1. 12 - 1© 2011 Pearson Education, Inc. publishing as Prentice Hall 12 Inventory Management

2. 12 - 2© 2011 Pearson Education, Inc. publishing as Prentice Hall Outline  The Importance of Inventory  Functions of Inventory  Types of Inventory  Independent vs. Dependent Demand  Managing Inventory  ABC Analysis  Record Accuracy  Cycle Counting  Control of Service Inventories

3. 12 - 3© 2011 Pearson Education, Inc. publishing as Prentice Hall Outline – Continued  Inventory Models for Independent Demand  The Basic Economic Order Quantity (EOQ) Model  Production Order Quantity Model  Quantity Discount Models

4. 12 - 4© 2011 Pearson Education, Inc. publishing as Prentice Hall Learning Objectives When you complete this chapter you should be able to: 1.Conduct an ABC analysis 2.Explain and use cycle counting 3.Explain and use the EOQ model for independent inventory demand 4. Apply the production order quantity model 5.Explain and use the quantity discount model

5. 12 - 5© 2011 Pearson Education, Inc. publishing as Prentice Hall Amazon.com  Amazon.com started as a “virtual” retailer – no inventory, no warehouses, no overhead; just computers taking orders to be filled by others  Growth has forced Amazon.com to become a world leader in warehousing and inventory management

6. 12 - 6© 2011 Pearson Education, Inc. publishing as Prentice Hall Inventory Management The objective of inventory management is to strike a balance between inventory investment and customer service

7. 12 - 7© 2011 Pearson Education, Inc. publishing as Prentice Hall Importance of Inventory  One of the most expensive assets of many companies representing as much as 50% of total invested capital  Operations managers must balance inventory investment and customer service

8. 12 - 8© 2011 Pearson Education, Inc. publishing as Prentice Hall Functions of Inventory 1.To decouple or separate various parts of the production process 2.To protect the company against fluctuations in demand and provide a stock of goods that will provide a selection for customers 3.To take advantage of quantity discounts 4.To hedge against inflation

9. 12 - 9© 2011 Pearson Education, Inc. publishing as Prentice Hall Types of Inventory  Raw material  Purchased but not processed  Work-in-process  Undergone some change but not completed  A function of cycle time for a product  Maintenance/repair/operating (MRO)  Necessary to keep machinery and processes productive  Finished goods  Completed product awaiting shipment

10. 12 - 10© 2011 Pearson Education, Inc. publishing as Prentice Hall The Material Flow Cycle Figure 12.1 InputWait forWait toMoveWait in queueSetupRunOutput inspectionbe movedtimefor operatortimetime Cycle time 95%5%

11. 12 - 11© 2011 Pearson Education, Inc. publishing as Prentice Hall Important Issues in Inventory Management 1.Classifying inventory items 2.Keeping accurate inventory records

12. 12 - 12© 2011 Pearson Education, Inc. publishing as Prentice Hall ABC Analysis  Divides inventory into three classes based on annual dollar volume  Class A - high annual dollar volume  Class B - medium annual dollar volume  Class C - low annual dollar volume  Used to establish policies that focus on the few critical parts and not the many trivial ones

13. 12 - 13© 2011 Pearson Education, Inc. publishing as Prentice Hall ABC Analysis Item Stock Number Percent of Number of Items Stocked Annual Volume (units)x Unit Cost= Annual Dollar Volume Percent of Annual Dollar VolumeClass #1028620%1,000$ 90.00$ 90,00038.8%A #11526500154.0077,00033.2%A #127601,55017.0026,35011.3%B #1086730%35042.8615,0016.4%B #105001,00012.5012,5005.4%B 72% 23%

14. 12 - 14© 2011 Pearson Education, Inc. publishing as Prentice Hall ABC Analysis Item Stock Number Percent of Number of Items Stocked Annual Volume (units)x Unit Cost= Annual Dollar Volume Percent of Annual Dollar VolumeClass #12572600$ 14.17$ 8,5023.7%C #140752,000.601,200.5%C #0103650%1008.50850.4%C #013071,200.42504.2%C #10572250.60150.1%C 8,550$232,057100.0% 5%

