Operations

Management
and TQM
O U R L A D Y O F F AT I M A U N I V E R S I T Y

M O N D AY 1 0 : 2 0 A M – 1 : 2 0 P M

2 ND Y R . B S A A N D B S A I S
O perations

M
anagement
2
Inventory Management
➢ Inventory managers deal with two fundamental decisions:
1) When to order items from a supplier or when to initiate production runs if
the firm makes its own items.
2) How much to order or produce each time a supplier or production order is
placed.
Inventory management is all about making trade-offs among the costs
associated with these decisions.
4 Major Categories of Inventory
Costs
1) Ordering or setup cost
2) Inventory holding costs
3) Shortage Costs
4) Unit Cost of the SKUs
1. Ordering Costs or Setup Costs
➢ Incurred as a result of the work involved in placing orders with suppliers or
configuring tools, equipment, and machines within a factory to produce an
item.
➢ Order and setup costs do not depend on the number of items purchased or
manufactured, but rather on the number of orders placed.
 2. Inventory-Holding or Carrying
Costs
➢ Expenses associated with carrying inventory.
➢ Holding costs are typically defined as a percentage of the dollar value of inventory
per unit of time (generally one year). They include costs associated with maintaining
storage facilities, such as gas and electricity, taxes, insurance, and labor and
equipment necessary to handle, move, and retrieve inventory items, plus the
opportunity cost of capital represented by holding inventory, normally for one year.
➢ However, from an accounting perspective, it is difficult to precisely allocate such
costs to an individual stock-keeping unit (SKU). Essentially, holding costs reflect the
opportunity cost associated with using the funds invested in inventory for alternative
uses and investments.
 3. Shortage or Stockout costs
➢ Costs associated with inventory being unavailable when needed to meet demand.
➢ Examples are:
➢Backorders
➢Lost sales
➢Service interruptions for external customers
➢Cost associated with interruptions to manufacturing and assembly lines
for internal customers
 4. Unit Cost
➢ The price paid for purchased goods or the internal cost of producing them.
➢ In most situations, the unit cost is a “sunk cost” because the total purchase cost
is not affected by the order quantity. However, the unit cost of SKUs is an important
purchasing consideration when quantity discounts are offered; it may be more
economical to purchase large quantities at a lower unit cost to reduce the other
cost categories and thus minimize total costs.
Inventory Characteristics
1. Number of items
2. Nature of demand
3. Number and duration of time periods
3.a. Lead time
3.b. Stockouts
Number of Items
➢ Most firms maintain inventories for a large number of items, often at
multiple locations. To manage and control these inventories, each item is
often assigned a unique identifier, called a stcok-keeping unit, or SKU.
➢ A stock-keeping unit (SKU) is a single item or asset stored at a particular
location. For example, each color and size of a man’s dress shirt at a
department store and each type of milk (whole, 2 percent, skim) at a grocery
store would be a different SKU.
Nature of Demand
➢ Demand can be classified as:
a) Independent
b) Dependent
c) Constant
d) Uncertain
e) Dynamic
f) Static
Independent Demand
➢ Demand for an SKU that is unrelated to the demand for other SKUs and
needs to be forecasted. This type of demand is directly related to customer
(market) demand.
➢ Inventories of finished goods such as toothpaste and electric fans have
independent demand characteristics.
Dependent Demand
➢ Demand is directly related to the demand of other SKUs and can be
calculated without needing to be forecasted. For example, a chandelier may
consist of a frame and six lightbulb sockets. The demand for chandeliers is
an independent demand and would be forecasted, whereas the demand for
sockets is dependent on the demand for chandeliers. That is, for a forecast of
chandeliers we can calculate the number of sockets required.
Static Demand
➢ also called stable demand.
➢ Example:
➢The demand for milk might range from 90 to 110 gallons per
day, every day of the year. The parameters of the probability
distribution do not change over time.
Dynamic Demand
➢ Demand for airline flights (domestic and international flights) will probably
have different means and variances throughout the year, reaching peaks
around Holy Week, Summer, Christmas and holiday seasons.
Number and Duration of Time
Periods
➢ In some cases, the selling season is relatively short, and any leftover items cannot be physically
or economically stored until the next season.

