Chap 06 Inventory Control Models

3/9/14
Chapter 6
Inventory Control Models
To accompany Quantitative Analysis for Management, Tenth Edition, by Render, Stair, and Hanna Power Point slides created by Jeff Heyl
2008 Prentice-Hall, Inc. 2009 Prentice-Hall, Inc.
Introduction
!! Inventory is an expensive and important !! !! !!
!! !!
asset to many companies Lower inventory levels can reduce costs Low inventory levels may result in stockouts and dissatisfied customers Most companies try to balance high and low inventory levels with cost minimization as a goal Inventory is any stored resource used to satisfy a current or future need Common examples are raw materials, workin-process, and finished goods
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Introduction
!! Inventory may account for 50% of the total
invested capital of an organization and 70% of the cost of goods sold

Energy Costs Capital Costs
Labor Costs
Inventory Costs
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Introduction
!! All organizations have some type of inventory
control system !! Inventory planning helps determine what goods and/or services need to be produced !! Inventory planning helps determine whether the organization produces the goods or services or whether they are purchased from another organization !! Inventory planning also involves demand forecasting
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Introduction
!! Inventory planning and control
Planning on What Inventory to Stock and How to Acquire It Forecasting Parts/Product Demand Controlling Inventory Levels
Feedback Measurements to Revise Plans and Forecasts

Figure 6.1
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Importance of Inventory Control

!! Five uses of inventory !! The decoupling function !! Storing resources !! Irregular supply and demand !! Quantity discounts !! Avoiding stockouts and shortages !! The decoupling function !! Used as a buffer between stages in a manufacturing process !! Reduces delays and improves efficiency
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!! Storing resources !! Seasonal products may be stored to satisfy off-season demand !! Materials can be stored as raw materials, work-in-process, or finished goods !! Labor can be stored as a component of partially completed subassemblies !! Irregular supply and demand !! Demand and supply may not be constant over time !! Inventory can be used to buffer the variability
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!! Quantity discounts !! Lower prices may be available for larger orders !! Extra costs associated with holding more inventory must be balanced against lower purchase price !! Avoiding stockouts and shortages !! Stockouts may result in lost sales !! Dissatisfied customers may choose to buy from another supplier
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Inventory Decisions
!! There are only two fundamental decisions
in controlling inventory
!! How much to order !! When to order
!! The major objective is to minimize total
inventory costs !! Common inventory costs are

!! Cost of ordering
!! Cost of the items (purchase or material cost) !! Cost of carrying, or holding, inventory !! Cost of stockouts
Inventory Cost Factors

ORDERING COST FACTORS
Developing and sending purchase orders Processing and inspecting incoming inventory Bill paying Inventory inquiries Utilities, phone bills, and so on, for the purchasing department Salaries and wages for the purchasing department employees Supplies such as forms and paper for the purchasing department
CARRYING COST FACTORS

Cost of capital Taxes Insurance Spoilage Theft Obsolescence Salaries and wages for warehouse employees Utilities and building costs for the warehouse Supplies such as forms and paper for the warehouse
Table 6.1
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Inventory Cost Factors

!! Ordering costs are generally independent
of order quantity
!! Many involve personnel time !! The amount of work is the same no matter the
size of the order
!! Carrying costs generally varies with the
amount of inventory, or the order size

the order size increases
!! The labor, space, and other costs increase as
!! Of course, the actual cost of items
purchased varies with the quantity purchased

Economic Order Quantity

!! The economic order quantity (EOQ) model
is one of the oldest and most commonly known inventory control techniques !! It dates from 1915 !! It is easy to use but has a number of important assumptions
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Economic Order Quantity

!!
Assumptions
1.! 2.! 3.! 4.! Demand is known and constant Lead time is known and constant Receipt of inventory is instantaneous Purchase cost per unit is constant throughout the year 5.! The only variable costs are the placing an order, ordering cost, and holding or storing inventory over time, holding or carrying cost, and these are constant throughout the year 6.! Orders are placed so that stockouts or shortages are avoided completely
Inventory Usage Over Time

