Supply Chain Management (SCM) Inventory management Dr. Husam Arman 18/10/2009

Today’s Outline Inventory (system): What? Motivation for holding inventories Characteristics of inventory systems Types of inventory Inventory costs Identifying critical inventory items The EOQ model Overview of inventory policies P, Q and hybrid systems

Inventory System Inventory is the stock of any item of resource used in an organization and can include: raw materials, component parts, supplies, work-in-process and finished goods An inventory system is the set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be?

To summarize; Purposes of Inventory 1. To maintain independence of operations. 2. To meet variation in product demand. 3. To allow flexibility in production scheduling. 4. To provide a safeguard for variation in raw material delivery time. 5. To take advantage of economic purchase-order size. 4

Independent vs. Dependent Demand Independent Demand (Demand not related to other items or the final end-product) Dependent Demand (Derived demand items for component parts, subassemblies, raw materials, etc.) E(1) 6

Types of Inventory Cycle Inventory Safety Stock Inventory The portion of total inventory that varies directly with lot size (Q) Safety Stock Inventory Surplus inventory that a company holds to protect against uncertainties in demand, lead time and supply Anticipation Inventory Inventory used to absorb uneven rates of demand or supply Pipeline Inventory Inventory moving from point to point in the material system

Characteristics of inventory systems Demand Constant Vs. Variable Lead time External order: time between placement of an order until arrival of goods Internal production: amount of time required to produce a batch of items Lead time can be deterministic or random Replenishment How does the order arrive? uniform over time, instantaneous batches

Characteristics of inventory systems Review time Continuous review: inventory level is known at all times Periodic review: inventory level is known only discrete points in time Excess demand Back ordering: excess is satisfied in the future Lost sales: excess demand is lost Changing inventory Inventory may change over time: limited shelf life (perishable good –food), obsolescence (e.g. automotive parts)

Inventory costs Optimization criterion: cost minimization Holding (carrying) cost Cost of storage, handling, tax / insurance, breakage deterioration, obsolescence, opportunity cost of alternative investment (cost of capital) etc. Proportional to the amount of inventory on hand Dimension: $ per unit per year Setup (production change-over) or ordering cost Cost of arranging specific equipment setups or someone placing an order Penalty (shortage or stock-out) costs Lost sales, loss of goodwill

Identifying critical inventory items (ABC analysis)

Q 3 page 628, demonstrate graphically Homework - 2 Q 3 page 628, demonstrate graphically

The EOQ Model EOQ = Economic Order Quantity Simplest, most fundamental model, basis for more complex models Trade-off: fixed order costs and holding costs One of the oldest and most well known inventory control techniques Easy to use Based on a number of assumptions!

The EOQ Model Assumptions; Constant demand rate No constraints on lot size Only relevant costs are holding and ordering/setup Decisions for items are independent from other items No uncertainty in lead time or supply

The EOQ Model Average cycle inventory Q — 2

The EOQ Model

The EOQ Model Annual Holding Ordering Cost Total Annual Cost = + C = Total annual cost D = Demand Q = Order quantity S = Cost of placing an order or setup cost H = Annual holding and storage cost per unit of inventory

Two Methods for holding cost Holding cost (H) can be expressed either: As a fixed cost, such as H = $0.50 per unit per year As a percentage of the item’s purchase cost (P) H = I x P I = a percentage of the purchase cost

How can we find EOQ? From above The EOQ Model How can we find EOQ? From above

The EOQ Model

Have a look at example 13.2, page 604 The EOQ Model Have a look at example 13.2, page 604

Overview of inventory policies Two basic questions: Q1: When should we order (or produce)? Q2: How much? Typical answers to Q1: When inventory level is equal (or below) a level R Every P time units Typical answers to Q2: Order or produce Q units Order or produce such that the inventory level T Models: Continuous review: (R, Q) Periodic review: (P, T, Q)

Continuous Review (Q) System Tracks inventory after every withdrawal Determines if re-order (R) is necessary Fixed Order Quantity (Q) Inventory Position (IP) considers: Scheduled Receipts (SR) On-Hand Inventory (OH) Backorders (BO)

Periodic Review (P) Time between orders is fixed, P Quantity changes to meet needs Stock positions are restored on pre-determined dates to (T) Target Inventory Level When the order arrives (IP) and (OH) are identical

Comparison of Q and P Systems Q Systems P Systems Idle state Idle state Demand occurs Demand occurs Review time? Compute IP Reorder point? Compute IP Compute Q needed for T Issue order; Q Issue order; Q

Comparison of Q and P Systems Q Systems Individual review frequencies Possible quantity discounts as fixed Q Lower, less-expensive safety stocks P Systems Convenient to administer as fixed interval Orders may be combined IP only required at review

Q System – recording point Inv. Position = on hand inv. + scheduled receipts – backorders IP = OH + SR - BO

Reorder Point (ROP) ROP = d x L Where; d = demand and L = lead time d and L are certain

If demand and lead time is not certain we need to use Safety Stock

Q System- when demand and lead time are constant and certain

Q System- when demand and lead time are uncertain

Finding the safety stock using service level policy

Finding the safety stock using service level policy If cycle service level is 85%, then probability of stock out is 15% Safety stock

Finding the safety stock using service level policy Have a look at example 13.5 page 612

Q review system – total costs

Q review system – total costs Have a look at example 13.6 page 614

Visual system R R Full Empty Order One Bin of Inventory Two-Bin System Full Empty Order One Bin of Inventory R One-Bin System Order Enough to Refill Bin R 25

Periodic review (P) system We need to calculate; Time between reviews, P Target inventory level, T P = EOQ / D (years) T = d (P + L) + safety stock for protection interval Where d = demand during P + L Safety stock =

P System

P review system – total costs

P review system – total costs Have a look at example 13.8 page 617

Hybrid System

Hybrid System: Base-stock level System Very simple system Issue a replenishment order with a quantity equal to the withdrawal one This will maintain the IP at a base-stock level Expensive items (e.g. aero engine) Just-in-time 24

Hybrid System: Optional Replenishment System Maximum Inventory Level, M Actual Inventory Level, I q = M - I I M Do you remember the P system? Q = minimum acceptable order quantity If q > Q, order q, otherwise do not order any. 24

Inventory Accuracy and Cycle Counting Defined Inventory accuracy refers to how well the inventory records agree with physical count. Cycle Counting is a physical inventory-taking technique in which inventory is counted on a frequent basis rather than once or twice a year. (e.g. class A in particular) 27