Stevenson 14e Chap012 PPT

Chapter 12
Inventory
Management
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the
prior written consent of McGraw-Hill Education.
Chapter 12: Learning Objectives
You should be able to:
LO 12.1 Define the term inventory
LO 12.2 List the different types of inventory
LO 12.3 Describe the main functions of inventories
LO 12.4 Discuss the main requirements for effective management
LO 12.5 Explain periodic and perpetual review systems
LO 12.6 Describe the costs that are relevant for inventory management
LO 12.7 Describe the A-B-C approach and explain how it is useful
LO 12.8 Describe the basic EOQ model and its assumptions and solve typical problems
LO 12.9 Describe the economic production quantity model and solve typical problems
LO 12.10 Describe the quantity discount model and solve typical problems
LO 12.11 Describe reorder point models and solve typical problems
LO 12.12 Describe situations in which the fixed-order interval model is appropriate, and
solve typical problems
LO 12.13 Describe situations in which the single-period model is appropriate and solve
typical problems
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-
Hill Education.
12-2
Inventory
Inventory
 A stock or store of goods
Independent-demand items
 Items that are ready to be sold or used
Inventories are a vital part of business: (1) necessary for

operations and (2) contribute to customer satisfaction
A “typical” firm has roughly 30% of its current
assets and as much as 90% of its working capital
invested in inventory
LO 12.1 Hill Education.
12-3
Types of Inventory
 Raw materials and purchased parts
 Work-in-process (WIP)
 Finished goods inventories or merchandise
 Tools and supplies
 Maintenance and repairs (MRO) inventory
 Goods-in-transit to warehouses or customers (pipeline
inventory)
12-4
Inventory Functions
 Inventories serve a number of functions such as:
1. To meet anticipated customer demand
2. To smooth production requirements
3. To decouple operations
4. To protect against stockouts
5. To take advantage of order cycles
6. To hedge against price increases
7. To permit operations
8. To take advantage of quantity discounts
12-5
Objectives of Inventory Control
Inventory management has two main concerns:
1. Level of customer service
 Having the right goods available in the right quantity in the
right place at the right time
2. Costs of ordering and carrying inventories
 The overall objective of inventory management is to achieve
satisfactory levels of customer service while keeping
inventory costs within reasonable bounds
1. Measures of performance
2. Customer satisfaction
 Number and quantity of backorders
 Customer complaints
3. Inventory turnover
12-6
Inventory Turnover Ratio
Ratio of annual cost of goods sold to average
inventory investment
 How many times a year the inventory is sold
 Higher the better as it implies more efficient use of the
inventory
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
12-7
Effective Inventory Management
 Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
 Holding costs
 Ordering costs
 Shortage costs
5. A classification system for inventory items
12-8
Inventory Counting Systems
Periodic system
Physical count of items in inventory made at periodic
intervals
Perpetual inventory system
 System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
An order is placed when inventory drops to a
predetermined minimum level
 Two-bin system
 Two containers of inventory; reorder when the first is empty
12-9
Inventory Counting Technologies
Universal product code (UPC)
 Bar code printed on a label that has information about
the item to which it is attached
Radio frequency identification (RFID) tags
 A technology that uses radio waves to identify objects,
such as goods, in supply chains
12-10
Inventory Costs
 Purchase cost
 The amount paid to buy the inventory
 Holding (carrying) costs
 Cost to carry an item in inventory for a length of time, usually a year
 Ordering costs
 Costs of ordering and receiving inventory
 Setup costs
 The costs involved in preparing equipment for a job
 Analogous to ordering costs
 Shortage costs
 Costs resulting when demand exceeds the supply of inventory;
often unrealized profit per unit
12-11
ABC Classification System
 A-B-C approach
 Classifying inventory according to some measure of importance, and
allocating control efforts accordingly
 A items (very important)
 10 to 20 percent of the number of items in inventory and about 60 to 70
percent of the annual dollar value
 B items (moderately important)
 C items (least important)
 50 to 60 percent of the number
of items in inventory but only
about 10 to 15 percent of the
annual dollar value
12-12
Cycle Counting
 Cycle counting
 A physical count of items in inventory
 Cycle counting management
 How much accuracy is needed?
 A items: ± 0.2 percent
 B items: ± 1 percent
 C items: ± 5 percent
 When should cycle counting be performed?
 Who should do it?
12-13
How Much to Order: EOQ Models
Economic order quantity models identify the optimal
order quantity by minimizing the sum of annual costs
that vary with order size and frequency
1. The basic economic order quantity model
2. The economic production quantity model
3. The quantity discount model
12-14
Basic EOQ Model
 The basic EOQ model is used to find a fixed order
quantity that will minimize total annual inventory
costs
 Assumptions:
1. Only one product is involved
2. Annual demand requirements are known
3. Demand is even throughout the year
4. Lead time does not vary
5. Each order is received in a single delivery
6. There are no quantity discounts
12-15
The Inventory Cycle
Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand
Reorder
point
Time
Receive Place Receive Place Receive
order order order order order
Lead time
12-16
Total Annual Cost
Total Cost  Annual Holding Cost  Annual Ordering Cost

Q D
 H  S
2 Q
where
Q  Order quantity in units
H  Holding (carrying) cost per unit, usually per year
D  Demand, usually in units per year
S  Ordering cost per order
12-17
Goal: Total Cost Minimization
The Total-Cost Curve Is U-Shaped

