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CHAPTER 10

INVENTORY MANAGEMENT

Learning Objectives

After reading this chapter, you will be able to…

describe the purpose of inventory;

explain different types of inventory cost;

describe fixed order quantity models and fixed time period models;

compute economic order quantity, economic order period and safety stock;

describe simple applications of inventory control methods.

Inventory refers to stock of any item or resource used in an organization. Inventory is available in both manufacturing and service organizations. Manufacturing inventory includes raw materials, finished products, component parts, supplies and work-in-process. In services, inventory generally refers to the tangible goods to be sold and the supplies necessary to provide and administer the service. An inventory management system is the set of policies and control mechanism that monitor levels of inventory and determines the levels of inventory to be maintained, size of the order and time of order placement.

PURPOSE OF INVENTORY

Firms keep inventory due to following reasons.

1. To maintain independence of operations

Inventory between the operations provide independence to carry out operations. For example, raw material stock gives flexibility to carry out manufacturing activities without depending on the schedules of purchasing department.

2. To cope up with uncertainties in product demand

Product demand is not known precisely due to uncertainties of the market. Companies use safety or buffer stocks to cope up uncertainties in product demand.

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151

3. To safeguard delays in shipment

When material is ordered from a vendor, supplies can be delayed due to variety of reasons such as variations in shipping time and shortages of material at the vendor's plant. Usually organizations keep safety stocks to safeguard the situation.

4. To allow flexibility in production scheduling

A stock of inventory provides opportunities for large lot sizes under high setup cost.

Inventory is useful to adjust the capacity under high demand situations,

5. To take advantage of economic purchase order size

There are certain costs incurred in placing orders: documentation, phone calls, postage, and so on. Therefore, larger the each order is, the fewer the number of orders that need to be placed. In addition to that, larger orders reduce the number of shipments and hence reduce the total transport cost. There is a possibility to get quantity discounts through larger orders.

6.

To get price advantages

If

there are possibilities for future price escalation, organizations purchase items

more than their present requirements and keep them in inventory for future use.

NEGATIVE ASPECTS OF INVENTORY

1. Poor quality of products

Large inventories can prohibit meaningful feedback on the quality of the product. With large inventories, there is usually a long delay between the production of an item and its use. Thus, when problems are discovered, it is usually too late to investigate and correct the problem.

2. Hiding operational problems

Operational problems such as delays in order processing and production backlogs are

hidden by the excessive inventories. These problems reduce the level of performance

of

the operation system.

3.

Risk of damage

There is some risk of damage to goods held in inventory. Often, warehouse workers have to move and replace large quantities of inventory just to find a specific item. When each time an item is handled, there is some chance that it will be damaged.

152 Operations Management: Concepts and Applications

4. Risk of product obsolescence and depreciation

Large inventories are associated with a risk of product obsolescence and losses due to depreciation.

5. Cost of maintaining inventory

In maintaining inventory, it is required to track and keep records. This needs additional effort and cost.

INVENTORY COSTS

In making inventory decisions such as order quantity and order frequency the following costs must be considered.

1 . Holding (or carrying) costs

This includes the costs for storage facilities, handling, insurance, pilferage, damages, obsolescence, depreciation, taxes, and the opportunity cost of capital. High holding costs tend to favour low inventory levels and frequent replenishment.

2. Ordering costs

These costs refer to the administrative costs to prepare the purchase or production order. The costs associated with maintaining the system need to track orders and receiving orders are also included in ordering costs.

3. Setup (or production changeover) costs

The production system should be setup for each production order. Each setup incurs certain cost. The larger the production lot sizes the lower the total setup cost.

4. Shortage costs

Shortage costs occur due to stock out of products or raw material. Shortage cost includes lost profits and lateness penalties. Shortage may cause customer dissatisfaction leading to loss of customers, which can be considered as a cost but difficult to quantify.

INDEPENDENT VERSUS DEPENDENT DEMAND

Inventories may contain items that have either dependent demand or independent demand. In independent demand inventories, demand for an item is independent of the demand for any other item carried in the inventory. Finished goods delivered to

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153

customers are considered as independent demand items. Demand for dependent demand items depends on the other items in the inventory. For example, demand for wheels and seats, which are components, are dependent on the demand for cars. Quantities of independent items to be produced are based on the realized orders or sales forecast. This chapter mainly considers the issues related to independent demand. Requirements of dependent demand items are derived from the demand of independent items. Order quantity and order point decisions for dependent demand items are different from those independent demand inventories; these decisions will be discussed in Chapter 11.

