Inventory Management

Inventory: a stock or store of goods

Independent Demand

Dependent Demand

B(4)

C(2)

D(2)

E(1)

D(3)

F(2)

Independent demand is uncertain. Dependent demand is certain.

Independent Demand
Independent demand items are finished products or

parts that are shipped as end items to customers. Forecasting plays a critical role Due to uncertainty- extra units must be carried in inventory

Dependent Demand
Dependent demand items are raw materials, component

parts, or subassemblies that are used to produce a finished product.

Inventory Management involves the control of assets being produced for the purpose of sale in the normal course of the cos operations. Inventory Management Motives: 1. The Transaction Motives: Includes smooth production of goods and sale of goods. 2. The precautionary Motives: This motive necessities the holding of inventories for unexpected changes in demand an supply factors. 3. The Speculative Motive: This compels to hold some inventories to take the advantage of changes in prices and getting quality discounts

Components of Inventory

Raw Materials

Work In Progress

Finished Products

Stores & Spares

Functions of Inventory
To meet anticipated demand To smooth production requirements To protect against stock-outs To help hedge against price increases To permit operations

To take advantage of quantity discounts

Objective of Inventory Control

To achieve satisfactory levels of customer service

while keeping inventory costs within reasonable bounds

Level of customer service Costs of ordering and carrying inventory

Two Fundamental Inventory Decisions

How much to order of each material when orders are

placed with either outside suppliers or production departments within organizations When to place the orders

Inventory Control Systems

Periodic System (P System) Physical count of items made at fixed intervals Fixed time period system

Inventory Control Systems

Perpetual Inventory System (fixedorder-quantity) (Q System)
a. System that keeps track of removals from inventory continuously, thus monitoring current levels of each item b. Constant amount ordered when inventory declines to predetermined level
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Key Inventory Terms

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 Ordering costs: costs of ordering and receiving inventory Shortage costs: costs when demand exceeds supply

Ordering Cost Order placing Transportation Receiving, Inspecting and storing Clerical and staff

Carrying Cost Warehousing Handling Clerical and staff Insurance Deterioration and Obsolescence

Ordering and Carrying cost trade off

The optimum inventory size is commonly referred to as economic order quantity

1. Trial and error approach 2. Order formula 3. Graphical approach

Economic Order Quantity

Definition of EOQ How to use the EOQ model in a business

organization How the EOQ model works Real world example

The Definition of EOQ

EOQ, or Economic Order Quantity, is defined as the optimal quantity of orders that minimizes total variable costs required to order and hold inventory.

Assumptions of EOQ Model

Only one product is involved Annual demand requirements known

Demand is even throughout the year

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

The Inventory Cycle

Q
Quantity on hand Profile of Inventory Level Over Time

Usage rate

Reorder point

Receive order

Place Receive order order

Place Receive order order

Time

Lead time

How to use EOQ in your organization

How much inventory should we order each month?

The EOQ tool can be used to model the amount of inventory that we should order each month.

How EOQ Works

The Principles Behind EOQ: The Total Cost Curve

&

How EOQ Works

The Principles Behind EOQ: The Holding Costs Keeping inventory on hand Interest Insurance

Taxes
Theft Obsolescence Storage Costs

How EOQ Works

The Principles Behind EOQ: The Holding Costs

Interest

Obsolescence

Storage

How EOQ Works

The Principles Behind EOQ: The Procurement Costs Primarily the labor costs associated with processing the order: Ordering and requisition A portion of the freight if the amounts according to the size of the order Receiving, inspecting, stocking Invoice processing vary

Trial and Error Approach:

Estimated annual requirement, A Purchasing cost per unit, P (Rs) Ordering cost (per order), O Carrying cost per unit, C

1200 units 50 37.5 1

1. Purchase entire requirement in the beg. of the year in a single lot

2. Or 12 monthly lots of 100 units each.

1. Purchase entire requirement in the beg. of the year in a single lot Starting of the year End of the year Average inventory Average Value 2. 100 units every month Start of the month End of the month Average Inventory Average Value 100 0 50 Units 50*50 = 1200 0 600 units 600*50 =

30000 Rs

2500 Rs

Order Size (Q) Average Inventory(Q/2) No of orders (A/Q) Annual Carrying Cost ( cQ/2)

1200 600 600 1 600 300 2 300 75

400 200 3 200 112.5

300 150 4 150 150

240 120 5 120 187.5

200 100 6 100 225

150 75 8 75 300

120 60 10 60 375

100 50 12 50 450

Annual Ordering 37.5 Costs (OA/Q)

Total Annual Costs

637.5 375

312.5

300

307.5

325

375

435

500

Total Ordering Cost : Annual Req/Order Size * per order cost

No. of orders

TOC = AO/Q

Total Carrying Costs = Average Inventory * per unit carrying cost

Average Inventory = Order Size/2

TCC = QC/2

TC = QC/2 + AO/Q

Differentiate equation with respect to Q to get EOQ formula

Balancing Carrying against Ordering Costs

Annual Cost ($)
Higher Minimum Total Annual Stocking Costs Total Annual Stocking Costs Annual Carrying Costs Annual Ordering Costs Smaller EOQ Larger Order Quantity

