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11-1 Inventory Management

Inventory
Management
11-2 Inventory Management

outline
Concepts on inventory and inventory management
Inventory Counting Systems
ABC classification
Key inventory terms
How much to order (perpetual system)
Economic Order Quantity

Economic Production Quantity

Price Break Model / Quantity Discount

When to reorder /Reorder point


How much to order (periodic system)
Single Period Model
11-3 Inventory Management

Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.


Dependent demand is certain.
11-4 Inventory Management

Types of Inventories

Raw materials & purchased parts


Partially completed goods called
work in progress
Finished-goods inventories
(manufacturing firms)
or merchandise
(retail stores)
11-5 Inventory Management

Types of Inventories (Contd)

Replacement parts, tools, & supplies


Goods-in-transit to warehouses or customers
11-6 Inventory Management

Functions of Inventory

To meet anticipated demand


To smooth production requirements
To decouple operations
To protect against stock-outs
11-7 Inventory Management

Functions of Inventory (Contd)

To take advantage of order cycles


To help hedge against price increases
To permit operations
To take advantage of quantity discounts
11-8 Inventory Management

Objective of Inventory Control

To achieve satisfactory levels of customer


service while keeping inventory costs within
reasonable bounds
Level of customer service
Costs of ordering and carrying inventory
11-9 Inventory Management

Effective Inventory Management

A system to keep track of inventory


A reliable forecast of demand
Knowledge of lead times
Reasonable estimates of
Holding costs
Ordering costs
Shortage costs
A classification system
11-10 Inventory Management

Inventory Counting Systems

Periodic System
Physical count of items made at periodic
intervals
Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
11-11 Inventory Management

ABC Classification System

Classifying inventory according to some


measure of importance and allocating control
efforts accordingly.
A - very important
B - mod. important
High
A
C - least important Annual
$ value B
of items

Low C
Few Many
Number of Items
11-12 Inventory Management

ABC Classification System


Example#1
Item Annual Unit Annual Classification
Number Demand Cost Dollar Value
8 1000 4000 4000000 A
5 3900 700 2730000 A
3 1900 500 950000 B
6 1000 915 915000 B
1 2500 330 825000 B
4 1500 100 150000 C
12 400 300 120000 C
11 500 200 100000 C
9 8000 10 80000 C
2 1000 70 70000 C
7 200 210 42000 C
10 9000 2 18000 C
11-13 Inventory Management

ABC Classification System


Exercise#1
Item Monthly Unit Cost Monthly Dollar Classification
Number Usage Value

4021 50 1400

9402 300 12

4066 40 700

6500 150 20

9280 10 1020

4050 80 140

6850 2000 15

3010 400 20

4400 7000 5
11-15 Inventory Management

Uses of ABC Classification

Customer Service (How much stock out is allowed)


Cycle Counting (Quality and frequency of counting)
A physical count of items in inventory
Cycle counting management
How much accuracy is needed?
When should cycle counting be performed?
Who should do it?

Stocking position in supply network


Judgment must be applied in using ABC method and 80/20 rule should only be
used as a general guideline
11-16 Inventory Management

Key Inventory Terms

Lead time: time interval between ordering


and receiving the order
Holding (carrying) costs: cost to carry an
item in inventory for a length of time,
usually a year
Cost of Capital
Obsolescence (spoilage) cost
Handling cost
Occupancy cost
Miscellaneous costs (theft, damage, tax, insurance etc.)
11-17 Inventory Management

Key Inventory Terms

Ordering costs: costs of ordering and


receiving inventory
Documentation cost
Transportation cost

Receiving cost

Other cost (cost incurred regardless of


quantity)
Shortage costs: costs when demand exceeds
supply
11-18 Inventory Management
How Much To Order
(Perpetual Inventory System)

Economic order quantity model


Economic production model
11-19 Inventory Management

Economic Order Quantity (EOQ Model)

