Inventory Management

Inventory Management
Inventory is one of the
most expensive assets
of many companies.

It represents as much
as 40% of total
invested capital.
Inventory Management
Inventory is any stored resource that is used
to satisfy a current or future need.
Raw materials, work-in-process, and finished
goods are examples of inventory.
Two basic questions in inventory
management are (1) how much to order (or
produce), and (2) when to order (or
produce).
Basic Functions of Inventory
1. If product demand is high in summer, a
firm might produce during winter.
(Decoupling).
2. Inventory can be a hedge against price
changes and inflation.
3. Another use of inventory is to take
advantage of quantity discounts (when
buying).
(Many suppliers offer discounts for large
orders)
ABC Analysis
ABC analysis divides on-hand inventory
into three classifications on the basis of
dollar (TL) volume.
It is also known as Pareto analysis.
(which is named after principles
dictated by Pareto).
ABC Analysis
The idea is to focus resources on the
critical few and not on the trivial
many.
(Annual Dollar Volume of an Item) =
(Its Annual Demand) x (Its Cost per
unit)
ABC Analysis
Class A items are those on which the
annual dollar volume is high.
They represent 70-80% of total
inventory costs, but they account for
only 15% of total inventory items.
ABC Analysis
Class B items are those on which
annual dollar volume is medium.
They represent 15-25% of total dollar
value, and they account for 30% of
total inventory items on the average.
ABC Analysis
Class C items are low dollar volume
items.
They represent only the 5% of total
dollar volume, but they include as many
as 50-60% of total inventory items.
ABC Analysis
ABC Analysis
Some of the Inventory Management Policies
that may be based on ABC analysis include:
a) Class A items should have tighter inventory
control.
b) Class A items may be stored in a more
secure area.
c) Forecasting Class A items may warrant
more care.
Cycle Counting of Inventory
Inventory records must be verified
through a continuing audit.
Such audits are known as (periodical)
cycle counting.. (e.g., counting items at
supermarket).
Cycle Counting of Inventory
Cycle counting uses inventory classifications
developed by ABC analysis.
That is:
Class A items are counted frequently, perhaps
once a month.
Class B items are counted less frequently,
perhaps once a quarter.
Class C items are counted perhaps once
every six months.
Just-in-Time Inventory
Just in Time
Inventory is the
minimum
inventory that is
necessary to keep
a system perfectly
running.
Just-in-Time Inventory
With just in time (JIT) inventory, The
exact amount of items arrive at the
moment they are needed, Not a
minute before OR not a minute after.

Just-in-Time Inventory
To achieve JIT inventory, Managers
should Reduce the Variability Caused
by some Internal and External Factors.
(Goldratts boys scout example Apply
the pace of the slowest boy).
Existence of Inventory hides the
variability. What causes variability?
Just-in-Time Inventory
Most variability is caused by tolerating
waste (inventory).

