Operations Management

Chapter 12 Inventory Management

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Inventory
One of the most expensive assets of many companies representing as much as 50% of total invested capital

Operations managers must balance inventory investment and customer service

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Types of Inventory
Raw material
Purchased but not processed

Work-in-process
Undergone some change but not completed A function of cycle time for a product

Maintenance/repair/operating (MRO)
Necessary to keep machinery and processes productive

Finished goods
Completed product awaiting shipment
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Holding, Ordering, and Setup Costs

Holding costs - the costs of holding or carrying inventory over time

Ordering costs - the costs of placing an order and receiving goods

Setup costs - cost to prepare a machine or process for manufacturing an order
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Holding Costs
Housing costs (including rent or depreciation, operating costs, taxes, insurance) Material handling costs (equipment lease or depreciation, power, operating cost) Labor cost Investment costs (borrowing costs, taxes, and insurance on inventory) Pilferage, space, and obsolescence
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Table 12.1
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Inventory Models for Independent Demand

Need to determine when and how much to order Basic economic order quantity

Production order quantity

Quantity discount model

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Basic EOQ Model

Important assumptions
1. Demand is known, constant, and independent 2. Lead time is known and constant 3. Receipt of inventory is instantaneous and complete 4. Quantity discounts are not possible 5. Only variable costs are setup and holding 6. Stockouts can be completely avoided
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Inventory Usage Over Time

Order quantity = Q (maximum inventory level) Usage rate Average inventory on hand Q 2

Inventory level

Minimum inventory

Time
Figure 12.3
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Minimizing Costs
Objective is to minimize total costs
Curve for total cost of holding and setup Minimum total cost Annual cost Holding cost curve

Setup (or order) cost curve Optimal order quantity Order quantity
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Table 11.5
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D The EOQ Model setup cost = Q S Annual

Q Q* D S H

= Number of pieces per order = Optimal number of pieces per order (EOQ) = Annual demand in units for the Inventory item = Setup or ordering cost for each order = Holding or carrying cost per unit per year Annual setup cost = (Number of orders placed per year) x (Setup or order cost per order) Annual demand Setup or order = Number of units in each order cost per order = D (S) Q
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D The EOQ Model setup cost = Q S Annual

Annual holding cost =

Q Q* D S H

= Number of pieces per order = Optimal number of pieces per order (EOQ) = Annual demand in units for the Inventory item = Setup or ordering cost for each order = Holding or carrying cost per unit per year Annual holding cost = (Average inventory level) x (Holding cost per unit per year) = Order quantity (Holding cost per unit per year) 2 Q (H) 2

Q H 2

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D The EOQ Model setup cost = Q S Annual

Annual holding cost =

Q Q* D S H

= Number of pieces per order = Optimal number of pieces per order (EOQ) = Annual demand in units for the Inventory item = Setup or ordering cost for each order = Holding or carrying cost per unit per year Optimal order quantity is found when annual setup cost equals annual holding cost D Q S = H Q 2 Solving for Q*

Q H 2

2DS = Q2H Q2 = 2DS/H Q* = 2DS/H

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An EOQ Example
Determine optimal number of needles to order D = 1,000 units S = $10 per order H = $.50 per unit per year

Q* = Q* =

2DS H 2(1,000)(10) = 0.50 40,000 = 200 units

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An EOQ Example
Determine optimal number of needles to order D = 1,000 units Q* = 200 units S = $10 per order H = $.50 per unit per year Expected Demand D number of = N = = Order quantity Q* orders 1,000 N= = 5 orders per year 200

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An EOQ Example
Determine optimal number of needles to order D = 1,000 units Q* = 200 units S = $10 per order N = 5 orders per year H = $.50 per unit per year Number of working Expected days per year time between = T = N orders T= 250 = 50 days between orders 5

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An EOQ Example
Determine optimal number of needles to order D = 1,000 units Q* = 200 units S = $10 per order N = 5 orders per year H = $.50 per unit per year T = 50 days Total annual cost = Setup cost + Holding cost

