ATHENS SOCRATES

Michal Kavan

The Goals of Managers and Organizations

Management is the accomplishment of an organizations goals by the defining
of goals, organization of work, motivation of others, staffing of the positions, the
control of the labor, material and evaluation of completed effort. Management is
working with and through other people to accomplish the objectives of both the
organization and its members.
1.1 Which are the excellent companies?
Eight characteristics of excellent enterprises:
Were oriented toward action
Learned about the needs of their customers
Promoted managerial autonomy and entrepreneurship
Achieved productivity by paying close attention to the needs of their people
Were driven by a company philosophy often based on the values of their leaders
Focused on the business they knew best
Had a simple organization structure with a lean staff
Were centralized as well as decentralized, depending on appropriateness.
1.2 Productivity, Effectiveness, and Efficiency
Another way to view the aim of all managers is to say that they must be productive.
Definition of productivity:
The output-input ratio within a time period with due consideration for quality.
Productivity = outputs / inputs (within a time period, quality considered)
Companies use several kinds of inputs, such as labor, materials, and capital.
Peter F. Drucker: one of the most prolific writers in management, observed, The
greatest opportunity for increasing productivity is surely to be found in knowledge
work itself, and especially in management. Productivity implies effectiveness and
efficiency in individual and organizational performance.
Effectiveness is the achievement of objectives.
Efficiency is the achievement of the ends with the least amount of resources.
1.3 Innovation and Entrepreneurship
The essence of entrepreneurship is innovation, goal-oriented change to utilize
the enterprises potential. As entrepreneurs, managers try to improve the situation.
Entrepreneurs have creative ideas; they use their management skills and resources
to meet identifiable needs in the marketplace. If successful, an entrepreneur can
become wealthy.

Peter Drucker suggests that innovation applies not only to high-tech

companies but equally to low-tech, established business. Worthwhile innovation is
not a matter of sheer luck; it requires systematic and rational work, well organized
and managed for results.
What does entrepreneurship imply? It suggests dissatisfaction with how things
are and an awareness of a need to do things differently. Innovation comes about
because of some of the following situations:
1. The unexpected event, failure, or success
2. The incongruous-what is assumed and what really is
3. The process or task that needed improvement
4. Changes in the market or industry structure
5. Changes in demographics
6. Changes in meaning or in the way things are perceived
7. Newly acquired knowledge.
The most successful innovations are often the mundane ones. Take the
Japanese, who make minor innovations (providing, for example, little conveniences
that customers like) in their cars or in their electronic equipment. James Brian Quinn
found in his research that successful large companies are listening carefully to the
needs of their customers. They establish teams that search for creative alternatives
to serve their customers-but within a limiting framework and with clear goals in mind.
1.4 Change and the Importance of Innovation
Because customer needs and desires as well as competitive offerings are constantly
changing, the company needs to innovate continually just to stay even with
competition. This means the firm needs to search perpetually for new and improved
products, services, and messages to give to the customer. Furthermore, it needs to
improve its manufacturing or service delivery process continually. The company that
loses its ability to innovate quickly falls behind.
Responsibility - the duty or task to be performed.
Authority - the power to act for someone else.
Accountability - the obligation to be held responsible for what was expected or
what happened that was unexpected.
Managerial strategy - the long-term goals and objectives of the enterprise, the
allocation of resources, and the adoption of appropriate courses of action (to carry
out these goals).
Long-range objectives - the owners business objectives that extend beyond the
current budget cycle of the organization.
Policies - general broad guidelines to action that relate to goal attainment.
Organizational purpose - the reason the business is in existence. It is the current
and future business and can be viewed as the primary objective of the organization.
2

