Operations

Management
Inventory Management
Chapter 12

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 Outline
 GLOBAL COMPANY PROFILE: AMAZON.COM
 FUNCTIONS OF INVENTORY
 Types of Inventory
 INVENTORY MANAGEMENT
 ABC Analysis
 Record Accuracy
 Cycle Counting
 Control of Service Inventories

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 Outline - Continued
 INVENTORY MODELS
 Independent versus Dependent Demand
 Holding, Ordering, and Setup Costs

 INVENTORY MODELS FOR INDEPENDENT

DEMAND
 Basic Economic Order Quantity (EOQ) Model
 Minimizing Costs
 Reorder Points
 Production Order Quantity Model
 Quantity Discount Models
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 Outline - Continued
 PROBABILISTIC MODELS WITH CONSTANT
LEAD TIME
 FIXED PERIOD (P) SYSTEMS

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 Learning Objectives
When you complete this chapter, you should be
able to :
Identify or Define:
 ABC analysis
 Record accuracy
 Cycle counting
 Independent and dependent demand
 Holding, Ordering, and Setup Costs

Describe or Explain:
 The functions of inventory and basic inventory
models
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 AMAZON.com
 Jeff Bezos, in 1995, started AMAZON.com as a
“virtual” retailer – no inventory, no warehouses, no
overhead; just a bunch of computers.
 Growth forced AMAZON.com to excel in inventory
management!
 AMAZON is now a worldwide leader in warehouse
management and automation.

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 Order Fulfillment at AMAZON
1. You order items;, computer assigns your order to
distribution center [closest facility that has the
product(s)]
2. Lights indicate products ordered to workers who
retrieve product and reset light.
3. Items placed in crate with items from other
orders, and crate is placed on conveyor. Bar
code on item is scanned 15 times – virtually
eliminating error.

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 Order Fulfillment at AMAZON-
Continued

4. Crates arrive at central point where items are

boxed and labeled with new bar code.
5. Gift wrapping done by hand (30 packages per
hour)
6. Box is packed, taped, weighed and labeled
before leaving warehouse in a truck.
7. Order appears on your doorstep within a week

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 What is Inventory?
 Stock of materials
 Stored capacity © 1995
Corel Corp.

 Examples

© 1984-1994 T/Maker Co. © 1984-1994 T/Maker Co.

© 1995 Corel Corp.

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 The Functions of Inventory

 To ”decouple” or separate various parts of the

production process
 To provide a stock of goods that will provide a
“selection” for customers
 To take advantage of quantity discounts
 To hedge against inflation and upward price
changes

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 Types of Inventory

 Raw material
 Work-in-progress
 Maintenance/repair/operating supply
 Finished goods

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 The Material Flow Cycle

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 Disadvantages of Inventory

 Higher costs
 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

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 Inventory Classifications

Inventory © 1984-1994
T/Maker Co.

Process Number Demand

Other
stage & Value Type

Raw Material A Items

Independent Maintenance
WIP B Items
Dependent Operating
Finished Goods C Items

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 The Material Flow Cycle
Other Wait Move Queue Setup Run
Input Time Time Time Time Time Output

Cycle Time

1 Run time: Job is at machine and being worked on

2 Setup time: Job is at the work station, and the work station is being
"setup."
3 Queue time: Job is where it should be, but is not being processed
because other work precedes it.
4 Move time: The time a job spends in transit
5 Wait time: When one process is finished, but the job is waiting to be
moved to the next work area.
6 Other: "Just-in-case" inventory.
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 ABC Analysis

 Divides on-hand inventory into 3 classes

 A class, B class, C class
 Basis is usually annual $ volume
 $ volume = Annual demand x Unit cost
 Policies based on ABC analysis
 Develop class A suppliers more
 Give tighter physical control of A items
 Forecast A items more carefully

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 Classifying Items as ABC
% Annual $ Usage Class % $ Vol % Items
100 A 80 15
B 15 30
80
C 5 55
60
40
A
B
20 C
0
0 50 100
% of Inventory Items
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 Cycle Counting

 Physically counting a sample of total inventory on

a regular basis
 Used often with ABC classification
 A items counted most often (e.g., daily)

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 Advantages of Cycle Counting

 Eliminates shutdown and interruption of

production necessary for annual physical
inventories
 Eliminates annual inventory adjustments
 Provides trained personnel to audit the accuracy
of inventory
 Allows the cause of errors to be identified and
remedial action to be taken
 Maintains accurate inventory records
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 Techniques for Controlling
Service Inventory Include:

 Good personnel selection, training, and discipline

 Tight control of incoming shipments
 Effective control of all goods leaving the facility

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 Independent versus
Dependent Demand

 Independent demand - demand for item is

independent of demand for any other item
 Dependent demand - demand for item is
dependent upon the demand for some other item

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 Inventory Costs

 Holding costs - associated with holding or

“carrying” inventory over time
 Ordering costs - associated with costs of placing
order and receiving goods
 Setup costs - cost to prepare a machine or
process for manufacturing an order

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 Holding (Carrying) Costs
 Obsolescence
 Insurance
 Extra staffing
 Interest
 Pilferage
 Damage
 Warehousing
 Etc.

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 Inventory Holding Costs
(Approximate Ranges)
Cost as a
Category % of Inventory Value
Housing costs (building rent, depreciation, 6%
operating cost, taxes, insurance) (3 - 10%)

Material handling costs (equipment, lease 3%

or depreciation, power, operating cost) (1 - 3.5%)
Labor cost from extra handling 3%
(3 - 5%)
Investment costs (borrowing costs, taxes, 11%
and insurance on inventory) (6 - 24%)

Pilferage, scrap, and obsolescence 3%

(2 - 5%)
Overall carrying cost 26%
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 Ordering Costs

 Supplies
 Forms
 Order processing
 Clerical support
 Etc.