EOQ is the order size that minimizes total annual


cost
Assumptions of EOQ
Annual demand requirements known
Each order is received in a single delivery
Demand is even throughout the year
Lead time does not vary
There are no quantity discounts
Only one product is involved
11-20 Inventory Management

The Inventory Cycle

Profile of Inventory Level Over Time


Q Usage
Quantity rate
on hand

Average
Cycle
Inventory

Time
Receive Place Receive Place Receive
order order order order order
11-21 Inventory Management

Total Cost

Annual Annual Product


Total cost = carrying + ordering +
cost
cost cost
Q + DS + D * p
TC = H
2 Q
Here,
D = Quantity demanded per year
Q = Regular Order Quantity
H = Holding cost per unit per year
S = Ordering or Setup cost per order or batch respectively
p = Price per unit of product
11-22 Inventory Management

Total Costs with PD


Cost

Adding Constant Purchasing cost


doesnt change EOQ
TC with PD

TC without PD

CC a,b,c

OC PD

0 EOQ Quantity
11-23 Inventory Management

Cost Minimization Goal


Figure 11.4C

The Total Inventory Cost Curve is U-Shaped


Q D
TC H S
Annual Cost

2 Q

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)
11-24 Inventory Management

Deriving the EOQ

Using calculus, we take the derivative of the


total cost function and set the derivative
(slope) equal to zero and solve for Q.

2DS 2(Annual Demand)(Or der or Setup Cost)


Q OPT = =
H Annual Holding Cost
11-25 Inventory Management

Minimum Total Cost

The total cost curve reaches its minimum


where the carrying and ordering costs are
equal.
QOPT D
H S
2 QOPT

Length of Order Cycle = QOPT/D


11-26 Inventory Management

Economic Order Quantity Models

Example #2: Every tire sales at $ 2 per unit.


Forecasted Demand of tire in next year is 9,600.
Annual carrying cost is $16 per tire and ordering
cost is $ 75. The distributor operates 288 days a
year.
a) What is the EOQ?

b) How many times per year does the store


reorder?
c) What is the length of an order cycle?

d) What is the total annual cost if the EOQ


quantity is ordered
11-27 Inventory Management

Economic Order Quantity Models


Example #2: Given that,
D = 9,600 tires per year

H =$16 per unit per year

S = $ 75 per order

2DS 2(9600)75
a)....EOQ Qopt 300tires
H 16
b) Number of order per year = D/ Qopt = 9600 /300 = 32 times
c) Length of Order Cycle = Qopt/ D = 300 / 9600 = 1/32 of a year or
(1/32)*288 = 9 working day.
d) Total Annual Cost = Ordering cost + Holding cost + Product cost
= ( D / Qopt ) * S + (Qopt / 2)*H + P * D
= 32 * 75 + 150 * 16 + 2 * 9600
= 20904
11-28 Inventory Management

Economic Order Quantity Models


Exercise # 6: A distributor uses 800 packing crates a month,
which it purchase at a cost of $ 10 each. The manager has
assigned an annual carrying cost of 35 percent of the purchase
price per crate. Ordering costs are $28. Currently the manager
orders once a month. How much could the firm save annually in
ordering and carrying costs by using the EOQ?
11-29 Inventory Management
How Much To Order
(Perpetual Inventory System)

Economic order quantity model


Economic production model
11-30 Inventory Management

Economic Production Quantity (EPQ)

Run time

Cycle time

Production done in batches or lots


Capacity to produce a part exceeds the parts usage or
demand rate
Assumptions of EPQ are similar to EOQ except orders
are received incrementally during production
11-31 Inventory Management

Economic Production Quantity

Assumptions Economic Run Size


Only one item is involved 2 DS p
Q0
Annual demand is known H p u
Usage rate is constant
Q0
Usage occurs continually Cycle _ Time
Production rate is constant u
Lead time does not vary Q0
No quantity discounts
Run _ Time
p
Q0
Maximum _ Inventory, I max ( p u)
Here,
p
p= production or delivery rate I max
u= usages rate Average _ Inventory
2
11-32 Inventory Management

