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ABC Classification
Annual dollar volume = annual demand x cost per unit
Typically three (3) classes of items are used: A (very important), B
(moderately important), and C (least important)
The actual number of categories may vary from organization to organization,
depending on the extent to which a firm wants to differentiate control efforts.
Inventory Classification System
ABC Classification
Class A items generally account for about only 15% to
20% of the number of items in inventory but represent
70% to 80% of the total dollar usage
Class C items may represent only 5% to 10% of the annual
dollar volume but about 55% to 60% of the total inventory
items
Class B items are those inventory items with medium
annual dollar volume, about 15% to 20% of the total value
representing about 30% of the the number of inventory
items
Percentages vary from firm to firm, but in most instances a
relatively small number of items will account for a large
share of the value or cost associated with an inventory
Inventory Classification System
ABC Classification
Class A items should receive a close attention through
frequent reviews of amounts on hand and control over
withdrawals
Class C items should receive only loose control (two-bin
system, bulk orders)
Class B items should have controls that lie between A & C
Note that Class C items are not necessarily unimportant;
incurring a stockout of C items such as the nuts and bolts
used to assemble manufactured goods can result in a costly
shutdown of an assembly line (due to low annual dollar
volume, larger orders or ordering in advance will help
without incurring much additional cost)
Inventory Classification System
Example No.1
Annual
Annual Unit Dollar
Item x =
Demand Cost Value
1 1,000 $4,300 $4,300,000
Class A
2 5,000 720 3,600,000
3 1,900 500 950,000
4 1,000 710 710,000
5 2,500 250 625,000 Class B
6 2,500 192 480,000
7 400 200 80,000
8 500 100 50,000
9 200 210 42,000
Class C
10 1,000 35 35,000
11 3,000 10 30,000
12 9,000 3 27,000
Inventory Classification System
Example No.2
Item % of No. Annual Annual Percent of
Stock Of Items Volume x Unit Dollar Annual $
=
Number Stocked (Units) Cost Value Volume Class
# 10286 1,000 $90.00 $90,000 38.8%
20% 72% A
# 11526 500 154.00 77,000 33.2%
SOLUTION:
Item Number of Item
Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month (20 working days) 500 / 20 = 25/day
B 1,750 Each quarter (60 working days) 1,750 / 60 = 29/day
C 2,750 Every 6 months (120 working days) 2,750 / 120 = 23/day
Seventy-seven items are counted each day 77/day
Demand Forecasts and
Lead-Time Information
Inventories are used to satisfy demand requirements, so it is
essential to have reliable estimates of the amount and timing of
demand.
It is also essential to know how long it will take orders to be
delivered or the leadtime (the time between submitting an order
and receiving it)
Managers need to know the extent of variability of demand and
leadtime
The greater the potential variability, the greater the need for additional
stock to reduce the risk of a shortage between deliveries.
Thus, there is a crucial link between forecasting and inventory
management
Point-of-sale (POS) systems electronically record actual sales. Knowledge of actual
sales can greatly enhance forecasting and inventory management. Real time information
on actual demand enables management to make necessary changes to restocking
decisions.