INVENTORY MANAGEMENT SYSTEMS

An inventory management system provides a set of rules and policies for planning and controlling inventory. To maintain appropriate level of inventory, decision rules are needed to answer the questions such as:

1. When should an order be placed to replenish the inventory?

2. How much should be ordered?

3. What level of safety stock to be maintained?

Various types of inventory control models incorporate different rules to decide

‘when’ and ‘how many’ to order. In managing independent inventory, there are two basic inventory control models:

1. Fixed order quantity model

2. Fixed time period model

In addition to above models, single period inventory models are used for the items

with a short selling period.

Fixed Order Quantity Model

The Fixed order quantity model places orders for same quantity of material at each order. It initiates an order when the inventory level reaches a specified reorder level (i.e. order placement is ‘event triggered’). This event may take place at any time depending on the demand for the items considered. Inventory position must be continuously monitored to check whether it has reached to the reorder level. Thus, the fixed order quantity model is a perpetual system, which requires that every time a withdrawal from inventory or an addition to inventory is made, records must be updated and also known as continuous review system. Fixed order quantity models attempt to determine the quantity to be ordered (Q) and reorder level (R). Inventory position is equal to the on-hand plus on-order minus back order quantities. The fixed order quantity model is implemented something like

154 Operations Management: Concepts and Applications

this: When the inventory position drops to R, place an order of Q items. Quantity to be ordered is determined so that total cost is minimum and it is referred to as economic order quantity. In deriving formulae for economic order quantity (EOQ) and reorder level, fixed order quantity models have following assumptions.

Demand for the product is constant and uniform throughout the period.

Lead time (time from ordering to receipt) is constant.

Price per unit of product is constant.

Inventory holding cost is based on average inventory.

Ordering or setup costs are constant.

All demands for the product will be satisfied (No shortages are allowed).

Figure 10.1 shows the pattern of variation of inventory for fixed order quantity model. When the inventory position drops to reorder level R, order of quantity Q is placed. This order is received at the end of time period L.

Inventory

Position

Q Q Q R Time L L
Q
Q
Q
R
Time
L
L

Figure 10.1: Variation of Inventory for Fixed Order Quantity Model

In deriving formula for economic order quantity, it is required to develop the relationship between variables interest and total cost, since the objective of economic order quantity is to minimize the total cost. Total annual cost of the items in the inventory can be given as follows:

Total annual cos t Annual purchase cos t Annual ordering cos t Annual holding cos t

Annual purchase cost = Annual demand × Cost per unit = D C Annual ordering cost = Number of orders per year × Cost of each order

D  


Q

S

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155

Annual holding cost

inventory

= Average inventory × Annual holding cost per unit of

=

Q

2

 H

Then total annual cost is given by,

TC

DC

where,

D

Q

S

Q

2

H

TC

=

Total annual cost

D

=

Demand

C

=

Cost per unit

Q

=

Order quantity

S

=

Cost of placing an order or setup cost

R

=

Reorder point

L

=

Lead time

H

=

Annual holding cost per unit of average inventory

It can be noted that total annual cost varies with the order quantity. Figure 10.2 shows the variation of costs with order quantity Q.

Cost

Total Cost Holding Cost Annual cost of items Annual ordering cost Order Qty (Q) Q
Total Cost
Holding Cost
Annual cost of
items
Annual ordering
cost
Order Qty (Q)
Q (OPT)

Figure 10.2: Variation of Cost with Quantity Order

Deriving EOQ – Calculus Method

Order quantity Q opt is the point at which the total cost is a minimum. The total cost is minimal at the point where the slope of the curve is zero. Using calculus, taking the derivative of the total cost with respect to Q and setting this equal to zero will results,

156 Operations Management: Concepts and Applications

TC

DC

D

S

Q

H

 

Q

2

For minimum TC,

 

dTC

dQ

0

    DS

Q

2

 

H

2

0

Q opt

Q op t =

2 DS H
2
DS
H
 

2

Annual demand

Order or setup

cos

t

Annual holding cos t per unit of inventory

Annual holding

cos

t per unit of inventory

This quantity is known as the Economic Order Quantity (EOQ).

