Session 7

Costs that are relevant in deciding how much to order Economic order quantity (EOQ) formula Order point Safety stock Service level

Basics of Supply Chain Management, rev. 2

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Session 7 (cont.)

Two-bin and perpetual inventory systems The periodic review system Auditing inventory records Cycle counting process

Basics of Supply Chain Management, rev. 2

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7-2

How Much to Order at One Time

Management will want to

Minimize sum of all costs involved Maximize customer service

Management has to make decision rules Methods of deciding how much to order at one time:

Lot-for-lot Fixed order quantity Economic order quantity

Visual

Basics of Supply Chain Management, rev. 2

7-3

Lot-for-Lot

Only required amount is ordered No unused lot-size inventory is created Is used

For dependent demand items For expensive components (A items) In a Just-in-Time (JIT) environment

Basics of Supply Chain Management, rev. 2

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Fixed-Order Quantity

Specific amount is ordered each time an order is placed Is quick and simple Is often made on the basis of what seems reasonable Does not always produce the best results

Basics of Supply Chain Management, rev. 2

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7-5

Economic Order Quantity

Assumes that

Demand is relatively constant and known Items are produced or purchased in lots or batches Order preparation costs and inventory carrying costs are constant and known Replacement occurs all at once

Basics of Supply Chain Management, rev. 2

Visual

7-6

Average Inventory Number of Orders Per Year

Weekly demand = 100 units; order quantity is 200 units

Average lot size inventory =
Number of orders per year =

Order quantity 200 = = 100 units 2 2

Annual demand Order quantity

100 x 52 = 26 orders per year 200

Visual

Reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, 3rd edition, Prentice-Hall, 1998
Basics of Supply Chain Management, rev. 2

7-7

Order Quantity
If the order quantity (Q) increases

Annual cost of ordering decreases Annual cost of carrying increases

We want an order quantity where the sum of these two costs is a minimum.
Annual cost of ordering = Annual demand x cost of ordering Q

Annual cost of carrying =

Basics of Supply Chain Management, rev. 2

Q x unit cost x cost of carrying 2

Visual

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Economic Order Quantity

Reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-Hall, 1996

Basics of Supply Chain Management, rev. 2

Visual

7-9

Economic Order Quantity Formula

Where A = Annual usage in units S = Ordering cost in dollars i = Annual inventory carrying cost as a decimal c = Unit cost
Basics of Supply Chain Management, rev. 2
Visual

2AS EOQ = ic

7-10

Economic Order Quantity Formula

For example, if A = 1,000 units S = $20 per order i = 20% = .2 c = $5 per unit
2 x 1,000 units x $20 EOQ = = 200 units 0.2 x $5
Basics of Supply Chain Management, rev. 2
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Problem 7.1
A S i c = = = = 100,000 units $32 per order 20% = .20 $8 per unit

2AS EOQ = ic
Basics of Supply Chain Management, rev. 2
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7-12

How to Reduce Lot Size

2AS EOQ = ic
What can be controlled

Annual demand? Cost of carrying inventory? Unit cost? Ordering cost?

Visual

Basics of Supply Chain Management, rev. 2

7-13

When to Place an Order

If an order is placed late, there is the possibility of a stockout. If an order is placed early, there will be extra inventory and cost. A system is needed to tell when to order. Common systems include
Order point system Periodic review system Master scheduling

Basics of Supply Chain Management, rev. 2

Visual

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Order Point System

Order point = demand during lead time + safety stock OP = DDLT + SS

Reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-Hall, 1996

Basics of Supply Chain Management, rev. 2

Visual

7-15

Order Point FormulaExample

Demand Lead time Safety stock OP = 100 units per week = 4 weeks = 100 units = DDLT + SS = 100 (4) + 100 = 500 Place an order when 500 units are on hand
Basics of Supply Chain Management, rev. 2
Visual

7-16

Order Point

Order quantities are usually fixed Order point is determined by the average demand during the lead time Intervals between replenishments are not constant Average inventory Order point = Demand during lead time + safety stock
Order quantity Average inventory = + safety stock 2

Basics of Supply Chain Management, rev. 2

Visual

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Problem 7.2
The lead time for a particular SKU is four weeks, the average demand is 200 units per week, and safety stock is set at one weeks demand. The order quantity is 2,000 units. Calculate the order point.

Basics of Supply Chain Management, rev. 2

Visual

7-18

Safety Stock

Safety stock is used to prevent a stockout. The amount of safety stock carried depends on
Variability of demand during the lead time Frequency of ordering Desired service level Length of the lead time Ability to forecast and control lead times

Basics of Supply Chain Management, rev. 2

Visual

7-19

Service Levels

The cost of carrying safety stock plus the cost of a stockout should be a minimum Costs of a stockout:
Cost of backorder Cost of lost sales Cost of lost customers

All are difficult to calculate Management should state the number of stockouts per year that is tolerable
Visual

Basics of Supply Chain Management, rev. 2

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Determining When to Order

Two basic systems

Two-bin system
Perpetual inventory record system

Basics of Supply Chain Management, rev. 2

Visual

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Perpetual Inventory Record

Order quantity = 500 units Order point = 100 units On Hand Allocated Available 500 500 500 100 400 500 100 100 0 100 600 600

426254 Screw On Date Order Received 01 02 03 500 04 05 500

Issued

400

Basics of Supply Chain Management, rev. 2

Visual

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Periodic Review System

The quantity of an item on hand is determined at fixed intervals and an order is placed.

