What Is Inventory?

Inventory Management
Homework (page 602): 13.5, 13.6, 13.19, 13.22, 13.34, 13.41

Three measures of process performance

Flow rate (throughput rate): the rate at which
the process is delivering output Flow Time: the time it takes a flow unit to get through the process Inventory: The number of units contained within the process.

Littles Law:
Average Inventory=average flow rate * average flow time

Types of Inventories
Raw materials & purchased parts Partially completed goods called work in process

Inventory Turnover
Flow Time = Inventory Flow rate Inventory turnover = 1 Flow time

(WIP)
Finished-goods inventories (manufacturing firms) or merchandise (retail stores) Replacement parts, tools, & supplies Goods-in-transit to warehouses or customers (Pipeline inventory)

Inventory turnover is the ratio of annual cost of goods sold to average inventory investment. The turnover ratio indicates how many times a year the inventory is sold. The higher the ratio, the better.

Inventory Counting Systems

Periodic System

Inventory Counting Systems (Contd)

Two-Bin System - Two containers of inventory; reorder when the first is empty (ROP: the amount contained in the 2nd bin) Universal Bar Code - Bar code printed on a label that has information about the item 0 to which it is attached
214800 232087768

Physical count of items made at periodic intervals

Perpetual Inventory System (Continual System)
System that keeps track of removals from inventory continuously, thus monitoring current levels of each item

Inventory Costs
Lead time: time interval between ordering and receiving the order Holding (carrying) costs: cost to carry an item in inventory for a length of time, usually a year.
Interest, insurance, depreciation, warehousing cost, deterioration, etc.

ABC Classification System

Form of Pareto analysis (80/20 rule) Classifying inventory according to some measure of importance, usually annual dollar usage, and allocating control efforts accordingly.

Ordering costs: costs of ordering and receiving

inventory
Preparing invoices, shipping cost, inspecting goods upon arrival, etc.

Shortage costs: costs when demand exceeds supply

Opportunity cost of not making a sale, loss of customer goodwill, late charges.

A - very important B - mod. important C - least important

High Annual $ volume of items Low

A B C
Few Many

Number of Items

ABC Classification System -Example

Item 1 2 3 4 5 6 7 8 9 10 11 12 Demand Unit Cost 1,000 $4,300 5,000 $720 1,900 $500 1,000 $710 2,500 $250 2,500 $192 400 $200 500 $100 200 $210 1,000 $35 3,000 $10 9,000 $3 Total Dollar Value $4,300,000 $3,600,000 $950,000 $710,000 $625,000 $480,000 $80,000 $50,000 $42,000 $35,000 $30,000 $27,000 $10,929,000 Dollar Usuage 39.34% 32.94% 72.28% 8.69% 6.50% 5.72% 4.39% 25.30% 0.73% 0.46% 0.38% 0.32% 0.27% 0.25% 6.8 1%

Basic Inventory Planning Questions

How much to order When to order?

Purchase Order Description Qty. Microwave 1000

Inventory Models
Fixed order quantity models Economic order quantity Production order quantity Quantity discount Probabilistic models Fixed order interval models

Help Help answer answerthe the inventory inventory planning planning questions! questions!

Economic Order Quantity (EOQ) Model

Inventory Cost Components

Purchase cost, P($/unit) Holding cost, H ($/unit/period) Ordering cost, S ($/order)

Assumptions of EOQ Model

Known & constant demand Known & constant lead time Demand is even throughout the year Each order is received in a single delivery There are no quantity discounts No stockouts

An EOQ System
Inventory Level
Order Quantity (Q) (Q=350)

Order size=350 Usage rate=50/day Lead time=2 days

EOQ Model Output Example

When the inventory of microwaves gets down to 15 units (reorder point), order 35 units (EOQ).