➢ For example, Christmas trees that have been cut cannot be stored until the following year;
similarly, other items such as seasonal fashions are sold at a loss simply because there is no
storage space or it is uneconomical to keep them for next year.

➢ In other situations, firms are concerned with planning inventory requirements over an extended
number of time periods – for example, monthly over a year – in which inventory is held from one
time period to the next. The type of approach used to analyze “single period” inventory problems
is different from the approach needed for the “multiple-period” inventory situation.
Lead Time
➢ The time between placement of an order and its receipt.
➢ Lead time is affected by transportation carriers, buyer order frequency and
size, and supplier production schedules, and may be deterministic or
stochastic (in which case it may be described by some probability
distribution).
Stockouts
➢ The inability to satisfy the demand for an item.

➢ When stockouts occur, the item is either back-ordered or a sale is lost. A backorder occurs when
a customer is willing to wait for the item.

➢ A lost sale occurs when the customer is unwilling to wait and purchases the item elsewhere.

➢ Backorders result in additional costs for transportation, expediting, or perhaps buying from
another supplier at a higher price. A lost sale has an associated opportunity cost, which may
include loss of goodwill and potential future revenue.
ABC Inventory Analysis
➢ One useful method for defining inventory value is ABC analysis. It is an application
of the Pareto principle, named after Italian economist who studied the distribution of
wealth in Milan during the 1800s. He found that a “vital few” controlled a high
percentage of the wealth. ABC analysis consists of categorizing inventory items or
SKUs into three groups according to their total annual dollar usage:
1. “A” items account for a large dollar value but a relatively small percentage of total
items
2. “C” items account for a small dollar value but a large percentage of total items.
3. “B” items are between A and C.
Inventory Categories
➢ Comprise 60-80% of the total dollar usage but only 10-30% of the items.

➢ “C” items account for 5-15% of the total dollar value and about 50% of the items.

➢ There is no specific rule on where to make the division between A,B, and C items; the
percentages used here simply serve as a guideline.

➢ Total dollar usage or value is computed by multiplying item usage (volume) times the item’s
dollar value (unit cost). Therefore, an “A” item could have a low volume but high unit cost, or a high
volume and low unit cost.

➢ ABC analysis gives managers useful information to identify the best methods to control each
category of inventory. Class “A” items require close control by operations managers. Class “C”
items need not be as closely controlled and can be managed using automated computer systems.
Class “B” items are somewhere in the middle.
Fixed-Quantity Systems (FQS)
➢ The order quantity (Q) or lot size is fixed; that is, the same amount, Q, is ordered
every time.
➢ The order quantity (Q) can be any quantity of product, such as a box, pallet, or
container, as determined by the vendor or shipping standards; it does not have to be
determined economically.
➢ FQS are used extensively in the retail industry. For example, most department
stores have cash registers that are tied into a computer system. When the clerk
enters the SKU number, the computer recognizes that the item is sold, recalculates
the inventory position, and determines whether a purchase order should be initiated
to replenish the stock. If computers are not used in such systems, some form of
manual system is necessary for monitoring daily usage.
Managing Fixed-Quantity Systems
(FQS)
➢ A more appropriate way to manage an FQS is to continuously monitor the
inventory level and place orders when the level reaches some “critical” value.
The process of triggering an order is based on the inventory position.
➢ Inventory position (IP) is defined as the on-hand quantity (OH) plus any orders
placed but which have not arrived (called Scheduled Receipts SR), minus any
backorders (BO), or
IP = OH + SR - BO
➢ When the inventory position falls at or below a certain value, r, called the
reorder point, a new order is placed. The reorder point is the value of the
inventory position that triggers a new order.
Why not based the reordering decision
based on the physical inventory?
➢ Why use the complex calculation?
The explanation is that when an order is placed but has not been
received, the physical stock level will continue to fall below the reorder point
before the order arrives. If the ordering process is automated, the computer logic
will continue to place many unnecessary orders simply because it will see the
stock level being less than r, even though the original order will soon arrive and
replenish the stock. By including scheduled receipts, the inventory position will
be larger than the reorder point, thus preventing duplicate orders. Once the
order arrives and no scheduled receipts are outstanding, the inventory position
is the same as the physical inventory. Backorders are included in the IP
calculation because these items have already been sold and are reserved for
customers as soon as the order arrives.
The EOQ Model
➢ The economic order quantity (EOQ) model is a classic economic model developed
in the early 1900s that minimizes the total cost, which is the sum of the inventory-
holding cost and the ordering cost.
Key Assumptions
1) Only a single item (SKU) is considered
2) The entire order quantity (Q) arrives in the inventory at one time.
3) Only two types of costs are relevant – order/setup and inventory-holding
costs.
4) No stockouts are allowed
5) The demand for the item is constant and continuous over time
6) Lead time is constant
Cycle Inventory
➢ Also called order or lot size inventory.

