INVENTORY MANAGEMENT What to Inventory?

Inventory is a stock or store of goods. It includes raw materials or stock incoming suppliers . (A) (B) (C) (D) (E) Raw materials and purchased parts Partially completed goods Finished-goods inventories or merchandise Replacement parts, tools, and suppliers oods-in-transit to warehouses or oods In progress

!ypes of "emand#

$% "ependent "emand !hese are items that are typically su&assem&lies or component parts that will &e used in the production of a final or finished product. 'u&assem&lies and component a part is derived from the num&er of finished units that will &e produced. ()ample# "emand for wheels for new cars. *% Independent "emand !hese are items that are the finished goods or other end items. !hese items are sold or at least shipped out rather than used in making another product.

Functions of Inventory

$. !o meet anticipated customer demand. !hese inventories are referred to as anticipation stocks &ecause they are held to satisfy planned or e)pected demand. *. !o smooth production re+uirements. Firms that e)perience seasonal patterns in demand often &uild up inventories during off-season to meet overly high re+uirements during certain seasonal periods. ,ompanies that process fresh fruits and vegeta&le deal with seasonal inventories -. !o decouple operations. !he &uffers permit other operations to continue temporarily while the pro&lem is resolved. Firms have used &uffers of raw materials to insulate production from disruptions in deliveries from suppliers, and finished goods inventory to &uffer sales operations from manufacturing disruptions. !o protect against stock-outs. "elayed deliveries and une)pected increases in demand increase the risk of shortages. !he risk of shortages can &e reduced &y holding safety stocks, which are stocks in e)cess of anticipated demand. !o take advantage of order cycles. Inventory storage ena&les a firm to &uy and produce in economic lot si.es without having to try to match purchases or production with demand re+uirements in short run. !o hedge against price increase. !he a&ility to store e)tra goods also allows a firm to take advantage of price discounts for large orders. !o permit operations. Production operations take a certain amount of time means that there will generally &e some work-in-process inventory. /. 0. 1. 2.
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Inade+uate control of inventories

Inade+uate control of inventories can result into two categories# $% *% 3nder stocking results in missed deliveries, lost sales, dissatisfied customers and production &ottlenecks. 4verstocking unnecessarily ties up funds that might &e more productive

!wo 5ain ,oncerns of Inventory 5anagement 4&7ectives of Inventory 5anagement

First ,oncern 6evel of customer service to have the right goods, in sufficient +uantities, in the right place, and at the right time, second ,ost of ordering and carrying inventories. !o achieve satisfactory levels of customer service while keeping inventory costs within reasona&le &ounds. 'pecifically "ecision maker tries to achieve a &alance in stocking and Fundamental decision must &e made related to the timing and si.e of orders

Re+uirements for (ffective Inventory 5anagement

!o &e effective, management must have the following# $. 8 system to keep track of the inventory on the hand on order. *. 8 relia&le forecast of demand that includes an indication of possi&le forecast error. -. 9nowledge of lead times and lead time varia&ility. /. Reasona&le estimates of inventory holding costs, ordering costs, and shortage costs. 0. 8 classification system for inventory items.

Inventory ,ounting 'ystems

$% Periodic 'ystem !his is a physical count of items in inventory is made at periodic intervals :e.g. weekly, monthly% in order to decide how much to order of each item. 5a7or users# 'upermarkets, discounts stores, and department stores. 8dvantage 4rders for many items occur at the same time, which can result in economies in processing and shipping orders "isadvantages a% &% c% 6ack of control &etween reviews. !he need to protect against shortages &etween review periods &y carrying e)tra stock. !he need to make a decision on order +uantities at each review
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*% Perpetual Inventory 'ystem :also known as a continual system% !his keeps track of removals from inventory on a continuous &asis, so the system can provide information on the current level of inventory for each item. 8dvantages $. !he control provided &y the continuous monitoring of inventory withdrawals. *. !he fi)ed-order +uantity; management can identify an economic order si.e. "isadvantage $. !he added cost of record keeping. !wo-&in-system method Is two containers of inventory; reorder when the first is empty. !he advantage of this system is that there is no need to record each withdrawal from inventory; the disadvantage is that the reorder card may not &e turned in for a variety of reasons. !racking 'ystem 3niversal Product ,ode :3P,% &ar code printed on a la&el that has information a&out the item to which it is attached. <ar coding represents an important development for other sectors of &usiness &esides retailing. In manufacturing, &ar codes attached to parts, su&assem&lies, and finished goods greatly facilitate counting and monitoring activities. "emand Forecast and 6ead time Information 5anagers need to know the e)tent to which demand and lead time might vary; the greater the potential varia&ility, the greater the need for additional stock to reduce the risk of a shortage &etween deliveries. 6ead time is time interval &etween ordering and receiving the order. Inventory ,ost :Three Basic Costs) $. =olding or ,arrying ,ost is the costs to carry an item in inventory for a length of time usually a year. ,ost includes interest, insurance, ta)es, depreciation, o&solescence, deterioration, spoilage, pilferage, &reakage, etc. *. 4rdering ,ost is cost of ordering and receiving inventory. !hese include determining how much is needed, preparing invoices, inspecting goods upon arrival for +uality and +uantity, and moving the goods to temporary storage. -. 'torage ,ost is cost resulting when demand e)ceeds the supply of inventory on hand. !hese costs can include the opportunity cost of not making a sale, loss of customer goodwill, late charges, and similar costs
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Inventory 5anagement ,ontinue?. ,lassification 'ystem