Economic Production Quantity (Example)


A toy manufacturer uses 48,000 rubber wheels per year for its
popular dump truck series. The firm makes its own wheels, which it
can produce at a rate of 800 per day. The toy trucks are assembled
uniformly over the entire year. Carrying cost is $1 per wheel a year.
Setup cost for a production run of wheels is $45. The firm operates
240 days per year. Determine the:
Optimal run size
Minimum total annual cost for carrying and setup
Cycle time for the optimal run size
Run time
11-33 Inventory Management

Economic Production Quantity (Example)


Solution:
D = 48,000 wheels per year
S = $45
H = $1 per wheel per year
p = 800 wheels per day
u = 48,000 wheels per 240 days, or 200 wheels per day

2 DS p 2(48000)45 800
Q0 2,400wheels
H p u 1 800 200
I max D
TCmin carrying cos t Setup cos t H S
2 Q0
Q0 2,400
I max ( p u) (800 200) 1,800wheels
p 800
1,800 48,000
TC $1 $45 $900 $900 $1,800
2 2,400
11-34 Inventory Management

Economic Production Quantity (Example)


Example: Continued
Q0 2,400wheels
Cycle _ time 12 _ days
u 200wheels / day
Thus, a run of wheels will be made every 12 days

Q0 2,400wheels
Run _ time 3 _ days
p 800wheels / day

Thus, each run will require 3 days to complete


11-35 Inventory Management

Exercise
Exercise 10:
The Friendly Sausage Factory (FSF) can produce hot dogs at a rate of
5000 per day, FSF supplies hot dogs to local restaurants at a steady
rate of 250 per day. The cost to prepare the equipment for producing
hot dogs is $66. Annual holding costs are 45 cents per hot dog. The
factory operates 300 days a year. Find
a) The optimal run size
b) The number of runs per year
c) The length (in days) of a run
d) What is the total inventory cost?
11-36 Inventory Management

Quantity discount model


11-37 Inventory Management

Total Costs with PD


Cost

TC with PD

TC without PD

CC a,b,c

OC PD
PD
0 EOQ Quantity
11-38 Inventory Management

Total Cost with Price Breaks for quantity discounts


11-39 Inventory Management

Total Cost with Constant Carrying Costs


Figure 11.9

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
11-40 Inventory Management

Price Break with constant carrying costs


11-41 Inventory Management

Total Cost with varying Carrying Costs


11-42 Inventory Management

Price Break with varying carrying costs


11-43 Inventory Management
Quantity discount model Solving Method

When carrying costs are constant:


1.Compute the common minimum point.
2.Only one of the unit prices will have the minimum point in its
feasible rage since the ranges do not overlap. Identify that range.
i. If the feasible minimum point is on the lowest price range,
that is the optimal order quantity.
ii. If the feasible minimum point is in any other range, compute
the total cost for the minimum point and for the price breaks
of all lower unit costs.
iii. Compare the total costs; the quantity (minimum point or
price break) that yields the lowest total cost is the optimal
order quantity.
11-44 Inventory Management
Quantity discount model Solving Method

When carrying costs are specified as a percentage of unit


price:
1.Beginning with the lowest unit price, compute the minimum
points for each price range until you find a feasible minimum point
(i.e., until a minimum point falls in the quantity range for its price).
2.If the minimum point for the lowest unit price is feasible, it is the
optimal order quantity. If the minimum point is not feasible in the
lowest price range, compare the total cost at the price break for all
lower prices with the total cost of the largest feasible minimum
point. The quantity that yields the lowest total cost is the optimum.
11-45 Inventory Management