Average Inventory (Q/2)

Reorder Point (ROP)

ROP=100 5 7 (2 days supply) Lead Time 12 14

15
left
Time

Purchase Order Description Qty. Microwave 35

1 year
Low Q Average Inventory (Q/2)

EOQ Model: total cost (Carrying Cost + Ordering Cost)

Annual Cost Total Cost Curve Time

Many orders produce a low average inventory High Q

Holding (Carrying) Cost Order (Setup) Cost Optimal Order Quantity (Q*) Order Quantity

Average Inventory (Q/2)

Few orders produce a high average inventory

Time

Carrying costs are linearly related to order size Ordering costs are inversely and nonlinearly related to order size

Total Cost (Carrying Cost + Ordering Cost)

Annual Annual Total cost = carrying + ordering cost cost TC = Q H 2 + DS Q

EOQ Model Equations

Optimal Order Quantity = Q* = Number of Orders = m = D Q* Q* D Q* D H + * S = Q H Q 2 2DS H

Expected Time Between Orders = T =

Q D = S 2 Q
2 DS H

Total Cost (Carrying and Ordering Cost) = Total Annual Cost = pD + Q* D H+ *S Q 2

Q* =

D= Demand rate (e.g., per year) S= Setup (ordering) cost per order H= Holding (carrying) cost

EOQ Model: Example

Youre a buyer for Wal-Mart. WalMart needs 1000 coffee makers per year. The cost of each coffee maker is $78. Ordering cost is $100 per order. Carrying cost is 40% of per unit cost. Lead time is 5 days. Wal-Mart is open 365 days/yr. What is the optimal order quantity & ROP?

EOQ Solution
Optimal Order Quantity:
Q* = 2 DS = H

(2 )(1000)(100) = 80 units (.40)(78)

Number of orders per year: m = Length of order cycle: T = Daily usage:

D 1000 = = 12.5 13 (Orders) 80 Q

Q* 80 = = 0.08 (Year) = 29.2 (Days) D 1000

d=

1000 = 2.74 units/day 365

Reorder Point: ROP = d .LT = (2.74 )(5 ) = 13.7 units Total Cost: =(Q*/2)*H+(D/Q*)*S =80/2*31.2+13*100=$2548 Inventory Turnover: =1000/40=25

D=1000/year

S=$100/order

H=0.4*78=$31.2/unit/year

Sensitivity Analysis (Order Quantity)

A. As demand increases, EOQ increases in proportion of square root of D rather than in direct proportion to demand. B. What if the optimal policy is followed, but values of D, S, or h are incorrectly specified? Specifically, suppose we dont know S, but rather only have . Given this estimate, wed compute an order an estimate S quantity which is optimal with respect to the estimate: = optimal order quantity based on estimates Q

Sensitivity Analysis (Total Cost)

Total Cost is not particularly sensitive to the optimal order quantity

T (Q) 1 Q Q * = ( * + ) T (Q ) 2 Q Q
Order Quantity50% 80% 90% 100% 110% 120% 150% 200% Cost Increase 125% 103% 101% 100% 101% 102% 108% 125%

= 2 SD Q h

EOQ Zone
Annual Cost Total Cost Curve

When to Reorder with EOQ Ordering

Reorder Point (ROP) - When the quantity on hand of an item drops to this amount, the item is reordered Safety Stock(SS) - Stock that is held in excess of expected demand due to variable demand rate and/or lead time.

Q*

Order Quantity

Service Level (SL)- Probability that demand will not exceed supply during lead time.

EOQ Zone

The total cost curve is relatively flat near the EOQ

Safety Stock
Inventory Level
Maximum probable demand during lead time Expected demand during lead time

Reorder Point Under Uncertainty

Service level Probability of no stockout Expected demand

Risk of a stockout

ROP
Safety Stock LT Place Receive order order

ROP
Safety stock z

Quantity

z-scale

Time

ROP=Expected demand during lead time+ Safety Stock =Expected demand during lead time+ z dLT

ROP Example 1
Suppose that the manager of a construction supply house determined from historical record that demand for sand during lead time average 50 tons. In addition, suppose the manager determined that demand during lead time could be described by a normal distribution that has a mean of 50 tons and a standard deviation of 5 tons. Assuming that the manager is willing to accept a stockout risk of no more than 3%.
3% 5 50 0 What value of z is appropriate? z z Z=1.88
EXCEL: =NORMSINV(0.97)

How much safety stock should be held?

z dLT = 1.88 * 5 = 9.40

What reorder point should be used? ROP=50+9.40=59.40

Levers for Reducing Safety Inventory

Reduce demand variability through improved forecasting. Reduce replenishment lead time. Pool safety inventory for multiple locations or products through physical or virtual centralization. Exploit product substitution. Postpone product-differentiation processing until closer to the point of actual demand

Uniform Distribution
A random variable (X) between some minimum (a) and maximum (b) value are equally likely.

