Inventory Management for Independent Demand Chapter 12, Part 1

Management 326 Operations and Operations Strategy Designing an Operations System Managing an Operations System Improving an Operations System Inventory Management for Independent Demand

Presentation Outline Objectives of inventory management Types of inventory and types of demand Relevant inventory costs Fixed order quantity method Optimizing the order quantity: the economic order quantity method (EOQ)

Objectives of Inventory Management Maintain good customer service Keep costs as low as possible, consistent with the required level of customer service Minimize inventory investment

Types of Demand Dependent Demand Demand for raw materials, component parts, and subassemblies used to make a finished product Both the amount of demand and the date required depend on the production schedule

Types of Demand (2) Independent Demand Any demand that is not used to meet a production schedule is called independent demand Examples of independent demand: finished goods; retail and distributor inventories; service inventories; maintenance, repair, and operating (MRO) inventories MRO includes fuels, repair parts, office supplies, cleaning supplies

Dependent and Independent Demand: Types of Inventory Dependent demand: used to meet a production schedule in manufacturing Independent demand: not used to meet a production schedule Work-in-process (WIP) Raw materials Component parts Manufacturer Service Company Finished goods MRO Retail and distributor inventories Service inventories MRO

Relevant Inventory Costs Measurable Cost of Inventory = Item Costs Holding Costs Order Costs for purchased items OR Setup Costs for items made by your company Shortage costs: Administrative & transportation costs related to back orders +++ Shortages and back orders result in lost sales and lost goodwill. These costs are relevant but hard to measure.

Item Costs Item costs For purchased items, the item cost is the purchase price, plus shipping For work in process, the item cost is the cost of materials and labor used in the item For finished goods, the item cost is the cost of goods sold.

Inventory Holding Costs Inventory holding costs include capital costs, storage costs, and risk costs Capital costs: If inventory is financed with borrowed money, the capital cost is the interest rate paid If inventory is financed from retained earnings, the capital cost is the opportunity cost of not putting the money into other investments Storage costs: the costs of space, people, and equipment used in inventory storage

Inventory Holding Costs (2) Risk costs: cost of taxes and insurance on inventory, damage, obsolescence, and theft Inventory holding costs are usually computed as a percentage of item costs

Ordering and Setup Costs For purchased items, ordering costs are the fixed costs associated with placing an order with a supplier For items made internally, setup costs are used instead of order costs. The setup cost is the cost of work that must be done before production actually begins.

Shortage Costs Administrative and transportation costs related to back orders Lost good will and lost sales due to product shortages – hard to measure

Inventory Management Policies An inventory management policy should determine How much to order When to order

Fixed Order Quantity Method An inventory policy for independent demand. Based on the following rules: 1. Order the same amount, Q, each time Q is called the order quantity 2. Place an order when the amount in inventory gets down to the reorder point, R Compute Q and R for each item.

Fixed Order Quantity Method (2) Relevant Costs Assume Quantity discounts are not available Orders are placed early enough that shortages do not occur Relevant costs Order costs Inventory holding costs

Fixed Order Quantity Method (3) Notation Q = order quantity D = annual demand for the item S = cost of placing one order H = inventory holding cost per unit per year (commonly called holding cost) L = lead time (time between order placement and order receipt) R = reorder point TC = annual cost of placing orders + annual cost of holding inventory

Fixed Order Quantity Method (4) Annual Cost of Placing Orders Annual cost of placing orders = (orders per year) (cost of 1 order)

Fixed Order Quantity Method (5) Annual Inventory Cost Figure 12.2, page 430 Given: D = annual demand = 10,400 Weekly demand = 200 L = lead time = 1 week Q = order quantity = 600 Average inventory = (Q/2) = 600/2 = 300 Inventory cost =

Fixed Order Quantity Method (5)

Economic Order Quantity The economic order quantity (EOQ) is the fixed order quantity (Q) that minimizes the total annual costs of placing orders and holding inventory (TC).

Economic Order Quantity (2) Demand (D) is known and constant H is known and constant Order costs (S) are constant The order quantity arrives in a single shipment No quantity discounts are available All demand will be met (no shortages)

We want to minimize TC D, S, and H are constant. TC is a function of Q.

Economic Order Quantity (3) Let Q * be the economic order quantity. Then For Q *, annual order cost = annual inventory cost