Atomic Dog Publishing, Inc.

Atomic Dog Publishing, Inc.

Chapter Fourteen: Inventory Management 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Outline of Chapter Fourteen 14-1 Types of Inventory Situations 14-2 Costs of Inventory 14-3 Differentiation of Inventory Costs by Process Type 14-4 Order Point Policies (OPP) 14-5 Economic Order Quantity (EOQ) ModelsBatch Delivery

14-6 Economic Lot Size (ELS) Models 14-7 Perpetual Inventory Systems 14-8 Periodic Inventory Systems 14-9 Quantity Discount Model 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-1 Types of Inventory Situations Seven issues differentiate classes of inventory situations. Here are 1 thru 3. 1. Static vs. Dynamic Inventory Models: Static applies when one decision is allowed about how much to buy for a constrained marketing window such as Valentines Day. Dynamic situations require continuous decisions

about how much to order at different points in time. 2. Make or Buy Decisions: A major decision with many factors. Definitive ways exist to decide whether to do-it-yourself or outsource the work. 3. How certain is demand? Certainty exists if there is a contract for a given number of units. Risk exists when a distribution of demand possibilities has been accepted as a reasonable forecast. Uncertainty is when a reasonable forecast has not been derivedand anything could occur. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-1 Types of Inventory Situations (continued) Seven issues differentiate classes of inventory situations. Here are 4 thru 7. 4. Seasonality will alter demand distributions in a stable fashion. If other drivers of change occur which are not anticipated, the forecasting system for demand is not stable, and the distribution will vary in unexpected ways. 5. Smooth demand systems allow regular withdrawals from inventory and good production planning. Lumpy and sporadic demands may lead to stock outages as well as overstock situations. 6. The interval between placing an order and receiving the replenishment stock is the lead time. Inventory planning is more difficult when lead time can vary a great deal. 7. Dependent demand exists when components are required as part of an assembly, e.g., steering wheels and autos. Independent demands are not tied to other item demands. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved.

14-2 Costs of Inventory The core of inventory analysis lies in finding and measuring relevant costs. Six major costs are listed and a seventh for others. Here are 1 thru 3. 1. Ordering costs (Cr) include operating systems to signal need; determining from whom to order and how much; placing the order; receiving, inspecting, storing items, documenting receipt, paying suppliers, and notifying users. 2. Setup, takedown, and changeover functions (Cs) are job shop costs. Efforts have led to major cost-cutting. This has promoted higher production variety levels. Such cost savings are termed economy of scope. 3. Costs of carrying inventory (cCc) are best summarized by Table 14-1 which has estimates for high, medium, and low carrying cost rates (Cc). The per unit costs (c) of inventoried items are charged a tax (Cc) for interest that is not earned, storage, spoilage, pilferage, insurance, etc. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Carrying Costs of Inventory Table 14-1 Components of Carrying Costs (Cc): Historically High, Medium, and Low Estimates as a Percent of the Products Cost per Year Category High

Medium Low Lost opportunity costs* 15.00 9.00 6.00 Obsolescence 3.00 1.00 0.00 Deterioration 3.00

1.00 0.25 Shipping and handling 2.00 1.00 0.25 Taxes 0.25 0.10 0.05 Storage cost 0.25 0.10

0.05 Insurance 0.25 0.10 0.05 Miscellaneous 0.25 0.10 0.05 Theft 6.00 0.10

0.05 Cc totals 30.00% 12.50% 6.75% *Loss due to inability to invest funds in profit-making ventures, including loss of interest. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-2 Costs of Inventory The core of inventory analysis lies in finding and measuring relevant costs. Six major costs are listed and a seventh for others. Here are 4 thru 6. 4. Accepting discounts offered for buying larger volumes entails extra carrying costs and reductions in ordering costs. Discounts must at least offset any net additional costs to make them worth consideration. 5. Out-of-stock costs can vary from trivial to significant penalties. If the outage applies to a critical item, the problem can assume major proportions. 6. Costs of running the inventory system include processing data, updating information, etc. These systemic costs will vary according to the size and geographic dispersion of the inventory, the need to be up-to-the-minute,

the capabilities of the computer system, and the training of personnel. It will also depend on whether the inventory system is perpetual or periodic 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-2 Costs of Inventory (continued) The core of inventory analysis lies in finding and measuring relevant costs. Six major costs are listed and a seventh for others. Here is 7. 7. Other costs are associated with special circumstances. For example the cost of delay in processing orders can be crucial for heart transplant patients. Service organizations are sensitive to customer displeasure with delays in providing services such as healthcare, restaurant food, restoration of electricity, or telephone repair. Production interruptions can be costly. Salvage costs can be relevant in static inventory situations, for E-bay and for the antique business. Spoilage costs, in some instances, might be better treated separately from carrying costs. The key is to capture costs that are the true drivers of the inventory system. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-3 Differentiation of Inventory Costs by Process Type Significantly different inventory costs characterize each type

of work configuration. The cost differentials play a major strategic role in P/OM planning for capacity, quality, and delivery speed. Flow shops have low ordering cost, rarely incur setup costs, obtain discounts on volume purchases, suffer serious penalties for production interruptions. Therefore, deliveries are crucial. Job shops have salvage problems, do not obtain discounts, have high ordering costs and low carrying costs, high setup costs but low outage costs. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-3 Differentiation of Inventory Costs by Process Type Projects have high ordering costs with single orders to fulfill expected demand. Interruptions can be prohibitively

costly. Time is of the essence. Good project management controls setup and cleanup costs which can be substantial. Modularity can help cut setup times and costs. Flexible Process Systems (FPS) including FMS use common parts for production families. This promotes volume discounts. By the very nature of flexibility, setup costs are low but the capital costs of equipment is high and so full utilization must be promoted. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-4 Order Point Policies (OPP) OPP define the stock level for reordering, called the reorder point (RP), or OPP define an interval (to) between orders. Perpetual inventory systems continuously monitor stock levels. Stock withdrawals are usually onlinereal time. The computer is

programmed to note that the RP is reached and calls for an order of fixed size. Intervals between orders vary with demand. Periodic inventory systems operate a time-based reorder point policy. Orders are placed at specific dates, often coordinated with delivery constraints. Orders are of varying size, placed at specific points in time, with fixed intervals between orders. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Conditions for OPP and MRP MRP is the acronym for material requirements planning. It is an alternative system for managing inventories. Table 14-2 describes the conditions under which OPP and MRP apply. Table 14-2 Continuity Requirement Model Type Static order One-shot, single period

Dynamic orders OPP Continuous smooth demand OPP Sporadic demand in clusters MRP Demand Dependency Requirement Model Type Independent OPP Components dependent on end item MRP 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved.

14-5 Economic Order Quantity (EOQ) ModelsBatch Delivery EOQ models determine fixed order quantities (Qo) based on minimizing total variable costs (TVC) which are the sum of the carrying costs and the ordering costs for each stock keeping unit (SKU). These costs are shown in Figure 14-1. Figure 14-1 Variable Carrying Cost Line (A) and Variable Carrying Cost Curve (B) 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Economic Order Quantity (EOQ) Models Figure 14-2 shows two separate situations in one diagram. The first has order quantity of Q = 1,000. Withdrawals from stock are continuous and regular. For Q = 1,000, the average inventory is half that amount, i.e., 500. Delivery occurs at year 1 and 2. The 1,000 items enter inventory in a single batch. Work out the details for Q = 500. Figure 14-2 Constant Withdrawal Order Policies for Q = 1,000 and Q = 500 units; Demand (D) = 1,000 Units/Year 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Economic Order Quantity (EOQ) Models Figure 14-4 has more information than Figure 14-1, but it portrays the same situation. The minimum of the total variable cost line (TVC)

occurs at (Qo). c is the cost per unit; D is the demand per year; Cc is the carrying cost rate per year, Cr is the ordering cost per order. Figure 14-4 Total Variable Cost: TVC = (Carrying Costs + Ordering Costs) in Dollars/Year As a Function of Q 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Economic Order Quantity (EOQ) Models The fixed and optimal (Q-sub-oh for Qoptimal) order quantities (Qo) result from the square root formula shown here where c is the cost per unit, D is the demand per time period, Cc is the carrying cost rate, Cr is the ordering cost. 2 DCr Qo cCc 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-6 Economic Lot Size (ELS) Models ELS models provide continuous delivery of product instead of delivery in batches. The EOQ delivery pattern is shown in Table 14-3 where a batch delivery of 6 units is made every third day (called A). The ELS delivery pattern of two units every