Lower

How EOQ Works

The Total Cost Formula

TC = QC/2 + AO/Q
Total Cost = Order Cost + Carrying Cost

EOQ = 2 * quantity required* ordering Cost Carrying Cost EOQ = 2AO/c

How EOQ Works

The Total Cost Formula

This represents the variable holding costs

P = Purchase cost per unit R = Forecasted monthly usage C = Cost per order event (not per unit) Q = The number of units ordered F = Holding cost factor

How EOQ Works

The EOQ Formula Total Cost Formula

Taking the derivative of both sides of the equation and setting equal to zero to find the minimum value of the function, one obtains:

How EOQ Works

The EOQ Formula The result of differentiation

The Economic Order Quantity

Q . The

following details are available in respect of a firm:

Annual requirement of inventory, 40000 units Cost per unit(other than carrying and ordering cost), Rs16 Carrying costs are likely to be 15% per year Cost of placing order, Rs 480 per order

Determine the EOQ

EOQ = 2AO/C

= (2 * 40000 *480)/2.4
= 4000 Units

Quantity Discount: Q2. Economic Enterprises require 90000 units of certain items annually. The cost per purchase order is Rs 300 and the inventory carrying is Rs 6 per unit per year. A. What is EOQ B. What should the firm do if the suppliers offer discounts as detailed below: Order Quantity 4500- 5999 6000 and above Discount 2% 3%

A. EOQ = 2AO/C
= (2* 90000* 300)/6 = 3000 Units

1 2 3 4 5 6 7 8 9

Order size (units) Average Inventory (Units) Annual Requirement (units) Number of orders Price per Unit (Rs) Cost of purchase Carrying Cost @ Rs 6 per unit Total Ordering Cost Total Cost

3000 1500 90000 30 3 270000 9000 9000 288000

4500 2250 90000 20 2.94 264600 13500 6000 284100

6000 3000 90000 15 2.91 261900 18000 4500 284400

The TC is min at the order size of 4500 units and therefore , the firm should place order For 4500 units

Q3. G ltd produces a product which has a monthly demand of 4000 units. The Product requires a component X which purchased at Rs 20. For every finished product, one unit of component is required. The ordering cost is Rs 120 per order and the holding cost is 10% per annum. You are required to calculate: 1. EOQ 2. If the minimum lot size to be supplied is 4000 units, what is the extra cost, the company has to incur. 3. What is the min carrying cost, the company has to incur. 1. EOQ = 2AO/C = (2 * 48000 * 120)/2 = 2,400 Units

1 2 3 4 5 6 7 8 9

Particulars Annual usage Size of order No. of Orders Cost per order Total ordering costs Carrying cost per unit annum Average inventory (Size of order/2) Total Carrying cost Total costs

4000 Units 48000 4000 12 120 1440 2 2000 4000 5440

2400 Units 48000 2400 20 120 2400 2 1200 2400 4800

Extra cost to be incurred is Rs 640 (Rs 5440 -4800), when the order size is 4000 units

Re Order Point:: That Inventory level at which an order should be placed to replenish the inventory

ROP = Lead time * Average Usage

Suppose EOQ is 500 units , lead time is three weeks and average usage is 50 units/week IF NO Lead time than New order will be placed at 10th Week (500/50) But as lead time is 3 weeks so new order will be placed at end of 7th week ROP = 3 * 50 = 150 Units

Safety Stocks
Safety stock
buffer added to on hand inventory during lead time

Stockout
an inventory shortage

Service level
probability that the inventory available during lead time will meet demand

Copyright 2006 John Wiley & Sons, Inc.

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Reorder Point with a Safety Stock

Inventory level

Q
Reorder point, R

Safety Stock

0 LT
Copyright 2006 John Wiley & Sons, Inc.

LT Time

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Re Order Point = Lead time* Average usage + Safety Stock

Q. A firms estimated demand for a material during the next year is 2500 units. Acquisition costs are Rs 400 per order and carrying cost is Rs 50 per unit. The Safety Stock is set at 25% of the EOQ. The daily usage is 10 units and lead time is 10 days. Determine (a) the EOQ (b) the safety stock, and the ( c ) the reorder point.

