INVENTORY MANAGEMENT

COURSE OUTLINE
1. Introduction II. Forecasting Material Demand
 Definition  Nature of forecasting
 Objective of inventory  Common features to all forecasts
 Functions of inventory  Elements of a Good Forecast
 Type of inventory  Forecasting time horizons
 Inventories in profit and non-profit organizations  Steps in the forecasting process
 Views of different departments towards inventory  Methods of forecasting
 Evaluating forecasting accuracy & controlling model

III. Inventory Classification and Stock Taking IV. Inventory Cost Control Models
 Introduction  Inventory costs
 Inventory classification  The basic Economic Order Quantity (EOQ) model
- ABC classification system or the value volume Analysis  Economic Production Quantity (EPQ)
- Other method of Analysis  EOQ with quantity discounts & Price breaks
 Storage practice
 Stocking taking

V. Material Requirements Planning (MRP) VI. Just In Time System (JIT)

 An overview of MRP  Introduction
 MRP inputs and out puts  The Just- In – Time concept
 MRP processing  Key elements of JIT systems
 JIT versus traditional manufacturing
 Benefits of JIT systems
 Converting to a JIT system
 CHAPTER ONE
INTRODUCTION TO INVENTORY
MANAGEMENT
 Basic Concepts
Inventory is an idle resource (physical stock of
goods) possessing economic value which is waiting or
kept for future use or sale.
Inventory is a stock of materials that are used to
facilitate production or to satisfy customers’ demand
 Functions of Inventory
◦ To meet anticipated customer demand
◦ To smooth production
◦ To decouple operations
◦ To protect against stock outs
◦ To take advantage of order cycles
◦ To hedge against price increases
◦ To take advantage of quantity discounts
Types of Inventories
Although inventories are classified in many ways, but
according to Dobler and Burt (1996) inventories are
classified in to:
◦ Production inventories - Raw materials, parts, &
components w/c enter firm’s product in PP.
◦ MRO inventories - Maintenance, Repair, and
Operating supplies which are consumed in the
production process but which do not become part of
the product (e.g., lubricant, soap).
◦ In-process inventories - Semi finished products
found at various stages of the production.
◦ Finished goods inventories - completed products
ready for shipment, or awaiting for sale.
 Objectives of Inventory
Inventory management has two main concerns.
◦ One is to have the right goods, in sufficient
quantities, in the right place, at the right time.
◦ The other is the cost of ordering and carrying
inventories.
The overall objective of inventory management is to
achieve satisfactory levels of customer service
while keeping inventory costs within reasonable
bounds.
 Cont’d
Specifically, inventory control has the following
objective;
 Minimize - the investment in inventory, Warehouse
costs, Losses from damage, obsolescence and
Perishablity, & Chances of going out of stock.
 Maximize - customer service, the efficiency of
purchasing and production & Profit.
 Make forecasts of inventory requirements for the future.
 Establish an inventory system (policies and regulation
that monitors inventories).
 Ensures availability of materials.
 Offers advantage of price discounts from bulk
purchasing.
 Inventories in profit and non-profit organizations

 Do all organizations require inventory to function

smoothly?
 All organizations are in need of inventories regardless
of their nature of activities. Profit making, service
giving, merchandising, manufacturing organizations
have to keep an adequate inventory level.
 Profit making organizations needs to keep an adequate
inventory level either to minimize waste or to
maximize profits.
 Non-profit making organizations need to keep
adequate inventory level to provide better service to
the public at large.
Views of different departments towards inventory

All departments have a big concern towards

inventory
 CHAPTER TWO
FORECASTING MATERIALS DEMAND
What is Forecasting?

Forecasting is the art and science of predicting future

events.

It involves estimation of the occurrence, timing,

and/or magnitude of uncertain future events or levels
of activities

Example: We hear the weather forecast by the

metrology people and Central Statistics Authority
forecast the number of Ethiopian population.

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 Why Forecast?
 In business,
 Forecasts are the basis for capacity planning,
budgeting, sales planning, production and inventory
planning, manpower planning and purchasing
planning.
 Forecasts play important role in the planning
process because they enable managers to anticipate
the future and to plan accordingly.
 Forecasts are used to predict revenues, costs and
availability of energy and raw materials.

12
 Common Features to All Forecasts
 Forecasting techniques generally assume that
existed in the past will continue to exist in the
future.
 Forecasts are rarely perfect: actual results will
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 increases.

