POM 370

Materials Management

Materials Management
Importance
Component of cost of goods sold (COGS) Labor component of COGS declining Significant increase in cost of materials

Direct Indirect (overhead)

Materials Management
Enterprise
Finished-goods Storage
Orders Purchasing Raw-material Storage Transformation Processes Receiving

Customers

Suppliers

Distribution

In-process Storage
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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

Inventory
What is inventory?
Stock of materials Stored Capacity Examples:

Inventory
Functions of inventory:
To meet anticipated customer demand To decouple suppliers production

distribution To take advantage of quantity discounts To hedge against inflation & price increases To protect against delivery variations To avoid production disruptions through use of Work-In-Process (WIP)
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Inventory
Negative aspects of inventory:
Large inventories hide operational problems Financial cost in carrying excess inventories Risk of damage to goods held in inventory Risk of product obsolescence

Inventory
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
Necessary to keep machinery and processes productive Completed product awaiting shipment
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Maintenance/repair/operating (MRO)

Finished goods

Inventory
Examples:
Raw material

Iron ore steel mill Flour bakery Radiator auto manufacturer Draft contract attorney

Work-in-process

Inventory
Examples:
Maintenance / repair / operating supplies

(MRO)

Lubricating oil machine shop Soap and shampoo hotel Candy bar confectioner Policy insurance company

Finished goods

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Inventory
Transformation Process

Raw Materials Vendors Work in process

Finished goods Customers

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Water Tank Analogy

Inventory Level Supply Rate

Inventory Level

Demand Rate
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ABC Analysis
How inventory items can be classified
How accurate inventory records can be

maintained

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ABC Analysis
Divides inventory into three classes based on

annual dollar volume

Class A - high annual dollar volume

Class B - medium annual dollar volume

Class C - low annual dollar volume

Used to establish policies that focus on the

few critical parts and not the many trivial ones

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ABC Analysis
% Annual $ Usage
100 80 60 40 20 0

Class A B C

% $ Vol 80 15 5

% Items 15 30 55

A B
0 50

C
100
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% of Inventory Items

ABC Analysis
Percent of Item Number Stock of Items Number Stocked #10286 #11526 #12760 #10867 #10500 30% 20% Annual Volume (units) 1,000 500 1,550 350 1,000 Unit Cost $ 90.00 154.00 17.00 42.86 12.50 Annual Dollar Volume $ 90,000 77,000 26,350 15,001 12,500 Percent of Annual Dollar Volume 38.8% 33.2% 11.3% 6.4% 5.4% 23% 72%

Class
A A B B B
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ABC Analysis
Percent of Item Number Stock of Items Number Stocked #12572 #14075 #01036 #01307 #10572 50% Annual Volume (units) 600 2,000 100 1,200 250 Unit Cost $ 14.17 .60 8.50 .42 .60 Annual Dollar Volume $ 8,502 1,200 850 504 150 Percent of Annual Dollar Volume 3.7% .5% .4% .2% .1% 5%

Class
C C C C C
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ABC Analysis
Percent of annual dollar usage

80 70 60 50 40 30 20 10 0

A Items B Items | | | | 10 20 30 40

C Items
| | | | | |

50

60

70

80

90 100

Percent of inventory items

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ABC Analysis
Other criteria than annual dollar volume may

be used

Key accounts

Anticipated engineering changes

Delivery problems Quality problems

High unit cost

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ABC Analysis
Policies employed may include

More emphasis on supplier development for A items

Tighter physical inventory control for A items

More care in forecasting A items

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Cycle Counting
Items are counted and records updated on a

periodic basis
Often used with ABC analysis to determine

cycle

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Cycle Counting
Has several advantages

Eliminates shutdowns and interruptions Eliminates annual inventory adjustment Trained personnel audit inventory accuracy Allows causes of errors to be identified and corrected Maintains accurate inventory records

