Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints

1. Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints Chapter 20

2. chapter 20 Objectives • Describe the just-in-case inventory management model • Discuss just-in-time (JIT) inventory management • Explain the basic concepts of constrained optimization • Define the theory of constraints, and tell how it can be used to manage inventory

3. Just-In-Case Inventory Management Just-in-case inventory management: a traditional inventory model based on anticipated demand Three types of inventory costs can be readily identifies with inventory • The cost of acquiring inventory • The cost of holding inventory • The cost of not having inventory on hand when needed LO-1

4. Just-In-Case Inventory Management Ordering costs: costs of placing and receiving an order Examples: costs of processing an order (clerical costs and documents), insurance for shipment, and unloading costs LO-1

5. Just-In-Case Inventory Management Setup costs: costs of preparing equipment and facilities so they can be used to produce a particular product or component Examples: wages of idled production workers, the cost of idled production facilities (lost income), and the costs of test runs (labor, materials, and overhead) LO-1

6. Just-In-Case Inventory Management Carrying costs: costs of holding inventory Examples: insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, handling costs, and storage LO-1

7. Just-In-Case Inventory Management Stock-out costs: costs of not having a product available when demanded by a customer Examples: lost sales (both current and future), the costs of expediting (increased transportation charges, overtime, and so on), and the costs of interrupted production LO-1

8. EXHIBIT 20.1—Traditional Reasons for Carrying Inventory LO-1

9. Just-In-Case Inventory Management Economic Order Quantity: A Model for Balancing Acquisition and Carrying Costs To develop an inventory policy that deals with the tradeoff between acquisition costs and carrying costs, two basic questions must be addressed • How much should be ordered (or produced) to minimize inventory costs? • When should the order be placed (or the setup done)? LO-1

10. Just-In-Case Inventory Management Minimizing Total Ordering and Carrying Costs Assuming that demand is known, the total ordering (or setup) and carrying cost can be described by the following equation TC = PD/Q + CQ/2 = Ordering (or setup) cost + Carrying cost where TC = the total ordering and carrying cost P = the cost of placing and receiving an order Q=the number of units ordered each time an order is placed D = the known annual demand C = the cost of carrying one unit of stock for one year LO-1

11. Just-In-Case Inventory Management The objective of inventory management is to identify the order quantity that minimizes the total cost, called the economic order quantity LO-1

12. Just-In-Case Inventory Management When to Order or Produce Reorder point: point in time when a new order should be placed Lead time: time required to receive the economic order quantity once an order is place or a setup is initiated Reorder point = Rate of usage × Lead time LO-1

13. Just-In-Case Inventory Management When to Order or Produce If the demand for a product is not known with certainty, the possibility of a stock-out exits • Safety stock can help avoid this • Safety stock is extra inventory carried to serve as insurance against fluctuations in demand Reorder point = (Average rate of usage × Lead time) + Safety stock LO-1

14. EXHIBIT 20.2—THE REORDER POINT LO-1

15. EXHIBIT 20.3—EOQ and Reorder Point Illustrated LO-1

16. JIT Inventory Management Setup and Carrying Costs: The JIT/Lean Approach Long-term contracts: negotiating long-term contracts for the supply of outside materials will obviously reduce the number of orders and the associated ordering costs Continuous replenishment: a manufacturer assumes the inventory management function for the retailer Electronic data interchange (EDI): allows suppliers access to a buyer’s online database LO-2

17. JIT Inventory Management Due-Date Performance: The JIT (Lean) Solution Measure of a firm’s ability to respond to customer needs Lead times are reduced so that the company can meet requested delivery dates and to respond quickly to the demands of the market Lead times are reduced by reducing setup times, improving quality, and using cellular manufacturing LO-2

18. JIT Inventory Management Avoidance of Shutdown and Process Reliability: The JIT/Lean Approach Total preventive maintenance: zero machine failures Total quality control: the problem of defective parts is solved by striving for zero defects The Kanban system: ensure that parts or materials are available when needed LO-2

19. JIT Inventory Management The Kanban System Withdrawal Kanban specifies the quantity that a subsequent process should withdraw from the preceding process A production Kanban specifies the quantity that the preceding process should produce A vendor Kanban is used to notify suppliers to deliver more parts; it also specifies when the parts are needed LO-2

20. EXHIBIT 20.4—Withdrawal Kanban LO-2

21. EXHIBIT 20.5—Production Kanban LO-2

22. EXHIBIT 20.6—Vendor Kanban LO-2

23. EXHIBIT 20.7—The Kanban Process LO-2

24. JIT Inventory Management Discounts and Price Increases: JIT Purchasing Versus Holding Inventories Negotiate long-term contracts with a few chosen suppliers located close to the production facility and establish more extensive supplier involvement • Stipulate prices and acceptable quality levels • Reduce dramatically the number of orders placed, which helps to drive down the ordering cost LO-2

25. JIT Inventory Management JIT’s Limitations Patience in implications is needed Time is required JIT may cause lost sales and stressed workers Production may be interrupted due to an absence of inventory LO-2

26. Basic Concepts of Constrained Optimization Every firm faces limited resources and limited demand for each product • External constraints: limiting factors imposed on the firm from external sources, such as market demand • Internal constraints: limiting factors found within the firm, such as machine or labor time availability LO-3

27. Basic Concepts of Constrained Optimization Loose constraints: constraints whose limited resources are not fully used by a product mix are Binding constraint: a product mix that uses all of the limited resources of a constraint Constrained optimization is choosing the optimal mix given the constraints faced by the firm LO-3

28. Basic Concepts of Constrained Optimization One Binding Internal Constraint The function to be optimized (maximized in the case of contribution margin) is called the objective function LO-3

29. Basic Concepts of Constrained Optimization Multiple Internal Binding Constraints Linear programming model: expresses a constrained optimization problem as a linear objective function subject to a set of linear constraints All constraints, taken together, are referred to as the constraint set A feasible solution is a solution that satisfies the constraints in the linear programming model Linear programming is a method that searches among possible solutions until it finds the optimal solution LO-3

30. EXHIBIT 20.8—Constraint Data: Schaller Company LO-3

31. EXHIBIT 20.9—graphical solution LO-3

32. Theory of Constraints (TOC) Goal is to make money now and in the future by managing constraints Recognizes that the performance of any organization (system) is limited by its constraints Focuses on the system-level effects of continuous improvement LO-4

33. Theory of Constraints (TOC) Operational Measures TOC focuses on three operational measures of systems performance • Throughput: rate at which an organization generates money through sales Throughput = (Sales revenue – Unit level variable expenses)/Time • Inventory: all the money the organization spends in turning materials into throughput • Operating expenses:all the money the organization spends in turning inventories into throughput and represent all other money that an organization spends LO-4

34. Theory of Constraints (TOC) Five Step Method for Improving Performance Identify an organization’s constraints Exploit the binding constraints Subordinate everything else to the decisions made in Step 2 Elevate the organization’s binding constraints Repeat the process as a new constraint emerges to limit output LO-4

35. exhibit 20.10—Drum-Buffer-Rope System: General Description LO-4

36. exhibit 20.11—Drum-Buffer-Rope: Schaller Company LO-4

37. exhibit 20.12—New Constraint Set: Schaller Company LO-4

38. End of Chapter 20