day is called B, and is shown in Table 14-4. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. The Intermittent Flow Shop (IFS) Model The ELS model determines optimal online run time for an item. Run time is equivalent to production output in units so ELS determines optimal online number of production units (Qo). 2 DCs p Qo cCc p d where c is the cost per unit, D is the demand per time period, Cc is the carrying cost rate, Cs is the setup cost, p is production rate per day. d is demand in units per day. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Table 14-3 Batch Production of Table 14-4 Continuous Production Six Units at a Time

Day # of Units Stage of Completion Day # of Units Stage of Completion 1 6 units started Six units are one-third finished 1 2 units

started Two units are finished and delivered 2 Six units are two-thirds finished 2 2 units started Two units are finished and delivered 3 Six units are completed and delivered 3

2 units started Two units are finished and delivered Six units are one-third finished 4 2 units started Two units are finished and delivered 5 Six units are two-thirds finished 5 2 units

started Two units are finished and delivered 6 Six units are completed and delivered 6 2 units started Two units are finished and delivered Six units are one-third finished 7 2 units started

Two units are finished and delivered 8 Six units are two-thirds finished 8 2 units started Two units are finished and delivered 9 Six units are completed and delivered 9 2 units

started Two units are finished and delivered 18 units delivered in 9 days Total 18 units finished 18 units delivered in 9 days 4 7 Total 6 units started

6 units started 18 units finished 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. The Intermittent Flow Shop (IFS) Model Figure 14-5 graphically depicts the behavior of the ELS model. Note the production rate line is calculated by pt1. Time, t1, is online production run time for our item. It is 415 days in the figure. Then, production of our item ceases until day 500. Off-line time, t2 = 85, can and should be used to make other items that are group technology compatible. Figure 14-5 The Operation of the Economic Lot Size (ELS) Model for Intermittent Flow Shop Planning 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. The IFS Model Figure 14-6 shows maximum storage required as well as rates (p-d) and d where (p-d) is daily production for period t1 minus daily withdrawal for period t2. Figure 14-6 The ELS triangle is divided into two right triangles called A

and B: A shows stock accumulation at the rate of (p d), and B reflects continuous deliveries at the rate of (d) units per time period. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Buy (EOQ) or Make (ELS) with Lead Time (LT) Determination Figure 14-7 compares the EOQ purchasing model with the ELS producer model. The costs of each system can be derived and compared to determine Make or Buy. LT controls should be exercised including expediting when required. Figure 14-7 Lead Time Determines the Reorder Point for Both EOQ and ELS Models Lead time = LT Reorder point = QRP 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-7 The Perpetual Inventory System EOQ and ELS models assume no variability of demand. Variability of demand is a fact of life except under contract. Figure 14-8 shows the calculation of the reorder point QRP for the online, real time, continuous monitoring of the perpetual inventory system. Note how Buffer (Safety) stock is included in QRP. The size of the tail (probability for outages) is determined by QRP.

Figure 14-8 Determination of the Reorder Point QRP 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Operating the Perpetual Inventory System Saw tooth shape of the EOQ is evident in this purchase Qo situation. In Figure 14-9 Buffer stock is shaded; QRP is indicated; LT for replenishment is constant; interval between orders varies. Figure 14-9 A Perpetual Inventory System SOH Computed with Each Withdrawal 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Two-Bin Perpetual Inventory Control System Figure 14-10 shows a two-bin (PIC) system. It is ideal for liquid and small part inventories. When replenishment order, Qo is received, Bin 1 is filled to QRP and (Qo - QRP) is added to Bin 2 which is used for stock withdrawal. When Bin 2 is empty, QRP is activated. Figure 14-10 The Two-Bin System Is a Self-Operating Perpetual Inventory System Where QRP = DLT + buffer stock 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-8 The Periodic Inventory System Periodic inventory systems are based on ordering up to a level M as shown in Figure 14-11.

