INVENTORY MANAGEMENT: ECONOMIC ORDER QUANTITY, JIT, AND THE THEORY OF CONSTRAINTS CHAPTER 20 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use CHAPTER 20 OBJECTIVES Describe the just-in-case inventory management model Discuss just-in-time (JIT) inventory management Explain the basic concepts of constrained optimization Define the theory of constraints, and tell how it can be used to manage inventory © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT • Just-in-case inventory management: a traditional inventory model based on anticipated demand • Three types of inventory costs can be readily identifies with inventory • The cost of acquiring inventory • The cost of holding inventory • The cost of not having inventory on hand when needed LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT • Ordering costs: costs of placing and receiving an order • Examples: costs of processing an order (clerical costs and documents), insurance for shipment, and unloading costs LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT • Setup costs: costs of preparing equipment and facilities so they can be used to produce a particular product or component • Examples: wages of idled production workers, the cost of idled production facilities (lost income), and the costs of test runs (labor, materials, and overhead) LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT • Carrying costs: costs of holding inventory • Examples: insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, handling costs, and storage LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT • Stock-out costs: costs of not having a product available when demanded by a customer • Examples: lost sales (both current and future), the costs of expediting (increased transportation charges, overtime, and so on), and the costs of interrupted production LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use EXHIBIT 20.1—TRADITIONAL REASONS FOR CARRYING INVENTORY LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT Economic Order Quantity: A Model for Balancing Acquisition and Carrying Costs •To develop an inventory policy that deals with the tradeoff between acquisition costs and carrying costs, two basic questions must be addressed • How much should be ordered (or produced) to minimize inventory costs? • When should the order be placed (or the setup done)? LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JUST-IN-CASE INVENTORY MANAGEMENT Minimizing Total Ordering and Carrying Costs •Assuming that demand is known, the total ordering (or setup) and carrying cost can be described by the following equation TC = PD/Q + CQ/2 = Ordering (or setup) cost + Carrying cost where TC = the total ordering and carrying cost P = the cost of placing and receiving an order Q=the number of units ordered each time an order is placed D = the known annual demand C = the cost of carrying one unit of stock for one year LO-1 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JIT INVENTORY MANAGEMENT Discounts and Price Increases: JIT Purchasing Versus Holding Inventories •Negotiate long-term contracts with a few chosen suppliers located close to the production facility and establish more extensive supplier involvement • Stipulate prices and acceptable quality levels • Reduce dramatically the number of orders placed, which helps to drive down the ordering cost LO-2 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use JIT INVENTORY MANAGEMENT JIT’s Limitations •Patience in implications is needed •Time is required •JIT may cause lost sales and stressed workers •Production may be interrupted due to an absence of inventory LO-2 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use BASIC CONCEPTS OF CONSTRAINED OPTIMIZATION • Every firm faces limited resources and limited demand for each product • External constraints: limiting factors imposed on the firm from external sources, such as market demand • Internal constraints: limiting factors found within the firm, such as machine or labor time availability LO-3 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use BASIC CONCEPTS OF CONSTRAINED OPTIMIZATION • Loose constraints: constraints whose limited resources are not fully used by a product mix are • Binding constraint: a product mix that uses all of the limited resources of a constraint • Constrained optimization is choosing the optimal mix given the constraints faced by the firm LO-3 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use BASIC CONCEPTS OF CONSTRAINED OPTIMIZATION One Binding Internal Constraint •The function to be optimized (maximized in the case of contribution margin) is called the objective function LO-3 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use BASIC CONCEPTS OF CONSTRAINED OPTIMIZATION Multiple Internal Binding Constraints •Linear programming model: expresses a constrained optimization problem as a linear objective function subject to a set of linear constraints •All constraints, taken together, are referred to as the constraint set •A feasible solution is a solution that satisfies the constraints in the linear programming model •Linear programming is a method that searches among possible solutions until it finds the optimal solution LO-3 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use EXHIBIT 20.8—CONSTRAINT DATA: SCHALLER COMPANY LO-3 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use EXHIBIT 20.9—GRAPHICAL SOLUTION LO-3 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use THEORY OF CONSTRAINTS (TOC) • Goal is to make money now and in the future by managing constraints • Recognizes that the performance of any organization (system) is limited by its constraints • Focuses on the system-level effects of continuous improvement LO-4 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use THEORY OF CONSTRAINTS (TOC) Operational Measures •TOC focuses on three operational measures of systems performance • Throughput: rate at which an organization generates money through sales Throughput = (Sales revenue – Unit level variable expenses)/Time • Inventory: all the money the organization spends in turning materials into throughput • Operating expenses: all the money the organization spends in turning inventories into throughput and represent all other money that an organization spends LO-4 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use THEORY OF CONSTRAINTS (TOC) Five Step Method for Improving Performance •Identify an organization’s constraints •Exploit the binding constraints •Subordinate everything else to the decisions made in Step •Elevate the organization’s binding constraints •Repeat the process as a new constraint emerges to limit output LO-4 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use EXHIBIT 20.10—DRUM-BUFFER-ROPE SYSTEM: GENERAL DESCRIPTION LO-4 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use EXHIBIT 20.11—DRUM-BUFFER-ROPE: SCHALLER COMPANY LO-4 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use EXHIBIT 20.12—NEW CONSTRAINT SET: SCHALLER COMPANY LO-4 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use END OF CHAPTER 20 © 2014 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use ... INVENTORY MANAGEMENT • Ordering costs: costs of placing and receiving an order • Examples: costs of processing an order (clerical costs and documents), insurance for shipment, and unloading costs... JUST-IN-CASE INVENTORY MANAGEMENT • Carrying costs: costs of holding inventory • Examples: insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, handling costs, and... INVENTORY MANAGEMENT • Setup costs: costs of preparing equipment and facilities so they can be used to produce a particular product or component • Examples: wages of idled production workers, the cost