Chapter 15.

Inventory Management
 Inventory is the stock of any item or resource used in an organization and can include: raw materials, finished products, component parts, supplies, and work-in-process  An inventory system is the set of policies and controls that monitor levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be  Firms invest 25-35 percent of assets in inventory but many do not manage inventories well

Purposes of Inventory
1. To maintain independence of operations
 

Provide optimal amount of cushion between work centers Ensure smooth work flow

2. To allow flexibility in production scheduling 3. To meet variation in product demand 4. To provide a safeguard for variation in raw material or parts delivery time


Protect against supply delivery problems (strikes, weather, natural disasters, war, etc.)

5. To take advantage of economic purchase-order size

Inventory Control (Management)

 Independent vs. Dependent Demand  Inventory costs  Single-Period Model  Multi-Period Models: Basic Fixed-Order Quantity Models


Event triggered (Example: running out of stock, or dropping below a reorder point)

EOQ, EOQ with reorder point (ROP) , and with safety stock

 Multi-Period Models: Basic Fixed-Time Period Model  EOQ with Quantity Discounts  ABC analysis

Independent vs. Dependent Demand

Independent Demand (Demand not related to other items or the final end-product)
Dependent Demand (Derived demand items for component parts, subassemblies, raw materials, etc.)
E(1 )

Inventory Costs
 Holding (or carrying) costs.


Costs for capital, taxes, insurance, etc. (Dealing with storage and handling)

 Setup (or production change) costs. (manufacturing)



Costs for arranging specific equipment setups, etc.

 Ordering costs (services & manufacturing)



Costs of someone placing an order, etc.

 Shortage (backordering) costs.



Costs of canceling an order, customer goodwill, etc.

A Single-Period Model
 Sometimes referred to as the newsboy problem  Is used to handle ordering of perishables (fresh seafood, cut flowers, etc.) and items that have a limited useful life (newspaper, magazines, high fashion goods, some high tech components, etc)  The optimal stocking level uses marginal analysis is where the expected profit (benefit from derived from carrying the next unit) is less than the expected cost of that unit (minus salvage value)  Co = Cost/unit of overestimated demand (excess demand) Co = Cost per unit salvage value per unit  Cu = Cost/unit of underestimated demand Cu = Price/unit cost/unit + cost of loss of goodwill per unit  Optimal order level is where P <= Cu /(Co + Cu )


This model states that we should continue to increase the size of the inventory so long as the probability of selling the last unit added is equal to or greater than the ratio of: Cu/Co+Cu

Single Period Model Example

 UNC Charlotte basketball team is playing in a tournament game this weekend. Based on our past experience we sell on average 2,400 shirts with a standard deviation of 350. We make $10 on every shirt we sell at the game, but lose $5 on every shirt not sold. How many shirts should we make for the game?
1. 2. 3. 4. 5. 6. 7. Determine Cu = $10 and Co = $5 (this time, these were directly given) Compute P $10 / ($10 + $5) = 0.667 66.7% Order up to ~ 66.7% of the demand How do you determine it? Normal distribution, Z transformation, Z0.667 = 0.432 (use NORMSDIST(.667) or Appendix E) Therefore we need 2,400 +0.432(350) = 2,551 shirts 7

Single Period Model, Marginal Analysis

 
1. 2. 3. 4.

Marginal analysis approach. Consider solved problem 1, p. 617

Determine Cu = 100-70 = $30 and Co = 70-20 = $50 Compute P 30/(30+50) 0.375 Develop a full marginal analysis table (Excel time!) Assume we purchase 35 units, compute the expected total cost

5.

Repeat step 4, for 36,, 40

The optimal order (purchase) size is the no. of units with the minimum expected total cost

Fixed-Order Quantity Models: Assumptions

 Demand for the product is constant and uniform throughout the period.  Inventory holding cost is based on average inventory.  Ordering or setup costs are constant.  All demands for the product will be satisfied. (No back orders are allowed.)  Lead time (time from ordering to receipt) is constant (later, this
assumption is relaxed with safety stocks).

 Price per unit of product is constant.

