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The McGraw-Hill Companies,

Chapter 14
Inventory Control

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OBJECTIVES

Inventory System Defined


Inventory Costs
Independent vs. Dependent Demand
Single-Period Inventory Model
Multi-Period Inventory Models: Basic Fixed-Order
Quantity Models
Multi-Period Inventory Models: Basic Fixed-Time
Period Model
Miscellaneous Systems and Issues

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Inventory System
Defined

Inventory is the stock of any item or resource


used in an organization and can include: raw
materials, finished products, component
parts, supplies, and work-in-process
An inventory system is the set of policies and
controls that monitor 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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Purposes of Inventory
1. To maintain independence of operations
2. To meet variation in product demand
3. To allow flexibility in production scheduling
4. To provide a safeguard for variation in raw
material delivery time
5. To take advantage of economic purchaseorder size
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Inventory Costs
Holding (or carrying) costs
Costs for storage, handling, insurance, etc
Setup (or production change) costs
Costs for arranging specific equipment setups, etc
Ordering costs
Costs of someone placing an order, etc
Shortage costs
Costs of canceling an order, etc

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Independent vs. Dependent Demand


Independent Demand (Demand for the final endproduct or demand not related to other items)

Finished
product

E(1
)

Component parts

Dependent
Demand
(Derived demand
items for
component
parts,
subassemblies,
raw materials,
etc)
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Inventory Systems
Single-Period Inventory Model
One time purchasing decision (Example: 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 (Example: running out of
stock)
Fixed-Time Period Models
Time triggered (Example: Monthly sales call by
sales representative)
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Single-Period Inventory Model

C
Cuu
P
P
C
Coo C
Cuu

This
Thismodel
modelstates
statesthat
thatwe
we
should
shouldcontinue
continueto
toincrease
increase
the
thesize
sizeof
ofthe
theinventory
inventoryso
so
long
longas
asthe
theprobability
probabilityof
of
selling
sellingthe
thelast
lastunit
unitadded
addedisis
equal
equalto
toor
orgreater
greaterthan
thanthe
the
ratio
ratioof:
of:Cu/Co+Cu
Cu/Co+Cu

Where :
Co Cost per unit of demand over estimated
Cu Cost per unit of demand under estimated
P Probability that the unit will be sold
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Single Period Model Example


Our college basketball team is playing in a
tournament game this weekend. Based on our past
experience we sell on average 2,400 shirts with a
standard deviation of 350. We make $10 on every
shirt we sell at the game, but lose $5 on every shirt
not sold. How many shirts should we make for
the game?
Cu = $10 and Co = $5; P $10 / ($10 + $5) = .667
Z.667 = .432 (use NORMSDIST(.667) or Appendix E)
therefore we need 2,400 + .432(350) = 2,551 shirts

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Multi-Period Models:
Fixed-Order Quantity Model Model
Assumptions (Part 1)
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
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Multi-Period Models:
Fixed-Order Quantity Model Model
Assumptions (Part 2)
Inventory holding cost is based on average
inventory
Ordering or setup costs are constant
All demands for the product will be satisfied
(No back orders are allowed)
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Basic Fixed-Order Quantity Model and


Reorder Point Behavior
4. The cycle then repeats.

1. You receive an order quantity Q.


Number
of units
on hand

2. Your start using


them up over time.

R = Reorder point
Q = Economic order quantity
L = Lead time

Time

L
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.
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Cost Minimization Goal


By
Byadding
addingthe
theitem,
item,holding,
holding,and
andordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichin
in
turn
inventory order point that
turnis
isused
usedto
tofind
findthe
theQ
Qopt
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs
Total Cost
C
O
S
T

Holding
Costs
Annual Cost of
Items (DC)
Ordering Costs
QOPT
Order Quantity (Q)
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Basic Fixed-Order Quantity


(EOQ) Model Formula
Total
Annual =
Cost

Annual
Annual
Annual
Purchase + Ordering + Holding
Cost
Cost
Cost

D
Q
D
Q
TC
TC == DC
DC ++ SS++ H
H
Q
22
Q

TC=Total
TC=Totalannual
annual
cost
cost
DD=Demand
=Demand
CC=Cost
=Costper
perunit
unit
QQ=Order
=Orderquantity
quantity
SS=Cost
=Costof
ofplacing
placing
an
anorder
orderor
orsetup
setup
cost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
H=Annual
H=Annualholding
holding
and
andstorage
storagecost
cost
per
perunit
unitof
ofinventory
inventory

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Deriving the EOQ


Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative of
of the
the
total
total cost
cost function
function with
with respect
respect to
to Q,
Q, and
and set
set the
the
derivative
derivative (slope)
(slope) equal
equal to
to zero,
zero, solving
solving for
forthe
the
optimized
optimized (cost
(cost minimized)
minimized) value
value of
of Q
Qopt
opt
QQOPT
=
OPT =

