MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 1 of 30

FUNDAMENTALS OF INVENTORY
Within most organizations inventory exists in a variety of places, and in a variety of forms, and for a variety of reasons. Although these inventories represent a substantial cost investment (in some cases as much as 50% of total capital invested , they are necessary to provide a desired level of service to customers. !he ob"ective of inventory management is to stri#e a balance bet$een inventory investment and customer service.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 2 of 30

FUNCTIONS OF INVENTORY
%nventory exists for a variety of reasons (i.e., serves several functions $ithin organizations. 1. De o!p"ing #tage# in t$e prod! tion pro e##. %nventory bet$een successive stages of a transformation process ma#e each stage less dependent upon the output of the prior stage. %f there is an interruption in output at one stage, succeeding stages may be able to continue operation by feeding off the inventory held bet$een stages. !his applies both to internal operations and to external lin#ages $ith suppliers. !his inventory is called %!ffering inventory. 2. De o!p"ing from demand f"! t!ation#. !his manifests itself in both #ea#ona" inventory and #afety #to &. When there is predictable variation in demand throughout the year, and $hen an organization does not have the capacity to produce pea# demand $hen it is demanded, the organization may have to produce and store finished products in advance of that demand. !his inventory is called #ea#ona" inventory. When there is unpredictable (i.e. erratic and random short term variation in demand, the organization may have to maintain additional inventory to cover the unpredictable spi#es in demand. !his inventory is called #afety #to &. 3. 'o"!me p!r $a#ing. &urchases in large 'uantities may result in reduced purchase price and(or reduced delivery cost. )uch incentives often lead organizations to ac'uire more inventory than is immediately needed. !his inventory is called vo"!me di# o!nt inventory. (. )edge again#t po##i%"e f!t!re event#. %n many instances organizations perceive that there may be a disruptive economic or environmental event in the not too distant future. %nflation may suggest that there $ill soon be a price increase in some supply. *abor negotiations may suggest that an impending truc#er stri#e might affect delivery of supplies. Weather conditions indicate that a bre$ing tropical storm might affect shipments of supplies. %n circumstances li#e these organizations may choose to order more inventory than is immediately needed to provide protection in the event that any of these situations actually occur. !his inventory is called $edge inventory.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 3 of 30

TYPES OF INVENTORY
!o better accommodate the functions of inventory, organizations maintain four types of inventories. +. *a+ materia" inventory. ,aterials that are usually purchased and have not yet entered the transformation process. -. ,or&-in-pro e## .,IP/ inventory. ,aterials and components that have undergone some change but have not yet advanced to the stage of completed product. .. 0ini#$ed-good# inventory. /ompleted products a$aiting shipment. 0. Maintenan e1repair1operating .M*2/ inventory. )upplies necessary to #eep machinery, processes, facilities, and office operations running. !hese items do not get absorbed into the products being made, but are crucial to the smooth operation of the organization. !hey range from such things as lubricating oil for machines and "anitorial cleaning products, to printer toner cartridges and other office supplies.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page ( of 30

BASIC INVENTORY DECISIONS

!here are t$o basic decisions that must be made for every item that is maintained in inventory. !hese decisions have to do $ith the timing of orders for the item and the size of orders for the item. We $ill be examining several models and philosophies related to these t$o decisions. As noted on page +, the ob"ective of these inventory management models is to stri#e a balance bet$een inventory investment and customer service.

B%sic In&"nto'( D"cisions

How Much? Lot sizin !"cision 1etermination of the 'uantity to be ordered.

#h"n? Lot ti$in !"cision 1etermination of the timing for the orders

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 5 of 30

INDEPENDENT VS) DEPENDENT DEMAND INVENTORY

2efore examining specific inventory models, an important distinction must be made. )ome inventory items can be classified as independent demand items, and some can be classified as dependent demand items. We need to ma#e the timing and sizing decisions for all inventory items, but $e $ill find that the manner in $hich $e ma#e these decisions $ill differ depending upon $hether the item has independent demand or dependent demand. In!"*"n!"nt !"$%n! in&"nto'( it"$+ %nventory item $hose demand is not related to (or dependent upon some higher level item. 1emand for such items is usually thought of as forecasted demand. %ndependent demand inventory items are usually thought of as finished products. D"*"n!"nt !"$%n! in&"nto'( it"$+ %nventory item $hose demand is related to (or dependent upon some higher level item. 1emand for such items is usually thought of as derived demand. 1ependent demand inventory items are usually thought of as the materials, parts, components, and assemblies that ma#e up the finished product.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 3 of 30

RELEVANT INVENTORY COSTS

R","&%nt In&"nto'( Costs

It"$ Costs
1irect cost for getting an item. &urchase cost for outside orders, manufacturing cost for internal orders.

