Chapter 12 – Independent

Demand Inventory Management

Operations Management
by
R. Dan Reid & Nada R. Sanders
2nd Edition © Wiley 2005

PowerPoint Presentation by R.B. Clough - UNH

Inventories in the Supply Chain
Independent vs. Dependent
Demand
 Independent demand items are finished
goods or other items sold to someone
outside the company
 Dependent demand items are materials
or component parts used in the
production of another item (e.g.,
finished product)
 Types of Inventory:
How Inventory is Used
 Anticipation or seasonal inventory
 Safety stock: buffer demand fluctuations
 Lot-size or cycle stock: take advantage of quantity
discounts or purchasing efficiencies
 Pipeline or transportation inventory
 Speculative or hedge inventory protects against
some future event, e.g. labor strike
 Maintenance, repair, and operating (MRO)
inventories
Objectives of Inventory
Management
 Provide acceptable level of customer
service (on-time delivery)
 Allow cost-efficient operations
 Minimize inventory investment
 Relevant Inventory Costs
Item Cost Cost per item plus any other direct costs
associated with getting the item to the
plant
Holding Capital, storage, and risk cost typically
Costs stated as a % of the unit value,
e.g. 15-25%
Ordering Fixed, constant dollar amount incurred
Cost for each order placed

Shortage Loss of customer goodwill, back order

Costs handling, and lost sales
 Order Quantity Strategies
Lot-for-lot Order exactly what is needed for the
next period
Fixed-order Order a predetermined amount each
quantity time an order is placed
Min-max When on-hand inventory falls below a
system predetermined minimum level, order
enough to refill up to maximum level
Order n Order enough to satisfy demand for
periods the next n periods
Examples of Ordering Approaches
 Three Mathematical Models for
Determining Order Quantity
 Economic Order Quantity (EOQ or Q System)
 An optimizing method used for determining order
quantity and reorder points
 Part of continuous review system which tracks on-
hand inventory each time a withdrawal is made
 Economic Production Quantity (EPQ)
 A model that allows for incremental product delivery
 Quantity Discount Model
 Modifies the EOQ process to consider cases where
quantity discounts are available
 Economic Order Quantity
 EOQ Assumptions:
 Demand is known & constant -
no safety stock is required
 Lead time is known & constant
 No quantity discounts are
available
 Ordering (or setup) costs are
constant
 All demand is satisfied (no
shortages)
 The order quantity arrives in a
single shipment
EOQ: Total Cost Equation
 D  Q 
TC EOQ   S    H 
Q   2 
Where
TC  total annual cost
D  annual demand
Q  quantity to be ordered
H  annual holding cost
S  ordering or setup cost
EOQ Total Costs
Total annual costs = annual ordering costs + annual holding costs
The EOQ Formula
Minimize the TC by ordering the EOQ:

2 DS
EOQ 
H
When to Order:
The Reorder Point
 Without safety stock:
R  dL
where R  reorder point in units
d  daily/weekly demand in units
L  lead time in days/weeks
 With safety stock:
R  dL  SS
where SS  safety stock in units
EOQ Example
 Weekly demand = 240 units
 No. of weeks per year = 52
 Ordering cost = $50
 Unit cost = $15
 Annual carrying charge = 20%
 Lead time = 2 weeks
EOQ Example Solution
D  52  240  12,480 units / year
H  0.2  15  $3 per unit per year
2 DS 2 12,480  50
Q   644.98  645 units
H 3
 D   Q   12,480   645 
TC   S    H     50     3
 Q   2   645   2 
 967.44  967.5  $1,934.94

R  dL  240  2  480 units

EPQ (Economic Production
Quantity) Assumptions
 Same as the EOQ except: inventory arrives in
increments & is drawn down as it arrives
 EPQ Equations
 D   I MAX 
 Adjusted total cost: TC EPQ   S    H
Q   2 

 d
 Maximum inventory: I MAX  Q1  
 p

2 DS
EPQ 
 Adjusted order quantity:  d
H 1  
 p
EPQ Example
 Annual demand = 18,000 units
 Production rate = 2500 units/month
 Setup cost = $800
 Annual holding cost = $18 per unit
 Lead time = 5 days
 No. of operating days per month = 20
EPQ Example Solution
18,000
d  1500 units / month; p  2500 units / month
12
2 DS 2  18,000  800
Q   2000 units
 d  1500 
H 1   18  1  
 p  2500 

 d  1500 
I MAX  Q1    2000  1    800 units
 p  2500 
D  I   18,000   800 
TC   S    MAX H     800    18
Q   2   2000   2 
 7,200  7,200  14,400
EPQ Example Solution (cont.)
 The reorder point:

1500
R  dL   5  375 units
20
 With safety stock of 200 units:
1500
R  dL  SS   5  200  575 units
20
Quantity Discount Model
Assumptions
 Same as the EOQ, except:
 Unit price depends upon the quantity
ordered
 Adjusted total cost equation:
 D  Q 
TCQD   S    H   PD
Q   2 
Quantity Discount Procedure
 Calculate the EOQ at the lowest price
 Determine whether the EOQ is feasible at
that price
 Will the vendor sell that quantity at that price?
 If yes, stop – if no, continue
 Check the feasibility of EOQ at the next
higher price

 Continue to the next slide ...

