BA 314 Operations Management: Chapter 9 Inventory Management

Selecting the Target Inventory Level when Demand and Lead Time are Variable in P system

A useful approach for finding P and T in practice is simulation. Given discrete probability distributions for demand and lead time, simulation can be used to estimate the demand during the protection interval distribution.

Pressures for Small Inventories

Cost of Capital Storage and Handling Costs Tax, Insurance and Shrinkage (in 3 forms: pilferage, obsolescence, & deterioration)

Systems Based on the P System

Single-bin system Optional replenishment system

Inventory Reduction Tactics for Anticipation Inventory ...match demand rate with production rate. Secondary levers can be used to even out customer demand in one of the following ways:

1. Add new products with different demand cycles so that a peak in the demand for one product compensates for the seasonal low for another. 2. Provide off-season promotional campaigns. 3. Offer seasonal pricing plans.

Inventory Reduction Tactics for Pipeline Inventory ...reduce the lead time. Two secondary levers can help managers cut lead times:

1. Find more responsive suppliers and select new carriers for shipments between stocking locations or improve materials handling within the plant. Improving the information system could overcome information delays between a distribution center and retailer. 2. Change Q in those cases where the lead time depends on the lot size.

Inventory Reduction Tactics for Safety Stock Inventory Place orders closer to the time when they must be received, but can lead to unacceptable customer service--see four secondary levers

1. Improve demand forecasts 2. Cut the lead times of purchased or produced items 3. Reduce supply uncertainties. 4. Rely more on equipment and labor buffers, such as capacity cushions and cross-trained workers.

Advantages of the Q system

1. The review frequency of each SKU may be individualized. Tailoring the review frequency to the SKU can reduce total ordering and holding costs. 2. Fixed lot sizes, if large enough, can result in quantity discounts. The firm's physical limitations, such as its truckload capacities, materials handling methods, and shelf space might also necessitate a fixed lot size. 3. The system requires low levels of safety stock for the amount of uncertainty in demands during the lead time.

Advantages of the P systems

1. The system is convenient because replenishments are made at fixed intervals. Fixed replenishment intervals allow for standardized pickup and delivery times. In contrast, individual items are ordered on their own best intervals with the Q system, which can differ widely. 2. Orders for multiple items from the same supplier can be combined into a single purchase order. This approach reduces ordering and transportation costs and can result in a price break from the supplier. 3. The inventory position, IP, needs to be known only when a review is made (not continuously, as in a Q system). However, this advantage is moot for firms using computerized record-keeping systems, in which a transaction is reported upon each receipt or withdrawal. When inventory records are always current, the system is called a perpetual inventory system.

Selecting the Target Inventory Level when Demand is Variable and Lead Time is Constant in P system

A fundamental difference between the Q and P systems is the length of time needed for stockout protection. A Q system needs stockout protection only during the lead time because orders can be placed as soon as they are needed and will be received L periods later. A P system, however, needs stockout protection for the longer P+LP+L protection interval because orders are placed only at fixed intervals, and the inventory is not checked until the next designated review time.

optional replenishment system

A system used to review the inventory position at fixed time intervals and, if the position has dropped to (or below) a predetermined level, to place a variable-sized order to cover expected needs.

Selecting the Reorder Point when Demand Is Variable and Lead Time Is Constant There are three steps to arrive at a reorder point: 1. Choose an appropriate service-level policy. 2. Determine the distribution of demand during lead time. 3. Determine the safety stock and reorder point levels.

Because the average demand during lead time is variable, the real decision to be made when selecting R concerns the safety stock level. Deciding on a small or large safety stock is a trade-off between customer service and inventory holding costs. Cost minimization models can be used to find the best safety stock, but they require estimates of stockout and backorder costs, which are usually difficult to make with any precision because it is hard to estimate the effect of lost sales, lost customer confidence, future loyalty of customers, and market share because the customer went to a competitor. The usual approach for determining R is for management—based on judgment—to set a reasonable service-level policy for the inventory and then determine the safety stock level that satisfies this policy.