Ho,!in Costs
/osts associated $ith carrying items in inventory. )torage and other related costs.

O'!"'in -S"tu* Costs

3ixed costs associated $ith placing an order (either an ordering cost for outside orders, or a setup cost for internal orders .

Sho't% " Costs

/osts associated $ith not having enough inventory to meet demand.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 4 of 30

BEHAVIOR OF COSTS FOR DIFFERENT INVENTORY DECISIONS

When assessing the cost effectiveness of an inventory policy, it is helpful to measure the total inventory costs that $ill be incurred during some reference period of time. ,ost fre'uently, that time interval used for comparing costs is one year. 4ver that span of time, there $ill be a certain need, or demand, or re'uirement for each inventory item. %n that context, the follo$ing describes ho$ the annual costs in each of the four categories $ill vary $ith changes in the inventory lot sizing decision. It"$ costs+ 5o$ the per unit item cost is measured depends upon $hether the item is one that is obtained from an external source of supply, or is one that is manufactured internally. 3or items that are ordered from external sources, the per unit item cost is predominantly the purchase price paid for the item. 4n some occasions this cost may also include some additional charges, li#e inbound transportation cost, duties, or insurance. 3or items that are obtained from internal sources, the per unit item cost is composed of the labor and material costs that $ent into its production, and any factory overhead that might be allocated to the item. %n many instances the item cost is a constant, and is not affected by the lot sizing decision. %n those cases, the total annual item cost $ill be unaffected by the order size. 6egardless of the order size ($hich impacts ho$ many times $e choose to order that item over the course of the year , our total annual ac'uisitions $ill e'ual the total annual need. Ac'uiring that total number of units at the constant cost per unit $ill yield the same total annual cost. (!his situation $ould be some$hat different if $e introduced the possibility of 'uantity discounts. We $ill consider that later.

/ost

!otal Annual %tem /ost (assumes no 'uantity discounts

*ot )ize (ho$ much decision

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 5 of 30

INVENTORY COST BEHAVIOR .CONTINUED/

Ho,!in costs .%,so c%,,"! c%''(in costs/+ Any items that are held in inventory $ill incur a cost for their storage. !his cost $ill be comprised of a variety of components. 4ne obvious cost $ould be the cost of the storage facility ($arehouse space charges and utility charges, cost of material handlers and material handling e'uipment in the $arehouse . %n addition to that, there are some other, more subtle expenses that add to the holding cost. !hese include such things as insurance on the held inventory7 taxes on the held inventory7 damage to, theft of, deterioration of, or obsolescence of the held items, and opportunity costs associated $ith having money tied up in inventory. !he order size decision impacts the average level of inventory that must be carried. %f smaller 'uantities are ordered, on average there $ill be fe$er units being held in inventory, resulting in lo$er annual inventory holding costs. %f larger 'uantities are ordered, on average there $ill be more units being held in inventory, resulting in higher annual inventory holding costs.

/ost

!otal Annual 5olding /ost

*ot )ize (ho$ much decision

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 6 of 30

INVENTORY COST BEHAVIOR .CONTINUED/

O'!"'in .o' s"tu*/ costs+ Any time inventory items are ordered, there is a fixed cost associated $ith placing that order. When items are ordered from an outside source of supply, that cost reflects the cost of the clerical $or# to prepare, release, monitor, and receive the order. !his cost is considered to be constant regardless of the size of the order. When items are to be manufactured internally, the order cost reflects the setup costs necessary to prepare the e'uipment for the manufacture of that order. 4nce again, this cost is constant regardless of ho$ many items are eventually manufactured in the batch. %f one increases the size of the orders for a particular inventory item, fe$er of those orders $ill have to be placed during the course of the year, hence the total annual cost of placing orders $ill decline.

/ost

!otal Annual 4rdering /ost

*ot )ize (ho$ much decision

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 10 of 30

INVENTORY COST BEHAVIOR .CONTINUED/

Sho't% " costs+ /ompanies incur shortage costs $henever demand for an item exceeds the available inventory. !hese shortage costs can manifest themselves in the form of lost sales, loss of good $ill, customer irritation, bac#order and expediting charges, etc. /ompanies are less li#ely to experience shortages if they have high levels of inventory, and are more li#ely to experience shortages if they have lo$ levels of inventory. !he order size decision directly impacts the average level of inventory. *arger orders mean more items are being ac'uired than are immediately needed, so the excess $ill go into inventory. 5ence, smaller order 'uantities lead to lo$er levels of inventory, and correspondingly a higher li#elihood of shortages and their associated shortage costs. *arger order 'uantities lead to higher levels of inventory, and correspondingly a lo$er li#elihood of shortages and their associated costs. !he bottom line is this8 larger order sizes $ill lead to lo$er annual shortage costs.

