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Chapter 6 Inventory Management Om
Chapter 6 Inventory Management Om
Inventory Management
© Wiley 2007
Types of Inventory
• Inventory comes in many shapes and sizes
such as
– Raw materials – purchased items or extracted
materials transformed into components or
products
– Components – parts or subassemblies used in final
product
– Work-in-process – items in process throughout
the plant
– Finished goods – products sold to customers
– Distribution inventory – finished goods in the
distribution system
Types of Inventory
Uses of Inventory
• Anticipation or seasonal inventory
• Fluctuation Inventory or Safety stock: buffer
demand fluctuations
• Lot-size or cycle stock: take advantage of
quantity discounts or purchasing efficiencies
• Transportation or Pipeline 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 desired customer service level
• Customer service is the ability to satisfy
customer requirements
– Percentage of orders shipped on schedule
– Percentage of line items shipped on schedule
– Percentage of dollar volume shipped on
schedule
– Idle time due to material and component
shortages
Inventory Management
Objectives
Provide for cost-efficient operations:
– Buffer stock for smooth production flow
– Maintain a level work force
– Allowing longer production runs & quantity
discounts
• Minimum inventory investments:
– Inventory turnover
– Weeks, days, or hours of supply
Customer Service Level Examples
• Percentage of Orders Shipped on Schedule
– Good measure if orders have similar value. Does not capture
value.
– If one company represents 50% of your business but only 5%
of your orders, 95% on schedule could represent only 50% of
value
• Percentage of Line Items Shipped on Schedule
– Recognizes that not all orders are equal, but does not capture
$ value of orders. More expensive to measure. Ok for finished
goods.
– A 90% service level might mean shipping 225 items out of the
total 250 line items totaled from 20 orders scheduled
• Percentage Of Dollar Volume Shipped on Schedule
– Recognizes the differences in orders in terms of both line
items and $ value
Inventory Investment Measures Example: The Coach
Motor Home Company has annual cost of goods sold of
$10,000,000. The average inventory value at any point in
time is $384,615. Calculate inventory turnover and
weeks/days of supply.
• Inventory Turnover:
annual cost of goods sold $10,000,000
Turnover 26 inventory turns
average inventory value $384,615
• Weeks/Days of Supply:
average inventory on hand in dollars $384,615
Weeks of Supply 2weeks
average weekly usage in dollars $10,000,000/52
$384,615
Days of Supply 10 days
$10,000,000/260
Relevant Inventory Costs
• Maximum inventory: d
– d=avg. daily demand rate I MAX Q 1
p
– p=daily production rate
2DS
• Calculating EPQ EPQ
d
H
1
p
EPQ Problem: HP Ltd. Produces its premium plant food in 50# bags.
Demand is 100,000 lbs. per week and they operate 50 wks. each
year and HP can produce 250,000 lbs. per week. The setup cost is
$200 and the annual holding cost rate is $.55 per bag. Calculate the
EPQ. Determine the maximum inventory level. Calculate the total
cost of using the EPQ policy.
2DS
EPQ
d
H 1
p
d
I MAX Q 1
p
D I MAX
TC EPQ S H
Q 2
2DS 2(50)(100,000)(200)
EPQ EPQ 77,850 Bags
d 100,000
H 1 .551
p
250000
I MAX
d
Q 1
p
I 100 , 000
MAX 77 , 850 1 46 , 710 bags
250 , 000
5,000,000 46,710
D I
TC EPQ S MAX H TC 200 .55 $25,690
Q 2 77,850 2
Quantity Discount Model
• Same as the EOQ model, except:
– Unit price depends upon the quantity ordered
TC QD
D Q
S H
Q 2
CD
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 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?
Quantity Discount Example: Collin’s Sport store is considering going
to a different hat supplier. The present supplier charges $10 each
and requires minimum quantities of 490 hats. The annual demand is
12,000 hats, the ordering cost is $20, and the inventory carrying
cost is 20% of the hat cost, a new supplier is offering hats at $9 in
lots of 4000. Who should he buy from?
• EOQ at lowest price $9. Is it feasible?
2(12,000)(20)
EOQ$9 516 hats
$1.80
• Since the EOQ of 516 is not feasible, calculate the total cost
(C) for each price to make the decision
12,000 490
C$10
$20 $2 $1012,000 $120,980
490 2
12,000 4000
C$9 $20 $1.80 $912,000 $101,660
4000 2
• 4000 hats at $9 each saves $19,320 annually. Space?
Safety Stock and Service Levels
• If demand or lead time is
uncertain, safety stock can be
added to improve order-cycle
service levels
– R = dL +SS
– Where SS =zσdL, and Z is the
number of standard deviations and
σdL is standard deviation of the
demand during lead time
• Order-cycle service level
– The probability that demand
during lead time will not
exceed on-hand inventory
– A 95% service level (stockout
risk of 5%) has a Z=1.645
Periodic Review Systems
• Orders are placed at specified, fixed-time intervals (e.g.
every Friday), for a order size (Q) to bring on-hand
inventory (OH) up to the target inventory (TI), similar to
the min-max system.
• Advantages are:
– No need for a system to continuously monitor item
– Items ordered from the same supplier can be reviewed on the
same day saving purchase order costs
• Disadvantages:
– Replenishment quantities (Q) vary
– Order quantities may not quality for quantity discounts
– On the average, inventory levels will be higher than Q systems-
more stockroom space needed
Periodic Review Systems: Calculations for
TI
• Targeted Inventory level:
TI = d(RP + L) + SS
d = average period demand
RP = review period (days, wks)
L = lead time (days, wks)
SS = zσRP+L
• Replenishment Quantity (Q)=TI-OH
P System: an auto parts store calculated the EOQ for Drive Belts at 236 units and
wants to compare the Total Inventory Costs for a Q vs. a P Review System.
Annual demand (D) is 2704, avg. weekly demand is 52, weekly σ is 1.77 belts, and
lead time is 3 weeks. The annual TC for the Q system is $229; H=$97, S=$10.
Q 236
• Review Period RP x 52weeks x52 5wks
D 2704
• Target Inventory for 95% Service Level
TI d(RP L) SS d(RP L) zσRP L
TI 52 units 5 3 1.645 1.77 5 3 416 8 424 belts
• Average On-Hand
OHavg= TI-dL=424-(52belts)(3wks) = 268 belts
• Annual Total Cost (P System)
52 268
TCp $10 $.97 115 130 $245
5 2
Annual Cost Difference $245 $229 $16
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
The AAU Corp. is considering doing an ABC analysis on its
entire inventory but has decided to test the technique on
a small sample of 15 of its SKU’s. The annual usage and
unit cost of each item is shown below
(A) First calculate the annual dollar volume for
each item
B) List the items in descending order based on annual dollar volume.
(C) Calculate the cumulative annual dollar volume as a percentage of
total dollars. (D) Classify the items into groups
Graphical solution For Example 12.15 showing the ABC
classification of materials
• The A items (106 and 110) account for 60.5% of the value and 13.3% of the items
• The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the
items
• The C items make up the last 14.5% of the value and 60% of the items
• How might you control each item classification? Different ordering rules for each?
Justifying Smaller Order Quantities
• JIT or “Lean Systems” would recommend reducing
order quantities to the lowest practical levels
• Benefits from reducing Q’s:
– Improved customer responsiveness (inventory = Lead time)
– Reduced Cycle Inventory
– Reduced raw materials and purchased components
• Justifying smaller EOQ’s:
2DS
Q
H