Pressures for Large Inventories: Labor and Equipment Utilization

By creating more inventory, management can increase workforce productivity and facility utilization in three ways. First, placing larger, less frequent production orders reduces the number of unproductive setups, which add no value to a service or product. Second, holding inventory reduces the chance of the costly rescheduling of production orders because the components needed to make the product are not in inventory. Third, building inventories improves resource utilization by stabilizing the output rate when demand is cyclical or seasonal.

Pressures for Large Inventories: Customer Service

Creating inventory can speed delivery and improve the firm's on-time delivery of goods. High inventory levels reduce the potential for stockouts and backorders, which are key concerns of wholesalers and retailers. A stockout is an order that cannot be satisfied, resulting in loss of the sale. A backorder is a customer order that cannot be filled when promised or demanded but is filled later. Customers do not like waiting for backorders to be filled. Many of them will take their business elsewhere. Sometimes, customers are given discounts for the inconvenience of waiting.

Pressures for Large Inventories:

Customer Service Ordering cost Setup Cost Labor and Equipment Utilization Transportation Cost Payments to Suppliers

Inventory Reduction Tactics --find cost-effective ways to reduce inventory in supply chains the basic tactics (which we call levers) for reducing inventories --A primary lever is one that must be activated if inventory is to be reduced. --A secondary lever reduces the penalty cost of applying the primary lever and the need for having inventory in the first place.

Cycle inventory - Reduce the lot size, but use secondary levers to keep setup and ordering costs down Safety stock inventory - Place orders closer to the time when they must be received, but can lead to unacceptable customer service--see four secondary levers Anticipation inventory - Match demand rate with production rates Pipeline inventory - Reduce lead times

Step 2: Distribution of Demand during Lead Time of Selecting the Reorder Point when Demand Is Variable and Lead Time Is Constant

Determine the distribution of demand during lead time, which requires the specification of its mean and standard deviation. To translate a cycle-service level policy into a specific safety stock level, we must know how demand during the lead time is distributed.

Guidelines on when to use or modify the EOQ:

Do not use the EOQ --If you use the "make-to-order" strategy and your customer specifies that the entire order be delivered in one shipment --If the order size is constrained by capacity limitations such as the size of the firm's ovens, amount of testing equipment, or number of delivery trucks Modify the EOQ --If significant quantity discounts are given for ordering larger lots --If replenishment of the inventory is not instantaneous, which can happen if the items must be used or sold as soon as they are finished without waiting until the entire lot has been completed Use the EOQ --If you follow a "make-to-stock" strategy and the item has relatively stable demand --If your carrying costs per unit and setup or ordering costs are known and relatively stable

Calculating EOQ: most efficiently with this formula

EOQ = √2DS / H square root of (2DS / H) C = total annual cycle-inventory cost Q = lot size, in units H = cost of holding one unit in inventory for a year, often expressed as a percentage of the item's value D = annual demand, in units per year S = cost of ordering or setting up one lot, in dollars per lot

Types of Inventory: Operational

Inventories can also be classified by how they are created. In this context, inventory takes four forms: (1) cycle, (2) safety stock, (3) anticipation, and (4) pipeline. They cannot be identified physically; that is, an inventory manager cannot look at a pile of widgets and identify which ones are cycle inventory and which ones are safety stock inventory. However, conceptually, each of the four types comes into being in an entirely different way. Once you understand these differences, you can prescribe different ways to reduce inventory.

Types of Inventory: Accounting

Inventory exists in three aggregate categories that are useful for accounting purposes. 1. Raw materials (RM) 2. Work-in-process (WIP) 3. Finished goods (FG) An important distinction regarding the three categories of inventories is the nature of the demand they experience. See "independent demand items" and "dependent demand items"

anticipation inventory Uneven demand can motivate a manufacturer to stockpile anticipation inventory during periods of low demand so that output levels do not have to be increased much when demand peaks. Anticipation inventory also can help when suppliers are threatened with a strike or have severe capacity limitations.