15. 12 - 15© 2011 Pearson Education, Inc. publishing as Prentice Hall C Items ABC Analysis A Items B Items Percent of annual dollar usage 80 – 70 – 60 – 50 – 40 – 30 – 20 – 10 – 0 – |||||||||| 102030405060708090100 Percent of inventory items Figure 12.2

16. 12 - 16© 2011 Pearson Education, Inc. publishing as Prentice Hall ABC Analysis  Policies employed may include  More emphasis on supplier development for A items  Tighter physical inventory control for A items  More care in forecasting A items

17. 12 - 17© 2011 Pearson Education, Inc. publishing as Prentice Hall Other Criteria for Classification  Besides annual dollar volume, the following criteria can be also used for classification:  Anticipated engineering changes (obsolete)  Delivery problems  Quality problems  High unit cost

18. 12 - 18© 2011 Pearson Education, Inc. publishing as Prentice Hall Record Accuracy  Accurate records are a critical ingredient in production and inventory systems  Allows organization to focus on what is needed  Necessary to make precise decisions about ordering, scheduling, and shipping  Incoming and outgoing record keeping must be accurate  Stockrooms should be secure

19. 12 - 19© 2011 Pearson Education, Inc. publishing as Prentice Hall Cycle Counting  Items are counted and records updated on a periodic basis  Often used with ABC analysis to determine cycle  Has several advantages 1.Eliminates shutdowns and interruptions 2.Eliminates annual inventory adjustment 3.Trained personnel audit inventory accuracy 4.Allows causes of errors to be identified and corrected 5.Maintains accurate inventory records

20. 12 - 20© 2011 Pearson Education, Inc. publishing as Prentice Hall Cycle Counting Example, page 504, Ch.12 5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C items Policy is to count A items every month (20 working days), B items every quarter (60 days), and C items every six months (120 days) Item ClassQuantityCycle Counting Policy Number of Items Counted per Day A500Each month500/20 = 25/day B1,750Each quarter1,750/60 = 29/day C2,750Every 6 months2,750/120 = 23/day 77/day

21. 12 - 21© 2011 Pearson Education, Inc. publishing as Prentice Hall Independent Versus Dependent Demand  Independent demand  Independent demand - the demand for item is independent of the demand for any other item in inventory  Dependent demand  Dependent demand - the demand for item is dependent upon the demand for some other item in the inventory

22. 12 - 22 22 Examples for Independent Versus Dependent Demand  Independent demand – finished goods, items that are ready to be sold  E.g. computers, cars,  Dependent demand – components of finished products  E.g. parts such as chip, and engine that make up these finished goods

23. 12 - 23 23 Independent Demand A B(4) C(2) D(2)E(1) D(3) F(2) Dependent Demand Independent demand is uncertain. That is why it is forecasted. Dependent demand is certain and it is calculated. Inventory

24. 12 - 24© 2011 Pearson Education, Inc. publishing as Prentice Hall Holding, Ordering, and Setup Costs  Holding costs  Holding costs - the costs of holding or “carrying” inventory over time  Ordering costs  Ordering costs - the costs of placing an order and receiving goods  Setup costs  Setup costs - cost to prepare a machine or process for manufacturing an order

25. 12 - 25© 2011 Pearson Education, Inc. publishing as Prentice Hall Holding Costs Category Cost (and range) as a Percent of Inventory Valu e Housing costs (building rent or depreciation, operating costs, taxes, insurance) 6% (3 - 10%) Material handling costs (equipment lease or depreciation, power, operating cost) 3% (1 - 3.5%) Labor cost3% (3 - 5%) Investment costs (borrowing costs, taxes, and insurance on inventory) 11% (6 - 24%) Pilferage, space, and obsolescence3% (2 - 5%) Overall carrying cost26% Table 12.1

26. 12 - 26© 2011 Pearson Education, Inc. publishing as Prentice Hall Holding Costs Category Cost (and range) as a Percent of Inventory Valu e Housing costs (building rent or depreciation, operating costs, taxes, insurance) 6% (3 - 10%) Material handling costs (equipment lease or depreciation, power, operating cost) 3% (1 - 3.5%) Labor cost3% (3 - 5%) Investment costs (borrowing costs, taxes, and insurance on inventory) 11% (6 - 24%) Pilferage, space, and obsolescence3% (2 - 5%) Overall carrying cost26% Table 12.1 Holding costs vary considerably depending on the business, location, and interest rates. Generally greater than 15%, some high tech items have holding costs greater than 40%.

