Operations

Management
Chapter 6
P R O F. D R . F R A N C E S C O D . S A N D U L L I
UNIVERSITY COMPLUTENSE OF MADRID
 Operations Management
Chapter 6
Inventory Management

Functions of Inventory
Inventory Management
Inventory Models
Inventory Models for Independent Demand with Deterministic Demand

Heizer & Render (10th edition). Chapter 12 (pp 500-519).

 Inventory

One of the most expensive assets

of many companies representing as
much as 50% of total invested
capital
Operations managers must balance
inventory investment and customer
service
 Functions of Inventory
1. To decouple or separate various
parts of the production process
2. To decouple the firm from
fluctuations in demand and
provide a stock of goods that will
provide a selection for customers
3. To take advantage of quantity
discounts
4. To hedge against inflation
 Types of Inventory
Raw material
Purchased but not processed
Work-in-process
Undergone some change but not completed
A function of cycle time for a product
Maintenance/repair/operating (MRO)
Necessary to keep machinery and processes
productive
Finished goods
Completed product awaiting shipment
 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
 Inventory Management

How inventory items can be classified

How accurate inventory records can be
maintained
The objective of inventory management is
to strike a balance between inventory
investment and customer service:
minimize inventory cost needed to
maximize customer service
 ABC Analysis
Divides inventory into three classes
based on annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar
volume
Class C - low annual dollar volume
Used to establish policies that focus
on the few critical parts and not the
many trivial ones
 ABC Analysis
Item Percent of Annual x Unit = Annual Percent of Class
Stock Number of Volume Cost Dollar Annual
Number Items (units) Volume Dollar
Stocked Volume

#10286 20% 1,000 $ 90.00 $ 90,000 38.8% 72% A

#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

 ABC Analysis
Item Percent of Annual x Unit = Annual Percent of Class
Stock Number of Volume Cost Dollar Annual
Number Items (units) Volume Dollar
Stocked Volume

#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%
Percent of annual dollar usage ABC Analysis

A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
 ABC Analysis

Other criteria than annual dollar

volume may be used
Anticipated engineering changes
Delivery problems
Quality problems
High unit cost
 ABC Analysis

Policies employed may include

More emphasis on supplier
development for A items
Tighter physical inventory control for
A items
More care in forecasting A items
 Cycle Counting

Items are counted and records updated on a periodic

basis

Often used with ABC analysis to

determine cycle
Has several advantages
Eliminates shutdowns and interruptions
Eliminates annual inventory adjustment
Trained personnel audit inventory accuracy
Allows causes of errors to be identified and corrected
Maintains accurate inventory records
 Cycle Counting
Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C
items
Policy is to count A items every month (20 working days), B
items every quarter (60 days), and C items every six months
(120 days)

Item Number of Items

Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
77/day
Independent Versus
Dependent Demand
Independent demand - the
demand for item is independent
of the demand for any other
item in inventory
Dependent demand - the
demand for item is dependent
upon the demand for some
other item in the inventory
 Holding, Ordering,
and Setup Costs
Holding costs - the costs of holding
or “carrying” inventory over time
Ordering costs - the costs of
placing an order and receiving
goods
Setup costs - cost to prepare a
machine or process for
manufacturing an order
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value

Housing costs (building rent or 6% (3 - 10%)

depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value

Housing costs (building rent or 6% (3 - 10%)

depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%

Table 12.1
 Inventory Models for
Independent Demand

Need to determine when and how

much to order

Basic economic order quantity

Production order quantity
Quantity discount model
 Basic EOQ Model

Important assumptions
1. Demand is known, constant, and
independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
 Inventory Usage Over Time

Usage rate Average

Order inventory
Inventory level

quantity = Q on hand
(maximum Q
inventory
level) 2

Minimum
inventory

0
Time

Figure 12.3
 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
quantity (Q*)
 EOQ Model
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

