Inventory Management

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Production and Operations Management

Rajesh K Tyagi

Plan
Introduction to Inventory Management

ABC Classification
Inventory related Costs

Inventory Models Economic Order Quantity Economic Production Quantity Reorder Point System: introducing
Lead times Uncertainty

Periodic Review System (fixed-time-period)

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Inventory Management : Introduction

Marketing : Level of service Operations : stocks in sufficient quantities

Inventory Management

Finance : Cash flow and Cost of money

Information Systems : Inventory control systems

Judicial Aspects : Ownership and responsibility

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Types of Inventories
Raw materials Components (purchased parts) Partially completed goods: work in progress (WIP) Finished Goods M.R.O. (Maintenance, Repairs and Operating supplies)

Independent versus dependent demand

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Functions of Inventory
To meet anticipated demand (make-to-stock)

In-Transit inventory: goods being transported

To take advantage of order cycles or to take advantage of quantity discounts (cycle stock) To protect against stock-outs (safety stocks) To smooth production requirements (seasonal inventories)

To decouple production and distribution (WIP buffers) To help hedge against price increases (speculative inventories) Strategic flooding (?)
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Independent versus Dependent Demand

Independent demand
A Chair

B (1) Back subassembly

C (1) Seat subassembly

D (2) Front legs

E (4) Leg supports

Dependent demand

F (2) Back legs

G (4) Back slats

H (1) Seat frame

I (1) Seat cushion

J (4) Seat-frame boards

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ABC Analysis
Percentage of dollar usage value
100 90 Class A 80 70 60 50 40 30 20 Class B Class C

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90 100
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Percentage of items

ABC Classification : Guidelines

A Percentage of total number of items Percentage of total annual value ($) Inventory control Purchasing process B C

10 to 20 % 30 to 40 % 40 to 50 % 70 to 80 % 15 to 20 %
Rigourous Precise with constant revisions Normal Normal

5 to 10 %
Simple Periodical

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Inventory Related Costs

Acquisition Cost Holding (carrying) Cost Ordering (set-up) Cost Shortage Cost

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Acquisition Cost

Price paid to acquire the product. Can be subject quantity discounts

Quantity 1 99 100 499 500 et +

Price 12.75 $ 11.48 $ 10.20 $

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Holding (Carrying) Cost

Total holding cost is composed of a multitude of costs which vary depending on the type of product stocked. It includes:
Cost of money / opportunity cost (3-24%) Obsolescence (2-20%) Spoilage / Damage (1-5%) Warehousing (1-3%) Insurance / Administration / Maintenance (1-5%)

Total ~ 8-50% (1224%)

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Ordering Cost
Order processing

Supplies / Forms
Clerical support Receiving / Inspection Follow up / Expediting For manufacturing
Clean-up cost
Re-tooling cost Adjustment cost

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Shortage Cost
Reputation of the company; Loss of orders / profits Increase in the costs: Overtime/ sub-contracting Additional delivery Purchasing price premium Idle machinery and human resources Etc

IMPACT ON THE CUSTOMER... DIFFICULT TO DETERMINE

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Inventory Models

Two questions:

How Much to order? When to order ?

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Basic Economic Order Quantity (EOQ): Principles

Assumptions of the basic EOQ model Only one product is involved Annual demand requirements are known

Demand is spread evenly throughout the year (constant demand rate)

Lead time does not vary Each order is received in a single delivery There are no quantity discounts

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EOQ: cycle inventory levels (graphical)

Inventory Level
Order Quantity (large Q)

Inventory Level
Order Quantity (small Q)

Time
Smaller Q more orders, but lower inventory

Time
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Total (Annual) Ordering Cost

Annual Ordering Cost
Number of Orders =

Number of Orders

Cost per X Order

Annual Demand Lot Size

D OC xS Q
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Annual Holding (Carrying) Cost

Holding cost = Average Inventory x Annual Holding Cost per Unit Average CYCLE inventory = Lot Size 2 Holding cost per unit = % Holding Cost X Unit Cost

Q HC x H 2

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Basic Economic Order Quantity : Model

Total Annual Cost

Q D TC H S D C 2 Q
Annual Holding Cost Order of set-up cost Total acquisition cost

TC : Total annual cost

D : Total annual demand Q : Quantity ordered H : Unit holding cost S : Order or set-up cost C: Unit cost (price)
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Basic Economic Order Quantity : Principles TOTAL COST

Costs $ TOTAL ANNUAL HOLDING COSTS

TOTAL ANNUAL ORDER COSTS EOQ

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QUANTITY (UNITS)
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E.O.Q. = Minimum Total Cost

The total cost curve reaches its minimum where the carrying and ordering costs are equal.