Example- quantity discount


1. The maintenance department of a large hospital uses about 816 cases of liquid
cleanser annually. Ordering costs are $12, carrying costs are $4 per case per
year, and the new price schedule indicates that orders of less than 50 cases will
cost $20 per case, 50 to 79 cases will cost $18 per case, 80 to 99 cases will cost
$17 per case, and larger orders will cost $16 per case. Determine the optimal
order quantity and the total cost.
Range Price
1 to 49 $20
Solution: D = 816 cases per year, S = $12, H = $4 /case/ year.
50 to 79 18
80 to 99 17
100 or more 16
2DS 2 816 12
Compute the common EOQ: H 4
70 _ cases

The 70 cases can be bought at $18 per case because 70 falls in the range of
50 to 79 cases. The total cost to purchase 816 cases a year, at the rate of 70 cases
Q0 D
per order, will be TC70 H S PD
2 Q0
70 816
4 12 18 816 $14,968
2 70
11-46 Inventory Management

Example - quantity discount


Solution: Continued

Because lower cost ranges exist, each must be checked against the minimum cost

TC80 (80 / 2)4 (816 / 80)12 17(816) $14,154

TC100 (100 / 2)4 (816 / 100)12 16(816) $13,354

Hence purchasing 100 units is cheaper than other options.


11-47 Inventory Management

Exercise-13
A mail-order house uses 18,000 boxes a year. Carrying costs are 60 cents per
box a year, and ordering cost are $96. The following price schedule applies.
Determine
a) The optimal order quantity
b) The number of orders per year

Number of Boxes Price per box


1,000 to 1,999 $1.25
2,000 to 4,999 1.20
5,000 to 9,999 1.15
10,000 or more 1.10
11-48 Inventory Management

Example - quantity discount


Surge Electric uses 4,000 toggle switches a year.
Switches are priced as follows: 1 to 499, 90 cents
each; 500 to 999, 85 cents each; and 1,000 or
more, 80 cents each It costs approximately $30 to
prepare an order and receive it, and carrying costs
are 40 percent of purchase price per unit on an
annual basis. Determine the optimal order quantity
and the total annual cost.
11-49 Inventory Management

Example - quantity discount


Solution: D = 4,000 switches per year, S = $30, H = .40P.
Range Unit Price H
Find the minimum point for each price, starting
with the lowest price, until you locate a feasible 1 to 499 $0.90 $0.36
minimum point.
500 to 999 $0.85 $0.34
1,000 or
more $0.80 $0.32

2DS 2 4000 30
Minimum _ po int 0.80 866 _ switches
H 0.32
2DS 2 4000 30
Minimum _ po int 0.85 840 _ switches
H 0.34

Because an order size of 866 switches will cost $0.85 each rather than $0.80
each, 866 is not a feasible minimum point for $0.80 per switch. Next, try $0.85 per
unit. This is feasible; it falls in the $0.85 per switch range of 500 to 999.
11-50 Inventory Management

Example - quantity discount


Solution: Continued
Now compute the total cost for 840, and compare it to the total cost of the
minimum quantity necessary to obtain a price of $0.80 per switch.

TC840 = carrying cost + ordering cost + purchasing cost


Q D
H S PD
2 Q
840 4,000
(.34) (30) 0.85(4000) $3,686
2 840
1,000 4,000
TC1, 000 (.32) (30) 0.80(4,000) $3,480
2 1000
Thus, the minimum-cost order size is 1,000 switches.
11-51 Inventory Management

Exercise-16
A company will begin stocking remote control devices. Expected monthly demand is
800 units. The controllers can be purchased from either supplier A or supplier B.
Their price lists are as follows:

Supplier A Supplier B
Quantity Unit price Quantity Unit price
1-199 $14.00 1-149 $14.10
200 499 13.80 150 349 13.90
500+ 13.60 350+ 13.70
Ordering cost is $ 40 and annual holding cost is 25 percent of unit price per unit.
Which supplier should be used and what order quantity is optimal if the intent is to
minimize total annual cost?
11-52 Inventory Management

