1. Copyright 2006 John Wiley & Sons, Inc. Beni Asllani University of Tennessee at Chattanooga Inventory Management Operations Management - 5 th Edition Chapter 12 Roberta Russell & Bernard W. Taylor, III

2. Copyright 2006 John Wiley & Sons, Inc.12-2 Lecture Outline   Elements of Inventory Management   Inventory Control Systems   Economic Order Quantity Models   Quantity Discounts   Reorder Point   Order Quantity for a Periodic Inventory System

3. Copyright 2006 John Wiley & Sons, Inc.12-3 What Is Inventory?   Stock of items kept to meet future demand   Purpose of inventory management how many units to order when to order

4. Copyright 2006 John Wiley & Sons, Inc.12-4 Types of Inventory   Raw materials   Purchased parts and supplies   Work-in-process (partially completed) products (WIP)   Items being transported   Tools and equipment

5. Copyright 2006 John Wiley & Sons, Inc.12-5 Inventory and Supply Chain Management  Bullwhip effect demand information is distorted as it moves away from the end-use customer demand information is distorted as it moves away from the end-use customer higher safety stock inventories to are stored to compensate higher safety stock inventories to are stored to compensate  Seasonal or cyclical demand  Inventory provides independence from vendors  Take advantage of price discounts  Inventory provides independence between stages and avoids work stop-pages

6. Copyright 2006 John Wiley & Sons, Inc.12-6 Two Forms of Demand  Dependent  Demand for items used to produce final products   Tires stored at a Goodyear plant are an example of a dependent demand item  Independent  Demand for items used by external customers   Cars, appliances, computers, and houses are examples of independent demand inventory

7. Copyright 2006 John Wiley & Sons, Inc.12-7 Inventory and Quality Management   Customers usually perceive quality service as availability of goods they want when they want them   Inventory must be sufficient to provide high-quality customer service in TQM

8. Copyright 2006 John Wiley & Sons, Inc.12-8 Inventory Costs  Carrying cost  cost of holding an item in inventory  Ordering cost  cost of replenishing inventory  Shortage cost  temporary or permanent loss of sales when demand cannot be met

9. Copyright 2006 John Wiley & Sons, Inc.12-9 Inventory Control Systems  Continuous system (fixed- order-quantity)  constant amount ordered when inventory declines to predetermined level  Periodic system (fixed-time- period)  order placed for variable amount after fixed passage of time

10. Copyright 2006 John Wiley & Sons, Inc.12-10 ABC Classification  Class A 5 – 15 % of units 5 – 15 % of units 70 – 80 % of value 70 – 80 % of value  Class B 30 % of units 30 % of units 15 % of value 15 % of value  Class C 50 – 60 % of units 50 – 60 % of units 5 – 10 % of value 5 – 10 % of value

11. Copyright 2006 John Wiley & Sons, Inc.12-11 ABC Classification: Example 1$ 6090 235040 330130 48060 530100 620180 710170 832050 951060 1020120 PARTUNIT COSTANNUAL USAGE

12. Copyright 2006 John Wiley & Sons, Inc.12-12 ABC Classification: Example (cont.) Example 10.1 1$ 6090 235040 330130 48060 530100 620180 710170 832050 951060 1020120 PARTUNIT COSTANNUAL USAGE TOTAL% OF TOTAL% OF TOTAL PARTVALUEVALUEQUANTITY% CUMMULATIVE 9$30,60035.96.06.0 816,00018.75.011.0 214,00016.44.015.0 15,4006.39.024.0 44,8005.66.030.0 33,9004.610.040.0 63,6004.218.058.0 53,0003.513.071.0 102,4002.812.083.0 71,7002.017.0100.0 $85,400 AB C % OF TOTAL CLASSITEMSVALUEQUANTITY A9, 8, 271.015.0 B1, 4, 316.525.0 C6, 5, 10, 712.560.0

13. Copyright 2006 John Wiley & Sons, Inc.12-13 Economic Order Quantity (EOQ) Models   EOQ optimal order quantity that will minimize total inventory costs   Basic EOQ model   Production quantity model