Deriving the EOQ - Graphical Method

At the optimal order quantity, the total annual holding cost is equal to the total annual ordering cost.

Q D Solving, H  2 Q 2 DS  Q opt H
Q
D
Solving,
H 
2
Q
2
DS
Q opt
H

S

Economic Order Quantity (EOQ) =

 

2

Annual demand

Order or setup

cos

t

Annual holding cos t per unit of inventory

Annual holding

cos

t per unit of inventory

At the reorder point, the inventory should fulfill the demand during lead time and the reorder point R is,

R dL

where,

d

=

Average daily (weekly) demand

L

=

Lead time in days (weeks)

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157

Example 10.1: Economic Order Quantity and the Reorder Point

Find the economic order quantity and reorder point for following data. =

Annual Demand Cost to place an order

=

1,000 units Rs. 2000

Holding cost per unit per year

=

20% of price

Lead time

=

7 days

Cost per unit

=

Rs. 2500

Solution

2DS 2  1000  2000 Q = =  89 44 . units opt
2DS
2
1000
2000
Q
=
=
 89 44
.
units
opt
H
2500
 0
.2
The reorder point is
1000
R  dL 
7
19 . 18 units = 20 units (round up to avoid stock outs)
365

The inventory policy is as follows: When the inventory position drops to 20 units place an order for 89 units. The total annual cost will be

TC

DC

D

Q

S

1000 2500

Q

2

H

1000

89

2000

= Rs. 2,544,721.91

89

2

500

Fixed Order Model with Quantity Discounts

Suppliers usually offer quantity discounts for large purchase quantities. Economic order quantity can deviate from the previously derived Q opt due to the cost savings gained through quantity discounts.

Example 10.2: Economic Order Quantity with Quantity Discounts

The supplier offers quantity discounts and discounted prices are as follows.

Quantity

Unit Price

0 – 500 units 500 – 1000 units 1000 and above

35 cents

33 cents

31 cents

158 Operations Management: Concepts and Applications

Assume demand is 1000 per year; cost of placing an order is Rs. 8 and annual holding cost is 20 percent of unit price. What is the economic order quantity?

Solution

Find Q optimal for different ranges of order quantities.

2DS 2  1000  8 Q = =  478 units opt(0) H 0
2DS
2 
1000 
8
Q
=
=
 478 units
opt(0)
H
0 .2
 0
.35
2DS
2 
1000 
8
=
=
 492 units
Q opt(1)
H
0 .2
 0
.33
2DS 2 
1000 
8
=
=
 508 units
Q opt(2)
H
0 .2
 0 31
.
440
420
TC (0)
400
TC (1)
380
TC (2)
360
340
320
300
100
200
300
400
500
600
700
800
900
1,000
1,100
1,200
Total Cost (TC)

Order Quantity (Q)

Figure 10.3: Cost Variation with Quantity Discounts

Only Q opt (0) is realisable. Since others are not fallen into the corresponding unit cost range, Q opt (1), Q opt (2) are not realisable. But there are two price breaks (Q = 500, Q = 1000) above the optimal realisable quantity, (Q = 478). There is a possibility that the total costs at these price breaks are lower than the cost at Q opt(0) (Q = 478). Therefore the total cost should be calculated for quantities 478, 500 and 1000 to determine the economic order quantity.

TC

TC

TC

TC

DC

478

500

D

S

Q

H

Q 2

1000

1000

0.35

0.33

1000

478

1000

500

8  

478

2

8  

500

2

0

0

.

.

2

2

1000

1000

0 31

.

1000

1000

8    1000   

2

0

.

2

Inventory Management

0 35

.

0 33

.

0 31

.

383 47

.

362 50

.

349

159

Total cost is minimum at 1000. Hence the economic order quantity is 1000 units.

Fixed Order Quantity Model with Consumption during Production

Basic economic order quantity model assumes that the quantity ordered would be received in one lot, but there are deviations from this situation. In many situations of production environment, production of inventory items and usage of those items take place simultaneously. Figure 10.4 shows the variation of inventory for this situation. It can be observed that maximum inventory is less than the order quantity Q. If the production rate p and the demand rate d (<p), it can be proved that average inventory is equal to (1-d/p) Q/2.