Cost Information
ROP
= 100
0 5 7 12 14 Day
Receive Place Receive Place Receive
order order order order order
LT = 2 days
Basic EOQ Model
Average Q
Inventory =
2
0 Time
1 year
Q
Average Q
=
Inventory 2
Annual Cost
Q
Annual carrying cost = H
2
Where, Q H
Q = order quantity in units 2
H = holding (carrying) cost
Order Qty
Annual Cost
D
Annual ordering cost = S
Q D S
Where, Q
D = Annual Demand, in units
S = ordering cost
Order Qty
Basic EOQ Model
The total annual cost associated with carrying and ordering inventory when Q
units are ordered each time is
Annual Annual
Q H + DS
TC = carrying + ordering =
2 Q
cost cost
2DS = Q2H
Q2 = 2DS
H
(EOQ) Q* =
2DS
H
D
Expected number of orders = N = Demand =
Order Quantity Q*
Length of order cycle = Q* (the time between orders) or
D
No. of Working Days per Year
Expected time between orders = T =
N
Basic EOQ Model –Example # 1
Sharp, Inc. a company that markets painless hypodermic
needles to hospitals, would like to reduce its inventory cost
by determining the optimal number of hypodermic needles
to obtain per order. The annual demand is 1,000 units; the
ordering cost is $10 per order; and the holding cost per unit
per year is $0.50. Using these figures,
a) Q* = 2DS = 2 (1,000) (10) = 200 units
H 0.50
a) Q* = 2DS = 2 (9,600) 75 = 300 tires
H 16
a) Q* = 2DS = 2 (3,600) 31 = 131 cathode ray tubes
H 13
Imax
Amount
on hand
Q
I max
Total cost = TC = Carrying Cost + Setup cost = H + DS
2 Q*
where, Imax = maximum inventory = Q* ( p – u ) or Q* ( 1 – u / p )
p
=
2
b) TCmin
Imax
H + D S = 1,800 x $1 + 48,000 x $45
Q* 2 2,400
= $900 + $900
= $1,800
Compute first for Imax = Q* ( p – u ) = 2,400 (800 – 200 ) = 1,800 wheels
p 800 Thus, a run of
c) Cycle time = Q* = 2,400 wheels wheels will be
= 12 days made every 12
u 200 wheels per day
days
Q* 2,400 wheels Each run will
d) Run time = = = 3 days
p 800 wheels per day require 3days
to complete
EPQ Model - Example # 2
=
0.50 ( 1 – 4 / 8)
2 (1,000) 10
=
0.50 ( 1/2 )
20,000 = 80,000
TC with PD
TC without PD
QH
2
PD
D
S
Q
EOQ* Order Qty
Quantity Discount Model
Note that no one curve applies to the entire range of
Order Price quantities; each curve applies to only a portion of the
Quantity per Box range. Hence, the applicable or feasible total cost is
1 to 44 $2.00 initially on the curve with the highest unit price and drops
45 to 69 1.70 down, curve by curve, at the price breaks, which are the
70 or more 1.40 minimum quantities needed to obtain the discounts.
Cost TC @ $2.00 each
Though each
curve has a TC @ $1.70 each
minimum, those
points are not
TC @ 1.40 each
necessarily
feasible.
PD @
The actual total- $2.00 each PD @
cost curve is $1.70 each PD @ 1.40 each
denoted by the
solid lines; only
those price-quantity Order Qty
combinations are feasible. 45 70
Quantity Discount Model
The objective of the QD model is to identify an order
quantity that will represent the lowest total cost for the
entire set of curves
Two (2) general cases of the QD model:
1. Carrying costs are constant (fixed amount per unit)
2. Carrying costs are stated as a percentage of purchase price
TCa TCa
Cost
Wohl’s Discount Store stocks toy race cars. Recently, the store has
been given a quantity discount schedule for these cars. This
quantity schedule is shown in the table below. Ordering cost is
$49.00 per order, annual demand is 5,000 race cars, and inventory
carrying charge is 20% of the price. What order quantity will
minimize the total inventory cost?
The following table summarizes the total costs for each alternative:
Safety Additional Total
Stock Holding Cost Stockout Cost Cost
20 (20)($5) = $100 = 0 $100
10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290
0 0 (10)(.2)($40)(6) +
(20)(.1)($40)(6) = $960 $960
The safety stock with the lowest total cost is 20 frames. Therefore, this safety
stock changes the reorder point to 50 + 20 = 70 frames.
Service Level
Service
where,
Level
z = number of standard deviations
(Probability of
no strockout) dLT = the standard deviation
of leadtime demand
Expected ROP Quantity
Demand The value of z depends on
Safety the stockout risk that the
stock manager is willing to
accept.
0 z z-axis The smaller the risk the
manager is willing to
Use Appendix B, Table B to obtain z-values, accept, the greater the
given desired service level for leadtime value of z.
