Independent-Demand Inventory

Chapter 15

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc. 2007, All Rights Reserved

Chapter 15 Outline
Introduction Purpose of Inventories Inventory Cost Structures Independent versus Dependent Demand Economic Order Quantity Continuous Review System Periodic Review System Using P and Q System in Practice ABC Inventory Management

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Introduction
Inventory: a stock of materials used to facilitate production or to satisfy customer demand. Types of inventory
Raw materials (RM) Work in process (WIP) Finished goods (FG) Maintenance, repair & operating supplies (MRO)
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A Material-Flow Process
Productive Process
Work in process
Vendors

Raw Materials Work in process

Work in process

Finished Customer goods

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A Water Tank Analogy for Inventory

Inventory Level Supply Rate

Inventory Level

Demand Rate
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Purpose of Inventories (1)

To protect against uncertainties
in demand (finished goods, MRO) supply (RM, MRO) lead times (RM/PP or WIP) schedule changes (WIP)

To allow economic production and purchase (as in discounts for buying RM/PP in bulk)

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Purpose of Inventories (2)

To cover anticipated changes in demand (as in a level strategy) or supply
finished goods RM/PP

To provide for transit (pipeline inventories)

RM/PP finished goods WIP (independence of operations)

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Inventory Cost Structures (1)

Item or SKU cost
Expressed as cost per unit or SKU. Gets into LIFO and FIFO issues. Problem can be compounded by quantity discounts.

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Inventory Cost Structures (2)

Ordering (or setup) cost
Paperwork, worker time (ordering) worker time, downtime (setup) Typically expressed as a fixed cost per order or setup.

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Inventory Cost Structures (3)

Carrying (or holding) cost:
Cost of capital (market rate or internal rate of return) Cost of storage (building, utilities, insurance, handling) Cost of obsolescence, deterioration, and loss (shrinkage) Management cost (record keeping, counting)

Typically expressed as a percentage of SKU cost. Average in U.S. is estimated to be 35 percent per year. Businesses often use only cost of capital (understatement).
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Inventory Cost Structures (4)

How the 35 percent carrying cost is distributed

Cost of Capital9-20 percent Obsolescence2-5 percent Storage2-5 percent Material Handling1-3 percent Shrinkage1-3 percent Taxes & Insurance1-3 percent
Source: Mark Williams, APICS Instructor Listserv, 22 January 2001

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Inventory Cost Structures (5)

Stock out cost (back order or lost sales)
record maintenance lost income customer dissatisfaction Typically expressed as a fixed cost per backorder or as a function of aging of backorders.

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Two Forms of Demand (1)

Independent demand (this chapter)
finished goods, spare parts, MRO based on market demand requires forecasting managed using replenishment philosophy, i.e. reorder when reach a pre-specified level.

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Two Forms of Demand (2)

Dependent demand (next two chapters)
parts that go into the finished products, RM/PP or WIP dependent demand is a known function of independent demand calculate instead of forecast Managed using a requirements philosophy, i.e. only ordered as needed for higher level components or products.
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Independent versus Dependent Demand

A pattern plus random influences

Lumpy because of production lots

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Economic Order Quantity (EOQ)

Developed in 1915 by F.W. Harris Answers the question How much do I order? Used for independent demand items. Objective is to find order quantity (Q) that minimizes the total cost (TC) of managing inventory. Must be calculated separately for each SKU. Widely used and very robust (i.e. works well in a lot of situations, even when its assumptions dont hold exactly).
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Economic Order Quantity (EOQ) Basic Model Assumptions Demand rate is constant, recurring, and known. Lead time is constant and known. No stockouts allowed. Material is ordered or produced in a lot or batch and the lot is received all at once Costs are constant
Unit cost is constant (no quantity discounts) Carrying cost is a constant per unit (SKU) Ordering (setup) cost per order is fixed

The item is a single product or SKU.

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EOQ Lot Size Choice

There is a trade-off between frequency of ordering (or the size of the order) and the inventory level.
Frequent orders (small lot size) lead to a lower average inventory size, i.e. higher ordering cost and lower holding cost. Fewer orders (large lot size) lead to a larger average inventory size, i.e. lower ordering cost and higher holding cost.
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EOQ Inventory Levels

(sawtooth model)

Order Interval

Lot size = Q

Average Inventory Level = Q/2

Time

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Notations and measurement units in EOQ

D = Demand rate, units per year S = Cost per order placed, or setup cost, dollars per order C = Unit cost, dollars per unit i = Carrying rate, percent of value per year Q = Lot size, units TC= total of ordering cost plus carrying cost
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Cost Equations in EOQ

Ordering cost = (cost per order) x orders per year) = SD/Q Carrying cost per year = (annual carrying rate) x (unit cost) x average inventory = iCQ/2

Total annual cost (TC) = ordering cost per year + carrying cost per year = SD/Q + iCQ/2
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Total Cost of Inventory

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TC and EOQ
TC = ordering cost + holding cost = S*(D/Q) + iC*(Q/2) EOQ = Q

2 SD iC

note: Although we have used annual costs, any time period is all right. Just be consistent! The same is true for currency designations.

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EOQ Example
Sales = 10 cases/week S = $12/order i = 30 pct/year C = $80/case _________ EOQ = (2SD)/iC = SQRT[(2*12*10*52)/(80*.3)]

= SQRT[12,480/24] = 22.8 cases/order

TC = ordering cost + holding cost = S*(D/Q) + iC*(Q/2) = 10(520/22.8) + 24 * 11.4 = 228.70 + 273.60 = $547.28/year If order 22 cases instead, TC = $547.64; if 23, TC = $547.30
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EOQ Example
Total Inventory Cost
800 600

Dollars

400 200 0

13

17

21

24

28

32

36

Order Size

40

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Continuous Review System

Relax assumption of constant demand. Demand is assumed to be random. Check inventory position each time there is a demand (i.e continuously). If inventory position drops below the reorder point, place an order for the EOQ. Also called fixed-order-quantity or Q system (the fixed order size is EOQ).

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A Continuous Review (Q) System

R = Reorder Point Q = Order Quantity L = Lead time

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A Continuous Review (Q) System

Amount to order = EOQ

Order when inventory position = reorder point.

Reorder point = lead time * demand/period = R = lead time demand (when demand is constant) Reorder point is independent of EOQ! EOQ tells how much to order. Reorder point tells when to order.
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Service Level
When demand is random, the reorder point must take into account the service level or fill rate. Service level has many definitions:
Probability that all orders will be refilled while waiting for an order to arrive. Percentage of demand filled from stock in a time period. Percentage of time the system has stock on hand.
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Probability Distribution of Demand over Lead Time

m = mean demand

R = Reorder point

s = Safety stock

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Periodic Review System (1)

Instead of reviewing continuously, we review the inventory position at fixed intervals. For example, the bread truck visits the grocery store on the same days every week. Also known as P system, Fixed-orderinterval system or Fixed-order-period system

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Periodic Review System (2)

Each time we review the inventory, we either order or dont. The decision depends upon our reorder point. The amount we order may be fixed, or may be the amount needed to bring us up to a target (T).

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A Periodic Review (P) System

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Time Between Orders (P) and Target Level (T) Calculation

2S P iC D

T m' s'
Where:
T = target inventory level m = average demand over P+L s = safety stock

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Using P and Q System in Practice

Use P system when orders must be placed at specified intervals. Use P systems when multiple items are ordered from the same supplier (jointreplenishment). Use P system for inexpensive items.

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Using P and Q Systems in Practice

P may be easier to use since levels are reviewed less often. P requires more safety stock since may only order at fixed points. P is more likely to run out since cannot respond to increases in demand immediately Either may be more costly: P in safety stock, Q in monitoring cost.
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Service Level versus Inventory Level (Figure 15.10)

105% 100% 2.5 1.7 2.0 1.8 1.9 2.4 2.1 2.2 2.3

ervice Level (%) S

95% 90% 1.2 85% 1.0 80% 75% 1.1 1.3 1.4 1.5

1.6

z values

150 160 170 180 190 200 210 220 230 240 250 260 270 280 290 300

Q 100

Average Inventory Level

100

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ABC Inventory Management (1)

Based on Pareto concept (80/20 rule) and total usage in dollars of each item. Classification of items as A, B, or C based on usage. Purpose is to set priorities on effort used to manage different SKUs, i.e. to allocate scarce management resources.

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ABC Inventory Management (2)

A items: 20% of SKUs, 80% of dollars B items: 30 % of SKUs, 15% of dollars C items: 50 % of SKUs, 5% of dollars Three classes is arbitrary; could be any number. Percents are approximate. Danger: dollar use may not reflect importance of any given SKU!

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Annual Usage of Items by Dollar Value (Table 15.4)

Percentage of Annual Usage in Total Dollar Units Unit Cost Dollar Usage Usage 5,000 $ 1.50 $ 7,500 2.9% 1,500 8.00 12,000 4.7% 10,000 10.50 105,000 41.2% 6,000 2.00 12,000 4.7% 7,500 0.50 3,750 1.5% 6,000 13.60 81,600 32.0% 5,000 0.75 3,750 1.5% 4,500 1.25 5,625 2.2% 7,000 2.50 17,500 6.9% 3,000 2.00 6,000 2.4% $ 254,725 100.0%
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Item 1 2 3 4 5 6 7 8 9 10 Total

ABC Chart for Table 15.4

45.0% 40.0% 35.0% 120.0% 100.0%

Percent Usage

30.0% 25.0%

80.0% 60.0%

20.0% 15.0% 10.0% 20.0% 5.0% 0.0% 3 6 9 2 4 1 10 8 5 7 0.0% 40.0%

Item No. Percentage of Total Dollar Usage Cumulative Percentage

Cumulative % Usage
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Managing A items:

Diamonds

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Summary
Introduction Purpose of Inventories Inventory Cost Structures Independent versus Dependent Demand Economic Order Quantity Continuous Review System Periodic Review System Using P and Q System in Practice ABC Inventory Management
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End of Chapter Fifteen

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