INE446 Production Systems II

Lecture 1
The Importance of Inventory Management and Production Planning and Scheduling
Frameworks for Inventory Management and Production Planning and Scheduling

1
Economic Indicators:
Rising costs in inventory and transportation

2
Fluctuations but with Trends

3
Why Aggregate Inventory Investment Fluctuates:
The Business Cycle

4
Hiking to the peak then
down to the trough
• The economy expands.
• Managers are optimistic about future
sales.
• They become overzealous in their
optimism.
• Too many products are manufactured
but cannot be sold.
• Surplus goods increase aggregate
inventories
• Producers start to decrease
production levels.
• Eventually, the rate of sale exceeds
the rate of production of goods.
• The resulting disinvestment in History:
inventories creates a recession during The financial crisis of 2007–2008 led to a rapid drop in
which prices, production, and profits sales and a subsequent buildup of inventory
fall and unemployment is prevalent.
5
The business cycle
Inventory liquidations economic recovery
drop prices

Firms expand their operations hire additional

A crisis follows with uncertainty and more money into

money scarcity causes the banks to Consumers, with money to spend, start
raise their interest rates. to bid up prices of available goods

costs of materials increase by competing executives expand

6
Corporate Strategy and the Role of Top Management
• The key organizational role of top managers is strategic business planning.
• Senior management has the responsibility for defining in broad outline
what needs to be done, and how and when it should be done.
• Four levels of strategy can be delineated (listed from the highest to the
lowest level):
1. Enterprise Strategy: What role does the organization play in the economy and in
society? What should be its legal form and how should it maintain its moral
legitimacy?
2. Corporate Strategy: What set of businesses or markets should the corporation
serve? How should resources be deployed among the businesses?
3. Business Strategy: How should the organization compete in each particular
industry or product/market segment? Based on price, service, or what other factor
there is?
4. Functional Area Strategy: At this level, the principal focus of strategy is on the
maximization of resource productivity and the development of distinctive
competencies.

7
The Relationship of Finance to Inventory
Management and Production Planning and
Scheduling
• Income statements represent the flow of revenues and expenses for a
given period (e.g., 1 year). Specifically,
Operating profit = Revenue − Operating expenses
• Changes in inventory levels can affect both terms on the right side of
the equation:
• Sales revenue increase if inventories are allocated among different items in an
improved way.
• Inventory carrying charges represent a significant component of operating
expenses, this term can be reduced if aggregate inventory levels decrease.

8
Inventory Turn-over (Stockrun)
• Defined as

• An increase in sales without a corresponding increase in inventory will

9
Complexities in Inventory Management - Production
• Items produced and held in inventory can differ in many ways.
• They may differ in cost, weight, volume, color, or physical shape.
• Units may be stored in crates, in barrels, on pallets, in cardboard boxes, or loose on shelves.
• They may be packaged by the thousands or singly.
• They may be perishable because of deterioration over time, perishable through theft and
pilferage, or subject to obsolescence because of style or technology.
• Some items are stored in dust-proof, temperature-controlled rooms, while others can lie in
mud, exposed to the elements.

10
Complexities in Inventory Management - Demand
• Demand for items also can occur in many ways:
• Items may be withdrawn from inventory by the thousands, by the dozen, or unit by unit.
• They may be substitutes for each other, so that, if one item is out of stock, the user may be
willing to accept another. Items can also be complements; that is, customers will not accept
one item unless another is also available.
• Units could be picked up by a customer, or they may have to be delivered by company-owned
vehicles or shipped by rail, boat, airplane, or truck.
• Some customers are willing to wait for certain types of products; others expect immediate
service on demand. Many customers will order more than one type of product on each
purchase order submitted.