2DS
2DS =
=
HH

We
Wealso
alsoneed
needaa
reorder
reorderpoint
pointto
to
tell
tellus
uswhen
whento
to
place
placean
anorder
order

2(Annual
2(AnnualDemand)(Order
Demand)(Orderor
orSetup
SetupCost)
Cost)
Annual
AnnualHolding
HoldingCost
Cost
__

Reorder
Reorder point,
point, R
R == ddLL

d = average daily demand (constant)


L = Lead time (constant)
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EOQ Example (1) Problem Data


Given
Giventhe
theinformation
informationbelow,
below,what
what are
arethe
theEOQ
EOQ and
and
reorder
reorderpoint?
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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EOQ Example (1) Solution


Q
=
QOPT
OPT =

2DS
2DS =
=
H
H

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

1,000
units
//year
1,000
units
year = 2.74 units / day
dd ==
= 2.74 units / day
365
days
/
year
365 days / year
__

Reorder
Reorderpoint,
point, RR==dd LL==2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18or
or 20
20units
units

In
Insummary,
summary,you
youplace
placean
anoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have20
20units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90
units.
units.
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EOQ Example (2) Problem Data


Determine
Determine the
the economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following
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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EOQ Example (2) Solution


2DS
2(10,000
)(10)
2DS
2(10,000
)(10) = 365.148 units, or 366 units
Q
=
=
QOPT
=
= 365.148 units, or 366 units
OPT =
H
1.50
H
1.50

10,000
units
//year
10,000
units
year = 27.397 units / day
dd==
= 27.397 units / day
365
days
/
year
365 days / year
__

R
R ==dd LL==27.397
27.397units
units//day
day(10
(10days)
days)==273.97
273.97or
or 274
274units
units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin
in the
thecourse
courseof
of
using
usingthe
theinventory
inventoryyou
you are
areleft
left with
with only
only274
274units,
units,
place
placethe
thenext
next order
orderof
of366
366units.
units.
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Fixed-Time Period Model with Safety


Stock Formula
qq==Average
Averagedemand
demand++Safety
Safetystock
stockInventory
Inventorycurrently
currentlyon
onhand
hand
qq==dd(T
(T++L)
L)++ZZTT++LL--II
Where
Where::
qq==quantitiy
quantitiyto
tobe
beordered
ordered
TT==the
thenumber
numberof
ofdays
daysbetween
betweenreviews
reviews
LL==lead
leadtime
timein
indays
days
dd==forecast
forecast average
averagedaily
dailydemand
demand
zz==the
thenumber
numberof
ofstandard
standarddeviations
deviationsfor
foraaspecified
specifiedservice
serviceprobabilit
probabilityy
T + L ==standard
standarddeviation
deviationof
ofdemand
demandover
overthe
thereview
reviewand
andlead
leadtime
time
T+L

II==current
currentinventory
inventorylevel
level(includes
(includesitems
itemson
onorder)
order)

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Multi-Period Models: Fixed-Time Period


Model:
Determining the Value of T+L
T+T+LL ==

T+
L
T+L
i i 11

22

ddi
i

Since
Sinceeach
eachday
dayisisindependent
independentand
anddd isisconstant,
constant,
22
T+T+LL == (T
+
L)

(T + L)dd

The standard deviation of a sequence of


random events equals the square root of the
sum of the variances
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23

Example of the Fixed-Time Period Model


Given
Given the
the information
information below,
below, how
how many
many units
units
should
should be
be ordered?
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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Example of the Fixed-Time Period Model:


Solution (Part 1)
T+T+LL ==

(T
(T++ L)
L) ==
22
dd

30
30++10
10 44 == 25.298
25.298
22

The
The value
value for
forz
z isis found
found by
byusing
using the
theExcel
Excel
NORMSINV
NORMSINVfunction,
function, or
oras
as we
we will
will do
do here,
here, using
using
Appendix
Appendix D.
D. By
Byadding
adding 0.5
0.5 to
to all
all the
the values
values in
in
Appendix
Appendix D
D and
and finding
finding the
the value
value in
in the
the table
table that
that
comes
comes closest
closest to
to the
the service
service probability,
probability,the
the z
z
value
value can
can be
be read
read by
by adding
adding the
thecolumn
column heading
heading
label
label to
to the
the row
rowlabel.
label.
So,
So,by
byadding
adding0.5
0.5to
tothe
thevalue
valuefrom
fromAppendix
AppendixDDof
of0.4599,
0.4599,
we
wehave
haveaaprobability
probabilityof
of0.9599,
0.9599,which
whichisisgiven
givenby
byaazz==1.75
1.75
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Example of the Fixed-Time Period Model:


