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Inventory Management

Inventory Management

Inventory is one of the most expensive assets of many companies. It represents as much as 40% of total invested capital.

What is Inventory?

Stock of materials Stored capacity Examples

Inventory- An idle resource that a firm holds in stock with the intent(anticipation of future demand) of selling it or transforming it into a more valuable state (Fred Hansmann). Inventory System- A set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be
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Inventory?

Excessive inventory levels are costly

Insufficient inventory levels lead to stockouts

We have to keep right amount of Inventory

Inventory Level
Supply Rate

Inventory Level

Buffers Demand Rate from Supply Rate

Demand Rate

Inventory Management

Inventory management is the planning, coordinating, and

controlling the acquisition, storage, handling, movement, distribution of inventories in order to meet the competitive
priorities of the organization.

Effective inventory management is essential for realizing the full potential of any value chain.

Inventory management requires information about expected demands, amounts on hand and amounts on order for every item stocked at all locations.

The appropriate timing and size of the reorder quantities must also be determined.

Inventory Planning and Control


For maintaining the right balance between high and low inventory to minimize cost

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Objective: Minimize total inventory cost


Decisions:

How much to order or produce each time a supplier or production order is placed? When to order items from a supplier or when to initiate production runs if the firm makes its own items?

Basic Inventory Concepts


Raw materials, component parts,

subassemblies, and supplies are inputs to manufacturing and service-delivery processes. partially finished products in various stages of completion that are awaiting further processing. ready for distribution or sale to customers.

Work-in-process (WIP) inventory consists of

Finished goods inventory is completed products

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Basic Inventory Concepts


Cycle inventory (order or Lot size inventory) is inventory that results from purchasing or producing in larger lots than are needed for immediate consumption or sale. Safety stock inventory is an additional amount

of inventory that is kept over and above the average amount required to meet demand.

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Design of Inventory Mgmt. Systems: Micro Issues

Order Quantity
Economic Order Quantity

Order Timing

Reorder Point

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Factors Affecting Inventory System

What costs do we experience because we carry inventory?

Factors Affecting Inventory System

Material Cost

Carrying Cost

Costs

Ordering Cost

Shortage Cost

Cost Cost Cost Cost

of of of of

items ordering (or setup) carrying or holding inventory stockouts

Ordering Cost
Ordering Costs include,

Factors Affecting Inventory System

Paper work costs, typing and despatching an order. 2. Follow-up costs required to ensure timely supplies includes the travel cost for purchase follow-up, telephone, telex and postal bills. 3. Costs involved in receiving the order, inspection, checking and handling in the stores. 4. Any set up cost of machines if charged by the supplier, either directly indicated in quotations or assessed through quotations for various quantities. 5. The salaries and wages to the purchase department. The ordering cost is valid if the products are purchased NOT produced internally.
1.

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Set-up cost

Factors Affecting Inventory System

Set-up cost is the cost to prepare a


machine for manufacturing an order.


Clean-up costs Re-tooling costs Adjustment costs

Set-up cost is highly correlated with set-up time.


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Factors Affecting Inventory System

Carrying Costs
This cost includes: 1) interest on capital. 2) insurance and tax charges. 3) storage costs any labour, the costs of provisions of storage area and facilities like bins, racks, etc. 4) allowance for deterioration or spoilage. 5) salaries of stores staff. 6) Obsolescence.
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Typical Inventory Carrying Costs


Housing cost: Building rent or depreciation Building operating cost Taxes on building Insurance Material handling costs: 3% Equipment, lease, or depreciation (1% - 4%) Power Equipment operating cost Manpower cost from extra handling and supervision 3% (3% - 5%) 10% Investment costs: (6% - 24%) Borrowing costs Taxes on inventory Insurance on inventory 5% Pilferage, scrap, and obsolescence (2% - 10%) (15% - 50%) Overall carrying cost

Costs as % of Inventory Value 6% (3% - 10%)

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Factors Affecting Inventory System

Out-of-Stock Costs

Lost sales cost Back-order cost

A stockout is the inability to satisfy demand for an item. When a stockout


happens, the item is either back-ordered or a sale is lost.

A backorder occurs when a customer is willing to wait for an item. A lost sale occurs when the customer is unwilling to wait and purchases the item elsewhere.

