Inventory System

Defined
Inventory is the stock of any item or resource
used in an organization and can include: raw
materials, finished products, component parts,
supplies, and work-in-process
An inventory system is the set of policies and
controls that monitor levels of inventory and
determines what levels should be maintained,
when stock should be replenished, and how
large orders should be
Purposes of Inventory
1. To maintain independence of operations
2. To meet variation in product demand
3. To allow flexibility in production scheduling
4. To provide a safeguard for variation in raw
material delivery time
5. To take advantage of economic purchase-order
size
3
Uses of Inventory
Inventory
To satisfy the
expected customer
demand (Anticipation
Inventory)
To provide buffer between
successive operations
(Decoupling Inventory or
Work-in-process
Inventory)
To protect against
price increases
and to take
advantage of
Quantity
Discounts
To satisfy periods of
seasonal high demand
(Seasonal Inventory)
To avoid stock
outs (Safety Stock
or Buffer Stock)
To minimize the
total cost by
ordering the
Economic Order
Quantity
(Cycle Stock)
To act as a buffer between
various elements of the Supply-
Chain (Suppliers-Producers-
Distributors-Wholesalers-
Retailers-Customers) (Pipeline
or Transit Stock)
E(1)
Independent vs. Dependent Demand
Independent Demand (Demand for the final end-
product or demand not related to other items)
Dependent
Demand
(Derived demand
items for
component
parts,
subassemblies,
raw materials,
etc)
Finished
product
Component parts
Inventory Planning
Independent demand items
Finished goods and spare parts typically belong to independent
demand items in manufacturing organisations
Two attributes characterise and distinguish independent demand
items:
Timing of demand: Independent demand items have a continuous
demand
Uncertainty of demand: There is considerable element of
uncertainty in the demand in the case of independent demand
items
Inventory planning of independent demand items must address
the following two key questions:
How much?
When?
6
Material Requirements Planning (MRP)


Material Requirements Planning (MRP) is a
system for planning the future requirements
of dependent demand items.
7
Inputs & Outputs in MRP
Bill of
Materials
(BOM)
Master
Production
Schedule
(MPS)
Inventory
Status
MRP Processing Logic
(Computer-based/
Manual)
Order
Changes
Report
Planned
Orders Report
Order Release
Report
INPUTS
OUTPUTS
Inputs and Outputs in Material Requirements Planning
Material Requirements Planning (MRP)
Seat cushion
Seat-frame
boards
Front
legs
A
Ladder-back
chair
Back
legs
Leg supports
Back slats
Material Requirements Planning
Materials requirements planning (MRP) is a means
for determining the number of parts, components,
and materials needed to produce a product
MRP provides time scheduling information
specifying when each of the materials, parts, and
components should be ordered or produced
Dependent demand drives MRP
MRP is a software system
Example of MRP Logic and Product Structure
Tree
B(4)
E(1) D(2)
C(2)
F(2) D(3)
A
Product Structure Tree for Assembly A
Lead Times
A 1 day
B 2 days
C 1 day
D 3 days
E 4 days
F 1 day
Total Unit Demand
Day 10 50 A
Day 8 20 B (Spares)
Day 6 15 D (Spares)
Given the product structure tree for A and the lead time and
demand information below, provide a materials requirements
plan that defines the number of units of each component and
when they will be needed
LT = 1 day
Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
Order Placement 50
First, the number of units of A are scheduled
backwards to allow for their lead time. So, in the
materials requirement plan below, we have to place
an order for 50 units of A on the 9
th
day to receive
them on day 10.
Next, we need to start scheduling the components that make up
A. In the case of component B we need 4 Bs for each A.
Since we need 50 As, that means 200 Bs. And again, we back
the schedule up for the necessary 2 days of lead time.
D a y : 1 2 3 4 5 6 7 8 9 1 0
A R e q u i r e d 5 0
O r d e r P l a c e m e n t 5 0
B R e q u i r e d 2 0 2 0 0
O r d e r P l a c e m e n t 2 0 2 0 0
B(4)
E(1) D(2)
C(2)
F(2) D(3)
A
Spares
LT = 2
4x50=200
Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
LT=1 Order Placement 50
B Required 20 200
LT=2 Order Placement 20 200
C Required 100
LT=1 Order Placement 100
D Required 55 400 300
LT=3 Order Placement 55 400 300
E Required 20 200
LT=4 Order Placement 20 200
F Required 200
LT=1 Order Placement 200
B(4)
E(1) D(2)
C(2)
F(2) D(3)
A
40 + 15 spares
Part D: Day 6
Finally, repeating the process for all components, we have the
final materials requirements plan:
14
MRP Example
A(2) B(1)
D(5) C(2)
X
C(3)
Item On-Hand Lead Time (Weeks)
X 50 2
A 75 3
B 25 1
C 10 2
D 20 2
Requirements include 95 units (80 firm orders and 15 forecast) of X
in week 10
A(2) B(1)
D(5) C(2)
X
C(3)
Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
hand Planned order receipt 15
75 Planner order release 15
B Gross requirements 45
LT=1 Scheduled receipts
Proj. avail. balance 25 25 25 25 25 25 25 25
On- Net requirements 20
hand Planned order receipt 20
25 Planner order release 20
C Gross requirements 45 40
LT=2 Scheduled receipts
Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
hand Planned order receipt 80
20 Planner order release 80
It takes 5 Ds for
each B
Manufacturing Resource Planning
(MRP II)
Goal: Plan and monitor all resources of a
manufacturing firm (closed loop):
manufacturing
marketing
finance
engineering
Simulate the manufacturing system
Types of Inventory
Seasonal Inventory: Seasonality in demand is absorbed
using inventory
Decoupling Inventory: Complexity of production control
is reduced by splitting manufacturing into stages and
maintaining inventory between these stages
Cyclic Inventory: Periodic replenishment causes cyclic
inventory
Pipeline Inventory: Exists due to lead time
Safety Stock: Used to absorb fluctuations in demand due
to uncertainty
Economic Order Quantity
Inventory depletion
(demand rate)
Receive
order
1 cycle
O
n
-
h
a
n
d