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Elements of A Good Forecast

1) The forecast should be timely

2) The forecast should be accurate and the degree of
accuracy should be stated
3) The forecast should be reliable (consistent)
4) The forecast should be expressed in meaningful
terms (Financial in dollars ,operations by units,
human resources by skills...)
5) The forecast should be in writing
6) The forecasting technique should be simple to
understand and use

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Forecasting Time Horizons

1. Short-range Forecast
 This forecast has a time span less than three
months.
 It is used for planning purchasing, job scheduling,
workforce levels, job assignments, and production
levels.
2. Medium-range Forecast.
A medium-range, or intermediate, forecast generally
spans from 3 months to 3 years.
 It is useful in sales planning, production planning
and budgeting, cash budgeting, and analyzing various
operating plans. 15
3. Long-range Forecast
 Generally 3 years or more in time span
 Long-range forecasts are used in planning for new
products, capital expenditures, facility location or
expansion, and research and development

16
 Steps In Forecasting Process

Six basic steps in forecasting process:

1. Determine the purpose of the forecast
2. Establish the time horizon that the forecast must
cover
3. Select appropriate forecasting technique
4. Gather and analyze the appropriate data and then
prepare the forecast
5. Make the forecast
6. Monitor the forecast

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Approaches To Forecasting

There are two general techniques to forecasting;

Qualitative and Quantitative.

1. Qualitative Forecasting
 Qualitative techniques are subjective or judgmental
in nature and are based on estimates and opinions.
 It rely on analysis of subjective inputs obtained
from customers, sales Person, managers and
experts.

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Forecasts based on judgment, experience or opinions are
appropriate when:

 Available data may be obsolete or up to date information

might not be available

 There is no historical data, like demand for a newly

introduced product.

 The forecasting period is long range that past events will

not repeat themselves in a similar fashion.

 When a forecast must be prepared quickly, there is usually

not enough time to gather and analyze quantitative data.
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Qualitative Forecasting Techniques
1. Expert opinions - collecting opinions and judgments of
individuals who are expected to have the best knowledge of
current activities or future plans

2. Sales force opinions - sales representatives are required

to estimate the demand for each product

3. Consumer Surveys - based on the data which is collected

from the consumers

4. Delphi method - It involves circulating a series of

questionnaires among those individuals who possess the
knowledge and ability to contribute meaningfully
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2. Quantitative Forecasting
 Quantitative forecasting methods use historical data
 Uses mathematical and statistical methods to
forecast demand
 It is objective and is also called statistical
forecasting
 It falls in to two categories;

1. Time series models

2. Associative/causal models
21
1.Time Series Models:
 A time series is a time-ordered sequence of
observations taken at regular intervals over a period
of time.
 Assumes that factors influencing past and present
will continue influence in future.
 Time series analysis will have a variable which is
dependent and another independent variable
 The time is independent variable because it doesn’t
dependent on the other variable.
 The other variable becomes a dependent variable
when it depends on time.

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Time Series Components
1. Trend Component
 Regular pattern of up & down fluctuations
 Occurs within 1 year
2.Cyclical Component
Repeating up & down movements
Usually 2-10 years duration
3.Random Component
 Erratic, unsystematic, ‘residual’ fluctuations
 Short duration & non-repeating
4. Seasonal component

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Time series models include the following techniques
to forecast:
1. Naive forecasts
2. Simple Moving averages
3. Weighted moving average
4. Exponential smoothing
5. Trend projection / Equation/

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A. Naive Approach
¨ Assumes demand in next period is the same as
demand in most recent period
Ft = At-1
Example: If the actual demand of umbrella is 60
units on Monday, the forecasted demand for
Tuesday will be 60 units.
Ft = At-1
F(Tuesday) = A(Monday) = 60 units

25
B. Simple Moving averages
 Moving average forecast uses a number of historical
actual data values to generate a forecast
 Simple Average is taking the average of all the
available data to be the forecasted.
 But, Simple Moving Average is taking the average
of only the recent available data to be the forecasted.
 Mathematically expressed as;
Simple average (SA) =  x periods
No of periods
Simple Moving Average (SMA) =  x (only recent ones)
No. of recent periods

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Example:
Compute a three-period moving average forecast
given demand for shopping spare parts for the last
five periods.
Period Demand
1 42
2 40
3 43
4 40
5 41

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 Solution SMA6 = 41+40+43 = 41.33
3
 If actual demand in period 6 turns out to be 39, the
moving average forecast for period 7 would be

SMA7 = 39+41+40 = 40
3

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Activity - 1
Actual demand for a product for the past three months
was as follows:
 Three months ago 400 units
 Two months ago 350 units
 Last months 325 units
1. Using a three month moving average, make a
forecast for this month?
2. If 300 units were actually demanded this month,
what would your forecast be for the next month?

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C. Weighted Moving Average
 Weighted average is assigning weights to all the
data available to make forecast.
 But in weighted moving average weights can be
used to place more emphasis on recent values.
 The most recent observation receives the most
weight. Weight often lay between 0 & 1, & sum to 1
 Mathematically: WA =  X (weight)

Weight
WMA=  x (only recent one x weight)
Weight
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Example: a super market may find that in a four -
month period the best forecast is derived by using
40% of the actual sales for the most recent month,
30% of two months ago, 20% of three months ago,
and 10% of four months ago.
If actual sales experience was as follows:
Month-1 Month-2 Month-3 Month-4 Month-5
100 90 105 95 ?

