24-1 Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University

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. ObjectivesObjectives After studying this chapter, you should be able to:

24-3 Just-in-Case Inventory Management Three types of inventory costs can be readily identified with inventory: (1)The cost of acquiring inventory. (2)The cost of holding inventory. (3)The cost of not having inventory on hand when needed.

Ordering Costs: The costs of placing and receiving an order. Examples:Clerical costs, documents, insurance for shipment, and unloading. 2.Carrying Costs: The costs of carrying inventory. Examples:Insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, and storage. Economic Order Quantity

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. 4.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. Economic Order Quantity

To balance ordering or setup costs and carrying costs 2.Demand uncertainty 3.Machine failure 4.Defective parts 5.Unavailable parts 6.Late delivery of parts 7.Unreliable production processes 8.To take advantage of discounts 9.To hedge against future price increases Traditional Reasons for Carrying Inventory

24-7 Economic Order Quantity TC = PD/Q + CQ/2 The total ordering (or setup) and carrying cost The cost of placing and receiving an order (or the cost of setting up a production run) The known annual demand The number of units ordered each time an order is placed (or the lot size for production) The cost of carrying one unit of stock for one year

24-8 An EOQ Illustration EOQ =  2PD/C D = 25,000 units Q = 500 units P = $40 per order C = $2 per unit EOQ =  (2 x 25,000 x $40) / $2 EOQ =  1,000,000 EOQ = 1000 units

24-9 Reorder point = Rate of usage x Lead time Example: Assume that the average rate of usage is 4 units per day for a component. Assume also that the time required to place and receive an order is 10 days. What is the reorder point? Reorder point = 4 x 10 = 40 units Thus, an order should be placed when inventory drops to 40 units. When to Order or Produce

24-10 The Reorder Point Reorder point = Rate of usage x Lead time Reorder Point (EOQ) Days Inventory (units)

24-11 Demand Uncertainty and Reordering To avoid running out of parts, organizations often choose to carry safety stock. Safety stock is extra inventory carried to serve as insurance against fluctuations in demand. Example: If the maximum usage of the VCR part is 120 units per day, the average usage is 100 units per day, and the lead time is four days, the safety stock is 80. Maximum usage120 Average usage-100 Difference20 Lead time x 4 Safety stock80

24-12 Example Involving Setups Expedition Company manufactures edgers. The manager is trying to determine the size of the production run. The controller has supplied the following information: Average demand for edgers: 720 per day Maximum demand for edgers: 780 per day Annual demand for edgers: 180,000 Unit carrying cost: $4 Setup cost: $10,000 Lead time: 22 days

24-13 Example Involving Setups EOQ =  2PD/C EOQ =  (2 x 180,000 x $10,000)/$4 EOQ =  900,000,000 EOQ = 30,000 edgers

24-14 Example Involving Setups Safety stock: Maximum usage780 Average usage 720 Difference60 Lead time x 22 Safety stock1,320 Reorder point = (Average usage x Lead time) + Safety stock Reorder point = (720 x 22) + 1,320 Reorder point = 17,160 edgers

24-15 JIT reduces the costs of acquiring inventory to insignificant levels by: 1. Drastically reducing setup time 2. Using long-term contracts for outside purchases Carrying costs are reduced to insignificant levels by reducing inventories to insignificant levels. Setup and Carrying Costs: The JIT Approach JIT Inventory Management

24-16 JIT Inventory Management Due-Date Performance: The JIT Solution Lead times are reduced so that the company can meet requested delivery dates and to respond quickly to customer demand. Lead times are reduced by: reducing setup times improving quality using cellular manufacturing

24-17 JIT Inventory Management Avoidance of Shutdown: The JIT Approach  Total preventive maintenance to reduce machine failures  Total quality control to reduce defective parts  The use of the Kanban system is also essential

24-18 What is the Kanban System? A card system is used to monitor work in process  A withdrawal Kanban  A production Kanban  A vendor Kanban The Kanban system is responsible for ensuring that the necessary products are produced in the necessary quantities at the necessary time.

24-19 Withdrawal Kanban Item no.__________________________ Preceding Process Item name_____________________________________ Computer Type_________________________________ Box Capacity_____________________ Subsequent Process Box Type_______________________________________________ 15670T07 Circuit Board TR6547 PC CB Assembly 8 CFinal Assembly

24-20 Production Kanban Item no.__________________________ Preceding Process Item name_____________________________________ Computer Type___________________ Box Capacity_____________________ Box Type______________________________ 15670T07 Circuit Board TR6547 PC CB Assembly 8 C

24-21 Vendor Kanban Item no.____________________ Name of Receiving Company Item name_____________________________________ Box Capacity___________________ Box Type___________________ _ _ Time to Deliver__________________________________________ Name of Supplier_________________________________________ 15670T07 Circuit Board 8 Electro PC A 8:30 A.M., 12:30 P.M., 2:30 P.M. Receiving Gate 75 Gerry Supply

24-22 The Kanban Process WithdrawalStore CBStores Lot with P-Kanban Production Ordering Post (6) Signal CB Assembly Remove (4) P-Kanban Attach to Post (5) Attach W-Kanban (1) Remove W-Kanban Attach to Post Withdrawal Post (2), (3) (7) Final Assembly (1)

24-23 Discounts and Price Increases: JIT Purchasing Versus Holding Inventories  Careful vendor selection  Long-term contracts with vendors  Prices are stipulated (usually producing a significant savings)  Quality is stipulated  The number of orders placed are reduced JIT Inventory Management

24-24 JIT Limitations Patience in implications is needed. Time is required. JIT may cause lost sales and stressed workers. Production may be interrupted due to an absence of inventory.

24-25 Linear Programming The unit contribution margins are $300 and $600 for X and Y, respectively. Z = $300X + $600 Y Total contribution margin This equation is called the objective function, the function to be optimized.

24-26 Linear Programming Internal constraints: X + Y  80 X + 3Y  120 2X + Y  90 External constraints: X  60 Y  100

24-27 Linear Programming X + Y  80 X + 3Y  120 2X + Y  90 X  60 Y  100 X  0 Y  0

24-28 Multiple Constrained Resource Y  100 X  60 X + Y  80 X + 3Y  120 2X + Y  90

24-29 Multiple Constrained Resource A B C D

24-30 Linear Programming Corner Point X-Value Y-Value Z = $300X + $600Y A00$ 0 B04024,000 C303027,000 D45013,500 C is the optical solution!

24-31 Throughput Inventory Operating expenses Three Measures of Systems Performance: Theory of Constraints (Sales revenue – Unit-level variable expenses)/Time

Identify an organization’s constraints. 2. Exploit the binding constraints. 3. Subordinate everything else to the decisions made in Step Elevate the organization’s binding constraints. 5. Repeat the process as a new constraint emerges to limit output. Five-Step Method for Improving Performance

24-33 The Drum-Buffer-Rope System Materials Process A Process C Rope Drummer Process Time Buffer Final Process Finished Goods Initial Process Process B

24-34 New Constraint Set: Schaller Co Y  100 X  60 X + Y  80 2X + Y  90 X + 3Y  240

24-35 New Constraint Set: Schaller Co ABC D

24-36 End of Chapter

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