Production Planning and Control

Inventory Management

Dr. Lotfi K. Gaafar

Production Planning and Control- Inventory Management (1) Gaafar 2005

 Production Planning and Control
The Production Control System

Demand Sales and

order entry Customer
forecasting

Aggregate Materials Shop-floor Shipping

planning requirement scheduling Production and
planning and control receiving

Inventory
Inventory Vendors
management

Production Planning and Control- Inventory Management (2) Gaafar 2005

 Demand Management

• Basic Problem: establish an interface between the customer and the plant
floor, that supports both competitive customer service and workable
production schedules.

• Issues:
– Customer Lead Times: shorter is more competitive.
– Customer Service: on-time delivery.
– Batching: grouping like product families can reduce lost capacity
due to setups.
– Interface with Scheduling: customer due dates are are an
enormously important control in the overall scheduling process.

Production Planning and Control- Inventory Management (3) Gaafar 2005

 Why Manage Inventory?
• Total $ investment on in inventories is $1.37 trillion (last
quarter of 1999)
• 34% in Manufacturing
• 26% in Retail 82% of the total
• 22% in Wholesale
• 8% in Farm
• 10% in Other

Production Planning and Control- Inventory Management (4) Gaafar 2005

 Why Manage Inventory?

• In 1998, American companies spent $898 billion in logistics-related

activities (or 10.6% of Gross Domestic Product).
– Transportation 58%
– Inventory 38%
– Management 4%
• By effectively managing inventory:
– Xerox eliminated $700 million inventory from its supply chain
– Wal-Mart became the largest retail company utilizing efficient
inventory management
– GM has reduced parts inventory and transportation costs by 26%
annually

Production Planning and Control- Inventory Management (5) Gaafar 2005

 Customers,
Field demand
Sources: Regional Warehouses: centers
plants Warehouses: stocking sinks
vendors stocking points
ports points

Supply

Inventory &
warehousing
costs
Production/
purchase Transportation Transportation
costs costs costs
Inventory &
Production Planning and Control- Inventory Management (6) warehousing Gaafar 2005
costs
 Why Manage Inventory?

• By not managing inventory successfully

– In 1994, “IBM continues to struggle with shortages in their
ThinkPad line” (WSJ, Oct 7, 1994)
– In 1993, “Liz Claiborne said its unexpected earning decline is the
consequence of higher than anticipated excess inventory” (WSJ,
July 15, 1993)
– In 1993, “Dell Computers predicts a loss; Stock plunges. Dell
acknowledged that the company was sharply off in its forecast of
demand, resulting in inventory write downs” (WSJ, August 1993)

Production Planning and Control- Inventory Management (7) Gaafar 2005

 Inventory

• Where do we hold inventory?

– suppliers and manufacturers
– warehouses and distribution centers
– retailers
• Types of Inventory
– WIP and subassemblies
– raw materials
– finished goods
• Why do we hold inventory? (Short answer)
– Economies of scale
– Uncertainty in supply and demand

Production Planning and Control- Inventory Management (8) Gaafar 2005

 Why do we hold inventory?

• Economies of scale
• Uncertainty in supply and demand
• Speculation
• Transportation
• Smoothing production/purchasing
• Logistics
• Cost of controlling inventory

Production Planning and Control- Inventory Management (9) Gaafar 2005

 Decisions to Make

• We have to decide
– How often we review the inventory
– When we should issue a (replenishment/production) order
– How large the order should be

Production Planning and Control- Inventory Management (10) Gaafar 2005

 Characteristics of Inv. Systems

• Demand
– Constant (level) or variable
– Deterministic (known) or Stochastic (random or uncertain)
• Lead Time
• Review Time
– Continuous or periodic review
• Excess Demand
– Backordered or lost
• Changing inventory

Production Planning and Control- Inventory Management (11) Gaafar 2005

 Relevant Costs

• Unit value or unit variable cost (c)

– Cost of making a part available for usage
• Purchase + Freight + Mfg. Costs
– Usually different from “accounting” cost
– Should include more than just book value

Production Planning and Control- Inventory Management (12) Gaafar 2005

 Relevant Costs

• Holding cost (cost of carrying in inv.)

– Opportunity costs of the money tied to inventory (I = ic), where i is
the available rate of return on investment (may use IRR).
– Warehousing and Handling (cost of providing space to store items,
counting and moving items in the warehouse)
– Deterioration, damage, obsolescence
– Insurance and taxes
W: Warehousing cost, $ per item per year

Production Planning and Control- Inventory Management (13) Gaafar 2005

 Relevant Costs

Inv.
Avg. inv. level

Time, t
1 2

Production Planning and Control- Inventory Management (14) Gaafar 2005

 Relevant Costs

• Ordering or Setup Cost (P)

– Fixed cost
• Independent of the size of the replenishment or production
order
– Ordering forms, phone calls, other communication costs, receiving,
inspection, cost of interrupted production, opportunity cost of lost
time, etc.

