Fundamentals of Production Planning and Control Chapter 5 Inventory Management

Basic Inventory Concepts  Inventory is stored capacity  Inventory is a symptom not a problem

Categories of Inventory  Sources of demand  Position of the inventory in the process  Function or use of the inventory

Sources of Demand  Independent Demand (Forecasting/EOQ)  Dependent Demand (MRP or Kanban)

Position of the Inventory  Raw Materials  Work in Process (WIP)  Finished Goods  Maintenance, Repair, and Operations (MRO)

Function of the Inventory  Transit or Transportation Inventory  Cycle or Lot-Size Inventory  Buffer or Fluctuation Inventory  Anticipation Inventory  Decoupling Inventory  Hedge Inventory

Cost of Inventory  Not Having Inventory  Having Inventory

Costs of Not Having Inventory  Stockouts/Customer Goodwill  Excessive Setups (split lots)  Expediting  Backorders  Extra Shipping Expenses  Production rate problems  Poor facility utilization

Costs of Having Inventory  Setup Costs/Order Costs  Holding Costs

Setup Costs/Order Costs  Manufacturing – cost of changeover  Lost production  Cost of scrap incurred  Purchasing - cost of placing an order  Paperwork for making purchase  Cost of receiving

Holding Costs  Rent, lease, mortgage  Utilities  Maintenance  Tracking and monitoring of inventory  Damage/spoilage  Pilferage/shrinkage  Obsolescence  Taxes and Insurance  Interest (cost of capital)

Calculation of Holding Cost  H – cost of holding a unit in inventory  H = rP  P – unit production/procurement cost  r – percentage based on cost of capital

EOQ Model TC  DC  Q 2 H  D S Q TC – Total Cost D – Annual Demand C – Cost per item Q – order quantity per order H – holding cost per year (Ci) S – order or setup cost

EOQ Model

Economic Order Quantity (EOQ)

EOQ

 2

DS H

EOQ Example A company decides to establish an EOQ for an item. The annual demand is 400,000 units, each costing $8.00, ordering costs are $32 per order, and inventory carrying costs are 20%.

Calculate the EOQ

EOQ Example EOQ  2DS H D  400,000 per year S  $32 per order H  rP  .2(8)  1.6

EOQ Example EOQ  2(400,000) (32) 1.6

 25 , 600 , 000 1 .

6  16 , 000 , 000  4000

EOQ Example How many orders will they place per year?

EOQ Example EOQ  4000 units D  400,000 units Orders per year  400,000 4000  100

EOQ Example What are the costs of ordering the cost of carrying and the total cost?

EOQ Example TC  DC  Q H  2 D Q S   (400,000)( 8)  4000 3 , 200 , 000  3200 2  (1.6) 3200  400,000 32 4000  3 , 206 , 400

Economic Order Quantity (EOQ)  Demand is constant, continuous, and known  Demand is independent  Set cost is fixed  Holding cost is known and constant  Total holding cost is a linear function of lot size  Instantaneous replenishment  Unit purchase cost is fixed (no quantity discounts or production economies)  Stockouts do not occur

Problems with EOQ-based Methods  Assumptions limit applicability  Demand is rarely constant and known  Costs are difficult to identify  Replenishment is not instantaneous

EOQ Model is Robust

Inventory Pattern over Time Inventory Level 0 Time

Relax Instantaneous Replenishment Assumption  Replenishment Lead Time - The time it takes from order until arrival  Must reorder before zero point is reached

Determination of Reorder Point Inventory Level Reorder Point Time 0 Lead Time

Reorder Point Calculation R  d L where d the average demand L lead time both must be in the same unit of measure

Reorder Point Example Lead time for the previous product is 2 weeks. What is the Reorder Point (assume 50 weeks in a year)?

Reorder Point Example R  d L d  400,000 50  8000 (average weekly demand) L  2 weeks R  8000 (2)  16000

Relax Additional Assumptions  Things can disrupt the conditions established  Supplier late  Demand exceeds expectations  Maintain safety stock

Safety Stock Calculation SS  z  L z z score representi ng customer service level σ L  standard deviation of demand during lead time  L  

d L

Z-scores  90% customer service level, z = 1.29

 95% customer service level, z = 1.65

 99% customer service level, z = 2.33

Reorder Point with Safety Stock R  demand during lead time plus safety stock  d L  z  L

Safety Stock Example Assume the standard deviation of demand is 1000 units. If the company wants to maintain a 95% customer service level, what should safety stock be and the new reorder point?

Safety Stock Example  L  

d L

 1000 2  1414 SS  z  L  ( 1 .

65 )( 1414 )  2333 .

1

R

 16000  2333 .

1  18333 .