8n important aspect of inventory management is that items held in inventory are not of e+ual importance in terms of dollars invested, profit potential, sales or usage volume, or stock-out penalties. ()ample# 8 producer of electrical e+uipment might have electric generators, coils of wire, and miscellaneous nuts and &olts among the items carried in inventory. It would &e unrealistic to devote e+ual attention to each of these items.

8-<-, 8pproach

8-<-, 8pproach classifies inventory items according to some measure of importance, usually annual dollar usage, and then allocates control efforts accordingly. !hree ,lasses of Items 3sed# 8 :very important% < :moderately important% , :least important% !he key +uestions concerning cycle counting for management are# $. =ow much accuracy is needed? *. When should cycle counting &e performed? -. Who should do it?

(,4@45I, 4R"(R A38@!I!B 54"(6'

(conomic 4rder Auantity :(4A% is the order si.e that minimi.es total cost. (4A models identify the optimal order +uantity in terms of minimi.ing the sum of certain annual costs that vary with order si.e. !hree :-% 4rder 'i.e $. !he economic order +uantity model. *. !he economic order +uantity model with non instantaneous delivery. -. !he +uantity discount model. Inventory ,ycles &egins with the receipt of an order of A units, which are withdrawn at instant rate over time. When the +uantity on the hand is 7ust sufficient to satisfy demand during lead time, an order for A units is su&mitted to the supplier.
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"eveloping (4A 5athematical 5odel

8ssumption of the <asic (4A 5odel $. 4nly one product is involved. *. 8nnual demand re+uirements are known. -. "emand is spread evenly throughout the year so that the demand rate is reasona&ly constant. /. 6ead time does not vary. 0. (ach order is received in a single delivery. 1. !here are +uantity discounts.

EOQ Model
Annual Cost

=olding ,ost:=% or carrying cost relate to having items in storage. ,ost includes interest, insurance, ta), depreciation 4&solesce, deterioration, spoilage, &reakage. Warehouse cost :heat, light, security and rent.
Holdin Cost Order !uantit"

In (4A 5odel =olding ,ost is ()press in terms of unit, 'o# !otal holding ,ost C @um&er of unit ) +uantity

EOQ Model
Annual Cost

4rdering ,osts are the costs of ordering and receiving inventory. !hey are the cost that varies with the actual placement of an order such as shipping cost, preparing invoices, inspecting goods upon arrivals.
Holdin Cost Order (#etu$) Cost Order !uantit"

!he ordering ,ost e)press as Fi)ed dollars per order regardless of order si.e.

EOQ Model
Annual Cost Total Cost Cur%e Holdin Cost Order (#etu$) Cost Order !uantit"

<y merging the two raphs we can notice that the minimum Inventory ,ost is at the intersection point. !otal ,ost C =olding ,ost D 4rdering ,ost
O$ti&al Order !uantit" (!')

