BUS 105: Production and Operations Management

BUS 105 Production/Operations Management

Inventory Management

Inventory

Inventory can be visualized as stacks of money sitting on forklifts, on shelves, and in trucks and planes while in transit. For many businesses, inventory is the largest asset on the balance sheet at any given time. Inventory can be difficult to convert back into cash. It is a good idea to try to get your inventory down as far as possible.

The average cost of inventory in the United States is 30 to 35 percent of its value.
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Supply Chain Inventory Models

Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Inventory Models
Single-period model Used when we are making a one-time purchase of an item Fixed-order quantity model Used when we want to maintain an item in-stock, and when we restock, a certain number of units must be ordered Fixedtime period model Item is ordered at certain intervals of time
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Inventory: Definition & Types

Inventory: the stock of any item or resource used in an organization Includes raw materials, finished products, component parts, supplies, and work-in-process Manufacturing inventory: refers to items that contribute to or become part of a firms product Replacement parts, tools, & supplies Goods-in-transit to warehouses or customers

Inventory Systems

The set of policies and controls that monitor levels of inventory Determines what levels should be maintained, when stock should be replenished, and how large orders should be

Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Purposes of Inventory
To maintain independence of operations To meet variation in product demand To allow flexibility in production scheduling

To provide a safeguard for variation in raw material delivery time

To take advantage of economic purchase order size

Inventory Costs
Holding (or carrying) costs
Costs for storage, handling, insurance, and so on

Setup (or production change) costs

Costs for arranging specific equipment setups, and so on

Costs Ordering costs

Costs of placing an order

Shortage costs
Costs of running out

Demand Types
Independent demand the demands for various items are unrelated to each other
For example, a workstation may produce many parts that are unrelated but meet some external demand requirement

Dependent demand the need for any one item is a direct result of the need for some other item
Usually a higher-level item of which it is part
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Inventory Systems Comparison

Single-period inventory model
One-time purchasing decision (e.g., vendor selling T-shirts at a football game) Seeks to balance the costs of inventory overstock and under stock

Multi-period inventory models

Fixed-order quantity models Event triggered (e.g., running out of stock) Fixed-time period models Time triggered (e.g., monthly sales call by sales representative)
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Single Period Inventory Model

Consider the problem of deciding how many newspapers to put in a hotel lobby
Too few papers and some customers will not be able to purchase a paper, and profits associated with these potential sales are lost. Too many papers and the price paid for papers that were not sold during the day will be wasted, lowering profit.
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Solving the Newspaper Problem

Consider how much risk we are willing to take of running out of inventory. Assume a mean of 90 papers and a standard deviation of 10 papers. Assume we want an 80 percent chance of not running out. Assume that the probability distribution associated with sales is Normal, stocking 90 papers yields a 50 percent chance of stocking out.

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Solving the Newspaper Problem

From Appendix G, we see that we need approximately 0.85 standard deviation of extra papers to be 80 percent sure of not stocking out.

Using Excel, =NORMSINV(0.8) = 0.84162 Hence, the number of extra papers = 0.84162x10 = 9 papers (rounded)

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Single-Period Inventory Models

P Cu Co C u

Co cost per unit of demand over stocking level Cu cost per unit of demand under stocking level P probability that a given unit will be sold
We should increase the size of the inventory so long as the probability of selling the last unit added is equal to or greater than the ratio C u (Co Cu )
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Single-Period Inventory Models Example Hotel Reservations

A hotel near the university always fills up on the evening before football games. History has shown that when the hotel is fully booked, the number of last-minute cancellations has a mean of 5 and standard deviation of 3. The average room rate is $ 80. When the hotel is overbooked, the policy is to find a room in a nearby hotel and to pay for the room for the customer. This usually costs the hotel approximately $200 since rooms booked on such late notice are expensive. How many rooms should the hotel overbook?

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Single-Period Inventory Models Example Hotel Reservations

Mean demand is 5 Cu 80 Standard deviation of P 0.2857 demand is 3 Co Cu 200 80 Room rate is $80 (this is the cost if overbookings are less than cancellations Cu) Penalty for overbooking is $200 (this is the cost if overbookings are more than cancellations Co)

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Single-Period Inventory Models Example Hotel Reservations

From Appendix G, we see that our desired level falls about 0.55 standard deviations below the mean (z = -0.55)

Using Excel, =NORMSINV(0.2857) = 0.56599

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Single-Period Inventory Models Example Hotel Reservations

Number of No-Shows 0 1 2 3 4 5 6 7 8 9 10 Probability 0.05 0.08 0.10 0.15 0.20 0.15 0.11 0.06 0.05 0.04 0.01 Cumulative Probability 0.05 0.13 0.23 0.38 0.58 0.73 0.84 0.90 0.95 0.99 1.00
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Single-Period Inventory Models Example Hotel Reservations

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Single-Period Inventory Models Example Hotel Reservations

If we overbook by 1 and we have zero no-shows, we incur the penalty of $200 one person must be compensated for having no room.