i
n
v
e
n
t
o
r
y

(
u
n
i
t
s
)

Time
Q
Average
cycle
inventory
Q

2
Q
u
a
n
t
i
t
y

Time
Safety stock
Cyclic Stock
Pipeline inventory
L
Cyclic, Pipeline and Safety Stocks
A graphical illustration
Cyclic inventory, pipeline inventory and safety stocks are critically linked to how much and
when decisions in inventory planning
Costs in Inventory Planning
Carrying Cost
Interest for short-term borrowals for working capital
Cost of stores and warehousing
Administrative costs related to maintaining and
accounting for inventory
Insurance costs, cost of obsolescence, pilferage, damages
and wastage
All these costs are directly related to the level of
inventory
Costs in Inventory Planning
Ordering Cost
Search and identification of appropriate sources of
supply
Price negotiation, contracting and purchase order
generation
Follow-up and receipt of material
Eventual stocking in the stores after necessary
accounting and verification
A larger order quantity will require less number of orders
to meet a known demand and vice versa
Cost of carrying and cost of ordering are fundamentally two opposing cost
structures in inventory planning
Costs in Inventory Planning
Shortage Cost
Costs arising out of pushing the order back and
rescheduling the production system to accommodate
these changes
Rush purchases, uneven utilisation of available resources
and lower capacity utilisation
Missed delivery schedules leading to customer
dissatisfaction and loss of good will
The effects of shortage are vastly intangible, it is indeed
difficult to accurately estimate
Inventory Control for deterministic demand:
EOQ Model
o
C
|
|
.
|

\
|
o
C
Q
D
*
Demand during the planning period = D
Order quantity = Q
The cost of ordering per order =
Inventory carrying cost per unit per unit time =
The total ordering cost is given by
2
Q
|
.
|

\
|
c
C
Q
*
2
The average inventory carried by an organisation=
The cost associated with carrying inventory =
c
C
|
.
|

\
|
c
C
Q
*
2
|
|
.
|

\
|
o
C
Q
D
*
Total cost of the plan =
Total cost of carrying inventory + Total cost of ordering

TC(Q) = +
Inventory Control for deterministic demand:
EOQ Model
c
o
C
D C
Q
2
*
=
2
2
) (
Q
D C C
dQ
Q dTC
o c
=
When the total cost is minimum, we obtain the most economic order quantity
(EOQ). By taking the first derivative of with respect to Q and equating it to zero
we can obtain the EOQ
Differentiating total cost equation with respect to Q we obtain,



The second derivative is positive and hence we obtain the minimum cost by
equating the first derivative to zero.