(1) For example, employees or machines
produce units that do not conform to
standards. These are waste. And they
cause variability.
Just-in-Time Inventory
(2) Or, engineering drawings are
inaccurate, Again resulting in loss of
production And consecutively resulting
in Variability.
These are the internal (controllable)
factors that cause Variability.
However, Some of the variability is
caused by some external factors.
Just-in-Time Inventory
For example, customer demands may
change due to some external factors
(such as competitors actions or
promotions)
In summary, To achieve JIT inventory,
Managers must begin with Reducing
Inventory.
Just-in-Time Inventory
Reducing Inventory uncovers the Rocks
located along the way on a river, And
the water stream becomes more clear.
Just-in-Time Inventory
Just-in-Time Inventory
In the figure, the section called
Others are the Rocks on the river.
Those rocks include Quality Variability,
In-transit Delays, Machine Breakdowns,
Large Lot-sizes, Inaccurate drawings,
Employee attendance variability.
Just-In-Time Production
JIT production means (1) Elimination of
Waste, (2) Synchronized Manufacturing,
and (3) Little Inventory.
Reducing the order batch size can be a
major help in reducing inventory.
Average Inventory = (Maximum
Inventory + Minimum Inventory) / 2
Just-In-Time Production
Average Inventory drops as the
inventory re-order quantity drops
because the maximum inventory level
drops. (show by drawing)
Moreover, the smaller the lot size, the
fewer the problems are hidden.
One way to achieve small lot sizes is to
Move Inventory through the shop Only
as needed.
Just-In-Time Production
This is called a pull system. In this
system, Ideal Lot size is 1.
Japanese call this system as Kanban
system.
Kanban is a Japanese word for Card.
A card is used to signal the need for
material in a work center.
Just-In-Time Production
Sending a card authorizes the previous
work center to send its finished batch to
the subsequent work center.
Batches are typically very small. Such a
system requires tight schedules and
frequent set-ups for machines.
Just-In-Time Production
On the other hand,
Small batches allow
a very limited
amount of faulty
material, less
damages, less space
occupation, less
material handling,
less accidents, etc.
Holding, Ordering and Set-
up Costs
Holding Costs are the costs associated
with holding or carrying inventory
over time.
It includes costs related to Storage;
such as insurance, extra staffing,
interest, and so on.
Holding, Ordering and Set-
up Costs
Some example holding costs are
building rent or depreciation, building
operating cost, taxes on building,
insurance on building, material handling
equipment leasing or depreciation,
equipment operating cost, handling
manpower cost, taxes on inventory,
insurance, etc.
Holding, Ordering and Set-
up Costs
Ordering Costs include, cost of supplies,
order processing, clerical cost, etc.
The ordering cost is valid if the
products are purchased NOT produced
internally.
Holding, Ordering and Set-
up Costs
Set-up cost is the cost to prepare a
machine for manufacturing an order.
Set-up cost is highly correlated with set-
up time.
Holding, Ordering and Set-
up Costs
Machines that traditionally have taken
long hours to set up Are Now being set
up in less than a minute by employing
FMSs or CIM systems.
Reducing set up times is an excellent
way to Reduce Inventory.
Inventory Models
Demand for an item is either dependent
on the demand for other items or it is
independent.
For example, demand for refrigerator is
independent of the demand for cars.
But, demand for auto tires is certainly
dependent on the demand of cars.
Inventory Models
In this section, we will deal with the
Independent Demand Situation.
In the independent demand situation,
we should be interested in answering:
a) When to place an order for an item,
and
b) how much of an item to order.
Inventory Models
There are Four Basic Independent
Demand Inventory Models:
1) Economic Order Quantity (EOP) Model
(the most known model).
2) Production Order Quantity Model.
3) Back order inventory model.
4) Quantity discount model.
Economic Order Quantity
(EOQ) Model
EOQ model makes a number of
assumptions:
1-) Demand is known and constant.
2-) Lead time (the time between
placement of order and receipt of the
order) is constant and known.
Economic Order Quantity
(EOQ) Model
3-) Orders arrive in one batch at a time, and
they arrive in one point in time.
4-) Quantity discounts are not possible.
5-) The costs include only setup cost (or
ordering cost when buying) and holding cost.
6-) Orders are always placed at the right times.
Therefore, stock outs (or shortages) can be
completely avoided.
Economic Order Quantity
(EOQ) Model
With these assumptions, the graphic of
inventory usage over time is as follows:
Economic Order Quantity
(EOQ) Model
Economic Order Quantity
(EOQ) Model
Q = order quantity (That is also equal
to the Maximum Inventory)
Minimum Inventory = 0
When inventory level reaches 0, a new
order is placed and received.
Economic Order Quantity
(EOQ) Model
The objective of inventory models is to
minimize total cost.
If we minimize the setup and holding
costs, we will be able to minimize total
cost:
Economic Order Quantity
(EOQ) Model
Economic Order Quantity
(EOQ) Model
As the quantity ordered (Q) increases,
holding cost increases, And setup cost
decreases.
In this graph, Optimal order quantity
(Q*) occurs at a point where setup cost
is equal to the total (annual) holding
cost.
Economic Order Quantity
(EOQ) Model
By using this fact, we can write an equation
for Q* as follows:
D: Annual Demand in units for the inventory
item.
S: Setup cost (or the ordering cost) for each
order.
Notice: (Setup cost for production, order cost
for buying).
H: Annual Holding cost of inventory per unit.
Economic Order Quantity
(EOQ) Model
There will be (D/Q) times of ordering in a
whole year.
Therefore,
Annual Setup cost = (D/Q) . S
Average Annual Holding Cost = (Average
Inventory) . H = (Q/2) . H
Annual Setup Cost = Annual Holding
Cost
(D/Q) . S = (Q/2) . H
Economic Order Quantity
(EOQ) Model
Therefore,
Q2 = 2DS / H
Q* = [2DS / H]1/2
Q* value is also called as EOQ.
Example
An Inventory model has the following
characteristics:
Annual Demand (D) = 1000 units
Ordering (Setup) cost (S)= $10 per order;
Holding cost per unit per year (H) = $.50
Assume that there are 270 working days in a
year (excluding holidays and weekends).
Example
Questions:
a) Find the Economic Order Quantity (Q*) for
this inventory model.
b) How many orders should be placed during
one year?
c) What is the expected time between two
consecutive orders?
d) What is the total annual cost of this
inventory model?
Example
Answers:
a) Q* = [2(1000)10 / .50]1/2 = 200 units
b) Expected number of orders placed
during the year (N) = D / Q* = 1000 /
200 = 5 times.
Example
c) Expected time between orders (T) =
(Working days in a year) / N = 270 / 5 = 54
days.
d) Total Annual Cost = Annual Setup Cost
+ Annual Holding Cost
= DS / Q* + (Q*)H / 2
= 1000 (10) / 200 + (200) (.50) / 2
= $100
Proof of Optimality by Using
Derivation
If we take the derivative of Total Cost
(TC) function, based on the order
quantity (Q), we get the following:

