Basic inventory systems

Investment in inventory is currently over $1.25 Trillion

(U.S. Department of Commerce)
Inventories are assets:

held for sale in the ordinary course of business; or

in the process of production for such sale; or

in the form of materials or supplies to be consumed in the
production process or in the rendering of services


Inventory ?
Inventory is the term used to indicate the stock of any item or resource used in
an organization
It can include: raw materials, finished products, component parts, supplies,
and work-in-process.

Inventories include:
goods: commodities purchased and held for resale
supplies: raw materials
products: intermediate products, finished goods


Raw Materials Work in Progress Finished Goods
Inventory system
An Inventory system is the set of policies that controls and monitor
levels of inventory and determines what levels should be
maintained, when stock should be replenished, and how large
orders should be.
Why inventory ?
The fundamental reason for carrying inventories is that it is physically
impossible and economically impractical for each stock item to arrive
exactly where it is needed and exactly when it is needed.
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.
Stock Keeping unit : Each distinct item in the inventory at a location is termed as
SKU
TYPES OF INVENTORY: Basically classified in to 2 types
1. Transaction stocks: Those necessary to support the transformation,
movement and sales operations of the firm
2. Organization stocks : represent investment opportunities to achieve
operating efficiencies

1. Transaction stocks: Those necessary to support the
transformation, movement and sales operations of the firm.
(a) Work in process stocks: materials currently being worked on or
moving between work centers .
(b) Transportation or Pipeline inventories : When transportation
requires a long time, the items in transportation represent
inventory
Organization stocks : represent investment opportunities to achieve
operating efficiencies.
(a) Fluctuation or safety stock
(b) Anticipation inventory or leveling inventory
(c) Lot size or cycle inventories
Inventory costs
1. Ordering costs: involves clerical cost for Purchasing,
Inspection, Accounting and Transportation
2. Holding or Carrying costs: Storage, handling, Insurance , record
keeping, product deterioration and loss due to perishable nature
3. Stockout costs
4. Miscellaneous such as Setup costs, purchase or production cost.
ABC Inventory Classification
ABC classification is a method for determining level of control and
frequency of review of inventory items

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 Analysis: The information that is required to do the analysis is:
Unit item 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.
ABC example
S.No Unit value
(Rs.)
Annual usage
(Qty)
1 100 165
2 125 100
3 450 10
4 16 200
5 225 10
6 5 400
7 6 200
8 100 10
9 10 96
10 60 10
Item
Annual
Usage
value
% of Total
value
Cumulative %
of Total value
Item
Classifn
1 16,500 34.4 34.4 A
2 12,500 26.1 60.5 A
3 4500 9.4 69.9 B
4 3200 6.7 76.6 B
5 2250 4.7 81.3 B
6 2000 4.2 85.5 B
7 1200 2.5 88 C
8 1000 2.1 90.1 C
9 960 2 92.1 C
10 875 1.8 93.9 C
11 750 1.6 95.5 C
12 600 1.3 96.8 C
13 600 1.3 98.1 C
14 500 1 99.1 C
15 500 1 100.1 C
Fundamental decision of Inv. Mgm
The Fundamental decisions of Inv. Mgm are:

1. What to order : Depends on MRP

2. When to order : Depends on MRP

3. How much to order : Depends on the order system followed
Master Production Schedule (MPS):

Example




Production of 1000 no. 12468 staplers is planned for weeks 1, 2, and 3,
followed by no more stapler production until week 6 in which 1500 staplers
will be produced.
Product: personal stapler no. 12468
1 2 3 4 5 6
Planned order releases 1000 1000 1000 0 0 1500
Week
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
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
Economic Order Quantity
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 Costs
Total annual costs = annual ordering costs + annual holding costs

EOQ: Total Cost Equation
cost setup or ordering
cost holding annual
ordered be o quantity t
demand annual
cost annual total
2
=
=
=
=
=
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\
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+
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\
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=
S
H
Q
D
TC
Where
H
Q
S
Q
D
TC
EOQ
EOQ Total Costs
Total annual costs = annual ordering costs + annual holding costs

The EOQ Formula
Minimize the TC by ordering the EOQ:
H
DS
EOQ
2
=
When to Order:
The Reorder Point
Without safety stock:




