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Chapter 15. Inventory Management

Chapter 15. Inventory Management. Inventory is the stock of any item or resource used in an organization and can include: raw materials, finished products, component parts, supplies, and work-in-process

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Chapter 15. Inventory Management

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  1. Chapter 15. Inventory Management • Inventoryis the stock of any item or resource used in an organization and can include: raw materials, finished products, component parts, supplies, and work-in-process • An inventory system is the set of policies and controls that monitor levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be • Firms invest 25-35 percent of assets in inventory but many do not manage inventories well

  2. Purposes of Inventory • To maintain independence of operations • Provide “optimal” amount of cushion between work centers • Ensure smooth work flow • To allow flexibility in production scheduling • To meet variation in product demand • To provide a safeguard for variation in raw material or parts delivery time • Protect against supply delivery problems (strikes, weather, natural disasters, war, etc.) • To take advantage of economic purchase-order size

  3. Inventory Control (Management) • Independent vs. Dependent Demand • Inventory costs • Single-Period Model • Multi-Period Models: Basic Fixed-Order Quantity Models • Event triggered (Example: running out of stock, or dropping below a “reorder point”) • EOQ, EOQ with reorder point (ROP) , and with safety stock • Multi-Period Models: Basic Fixed-Time Period Model • EOQ with Quantity Discounts • ABC analysis

  4. Independent vs. Dependent Demand Independent Demand (Demand not related to other items or the final end-product) Dependent Demand (Derived demand items for component parts, subassemblies, raw materials, etc.) E(1)

  5. Inventory Costs • Holding (or carrying) costs. • Costs for capital, taxes, insurance, etc. (Dealing with storage and handling) • Setup (or production change) costs. (manufacturing) • Costs for arranging specific equipment setups, etc. • Ordering costs (services & manufacturing) • Costs of someone placing an order, etc. • Shortage (backordering) costs. • Costs of canceling an order, customer goodwill, etc.

  6. A Single-Period Model • Sometimes referred to as the newsboy problem • Is used to handle ordering of perishables (fresh seafood, cut flowers, etc.) and items that have a limited useful life (newspaper, magazines, high fashion goods, some high tech components, etc) • The optimal stocking level uses marginal analysis is where the expected profit (benefit from derived from carrying the next unit) is less than the expected cost of that unit (minus salvage value) • Co = Cost/unit of overestimated demand (excess demand) Co = Cost per unit – salvage value per unit • Cu = Cost/unit of underestimated demand Cu = Price/unit – cost/unit + cost of loss of goodwill per unit • Optimal order level is where P <= Cu /(Co + Cu ) • This model states that we should continue to increase the size of the inventory so long as the probability of selling the last unit added is equal to or greater than the ratio of: Cu/Co+Cu

  7. Single Period Model Example • UNC Charlotte basketball team is playing in a tournament game this weekend. Based on our past experience we sell on average 2,400 shirts with a standard deviation of 350. We make $10 on every shirt we sell at the game, but lose $5 on every shirt not sold. How many shirts should we make for the game? • Determine Cu = $10 and Co= $5 (this time, these were directly given) • Compute P≤ $10 / ($10 + $5) = 0.667  66.7% • Order up to ~ 66.7% of the demand • How do you determine it? • Normal distribution, Z transformation, • Z0.667 = 0.432 (use NORMSDIST(.667) or Appendix E) • Therefore we need 2,400 +0.432(350) = 2,551 shirts

  8. Single Period Model, Marginal Analysis • Marginal analysis approach. • Consider solved problem 1, p. 617 • Determine Cu = 100-70 = $30 and Co= 70-20 = $50 • Compute P≤ 30/(30+50)  0.375 • Develop a full marginal analysis table (Excel time!) • Assume we purchase 35 units, compute the expected total cost • Repeat step 4, for 36,…, 40 • The optimal order (purchase) size is the no. of units with the minimum expected total cost

  9. Fixed-Order Quantity Models: Assumptions • Demand for the product is constant and uniform throughout the period. • Inventory holding cost is based on average inventory. • Ordering or setup costs are constant. • All demands for the product will be satisfied. (No back orders are allowed.) • Lead time (time from ordering to receipt) is constant (later, this assumption is relaxed with “safety stocks”). • Price per unit of product is constant.