/ost

!otal Annual )hortage /ost

*ot )ize (ho$ much decision

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 11 of 30

INVENTORY COST BEHAVIOR .CONTINUED/

A,, Fou' Cost C%t" o'i"s Co$0in"!+ When all four inventory cost categories are superimposed on the same graph, $e obtain the follo$ing (some$hat cluttered picture $hich suggests that there is one best ans$er to the 9ho$ much decision.: !he 'uantity that should be ordered is the lot size that corresponds to the lo$est point on the total annual cost curve. !his 'uantity is referred to as the 9economic order 'uantity,: or ;4<.

/ost

!otal Annual /ost

Annual 5olding /ost Annual )hortage /ost Annual %tem /ost *ot )ize (ho$ much decision Annual 4rdering /ost

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 12 of 30

BASIC ECONOMIC ORDER 1UANTITY .EO1/ MODEL

!he ;4< model is a techni'ue for determining the best ans$ers to the ho$ much and $hen 'uestions. %t is based on the premise that there is an optimal order size that $ill yield the lo$est possible value of the total inventory cost. !here are several assumptions regarding the behavior of the inventory item that are central to the development of the model EO1 %ssu$*tions+ +. 1emand for the item is #no$n and constant. -. *ead time is #no$n and constant. (*ead time is the amount of time that elapses bet$een $hen the order is placed and $hen it is received. .. When an order is received, all the items ordered arrive at once (instantaneous replenishment . 0. !he cost of all units ordered is the same, regardless of the 'uantity ordered (no 'uantity discounts . 5. 4rdering costs are #no$n and constant (the cost to place an order is al$ays the same, regardless of the 'uantity ordered . =. )ince there is certainty $ith respect to the demand rate and the lead time, orders can be timed to arrive "ust $hen $e $ould have run out. /onse'uently the model assumes that there $ill be no shortages. 2ased on the above assumptions, there are only t$o costs that $ill vary $ith changes in the order 'uantity, (+ the total annual ordering cost and (- the total annual holding cost. )hortage cost can be ignored because of assumption =. 3urthermore, since the cost per unit of all items ordered is the same, the total annual item cost $ill be a constant and $ill not be affected by the order 'uantity. %nventory levels $ill fluctuate over time as in the follo$ing graph8 %nventory *evel < < < < > 4rder )ize <(-

!ime EO1 s($0o,s+ 1 > annual demand (units per year ) > cost per order (dollars per order 5 > holding cost per unit per year (dollars to carry one unit in inventory for one year < > order 'uantity

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 13 of 30

CLASSIC ECONOMIC ORDER 1UANTITY .EO1/ MODEL

We sa$ on the previous page that the only costs that need to be considered for the ;4< model are the total annual ordering costs and the total annual holding costs. !hese can be 'uantified as follo$s8 Annu%, O'!"'in Cost !he annual cost of ordering is simply the number of orders placed per year times the cost of placing an order. !he number of orders placed per year is a function of the order size. 2igger orders means fe$er orders per year, $hile smaller orders means more orders per year. %n general, the number of orders placed per year $ill be the total annual demand divided by the size of the orders. %n short, !otal Annual 4rdering /ost > (1(< ) Annu%, Ho,!in Cost !he annual cost of holding inventory is a bit tric#ier. %f there $as a constant level of inventory in the $arehouse throughout the year, $e could simply multiply that constant inventory level by the cost to carry a unit in inventory for a year. ?nfortunately the inventory level is not constant throughout the year, but is instead constantly changing. %t is at its maximum value ($hich is the order 'uantity, < $hen a ne$ batch arrives, then steadily declines to zero. @ust $hen that inventory is depleted, a ne$ order is received, thereby immediately sending the inventory level bac# to its maximum value (< . !his pattern continues throughout, $ith the inventory level fluctuating bet$een < and zero. !o get a handle on the holding cost $e are incurring, $e can use the average inventory level throughout the year ($hich is <(- . !he cost of carrying those fluctuating inventory levels is e'uivalent to the cost that $ould be incurred if $e had maintained that average inventory level continuously and steadily throughout the year. !hat cost $ould have been e'ual to the average inventory level times the cost to carry a unit in inventory for a year. %n short, !otal Annual 5olding /ost > (<(- 5 Tot%, Annu%, Cost !he total annual relevant inventory cost $ould be the sum of the annual ordering cost and annual holding cost, or !/ > (1(< ) A (<(- 5 !his is the annual inventory cost associated $ith any order size, <.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 1( of 30

