CHAPTER 17 Inventory Control

Tata McGraw

Chapter 17

Inventory Control

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OBJECTIVES
Inventory System Defined Inventory Costs Independent vs. Dependent Demand Single-Period Inventory Model Multi-Period Inventory Models: Basic Fixed-Order Quantity Models Multi-Period Inventory Models: Basic Fixed-Time Period Model Miscellaneous Systems and Issues

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Inventory System

Inventory is the stock of any item or resource used in an organization and can include: raw materials, finished products, component parts, supplies, and work-in-process An inventory system is the set of policies and controls that monitor levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be

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Purposes of Inventory

1. To maintain independence of operations 2. To meet variation in product demand 3. To allow flexibility in production scheduling 4. To provide a safeguard for variation in raw material delivery time 5. To take advantage of economic purchase-order size

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Inventory Costs

Holding (or carrying) costs Costs for storage, handling, insurance, etc Setup (or production change) costs Costs for arranging specific equipment setups, etc Ordering costs Costs of someone placing an order, etc Shortage costs Costs of canceling an order, etc

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Independent vs. Dependent Demand

Independent Demand (Demand for the final endproduct or demand not related to other items)

Finished product
Dependent Demand (Derived demand items for component parts, subassemblies, raw materials, etc)

E(1 )

Component parts

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Inventory Systems

Single-Period Inventory Model One time purchasing decision (Example: vendor selling t-shirts at a football game) Seeks to balance the costs of inventory overstock and under stock Multi-Period Inventory Models Fixed-Order Quantity Models Event triggered (Example: running out of stock) Fixed-Time Period Models Time triggered (Example: Monthly sales call by sales representative)

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Single-Period Inventory Model

Cu P Co Cu
Where :

This model states that we should continue to increase the size of the inventory so long as the probability of selling the last unit added is equal to or greater than the ratio of: Cu/Co+Cu

Co Cost per unit of demand over estimated Cu Cost per unit of demand under estimated P Probability that theunit will be sold

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Single Period Model Example

Our college basketball team is playing in a tournament game this weekend. Based on our past experience we sell on average 2,400 shirts with a standard deviation of 350. We make $10 on every shirt we sell at the game, but lose $5 on every shirt not sold. How many shirts should we make for the game?
Cu = $10 and Co = $5; P $10 / ($10 + $5) = .667 Z.667 = .432 (use NORMSDIST(.667) or Appendix E) therefore we need 2,400 + .432(350) = 2,551 shirts

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Multi-Period Models: Fixed-Order Quantity Model Model Assumptions (Part 1)

Demand for the product is constant and uniform throughout the period Lead time (time from ordering to receipt) is constant Price per unit of product is constant

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Multi-Period Models: Fixed-Order Quantity Model Model Assumptions (Part 2)

Inventory holding cost is based on average inventory

Ordering or setup costs are constant All demands for the product will be satisfied (No back orders are allowed)

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Basic Fixed-Order Quantity Model and Reorder Point Behavior

1. You receive an order quantity Q.

4. The cycle then repeats.

Number of units on hand

Q R

2. Your start using them up over time.

L
Time

R = Reorder point Q = Economic order quantity L = Lead time

L 3. When you reach down to a level of inventory of R, you place your next Q sized order.

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Cost Minimization Goal

By adding the item, holding, and ordering costs together, we determine the total cost curve, which in turn is used to find the Qopt inventory order point that minimizes total costs
Total Cost
C O S T

Holding Costs Annual Cost of Items (DC) Ordering Costs

QOPT Order Quantity (Q)

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Basic Fixed-Order Quantity (EOQ) Model Formula

TC=Total annual cost D =Demand C =Cost per unit Q =Order quantity S =Cost of placing an order or setup cost R =Reorder point L =Lead time H=Annual holding and storage cost per unit of inventory

Total Annual = Cost

Annual Annual Annual Purchase + Ordering + Holding Cost Cost Cost

D Q TC = DC + S + H Q 2

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Deriving the EOQ

Using calculus, we take the first derivative of the total cost function with respect to Q, and set the derivative (slope) equal to zero, solving for the optimized (cost minimized) value of Qopt
Q O PT = 2DS = H 2(Annual D em and)(Order or Setup Cost) Annual Holding Cost
_

We also need a reorder point to tell us when to place an order

R eo rd er p o in t, R = d L
_

d = average daily demand (constant) L = Lead time (constant)

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EOQ Example (1) Problem Data

Given the information below, what are the EOQ and reorder point?

Annual Demand = 1,000 units Days per year considered in average daily demand = 365 Cost to place an order = $10 Holding cost per unit per year = $2.50 Lead time = 7 days Cost per unit = $15

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EOQ Example (1) Solution

Q O PT =

2D S = H

2(1,000 )(10) = 89.443 units or 90 u n its 2.50

1,000 units / year d = = 2.74 units / day 365 days / year

_

R eo rd er p o in t, R = d L = 2 .7 4 u n its / d ay (7 d ays) = 1 9 .1 8 o r 2 0 u n its

In summary, you place an optimal order of 90 units. In the course of using the units to meet demand, when you only have 20 units left, place the next order of 90 units.

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EOQ Example (2) Problem Data

Determine the economic order quantity and the reorder point given the following

Annual Demand = 10,000 units Days per year considered in average daily demand = 365 Cost to place an order = $10 Holding cost per unit per year = 10% of cost per unit Lead time = 10 days Cost per unit = $15

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EOQ Example (2) Solution

Q OPT =

2D S = H

2 (1 0 ,0 0 0 )(1 0 ) = 3 6 5 .1 4 8 u n its, o r 3 6 6 u n its 1 .5 0

10,000 units / year d= = 27.397 units / day 365 days / year

_

R = d L = 2 7 .3 9 7 u n its / d ay (1 0 d ays) = 2 7 3 .9 7 o r 2 7 4 u n its

Place an order for 366 units. When in the course of using the inventory you are left with only 274 units, place the next order of 366 units.

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Fixed-Time Period Model with Safety Stock Formula

q = Average demand + Safety stock Inventory currently on hand

q = d(T + L) + Z T + L - I Where : q = quantitiy to be ordered T = the number of days between reviews L = lead time in days d = forecast average daily demand z = the number of standard deviations for a specified service probabilit y T + L = standard deviation of demand over thereview and lead time I = current inventorylevel (includes items on order)

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Multi-Period Models: Fixed-Time Period Model: Determining the Value of sT+L

T+ L =

T+ L i 1

di

Since each day is independent and d is constant,

T+ L =

(T + L) d 2

The standard deviation of a sequence of random events equals the square root of the sum of the variances

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Example of the Fixed-Time Period Model

Given the information below, how many units should be ordered? Average daily demand for a product is 20 units. The review period is 30 days, and lead time is 10 days. Management has set a policy of satisfying 96 percent of demand from items in stock. At the beginning of the review period there are 200 units in inventory. The daily demand standard deviation is 4 units.

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Example of the Fixed-Time Period Model: Solution (Part 1)

T+ L =

(T + L) d 2 =

30 + 10 4 2 = 25.298

The value for z is found by using the Excel NORMSINV function, or as we will do here, using Appendix D. By adding 0.5 to all the values in Appendix D and finding the value in the table that comes closest to the service probability, the z value can be read by adding the column heading label to the row label.
So, by adding 0.5 to the value from Appendix D of 0.4599, we have a probability of 0.9599, which is given by a z = 1.75

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Example of the Fixed-Time Period Model: Solution (Part 2)

q = d(T + L) + Z T +L - I q = 20(30 + 10) + (1.75)(25. 298) - 200 q = 800 44.272 - 200 = 644.272, or 645 units

So, to satisfy 96 percent of the demand, you should place an order of 645 units at this review period

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Price-Break Model Formula

Based on the same assumptions as the EOQ model, the price-break model has a similar Qopt formula:

2DS 2(Annual Demand)(Or der or Setup Cost) QOPT = = iC Annual Holding Cost
i = percentage of unit cost attributed to carrying inventory C = cost per unit Since C changes for each price-break, the formula above will have to be used with each price-break cost value

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Price-Break Example Problem Data (Part 1)

A company has a chance to reduce their inventory ordering costs by placing larger quantity orders using the price-break order quantity schedule below. What should their optimal order quantity be if this company purchases this single inventory item with an e-mail ordering cost of $4, a carrying cost rate of 2% of the inventory cost of the item, and an annual demand of 10,000 units?
Order Quantity(units) Price/unit($) 0 to 2,499 $1.20 2,500 to 3,999 1.00 4,000 or more .98

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Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of C

Annual Demand (D)= 10,000 units Cost to place an order (S)= $4

Carrying cost % of total cost (i)= 2% Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the Qopt value is feasible Interval from 2500-3999, the Qopt value is not feasible

QOPT = QOPT =

2DS = iC 2DS = iC 2DS = iC

2(10,000)( 4) = 1,826 units 0.02(1.20) 2(10,000)( 4) = 2,000 units 0.02(1.00) 2(10,000)( 4) = 2,020 units 0.02(0.98)

Interval from 4000 & more, the QOPT = Qopt value is not feasible

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Price-Break Example Solution (Part 3)

Since the feasible solution occurred in the first pricebreak, it means that all the other true Qopt values occur at the beginnings of each price-break interval. Why? Because the total annual cost function is a u shaped function So the candidates for the pricebreaks are 1826, 2500, and 4000 units
0 1826 2500 4000 Order Quantity

Total annual costs

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Price-Break Example Solution (Part 4)

Next, we plug the true Qopt values into the total cost annual cost function to determine the total cost under each price-break

D Q TC = DC + S+ iC Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20) = $12,043.82 TC(2500-3999)= $10,041 TC(4000&more)= $9,949.20

Finally, we select the least costly Qopt, which is this problem occurs in the 4000 & more interval. In summary, our optimal order quantity is 4000 units

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Miscellaneous Systems: Optional Replenishment System

Maximum Inventory Level, M

q=M-I Actual Inventory Level, I

M
I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

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Miscellaneous Systems: Bin Systems

Two-Bin System

Order One Bin of Inventory

Full

Empty

One-Bin System

Order Enough to Refill Bin

Periodic Check

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ABC Classification System

Items kept in inventory are not of equal importance in terms of:

dollars invested profit potential

% of $ Value 30
0
30

60

A B C

sales or usage volume % of

stock-out penalties
Use

60

So, identify inventory items based on percentage of total dollar value, where A items are roughly top 15 %, B items as next 35 %, and the lower 65% are the C items

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Inventory Accuracy and Cycle Counting

Inventory accuracy refers to how well the inventory records agree with physical count Cycle Counting is a physical inventory-taking technique in which inventory is counted on a frequent basis rather than once or twice a year

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Question Bowl

Which of the following is a reason why firms keep a supply of inventory? a. To maintain independence of operations b. To meet variation in product demand c. To allow flexibility in production scheduling d. To take advantage of economic purchase order size e. All of the above Answer: e. All of the above (Also can include to provide a safeguard for variation in raw material delivery time.)

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Question Bowl

An Inventory System should include policies that are related to which of the following? a. How large inventory purchase orders should be b. Monitoring levels of inventory c. Stating when stock should be replenished d. All of the above e. None of the above

Answer: d. All of the above

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Question Bowl

Which of the following is an Inventory Cost item that is related to the managerial and clerical costs to prepare a purchase or production order? a. Holding costs Answer: e. None of the b. Setup costs c. Carrying costs above (Correct answer is Ordering Costs.) d. Shortage costs e. None of the above

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Question Bowl

Which of the following is considered a Independent Demand inventory item? a. Bolts to a automobile manufacturer b. Timber to a home builder c. Windows to a home builder d. Containers of milk to a grocery store e. None of the above
Answer: d. Containers of milk to a grocery store

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Question Bowl

If you are marketing a more expensive independent demand inventory item, which inventory model should you use? a. Fixed-time period model b. Fixed-order quantity model c. Periodic system d. Periodic review system e. P-model Answer: b. Fixed-order quantity model

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Question Bowl

If the annual demand for an inventory item is 5,000 units, the ordering costs are $100 per order, and the cost of holding a unit is stock for a year is $10, which of the following is approximately the Qopt? a. 5,000 units Answer: d. 316 b. $5,000 units c. 500 units (Sqrt[(2x1000x10 d. 316 units e. None of the above 0)/10=316.2277)

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Question Bowl

The basic logic behind the ABC Classification system for inventory management is which of the following? a. Two-bin logic b. One-bin logic c. Pareto principle d. All of the above e. None of the above Answer: c. Pareto principle

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Question Bowl

A physical inventory-taking technique in which inventory is counted frequently rather than once or twice a year is which of the following? a. Cycle counting b. Mathematical programming c. Pareto principle d. ABC classification e. Stockkeeping unit (SKU)

Answer: a. Cycle counting

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End of Chapter 17