When to Reorder with EOQ Ordering

Profile of Inventory Level Over Time


Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
11-53 Inventory Management

When to Reorder with EOQ Ordering


Reorder Point is the level of inventory at which a
new order is placed
Reorder Point Example
(demand and lead time both constant)

ROP = daily demand x Lead time in days


Demand = 10,000 units/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154 units/day
Lead time = L = 10 days

R = d*L = (32.154)(10) = 321.54 units


11-54 Inventory Management

Reorder Point & Safety Stock

Profile of Inventory Level Over Time


Q Usage
Quantity rate
on hand
Expected demand
during lead time

Maximum probable demand


Reorder during lead time
point

Time
Safety Stock

ROP = daily demand x Lead time in days + Safety Stocks


11-55 Inventory Management
When to Reorder with EOQ Ordering
(Probabilistic Models)
Safety Stock - Stock that is held in excess of expected
demand due to variable demand rate and/or lead time.
Service Level - Probability that demand will not exceed
supply during lead time (probability that inventory
available during the lead time will meet the demand)
1 - Probability of stockout
Answer how much & when to order
Allow demand and lead time to vary
Follows normal distribution
Other EOQ assumptions apply
Consider service level & safety stock
Service level = 1 - Probability of stockout
Higher service level means more safety stock
More safety stock means higher ROP
11-56 Inventory Management

Safety Stock and Service Level


Figure 11.13

The ROP based on a normal


Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
11-57 Inventory Management

Reorder Point for Service Level


Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd LT

dL R
Expected Demand
d = Demand rate (units per day or week)

d LT = d LT d LT = Standard deviation of Lead time demand


d = Standard deviation of demand per day or week
Z = Number of standard deviations
LT = Lead Time
11-58 Inventory Management
Reorder Point
(With Variable Demand and Constant Lead Time)
Safety Stock = z dLT = z d LT

Reorder Point = ROP = dLT + zd LT

where
d = average daily demand
LT = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd LT = safety stock
11-59 Inventory Management

Reorder Point for Variable Demand and Constant


Lead Time (Example)

The carpet store wants a reorder point with a 95% service level
and a 5% stockout probability

d = 30 yards per day, (demand is normally distributed)


d = 5 yards per day
LT= 10 days

For a 95% service level, z = 1.65

R = dL + z d LT Safety stock = z d LT
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 yards = 26.1 yards
Reorder Point
11-60 Inventory Management

(With Constant Demand and Variable Lead Time)


d LT = d LT

SS = z d LT
ROP = d x LT + z d LT
where
d = Daily or weekly demand
LT = Average lead time in days or weeks
LT = Standard deviation of lead time in days or weeks
z = number of standard deviations corresponding to
the service level probability
z d LT = safety stock
11-61 Inventory Management

Example
Q. The EOQ is 75 units. Suppose that the average
demand is 18 units per week. Average lead time is 14
days with a standard deviation of 3 days (6 working
days in a week). Determine safety stock and reorder
point if management wants a 90 percent cycle-service
level.
Given that: EOQ =75 units, d = 18/6 = 3 units,

LT = 14 days, LT= 3 days


Safety Stock: z d LT = 1.28 * 3 * 3 =11.52

Reorder Point: Lead time demand + Safety Stock


=14*3+11.52 = 53.52 or 54 units (approx)
11-62 Inventory Management
Reorder Point
With Variable Demand and Variable Lead Time
2
____
dLT LT d d LT
2 2

2
___ ____
ROP d LT z LT d d LT
2 2

where
d = average daily demand
LT = average lead time
LT = Standard deviation of lead time in days or weeks
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
2
____ probability
z LT d d LT = safety stock
2 2
11-63 Inventory Management