Inventory Level Order Quantity = Q = Maximum Inventory Level
Minimum Inventory 0 Time

Figure 6.2
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Inventory Costs in the EOQ Situation

!! Objective is generally to minimize total cost !! Relevant costs are ordering costs and carrying
costs
Average inventory level =

DAY April 1 (order received) April 2 April 3 April 4 April 5
Maximum level April 1 = 10 units Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25 Number of days = 5 Average inventory level = 25/5 = 5 units
Q 2
AVERAGE 9 7 5 3 1 8 6 4 2 0
INVENTORY LEVEL BEGINNING 10 8 6 4 2 ENDING
Table 6.2

!! Mathematical equations can be developed using
Q = number of pieces to order EOQ = Q* = optimal number of pieces to order D = annual demand in units for the inventory item Co = ordering cost of each order Ch = holding or carrying cost per unit per year
Number of Ordering orders placed Annual ordering cost = ! cost per per year order
D Co Q
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!! Mathematical equations can be developed using
Q = number of pieces to order EOQ = Q* = optimal number of pieces to order D = annual demand in units for the inventory item Co = ordering cost of each order Ch = holding or carrying cost per unit per year
Average Annual holding cost = inventory
Carrying ! cost per unit per year
Q Ch 2

Cost
Curve of Total Cost of Carrying and Ordering
Minimum Total Cost Carrying Cost Curve Ordering Cost Curve
Figure 6.3
Optimal Order Quantity
Order Quantity
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Finding the EOQ

!! When the EOQ assumptions are met, total cost is
minimized when Annual ordering cost = Annual holding cost D Q Co = Ch Q 2
!! Solving for Q
2 DC o = Q 2C h
2 DC o = Q2 Ch
2 DC o = Q = EOQ = Q * Ch
Economic Order Quantity (EOQ) Model

!! Summary of equations
Annual ordering cost =
D Co Q
Annual holding cost =

EOQ = Q * =
Q Ch 2
2 DC o Ch
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Sumco Pump Company Example

!! Company sells pump housings to other
companies !! Would like to reduce inventory costs by finding optimal order quantity
!! Annual demand = 1,000 units !! Ordering cost = $10 per order !! Average carrying cost per unit per year = $0.50
Q* =
2 DC o 2(1,000 )(10) = = 40,000 = 200 units Ch 0.50
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Sumco Pump Company Example

Total annual cost = Order cost + Holding cost
TC =
=
D Q Co + Ch Q 2
1,000 200 (10) + (0.5 ) 200 2
= $50 + $50 = $100
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Purchase Cost of Inventory Items

!! Total inventory cost can be written to include the
cost of purchased items !! Given the EOQ assumptions, the annual purchase cost is constant at D ! C no matter the order policy !! C is the purchase cost per unit !! D is the annual demand in units !! It may be useful to know the average dollar level of inventory
Average dollar level =
(CQ ) 2
Purchase Cost of Inventory Items

!! Inventory carrying cost is often expressed as an
annual percentage of the unit cost or price of the inventory !! This requires a new variable I= Annual inventory holding charge as a percentage of unit price or cost
!! The cost of storing inventory for one year is then
C h = IC
thus,
Q* =
2 DC o IC
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Sample Problem 1
!! Patterson Electronics supplies microcomputer circuitry to a
a.! b.! c.! d.!
company that incorporates microprocessors into refrigerators and other home appliances. One of the components has an annual demand of 250 units, and this is constant throughout the year. Carrying cost is estimated to be $1 per unit per year, and the ordering cost in $20 per order. To minimize cost, how many units should be ordered each time an order is placed? How many orders per year are needed with the optimal policy? What is the average inventory if costs are minimized? Suppose the ordering cost is not $20, and Patterson has been ordering 150 units each time an order is placed. For this order policy to be optimal, what would the ordering cost have to be?
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Sample Problem 2
!! The Garcia Company sells electric irons.
Annual inventory requirements is 6400 units. Price is P200 per unit. The company estimates ordering costs to be P500 per order, and carrying cost is 20% of average inventory. Calculate the following: a.! Annual ordering cost b.! Annual carrying cost c.! Total annual inventory cost for the proper lot size order
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Reorder Point: Determining When To Order

