DBH11

Chapter 11 Inventory Management

Inventory: An inventory is a stock or store of goods. Firms stock hundreds or even thousands of items in inventory ranging from small things (eg. pencil, paper clips etc) to large items (eg. machines, trucks etc).

Major reasons for holding inventory:

o understand !hy firms hold inventories, !e need to understand the follo!ing functions of inventory. (i) o meet anticipated customer demand" A customer can #e a person !ho !alks in off the street to #uy a ne! stereo system, a mechanic !ho re$uests a tool at a tool cri#, or a manufacturing operation. hese inventories are called anticipated stocks #ecause they are held to satisfy e%pected demand. (ii) o smooth production re$uirements" Firms that e%perience seasonal patterns in demand often #uild up inventories during pre&season periods to meet overly high re$uirements during seasonal periods. 'ompanies that process fruits and vegeta#les deal !ith this inventory. (iii) o decouple operations" (anufacturing firms often use inventories as #uffer #et!een successive operations to maintain continuity of production that !ould other!ise #e disrupted #y events such as #reakdo!n of e$uipments, and accidents that cause a portion of the operation to shut do!n temporarily. (iv) o protect against stockouts" Delayed deliveries and une%pected increases in demand increase the risk of shortages. his risk of shortages can #e reduced #y holding safety stocks. (v) o take advantage of order cycles" o minimi)e purchasing costs, a firm often #uys in $uantities that e%ceed immediate re$uirements. his necessitates storing some or the entire purchased amount for later use. (vi) o hedge against price increase" (vii) o permit operations" he production operations take a certain amount of time means that there is some !ork&in&process inventory. (viii) o take advantage of $uality discounts" *uppliers may give discounts on large orders.

Objectives of inventory control:

+nventory management has t!o main concerns" (i) 'ustomer service" hat is, to have the right goods, in sufficient $uantities, in the right place, at the right time. (ii) 'ost of ordering and carrying inventories. (anagers have a num#er of measures of performance they can use to ,udge the effectiveness of inventory management. A !idely used measure is inventory turnover. Another useful measure is days of inventory on hand. Inventory turnover: +t is the ration of annual cost of goods sold to average inventory investment. Days of inventory on hand: +t is a num#er that indicates the e%pected num#er of days of sales that can #e supplied from e%isting inventory. 1

DBH11

Inventory counting system:

+t can #e (i) periodic or (ii) perpetual. Periodic inventory system: A physical count of items in inventory is made at periodic intervals such as monthly or !eekly in order to decide ho! much to order of each item. -%ample" a retailer periodically checks the selves and stock room to determine the $uantity on hand. hen he estimates ho! much !ill #e demanded prior to the ne%t delivery period. .erpetual or continual inventory system" *ystem that keeps track of removals from inventory continuously, thus monitoring current level of each item. ead time: ime interval #et!een ordering and receiving the order. .oint&of&sale" /ecord items at time of sale.

Inventory costs:
here are three #asic costs associated !ith inventories. hey are as follo!s" (i) inventory holding or carrying costs (ii) transaction or ordering costs (iii) shortage costs (i) !olding costs: +t relates to physically having items in storage. "#ample: costs include interest, insurance, ta%es, #reakage, heat, light, rent security etc. (ii) $ransaction costs: he cost of ordering and receiving inventory. "#ample: preparing invoices, shipping costs, inspection costs, moving the goods to temporary storage. (iii) %hortage cost: *hortage costs result !hen demand e%ceeds the supply of inventory on hand. "#ample: loss of customer good!ill, late charges etc.

!o& much to order: '"conomic order (uantity '"O)* models*

"conomic order (uantity '"O)*" he order si)e that minimi)e total annual costs. "O) models: hese models identify the optimal order $uantity #y minimi)ing the sum of certain annual costs that vary !ith order si)e. hree important models are" (i) he #asic -01 model. (ii) he economic production $uantity (-.1) model (iii) he $uantity model (i) $he basic "O) model: +t is used to identify the optimal order $uantity #y minimi)ing the sum of certain annual costs of holding inventory and ordering inventory. his model involves the follo!ing assumptions" 1. 0nly one product is involved. 2. Annual demands are kno!n 3. Demand rate is reasona#ly constant 4. 5ead time does not vary 6. -ach order is received in a single delivery 7. here are no $uantity discount 2

DBH11 Annual carrying cost 8

Q H ............................(i) 2

!here 1 8 order $uantity in units and H 8 carrying cost per unit. +t is proportional to 1.

Annual cost

Q H 2

Annual ordering cost 8 Q S ..............................(ii) !here D 8 demand in units per year and * 8 ordering cost.

D S Q

otal annual cost 8 Annual carrying cost 9 Annual ordering cost TC 8

D Q S .......................................(iii) H 9 Q 2

Differentiating (iii) !. r. to 1, setting the results e$ual to )ero and solving for 1, !e find the minimum order $uantity Q: =
2 DS ...............................(iv) H

Annual cost

TC =

Q D H + S 2 Q

5ength of order cycle 8

Q: .............................................(v) D
D .....................................(vi) Q:

;um#er of orders per year 8

"#ample: A local distri#utor for a national tire company e%pects to sell appro%imately <,7:: steel& #elted radial tires of a si)e and tread design ne%t year. Annual carrying cost is =17 per tire and ordering cost is =>6. he distri#utor operates 2?? days a year. 3

