Operations

Management
Chapter 12 –
Inventory Management

PowerPoint presentation to accompany

Heizer/Render
Principles of Operations Management, 7e
Operations Management, 9e
© 2008 Prentice Hall, Inc. 12 – 1
 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 – 2

 Functions of Inventory
1. To decouple or separate various
parts of the production process
2. To decouple the firm from
fluctuations in demand and
provide a stock of goods that will
provide a selection for customers
3. To take advantage of quantity
discounts
4. To hedge against inflation
© 2008 Prentice Hall, Inc. 12 – 3
 Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 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
© 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

 Inventory Management

 How inventory items can be

classified
 How accurate inventory records
can be maintained

© 2008 Prentice Hall, Inc. 12 – 6

 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 – 7
 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 – 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
#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 – 9

 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 – 10

 ABC Analysis
 Other criteria than annual dollar
volume may be used
 Anticipated engineering changes
 Delivery problems
 Quality problems
 High unit cost

© 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
 Items are counted and records updated
on a periodic basis
 Often used with ABC analysis
to determine cycle
 Has several advantages
 Eliminates shutdowns and interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and
corrected
 Maintains accurate inventory records
© 2008 Prentice Hall, Inc. 12 – 14
 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 – 15

 Independent Versus
Dependent Demand
 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

© 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 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 – 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

 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 – 21
 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 – 22
 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 – 23
 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

© 2008 Prentice Hall, Inc. 12 – 24

 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 – 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

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 – 26
 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 – 27

 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 Order quantity Q*
1,000
N= = 5 orders per year
200

© 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 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 – 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 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 – 30
 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 – 31

 An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2
1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

© 2008 Prentice Hall, Inc. 12 – 32

 An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2 Only 2% less
1,500 244.9 than the total
TC = ($10) + ($.50) cost of $125
244.9 2
when the
TC = $61.24 + $61.24 = $122.48 order quantity
was 200

© 2008 Prentice Hall, Inc. 12 – 33

 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 – 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
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 – 38

 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 inventory Holding cost

= (Average inventory level) x
holding cost per unit per year

Annual inventory
= (Maximum inventory level)/2
level

Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt

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

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p

© 2008 Prentice Hall, Inc. 12 – 40

 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

Setup cost = (D/Q)S

1
Holding cost = 2 HQ[1 - (d/p)]
1
(D/Q)S = 2 HQ[1 - (d/p)]
2DS
Q =
2
H[1 - (d/p)]

2DS
Q*p =
H[1 - (d/p)]
© 2008 Prentice Hall, Inc. 12 – 41
 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

© 2008 Prentice Hall, Inc. 12 – 42

 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

2DS
Q* =
annual demand rate
H 1–
annual production rate

© 2008 Prentice Hall, Inc. 12 – 43

 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 – 44

 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

© 2008 Prentice Hall, Inc. 12 – 45

 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 – 46
 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 1,000 2,000
Figure 12.7
Order quantity
© 2008 Prentice Hall, Inc. 12 – 47
 Probabilistic Models and
Safety Stock
 Used when demand is not constant or
certain
 Use safety stock to achieve a desired
service level and avoid stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short

x the probability x the stockout cost/unit
x the number of orders per year

© 2008 Prentice Hall, Inc. 12 – 48

 Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Number of Units Probability

30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0

© 2008 Prentice Hall, Inc. 12 – 49

 Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Safety Additional Total

Stock Holding Cost Stockout Cost Cost

20 (20)($5) = $100 $0 $100

10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
© 2008 Prentice Hall, Inc. 12 – 50
 Probabilistic Demand

Minimum demand during lead time

Inventory level

Maximum demand during lead time

Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5
ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)

Safety stock 16.5 units

0 Lead
time Time
Figure 12.8 Place Receive
order order
© 2008 Prentice Hall, Inc. 12 – 51