!! Once the order quantity is determined, the
next decision is when to order !! The time between placing an order and its receipt is called the lead time (L) or delivery time !! When to order is generally expressed as a reorder point (ROP)
ROP = Demand per day ! Lead time for a new order in days
=d!L
Procomps Computer Chip Example

!! Demand for the computer chip is 8,000 per year !! Daily demand is 40 units !! Delivery takes three working days
ROP = d ! L = 40 units per day ! 3 days = 120 units

!! An order is placed when the inventory reaches
120 units
!! The order arrives 3 days later just as the
inventory is depleted
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EOQ Without The Instantaneous Receipt Assumption

!! When inventory accumulates over time, the
instantaneous receipt assumption does not apply !! Daily demand rate must be taken into account !! The revised model is often called the production run model
Inventory Level Maximum Inventory Part of Inventory Cycle During Which Production is Taking Place There is No Production During This Part of the Inventory Cycle
t
Figure 6.5
Time
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Annual Carrying Cost for Production Run Model

!! In production runs, setup cost replaces ordering
cost !! The model uses the following variables
Q= number of pieces per order, or production run Cs= setup cost Ch= holding or carrying cost per unit per year p= daily production rate d= daily demand rate t= length of production run in days
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Maximum inventory level
= (Total produced during the production run) (Total used during the production run) = (Daily production rate)(Number of days production) (Daily demand)(Number of days production) = (pt) (dt)
since we know
Total produced = Q = pt
t=
Q p
Maximum Q Q & d# inventory = pt ' dt = p ' d = Q$ 1' ! p p p" % level


!! Since the average inventory is one-half the
maximum
Average inventory =
and
Q& d # $ 1' ! 2% p"
Q& d # $ 1 ' !C h 2% p"
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Annual Setup Cost for Production Run Model

!! Setup cost replaces ordering cost when a product
is produced over time
Annual setup cost =

and
D Cs Q D Co Q
Annual ordering cost =
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Determining the Optimal Production Quantity

!! By setting setup costs equal to holding costs, we
can solve for the optimal order quantity
Annual holding cost = Annual setup cost
Q& d # D $ 1 ' !C h = C s 2% p" Q

!! Solving for Q, we get
Q* =
2 DC s & d# C h $ 1' ! p" %

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Production Run Model

!! Summary of equations
Q& d # $ 1 ' !C h 2% p"
Annual setup cost =
D Cs Q
2 DC s & d# C h $ 1' ! p" %
Optimal production quantity Q * =
Brown Manufacturing Example

!! Brown Manufacturing produces commercial
refrigeration units in batches
Annual demand= D = 10,000 units Setup cost = Cs = $100 Carrying cost = Ch = $0.50 per unit per year Daily production rate = p = 80 units daily Daily demand rate = d = 60 units daily Find: 1.! The optimal production quantity, Q* 2.! How long is the production cycle?
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Brown Manufacturing Example

1.
Q* =
2 DC s & d# C h $ 1' ! p" %

2 ( 10,000 ( 100 & 60 # 0.5$ 1 ' ! % 80 "
Production cycle =
Q p
4,000 = 50 days 80
2.
Q* =
2,000,000 = 16,000,000 0.5 1 4
( )
= 4,000 units
Sample Problem 3
!! Flemming Accessories produces paper slicers
used in offices and in art stores. The minislicer has been one of its most popular items: Annual demand is 6,750 units and is constant throughout the year. Kristen Flemming, owner of the firm, produces the minislicers in batches. On average, Kristen can manufacture 125 minislicers per day. Demand for this slicers during the production process is 30 per day. The setup cost for the equipment necessary to produce the minislicers is $150. Carrying costs are $1 per minislicer per year. How many minislicers should Kristen manufacture in each batch?
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Quantity Discount Models