Annual material requirement (units) Acquisition cost per order (Rs) Carrying cost per unit (Rs) EOQ (units): 2400x 2,500 50 Safety stock: 0.25 x EOQ Daily usage Lead time (days) Usage during lead time (units) Re-order point (units) (Safety stock + lead time)

2,500 400 50 200

50 10 10 100 150

Minimum level is that level that must be maintained always, if it is less than production Will be disturbed. Min Stock Level = Re order level ( Normal Usage * Average delivery time) Maximum level of stock, is that level of stock beyond which a firm should not maintain The stock. Max. Stock level = ROL + ROQ (min usage * Min delivery time)

Q. Two Components A and B used as follows; Normal usage: Minimum Usage Maximum usage Re Order Quantity Re order Period 50 units each per week 25 units each per week 75 units each per week A 300 Units; B 500 Units A: 4 to 6 weeks; B 2 to 4 weeks

Calculate for each component a. Reorder level b. Min Level c. Max Level d. Average stock level

a. Re order level: Maximum usage * Max delivery time A = 75* 6 weeks B = 75*4 weeks = 450 Units = 300 Units

b. Minimum Level = ROL (normal usage * Average delivery time in weeks) A = 450 units (50 units * 5 weeks) = 200 Units B = 300 units (50 units * 3 weeks) = 150 units c. Maximum level = ROL + ROQ (min usage * min delivery time) A = 450 units (25 * 4) + 300 units = 650 units B = 300 units (25*2) + 500 units = 750 units

Safety Stock
Quantity

Maximum probable demand during lead time Expected demand during lead time

ROP

Safety stock reduces risk of stockout during lead time

Safety stock
LT Time

Tools and techniques of Inventory Management: 1. 2. 3. 4. 5. 6. 7. 8. ABC Analysis EOQ Two Bin Techniques VED Classification (Vital, Essential and Desirable) HML Classification (High, Medium , low) SDE Classification ( Scarce, difficult and easy) FSN Classification (Fast moving, slow and non moving) JIT

ABC Classification
Typical observations A small percentage of the items (Class A) make up a large percentage of the inventory value A large percentage of the items (Class C) make up a small percentage of the inventory value These classifications determine how much attention

should be given to controlling the inventory of different items Control by importance and Exception (CIE) Selective control system

ABC Analysis
A firm, which carries a number of items in inventory which

differ in value, can follow a selective control system. The firm should, therefore, classify inventories to identify which items should receive the most efforts in controlling. A selective control system, such as the A-B-C analysis, (known as Always Better Control), classifies inventories into three categories according to the consumption value of items: A Category consists of highest value items, C category consists of lowest value items; and B category consists of high value items. Tight control may be applied on A category of items, and relatively loose control for C category of items

ABC Classification System Items kept in inventory are not of equal importance in
terms of:

dollars invested profit potential sales or usage volume stock-out penalties

% of Use % of $ Value 30
0 30 60 60

A
B C

The following steps are involved in implementing the ABC analysis. Classify the items of inventories, determining the expected use in units and the price per unit for each item. Determine the total value of consumption. Rank the items in accordance with total consumption value in ascending order. Compute the ratios or percentages of number of items of each item to total units of all items, and the ratio of total value of each item to total value of all items. Combine items on the basis of their value to form three categories A, B and C.

Illustration:

Item Units

% of Cumulative Unit total Price Rs.

Total Costs Rs.

% of Cumulative Total

1
2 3 4 5 6 7

10,000 5,000
16,000 14,000 30,000 15,000 10,000

10 } 5 } 15%
16 } 14 } 30% 30 } 15 } 55% 10 }

15%

30.40 51.20
5.50 5.14 1.70 1.50 0.65

3,04,000 2,56,000
88,000 72,000 51,000 22,500 6,500 800,000

38 } 32 }
11 } 09 } 6.38 } 2.81 } 0.81 }

70%

45%

90%

100%

100%

Total 100,000

How EOQ Works

The EOQ Formula Review and Summary of the EOQ Formula Here is the a graphic representation of the EOQ equation

Real Life Example:

Real Life Example:

Real Life Example:

First, Recall the EOQ Equation:

P = Purchase cost per unit R = Forecasted monthly usage C = Cost per order event (not per unit) F = Holding cost factor

Real Life Example:

Next lets identify the correct variables

Real Life Example:

Next lets identify the correct variables
Forecasted Amount

Real Life Example:

Next lets identify the correct variables
Ordering Costs

Real Life Example:

Next lets identify the correct variables
Cost per Unit

Real Life Example:

Next lets identify the correct variables

Holding Cost Factor

Real Life Example:

R = Annual demand C = Fixed ordering cost

P = Cost per case

F = Holding Cost Factor

Real Life Example:

R = 5200 C = $10 per order P = $2 F = 20% of value of inventory per year

Real Life Example:

R = 5200 C = $10 per order P = $2

EOQ =

2 (10) (5200)

(2 )(.20)

F = 20% of value of inventory per year

Real Life Example:

EOQ =

2 (10) (5200) (2 )(.20)

EOQ = 510 cases

Wrapping It Up EOQ, or Economic Order Quantity, is defined as the

optimal quantity of orders that minimizes total variable costs required to order and hold inventory.

Closing Comments
EOQ is a tool, not a simple solution.
EOQ is useful in determining optimal order quantity Understand the equation and what you are trying to

find Find accurate inputs for the equation