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Then the forecast for month 5 would be:
 F5=0.40(95)+ 0.3(105)+0.2(90)+0.10(100)
=38+31.5+18+10 = 97.5
 Suppose sales for month 5 actually turned out to be
110; then the forecast for month 6 would be
 F6=0.40(110)+0.30(95)+0.20(105)+0.10(90)
=44+28.5+21+9 =102.5

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D. Exponential Smoothing
 In this method three pieces of data are needed to
forecast the future.
1. The previous year's forecast (Ft-1)
2. The actual demand for that year (At-1)
3. A smoothing constant alpha (): it is a number
between 0 and 1.
 This smoothing constant determines the level of
smoothing and the speed of reaction to
differentiate between forecasts and actual
occurrences.

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 The value for the constant is arbitrary and is
determined both by the nature of the product and
the manager’s sense of what constitutes a good
response rate.
 For example, if a firm produced a standard item
with relatively stable demand, the reaction rate to
differentiate between actual and forecast demand
would tend to be small, perhaps just a few
percentage points.

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 Theequation for a single exponential smoothing
forecast is:
New forecast = Old forecast + (Actual – Old
forecast)
Ft = Ft-1 +  (At-1 - Ft-1)
Where:
 Ft= the exponentially smoothed forecast for period t
 Ft-1 =the exponentially smoothed forecast made for
the prior/previous period
 At-1 = the actual demand in the prior/previous period
and
  = smoothing constant.

35
Example: In February a car dealer predicted demand
March 142 autos, but in March demand was turned
out153 autos. Using a smoothing constant chosen by
management of auto dealer  = 0.2, forecast April
demand.
 New forecast (April demand) =
Ft = Ft-1 + (At-1 - Ft-1)
=142 + 0.2(153-142) = 144.2
 Then the April demand is 144 autos.

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Activity -2
The production supervisor at a fiber board plant uses
a simple exponential smoothing technique ( = 0.2)
to forecast demand. In April, the forecast was for 20
shipments, and the actual demand was for 20
shipments. The actual demand in May and June was
25 and 26 shipments. Forecast the value for July.
Bahir Dar University forecasted 2500 quintals of
bread for October, while actual demand turned out to
be 2300 quintals. What would be November's
forecast using smoothing constant =10%? If actual
demand for November turned out to be 2600 of
quintal what would be December's forecast?
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E. Trend Equation
Time series analysis can calculated using liner equation.
The equation of the line is given by:
Y = a + b(t)
Where:
Y = the dependent variable
t = the independent variable (unit of time)
a = value of y when t = 0
b = slope of the line

a=y–bt Y = y t =  t
n n
b = n t y -  t  y
nt2 - ( t) 2
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Example: Consider the following three companies A,
B and C and their demand for Aluminum
Year Companies /Aluminum in tones
A B C
1995 20 15 13
1996 20 16 17
1997 20 17 16
1998 20 18 16
1999 20 19 21
2000 20 20 20
2001 20 21 20
2002 20 22 23
2003 20 23 25
2004 20 24 24
2005 20 25 25
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Required: Fore cast the demand for Aluminum for
2006 for each company?
Solution:
 For companies ‘A’ and ‘B’, we can make use of
simple observation to make the forecast, which will
be 20 and 26 tones respectively.
 But, for company ‘C’ we cannot forecast using
simple observation.
 Therefore, first select one of the years as abase year
and assign zero, negative integers above it and
positive integers below it.
 Then complete the table as follows:

40
Year t Y tY t2

1995 -5 13 -65 25
1996 -4 17 -68 16
1997 -3 16 -48 9
1998 -2 16 -32 4
1999 -1 25 -21 1
2000 0 20 0 0
2001 1 20 20 1
2002 2 23 46 4
2003 3 25 75 9
2004 4 24 96 16
2005 5 25 125 25
 0 220 128 110

41
Then find the equation of the line that fits the data.
The equation of the line is given by: Y = a + b(t)
a=y–bt b = n t y -  t  y
nt2 - ( t) 2
220 ty 128
y  20  a b   1.16
11 t 2
110
y  20  1.16t
Where ‘t’ is the no of year counted from the base
year, forecast for
y  20  1.163(6)  27

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2. Associative (Causal) Forecasting Techniques
Associative or explanatory forecasting models
incorporate one or more variables that are related to the
variable of interest.
Often, leading indicators can help to predict changes in
future demand e.g. rain & umbrella
Causal models establish a cause-and-effect relationship
between independent and dependent variables
Unlike, time series forecasting associative forecasting
models usually consider several variables that are
related to the quantity being predicted.

43
Example
Sales of Samsung TV might be related to
 The company’s advertising budget, the company’s
prices, competitor’s prices and promotional
strategies, and even the nation’s economy and
unemployment rates.
Real estate prices are usually related to
Property location - Square footage
Crop yield are related to
 Soil conditions - Amounts and timings of water -
Fertilizer application

44
 A common tool of causal modeling is linear
regression
Linear regression:
 Shows linear relationship between dependent &
independent variables.
 It is useful for long-term forecasting of major
occurrences and aggregate planning.
 In order to make a forecast, the two variables must
be expressed in a linear equation of the form:
Y = a+bx
y = the dependent variable
x = the independent variable
a = value of y when x= 0 b = slope of the line
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Linear Regression

46
Steps to compute liner regression equation
1. Identify dependent (y) and independent (x)
variables n.xy  x.y
b=
2. Solve for the slope of the line: n.x  (x) 2 2

b 
 XY  n X Y
 X  nX
2 2

 y  b x
a= , or y  b x
3. Solve for the
y
y bintercept:
x
n
a   y  bx
n n

4. Develop your equation for the trend line:

Y= a + bX
Correlation
 Correlation coefficient (r) measures the direction
and strength of the linear relationship between two
variables.
 Values range from -1 to +1
 Correlation becomes -1 if they are strongly
unrelated i.e. the dependent and the independent
variables move in different directions
 If Correlation coefficient (r) = 0, no correlation
 Correlation is +1 if both moves to the same
direction and have strong relation.
 The closer the r value is to 1.0 the better the
regression line fits the data points.
48
y y

(a) Perfect positive x (b) Positive x

correlation: correlation:
r = +1 0<r<1

y y

(d) Perfect negative x (c) No correlation: x

correlation: r=0
r = -1
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 Coefficient of Determination, r2, measures the
percent of change in y predicted by the change in x
 Values range from 0 to 1
 The formula is given as follows:
n.xy  x.y
Coefficient of correlation (r) =
n.x  x ny  y 
2 2 2 2

50
Example 1: The general manager of a building materials
production plant feels the demand for plaster board shipments
may be related to the number of constructions permits issued
in the country during the previous quarter. The manager has
collected the data shown in the accompanying table.

Construction permits Plaster board shipments

15 6
9 4
40 16
20 6
25 13
25 9
15 10
35 16
51
Required:
a) Derive a regression forecasting equation?
b) Determine plaster board demand when the number
of construction permit is 30, 35 & 40
c) Compute coefficient of determination (r 2) and
coefficient of correlation (r), and interpret the
numbers

52
Solution

X Y XY X2 Y2
15 6 90 225 36
9 4 36 81 16
40 16 640 1600 256
20 6 120 400 36
25 13 325 625 139
25 9 225 625 81
15 10 150 225 100
35 16 560 1225 256
x=184 y=80 xy=2146 x2=5006  y2=950
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 n.xy  x.y
b=
n.x 2  (x ) 2
8 x 2146 184 x 80
=
8 x 5006  (184) 2
2448
=  0.39
6192
 y  b x 80  0.39(184)
a = = = 0.915
n 8
Thus, the regression equation is;
Y = a + bx
 Y = 0.915 + 0.395x
B) plaster board demand,
i) if no of permit = 30
Y = 0.915 + 0.395 (30) = 12.76
= 13 shipments
ii) if not of permit = 35
Y = 0.915 + 0.395 (35)
= 14.74
= 15 shipments
iii) if not of permit = 40
Y = 0.915 + 0.395 (40)
= 16.75
= 17 shipments
C) Coefficient of correlation and determination
n.xy  x.y
Coefficient of correlation (r) =
 
n.x  x 2 ny 2  y 
2 2

8 x 2146 184 x 80
r=
8 x 5006  184  x 8 x 950  80 
2 2

2448
r=
2,430,400
r = 0.90  r2 = 0.81
Interpretation
* r = 0.81 means 81 percent of the total variation in plaster board shipments is explained
construction permits. What remains is the coefficient of determination (i.e. 0.19). It indicates t
19% of the total variation, which remains unexplained, is due to the factors other than the quantity
shipments.
Example 2: The following table lists Meta brewery’s
revenues and the amount of money earned by wage
by construction employees in Addis during the past
six months.
Sales of draft Payroll

(00,000), y (000,000), x
2 1
3 3
2.5 4
2 2
2 1
3.5 7
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Then, find a mathematical equation by using the least
squares regression approach?
Sales, Y wage, X X2 XY
2 1 1 2
3 3 9 9
2.5 4 16 10
2 2 4 4
2 1 1 2
3.5 7 49 24.5

y=15.0 x=18 x2=80 xy=51.5

mean = 2.5 mean = 3

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 
X=
 x 18
= =3
6 6

Y=
Y 15
= = 2.5
6 6


b=
 XY  n xy 51.5  632.5
= =0.25
 x  nx 80  63 
2 2 2

 
a= Y  b X = 2.5-(0.25) (3) = 1.75
The estimated regression equation, therefore, is
Y= 1.75 + 0.25 (wage)
If the housing agency predicts that the employees wage will be birr 6 million next month, we can
estimate sales using the regression equation.
Sales (in hundreds thousands) = 1.75 + 0.25(6) =1.75 + 1.50 =3.25,
Thus sales = Birr 3250.

57
 CHAPTER THREE
INVENTORY CLASSIFICATION
 Inventory Analysis System
(Classification)

 Items that are in the inventory are not of equal importance in

terms of the amount invested, profit potential, sock-out
penalties…etc
 All items do not deserve the same degree of attention.

There fore,
1. ABC Inventory Analysis (Always, Better, Control) Analysis.
2. VED Inventory Analysis (Vital, Essential, Desirable) Analysis.
3. SDE Inventory Analysis (Scarce, Difficulty, Easy) Analysis.
4. HML Inventory Analysis (High, Medium, Low) Analysis.
5. FNSD Inventory Analysis (Fast moving, Normal, Slow Dead)
Analysis.
6. XYZ Inventory Analysis (High, Moderate & Low closing
inventory items) Analysis.
 Cont’d
1. ABC Inventory Analysis
 Based on money value of importance
 “A” items constitute about 5-10% of the total
number of items purchased (in inventory) that would
account for about 70–80% of the total dollar value
(usage value).
 “B” items constitute about 10-20% of the total
number of items purchased (in inventory) that would
account for about 10–15% of the total dollar value.
 “C” items constitute about 65-80% of the total
number of items purchased (in inventory) that would
account for about 5 to 10% of the total dollar value.
ABC Procedures
1. Calculate the annual usage in birr for each
item
2. Rank the items from highest birr usage
annually to the lowest annual usage in birr.
3. Determine the cumulative annual usage
value and total number of items.
4. Convert the annual usage value and total
number of items in to percentage.
5. Categorize the items in A, B, and C
categories
Example - XYZ factory adopts the ABC method of
classifying inventories. Currently, the factory has 10
items. The following is the data related to the items.
Item No Annual usage, Q Unit cost (birr)
22 1100 2
68 600 40
27 100 4
03 1300 1
82 100 60
54 10 25
36 100 23e
19 1500 2
23 200 2
41 500 2
 Item No Quantity Unit cost Total cost
22 1100 2 2,200 (4)
68 600 40 24,000 (1)
27 100 4 400 (8)
03 1300 1 1,300 (5)
82 100 60 6,000 (2)
54 10 25 250 (9)
36 100 2 200 (10)
19 1500 2 3,000 (3)
23 200 2 400 (7)
41 500 2 1,000 (6)

Item No Annual Expenditure % of total value Com. % of total value

68 24,000 61.93 20% A
77.41
82 6,000 15.48
19 3,000 7.74
22 2,200 5.68 16.77 30% B
03 1,300 3.35
41 1,000 2.58
23 400 1.03
27 400 1.03
5.8 50% C
54 250 0.645
 Cont’d
2. VED (Vital, Essential, Desirable) Analysis\
Based on the criticality of inventory
V-item - Completely bring the production to a halt
E-item - Temporary losses of production or
dislocation of production work occurs.
 D-item - Are necessary but do not cause any
immediate effect on production.
 Cont’d
3. SDE (Scarce, Difficult, Easily) Analysis
Based on availability of items (raw materials).
S-item – are items which are in small supply and are
usually imported items.
D-item – are items which are available in the market
but cannot be procured easily.
E-item – are easily available items; mostly local items