!! Quantity discounts are commonly available !! The basic EOQ model is adjusted by adding in the
purchase or materials cost
Total cost = Material cost + Ordering cost + Holding cost
Total cost = DC +
where
D Q Co + Ch Q 2
D = annual demand in units Cs = ordering cost of each order C = cost per unit Ch = holding or carrying cost per unit per year

!! Quantity discounts are commonly available !! The basic EOQ model is adjusted by adding in the
purchase or materials cost
Total cost = Material cost + Ordering cost + Holding cost
Total cost = DC +
where
D Q Co + Ch Q 2
D = annual demand in units unit cost now variable Cs Because = ordering cost of is each order Holding C = cost per unit cost = Ch = IC I =C holding cost as acarrying percentage of the unit cost (C) = holding or cost per unit per year h
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!! A typical quantity discount schedule
DISCOUNT NUMBER 1 2 3
Table 6.3
DISCOUNT QUANTITY 0 to 999 1,000 to 1,999 2,000 and over
DISCOUNT (%) 0 4 5
DISCOUNT COST ($) 5.00 4.80 4.75
!! Buying at the lowest unit cost is not always the
best choice
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!! Total cost curve for the quantity discount model
Total Cost $ TC Curve for Discount 3 TC Curve for Discount 1
TC Curve for Discount 2
EOQ for Discount 2 0 Figure 6.6 1,000 2,000

Order Quantity
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Brass Department Store Example

!! Brass Department Store stocks toy race cars !! Their supplier has given them the quantity
discount schedule shown in Table 6.3

holding cost is 20% of the cost of the car
!! Annual demand is 5,000 cars, ordering cost is $49, and
!! The first step is to compute EOQ values for each
discount
(2)(5,000)( 49) = 700 cars per order (0.2)(5.00) (2)(5,000 )( 49) EOQ 2 = = 714 cars per order (0.2)( 4.80) (2)(5,000 )( 49) EOQ 3 = = 718 cars per order (0.2)( 4.75) EOQ1 =

!! The second step is adjust quantities below the
allowable discount range !! The EOQ for discount 1 is allowable !! The EOQs for discounts 2 and 3 are outside the allowable range and have to be adjusted to the smallest quantity possible to purchase and receive the discount Q1 = 700 Q2 = 1,000 Q3 = 2,000
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!! The third step is to compute the total cost for
each quantity
UNIT PRICE (C)
DISCOUNT NUMBER
ORDER QUANTITY (Q )
ANNUAL MATERIAL COST ($) = DC
ANNUAL ORDERING COST ($) = (D/Q)Co
ANNUAL CARRYING COST ($) = (Q/2)Ch
TOTAL ($)
1 2 3 Table 6.4
$5.00 4.80 4.75
700 1,000 2,000
25,000 24,000 23,750
350.00 245.00 122.50
350.00 480.00 950.00
25,700.00 24,725.00 24,822.50
!! The fourth step is to choose the alternative
with the lowest total cost
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Sample Problem 3
!! Dorsey Distributors has an annual
demand for a metal detector of 1,400. The cost of a typical detector to Dorsey is $400. Carrying cost is estimated to be 20% of the unit cost, and the ordering cost is $25 per order. If Dorsey orders in quantities of 300 or more, it can get a 5% discount on the cost of the detectors. Should Dorsey take the quantity discount? Assume the demand is constant.
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Use of Safety Stock

