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

Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints. Prepared by Douglas Cloud Pepperdine University. Objectives. 1. Describe the just-in-case inventory management model. 2. Discuss just-in-time (JIT) inventory management.

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

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  1. Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints Prepared by Douglas Cloud Pepperdine University

  2. Objectives 1. Describe the just-in-case inventory management model. 2. Discuss just-in-time (JIT) inventory management. 3. Explain the basic concepts of constrained optimization. 4. Define the theory of constraints, and tell how it can be used to manage inventory. After studying this chapter, you should be able to:

  3. Just-in-Case Inventory Management Three types of inventory costs can be readily identified with inventory: • The cost of acquiring inventory. • The cost of holding inventory. • The cost of not having inventory on hand when needed.

  4. Economic Order Quantity 1. Ordering Costs: The costs of placing and receiving an order. Examples:Clerical costs, documents, insurance for shipment, and unloading. 2. Carrying Costs: The costs of carrying inventory. Examples:Insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, and storage.

  5. Economic Order Quantity 3. Stock-Out Costs: The costs of not having sufficient inventory. Examples:Lost sales, costs of expediting (extra setup, transportation, etc.) and the costs of interrupted production. 4. Setup Costs: The costs of preparing equipment and facilities so they can be used to produce a particular product or component. Examples:Setup labor, lost income (from idled facilities), and test runs.

  6. Traditional Reasons for Carrying Inventory 1. To balance ordering or setup costs and carrying costs 2. Demand uncertainty 3. Machine failure 4. Defective parts 5. Unavailable parts 6. Late delivery of parts 7. Unreliable production processes 8. To take advantage of discounts 9. To hedge against future price increases

  7. The total ordering (or setup) and carrying cost The cost of placing and receiving an order (or the cost of setting up a production run) The known annual demand The number of units ordered each time an order is placed (or the lot size for production) The cost of carrying one unit of stock for one year Economic Order Quantity TC = PD/Q + CQ/2

  8. An EOQ Illustration EOQ =  (2 x 25,000 x $40) / $2 EOQ =  1,000,000 EOQ = 1000 units EOQ =  2PD/C D = 25,000 units Q = 500 units P = $40 per order C = $2 per unit

  9. When to Order or Produce Reorder point = Rate of usage x Lead time Example: Assume that the average rate of usage is 4 units per day for a component. Assume also that the time required to place and receive an order is 10 days. What is the reorder point? Reorder point = 4 x 10 = 40units Thus, an order should be placed when inventory drops to 40 units.

  10. The Reorder Point Reorder point = Rate of usage x Lead time Inventory (units) (EOQ) 1000 800 600 400 200 0 Reorder Point 2 4 6 8 10 12 14 16 18 20 Days

  11. Maximum usage 120 Average usage -100 Difference 20 Lead time x 4 Safety stock 80 Demand Uncertainty and Reordering To avoid running out of parts, organizations often choose to carry safety stock. Safety stock is extra inventory carried to serve as insurance against fluctuations in demand. Example: If the maximum usage of the VCR part is 120 units per day, the average usage is 100 units per day, and the lead time is four days, the safety stock is 80.

  12. Example Involving Setups Expedition Company manufactures edgers. The manager is trying to determine the size of the production run. The controller has supplied the following information: Average demand for edgers: 720 per day Maximum demand for edgers: 780 per day Annual demand for edgers: 180,000 Unit carrying cost: $4 Setup cost: $10,000 Lead time: 22 days

  13. EOQ =  2PD/C EOQ = (2 x 180,000 x $10,000)/$4 EOQ =  900,000,000 Example Involving Setups EOQ = 30,000 edgers

  14. Example Involving Setups Safety stock: Maximum usage 780 Average usage 720 Difference 60 Lead time x 22 Safety stock 1,320 Reorder point = (Average usage x Lead time) + Safety stock Reorder point = (720 x 22) + 1,320 Reorder point = 17,160 edgers

  15. JIT Inventory Management Setup and Carrying Costs: The JIT Approach JIT reduces the costs of acquiring inventory to insignificant levels by: 1. Drastically reducing setup time 2. Using long-term contracts for outside purchases Carrying costs are reduced to insignificant levels by reducing inventories to insignificant levels.