CLASSIC ECONOMIC ORDER 1UANTITY .EO1/ MODEL

At this point $e are not interested in any old < value. We $ant to find the optimal < (the ;4<, $hich is the order size that results in the lo$est annual cost . !his can be found using a little calculus (ta#e a derivative of the total cost e'uation $ith respect to <, set this e'ual to zero, then solve for < . 3or those $hose calculus is a little rusty, there is another option. !he uni'ue characteristics of the ordering cost line and the holding cost line on a graph are such that the optimal order size $ill occur $here the annual ordering cost is e'ual to the annual holding cost. EO1 occu's wh"n+ (1(< ) > (<(- 5 a little algebra cleanBup on this e'uation yields the follo$ing8 <- > (-1) (5 and finally CCCCCC <D > E-1)(5 (<D represents the optimal value for <7 this is $hat $e call the ;4<

/ost

!otal Annual /ost

Annual 5olding /ost

Annual 4rdering /ost ;conomic 4rder <uantity (;4<

*ot )ize (ho$ much decision

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 15 of 30

EO1 ILLUSTRATION
Fiven the follo$ing data for an inventory scenario $hose characteristics fit the assumptions of the basic ;4< model8 1 > +5,000 units per year ) > G. per order 5 > G+ per unit per year *! > 6eplenishment lead time > - days Assume $e have .00 operating days per year 3ind the follo$ing8 +. Average daily demand -. ;4< .. Humber of orders placed per year 0. !otal annual ordering cost 5. !otal annual holding cost =. !ime bet$een orders I. 6eorder point (in units J. Average inventory level Ans$ers8 +. Average daily demand +5,000 units(yr K .00 days(yr > 50 units per day CCCCCC CCCCCCCCCCCCCC -. ;4< > E-1)(5 > E(- (+5,000 (. ((+ > .00 units(order .. Humber of orders placed per year 1(< > (+5,000 units(yr ((.00 units(order > 50 orders(yr 0. !otal annual ordering cost (1(< () > L(+5,000units(yr ((.00 units(order M(G.(order > G+50(yr 5. !otal annual holding cost (<(- 5 > L(.00 units(order(- M(G+(unit(yr > G+50(yr =. !ime bet$een orders (<(d > (.00 units(order ((50 units(day > = days(order Lor, .00days(yrK50 orders(yr > = days(orderM I. 6eorder point (in units 64& > (daily demand (*ead time > (50 units(day (- days > +00 units J. Average inventory level <(- > .00 units(- > +50 units

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 13 of 30

OBSERVATIONS ABOUT OUR EO1 ILLUSTRATION

R"su,ts o2 co$*ut%tions ;4< > .00 units Humber of orders placed per year > 50 Average inventory level > +50 units Annual ordering cost > G+50 Annual holding cost > G+50 !ime bet$een the placement of orders > = days O0s"'&%tion 34+ #%tch th" in&"nto'( ,"&", inst"%! o2 th" c%,"n!%' 2o' 5wh"n6 !"cision We discovered that our order 'uantity of .00 units $ould lead to a replenishment every = days. We pro"ected that $e $ould run out on days =, +-, +J, -0, .0, .=, etc. With a - day lead time, $e $ere smart enough to order - days in advance of $hen $e $ould run out, $hich had us placing orders on days 0, +0, +=, --, -J, .0, etc. We only have to $atch the calendar to #eep trac# of $hen those order instants arise so that $e can place the orders. An alternative to $atching the calendar $ould be to $atch the inventory levels. 6ecall that the average daily demand for this item is 50 units per day. !his means that at the moment $e place an order, $e have "ust enough inventory to cover the demand that $ill occur during the - day lead time. !he demand during the - day lead time is - days x 50 units per day > +00 units. )o, all $e have to do is #eep our eyes on our inventory level, and $hen it reaches +00 units, that is the signal that it is time to reorder. !his level of inventory that triggers a reorder is called the reorder point (6 . %nventory *evel