Review intervals are fixed Order quantities vary

Figure reprinted with permission, J.R. Tony Arnold, Introduction to Materials Management, second edition, Prentice-Hall, 1996 Basics of Supply Chain Management, rev. 2
Visual

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Periodic Review System

The quantity on hand plus the quantity ordered must last until the next shipment is received.
Target level = Demand during the lead time

T Where: T D R L Order quantity

+ Demand during the review period + Safety stock = D (R + L) + SS

= = = = = = Target level Demand per unit of time Review period Lead time Target level quantity on hand TI
Visual

Basics of Supply Chain Management, rev. 2

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Periodic Review Example

D R L SS I T = = = = = = Demand per working day Review period Lead time Safety stock Inventory on hand Target level Order quantity = = = = = = = = = 300 5 = 60/day 20 days 2 days 3 days supply = 180 units 260 units D (R + L) + SS 60 (20 + 2) + 180 = 1,500 units TI 1,500 260 = 1,240 units

Basics of Supply Chain Management, rev. 2

Visual

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Periodic Review System

Used where:

There are many small issues from inventory, and posting transactions is expensive Many different items are ordered from one source Ordering costs are small

Basics of Supply Chain Management, rev. 2

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Problem 7.3
T = = = D (R + L) + SS

Order quantity = = =

TI

Basics of Supply Chain Management, rev. 2

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Auditing Inventory Records

Two basic methods

Periodic, usually annual, counts of all items Cycle, usually daily, counts of selected items

Basics of Supply Chain Management, rev. 2

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Periodic Inventory Audit

Primary purpose is to verify the financial value of the inventory Production is disrupted while inventory takes place Labor and paperwork are expensive Accuracy is poor
People taking the inventory are usually inexperienced and error prone

Basics of Supply Chain Management, rev. 2

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Cycle Counting

Inventory is counted continually throughout the year Some items are counted each day All items are counted a predetermined number of times a year depending on their importance Cycle counting uses trained and dedicated personnel
Visual

Basics of Supply Chain Management, rev. 2

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Cycle Counting
Purpose: To identify items in error and eliminate causes of error Advantages

Timely detection and correction of problems Little or no loss of production Identification and elimination of causes of error

Basics of Supply Chain Management, rev. 2

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Count Frequency Process

Classify items by their importance into A, B, and C categories

Establish rules for count frequency of each classification Establish count schedule

Basics of Supply Chain Management, rev. 2

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Count Frequency Schedule Example

Classification A B C Total counts Workdays per year Counts per day

Number of Items 2,000 3,000 5,000

Count Frequency 12 4 2

Number of Counts 24,000 12,000 10,000 46,000 250 184

Basics of Supply Chain Management, rev. 2

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Problem 7.4

Classification A B C Total counts Workdays per year Counts per day

Number of Items 1,100 1,650 2,250

Count Frequency 12 4 2

Number of Counts

250

Basics of Supply Chain Management, rev. 2

Visual

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Session 7: Objectives

Understand the costs that are relevant in deciding how much to order at one time Explain the assumptions used in deriving the economic order quantity and calculate an economic order quantity using the standard EOQ formula Explain the concept of an order point Understand the reasons for carrying safety stock
Visual

Basics of Supply Chain Management, rev. 2

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Session 7: Objectives

Describe the idea of service level and the factors influencing it Explain the two-bin system and the perpetual inventory system Understand the use of the periodic review system Recognize the purpose of auditing inventory records Explain the cycle counting process
Visual

Basics of Supply Chain Management, rev. 2

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Problem 7.5
A S i c = = = =
EOQ = 2AS 2 x 12,000 units x $20 = = 506 units ic .25 x $7.50

Basics of Supply Chain Management, rev. 2

Visual

7-37

Problem 7.5
A S i c = 12,000 units = $20 = 25% = .25 = $7.50
EOQ = 2AS 2 x 12,000 units x $20 = = 506 units ic .25 x $7.50

Annual demand 12,000 Orders per year = = = 23.7 Order quantity 506
Basics of Supply Chain Management, rev. 2
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7-37a

Problem 7.6
Target level = D (R + L) + SS = Order quantity =

Basics of Supply Chain Management, rev. 2

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Problem 7.7
Classification Number of Items Count Frequency Number of Counts

A B C Total counts Workdays per year Counts per day

Basics of Supply Chain Management, rev. 2

Visual

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