Production Planning and Control- Inventory Management (15) Gaafar 2005

 EOQ History

– Introduced in 1913 by Ford W. Harris, “How Many Parts to Make

at Once”

– Interest on capital tied up in wages, material and overhead sets a

maximum limit to the quantity of parts which can be profitably
manufactured at one time; “set-up” costs on the job fix the
minimum. Experience has shown one manager a way to determine
the economical size of lots.

– Early application of mathematical modeling to Scientific

Management

Production Planning and Control- Inventory Management (16) Gaafar 2005

 EOQ Modeling Assumptions

1. Production is instantaneous – there is no capacity constraint and

the entire lot is produced simultaneously.
2. Delivery is immediate – there is no time lag between production
and availability to satisfy demand.
3. Demand is deterministic – there is no uncertainty about the
quantity or timing of demand.
4. Demand is constant over time – in fact, it can be represented as a
straight line, so that if annual demand is 365 units this translates
into a daily demand of one unit.
5. A production run incurs a fixed setup cost – regardless of the
size of the lot or the status of the factory, the setup cost is constant.
6. Products can be analyzed singly – either there is only a single
product or conditions exist that ensure separability of products.
Production Planning and Control- Inventory Management (17) Gaafar 2005
 EOQ Model

• Time unit: one year

• Total Cost = setup cost + opportunity cost + Warehousing cost, total
cost is calculated per unit.
• Purchase Cost Constant
• Opportunity cost is always based on average quantity
• Warehousing cost may be based on average quantity for mixed storage
areas, or on maximum quantity for dedicated storage.
• Goal: Find the order quantity that minimizes total costs

• General Equation
P ITQavg
TC    WT , for dedicated storage
Q Q
P ( I  W )TQavg
TC   , for mixed storage
Q Q

Production Planning and Control- Inventory Management (18) Gaafar 2005

 EOQ Model

Assumptions:
• No Stockouts
• Order when no inventory
• Order size determines policy

Inventory
Qavg = Q/2

Order Avg. Inventory (Qavg)

Quantity
Q

Production Planning and Control- Inventory Management (19) Gaafar 2005

 EOQ Model
160
140
120 Total Cost
100
Cost

Holding Cost
80
60
40 Order Cost
20
0
0 500 1000 1500
Optimal Order Order Quantity
Quantity,
Production Q*and Control- Inventory Management (20)
Planning Gaafar 2005
 EOQ Model

P ITQavg
TC    WT , for dedicated storage
Q Q
P ( I  W )TQavg
TC   , for mixed storage
Q Q
By differentiation:

2 PD
EOQ  Q  *
for dedicated storage
( I  2W )

2 PD
EOQ  Q  *
for mixed storage
(I  W )

Production Planning and Control- Inventory Management (21) Gaafar 2005

 EOQ Model
Example:
Zartex Co. produces fertilizer to sell to wholesalers. One raw material –
calcium nitrate – is purchased from a nearby supplier at $22.50 per ton. Zartex
estimates it will need 5,750,000 tons of calcium nitrate next year. The annual
carrying cost for this material is 40% of the acquisition cost, and the ordering
cost is $595.
a) What is the most economical order quantity?
b) How many orders will be placed per year?
c) How much time will elapse between orders?

Production Planning and Control- Inventory Management (22) Gaafar 2005

 EOQ Model
• Tradeoff between set-up costs and holding costs when determining order
quantity. In fact, we order so that these costs are equal per unit time
• Total Cost is not particularly sensitive to the optimal order quantity

Order Quantity 50% 80% 90% 100% 110% 120% 150% 200%
Cost Increase 125% 103% 101% 100% 101% 102% 108% 125%

Production Planning and Control- Inventory Management (23) Gaafar 2005

 EOQ Observations

• Batching causes inventory (i.e., larger lot sizes translate into more
stock).
• Under specific modeling assumptions the lot size that optimally
balances holding and setup costs is given by the square root formula:

• Total cost is relatively insensitive to lot size (so rounding for other
reasons, like coordinating shipping, may be attractive).

2 PD
Q *
carrying cost (cc) = I + W or cc = I + 2W
cc

Production Planning and Control- Inventory Management (24) Gaafar 2005

 EOQ Trade-off

• Two interpretations:
– If you order more (larger Q), you incur higher inventory cost, but
less setup cost
– If you order less frequently, you incur larger inventory cost, but
less setup cost
• The trade-off is not linear!

