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many companies. It represents as much as 40% of total invested capital. Inventory is any stored resource that is used to satisfy a current or future need. Raw materials, work-in-process, and finished goods are examples of inventory. Two basic questions in inventory management are (1) how much to order (or produce), and (2) when to order (or produce).
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ABC Analysis
ABC analysis divides on-hand inventory into
three classifications on the basis of dollar (TL) volume. It is also known as Pareto analysis. (which is named after principles dictated by Pareto). The idea is to focus resources on the critical few and not on the trivial many. (Annual Dollar Volume of an Item) = (Its Annual Demand) x (Its Cost per unit)
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ABC Analysis
Class A items are those on which the annual dollar
volume is high.
They represent 70-80% of total inventory costs, but they account for only 15% of total inventory items.
volume is medium.
They represent 15-25% of total dollar value, and they account for 30% of total inventory items on the average.
Class C items are low dollar volume items. They represent only the 5% of total dollar volume, but they include as many as 50-60% of total inventory items.
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ABC Analysis
Percent of Annual Dollar Volume
80
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ABC Analysis
Some of the Inventory Management Policies that may be based on ABC analysis include:
a) Class A items should have tighter inventory control. b) Class A items may be stored in a more secure area. c) Forecasting Class A items may warrant more care.
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continuing audit. Such audits are known as (periodical) cycle counting.. (e.g., counting items at supermarket). Cycle counting uses inventory classifications developed by ABC analysis.
That is: Class A items are counted frequently, perhaps once a month. Class B items are counted less frequently, perhaps once a quarter. Class C items are counted perhaps once every six months.
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Just-in-Time Inventory
Just in Time Inventory is the minimum inventory that
is necessary to keep a system perfectly running. With just in time (JIT) inventory, The exact amount of items arrive at the moment they are needed, Not a minute before OR not a minute after. To achieve JIT inventory, Managers should Reduce the Variability Caused by some Internal and External Factors.
(Goldratts boys scout example Apply the pace of the slowest boy).
(inventory).
(1) For example, employees or machines produce units that do not conform to standards. These are waste. And they cause variability. (2) Or, engineering drawings are inaccurate, Again resulting in loss of production And consecutively resulting in Variability.
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cause Variability. However, Some of the variability is caused by some external factors. For example, customer demands may change due to some external factors (such as competitors actions or promotions) In summary, To achieve JIT inventory, Managers must begin with Reducing Inventory. Reducing Inventory uncovers the Rocks located along the way on a river, And the water stream becomes more clear.
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Input
Move Time
Set-up Time
Run Time
Cycle Time
The section called Others are the Rocks on the river. Those rocks include Quality Variability, In-transit Delays, Machine Breakdowns, Large Lot-sizes, Inaccurate drawings, Employee attendance variability.
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Just-In-Time Production
JIT production means (1) Elimination of Waste, (2) Synchronized Manufacturing, and (3) Little Inventory. Reducing the order batch size can be a major help in
reducing inventory. Average Inventory = (Maximum Inventory + Minimum Inventory) / 2 Average Inventory drops as the inventory re-order quantity drops because the maximum inventory level drops.
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Kanban System
Moreover, the smaller the lot size, the fewer the
problems are hidden. One way to achieve small lot sizes is to Move Inventory through the shop Only as needed. This is called a pull system. In this system, Ideal Lot size is 1. Japanese call this system as Kanban system. Kanban is a Japanese word for Card. A card is used to signal the need for material in a work center.
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Kanban System
Sending a card authorizes the previous work
center to send its finished batch to the subsequent work center. Batches are typically very small. Such a system requires tight schedules and frequent set-ups for machines. On the other hand, Small batches allow a very limited amount of faulty material, less damages, less space occupation, less material handling, less accidents, etc.
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or carrying inventory over time. It includes costs related to storage; such as insurance, extra staffing, interest, and so on. Some example holding costs are:
building rent or depreciation, building operating cost, taxes on building, insurance on building, material handling equipment leasing or depreciation, equipment operating cost, handling manpower cost, taxes on inventory, insurance, etc.
