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

2. Copyright 2006 John Wiley & Sons, Inc.12-2 Lecture Outline  Inventory management objectives  Relevant inventory costs  Dependent and independent demand  Fixed order quantity and reorder point Computing total costs (TC) Computing total costs (TC) Economic order quantity (optimal) Economic order quantity (optimal) Reorder point Reorder point

3. Copyright 2006 John Wiley & Sons, Inc.12-3 Inventory Management Objectives  Maintain good customer service  Keep costs as low as possible, consistent with the desired level of customer service  Minimize inventory investment

4. Copyright 2006 John Wiley & Sons, Inc.12-4 Relevant Inventory Costs in Inventory Management 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 hard to measure.

5. Copyright 2006 John Wiley & Sons, Inc.12-5 Item Costs  Item costs For purchased items, the item cost is the purchase price, plus shipping 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 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. For finished goods, the item cost is the cost of goods sold.

6. Copyright 2006 John Wiley & Sons, Inc.12-6 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 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 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

7. Copyright 2006 John Wiley & Sons, Inc.12-7 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

8. Copyright 2006 John Wiley & Sons, Inc.12-8 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

9. Copyright 2006 John Wiley & Sons, Inc.12-9 Shortage Costs  Administrative and transportation costs related to back orders  Lost good will and lost sales due to product shortages – hard to measure

10. Copyright 2006 John Wiley & Sons, Inc.12-10 Dependent Demand Inventory  Raw materials, component parts, and work in process used to make finished goods  Demand and due date are tied to production schedule.

11. Copyright 2006 John Wiley & Sons, Inc.12-11 Methods of Controlling Dependent Demand Inventory  Material requirement planning (MRP)  Enterprise resource planning (ERP)  Just-in-time

12. Copyright 2006 John Wiley & Sons, Inc.12-12 Independent Demand Inventory  Finished goods  Retail and distributor inventories  Repair parts  Supplies (office supplies, cleaning supplies, etc.)  Fuels

13. Copyright 2006 John Wiley & Sons, Inc.12-13 Inventory Policy  An inventory policy should specify How much to order at one time How much to order at one time When to place orders When to place orders

14. Copyright 2006 John Wiley & Sons, Inc.12-14 Fixed Order Quantity Method  An order policy for controlling independent demand inventory Order the same amount, Q, each time Order the same amount, Q, each time Q is called the order quantity Q is called the order quantity Place an order when the amount in inventory gets down to a reorder point, R. Place an order when the amount in inventory gets down to a reorder point, R. L = lead time = time between order placement and order receipt L = lead time = time between order placement and order receipt See Figure 12.2, page 537 See Figure 12.2, page 537

15. Copyright 2006 John Wiley & Sons, Inc.12-15 Economic Order Quantity  The fixed order quantity that minimizes the total annual cost of placing orders and carrying inventory  See Figure 12.3, page 538, and Example 12.2, page 539.

16. Copyright 2006 John Wiley & Sons, Inc.12-16 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

17. Copyright 2006 John Wiley & Sons, Inc.12-17 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

18. Copyright 2006 John Wiley & Sons, Inc.12-18 EOQ Cost Model TC = + CoDQCoDQ CcQ2CcQ2 = + CoDQ2CoDQ2 Cc2Cc2  TC  Q 0 = + C0DQ2C0DQ2 Cc2Cc2 Q opt = 2CoDCc2CoDCc Deriving Q opt

19. Copyright 2006 John Wiley & Sons, Inc.12-19 Reorder Point – Constant Demand Level of inventory at which a new order is placed R = dL where d = demand rate per period L = lead time