4. HML (High, Medium, Low) Analysis

Based on cost

5. FSN (Fast, Slow, Normal) Analysis

Based on rate of consumption
 Cont’d
6. XYZ Analysis
Based on the value of closing inventory.
X-items – Items with high closing inventory.
Y-items – Items with moderate closing inventory.
Z-items – Items with low closing inventory
 CHAPTER FOUR
INVENTORY COST CONTROL MODELS
 Inventory Costs
Holding /Carrying/ Costs - is the sum of all costs that
are proportional to the amount of inventory physically on hand
at any point in time.
 Cost of providing the physical space to store the items
 Taxes and insurances
 Breakage, spoilage, deterioration, and obsolescence
 Opportunity cost of alternative investments
 The salaries and wages of storing, receiving and issue of
material personnel.
 Stationary and other consumables use by the stores.
 Order (setup) Costs – Sum of costs which are incurred
for the amount of inventory that is ordered or produced.
◦ Salaries of the staffs in the purchasing department.
◦ Negotiating purchases, placing orders and follow up.
◦ Rent for the space used by the purchasing department.
◦ The postage, telegram, telephone bills.
◦ The stationary and other consumables used by the purchasing
department.
◦ Entertainment charges for vendors.
◦ Traveling expense.
◦ Lawyers and court fees due to any legal matters arising out of
purchase.
◦ Inspecting shipment & moving goods to storage.
Penalty Costs - also known as the shortage cost or the
stock-out cost, is the cost of not having sufficient stock on
hand to satisfy demand when it occurs.
 Nature of Demand In Inventory
Dependent Demand of Items: are those items where
their demand is related to the demand for another item.
This demand is also known as Derived Demand.
Independent Demand of Items: are those items that
are not influenced by production/operation but by the
market forces.
 For example, if an automobile company plans on producing
500 automobiles per day, then obviously it will need 2,000
wheels and tires (plus spares). The number of wheels and tires
needed is dependent on the production level for automobiles
and not derived separately. The demand for automobiles, on the
other hand, is independent - it comes from many sources
external to the automobile firm and is not a part of other
products and so is unrelated to the demand for other products.
Inventory Cost Control Models

For Independent demand: EOQ & EPQ

For Dependent demand: MRP

 1- Economic Order Quantity
(EOQ)
A method of determining the adequate (optimum)
inventory level that will minimize the sum of the
annual costs of ordering and hold inventory.

EOQ = 2DCo
Cc
Where; EOQ = Economic order quantity
Cc = Annual carrying cost
D = Annual anticipated demand
Co = Order cost per order
Assumptions of this model are;
- Only one product is involved. - Lead time does not vary.
- Annual demand requirement are known. - Demand is constant.
- Each order is received in a single delivery. - There are no quantity
discounts

6000

5000

4000
Order Size

3000
Order Cost
Cost

2000 Carrying Cost

1000

0 1 2 3 4 5 6 7 8
Order
Size
 Cont’d
◦ Holding Costs – Is the carrying cost or the inventory
cost, is the sum of all costs that are proportional to the
amount of inventory physically on hand at any point
in time. Annual holding cost = Q/2*Cc
◦ Order (setup) Costs - Placement of purchase order
for a material is associated with certain obvious cost
due to advertising, consumption of stationary and
postage, telephone charges etc.
Annual Ordering cost = D/Q*Co
◦ Annual purchase cost = DP
◦ Total Cost = ACc + ACo + DP (Q/2*Cc + D/Q*Co + PD)
◦ Minimum Inventory Cost = ACc + Aco
Example
 A local distributor for Addis Tire Company expects to
approximately 9,600 steel belted tires of certain size next
year. The annual carrying cost is 16.00 Birr per tier per year
and the ordering cost are 75.00 Birr per order. The
distributor operates 288 days a year.
a) Determine EOQ.
b) What is the Ordering Cost per year and annual carrying cost at
EOQ?
c) What is the total incremental or total inventory cost at EOQ
d) If purchase price per tire is 80.00 Birr. What is the total cost at
EOQ?
e) How many times per year the store does reorders?
f) Determine the length of an order cycle.
g) Compute Ordering, Carrying, Total Inventory costs & overall
total costs. If order quantities are 100, 150, 200, 250, 300, 350,
400 and 450 units. What do you infer from this exercise?
EOQ with Quantity Discount & Price Breaks

1. A producer of photo equipment buys lenses from a

supplier at Birr 100 each. The producer requires 125
lenses per year, and the ordering cost is Birr 18 per order.
Carrying costs per unit per year are estimated to be Birr
20 each. The supplier offers 6% discount for purchases of
50 lenses and an 8% discount for purchases of 100 or
more lenses. Determine the optimal order quantity.
2. Determine the order quantity that will minimize total
annual inventory cost for the price schedule below.
Annual demand is 1200 units, ordering cost is Birr 41, and
holding cost is Birr 2 per unit per year.
Quantity in unit Unit price (Birr)
1 to 199 27
200 to 299 26
300 to 399 25
400 or more 24
Reorder Point (ROP)
1) ROP when demand and lead time are both
constant: ROP = d x LT
2) Reorder point when variability is present in
demand or lead time: ROP = Expected demand
during lead time + Safety stock
Safety Stock - used in order to prevent a stock out
occurring.
Service Level - the probability that demand will not
exceed supply during lead time.
ROP = Expected demand during lead time + zdLT
Example
1. Mr. X takes two vitamins tablets a Day, which are
delivered to his home by a route man seven days after an
order, is called in. At what point should Mr. X reorder?