22

Cycle Counting
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C items Policy is to count A items every month (20 working days), B items every quarter (60 days), and C items every six months (120 days)
Item Class A B C Quantity 500 1,750 2,750 Cycle Counting Policy Each month Each quarter Every 6 months Number of Items Counted per Day 500/20 = 25/day 1,750/60 = 29/day 2,750/120 = 23/day 77/day
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Control of Service Inventories

Can be a critical component of profitability
Losses may come from shrinkage or pilferage Applicable techniques include

Good personnel selection, training, and discipline Tight control on incoming shipments Effective control on all goods leaving facility
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Control of Service Inventories

Shrinkage

Unaccounted retail inventory between receipt and sale Due to damage, theft and sloppy paperwork Theft also known as pilferage Accounts for 1% to 3% of sales

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Control of Service Inventories

Controls

Good personnel selection, training, and discipline Tight control of incoming shipments Effective control of all goods leaving the facility

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Types of Demand
Independent demand - the demand for item is

independent of the demand for any other item in inventory

Refrigerator goods Hamburger services

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Types of Demand
Dependent demand - the demand for item is

dependent upon the demand for some other item in the inventory

Ice maker goods Ketchup services

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Materials Costs
Holding costs - associated with holding or

carrying inventory over time

Setup costs - associated with costs of placing

order and receiving goods

Out-of-stock costs - cost of back order and cost

of lost sales

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Holding Costs
Obsolescence
Insurance Extra staffing Cost of money (opportunity costs) Pilferage

Damage
Warehousing
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Holding Costs
Category Housing costs (including rent or depreciation, operating costs, taxes, insurance)
Cost (and Range) as a Percent of Inventory Value

6% (3 - 10%)

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

3% (1 - 3.5%)
3% (3 - 5%) 11% (6 - 24%) 3% (2 - 5%)

Overall carrying cost

26%
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Setup Cost
Supplies
Forms Order processing Clerical support

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Independent Demand Models

Fixed order-quantity models

Economic order quantity (EOQ) Production order quantity (POQ) Quantity discount

Help Helpanswer answerthe the inventory inventoryplanning planning questions! questions!

Probabilistic models Fixed order-period models

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EOQ Model
EOQ assumptions:
Known and constant demand Known and constant lead time Instantaneous receipt of material No quantity discounts

Only order (setup) cost and holding cost

No stockouts
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EOQ Model
EOQ inventory over time:
Order quantity = Q (maximum inventory level) Inventory Level Usage Rate Average Inventory (Q*/2)

Minimum inventory 0

Time
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EOQ Model
EOQ Order Quantity:
Annual Cost

Minimum total cost

Order (Setup) Cost Curve Optimal Order Quantity (Q*)

Order quantity
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EOQ Model
Q Q* D S H

Annual setup cost =

D S Q

= 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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EOQ Model
Q Q* D S H

D S Q Q Annual holding cost = H 2 Annual setup cost =

= 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
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EOQ Model
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*

2DS = Q2H Q2 = 2DS/H

Q* =

2DS/H
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EOQ Model - 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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EOQ Model - 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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EOQ Model - 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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EOQ Model - 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 TC = TC = D Q S + H Q 2 1,000 200 ($10) + ($.50) 200 2

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

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POQ Model
Answers how much to order and when to

order Allows partial receipt of material

Other EOQ assumptions apply Material produced, used immediately Provides production lot size

Suited for production environment

Lower holding cost than EOQ model

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Quantity Discount Model

Answers how much to order & when to order
Allows quantity discounts

Reduced price when item is purchased in larger quantities Other EOQ assumptions apply

Trade-off is between lower price & increased

holding cost

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Probabilistic Model
Answer how much & when to order
Allow demand to vary

Follows normal distribution

Other EOQ assumptions apply

Consider service level & safety stock

Service level = 1 - Probability of stockout Higher service level means more safety stock
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Fixed Period Model

Answers how much to order
Orders placed at fixed intervals

Inventory brought up to target amount Amount ordered varies Possibility of stockout between intervals Example: Paul Mitchell representative calls on salon every two weeks
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No continuous inventory count

Useful when vendors visit routinely