27. 12 - 27 Two Basic Questions to Answer Through Inventory Management 1.How much to order of each material when orders are placed with either outside suppliers or production departments within organizations. 1.When to place the orders. The overall objective of inventory management is to achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds by answering these two questions.

28. 12 - 28© 2011 Pearson Education, Inc. publishing as Prentice Hall Inventory Models for Independent Demand 1.Basic Economic Order Quantity (EOQ) 2.Production Order Quantity (POQ) 3.Quantity discount model Need to determine when and how much to order

29. 12 - 29© 2011 Pearson Education, Inc. publishing as Prentice Hall Basic EOQ Model 1.Demand is known, constant, and independent 2.Lead time is known and constant 3.Receipt of inventory is instantaneous and complete 4.Quantity discounts are not possible 5.Only variable costs are setup and holding 6.Stockouts can be completely avoided Important assumptions

30. 12 - 30© 2011 Pearson Education, Inc. publishing as Prentice Hall Inventory Usage Over Time Figure 12.3 Order quantity = Q (maximum inventory level) Usage rate Average inventory on hand Q 2 Minimum inventory Inventory level Time 0

31. 12 - 31© 2011 Pearson Education, Inc. publishing as Prentice Hall Minimizing Costs Objective is to minimize total costs Table 12.4(c) Annual cost Order quantity Total cost of holding and setup (order) Holding cost Setup (or order) cost Minimum total cost Optimal order quantity (Q*)

32. 12 - 32© 2011 Pearson Education, Inc. publishing as Prentice Hall The EOQ Model Q= Number of pieces per order Q*= Optimal number of pieces per order (EOQ) D= Annual demand in units for the inventory item S= Setup or ordering cost for each order H= Holding or carrying cost per unit per year Annual setup cost =(Number of orders placed per year) x (Setup or order cost per order) Annual demand Number of units in each order Setup or order cost per order = Annual setup cost = S DQDQ = (S) DQDQ

33. 12 - 33© 2011 Pearson Education, Inc. publishing as Prentice Hall The EOQ Model Q= Number of pieces per order Q*= Optimal number of pieces per order (EOQ) D= Annual demand in units for the inventory item S= Setup or ordering cost for each order H= Holding or carrying cost per unit per year Annual holding cost =(Average inventory level) x (Holding cost per unit per year) Order quantity 2 = (Holding cost per unit per year) = (H) Q2Q2 Annual setup cost = S DQDQ Annual holding cost = H Q2Q2

34. 12 - 34© 2011 Pearson Education, Inc. publishing as Prentice Hall The EOQ Model Q= Number of pieces per order Q*= Optimal number of pieces per order (EOQ) D= Annual demand in units for the inventory item S= Setup or ordering cost for each order H= Holding or carrying cost per unit per year Optimal order quantity is found when annual setup cost equals annual holding cost Annual setup cost = S DQDQ Annual holding cost = H Q2Q2 DQDQ S = H Q2Q2 Solving for Q* 2DS = Q 2 H Q 2 = 2DS/H Q* = 2DS/H

35. 12 - 35© 2011 Pearson Education, Inc. publishing as Prentice Hall An EOQ Example Determine optimal number of needles to order D = 1,000 units per year S = $10 per order H = $.50 per unit per year Q* = 2DS H Q* = 2(1,000)(10) 0.50 = 40,000 = 200 units