ROP based on Normal Distribution
of LT demand - Example No. 1
Example : Suppose that the manager of a construction supply
house determined from historical records that demand for sand
during leadtime averages 50 tons. In addition, suppose the
manager determined that the demand during leadtime could be
described by a normal distribution that has a mean of 50 tons
and a standard deviation of 5 tons. Answer the following
questions, assuming that the manager is willing to accept a
stockout risk of no more than 3 percent:
a) What value of z is appropriate?
b) How much safety stock should be held?
c) What reorder point should be used?
ROP based on Normal Distribution
of LT demand - Example No. 1
SOLUTION: Expected leadtime demand = 50 tons
dLT = 5 tons
Stockout risk = 3 percent
NOTE: Each of these models assumes that demand and leadtime are
independent
ROP based on Normal Distribution of
LT demand - Example No. 2
A restaurant uses an average of 50 jars of a special sauce each week. Weekly
usage of sauce has a standard deviation of 3 jars. The manager is willing to
accept no more than a 10 percent risk of stockout during leadtime, which is
two weeks. Assume the distribution of usage is normal.
a) Which of the above formulas is appropriate for this situation? Why?
b) Determine the value of z.
c) Determine the ROP.
SOLUTION: d = 50 jars per week LT = 2 weeks
d = 3 jars per week SL = 1 - .10 = .90
• Because demand is variable (i.e., has a standard deviation), formula no. 1 is
appropriate.
• From Appendix B, Table B, using a service level of .9000, z = +1.28
• ROP = d x LT + z LT d = 50 x 2 + 1.28 2 (3) = 100 + 5.43 = 105.43
Shortages and Service Levels
Given a leadtime service level of 90, D = 1,000, Q = 250, and dLT = 16,
determine the annual service level and the amount of cycle safety stock
that would provide an annual service level of .98.
From the table, E(z) = 0.048 for a 90 percent leadtime service level.
a) SLannual = 1 – 0.048(16)/250 = .997
b) SLannual = 1 – E(z) dLT / Q
0.98 = 1 – E(z)(16)/250
Solving, E(z) = 0.312; From the table, with E(z)=0.312, it can be seen
that this value if E(z) is a little more than the value of 0.307. So it appears
that an acceptable value of z might be 0.19. The necessary safety stock to
achieve the specified annual service level is equal to z dLT. Hence, the
safety stock is 0.19(16) = 3.04, or approximately 3 units
How Much to Order:
Fixed-Order-Interval Model
FOI Model is used when orders must be placed at fixed time
intervals (weekly, twice a month, etc.)
Is widely used by retail businesses
Question to be answered at each order point is: How much
should be ordered for the next (fixed)interval?
If demand is variable, the order size will tend to vary from
cycle to cycle.
Different from EOQ/ROP approach in which the order size
generally remains fixed from cycle to cycle, while the length of
the cycle varies (shorter if demand is above average, and longer
if demand is below average)
How Much to Order:
Fixed-Order-Interval Model
Reasons to use FOI Model:
1) A supplier’s policy might encourage orders at
fixed intervals
2) Grouping orders for items from the same supplier
can produce savings in shipping costs
3) An alternative for retail operations which do not
lend itself to continuous monitoring of inventory
levels (only periodic checks will do with the use
of fixed-interval ordering)
Differences between Fixed-Quantity
Systems & Fixed-Order-Interval
Models
FIXED-QUANTITY MODEL FIXED-ORDER-INTERVAL
Orders are triggerred by Orders are triggered by time
quantity (ROP) Stockout protection for
Stockout protection only leadtime plus the next order
during leadtime cycle
Higher than normal demand Result of higher than
causes a shorter time normal demand is a larger
between orders order size
Close monitoring of Only a periodic review
inventory is required to (physical inspection) of
know when ROP is reached inventory on hand is needed
prior to ordering
Fixed-Order-Interval Model