Mba om 08_inventory_management

Operations Management
Author: Prof. Niranjana K.R.
B.E. (Mech), PGDM, SSBB, LA ISO9001 & AS9100, Member – PMI & QCFI
Email: niranjanakoodavalli@gmail.com

Agreements
24-08-2016 Author: Niranjana K R 2

References
1. Operations Management – An Integrated Approach, by R. Dan
Reid, Nada R. Sanders, 5th Edition, Wiley ,2012.
2. Operations Management For Competitive Advantage – 11th
edition – Richard B. Chase, F. Robert Jacobs, Nicholas J.
Aquilano
3. Operations Management, 10th edition Author(s): Jay Heizer,
Barry Render
4. Production/Operations Management – 5th Ed. – Willian J.
Stevenson

Operations Management
Inventory Management
Author: Prof. Niranjana K.R.
B.E. (Mech), PGDM, SSBB, LA ISO9001 & AS9100, Member – PMI & QCFI
Email: niranjanakoodavalli@gmail.com

Learning Objectives (1 of 2)
After studying this chapter you should be able to -
1. Describe the different types and uses of inventory.
2. Describe the objectives of inventory management.
3. Calculate inventory performance measures.
4. Understand the relevant costs associated with inventory.
5. Perform ABC inventory control and analysis.
6. Understand the role of cycle counting in inventory record
accuracy.
7. Understand the role of inventory in service organizations.
Continued ..
Author: Niranjana K R24-08-2016 5

Learning Objectives (2 of 2)
Continued ..
After studying this chapter you should be able to –
8. Calculate order quantities.
9. Evaluate the total relevant costs of different inventory policies.
10. Understand why companies don’t always use the optimal
order quantity.
11. Understand how to justify smaller order sizes.
12. Calculate appropriate safety stock inventory policies.
13. Calculate order quantities for single-period inventory.
Author: Niranjana K R24-08-2016 6

Just think!
• What happens when a cashier of a super market scans the
label of the items purchased by you?
• What does the cashier do when you have purchased multiple
quantities of the same item?

Types of Inventory
24-08-2016 8Author: Niranjana K R

Definitions
• Inventory
– A Stock or store of goods
• Raw materials
– Purchased items or extracted materials transformed into components or products. Ex.:
Steel bar, Ferrous powder, Plastic, metal strip etc.
• Components
– Parts or subassemblies used in the final product. Ex: Capacitor, screws, nuts etc.
• Work-in-process (WIP)
– Items in process throughout the plant.
• Finished goods
– Products sold to customers. Ex.: Bycycle, stereos, CD, automobile etc.
• Distribution inventory
– Finished goods in the distribution system. Ex: Stored in warehouse or in transit between
warehouses and consumers.

Independent vs. Dependent Demand
• A major distinction in the way inventory planning and control
are managed is whether demand for items in inventory is
independent or dependent.
• Independent demand is the Demand for items that are
finished goods or other items sold to someone outside the
company
• Dependent demand for items in inventory that are
subassemblies or component parts to be used in the
production of finished goods.

Six ways of using Inventory by Company’s
1. Anticipation or Seasonal - Inventory built in anticipation of
future demand.
2. Fluctuation Inventory or Safety stock - Provides a cushion
against unexpected demand.
3. Lot-size or cycle stock: A result of the quantity ordered or
produced.
4. Transportation or Pipeline - Inventory in movement between
locations.
5. Speculative or Hedge - Used to protect against some future
event.
6. Maintenance, Repair, and Operating (MRO) - Items used in
support of manufacturing and maintenance.

Functions of Inventory
Anticipation inventory
Items built in anticipation of future demand. Allows
company to maintain a level production strategy.
Fluctuation inventory
Protects against unexpected demand variations. Assures
customer service levels.
Lot-size inventory
Results from the actual quantity purchased. Allows for
lower unit costs.
Transportation
inventory
Items in movement between locations. Inventory moves
from manufacturer to distribution facilities.
Speculative inventory
Extra inventory built up or purchased to protect against
some future events. Allows for continuous supply.
MRO
Includes maintenance supplies, spare parts, lubricants,
cleaning agents, and daily operating supplies. Facilitates
day-to-day operations.

Objectives of Inventory Management
• Provide acceptable level of customer service (on-time
delivery)
• Allow cost-efficient operations
• Minimize inventory investment

Customer Service – Measures
• Customer service is a company’s ability to satisfy the needs of its
customers.
Following are measures of Customer Service:
• Percentage of orders shipped on schedule : A customer service measure
appropriate for use when orders have similar value.
• Percentage of line items shipped on schedule: A customer service
measure appropriate when customer orders vary in number of line items
ordered.
• Percentage of dollar volume shipped on schedule: A customer service
measure appropriate when customer orders vary in value.
• Idle Time Due to Material and Component Shortages applies to internal
customer service.