11
Complexities in Inventory Management - Delivery
• Goods also arrive to inventory in a variety of modes different quantities different
as ordered:
• Some goods arrive damaged; others differ in number or kind from that which was
requisitioned (from a supplier or from an in-house production operation).
• Some items are unavailable because of strikes or other difficulties in-house or at a supplier’s
plant.
• Delivery of an order may take hours, weeks, or even months, and the delivery time may or
may not be known in advance

12
Decision making in production, inventory, and
supply chain management
Three basic issues must be resolved:
1. How often the inventory status should be determined
2. When a replenishment order should be placed
3. How large the replenishment order should be

13
Functional Classifications of Inventories
• Cycle Inventory or batch stocks
• Congestion stocks
• Safety Stocks
• Anticipation inventory
• Pipeline or Work-in-process inventory (WIP)
• Decoupling stock

14
Cycle Inventory
• Cycle inventories result from an attempt to order or produce in
batches instead of one unit at a time.
• The amount of inventory on hand, at any point, that results from
these batches is called cycle stock.
• The reasons for batch replenishments include
(1) economies of scale (because of large setup costs),
(2) quantity discounts in purchase price or freight cost, and
(3) technological restrictions such as the fixed size of a processing tank in a
chemical process.
• The amount of cycle stock on hand at any time depends directly on
how frequently orders are placed.

15
Congestion stocks
• When multiple items share the same production equipment,
particularly when there are significant setup times, inventories of
these items build up as they wait for the equipment to become
available.

16
Safety Stocks
• Safety stock is the amount of inventory kept on hand, on the average,
to allow for the uncertainty of demand and the uncertainty of supply
in the short run.
• Safety stocks are not needed when the future rate of demand and the
length of time it takes to get complete delivery of an order are known
with certainty.
• The level of safety stock is controllable in the sense that this
investment is directly related to the desired level of customer service
(i.e., how often customer demand is met from stock).

17
Anticipation inventory
• Anticipation inventory consists of stock accumulated in advance of an
expected peak in sales.
• When demand is regularly lower than average during some parts of
the year, excess inventory (above cycle and safety stock) can be built
up so that, during the period of high anticipated requirements, extra
demand can be serviced from stock rather than from working
overtime in the plant or purchasing from the market.
• The aggregate production rate can be stabilized through the use of
anticipatory stock.
• Anticipation stock can also occur because of seasonality of supply
such tomato cropping to produce ketchup products.

18
Work-in-process inventory
• Pipeline (or WIP) inventories include goods in transit (e.g., in physical
pipelines, on trucks, or in railway cars) between levels of a
multiechelon distribution system or between adjacent workstations in
a factory.
• The pipeline inventory of an item between two adjacent locations is
proportional to the usage rate of the item and to the transit time
between the locations.

19
Decoupling stock
• Decoupling stock is used in a multi-echelon situation to permit the
separation of decision making at the different echelons.
• For example, decoupling inventory allows decentralized decision
making at branch warehouses without every decision at a branch
having an immediate impact on the central warehouse or factory.

20
Stock-Keeping Units
• The specific unit of stock to be controlled will be called a stock-
keeping unit (or SKU), where an SKU will be defined as an item of
stock that is completely specified as to function, style, size, color, and,
often, location.
• Examples:
• The same-style shoes in two different sizes would constitute two different
SKUs.
• Each combination of size and grade of steel rod in raw stock constitutes a
separate SKU.
• An oil company must regard each segregation of crude as a separate SKU.
• A tire manufacturer would normally treat the exact same tire at two
geographically remote locations as two distinct SKUs.

21
Inventory Distribution by Value (DBV)
• A DBV curve can be developed as follows:
• The value 𝑣, in dollars per unit, and the annual usage (or demand) 𝐷, in
specific units, of each SKU in inventory are identified.
• Then, the product 𝐷𝑣 is calculated for each SKU, and the 𝐷𝑣 values for all
SKUs are ranked in descending order starting with the largest value.

22
The A–B–C Classification
• Class A items should receive the most personalized attention from
management. The first 5%–10% of the SKUs, as ranked by the DBV analysis,
are often designated for this most important class of items although up to
20% of the SKUs can be designated as class A in some settings. Usually,
these items also account for about 50% or more of the total annual dollar
movement (σ 𝐷𝑣) of the population of items under consideration.
• Class B items are of secondary importance in relation to class A. These
items, because of their 𝐷𝑣 values or other considerations, rate a moderate
but significant amount of attention. The largest number of SKUs fall into
this category—usually more than 50% of total SKUs, accounting for most of
the remaining 50% of the annual dollar usage.
• Class C items are the relatively numerous remaining SKUs that make up
only a minor part of the total dollar investment. For these SKUs, decision
systems must be kept as simple as possible.