D
= (S)
Q
 EOQ Model

D = Annual demand in units for the inventory item

S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

Q
= (H)
2
 EOQ Model

D = Annual demand in units for the inventory item

S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup cost

equals annual holding cost
DS = Q
H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
 EOQ Model

Determine optimal number of needles to order

D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
 EOQ Model

Determine optimal number of needles to order

D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected
number of = N = Demand D
=
orders Order quantity Q*
1,000
N= = 5 orders per year
200
 EOQ Model

Determine optimal number of needles to order

D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected days per year
time between = T =
orders N
250
T= = 50 days between orders
5
 EOQ Model

Determine optimal number of needles to order

D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

TC = D S + Q H
Q 2
1,000
TC = ($10) + 200 ($.50)
200 2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100
 Robust Model

The EOQ model is robust

It works even if all parameters
and assumptions are not met
The total cost curve is relatively
flat in the area of the EOQ
 An EOQ Example

Management underestimated demand by 50%

D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

TC = D S + Q H
Q 2
1,500
TC = ($10) + 200 ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

 An EOQ Example

Actual EOQ for new demand is 244.9 units

D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

TC = D S + Q H
Q 2 Only 2% less
1,500 than the total
TC = ($10) + 244.9 ($.50) cost of $125
244.9 2 when the
order quantity
TC = $61.24 + $61.24 = $122.48 was 200
 Reorder Points

EOQ answers the “how much” question

The reorder point (ROP) tells when to
order
Demand Lead time for a
ROP = per day new order in days

=dxL
D
d = Number of working days in a year
 Reorder Point Curve

Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Figure 12.5 Lead time = L
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days

D
d=
Number of working days in a year
= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
Production Order Quantity
Model
Used when inventory builds up
over a period of time after an
order is placed
Used when units are produced
and sold simultaneously
 Production Order Quantity
Model

Part of inventory cycle during

which production (and usage)
is taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time

Figure 12.6
 Production Order Quantity
Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory Holding cost

holding cost = (Average inventory level) x per unit per year

Annual inventory
level = (Maximum inventory level)/2

Maximum Total produced during Total used during

inventory level = the production run – the production run
= pt – dt
 Production Order Quantity
Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum Total produced during Total used during

inventory level = the production run – the production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level = p –d =Q 1–
p p p

Holding cost = Maximum inventory level (H) = Q

1–
d
H
2 2 p
 Production Order Quantity
Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand

Setup cost = (D/Q)S

1
Holding cost = HQ[1 - (d/p)]
2
1
HQ[1 - (d/p)]
(D/Q)S = 2
2DS
Q2 = H[1 - (d/p)]

2DS
Q*p = H[1 - (d/p)]
Production Order Quantity
Example
D = 1,000 units
S = $10 p = 8 units per day
H = $0.50 per unit per year d = 4 units per day

2DS
Q* =
H[1 - (d/p)]

2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283 hubcaps
 Production Order Quantity
Model
Note:
D 1,000
d=4= =
Number of days the plant is in operation 250

When annual data are used the equation becomes

2DS
Q* =
H 1– annual demand rate
annual production rate
 Quantity Discount Models
Reduced prices are often available when
larger quantities are purchased
Trade-off is between reduced product cost
and increased holding cost

Total cost = Setup cost + Holding cost + Product cost

D Q
TC = S+ H + PD
Q 2
 Quantity Discount Models

A typical quantity discount schedule

Discount Discount
Number Discount Quantity Price (P)
Discount (%)
1 0 to 999 $5.00
no discount
2 1,000 to 1,999 $4.80
4
3 2,000 and over 5 $4.75

Table 12.2
 Quantity Discount Models

Steps in analyzing a quantity discount

1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify,
choose the smallest possible order size
to get the discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
Quantity Discount Models

Total cost Total cost curve for discount 2

curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
 Quantity Discount Example Annual Annual Annual

Discount Unit Order Product Ordering Holding

Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Table 12.3

Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit