Lecture 7 Inventory Planning

Chapter 12: Operations Management - 5th Edition Roberta Russell & Bernard W. Taylor, III And Chapter 8: Operations Management Krajewski and Ritzman 6/e

What Is Inventory?
Stock of items kept to meet future demand

Purpose of inventory management

how many units to order when to order

Types of Inventory
Raw materials

Purchased parts and supplies

Work-in-process (partially completed) products

(WIP) Items being transported Tools and equipment

Inventory and Supply Chain Management

Bullwhip effect Seasonal or cyclical demand Inventory provides independence from

vendors Take advantage of price discounts Inventory provides independence between stages and avoids work stop-pages or delays

Two Forms of Demand

Dependent Demand for items used to produce final products Tires stored at a Goodyear plant are an example of a dependent demand item

Independent Demand for items used by external customers Cars, appliances, computers, and houses are examples of independent demand inventory

Inventory and Quality Management

The ability to meet effectively internal

organisational demand or customer demand in a timely, efficient manner is referred to as the level of customer service.
Customers usually perceive quality service as

availability of goods they want when they want them Inventory must be sufficient to provide high-quality customer service in TQM

Inventory Costs
Carrying cost

cost of holding an item in inventory Ordering cost / Setup cost

cost of replenishing inventory Shortage cost temporary or permanent loss of

sales when demand cannot be met

Carrying Costs
Carrying costs can include the following items: Facility storage Material handling Labour Record keeping Borrowing to purchase inventory (loan from banks)

Product deterioration, spoilage, breakage, obsolescence,

pilferage Carrying cost may be shown as total or as percentage of the value of an item Carrying costs range from 10 to 40 percent of the value of a manufactured item

Inventory Control Systems

An inventory system controls the level of inventory by

determining how much to order and when to order. There are two basic types of inventory systems:

Continuous or fixed-order-quantity system Periodic or fixed-time-period system

Continuous System
Constant amount ordered when inventory

declines to predetermined level

Inventory level is continuously monitored Order time may vary Also known as perpetual system

Periodic System
Order placed for variable

amount after fixed passage of time Order size differs. O = T IP Also known as periodic review system

ABC Classification
Class A 5 15 % of units 70 80 % of value Class B 30 % of units 15 % of value Class C 50 60 % of units 5 10 % of value

ABC Classification: Example

PART
1 2 3 4 5 6 7 8 9 10

UNIT COST
$ 60 350 30 80 30 20 10 320 510 20

ANNUAL USAGE
90 40 130 60 100 180 170 50 60 120

PART

TOTAL PART VALUE

% OF TOTAL % OF TOTAL UNIT COSTQUANTITY % CUMMULATIVE ANNUAL USAGE VALUE

9 8 2 1 4 3 6 5 10 7

9 $85,400 10

$30,600 1 16,000 2 14,000 3 5,400 4 4,800 5 3,900 3,600 6 3,000 7 2,400 8 1,700

35.9 $ 60 18.7 350 16.4 30 6.3 80 5.6 30 4.6 4.2 20 3.5 10 2.8 320 2.0

510 20

6.0 5.0 4.0 9.0 6.0 10.0 18.0 13.0 12.0 17.0

90 40 A 130 60 B 100 180 170 C 50 60 120

6.0 11.0 15.0 24.0 30.0 40.0 58.0 71.0 83.0 100.0

CLASS A B C

% OF TOTAL ITEMS VALUE 9, 8, 2 71.0 1, 4, 3 16.5 6, 5, 10, 7 12.5

% OF TOTAL QUANTITY 15.0 25.0 Example 10.1 60.0

Economic Order Quantity (EOQ) Models

EOQ
optimal order quantity that will minimize

total inventory costs

Basic EOQ model

Production quantity model

Definitions
Order Cycle:
The time between the receipt of orders in an

inventory system
Lead Time:
The time required to receive the order after an order

is placed.

Inventory Order Cycle

Order quantity, Q Inventory Level

Demand rate

Reorder point, R

Lead time Order Order placed receipt

Lead time Order Order placed receipt

Time

Assumptions of Basic EOQ Model

Demand is known with certainty and is constant over time 2. No shortages are allowed 3. Lead time for the receipt of orders is constant 4. Order quantity is received all at once
1.

EOQ Cost Model

Co - cost of placing order Cc - annual per-unit carrying cost D - annual demand Q - order quantity CoD Q CcQ 2 CcQ 2

Annual ordering cost =

Annual carrying cost = Total cost = CoD + Q

EOQ Cost Model

Deriving Qopt Proving equality of costs at optimal point CoD CcQ = Q 2 Q2 2CoD = Cc 2CoD Cc

Co D CcQ TC = + Q 2
CoD Cc TC = + Q2 2 Q C0D Cc 0= + Q2 2 Qopt = 2CoD Cc

Qopt =

EOQ Cost Model (cont.)

