1. Inventory Management Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. 13-2 You should be able to: LO 13.1Define the term inventory LO 13.2List the different types of inventory LO 13.3Describe the main functions of inventory LO 13.4Discuss the main requirements for effective management LO 13.5Explain periodic and perpetual review systems LO 13.6Describe the costs that are relevant for inventory management LO 13.7Describe the A-B-C approach and explain how it is useful LO 13.8Describe the basic EOQ model and its assumptions and solve typical problems LO 13.9Describe the economic production quantity model and solve typical problems LO 13.10Describe the quantity discount model and solve typical problems LO 13.11Describe reorder point models and solve typical problems LO 13.12Describe situations in which the fixed-order interval model is appropriate and solve typical problems LO 13.12Describe situations in which the single-period model is appropriate, and solve typical problems

3. 13-3 Inventory A stock or store of goods Independent demand items Items that are ready to be sold or used Inventories are a vital part of business: (1) necessary for operations and (2) contribute to customer satisfaction A “typical” firm has roughly 30% of its current assets and as much as 90% of its working capital invested in inventory LO 13.1

4. 13-4 Raw materials and purchased parts Work-in-process (WIP) Finished goods inventories or merchandise Tools and supplies Maintenance and repairs (MRO) inventory Goods-in-transit to warehouses or customers (pipeline inventory) LO 13.2

5. 13-5 Inventories serve a number of functions such as: 1. To meet anticipated customer demand 2. To smooth production requirements 3. To decouple operations 4. To protect against stockouts 5. To take advantage of order cycles 6. To hedge against price increases 7. To permit operations 8. To take advantage of quantity discounts LO 13.3

6. 13-6 Inventory management has two main concerns: 1. Level of customer service Having the right goods available in the right quantity in the right place at the right time 2. Costs of ordering and carrying inventories The overall objective of inventory management is to achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds 1. Measures of performance 2. Customer satisfaction Number and quantity of backorders Customer complaints 3. Inventory turnover LO 13.3

7. 13-7 Requires: 1. A system keep track of inventory 2. A reliable forecast of demand 3. Knowledge of lead time and lead time variability 4. Reasonable estimates of holding costs ordering costs shortage costs 5. A classification system for inventory items LO 13.4

8. 13-8 Periodic System Physical count of items in inventory made at periodic intervals Perpetual Inventory System System that keeps track of removals from inventory continuously, thus monitoring current levels of each item An order is placed when inventory drops to a predetermined minimum level Two-bin system Two containers of inventory; reorder when the first is empty LO 13.5

9. 13-9 Universal product code (UPC) Bar code printed on a label that has information about the item to which it is attached Radio frequency identification (RFID) tags A technology that uses radio waves to identify objects, such as goods, in supply chains LO 13.5

10. 13-10 Purchase cost The amount paid to buy the inventory Holding (carrying) costs Cost to carry an item in inventory for a length of time, usually a year Ordering costs Costs of ordering and receiving inventory Setup costs The costs involved in preparing equipment for a job Analogous to ordering costs Shortage costs Costs resulting when demand exceeds the supply of inventory; often unrealized profit per unit LO 13.6

11. 13-11 A-B-C approach Classifying inventory according to some measure of importance, and allocating control efforts accordingly A items (very important) 10 to 20 percent of the number of items in inventory and about 60 to 70 percent of the annual dollar value B items (moderately important) C items (least important) 50 to 60 percent of the number of items in inventory but only about 10 to 15 percent of the annual dollar value LO 13.7

12. 13-12 Cycle counting A physical count of items in inventory Cycle counting management How much accuracy is needed? A items: ± 0.2 percent B items: ± 1 percent C items: ± 5 percent When should cycle counting be performed? Who should do it? LO 13.7

13. 13-13 Economic order quantity models identify the optimal order quantity by minimizing the sum of annual costs that vary with order size and frequency 1. The basic economic order quantity model 2. The economic production quantity model 3. The quantity discount model LO 13.8

14. 13-14 The basic EOQ model is used to find a fixed order quantity that will minimize total annual inventory costs Assumptions: 1. Only one product is involved 2. Annual demand requirements are known 3. Demand is even throughout the year 4. Lead time does not vary 5. Each order is received in a single delivery 6. There are no quantity discounts LO 13.8

15. 13-15 Profile of Inventory Level Over Time Quantity on hand Q Receive order Place order Receive order Place order Receive order Lead time Reorder point Usage rate Time LO 13.8

16. 13-16 LO 13.8

17. 13-17 Order Quantity (Q) The Total-Cost Curve is U-Shaped Ordering Costs QOQO Annual Cost ( optimal order quantity) Holding Costs LO 13.8

18. 13-18 Using calculus, we take the derivative of the total cost function and set the derivative (slope) equal to zero and solve for Q. The total cost curve reaches its minimum where the carrying and ordering costs are equal. LO 13.8