;4< > .00

64&

+00

!ime

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 14 of 30

OBSERVATIONS ABOUT OUR EO1 ILLUSTRATION

O0s"'&%tion 37+ Mo!", is 'o0ust .ins"nsiti&" to "''o's in "sti$%t"s 2o' in*ut !%t%/ We estimated our holding cost to be G+(unit(yr $hen $e made our ;4< calculation. )uppose this estimate $as in error, and the actual holding cost that $ill be incurred is G-(unit(yr (an error of +00%N . %f $e had been a$are of this true holding cost, and had used G-(unit(yr in our ;<< calculation, $e $ould have determined the ;4< to be -+- units, and the ordering cost and holding cost $ould have each been G-+-, for a total annual cost of G0-0 (you can practice the application of the model to confirm these numbers on your o$n . 2ut, unfortunately $e $ere not a$are that the holding cost $ould be G-(unit(yr, so $e made our ;4< calculation using the incorrect G+(unit(yr. !hat calculation had us ordering .00 units each time $e placed an order. With this order size, the true cost $e $ill incur is as follo$s8 4rdering cost8 (1(< ) > (+5,000 units(yr(.00 units(order (G.(order > G+50 5olding cost8 (<(- 5 > (.00 units(order(- (G-(unit(yr > G.00 !otal annual cost > G+50 A G.00 > G050 %n summary, $e could have been incurring an annual cost of G0-0 if $e had better information about the holding cost, and $ere ordering the correct ;4< of -+- units. 2ut, $e used the $rong holding cost in our model ($e $ere off by +00% , ended up ordering .00 units every time $e ordered, and incurred an annual cost of G050. Hotice that the cost $e are incurring (G050 is a little more than =% higher than the absolute minimum cost (G0-0 that $e might have incurred. Hot bad. We made a +00% error on the input side, but our results are only about =% $orse than they could have been. !hat is because the total cost line on our cost graph is relatively flat in the vicinity of the ;4<. Oou can drift to the right or left of the optimal order size and find that the resulting cost doesnPt rise substantially. !his is $hat is meant by the model being robust (or insensitive to errors .

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 15 of 30

IMPACT OF CHAN8IN8 ASSUMPTIONS ON MODEL DEVELOPMENT

4ur focus has been on the basic ;4< model. !hat is "ust one of dozens of inventory models for independent demand items. !he basic ;4< model $as derived from a set of underlying assumptions. %f any of those assumptions do not fit a particular situation, then one must turn to a different model. ;ach of those available models is predicated upon a different set of underlying assumptions. )ome of the more popular ones (and ones described in the textboo# are summarized belo$. We $ill not be expected to be #no$ledgeable about or $or# $ith any of these model extensions. Econo$ic P'o!uction 1u%ntit( .EP1/ Mo!",+ When replenishment items come from inside sources, the entire batch is usually not received all at once (instantaneous replenishment , but instead is gradually received as a production batch is run (continuous replenishment . !he pattern of inventory level fluctuations over time changes, resulting in a slightly different 'uantitative model for the optimal lot size. 1u%ntit( Discount Mo!",+ When the supplier is $illing to offer a lo$er price if large 'uantities of an item are ordered, the total annual purchase cost line $ill no longer be horizontal, but $ill instead have step decreases in it. !his $ill lead to a total cost curve that has brea#s in its continuity (step changes resulting in a slightly different model for determining the optimal order size. Cont'o,,"! B%c9o'!"' Mo!", .not $"ntion"! in th" 0oo9/+ %n some instances it might be beneficial to have shortages. %f the bac#order cost of a shortage is not very high, but the cost of carrying inventory is relative high, it may be more cost effective to incur some bac# orders on each order cycle (the sa$ tooth graph dips belo$ the horizontal axis on each order cycle . !his means that there $ill be less inventory being carried on average (resulting in lo$er holding costs and some shortages that $ill incur some cost. 5o$ lo$ belo$ the horizontal axis this graph dips is a function of the relative values of the cost of holding inventory and the cost of incurring a shortage. Sin ,":P"'io! In&"nto'( Mo!",+ )ometimes a uni'ue situation that arises is one in $hich there $ill be demand for an item in only one period, so the challenge is to determine the order size (stoc# size that $ill best accommodate the anticipated (and uncertain demand. Any items stoc#ed in excess of demand $ill be scrapped. Any demand in excess of $hat has been stoc#ed $ill represent a missed opportunity for more profit. (!his problem is sometimes referred to as the ne$sboy problem, or the /hristmas tree problem. !hese are but a fe$ of the many variations to the basic ;4< model that are in existence. !hey all are designed to provide optimal ans$ers to the ho$ much and $hen 'uestions. /hoice of a model should be dictated by the characteristics of the inventory situation that you are facing.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 16 of 30

DEMAND VARIABILITY AND UNCERTAINTY

!he basic ;4< model assumes that demand rate is constant and predictable. As a result $e al$ays #ne$ $hen $e $ere going to run out of inventory, so $e could al$ays reorder in a timely fashion so that the ne$ replenishment order $ould be received "ust $hen $e ran out of inventory. %n reality demand rates are rarely constant and rarely completely predictable. %t is more li#ely that demand rates $ill vary from day to day, and there $ill be uncertainty about $hat those demand rates $ill be at any one time. /onse'uently, there is a possibility that $e may run out of inventory before a replenishment order arrives. !o prevent a shortage situation organizations must rely on safety stoc#.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 20 of 30

