Inventory Management

Inventory Management

Inventory Management • Inventory is one of the most expensive assets of many companies. • • It represents as much as 40% of total invested capital.

Inventory Management • Inventory is any stored resource that is used to satisfy a current or future need. • Raw materials, work-in-process, and finished goods are examples of inventory. • Two basic questions in inventory management are 1.How much to order 2.When to order

Basic Functions of Inventory

Types of Inventory

Holding and Ordering Costs

Lot Sizing • “How many parts to make at once” • Objective: Find optimum production quantities  TRADE -OFF Meeting demand requirements and Set up, inventory, holding and back order costs

Techniques of Lot Sizing I. LOT – FOR – LOT – Produces exactly the required amount each period – Minimizes carrying cost – Neglects set up costs and capacity limitations 

II.Economic Order Quantity – –

Techniques of Lot Sizing III.Least Total Cost – Dynamic lot sizing method – Compares carrying cost and Set up(ordering) costs – Selects the lot where the two are almost equal 

IV.Least Unit Cost – Adds ordering and carrying cost to each lot size and divides with the number of units – The lot with the lowest unit cost is

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ABC Analysis

• ABC analysis divides on-hand inventory into three classifications on the basis of dollar volume. • It is also known as Pareto analysis. (which is named after principles dictated by Pareto). • The idea is to focus resources on the critical few and not on the trivial many. • (Annual Dollar Volume of an Item) = (Its Annual Demand) x (Its Cost per unit) •

ABC Analysis Item Class

Annual Dollar Volume

Total Inventory Costs Total Inventory items

Class A

High

70% – 80%

15%

Class B

Medium

15% - 25%

30%

Class C

Low

5%

50% - 60%

ABC Analysis

ABC Analysis Uses

Just-in-Time Inventory • • Just in Time Inventory is the minimum inventory that is necessary to keep a system perfectly running. • • With just in time (JIT) inventory, the exact amount of items arrive at the moment they are needed, Not a minute before OR not a minute after. 

Achieving JIT Inventory • • To achieve JIT inventory, Managers should Reduce the Variability caused by some Internal and External Factors. • • Existence of Inventory hides the variability. What causes variability?

Just-in-Time Inventory • Most Internal Variability is caused by tolerating waste (inventory). • Employees or machines produce units that do not conform to standards which are waste and cause variability. • Engineering drawings are inaccurate, resulting in loss of production and resulting in Variability.

• Customer Demands may change due to some External Factors (such as competitors’ actions or promotions).

Just-in-Time Inventory

Just-in-Time Inventory

Inventory Models • Demand for an item is either dependent on the demand for other items or it is independent. • For example, demand for refrigerator is independent of the demand for cars. • But, demand for auto tires is certainly dependent on the demand of cars.

Inventory Models • In this section, we will deal with the Independent Demand Situation. • In the independent demand situation, we should be interested in answering: • a) When to place an order for an item, and • b) how much of an item to order.

Inventory Models

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EOQ Model Assumptions Demand is known and constant.

• Lead time (the time between placement of order and receipt of the order) is constant and known. • Orders arrive in one batch at a time, and they arrive in one point in time. • Quantity discounts are not possible. • The costs include only setup cost (or ordering cost when buying) and holding cost. • Orders are always placed at the right times. Therefore, stock outs (or shortages) can be completely avoided.

EOQ Model Q Quantity on hand

Profile of Inventory Level Over Time

Usage rate

Reorder point

Receive order

Place Receive order order

Lead time

Place Receive order order

Time

EOQ Model • Q = order quantity (That is also equal to the Maximum Inventory) • Minimum Inventory = 0 • When inventory level reaches 0, a new order is placed and received.

EOQ Model • The objective of inventory models is to minimize total cost. • If we minimize the ordering and holding costs, we will be able to minimize total cost

Annual Cost

EOQ Model Curve Q D TC = H + S 2 Q

Holding Cost

Ordering Costs Q* (optimal order quantity)

Optimal order quantity (Q*) occurs at a point where ordering cost is equal to the holding cost.

EOQ Model - Equation • We can write an equation for Q* as follows: • There will be (D/Q) times of ordering in a whole year. 

