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Management
12
12 - 1
Outline
12 - 2
Outline - Continued
Single-Period Model
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Learning Objectives
When you complete this chapter you
should be able to:
1. Conduct an ABC analysis
2. Explain and use cycle counting
3. Explain and use the EOQ model for
independent inventory demand
4. Compute a reorder point and safety
stock
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Learning Objectives
When you complete this chapter you
should be able to:
5. Apply the production order quantity
model
6. Explain and use the quantity discount
model
7. Understand service levels and
probabilistic inventory models
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Inventory Management
The objective of inventory
management is to strike a balance
between inventory investment and
customer service
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Importance of Inventory
One of the most expensive assets of
many companies representing as
much as 50% of total invested capital
Operations managers must balance
inventory investment and customer
service
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Functions of Inventory
1. To provide a selection of goods for
anticipated demand and to separate
the firm from fluctuations in demand
2. To decouple or separate various
parts of the production process
3. To take advantage of quantity
discounts
4. To hedge against inflation
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Types of Inventory
Raw material
Purchased but not processed
Work-in-process (WIP)
Undergone some change but not completed
A function of cycle time for a product
Maintenance/repair/operating (MRO)
Necessary to keep machinery and processes
productive
Finished goods
Completed product awaiting shipment
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Wait for
inspection
Wait to
be moved
5%
Run
time
Output
Figure 12.1
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Managing Inventory
1. How inventory items can be classified
(ABC analysis)
2. How accurate inventory records can
be maintained
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ABC Analysis
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
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ABC Analysis
ABC Calculation
(1)
(2)
(3)
ITEM
STOCK
NUMBER
PERCENT
OF
NUMBER
OF ITEMS
STOCKED
ANNUAL
VOLUME
(UNITS)
#10286
(5)
(6)
(7)
UNIT
COST
ANNUAL
DOLLAR
VOLUME
PERCENT
OF ANNUAL
DOLLAR
VOLUME
CLASS
1,000
$ 90.00
$ 90,000
38.8%
#11526
500
154.00
77,000
33.2%
#12760
1,550
17.00
26,350
11.3%
350
42.86
15,001
6.4%
#10500
1,000
12.50
12,500
5.4%
#12572
600
$ 14.17
$ 8,502
3.7%
#14075
2,000
.60
1,200
.5%
100
8.50
850
.4%
#10867
#01036
20%
(4)
30%
50%
#01307
72%
A
A
23%
B
B
5%
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1,200
.42
504
.2%
ABC Analysis
80
70
60
50
40
30
20
10
0
A Items
B Items
|
|
|
|
10 20 30 40
Figure 12.2
C Items
|
50
60
70
80
90 100
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ABC Analysis
Other criteria than annual dollar volume
may be used
High shortage or holding cost
Anticipated engineering changes
Delivery problems
Quality problems
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ABC Analysis
Policies employed may include
1. More emphasis on supplier development for
A items
2. Tighter physical inventory control for A items
3. More care in forecasting A items
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Record Accuracy
Two-bin system
May be semi-automated
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Record Accuracy
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Cycle Counting
Items are counted and records updated on a
periodic basis
Often used with ABC analysis
Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records
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ITEM
CLASS
QUANTITY
500
Each month
1,750
Each quarter
2,750
Every 6 months
NUMBER OF ITEMS
COUNTED PER DAY
500/20 =
25/day
1,750/60 =
29/day
2,750/120 =
23/day
77/day
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Inventory Models
Independent demand - the demand for
item is independent of the demand for any
other item in inventory
Dependent demand - the demand for
item is dependent upon the demand for
some other item in the inventory
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Inventory Models
Holding costs - the costs of holding or
carrying inventory over time
Ordering costs - the costs of placing an
order and receiving goods
Setup costs - cost to prepare a machine
or process for manufacturing an order
May be highly correlated with setup time
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Holding Costs
TABLE 12.1
CATEGORY
6% (3 10%)
3% (1 3.5%)
3% (3 - 5%)
11% (6 24%)
3% (2 - 5%)
26%
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Holding Costs
TABLE 12.1
rably
e
id
s
n
o
c
y
r
a
. (3 tes6%
a
osts vrent or depreciation,
r
t
Housing
s
e
ing c(building
r
e
t
oldcosts
in
H
d
n, an
io
t
a
c
operating costs,
taxes,
insurance)
10%)
lo
tech
,
s
h
s
ig
e
h
in
e
s
u
m
b
o
s
e
,
h
t
5% or
1lease
n
a
h
t
r r
e
t
ate(1
a
e
Material handling
costs
(equipment
3%
e
r
r
g
g
s
y
t
ll
s
a
o
r
c
e
n
g
Ge power, operating
oldin
h
e
v
depreciation,
cost)
3.5%)
a
h
s
m
e
it
n
io
h
s
a
f
nd
Laboracost (receiving,
warehousing, security)
3% (3 - 5%)
.
%
0
than 4
CATEGORY
11% (6 24%)
3% (2 - 5%)
26%
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Inventory level
Minimum
inventory 0
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Usage rate
Average
inventory
on hand
Q
2
Time
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Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)
Total cost of
holding and
setup (order)
Annual cost
Minimum
total cost
Holding cost
Order quantity
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Minimizing Costs
By minimizing the sum of setup (or
ordering) and holding costs, total costs are
minimized
Optimal order size Q* will minimize total
cost
A reduction in either cost reduces the total
cost
Optimal order quantity occurs when
holding cost and setup cost are equal
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D
Minimizing Costs
Annual setup cost = S
Q
Q
Q*
D
S
H
Annual demand
Number of units in each order
Setup or order
cost per order
D
= S
Q
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D
Minimizing Costs
Annual setup cost = S
Q
Q
Q*
D
S
H
Q
H
2
Order quantity
2
Q
= H
2
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D
Minimizing Costs
Annual setup cost = S
Q
Q
Q*
D
S
H
Q
H
2
Q
H
2
Solving for Q*
2DS Q2 H
2DS
Q2
H
Q*
2DS
H
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An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
2DS
Q
H
*
2(1,000)(10)
Q
40,000 200 units
0.50
*
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An EOQ Example
Determine expected number of orders
D = 1,000 units
Q* = 200 units
S = $10 per order
H = $.50 per unit per year
Expected
Demand
number of = N = Order quantity
orders
N=
D
= *
Q
1,000
= 5 orders per year
200
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An EOQ Example
Determine optimal time between orders
D = 1,000 units
Q* = 200 units
S = $10 per order
N = 5 orders/year
H = $.50 per unit per year
Expected
Number of working days per year
time between = T =
Expected number of orders
orders
T=
250
5
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An EOQ Example
Determine the total annual cost
D = 1,000 units
Q* = 200 units
S = $10 per order
N = 5 orders/year
H = $.50 per unit per year
T = 50 days
Total annual cost = Setup cost + Holding cost
D
Q
TC S H
Q
2
1,000
200
($10)
($.50)
200
2
(5)($10) (100)($.50)
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TC
D
Q
S H PD
Q
2
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Robust Model
The EOQ model is robust
It works even if all parameters and
assumptions are not met
The total cost curve is relatively flat in
the area of the EOQ
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An EOQ Example
Determine optimal number of needles to order
Only 2% less than
D = 1,000 units 1,500 units Q* =the
200
units
total
cost of
S = $10 per order
N =$125
5 orders/year
when the
H = $.50 per unit per year
T order
= 50 quantity
days
was
200
D
Q
TC S H
Q
2
1,500
244.9
1,500
200
($10)
($.50)
($10)
($.50)
244.9
2
200
2
6.125($10) 122.45($.50)
$75 $50 $125
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Reorder Points
EOQ answers the how much question
The reorder point (ROP) tells when to order
Lead time (L) is the time between placing and receiving
an order
ROP =
Demand
per day
=dxL
d=
D
Number of working days in a year
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Q*
Resupply takes place as order arrives
Slope = units/day = d
ROP
(units)
Lead time = L
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Time (days)
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D
Number of working days in a year
= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units
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Inventory level
Maximum
inventory
t
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Time
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=p
Q
p
Q
p
=Q 1
d
p
Q
Maximum inventory level
Holding cost =
(H) =
1
2
2
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d
p
H
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D
S 21 HQ 1 d p
Q
Q2
Q*p
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2DS
H 1 d p
2DS
H 1 d p
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2DS
H 1 d p
2(1,000)(10)
0.50 1 (4 8)
20,000
80,000
0.50(1 2)
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1,000
=
250
2DS
Annual demand rate
1
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DISCOUNT
NUMBER
DISCOUNT QUANTITY
DISCOUNT (%)
DISCOUNT
PRICE (P)
0 to 999
no discount
$5.00
1,000 to 1,999
$4.80
$4.75
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TC
where
D
Q
S H PD
Q
2
Q = Quantity ordered
P = Price per unit