Cost-Efficient Operations
• Use work-in-process (WIP) inventory to buffer
operations
• Building inventory in advance of seasonal demands
• Building inventory in long production runs
• Buy in larger quantities at a discount

Minimum Inventory Investment (1 of 4)
• Minimum Inventory investment is measured by inventory turnover.
• A measure of inventory policy effectiveness.
• This ratio should be compared with that achieved by other companies in the
industry.
• Higher the number, the more effectively the company is using its inventory.

• One measure of the level of demand that can be satisfied by on-hand inventory is
weeks of supply.

• In some companies, inventory performance is measured in either days or hours of supply. To
calculate days of supply, we use the formula
Step1: Calculate the Average Daily usage = Annual cost of goods sold /number of days the company operates =
$1,300,000/250 = $5200
Step 2: Days of supply = $15,600/$5200 = 3 days of supply.
Suppose the Jenny Company uses a new process that reduces the average inventory held to $3250.
Step 1: Calculate he average Hourly usage, assuming 8 Hrs/day = Ave. Daily usage/8 = $5200/8 = $650
Step 2: Hours of Supply = $3250/$650 = 5 hours of supply.

Relevant Inventory Costs
Item Cost
Cost per item plus any other direct costs associated with getting
the item to the plant
Holding Costs
Capital, storage, and risk cost typically stated as a % of the unit
value, e.g. 15-25%
Ordering Cost Fixed, constant dollar amount incurred for each order placed
Shortage Costs Loss of customer goodwill, back order handling, and lost sales
Risk Costs
Obsolescence, damage of deterioration, theft, insurance, and
taxes.

Order Quantity Strategies
Lot-for-lot Order exactly what is needed for the next period
Fixed-order
quantity
Order a predetermined amount each time an order is
placed
Min-max system
When on-hand inventory falls below a predetermined
minimum level, order enough to refill up to maximum
level
Order n periods Order enough to satisfy demand for the next n periods

Examples of Ordering Approaches
Lot for Lot Example
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 0 0 0 0 0 0 0
Order Placement 40 70 65 60 55 85 75 85
Fixed Order Quantity Example with Order Quantity of 200
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 160 90 25 165 110 25 150 65
Order Placement 200 200 200
Min-Max Example with min.= 50 and max.= 250 units
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Order Placement 220 140 180 160
Order n Periods with n = 3 periods
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Order Placement 175 200 160

ABC Inventory Classification
• ABC classification is a method for determining level of control
and frequency of review of inventory items
– Pareto’s law (for inventory) implies that about 20% of the inventory
items will account for about 80% of the inventory value.
– A Pareto analysis can be done to segment items into value categories
depending on annual dollar volume.
• A Items – typically 20% of the items accounting for 80% of the
inventory value-use Q system
• B Items – typically an additional 30% of the items accounting
for 15% of the inventory value-use Q or P
• C Items – Typically the remaining 50% of the items accounting
for only 5% of the inventory value-use P

ABC Example: the table below shows a solution to an ABC analysis. The information
that is required to do the analysis is: Item #, Unit $ Value, and Annual Unit Usage. The
analysis requires a calculation of Annual Usage $ and sorting that column from
highest to lowest $ value, calculating the cumulative annual $ volume, and grouping
into typical ABC classifications.
Item Annual Usage ($) Percentage of Total $ Cumulative Percentage of Total $ Item Classification
106 16,500 34.4 34.4 A
110 12,500 26.1 60.5 A
115 4500 9.4 69.9 B
105 3200 6.7 76.6 B
111 2250 4.7 81.3 B
104 2000 4.2 85.5 B
114 1200 2.5 88 C
107 1000 2.1 90.1 C
101 960 2 92.1 C
113 875 1.8 93.9 C
103 750 1.6 95.5 C
108 600 1.3 96.8 C
112 600 1.3 98.1 C
102 500 1 99.1 C
109 500 1 100.1 C

Inventory Control using ABC Classification (1 of 3)
• Appropriate level of control is established after ABC Classification.

• Expensive A items need :
– Very tight control
– Highly accurate inventory records
– Frequent or Continuous review
– Continuous review system
• Updates inventory balances after each inventory transaction
• Keeps track of an inventory item 24/7
• EOQ model is used
• B items need normal control
– Moderately accurate inventory records
– A reasonable time period between reviews
– Periodic review system
• Requires regular periodic reviews (daily, weekly, monthly) of the on-hand
quantity to determine the size of the replenishment order.