ILLUSTRATION OF SAFETY STOC; DETERMINATION

D%t%+ Average daily demand > 50 units per day 4perating year contains .00 days of operation (1 > +5,000 units per year 4rdering cost ) > G. per order 5olding cost 5 > G+ per unit per year *ead time > + day Co$*ut%tions+ ;4< (from ;4< formula > .00 units per order 6esulting number of orders per year > 50 orders per year 6eorder point > 50 units (the average number of units demanded during the + day lead time A!!ition%, D%t%+ 1emand is not al$ays a constant 50 units per day. !here is variability in daily demand according to the follo$ing table of demands and probabilities8 1aily 1emand &robability /umulative &robability
%nventory *evel

+0 .0+ .0+

-0 .00 .05

.0 .05 .+0

00 ...0

50 .0 .I0

=0 ..Q0

I0 .05 .Q5

J0 .00 .QQ

Q0 .0+ +.00

.00

.00

6eorder &oint, 50

!ime
*! *!

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 21 of 30

!he graph above suggests that if you $aited until you had 50 units left in inventory before placing an order for .00 more units, you $ould be 4.R. if the demand during the + day lead time $as +0, -0, .0, 00, or 50. 5o$ever, if the demand during the + day lead time $as =0, I0, J0, or Q0 you $ould have had a shortage. !he size of the shortage $ould depend upon ho$ many units $ere demanded during the lead time, but the maximum possible shortage $ould have been 00 units (if demand $as the largest possible value of Q0 . Oou can prevent shortages by providing safety stoc# $hen there is uncertainty in demand. ()afety stoc# can be vie$ed as a cushion placed at the bottom of the sa$ tooth graph of inventory fluctuations over time. %f you $anted to guarantee that you $ould never have a shortage in this situation, you $ould need 00 units of safety stoc# at the bottom of the graph to Sdip intoS if demand spi#ed to higher than average values. 2ut, adding 00 units of safety stoc# really means that you have elevated your reorder point. Oou are not $aiting until there are only 50 units in inventory to place your order. Oou are ordering $hen there are Q0 units in inventory. And, of course, Q0 units are sufficient to cover the $orst case scenario for this problem. !he graph belo$ illustrates the impact of 00 units of safety stoc# maintained in the system.
%nventory *evel

.00

.00

4riginal 6eorder &oint, 50

!ime )afety )toc#, 00

*! *!

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 22 of 30

HO# MUCH SAFETY STOC; IS APPROPRIATE?

S"'&ic" ,"&",+ !he probability that demand during lead time $ill not exceed the inventory on hand $hen the order is placed. %n the previous illustration, it $as suggested that you might provide 00 units of safety stoc#. %f you had done so, you $ould never experience a shortage. Oou $ould have achieved a service level of +00%. !his might not be a desirable solution for this problem. We are carrying a relatively high amount of safety stoc#, and there is a very lo$ probability that lead time demand $ill actually go as high as Q0 units (only a +% chance . %f you had chosen to carry only .0 units of safety stoc# (order $hen inventory drops to J0 units , you $ill be fine if lead time demand is anything up to and including J0 units. %f lead time demand turns out to be Q0 (there is a +% chance of that , you $ill come up +0 units short. 2ut, since you had enough inventory to cover QQ% of the demands that might have occurred, you achieved a QQ% service level. ,any people might opt for this policy, for it $ill reduce the average annual level of inventory carried (i.e., reduce holding costs and run only a slight ris# of incurring a shortage cost. 4thers might be even more aggressive, and opt for an even lo$er service level. We could have achieved a Q5% service level $ith a reorder point of I0 (only -0 units of safety stoc# . WeTve lo$ered our inventory holding costs even further, but exposed ourselves to even more shortage cost ris#.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 23 of 30

INVENTORY MONITORIN8 APPROACHES

Fi<"! 1u%ntit(= o' 1 S(st"$+ !his approach maintains a constant order size, but allo$s the time bet$een the placement of orders to vary. !his method of monitoring inventory is sometimes referred to as a perpet!a" revie+ met$od, a ontin!o!# revie+ #y#tem, a reorder point #y#tem, and a t+o-%in #y#tem. !he inventory level is continuously (perpetually monitored, and $hen the inventory drops to the reorder point level, a replenishment order is placed. !he size of the order is constant (fixed 'uantity, typically the calculated economic order 'uantity for the item . 2ecause demand continues to occur $hile $e are $aiting for the replenishment order to arrive (i.e., demand continues to occur during the lead time , the inventory level $ill generally be belo$ the reorder point level $hen the replenishment arrives. !his type of system provides closer control over inventory items since the inventory levels are under perpetual scrutiny.