2. Functions within Business Organizations

There are three basic functions in typical business organization: finance, marketing,
and production/operations. Often the success of an organization depends not only
on how well each area performs but also on how well the areas interface with each
other.
2.1 Marketing
Marketing consists of selling and/or promoting the goods or services of an
organization. Advertising and pricing decisions are made by marketing people.
Marketing is also responsible for assessing customer wants and needs, and for
communicating those to operations people (short term) and to design people (long
term). That is, operations needs information about demand over the short-tointermediate term so that it can plan accordingly (e.g., purchase materials or
schedule work), while design needs information that would relate to improving current
products and services and would suggest new ones.
Marketing, design, and production must work closely in order to successfully
implement design changes and to develop and produce new products. Marketing can
supply information on consumer preferences so that design will know the kinds of
products and features needed; operations can supply information about capacities
and judge the manufacturability of designs. Operations will also have advance
warning if new equipment or skills will be needed for new products or services.
Finance people should be included in these exchanges in order to provide
information on what funds might be available (short term) and to learn what new
funds might be needed for new products or services (intermediate to long term). One
important piece of information marketing needs from operations is the manufacturing
or service lead time so that customers can be given realistic estimates of how long it
will take to fill their orders.
Thus, marketing, operations, and finance must interface on product and
process design, forecasting, setting realistic schedules, quality and quantity
decisions, and keeping each other informed on the others
strengths and
weaknesses.
2.2 Operations
The operations function consists of all activities that are directly related to
producing goods or providing services. The production function exists not only in
manufacturing and assembly operations, which are goods-oriented, but also in such
areas as health care, transportation, food handling, and retailing, which are primarily
service-oriented.
The operations function is the core of most business organizations; it is
responsible for the creation of an organizations goods or services. Inputs are used to
obtain finished goods or services using one or more transformation processes (e.g.,

storing, transporting, cutting). To insure that the desired outputs are obtained,
measurements are taken at various points in the transformation process (feedback)
and then compared to previously established standards to determine if corrective
action is needed (control).
2.4 Other Functions
There are a host of other supporting functions that interface with operations,
finance, and marketing. Among them are accounting and purchasing. Depending on
the nature of the organization, there may also be personnel, product design and
development, industrial engineering, and maintenance.

Review Questions:

How would you define management? Does your definition differ from the one
offered in this book? Explain.
What are the managerial functions?
How do the required managerial skills differ in the organizational hierarchy?
In what fundamental way are the basic goals of all managers at all levels and in
all kinds of enterprises the same?
What are some of the characteristics of excellent companies (according to Peters
and Waterman)? Do the companies you know have these characteristics?
What are the differences between productivity, effectiveness, and efficiency?
How would you define entrepreneurship?
What does entrepreneurship imply?
What are several problems managing innovation?
What kind of resources are required to make a change in each component?
Why do management analysis and practice require a system approach (Models)?
Briefly describe the term Marketing Management, Production/Operations
Management, Purchasing, Personnel, Public relations, Industrial engineering,
Maintenance).
Describe the Pareto phenomenon and tell why it is important in problem solving.
Identify the three major functional areas of business organizations and briefly
describe how they interrelate.
Describe the operations function and the nature of the operations managers job.
Identify some of the current trends in operations management.
Contrast the terms mass production and job shop. What kinds of products does
each system produce?

6. Demand Measurement and Forecasting

The forecasting of sales is a critical input to decision making as well as that of
other functional areas such as production, finance, and personnel. Poor forecasting

can result in excessive inventory, inefficient sales-force expenditures, costly price

reductions, lost sales, inefficient scheduling of production, and inadequate planning
for Cash flow and capital investments. Business forecasting pertains to more than
predicting demand. Forecasts are also used to predict profits, revenues, costs,
productivity changes, prices and availability of energy and raw materials, interest
rates, movements of key economic indicators (e.g., GNP, inflation, government
borrowing), and prices of stocks and bonds, as well as other variables.
6.1 Forecasting
Forecast can help managers by reducing some of the uncertainty, thereby
enabling them to develop more meaningful plans than they might otherwise.
A forecast is a statement about the future.

1.
2.
3.
4.

6.2 Features common to all forecasts

The same underlying causal system that existed in the past will continue to exist
in the future.
Forecasts are rarely perfect; actual results usually differ from predicted values.
Forecasts for groups of items tend to be more accurate than forecasts for
individual items.
Forecast accuracy decreases as the time period covered by the forecast-the time
horizon-increases.

There are two general approaches to forecasting:

Qualitative:
Judgmental methods:
Consumer surveys
Sales force composites
Executive opinion

Questioning consumers on future plans.

Joint estimates obtained from salespeople.
Finance,
marketing,
and
manufacturing

Delphi technique

managers join to prepare forecast.

Series of questionnaires answered anonymously

Outside opinion

by managers and staff; successive

questionnaires are based on information
obtained from previous surveys.
Consultants or other outside experts prepare the
forecast.

Quantitative:
Time series:
Naive

Next value in a series will equal the previous

value.
5

Moving averages

Forecast is based on an average of recent

values.
Exponential smoothing

Sophisticated form of averaging.