• C items require the least amount of control
– Possible options are: Two-bin system or an infrequent periodic review
system
• Two-bin system
– A two-bin system splits an incoming replenishment order into two
separate bins.
– One bin with enough stock to satisfy demand during replenishment time is
kept in the storeroom;
– The other bin is placed on the manufacturing floor so that, workers can
take what they need.
– This second bin should have enough items to cover normal demand during
the replenishment lead time.
• Lead time
– Time from order placement to order receipt.

Inventory Record Accuracy
• Inaccurate inventory records can cause:
– Lost sales
– Disrupted operations
– Poor customer service
– Lower productivity
– Planning errors and expediting
• Two methods are available for checking record accuracy
– Periodic counting-physical inventory
– Cycle counting-daily counting of pre-specified items provides the
following advantages:
• Timely detection and correction of inaccurate records
• Elimination of lost production time due to unexpected stock outs
• Structured approach using employees trained in cycle counting

Determining Order Quantities (1 of 6)
• The objectives of inventory management are –
– To provide the desired level of customer service,
– Enable cost-efficient operations, and
– Minimize the inventory investment.
• How to achieve these objectives?
• We must first determine how much of an item to
order at a time.

• Inventory management and control are done at the level of
the individual item
• This is called Stock-keeping unit (SKU)
• An SKU is a specific item at a particular geographic location.
• Examples:
– A pair of jeans, size 32 X 32, in inventory at the plant and also eight
different warehouses, represents nine different SKUs.
– A pair of the same jeans held at the same locations but a different size
(32 X 34) represents nine additional SKUs.
– The same style of jeans in a different colour represents additional
SKUs.

• Approaches for Determining SKU order:

• Lot-for-lot
– Lot-for-lot is ordering exactly what you need.
– Adjust the ordering quantity to our ordering needs, which ensures that
you will not have leftover inventory.
– We use lot-for-lot when demand is not constant and you have information
about expected needs.
• Fixed-order quantity
– Fixed-order quantity specifies the number of units to order each time you
place an order for a certain SKU or item.
– The quantity may be arbitrary (ex: 100 units at a time), or it may be the
result of how the item is packaged or prepared (such as 144 per box or a
loaf of bread).
– The advantage of this system is that it is easily understood;
– The disadvantage is that it does not minimize inventory costs.

• Min-Max system
– Min-Max system places a replenishment order when the on-hand
inventory falls below the predetermined minimum level.
– An order is placed to bring the inventory back up to the maximum
inventory level.
– Example:
• If the minimum is set at 50 units,
• The maximum is set at 250 units,
• The quantity available at the time of the order is 40 units,
• The order quantity is 210 units (250 − 40).
• With this system, both the time between orders and the
quantity ordered can vary.

• Order n periods
– In Order n periods - The order quantity is determined by total demand
for the item for the next n periods.
• For example,
– Let’s say that you have to order enough each time you place an order
to satisfy your company’s requirements for the next three periods.
• Requirements for the next three weeks are 60, 45, and 100, your order is
for 60+45+100 = 205 units.
– A concern with this system is determining the number of periods to
include in the order.

Three Mathematical Models for Determining Order
Quantity
• Economic Order Quantity (EOQ or Q System)
– An optimizing method used for determining order quantity and reorder
points
– Part of continuous review system which tracks on-hand inventory each
time a withdrawal is made
• Economic Production Quantity (EPQ)
– A model that allows for incremental product delivery
• Quantity Discount Model
– Modifies the EOQ process to consider cases where quantity discounts are
available

EOQ Model

Economic Order Quantity
• EOQ Assumptions:
– Demand is known & constant - no safety stock is required
– Lead time is known & constant
– No quantity discounts are available
– Ordering (or setup) costs are constant
– All demand is satisfied (no shortages)
– The order quantity arrives in a single shipment

EOQ: Total Cost Equation
• The formula for calculating the total relevant annual costs for
the basic EOQ model is:
costsetuporordering
costholdingannual
orderedbeoquantity t
demandannual
costannualtotal
2


















S
H
Q
D
TC
Where
H
Q
S
Q
D
TCEOQ

EOQ Total Costs
Total annual costs = annual ordering costs + annual holding costs

The EOQ Formula
Minimize the Total Cost (TC) by ordering the EOQ:
H
DS
EOQ
2


When to Order? : The Reorder Point
• Without safety stock:
• With safety stock:
days/weeksintimelead
unitsindemandlydaily/week
unitsinpointreorderwhere