Denoting EOQ by Q
*
, we obtain the expression of Q
*
as:



The optimal number of orders =
*
Q
D

Time between orders =
D
Q
*

Total cost of carrying
Total cost of ordering
Sum of the two costs
Minimum Cost
Economic
Order Qty.
Level of Inventory
C
o
s
t

o
f

I
n
v
e
n
t
o
r
y

EOQ Model
A graphical representation
Issues in using EOQ Model
Model assumptions
1. The demand is known with certainty
2. Demand is continuous over time
3. There is an instantaneous replenishment of items
4. The items are sourced from an outside supplier
5. Assumptions about order quantity
a) There are no restrictions in the quantity that we can order
b) There are no preferred order quantities for the items
c) No price discount is offered when the order size is large

Despite this, the EOQ model could be applied with suitable modifications
because it is robust
Assumptions 3, 4 and 5 can be addressed with required modifications
Relaxing assumption 1 will result in shortages due to difficulty in estimating
demand
ROP
SS
Q
L
I
n
v
e
n
t
o
r
y

L
e
v
e
l

Time
Safety Stock
Mean Demand during LT
Inventory Position
Physical Inventory
Continuous Review (Q) System
An illustration
SS
L
I
n
v
e
n
t
o
r
y

L
e
v
e
l

Time
Safety Stock
Inventory Position
Physical Inventory
R 2R
3R
Q
R

Q
2R
Q
3R

Order Up to Level
S
Periodic Review (P) System
An illustration
Periodic & Continuous Review Systems: A
comparison
Criterion Continuous Review (Q) System Periodic Review (P) System
How Much to Order Fixed Order Qty: Q
S =
) ( R L+

+
) (
*
R L
Z
+
o
o

Q
R
= S - I
R

When to Order
ROP =
) (L

+
) (
*
L
Z o
o

Every R Periods
Safety Stock
SS =
) (
*
L
Z o
o
SS =
) (
*
R L
Z
+
o
o

Salient Aspects Implemented using two bin system
Suited for medium and low value
items
More safety stock
More responsive to demand
Ease of implementation

Inventory Planning Models
(EOQ)
Mean of weekly demand : 200
Standard deviation of weekly demand : 40
Unit cost of the raw material : Rs. 300/-
Ordering cost : Rs. 460/- per order
Carrying cost percentage : 20% per annum
Lead time for procurement : 2 weeks
400 33 . 399
54
10400 * 460 * 2 2
~ = =
c
o
C
D C
weeks 2
52
2
10400
400
= =
EOQ Model
Weekly demand = 200
Number of weeks per year = 52
Annual demand, D = 200*52 = 10,400
Carrying cost, C
c
= Rs. 60.00 per unit per year

Economic Order Quantity =
Time between orders =
Inventory Planning Models
(Q System)
) ( L

) ( L
o
57 . 56 40 * 2 = Standard deviation of demand during L,
=
) ( L

) (
*
L
Z o
o
ROP =
+
= 400 + 93 = 493
Q System
Standard deviation of weekly demand = 40
Lead time, L = 2 weeks
Mean demand during L, = 2* 200 = 400
) (
*
L
Z o
o ~ For a service level of 95%, SS = = 1.645*56.57 = 93.05 93
Using EOQ as the fixed order quantity, Q system can be designed as follows: As the
inventory level in the system reaches 493, place an order for 400 units. This will
ensure in the long run a service level of 95%.
Inventory Planning Models
(P System)
) ( R L+

Using the time between orders derived from the EOQ model as the basis for review period
Review period, R = 2 weeks
Mean demand during (L + R),
= 200*(2 + 2) = 800
For a service level of 95%,
) ( R L+

) (
*
R L
Z
+
o
o
Order up to level, S =
+
= 800 + 132 = 932
) (
*
R L
Z
+
o
o
~
= 1.645*80 = 131.6 132
SS =
) ( R L+
o
80 40 * 2 2 = +
= Standard deviation of demand during (L + R),
P System
The P system can be designed as follows: The inventory level in the system is
reviewed every two weeks and an order is placed to restore the inventory level back
to 932 units. This will ensure a service level of 95%.
Selective Control of Inventories
Alternative Classification Schemes
ABC Classification (on the basis of consumption value)
XYZ Classification (on the basis of unit cost of the item)
High Unit cost (X Class item)
Medium Unit cost (Y Class item)
Low unit cost (Z Class item)
FSN Classification (on the basis of movement of inventory)
Fast Moving
Slow Moving
Non-moving
VED Classification (on the basis of criticality of items)
Vital
Essential
Desirable
On the basis of sources of supply
Imported
Indigenous (National Suppliers)
Indigenous (Local Suppliers)
ABC Classification
A graphical illustration
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0
%
1
0
%
2
0
%
3
0
%
4
0
%
5
0
%
6
0
%
7
0
%
8
0
%
9
0
%
1
0
0
%
No. of items (%)
C
o
n
s
u
m
m
p
t
i
o
n

v
a
l
u
e

(
%
)

Class B
Class C
Class A
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
0
30
60
30
60
A
B
C
% of
$ Value
% of
Use
So, identify inventory items based on percentage of total dollar value, where
A items are roughly top 15 %, B items as next 35 %, and the lower 65%
are the C items