Example
The mote replaces broken grasses at a rate of 25 per day. In the
past, this quantity has tended to vary normally and have a standard
deviation of 3 glasses per day. Glasses are ordered from a
Cleveland supplier. Lead time is normally distributed with an
average of 10 days and a standard deviation of 2 days. What ROP
should be used to achieve a service level of 95%?
Solution:

d = 25 glasses per day, LT = 10 days

d = 3 glasses per day LT = 2 days

SL = 95 percent, so z = 1.65 2
___ ____
ROP d LT z LT d d LT
2 2

ROP 25 10 1.65 10(3) 2 (25) 2 (2) 2 334 glasses


11-64 Inventory Management

Determinants of the Reorder Point

The rate of demand


The lead time

Demand and/or lead time variability

Stock-out risk (safety stock)


11-65 Inventory Management
How Much To Order
(Periodic Inventory System)
Fixed-Order-Interval Model
Orders are placed at fixed time intervals
Order quantity for next interval?

Suppliers might encourage fixed intervals

May require only periodic checks of


inventory levels
Risk of stock-out
11-66 Inventory Management

Fixed-Interval Benefits

Tight control of inventory items


Items from same supplier may yield savings
in:
Ordering
Packing
Shipping costs
May be practical when inventories cannot be
closely monitored
11-67 Inventory Management

Fixed-Interval Disadvantages

Requires a larger safety stock


Increases carrying cost

Costs of periodic reviews


11-68 Inventory Management

Inventory Level in a Fixed Period System

Various amounts (Qi) are ordered at regular time intervals (p) based
on the quantity necessary to bring inventory up to target maximum

Target maximum
Q1 Q2 Q4

Q3
d Inventory

p p p

Time
11-69 Inventory Management

Fixed-Time Period Model with Safety Stock Formula

q = Average demand + Safety stock Inventory currently on hand

q = d(T + L) + Z T + L - I

Where :
q = quantitiy to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probabilit y
T + L = standard deviation of demand over the review and lead time
I = current inventory level (includes items on order)
Fixed-Time Period Model:
11-70 Inventory Management

Determining the Value of T+L


T+ L 2
T+ L = di
i 1

Since each day is independent and d is constant,


T+ L = (T + L) d 2

The standard deviation of a sequence of random


events equals the square root of the sum of the
variances
11-71 Inventory Management
Order Quantity for a Periodic Inventory System

Q = d(T + L) + zd T+L - I
where
d = average demand rate
T = the fixed time between orders
L = lead time
d = standard deviation of demand
zd T + L = safety stock
I = inventory level
z = the number of standard deviations
for a specified service level
11-72 Inventory Management
Fixed-Period Model with Variable
Demand (Example 1)

d = 6 bottles per day


d = 1.2 bottles
T = 60 days
L = 5 days
I = 8 bottles
z = 1.65 (for a 95% service level)

Q = d(T + L) + zd T+L -I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 bottles
Fixed-Time Period Model with
11-73 Inventory Management

Variable Demand (Example 2)(1 of 3)

Given the information below, how many units


should be ordered?
Average daily demand for a product is 20
units. The review period is 30 days, and
lead time is 10 days. Management has set
a policy of satisfying 96 percent of demand
from items in stock. At the beginning of the
review period there are 200 units in
inventory. The standard deviation of daily
demand is 4 units.
Fixed-Time Period Model with Variable
11-74 Inventory Management

Demand (Example 2)(2 of 3)

T+ L = (T + L) d =
2
30 + 10 4 2 = 25.298

So, by looking at the value from the Table, we have a


probability of 0.9599, which is given by a z = 1.75
11-75 Inventory Management

Fixed-Time Period Model with Variable


Demand (Example 2) (3 of 3)

q = d(T + L) + Z T + L - I

q = 20(30 + 10) + (1.75)(25. 298) - 200

q = 800 44.272 - 200 = 644.272, or 645 units

So, to satisfy 96 percent of the


demand, you should place an order of
645 units at this review period
11-76 Inventory Management