Associative models:
Simple regression

Values of one variable are used to predict

Multiple regression

values of another variable.

Two or more variables are used to predict
values of another variable.

6.3 Steps in the Forecasting Process

There are five basic steps in the forecasting process:
1. Determine the purpose of the forecast and when it will be needed. This will
provide an indication of the level of detail required in the forecast, the amount of
resources (manpower, computer time, dollars) that can be justified, and the level
of accuracy necessary.
2. Establish a time horizon that the forecast must cover, keeping in mind that
accuracy decreases as the time horizon increases.
3. Select a forecasting technique.
4. Gather and analyze the appropriate data, and then prepare the forecast. Identify
any assumptions that are made in conjunction with preparing and using the
forecast.
5. Monitor the forecast to see if it is performing in a satisfactory manner. If it is not,
reexamine the method, assumptions, validity of data, and so on; modify as
needed; and prepare a revised forecast.
Moving Averages
A moving average forecast uses a number of the most recent actual data
values in generating a forecast. The moving average forecast can be computed using
the following equation:
n

MAn =
Where

i =
n
Ai

i 1

n
Age of the data (i = 1,2,3 )
Number of periods in the moving average
Actual value with age i

Exponential Smoothing:
Exponential Smoothing is a sophisticated weighted averaging method that is
still relatively easy to use and understand. Each new forecast is based on the
previous forecast plus a percentage of the difference between that forecast and the
actual value of the series at that point. That is:

New forecast = Old forecast + (Actual Old forecast)

Where is a percentage and (Actual Old forecast) represents the forecast error.
More concisely,
Ft = Ft-1 + ( At-1 - Ft-1 )
Where:
Ft = Forecast for period t
Ft-1 = Forecast for period t - 1

= Smoothing constant
At-1 = Actual demand or sales for period t-1
Trend Equation:
A linear trend equation has the form
yt = a + bt
where:
yt
a
b

t = Specified number of time periods from t = 0

Forecast for period t
Value of yt at t = 0,
Slope of yt the line

The coefficients of the line, a and b, can be computed from historical data using
these two equations:
n ty t y
y b t
b=
a=
2
2
n t t
n
where:

n = Number of periods
y = Value of the time series

Techniques for Seasonality:

The term seasonal variation is also applied to daily, weekly, monthly, and
other regularly recurring patterns in data.
Centered Moving Average:
Computations are the same as for a moving average forecast, as are the
resulting values. However, the values are not projected as in a forecast; instead, they
are positioned in the middle of the periods used to compute the moving average.
Simple Linear Regression:
The simplest and most widely used form of regression involves a linear
relationship between two variables. The object in linear regression is to obtain an

equation of a straight line that minimizes the sum of squared vertical deviations of
data points from the line.
Correlation measures the strength and direction of relationship between two
variables. Correlation can range from -1,0 to + 1,0. A correlation of +1,0 indicates
that changes in one variable are always matched by changes in the other; a
correlation of -1,0 indicates that increases in one variable are matched by decreases
in the other; and a correlation close to zero indicates little linear relationship between
two variables. The correlation between two variables can be computed using the
equation:
r =

n xy x y

n x 2 x n y 2 y
2

6.5 Accuracy and control of forecasts

There are two aspects of forecast accuracy that have potential significance
then deciding among forecasting alternatives. One is the historical error performance
of a forecast, and the other is the ability of a forecast to respond to changes.
Two commonly used measures for summarizing historical errors are the mean
absolute deviation (MAD) and the mean squared error (MSE). MAD is the average
absolute error, and MSE is the average of squared errors. The formulas used to
compute MAD and MSE are:
MAD =
MSE =

Actal forecast

( Actual forecast )

n 1

The sample standard deviation, s, equals the square root of MSE. From a
computational standpoint, the difference between these two measures is that one
weights all errors evenly (MAD) and the other weights errors according to their
squared values (MSE).
Forecasts can be monitored using either tracking signals or control charts. A
tracking signal focuses on the ratio of cumulative forecast error to the corresponding
value of MAD:
Tracking signal =

( Actual Forecast )

MAD

The resulting values are compared to predetermined limits. These are based
on judgment and experience and often range from 3 to 8. We shall use limits of
4 for the most part. These are roughly comparable to three standard deviation
limits. Values within the limits suggest but do not guarantee that the forecast is
performing adequately. After an initial value of MAD has been computed, MAD can
be updated using exponential smoothing:
MADt = MADt-1 + (Actual - Forecastt - MADt-1)
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The control chart approach involves setting upper and lower limits for
individual forecast errors (instead of cumulative errors, as is the case with a tracking
signal). The limits are multiples of the square root of MSE. This method assumes the
following:
a) Forecast error are randomly distributed around a mean of zero.
b) The distribution of errors is normal.
In effect, the square root of MSE is an estimate of the standard deviation of the
distribution of errors. That is:
s = MSE .
Selection of a forecasting technique involves choosing a technique that will
serve the intended purpose at an acceptable level of cost and accuracy.