QD Procedure (continued)

 Continue until you identify a feasible EOQ

 Calculate the total costs (including total item
cost) for the feasible EOQ model
 Calculate the total costs of buying at the
minimum quantity required for each of the
cheaper unit prices
 Compare the total cost of each option &
choose the lowest cost alternative
 Any other issues to consider?
QD Example
 Annual Demand = 5000 units
 Ordering cost = $49
 Annual carrying charge = 20%
 Unit price schedule:
Quantity Unit Price
0 to 999 $5.00
1000 to 1999 $4.80
2000 and over $4.75
QD Example Solution
 Step 1
2  5,000  49
QP $4.75   718  not feasible 
0.2  4.75

2  5,000  49
QP $4.80   714  not feasible 
0.2  4.80

2  5,000  49
QP $5.00   700  feasible 
0.2  5.00
 QD Example Solution (Cont.)
 Step 2
5,000 700
TCQ 700   49   0.2  5.00  5.00  5000  $25,700
700 2

5,000 1000
TCQ 1000   49   0.2  4.80  4.80  5000  $24,725
1000 2

5,000 2000
TCQ  2000   49   0.2  4.75  4.75  5000  $24,822.50
2000 2
What if Demand is Uncertain?
Safety Stock and Service Level
 Order-cycle service level is the
probability that demand during lead
time won’t exceed on-hand inventory.
 Risk of a stockout = 1 – (service level)
 More safety stock means greater service
level and smaller risk of stockout
Safety Stock and Reorder
Point
 Without safety stock:
R  dL
where R  reorder point in units
d  daily demand in units
L  lead time in days

 With safety stock:

R  dL  SS
where SS  safety stock in units
 Reorder Point Determination
SS  z dL
i.e.,
R  dL  z dL
R = reorder point
d = average daily demand
L = lead time in days
z = number of standard deviations associated with
desired service level
 = standard deviation of demand during lead time
Safety Stock Example
 Daily demand = 20 units
 Lead time = 10 days
 S.D. of lead time demand = 50 units
 Service level = 90%
Determine:
1. Safety stock
2. Reorder point
Safety Stock Solution
Step 1 – determine z
From Appendix B : z  1.28
Step 2 – determine safety stock
SS  1.28  50  64 units
Step 3 – determine reorder point
R  dL  SS  20 10  64  264 units
ABC Inventory Classification
 ABC classification is a method for determining
level of control and frequency of review of inventory
items
 A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
 A Items – typically 20% of the items accounting for
80% of the inventory value-use Q system
 B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use Q or P
 C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value-use P
ABC Example: the table below shows a solution to an ABC analysis. The
information that is required to do the analysis is: Item #, Unit $ Value, and
Annual Unit Usage. The analysis requires a calculation of Annual Usage $ and
sorting that column from highest to lowest $ value, calculating the cumulative
annual $ volume, and grouping into typical ABC classifications.

Item Annual Usage ($) Percentage of Total $ Cumulative Percentage of Total $ Item Classification
106 16,500 34.4 34.4 A
110 12,500 26.1 60.5 A
115 4500 9.4 69.9 B
105 3200 6.7 76.6 B
111 2250 4.7 81.3 B
104 2000 4.2 85.5 B
114 1200 2.5 88 C
107 1000 2.1 90.1 C
101 960 2 92.1 C
113 875 1.8 93.9 C
103 750 1.6 95.5 C
108 600 1.3 96.8 C
112 600 1.3 98.1 C
102 500 1 99.1 C
109 500 1 100.1 C
Inventory Record Accuracy
 Inaccurate inventory records can cause:
 Lost sales
 Disrupted operations
 Poor customer service
 Lower productivity
 Planning errors and expediting

 Two methods are available for checking record accuracy

 Periodic counting-physical inventory
 Cycle counting-daily counting of pre-specified items provides the
following advantages:
 Timely detection and correction of inaccurate records
 Elimination of lost production time due to unexpected stock outs
 Structured approach using employees trained in cycle counting
Chapter 12 HW Assignment
Problems
6, 7, 9 – 13, 16, 17, 22 – 24.