Inventory used to absorb uneven rates of demand or supply. Any product that is manufactured from one or more components.

Pressures for Large Inventories: Transportation Cost

Sometimes, outbound transportation cost can be reduced by increasing inventory levels. Having inventory on hand allows more full-carload shipments to be made and minimizes the need to expedite shipments by more expensive modes of transportation. Inbound transportation costs can also be reduced by creating more inventory. Sometimes, several items are ordered from the same supplier. Placing these orders at the same time will increase inventories because some items will be ordered before they are actually needed; nonetheless, it may lead to rate discounts, thereby decreasing the costs of transportation and raw materials.

Calculating Total P System Costs

The total costs for the P system are the sum of the same three cost elements for the Q system. The differences are in the calculation of the order quantity and the safety stock. The average order quantity will be the average consumption of inventory during the P periods between orders. Consequently, Q = dP. Total costs for the P system are C = dP/2 (H) + D/dP (S) + (H)(Safety stock)

Calculating Total Q System Costs

Total costs for the continuous review (Q) system is the sum of three cost components: Total cost = Annual cycle inventory holding cost + annual ordering cost + annual safety stock holding cost C = Q/2 (H) + D/Q (S) + (H)(Safety stock)

Step 3: Safety Stock and Reorder Point of Selecting the Reorder Point when Demand Is Variable and Lead Time Is Constant

When selecting the safety stock, the inventory planner often assumes that demand during the lead time is normally distributed

quantity discount

a drop in the price per unit when an order is sufficiently large

inventory

a stock of materials used to satisfy customer demand or to support the production of services or goods

reorder point (ROP) system or fixed order-quantity system Another name for continuous review (Q) system

a system designed to track the remaining inventory of a SKU each time a withdrawal is made to determine whether it is time to reorder

continuous review (Q) system sometimes called a reorder point (ROP) system or fixed order-quantity system --although the order quantity Q is fixed, the time between orders can vary. Hence, Q can be based on the EOQ, a price break quantity (the minimum lot size that qualifies for a quantity discount), a container size (such as a truckload), or some other quantity selected by management.

a system designed to track the remaining inventory of a SKU each time a withdrawal is made to determine whether it is time to reorder In practice, these reviews are done frequently (e.g., daily) and often continuously (after each withdrawal).

periodic review (P) system sometimes called a fixed interval reorder system or periodic reorder system alternative inventory control system Under a P system, four of the original EOQ assumptions are maintained: (1) no constraints are placed on the size of the lot, (2) the relevant costs are holding and ordering costs, (3) decisions for one SKU are independent of decisions for other SKUs, and (4) lead times are certain and supply is known.

a system in which an item's inventory position is reviewed periodically rather than continuously Such a system can simplify delivery scheduling because it establishes a routine. A new order is always placed at the end of each review, and the time between orders (TBO) is fixed at P. Demand is a random variable, so total demand between reviews varies. In a P system, the lot size, Q, may change from one order to the next, but the time between orders is fixed.

single-bin system

a system of inventory control in which a maximum level is marked on the storage shelf or bin, and the inventor is brought up to the mark periodically

perpetual inventory system

a system of inventory control in which the inventory records are always current

visual system Visual systems are easy to administer because records are not kept on the current inventory position. The historical usage rate can simply be reconstructed from past purchase orders. Visual systems are intended for use with low-value SKUs that have a steady demand, such as nuts and bolts or office supplies. Overstocking is common, but the extra inventory holding cost is minimal because the items have relatively little value.

a system that allows employees to place orders when inventory visibly reaches a certain marker

two-bin system

a visual system version of the Q system in which a SKU's inventory is stored at two different locations

stock-keeping unit (SKU)

an individual item or product that has an identifying code and is held in inventory somewhere along the supply chain

cycle counting

an inventory control method whereby storeroom personnel personally count a small percentage of the total number of items each day, correcting errors that they find

base-stock system This one-for-one replacement policy maintains the inventory position at a base-stock level equal to expected demand during the lead time plus safety stock. The base-stock level, therefore, is equivalent to the reorder point in a Q system. However, order quantities now vary to keep the inventory position at R at all times.Because this position is the lowest IP possible that will maintain a specified service level, the base-stock system may be used to minimize cycle inventory. More orders are placed, but each order is smaller. This system is appropriate for expensive items, such as replacement engines for jet airplanes. No more inventory is held than the maximum demand expected until a replacement order can be received.

