system, an order must be placed when there is enough stock on hand to satisfy demand
from the time the order is placed until the new stock arrives (called the lead time).
• Suppose that for a particular item the average demand is 100 units a week and the lead time is 4
weeks. If an order is placed when there are 400 units on hand, demand during any one lead time
period probably varies from the average-sometimes more and sometimes less than 400.
• Statistically half the time the demand is greater than average, and there is a stock out; half the time
the demand is less than average, and there is extra stock.
Independent demand system
Order point system
• If it is necessary to provide some protection against a stock out, safety stock can be added. The item is
ordered when the quantity on hand falls to a level equal to the demand during the lead time plus the
safety stock.
• OP = DDLT + SS
• OP = order point
• DDLT = demand during the lead time
• SS = Safety stock
Independent demand system
Order point system
• Average Inventory = Order quantity + Safety stock
2
Figure : Quantity on hand versus time : Independent
Demand items
• Order quantities are usually fixed.
• The order point is determined by the average demand during the lead time. If the average demand or the
lead time changes and there is no corresponding change in the order point, effectively there has been a
change in safety stock.
• The intervals between replenishment are not constant but vary depending on the actual demand during
the reorder cycle.
Independent demand system
Order point system
• Safety stock is intended to protect against uncertainty in supply and demand. Uncertainty
may occur in two ways : quantity uncertainty and timing uncertainty.
• Quantity uncertainty occurs when the amount of supply or demand varies; Timing
uncertainty occurs when the time of receipt of supply or demand differs from that
expected.
• There are two ways to protect against uncertainty : carry extra stock called safety stock,
or order early, called safety lead time.
Independent demand system
Determining when the Order point is reached
• There must be some method to show when the quantity of an item on hand has reached the order
point.
• Two basic systems : The two-bin system, and the perpetual inventory system
Two Bin system
• A quantity of an item equal to the order point quantity is set aside (frequently in a separate or second
bin) and not touched until all the main stock is used up. When this stock needs to be used, the
production control or purchasing department is notified and a replenishment order is placed.
Independent demand system
Determining when the Order point is reached
Perpetual Inventory record system
• A Perpetual Inventory record is a continual account of inventory transactions as they occur. At
any instant, it holds an up-to-date record of transactions. At a minimum, it contains the balance on
hand, but it may also contain the quantity on order but not received, the quantity allocated but not
issued, and the available balance.
• The accuracy of the record depends upon the speed with which transactions are recorded and the
accuracy of the input. Because manual systems rely on input of humans, they are more likely to have
slow response and inaccuracies.
Independent demand system
Periodic review system
• In the order point system, an order is placed when the quantity on hand falls to a predetermined
level called the order point.
• Using the periodic review system, the quantity on hand of a particular item is determined at
specified, fixed-time intervals, and an order is placed.
• Review period is fixed, and the order quantity is allowed to vary. The quantity on hand plus the
quantity ordered must be sufficient to last until the next shipment is received.
Independent demand system
Periodic review system
• The quantity on hand plus the quantity ordered must equal the sum of the demand during
the lead time plus the demand during the review period plus the safety stock.
• The quantity equal to the demand during the lead time plus the demand during the review
period plus safety stock is called the target level or maximum-level inventory.
• T = D (R+L) + SS
• T= target (maximum) inventory level
• D = demand per unit of time
• L = lead-time duration
• R = review period duration
• SS = safety stock
Independent demand system
Periodic review system
• The order quantity is equal to the maximum inventory level minus the quantity of
hand at the review period.
• Q=T–I
• Q = Order quantity
• I = Inventory on hand
The periodic review system is useful for the following :
• Where there are many small issues from inventory, and posting transactions to inventory
records are very expensive. Supermarkets and retailers are in this category.
• When ordering costs are small. This occurs when many different items are ordered from
one source. A regional distribution center may order most or all of its stock from a
central warehouse.
Dependent demand system
Material requirements planning
• Material requirements planning (MRP) is the system used to avoid missing parts.
• It establishes a schedule (priority plan) showing the components required at each level of the assembly
and, based on lead times, calculates the time when these components will be needed.
• Since dependent demand is directly related to the demand for higher level assemblies or products, it can be
calculated. MRP is designed to this calculation.
Objectives of MRP
Determine requirements
• The MRP’s objectives is to determine what components are needed to meet the master production schedule
(MPS) and , based on lead time, to calculate the periods when the components must be available. It must
determine the following :
• What to order
• How much to order
• When to order
• When to schedule delivery
• Keep priorities current
Dependent demand system
Material requirements planning
Objectives of MRP
Keep priorities current
• The demand for, and supply of, components changes daily. Customers enter or change orders.
• Components get used up, suppliers are late with delivery, scrap occurs, orders are completed, and
machines break down.
• In this ever-changing world, a MRP must be able to reorganize priorities to keep plans current.
• It must be able to add and delete, expedite, delay, and change orders.
Dependent demand system
Material requirements planning
Inputs to MRP system
• MPS : MPS is a statement of which end items are to be produced. The quantity of each, and the
dates they are to be completed. It drives the MRP system by providing the initial input for the items
needed.
• Inventory Records : Planning factors includes information such as order quantities, lead times,
safety stock, and scrap. It is needed to plan what quantities to order and when to order for timely
deliveries.
• Status of each item- how much is available, how much is allocated, and how much is available
for future demand. This information is dynamic and changes with every transaction. This data
is maintained in inventory record file.
• Bills of material (BOM) : Recipe or a formula for making any product lists each part, assemblies,
sub assemblies, Raw materials and showing the quantities of each required to make an assembly.
• Each part or item has only one part number. A specific number is unique to one part and not
assigned to any other part.
• A part is defined by its fit, or function. If any of these change, then it is not the same part and
must have a different part number.
Dependent demand system
Material requirements planning
Managing the MRP :
The planner receives feedback from many sources such as :
• Suppliers’ action from purchasing
• Changes to open orders in the factory such as early or late completions or differing quantities.
• Management action such as changing the MPS.
The planner must evaluate this feedback and take corrective action if necessary.
The planner must consider three important factors in managing the MRP.
• Priority : It refers to maintaining the correct due dates by constantly evaluating the true due date
needed for released orders and if necessary , expediting or de-expediting.
Dependent demand system
Material requirements planning
The planner must consider three important factors in managing the MRP.
• Bottom-up planning : Action to correct for changed conditions should occur as low in
the product structure as possible.
• Reducing system nervousness : Sometimes requirements change rapidly and by small
amounts, causing the MRP to change back and forth. The planner must judge whether
the changes are important enough to react to and whether an order should be released.
Thank You.
BOM Mahasweta Das Saha
91-9366294595
mahasweta_saha@[Link]
[Link]
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