%nventory *evel

4rder U< 4rder U+ < 4rder U. <

6eorder &oint

*!

*!

*!

!ime

How $uch !"cision+ O'!"' siz" is const%nt .2i<"!/) #h"n !"cision+ Ti$" 0"tw""n th" *,%c"$"nt o2 o'!"'s c%n &%'()

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 2( of 30

P"'io!ic R"&i"w S(st"$s+ Th"'" %'" two= Fi<"! P"'io! S(st"$ .!"sc'i0"! in th" t"<t0oo9/= %n! % h(0'i! s(st"$ .!"sc'i0"! 0",ow 0ut not in th" t"<t0oo9/ Fi<"! P"'io! S(st"$+ !his approach maintains a constant time bet$een the placement of orders, but allo$s the order size to vary. !his method of monitoring inventory is sometimes referred to as a fi7ed interva" #y#tem. %t only re'uires that inventory levels be chec#ed at fixed periods of time. !he amount that is ordered at a particular time point is the difference bet$een the current inventory level and a predetermined maximum inventory level (also called an order up to level, or a target level . %f demand has been lo$ during the prior time interval, inventory levels $ill be relatively high $hen the revie$ time occurs, and the amount to be ordered $ill be relatively lo$. %f demand has been high during the prior time interval, inventory levels $ill have been depleted to lo$ levels $hen the revie$ time occurs, and the amount to be ordered $ill be higher. )ince demand continues to occur during the lead time, inventory levels $ill increase $hen the replenishment order arrives, but not all the $ay up to the maximum (i.e., target level.

%nventory *evel ,aximum (or 9order up to: or 9target: inventory level

4rder U4rder U.

4rder U+

<-

<.

<+

6evie$ time, !6evie$ time, !. 6evie$ time, !+

*! *! *!

!+

!-

!.

!ime

How $uch !"cision+ O'!"' siz" c%n &%'() #h"n !"cision+ Ti$" 0"tw""n th" *,%c"$"nt o2 o'!"'s is const%nt .2i<"!/)

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 25 of 30

H(0'i! S(st"$+ !his approach allo$s both the order size and the time bet$een the placement of orders to vary. !his method of monitoring inventory is sometimes referred to as an optiona" rep"eni#$ment #y#tem, or a min-ma7 #y#tem. %t is a hybrid system because it combines elements of both the fixed 'uantity system and the fixed period system. %t is similar to the periodic revie$ system in that it only chec#s inventory levels at fixed intervals of time, and it has a maximum inventory level (or 9order up to: or 9target: level . 5o$ever, $hen one of those revie$ periods arises the system does not automatically place an order. An order is only placed if the size of the order $ould be sufficient to $arrant placing the order. !his determination is made by incorporating the reorder point concept from the continuous revie$ system. At the revie$ period the inventory level on hand is compared to a minimum level for the item. %f inventory has not fallen belo$ this minimum level, no order is placed. 5o$ever, if the inventory level has dropped belo$ this minimum level, an order is placed. !he size of the order is the difference bet$een the inventory on hand and the maximum inventory level. )ince demand continues to occur during the lead time, inventory levels $ill increase $hen the replenishment order arrives, but not all the $ay up to the maximum (i.e., target level.

%nventory *evel ,aximum (or 9order up to: or 9target: inventory level

4rder U-

4rder U+

<<+

,inimum *evel
3irst order is placed at !+ since the inventory has fallen blo$ the minimum Ho order at !since inventory is not belo$ the minimum )econd order is placed at !. since the inventory has fallen blo$ the minimum

*!

*!

!+

!-

!.

!ime

How $uch !"cision+ O'!"' siz" c%n &%'() #h"n !"cision+ Ti$" 0"tw""n th" *,%c"$"nt o2 o'!"'s c%n &%'()

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 23 of 30

POSITIVES AND NE8ATIVES OF INVENTORY MONITORIN8 APPROACHES

Approach 3ixed <uantity

Advantages (&ositive aspects B provides tighter control over inventory items B less safety stoc# needed B "oint shipping advantage $ith multiple items from same source B does not re'uire constant monitoring B "oint shipping advantage $ith multiple items from same source B does not re'uire constant monitoring B no small 9nuisance: orders

3ixed &eriod

5ybrid

1isadvantages (Hegative aspects B re'uires constant monitoring (constant scrutiny B problems $ith multiple items from same source (many items arrive in separate shipments B re'uires more safety stoc# B occasional small 9nuisance: orders may result B provides looser control over inventory items B re'uires more safety stoc# B provides looser control over inventory items

COMPARISON OF INVENTORY MANA8EMENT SYSTEMS

S(st"$ Fi<"! 1u%ntit( Fi<"! P"'io! H(0'i!

