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Dr Valentina Plekhanova
CISM02: Decision Support for Management
Unit 8
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Inventory
Inventory: Stock of items for internal or external demand.
Tools, machinery , equipment
Raw materials
Working capital
Finished goods
The purpose of inventory management is to determine the amount
of inventory to keep in stock.
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Inventory Management
The word inventory was first recorded in 1601. The French term inventaire, or
"detailed list of goods," dates back to 1415.
Inventory management is primarily about specifying the size and placement of
stocked goods.
Inventory management is required at different locations within a facility or
within multiple locations of a supply network to protect the regular and planned
course of production against the random disturbance of running out of
materials or goods.
The scope of inventory management also concerns the fine lines between
replenishment lead time, carrying costs of inventory, asset management,
inventory forecasting, inventory valuation, inventory visibility, future inventory
price forecasting, physical inventory, available physical space for inventory,
quality management, replenishment, returns and defective goods and demand
forecasting.
CISM02 Decision Support for Management
Unit 8
Unit 8
Inventory Control
The problem of inventory exists in all companies whether big or small.
Exceeding inventory has contributed to the failure of many companies.
If stock is taken regularly to honour a demand at any time, a company
will never be out of stock and thereby lose the sales and goodwill of its
customers. But the cost of investment and keeping up the inventory
(holding cost) will increase.
Less inventory leads to frequent orders and stock out and costs
increase as a result.
The ideal inventory policy is to find out the break-even of these costs.
Also the policy should be adjustable to suit the existing system.
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Buffer Stocks
Many organisations keep an additional amount of inventory called
safety or buffer stocks for the following reasons:
Variations in demand
High seasonal demand
Variations in supplier deliveries
Volume discounts
High ordering price
etc.
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Inventory Costs
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Inventory Models:
Economic Parameters
Set-up cost: This involves the fixed charge associated with the
placement of an order or with the initial preparation of a production
facility. The set-up cost is usually assumed independent of the quantity
ordered or produced.
Purchase price or production cost: This parameter is of special interest
when quantity discounts or price breaks can be secured or when large
production runs may result in a decrease in the production cost. Under
these conditions, the order quantity must be adjusted to take advantage
of these price breaks.
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Inventory Models:
Economic Parameters
Holding cost: This represents the cost of carrying inventory in storage.
It includes the interest on invested capital, storage costs, handling
costs, depreciation costs, etc. Holding costs usually are assumed to
vary directly with the level of inventory as well as the length of time
the item is held in stock. As the inventory increases, this cost
increases.
Shortage cost or penalty cost: These are the penalty costs incurred as
a result of running out of stock when the commodity is needed (i.e.
when the demand is fulfilled). They generally include costs due to
loss in customers goodwill and potential loss in income.
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Inventory Level
Supply Rate
Inventory Level
Demand Rate
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Nature of Demand
Sometimes, the demand is known with certainty with its rate remaining the
same or not in relation to time. If demand is certain it is called a
deterministic demand.
Depending upon whether the rate of demand remains the same or not
with respect to time it is called static or dynamic demand.
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Fixed-order-quantity system ( or Continuous Review or Q-systems) constant amount ordered when inventory declines to predetermined level
Fixed-time-period system (or Periodic review or P-systems) - order
placed for variable amount after fixed passage of time
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The order that is placed is for a fixed amount that minimizes the total
inventory costs. This amount, called the economic order quantity.
A positive feature of a continuous system is that the inventory level is
continuously monitored, so management always knows the inventory
status. This is advantageous for critical items such as replacement parts
or raw materials and supplies. However, maintaining a continual record of
the amount of inventory on hand can also be costly.
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(1)
This model known as the economic order quantity model is the oldest
and best known inventory model which originated as early as 1915 with
Wilson and so the formula derived under this model to decide the
ordering quantity is called the Wilson formula (i.e. Wilsons economic
lot size).
It basically answers the question how much to order. Out of the four
components of inventory cost, here we are considering only two of
them, namely, the set-up cost and the holding cost.
The other two costs shortage cost and purchasing cost, we adjust in
such a way that shortage is not allowed and the holding cost takes care
of purchasing cost which is possible to some extent with the
assumption that there is no price break possible even if we order
quantity in big lots.
