Cost Management

ACCOUNTING AND CONTROL

Inventory Management: EOQ, JIT

and the Theory of Constraints

HANSEN & MOWEN

21-1
Just-in-Case Inventory Management 1

Three types of inventory costs can be readily

identified with inventory:

(1) The cost of acquiring inventory.

(2) The cost of holding inventory.
(3) The cost of not having inventory on
hand when needed.

21-2
Just-in-Case Inventory Management 1

1. Ordering Costs: The costs of placing and receiving

an order.
Examples: Clerical costs, documents, insurance
for shipment, and unloading.
2. Setup Costs: The costs of preparing equipment
and facilities so they can be used to produce a
particular product or component.
Examples: Setup labor, lost income (from idled
facilities), and test runs.

21-3
Just-in-Case Inventory Management 1

3. Stock-Out Costs: The costs of not having sufficient

inventory.
Examples: Lost sales, costs of expediting (extra
setup, transportation, etc.) and the
costs of interrupted production.
4. Carrying Costs: The costs of carrying inventory.
Examples: Insurance, inventory taxes,
obsolescence, opportunity cost of
capital tied up in inventory, and
storage.

21-4
Just-in-Case Inventory Management 1

Traditional Reasons for Carrying Inventory

21-5
Just-in-Case Inventory Management 1
Economic Order Quantity

TC = PD/Q + CQ/2

The total
The ordering
cost
TheThe
known
ofThe
number
placing
(orcost
annual
and
of units
carrying one
setup) and
receiving
carrying
ordered
demand
anunit
cost
order
each
of (or
stock
time an
for one
the cost
order
of setting
is placed
upyear
(or
a the
production
lot size for
run)
production)

21-6
Just-in-Case Inventory Management 1
An EOQ Illustration
EOQ =  2PD/C
D = 25,000 units
Q = 500 units
P = $40 per order
C = $2 per unit

EOQ =  (2 x 25,000 x $40) / $2

EOQ =  1,000,000
EOQ = 1,000 units
21-7
Just-in-Case Inventory Management 1
When to Order or Produce

Reorder point = Rate of usage x Lead time

Example: Assume that the average rate of usage

is 100 parts per day. Assume also that
the lead time is 4 days. What is the
reorder point?

Reorder point = 4 x 100 = 400 units

Thus, an order should be placed when inventory drops

to 400 units.

21-8
Just-in-Case Inventory Management 1

The Reorder Point

21-9
Just-in-Case Inventory Management 1
Demand Uncertainty and Reordering
To avoid running out of parts, organizations often choose to
carry safety stock. Safety stock is extra inventory carried to
serve as insurance against fluctuations in demand.

Example: If the maximum usage of the VCR part is 120 units

per day, the average usage is 100 units per day, and the lead
time is four days, the safety stock is 80.

Maximum usage 120

Average usage -100
Difference 20
Lead time x 4
Safety stock 80

21-10
Just-in-Case Inventory Management 1

EOQ and Reorder Point Illustrated

21-11
JIT Inventory Management 2

Setup and Carrying Costs: The JIT Approach

JIT reduces the costs of acquiring inventory to

insignificant levels by:
1. Drastically reducing setup time
2. Using long-term contracts for outside
purchases

Carrying costs are reduced to insignificant levels by

reducing inventories to insignificant levels.

21-12
JIT Inventory Management 2

Due-Date Performance: The JIT Solution

Lead times are reduced so that the company can
meet requested delivery dates and to respond
quickly to customer demand.
Lead times are reduced by:
 reducing setup times
 improving quality
 using cellular manufacturing

21-13
JIT Inventory Management 2

Avoidance of Shutdown: The JIT Approach

 Total preventive maintenance to reduce machine
failures
 Total quality control to reduce defective parts
 The use of the Kanban system is also essential

21-14
JIT Inventory Management 2

What is the Kanban System?

A card system is used to monitor work in process

 A withdrawal Kanban
The Kanban system is
 A production Kanban responsible for ensuring
 A vendor Kanban that the necessary
products are produced in
the necessary quantities
at the necessary time.

21-15
JIT Inventory Management 2

Withdrawal Kanban

Production Kanban

21-16
JIT Inventory Management 2

Vendor Kanban

21-17
JIT Inventory Management 2

The Kanban Process

21-18
JIT Inventory Management 2

Discounts and Price Increases: JIT Purchasing versus

Holding Inventories
 Careful vendor selection
 Long-term contracts with vendors

 Prices are stipulated (usually producing a

significant savings)
 Quality is stipulated
 The number of orders placed are reduced

21-19
JIT Inventory Management 2
JIT Limitations
• Patience in implications is
needed.
• Time is required.
• JIT may cause lost sales
and stressed workers.
• Production may be
interrupted due to an
absence of inventory.

21-20
Basic Concepts of Constrained Optimization 3

Every firm faces limited resources and limited

demand for each product.

 External constraints, such as market demand

 Internal constraints, such as machine or labor
time availability

Constrained optimization is choosing the optimal

mix given the constraints faced by the firm.

21-21
Basic Concepts of Constrained Optimization 3
Linear Programming
The unit contribution margins are $300 and
$600 for X and Y, respectively.

Z = $300X + $600 Y

Total contribution
margin

This equation is called the objective

function, the function to be optimized.

21-22
Basic Concepts of Constrained Optimization 3
Linear Programming
Internal constraints:
X + Y  80
X + 3Y  120
2X + Y  90

External constraints:
X  60
Y  100

21-23
Basic Concepts of Constrained Optimization 3
Linear Programming
X + Y  80
X + 3Y  120
2X + Y  90
X  60
Y  100
X0
Y0

21-24
 Basic Concepts of Constrained Optimization 3

Graphical Solution

160 X  60
140
120
Y  100
100
2X + Y  90
80
60 B
X + Y  80
C
40 X + 3Y  120
20 A D

20 40 60 80 100 120 140 21-25

Basic Concepts of Constrained Optimization 3

Linear Programming

Corner Point X-Value Y-Value Z = $300X + $600Y

A 0 0 $ 0
B 0 40 24,000
C 30 30 27,000
D 45 0 13,500

C is the optimal solution!

21-26
Theory of Constraints 4

Three Measures of Systems Performance:

(Sales revenue – Unit-level
 Throughput variable expenses)/Time
 Inventory
 Operating expenses

21-27
Theory of Constraints 4
Five-Step Method for Improving
Performance
1. Identify an organization’s constraints.
2. Exploit the binding constraints.
3. Subordinate everything else to the
decisions made in Step 2.
4. Elevate the organization’s binding
constraints.
5. Repeat the process as a new constraint
emerges to limit output.

21-28
Theory of Constraints 4
Drum-Buffer-Rope System: General Description

Continued from left

Continued 21-29
Theory of Constraints 4

Drum-Buffer-Rope System:
Schaller Company

21-30
Theory of Constraints 4
New Constraint Set: Schaller Company

21-31