Operations Management
Contemporary Concepts and Cases
Chapter Fifteen
Independent Demand Inventory
McGrawHill/Irwin
Copyright © 2011 by The McGrawHill Companies, Inc. All rights reserved.
Chapter 15 Outline
Purpose of Inventories
Costs of Inventories
Independent versus Dependent Demand
Economic Order Quantity
Continuous Review System
Periodic Review System
Using P and Q System in Practice
ABC Inventory Management
152
Definitions
Inventory: a stock of materials used to facilitate
production or satisfy customer demand
Types of inventory
–
–
–
–
Raw materials, purchased parts (RM)
Work in process (WIP)
Finished goods (FG)
Maintenance, repair & operating supplies (MRO)
153
Inventory Management
Technologies
Bar coding
Point of sale (data) (POS)
Radiofrequency Identification (RFID)
154
Materials-Flow Process (Fig. 15.1)
Productive Process
Work in
process
Vendors
Raw
Materials
Work in
process
Finished Customer
goods
Work in
process
155
Water Tank Analogy for Inventory
Inventory Level
Supply Rate
Inventory Level
Demand Rate
156
Purpose of Inventories (1)
To protect against uncertainties (safety stock)
–
–
–
–
demand (FG, MRO)
supply (RM, MRO)
lead times (RM, WIP)
schedule changes (WIP)
To allow economic production and purchase
(discounts for buying RM in bulk)
157
Purpose of Inventories (2)
To cover anticipated changes in demand (as
in a level strategy) or supply
– FG
– RM
To provide for transit (pipeline inventories)
–
–
–
RM
FG
WIP (independence of operations)
158
Inventory Cost Structures (1)
Item cost
– Expressed as cost per unit or SKU. Gets into
LIFO and FIFO issues.
– Problem can be compounded by quantity
discounts.
Ordering (or setup) cost
–
–
–
Paperwork, worker time (ordering)
Worker time, downtime (setup)
Typically expressed as a fixed cost per order or
setup.
159
Inventory Cost Structures (2)
Carrying (or holding) cost:
– Cost of capital (market rate or internal rate of return)
– Cost of storage (building, utilities, insurance, handling)
– Cost of obsolescence, deterioration, and loss
(shrinkage)
– Management cost (record keeping, counting)
Typically expressed as a percentage of SKU cost.
Estimated U.S. average is 35% per year.
Businesses often use only cost of capital
(understatement).
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Inventory Cost Structures (3)
How the 35% carrying cost is distributed:
Cost of Capital—920 percent
Obsolescence—25 percent
Storage—25 percent
Material Handling—13 percent
Shrinkage—13 percent
Taxes & Insurance—13 percent
Source: Mark Williams, APICS Instructor Listserv, 22 January 2001
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Inventory Cost Structures (4)
Shrinkage
– “… ‘shrinkage’…costs U.S. retailers about $41.6
billion last year.” This is more than the combined
total from other crimes such as robberies, auto
theft and larceny.
Source: Wall Street Journal, 11 July 2007, p. B4.
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Inventory Cost Structures (5)
Stock out cost (back order or lost sales)
–
–
–
–
Record maintenance
Lost income
Customer dissatisfaction
Typically expressed as a fixed cost per backorder
or as a function of aging of backorders.
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Two Forms of Demand (1)
Independent demand (this chapter)
–
–
–
–
Finished goods, spare parts, MRO
Based on market demand
Requires forecasting
Managed using ‘replenishment philosophy’, i.e.,
reorder when reach a prespecified level.
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Two Forms of Demand (2)
Dependent demand (Chapter 16)
–
–
–
–
Parts that go into the finished products, RM or WIP
Demand is a known function of independent demand
Calculate instead of forecast
Managed using a ‘requirements philosophy’, i.e.,
only produced or ordered as needed for higher level
components or products (‘parents’).
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Figure 15.4: Demand Patterns
A pattern plus random influences
‘Lumpy’ because of production lots
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Economic Order Quantity (EOQ)
Developed in 1915 by F.W. Harris
Answers the question ‘How much do I order?’
Used for independent demand items.
Objective is to find order quantity (Q) that minimizes
the total cost (TC) of managing inventory.
Must be calculated separately for each SKU.
Widely used and very robust (i.e., works well in a
variety of situations, even when its assumptions don’t
hold exactly).
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Economic Order Quantity (EOQ)
Basic Model Assumptions
Demand rate is constant, recurring, and known.
Lead time is constant and known.
No stockouts allowed.
Material is ordered or produced in a lot or batch
and the lot is received all at once.
5. Costs are constant:
1.
2.
3.
4.
1.
2.
3.
Unit cost is constant (no quantity discounts)
Carrying cost is constant per unit (SKU)
Ordering (setup) cost per order is fixed
6. Item is a single product or SKU; demand not
influenced by other items.
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EOQ Lot Size Choice
There is a tradeoff between frequency of
ordering (or the size of the order) and the
inventory level.
– Frequent orders (small lot sizes) lead to lower
average inventory level, i.e., higher total ordering
costs and lower total holding costs.
– Fewer orders (large lot sizes) lead to higher
average inventory level, i.e., lower total ordering
costs and higher total holding costs.
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Figure 15.5: EOQ Inventory Levels
On Hand
(‘sawtooth model’)
Order
Interval
Average Inventory
Level = Q/2
Lot size = Q
Time
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Notation in EOQ Calculation
D = Demand rate, units per year
S = Cost per order placed or setup cost,
dollars per order
C = Unit cost, dollars per unit
i = Carrying rate, percent of value per year
Q = Lot size, units
TC= total of ordering cost plus carrying cost
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Cost Equations in EOQ
Ordering cost per year =
(cost per order) x (orders per year) = SD/Q
Carrying cost per year = (annual carrying rate) x
(unit cost) x (average inventory) = iCQ/2
Total annual cost (TC) = ordering cost per year
+ carrying cost per year = SD/Q + iCQ/2
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Total Cost of Inventory (Fig. 15.6)
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TC and EOQ
TC = ordering cost + holding cost
= S*(D/Q) + iC*(Q/2)
EOQ = Q
2 SD
iC
note: Although we use annual costs, any time period can be used.
Just be consistent! The same is true for currency designations.
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EOQ Example
Sales = 10 cases/week
i = 30% per year
_________
EOQ =
SD)/iC =
S = $12/order
C = $80/case
*12*10*52) / (.3*80)
= 22.8 cases/order
TC = ordering cost + holding cost
= S*(D/Q) + iC*(Q/2) = 12*(520/22.8) + .3*80(22.8/2)
= 273.68 + 273.60 = $547.28/year
If order 22 cases instead, TC = $547.64; if 23, TC = $547.30
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