Modified total cost equation

TC

DC

D

Q

S

1

d Q

p

2

H

By replacing H by (1 – d/p) H, Q optimal can be written

160 Operations Management: Concepts and Applications

Q opt

2 DS  d  H  1     p  
2 DS
d 
H  1 
p
Inventory level Maximum Inventory (1-d/p) Q Average Inventory level (1-d/p) Q/2 Order Begin Time End
Inventory
level
Maximum Inventory
(1-d/p) Q
Average
Inventory level
(1-d/p) Q/2
Order
Begin
Time
End order
receipt
order
receipt
period
receipt
Figure 10.4: Fixed Order Quantity Model with Consumption during Production
Time

Example 10.3: Fixed Order Quantity Model with Consumption during Production Time

Find the economic order quantity and reorder point, given =

Find the economic order quantity and reorder point, given =
Find the economic order quantity and reorder point, given =

Annual Demand Cost to place an order Holding cost per unit per year Lead time Cost per unit Production rate

Annual Demand Cost to place an order Holding cost per unit per year Lead time Cost
Annual Demand Cost to place an order Holding cost per unit per year Lead time Cost
Annual Demand Cost to place an order Holding cost per unit per year Lead time Cost
Annual Demand Cost to place an order Holding cost per unit per year Lead time Cost

=

=

=

=

=

1,000 units Rs. 1000 Rs. 250 2 weeks Rs. 1500 80 units per week

1,000 units Rs. 1000 Rs. 250 2 weeks Rs. 1500 80 units per week
1,000 units Rs. 1000 Rs. 250 2 weeks Rs. 1500 80 units per week
1,000 units Rs. 1000 Rs. 250 2 weeks Rs. 1500 80 units per week
1,000 units Rs. 1000 Rs. 250 2 weeks Rs. 1500 80 units per week

Assume that the plant operates 50 business weeks per year.

Solution

Demand rate, d

1000

50

20 units per week

Q opt

2 DS  d  H  1     p  
2 DS
d 
H  1 
p
2  1000  1000 Q  opt  20  250  1 
2
1000
1000
Q
opt
20 
250  1 
80
Q
opt  103 28
.
units
Reorder point is,

R d L 20 units / week 2 weeks

40 units

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161

Safety Stock for Fixed Order Quantity Model

The Fixed-order quantity model continuously monitors the inventory level and places

a new order when stock reaches reorder point, R. The fixed order quantity model

assumes that demand and lead time are constants. But, in actual practice these are not constants and fluctuate due to uncertainties in the environment. If there is increase in demand or lead time more than the normal, there can be stock out as shown in Figures 10.5 and 10.6. It should be noted that the danger of stock out in this model

occurs only during the lead time, between the time an order is placed and the time it

is received.

In many situations, demand and lead time are not constants but vary from day to day. Safety stock must therefore be maintained to provide some level of protection against stock outs. Safety stock can be defined as the amount of inventory carried in addition to the expected demand. Safety stock can be determined based on many different criteria. Some mangers follow simple deterministic approach to decide the level of safety stock. This simply states that a certain number of weeks of supply to be kept in safety stock (e.g. maintain 2 weeks supply as safety stock). Probabilistic approach is more scientific method in determining safety stock, which considers the probability of running out of stock.

162 Operations Management: Concepts and Applications Inventory level Normal demand Increased demand Time Stock out
162 Operations Management: Concepts and Applications
Inventory
level
Normal demand
Increased demand
Time
Stock out

L

Figure 10.5: Stock-out due to Demand Uncertainty Inventory level Time Normal lead time Stock out
Figure 10.5: Stock-out due to Demand Uncertainty
Inventory
level
Time
Normal lead time
Stock out

Increased lead time

Figure 10.6: Stock-out due to Lead Time Uncertainty

Assuming that demand and lead time follow the standard normal distribution, safety stock (SS) is given as,

SS z

DL

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163

σ DL is given by

DL

2

D

2

d

L

2

L

where,

L

=

Lead time in days

d

=

Demand per day

z

σ DL

σ D

σ L

= Number of standard deviations for a specified probability of not stocking outs (Probability of meeting demand is known as service level) Standard deviation of demand during lead time and review period Standard deviation of daily demand

=

=

= Standard

deviation of lead time

With safety stock, inventory position at reorder point should carry the demand during lead time and safety stock. Thus, the reorder point is given by,

R dL SS

where,

d

=

Average daily demand

L

=

Lead time in days

SS

=

Safety stock

Example 10.4: Safety Stock for Fixed Order Quantity Models

A company orders a product with an average daily demand of 100 units. Average lead time of shipment is 5 days. The company wishes to maintain a safety stock so that orders are met with of 0.95 service level. Standard deviations of daily demand and lead time are 20 units and 2 days respectively. Determine the safety stock and reorder point.

