Lecture Introduction to operations management - Chapter 15: Independent demand inventory

In this chapter we will discuss: Purpose of inventories, costs of inventories, independent versus dependent demand, economic order quantity, continuous review system, periodic review system, using P and Q system in practice, ABC inventory management.

Operations Management Contemporary Concepts and Cases Chapter Fifteen Independent Demand Inventory  McGraw­Hill/Irwin Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved Chapter 15 Outline Purpose of Inventories Costs of Inventories Independent versus Dependent Demand Economic Order Quantity Continuous Review System Periodic Review System Using P and Q System in Practice ABC Inventory Management 15­2 Definitions Inventory:  a stock of materials used to facilitate  production or satisfy customer demand Types of inventory – – – – Raw materials, purchased parts (RM) Work in process (WIP) Finished goods (FG) Maintenance, repair & operating supplies (MRO) 15­3 Inventory Management Technologies Bar coding Point of sale (data) (POS) Radio­frequency Identification (RFID)  15­4 Materials-Flow Process (Fig 15.1) Productive Process Work in process Vendors Raw Materials Work in process Finished Customer goods Work in process 15­5 Water Tank Analogy for Inventory Inventory Level Supply Rate Inventory Level Demand Rate 15­6 Purpose of Inventories (1) To protect against uncertainties (safety stock) – – – – demand (FG, MRO) supply (RM, MRO) lead times (RM, WIP) schedule changes (WIP) To allow economic production and purchase  (discounts for buying RM in bulk) 15­7 Purpose of Inventories (2) To cover anticipated changes in demand (as  in a level strategy) or supply – FG – RM To provide for transit (pipeline inventories) – – – RM FG WIP (independence of operations) 15­8 Inventory Cost Structures (1) Item cost – Expressed as cost per unit or SKU.  Gets into  LIFO and FIFO issues.   – Problem can be compounded by quantity  discounts Ordering (or setup) cost – – – Paperwork, worker time (ordering) Worker time, downtime (setup) Typically expressed as a fixed cost per order or  setup.   15­9 Inventory Cost Structures (2) Carrying (or holding) cost: – Cost of capital (market rate or internal rate of return) – Cost of storage (building, utilities, insurance, handling) – Cost of obsolescence, deterioration, and loss  (shrinkage) – Management cost (record keeping, counting) Typically expressed as a percentage of SKU cost.   Estimated U.S. average is 35% per year Businesses often use only cost of capital  (understatement) 15­10 Reorder Point The Reorder point is defined as: R = m + s where: R = reorder point     m = mean demand during lead time             s  = safety or buffer stock Using the normal distribution: s = zσ where:   z = safety factor (from normal table)              σ = standard deviation of lead time demand Thus: R = m + zσ 15­33 Periodic Review System (1) Instead of reviewing continuously, we review  the inventory position at fixed intervals.  For  example, the bread truck visits the grocery  store on the same days every week Inventory brought up to a ‘target’ level Also known as “P system,” “Fixed­order­ interval system” or “Fixed­order­period  system” 15­34 Periodic Review System (2) Has a target inventory level rather than a  reorder point Does not use EOQ (directly) since order  quantity varies according to demand The order interval is fixed, the order quantity  varies 15­35 Periodic Review (P) System (Fig 15.9) 15­36 Time Between Orders (P) and Target Level (T) Calculation P 2S iC D T m' s ' Where: T  = target inventory level m’ = average demand over P+L s’   = safety stock 15­37 Using P and Q System in Practice Use P system when orders must be placed at  specified intervals Use P systems when multiple items are  ordered from the same supplier (joint­ replenishment) Use P system for inexpensive items 15­38 Using P and Q Systems in Practice P may be easier to use since levels are  reviewed less often P requires more safety stock since may only  order at fixed points P is more likely to run out since cannot  respond quickly to increases in demand Either may be more costly:  P in safety  stock, Q in monitoring cost 15­39 P and Q Systems at Home P system:  You go to the grocery store on the  same day every week.  You ask:  “What will  we need for the next week?” – P is more likely to run out since cannot respond  quickly to increases in demand – P will carry more inventory (enough to last until  the next trip) Q system:  You go to the grocery store each  time you need something.  You ask:  “What  do we need?” – Q may require more ordering and unplanned  order (trips to the store) 15­40 Service Level versus Inventory Level (Fig 15.10) 105% Service Level (%) 100% 95% 90% 85% 1.1 1.0 1.2 1.3 1.4 1.5 1.6 2.1 2.2 2.3 2.4 2.0 1.9 1.7 1.8 2.5 z values 80% 75% 150 160 170 180 190 200 210 220 230 240 250 260 270 280 290 300 Q 100 100 Average Inventory Level 15­41 ABC Inventory Management (1) Based on “Pareto” concept (80/20 rule) and  total usage in dollars of each item Classification of items as A, B, or C based on  usage Purpose is to set priorities on effort used to  manage different SKUs, i.e., to allocate scarce  management resources 15­42 ABC Inventory Management (2) ‘A’ items:  20% of SKUs, 80% of dollars ‘B’ items:  30% of SKUs, 15% of dollars ‘C’ items:  50% of SKUs, 5% of dollars Three classes is arbitrary; could be any number Percents are approximate Danger:  Dollar use may not reflect importance of  any given SKU! Some low value, but critical  items may be classified as ‘A.’ 15­43 Annual Usage of Items by Dollar Value (Table 15.4) Item 10 Total Annual Usage in  Units Unit Cost Dollar Usage 5,000 $ 1.50 $ 7,500 1,500 8.00 12,000 10,000 10.50 105,000 6,000 2.00 12,000 7,500 0.50 3,750 6,000 13.60 81,600 5,000 0.75 3,750 4,500 1.25 5,625 7,000 2.50 17,500 3,000 2.00 6,000 $ 254,725 Percentage of  Total Dollar  Usage 2.9% 4.7% 41.2% 4.7% 1.5% 32.0% 1.5% 2.2% 6.9% 2.4% 100.0% 15­44 ABC Chart for Table 15.4 120.0% 40.0% A Percent Usage 35.0% 30.0% B 100.0% C 80.0% 25.0% 60.0% 20.0% 15.0% 40.0% 10.0% 20.0% 5.0% 0.0% Cumulative % Usage 45.0% 0.0% 10 Item No Percentage of Total Dollar Usage Cumulative Percentage 15­45 Summary Purpose of Inventories Costs of Inventories Independent versus Dependent Demand Economic Order Quantity Continuous Review System Periodic Review System Using P and Q System in Practice ABC Inventory Management 15­46 End of Chapter Fifteen 15­47 ... Using P and Q System in Practice ABC? ?Inventory? ?Management 15­2 Definitions Inventory:   a stock of materials used? ?to? ?facilitate  production or satisfy customer? ?demand Types of? ?inventory – – – – Raw materials, purchased parts (RM)... process Finished Customer goods Work in process 15­5 Water Tank Analogy for Inventory Inventory Level Supply Rate Inventory? ?Level Demand Rate 15­6 Purpose of Inventories (1) To? ?protect against uncertainties (safety stock)... Frequent orders (small lot sizes) lead? ?to? ?lower  average? ?inventory? ?level, i.e., higher total ordering  costs and lower total holding costs – Fewer orders (large lot sizes) lead? ?to? ?higher  average? ?inventory? ?level, i.e., lower total ordering