Basic Fixed-Order Quantity Model and Reorder Point Behavior

Usage rate

ROP

Receive order

Place order

Receive order

Place order

Receive order

Time

Lead time (L)

ROP = Reorder point Q = Economic order quantity L = Lead time

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Cost Minimization Goal

By adding the item, holding, and ordering costs together, we determine the total cost curve, which in turn is used to find the Qoptimal (a.k.a. EOQ) inventory order point that minimizes total costs. Total Cost
C O S T

Holding Costs Annual Cost of Items (DC) Ordering Costs

QOPTIMAL Order Quantity (Q)

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Basic Fixed-Order Quantity (EOQ) Model

Annual Purchase + Cost
TC D C Q S H

Total Annual Cost =

Annual Holding + Cost

Annual Ordering Cost

TC ! DC 

Q D H  S 2 Q

A little bit of calculus

EOQ !
_

2 DS H

A little bit of common sense

ROP = d L
ROP with safety stock
_

= Total annual cost = Demand = Cost per unit = Order quantity = Cost of placing an order or setup cost = Annual holding and storage cost per unit of inventory R or ROP = Reorder point L_ = Lead time (constant) d = average (daily, weekly, etc) demand L = Standard deviation of demand during lead time

ROP = d L  zW L
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Basic EOQ & ROP Example

Given the information below, what are the EOQ, reorder point, and total annual cost? Annual Demand = 1,000 units Days per year considered in average daily demand = 365 Cost to place an order = $10 Holding cost per unit per year = $2.50 Lead time = 7 days Cost per unit = $15

EOQ ROP

89.44 89 or 90 units 2.74*7 19.18 19 or 20 units

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Another example
Days per year considered in average daily demand = 360 Average daily demand is 3.5 units Standard deviation of daily demand is 0.95 units Cost to place an order = $50 Holding cost per unit per year = $7.25 Lead time = 4 days Compute the EOQ, and ROP is the firm wants to maintain a 97% service level (probability of not stocking out)
_

ROP = d L  zW L
L

WL !

W
i !1

2 di

Since each day is independent and W d is constant,

2 W L ! LW d

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Fixed-Time Period Model with Safety Stock

q = Average demand + Safety stock Inventory currently on hand
q = d (T + L) + Z W T + L - I Where : q = quantitiy to be ordered T = the number of days between reviews L = lead time in days d = forecast average daily demand z = the number of standard deviations for a specified service probabilit y
W T + L = standard deviation of demand over the review and lead time

I = current inventory level (includes items on order)

T+L

W T +L =

W 
di i !1

Since each day is independent and W d is constant,

W T +L = (T + L)W d
2

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Example of the Fixed-Time Period Model

Given the information below, how many units should be ordered?

Average daily demand for a product is 20 units. The review period is 30 days, and lead time is 10 days. Management has set a policy of satisfying 96 percent of demand from items in stock. At the beginning of the review period there are 200 units in inventory. The daily demand standard deviation is 4 units.

W T + L = (T + L)W d =

30 + 10 4 2

= 25.298
644.27 units

q = 20(30+10) + 1.75(25.30) 200

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A special purpose model

Price-Break Model (Quantity discounts)

 Based on the same assumptions as the EOQ model, the pricebreak model has a similar EOQ (Qopt) formula:
Q OPT = 2DS 2(Annual Demand)(Order or Setup Cost) = iC Annual Holding Cost

 Annual holding cost, H, is calculated using H = iC where

 

i = percentage of unit cost attributed to carrying inventory C = cost per unit

 Since C changes for each price-break, the formula above must be applied to each price-break cost value.  Determine the total cost for each price break  The lowest total cost suggests the optimal order size (EOQ)

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Price-Break Example
A company has a chance to reduce their inventory ordering costs by placing larger quantity orders using the price-break order quantity schedule below. What should their optimal order quantity be if this company purchases this single inventory item with an e-mail ordering cost of $4, a carrying cost rate of 2% of the inventory cost of the item, and an annual demand of 10,000 units?
Order Quantity(units) Price/unit($) 0 to 2,499 $1.20 2,500 to 3,999 $1.00 4,000 or more $0.98

Re-do the example with an order cost of $25 and an inventory carrying cost rate of 45%.

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1826

2500

4000

Order Quantity

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ABC Classification System

 Items kept in inventory are not of equal importance in terms of:
   

dollars invested profit potential sales or usage volume stock-out penalties

% of $ Value 30
0

60

A B C

% of Use


30 60

So, identify inventory items based on percentage of total dollar value, where A items are roughly top 15 %, B items as next 35 %, and the lower 65% are the C items

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Inventory Accuracy and Cycle Counting

 Inventory accuracy refers to how well the inventory records agree with physical count
 

Lock the storeroom Hire the right personnel for as storeroom manager or employees

 Cycle Counting is a physical inventory-taking technique in which inventory is counted on a frequent basis rather than 1-2 times a year
  

Easier to conduct when inventories are low Randomly (minimize predictability) Pay more attention to A items, then B, etc.

 

Suggested problems: 3, 6, 12, 14, 17, 18, 21, 24 Case: Hewlett-Packard

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