2. Suppose that the manager of a construction supply

house determined from historical records that demand for
sand during lead time averages 50 tons. In addition,
suppose the manager determined that demand during lead
time could be described by a normal distribution that has a
mean of 50 tons and a standard deviation of 5 tons.
Answer these questions, assuming that the manager is
willing to accept a stock out risk of no more than 3 %:
◦ What value of z is appropriate?
◦ How much safety stock should be held?
◦ What reorder point should be used?
2- Economic Production Quantity (Economic Run Lengths)(EPQ)

When the company is the producer and user of its

items, the run size is the economic production quantity
(EPQ).
In the determination of the EPQ the carrying cost
remains the same but the ordering cost is replaced by
set-up-cost which is the cost of preparing production
for operations.
If d = demand per day and P = production per day, then
the ratio d/p represents the proportion of production
that is allocated to daily demand, and 1-d/p represents
that portion of the production run that goes in to
inventory.
 Cont’d
EPQ = a radical of 2DSc
Cc(1-d/p)
S = Set up cost in birr/set up
D = annual demand in units
Cc = Carrying costs in birr//unit/year
d = demand rate
P = production rate
Example
 A toy manufacturer uses 48,000 rubber wheels per year
for its popular dump- truck series. The firm makes its
own wheel, which it can produce at a rate of 800 per
day. The toy trucks are assembled uniformly over the
entire year. Carrying cost is Br 1.00 per wheel a year.
Set up cost for a production and change over from the
previous production is Br. 45.00. The firm operates
240 days per year. Determine each of the following.
a) The optimum Size (EPQ)
b) The minimum total inventory cost
c) The cycle time for the optimal size
d) The run time
e) The number of production runs in a year
f) Maximum level of inventory
 CHAPTER FIVE
MATERIAL REQUIREMENT PLANNING
(MRP)
 Material Requirement Planning
(MRP)
Plans that should be developed prior to MRP:
Aggregate planning - establishes an overall level of
operations that balances the plant’s capability with
external sales demand.
Master Production Schedule (MPS) - translates the
aggregate plan into specific numbers of specific
products to be produced in identified time periods.
 Cont’d
MRP is a computer-based information system that
translates the finished product requirements of the
master schedule into time-phased requirements for
subassemblies, component parts, and raw materials,
working backward from the due date using lead
times and other information to determine when and
how much to order.
MRP is designed to answer three questions: what is
needed? How much is needed? And when it is
needed?
MRP Inputs

The Mater Schedule - states which end items are to

be produced, when they are needed, and in what
quantities.
The Bill of Materials - contains a listing of all of the
assemblies, subassemblies, parts, and raw materials
that are needed to produce one unit of a finished
product.
The Inventory records - refer to stored information
on the status of each item by time period, called time
buckets. Includes; gross requirements, scheduled
receipts, and expected amount on hand.
 Material Needed for a Chair

Side rails (2)

Seat
Front legs (2)

Cross bars (2)

Back supports (3)

Chair Structure Tree (Bill of Materials)
Chair

Leg Seat Back Assembly

Assembly

Back
Cross Side Cross Supports
Legs (2)
bar rails (2) bar (3)
 A Product Structure Tree For End Item - X

Level 0 X

1 B (2) C

2 D (3) E E (2) F (2)

3
E (4)

 End item X is composed of two Bs and one C. Moreover, each B requires

three Ds and E, and each D requires four Es. Similarly, each C is made up
of two Es and two Fs.
 These requirements are listed by level, beginning with 0 for the end item,
then 1 for the next level, and so on.
 The items at each level are components of the next level up and, as in a
family tree, are parents of their respective components.
 Note that the quantities of each item in the product structure tree refer only
to the amounts needed to complete the assembly at the next higher level.
 Example: Using the information presented in the
Figure above
A. Determine the quantities of B, C, D, E, and F, needed to
assemble One X.
B. Determine the quantities of these components that will
be required to assemble 10 Xs, taking into account the
quantities on hand (i.e., in inventory) of various
components:
Component On hand
B 4
C 10
D 8
E 60
Solution: (A)
X

B (2) C: 1 X 1 = 1
C
B: 2 X 1 = 2

D (3) E E (2) F (2)

E: 1 X 2 = 2
D: 3 X 2 = 6 E: 2 X 1 = 2 F: 2 X 1 = 2

E (4)
E: 4 X 6 =
24
Thus, One X will require
B: 2
C: 1
D: 6
E: 28 (Note that E occurs in three places, with requirements of 24 + 2 + 2 + = 28)
F: 2
 X
Solution: (b)

B (2) CC: 1 X 10 = 10 -10 = 0

B: 2 X 10 = 20 – 4 = 16
(No lower- Level
components
required)

D (3) E E: 1 X 16 = 16 E (2) F (2)

