Operations

Management
Chapter 12 –
Inventory Management

© 2008 Prentice Hall, Inc. 12 – 1

 [Link]
 [Link] started as a “virtual”
retailer – no inventory, no
warehouses, no overhead; just
computers taking orders to be filled
by others
 Growth has forced [Link] to
become a world leader in
warehousing and inventory
management

© 2008 Prentice Hall, Inc. 12 – 2

 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

© 2008 Prentice Hall, Inc. 12 – 3

 Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 Undergone some change but not completed
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
productive
 Finished goods
 Completed product awaiting shipment

© 2008 Prentice Hall, Inc. 12 – 4

 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

Figure 12.1

© 2008 Prentice Hall, Inc. 12 – 5

 Effective Inventory Management

1. Prioritize your inventory

2. Track all product information
3. Audit your inventory
4. Analyze supplier performance
5. Be consistent in how you receive stock
6. Track sales
7. Order restocks yourself
8. Invest in inventory management technology
9. Use technology that integrates well

[Link]
[Link]

© 2008 Prentice Hall, Inc. 12 – 6

 Managing Inventory

 How inventory items can be

classified
 How accurate inventory records
can be maintained

© 2008 Prentice Hall, Inc. 12 – 7

 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
© 2008 Prentice Hall, Inc. 12 – 8
 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

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

#10867 30% 350 42.86 15,001 6.4% 23% B

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

© 2008 Prentice Hall, Inc. 12 – 9

 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

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

#01036 50% 100 8.50 850 .4% 5% C

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

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

© 2008 Prentice Hall, Inc. 12 – 10

 Percent of annual dollar usage ABC Analysis
A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items Figure 12.2

© 2008 Prentice Hall, Inc. 12 – 11

 ABC Analysis
 Policies employed may include
 More emphasis on supplier
development for A items
 Tighter physical inventory control for
A items
 More care in forecasting A items

© 2008 Prentice Hall, Inc. 12 – 12

 Record Accuracy
 Accurate records are a critical
ingredient in production and inventory
systems
 Allows organization to focus on what
is needed
 Necessary to make precise decisions
about ordering, scheduling, and
shipping
 Incoming and outgoing record
keeping must be accurate
 Stockrooms should be secure
© 2008 Prentice Hall, Inc. 12 – 13
 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)

Item Number of Items

Class Quantity Cycle Counting 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

© 2008 Prentice Hall, Inc. 12 – 14

 Inventory Models
Independent Versus
Dependent Demand
Independent demand is demand for a finished
product such as bicycle, computer, television,
pizza, car or phone. Dependent demand, on the
other hand, is demand for component parts or
subassemblies. For example microchips in the
computer, wheels on bicycle, the cheese on the
pizza, and switch for television or mouthpiece
for phone.

© 2008 Prentice Hall, Inc. 12 – 15

 Inventory Models
Independent Versus
Dependent Demand
Independent demands for inventories
(goods) are based on confirmed customer
orders, forecasts, estimates and past
historical data. As for dependent demand
goods, a business will have to look at what
the forecast customers will demand for their
finished products and order the goods to
fulfill that order.

© 2008 Prentice Hall, Inc. 12 – 16

 Holding, Ordering, and
Setup Costs
 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
© 2008 Prentice Hall, Inc. 12 – 17
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, 3% (3 - 5%)
security)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage (theft), space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
Table 12.1
© 2008 Prentice Hall, Inc. 12 – 18
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
bl y d ep en d ing
Housing costs (building rent c ornsidera
o 6% (3 -s10%)
n g c o st s v a r y
i n t er e st r at e .
Holdi
depreciation, operating
s s ,
costs,
l o c attaxes,
i o n , and
tech
insurance)
t he b u si n e so m e h i g h
on a t e r t ha n 1 5%, 5 0 %- .3.5%)
r al l y g r e t er t ha n
Gene
Material handling costs
l d
(equipment
i n g c o s t s grea
lease or 3% (1
depreciation, ave hooperating
items hpower, cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%

Table 12.1
© 2008 Prentice Hall, Inc. 12 – 19
 Inventory Models for
Independent Demand
Need to determine when and how
much to order

 Basic economic order quantity

 Production order quantity
 Quantity discount model

© 2008 Prentice Hall, Inc. 12 – 20

 Inventory Models for
Independent Demand
 Economic order quantity (EOQ) is the ideal order
quantity a company should purchase to minimize
inventory costs such as holding costs, shortage
costs, and order costs
 This production-scheduling model was
developed in 1913 by Ford W. Harris and has
been refined over time Quantity discount model
 The formula assumes that demand, ordering, and
holding costs all remain constant

