PRODUCTION AND OPERATIONS

MANAGEMENT

Chelliah Sriskandarajah

University of Texas at Dallas

 Inventory Management

Inventory : A stock or store of goods.

Firms typically stock many items in inventory.

Many of the items a firm carries in inventory

relate to the kind of business it engages in.
Examples :

1. Manufacturing firms carry supplies of raw

materials, purchased parts, finished items, spare
parts, tools,....

2. Department stores carry clothing, furniture,

stationery, appliances,...

3. Hospitals stock drugs, surgical supplies, life-

monitoring equipment, sheets, pillow cases,...

4. Supermarkets stock fresh and canned foods,

packaged and frozen foods, household supplies,...
IBM Example : Approximately 1000 IBM
products are currently in service, with installed
units numbering in excess of ten of millions
dollars.
IBM has more than 200,000 part numbers to
support these services.
It is essential to maintain a service parts inven-
tory system to support the product they sell and
install.
IBM’s National Service Division (NSD) has de-
veloped an extensive and sophisticated parts in-
ventory management system (PIMS) to provide
prompt and reliable customer service.
2 central warehouses, 21 field distribution cen-
ters...
PIMS employed economic order quantity (EOQ)
formulas to determine parts and replenishment
batch sizes and to set service priority goals.
 Inventory Management

Good inventory management is essential to the

successful operation of most organizations for a
number of reasons :

1. The amount of money inventory represents

2. The impact that inventories have on the daily

operations of an organization.

We focus on management of independent items :

finished goods, purchased parts, raw materials,
etc.
We study :

1. Different functions of inventories

2. Requirements for effective inventory

management.

3. Objectives of inventory control

4. Techniques of determining how much to

order and when to order.
Dependent Demand : Demand for items in
inventory that are subassemblies or component
parts to be used in the production of finished
goods.

Independent demand : Demand for items

that are finished items.
The Nature and important of
inventories

Inventories are vital part of business

They are necessary for operations

They contribute to customer satisfaction.

A typical firm probably has about 30

percent of its current capital assets and
perhaps as much as 90 percent of its
working capital invested in inventory.
Return on investment (ROI) : One widely
used measure of managerial performance.

P rof it af ter taxes

ROI =
total assets

Inventories may represent a significant portion

of total assets.

A reduction of inventories can result in a signif-

icant increase in ROI.
Different type of inventories :

1. Raw materials and purchased parts

2. Partially completed goods

WIP (Work-in-Process)

3. Finished-goods inventories (manufacturing

firms) Merchandise (retail stores).

4. Replacement parts, tools, and supplies.

5. Goods-in-transit to warehouses or customers.

Function of Inventory

1. To meet anticipated demand.

2. To smooth production requirements.

3. To decouple components of the production-

distribution system.

4. To protect against stockouts.

5. To take advantage of order cycles.

6. To hedge against price increases or take

advantage of quantity discounts.

7. To permit operations.
Objectives of Inventory Control :

Inadequate control of inventories can result in

both under- and overstocking of items.

Understocking results in missed deliveries, lost

sales, dissatisfied customers, and production
bottlenecks.

Overstocking : ties up funds that might be more

productive elsewhere.

Inventory management has two main concerns :

1. Level of customers service.

2. Cost of ordering and carrying inventories.

The overall objective of inventory management
is to achieve satisfactory levels of customer ser-
vice while keeping inventory costs within rea-
sonable bounds.

This means, the manager tries to achieve a

balance in stocking.

Two fundamental decisions are to be made :

1. Timing of the order.

2. Size of the order.

Performance measures used to judge the effec-
tiveness of inventory management :

1. Customer satisfaction : the number and

quantity of backorders, customer complaints.

annual cost of sold goods

2. Inventory turnover =
average inventory investment

3. Days of inventory : the expected number of

days of sales that can be supplied from existing
inventory.
Requirements for Effective Inventory
Management

1. A system to keep track of the inventory on

hand and on order.

2. A reliable forecast of demand that includes

an indication of possible forecast error.

3. Knowledge of lead times and lead time

variability.

4. Reasonable estimates of inventory holding

costs, ordering costs, and shortage costs.

5. A classification systems for inventory items.

Inventory Counting Systems

1. Periodic system

2. Continuous (perpetual) system

3. Two-bin system

Universal product code : Bar code printed

on a label that has information about the items
to which it is attached.
Demand Forecasts and Lead Time In-
formation :

Inventories are used satisfy demand. Therfore,

it is essential to have reliable estimates of the
amount and timing of demand.

Lead time : Time interval between ordering

and receiving the order.
Cost Information
Holding (carrying) cost:
Physically holding item in storage.
• interest
• insurance
• taxes
• depreciation
• obsolescence
• deterioration
• spoilage
• breakage
• warehouse costs (heat, light, rent, security)
• Holding cost also include opportunity costs
having funds tied up in inventory.
Ordering cost:
Cost ordering and receiving inventory.

• determine how much needed, typing up

invoices.
• inspecting goods for quality and quantity.
• moving to storage.
• cost of machine setup

Shortage costs :

• Opportunity cost for not making a sale.

• loss of customer goodwill.
• lateness charges.
• cost of loss production.
Classification Systems :

A-B-C approach : Classifying inventory ac-

cording to some measure of importance, and al-
locating control efforts accordingly.

Cycle counting : A physical count of items

in inventory.
How Much to Order :

Economic Order Quantity : The order

size that minimizes total cost.

Economic Order Quantity Models:

1. The economic order quantity model.

2. The economic order quantity model with

noninstantaneous delivery.

3. The quantity discount model.

Basic Economic Order quantity Model

EOQ

Assumptions:

1. Only one product is involved.

2. Annual demand requirements are known.

3. Demand is spread evenly throughout the year

so that the demand rate is reasonably constant

4. Lead time does not vary.

5. Each order is received in a single delivery.

6. There are no quantity discounts.

Notations:

D = Demand, usually in units per year.

S = Ordering cost.

H = Holding (carrying) cost per unit per unit

period (year).

r = Holding (carrying) cost per dollar per unit

period (year).

P = Unit price (or cost C).

H = rP .
T C = Total cost (per year) associated with car-
rying and ordering inventory when Q units are
ordered.

T C = Annual carrying cost + Annual ordering cost

Q
Annual carrying cost = H
2

D
Annual ordering cost = S
Q

Q D
TC = H + S
2 Q
 Q D
TC = H + S
2 Q

Optimal order quantity

r
2DS
Qo =
H

Qo
Length of order cycle =
D
The economic order quantity model with
noninstantaneous delivery

D = Demand, usually in units per year.

S = Ordering cost.

H = Holding (carrying) cost per unit per unit

period (year).

p = Production or delivery rate.

u = usage (demand) rate.

Imax = Maximum inventory.

T C = Total cost (per year) associated with car-

rying and setup cost when Q units are produced.
T C = Annual carrying cost + Annual setup cost

Imax
Annual carrying cost = H
2

D
Annual setup cost = S
Q

Imax D
TC = H+ S
2 Q

Imax
Iaverage =
2
 Imax D
TC = H+ S
2 Q

Optimal run quantity

r
2DS
r
p
Qo =
H p−u

Qo
Cycle time =
u

Qo
Run time =
p

Qo
Imax = (p − u)
p
The quantity discount model

T C = Total cost (per year) associated with

carrying, ordering and purchasing cost.

T C = Annual carrying cost + Annual ordering cost

+P urchasing cost

Q D
TC = H + S + PD
2 Q
Reference

Production/Operations Management by William J. Steven-

son, Seventh Edition, Irwin/McGraw-Hill, 2002.