Chapter 11 INVENTORY MANAGEMENT Inventory. A stock or goods of goods. Independent and 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. Dependent demand. Demand for items in inventory that are subassemblies or component parts to be used in the production of finished goods. Demand of subassemblies and component parts is derived from the number of finished units that will be produced. Independent demand. Demand for items that are finished items. These items are sold or at least shipped out rather than used in making another product. The Nature and Importance of Inventories A typical manufacturing firm carries different types of inventories, including the following: 1. Raw materials and purchased parts 2. Partially completed goods, called work-in-process (WIP) 3. Finished-goods inventories (manufacturing firms) or merchandise (retail stores) 4. Replacement parts, tools, and supplies 5. Goods-in-transit to warehouse or customers Functions of Inventory 1. To meet anticipated demand. A customer can be a person who walks in off the street to buy a new stereo system, a mechanic who requests a tool at a tool crib, or a manufacturing operation. These inventories are referred to as anticipation stocks because they held to satisfy planned or expected demand. 2. To smooth production requirements. Firms that experience seasonal patterns in demand often build up inventories during off-season periods to meet overly high requirements during certain seasonal periods. These inventories are aptly named seasonal inventories. 3. To decouple operations. Manufacturing firms have used inventories as buffers between successive operations to maintain continuity of production that would otherwise be disrupted by events such as breakdowns of equipment and accidents that cause a portion of the operation to shut down temporarily. 4. To protect against stock-outs. Delayed deliveries and unexpected increases in demand increase the risk of shortages. 5. To take advantage of order cycles. To minimize purchasing and inventory costs, a firm often buys in quantities that exceed immediate requirements. Inventory storage enables a firm to buy and produce in economic lot sizes without having to try to match purchases or production with demand requirements in the short run. This results in periodic order or order cycles. The resulting stock is known as cycle stock. 6. To hedge against price increases. A firm will suspect that a substantial price increase is about to be made and purchase larger-than-normal amounts to avoid the increase. 7. To permit operation. Take a certain amount of time means that there will generally be some work-in-process inventory. Objectives of Inventory Control Inadequate control of inventories can result in both under- and overstocking of items. Understocking results in missed deliveries, lost sales, dissatisfied customers, and production bottlenecks; overstocking unnecessarily ties up funds that might be more predictive elsewhere. Although overstocking may appear to be the lesser of the two evils, the price tag fro excessive overstocking can be staggering when inventory holding costs are high.

Inventory management has two main concerns. On relates to the level of customer service, that is, to have the right goods, in sufficient quantities, in the right place, and at the right time. The other relates to the costs 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. The two fundamental decisions that must be made relate to the timing and size of orders. Requirements fro Effective Inventory Management 1. A system to keep track of the inventory on hand and on order. 2. A reliable forecast of demand that includes an indication of possible forecast error. 3. Knowledge of leas times and lead time variability. 4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs. 5. A classification system for inventory items. Inventory Counting Systems Periodic system. Physical count of items in inventory made at periodic intervals (weekly, monthly). Advantage is that orders for many items occur at the same time, which can result in economies in processing and shipping orders. Disadvantages are lack of control between reviews, the need to protect against shortages between review periods by carrying extra stock, and the need to make a decision on order quantities at each review. Perpetual inventory system. System that keeps track of removals from inventory continuously, thus monitoring current levels of each item. Advantage of this system is the control provided by the continuous monitoring of inventory withdrawals. Another is the fixedorder quantity; management can identify an economic order size. Disadvantage is the added cost of record keeping. Two-bin systems is tow containers of inventory; reorder when the first is empty. Advantage is there is no need to record each withdrawal from inventory; disadvantage is that the reorder card may not be turned in for a variety of reasons. Perpetual systems can be either batch or on-line. In batch systems, inventory records are collected periodically and entered into the system. In on-line systems, the transactions are recorded instantaneously. The advantage of on-line systems is that they are always up-to date. In batch systems, however, a sudden surge in demand could result in reading the amount of inventory below the reorder point between the periodic read-ins. Frequent batch collections can minimize that problem. Universal Product Code. Bar code printed on a label that has information about the item to which it is attached. Demand Forecasts and Lead Time information Inventories are used to satisfy demand requirements, so it is essential to have reliable estimates of the amount and timing of demand. Lead time is time interval between ordering and receiving the order. Cost Information Three basic costs are associated with inventories: 1. Holding (carrying) cost. Cost to carry an item in inventory for a length of time, usually a year. Costs include interest, insurance, taxes, depreciation, obsolescence, deterioration, spoilage, pilferage, breakage, and warehousing costs. Holding costs are stated in either of two ways: as a percentage of unit price or as in dollar amount per unit. 2. Ordering costs. Costs of ordering and receiving inventory. These include determining how much is needed, preparing invoices, inspecting goods upon arrival for quality and