Solution (Part 2)
qq==dd(T
(T++L)
L)++ZZTT++LL --II
qq==20(30
20(30++10)
10)++(1.75)(25.
(1.75)(25.298)
298)--200
200
qq==800
80044.272
44.272--200
200==644.272,
644.272,or
or645
645units
units

So,
So, to
to satisfy
satisfy 96
96 percent
percent of
of the
the demand,
demand,
you
you should
should place
place an
an order
order of
of 645
645 units
units at
at
this
this review
review period
period
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Price-Break Model Formula


Based on the same assumptions as the EOQ model,
the price-break model has a similar Qopt formula:

Q OPT

2DS
2(Annual Demand)(Order or Setup Cost)
=
=
iC
Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory


C = cost per unit
Since C changes for each price-break, the formula
above will have to be used with each price-break cost
value
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Price-Break Example Problem Data


(Part 1)
A
Acompany
company has
has aa chance
chance to
to reduce
reduce their
theirinventory
inventory
ordering
ordering costs
costs by
by placing
placing larger
largerquantity
quantity orders
orders using
using
the
the price-break
price-breakorder
orderquantity
quantity schedule
schedule below.
below. What
What
should
should their
theiroptimal
optimal order
orderquantity
quantity be
be ifif this
this company
company
purchases
purchases this
this single
single inventory
inventoryitem
item with
with an
an e-mail
e-mail
ordering
ordering cost
cost of
of $4,
$4, aa carrying
carrying cost
cost rate
rate of
of 2%
2%of
of the
the
inventory
inventory cost
cost of
of the
the item,
item, and
and an
an annual
annual demand
demand of
of
10,000
10,000 units?
units?
Order Quantity(units) Price/unit($)
0 to 2,499
$1.20
2,500 to 3,999 1.00
4,000 or more .98
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28

Price-Break Example Solution (Part 2)


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 Qopt values are feasible or not


Interval from 0 to 2499, the
Qopt value is feasible

Q OPT =

2DS
=
iC

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

Q OPT =

2DS
=
iC

2(10,000)(4)
= 2,000 units
0.02(1.00)

Interval from 4000 & more, the


Q OPT =
Qopt value is not feasible

2DS
=
iC

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

Interval from 2500-3999, the


Qopt value is not feasible

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Price-Break Example Solution (Part 3)


Since
Sincethe
thefeasible
feasiblesolution
solution occurred
occurredin
inthe
thefirst
firstpricepricebreak,
values occur
break,itit means
means that
thatall
all the
theother
othertrue
trueQ
Qopt
opt values occur
at
at the
thebeginnings
beginningsof
ofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?
Because
Becausethe
thetotal
total annual
annualcost
costfunction
functionis
is
aau
ushaped
shapedfunction
function

Total
annual
costs

So
So the
thecandidates
candidates
for
forthe
thepricepricebreaks
breaks are
are1826,
1826,
2500,
2500,and
and4000
4000
units
units
0

1826

2500

4000

Order Quantity
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Price-Break Example Solution (Part 4)


Next,
values into the total cost
Next,we
weplug
plugthe
thetrue
trueQ
Qopt
opt values into the total cost
annual
annualcost
costfunction
functionto
todetermine
determinethe
thetotal
total cost
costunder
under
each
eachprice-break
price-break

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

Finally,
, which is this
Finally,we
weselect
select the
theleast
least costly
costlyQ
Qopt
opt, which is this
problem
problem occurs
occursin
in the
the4000
4000 &&more
more interval.
interval. In
In summary,
summary,
our
ouroptimal
optimal order
orderquantity
quantityis
is4000
4000units
units
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Miscellaneous Systems:
Optional Replenishment System
Maximum Inventory Level, M

q=M-I
Actual Inventory Level, I

M
I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.


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Miscellaneous Systems:
Bin Systems
Two-Bin System

Order One Bin of


Inventory
Full

Empty

One-Bin System

Order Enough to
Refill Bin
Periodic Check
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33

ABC Classification System


Items kept in inventory are not of equal
importance in terms of:

dollars invested

profit potential

sales or usage volume

60

% of
$ Value 30
0

% of
Use

30

A
B

60

stock-out penalties

So, identify inventory items based on percentage of total


dollar value, where A items are roughly top 15 %, B
items as next 35 %, and the lower 50% are the C items
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Inventory Accuracy and Cycle Counting


Defined
Inventory accuracy refers to how well the
inventory records agree with physical
count
Cycle Counting is a physical inventorytaking technique in which inventory is
counted on a frequent basis rather than
once or twice a year

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35

End of Chapter 14

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