Production Planning and Control- Inventory Management (25) Gaafar 2005

 Economic Manufacturing Quantity (EMQ)

• What happens when there is finite production rate?

– A: production rate (in units per year)
– A>D (demand rate per year). Why?
• What happens if you keep producing?
– The inventory will keep growing forever with a rate of A-D.
There are many possible scenarios. The common two are:
A: Start producing Q when inventory reaches zero.
B: Start producing a batch of Q so that the quantity is finished when
the previous batch is consumed.

Production Planning and Control- Inventory Management (26) Gaafar 2005

 EMQ- Scenario A
Start producing Q when inventory reaches zero at the rate of A parts per
time unit. Consumption is continuous at the rate of D parts per time unit
until inventory reaches zero, at which time production starts again.

Inv
QM Q D
Qavg   [1  ]
Q 2 2 A
QM

TA TC Time
Start Start
Prod. Stop Prod.
Prod.
Production Planning and Control- Inventory Management (27) Gaafar 2005
 EMQ- Scenario A
P ITQavg
TC    WT , for dedicated storage
Q Q
P ( I  W )TQavg
TC   , for mixed storage
Q Q
By differentiation:

2 PD
EOQ  Q  * for dedicated storage
( I  2W )[1  ( D / A)]

2 PD
EOQ  Q  *

( I  W )[1  ( D / A)] for mixed storage

Production Planning and Control- Inventory Management (28) Gaafar 2005

 EMQ- Scenario B
Start producing a batch of Q, at the rate of A parts per time unit, so that the
quantity is finished when the previous batch is consumed. Consumption is
continuous at the rate of D parts per time unit. Inventory never reaches
zero. QM is the minimum inventory level.

QM  Q Q D
Inv Qavg   [1  ]
2 2 A
Q

QM QM

Start TA Start
Stop T
Prod. Prod. Time
Prod.
Production Planning and Control- Inventory Management (29) Gaafar 2005
 EMQ- Scenario B
P ITQavg
TC    WT , for dedicated storage
Q Q
P ( I  W )TQavg
TC   , for mixed storage
Q Q
By differentiation:

2 PD
EOQ  Q  * for dedicated storage
( I  2W )[1  ( D / A)]

2 PD
EOQ  Q  *

( I  W )[1  ( D / A)] for mixed storage

Production Planning and Control- Inventory Management (30) Gaafar 2005

 Resource Constrained Multiple Product Systems

• Another EOQ assumption:

– Even if you have multiple items to worry, you can analyze them
separately
• What happens if the items share capacitated resources?
– Budget
– Machines
– Personnel
– Space, etc.

Production Planning and Control- Inventory Management (31) Gaafar 2005

 MedEquip Example Costs

• D = 1000 racks per year

• c = $250

• P = $500 (estimated from supplier’s pricing)

• cc = (0.1)($250) + 10 = $35 per unit per year

2 PD
Q  *

cc

2(500 )(1000 )
Q *
 169
35
Production Planning and Control- Inventory Management (32) Gaafar 2005
 Costs in EOQ Model

Production Planning and Control- Inventory Management (33) Gaafar 2005

 Dynamic Lot Sizing

• Another EOQ assumption:

– Demand is constant over time
• Dynamic Lot Sizing relaxes this assumption
– Demand is changing over time
– But demand in each period is known (so still deterministic).

Production Planning and Control- Inventory Management (34) Gaafar 2005

 Dynamic Lot Sizing

• Examples:
– MRP
– Firm orders and contracts for future periods
– Seasonal demand patterns
– Demand with trend (increasing or decreasing over time)

Production Planning and Control- Inventory Management (35) Gaafar 2005

 Dynamic Lot Sizing

• Example:
Week 1 2 3 4 5 6 7 8 9 10
Demand 10 15 12 16 15 12 18 14 22 16
• Other data
– Beginning inventory: 0
– Setup cost: $150
– Inventory carrying cost: $2 per unit per period

Production Planning and Control- Inventory Management (36) Gaafar 2005

 Dynamic Lot Sizing

• Issues:
– Determine a planning horizon
– Calculate total cost over the planning horizon
– Implementing decisions over time
• Rolling horizon concept
– Discrete demand vs. Continuous demand
– Discrete Replenishments vs. Any-time replenishments

Production Planning and Control- Inventory Management (37) Gaafar 2005

 Dynamic Lot Sizing

• Quick Solutions
– Order every period exactly as much as you need
• Lot-for-Lot
– Determine a fixed order quantity and order when you need to order (i.e.,
when on-hand inventory is less than the next period’s demand)
• Example: EOQ
– Order constant time-supply (i.e., order the amount sufficient to cover total
demand in next three months)