Solution

Safety stock is given by,

SS z

DL

DL

L

d

σ

D

σ

L

D

2

2

d

L

2

L

=

=

=

=

5 days

100 units

20 units

2 days

164 Operations Management: Concepts and Applications

Service level (Probability of not stocking out) = 0.95

Corresponding z is found from standard normal distribution as shown in Figure 10.6 (Z values for standard normal distribution curve are given in appendix).

P- Service level P=0.95
P- Service level
P=0.95
curve are given in appendix). P- Service level P=0.95 Z = 1.64 Figure 10.6: Z Value

Z = 1.64

Figure 10.6: Z Value for Given Service Level

z = 1.64 2 2 2   5  20 100  2 DL
z
=
1.64
2
2
2
5  20
100  2
DL
 2000  40000  42000  204.94
DL
SS 1.64  204.93  336.1
R  dL  SS

R 1005 336 836

Safety stock is 336 units and the reorder point is 836 units.

Fixed Time Period Model

In the fixed time period model, inventory is reviewed only at fixed time intervals such as every week or every month, and orders are placed for enough items to bring inventory levels backup to some predetermined level. Figure 10.6 illustrates the fixed time inventory model.

Inventory Management 165 Place Place Inventory order order position Place order Safety L L L
Inventory Management
165
Place
Place
Inventory
order
order
position
Place
order
Safety
L
L
L
stock
T
T
T Time

Figure 10.6: Variation of Inventory for Fixed Time Period Model

In this model, maximum inventory level is given by,

Maximum Inventory level = Demand for review period and lead time+ Safety Stock

I max

D( T

L )

SS

where,

 

I max

=

Maximum inventory level

D

=

Annual demand

T

=

Review period (in years)

L

=

Lead time

 

SS

=

Safety stock

 

Order quantity varies depends on the inventory and is computed by,

Order quantity = Maximum inventory level - Current inventory position

In deriving formula for economic order period, it is required to develop the relationship between variables interest and total cost, since the objective of economic order quantity is to minimize the total cost. Total annual cost of the items in the inventory can be given as follows:

Total annual cost = Annual purchase cost + Annual ordering cost + Annual holding

cost

166 Operations Management: Concepts and Applications

Annual purchase cost = Annual demand× Cost per unit = D C

Annual ordering cost

= Number of orders per

year× Cost of each order

D

DT



S

S

T

Annual holding cost

= Averageinventory× Annual holding cost per unit

=

DT


2

SS

 H

Then total annual cost is given by,

TC

DC

S

DT

SS

H

T 2

where,

TC

=

Total annual cost

D

=

Annual demand

C

=

Cost per unit

T

=

Order period (Review period)

S

=

Cost of placing an order or setup cost

L

=

Lead time

H

=

Annual holding cost per unit of inventory

SS

=

Safety stock

For economic order period,

d TC

dT

0

S

DH

T

2

2

Economic order period =

0

T optimal

2 S DH
2 S
DH

Example 10.5: Fixed Time Period Model

Find the economic order period and the order quantity for the following data. =

7,500 units

Annual demand Cost per unit

=

Rs. 50

Cost to place an order

=

Rs. 800

Holding cost per unit per year

=

Rs. 7.7

Safety stock

=

200 units

Current inventory level

=

250 units

Lead time

=

1 month

Solution

T optimal

2 S 2  800  DH 7500  7.7
2 S
2
 800
DH
7500
 7.7

0.1665years

Economic order period is two months.

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2 months

167

Order quantity = Demand for review period & lead time + Safety Stock - Current inventory position

=

7500

1  

2

12

200

250

Order quantity is 1627 units.

