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Inventory Management

PowerPoint presentation to accompany Heizer and Render Operations Management, 10e Principles of Operations Management, 8e
PowerPoint slides by Jeff Heyl

2011 Pearson Education, Inc. publishing as Prentice Hall

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Inventory Management
The objective of inventory management is to strike a balance between inventory investment and customer service

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Importance of 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

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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
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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
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Managing Inventory
1. How inventory items can be classified
2. How accurate inventory records can be maintained

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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
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ABC Analysis
Item Stock Number #10286 #11526 #12760 #10867 #10500 30% Percent of Number of Items Stocked 20% Annual Volume (units) 1,000 500 1,550 350 1,000 Unit Cost $ 90.00 154.00 17.00 42.86 12.50 Annual Dollar Volume $ 90,000 77,000 26,350 15,001 12,500 Percent of Annual Dollar Volume 38.8% 72% 33.2% 11.3% 6.4% 5.4% 23% A B B B

Class A

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ABC Analysis
Item Stock Number #12572 #14075 #01036 #01307 #10572 50% Percent of Number of Items Stocked Annual Volume (units) 600 2,000 100 1,200 250 8,550 Unit Cost $ 14.17 .60 8.50 .42 .60 Annual Dollar Volume $ 8,502 1,200 850 504 150 $232,057 Percent of Annual Dollar Volume 3.7% .5% .4% .2% .1% 100.0% 5%

Class C C C C C

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

C Items
| | | | | |

50

60

70

80

90 100
Figure 12.2

Percent of inventory items

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

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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

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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

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Cycle Counting
Items are counted and records updated on a periodic basis Often used with ABC analysis to determine cycle Has several advantages
1. Eliminates shutdowns and interruptions 2. Eliminates annual inventory adjustment 3. Trained personnel audit inventory accuracy 4. Allows causes of errors to be identified and corrected 5. Maintains accurate inventory records
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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 Class A B C Number of Items Counted per Day 500/20 = 25/day 1,750/60 = 29/day 2,750/120 = 23/day 77/day
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Quantity 500 1,750 2,750

Cycle Counting Policy Each month Each quarter Every 6 months

Control of Service Inventories

Can be a critical component of profitability Losses may come from shrinkage or pilferage

Applicable techniques include

1. Good personnel selection, training, and discipline

2. Tight control on incoming shipments

3. Effective control on all goods leaving facility
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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
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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
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Holding Costs
Category Housing costs (building rent or depreciation, operating costs, taxes, insurance) Material handling costs (equipment lease or depreciation, power, operating cost) Labor cost Investment costs (borrowing costs, taxes, and insurance on inventory) Pilferage, space, and obsolescence Overall carrying cost
Cost (and range) as a Percent of Inventory Value

6% (3 - 10%)

3% (1 - 3.5%) 3% (3 - 5%) 11% (6 - 24%) 3% (2 - 5%) 26%

Table 12.1

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Inventory Models for Independent Demand

Need to determine when and how much to order 1. Basic economic order quantity

2. Production order quantity

3. Quantity discount model

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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
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Inventory Usage Over Time

Order quantity = Q (maximum inventory level) Usage rate Average inventory on hand Q 2

Inventory level

Minimum inventory
0 Time
Figure 12.3

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Minimizing Costs
Objective is to minimize total costs
Total cost of holding and setup (order) Minimum total cost Annual cost Holding cost

Setup (or order) cost Optimal order quantity (Q*) Order quantity
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Table 12.4(c)
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D The EOQ Model Annual setup cost = S Q

Q Q* D S H

= Number of pieces per order = Optimal number of pieces per order (EOQ) = Annual demand in units for the inventory item = Setup or ordering cost for each order = 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
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D The EOQ Model Annual setup cost = S Q

Q Q* D S H

= Number of pieces per order = Optimal number of pieces per order (EOQ) = Annual demand in units for the inventory item = Setup or ordering cost for each order = Holding or carrying cost per unit per year

Annual holding cost =

Q H 2

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
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D The EOQ Model Annual setup cost = S Q

Q Q* D S H

= Number of pieces per order = Optimal number of pieces per order (EOQ) = Annual demand in units for the inventory item = Setup or ordering cost for each order = Holding or carrying cost per unit per year

Annual holding cost =

Q H 2

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

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

Q* = Q* =

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

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

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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 = N orders T= 250 = 50 days between orders 5

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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 S + H Q 2 1,000 200 TC = ($10) + ($.50) 200 2 TC = TC = (5)($10) + (100)($.50) = $50 + $50 = $100
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Reorder Points
EOQ answers the how much question The reorder point (ROP) tells when to order

ROP =

Lead time for a Demand per day new order in days

=dxL
D d = Number of working days in a year
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Reorder Point Curve

Inventory level (units)

Q*
Resupply takes place as order arrives

Slope = units/day = d

ROP (units)

Time (days)
Figure 12.5
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Lead time = L
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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

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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

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Production Order Quantity Model

Q = Number of pieces per order H = Holding cost per unit per year D = Annual demand p = Daily production rate d = Daily demand/usage rate

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

2 1

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

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

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Production Order Quantity Example

D = 1,000 units S = $10 H = $0.50 per unit per year Q* = p = 8 units per day d = 4 units per day

2DS H[1 - (d/p)] 2(1,000)(10) 0.50[1 - (4/8)]

= 80,000

Q* =

= 282.8 or 283 hubcaps

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Production Order Quantity Model

Note:
1,000 D d = 4 = Number of days the plant is in operation = 250

When annual data are used the equation becomes

Q* =

2DS annual demand rate H 1 annual production rate

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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 TC = D Q S+ H + PD Q 2

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Quantity Discount Models

A typical quantity discount schedule
Discount Number
1 2 3 Discount Quantity 0 to 999 1,000 to 1,999 2,000 and over Discount (%) no discount 4 5

Discount Price (P)

$5.00 $4.80 $4.75
Table 12.2

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Quantity Discount Models

Steps in analyzing a quantity discount
1. For each discount, calculate Q* 2. If Q* for a discount doesnt 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
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Quantity Discount Models

Total cost curve for discount 1 Total cost curve for discount 2

Total cost $

Total cost curve for discount 3

a
1st price break

Q* for discount 2 is below the allowable range at point a and must be adjusted upward to 1,000 units at point b 2nd price break

1,000

2,000 Order quantity

Figure 12.7
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Quantity Discount Example

Calculate Q* for every discount
Q* = 2DS IP

Q1* =
Q2* = Q3* =

2(5,000)(49) = 700 cars/order (.2)(5.00) 2(5,000)(49) = 714 cars/order (.2)(4.80) 2(5,000)(49) = 718 cars/order (.2)(4.75)
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2011 Pearson Education, Inc. publishing as Prentice Hall

Quantity Discount Example

Calculate Q* for every discount
Q* = 2DS IP

Q1* =
Q2* = Q3* =

2(5,000)(49) = 700 cars/order (.2)(5.00) 2(5,000)(49) = 714 cars/order (.2)(4.80) 1,000 adjusted 2(5,000)(49) = 718 cars/order (.2)(4.75) 2,000 adjusted
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Quantity Discount Example

Discount Number 1 2 3 Unit Price $5.00 $4.80 $4.75 Order Quantity 700 1,000 2,000 Annual Product Cost $25,000 $24,000 $23.750 Annual Ordering Cost $350 $245 $122.50 Annual Holding Cost $350 $480 $950 Total $25,700 $24,725 $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

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

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