19. 13-19 The batch mode is widely used in production. In certain instances, the capacity to produce a part exceeds its usage (demand rate) Assumptions 1. Only one item is involved 2. Annual demand requirements are known 3. Usage rate is constant 4. Usage occurs continually, but production occurs periodically 5. The production rate is constant 6. Lead time does not vary 7. There are no quantity discounts LO 13.9

20. 13-20 Q QpQp I max Production and usage Production and usage Production and usage Usage only Usage only Cumulative production Amount on hand Time LO 13.9

21. 13-21 LO 13.9

22. 13-22 LO 13.9

23. 13-23 Quantity discount Price reduction for larger orders offered to customers to induce them to buy in large quantities LO 13.10

24. 13-24 Adding PD does not change EOQ LO 13.10

25. 13-25 The total-cost curve with quantity discounts is composed of a portion of the total-cost curve for each price LO 13.10

26. 13-26 Reorder point When the quantity on hand of an item drops to this amount, the item is reordered. Determinants of the reorder point 1. The rate of demand 2. The lead time 3. The extent of demand and/or lead time variability 4. The degree of stockout risk acceptable to management LO 13.11

27. 13-27 LO 13.11

28. 13-28 Demand or lead time uncertainty creates the possibility that demand will be greater than available supply To reduce the likelihood of a stockout, it becomes necessary to carry safety stock Safety stock Stock that is held in excess of expected demand due to variable demand and/or lead time LO 13.11

29. 13-29 LO 13.11

30. 13-30 As the amount of safety stock carried increases, the risk of stockout decreases. This improves customer service level Service level The probability that demand will not exceed supply during lead time Service level = 100% - Stockout risk LO 13.11

31. 13-31 The amount of safety stock that is appropriate for a given situation depends upon: 1. The average demand rate and average lead time 2. Demand and lead time variability 3. The desired service level LO 13.11

32. 13-32 The ROP based on a normal Distribution of lead time demand LO 13.11

33. 13-33 Note: If only demand is variable, then LO 13.11

34. 13-34 Note: If only lead time is variable, then LO 13.11

35. 13-35 Set safety stock level at a percentage of EDDLT OP = EDDLT + j(EDDLT) where j is a factor between 0 and 3. Set safety stock level at square root of EDDLT OP = EDDLT +

36. 13-36 Behavior of Economic Order Period (EOP) Systems Economic Order Period Model

37. 13-37 Fixed-order-interval (FOI) model Orders are placed at fixed time intervals Reasons for using the FOI model Supplier’s policy may encourage its use Grouping orders from the same supplier can produce savings in shipping costs Some circumstances do not lend themselves to continuously monitoring inventory position LO 13.12

38. 13-38 As demand for the inventoried item occurs, the inventory level drops When a prescribed period of time (EOP) has elapsed, the ordering process is triggered, i.e., the time between orders is fixed or constant At that time the order quantity is determined using order quantity = upper inventory target - inventory level + EDDLT... more

39. 13-39 After the lead time elapses, the ordered quantity is received, and the inventory level increases The upper inventory level may be determined by the amount of space allocated to an item This system is used where it is desirable to physically count inventory each time an order is placed

40. 13-40 Using an approach similar to that used to derive EOQ, the optimal value of the fixed time between orders is derived to be

41. 13-41 Fixed Interval Fixed Quantity LO 13.12

42. 13-42 LO 13.12

43. 13-43 Hybrid Inventory Models Single-Period Inventory Models

44. 13-44 Optional replenishment model Similar to the fixed order period model Unless inventory has dropped below a prescribed level when the order period has elapsed, no order is placed Protects against placing very small orders Attractive when review and ordering costs are large... more

45. 13-45 Base stock model Start with a certain inventory level Whenever a withdrawal is made, an order of equal size is placed Ensures that inventory maintained at an approximately constant level Appropriate for very expensive items with small ordering costs

46. 13-46 Order quantity decision covers only one period Appropriate for perishable items, e.g., fashion goods, certain foods, magazines Payoff tables may be used to analyze the decision under uncertainty... more

47. 13-47 One of the following rules can be used in the analysis greatest profit least total expected long and short costs least total expected costs

48. 13-48 Single-period model Model for ordering of perishables and other items with limited useful lives Shortage cost Generally, the unrealized profit per unit C shortage = C s = Revenue per unit – Cost per unit Excess cost Different between purchase cost and salvage value of items left over at the end of the period C excess = C e = Cost per unit – Salvage value per unit LO 13.13

49. 13-49 The goal of the single-period model is to identify the order quantity that will minimize the long-run excess and shortage costs Two categories of problem: Demand can be characterized by a continuous distribution Demand can be characterized by a discrete distribution LO 13.13

50. 13-50 LO 13.13 Service level S o Balance Point Quantity CeCe CsCs S o =Optimum Stocking Quantity