➢ An inventory that results from purchasing or producing in larger slots than needed for immediate
consumption or sale.

➢ From the constant demand assumption, the average cycle inventory can be easily computed as
the average of the maximum and minimum inventory levels:

Maximum Inventory + Minimum Inventory

Average Cycle Inventory =
2
( Q + 0)
Average Cycle Inventory =
2
Inventory Holding Cost
➢ The inventory holding cost can be calculated by multiplying the average inventory
by the cost of holding one item in inventory for the stated period. The period of time
selected for the model is up to the user; it can be a day, week, month, or year.
However, because the inventory holding costs for many industries and businesses
are expressed as an annual percentage or rate, most inventory models are
developed on an annual cost basis.
Inventory Holding Cost
Let I = annual inventory-holding charge expressed as a percent of unit cost
C = unit cost of the inventory item or SKU
includes two types of costs – cost of capital (money) plus any inventory-handling and
storage costs, both expressed as a percentage of the item cost. The cost of storing
one unit in inventory for the year, denoted by Ch , is given by
C h= ( I ) ( C )

Thus, the general equation for annual inventory holding cost is

Average Annual Holding
Annual Inventory Holding Cost
Inventory Cost Per Unit
Inventory Holding Cost

Average Annual Holding

Annual Inventory Holding Cost
Inventory Cost Per Unit

1
QC h
2
Ordering Cost
➢ Because the inventory holding cost is expressed on an annual basis, we need to
express ordering costs as an annual cost also. Letting D denote the annual demand
for the product, we know that by ordering Q items each time we order, we have to
place D/Q orders per year. If C 0 is the cost of placing one order, the general
expression for the annual ordering cost is shown below:
No. of orders
Annual Ordering Cost Cost Per Order
per year

D
C0
Q
Total Annual Cost
➢ The sum of the inventory-holding cost plus the order or setup cost.

1 D
Total Annual Cost QC h C0
2 Q
The Order Quantity
The next step is to find the order quantity, Q, that minimizes the total cost expressed
in the total annual cost equation. By using differential calculus, we can show that the
quantity that minimizes the total cost, denoted by Q* , is referred to as the economic
order quantity or EOQ shown below:

√C
2DC o
Q*
h
The Order Quantity
Finally, we need to determine when to place an order for Q* units. The reorder point,
r, depends on the lead time and the demand rate. Because we assume that demand
is constant in the EOQ model, the reorder point is found by multiplying the fixed
demand rate, d (units/day, units/month, etc.), by the length of the lead time, L (in
the same units, e.g. days or months). Note that it is easy to convert the annual
demand D (in units/year) to a demand rate, d, having the same time units as the
lead time. r = Lead time demand

= (demand rate) (lead time)

= (d) (L)
The Order Quantity
r = Lead time demand

= (demand rate) (lead time)

= (d) (L)