E: 2 X 0 = 0
F: 2 X 0 = 0
D: 3 X 16 = 48 -8 =
40
E (4)
E: 4 X 40 = 160 – 60 = 100

Thus, One X will require

B: 16
C: 0
D: 40
E: 116 (Note that D occurs in two places, with requirements of 100 + 16 = 116)
F: 0
 MRP Processing
MRP processing takes the end item
requirements specified by the master
production schedule and explode them into
time-phased requirements for assemblies,
parts, and raw materials using the bill of
materials offset by lead times.
MRP is driven by the master schedule and
End items ‘exploded’ into all components
using bill of materials (BOM). Schedules offset
based on lead time
 MRP Processing (Cont.)
 The quantities that are generated by exploding the bill of
materials are gross requirements; they do not take into
account any inventory that is currently on hand or due to be
received.
 The materials that a firm must actually acquire to meet
the demand generated by the master schedule are the net
material requirements.
 Determination of the net requirements: by subtracting from
gross requirements the sum of inventory on hand and any
scheduled receipts, and then adding in safety stock
requirements, if applicable:

Net Gross Projected

Requirements = Requirements - inventory + Safety
in period t in period t in period t stock
Gross requirements: the total expected demand for an
item or raw material during each time period without
regard to the amount on hand. For end items, these
quantities are shown in the master schedule; for
components, these quantities are derived from the
planned-order releases of their immediate “parents.”
Scheduled receipts: Open orders (orders that have been
placed and are) scheduled to arrive from vendors or
elsewhere in the pipeline by the beginning of a period.
Projected on hand: The expected amount of inventory
that will be on hand at the beginning of each time
period; Scheduled receipts plus available inventory
from last period.
Net requirements: The actual amount needed in each
period.
Planned-order receipts: The quantity
expected to be received by the beginning of
the period in which it is shown
Planned order releases: Includes a planned
amount to order in each time period; equals
planned-order receipts offset by lead time.
This amount generates gross requirements at
the next level in the assembly or production
chain. When an order is executed, it is
removed from “planned order releases” and
entered under “scheduled receipts”
Example of MRP
Given the Product Structure Tree for “A” and the lead time
and demand information below, provide a materials
requirements plan that defines the number of units of each
component and when they will be needed
Lead Times
Product Structure Tree for Assembly - A 1 day
A B 2 days
A
C 1 day
D 3 days
E 4 days
B(4) C(2) F 1 day

Total Unit Demand

D(2) E(1) D(3) F(2) Day 10 50 A
 First,
First, the
the number
number of of units
units of
of “A”
“A” are
are scheduled
scheduled backwards
backwards to to
allow
allow for
for their
their lead
lead time.
time. So,
So, in
in the
the materials
materials requirement
requirement plan
plan
below,
below, we we have
have to to place
place an
an order
order for
for 50
50 units
units of
of “A”
“A” on
on the
the 99 th
th

day
daytotoreceive
receivethem
themon onday
day10.
10.

Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
Order Placement 50

LT = 1 day
 Next,
Next, we
we need
need to
to start
start scheduling
scheduling the
the components
components that that make
make up
up
“A”.
“A”. In
In the
the case
case of
of component
component “B”
“B” wewe need
need 44 B’s
B’s for
for each
eachA.
A.
Since
Since we
we need
need 50
50A’s,
A’s, that
that means
means 200
200 B’s.
B’s. And
And again,
again, we
we back
back
the
theschedule
schedule up
up for
for the
the necessary
necessary 22days
days of
of lead
lead time.
time. 8
Day: 1 2 3 4 5 6 7 9 10
A Required 50
Order Placement 50
B Required 200
Order Placement 200

LT = 2
Spares

A 4x50=200

B(4) C(2)

D(2) E(1) D(3) F(2)

 99
Finally,
Finally,repeating
repeatingthe
theprocess
processfor
forall
allcomponents,
components,we
wehave
havethe
the
final
finalmaterials
materialsrequirements
requirementsplan:
plan:
Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
LT=1 Order Placement 50
B Required 200
LT=2 Order Placement 200
C Required 100
LT=1 Order Placement 100
D Required 400 300
LT=3 Order Placement 400 300
E Required 200
LT=4 Order Placement 200
F Required 200
LT=1 Order Placement 200

B(4) C(2)

D(2) E(1) D(3) F(2)

Illustration on MRP
Suppose that we want to produce product T, which consists of two
parts U, three parts V, and one part Y. Part U, in turn, is made of one
part W and two parts X. Part V is made of two parts W and two parts
Y. Figure 4.5 shows the product structure tree for product T.

Part Lead On-Hand Scheduled

Time(weeks) Inventory Receipts*
T 1 25 -
U 2 5 5
V 2 15 -
W 3 30 -
X 2 20 -
Y 1 10 -

If 100T is required, we can create a time schedule chart specifying

when all the material necessary to build T must be ordered and
received to meet this requirement.
 CHAPTER SIX
JUST IN TIME /JIT/

- Reading Assignment -