L
d
R
dLR
unitsinstocksafetywhere 

SS
SSdLR

EOQ Example
• Weekly demand = 240 units
• No. of weeks per year = 52
• Ordering cost = $50
• Unit cost = $15
• Annual carrying charge = 20%
• Lead time = 2 weeks

EOQ Example Solution
yearunitsD /480,1224052 
yearperunitperH 3$152.0 
units
H
DS
Q 64598.644
3
50480,1222



unitsdLR
H
Q
S
Q
D
TC
4802240
$1,934.945.96744.967
3
2
645
50
645
480,12
2




























EPQ (Economic Production Quantity)
Assumptions
• Same as the EOQ except: inventory arrives in increments & is
drawn down as it arrives

EPQ Equations
• Adjusted total cost:
• Maximum inventory:
• Adjusted order quantity:












 H
I
S
Q
D
TC MAX
EPQ
2







p
d
QIMAX 1








p
d
H
DS
EPQ
1
2

EPQ Example
• Annual demand = 18,000 units
• Production rate = 2500 units/month
• Setup cost = $800
• Annual holding cost = $18 per unit
• Lead time = 5 days
• No. of operating days per month = 20

EPQ Example Solution (1 of 2)
monthunitspmonthunitsd /2500;/1500
12
000,18

units
p
d
H
DS
Q 2000
2500
1500
118
800000,182
1
2


















units
p
d
QIMAX 800
2500
1500
120001 












400,14200,7200,7
18
2
800
800
2000
000,18
2

























 H
I
S
Q
D
TC MAX

• The reorder point:
• With safety stock of 200 units:
EPQ Example Solution (2 of 2)
unitsSSdLR 5752005
20
1500

unitsdLR 3755
20
1500


Quantity Discount Model Assumptions
• Same as the EOQ, except:
– Unit price depends upon the quantity ordered
• Adjusted total cost equation:
PDH
Q
S
Q
D
TCQD 












2

Quantity Discount Procedure
1. Calculate the EOQ at the lowest price
2. Determine whether the EOQ is feasible at that price
a) Will the vendor sell that quantity at that price?
3. If YES, stop – if NO, continue
4. Check the feasibility of EOQ at the next higher price
5. Continue until you identify a feasible EOQ
6. Calculate the total costs (including total item cost) for the feasible EOQ
model
7. Calculate the total costs of buying at the minimum quantity required for
each of the cheaper unit prices
8. Compare the total cost of each option & choose the lowest cost
alternative
9. Any other issues to consider?

Quantity Discount Example (1 of 3)
• Annual Demand = 5000 units
• Ordering cost = $49
• Annual carrying charge = 20%
• Unit price schedule:
Quantity Unit Price
0 to 999 $5.00
1000 to 1999 $4.80
2000 and over $4.75

SOLUTION:
• Step 1
 feasiblenotQP 718
75.42.0
49000,52
75.4$ 



 feasiblenotQP 714
80.42.0
49000,52
80.4$ 



 feasibleQP 700
00.52.0
49000,52
00.5$ 




• Step 2
700,25$500000.500.52.0
2
700
49
700
000,5
700 QTC
725,24$500080.480.42.0
2
1000
49
1000
000,5
1000 QTC
50.822,24$500075.475.42.0
2
2000
49
2000
000,5
2000 QTC

What if Demand is Uncertain?

Safety Stock and Service Level
• Order-cycle service level is the probability that demand during
lead time won’t exceed on-hand inventory.
• Risk of a stockout = 1 – (service level)
• More safety stock means greater service level and smaller risk
of stockout

Safety Stock and Reorder Point
• Without safety stock:
• With safety stock:
daysintimelead
unitsindemanddaily
unitsinpointreorderwhere




L
d
R
dLR
unitsinstocksafetywhere 

SS
SSdLR

Reorder Point Determination
R = reorder point
d = average daily demand
L = lead time in days
z = number of standard deviations associated with desired
service level
s = standard deviation of demand during lead time
dL
dL
zdLR
zSS
s
s


i.e.,

Safety Stock Example
• Daily demand = 20 units
• Lead time = 10 days
• S.D. of lead time demand = 50 units
• Service level = 90%
Determine:
1. Safety stock
2. Reorder point

Step 1 – determine z
Step 2 – determine safety stock
Step 3 – determine reorder point
Safety Stock Solution
units264641020  SSdLR
28.1:BAppendixFrom z
units645028.1 SS

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Editor's Notes