D = Annual demand in units
H = Holding cost per unit per year
S = Ordering or setup cost per order
Q*
2DS
IP
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Total cost $
Total cost
curve for
discount 1
b
a
1st price
break
2nd price
break
1,000
2,000
Order quantity
Figure 12.7
12 - 53
2DS
Q
IP
*
Q1* =
2(5,000)(49)
= 700 cars/order
(.2)(5.00)
Q2* =
2(5,000)(49)
= 714 cars/order
(.2)(4.80)
Q3* =
2(5,000)(49)
= 718 cars/order
(.2)(4.75)
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2DS
Q
IP
*
Q1* =
2(5,000)(49)
= 700 cars/order
(.2)(5.00)
Q2* =
2(5,000)(49)
= 714 cars/order
(.2)(4.80)
1,000 adjusted
Q3* =
2(5,000)(49)
= 718 cars/order
(.2)(4.75)
2,000 adjusted
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ANNUAL
PRODUCT
COST
ANNUAL
ORDERING
COST
ANNUAL
HOLDING
COST
DISCOUNT
NUMBER
UNIT
PRICE
$5.00
700
$25,000
$350
$350
$4.80
1,000
$24,000
$245
$480
$4.75
2,000
$23.750
$122.50
$950
TOTAL
$25,700
$24,725
$24,822.50
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NUMBER OF UNITS
PROBABILITY
30
.2
40
.2
ROP
50
.3
60
.2
70
.1
1.0
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ADDITIONAL
HOLDING COST
$100
50
(20)($5) =
(10)($5) = $
$
STOCKOUT COST
$0
(10)(.1)($40)(6)
$100
=
$240
(10)(.2)($40)(6) + (20)(.1)($40)(6)
$960
$290
=
$960
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Probabilistic Demand
Inventory level
Figure 12.8
0
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Place Lead
time Receive
order
order
16.5 units
Time
12 - 60
Probabilistic Demand
Use prescribed service levels to set safety
stock when the cost of stockouts cannot be
determined
ROP = demand during lead time + ZdLT
where
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Probabilistic Demand
Risk of a stockout
(5% of area of
normal curve)
Probability of
no stockout
95% of the time
Mean
demand
350
0
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ROP = ? kits
Quantity
Safety
stock
z
Number of
standard deviations
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Probabilistic Example
=Average demand = 350 kits
dLT = Standard deviation of
demand during lead time = 10 kits
Z =5% stockout policy (service level = 95%)
Using Appendix I, for an area under the curve of
95%, the Z = 1.65
Safety stock = ZdLT = 1.65(10) = 16.5 kits
Reorder point
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Lead time
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Probabilistic Example
Average daily demand (normally distributed) = 15
Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28
From Appendix I
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Probabilistic Example
Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time = LT = 1
Service level = 98%, so Z (from Appendix I) = 2.055
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Probabilistic Example
Average daily demand (normally distributed) = 150
Standard deviation = d = 16
Average lead time 5 days (normally distributed)
Standard deviation = LT = 1 day
Service level = 95%, so Z = 1.65 (from Appendix I)
dLT
1,280 22,500
5 256 22,500 1
23,780 154
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Single-Period Model
Only one order is placed for a product
Units have little or no value at the end of the
sales period
Cs = Cost of shortage = Sales price/unit Cost/unit
Co = Cost of overage = Cost/unit Salvage value
Service level =
Cs
Cs + Co
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Single-Period Example
Average demand = = 120 papers/day
Standard deviation = = 15 papers
Cs = cost of shortage = $1.25 $.70 = $.55
Co = cost of overage = $.70 $.30 = $.40
Service level =
Cs
Cs + Co
=
.55
.55 + .40
= .55 = .579
.95
Service
level
57.9%
= 120
Optimal stocking level
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Single-Period Example
From Appendix I, for the area .579, Z .20
The optimal stocking level
= 120 copies + (.20)()
= 120 + (.20)(15) = 120 + 3 = 123 papers
The stockout risk = 1 Service level
= 1 .579 = .422 = 42.2%
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Q4
On-hand inventory
Q2
Q1
Q3
P
Time
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Fixed-Period Systems
Inventory is only counted at each
review period
May be scheduled at convenient times
Appropriate in routine situations
May result in stockouts between
periods
May require increased safety stock
2014 Pearson Education, Inc.
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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or
otherwise, without the prior written permission of the publisher.
Printed in the United States of America.
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