an inventory control system that issues a replenishment order, Q, each time a withdrawal is made, for the same amount of the withdrawal

Managerial Insights from the EOQ Subjecting the EOQ formula to sensitivity analysis can yield valuable insights into the management of inventories. Sensitivity analysis is a technique for systematically changing crucial parameters to determine the effects of a change.

by substituting different values into the numerator or denominator of the formula D = Demand S = Order/Setup costs H = Holding costs

Creating ABC inventory classifications

inventory records must be accurate --Class A SKUs are reviewed frequently to reduce the average lot size and to ensure timely deliveries from suppliers. Need high inventory turnover. --Class B SKUs require an intermediate level of control --Class C SKUs can have much looser control

pipeline inventory This form of inventory exists because the firm must commit to enough inventory (on-hand plus in-transit) to cover the lead time for the order. Longer lead times or higher demands per week create more pipeline inventory.

inventory that is created when an order for an item is issued but not yet received

independent demand items ...must be forecasted

items for which demand is influenced by market conditions and is not related to the inventory decisions for any other item held in stock or produced Retailers, such as JCPenney and Dillards, deal with finished goods. Examples of independent demand items include: --Wholesale and retail merchandise --Service support inventory, such as stamps and mailing labels for post offices, office supplies for law firms, and laboratory supplies for research universities --Product and replacement-part distribution inventories --Maintenance, repair, and operating (MRO) supplies—that is, items that do not become part of the final service or product, such as employee uniforms, fuel, paint, and machine repair parts

dependent demand items ...should be calculated, not forecasted, and exhibits a pattern very different from that of independent demand

items whose required quantity varies with the production plans for other items held in the firm's inventory

Work-in-process (WIP)

items, such as components or assemblies, needed to produce a final product in manufacturing or service operations WIP is also present in some service operations, such as repair shops, restaurants, check-processing centers, and package delivery services.

Selecting the Time Between Reviews in P system

managers must make two decisions: the length of time between reviews, P, and the target inventory level, T.

scheduled receipts (SR) or open orders Inventory position includes SR plus on-hand inventory (OH) minus backorders (BO)

orders that have been placed but have not yet been received Inventory position = On-hand inventory + Scheduled receipts − Backorders IP = OH + SR − BO

safety stock inventory Used to avoid customer service problems and the hidden costs of unavailable components

surplus inventory that a company holds to protect against uncertainties in demand, lead time, and supply changes To create safety stock, a firm places an order for delivery earlier than when the item is typically needed.1 The replenishment order therefore arrives ahead of time, giving a cushion against uncertainty. For example, suppose that the average lead time from a supplier is 3 weeks, but a firm orders 5 weeks in advance just to be safe. This policy creates a safety stock equal to a 2-weeks' supply (5−3=2).

Cost of Capital Most firms use the weighted average cost of capital (WACC)

the average of the required return on a firm's sterm-39tock equity and the interest rate on its debt, weighted by the proportion of equity and debt in its portfolio.

time between orders (TBO) Expressed as a fraction of a year, the TBO is simply Q divided by annual demand. When we use the EOQ and express time in terms of months, the TBO is TBO∨EOQ = EOQ / D (12 months/year)

the average time between receiving replenished orderssed time between receiving (or placing) replenishment orders of Q units for a particular lot size

setup cost

the cost involved in changing over a machine or workspace to produce a different item

ordering cost

the cost of preparing a purchase order for a supplier or a production order for manufacturing

Repeatability Inventory Reduction Tactics a secondary lever used to decrease cycle inventory setup or ordering costs

the degree to which the same work can be done again Increased repeatability may justify new setup methods, reduce transportation costs, and allow quantity discounts from suppliers.