With safety stock:
days/weeks in time lead
units in demand ly daily/week
units in point reorder where
=
=
=
=
L
d
R
dL R
units in stock safety where =
+ =
SS
SS dL R
EOQ Example
Weekly demand = 240 units
No. of weeks per year = 52
Ordering cost = $50
Unit cost = $15
Annual carrying charge = 20% of unit cost
Lead time = 2 weeks
EOQ Example Solution
year units D / 480 , 12 240 52 = =
year per unit per H 3 $ 15 2 . 0 = =
units
H
DS
Q 645 98 . 644
3
50 480 , 12 2 2
~ =

= =
units dL R
H
Q
S
Q
D
TC
480 2 240
$1,934.94 5 . 967 44 . 967
3
2
645
50
645
480 , 12
2
= = =
= + =
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+
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\
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=
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\
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+
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\
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=
Setup cost


Setup costs apply when the required items are produced in the organization & comprise the following factors

1. Cost of setting up the process i.e.,
(a) Setting up necessary equipment & making necessary tool changes
(b) Instructing the operator and follow up
(c) Building up the skill in operator

2. Cost of scrap

3.Cost of planning production & controlling
(a) Scheduling & following up of work
(b) Accounting for job costs
(c) Preparing necessary production control paper work


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:
|
.
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\
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+
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|
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\
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= H
I
S
Q
D
TC
MAX
EPQ
2
|
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\
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=
p
d
Q I
MAX
1
|
|
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|

\
|

=
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
month units p month units d / 2500 ; / 1500
12
000 , 18
= = =
units
p
d
H
DS
Q 2000
2500
1500
1 18
800 000 , 18 2
1
2
=
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\
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=
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\
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=
units
p
d
Q I
MAX
800
2500
1500
1 2000 1 =
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\
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=
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\
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=
400 , 14 200 , 7 200 , 7
18
2
800
800
2000
000 , 18
2
= + =
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+
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\
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=
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\
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+
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\
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= H
I
S
Q
D
TC
MAX
EPQ Example Solution (cont.)
The reorder point:



With safety stock of 200 units:
units SS dL R 575 200 5
20
1500
= + = + =
units dL R 375 5
20
1500
= = =
Quantity Discount Model Assumptions
Same as the EOQ, except:
Unit price depends upon the quantity ordered
Adjusted total cost equation:
PD H
Q
S
Q
D
TC
QD
+
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\
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+
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\
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=
2
Quantity Discount Procedure
Calculate the EOQ at the lowest price
Determine whether the EOQ is feasible at that
price
Will the vendor sell that quantity at that price?
If yes, stop if no, continue
Check the feasibility of EOQ at the next higher
price

Continue to the next slide ...

QD Procedure (continued)
Continue until you identify a feasible EOQ
Calculate the total costs (including total item
cost) for the feasible EOQ model
Calculate the total costs of buying at the
minimum quantity required for each of the
cheaper unit prices
Compare the total cost of each option &
choose the lowest cost alternative
Any other issues to consider?

QD Example
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
QD Example Solution
Step 1
( ) feasible not Q
P
718
75 . 4 2 . 0
49 000 , 5 2
75 . 4 $
=

=
=
( ) feasible not Q
P
714
80 . 4 2 . 0
49 000 , 5 2
80 . 4 $
=

=
=
( ) feasible Q
P
700
00 . 5 2 . 0
49 000 , 5 2
00 . 5 $
=

=
=
QD Example Solution (Cont.)
Step 2
700 , 25 $ 5000 00 . 5 00 . 5 2 . 0
2
700
49
700
000 , 5
700
= + + =
= Q
TC
725 , 24 $ 5000 80 . 4 80 . 4 2 . 0
2
1000
49
1000
000 , 5
1000
= + + =
= Q
TC
50 . 822 , 24 $ 5000 75 . 4 75 . 4 2 . 0
2
2000
49
2000
000 , 5
2000
= + + =
= Q
TC
What if Demand is Uncertain?
Safety Stock and Service Level
Order-cycle service level is the probability that
demand during lead time wont 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:
days in time lead
units in demand daily
units in point reorder where
=
=
=
=
L
d
R
dL R
units in stock safety where =
+ =
SS
SS dL R
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
o = standard deviation of demand during lead time
dL
dL
z dL R
z SS
o
o
+ =
=
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

Safety Stock Solution
Step 1 determine z

Step 2 determine safety stock

Step 3 determine reorder point
units 264 64 10 20 = + = + = SS dL R
28 . 1 : B Appendix From = z
units 64 50 28 . 1 = = SS
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