X ~ u ( a, b)
1 b a

SL

ROP

Newsboy Problem

Newsboy Model

Example: On consecutive Sunday, Mac, the owner of a local newsstand, purchases a number of copies of the The Computer Journal. He pays 25 cents for each copy and sell each for 75 cents. Copies he has not sold during the week can be returned to his supplier for 10 cents each. The supplier is able to salvage the paper for printing future issues. Mac has kept careful records of the demand each week for the Journal. (This includes the number of copies actually sold plus the number of customer requests that could not be satisfied.)

The Single-period Model (Newsboy problem)

Used to handle ordering of perishables and items that have a limited useful life. (fashion and seasonal apparel, hotel rooms, airline tickets) Example:
Overbooking of airline flights Ordering of fashion items Any type of one-time order.

Underage cost & Overage cost

Underage cost (Shortage cost ): the unrealized profit per unit.

Cu =

Revenue per unit Cost per unit

Overage cost (Excess cost): cost of overstocking

Co =

Original cost per unit Salvage vale per unit

The Goal of Newsboy Model

To identify the order quantity, or stocking level, that will minimize the long-run excess and shortage costs. Demand could be continuous distribution or discrete distribution. Expected marginal benefit from raising order size=Expected marginal cost (1-SL*)Cu = SL* Co
Service level ( SL ) = Cu Cu + C o

Continuous Stocking Level

The service level is the probability that demand will not exceed the stocking level. Cu Service level (SL ) = Cu + C o Optimal stocking quantity ( S o )is then determined

Example
Sweet cider is delivered weekly to Cindys Cider Bar. Demand varies uniformly between 300 and 500 liters per week. Cindy pays 20 cents per liter for the cider and charges 80 cents per liter for it. Unsold cider has no salvage value and can not be carried over into the next week due to spoilage. Find the optimal stocking level and its stockout risks for that quantity.

SL =

Cu 0 .6 = = 0.75 Cu + Co 0.6 + 0.2

75%

300

So

500

Co = $0.20-$0=0.20 per unit Cu = $0.80-$0.20=0.60 per unit

So

=300+0.75(500-300)=450 liters

If demand is normal distribution with a mean of 200 liters per week and a standard deviation of 10 liters per week.

Discrete Stocking Level

Computer service level Round-up rule: Whenever you are looking up a target value in a table and the target value falls between two entries, choose the entry that leads to the larger order quantity.

S o = + z
75% 200

=200+0.675*10 =206.75 liters

So

Example
Demand for long-stemmed red roses at a small flower shop can be approximated using a Poisson distribution that has a mean of four dozen per day. Profit on the roses is $3 per dozen. Leftover flowers are marked down and sold the next day at a loss of $2 per dozen. Assume that all marked-down flowers are sold. What is the optimal stocking level? What is the expected profit?

Demand(dozen/ day) 0 1 2 3 4 5

Relative Frequency 0.018 0.074 0.146 0.196 0.195 0.156

Cumulative Frequency
0.018 0.092 0.238 0.434 0.629 0.785

SL =

Cu 3 = = 0.6 Cu + Co 3 + 2

S o =4 dozens

Expected Profit= -4*2*0.018+ [1*3-3*2]*0.074+

Cu = $3

Co = $2

[2*3-2*2]*0.146+ [3*3-1*2]*0.196+ 4*3*(1-0.434) =8.09

Example
A hotel near the university always fills up on the evening before football games. History has shown that when the hotel is fully booked, the number of last minute cancellations(no shows) is as follows.The average room rate is $80. When the hotel is overbooked, policy is to find a room in a near hotel and to pay for the room for the customer. This usually costs the hotel approximately $200 since rooms booked on such late notice are expensive. How many rooms should the hotel overbooked?

N umber of No-Shows 0 1 2 3 4 5 6 7 8 9 10

Probability 0.05 0.08 0.1 0.15 0.2 0.15 0.11 0.06 0.05 0.04 0.01

Cumulative Probability 0.05 0.13 0.23 0.38 0.58 0.73 0.84 0.9 0.95 0.99 1

Cu = $80

Co = $200

SL =

80 Cu = = 0.2857 Cu + Co 200 + 80

S o =3 rooms