1.
2.
3.
4.
5.
6.
7.
8.

Review Questions:
Outline the steps in the forecasting process.
What are the main advantages that quantitative techniques for forecasting have
over qualitative techniques? What limitations do quantitative techniques have?
What is the purpose of establishing control limits for forecasts?
Outline the features common to all forecasts.
Describe at least four qualitative forecasting techniques and the advantages and
disadvantages of each.
What advantages does exponential smoothing have over moving averages as a
forecasting tool?
How does the number of periods in a moving average affect the responsiveness
of the forecast?
What factors enter into the choice of a value for the smoothing constant in
exponential smoothing?

Logistics:
Logistics refers to the movement of materials within a production facility and to
incoming and outgoing shipments of goods and materials.
The numerous instances of materials movement include:
From incoming vehicles to receiving.
From receiving to storage.
From storage to the point of use (e.g., work center, office, maintenance).
From one work center to the next, or to temporary storage.
From the last operation to final storage.
From storage to packaging/shipping.
From shipping to outgoing vehicles.
Movement of materials must be coordinated to arrive at the appropriate destinations
at appropriate times. Care must be taken so that items are not lost, stolen, or
damaged during movement.
Traffic management overseeing the shipment of incoming and outgoing goods.
9

Bar codes patterns of black lines and white spaces that can be read by scanning
devices, containing a variety of information.
Distribution is the shipping of goods from the company through a distribution system
to warehouses, retail customers, or final customers.
Review Questions:

Define materials and briefly describe the materials management

function.
Describe how purchasing interfaces with other areas of the
organization and with suppliers.
Outline the objectives of purchasing.
Describe the purchasing cycle, especially determination of price and
sources of supply.
Discuss the issue of centralized purchasing versus decentralized
purchasing.
Describe and discuss value analysis.
Discuss the importance of good vendor relations.
Discuss the logistics aspects of materials management.

Just-in-Time Systems
Just-in-time (JIT) is a system of lean production used mainly in repetitive
manufacturing, in which goods move through the system and tasks are completed
just in tie to maintain the schedule. Such systems require very little inventory
because successive operations are closely coordinated.
Lean systems require that sources of potential disruption to the even flow of
work eliminated. High quality is stressed because problems with quality can disrupt
the process. Quick, low-cost setups; special layouts; allowing work to be pulled
through the system rather than pushed through; and a spirit of cooperation are all
important features of lean systems. So, too, are problem solving aimed at reducing
disruptions and making the system more efficient, and an attitude of working toward
continual improvement.
Key benefits of JIT / lean systems are reduced inventory levels, high quality,
flexibility, reduced lead times, increased productivity and equipment utilization,
reduced amounts of scrap and rework, and reduced space requirements.
JIT differs in many ways from traditional systems The benefits of JIT systems
have attracted the attention of Czech manufacturers, causing many to consider
converting their operations to JIT. In doing so, careful attention must be given to
obtaining the support of top management, achieving a cooperative spirit throughout

