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12-1 Operations Management Inventory Management Chapter 12 - Part I
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12-2 Outline Functions of Inventory. ABC Analysis. Inventory Costs. Inventory Models for Independent Demand. Economic Order Quantity (EOQ) Model. Production Order Quantity (POQ) Model. Quantity Discount Model. Probabilistic Models with Varying Demand. Fixed Period Systems.
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12-3 Types of Inventory Raw material. Work-in-progress. Maintenance/repair/operating (MRO) supply. Finished goods.
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12-4 The Functions of Inventory To ”decouple” or separate various parts of the production process. To smooth production (link supply and demand). To provide goods for customers (quick response). To take advantage of quantity discounts. To hedge against inflation and upward price changes (speculation).
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12-5 The Material Flow Cycle
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12-6 High cost - $$$$$ Item cost (if purchased). Ordering (or setup) cost. Costs of forms, clerks’ wages etc. Holding (or carrying) cost. Building lease, insurance, taxes etc. Difficult to control. Hides production problems. Disadvantages of Inventory
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12-7 Divide on-hand inventory into 3 classes based on annual $ volume. Annual $ volume = Annual demand x Unit cost. A class - Most important. 15-20% of products. 60-80% of value. B class -Less important. 20-40% of products. 15-30% of value. C class - Least important. 50-60% of products. 5-10% of value. ABC Analysis (Pareto)
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12-8 Sort products from largest to smallest annual $ volume. Divide into A, B and C classes. Focus on A products. Develop class A suppliers more. Give tighter physical control of A items. Forecast A items more carefully. Consider B products only after A products. ABC Analysis
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12-9 0 20 40 60 80 100 5 10 Product Annual $ Usage (x1000) Classifying Items as ABC 25 products sorted by Annual $ Volume (Sales) 15 20 25 ProductSales% 110014 2 9213 3 8812 4 66 9 5 58 8 6 50 7 7 46 6 8 41 6 9 32 4 10 26 4 11 21 3 12 18 2 13 16 2 14-25 66 9 Total720 1
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12-10 0 20 40 60 80 100 20 40 % of Products Classifying Items as ABC 60 80 100 A B C 0 Annual $ Usage (x1000) Class% $ Vol% Items A39% 12% (3/25) B52%40% (10/25) C9%48% (12/25)
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12-11 Count products to verify inventory records. Count A items most frequently (for example, once a month). Count B items less frequently (twice a year). Count C items least frequently (once a year). Do not shut down facility to count everything at one time (once per year). Cycle Counting
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12-12 Inventory Costs Holding costs Holding costs - Associated with holding or “carrying” inventory over time. Ordering costs Ordering costs - Associated with costs of placing order and receiving goods. Setup costs Setup costs - Cost to prepare a machine or process for manufacturing an order. Stockout costs Stockout costs - Cost of not making a sale and lost future sales.
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12-13 Holding Costs Investment costs (borrowing, interest). Insurance. Taxes. Storage and handling. Extra staffing. Pilferage, damage, spoilage, scrap. Obsolescence.
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12-14 Inventory Holding Costs Category Investment costs Housing costs Material handling costs Labor cost from extra handling Pilferage, scrap, and obsolescence Cost as a % of Inventory Value 6 - 24% 3 - 10% 1 - 3.5% 3 - 5% 2 - 5%
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12-15 Ordering Costs To order and receive product: Supplies. Forms. Order processing. Clerical support. etc.
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12-16 Setup Costs To change equipment and setup for new product: Clean-up costs. Re-tooling costs. Adjustment costs. etc.
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12-17 Stockout Costs For not making a sale and for lost future sales: - Customer may wait for a backorder, or - Cancel order (and acquire product elsewhere). Backorder costs: expediting, special orders, rush shipments, etc. Lost current sale cost. Lost future sales (hard to estimate).
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12-18 When to order? Every 3 days, every week, every month, etc. When only 5 items are left, when only 10 items are left, when only 20 items are left, etc. How much to order (each time)? 100 units, 50 units, 23.624 units, etc. Many different models can be used, depending on nature of products and demand. Inventory Questions
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12-19 Independent vs. Dependent Demand Independent demand Independent demand - Demand for item is independent of demand for any other item. Dependent demand Dependent demand - Demand for item depends upon the demand for some other item. Example: Demand for car engines depends on demand for new cars. We will consider only independent demand. (See Chapter 14 for dependent demand.)
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12-20 Fixed order-quantity models. 1. Economic order quantity (EOQ). 2. Production order quantity (POQ or ERS). 3. Quantity discount. Probabilistic models. Fixed order-period models. How much and when to order? Inventory Models
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12-21 Given a fixed annual demand for a product. With many small orders: Amount on hand is always small, so inventory is small. Frequent orders means cost of ordering is large. With few large orders: Amount on hand may be large (when order arrives), so inventory may be large. Infrequent orders mean cost of ordering is small. How Much and When to Order?
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12-22 Known and constant demand. Known and constant lead time. Instantaneous receipt of material. No quantity discounts. Only order cost and holding cost. No stockouts. EOQ Assumptions
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12-23 Order Quantity Annual Cost Holding Cost Curve Order Cost Curve EOQ Model - How Much to Order?