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Single-Period Inventory Models Example Hotel Reservations

If we overbook by 1 and we have two no-shows, we have lost sales of $80.

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Single-Period Inventory Models Example Hotel Reservations

Total cost of a policy of overbooking by 9 rooms is the weighted average of the events (number of noshows) and the outcome of those events.

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Single Period Model Applications

Overbooking of airline flights

Ordering of clothing and other fashion items

One-time order for events e.g., t-shirts for a concert

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Multi-Period Models
Fixed-order quantity models - Also called the economic order quantity, EOQ, and Qmodel - Event triggered Fixedtime period models - Also called the periodic system, periodic review system, fixedorder interval system, and Pmode - Time triggered
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Multi-Period Models Comparison

Fixed-Order Quantity

Fixed-Time Period

Inventory remaining must be continually monitored Has a smaller average inventory Favors more expensive items Is more appropriate for important items Requires more time to maintain but is usually more automated Is more expensive to implement

Counting takes place only at the end of the review period Has a larger average inventory Favors less expensive items Is sufficient for lessimportant items Requires less time to maintain Is less expensive to implement
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Fixed-Order Quantity Models Assumptions

Demand for the product is constant and uniform throughout the period. Lead time (time from ordering to receipt) is constant. Price per unit of product is constant. Inventory holding cost is based on average inventory. Ordering or setup costs are constant. All demands for the product will be satisfied.

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Fixed-Order Quantity Model

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Order Quantity Model

Always order Q units when inventory reaches reorder point (R).

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Fixed-Order Quantity Model

Inventory arrives after lead time (L). Inventory is raised to maximum level (Q).

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Fixed-Order Quantity Model

Inventory is consumed at a constant rate, with a new order placed when the reorder point (R) is reached once again.

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Order Quantity Model

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Economic Order Quantity (EOQ)

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Economic Order Quantity (EOQ)

The optimal order quantity (Qopt) occurs where total costs are at their minimum

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Economic Order Quantity (EOQ)

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Economic Order Quantity (EOQ) Example: Problem Data

Given the information below, what are the EOQ and reorder point?

Annual Demand = 1,000 units Days per year considered in average daily demand = 365 Cost to place an order = $10 Holding cost per unit per year = $2.50 Lead time = 7 days Cost per unit = $15

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Economic Order Quantity (EOQ) Example: Solution

Q*
d

2 DS 2(1,000 )(10) 89.443 units or 90 units H 2.50

1,000 units / year 2.74 units / day 365 days / year

Reorder point , R dL 2.74units / day (7days ) 19.18 or 20 units

In summary, you place an optimal order of 90 units. In the course of using the units to meet demand, when you only have 20 units left, place the next order of 90 units.
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Economic Order Quantity (EOQ) Example: Problem Data

Determine the economic order quantity and the reorder point given the following

Annual Demand = 10,000 units Days per year considered in average daily demand = 365 Cost to place an order = $10 Holding cost per unit per year = 10% of cost per unit Lead time = 10 days Cost per unit = $15
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Economic Order Quantity (EOQ) Example: Problem Data

Q* 2 DS 2(10,000 )(10) 365.148 units, or 366 units 1.50 H

10,000 units / year 27.397 units / day 365 days / year

R dL 27.397 units / day (10 days ) 273.97 or 274 units

Place an order for 366 units. When in the course of using the inventory you are left with only 274 units, place the next order of 366 units.
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Inventory Models with Price Break (Quantity Discount Models)

Under quantity discounts, a supplier offers a lower unit price if larger quantities are ordered at one time This model differs from the basic EOQ Model because the purchasing cost (C) varies with the quantity ordered

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Inventory Models with Price Break

Under this condition, purchasing cost becomes an incremental cost and must be considered in the determination of the EOQ If the holding cost is based on a percentage of the price (H=iC), then

TC = (Q/2)iC +(D/Q)S + (D)C

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Inventory Models with Price Break Finding The EOQ

For each discount price, compute the EOQ For any discount price, if the EOQ falls out of range, adjust the EOQ upward to the lowest quantity that will qualify for the discount. Compute the total cost associated with each EOQ (after adjustment) Select the EOQ with the lowest cost. It will be the quantity that minimizes the total cost.

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Inventory Models with Price-Break Example: Problem Data

A company has a chance to reduce their inventory ordering costs by placing larger quantity orders using the price-break order quantity schedule below. What should their optimal order quantity be if this company purchases this single inventory item with an e-mail ordering cost of $4, a carrying cost rate of 2% of the inventory cost of the item, and an annual demand of 10,000 units?
Order Quantity (units) 0 to 2,499 2,500 to 3,999 4,000 or more Price/unit($) $1.20 $1.00 $0.98
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Price-Break Example: Solution

First, plug data into formula for each price-break value of C
Annual Demand (D)= 10,000 units Cost to place an order (S)= $4 Carrying cost % of total cost (i)= 2% Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Q* values are feasible or not

Interval from 0 to 2499, the Q* value is feasible Interval from 2500-3999, the Q* value is not feasible Interval from 4000 & more, the Q* value is not feasible