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4ptimal Auantity C (4A A .= * " 8nnual ,arrying ,ost C .' A

*"' =
8nnual =olding ,ost C !otal annual Inventory ,ostC 6ength 4f order ,ycle C A . " A" .= D .' *A

"eterminants of Reorder point +uantity :when we have to reorder?%

a% &% c% d% Rate of demand !he lead time !he e)tent of demand !he degree of stock out risk accepta&le to management R4P :Reorder Point% C "aily "emand E 6ead !ime R4P C d ) 6 @ote that "emand is on daily &asis

()ample

'ave5art needs $FFF coffee makers per year. !he cost of each coffee maker is G2H. 4rdering cost is G$FF per order. ,arrying cost is G*F of per unit cost. 6ead time is 0 days. 'ave5art is open -1F daysIyr. (A) What is (4A 5odel? (B) =ow many times per year does the store reorder? (C) What is the length of order cycle? (D) What is the total annual cost if the (4A +uantity is ordered?

8nswer

:8% (4A *"' = * $FFF $FF $F A .= C $FF units * :<% @um&er of orders C $FFF" . C $F times.C $FFA :,% ,ycle 6ength C $FFA .C. C F.$ per year C F.$ ) -1F daysIyear C -1 days " $FFF A$FF$FFF" .= D .' C.) *F)$FF C*FFF **$FFA :"% !otal 8nnual Inventory ,ost C
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(4A with @on instantaneous Replenishment :(PA%

When a firm is &oth a producer and a user or deliveries are spread over time, inventories tend to &uild up gradually instead of instantaneously. If usage production :or delivery% rates are e+ual, there will &e no inventory &uildup since all output will &e used immediately and the issue of lot si.e doesn>t come up. In the more typical case, the production or delivery rate e)ceeds the usage rate. In the production case, production occurs over only a portion of each cycle &ecause the production rate is greater than the usage rate, and usage occurs over the entire cycle. * "' p !he economic Production Auantity C. =pu !otal Inventory cost C ,arrying cost D setup cost

!,min I ma) .= *
Ap u

" .' A

time &etween &eginning of range ,ycle !ime C Run time C Ap p production phase of the cycle I ma) * 8verage inventory I average !he ma)imum inventory level C Where Ap p .: p u % P is Production or "elivery Rate 3 is usage rate
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()ample

8 toy manufacturer uses /H,FFF ru&&er wheels per year for its popular dump truck. !he firm makes its own wheels, which it can produce at a rate of HFF per day. !he toy trucks are assem&led uniformly over entire year. ,arrying cost is G $ per wheel a year. 'etup cost of production run of wheels is G/0. !he firm operates */F days per year. "etermine the#a% 4ptimal Run 'i.e. &% 5inimum total annual cost for carrying and setup. c% ,ycle time for the optimum run si.e. d% Run time.

8nswer

" C /H,FFF wheels per year 'C G /0 =C G $ per wheel per year P C HFF wheels per day 3 C /H,FFF wheel per */F days or *FF wheels per day a% Ap C *:/HFFF%/0HFF* "' p .CC*/FF wheels. $HFF *FF= p u &% !,min

I ma) .= * " .' A

so we first must find Ima)

!he ma)imum inventory level C Ap p .: p u % C */FF HFF .:HFF *FF% $HFF wheel 'o !,min

I ma) .= *
Ap u

"$HFF/HFF .' C:$%:/0% $HFF A**FF

c% ,ycle !ime C d% Run time C */FF $* days *FF Ap p */FF HFF - days

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(4A with Auantity "iscount

Auantity "iscounts are price reductions for large orders offered to customers to induce them to &uy in large +uantities. If +uantity discounts are offered, the customer must weigh the potential &enefits of reduced purchase price and fewer orders that will result from &uying in large +uantities against the increase in carrying costs caused &y higher average inventories

!, C carrying cost D 4rdering cost D Purchasing ,ost !, C A .= * " .' A P". Where# P C 3nit price

E(AM)*E
!he maintenance department of a large hospital uses a&out $HF cases of li+uid cleanser annually. 4rdering costs are G*0, carrying costs are G0 per case a year, and the new schedule indicates that orders of less than /0 cases will cost G*.F per case, /0 to 1J will cost G$.2 per case, more than 2F cases will cost G$./ per case. "etermine the optimal order +uantity and total cost. (4A *"' = !otal ,ost C * $HF *0 0 /- unit A"/-$HF .= D .' C. )0) *0 * ) /- *JH.$0 */-*A If we order /0 unit we may get discount the price will &e reduced from G* to G$.2 and the total annual cost will &e#!otal 8nnual ,ost C A"/0$HF .= D .' C. )0) *0 $.2 ) /0 */0*A *HJ If we order 2F unit we may get further reduction as the price will &e reduced from G$.2 to G$./ the annual cost in this case would &e #!otal 8nnual ,ost C A"2F$HF .= D .' C. )0) *0 $./ )2F --2.*H *2F*A We can note that at some range from /0 to 2F units annual cost will &e appropriate even the (4A state other range due to discount effect.
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Pro&lemK$
8 local distri&utor for a national tires company e)pects to sells appro)imately J1FF steel &elted radial tires of certain si.e and treated design ne)t year. 8nnual carrying cost is G$1 per tire and ordering cost is G 20. !he distri&utor operates *HH days a year. (A) What is (4A 5odel? (B) =ow many times per year does the store reorder? (C) What is the length of order cycle? (D) What is the total annual cost if the (4A +uantity is ordered?

