1 Materials Management Operations Management Session 3

2 Objectives By the end of this session, student will be able to: –Appreciate the need to make key inventory decisions –Understand and calculate the costs associated with inventory –Use the Economic Order Quantity System to determine order volumes and frequencies –Understand the relationship between inventory control and customer service.

3 Topics How inventory comes about Decisions and Costs Economic Order Quantity (EOQ) Pareto principle of stock control

4 Definitions Inventory –the stock of any item or resource used in an organization: raw materials, finished products, component parts, supplies and work-in-process. An inventory system –policies and controls for monitoring levels of inventory Information system that records transactions and enables analysis of stock requirements and levels/quantities, costs etc

5 Stock Supply Rate Inventory Level Rate of Demand Stock Level

6 Independent vs. Dependent Demand Independent Demand (not related to other items or final end-product) e.g. Office Stationary Dependent Demand (derived from component parts, sub-assemblies, raw materials, etc.)

7 Why Does Inventory Arise? Raw-materials bought at advantageous price Components and Sub-assemblies Work-in-progress or in-transit Finished-goods –In the warehouse –Awaiting shipment –In delivery vehicles –In tanks –On shelves –In the stores Strategic inventory Scrap & re-work

8 Inventory Types Buffer Inventory compensates for unexpected fluctuations in supply or demand Cycle Inventory because a stage in the process cannot supply all items simultaneously De-coupling Inventory in a process layout WIP joins a queue Anticipation Inventory when demand fluctuations are large but predictable Pipeline Inventory when stock is allocated until it is available eg. In delivery

9 Single & Multi-Stage Inventory Systems Small Retail Shop Television Manufacturer Multi-Stage Inventory System Single-Stage Inventory System Stock Sales Operation Suppliers Input Stocks Stage 1 Stage 2Stage 3 Finished Goods Stock WIP

10 Inventory Decisions How much to order When to order How much it will cost What the re-order level is How much safety stock needed How to control a large inventory system

11 The Volume Decision Simple Illustration – Food Shopping –Do we hold little stock in the cupboards and the refrigerator and shop frequently or –Do we have a large refrigerator and larder and buy in bulk What issues do we think about when making the decision? Translate these into a business context.

12 Inventory Costs Ordering Costs –Administrative costs of ordering Production Inefficiency Cost –Inventory obscures operational problems Holding Costs –Working capital cost –Storage costs –Insurance –Deterioration and obsolescence Stock Out Costs –Cost to the business of running out of stock Discounts for Bulk Purchase

13 Order Quantities & Re-order Points R = Re-order point L = Lead time L q R Time No. of units on hand Safety or buffer level Average Stock q/2 q By having a lower buffer level and re-ordering more often inventory may be reduced

14 EOQ Aim = Cost Minimisation Cost Ordering Costs Holding Costs Q eoq Order Quantity (Q) Total Cost Holding + ordering costs = total cost curve Find Q EOQ inventory order point to minimise total costs

15 Economic Order Quantity (EOQ) Assumptions Single product line Demand rate: recurring, known, constant Lead time: constant, known No quantity discounts - stable unit cost No stock-outs allowed Items ordered/produced in a lot or batch Batch received all at once Holding cost is linear based on average stock level Fixed order + set up cost

16 Safety Stock and Re-order Levels Reserve –Buffer –Cushion against uncertain demand (usage) & lead time –"2-bin" system –Use of JIT Depends on: –Uncertainty: demand & lead time –Cost of being out of stock carrying inventory increasingly better service –Service level policy –% confidence of not hitting a stock-out situation

17 Bin Systems Two-Bin Order when Bin 1 empty One-Bin Periodic Check Order enough to refill bin? Bin 1 Items being used Bin 2 Re-order Level

18 Order Cost & Holding Cost Q = number of pieces per order Q EOQ = Optimum number of pieces per order D = annual demand in units for the inventory item S = Setup or ordering cost for each order H = Holding or carrying cost per unit per year Annual Holding Cost = Order Quantity 2 X Holding cost per unit per year Q2Q2 H = X Order Cost per Order Annual Demand Number of units in each order DQDQ S = Annual Order Cost =

19 Calculate EOQ Economic (optimal) order quantity is found when annual setup cost equals annual holding cost DQDQ S Q2Q2 H = Q 2 = 2DS H H Q EOQ =

20 EOQ & ROP Q EOQ = 2DS H = 2(Annual Demand)(Order or set-up cost) Annual Holding Cost ROP = DL D = Avg daily demand (constant) L = Lead time (constant) When to place an order – finding Re-order Point (ROP) Exercise – find EOQ and ROP: Annual demand = 1,000 units Days/year in average daily demand = 365 Cost to place an order = £10 Holding cost /unit p.a. = £2.50 Lead time = 7 days Cost per unit = £15

21 Solution Q EOQ = 2DS H = 2(1,000 )(10) 2.50 = units or 90 units D= 1,000 units p.a. 365 days p.a. = 2.74 units/day Reorder point D L = 2.74 units/day = or 20 for 7 day lead time EOQ order = 90 units. When only 20 units left, place next order for 90 units.

22 EOQ and ROQ - Example 2 Annual Demand = 10,000 units Days per year considered in average daily demand = 365 Cost to place an order = £10 Holding cost per unit per year = 10% of cost per unit Lead time = 10 days Cost per unit = £ (366 units)= (10,000)(10) = H 2DS =Q eoq D = 10,000 units/year 365 days = units/day If lead time = 10 days, ROL= = 274 units Place order for 366 units. When 274 left, place next order for 366.

23 Exercise 1 Each month a particular retailer sells 100 TV sets. The inventory holding cost is £50 per TV per month. The ordering cost is £100 and each TV set costs the retailer £80. –What is the EOQ? –How many orders will be placed each month? –If the inventory cost is increased by £5 per TV per month, what will be the change in the EOQ?

24 Exercise 2 A fishmonger with a market stall sells 5000kg of fish each month. It costs £10 to have fresh fish delivered, and each kg of fish ordered costs the fishmonger £2. The cost of keeping the fish is £1 per kg per month, which is largely due to the cost of refrigeration. All fish must be sold within a week of delivery or else be discarded. What is the EOQ? How many orders will be placed each month?

25 ABC System of Inventory Control % of total number of items Cumulative % of Inventory Value A B C Pareto – 20/80 Principle:- Class A Items 20% of high usage value items account for 80% of total usage value Class B Items next 30% accounts for around 10% of total usage value Class C Items about 50% of total items stocked only account for 10% of usage value

26 Interpretation of ABC System Often interpreted as indicating that managers should concentrate on A Class Items since these produce most revenue However, could also be interpreted as indicating that managers should look closely at C Class items since these tie up most working capital

27 Stock Check Book stock vs physical stock Stock valuation – wastage & shrinkage Audit stock security systems Organising the stock check Internal & external audit –Segmentation of duties