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Operations Functions of Inventory

Management 1. To decouple or separate various parts of the

production process
2. To decouple the firm from fluctuations in
Chapter 5– demand and provide a stock of goods that will
provide a selection for customers
Inventory Management 3. To take advantage of quantity discounts
4. To hedge against inflation

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Types of Inventory The Material Flow Cycle

 Raw material
 Purchased but not processed Cycle time
 Work-in-process
95% 5%
 Undergone some change but not completed
 A function of cycle time for a product Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
productive
 Finished goods
 Completed product awaiting shipment
Figure 12.1

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Inventory Management ABC Analysis

 Divides inventory into three classes
 How inventory items can be based on annual dollar volume
classified  Class A - high annual dollar volume
 Class B - medium annual dollar volume
 How accurate inventory records
can be maintained  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 ABC Analysis

Percent of Percent of Percent of Percent of
Item Number of Annual Annual Annual Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A #12572 600 $ 14.17 $ 8,502 3.7% C
72%
#11526 500 154.00 77,000 33.2% A #14075 2,000 .60 1,200 .5% C

#12760 1,550 17.00 26,350 11.3% B #01036 50% 100 8.50 850 .4% 5% C

#10867 30% 350 42.86 15,001 6.4% 23% B #01307 1,200 .42 504 .2% C

#10500 1,000 12.50 12,500 5.4% B #10572 250 .60 150 .1% C

8,550 $232,057 100.0%

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ABC Analysis
ABC Analysis
 Other criteria than annual dollar volume
may be used
Percent of annual dollar usage

A Items
80 –  Anticipated engineering changes
70 –  Delivery problems
60 –
 Quality problems
50 –
40 –  High unit cost
30 –  Policies employed may include
20 – B Items
10 –
 More emphasis on supplier development for
C Items
A items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100  Tighter physical inventory control for A

Percent of inventory items
items
Figure 12.2
 More care in forecasting A items

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Holding, Ordering, and Holding Costs

Setup Costs
Cost (and range)
as a Percent of
 Holding costs - the costs of holding Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
or “carrying” inventory over time depreciation, operating costs, taxes,
insurance)
 Ordering costs - the costs of Material handling costs (equipment lease or 3% (1 - 3.5%)
placing an order and receiving depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
goods
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
 Setup costs - cost to prepare a and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
machine or process for
Overall carrying cost 26%
manufacturing an order
Table 12.1

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Holding Costs Inventory Models for

Cost (and range)
Independent Demand
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%) Need to determine when and how
depreciation, operating costs, taxes,
insurance)
much to order
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
 Basic economic order quantity
Investment costs (borrowing costs, taxes,
and insurance on inventory)
11% (6 - 24%)  Production order quantity
Pilferage, space, and obsolescence 3% (2 - 5%)  Quantity discount model
Overall carrying cost 26%

Table 12.1

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Basic EOQ Model Inventory Usage Over Time

Important assumptions
Usage rate Average
Order inventory
1. Demand is known, constant, and

Inventory level
quantity = Q on hand
independent (maximum
Q
inventory
2. Lead time is known and constant level) 2

3. Receipt of inventory is instantaneous and

complete Minimum
inventory
4. Quantity discounts are not possible
5. Only variable costs are setup and holding 0
Time
6. Stockouts can be completely avoided
Figure 12.3

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Minimizing Costs The EOQ Model

Annual setup cost =
D
Q
S

Objective is to minimize total costs Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
Curve for total D = Annual demand in units for the inventory item
cost of holding S = Setup or ordering cost for each order
and setup H = Holding or carrying cost per unit per year
Minimum
total cost Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)
Annual cost

Holding cost
curve Annual demand Setup or order
=
Number of units in each order cost per order
Setup (or order)
cost curve = D (S)
Q
Optimal order Order quantity
Table 11.5 quantity (Q*)

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The EOQ Model

Annual setup cost =
D
Q
S The EOQ Model
Annual setup cost =
D
Q
S
Q Q
Annual holding cost = H Annual holding cost = H
Q = Number of pieces per order 2 Q = Number of pieces per order 2
Q* = Optimal number of pieces per order (EOQ) Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year H = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level) Optimal order quantity is found when annual setup cost
x (Holding cost per unit per year) equals annual holding cost

D Q
Order quantity S = H
= (Holding cost per unit per year) Q 2
2
Solving for Q*
2DS = Q2H
= Q (H) Q2 = 2DS/H
2
Q* = 2DS/H

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An EOQ Example An EOQ Example

Determine optimal number of needles to order Determine optimal number of needles to order
D = 1,000 units D = 1,000 units Q* = 200 units
S = $10 per order S = $10 per order
H = $.50 per unit per year H = $.50 per unit per year

2DS Expected Demand D

Q* = number of = N =
Order quantity
=
Q*
H orders
2(1,000)(10) 1,000
N= = 5 orders per year
Q* = = 40,000 = 200 units 200
0.50

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An EOQ Example An EOQ Example

Determine optimal number of needles to order Determine optimal number of needles to order
D = 1,000 units Q* = 200 units D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year S = $10 per order N = 5 orders per year
H = $.50 per unit per year H = $.50 per unit per year T = 50 days

Number of working Total annual cost = Setup cost + Holding cost

Expected days per year D Q
time between = T = TC = S + H
orders N Q 2
250 1,000 200
T= = 50 days between orders TC = ($10) + ($.50)
5 200 2

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

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Example 1 Practice
• One of the top-selling items in a shop is an ADSL
modem clock. Sales are 18 units/week, and the
• The South Face store has observed a stable monthly supplier charges $60/unit. The cost of placing an
demand for its line of Gore-Tex jackets of 100 jackets order with the supplier is $45. Annual holding
per month. The store incurs a fixed cost of $2,000 cost is 25% of a modem’s value and the shop
every time it places an order for additional jackets. operates 52 weeks/year. Management chose a
The store pays $200 per jacket. The store’s out-of- 390-unit lot size so that new orders could be
pocket costs of storing a jacket for a year are about placed less frequently.
20% and the opportunity cost of capital is 15%.
1. What is the annual cost of the current policy of
• What order size do you recommend for the South using a 390-unit lot size? Would a lot size of 468
Face store? be better?
2. Calculate the EOQ and its total cost. How
frequency will orders be placed if the EOQ is
used?