10

the organization, reducing setup times, and establishing good relationships with a
small number of vendors.
The JIT approach was developed at the Toyota Motor Company of Japan by
Mr. Taiichi Ohno (vice president of manufacturing) and several of his colleagues.
The development of JIT in Japan was probably influenced by the fact that Japan is a
crowded country with few natural resources. JIT systems are designed to achieve a
smooth flow of production using minimal inventories. The systems are fairly flexibly,
with a high degree of worker participation in problem solving, continuous
improvement, and attention to detail. However, the most important aspect of a JIT
system is that quality is built into the system.
High quality is a prerequisite for this system; no other element is as critical.
The key elements of the system are these:
a) Production smoothing.
b) High quality levels.
c) Low inventories.
d) Small lot sizes.
e) Quick, low-cost setups.
f) Layout.
g) Preventive maintenance and repair.
h) Multifunctional workers.
i) A cooperative spirit.
j) Few, reliable suppliers.
k) A pull system of moving goods.
l) Continual improvement.
m) Problem solving.
The terms push and pull are used to describe two different systems for moving
work through a production process. In a push system, when work is finished at a
workstation, the output is pushed to the next station; or, in the case of the final
operation, it is pushed on to final inventory. Conversely, in a pull system, control of
moving the work rests with the following operation; each workstation pulls the output
from the preceding station as it is needed; output of the final operation is pulled by
customer demand or the master schedule.
Thus, in a pull system, work is moved in response to demand from the next
stage in the process, whereas in a push system, work is pushed on as it is
completed, with no regard for whether the next station is ready for the work.
Consequently, work may pile up at workstations that fall behind schedule, say,
because of equipment failure or the detection of a problem with quality.
Just-in-time, Lean Manufacture, World-Class Manufacturing all these
labels describe excellence in manufacturing. Precise and universally accepted

11

definitions of these terms are hard to come by. But there is general agreement that
all these concepts have eight objectives in common, at least:
1) Low inventory
2) Short throughput time
3) Reliable delivery performance
4) Rapid response capability
5) Low reject and rework percentages
6) Committed trained workforce
7) Customer focus
8) Continuous improvement.
Very few companies achieve all of these objectives, though many are
striving to do so. Normally they find that by addressing one of them they are
impacting on another. So the pace of change increases. The point is to make a
deliberate start. Just-in-Time in factory can be introduced and developed by the
following eight efforts:
Reduce the lead time - the time it takes from launching the batch of work into
the first operation queue to the time it is available for sale to the customer.
Reduce the batch size - the number of items that travel together through the
factory.
Reduce work in progress - the number of batches available to be worked
on at all the operations in the factory.
Dont launch a batch of work until you have to
Minimize the distance between operations - the distance a batch travels on its
journey through the factory.
Make operators responsible for their work quality - rather than leaving it to a
separate quality control section.
Integrate testing into the production process.
Make labor, processes and machines available when and where the work is capacity availability and machine reliability.
All these efforts are geared to creating smooth flow in the factory.
In some systems the Kan Ban linkage is between the slowest operation
(bottleneck), no matter where it is, and the release of a batch to the first operation
in the production system. The principle is based on bottleneck or constraint
management theory. Its guiding rule: If you identify the slowest operation, the
capacity upstream and downstream of that slowest operation will be greater than
the bottleneck. Consequently, the system can deliver to or consume from the
bottlenecks at a faster rate than the bottleneck can consume or deliver. So the
imperative is clear: as the bottleneck limits the throughput of the system it must
work to maximum utilization and must never be starved of work. If you release into
the system at the consumption rate of the bottleneck, then there will always be

12

work for it. Batch reduction and bottleneck focus are crucial. But they can be
enhanced by space compression!
These control principles are simple in essence. But they are complex in
application. They require in-depth treatment in their own right and will be the
subject of a later video.
Kanban is a Japanese term that means signal or visible record. When a
worker needs materials or work from the preceding station, he or she uses a kanban
card to communicate this. In effect, the kanban card is the authorization to move or
work on parts. In kanban systems, no part or lot can be moved or worked on without
one of these cards. The system works this way:
A kanban card is affixed to each container. When a workstation needs to
replenish its supply of parts, a worker goes to the area where these parts are stored
and withdraws one container of parts. Each container holds a predetermined quantity.
The worker removes the kanban card from the container and posts it in a designated
spot where it will be clearly visible, and the worker then moves the lot to the
workstation. The posted kanban is then picked up by a stock person who replenishes
the stock with another container, and so on down the line.
Demand for parts triggers a replenishment, and parts are supplied as usage
dictates. Similar withdrawals and replenishments occur all the way up and down the
line from vendors to finished-goods inventories, all controlled by kanbans. In fact, if
supervisors decide the system is too loose because inventories are building up, they
may decide to withdraw some kanbans, thereby tightening the system. Conversely, if
the system seems too tight, additional kanbans may be introduced to bring the
system into balance.
Important questions:
What is the impact of halving the batch size?
On lot delay?
On throughput time?
On set-ups?
What is the impact of halving the set-up time?
On throughput time?
Can you identify major contributors to queue time?
How many line items does your manufacturing store carry?
How many products do you produce?
How many customers do you have?
How many suppliers do you have?
What is the total value of purchases of materials and components?
What is the expenditure on the top 10% of your suppliers?
How many suppliers make up this 10%?
What % of total purchases does this represent?
How many times have these suppliers been visited in the last year?