Q*
Q*

2(10,000)(4) 1,826 units 0.02(1.20)

2(10,000)(4) 2,000 units 0.02(1.00) 2(10,000)(4) 2,020 units 0.02(0.98)

Q* s

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Price-Break Example: Solution

Since the feasible solution occurred in the first pricebreak, it means that all the other true Q* values occur at the beginnings of each price-break interval. Why?
Total annual cost

Because the total annual cost function is a U shaped function So the candidates for the pricebreaks are 1826, 2500, and 4000 units
0 1826 2500 4000 Order Quantity

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Price-Break Example: Solution

Next, we plug the true Q* values into the total annual cost function to determine the total cost under each pricebreak

TC DC

D Q S iC 2 Q

TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20) = $12,043.82 TC(2500-3999)= $10,041 TC(4000&more)= $9,949.20

Finally, we select the least costly Qopt, which is this problem occurs in the 4000 & more interval. In summary, our optimal order quantity is 4000 units 45

Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Establishing Safety Stock Levels

Safety stock refers to the amount of inventory carried in addition to expected demand.
Safety stock can be determined based on many different criteria.

A common approach is to simply keep a certain number of weeks of supply.

A better approach is to use probability.

Assume demand is normally distributed. Assume we know mean and standard deviation. To determine probability, we plot a normal distribution for expected demand and note where the amount we have lies on the curve.
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Fixed-Order Quantity Model with Safety Stock

In the fixed order quantity model, the ordering process is triggered when the inventory level drops to a critical point, the Reorder Point (ROP). This starts the lead time for the item. Lead time is the time to complete all activities associated with placing, filling and receiving the order. During the lead time, customers continue to draw down the inventory It is during this period that the inventory is vulnerable to stockout (run out of inventory)
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Fixed-Order Quantity Model with Safety Stock

Customer service level is defined as the probability that a stockout will not occur during the lead time. The reorder point is set based on the Demand During Lead Time and the desired customer service level The amount of safety stock needed is based on the degree of uncertainty in the demand during the lead time and the customer service level desired
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Order Quantity Model with Safety Stock

Assumptions

Demand per day is normally distributed with mean d and standard deviation d Lead time (L) is constant The distribution of the demand during the lead time is normal with mean dL and standard deviation d L

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Fixed-Order Quantity Model with Safety Stock

The customer service level is converted into a z value using the normal distribution table Safety Stock:

SS z L z L d

Expected Demand During Lead Time:

EDDLT dL

Reorder Point:

R EDDLT SS dL z L( d) 2
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Fixed-Order Quantity Model with Safety Stock

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Order Quantity Model with Safety Stock

Demand is variable, but follows a known distribution/

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Fixed-Order Quantity Model with Safety Stock

After the reorder is placed, demand during the lead time may be higher than expected, consuming some (or all) of the safety stock/

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Fixed-Order Quantity Model with Safety Stock

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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Order Quantity Model with Safety Stock Example

Bob is an operations analyst for Sell-Rite Discount Stores. He is currently studying the ordering and stocking policies for one of their best moving items, a childs toy. An examination of historical supply and demand data for this item indicated a constant lead time (L) of 10 days a demand per day that is normally distributed with mean of 1,250 toys per day and a standard deviation of 375 toys per day. a. What is the EDDLT for the toy? b. What is the standard deviation of DDLT for the toy? c. Compute the reorder point for the toy if the service level is specified at 90 percent during lead time. d. How much safety stock is provided in your answer in part c.
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Fixed-Order Quantity Model with Safety Stock Example

L 10, d 1, 250 toys, d 375 toys
a. EDDLT dL 10(1, 250) 12,500 toys
2 b. L L d 375 10 1,186 toys

c. From the Normal table, using a service level of 90% or 0.9, we obtain z 1.28. Therefore,

R EDDLT z L 12,500 1.28(1,186)

14, 018 toys. d. SS z L 1.28(1,186) 1,518 toys.
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Fixed-Time Period Model

q = Average demand+Safety stockInventory 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 probability

T L = standard deviation of demand over the review and lead time

I = current inventory level (includes items on order)
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Time Period Model

T L
T L i 1

di

Since each day is independent and d is constant,

T L (T L) d 2 (T L) d

The standard deviation of a sequence of random events equals the square root of the sum of the variances
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Fixed-Time Period Model Example

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 daily demand standard deviation is 4 units.
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Fixed-Time Period Model Example

T L (T L ) d 2

30 10 4

25.298

The value of z is found by using the Excel NORMSINV function, or using Appendix G and finding the value in the table that comes closest to the service probability. So, from Appendix G, we have a probability of 0.9599, which is given by a z=1.75
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Mohsen ElHafsi 2014

BUS 105: Production and Operations Management

Fixed-Time Period Model Example

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
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Assignment (7): February 26th, 2014

Read Chapter 20 Problems: 4, 5, 9,12, 14, 15, 21, 24, 26, 37 pp. 544-550

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Mohsen ElHafsi 2014