Annual Ordering Cost = (D/Q) * S Average Annual Holding Cost = (Average Inventory) *H = (Q/2) * H 

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For Q*, Annual Setup Cost = Annual Holding Cost  (D/Q) * S = (Q/2) * H 

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EOQ Model - Equation  

2DS 2(Annual Demand)(Order or Setup Cost)  Q = = * H Annual Holding Cost  

Q* the Economic Order Quantity

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Example • An Inventory model has the following characteristics: • Annual Demand (D) = 1000 units • Ordering (Setup) cost (S)= $10 per order; • Holding cost per unit per year (H) = $.50 • Assume that there are 270 working days in a year (excluding holidays and weekends).

Example 1.EOQ, Q* = [2(1000)10 / .50]1/2 = 200 units 2.Expected number of orders placed during the year (N) = D / Q* = 1000 / 200 = 5 times. 3.Expected time between orders (T) = (Working days in a year) / N = 270 / 5 = 54 days. 4.Total Annual Cost = Annual Setup Cost + Annual Holding Cost 

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=

DS / Q*+ (Q*)H / 2 = $100

Reorder Point • So far, we only decided how much to order (That is Q*). • Now, we should find what time to order. • We assumed that firm will wait until its inventory reaches to zero before placing an order and the Orders will be received immediately. • However, there is a time between placement and receipt of an order called the LEAD TIME

Reorder Point • Reorder Point” (ROP) is the time when the order is to be placed. • ROP (in units) = (Demand Per Day)* (Lead time for a new order in days) •  ROP = d * L

Reorder Point

Reorder Point • When the inventory level reaches the ROP, a new order is required. • It will take a time that is equal to the Lead Time (L) to receive the new order. • Demand per day (d) = D / No. of working days in a year • This ROP equation assumes that demand is uniform and constant. • If this is not the case, an extra (safety) stock is added (because of uncertainty).

Reorder Point Example • Annual demand for an item is D = 8000/year. • This year there will be 200 working days in a year. • Delivery of an order for this item takes 3 working days (L = 3 days).

Example • Demand per day, d = 8000 / 200  = 40 units/ day. • ROP = d * L = 40 * 3  = 120 units. • When the inventory level becomes 120 units, an Order should be placed.

Make/Buy decision • Act of making a strategic choice between producing an item internally (in-house) or buying it externally (from an outside supplier) • This analysis is conducted at two levels – Strategic level – Operational level

Make/Buy decision • Variables considered at the strategic level include analysis of the future, as well as the current environment – Government regulation – Competing firms – Market trends

• Operational level confines to the operation of that particular company

Make/Buy decision • Two most important factors to consider in a make-or-buy decision – Cost – Availability of production capacity

Factors that influence firms to ‘make’ • • • • • • • • • • •

Cost considerations Desire to integrate plant operations Productive use of excess plant capacity Better quality control Design secrecy is required to protect proprietary technology Unreliable and no competent suppliers Desire to maintain a stable workforce Quantity too small to interest a supplier Control of lead time, transportation, and warehousing costs Greater assurance of continual supply Political, social and other reasons

Factors that influence firms to ‘buy’ • Lack of expertise • Suppliers' research and specialized knowhow exceeds that of the buyer • cost considerations • Small-volume requirements • Limited production facilities or insufficient capacity • Indirect managerial control considerations • Procurement and inventory considerations • Brand preference • Item not essential to the firm's strategy

Questions to be answered • Is this the organization’s core competency? • Could we be harmed by disclosing proprietary information? • What will be the impact on quality or delivery? • What additional risks would we be facing? • How irreversible is the decision? 

Cost considerations for “make" analysis Incremental inventory-carrying costs Direct labor costs Incremental factory overhead costs Delivered purchased material costs Incremental managerial costs Any follow-on costs stemming from quality and related problems • Incremental purchasing costs • Incremental capital costs • • • • • •

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Cost considerations for "buy" analysis • • • • • 

Purchase price of the part Transportation costs Receiving and inspection costs Incremental purchasing costs Any follow-on costs related to quality or service

Main factors to be considered • • • •

Volume Fixed costs associated with making Per-unit direct costs of making Per-unit landed cost from a supplier

Costs to be calculated • Cost To Buy, CTB = V * LC – V = Volume – LC = Supplier's Per Unit Landed Cost

• Cost To Make, CTM = FC + (PUDC * V) – FC = Fixed Costs (of making) – PUDC = Per Unit Direct Cost (of making)

• If CTM > CTB, it is more financially desirable to buy and vice versa

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