DBH11 (a) @hat is the -01A (#) Ho! many tires per year does the store orderA (c) @hat is the length of an order cycleA (d) @hat is the total annual cost if the -01 is orderedA %olution: Biven, D = <,7:: tires per year H 8 =17 per unit per year S 8 =>6 a. #. c. d.
2 <,7:: >6 = 3:: tires. 17 D <,7:: = = 32 . ;um#er of orders per year 8 Q: 3:: Q: = 2 DS = H

5ength of order cycle 8 TC 8

Q: 3:: 1 1 = = = 2?? = < !orkdays. D <,7:: 32 32

D 3:: <,7:: Q S = 17 + >6 = 2,4:: + 2,4:: = =4,?:: . H 9 Q 2 3:: 2

"#ample +: .iddling manufacturing assem#les security monitors. +t purchases 37:: #lack&and&!hite cathode ray tu#es a year at =76 each. 0rdering costs are =31, and annual carrying costs are 2:C of the purchasing price. 'ompute the optimal $uantity and the total annual cost of ordering and carrying the inventory. "conomic production (uantity '"P)*: his model involves the follo!ing assumptions" 1. 2. 3. 4. 6. 7. >. 0nly one item is involved. Annual demands are kno!n he usage rate is constant Dsage occurs continually #ut production occurs periodically he production rate is constant 5ead time does not vary here are no $uantity discount
I ma% D H + S !here +ma% 8(a%imum inventory. 2 Q:
p p u

'min 8 'arrying cost 9 *etup cost 8 he optimal run $uantity is Q: = rate.

2 DS H

!here p 8 production or delivery rate and u 8 usage

Q: u

'ycle time (the time #et!een orders or #et!een the #eginning of the runs) 8 /un time ( he production phase of the circle) 8 he ma%imum inventory level 8 I ma% = he average inventory level 8 I average =
Q: p

Q: ( p u) . p

I ma% 2 "#ample: A toy manufacturer uses 4?,::: ru##er !heels per year for its popular dump truck series. he firm makes its o!n !heels, !hich it can purchase at a rate of ?:: per day. he toy trucks are

DBH11 assem#led uniformly over the entire year. 'arrying cost is =1 per !heel a year. *etup cost for a production run of !heels is =46. he firm operates 24: days per year. Determine the (a) 0ptimal run si)e (#) (inimum total annual cost for carrying and setup (c) 'ycle time for the optimal run si)e (d) /un time %olution: Biven, D = 4?,::: !heels per year H 8 =1 per !heel per year S 8 =46 p 8 ?:: !heels per day u 8 4?,::: !heels per 24: days or 2:: !heels per day. a. #.
Q: = 2 DS H p = p u 2 4?,::: 46 1 ?:: = 2,4:: ?:: 2::

!heels.

he ma%imum inventory level 8 I ma% = he average inventory level 8 I average =

Q: ( p u ) = 24:: ( ?:: 2::) = 1?:: !heels. p ?::

I ma% 8 <:: 2

'min 8 'arrying cost 9 *etup cost 8 c. d. 'ycle time 8 /un time 8

I ma% D 1?:: 4?::: H + S = 1 + 46 = =1,?:: 2 Q: 2 24::

Q: 24:: = = 12 !orkdays. i.e., a run of !heels !ill #e made every 12 days u 2::
Q: 24:: = = 3 !orkdays. i.e., each run !ill take 3 days to complete. p ?::

)uantity discount Model: 1uantity discounts are prices reductions for large orders offered to customers to induce them to #uy in large $uantities. ' 8 'arrying cost 9 0rdering cost 9 .urchasing cost 8 2 H + Q S + P D !here . 8 Dnit price. "#ample: he maintenance department of a large hospital uses a#out ?17 cases of li$uid cleanser annually. 0rdering costs are =12, carrying costs are =4 per case a year, and the ne! price schedule indicates that orders of less than 6: cases !ill cost =2: per case, 6: to >< cases !ill cost =1? per case, ?: to << cases !ill cost =1> per case, and large orders !ill cost =17 per case. Determine the optimal order $uantity and the total cost. %olution: Biven D 8 ?17 cases per year * 8 =12 H 8 =4 per case per year and /ange 1 & 4< 6 .rice =2:
Q D

DBH11 6: & >< ?: & << 1:: or more

2 ?17 12 = 7<.<> >: cases 4

=1? =1> =17

1. Q: =
TC >: =

2 DS = H

2. otal cost to purchase ?17 cases a year at the rate of >: cases per order is
Q D >: ?17 H + S + P D = 4 + 12 +1? ?17 = =14,<7? 2 Q 2 >:

otal cost to purchase ?17 cases a year at the rate of ?: cases per order is
TC ?: = Q D ?: ?17 H + S + P D = 4 + 12 +1> ?17 = =14,164 2 Q 2 ?:

otal cost to purchase ?17 cases a year at the rate of 1:: cases per order is
TC1:: = Q D 1:: ?17 H + S + P D = 4 + 12 +17 ?17 = =13,364 2 Q 2 1::

*ince 1:: cases per order yields the lo!est cost, 1:: cases is the overall optimal order $uantity. "#ample +: *urge electric uses 4::: toggle s!itches a year. *!itches are priced as follo!s. +t costs appro%imately =3: to order and receive it and carrying costs are 4:C of the purchase price per unit on an annual #asis. Determine the optimal order $uantity and the total annual cost. /ange 1 & 4<< 6:: & <<< 1::: or more *olution" .rice =:.<: =:.?6 =:.?: