Inventory Control Models

LEARNING OBJECTIVES
After completing this topic, you will be able to: 1. Understand the importance of inventory control and ABC analysis 2. Use the economic order quantity (EOQ) to determine how much to order 3. Compute the reorder point (ROP) in determining when to order more inventory 4. Handle inventory problems that allow quantity discounts or noninstantaneous receipt

LEARNING OBJECTIVES
After completing this topic, you will be able to:

5. Understand the use of safety stock with known and unknown stockout costs 6. Describe the use of material requirements planning in solving dependent-demand inventory problems 7. Discuss just-in-time inventory concepts to reduce inventory levels and costs

INTRODUCTION

Inventory is an expensive and important asset to many companies Lower inventory levels can reduce costs Low inventory levels may result in stockouts and dissatisfied customers Most companies try to balance high and low inventory levels with cost minimization as a goal Inventory is any stored resource used to satisfy a current or future need Common examples are raw materials, work-inprocess, and finished goods

INTRODUCTION

Inventory may account for 50% of the total invested capital of an organization and 70% of the cost of goods sold
Energy Costs Capital Costs

Labor Costs

Inventory Costs

INTRODUCTION

All organizations have some type of inventory control system Inventory planning helps determine what goods and/or services need to be produced Inventory planning helps determine whether the organization produces the goods or services or whether they are purchased from another organization Inventory planning also involves demand forecasting

INTRODUCTION

Inventory planning and control

Planning on What Inventory to Stock and How to Acquire It Forecasting Parts/Product Demand Controlling Inventory Levels

Feedback Measurements to Revise Plans and Forecasts

Figure 6.1

IMPORTANCE OF INVENTORY CONTROL

Five uses of inventory

The decoupling function Storing resources Irregular supply and demand Quantity discounts Avoiding stockouts and shortages Used as a buffer between stages in a manufacturing process Reduces delays and improves efficiency

The decoupling function

IMPORTANCE OF INVENTORY CONTROL

Storing resources

Seasonal products may be stored to satisfy offseason demand Materials can be stored as raw materials, workin-process, or finished goods Labor can be stored as a component of partially completed subassemblies Demand and supply may not be constant over time Inventory can be used to buffer the variability

Irregular supply and demand

IMPORTANCE OF INVENTORY CONTROL

Quantity discounts

Lower prices may be available for larger orders Extra costs associated with holding more inventory must be balanced against lower purchase price Stockouts may result in lost sales Dissatisfied customers may choose to buy from another supplier

Avoiding stockouts and shortages

INVENTORY DECISIONS

There are only two fundamental decisions in controlling inventory

How much to order When to order

The major objective is to minimize total inventory costs Common inventory costs are

Cost of the items (purchase or material cost) Cost of ordering Cost of carrying, or holding, inventory Cost of stockouts

INVENTORY COST FACTORS

ORDERING COST FACTORS
Developing and sending purchase orders Processing and inspecting incoming inventory Bill paying Inventory inquiries Utilities, phone bills, and so on, for the purchasing department Salaries and wages for the purchasing department employees Supplies such as forms and paper for the purchasing department

CARRYING COST FACTORS

Cost of capital Taxes Insurance Spoilage Theft Obsolescence Salaries and wages for warehouse employees Utilities and building costs for the warehouse Supplies such as forms and paper for the warehouse

Table 6.1

INVENTORY COST FACTORS

Ordering costs are generally independent of order quantity

Many involve personnel time The amount of work is the same no matter the size of the order

Carrying costs generally varies with the amount of inventory, or the order size

The labor, space, and other costs increase as the order size increases

Of course, the actual cost of items purchased varies with the quantity purchased

ECONOMIC ORDER QUANTITY

The economic order quantity (EOQ) model is one of the oldest and most commonly known inventory control techniques It dates from 1915 It is easy to use but has a number of important assumptions

ECONOMIC ORDER QUANTITY

Assumptions
1. 2. 3. 4. Demand is known and constant Lead time is known and constant Receipt of inventory is instantaneous Purchase cost per unit is constant throughout the year 5. The only variable costs are the placing an order, ordering cost, and holding or storing inventory over time, holding or carrying cost, and these are constant throughout the year 6. Orders are placed so that stockouts or shortages are avoided completely

INVENTORY USAGE OVER TIME

Inventory Level Order Quantity = Q = Maximum Inventory Level

Minimum Inventory 0 Time

Figure 6.2

INVENTORY COSTS IN THE EOQ SITUATION

Objective is generally to minimize total cost Relevant costs are ordering costs and carrying costs
Average inventory level Q 2
AVERAGE 9

INVENTORY LEVEL DAY April 1 (order received) BEGINNING 10 ENDING 8

April 2
April 3 April 4 April 5
Maximum level April 1 = 10 units Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25 Number of days = 5 Average inventory level = 25/5 = 5 units

8
6 4 2

6
4 2 0

7
5 3 1

Table 6.2

INVENTORY COSTS IN THE EOQ SITUATION

Mathematical equations can be developed using
Q EOQ D Co Ch = number of pieces to order = Q* = optimal number of pieces to order = annual demand in units for the inventory item = ordering cost of each order = holding or carrying cost per unit per year

Annual ordering cost

Number of Ordering orders placed cost per per year order

D Co Q

INVENTORY COSTS IN THE EOQ SITUATION

Mathematical equations can be developed using
Q EOQ D Co Ch = number of pieces to order = Q* = optimal number of pieces to order = annual demand in units for the inventory item = ordering cost of each order = holding or carrying cost per unit per year

Average Annual holding cost inventory

Q Ch 2

Carrying cost per unit per year

INVENTORY COSTS IN THE EOQ SITUATION

Cost

Curve of Total Cost of Carrying and Ordering

Minimum Total Cost Carrying Cost Curve Ordering Cost Curve

Figure 6.3

Optimal Order Quantity

Order Quantity

FINDING THE EOQ

When the EOQ assumptions are met, total cost is minimized when Annual ordering cost = Annual holding cost D Q Co Ch Q 2
2 DCo Q 2C h

Solving for Q

2 DCo Q2 Ch

2 DCo Q EOQ Q* Ch

ECONOMIC ORDER QUANTITY (EOQ) MODEL

Summary of equations

D Annual ordering cost C o Q

Q Annual holding cost C h 2

EOQ Q*

2 DCo Ch

SUMCO PUMP COMPANY EXAMPLE

Company sells pump housings to other companies Would like to reduce inventory costs by finding optimal order quantity

Annual demand = 1,000 units Ordering cost = $10 per order Average carrying cost per unit per year = $0.50

2 DCo 2(1,000)(10) Q 40,000 200 units Ch 0.50

*

SUMCO PUMP COMPANY EXAMPLE

Total annual cost = Order cost + Holding cost

D Q TC C o C h Q 2
1,000 200 (10 ) ( 0 .5 ) 200 2

$50 $50 $100

SUMCO PUMP COMPANY EXAMPLE

Program 6.1A

SUMCO PUMP COMPANY EXAMPLE

Program 6.1B

PURCHASE COST OF INVENTORY ITEMS

Total inventory cost can be written to include the cost of purchased items Given the EOQ assumptions, the annual purchase cost is constant at D C no matter the order policy C is the purchase cost per unit D is the annual demand in units It may be useful to know the average dollar level of inventory
(CQ ) Average dollar level 2

PURCHASE COST OF INVENTORY ITEMS

Inventory carrying cost is often expressed as an annual percentage of the unit cost or price of the inventory This requires a new variable

Annual inventory holding charge as a percentage of unit price or cost

The cost of storing inventory for one year is then

C h IC
thus,

2 DCo Q IC
*

SENSITIVITY ANALYSIS WITH THE EOQ MODEL

The EOQ model assumes all values are know and fixed over time Generally, however, the values are estimated or may change Determining the effects of these changes is called sensitivity analysis Because of the square root in the formula, changes in the inputs result in relatively small changes in the order quantity 2 DCo EOQ Ch