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The ordering cost is valid if the products are purchased NOT produced internally.
manufacturing an order.
Set-up cost is highly correlated with set-up time. Machines that traditionally have taken long hours to set up Are Now being set up in less than a minute by employing FMSs or CIM systems. Reducing set up times is an excellent way to Reduce Inventory.
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Inventory Models
Demand for an item is either dependent on the
demand for other items or it is independent. For example, demand for refrigerator is independent of the demand for cars. But, demand for auto tires is certainly dependent on the demand of cars. We will deal with the Independent Demand Situation. In the dependent demand situation we use Material Requirement Planning (MRP) systems.
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What to answer?
In the independent demand situation, we
a) When to place an order for an item, and b) How much of an item to order.
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Inventory Models:
1) Economic Order Quantity (EOP) Model (the most known model). 2) Production Order Quantity Model. 3) Back order inventory model. 4) Quantity discount model.
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With these assumptions in EOQ Model, the graphic of inventory usage over time is as follows:
Q = order quantity (That is also equal to the Maximum Inventory)
Usage Rate Q
Inventory Level
Minimum Inventory = 0
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Optimal order quantity (Q*) occurs at a point where setup cost is equal to the total (annual) holding cost.
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Example
An Inventory model has the following characteristics:
Annual Demand (D) = 1000 units Ordering (Setup) cost (S)= $10 per order; Holding cost per unit per year (H) = $.50 Assume that there are 270 working days in a year (excluding holidays and weekends).
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Example
Questions:
a) Find the Economic Order Quantity (Q*) for this inventory model. b) How many orders should be placed during one year? c) What is the expected time between two consecutive orders? d) What is the total annual cost of this inventory model?
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Example
Answers: a) EOQ= Q* = [2(1000)10 / .50]1/2 = 200 units b) Expected number of orders placed during the year (N) = D / Q* = 1000 / 200 = 5 times. c) Expected time between orders (T) = (Working days in a year) / N = 270 / 5 = 54 days. d) Total Annual Cost = Annual Setup Cost + Annual Holding Cost
= = = DS / Q* + (Q*) H / 2 1000 (10) / 200 + (200) (.50) / 2 $100
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of Q. That is we take the second derivative of the total cost function based on Q. If the second derivative is positive, the Q* value is a real optimum. (Rule) In fact, second derivative is equal to 2DS / Q3 which is a positive value (It is a real optimum)
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(That is Q*). Now, we should find what time to order. We assumed that firm will wait until its inventory reaches to zero before placing an order. And, we also assumed that the Orders will receive immediately. However, there is a time between placement and receipt of an order.
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(ROP) for when to order. ROP (in units) = (Demand Per Day) x (Lead time for a new order in days)
ROP
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Reorder Point
Inventory
L = Lead Time
When the inventory level reaches the ROP, a new order is required. It will take a time that is equal to the Lead Time (L) to receive the new order.
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Reorder Point
Here, Demand per day (d) is found by the
following equation:
Example
Annual demand for an item is D = 8000/year. This year there will be 200 working days in a
year.
Delivery of an order for this item takes 3
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Example
Questions:
a) Find the demand per day for this item. b) What is the ROP for this item?
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Example
Answers:
a) Demand per day for this item (d) = 8000 / 200 = 40 units / day. b) ROP = d . L = 40 . 3 = 120 units.
When inventory level becomes 120 units, an Order should be placed.
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order was received at one time. However, Some Business Firms may receive their orders over a period of time. Such cases require a different inventory model. Here, we take into account the daily production rate and daily demand rate.
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Time t
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Here, Q is the total units that are produced. Therefore, Q=pxt and t=Q/p
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2 S Q ! d H 1 p
2
2 DS d 1 p
This formula gives us the optimum production quantity for the Production Order Quantity Model. It is used when inventory is consumed as it is produced.
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Q T1 0 b b T2
Time
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By using the graphical ratios, we know that: T2 / T = b / Q Therefore, if we replace T2/T in the above equation we get: Average Backordering = b2 / 2Q and b2 Annual Backordering Cost = ---------- . B 2Q
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2 S H B * Q ! H B
Q H b* ! H
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the lowest, We might be tempted to order 2000 or more units. However, this quantity might not be the one that minimizes the Total Cost. Remember that, As the quantity goes up, the holding cost increases. Here, there is a trade off between reduced product price (P) and increased holding cost (H).