© 2008 Prentice Hall, Inc. 12 – 21

 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 and holding
6. Stockouts can be completely avoided
© 2008 Prentice Hall, Inc. 12 – 22
 Inventory Usage Over Time

Usage rate Average

Order inventory
quantity = Q
Inventory level

on hand
(maximum
inventory Q
level) 2

Minimum
inventory

0
Time

Figure 12.3
© 2008 Prentice Hall, Inc. 12 – 23
 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
Table 11.5 quantity (Q*)
© 2008 Prentice Hall, Inc. 12 – 24
 The EOQ Model
Annual setup cost =
D
Q
S

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

D
= (S)
Q
Setup Cost = incurred to configure a machine for a production run

© 2008 Prentice Hall, Inc. 12 – 25

 The EOQ Model
Annual setup cost =
D
Q
S
Q
Annual holding cost = H
Q = Number of pieces per order 2
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

Q
= ( H)
2

© 2008 Prentice Hall, Inc. 12 – 26

 The EOQ Model
Annual setup cost =
D
Q
S
Q
Annual holding cost = H
Q = Number of pieces per order 2
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

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
© 2008 Prentice Hall, Inc. 12 – 27
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50

© 2008 Prentice Hall, Inc. 12 – 28

 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand D
number of = N = =
orders Optimal Order quantity Q*
1,000
N= = 5 orders per year
200

© 2008 Prentice Hall, Inc. 12 – 29

 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected days per year
time between = T =
orders N
250
T= = 50 days between orders
5

© 2008 Prentice Hall, Inc. 12 – 30

 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = ($10) + ($.50)
200 2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100
© 2008 Prentice Hall, Inc. 12 – 31
 Robust Model

 The EOQ model is robust

 It works even if all parameters
and assumptions are not met
 The total cost curve is relatively
flat in the area of the EOQ

© 2008 Prentice Hall, Inc. 12 – 32

 Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to
order
Demand Lead time for a
ROP = per day new order in days

=dxL
D
d = Number of working days in a year

© 2008 Prentice Hall, Inc. 12 – 33

 Reorder Points
The reorder point (ROP) is the minimum
inventory or stock level for a specific product
that triggers the reordering of more inventory
when reached
When calculating the reorder points for different
SKUs, the lead time it will take to replenish
inventory is factored in to ensure inventory
levels don’t reach zero
Setting accurate reorder points allows
businesses to avoid having products out of
stock while waiting for new inventory.
© 2008 Prentice Hall, Inc. 12 – 34
 Reorder Point Curve
Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Figure 12.5 Lead time = L
© 2008 Prentice Hall, Inc. 12 – 35
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days

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

© 2008 Prentice Hall, Inc. 12 – 36

 Production Order Quantity
Model
 Used when inventory builds up
over a period of time after an
order is placed
 Used when units are produced
and sold simultaneously

© 2008 Prentice Hall, Inc. 12 – 37

 Production Order Quantity
Model
Economic Production Quantity is the optimum
lot size that is to be manufactured in a
production unit to avoid unnecessary
blockage of funds and excess storage costs

This production quantity is adequate to

ensure uninterrupted work

© 2008 Prentice Hall, Inc. 12 – 38

 Production Order Quantity
Model
Part of inventory cycle during
which production (and usage)
is taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time

Figure 12.6

© 2008 Prentice Hall, Inc. 12 – 39

 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
D= Annual demand

2DS
Q*p =
H[1 - (d/p)]

© 2008 Prentice Hall, Inc. 12 – 40

 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

2DS
Q* =
H[1 - (d/p)]

2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283 hubcaps
283 is the Optimum Production Quantity when inventory is consumed as it is produced
© 2008 Prentice Hall, Inc. 12 – 41
 Quantity Discount Models
 Reduced prices are often available when
larger quantities are purchased
 Trade-off is between reduced product cost
and increased holding cost

Total cost = Setup cost + Holding cost + Product cost

D Q
TC = S+ H + PD
Q 2

© 2008 Prentice Hall, Inc. 12 – 42

 Quantity Discount Models
A typical 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

Table 12.2
S = $49, D = 5,000, I = 20%

© 2008 Prentice Hall, Inc. 12 – 43

 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 smallest possible order size
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
© 2008 Prentice Hall, Inc. 12 – 44
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
© 2008 Prentice Hall, Inc.
Data from Example 9: Page 49312 – 45
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
I is the holding cost = Percent of Cost x Unit Price
© 2008 Prentice Hall, Inc. 12 – 46
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
© 2008 Prentice Hall, Inc. 12 – 47
 Quantity Discount Example
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 $122.50 $950 $24,822.50

Table 12.3

Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit
© 2008 Prentice Hall, Inc. 12 – 48