O'!"' Siz" Const%nt .2i<"!/ V%'i"s V%'i"s

Ti$" B"tw""n O'!"'s V%'i"s Const%nt .2i<"!/ V%'i"s

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 24 of 30

ABC CLASSIFICATION OF ITEMS

%t is not unusual for organizations to maintain many items in inventory (hundreds or even thousands . ;ach of these items needs to be controlled. An important 'uestion is 95o$ much scrutiny does each item deserveV: )ome of these items may have a high annual investment, and logic $ould suggest that these items deserve very close scrutiny. 4n the other hand, some items may have a lo$ annual investment (these are often referred to as 9nuts and bolts items: , and they probably do not need as much attention. A2/ analysis provides a mechanism to separate the Simportant fe$S from the Strivial manyS so that the appropriate level of control can be assigned to each item. A2/ analysis assigns all inventory items to one of these three classifications8 A items need the tightest degree of control, $hile / items do not need very close scrutiny. !he general graphical display for an A2/ classification appears as follo$s8 /umulative % of Walue +00%

A %tems

2 %tems

/ %tems

/umulative % of %tems

+00%

!his type of diagram is referred to as a &areto graph, and is relevant to a variety of situations.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 25 of 30

ILLUSTRATION OF ABC ANALYSIS

!he follo$ing table displays an organizations inventory items, their value per unit, and their annual usage. (Hote8 !o #eep things manageable on the page, this illustration is greatly scaled do$n from reality. ,ost organizations $ould be dealing $ith considerably more than the ten inventory items displayed belo$. Walue &er ?nit G+. G5 G= G. G5 GJ G+0 G+ G5 G0 !otal 6earrange items in decreasing order of annual dollar usage8 %tem Humber = I + 0 5 Q . +0 J !otal Annual G ?sage G000,000 G.00,000 G+.0,000 GI0,000 G.0,000 G-5,000 G-0,000 G+-,000 GJ,000 G5,000 G+,000,000 % of *ine %tems +0% +0% +0% +0% +0% +0% +0% +0% +0% +0% /umulative % of %tems +0% -0% .0% 00% 50% =0% I0% J0% Q0% +00% % of Walue 00 .0 +. I . -.5 +..J .5 %nventory %tem Humber + . 0 5 = I J Q +0 Annual ?sage +0,000 +0,000 -,000 +0,000 5,000 50,000 .0,000 5,000 0,000 -,000 Annual 1ollar ?sage +.0,000 I0,000 +-,000 .0,000 -5,000 000,000 .00,000 5,000 -0,000 J,000 G+,000,000 /umulative % of Walue 00 I0 J. Q0 Q. Q5.5 QI.5 QJ.I QQ.5 +00 A2/ /lassD A A 2 2 / / / / / /

DHote8 When classifying the items as A, 2, or / items, it can be some$hat sub"ective as to $here the lines are dra$n. With the unrealistically small demonstration above, the first -0% of the inventory items constitute I0% of the inventory value, so these items (%tems = and I $ill be designated as A items. 4n the other extreme, =0% of the items constitute only +0% of the inventory value, so these items (%tems 0, 5, Q, ., +0, and J $ill be designated as / items. %n the middle, -0% of the items constitute -0 % of the inventory value, so these items (%tems + and $ill be designated as a 2 item.

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 26 of 30

DEVELOPMENT OF THE ABC INVENTORY PARETO 8RAPH

/umulative percentages extracted from previous table (and rotated Q0 degrees %tems (rearranged order /umulative % of items /umulative % of value
+st + +0 00 +st -0 I0 +st . .0 J+st 0 00 Q0 +st 5 50 Q. +st = =0 Q5.5 +st I I0 QI.5 +st J J0 QJ.I +st Q Q0 QQ.5 All +0 +00 +00

MAN 3520 Spring 2013 CP3 Independent Demand Inventory: Page 30 of 30

ALTERNATE REPRESENTATION OF OUR ABC ANALYSIS

!he data reflected in the &areto graph could also be displayed in a bar chart, as illustrated in the textboo#. !he follo$ing is such a representation for our simple A2/ illustration.

A items

B items C items

10 80

20 90

30 100

40

50

60

70