13

What is the value of raw materials?

What is the value of work-in-progress?
What is the value of finished goods?
What is the value of inventory?
What is the direct cost of annual production?
What is the work-in-progress turn ratio?

Inventory Management
Good inventory management is often the mark of a well-run organization. The
models described in this chapter are relevant for instances where demand for
inventory items is independent. Three classes of models are described: EOQ, ROP,
and fixed-interval. These are all appropriate if unused items can be carried over into
subsequent periods. The single-period model is appropriate when items cannot be
carried over.
EOQ models address the question of how much to order. The ROP models
address the question of when to order and are particularly helpful in dealing with
situations that include variations in either demand rate or lead time. ROP models
involve service level and safety stock considerations. When the time between orders
is fixed, the FOI model is useful.
An inventory is a stock or store of goods.
Many firms stock hundreds or even thousands of items. Raw materials,
purchased parts, partially completed items, and finished goods, as well as spare
parts for machines, tools, and other supplies.
Inventories serve a number of important functions. Among the most salient reasons
for holding inventories are the following:
To meet anticipated demand.
To smooth production requirements.
To decouple components of the production-distribution system.
To protect against stock-outs.
To take advantage of order cycles.
To hedge against price increases, or to take advantage of quantity discounts.
To permit operations.
The overall objective of inventory management is to achieve satisfactory levels of
customer service while keeping inventory costs within reasonable bounds. Toward
this end, the decision makers problem is to achieve a balance in stocking, avoiding
both overstocking and under stocking. The two fundamental decisions that must be
made relate to the timing and under stocking. The two fundamental decisions that
must be made relate to the timing and size of orders (i.e., when to order and how
much to order).
To be effective, management must have the following:
A system to keep track of the inventory on hand and on order.

14

 A reliable forecast of demand that includes an indication of possible forecast

error.
Knowledge of lead times and lead time variability.
Reasonable estimates of inventory holding costs, ordering costs, and
shortage costs.
A classification system for inventory items.
Periodic system physical count of items in inventory made at periodic intervals
(weekly, monthly).
Perpetual inventory system System that keeps track of removals from
inventory continuously, thus monitoring current levels of each item.
Two-bin system two containers of inventory; reorder when the first is empty.
Universal product code (UPC) bar code printed on a label that has information
about the item to which it is attached.
Holding (carring) costs relate to physically holding items in storage. They
include interest, insurance, taxes, depreciation, obsolescence, deterioration,
spoilage, pilferage, breakage, and warehousing costs (heat, light, rent, security).
Holding costs also include opportunity costs associated with having funds tied up in
inventory that could be used elsewhere.
Ordering costs are the costs associated with ordering and receiving inventory.
These include determining how much is needed, typing up invoices, inspecting goods
upon arrival for quality and quantity, and moving the goods to temporary storage.
Ordering costs are generally expressed as a fixed dollar amount per order,
regardless of order size.
Shortage costs result when demand exceeds the supply of inventory on hand.
These costs can include the opportunity cost of not making a sale, loss of customer
goodwill, lateness charges, and similar costs. Furthermore, if the shortage occurs in
an item carried for interval use (e.g., to supply an assembly line), the cost of lost
production or downtime is considered a shortage cost.
16.1 How much to order:
Economic order quantity models:
The question of how much to order is frequently determined by using an
economic order quantity (EOQ) model. EOQ models identify the optimal order
quantity in terms of minimizing the sum of certain annual costs that vary with order
size. Three order size models are described in the following sections:
A. The economic order quantity model.
B. The order quantity model with noninstantaneous delivery.
C. The quantity discount model.
A. Basic economic order quantity (EOQ) model :

15

Annual carrying cost is computed by multiplying the average amount of

inventory on hand by the cost to carry one unit for a year, even though any given unit
would not be held for a year.
Annual carrying cost =

Q
H
2

Annual ordering cost = Q S

The total annual cost (TC) associated with carrying and ordering inventory when Q
units are ordered each time is:
TC =
Where: D
Q
S
H

=
=
=
=

D
Q
H+ Q S
2

Demand, usually in units per year

Order quantity, in units
Ordering cost, in dollars
Carrying cost, usually in dollars per unit per year.
(D, H in the same units).