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An EOQ Example
Robust Model
Management underestimated demand by 50%
 The EOQ model is robust D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
 It works even if all parameters H = $.50 per unit per year T = 50 days
and assumptions are not met
D Q
TC = S + H
 The total cost curve is relatively Q 2
flat in the area of the EOQ 1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

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An EOQ Example Reorder Points

Actual EOQ for new demand is 244.9 units  EOQ answers the “how much” question
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year  The reorder point (ROP) tells when to
H = $.50 per unit per year T = 50 days order

D Q
Demand Lead time for a
TC = S + H ROP = per day new order in days
Q 2 Only 2% less
1,500 244.9 than the total =dxL
TC = ($10) + ($.50) cost of $125
244.9 2
when the D
TC = $61.24 + $61.24 = $122.48 order quantity d = Number of working days in a year
was 200

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Reorder Point Curve Reorder Point Example

Q*
Demand = 8,000 iPods per year
Inventory level (units)

250 working day year

Lead time for orders is 3 working days
Slope = units/day = d D
d=
Number of working days in a year
ROP = 8,000/250 = 32 units
(units)

ROP = d x L
= 32 units per day x 3 days = 96 units
Time (days)
Figure 12.5 Lead time = L

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Production Order Quantity Production Order Quantity

Model Model
 Used when inventory builds up Part of inventory cycle during
which production (and usage)
over a period of time after an is taking place

Inventory level
order is placed Demand part of cycle
with no production
 Used when units are produced Maximum
inventory
and sold simultaneously

t Time

Figure 12.6

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Production Order Quantity Production Order Quantity

Model Model
Q = Number of pieces per order p = Daily production rate Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days t = Length of the production run in days

Maximum Total produced during Total used during

Annual inventory Holding cost = –
= (Average inventory level) x inventory level the production run the production run
holding cost per unit per year
= pt – dt

Annual inventory However, Q = total produced = pt ; thus t = Q/p

= (Maximum inventory level)/2
level
Maximum Q Q d
inventory level = p p –d =Q 1–
p p
Maximum
= Total produced during
Total used during
–
inventory level the production run the production run
Maximum inventory level Q d
= pt – dt Holding cost = (H) = 1– H
2 2 p

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Production Order Quantity Production Order Quantity

Model Example
Q = Number of pieces per order p = Daily production rate D = 1,000 units p = 8 units per day
H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand
S = $10 d = 4 units per day
H = $0.50 per unit per year
Setup cost = (D/Q)S
Holding cost = 1 HQ[1 - (d/p)] 2DS
2 Q* =
1 H[1 - (d/p)]
(D/Q)S = 2 HQ[1 - (d/p)]
2DS 2(1,000)(10)
Q2 = Q* = = 80,000
H[1 - (d/p)] 0.50[1 - (4/8)]
2DS = 282.8 or 283 hubcaps
Q*p =
H[1 - (d/p)]

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Production Order Quantity Quantity Discount Models

Model
 Reduced prices are often available when
Note: larger quantities are purchased
D 1,000
d = 4 = Number of days the plant is in operation = 250  Trade-off is between reduced product cost
and increased holding cost

When annual data are used the equation becomes Total cost = Setup cost + Holding cost + Product cost

2DS D Q
Q* = TC = S+ H + PD
annual demand rate Q 2
H 1–
annual production rate

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Quantity Discount Models Quantity Discount Models

A typical quantity discount schedule Steps in analyzing a quantity discount
1. For each discount, calculate Q*
Discount Discount
Number Discount Quantity Discount (%) Price (P) 2. If Q* for a discount doesn’t qualify,
1 0 to 999 no discount $5.00 choose the smallest possible order size
2 1,000 to 1,999 4 $4.80 to get the discount
3 2,000 and over 5 $4.75 3. Compute the total cost for each Q* or
adjusted value from Step 2
Table 12.2
4. Select the Q* that gives the lowest total
cost

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Quantity Discount Models Quantity Discount Example

Calculate Q* for every discount 2DS
Total cost curve for discount 2 Q* =
Total cost
curve for IP
discount 1
2(5,000)(49)
Q1* = = 700 cars/order
Total cost $

(.2)(5.00)
Total cost curve for discount 3
b 2(5,000)(49)
a Q* for discount 2 is below the allowable range at point a Q2* = = 714 cars/order
and must be adjusted upward to 1,000 units at point b (.2)(4.80)
1st price 2nd price
break break 2(5,000)(49)
Q3* = = 718 cars/order
0 1,000 2,000 (.2)(4.75)
Figure 12.7
Order quantity

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Quantity Discount Example Quantity Discount Example

Calculate Q* for every discount 2DS
Q* = Annual Annual Annual
IP Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
2(5,000)(49) 1 $5.00 700 $25,000 $350 $350 $25,700
Q1* = = 700 cars/order
(.2)(5.00) 2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
Table 12.3

Choose the price and quantity that gives

2(5,000)(49) the lowest total cost
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted Buy 1,000 units at $4.80 per unit

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