36. 12 - 36© 2011 Pearson Education, Inc. publishing as Prentice Hall An EOQ Example Determine optimal number of needles to order D = 1,000 units Q*= 200 units S = $10 per order H = $.50 per unit per year = N = = Expected number of orders Demand Order quantity DQ*DQ* N = = 5 orders per year 1,000 200

37. 12 - 37© 2011 Pearson Education, Inc. publishing as Prentice Hall An EOQ Example Determine optimal number of needles to order D = 1,000 unitsQ*= 200 units S = $10 per orderN= 5 orders per year H = $.50 per unit per year = T = Expected time between orders Number of working days per year N T = = 50 days between orders 250 5

38. 12 - 38© 2011 Pearson Education, Inc. publishing as Prentice Hall An EOQ Example Determine optimal number of needles to order D = 1,000 unitsQ*= 200 units S = $10 per orderN= 5 orders per year H = $.50 per unit per yearT= 50 days Total annual cost = Setup cost + Holding cost TC = S + H DQDQ Q2Q2 TC = ($10) + ($.50) 1,000 200 2 TC = (5)($10) + (100)($.50) = $50 + $50 = $100

39. 12 - 39© 2011 Pearson Education, Inc. publishing as Prentice Hall Robust Model  The EOQ model is robust  It works even if all parameters and assumptions are not met  The total cost curve is relatively flat in the area of the EOQ

40. 12 - 40© 2011 Pearson Education, Inc. publishing as Prentice Hall An EOQ Example Suppose Management underestimates demand by 50% D = 1,000 units Q*= 200 units S = $10 per orderN= 5 orders per year H = $.50 per unit per yearT= 50 days TC = S + H DQDQ Q2Q2 TC = ($10) + ($.50) = $75 + $50 = $125 1,500 200 2 1,500 units Total annual cost increases by only 25%

41. 12 - 41© 2011 Pearson Education, Inc. publishing as Prentice Hall An EOQ Example Actual EOQ for new demand is 244.9 units D = 1,000 units Q*= 244.9 units S = $10 per orderN= 5 orders per year H = $.50 per unit per yearT= 50 days TC = S + H DQDQ Q2Q2 TC = ($10) + ($.50) 1,500 244.9 2 1,500 units TC = $61.24 + $61.24 = $122.48 Only 2% less than the total cost of $125 when the order quantity was 200

42. 12 - 42© 2011 Pearson Education, Inc. publishing as Prentice Hall Reorder Points  EOQ answers the “how much” question  The reorder point (ROP) tells “when” to order ROP = Lead time for a new order in days Demand per day = d x L d = D Number of working days in a year

43. 12 - 43© 2011 Pearson Education, Inc. publishing as Prentice Hall Reorder Point Curve Q*Q* ROP (units) Inventory level (units) Time (days) Figure 12.5 Lead time = L Slope = units/day = d Resupply takes place as order arrives

44. 12 - 44© 2011 Pearson Education, Inc. publishing as Prentice Hall Reorder Point Example Demand = 8,000 iPods per year 250 working day year Lead time for orders is 3 working days ROP = d x L d = D Number of working days in a year = 8,000/250 = 32 units = 32 units per day x 3 days = 96 units

45. 12 - 45© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity (POQ) Model  Used when inventory builds up over a period of time after an order is placed  Used when units are produced and sold simultaneously

46. 12 - 46© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity Model Inventory level Time Demand part of cycle with no production Part of inventory cycle during which production (and usage) is taking place t Maximum inventory Figure 12.6

47. 12 - 47© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity Model Q =Number of pieces per order p =Daily production rate H =Holding cost per unit per year d =Daily demand/usage rate t =Length of the production run in days = (Average inventory level) x Annual inventory holding cost Holding cost per unit per year = (Maximum inventory level)/2 Annual inventory level = – Maximum inventory level Total produced during the production run Total used during the production run = pt – dt

48. 12 - 48© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity Model Q =Number of pieces per order p =Daily production rate H =Holding cost per unit per year d =Daily demand/usage rate t =Length of the production run in days = – Maximum inventory level Total produced during the production run Total used during the production run = pt – dt However, Q = total produced = pt ; thus t = Q/p Maximum inventory level = p – d = Q 1 – QpQp QpQp dpdp Holding cost = (H) = 1 – H dpdp Q2Q2 Maximum inventory level 2