14. Copyright 2006 John Wiley & Sons, Inc.12-14 Assumptions of Basic EOQ Model  Demand is known with certainty and is constant over time  No shortages are allowed  Lead time for the receipt of orders is constant  Order quantity is received all at once

15. Copyright 2006 John Wiley & Sons, Inc.12-15 Inventory Order Cycle Demand rate Time Lead time Order placed Order receipt Inventory Level Reorder point, R Order quantity, Q 0

16. Copyright 2006 John Wiley & Sons, Inc.12-16 EOQ Cost Model C o - cost of placing orderD - annual demand C c - annual per-unit carrying costQ - order quantity Annual ordering cost = CoDCoDQQCoDCoDQQQ Annual carrying cost = CcQCcQ22CcQCcQ222 Total cost = + CoDCoDQQCoDCoDQQQ CcQCcQ22CcQCcQ222

17. Copyright 2006 John Wiley & Sons, Inc.12-17 EOQ Cost Model TC = + CoDQCoDQ CcQ2CcQ2 = + CoDQ2CoDQ2 Cc2Cc2  TC  Q 0 = + C0DQ2C0DQ2 Cc2Cc2 Q opt = 2CoDCc2CoDCc Deriving Q opt Proving equality of costs at optimal point = CoDQCoDQ CcQ2CcQ2 Q 2 = 2CoDCc2CoDCc Q opt = 2CoDCc2CoDCc

18. Copyright 2006 John Wiley & Sons, Inc.12-18 EOQ Cost Model (cont.) Order Quantity, Q Annual cost ($) Total Cost Carrying Cost = CcQCcQ22CcQCcQ222 Slope = 0 Minimum total cost Optimal order Q opt Q opt Ordering Cost = CoDCoDQQCoDCoDQQQ

19. Copyright 2006 John Wiley & Sons, Inc.12-19 EOQ Example C c = $0.75 per yardC o = $150D = 10,000 yards Q opt = 2CoD2CoDCcCc2CoD2CoDCcCc 2(150)(10,000)(0.75) Q opt = 2,000 yards TC min = + CoDCoDQQCoDCoDQQQ CcQCcQ22CcQCcQ222 (150)(10,000)2,000(0.75)(2,000)2 TC min = $750 + $750 = $1,500 Orders per year =D/Q opt =10,000/2,000 =5 orders/year Order cycle time =311 days/(D/Q opt ) =311/5 =62.2 store days

20. Copyright 2006 John Wiley & Sons, Inc.12-20 Production Quantity Model   An inventory system in which an order is received gradually, as inventory is simultaneously being depleted   AKA non-instantaneous receipt model assumption that Q is received all at once is relaxed   p - daily rate at which an order is received over time, a.k.a. production rate   d - daily rate at which inventory is demanded

21. Copyright 2006 John Wiley & Sons, Inc.12-21 Production Quantity Model (cont.) Q(1-d/p) Inventorylevel (1-d/p) Q2 Time 0 Order receipt period BeginorderreceiptEndorderreceipt Maximum inventory level Average

22. Copyright 2006 John Wiley & Sons, Inc.12-22 Production Quantity Model (cont.) p = production rated = demand rate Maximum inventory level =Q - d =Q 1 - Qp dp Average inventory level = 1 - Q2 dp TC = + 1 - dp CoDCoDQQCoDCoDQQQ CcQCcQ22CcQCcQ222 Q opt = 2C o D C c 1 - dp

23. Copyright 2006 John Wiley & Sons, Inc.12-23 Production Quantity Model: Example C c = $0.75 per yardC o = $150D = 10,000 yards d = 10,000/311 = 32.2 yards per dayp = 150 yards per day Q opt = = = 2,256.8 yards 2C o D C c 1 - dp 2(150)(10,000) 0.75 1 - 32.2150 TC = + 1 - = $1,329 dp CoDCoDQQCoDCoDQQQ CcQCcQ22CcQCcQ222 Production run = = = 15.05 days per order Qp2,256.8150

24. Copyright 2006 John Wiley & Sons, Inc.12-24 Production Quantity Model: Example (cont.) Number of production runs = = = 4.43 runs/year DQDQ 10,000 2,256.8 Maximum inventory level =Q 1 - = 2,256.8 1 - =1,772 yards dpdp 32.2 150