  10. Usage rate Q ROP Time Place order Place order Receive order Receive order Receive order Lead time (L) ROP = Reorder point Q = Economic order quantity L = Lead time Basic Fixed-Order Quantity Model and Reorder Point Behavior

  11. Total Cost Cost Minimization Goal By adding the item, holding, and ordering costs together, we determine the total cost curve, which in turn is used to find the Qoptimal (a.k.a. “EOQ”) inventory order point that minimizes total costs. C O S T Holding Costs Annual Cost of Items (DC) Ordering Costs QOPTIMAL Order Quantity (Q)

  12. Annual Purchase Cost Annual Ordering Cost Total Annual Cost = + + TC = Total annual cost D = Demand C = Cost per unit Q = Order quantity S = Cost of placing an order or setup cost H = Annual holding and storage cost per unit of inventory R or ROP = Reorder point L = Lead time (constant) = average (daily, weekly, etc) demand σL = Standard deviation of demand during lead time Basic Fixed-Order Quantity (EOQ) Model Annual Holding Cost A little bit of calculus… A little bit of common sense… ROP with safety stock…

  13. Basic EOQ & ROP Example Given the information below, what are the EOQ, reorder point, and total annual cost? Annual Demand = 1,000 units Days per year considered in average daily demand = 365 Cost to place an order = $10 Holding cost per unit per year = $2.50 Lead time = 7 days Cost per unit = $15 EOQ  89.44  89 or 90 units ROP  2.74*7  19.18  19 or 20 units

  14. Another example Days per year considered in average daily demand = 360 Average daily demand is 3.5 units Standard deviation of daily demand is 0.95 units Cost to place an order = $50 Holding cost per unit per year = $7.25 Lead time = 4 days Compute the EOQ, and ROP is the firm wants to maintain a 97% service level (probability of not stocking out)

  15. Fixed-Time Period Model with Safety Stock q = Average demand + Safety stock – Inventory currently on hand

  16. Example of the Fixed-Time Period Model Given the information below, how many units should be ordered? Average daily demand for a product is 20 units. The review period is 30 days, and lead time is 10 days. Management has set a policy of satisfying 96 percent of demand from items in stock. At the beginning of the review period there are 200 units in inventory. The daily demand standard deviation is 4 units. q = 20(30+10) + 1.75(25.30) – 200  644.27 units

  17. A special purpose model Price-Break Model (Quantity discounts) • Based on the same assumptions as the EOQ model, the price-break model has a similar EOQ (Qopt) formula: • Annual holding cost, H, is calculated using H = iC where • i = percentage of unit cost attributed to carrying inventory • C = cost per unit • Since “C” changes for each price-break, the formula above must be applied to each price-break cost value. • Determine the total cost for each price break • The lowest total cost suggests the optimal order size (EOQ)

  18. Price-Break Example A company has a chance to reduce their inventory ordering costs by placing larger quantity orders using the price-break order quantity schedule below. What should their optimal order quantity be if this company purchases this single inventory item with an e-mail ordering cost of $4, a carrying cost rate of 2% of the inventory cost of the item, and an annual demand of 10,000 units? Order Quantity(units) Price/unit($) 0 to 2,499 $1.20 2,500 to 3,999 $1.00 4,000 or more $0.98 Re-do the example with an order cost of $25 and an inventory carrying cost rate of 45%.

  19. 0 1826 2500 4000 Order Quantity

  20. ABC Classification System • Items kept in inventory are not of equal importance in terms of: • dollars invested • profit potential • sales or usage volume • stock-out penalties • So, identify inventory items based on percentage of total dollar value, where “A” items are roughly top 15 %, “B” items as next 35 %, and the lower 65% are the “C” items 60 % of $ Value A 30 B 0 C % of Use 30 60

  21. Inventory Accuracy and Cycle Counting • Inventory accuracy refers to how well the inventory records agree with physical count • Lock the storeroom • Hire the right personnel for as storeroom manager or employees • Cycle Counting is a physical inventory-taking technique in which inventory is counted on a frequent basis rather than 1-2 times a year • Easier to conduct when inventories are low • Randomly (minimize predictability) • Pay more attention to A items, then B, etc. • Suggested problems: 3, 6, 12, 14, 17, 18, 21, 24 • Case: Hewlett-Packard

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