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Factors Affecting Inventory System

Characteristics of Inventory Systems


Nature of Demand Independent demand is demand for an SKU that is unrelated to the

demand for other SKUs and needs to be forecast. Dependant demand is demand directly related to the demand for other SKUs and can be calculated without needing to be forecast. Deterministic demand is when uncertainty is not included in its characteristics. Stochastic demand incorporates uncertainty by using probability distributions. Static demand is stable demand. Dynamic demand varies over time.
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Factors Affecting Inventory System

Characteristics of Inventory Systems


Cost of Operating Information Processing System Number of items: each item is identified by its stock-keeping unit (SKU).
A stock-keeping unit (SKU) is a single item or asset stored at a particular

location.

Nature of Items:
Perishable Items Non-Perishable Items
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Factors Affecting Inventory System

Characteristics of Inventory Systems


Number of time periods in planning horizon: short or long planning horizon such as days, weeks, months, quarters, and years.

The lead time is the time between placement of an order and its receipt. Number of Supply Echelons

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Factors Affecting Inventory System

Inventory Control Systems


Continuous system (fixed-order-quantity)

Periodic system (fixed-time-period)

constant amount ordered when inventory declines to predetermined level

order placed for variable amount after fixed passage of time

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VITAL FEW (Selective Control)

Company deals with stock of thousands of items it may not be necessary to have the same closeness of control on each and every item. only a few of the inventories require close attention to achieve desired results and the balance many may be trivial for the purpose. An analysis of the inventories based on selected criterion will help in selecting the vital few and trivial many in respect of control for achieving the objective.
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VITAL FEW (Selective Control)


The criteria for classification may be

annual consumption cost, criticality of spare, weight, unit cost, etc.

Different types of analyses each having its own specific advantages and purposes, help in finding a practical solution to the control of inventory with minimum efforts.
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VITAL FEW (Selective Control)


Some important analysis carried out are :

ABC Analysis VED Analysis SDE Analysis HML Analysis FSN Analysis -

based on annual consumption. criticality for production. availability. weight / cost permit. consumption rate.

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ABC Analysis

(ABC = Always Better Control)

ABC is said to connote Always Better Control. It is also known as Pareto analysis. (which is named after principles dictated by Italian economist Vilfredo Pareto).

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ABC Analysis
The idea is to focus resources on the critical few and not on the trivial many. criterion used here is the money spent and not the quantity consumed Annual CONSUMPTION VALUE of an Item = (Its Annual Demand) x (Its Cost per unit)

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ABC Analysis

Class A items are those on which the annual CONSUMPTION VALUE is high. They represent 70-80% of total inventory costs, but they account for only 10% of total inventory items.

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ABC Analysis

Class B items are those on which annual CONSUMPTION VALUE is medium. They represent 15-25% of total value, and they account for 20% of total inventory items on the average.

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ABC Analysis

Class C items are low CONSUMPTION VALUE items. They represent only the 10% of total value, but they include as many as 60-70% of total inventory items.

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ABC Analysis Example


100
90 Class A 80 70 60 50 40

+Class B

+Class C

Percentage of dollar value

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20 10 0 10 20 30 40 50 60 70 80 90 100

Percentage of items
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Graphical solution for AAU Corp showing the ABC classification of materials

The A items (106 and 110) account for 60.5% of the value and 13.3% of the items The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the items The C items make up the last 14.5% of the value and 60% of the items How might you control each item classification? Different ordering rules for each?

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ABC Analysis

Some of the Inventory Management Policies that may be based on ABC analysis include: a) Class A items should have tighter inventory control. b) Class A items may be stored in a more secure area. c) Forecasting Class A items may warrant more care.
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VED ANALYSIS
This analysis specially pertain to the classification of maintenance spares denoting the essentiality of stocking spares according to their criticality.
It is a subjective analysis.

V E D -

Stands for vital items when out of stock or when not readily available, completely brings the production to a halt. is for Essential items without which temporary losses of production or dislocation of production work occurs. denotes Desirable items all other items which are necessary but do not cause any immediate effect on production.