TC = DS / Q + (Q)H / 2
dTC/dQ = (- DS / Q2) + (H / 2)
Proof of Optimality by Using
Derivation
As a mathematic rule, if we set this
derived equation equal to zero, we get
the optimal (minimum) point of the
total cost function:
Therefore,
Proof of Optimality by Using
Derivation
Proof of Optimality by Using
Derivation
One more check is needed for the optimality
of Q.
That is we take the second derivative of the
total cost function based on Q.
If the second derivative is positive, the Q*
value is a real optimum. (Rule)
In fact, second derivative is equal to 2DS /
Q3 which is a positive value (It is a real
optimum).
Considering the Reorder
Point
So far, we only decided how much to
order (That is Q*).
Now, we should find what time to
order.
We assumed that firm will wait until its
inventory reaches to zero before placing
an order.
Considering the Reorder
Point
And, we also assumed that the Orders
will receive immediately.
However, there is a time between
placement and receipt of an order.
This is called LEAD TIME or delivery
time.
Considering the Reorder
Point
Here, we will use the term Reorder
Point (ROP) for when to order.
ROP (in units) = (Demand Per Day) .
(Lead time for a new order in days)

ROP = d . L
Considering the Reorder
Point
Considering the Reorder
Point
When the inventory level reaches the
ROP, a new order is required.

It will take a time that is equal to the
Lead Time (L) to receive the new order.
Considering the Reorder
Point
Here, Demand per day (d) is found by
the following equation:
d = D / Number of working days in a
year
This ROP equation assumes that
demand is uniform and constant.
If this is not the case, an extra (safety)
stock is added (because of uncertainty).
Example
Annual demand for an item is D =
8000/year.
This year there will be 200 working
days in a year.
Delivery of an order for this item takes
3 working days (L = 3 days).
Example
Questions:

a) Find the demand per day for this item.
b) What is the ROP for this item?
Example
Answers:
a) Demand per day for this item (d) =
8000 / 200 = 40 units / day.
b) ROP = d . L = 40 . 3 = 120 units.

When inventory level becomes 120 units,
an Order should be placed.