49. 12 - 49© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity Model Q =Number of pieces per order p =Daily production rate H =Holding cost per unit per year d =Daily demand/usage rate D =Annual demand Q 2 = 2DS H[1 - (d/p)] Q* = 2DS H[1 - (d/p)] p Setup cost =(D/Q)S Holding cost = HQ[1 - (d/p)] 1212 (D/Q)S = HQ[1 - (d/p)] 1212

50. 12 - 50© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity Example D =1,000 units p =8 units per day S =$10 d =4 units per day H =$0.50 per unit per year Q* = 2DS H[1 - (d/p)] = 282.8 or 283 hubcaps Q* = = 80,000 2(1,000)(10) 0.50[1 - (4/8)]

51. 12 - 51© 2011 Pearson Education, Inc. publishing as Prentice Hall Production Order Quantity Model When annual data are used the equation becomes Q* = 2DS annual demand rate annual production rate H 1 – Note: d = 4 = = D Number of days the plant is in operation 1,000 250

52. 12 - 52© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Models  Reduced prices are often available when larger quantities are purchased  Trade-off is between reduced product cost and increased holding cost Total cost = Setup cost + Holding cost + Product cost TC = S + H + PD DQDQ Q2Q2

53. 12 - 53 Quantity Discount Models  There are two general cases of quantity discount models: 1.Carrying costs are constant (e.g. $2 per unit). 2.Carrying costs are stated as a percentage off purchase price (20% of unit price) © 2011 Pearson Education, Inc. publishing as Prentice Hall

54. 12 - 54 Total Cost with Constant Carrying Costs OC EOQ Quantity Total Cost TC a TC c TC b Decreasing Price CC a,b,c

55. 12 - 55© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Models (When carrying costs are specified as a percentage of unit price) 1.For each discount, calculate Q* 2.If Q* for a discount doesn’t qualify, choose the smallest possible order size to get the discount 3.Compute the total cost for each Q* or adjusted value from Step 2 4.Select the Q* that gives the lowest total cost Steps in analyzing a quantity discount

56. 12 - 56© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Models Discount NumberDiscount QuantityDiscount (%) Discount Price (P) 10 to 999no discount$5.00 21,000 to 1,9994$4.80 32,000 and over5$4.75 Table 12.2 A typical quantity discount schedule

57. 12 - 57© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Models (When carrying costs are specified as a percentage of unit price) 1,000 2,000 Total cost $ 0 Order quantity Q* for discount 2 is below the allowable range at point a and must be adjusted upward to 1,000 units at point b a b 1st price break 2nd price break Total cost curve for discount 1 Total cost curve for discount 2 Total cost curve for discount 3 Figure 12.7

58. 12 - 58© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Example Calculate Q* for every discount Q* = 2DS IP Q 1 * = = 700 cars/order 2(5,000)(49) (.2)(5.00) Q 2 * = = 714 cars/order 2(5,000)(49) (.2)(4.80) Q 3 * = = 718 cars/order 2(5,000)(49) (.2)(4.75)

59. 12 - 59© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Example Calculate Q* for every discount Q* = 2DS IP Q 1 * = = 700 cars/order 2(5,000)(49) (.2)(5.00) Q 2 * = = 714 cars/order 2(5,000)(49) (.2)(4.80) Q 3 * = = 718 cars/order 2(5,000)(49) (.2)(4.75) 1,000 — adjusted 2,000 — adjusted

60. 12 - 60© 2011 Pearson Education, Inc. publishing as Prentice Hall Quantity Discount Example Discount Number Unit Price Order Quantity Annual Product Cost Annual Ordering Cost Annual Holding CostTotal 1$5.00700$25,000$350 $25,700 2$4.801,000$24,000$245$480$24,725 3$4.752,000$23.750$122.50$950$24,822.50 Table 12.3 Choose the price and quantity that gives the lowest total cost Buy 1,000 units at $4.80 per unit