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VED ANALYSIS
V A B C AV BV CV E AE BE CE D AD BD CD CATEGORY 1 CATEGORY 2 CATEGORY 3 ITEM 10 20 70 COST 70% 20% 10%

CATEGORY 1 CATEGORY 2 CATEGORY 3

- NEEDS CLOSE MONITORING & CONTROL - MODERATE CONTROL. - NO NEED FOR CONTROL

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SDE ANALYSIS
This analysis is based on availability of an item S refers to Scarce Items, especially imported and those which are very much in short supply.

Managed by top level management Maintain big safety stocks

D -

are Difficult items which are procurable in market but not easily available. For example, items which have to come from far off cities or where there is not much competition in market or where good quality supplies are difficult to get or to be procured. refers to Easy items Items are those which are easily available; mostly local items.

E -

It is normally advantageous to consider A, V & S items for selective controls.

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HML ANALYSIS
The cost per item (per piece) is considered for this analysis.
High cost items (H), Medium Cost items (M) and Low Cost item (L)

help in bringing controls over consumption at the departmental level


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FSN ANALYSIS
This analysis is to help control obsolescence and is based on the consumption pattern of the items. The items are analyzed to be classified as Fast-moving (F), Slow-moving (S) and Non-moving (N) items. The Non-moving items (usually not consumed over a period of two years) are of great importance. Scrutiny of non-moving items is to be made to determine whether they could be used or be disposed off. The fast and slow-moving classifications help in arrangement of stock in stores and their distribution and handling methods.

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Inventory Models

Inventory Models

Fixed order-quantity models


Economic order quantity Production order quantity Quantity discount

Help answer the inventory planning questions!

Probabilistic models Fixed order-period models

Deterministic Inventory Models

Inventory Models

Here, we will deal with the Independent Demand Situation. In the independent demand situation, we should be interested in answering: a) When to place an order for an item, and b) how much of an item to order.

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Deterministic Inventory Models

Basic EOQ Model

History

Developed in 1912 by Ford Whitman Harris, a production engineer at Westinghouse, the U.S. electrical goods manufacturer.

In 1913, the journal, Factory: The Magazine of Management , published an article by Harris.
Engineer, inventor, author, and patent attorney. No formal education beyond high school. Calculus-based models that allow the firm to develop an inventory control doctrine for each material or component stocked.

Application was shown by R. H. Wilson (1934)

Finding the Optimal Order Quantity


Parameters: Q* = Optimal order quantity (the EOQ) D = Annual demand A = Ordering cost per order
H= Ch = (IC) Carrying (or holding) cost per unit per yr

C = Purchase cost per unit


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Two Methods for Carrying Cost


Carry cost (Ch) can be expressed either: 1. As a fixed cost, such as Ch = $0.50 per unit per year 2. As a percentage of the items purchase cost (C) Ch = I x C I = a percentage of the purchase cost
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Variable Interpretations
SERVICE SECTOR
Q* or EOQ is the optimal purchase amount from an outside vendor

MANUFACTURING
Q* or EOQ is the optimal production run or lot size

* ( ECONOMIC ORDER QUANTITY )

Variable Interpretations
SERVICE SECTOR MANUFACTURING
D is either: D is the external annual customer demand

Annual wholesaler demand


or

Annual internal demand from sister divisions within the firm

Variable Interpretations
SERVICE SECTOR
A is the fixed administrative cost of ordering Q* regardless of the amount

MANUFACTURING
A is the setup cost for Q*

Purchase Forms Supervisor Approvals Shipping Costs Delivery Inspections Stocking Costs Accounts Payable Processing

- Equipment Resets - Worker Preps - Lost Productivity - Product Scrappage and Rework

Variable Interpretations
SERVICE SECTOR

MANUFACTURING

H or CH is the carrying or holding cost: the cost of storing one unit for one year
SALARIES AND WAGES FOR WAREHOUSE EMPLOYEES WAREHOUSE PAPER AND FORMS WAREHOUSE DEPRECIATION MATERIALS HANDLING COST OF CAPITAL OBSOLESCENCE INSURANCE SPOILAGE UTILITIES TAXES THEFT

EOQ
Inventory Level Q* Optimal Order Quantity Decrease Due to Constant Demand

Time
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EOQ
Inventory Level Q* Optimal Order Quantity Instantaneous Receipt of Optimal Order Quantity

