To allow for: Errors in Demand Forecasting Errors in Demand Forecasting Mistakes in Planning Mistakes in Planning Record Inaccuracies Record Inaccuracies Quality, Workforce, Machine problems Quality, Workforce, Machine problems Optimum buying & production quantities Optimum buying & production quantities Smooth production cycles using seasonal stock Smooth production cycles using seasonal stock Maintaining High Customer Service Maintaining High Customer Service Inventory is a Financial Investment Inventory is a Financial Investment
$115 billion Better management of inventories can make a big difference
Three types of costs often affect most inventory decisions Cost of Having (Holding or carrying cost) Cost of Not Having (Shortage cost) Cost of Getting (Ordering cost)
Basic Trade-Offs COST Ordering or Setup Holding or Carrying Shortage or Backorder Inventory Level HighLow
HOLDING OR CARRYING COSTS * Capital Cost (Opportunity Cost of $ tied up) Liquidity Risk * Storage, Handling, Insurance * Obsolescence * Deterioration, Decay, Theft, Shrinkage Taxes …. SHORTAGE OR BACKORDER COSTS * Lost Sales * Customer Ill Will * Information and Follow up Costs * Expediting * Production Down Time ORDERING OR SETUP COSTS * Paperwork for order * Equipment Setup Sample testing Receiving and handling Inventory Costs
Page 8 IP&M Performance Measures ICC: Inventory Carrying Cost GIT: Global Inventory Turnover FTFR: First-Time-Fill-Rate FFR: Final Fill Rate FAC: Forecast Accuracy
1. HOW MUCH to order? Balance the costs associated with ordering frequency 2. WHEN to order? When there is enough to cover demand during lead time 1. HOW MUCH to order? Balance the costs associated with ordering frequency 2. WHEN to order? When there is enough to cover demand during lead time Basic Issues order Shipment
1. How Much to order? Balance holding cost with ordering cost “The EOQ Approach”
Let ’ s take the simplest case Known & constant demand Instantaneous receipt of orders No quantity discounts Time Units in Inventory Order Quantity Average Inventory= Order Quantity/2
Order Quantity Annual Cost Holding Cost Total Cost Curve Order (Setup) Cost Optimal Order Quantity (Q*) EOQ Model
D = Demand (units/time period) S =Cost per order ($) H =Holding cost ($/unit/time period) (= C*i) Economic Order Quantity
Demand = 1000 units per year Ordering Cost = 100 $/order Unit Cost = $50 Inventory holding cost = 40 % (or $ 0.4 per $ in Inventory /year) Order Lead Time = 2 weeks (assume 50 weeks per year) An Example What is the EOQ for this coffee maker? What is the ROP?
What if … Interest rates go up? Order processing is automated? Warehouse costs drop? Product is cost-reduced? Minimum order quantity imposed? Variability of demand increases? And a quick review of basic relationships
When? Is there enough on hand to cover the demand during lead time? Units in stock Time How often should we tolerate shortage during lead time? [Conversely, what “service level” is acceptable?] Arrival of Next Order Safety Stock Reorder Point Lead Time ? Shortage! ?
Each level of safety stock implies a different “ service level ” during the lead time Safety Stock Reorder Point Lead Time Units in stock Time Distribution of demand during lead time (DDLT) Probability of shortage during lead time [ =(1- Service Level”) ]
Safety Stock Reorder Point Lead Time Units in stock Time More clearly Average DDLT P(Stockout) SS Service Level Demand distribution during lead time
Balance Shortage Cost [Cu] with Holding Cost [Co] P (DDLT > ROP) * Cu = P (DDLT< ROP) * Co (1-Service Level) * Cu = Service Level * Co Service Level = Cu / (Co + Cu) This ratio is also called “Critical Fractile” Expected cost of having too few = Expected cost of having too many What is the appropriate service level?
= 350 Service Level = 95% P(Stockout) = 5% Frequency x = ? = 10 Safety Stock = x - ROP for ER Kits
So, how do we determine Reorder Point? 1. Determine desired service level during the lead time (For example, use the Critical Fractile formula) 2. If DDLT is normally distributed, find the z which corresponds to the service level 3. Safety stock = (z) (standard deviation of DDLT) 4. Reorder Point = Safety Stock + Average DDLT
Higher service levels require very high safety stocks 0.8 1.3 1.8 2.3 2.8 3.3 80%85%90%95%100% Service Level Safety Stock
Focus on Cost Optimization Economic Order Quantity (EOQ) Economic Shipment Load (TL,…) Good inventory management “ optimizes ” the relevant costs
And utilizes frequent and up-to-date information Focus on Cost Optimization Economic Order Quantity (EOQ) Economic Shipment Load (TL,…) Focus on Exchange of Information Materials Requirement Planning (MRP)… Enterprise Resource Planning (ERP)
But most important, good inventory management is about dealing with uncertainty and variability Focus on Cost Optimization Economic Order Quantity (EOQ) Economic Shipment Load (TL,…) Focus on Flexible & Rapid Response Just -in-Time (JIT) Mass Customized Production Focus on Exchange of Information Materials Requirement Planning (MRP)… Enterprise Resource Planning (ERP)