Annual cost ($) Slope = 0 Minimum total cost Carrying Cost = CcQ 2

Total Cost

Ordering Cost =

CoD Q

Optimal order Qopt

Order Quantity, Q

Example
The e-Paint Store paint in its warehouse and

sells it online on its Internet Web site. The store stocks several brands of paint; however, its biggest seller is Sharman-Wilson Ironcoat paint. The company wants to determine the optimal order size and total inventory cost for Ironcoat paint given an estimated annual demand of 10,000 gallons of paint, an annual carrying cost of $0.75 per gallon, and an ordering cost of $150 per order. They would also like to know the number of orders that will be made annually and the time between

EOQ Example
Cc = $0.75 per yard Qopt = Qopt = Co = $150 D = 10,000 yards

2CoD Cc
2(150)(10,000) (0.75)

CoD CcQ TCmin = + Q 2

TCmin
(150)(10,000) (0.75)(2,000) = + 2,000 2

Qopt = 2,000 yards

TCmin = $750 + $750 = $1,500

Order cycle time = 311 days/(D/Qopt) = 311/5 = 62.2 store days

Orders per year = D/Qopt = 10,000/2,000 = 5 orders/year

Production Quantity Model

An inventory system in which an order is

received gradually, as inventory is simultaneously being depleted AKA non-instantaneous receipt model
assumption that Q is received all at once is relaxed

p - daily rate at which an order is received

over time, a.k.a. production rate d - daily rate at which inventory is demanded

Production Quantity Model (cont.)

Inventory level Maximum inventory level Average inventory level

Q(1-d/p)

Q (1-d/p) 2

0 Order receipt period Begin End order order receipt receipt Time

Production Quantity Model

p = production rate
Maximum inventory level = Q - Q d p

d = demand rate

=Q1- d p
Q d Average inventory level = 12 p CoD CcQ d TC = Q + 2 1 - p

2CoD Qopt = d Cc 1 p

Example
Assume that the e-Paint Store has its own

manufacturing facility in which it produces Ironcoat paint. The ordering cost, C0, is the cost of setting up the production process to make the paint. C0 = $150. Recall that Cc = $0.75 per gallon and D = 10,000 gallons per year. The manufacturing facility operates the same days the store is open (311 days) and produces 150 gallons of paint per day. Determine the optimal order size, total inventory cost, the length of time to receive an order, the number of orders per year, and the maximum inventory level.

Cc = $0.75 per yard Co = $150 d = 10,000/311 = 32.2 yards per day

D = 10,000 yards p = 150 yards per day

2CoD Qopt =
Cc 1 - d p

2(150)(10,000)

32.2 0.75 1 150

= 2,256.8 yards

CoD CcQ d TC = Q + 2 1 - p

= $1,329

2,256.8 Q Production run = = = 15.05 days per order 150 p

Production Quantity Model: Example

Number of production runs =

10,000 D = = 4.43 runs/year 2,256.8 Q d p 32.2 150

Maximum inventory level = Q 1 -

= 2,256.8 1 -

= 1,772 yards

Reorder Point
Level of inventory at which a new order is placed

R = dL
where d = demand rate per period L = lead time

Reorder Point: Example

The ePaint Internet Store is open 311 days per

year. If annual demand is 10,000 gallons of Ironcoat paint and the lead time to receive an order is 10 days, determine the reorder point for paint.
Demand = 10,000 yards/year
Store open 311 days/year Daily demand = 10,000 / 311 = 32.154 yards/day Lead time = L = 10 days R = dL = (32.154)(10) = 321.54 yards

Safety Stocks
Safety stock: buffer added to on hand inventory
during lead time Stockout :an inventory shortage Service level: probability that the inventory available during lead time will meet demand

Variable Demand with a Reorder Point

Q Inventory level

Reorder point, R

0 LT Time LT

Reorder Point with a Safety Stock

Inventory level

Q
Reorder point, R

Safety Stock

0 LT Time LT

Reorder Point With Variable Demand

R = dL + zd L
where d = average daily demand L = lead time d = the standard deviation of daily demand z = number of standard deviations corresponding to the service level probability zd L = safety stock

Reorder Point for a Service Level

Probability of meeting demand during lead time = service level

Probability of a stockout

Safety stock zd L dL Demand

Example
For the e-Paint Internet Store , we will assume

that daily demand for Ironcoat paint is normally distributed with an average daily demand of 30 gallons and a standard deviation of 5 gallons of paint per day. The lead time for receiving a new order of paint is 10 days. Determine the reorder point and safety stock is the store wants a service level of 95% - that is, the probability of a stockout is 5%.

Reorder Point for Variable Demand

The carpet store wants a reorder point with a 95% service level and a 5% stockout probability
d = 30 yards per day L = 10 days d = 5 yards per day For a 95% service level, z = 1.65 R = dL + z d L Safety stock = z d L = (1.65)(5)( 10)

= 30(10) + (1.65)(5)( 10)

= 326.1 yards

= 26.1 yards

Order Quantity for a Periodic Inventory System

Q = d(tb + L) + zd where d tb L d zd = average demand rate = the fixed time between orders = lead time = standard deviation of demand tb + L - I

tb + L = safety stock I = inventory level

Example
The KVS Pharmacy stocks a popular brand of

over-the-counter flu and cold medicine. The average demand for the medicine is 6 packages per day, with a standard deviation of 1.2 packages. A vendor for the pharmaceutical company checks KVSs stock every 60 days. During one visit the store had 8 packages in stock. The lead time to receive an order is 5 days. Determine the order size for this order period that will enable KVS to maintain a 95% service level.

Fixed-Period Model with Variable Demand

d d tb L I z = 6 bottles per day = 1.2 bottles = 60 days = 5 days = 8 bottles = 1.65 (for a 95% service level) tb + L - I 60 + 5 - 8

Q = d(tb + L) + zd = 397.96 bottles

= (6)(60 + 5) + (1.65)(1.2)