2DS 2(AnnualDemand)(Or or Setup Cost) der EOQ = = H AnnualHolding Cost

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E.O.Q. - Example
A toy manufacturer uses approximately 32 000 silicone pieces per year. The pieces are used at a constant rate over 240 working days each year. Annual holding cost is 0,6$/u and ordering cost is 24$. Determine the economic order quantity as well as the total annual cost of this item.
EOQ = 2DS 2(AnnualDemand)(Or der or Setup Cost) = H AnnualHolding Cost

= 1600 pieces
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E.O.Q. Example
Omega is a company which manufactures megaphones. The company buys its speakers at a cost of $ 20 each. With each order, Omega must spend $ 50 (preparation of the purchase order, delivery, receiving, etc...). The annual demand for speakers is 10 000 units and the annual carrying cost is 20 % of the unit cost. Which quantity would minimize the annual total cost?

2 x 10 000 x $50 = 500 20% x $20

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Criticisms of EOQ
Successfully applied to many environments (where the underlying assumptions reasonably hold) E.g. used in setting lot sizes in batch manuf. environments, MRP type systems, managing input buffers, etc.

Simple system illustrating the economic trade-off between setups, inventory, demand.
Too simplified?

Stable and known demand

Independent products (ignores resource constraints) Setup costs are hard to estimate (True cost of a setup depends on the capacity utilization)
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Role of Lead time L:

The lead time from when The South Face places an order to when the order is received is one and a half weeks. If demand is stable as before, when should The South Face place an order?
Q

Inventory on hand Reorder point Receive order

Place Receive order order Lead time (L)

Place Receive order order

Time

Replenishment lead time : L Reorder point: ROP = D*L 25

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Introducing Lead Times

Q
Quantity on hand Profile of Inventory Level Over Time

Demand rate

Reorder point

Receive order

Place Receive order order

Place Receive order order

Time

Lead time
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Insights
Fixed order cost reduction & JIT Lowering fixed costs results in smaller order quantities and reduced inventory and flow time. Square root effect: Quadrupling outflow rate will only double the EOQ (and inventory and flow time) Inventory growth should not track sales growth proportionally! 100% increase in demand requires a 41% increase in cycle inventory (but order more frequently) Centralization
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Economic Production Quantity (EPQ)

Production done in batches or lots

Capacity to produce a part exceeds the parts usage or demand rate Assumptions of EPQ are similar to EOQ except orders are received incrementally during production

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Economic Production Quantity (EPQ)

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Centura health example (1)

Delivery network with 9 hospitals Currently each hospital manages its own inventory IV starter kit
Weekly demand: 600 units Cost: $3 Yearly Holding cost per unit: 30% = $0.9 Fixed order cost: $130 Lead time: 1 week

Current policy: each hospital orders 6000 units What happens if the frequence of ordering is changed? What happens if the order process is organized from a single warehouse?
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Centura Health Example (2)

R = 31.200 units per year

Yearly cost of the current policy (Q = 6000)

Annual Fixed Order Cost: $130 * 31.200/6000 = $676 Total Annual Holding Cost : $0.9 * 3.000 = $2.700

Total annual cost of material: $3 * 31.200 = $93.600

Total batch-dependent costs : $3.376 Total annual cost: $96.976

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Centura Health Example (3)

Optimal order quantity:

2SD 2 * $130 * 31.200 Q 3.002 H $0.9

*

Total batch dependent cost: $2.702 Total cost: $96.302 Time between orders = 4.86 weeks

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Problems
Solved problem #1 (p. 427)
To solve: Page 433 (p.550) #3 To solve: Page 433 (p.550) #6

The challenge of inventory management

Managers must avoid these two traps
Too much stock (overstock) Very costly (warehousing, insurance, staff, etc...) ; Immobilization of funds ; May cause cash-flow problems ; Increased risks of deterioration or obsolescence of products; May cause sales below cost.
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Not enough stock (shortages) Increased risks of stock-outs causing production delays;

Disruptions in the operations (bottlenecks, overtime, rushes) ;

Causes delays and shortages and increased lead times to customers.

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Readings:
Readings :
S&H 2007, chap. 11 pp 391-404 Learning goals Difference between independent and dependant demand; Types and functions of inventory;

Techniques of Inventory management- ABC classification; periodic review system and EOQ
EOQ- what is EOQ, how to use EOQ, rationale behind EOQ, how to use EOQ What is reorder point system; What is periodic review system; Probabilistic demand and calculation for safety stocks
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