= 1200 units

Safety Stock for Fixed Time Period Model

In a fixed time period system, stock out can occur at any point of the review period. Therefore safety stock should be enough to protect the demand uncertainties during the review period. Since the items ordered at the review point are received after the lead time period (L), the safety stock should protect demand uncertainties during the lead time in addition to review period (i.e. the safety stock should protect demand uncertainties during T+L period). Since the safety stock protects demand uncertainty for longer period, the level of safety stock in fixed time period systems is higher compare to the fixed order quantity systems.

Safety Stock (SS) is given by,

SS

 

z

DT

L

σ D(T+L) is expressed as,

D T

L

  T  L  D 2 2  d  L 2

T L

D

2

2

d

L

2

where,

T

L

d

z

=

=

=

= Number of standard deviations for a specified probability of not stocking

outs Standard deviation of demand over lead time and review period Standard deviation of daily demand = Standard deviation of lead time

=

Review Period Lead time in days Demand per day

σ D(T+L) =

σ D

σ L

168 Operations Management: Concepts and Applications

Example 10.6: Safety Stock for Fixed Time Period Models

Calculate the level of safety stock for the previous example assuming inventory is maintained according to the fixed time period model and the review period is 30 days.

Solution

SS

 

z

=

DT

L

5 days

=

100 units per day

=

20 units

=

2 days

=

30 days

1.64

L

d

σ D

σ L

T

Probability of not stocking out = 0.95

z =

D T

D T



L

T L

D

2

2

d

L

2

L

30 5  20 30 520

2

100

2

2 2

SS 1.64 232.38 381.1

Safety stock is 381units.

14000  40000  54000
14000 
40000
54000

232 38

.

Comparison of Fixed Order Quantity Model and Fixed Time Period Model

The inventory control models discussed above have their own characteristics. Selection of the suitable inventory control model depends on these characteristics. Table 10.1 shows some basic differences of the inventory control models.

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169

Table 10.1: Comparison of Inventory Control Models

Characteristic

Fixed Order Quantity Model

Fixed Time Period Model

 

Order quantity

Constant (usually economic order quantity)

Variable (fills

up

to

predetermined inventory level)

Order placement

When inventory position drops to the reorder level

When the review period arrives

Record keeping & maintenance

Each time a withdrawal or

Counted only at review period. Record keeping and maintenance cost is low due to periodic review

addition is Recordkeeping maintenance cost is high

made.

 

and

Size of inventory Less than fixed-time period model due to the less safety stock

Larger than fixed-order quantity model due to higher safety stock

Chance

for

stock

Low (Stock out can occur

High (Stock out can occur at

out

only during lead time)

any time)

Type of item

 

High-priced items

(to

Low-priced

and

non-critical

 

minimize

holding

cost and

items

capital tied-up)

Critical or important items (to minimize stock out of critical or important items)

Single Period Inventory Model

Some inventory situations involve placing to cover only one demand period or very short selling season. Items such as holiday decoration, Christmas trees, newspapers, and magazines are good examples. These products typically have a high value for a relatively short period; then value diminishes dramatically an either or some minimum scale value. This type of inventory model is called single period or ‘news boy’ problem.

The single period model is designed for products that share the following characteristics. They are sold at their regular prices only during a single-time period.

products that share the following characteristics. They are sold at their regular prices only during a
Demand for these products is highly variable but follows a known probability

Demand for these products is highly variable but follows a known probability

distribution. Salvage value of these products is less than its original cost so the seller

distribution. Salvage value of these products is less than its original cost so the seller loses money when they are sold for their salvage value.

170 Operations Management: Concepts and Applications

Example 10.7: Single Period Inventory Model

A product is providing to sell at Rs.100 per unit and its cost is constant at Rs.70 per unit. Demand is replaced to range between 40 and 60 units for the period. Each unsold unit has a salvage value of Rs 20. Based on the past demand data, the seller has determined the probability of selling different quantities as follows.

Demand (Products)

Probability

40

0.20

45

0.25

50

0.30

55

0.15

60

0.10

Determine how many products should be ordered to maximize the seller’s expected profits.

Solution

Based on the information provided develop a payoff table to determine expected profit with each possible order quantity.