Production Planning and Control- Inventory Management (38) Gaafar 2005

 Dynamic Lot Sizing

• Lot-for-lot solution:
Period 1 2 3 4 5 6 7 8 9 10 Total
Demand 10 15 12 16 15 12 18 14 22 16 150
Order 10 15 12 16 15 12 18 14 22 16 150
Beginning I. 10 15 12 16 15 12 18 14 22 16 150
End I. 0 0 0 0 0 0 0 0 0 0 0
Holding Cost 10 15 12 16 15 12 18 14 22 16 150

Total Cost = 150 + 10 * 150 = $1650

Production Planning and Control- Inventory Management (39) Gaafar 2005

 Dynamic Lot Sizing

• Other heuristics:
– EOQ as a Time Supply
– Periodic Order Quantity (POQ)
– Part-Period Balancing (PPB)
– Silver-Meal (or Least Period Cost)

Production Planning and Control- Inventory Management (40) Gaafar 2005

 Dynamic Lot Sizing

• Example
Week 1 2 3 4 5 6 7 8 9 10
Demand 10 15 12 16 15 12 18 14 22 16

• Calculate EOQ:
– Average demand per week = ____
– Holding cost per unit per week = ____
– EOQ = ____
– Total Holding and Setup Cost = ____

2PD 2(150)(15)
Q *
  47.43
cc 2
Production Planning and Control- Inventory Management (41) Gaafar 2005
 Dynamic Lot Sizing- EOQ

Period 1 2 3 4 5 6 7 8 9 10 Total
Demand 10 15 12 16 15 12 18 14 22 16 150
Order 48 48 48 48 192
Beginning I. 48 38 23 59 43 28 64 46 32 58
End I. 38 23 11 43 28 16 46 32 10 42
Holding Cost 86 61 34 102 71 44 110 78 42 100 642

Total Cost = 642 + 4 * 150 = $1242

Production Planning and Control- Inventory Management (42) Gaafar 2005

 Dynamic Lot Sizing - POQ

• Periodic Order Quantity

– Calculate EOQ using Average Demand
– Calculate Time Supply and round it to the nearest integer
– In each replenishment, order to cover that many periods’ demand
– Fixed order interval, but different quantity in each replenishment

Production Planning and Control- Inventory Management (43) Gaafar 2005

 Dynamic Lot Sizing - POQ

Period 1 2 3 4 5 6 7 8 9 10 Total
Demand 10 15 12 16 15 12 18 14 22 16 150
Order 37 43 54 16 150
Beginning I. 37 27 12 43 27 12 54 36 22 16
End I. 27 12 0 27 12 0 36 22 0 0
Holding Cost 64 39 12 70 39 12 90 58 22 16 422

Total Cost = 422 + 4 * 150 = $1022

Production Planning and Control- Inventory Management (44) Gaafar 2005

 Dynamic Lot Sizing - PPB

• Part-Period Balancing
– Select the number of periods covered by the replenishment such
that the total inventory carrying costs are as close as possible to the
setup cost.

Production Planning and Control- Inventory Management (45) Gaafar 2005

 Dynamic Lot Sizing - PPB
Period 1 2 3 4 5 6 7 8 9 10 Total
Demand 10 15 12 16 15 12 18 14 22 16 150
Order 37 43 54 16 150
Beginning I. 37 27 12 43 27 12 54 36 22 16
End I. 27 12 0 27 12 0 36 22 0 0
Holding Cost 64 39 12 70 39 12 90 58 22 16 422

Total Cost = 422 + 4 * 150 = $1022

Production Planning and Control- Inventory Management (46) Gaafar 2005

 Dynamic Lot Sizing - SM

• Silver-Meal (SM) Heuristic

– Minimize total relevant costs per unit time for the duration of the
replenishment quantity.
– Replenishment quantity Q should last for an integer number of periods:
cover the total demand in periods 1 through T (decision variable T)
• Min (Setup Cost + Inv Cost through T) / T
• Q = D1 + … + DT
• Total Relevant Cost through T: TRC(T)
• Select T such that TRC(T)/T is minimized.

Production Planning and Control- Inventory Management (47) Gaafar 2005

 Dynamic Lot Sizing - SM

Period 1 2 3 4 5 6 7 8 9 10 Total
Demand 10 15 12 16 15 12 18 14 22 16 150
Order 37 43 32 38 150
Beginning I. 37 27 12 43 27 12 32 14 38 16
End I. 27 12 0 27 12 0 14 0 16 0
Holding Cost 64 39 12 70 39 12 46 14 54 16 366

Total Cost = 366 + 4 * 150 = $966

Production Planning and Control- Inventory Management (48) Gaafar 2005