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(2)
Our aim is to reduce the total cost per unit (TCU) time. This is expressed
it terms of inventory as we are finding out the optimal inventory level
which reduces TCU.
With our assumptions TCU can be expressed as
TCU = set-up cost per unit time + holding cost per unit time
Let us denote
B = rate of demand or consumption
Y = quantity to be ordered
H = holding cost per unit per item
K = set-up cost per order
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SS
t0=Y/B
Time
Figure: Variation of the Inventory Level
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SS
Time
The smaller the order quantity Y, the more frequent will be the placement of new orders. However, the
average level of inventory held in stock will be reduced. On the other hand, larger order quantities
indicate larger inventory level but less frequent placement of orders.
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(3)
Holding cost per unit time = Average inventory x Holding cost per unit per item =
=YxH/2
Y/2 becoming average inventory.
The cycle time is denoted by t0 and defined as t0
Y
B
Set-up cost per unit time = K x Number of orders per unit time = K x B/Y =
= K/ (Y/B)
Reminder: TCU = set-up cost per unit time + holding cost per unit time
TCU (Y )
or
KH
Y
t0
2
t0
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(4)
Using the calculus method to find the optimal inventory we have to differentiate
TCU with respect to Y (assuming Y is a continuous variable) and equate to zero:
dTCU (Y ) KB H
2 0
dY
Y
2
This will give us the value of Y as
Y (2KB) / H
The above order quantity is usually referred as Wilsons economic lot size.
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2 KB
2 100 100
1000 (units )
0.02
Since the lead time is 12 days and the cycle length is 10 days, reordering
occurs when the level of inventory is sufficient to satisfy the demand for two
(12-10) days. Thus, the quantity Y*=1000 is ordered when the level of inventory
reaches 2 x 100 = 200 units. And the optimum cost TCU is defined as
TCU (Y )
K
Y
100
1000
H
0.02
20 ( per day)
Y
1000
2
2
B
100
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Inventory Models
More models:
Single Item Static Model with Simultaneous Production and Sales
Single Item Static Model with Simultaneous Production and Sales
where Shortage is allowed
Single Item Static Model with Time Lag
Single Item Static Model with Price Breaks
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ABC Analysis
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ABC classification:
Applications in Inventory Control
ABC classification could be used to determine the importance rating for
different items and help the Stores in better inventory control. We could
have the following objectives for classifications:
Purchasing and Finance may want to classify the items in three
classes, i.e. A, B and C based upon last years consumption value.
Stores may want to classify the items in class High, Medium, and
Low based upon on-hand quantities for the purpose of doing a better
store space planning.
Inventory Controller may want to classify the items in High
movement, Medium movements and Low movements for
analysing the Min-Max Levels of different items.
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No shortages are allowed in any period so that the demand for all
periods must be filled. If the level of production in period i is increased
over that in period (i-1), that is, xi > xi-1, a cost ai pounds per excess unit
is incurred.
On the other hand, if xi < xi-1, a cost bi pounds per decreased unit is
added for decreasing the level of production.
An inventory holding cost ci pounds is incurred for every unit held over to
the next period.
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ai ( xi xi 1 ), if xi xi 1
yi bi ( xi 1 xi ), if xi xi 1
0, if x = x
i
i 1
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yi max{ai ( xi xi 1 ), bi ( xi 1 xi )}
This follows since if production is increased, xi-1 xi
< 0 so that
bi (xi-1 xi)<0 while ai (xi xi-1)>0. Thus bi (xi-1 xi)<ai (xi xi-1),
which gives yi= ai(xi xi-1) as desired. The case where production is
decreased is interpreted similarly. Thus, the overall objective function is
given by
n
minimise x0 (ci I i 1 yi )
i 1
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yi max{ai ( xi xi 1 ), bi ( xi 1 xi )}
ai ( xi xi 1 ) yi
bi ( xi 1 xi ) yi
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minimise x0 (ci I i 1 yi )
i 1
subject to
ai xi ai xi 1 yi 0
bi xi bi xi 1 yi 0
xi I i I i 1 ri
I i , xi , yi 0, i 1, 2,..., n
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