In calculating payoff, there are three possible outcomes,

when the number of products ordered equals the number of shirts demanded, Pay off = demand (selling price – unit cost)

e.g. demand = 50 and number of product ordered = 50 Pay off = 50(100-70) = Rs.1500

when the number products is less than demand, Pay off = number of products ordered (selling price – unit cost)

e.g. demand = 50 and number of products ordered = 40 Pay off = 40(100-70) = Rs. 1200

when the number of products ordered exceeds the demand, Pay off = number of products demanded x (selling price – unit cost) – (products of ordered – products demanded) x (unit cost – salvage value)

e.g. demand = 50 and products ordered = 60 Pay off = 50 (100-70) – (60-50)(70-20) = Rs. 1000

Pay off Table

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171

Probability of

0.20

0.25

0.30

0.15

0.10

occurrence

Customer demand

40

45

50

55

60

Number of product ordered

 

Expected

profit

40

1200

1200

1200

1200

1200

1200

45

950

1350

1350

1350

1350

1270*

50

700

1100

1500

1500

1500

1240

55

450

850

1250

1650

1650

1090

60

200

600

1000

1400

1800

880

The seller should select the order quantity of 45 units with the highest expected profit (i.e. Rs 1270).

APPLICATIONS OF INVENTORY CONTROL MODELS

Practitioners use some simple systems based on the inventory control models presented above. Following are three simple systems used in practice.

Two-Bin System

Two-bin system of inventory control is a simple application of fixed order quantity model. In the two bin system, items are used from one bin and the second bin provides an amount large enough to ensure demand during the replenishment lead time. Ideally the second bin would contain an amount equal to the reorder point (R) calculated earlier. Items are withdrawn from a large bin until the large bin is empty. When the large bin is empty, an order is placed to replenish the items and the items are drawn from the second bin, a smaller one. When the inventory is replenished, the both bins are filled with the items. The order quantity is the amount needed to fill both bins. The re-order point is the amount needed to fill the second bin.

One -Bin System

One-bin inventory system is a simple application of fixed time period model. The items are filled in a bin and drawn when the demand arises. At fixed periods (such as weekly or monthly) the inventory is brought up to its predetermined maximum level.

172 Operations Management: Concepts and Applications

Optional Replenishment System

Optional replenishment system is another version of fixed time period model. In this system inventory is reviewed at fixed time interval, but replenishment orders are placed if the inventory level has dropped below a predetermined level. This system establish a minimum order size and avoid small orders because each order takes time and cost.

ABC INVENTORY PLANNING

When an organization’s inventory items are listed by their value of usage (their usage

is multiplied by their individual value), generally a small number of items accounts

for a high value of usage, and large number of items account for low value of usage. This phenomenon is known as the Pareto law, sometime referred to as 80/20 rule.

ABC classification scheme divides inventory items into three groupings:

Class A items are those of high-value items which account for around 80 per cent of the total stock value. Generally there are 20 per cent of inventory items in this category.

Class B items are those of medium value, usually the next 30 per cent of items which account for around 10 per cent of the total stock value.

Class C items are those low-value items comprising around 50 per cent of inventory items. These items value around 10 percent of the total stock value.

In controlling inventory, class A items should receive the attention first. One of the major costs of inventory is annual carrying costs; money is invested largely in class A. In managing inventory of class A items, more savings can be achieved through tight control and sound operating practices with a reasonable amount of time and effort. Fixed order quantity systems are more suitable for managing these

inventory items. Fixed time period model is suitable to manage the inventory of class

B and class C items. Class B items can be reviewed in shorter time period while

larger time period for class C items.

Example 10.8: ABC Classification

Table 10.2 lists a number of stock items according to decreasing value of usage. Table 10.3 groups these items into ABC classification and Pareto chart of ABC classification is given in Figure 10.7.

Table 10.2: Annual Usage of Inventory by Value

Inventory Management

173

 

Item Number

Unit Value

Annual Usage

Annual Value

Percentage of Total Value

 

(Rs.)

(Rs.)

 

P101

8,050

150

12,075,000

32.6

P301

1,095

956

10,468,200

28.2

P109

830

600

4,980,000

13.4

P121

211

1,500

3,165,000

8.5

P107

655

325

2,128,750

5.7

P205

25

5,000

1,250,000

3.4

P302

400

300

1,200,000

3.2

P256

435

150

652,500

1.8

P191

100

640

640,000

1.7

P408

89

354

315,060

0.9

P246

375

50

187,500

0.5

P369

112

75

84,000

0.2

P296

150

25

37,500

0.1

 

37,062,010

100.0

Table 10.3: ABC Grouping of Inventory Items

 
 

Classification

Item Numbers

Annual Value

Percentage of

 

(Rs.)

