Chapter 12 – Independent Demand Inventory Management Operations Management by R. Dan Reid & Nada R. Sanders 2 nd Edition © Wiley 2005 PowerPoint Presentation by R.B. Clough - UNH

Types of Inventory

Inventory Management Objectives Maintain good customer service Keep costs as low as possible, consistent with the desired level of customer service Minimize inventory investment

Customer Service Level Examples Percentage of Orders Shipped on Schedule Good measure if orders have similar value. Does not capture value. If one company represents 50% of your business but only 5% of your orders, 95% on schedule could represent only 50% of value Percentage of Line Items Shipped on Schedule Recognizes that not all orders are equal, but does not capture $ value of orders. A 90% service level might mean shipping 225 items out of the total 250 line items totaled from 20 orders scheduled Percentage Of Dollar Volume Shipped on Schedule Recognizes the differences in $ value of orders and line items

Inventory Investment Measures Example: The Coach Motor Home Company has annual cost of goods sold of $10,000,000. The average inventory value at any point in time is $384,615. Calculate inventory turnover and weeks/days of supply. Inventory Turnover: Weeks/Days of Supply:

Relevant Inventory Costs Item Costs Item costs For purchased items, the item cost is the purchase price, plus shipping For work in process, the item cost is the cost of materials and labor used in the item For finished goods, the item cost is the cost of goods sold.

Relevant Inventory Costs (2) Inventory Holding Costs Inventory holding costs include capital costs, storage costs, and risk costs Capital costs: If inventory is financed with borrowed money, the capital cost is the interest rate paid If inventory is financed from retained earnings, the capital cost is the opportunity cost of not putting the money into other investments Storage costs: the costs of space, people, and equipment used in inventory storage

Relevant Inventory Costs (3) Inventory Holding Costs (continued) Risk costs: cost of taxes and insurance on inventory, damage, obsolescence, and theft Inventory holding costs are usually computed as a percentage of item costs

Relevant Inventory Costs (4) Ordering and Setup Costs For purchased items, ordering costs are the fixed costs associated with placing an order with a supplier For items made internally, setup costs are used instead of order costs

Relevant Inventory Costs (5) Shortage Costs Administrative and transportation costs related to back orders Lost good will and lost sales due to product shortages – hard to measure

Dependent Demand Demand for raw materials, component parts, and subassemblies used to make a finished product Both the amount of demand and the date required depend on the production schedule Control systems for dependent demand Material Requirement Planning (MRP) Enterprise Resource Planning (ERP)

Independent Demand Any demand that is not dependent is called independent demand Examples of independent demand: finished goods, retail inventories, distributor inventories, fuels, repair parts; maintenance, repair, and operating (MRO) supplies

Inventory Management Policies An inventory management policy should determine How much to order When to order

Ways to Compute Optimal Order Quantities Economic Order Quantity (EOQ) Used to compute optimal order quantity for independent demand items Economic Production Quantity (EPQ) Order can be delivered in small batches Often used to determine lot size for parts in manufacturing (dependent demand)

Economic Order Quantity EOQ Assumptions: Demand is known & constant - no safety stock is required Lead time is known & constant No quantity discounts are available Ordering (or setup) costs are constant All demand is satisfied (no shortages) The order quantity arrives in a single shipment

Total Annual Inventory Cost with EOQ Model Total annual cost= annual ordering cost + annual holding costs

Continuous (Q) Review System Example: A computer company has annual demand of 10,000. They want to determine EOQ for circuit boards which have an annual holding cost (H) of $6 per unit, and an ordering cost (S) of $75. Calculate TC and the reorder point (R) if the purchasing lead time is 5 days. EOQ (Q) Reorder Point (R) Total Inventory Cost (TC)

Economic Production Quantity (EPQ) Same assumptions as the EOQ except: inventory arrives in increments & is drawn down as it arrives

EPQ Equations Total cost: Maximum inventory: d=avg. daily demand rate p=daily production rate Calculating EPQ

Safety Stock and Service Levels If demand or lead time is uncertain, safety stock can be added to improve order-cycle service levels R = dL +SS Where SS = zσ dL, and Z is the number of standard deviations and σ dL is standard deviation of the demand during lead time Order-cycle service level The probability that demand during lead time will not exceed on-hand inventory A 95% service level (stockout risk of 5%) has a Z=1.645

Justifying Smaller Order Quantities in Manufacturing JIT or “Lean Systems” would recommend reducing order quantities to the lowest practical levels Benefits from reducing Q’s: Improved customer responsiveness (inventory = Lead time) Reduced Cycle Inventory Reduced raw materials and purchased components Justifying smaller EOQ’s: Reduce Q’s by reducing setup time, which also reduces setup cost.