Single Period Model

Single period model: model for ordering of perishables and


other items with limited useful lives
Shortage cost (Cs ): generally the unrealized profits per unit
Excess cost (Ce): difference between purchase cost and
salvage value of items left over at the end of a period
Service level (SL) = the probability that demand will not
exceed the stocking level
Cs
Service _ level
C s Ce
Optimal _ Stocking _ Level, S 0 d z
11-77 Inventory Management

Single Period Model

Continuous stocking levels


Identifies optimal stocking levels
Optimal stocking level balances unit shortage
and excess cost

Example: Cindys Cider Bar sells a blend of cherry juice and apple cider.
Demand for the blend is approximately normal, with a mean of 200 liters
per week and a standard deviation of 10 liters per week. Cs = 60 cents
per liter and Ce = 20 cents per liter. Find the optimal stocking level for the
apple-cherry blend
11-78 Inventory Management

Operations Strategy

Too much inventory


Tends to hide problems
Easier to live with problems than to eliminate
them
Costly to maintain

Wise strategy
Reduce lot sizes
Reduce safety stock
11-79 Inventory Management

APPENDIX
Relationship between desired lot size and
11-80 Inventory Management

ordering cost

If yearly demand increases by a factor of k,


Optimal lot size increases by a factor of sqrt (k).
The number of orders per year increases by a factor of sqrt
(k).
Flow time decreases by a factor of sqrt (k)

If lot size is to be reduced, one has to reduce fixed


order cost. To reduce the optimal lot size by a factor
of k, the fixed order cost S must be decreased by a
factor of k2
Aggregating Multiple Products
11-81 Inventory Management

in a Single Order
Transportation is a significant contributor to the fixed cost per order
Can possibly combine shipments of different products from the same
supplier
same overall fixed cost
shared over more than one product
effective fixed cost is reduced for each product
lot size for each product can be reduced
Can also have a single delivery coming from multiple suppliers or a
single truck delivering to multiple retailers
Aggregating across products, retailers, or suppliers in a single order
allows for a reduction in lot size for individual products because
fixed ordering and transportation costs are now spread across
multiple products, retailers, or suppliers
10-81
Example 4:Aggregating Multiple Products in
11-82 Inventory Management

a Single Order
Suppose there are 4 computer products in the previous
example: Deskpro, Litepro, Medpro, and Heavpro
Annual figures for each is D=12000, H =100, S =4000
If each product is ordered separately:
Q* = 980 units for each product
Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1960 units
Aggregate orders of all four products:
Combined Q* = 1960 units
For each product: Q* = 1960/4 = 490
Cycle inventory for each product is reduced to 490/2 = 245
Total cycle inventory = 1960/2 = 980 units
Average flow time, inventory holding costs will be reduced
10-82
Lot Sizing with Multiple
11-83 Inventory Management

Products or Customers
In practice, the fixed ordering cost is dependent at least in part
on the variety associated with an order of multiple models
A portion of the cost is related to transportation (independent
of variety)
A portion of the cost is related to loading and receiving (not
independent of variety)
Three scenarios:
Lots are ordered and delivered independently for each product

Lots are ordered and delivered jointly for all three models

Lots are ordered and delivered jointly for a selected subset of


models

10-83
11-84 Inventory Management

Lot Sizing with Multiple Products


Example 5:

Demand per year


DL = 12,000; DM = 1,200; DH = 120
Common transportation cost, S = $4,000
Product specific order cost
sL = $1,000; sM = $1,000; sH = $1,000
Holding cost, h = 0.2
Unit cost
CL = $500; CM = $500; CH = $500

10-84
11-85 Inventory Management

Delivery Options

No Aggregation: Each product ordered


separately
Complete Aggregation: All products
delivered on each truck
Tailored Aggregation: Selected subsets of
products on each truck