1

Inventory Control Having the right stuff in the right place at the right time

Location Approaches  Fixed or Home Locations  Floating or Random Locations  Combinations  Zoned Random  Home with Reserve Stock

ABC inventory control  Uses Pareto’s law  About 20% of the items account for 80% of the dollar usage  About 30% of the items account for 15% of the dollar usage  About 50% of the items account for 5% of the dollar usage

Steps in making an ABC analysis 1. Determine the annual usage for each item 2. Multiply the annual usage of each item by its item cost to get is total annual dollar usage 3. List the items according to their annual dollar usage

Steps (continued) 4. Calculate the cumulative annual dollar usage and the cumulative percentage of items 5. Exam the annual usage distribution and group the items into A,B, and C groups based on the percentage of annual usage.

ABC Example (Steps 1 and 2) Part Number TOTAL 8 9 10 5 6 7 1 2 3 4 Unit Usage 1,100 600 100 1,300 100 10 100 1,500 200 500 5,510 Unit Cost $ 2 40 4 1 60 25 2 2 2 1 Annual $ Usage $2,200 24,000 400 1,300 6,000 250 200 3,000 400 500 38,250

ABC Example (Steps 3 and 4) Part Number Annual $ Usage 2 5 8 1 4 10 9 3 6 7 $24,000 6,000 3,000 2,200 1,300 500 400 400 250 200 Cumulative $ Usage 24,000 30,000 33,000 35,200 36,500 37,000 37,400 37,800 38,050 38,250 Cumulative % $ usage 62.75

78.43

86.27

92.03

95.42

96.73

97.78

98.82

99.48

100

ABC Example (Step 5) Part Number 4 10 9 2 5 8 1 3 6 7 Cumulative % $ usage 62.75

78.43

86.27

92.03

95.42

96.73

97.78

98.82

99.48

100 Cumulate % of items 10 20 30 40 50 60 70 80 90 100 Class C C C B C C A A B B

Control Based on ABC Classification  Have plenty of low-value items  Use the money and control effort saved to reduce the inventory of high-value items

A Items – tight control  Complete accurate inventory records  Regular and frequent review by management  Frequent review of demand forecasts  Close follow-up and expediting to reduce lead time

B Items – Normal Controls  Good records  Regular attention  Normal processing

C items – Simple or No Records  2 –bin system or periodic review system  Order large quantities  Carry safety stock

Importance of inventory accuracy  Allows firms to maintain customer service  Operate efficiently and effectively

Inaccurate records cause  Lost sales  Shortages and disrupted schedules  Excess inventory  Low productivity  Poor delivery performance  Excessive expediting

Causes of inventory record errors  Unauthorized withdrawal of material  Unsecured stockroom  Poorly trained personnel  Inaccurate transaction recording  Poor transaction recording systems  Lack of audit capability to catch mistakes

Inaccurate Transaction Recording  Inaccurate piece counts  Unrecorded transactions,  Delay in recording transactions  Inaccurate material location  Incorrectly identified parts

Measuring inventory record accuracy  Record accuracy = Number of records within tolerance/total number of records  Tolerance – amount of variation permitted due to  Inaccuracies of count  Expense of perfect accuracy

Inventory Accuracy Example 1 2 3 4 5 6 7 8 9 10 Part Number Inventory Record 100 100 100 100 100 100 100 100 100 100 Shelf Count 105 100 98 97 102 103 99 100 97 99 Tolerance 5% 0% 3% 2% 2% 2% 3% 0% 5% 5% Count OK?

X X X X X X X X

Auditing accuracy  Physical Inventory  Cycle Counting

Physical Inventory Process  Housekeeping  Identification  Training  Take inventory

Taking the inventory Count items and record the count on a ticket left on the item  Verify this count by recounting or by sampling  When the verification is finished collect the tickets and list the items in each department  Reconcile the inventory records for differences between the physical count and inventory records

Disadvantages  Lost production time  Not accurate  Have people counting that don’t really understand  Often more errors are introduced  Expensive  Not timely

Cycle Counting  Advantages  Timely detection and correction of problems  Partial reduction of lost production  Use of personnel trained and dedicated to cycle counting

When to count  When an order is placed  When an order is received  When inventory reaches zero  When a specified number of transactions have occurred  When an error occurs  Randomly generated using ABC

ABC method Count parts on a rotating cycle based an ABC classification  A – 12 times per year  B - 4 times per year  C –1 time per year

Additional Cycle Counting Techniques  Location Audit System  Zone Method

Location audit system  If using ABC counts and floating locations  System only counts what it thinks is there  Count every location a specified number of times

Zone method Items are grouped by zones to make counting more efficient

Homework  Problems 3 (assume slow season lasts 6 months), 6 and 7