➢ The EOQ model depends only on the order quantity, fixed costs associated with any
ordering or inventory holding are irrelevant. Therefore, only variable costs of ordering
and inventory holding are required for the model.
Safety Stock
➢ Stockouts occur whenever the lead-time demand exceeds the reorder point. When
demand is uncertain, using EOQ based only on the average demand will result in a high
probability of a stockout. One way to reduce this risk is to increase the reorder point by
adding additional stock-called safety stock – to the average lead time demand.
➢ Safety stock is additional, planned on-hand inventory that acts as a buffer to reduce
the risk of a stockout.
➢ To determine the appropriate reorder point, we first need to know the probability
distribution of the lead-time demand, which often assume to be normally distributed.
The appropriate reorder point depends on the risk that management wants to take of
incurring a stockout.
Uncertain Demand in a Fixed-
Order-Quantity System
➢ A service level is the desired probability of not having a stockout during a lead-time
period. For example, a 95% service level means that the probability of a stockout
during the lead time is 0.05 or 5%. Choosing a service level is a management policy
decision.
➢ When demand is uncertain, then the reorder point is the average demand during
the lead time, μ L plus the additional safety stock. The average demand during the
lead time is found by multiplying the average demand per unit of time by the length
of the lead time expressed in the same time units. When a normal probability
distribution provides a good approximation of lead-time demand, the general
expression for reorder point is
r= Μ L + Zσ L
 Reorder Point
➢When a normal probability distribution provides a good approximation of lead-time demand, the
general expression for reorder point is:
r= Μ L + Zσ L

where μ L = average demand during the lead time

σ L = standard deviation of demand during the lead time
Z = the number of standard deviations necessary to achieve the acceptable service level

The term “ z σ L “ represent the amount of safety stock.

Problem Solving
The sales of a popular mouthwash at Merkle Pharmacies over the past 6 months have averaged
2,000 cases per month, which is the current order quantity. Merkle’s cost is $ 12 per case. The
company estimates its cost of capital to be 12%. Insurance, taxes, breakage, handling, and
pilferage are estimated to be approximately 6% of item cost. Thus, the annual inventory holding
cost are estimated to be 18% of item cost. Because the cost of one case is $ 12, the cost of
holding one case in inventory for one year is Ch = (IC) = 0.18 ($12) per case per year. The cost of
placing an order is estimated to be $38 per order regardless of the quantity requested in the
order. From this information we have,

D = 24,000 cases per year

C 0= $ 38 per order
I = 18%
C = $ 12 per case
Ch = IC = $ 2.16
Solution:
D = 24,000 cases per year
C 0= $ 38 per order
I = 18%
C = $ 12 per case
Ch = IC = $ 2.16
Thus, the minimum cost EOQ is derived below:

√C
2DC o
Q*
h

√
2(24,000)($38)
Q*
2.16

Q* 919 cases rounded to a whole number

Thus, the total annual cost using the EOQ model is
1 D
Total Annual Cost QC h C0
2 Q

1 Q($2.16) 24,000
($ 38)
Total Annual Cost
2 Q
912,000
Total Annual Cost $ 1.08 Q
Q

912,000
Total Annual Cost $ 1.08 (919)
919

Total Annual Cost $ 992.52 $ 992.38

Total Annual Cost $ 1,984.9

Solution
Using the same information, assume that the lead time to order a case of mouthwash from the
manufacturer is L = 3 days. Considering weekends and holidays, Merkle operates 250 days per
year, so on a daily basis, the deterministic annual demand of 24,000 cases corresponds to a daily
demand of d = 24,000 / 250 = 96 cases per day. Thus, the reorder point is calculated as follows:
r = Lead time demand

= (demand rate) (lead time)

= (96) (3)

Reorder Point = 288 cases To be sold during the 3-day lead time,
therefore, Merkle should order a new
shipment from manufacturer when the
inventory level reaches 288 cases.
Solution
Also note that the company will place D/Q = 24,000 / 919 = 26.12
approximately 26 orders per year. With 250 working days per year, an order
would be placed every (250 days per year)/(26.1 orders per year) = 9.6 days
per order. This represents the average time between order (TBO).
THANK YOU!