Inventory
Management
12
PowerPoint presentation to accompany
Heizer, Render, Munson
Operations Management, Twelfth Edition, Global Edition
Principles of Operations Management, Tenth Edition, Global Edition
PowerPoint slides by Jeff Heyl
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Outline
► Global Company Profile:
Amazon.com
► The Importance of Inventory
► Managing Inventory
► Inventory Models
► Inventory Models for Independent
Demand
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Inventory Management at
Amazon.com
► Amazon.com started as a “virtual”
retailer – no inventory, no warehouses,
no overhead – just computers taking
orders to be filled by others
► Growth has forced Amazon.com to
become a world leader in
warehousing and inventory
management
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Inventory Management at
Amazon.com
1. Each order is assigned by computer to the
closest distribution center that has the
product(s)
2. Technology helps workers pick the correct
items from the shelves with almost no errors
3. Items are placed in crates on a conveyor, bar
code scanners scan each item 15 times to
virtually eliminate errors
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Inventory Management at
Amazon.com
5. Crates arrive at central point where items
are boxed and labeled with new bar code
6. Gift wrapping is done by hand at 30
packages per hour
7. Completed boxes are packed, taped,
weighed and labeled before leaving
warehouse in a truck
8. Order arrives at customer within 1 - 2 days
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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
▶ Less inventory lowers costs but
increases chances of running out
▶ More inventory raises costs but
always keeps customers happy
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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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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
▶ Used to establish policies that focus on the
few critical parts and not the many trivial
ones
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Percentage of annual dollar usage ABC Analysis
Figure 12.2
A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |
10 20 30 40 50 60 70 80 90 100
Percentage of inventory items
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ABC Analysis
ABC Calculation
(1) (2) (3) (4) (5) (6) (7)
PERCENT
OF PERCENT
ITEM NUMBER ANNUAL ANNUAL OF ANNUAL
STOCK OF ITEMS VOLUME UNIT DOLLAR DOLLAR
NUMBER STOCKED (UNITS) x COST = VOLUME VOLUME CLASS
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4% B
#12572 600 14.17 8,502 3.7% C
#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $232,057 100.0%
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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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Record Accuracy
► Accurate records are a
critical ingredient in
production and inventory
systems
► Periodic systems require
regular checks of inventory
► Two-bin system
► Perpetual inventory tracks receipts
and subtractions on a continuing basis
► May be semi-automated
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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 cost - the costs of placing an
order and receiving goods
▶ Setup cost - 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 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6%
operating costs, taxes, insurance) (3 - 10%)
Material handling costs (equipment lease or 3%
depreciation, power, operating cost) (1 - 3.5%)
Labor cost (receiving, warehousing, security) 3%
(3 - 5%)
Investment costs (borrowing costs, taxes, and 11%
insurance on inventory) (6 - 24%)
Pilferage, space, and obsolescence (much 3%
higher in industries undergoing rapid change like (2 - 5%)
tablets and smart phones)
Overall carrying cost 26%
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Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT
pe n d
deINVENTORYin g on OF
CATEGORY
c on s id er ab ly VALUE
osts va r y r a t es. 6%
ing c(building
Holdcosts
Housing in
rent or depreciation,
n , and t e r est
ss , lo c a t io tech
(3h- 10%)
the b usine
operating costs, taxes, insurance)
a n 15 % , so me hig
ally gr e er t h
at(equipment lease in org costs greate3% r
G ne r
Materialehandling costs
v e hold
depreciation, em
power,noperating
h io it s h a
cost) (1 - 3.5%)
and f a s
Labor cost (receiving,
% . warehousing, security) 3%
tha n 4 0 (3 - 5%)
Investment costs (borrowing costs, taxes, and 11%
insurance on inventory) (6 - 24%)
Pilferage, space, and obsolescence (much 3%
higher in industries undergoing rapid change like (2 - 5%)
PCs and cell phones)
Overall carrying cost 26%
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Inventory Models for Independent
Demand
Need to determine when and
how much to order
1. Basic economic order quantity
(EOQ) model
2. Production order quantity model
3. Quantity discount model
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Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering)
and holding
6. Stockouts can be completely avoided
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Inventory Usage Over Time
Figure 12.3
Total order received
Average
Order Usage rate inventory
quantity = Q on hand
Inventory level
(maximum Q
inventory
level) 2
Minimum
inventory 0
Time
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Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)
Total cost of
holding and
setup (order)
Minimum
total cost
Annual cost
Holding cost
Setup (order) cost
Optimal order Order quantity
quantity (Q*)
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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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Minimizing Costs
Q = Number of units per order
Q* = Optimal number of units per order
(EOQ)
D = Annual demand in units for the
inventory item
S = Setup or ordering cost for each order
Annual setup cost = (Number of orders placed per year)
H = Holdingxor carrying
(Setup cost
or order per
cost perunit per
order)
year
Annual demand Setup or order
=
Number of units in each order cost per order
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Minimizing Costs
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)
Annual demand Setup or order
=
Number of units in each order cost per order
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Minimizing Costs
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)
Order quantity
= (Holding cost per unit per year)
2
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Minimizing Costs
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Optimal order quantity is found when annual setup
cost equals annual holding cost
Solving for Q*
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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
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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 = =
orders Order quantity
1,000
N= = 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 =
orders Expected number of orders
250
T= = 50 days between orders
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
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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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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
Demand Lead time for a new
ROP = per day order in days
ROP = d x L
d= D
Number of working days in a year
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Reorder Point Curve
Figure 12.5
Q*
Stock is replenished as order arrives
Inventory level (units)
Slope = units/day = d
ROP
(units)
Time (days)
Lead time = L
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Reorder Point Example
Demand = 8,000 iPhones per year
250 working day year
Lead time for orders is 3 working days, may take 4
D
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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Quantity Discount Models
▶ Reduced prices are often available when larger
quantities are purchased
▶ Trade-off is between reduced product cost and
increased holding cost
TABLE 12.2 A Quantity Discount Schedule
PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P
Initial price 0 to 119 $ 100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96
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Quantity Discount Models
Total annual cost = Setup cost + Holding cost + Product cost
where Q = Quantity ordered P = Price per unit
D = Annual demand in units I = Holding cost per unit per year
S = Ordering or setup cost per order expressed as a percent of price P
Because unit price varies, holding cost is expressed
as a percent (I) of unit price (P)
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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
Cs
Service level =
Cs + Co
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Fixed-Period (P) Systems
▶ Fixed-quantity models require
continuous monitoring using perpetual
inventory systems
▶ In fixed-period systems orders placed
at the end of a fixed period
▶ Periodic review, P system
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