D Q S + H Q 2 1,000 200 TC = ($10) + ($.50) 200 2

TC = TC = (5)($10) + (100)($.50) = $50 + $50 = $100
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Robust Model
The EOQ model is robust
It works even if all parameters and assumptions are not met

The total cost curve is relatively flat in the area of the EOQ

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Reorder Points
EOQ answers the how much question The reorder point (ROP) tells when to order

ROP =

Lead time for a Demand per day new order in days

=dxL
D d = Number of working days in a year
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Reorder Point Curve

Inventory level (units) Q*

Slope = units/day = d

ROP (units)

Figure 12.5
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Time (days) Lead time = L

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Reorder Point Example

Demand = 8,000 DVDs per year 250 working day year Lead time for orders is 3 working days

D d= Number of working days in a year

= 8,000/250 = 32 units ROP = d x L

= 32 units per day x 3 days = 96 units

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Production Order Quantity Model

Used when inventory builds up over a period of time after an order is placed Used when units are produced and sold simultaneously

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Production Order Quantity Model

Inventory level Part of inventory cycle during which production (and usage) is taking place

Maximum inventory

Demand part of cycle with no production

Time
Figure 12.6

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Production Order Quantity Model

Q = Number of pieces per order H = Holding cost per unit per year D = Annual demand p = Daily production rate d = Daily demand/usage rate

Setup cost = (D/Q)S Holding cost = 1/2 HQ[1 - (d/p)] (D/Q)S = 1/2 HQ[1 - (d/p)] Q2 2DS = H[1 - (d/p)] 2DS H[1 - (d/p)]
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Q* =
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Production Order Quantity Example

D = 1,000 units S = $10 H = $0.50 per unit per year Q* = p = 8 units per day d = 4 units per day

2DS H[1 - (d/p)] 2(1,000)(10) 0.50[1 - (4/8)]

= 80,000

Q* =

= 282.8 or 283 hubcaps

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Quantity Discount Models

Reduced prices are often available when larger quantities are purchased Trade-off is between reduced product cost and increased holding cost
Total cost = Setup cost + Holding cost + Product cost TC = D QH S+ + PD Q 2

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Quantity Discount Models

A typical quantity discount schedule
Discount Number
1 2 3 Discount Quantity 0 to 999 1,000 to 1,999 2,000 and over Discount (%) no discount 4 5

Discount Price (P)

$5.00 $4.80 $4.75
Table 12.2

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Quantity Discount Models

Steps in analyzing a quantity discount
1. For each discount, calculate Q*

2. If Q* for a discount doesnt qualify, choose the smallest possible order size to get the discount
3. Compute the total cost for each Q* or adjusted value from Step 2 4. Select the Q* that gives the lowest total cost
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Quantity Discount Example

Calculate Q* for every discount
Q* = 2DS IP

Q1* =
Q2* = Q3* =
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2(5,000)(49) = 700 cars order (.2)(5.00) 2(5,000)(49) = 714 cars order (.2)(4.80) 2(5,000)(49) = 718 cars order (.2)(4.75)
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Quantity Discount Example

Calculate Q* for every discount
Q* = 2DS IP

Q1* =
Q2* = Q3* =
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2(5,000)(49) = 700 cars order (.2)(5.00) 2(5,000)(49) = 714 cars order (.2)(4.80) 1,000 adjusted 2(5,000)(49) = 718 cars order (.2)(4.75) 2,000 adjusted
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Quantity Discount Example

Discount Number 1 2 3 Unit Price $5.00 $4.80 $4.75 Order Quantity 700 1,000 2,000 Annual Product Cost $25,000 $24,000 $23.750 Annual Ordering Cost $350 $245 $122.50 Annual Holding Cost $350 $480 $950 Total $25,700 $24,725 $24,822.50
Table 12.3

Choose the price and quantity that gives the lowest total cost Buy 1,000 units at $4.80 per unit
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