10-85
Multiple products ordered and delivered
11-86 Inventory Management

independently
Item L Item- M Item- H Total
Demand per year 12000 1200 120
Fixed cost/order 5000 5000 5000
Holding cost 100 100 100
Optimal order size 1095 346 110
Cycle Inventory 548 173 55 776
Annual holding cost 54772 17321 5477 77570
Order frequency 11.0 3.5 1.1
Annual ordering cost 54772 17321 5477 77570
Average flow time 0.05 0.14 0.46
Annual Inventory cost 109545 34641 10954 155140
11-87 Inventory Management

Multiple products ordered and delivered jointly

Joint ordering cost, S* = S + sL + sM + sH


Annual joint ordering cost, S* x n *

Annual total holding cost, DL DM DH


* * *
n HL n HM n HH
2 2 2
Annual inventory cost,
DL DM DH
* * *
n HL n HM n H H S * n*
2 2 2

Optimal number of order: after first derivatives of total


cost with respect to n and setting it equal to 0,

k
Di H i
n
* i 1
2S *
Multiple products ordered and
11-88 Inventory Management

delivered jointly
Item L Item- M Item- H Total
Demand per year 12000 1200 120
Common cost/order 4000
Specific cost/order 1000 1000 1000
Holding cost/unit/year 100 100 100
Optimal number of order 9.75
Optimal order size 1230 123.0 12.3 1366
Avg.(cycle) Inventory 615 61.5 6.15 683
Annual holding cost 61512 6151 615 68279
Annual ordering cost 68279 68279
Annual Inventory cost 136558 136558
11-89 Inventory Management

Aggregation with capacity constraints


If there is an capacity constraints (e.g. capacity per truck)
then optimal number of order (n*) must be increase to
ensure proportionate order quantity from each supplier
and total demand.
Number of order , n = 13320/1200 =11.1

For previous example if truck capacity is 1200 unit

Then , QL=(12000/11.1)=1081
QM=(1200/11.1)=108
QH=(120/11.1)=11
Total Inventory Cost =
11.1*7000+(1081/2)*100+(108/2)*100+(11/2)*100 =137700
11-90 Inventory Management

Tailored Aggregation (Example)


A Company jointly orders three product A, B, and C
having annual demand 10000, 1000, and 100 units
respectively. The annual holding cost of the
products are 5, 4, and 6 respectively. The common
ordering cost of all products is 400, whereas
additional product specific ordering cost for each
of product A, B, and C is 30. The company
follows tailored aggregation of products in joint
ordering. How does the company order the
products in order to minimize inventory cost?
Tailored Aggregation (Example)
11-91 Inventory Management

continued
Step #1: Identify optimal frequency of order for
each product assuming each product is ordered
independently and than select the most frequently
ordered product.

Step #2: Recalculate the frequency of other than


most frequently ordered product excluding
common ordering cost.
Tailored Aggregation (Example)
11-92 Inventory Management

continued
Step #3: Calculate relative frequency of all
product to the most frequently ordered product
and round them up
Step #4: Recalculate the ordering frequency of
the most frequently ordered product using
following formula:


h m D
i i i
n mf
s
2( S i

m i
Tailored Aggregation (Example)
11-93 Inventory Management

continued
Step #5: For each product calculate order
frequency and total cost.
Ordering frequency is calculated by dividing
recalculated frequency of the most frequently
ordered product (step 4) with respective products
relative ordering frequency (step 3)
Total cost = Annual ordering cost + Annual Holding cost
Annual ordering cost = Common ordering cost + Specific
ordering cost
Annual holding cost = Summation of each products holding cost
11-94 Inventory Management

Lessons from Aggregation

Aggregation allows firms to lower lot size


without increasing cost
Complete aggregation is effective if product
specific fixed cost is a small fraction of joint
fixed cost
Tailored aggregation is effective if product
specific fixed cost is a large fraction of joint
fixed cost

10-94

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