quantity, and moving the goods to temporary storage. Ordering costs are generally expressed as a fixed dollar amount per order. 3. Shortage costs. Costs resulting when demand exceeds the supply of inventory on hand; often unrealized profit per unit. These costs can include the opportunity cost of not making a sale, loss of customer goodwill, late charges, and similar costs. Classification System A-B-C approach. Classifying inventory according to some measure of importance, and allocating control efforts accordingly. Three classes used; A (very important), B (moderately important), and C (least important). Another application of the A-B-C concept is a guide to cycle counting. Cycle counting is a physical count of items in inventory. The purpose of cycle counting is to reduce discrepancies between the amounts indicated by inventory records and the actual quantities of inventory on hand. The American Production and Inventory Control Society (APICS) recommend the following guidelines for inventory record accuracy: +0.2 percent for A items, +1 percent for B items, and +5 percent for C items. How Much to Order: Economic Order Quantity Models Economic order quantity. The order size that minimizes total cost. Three ordered size models are described: 1. The economic order quantity model. 2. The economic order quantity model with noninstantaneous delivery. 3. The quantity discount model. Basic Economic Order Quantity (EOQ) Model The basic EOQ model is the simplest of the three models. It is used to identify the order size that will minimize the sum of the annual costs of holding inventory and ordering inventory. Assumptions: 1. Only one product is involved. 2. Annual demand requirements are known. 3. Demand is spread evenly throughout the year so that the demand rate is reasonably constant. 4. Lead time does not vary. 5. Each order is received in a single delivery. 6. There are no quantity discounts. Annually carrying cost is computed by multiplying the average amount of inventory on hand by the cost to carry one unit for one year, even though any given unit would not be held for a year. Annual carrying cost = (Q/2)H Annual ordering cost is a function of the number of orders per year and the ordering cost per order: Annual ordering cost = (D/Q)S Where S ordering cost The total annual cost associated with carrying and ordering inventory when Q units are ordered each time is: TC = Annual carrying cost + Annual ordering cost An expression for the optimal order quantity, Q o can be obtained: Qo = 2DS/H The length of an order Length of order cycle = Qo /D

EOQ with Non instantaneous Replenishment The basic EOQ model assumes that each order is delivered at a single point in time (instantaneous replenishment). Total cost TCmin = (Imax/2) + (D/Qo)S Where Imax Maximum Inventory The economic run quantity is Where p production or delivery rate u usage rate The maximum and average inventory levels Imax = (Qo/p)(p u) and Iaverage = Imax/2 The cycle time for the economic run size is a function of the run size and usage rate Cycle time = Qo/u The run time is a function of the run size and the production rate Run time = Qo/p Quantity discounts Quantity discounts. Price reductions for large orders. TC = (Q/2)H + (D/Q)S + PD Where PD unit price The objective of the quantity discount model is identify an order quantity that will represent the lowest total cost for the entire set of curves. The procedure for determining the overall EOQ differ slightly, depending on which of these two cases is relevant. For carrying costs that are constant, the procedure is as follows: 1. Compute the common EOQ. 2. Only one of the unit prices will have the EOQ in its feasible range since the ranges do not overlap. Identify that range. a. If the feasible EOQ is on the lowest price range, that is the optimal order quantity. b. If the feasible EOQ is in any other range, compute the total cost for the EOQ and for the price breaks of all lower unit costs. Compare the total costs; the quantity that yields the lowest total cost is the optimal order quantity. When carrying costs are expressed as a percentage of price, determine the best purchase quantity with the following procedure: 1. Beginning with the lowest price, compute the EOQs for each price range until a feasible EOQ is found. 2. If the EOQ for the lowest price is feasible, it is the optimal order quantity. If the EOQ is not the lowest price range, compare the total cost at the price break for all lower prices with the total cost of the largest feasible EOQ. The quantity that yields the lowest total cost is the optimum. When to Reorder with EOQ Ordering Reorder point (ROP). When the quantity on hand of an item drops to this amount, the item is reordered. Q0 = 2DS/H x p/p u

The basic concern of the manager is to place an order when the amount of inventory on hand is sufficient to satisfy demand during the time it takes to receive that order. There are four determinants of the reorder point quantity: 1. The rate of demand 2. The length of lead time 3. The extent of demand and/or lead time variability 4. The degree of stock-out risk acceptable to management Where d demand per day or week LT lead time in days or weeks ROP = d x LT

Safety stock. Stock that is held in excess of expected demand due to variable demand rate and/or lead time. ROP = Expected demand during lead time + Safety stock Service level. Probability that demand will not exceed supply during lead time. Service level = 100 percent Stock-out risk The amount of safety stock that is appropriate for a given situation depends on the following factors: 1. the average demand rate and average lead time 2. demand and lead time variability 3. desired service level Several models will be described that can be used in cases when variability is present. The first model can be used if an estimate of expected demand during lead time and its standard deviation are available. ROP = expected demand during lead time + z dLT Where z number of standard deviations dLT the standard deviation of lead time demand Shortages and Service Levels The ROP computation does not reveal the expected amount of shortage for a given lead time service level. E(n) = E(z) dLT Where E(n) expected number of units short per order cycle E(z) standardized number of units short obtained dLT standard deviation of lead time demand Having determined the expected number of units short for an order cycle, determine the expected number of units short per year. It is simply the expected number of units short per cycle multiplied by the number per year. E(N) = E(n) D/Q Whre E(N) expected number of units short per year The annual service level and the lead time service level can be related using the following formula: SLannual= 1 [E(N)/D]

