1 Lecture 6 Inventory Management Chapter 12

2 Types of Inventories  Raw materials & purchased parts  Partially completed goods called work in progress  Finished-goods inventories  (manufacturing firms) or merchandise (retail stores)  Replacement parts, tools, & supplies  Goods-in-transit to warehouses or customers

3 Functions of Inventory  To meet anticipated demand  To smooth production requirements  To decouple operations  To protect against stock-outs  To take advantage of order cycles  To help hedge against price increases  To permit operations  To take advantage of quantity discounts

4 Objective of Inventory Control  To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds  Level of customer service  Costs of ordering and carrying inventory

5  Lead time: time interval between ordering and receiving the order  Holding (carrying) costs: cost to carry an item in inventory for a length of time, usually a year  Ordering costs: costs of ordering and receiving inventory  Shortage costs: costs when demand exceeds supply Key Inventory Terms

6  Divides inventory into three classes based on annual dollar volume  Class A - high annual dollar volume  Class B - medium annual dollar volume  Class C - low annual dollar volume  Used to establish policies that focus on the few critical parts and not the many trivial ones  No “hard-and-fast” rule to classify into different categories Inventory Classification Systems ABC Analysis

7 Item Stock Number Percent of Number of Items Stocked Annual Volume (units)xUnit Cost= Annual Dollar Volume Percent of Annual Dollar VolumeClass # %1,000$ 90.00$ 90, %72%A # , %A #127601, $ 26, %B # % ,0016.4%23%B #105001, ,5005.4%B ABC Analysis Example # $ 14.17$ 8,5023.7%C #140752, ,200.5%C # % %5%C #013071, %C # %C $232,057

8  Economic order quantity (EOQ) model  Economic production model (EPQ)  Quantity discount model Economic Order Quantity Models

9 The Inventory Cycle Profile of Inventory Level Over Time Quantity on hand Q Receive order Place order Receive order Place order Receive order Lead time Reorder point Usage rate Time

10 Total Cost Annual carrying cost Annual ordering cost Total cost =+ Q 2 H D Q S TC = + Formula (11-1)

11 Cost Minimization Goal Order Quantity (Q) The Total-Cost Curve is U-Shaped Ordering Costs QOQO Annual Cost ( optimal order quantity)

12 Deriving the EOQ & Minimum Total Cost The total cost curve reaches its minimum where the carrying and ordering costs are equal. Number of orders per year = D/Q 0 Length of order cycle = Q 0 /D Formula (11-2) Formula (11-3)

13 Inventory Management – In-class Example  Number 2 pencils at the campus book-store are sold at a fairly steady rate of 60 per week. It cost the bookstore $12 to initiate an order to its supplier and holding costs are $0.005 per pencil per year.  Determine  (a) The optimal number of pencils for the bookstore to purchase to minimize total annual inventory cost,  (b) Number of orders per year,  (c) The length of each order cycle,  (d) Annual holding cost,  (e) Annual ordering cost, and  (f) Total annual inventory cost.  (g) If the order lead time is 4 months, determine the reorder point.  Illustrate the inventory profile graphically.  What additional cost would the book-store incur if it orders in batches of 1000?

14 Management Scientist Solutions (a) (b) (c) (d) (e) (f) (g)

15  Only one product is involved  Annual demand requirements known  Demand is even throughout the year  Lead time does not vary  Each order is received in a single delivery  There are no quantity discounts Assumptions of EOQ Model

16 EOQ with Quantity Discounts  The EOQ with quantity discounts model is applicable where a supplier offers a lower purchase cost when an item is ordered in larger quantities.  This model's variable costs are  Annual holding,  Ordering cost, and  Purchase costs  For the optimal order quantity, the annual holding and ordering costs are not necessarily equal.

17 EOQ with Quantity Discounts  Formulae  Optimal order quantity: the procedure for determining Q * will be demonstrated  Number of orders per year: D/Q *  Time between orders (cycle time): Q */D years  Total annual cost: (formula 11.9 of book) (holding + ordering + purchase)

18 Example – EOQ with Quantity Discount  Walgreens carries Fuji 400X instant print film  The film normally costs Walgreens $3.20 per roll  Walgreens sells each roll for $5.25  Walgreens's average sales are 21 rolls per week  Walgreens’s annual inventory holding cost rate is 25%  It costs Walgreens $20 to place an order with Fujifilm, USA  Fujifilm offers the following discount scheme to Walgreens  7% discount on orders of 400 rolls or more  10% discount for 900 rolls or more, and  15% discount for 2000 rolls or more  Determine Walgreen’s optimal order quantity

19 Management Scientist Solutions

20  Too much inventory  Tends to hide problems  Easier to live with problems than to eliminate them  Costly to maintain  Wise strategy  Reduce lot sizes  Reduce safety stock Operations Strategy

21 The Balance Sheet – Dell Computer Co.

22 Income Statement – Dell Computer Co.

23 Debt Ratio  What It Measures: The extent to which a firm uses debt financing  How You Compute: The ratio of total debt to total assets

24 Inventory Turnover Ratio  What It Measures: How effectively a firm is managing its inventories.  How You Compute: This ratio is computed by dividing sales by inventories Inventory turnover ratio =

25 Course Conclusions  Recognize that not every tool is the best fit for every problem  Pay attention to variability  Forecasting  Inventory management - Deliveries from suppliers  Build flexibility into models  Pay careful attention to technology  Opportunities  Improvement in service and response times  Risks  Costs involved  Difficult to integrate  Need for periodic updates  Requires training  Garbage in, garbage out  Results and recommendations you present are only as reliable as the model and its inputs  Most decisions involve tradeoffs  Not a good idea to make decisions to the exclusion of known information