  16. JIT Inventory Management Due-Date Performance: The JIT Solution Lead times are reduced so that the company can meet requested delivery dates and to respond quickly to customer demand. Lead times are reduced by: • reducing setup times • improving quality • using cellular manufacturing

  17. JIT Inventory Management Avoidance of Shutdown: The JIT Approach • Total preventive maintenance to reduce machine failures • Total quality control to reduce defective parts • The use of the Kanban system is also essential

  18. What is the Kanban System? A withdrawal Kanban A production Kanban A vendor Kanban A card system is used to monitor work in process The Kanban system is responsible for ensuring that the necessary products are produced in the necessary quantities at the necessary time.

  19. Withdrawal Kanban Item no.__________________________ Preceding Process Item name_____________________________________ Computer Type_________________________________ Box Capacity_____________________Subsequent Process Box Type_______________________________________________ 15670T07 Circuit Board CB Assembly TR6547 PC 8 C Final Assembly

  20. Item no.__________________________ Preceding Process Item name_____________________________________ Computer Type___________________ Box Capacity_____________________ Box Type______________________________ Production Kanban 15670T07 Circuit Board CB Assembly TR6547 PC 8 C

  21. Item no.____________________Name of Receiving Company Item name_____________________________________ Box Capacity___________________ Box Type___________________ _ _ Time to Deliver__________________________________________ Name of Supplier_________________________________________ Vendor Kanban 15670T07 Circuit Board Electro PC 8 Receiving Gate A 75 8:30 A.M., 12:30 P.M., 2:30 P.M. Gerry Supply

  22. The Kanban Process (7) Withdrawal Store (1) Lot with P-Kanban CB Assembly (1) Remove W-Kanban Attach to Post (5) Attach W-Kanban (6) Signal Remove (4) P-Kanban Attach to Post CB Stores (2), (3) Withdrawal Post Production Ordering Post Final Assembly

  23. Discounts and Price Increases: JIT Purchasing Versus Holding Inventories JIT Inventory Management • Careful vendor selection • Long-term contracts with vendors • Prices are stipulated (usually producing a significant savings) • Quality is stipulated • The number of orders placed are reduced

  24. JIT 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.

  25. Total contribution margin Linear Programming The unit contribution margins are $300 and $600 for X and Y, respectively. Z = $300X + $600 Y This equation is called the objective function, the function to be optimized.

  26. Internal constraints: X + Y  80 X + 3Y  120 2X + Y  90 External constraints: X  60 Y  100 Linear Programming

  27. Linear Programming X + Y  80 X + 3Y  120 2X + Y  90 X  60 Y  100 X  0 Y  0

  28. Multiple Constrained Resource 2X + Y  90 X + Y  80 X + 3Y  120 160 140 120 100 80 60 40 20 X  60 Y  100 20 40 60 80 100 120 140

  29. B C D A Multiple Constrained Resource 160 140 120 100 80 60 40 20 20 40 60 80 100 120 140

  30. Linear Programming Corner Point X-Value Y-Value Z = $300X + $600Y A 0 0 $ 0 B 0 40 24,000 C 30 30 27,000 D 45 0 13,500 C is the optical solution!

  31. Throughput Inventory Operating expenses Theory of Constraints (Sales revenue – Unit-level variable expenses)/Time Three Measures of Systems Performance:

  32. Five-Step Method for Improving Performance 1. Identify an organization’s constraints. 2. Exploit the binding constraints. 3. Subordinate everything else to the decisions made in Step 2. 4. Elevate the organization’s binding constraints. 5. Repeat the process as a new constraint emerges to limit output.

  33. The Drum-Buffer-Rope System Initial Process Process C Rope Process A Final Process Process B Finished Goods Time Buffer Drummer Process Materials

  34. 2X + Y  90 X + Y  80 X + 3Y  240 New Constraint Set: Schaller Co. 160 140 120 100 80 60 40 20 X  60 Y  100 20 40 60 80 100 120 140 160 200 220 240

  35. D A B C New Constraint Set: Schaller Co. 160 140 120 100 80 60 40 20 20 40 60 80 100 120 140 160 200 220 240

  36. End of Chapter

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