SENSITIVITY ANALYSIS WITH THE EOQ MODEL

In the Sumco example

2(1,000 )(10) EOQ 200 units 0.50

If the ordering cost were increased four times from

$10 to $40, the order quantity would only double

2(1,000 )( 40) EOQ 400 units 0.50

In general, the EOQ changes by the square root

of a change to any of the inputs

REORDER POINT: DETERMINING WHEN TO ORDER

Once the order quantity is determined, the next decision is when to order The time between placing an order and its receipt is called the lead time (L) or delivery time When to order is generally expressed as a reorder point (ROP)
ROP Demand per day Lead time for a new order in days

dL

PROCOMPS COMPUTER CHIP EXAMPLE

Demand for the computer chip is 8,000 per year Daily demand is 40 units Delivery takes three working days ROP d L 40 units per day 3 days 120 units

An order is placed when the inventory reaches

120 units The order arrives 3 days later just as the inventory is depleted

EOQ WITHOUT THE INSTANTANEOUS RECEIPT ASSUMPTION

When inventory accumulates over time, the instantaneous receipt assumption does not apply Daily demand rate must be taken into account The revised model is often called the production run model
Inventory Level Maximum Inventory Part of Inventory Cycle During Which Production is Taking Place There is No Production During This Part of the Inventory Cycle

t
Figure 6.5

Time

QUANTITY DISCOUNT MODELS

Quantity discounts are commonly available The basic EOQ model is adjusted by adding in the purchase or materials cost

Total cost Material cost + Ordering cost + Holding cost

D Q Total cost DC C o C h Q 2
where D annual demand in units Cs ordering cost of each order C cost per unit Ch holding or carrying cost per unit per year

QUANTITY DISCOUNT MODELS

QuantityBecause unit cost is now variable discounts are commonly available Holding cost Ch by adding in the The basic EOQ model is adjusted IC I holding materials percentage of the unit cost (C) purchase or cost as a cost

Total cost Material cost + Ordering cost + Holding cost

D Q Total cost DC C o C h Q 2
where D annual demand in units Cs ordering cost of each order C cost per unit Ch holding or carrying cost per unit per year

QUANTITY DISCOUNT MODELS

A typical quantity discount schedule

DISCOUNT QUANTITY 0 to 999 1,000 to 1,999 2,000 and over DISCOUNT (%) 0 4 5 DISCOUNT COST ($) 5.00 4.80 4.75

DISCOUNT NUMBER 1 2 3
Table 6.3

Buying at the lowest unit cost is not always the

best choice

QUANTITY DISCOUNT MODELS

Total cost curve for the quantity discount model

Total Cost $ TC Curve for Discount 3 TC Curve for Discount 1

TC Curve for Discount 2

EOQ for Discount 2

0 Figure 6.6

1,000

2,000

Order Quantity

BRASS DEPARTMENT STORE EXAMPLE

Brass Department Store stocks toy race cars Their supplier has given them the quantity discount schedule shown in Table 6.3

Annual demand is 5,000 cars, ordering cost is $49, and holding cost is 20% of the cost of the car

The first step is to compute EOQ values for each discount (2)(5,000 )( 49 ) EOQ 1 700 cars per order (0.2)(5.00 )
EOQ 2 (2)(5,000 )( 49 ) 714 cars per order (0.2)( 4.80 )

(2)(5,000 )( 49 ) EOQ 3 718 cars per order (0.2)( 4.75 )

BRASS DEPARTMENT STORE EXAMPLE

The second step is adjust quantities below the allowable discount range The EOQ for discount 1 is allowable The EOQs for discounts 2 and 3 are outside the allowable range and have to be adjusted to the smallest quantity possible to purchase and receive the discount Q1 700 Q2 1,000 Q3 2,000