Total

 

A P101, P301, P109

 

27,523,200

74

B P121, P107, P205, P302,

7,743,750

21

C P256, P191, P408, P246, P369,

P296

1,916,560

5

 

Total

37,062,010

100

174 Operations Management: Concepts and Applications

% of total inventory value

80

70

60

50

40

30

20

10

0

A items B items C items 23 54 100
A items
B items
C items
23
54
100

% of total list of different stock items

Figure 10.6: ABC Inventory Classification

CHAPTER HIGHLIGHTS

Inventory control models discussed in this chapter mainly focuses on independent demand items.

Two main inventory control models are used for managing inventory: fixed order quantity models and fixed time period models.

Economic order quantity is a trade off between holding cost and order cost.

Safety stocks are maintained to cope up with demand and lead time uncertainties.

Price breaks are considered to decide the economic order quantity.

ABC classification is useful to decide the most appropriate inventory model.

DISCUSSION QUESTIONS

1. Why are inventories necessary? Discuss.

2. Name two purpose of carrying these inventories: (a) finished goods, (b) in- process, and (c) raw materials.

3. Compare and contrast fixed order quantity inventory systems with fixed order period inventory systems.

Inventory Management

175

4. What are the assumptions of the basic EOQ model and to what extent do they limit the usefulness of the model.

5. What are the purposes of safety stock? How will the use of safety stock affect the EOQ?

6. Explain

the

following

terms

and

discuss

their

importance

in

inventory

management.

 

a) Economic order quantity

 

b) Reorder point

 

c) Safety stock

7. Explain

following

applications

in

inventory

management

and

indicate

their

advantages.

a) Two bin system.

b) ABC inventory classification system.

PROBLEMS

1. A maintenance department of a manufacturing plant needs to plan inventories for frequently used maintenance part, a bearing. Under consideration is the order point and order quantity for this item. Average demand per week is 15 bearings and average lead time is 5 weeks. The plant operates under a policy of carrying 50 percent of expected demand during lead time as safety stock across all items in the same class as this bearing. Order cost is Rs. 1000 per order and holding cost is Rs. 25 per year per item. Determine

a) re-order level and

b) economic order quantity.

2. Mihiri fast-food uses 300 breakfast paper cartons per day. The outlet plans to be open 365 days a year. A box of 10 cartons costs Rs. 50; ordering cost is Rs. 180 per order and holding cost is 10% of cost per day. Delivery lead time is one day. Currently cartons are ordered every 14 days. Do you accept the current ordering system? If not, what is your proposed system? What is the amount of savings due to new system?

3. A grocery store carries a particular brand of fruit drink which has following details. Sales: 10 cases per week Ordering cost: Rs. 2,000 per order Inventory holding cost: 30% of cost per case per year Item cost: Rs. 6,000 per case

a) How many cases should be ordered at a time?

b) How often will the drink be ordered?

c) What is the total annual cost?

176 Operations Management: Concepts and Applications

Suppose that the grocery store is offered a price discount of 5% if 50 or more than 50 cases were ordered. Should the grocery take this discount offer?

4. Annual demand for a product is 13,000 units. It has been estimated that that the weekly demand is 250 units with a standard deviation of 50 units. The cost of placing an order is Rs 1000, and the time from ordering to receipt is 5 weeks. The annual inventory carrying cost is Rs 15 per unit. To provide a 98% service probability, what must the reorder point be? Suppose the production manager is told to reduce the safety stock of this item by 100 units. If this is done, what will the new service probability be?

5. Shakthi Food Products Ltd. (SFPL) produces a cereal which is manufactured from green-gram. SFPL wanted to decide an order quantity, to meet the annual demand at the lowest cost. The price of green-gram depends on the quantity ordered. The price break details and other data are as follows:

Price of the green-gram

:

Rs. 82 per kg up to 2499 kg.

Annual demand

:

Rs. 81 per kg for orders between 2500 and 5000 kg. Rs. 80 per kg for orders greater than 5000 kg. 50,000 kg per year

Holding cost

:

25% per unit per year of the price of the green-

Ordering cost

:

gram Rs. 3,000 / order

a) Calculate the best quantity that SFPL should purchase.

b) Graphically represent the variation of total cost with order quantity.