25. Copyright 2006 John Wiley & Sons, Inc.12-25 Quantity Discounts Price per unit decreases as order quantity increases TC = + + PD CoDCoDQQCoDCoDQQQ CcQCcQ22CcQCcQ222 where P = per unit price of the item D = annual demand

26. Copyright 2006 John Wiley & Sons, Inc.12-26 Quantity Discount Model (cont.) Q opt Carrying cost Ordering cost Inventory cost ($) Q( d 1 ) = 100 Q( d 2 ) = 200 TC ( d 2 = $6 ) TC ( d 1 = $8 ) TC = ($10 ) ORDER SIZE PRICE 0 - 99 $10 100 – 199 8 ( d 1 ) 200+ 6 ( d 2 )

27. Copyright 2006 John Wiley & Sons, Inc.12-27 Quantity Discount: Example QUANTITYPRICE 1 - 49$1,400 50 - 891,100 90+900 C o =$2,500 C c =$190 per computer D =200 Q opt = = = 72.5 PCs 2CoD2CoDCcCc2CoD2CoDCcCc2(2500)(200)190 TC = + + PD = $233,784 C o D Q opt C c Q opt 2 For Q = 72.5 TC = + + PD = $194,105 CoDCoDQQCoDCoDQQQ CcQCcQ22CcQCcQ222 For Q = 90

28. Copyright 2006 John Wiley & Sons, Inc.12-28 Reorder Point Level of inventory at which a new order is placed R = dL where d = demand rate per period L = lead time

29. Copyright 2006 John Wiley & Sons, Inc.12-29 Reorder Point: Example Demand = 10,000 yards/year Store open 311 days/year Daily demand = 10,000 / 311 = 32.154 yards/day Lead time = L = 10 days R = dL = (32.154)(10) = 321.54 yards

30. Copyright 2006 John Wiley & Sons, Inc.12-30 Safety Stocks  Safety stock  buffer added to on hand inventory during lead time  Stockout  an inventory shortage  Service level  probability that the inventory available during lead time will meet demand

31. Copyright 2006 John Wiley & Sons, Inc.12-31 Variable Demand with a Reorder Point Reorder point, R Q LT Time LT Inventory level 0

32. Copyright 2006 John Wiley & Sons, Inc.12-32 Reorder Point with a Safety Stock Reorder point, R Q LT Time LT Inventory level 0 Safety Stock

33. Copyright 2006 John Wiley & Sons, Inc.12-33 Reorder Point With Variable Demand R = dL + z  d L where d=average daily demand L=lead time  d =the standard deviation of daily demand z=number of standard deviations corresponding to the service level probability z  d L=safety stock

34. Copyright 2006 John Wiley & Sons, Inc.12-34 Reorder Point for a Service Level Probability of meeting demand during lead time = service level Probability of a stockout R Safety stock dL Demand z  d L

35. Copyright 2006 John Wiley & Sons, Inc.12-35 Reorder Point for Variable Demand The carpet store wants a reorder point with a 95% service level and a 5% stockout probability d= 30 yards per day L= 10 days  d = 5 yards per day For a 95% service level, z = 1.65 R= dL + z  d L = 30(10) + (1.65)(5)( 10) = 326.1 yards Safety stock= z  d L = (1.65)(5)( 10) = 26.1 yards

36. Copyright 2006 John Wiley & Sons, Inc.12-36 Order Quantity for a Periodic Inventory System Q = d(t b + L) + z  d t b + L - I where d= average demand rate t b = the fixed time between orders L= lead time  d = standard deviation of demand z  d t b + L= safety stock z  d t b + L= safety stock I= inventory level

37. Copyright 2006 John Wiley & Sons, Inc.12-37 Fixed-Period Model with Variable Demand d= 6 bottles per day  d = 1.2 bottles t b = 60 days L= 5 days I= 8 bottles z= 1.65 (for a 95% service level) Q= d(t b + L) + z  d t b + L - I = (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8 = 397.96 bottles

38. Copyright 2006 John Wiley & Sons, Inc.12-38 Copyright 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permission Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.