BRASS DEPARTMENT STORE EXAMPLE

The third step is to compute the total cost for each quantity
UNIT PRICE (C) ORDER QUANTITY (Q) ANNUAL MATERIAL COST ($) = DC ANNUAL ORDERING COST ($) = (D/Q)Co ANNUAL CARRYING COST ($) = (Q/2)Ch

DISCOUNT NUMBER

TOTAL ($)

1 2 3 Table 6.4

$5.00 4.80 4.75

700 1,000 2,000

25,000 24,000 23,750

350.00 245.00 122.50

350.00 480.00 950.00

25,700.00 24,725.00 24,822.50

The fourth step is to choose the alternative

with the lowest total cost

BRASS DEPARTMENT STORE EXAMPLE

Program 6.3A

BRASS DEPARTMENT STORE EXAMPLE

Program 6.3B

USE OF SAFETY STOCK

If demand or the lead time are uncertain, the exact ROP will not be known with certainty To prevent stockouts, it is necessary to carry extra inventory called safety stock Safety stock can prevent stockouts when demand is unusually high Safety stock can be implemented by adjusting the ROP

USE OF SAFETY STOCK

The basic ROP equation is ROP d L

d daily demand (or average daily demand) L order lead time or the number of working days it takes to deliver an order (or average lead time)

A safety stock variable is added to the equation

to accommodate uncertain demand during lead time ROP d L + SS

where

SS safety stock

USE OF SAFETY STOCK

Inventory on Hand

Time Figure 6.7(a) Stockout

USE OF SAFETY STOCK

Inventory on Hand

Safety Stock, SS Stockout is Avoided Time Figure 6.7(b)

ROP WITH KNOWN STOCKOUT COSTS

With a fixed EOQ and a ROP for placing orders, stockouts can only occur during lead time Objective is to find the safety stock quantity that will minimize the total of stockout cost and holding cost Need to know the stockout cost per unit and the probability distribution of demand during lead time Estimating stockout costs can be difficult as there are direct and indirect costs

ABC ANALYSIS

The purpose of ABC analysis is to divide the inventory into three groups based on the overall inventory value of the items Group A items account for the major portion of inventory costs

Typically about 70% of the dollar value but only 10% of the quantity of items Forecasting and inventory management must be done carefully
May represent 20% of the cost and 20% of the quantity It is not cost effective to spend a lot of time managing these items

Group B items are more moderately priced

Group C items are very low cost but high volume

ABC ANALYSIS

Summary of ABC analysis

DOLLAR USAGE (%) INVENTORY ITEMS (%) ARE QUANTITATIVE CONTROL TECHNIQUES USED?

INVENTORY GROUP

A B C
Table 6.10

70 20 10

10 20 70

Yes In some cases No

JUST-IN-TIME INVENTORY CONTROL

To achieve greater efficiency in the production process, organizations have tried to have less in-process inventory on hand This is known as JIT inventory The inventory arrives just in time to be used during the manufacturing process One technique of implementing JIT is a manual procedure called kanban

JUST-IN-TIME INVENTORY CONTROL

Kanban in Japanese means card With a dual-card kanban system, there is a conveyance kanban, or C-kanban, and a production kanban, or P-kanban Kanban systems are quite simple, but they require considerable discipline As there is little inventory to cover variability, the schedule must be followed exactly

4 STEPS OF KANBAN
1. A user takes a container of parts or inventory along with its C-kanban to his or her work area When there are no more parts or the container is empty, the user returns the container along with the C-kanban to the producer area At the producer area, there is a full container of parts along with a P-kanban The user detaches the P-kanban from the full container and takes the container and the C-kanban back to his or her area for immediate use

2.

4 STEPS OF KANBAN
3. The detached P-kanban goes back to the producer area along with the empty container The P-kanban is a signal that new parts are to be manufactured or that new parts are to be placed in the container and is attached to the container when it is filled This process repeats itself during the typical workday

4.

THE KANBAN SYSTEM

P-kanban and Container 4 C-kanban and Container 1 Storage Area 3 2 User Area

Producer Area

VED ANALYSIS

V- Vital E-Essential D-Desirable