service level or cycle-service level Step 1: Service Level Policy of Selecting the Reorder Point when Demand Is Variable and Lead Time Is Constant

the desired probability of not running out of stock in any one ordering cycle, which begins at the time an order is placed and ends when it arrives in stock

lot sizing

the determination of how frequently and in what quantity to order inventory

Selecting the Reorder Point when Both Demand and Lead Time are Variable

the equations for the safety stock and reorder point become more complicated. See image for the equation: we make two simplifying assumptions. 1. the demand distribution and the lead time distribution are measured in the same time units. For example, both demand and lead time are measured in weeks. 2. demand and lead time are independent. That is, demand per week is not affected by the length of the lead time.

Raw materials (RM)

the inventories needed for the production of services or goods

Finished goods (FG)

the items in manufacturing plants, warehouses, and retail outlets that are sold to the firm's customers The finished goods of one firm may actually be the raw materials for another.

economic order quantity (EOQ) 9.5 Supply chain managers face conflicting pressures to keep inventories low enough to avoid excess inventory holding costs but high enough to reduce ordering and setup costs. Inventory holding cost is the sum of the cost of capital and the variable costs of keeping items on hand, such as storage and handling, taxes, insurance, and shrinkage. --will be optimal when all five assumptions are satisfied. In reality, few situations are so simple.

the lot size that minimizes total annual inventory holding and ordering costs --based on the following assumptions: 1. demand rate for the item is constant and known with certainty. 2. No constraints are placed (such as truck capacity or materials handling limitations) on the size of each lot. 3. The only two relevant costs are the inventory holding cost and the fixed cost per lot for ordering or setup. 4. Decisions for one item can be made independently of decisions for other items. In other words, no advantage is gained in combining several orders going to the same supplier. 5. The lead time is constant and known with certainty. The amount received is exactly what was ordered and it arrives all at once rather than piecemeal.

inventory position (IP)

the measurement of a SKU's ability to satisfy future demand

protection interval For the Q system, the lead time is the protection interval.

the period over which safety stock must protect the user from running out of stock

inventory management

the planning and controlling of inventories in order to meet the competitive priorities of the organization

cycle inventory At the beginning of the interval, the cycle inventory is at its maximum, or Q. At the end of the interval, just before a new lot arrives, cycle inventory drops to its minimum, or 0. The average cycle inventory is the average of these two extremes: Average cycle inventory = (Q + 0) / 2= Q / 2 This formula is exact only when the demand rate is constant and uniform. However, it does provide a reasonably good estimate even when demand rates are not constant. Factors other than the demand rate (e.g., scrap losses) also may cause estimating errors when this simple formula is used.

the portion of total inventory that varies directly with lot size Two principles apply: 1. The lot size, Q, varies directly with the elapsed time (or cycle) between orders. If a lot is ordered every 5 weeks, the average lot size must equal 5 weeks' demand. 2. The longer the time between orders for a given item, the greater the cycle inventory must be.

reorder point (R)

the predetermined minimum level that an inventory position must reach before a fixed quantity Q of the SKU is ordered

ABC Analysis 9.4 Used to determine the items deserving most attention and tightest inventory control. This method is the equivalent of creating a Pareto chart except that it is applied to inventory rather than to process errors. Begin by multiplying annual demand rate for SKU by dollar value of one unit to find its dollar usage. dollar usage = SKU annual demand x one unit SKU dollar value

the process of dividing SKUs into three classes, according to their dollar usage, so that managers can focus on items that have the highest dollar value. Typically: Class A is 20% of SKUs / 80% dollar usage Class B is 30% of SKUs / 15% dollar usage Class C is 50% of SKUs / 5% dollar usage

lot size

the quantity of an inventory item management either buys from a supplier or manufactures using internal processes

inventory holding cost (or carrying cost)

the sum of the cost of capital and the variable costs of keeping items on hand, such as storagterm-33e and handling, taxes, insurance, and shrinkageterm-38

Systems Based on the Q System

two-bin system base-stock system