23
A-B-C classification on 𝐷𝑣 cumulative percentages
versus total number of SKUs
Class c

Class B

Class A

24
Reference: https://www.eazystock.com/blog/calculate-apply-abc-classification-inventory/
The Product Life Cycle
• Three basic generalizations seem to hold for total annual sales over
time:
1. Products have a limited life. They are introduced to the market, may (or may
not) pass through a strong growth phase, and eventually decline or
disappear.
2. Product profits tend to follow a predictable course through the life cycle.
Profits are absent in the introductory stage, tend to increase substantially in
the growth stage, slow down and then stabilize in the maturity and
saturation stages, and can disappear in the decline stage.
3. Products require a different marketing, production planning, inventory
management, and financial strategy in each stage. The emphasis given to
the different functional areas must also change.

26
Product Life Cycle

27
Types of Production Processes - 1

28
Types of Production Processes - 2

29
Types of Production Processes - 3

30
Types of Production Processes - 4

31
The Product-Process Matrix

32
Production Planning and Scheduling systems

33
Cost Factors in Inventory Management
• The Unit Value or Unit Variable Cost, 𝑣
• The Cost of Carrying Items in Inventory
• The Ordering or Setup Cost, 𝐴
• The Costs of Insufficient Capacity in the Short Run or the Stockout
Cost.

34
The Unit Value or Unit Variable Cost, 𝑣
• The unit value (denoted by the symbol 𝑣) of an item is expressed in
dollars per unit.
• For a merchant it is simply the price (including freight) paid to the
supplier, plus any cost incurred to make it ready for sale. It can
depend, via quantity discounts, on the size of the replenishment.
• For producers, the unit value of an item is usually more difficult to
determine.

35
The Cost of Carrying Items in Inventory
• The cost of carrying items in inventory includes the opportunity cost of the
money invested, the expenses incurred in running a warehouse, handling
and counting costs, the costs of special storage requirements, deterioration
of stock, damage, theft, obsolescence, insurance, and taxes.
• The most common convention of costing is to use
ҧ
Carrying costs per year = 𝐼𝑣𝑟
• where 𝐼 ҧ is the average inventory in units (hence 𝐼𝑣ҧ is the average inventory
expressed in dollars), and 𝑟 is the carrying charge, the cost in dollars of
carrying one dollar of inventory for 1 year.
• By far, the largest portion of the carrying charge is made up of the
opportunity costs of the capital tied up that otherwise could be used
elsewhere in an organization and the opportunity costs of warehouse
space claimed by inventories.

36
The Ordering or Setup Cost, 𝐴
• The fixed cost is independent of the size of the replenishment and is
associated with a new order for replenishment.
• For a merchant, it is called an ordering cost and it includes the cost of
order forms, postage, telephone calls, authorization, typing of orders,
receiving, (possibly) inspection, following up on unexpected
situations, and handling of vendor invoices.
• For a producer, the production setup cost includes many of these
components and other costs related to interrupted production.

37
The Costs of Insufficient Capacity in the Short Run
or the Stockout Cost.
• These costs could also be called the costs of avoiding stockouts and the
costs incurred when stockouts take place.
• In the case of a producer, they include the expenses that result from
changing over equipment to run emergency orders and the attendant costs
of expediting, rescheduling, split lots, and so forth.
• For a merchant, they include emergency shipments or substitution of a
less-profitable item.
• All these costs can be estimated reasonably well. However, there are also
costs, that can result from not servicing customer demand.
• Will the customer be willing to wait while the item is backordered, or is the sale lost
for good?
• How much goodwill is lost as a result of the poor service?
• Will the customer ever return?
• Will the customer’s colleagues be told of the disservice?

38
Replenishment Lead Time, 𝐿
• the replenishment lead time, as the time that elapses from the
moment at which it is decided to place an order, until it is physically
on the shelf ready to satisfy customers’ demands.
• The symbol 𝐿 will be used to denote the replenishment lead time.
• The lead time is made up of five distinct components:
1. Administrative time at the stocking point (order preparation time)
2. Order transit time to the supplier
3. Time at the supplier: if L is variable, this time is responsible for most of the
variability. Its duration is materially influenced by the availability of stock at
the supplier when the order arrives.
4. Physical transit time back to the stocking point.
5. Time from order receipt until it is available on the shelf: this time is often
wrongly neglected. Certain activities, such as inspection and cataloging, can
take a significant amount of time.

39