COST MANAGEMENT

Guan ▪ Hansen ▪ Mowen

Chapter 21
Inventory Management:
Economic Order Quantity, JIT,
and the Theory of Constraints
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 1
Cengage Learning and South-Western are trademarks used herein under license.
 Study Objectives
1. Describe the just-in-case inventory
management model.
2. Discuss just-in-time (JIT) inventory
management.
3. Explain the basic concepts of
constrained optimization.
4. Define the theory of constraints, and tell
how it can be used to manage inventory.
2
 Just-in-Case Inventory
Management
• Three types of inventory costs can be readily
identified with inventory:
– The cost of acquiring inventory.
– The cost of holding inventory.
– The cost of not having inventory on hand when
needed.

3
 Just-in-Case Inventory
Management
Ordering Costs: The costs of placing and
receiving an order.
Examples: Clerical costs, documents, insurance for
shipment, and unloading.
Setup Costs: The costs of preparing equipment
and facilities so they can be used to produce a
particular product or component.
Examples: Setup labor, lost income (from idled
facilities), and test runs.

4
 Just-in-Case Inventory
Management
Stock-Out Costs: The costs of not having
sufficient inventory.
Examples: Lost sales, costs of expediting (extra setup,
transportation, etc.) and the costs of interrupted
production.
Carrying Costs: The costs of carrying inventory.
Examples: Insurance, inventory taxes, obsolescence,
opportunity cost of capital tied up in inventory, and
storage.

5
Just-in-Case Inventory
Management

6
 Just-in-Case Inventory
Management
Economic Order Quantity
TC = PD/Q + CQ/2
Where

TC = The total ordering (or setup) and carrying cost

P = The cost of placing and receiving an order (or the
cost of setting up a production run)
Q = The number of units ordered each time an order is
placed (or the lot size for production)
D = The known annual demand
C = The cost of carrying one unit of stock for one year

7
 Just-in-Case Inventory
Management
Economic Order Quantity illustrated
Assume
P = $40 per order
D = 25,000 units
C = $2 per unit

EOQ =  2DP  C 
= (2  25,000  50)  $2
= 1,000,000
= 1,000

8
 Just-in-Case Inventory
Management
When to Order or Produce
Example: Assume that the average rate of usage is
100 parts per day. Assume also that the
lead time is 4 days. What is the reorder
point?

Reorder point = rate of usage × lead time

= 4 × 100 = 400 units

An order should be placed when inventory drops to

400 units.

9
Just-in-Case Inventory
Management

10
 Just-in-Case Inventory
Management
Demand Uncertainty and Reordering
To avoid running out of parts, organizations often
choose to carry safety stock (extra inventory
carried to serve as insurance against fluctuations in
demand).

Example: If the maximum Maximum usage 120

usage of the VCR Average usage (100)
part is 120 units per
day, the average Difference 20
usage is 100 units Lead time × 4
per day, and the lead Safety stock 80
time is four days, the
safety stock is 80.
11
Just-in-Case Inventory
Management

12
 JIT Inventory Management
Setup and Carrying Costs: The JIT Approach
• JIT reduces the costs of acquiring inventory to
insignificant levels by
– Drastically reducing setup time
– Using long-term contracts for outside purchases
• Carrying costs are reduced to insignificant levels
by reducing inventories to insignificant levels.

13
 JIT Inventory Management
Avoidance of Shutdown: the JIT approach
• Total preventive maintenance
– to reduce machine failures
• Total quality control
– To reduce defective parts
• The Kanban system
– To control production

14
 JIT Inventory Management
• The Kanban system is responsible for
ensuring that the necessary products are
produced in the necessary quantities at
the necessary time.
• A card system is used to monitor work in
process
– A withdrawal Kanban
– A production Kanban
– A vendor Kanban

15
JIT Inventory Management

16
JIT Inventory Management

17
 JIT Inventory Management
• Managing discounts and price increases
– Traditional: holding inventories
– JIT: negotiate long-term contracts
• Vendors
– Careful selection; consider more than price
– Close to production facility
– Establish more extensive supplier
involvement

18
 JIT Inventory Management
JIT Limitations
• Patience in implementation is needed.
• Time is required.
• JIT may cause lost sales and stressed
workers.
• Production may be interrupted due to an
absence of inventory.

19
 Basic Concepts of
Constrained Optimization
Every firm faces limited resources and
limited demand for each product.
– External constraints (e.g., market demand)
– Internal constraints (e.g., machine or labor
time availability)
Constrained optimization is choosing the
optimal mix given the constraints faced by
the firm.

20
 Basic Concepts of
Constrained Optimization
Linear Programming
A method that searches among possible solutions until
the optimal solution is identified

Example: Two products, X and Y, The objective function:

provide contribution Z = $300X + $600Y
margins of $300 and
$600, respectively.
The objective is to
maximize total
contribution margin.

21
 Basic Concepts of
Constrained Optimization
Linear Programming

22
 Basic Concepts of
Constrained Optimization

Internal constraints: Linear Programming

X+Y  80 X+Y  80
X + 3Y  120 X + 3Y  120
2C + Y  90 2C + Y  90
X  60
External constraints:
Y  100
X  60 X  0
Y  100 Y  0

23
 Basic Concepts of
Constrained Optimization

24
 Basic Concepts of
Constrained Optimization
Linear Programming

Corner Point X-Value Y-Value Z = $300X + $600Y

A 0 0 $ 0
B 0 40 24,000
C 30 30 27,000
D 45 0 13,500

C is the optimal solution!

25
 Theory of Constraints
Measures of Systems Performance
– Throughput*
• The rate at which an organization generates money
through sales
– Inventory
• The money the organization spends in turning
materials into throughput
– Operating expenses
• The money the organization spends in turning
inventories into throughput

*Throughput =
 Var Exp 
Sales - Unit-level
Rev
Time
26
 Theory of Constraints
Five-Step Method for Improving Performance
• Identify an organization’s constraints.
• Exploit the binding constraints.
• Subordinate everything else to the decisions
made in Step 2.
• Elevate the organization’s binding constraints.
• Repeat the process as a new constraint
emerges to limit output.

27
Theory of Constraints

28
Theory of Constraints

29
Theory of Constraints

30
COST MANAGEMENT

Guan ▪ Hansen ▪ Mowen

End Chapter 21

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 31

Cengage Learning and South-Western are trademarks used herein under license.