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value of Q* = [2DS / IP]1/2 Here, instead of using a value of H, the holding cost is equal to I . P That is, If the item is expensive (such as a Class A Item), Its holding cost will be higher. Since the price of item (P) is a factor in Annual Holding Cost, we can no longer assume that the holding cost is constant (such as H) when price changes.
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low to qualify for the discount range, Then, Adjust the order quantity upward to the lowest quantity that will qualify for the particular discount alternative. Step 3: Using the total cost (TC) equation above, compute a total cost for every order quantity (Q). Use the adjusted Q values. Step 4: Select the discount alternative which has the minimum Total Cost (TC).
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Example
Consider the quantity discount schedule
given in the beginning (above). Assume that the Ordering (Setup) Cost (S) is $49 per each order. Annual Demand (D) is 5000 units, and Inventory carrying charge is a percentage (I=0.20) of product cost (P). Question: What order quantity will minimize the total inventory cost.
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Example
Answer: Step 1: Compute Q* for every discount range.
Q !
Q !
* 2
* 1
2 DS ! IP
2 S ! I
2 S ! I
Q !
* 3
Example
Step 2: Adjust values of Q* that are below allowable discount ranges. - For Q1, allowable range is 0-999. Since Q1* = 700 is between 0 and 999, It does not have to be adjusted. - For Q2, allowable range is 1000-1999. Since Q2* = 714 is not in the allowed range, we adjust it to the lowest allowable value, That is Q2* = 1000. - For Q3, allowable range is 2000-. Since Q3* = 718 is not in the allowed range, we adjust it to the lowest allowable value, That is Q3* = 2000.
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Example
Step 3: Compute total cost for each of the order quantities (Q*):
(Q / 2) x (I x P) = (700 / 2) x (5 x 0,20)
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Example
Step 4: An Order quantity of 1000 units will minimize the total cost. However, if the third discount cost is lowered to $4.65, selecting this discount alternative (2000 units) would be the optimum solution.
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Probabilistic Models
So far we assumed that demand is constant
and uniform.
However, In Probabilistic models, demand is
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Probabilistic Models
One method of reducing stock outs is to hold extra inventory (called Safety Stock). In this case, we change the ROP formula to include that safety stock (ss). ROP = d . L d = daily demand, and
Now it will be as follows: ROP = d . L + (ss) where (ss) is the safety stock
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Example
AMP Ltd. company determined its ROP = 50 units. Its holding cost (H) is $5 per unit per year. Its stock out cost (B) is $40 per unit. Probability of stock out is based on the following probability distribution:
Question: Find the Level of Safety Stock (ss) that minimizes the total additional holding cost and Stock out costs (annually).
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Example
Stock out cost is an expected cost; That is:
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Example
Possible stock outs per year is actually the number of orders per year (D/Q). Since it is not known (or not given) assume that it is 6 times / year. For zero safety stock, there is no additional holding cost for extra (safety) stock. But there are stock out costs for two levels: 1) If demand is 60 units at the ROP, Then a shortage of 10 units will occur. (Because, ROP is 50 units) 2) If demand is 70 units at the ROP, Then a shortage of 20 units will occur.
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The safety stock with the lowest total cost is (ss = 20) units. Therefore, ROP = 50 + 20 = 70 units.
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stock out only to a small percentage, say 5%. If demand level is assumed to be a normal distribution, By using mean and standard deviation of the normal distribution, We can determine a safety stock that is necessary for %95 service level.
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Example
The SAC company carries an inventory item
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Example
We use the properties of a standardized normal curve to get a z value that corresponds to the.95 of the curve.
x : mean demand + safety stock x-Q z = -----W Using a standard Normal table we find z = 1.65 for 95% confidence.
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Example
Therefore, x-Q ss z = ------ = ---- = 1.65 W W ss = 16.5 units Reorder point is elevated up by 16.5 units.
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Example
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