SLannual= 1 [E(z) dLT /Q] How Much to Order: Fixed-Order-Interval Model Fixed-order-interval model. Order are placed at fixed time intervals. There are number of differences between these two approaches to reordering. Both are sensitive to demand to demand experience just prior to reordering, but in somewhat different ways. In the fixed-quantity model, a higher than normal demand causes a shorter time between orders, whereas in the fixed interval model, the result is a large order size. Another difference is that the fixed quantity model requires close monitoring of inventory levels in order to know when the amount on hand has reached the reorder point. The fixed-interval model requires only a periodic review of inventory levels just prior to placing an order to determine how much is needed. Reasons for Using the Fixed Order Interval Model Under certain conditions, the use of fixed order intervals is very practical. The alternative for them is to use fixed interval ordering, which requires only periodic checks of inventory levels. Determining the Amount to Order If both the demand rate and lead time are constant, the fixed interval model and the fixed quantity model function identically. The differences in the two models become apparent only when examined under conditions of variability. In the fixed quantity arrangement, orders are triggered by a quantity while in the fixed interval arrangement orders are triggered in time. Therefore, the fixed interval system must have stock out protection for lead time plus the next order cycle, but the fixed quantity system needs protection only during lead time since additional orders can be placed at any time and will be received shortly thereafter. Order size in the fixed interval model is determined by the following computation: Amount to order = Expected demand during protection interval + Safety stock Amount on hand at reorder time Benefits and Disadvantages The fixed interval system results in the tight control needed for A items in an ABC classification due to the periodic reviews it requires. In addition, when two or more items come from the same supplier, grouping orders can yield savings in ordering, packing, and shipping costs. Moreover, it may be the only practical approach if inventory withdrawals cannot be closely monitored. On the negative side, the fixed interval system necessitates a larger amount of safety stock for a given risk of stock out because of the need to protect against shortages during an entire order interval plus lead time, and this increases the carrying cost. Also, there are the costs of the periodic reviews Single-period model. Model ordering of perishables and other items with limited useful lives. Analysis of single-period situations generally focuses on two costs: Shortage cost. May include a charge a loss of customer goodwill as well as the opportunity cost of lost sales. Cs = Revenue per unit Cost per unit Excess cost. Difference between purchase cost and salvage value of items left over at the end of a period. Ce = original cost per unit salvage value per unit The goal of the single-period model is to identify the order quantity, or stocking level, that will minimize the long run excess cost per unit.

There are two general categories of problems that we will consider: those for which demand can be approximated using a continuous distribution and those for which demand can be approximated using a discrete distribution. Continuous Stocking Levels The concept of identifying an optimal stocking level is perhaps easiest to visualize when demand is uniform. Choosing the stocking level is similar to balancing a seesaw, but instead of a person on each end of the seesaw, we have excess cost per unit (C e) on one end of the distribution and shortage cost per unit (C s) on the other. The optimal stocking level is analogous to the fulcrum of the seesaw; the stocking level equalizes the cost weights. The service level is the probability that demand will not exceed the stocking level, and computation of the service level is the key to determining the optimal stocking Service level = Cs/(Cs+ Cs) Where Cs Shortage cost per unit Ce Excess cost per unit Discrete Stocking Levels When stocking levels are discrete rather than continuous, the service lead computed using the ratio Cs/(Cs + Ce) usually does not coincide with a feasible stocking level. The solution is to stock at the next higher level. In other words, choose the stocking level so that the desired service level is equaled ore exceeded. One final point about discrete stocking levels: If the computed service level is exactly equal to the cumulative probability associated with one of the stocking levels, there are two equivalent stocking levels in terms of minimizing long-run cost the one with equal probability and the next higher one. OPERATIONS STRATEGY Inventories are a necessary part of doing business, but having too much inventory is not good. One reason is that inventories tend to hide problems; they make it easier to live with problems rather than eliminate them. Another reason is that inventories are costly to maintain. Consequently, a wise operation strategy is to work toward cutting back inventories by (1) reducing lot size and (2) reducing safety stocks. Japanese manufacturers use smaller lot sizes than their Western counterparts because they have a different perspective on inventory carrying costs. In addition to the usual components, the Japanese recognize the opportunity costs of disrupting the work flow, inability to place machines and workers closer together, and hiding problems related to product quality and equipment breakdown. When these are factored in, carrying costs become higher perhaps much higher than before.