Figure 14-11 The Periodic Inventory System Where SOH Is Computed at Fixed Intervals and Q is Variable 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-8 The Periodic Inventory System M-level is calculated in terms of the optimal interval between orders (to). This interval is a function of the optimal order quantity (Qo). Qo 2Cr to D DcCc Advances in computing have made perpetual inventory systems preferred for most situations. Nevertheless, there are circumstances when periodic systems are essential. For example, to coordinate truck deliveries to auto part stores or to assemble car load lots for freight trains. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. 14-9 Quantity Discount Model When discounts are offered as incentives for ordering more units, total cost

curves become discontinuous at the price breaks. This is shown in the side-by-side curves of Figure 14-12. Ordering more units to qualify for discounts is not always cost effective. The indicated solution in Figure 1412 is to order more than the discount quantity, Q1, i.e., order b. Figure 14-12 Quantity Discount Model: Total Cost Curves (Break Point, Q1) 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Spotlights in Review 14-1 The Demand for Business Intelligence Humans (smart, slow, and prone to error) are giving up some control to let machines (obedient, fast, and accurate) replace traditional business methods with on-demand data and retrieval systems. By automating an entire companys operations into a well-managed business intelligence system, it is possible to analyze contracts with suppliers and negotiate better ones; see which regional offices are underperforming, and do a lot more. A few years ago, business intelligence systems were a future goal;

now they are a reality for many firms. Installing a reliable system that integrates all major variables with speed and agility, using the enormous capabilities of the web to connect all parts of the business on a global scale is a tremendous achievement. Limits have not been reached. Developments continue to astound. Business intelligence capabilities have been amplified and enhanced to a point where architecture of internal and external services is radically improved. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Spotlights in Review 14-2 The Race for Next-Generation Technology Methods for motivating innovation arise when an organization mandates a fundamental change in its inventory. By congressional decree, one-third of all ground combat vehicles must be able to operate unassisted by 2015. DARPA was commissioned to achieve the result. It spent millions pursuing this goal with no luck at first. A new tack was tried. DARPA proposed a competition for the private sector with large rewards. The Grand Challenge for Autonomous Ground Vehicles has been successful with its contest for mobile robotic vehicles riding unassisted over rugged desert-like terrain. In March 2004, 15 challengers failed to complete the course and no one

earned the 7-figure reward. A 2nd Grand Challenge was held in Oct. 2005. The race began with distribution of CDs containing GPS route coordinates for each vehicles computer. Stanfords Artificial Intelligence Laboratory entry completed the race with an average speed of 19.1 mph. Clearly a triumph for MOT and the private sector. 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Questions You Can Now Answer What does inventory management entail? What differences differentiate static and dynamic inventory models? How do demand distributions effect inventory situations? How do lead-times play important roles in inventory management?

How many costs are significant in inventory analysis? What are the important inventory costs and how do they differ? What is OPP all about? What is an EOQ model? What is an ELS model? What is MRP? 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved.

Questions You Can Now Answer How does a perpetual inventory system work? Does the perpetual inventory system influence days of inventory? Does the perpetual inventory system influence inventory turns? How does the periodic inventory system work? Does the periodic inventory system influence days of inventory? When should a discount be offered?

When should a discount be taken? Why would a marketing manager like inventory levels to be high? 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved. Study Areas Ahead Spotlight 15-1 is titled, Innovation: Everyone Has Something to Say about It (from the Latin innovare, to renew) Understanding MRP is essential for P/OM and other functional manager as well. MRP applies to about 70 percent of all inventory. Learn why the Master Production Schedule (MPS) is a crucial

planning document. Know how Closed-Loop MRP and MRP II lead to the powerful status of ERP in todays world. Spotlight 15-2 is an interview with one of the most influential P/OM thinkers of our time. Dr. Eliyahu M. Goldratt expounds on The Fallacy of Pursuing Local Optimums. Why projects are increasingly important for anyone who hopes to succeed in business, government, or the private sector. And there is more! 2007 Thomson, a part of the Thomson Corporation. Thomson, the Star logo, and Atomic Dog are trademarks used herein under license. All rights reserved.

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