Time
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Deterministic Inventory Models


Basic Economic Order Quantity Model (EOQ Model)
Inventory Level Q Depletion Replenishment Maximum Level

Q/2 Order Arrives 0 Cycle 1 Cycle 2

Average Level

Cycle 3

Time

EOQ
Inventory Level Q*

Reorder Point (ROP)

Time
Lead Time
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EOQ
Inventory Level Q* Average Inventory Q/2 Reorder Point (ROP)

Time
Lead Time
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Deterministic Inventory Models


EOQ Model
Example Brewery
Total annual cost

TC HC OC
Total annual ORDERING cost

Total annual HOLDING cost

Deterministic Inventory Models


EOQ Model
Inventory Level Q Order quantity Q/2 Maximum Level

Average Level

0 Time

Deterministic Inventory Models


EOQ Model
Order quantity - Q

Maximum inventory level


Qm ax Q

Average inventory level


Qavg Q 2

Deterministic Inventory Models


EOQ Model
Total annual HOLDING cost
HC HQavg H Q 2

Total annual ORDERING cost


OC An A D Q

Deterministic Inventory Models


EOQ Model
Example Brewery
Total annual cost
TC (Q) H Q D A 2 Q

Minimizing EOQ Model Costs

Only ordering and carrying costs need to be minimized (all other costs are assumed constant) As Q (order quantity) increases: Carry cost increases Ordering cost decreases (since the number of orders per year decreases)
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EOQ Model Total Cost


Annual Cost

Holding Cost = H * Q/2

Order Quantity
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EOQ Model Total Cost


Annual Cost Ordering Cost = A * D/Q

Holding Cost = H * Q/2

Order Quantity
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EOQ Model Total Cost


Annual Cost Total Cost = Holding + Ordering

Order Quantity
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Total Cost = Holding + Ordering

EOQ Model Total Cost


Annual Cost
At optimal order quantity (Q*): Carrying cost = Ordering cost

Optimal Q

Order Quantity
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What Happens at Q* / EOQ


Annual Order

Annual Carry Costs (H)

EQUAL

or

Setup Costs (S)

.AND TOTAL VARIABLE COST ( TVC ) IS MINIMIZED !

Finding the Optimal Order Quantity


Parameters: Q* = Optimal order quantity (the EOQ) D = Annual demand A = Ordering cost per order
H= Ch = (IC) = Carrying (or holding) cost per unit per yr

C = Purchase cost per unit

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EOQ Total Cost


Total ordering cost Total carrying cost Total purchase cost = (D/Q) x A = (Q/2) x Ch =CxD

Annual Total Costs = Holding + Ordering

Note: (Q/2) is the average inventory level (D/Q) are the number of orders Purchase cost does not depend on Q

Q D TC (Q) Ch * A * 2 Q

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Finding Q*
Recall that at the optimal order quantity (Q*): Carry cost = Ordering cost (D/Q*) x A = (Q*/2) x Ch
Rearranging to solve for Q*: Q* = (2 AD / Ch ) (2 AD / IC)
TC (Q* ) 2 ADIC
since Q DT Q 1 T D D 2 AD IC 2A DIC

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Optimal Quantity (Derivative)


Total Costs =

Q D IC * A * 2 Q

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EOQ Model Equations


Optimal Order Quantity =Q* =
2 AD IC
* Optimal Variable Cost = TC (Q ) 2 ADIC Total Optimal Cost = CD 2 ADIC

Expected Number of Orders = N = Expected Time Between Orders

D Q*
=T =
IC *

Q D A* 2 Q

d =

D
Working Days / Year

ROP = d L

D = Demand per year A = Setup (order) cost per order Ch = Holding (carrying) cost d = Demand per day L = Lead time in days

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Sensitivity of EOQ Model to Quantity


| SENSITIVITY ANALYSIS OF THE EOQ
EOQ Parameter Change EOQ Change Comments Increase in lot size is in proportion to the square root of . Weeks of supply decreases and inventory turnover increases because the lot size decreases. Larger lots are justified when holding costs decrease.

Parameter

Demand Order/Setup Costs Holding Costs