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12-24 Order Quantity Annual Cost Holding Cost Curve Total Cost Curve Order Cost Curve Optimal Order Quantity (EOQ=Q*) EOQ Model - How Much to Order?
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12-25 More units must be stored if more are ordered. Purchase Order DescriptionQty. Microwave1000 Order quantity Why Holding Costs Increase DescriptionQty. Microwave2 Order quantity
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12-26 Cost is spread over more units. Example: You need 1000 microwave ovens. Purchase Order DescriptionQty. Microwave1 Purchase Order DescriptionQty. Microwave1 Purchase Order DescriptionQty. Microwave1 Purchase Order Description Qty. Microwave 2 1 Order (Postage $ 0.34) 500 Orders (Postage $170) Order quantity Purchase Order Description Qty. Microwave1000 Why Order Costs Decrease
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12-27 Deriving an EOQ Develop an expression for total costs. Total cost = order cost + holding cost Find order quantity that gives minimum total cost (use calculus). Minimum is when slope is flat. Slope = Derivative. Set derivative of total cost equal to 0 and solve for best order quantity.
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12-28 Expected Number of Orders per year == N D Q D = Demand per year (known and relatively constant) S = Order cost per order H = Holding (carrying) cost per unit per year d = Demand per day L = Lead time in days (known and relatively constant) Q = order size (number of pieces or items per order) EOQ Model Equations Order Cost per year = S D Q Holding Cost per year = (average inventory level) H
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12-29 EOQ Model - average inventory level Average Inventory (Q/2) Time Inventory Level Order Quantity (Q) 0 Maximum inventory = Q Minimum inventory = 0
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12-30 Expected Number of Orders per year == N D Q D = Demand per year (known and relatively constant) S = Order cost per order H = Holding (carrying) cost per unit per year d = Demand per day (known and relatively constant) L = Lead time in days (known and relatively constant) Q = order size (number of pieces or items per order) EOQ Model Equations Order Cost per year = S D Q Holding Cost per year = (average inventory level) H = H Q 2
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12-31 Order Quantity Annual Cost Holding Cost =(Q/2)H Total Cost Curve = (D/Q)S+(Q/2)H Order Cost Curve = (D/Q)S Optimal Order Quantity (EOQ=Q*) EOQ Model - How Much to Order?
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12-32 = ×× EOQ = Q* DS H 2 EOQ Total Cost Optimization Total Cost = D Q S + Q 2 H Take derivative of total cost with respect to Q and set equal to zero: Solve for Q to get optimal order size: D Q 2 S + 1 2 H = 0
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12-33 Optimal Order Quantity == ×× Q* DS H Expected Number of Orders == N D Q*Q* Expected Time Between Orders Working Days / Year == T N 2 D = Demand per year S = Order cost per order H = Holding (carrying) cost d = Demand per day L = Lead time in days EOQ Model Equations
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12-34 Working Days / Year = =× d D ROPdL D = Demand per year (known and relatively constant) d = Demand per day (known and relatively constant) L = Lead time in days (known and relatively constant) ROP = reorder point (number of pieces or items remaining when order is to be placed) EOQ Model - When to order? Suppose demand is 10 per day and lead time is (always) 4 days. When should you order? When 40 are left!
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12-35 EOQ Model - When To Order Time Inventory Level Q* Reorder Point (ROP) 2nd order 3rd order 4th order 1st order placed 1st order received Lead Time = time between placing and receiving an order
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12-36 2 ×1200 ×50 EOQ Example Demand = 1200/year Order cost = $50/order Holding cost = $5 per year per item 260 working days per year = Q* 5 = 154.92 units/order ; so order 155 each time Expected Number of Orders = N = 1200/year 155 = 7.74/year Expected Time Between Orders = T = 260 days/year 7.74 = 33.6 days Total Cost = 1200 155 50 + 155 2 5 = 387.10 + 387.50 = $774.60/year
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12-37 EOQ is Robust Demand = 1200/year Order cost = $50/order Holding cost = $5 per year per item 260 working days per year Q = 155 units/order TC = $774.60/year Q* = 154.92 units/order TC = $774.60/year = 387.30 + 387.30 Suppose we must order in multiples of 20: Q = 140 units/order TC = $778.57/year (+0.5%) Q = 160 units/order TC = $775.00/year (+0.05%) Suppose we wish to order 6 times per year (every 2 months): Q = 1200/6 = 200 units/order TC = $800.00/year = 300.00 + 500.00 ( 200 units/order is 29% above Q* - but cost is only 3.3% above optimal )
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12-38 Order Quantity Annual Cost Total Cost Curve 154.92 EOQ Model is Robust Small variation in cost Large variation in order size
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12-39 EOQ amount can be adjusted to facilitate business practices. If order size is reasonably near optimal (+ or - 20%), then cost will be very near optimal (within a few percent). If parameters (order cost, holding cost, demand) are not known with certainty, then EOQ is still very useful. Robustness
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12-40 260 days/year = d 1200/year ROP = 4.615 units/day 5 days = 23.07 units -> Place an order whenever inventory falls to (or below) 23 units EOQ Model - When to order? Demand = 1200/year Order cost = $50/order Holding cost = $5 per year per item 260 working days per year Lead time = 5 days = 4.615/day
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