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 Setup Costs

 Clean-up costs
 Re-tooling costs
 Adjustment costs
 Etc.

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 Inventory Models

 Fixed order-quantity models Help answer the

inventory planning
 Economic order quantity questions!
 Production order quantity
 Quantity discount

 Probabilistic models
 Fixed order-period models

© 1984-1994
T/Maker Co.

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 EOQ Assumptions

 Known and constant demand

 Known and constant lead time
 Instantaneous receipt of material
 No quantity discounts
 Only order (setup) cost and holding cost
 No stockouts

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 Inventory Usage Over Time

Order quantity = Q Usage Rate

(maximum Average
inventory level) Inventory
(Q*/2)
Inventory Level

Minimum
inventory 0
Time

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 EOQ Model
How Much to Order?
Annual Cost

Minimum
total cost

Order (Setup) Cost Curve

Optimal Order quantity

Order Quantity (Q*)

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 Why Holding Costs Increase

 More units must be stored if more are ordered

Purchase Order Purchase Order

Description Qty. Description Qty.
Microwave 1 Microwave 1000

Order quantity Order quantity

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 Why Order Costs Decrease
Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage $ 0.33) 1000 Orders (Postage $330)

Purchase Order PurchaseOrder

Purchase Order
Description
PurchaseOrder
OrderQty.
Description
Purchase
Qty. Description Qty.
Qty.
Microwave 1000 Description
Microwave Qty. 11
Description
Microwave
Microwave
Microwave 11
Order quantity

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 Deriving an EOQ

1. Develop an expression for setup or ordering

costs
2. Develop an expression for holding cost
3. Set setup cost equal to holding cost
4. Solve the resulting equation for the best order
quantity

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 EOQ Model
When To Order
Inventory Level
Optimal Average
Order Inventory
Quantity (Q*/2)
(Q*)

Reorder
Point
(ROP)

Time
Lead Time

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 EOQ Model Equations
Optimal Order Quantity 2 ×D ×S
= Q* =
H
D
Expected Number of Orders =N =
Q*
Expected Time Between Orders Working Days / Year
=T =
N
D D = Demand per year
d =
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d × L d = Demand per day
L = Lead time in days
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 The Reorder Point (ROP) Curve
Q*

Slope = units/day = d
Inventory level (units)

ROP
(Units)

Time (days)
Lead time = L
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 Production Order Quantity Model
 Answers how much to order and when to order
 Allows partial receipt of material
 Other EOQ assumptions apply
 Suited for production environment
 Material produced, used immediately
 Provides production lot size

 Lower holding cost than EOQ model

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 EOQ POQ Model
When To Order
Both production
and usage take Usage only takes
Maximum place
place
inventory
level
Inventory Level

Time
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 EOQ POQ Model
When To Order
Inventory Level
Optimal Average
Order Inventory
Quantity
(Q*)

Reorder
Point
(ROP)

Time
Lead Time
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 Reasons for Variability in Production

Most variability is caused by waste or by poor

management. Specific causes include:
 employees, machines, and suppliers produce units that do
not conform to standards, are late or are not the proper
quantity
 inaccurate engineering drawings or specifications
 production personnel try to produce before drawings or
specifications are complete
 customer demands are unknown

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 POQ Model Inventory Levels
Inventory Level

Production portion of cycle

Demand portion of cycle with no

supply

Supply Supply
Time
Begins Ends

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 POQ Model Equations

= Q* = 2*D*S
Optimal Order Quantity

( )
p d
H* 1 -
p

Maximum inventory level = Q* ( 1 -

d
p )
D D = Demand per year
Setup Cost = * S
Q S = Setup cost
H = Holding cost
Holding Cost = 0.5 * H * Q
( )
1-
d
p
d = Demand per day
p = Production per day
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 Quantity Discount Model
 Answers how much to order &
when to order
 Allows quantity discounts
 Reduced price when item is purchased in larger
quantities
 Other EOQ assumptions apply
 Trade-off is between lower price & increased
holding cost

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 Quantity Discount Schedule

Discount Discount Discount Discount

Number Quantity (%) Price (P)
1 0 to 999 No discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

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 Quantity Discount – How Much to
Order

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 Probabilistic Models

 Answer how much & when to order

 Allow demand to vary
 Follows normal distribution
 Other EOQ assumptions apply

 Consider service level & safety stock

 Service level = 1 - Probability of stockout
 Higher service level means more safety stock
 More safety stock means higher ROP

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 Probabilistic Models
When to Order?
Frequency Service
Inventory Level
Level P(Stockout)
Optimal
Order
X
Quantity SS
ROP
Reorder
Point
(ROP)

Safety Stock (SS)

Place Receive Time
order Lead Time order
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 Fixed Period Model
Answers how much to order
Orders placed at fixed intervals
 Inventory brought up to target amount
 Amount ordered varies
No continuous inventory count
 Possibility of stockout between intervals
Useful when vendors visit routinely
 Example: P&G representative calls every 2 weeks

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 Inventory Level in a Fixed Period
System
Various amounts (Qi) are ordered at regular time intervals
(p) based on the quantity necessary to bring inventory up
to target maximum
Target maximum
Q1 Q2 Q4
On-Hand Inventory

Q3

p p p

Time
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 Fixed Period Model
When to Order?
Inventory Level Target maximum

Time
Period Period Period
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