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Operations Management

Inventory Management Chapter 12


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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

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

1984-1994 T/Maker Co. 1995 Corel Corp.

1984-1994 T/Maker Co.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Types of Inventory
Raw material Work-in-progress Maintenance / repair / operating supplies Finished goods

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

The Material Flow Cycle

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

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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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Disadvantages of Inventory
Higher costs
Interest or opportunity costs Holding (or carrying) costs storage, handling, taxes, insurance, shrinkage Ordering (or setup) costs

Risk of deterioration or obsolescence Hides production problems

Yield / scrap variations Unscheduled downtime

Total cost = 20% - 40% of inventory value / year


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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Pressures on inventory
Pressure for lower inventory
Inventory investment Inventory holding cost

Pressure for higher inventory


Customer service Other costs related to inventory
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Different Views of Inventory


Demand Type
Independent Dependent

Types of Inventory
Cycle Pipeline Safety Stock Anticipation

Process stage
Raw Material Work in Process Finished Goods

Annual $ Volume
A B C

Other
Maintenance / Repair Operating Supplies
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

How Is Inventory Created?


Cycle Inventory result of lot size
Q+0 Average cycle inventory = 2

Pipeline Inventory in transit


Pipeline inventory = DL = dL

Safety Stock Anticipation Inventory

Types of Inventory
Cycle Pipeline Safety Stock Anticipation
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Calculations
We use 70 hypodermic needles a week. We buy them in lots of 280. It takes three weeks for order handling and shipment.
Cycle inventory = Q/2 = 280/2 = 140 needles

Pipeline inventory = DL = dL = (70 needles/week)(3 weeks) = 210 drills


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Inventory Worksheets
2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Reduction Tactics


Cycle inventory
Pipeline inventory Safety Stock

Reduce lot size


Reduce lead time Reduce uncertainties

Anticipation inventory

Various

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

ABC Analysis
Divides on-hand inventory into three classes on the basis of annual dollar volume A, B, and C

$ volume = Annual demand x Unit cost Develop class A suppliers more Maintain tighter physical control of A items Forecast A items more carefully
Annual $ Volume

Policies based on ABC analysis


A B C
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

ABC Analysis
% Annual $ Usage 100
80 60 40 20 0 0 50 100 % of Inventory Items
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Class A B C

% $ Vol 80 15 5

% Items 20 30 50

A
B

Inventory Models for Independent Demand


Fixed order-quantity models
Economic order quantity Production order quantity Quantity discount

Help answer the inventory planning questions!

Probabilistic models Fixed order-period models


1984-1994 T/Maker Co.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

EOQ Economic Order Quantity


Objective: minimize (ordering cost + holding cost)

Assumptions:

Known and constant demand Known and constant lead time Instantaneous receipt of material No quantity discounts Only ordering / setup cost and holding cost No stockouts
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Usage Over Time


Usage Rate
Q
Inventory Level

Q 2

Average Cycle Inventory

Time

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

EOQ Model How Much to Order?


Annual Cost

Minimum total cost


Ordering (Setup) Cost

Optimal Order Quantity (Q*)


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Order quantity (Q)

2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Why Holding Costs Increase


More units must be stored if more are ordered

Purchase Order Description Qty. Microwave 1

Purchase Order Description Qty. Microwave 1000

Order quantity
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Why Ordering Costs Decrease


Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage $ 0.33)
Purchase Order Description Qty. Microwave 1000

1000 Orders (Postage $330)

Purchase Order Purchase Order Purchase Order Purchase Order Qty. Description Qty. Description Qty. Description Qty. 1 Microwave Description Microwave Microwave 11 Microwave 1

Order quantity
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

EOQ Model When to Order


Inventory Level

Q*
Average Cycle Inventory

Reorder Point (ROP)

Time

Lead Time
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

EOQ Model Equations


Optimal Order Quantity Expected Number of Orders

2 D S H =N = D Q* = Q* =

Expected Time Between Orders

=T =

Working Days

/ Year

d =

D
Working Days / Year

ROP = d L

D = Demand per year S = Setup (order) cost per order H = Holding (carrying) cost d = Demand per day L = Lead time in days
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Models for Independent Demand


Fixed order-quantity models
Economic order quantity Production order quantity Quantity discount

Help answer the inventory planning questions!

Probabilistic models Fixed order-period models


1984-1994 T/Maker Co.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

POQ Production Order Quantity


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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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

EOQ POQ Model


Both production and usage take place Usage only takes place

Maximum inventory level


Inventory Level

Time

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Models for Independent Demand


Fixed order-quantity models
Economic order quantity Production order quantity Quantity discount

Help answer the inventory planning questions!

Probabilistic models Fixed order-period models


1984-1994 T/Maker Co.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Quantity Discount Model


Answers how much to order & when to order Allows quantity discounts

Other EOQ assumptions apply

Trade-off is between lower price & increased holding cost


Discount Number 1 Discount Quantity 0 to 999 Discount (%) No discount Discount Price (P) $ 5.00

2
3

1,000 to 1,999
2,000 and over
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5

$ 4.80
$ 4.75

2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Quantity Discount How Much to Order

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Models for Independent Demand


Fixed order-quantity models
Economic order quantity Production order quantity Quantity discount

Help answer the inventory planning questions!

Probabilistic models Fixed order-period models


1984-1994 T/Maker Co.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Probabilistic Models
Answer how much & when to order Allow demand to vary

Frequency

Service Level

P(Stockout)

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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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Probabilistic Models - When to Order?


Inventory Level
Frequency

Service Level

P(Stockout)

SS ROP

Reorder Point (ROP)

Safety Stock (SS)


Lead Time Place order
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Time Receive order


2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Models for Independent Demand


Fixed order-quantity models
Economic order quantity Production order quantity Quantity discount

Help answer the inventory planning questions!

Probabilistic models Fixed order-period models


1984-1994 T/Maker Co.

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Fixed Period (P) Systems


Answers how much to order Orders placed at fixed intervals

Inventory brought up to target amount Amount ordered varies Possibility of stockout between intervals Example: Office Max representative calls every week

No continuous inventory count

Useful when vendors visit routinely

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory 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
On-Hand Inventory

Q2
Q3 p p p

Q4

Time
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Comparison of Q and P Systems


Continuous Review System (Q)
A system designed to track the remaining inventory of an item each time a withdrawal is made, to determine whether it is time to replenish

Periodic Review System (P)


A system in which an items inventory position is reviewed periodically rather than continuously

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Comparison of Q and P Systems


Continuous Review System (Q)
Individual review frequencies Possible quantity discounts Lower, less-expensive safety stocks

Periodic Review System (P)


Convenient to administer Orders may be combined Inventory position only required at review

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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Inventory Measures
Average inventory = $2 million Cost of goods sold = $10 million 52 business weeks per year
Average inventory value Weekly sales (at cost) $2 million = = 10.4 weeks ($10 million)/(52 weeks)

Weeks of supply =

Inventory turns = =

Annual sales (at cost) Average inventory value $10 million = 5 turns/year $2 million
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458

Summary
Functions of inventory
Inventory enables value creation for many processes

Costs of inventory Different views of inventory Inventory reduction tactics ABC and EOQ are traditional tools used to manage inventory still used in many circumstances Continuous review system (Q) for high-value parts; Periodic review system (P) for some low value parts Weeks of Supply and inventory turns are widely-used measures of inventory
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2004 by Prentice Hall, Inc., Upper Saddle River, N.J. 07458