Annual Cost
Q D
TC  H  S
2 Q
Holding Costs
Ordering Costs
Order Quantity
QO (optimal order quantity) (Q)
12-18
Deriving EOQ
 Using calculus, we take the derivative of the total cost
function and set the derivative (slope) equal to zero and
solve for Q.
 The total cost curve reaches its minimum where the
carrying and ordering costs are equal.
𝑄O =
𝐻
=
√ √
2 𝐷𝑆 2(annual demand)(order cost)
annual holding cost per unit
 Length of the optimal order cycle = Q0 / D
12-19
Economic Production Quantity (EPQ)
 The batch mode is widely used in production. In certain
instances, the capacity to produce a part exceeds its usage
(demand rate).
 Assumptions
 Only one item is involved
 Annual demand requirements are known
 Usage rate is constant
 Usage occurs continually, but production occurs periodically
 The production rate is constant
 Lead time is known and constant
 There are no quantity discounts
12-20
EPQ: Inventory Profile
Q
Production Usage Production Usage Production
and usage only and usage only and usage
Qp
Cumulative
production
Imax
Amount
on hand
Time
12-21
EPQ – Total Cost
12-22
Economic Production Quantity
2 DS p
Qp 
H p u
12-23
Economic Production Quantity (cont.)
Other parameters
𝑄𝑝
Cycle time=
𝑢
𝑄𝑝
Run time=
𝑝
𝑄𝑝
Max Inventory 𝐼 𝑚𝑎𝑥 = (𝑝 − 𝑢)
𝑝
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
12-24
Quantity Discount Model
Quantity discount
 Price reduction for larger orders offered to customers to
induce them to buy in large quantities
Total Cost  Carrying Cost  Ordering Cost  Purchasing Cost
Q D
 H  S  PD
2 Q
where
P  Unit price
12-25
Quantity Discounts
12-26
Quantity Discounts (cont.)
The total-cost curve

with quantity discounts
is composed of a
portion of the total-cost
curve for each price
12-27
When to Reorder
 Reorder point
 When the quantity on hand of an item drops to this amount, the
item is reordered.
 Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management
12-28
Reorder Point: Under Certainty
ROP  d  LT
where
d  Demand rate (units per period, per day, per week)
LT  Lead time (in same time units as d )
12-29
Reorder Point: Under Uncertainty
 Demand or lead time uncertainty creates the possibility
that demand will be greater than available supply
 To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
 Safety stock
 Stock that is held in excess of expected demand due to variable
demand and/or lead time
Expected demand
ROP   Safety Stock
during lead time
12-30
Safety Stock
12-31
Safety Stock?
 As the amount of safety stock carried increases, the
risk of stockout decreases.
 This improves customer service level
 Service level
 The probability that demand will not exceed supply during lead
time
 Service level = 100% − stockout risk
12-32
How Much Safety Stock?
The amount of safety stock that is appropriate for a
given situation depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level
Expected demand
ROP   z dLT
during lead time
where
z  Number of standard deviations
 dLT  The standard deviation of lead time demand
12-33
Reorder Point
The ROP based

on a normal
distribution of lead
time demand
12-34
Reorder Point: Demand Uncertainty
ROP  d  LT  z d LT
where
d  Average demand per period (per day, per week)
 d  The stdev. of demand per period (same time units as d )
LT  Lead time (same time units as d )
Note: If only demand is variable, then  dLT   d LT
12-35
Reorder Point: Lead Time Uncertainty
ROP  d  LT  zd LT
where
d  Demand per period (per day, per week)
 LT  The stddev. of lead time (same time units as d )
LT  Average lead time (same time units as d )
Note: If only lead time is variable, then  dLT  d LT
12-36
How Much to Order: FOI
 Fixed-order-interval (FOI) model
 Orders are placed at fixed time intervals
 Reasons for using the FOI model
 Supplier’s policy may encourage its use
 Grouping orders from the same supplier can produce savings in
shipping costs
 Some circumstances do not lend themselves to continuously
monitoring inventory position
12-37
Fixed-Quantity vs.
Fixed-Interval Ordering
Fixed Quantity
Fixed Interval
12-38
FOI Model
Expected demand
Amount  during protection  Safety  Amount on hand
to Order stock at reorder time
interval
 d (OI  LT)  z d OI  LT  A
where
OI  Order interval (length of time between orders)
A  Amount on hand at reorder time
12-39
Single-Period Model
 Single-period model
 Model for ordering of perishables and other items with limited
useful lives
 Shortage cost
 Generally, the unrealized profit per unit
 Cshortage = Cs = Revenue per unit – Cost per unit
 Excess cost
 Different between purchase cost and salvage value of items left
over at the end of the period
 Cexcess = Ce = Cost per unit – Salvage value per unit
12-40
Single-Period Model (cont.)
 The goal of the single-period model is to identify the order
quantity that will minimize the long-run excess and
shortage costs
 Two categories of problem:
 Demand can be characterized by a continuous distribution
 Demand can be characterized by a discrete distribution
12-41
Stocking Levels
Cs
Service level 
C s  Ce
where
Cs  shortage cost per unit
Ce  excess cost per unit
Ce Cs
Service level
Quantity
So So =Optimum
Balance Point Stocking Quantity
12-42

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Chapter 12

Inventories are a vital part of business: (1) necessary for

Profile of Inventory Level Over Time

Total Cost  Annual Holding Cost  Annual Ordering Cost

The Total-Cost Curve Is U-Shaped

The total-cost curve

The ROP based

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