Thus, Q0:
1.
2.

dTC dQ

H d ( D / Q ) S H / 2 DS / Q 2
dQ
2

0 = H/2 DS/Q2, so Q2 =

2 DS
H

Q0 =

or
2 DS
H

Number of orders per year: D/ Q0 and Length of order cycle: Q0/D .

B. The order quantity model with noninstantaneous delivery:
The basic EOQ model assumes that orders are delivered as whole units at a
single point in time (instantaneous replenishment). However, in some instances such
as when a firm is both a producer and user, or when deliveries are spread over time,
inventories tend to build up gradually instead of instaneously.
When a company makes the product itself, there are no ordering costs as such.
Nonetheless, with every run there are setup costs costs required to prepare the
equipment for the job, such as cleaning, adjusting, and changing tools and fixtures.
These are analogous to ordering costs.
The number of runs is D/Q, and the annual setup cost is equal to the number of runs
per year times the setup cost per run: (D/Q)S.
Total cost is:
I max
H ( D / Q0 ) S
TCmin = Carrying cost + Setup cost
=
2
Imax = maximum inventory
The economic run quantity is:
where:

Q0 =

2 DS
H

p
p u

p = Production or delivery rate

u = Usage rate

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The maximum and average inventory levels are: I max =

Q0
I
( p u ) and Iprm = max
p
2

The cycle time (the time between orders, or between the beginnings of runs) for the
economic run size is a function of the run size and usage (demand) rate:
Q0
Cycle time =
u
Similarly, the run time (the production time) is a function of the run size and the
production rate:
Run time =

Q0
p

C. The quantity discount model.

Quantity discounts are price reductions for large orders offered to customers to
induce them to buy in large quantities.
If quantity discounts are offered, the customer must weigh the potential benefits of
reduced purchase price and fewer orders that will result from buying in large
quantities against the increase in carrying costs caused by higher average
inventories. Hence, the buyers goal in the case of quantity discounts is to select the
order quantity that will minimize total cost, where total cost is the sum of carrying
cost, ordering cost, and purchasing cost:
TC = Carrying cost + Ordering cost + Purchasing cost
D
Q
S PD
H
2
Q

TC =

where: P unit price

16.2 When to reorder:

EOQ models answer the question of how much to order, but not the question
of when to order. The latter is the function of models that identify the reorder point
(ROP) in terms of a quantity: the reorder point occurs when the quantity on hand
drops to a predetermined amount. That amount generally includes expected demand
during lead time and perhaps an extra cushion of stock, which serves to reduce the
probability of experiencing a stock-out during lead time. We will consider reorder
point models for these cases:
Constant demand rate, constant lead time.
Variable demand rate, constant lead time.
Constant demand rate, variable lead time.
Variable demand rate, variable lead time.
The following symbols are used in the various models:
d = Constant demand rate,
LT = Constant lead time,
d = Average demand rate,
LT = Average lead time,
d = Standard deviation of demand rate or forecast error,
LT = Standard deviation of lead time.

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 Constant demand rate, constant lead time.

Variable demand rate, constant lead time.
ROP = Expected demand during lead time + Safety stock
= d LT + z LT (d)
where:
z = Number of standard deviation from the mean
The standard deviation of lead time demand is LT (d).
Constant demand rate, variable lead time.
In this case, the expected demand during lead time is equal to d LT , and the
standard deviation of demand during lead time is equal to dLT.
The reorder point is:
ROP = d LT + zdLT.
where:
d = Constant demand rate,
LT = Standard deviation of lead time.
LT = Average lead time,
Variable demand rate, variable lead time.
2
2
lead
Standard deviation of total demand during lead time = demand
time
where:
Hence:
dLT =

demand =
lead time =

LT

LT

( LT d ) 2 ( d LT ) 2

ROP =

d ( LT ) z

2
LT d2 d LT
2

2
LT d2 d LT

Review Questions:
1. What are the primary reason for holding inventory?
2. What are the requirements for effective inventory management?
3. Briefly describe each of the costs associated with inventory.
4. Contrast independent and dependent demand with respect to inventories.
5. List the major assumptions of the EOQ model.
6. Why isnt price considered explicity in the basic EOQ model? What are
quantity discounts? What three costs enter into the order quantity decision
when discounts are available?
7. What is safety stock, and why is it held?
8. What is meant by the term service level?
9. Generally speaking, how is service level related to the amount of safety
stock held?
10. Describe briefly the A,B,C approach to inventory control.

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