Pro&lemK*

8 large &akery &uys flour in *0-pound &ags. !he &akery uses an average ofL /,H1F &ags a year. Preparing an order and receiving a shipment of flour involves a cost of G$F per order. 8nnual carrying costs are G20 per &ag. (A) "etermine the economic order +uantity. (B) What is the average num&er of &ags on hand? (C) =ow many orders per year will there &e? (D) ,ompute the total cost of ordering and carrying flour. (E) If ordering costs were to increase &y G$ per order, how much that would affect the minimum total annual cost?

Pro&lemK-

8 large law firm uses an average of /F &o)es of copier paper a day. !he firm operates *1F days a year. 'torage and handling costs for the paper are G-F a year per &o), and its costs appro)imate G 1F to order and receive a shipment of paper. (A) What order si.e would minimi.e the sum of annual ordering and carrying costs? (B) ,ompute the total annual cost using your order si.e from part a? (C) ()cept for rounding, are annual ordering and carrying costs always e+ual at (4A? (D) !he office manager is currently using an order si.e of *FF &o)es. !he partners of the firm e)pect the office to &e managed Min a cost-efficient manner.M Would you recommend that the office manages use the optimal order si.e instead of *FF &o)es? Nustify your answer.

Pro&lemK/

=ighland (lectric ,o. &uys coal from ,edar ,reek ,oal ,o. to generate electricity. ,,,, can supply coal at the rate of -,0FF tons per day for G$F.0F per ton. =(, uses the coal at a rate of HFF tons per day and operates -10 days per year. =(,>s annual carrying cost for coal is G* per ton, and the ordering cost is G0,FFF. a% What is the economical production lot si.e? &% What is =(,>s ma)imum inventory level for coal? c% What is ,ycle time and run time for the optimum run si.e.
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Pro&lemK0
!he friendly 'ausage factory :F'F% can produce hot dogs at a rate of 0,FFF units per day. F'F supplied hot dogs to local restaurant at a steady state rate of *0F per day. !he cost to prepare e+uipment for producing hot dog is G11. 8nnual holding cost is /0 cents per hot dog. !he factory operates -FF days a year. Find a% !he optimal run si.e. &% !he num&er of runs per year. c% !he length :in days% of a run.

Pro&lemK1

8 chemical firm produces sodium &isulphate in $FF-pound &ags. "emand for this product is *F tons per day. !he capacity for producing the product is 0F tons per day. 'etup cost G$FF and storage and handling cost are G0 per ton a year. !he firm operates *FF days a year. :@ote $ ton C *FFF pounds% a% =ow many &ags per run are optimal? &% What would the average inventory &e for this lot si.e? c% "etermine the appro)imate length of a production run in days? d% 8&out how many runs per year would there &e? e% =ow much could the company save annually if the setup cost reduced to G*0 per run?

Pro&lemK2

8-$ 8uto Parts has a regional tire warehouse in 8tlanta. 4ne popular tire, the ERE20, has estimated demand of *0,FFF ne)t year. It costs 8-$ G$FF to place an order for the tires, and the annual carrying cost is G-F per unit. !he supplier +uotes these prices for the tire# @um&er of &o)es $ to /JF 0FF to JJJ 5ore than $FFF Price per &o) G *$.1F G *F.J0 G *F.JF

Pro&lemKH

8 mail order house uses $H,FFF &o)es a year. ,arrying cost are 1F percent of a &o) cost price and ordering cost are GJ1 per order. !he following price schedule applied. "etermine#a% !he optimal order +uantity? &% !he num&er of orders per year? @um&er of &o)es $FFF to $JFF *FFF to /JJJ 0FFF to JJJJ $FFFF or more Price per &o) G $.*0 G $.*F G $.$0 G$.$F
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