!! If demand or the lead time are uncertain,
the exact ROP will not be known with certainty !! To prevent stockouts, it is necessary to carry extra inventory called safety stock !! Safety stock can prevent stockouts when demand is unusually high !! Safety stock can be implemented by adjusting the ROP
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Use of Safety Stock

!! The basic ROP equation is
ROP = d ! L
d= daily demand (or average daily demand) L = order lead time or the number of working days it takes to deliver an order (or average lead time)
!! A safety stock variable is added to the equation
to accommodate uncertain demand during lead time where ROP = d ! L + SS SS = safety stock
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Use of Safety Stock

Inventory on Hand
Time Figure 6.7(a) Stockout

Use of Safety Stock

Inventory on Hand
Safety Stock, SS Stockout is Avoided Time Figure 6.7(b)

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ABC Analysis
!! The purpose of ABC analysis is to divide the
inventory into three groups based on the overall inventory value of the items !! Group A items account for the major portion of inventory costs
!! Typically about 70% of the dollar value but only 10% of
the quantity of items carefully
!! Forecasting and inventory management must be done
!! Group B items are more moderately priced !! May represent 20% of the cost and 20% of the quantity !! Group C items are very low cost but high volume !! It is not cost effective to spend a lot of time managing these items
ABC Analysis
!! Summary of ABC analysis
INVENTORY GROUP DOLLAR USAGE (%) INVENTORY ITEMS (%) ARE QUANTITATIVE CONTROL TECHNIQUES USED?
A B C
Table 6.10
70 20 10
10 20 70
Yes In some cases No
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3/9/14

Inventory Control Models

2008 Prentice-Hall, Inc. 2009 Prentice-Hall, Inc.

invested capital of an organization and 70% of the cost of goods sold

2009 Prentice-Hall, Inc.

2009 Prentice-Hall, Inc.

Feedback Measurements to Revise Plans and Forecasts

Importance of Inventory Control

2009 Prentice-Hall, Inc.

Importance of Inventory Control

Importance of Inventory Control

2009 Prentice-Hall, Inc.

!! The major objective is to minimize total

inventory costs !! Common inventory costs are

Inventory Cost Factors

CARRYING COST FACTORS

Inventory Cost Factors

size of the order

!! Carrying costs generally varies with the

amount of inventory, or the order size

!! The labor, space, and other costs increase as

!! Of course, the actual cost of items

purchased varies with the quantity purchased

Economic Order Quantity

2009 Prentice-Hall, Inc.

Economic Order Quantity

Inventory Usage Over Time

Minimum Inventory 0 Time

Inventory Costs in the EOQ Situation

Average inventory level =

INVENTORY LEVEL BEGINNING 10 8 6 4 2 ENDING

Inventory Costs in the EOQ Situation

Inventory Costs in the EOQ Situation

Average Annual holding cost = inventory

Carrying ! cost per unit per year

Inventory Costs in the EOQ Situation

Curve of Total Cost of Carrying and Ordering

Minimum Total Cost Carrying Cost Curve Ordering Cost Curve

Optimal Order Quantity

2009 Prentice-Hall, Inc.

Finding the EOQ

minimized when Annual ordering cost = Annual holding cost D Q Co = Ch Q 2

Economic Order Quantity (EOQ) Model

Annual ordering cost =

Annual holding cost =

2009 Prentice-Hall, Inc.

Sumco Pump Company Example

2 DC o 2(1,000 )(10) = = 40,000 = 200 units Ch 0.50

2009 Prentice-Hall, Inc.

Sumco Pump Company Example

= $50 + $50 = $100

2009 Prentice-Hall, Inc.

Purchase Cost of Inventory Items

Average dollar level =

Purchase Cost of Inventory Items

!! The cost of storing inventory for one year is then

a.! b.! c.! d.!

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Reorder Point: Determining When To Order

Procomps Computer Chip Example

ROP = d ! L = 40 units per day ! 3 days = 120 units

!! The order arrives 3 days later just as the

2009 Prentice-Hall, Inc.