Operations Management & Total Quality Management

OMGT 1013 – Code: 775

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FINALS - WEEK 2
Inventory Management Part 2
LEARNING CONTENT
Introduction:
After knowing the nature and importance of Inventory Management, it is also important to know the
reasons why inventories should be properly maintained for the smooth flow of operations of the business.
This is to keep a balance between inventory investment and customer service.

In this module, you will learn more about inventory as additional concepts will be introduced such as
the pressures for high and low inventories, types of inventory, and the economic order quantity which is the
most commonly used model of inventory in most businesses.

Lesson Proper:

INVENTORY CONCEPTS

INVENTORY is created when the receipt of materials, parts, or finished goods exceeds their disbursement; it
is depleted when their disbursement exceeds their receipt.

Pressures for Low Inventories

 INVENTORY HOLDING (OR CARRYING) COST is the variable cost of keeping items on
hand, including interest, storage and handling, taxes, insurance, and shrinkage.
o Interest or Opportunity Cost whichever is greater, usually is the largest
component of holding cost.
o Storage and Handling Costs may be incurred when a firm rents space on
either a long-term or short-term basis.
o Taxes, Insurance, and Shrinkage.
- More taxes are paid if end-of-year inventories are high.
- Insurance on assets increases when there is more to insure.
- Shrinkage takes three forms:

1. PILFERAGE - theft of inventory by customers or employees.

2. OBSOLESCENCE – occurs when inventory cannot be used or sold
at full value, owing to model changes, engineering modifications, or
unexpectedly low demand.
3. DETERIORATION – physical spoilage or damage

Pressures for High Inventories

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 Why are inventories necessary?
 CUSTOMER SERVICE
o Creating inventory can speed delivery and improve on-time-delivery.
STOCKOUT – occurs when an item that is typically stocked isn’t
o
available to satisfy a demand the moment it occurs, resulting in loss
of the sale.
o BACKORDER – is a customer order that can’t be filled when
promised or demanded but is filled later.
 ORDERING COST
o For the same item, the ordering cost is the same regardless of the
order size.
o ORDERING COST - Cost of preparing a purchase order for a supplier
or a production order for the shop
 SETUP COST
o It is also independent of the order size.
It is the cost involved in changing in changing over a machine to
o
produce a different component or item
 LABOR AND EQUIPMENT UTILIZATION
o By creating more inventory, management can increase work-force
productivity and facility utilization.
 TRANSPORTATION COSTS
o Outbound and inbound transportation cost can be reduced by
increasing inventory levels.
 PAYMENT TO SUPPLIERS
o A firm often can reduce total payment to suppliers if it can tolerate
higher inventory levels.
o QUANTITY DISCOUNT – price per unit drops when the order is
sufficiently large. It is an incentive to order larger quantities.

TYPES OF INVENTORY
A. CYCLE INVENTORY – the portion of total inventory that varies directly with lot size


 LOT SIZING – determining how frequent to order, and in what quantity

2 Principles of Lot Sizing

1. The lot size, Q, varies directly with the elapsed time (or cycle) between orders.
2. The longer the time between orders for a given time, the greater the cycle inventory
must be.

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 Average Cycle Inventory (ACI) is the average of the maximum and minimum cycle inventory level at
the beginning and end of the interval respectively. At the beginning of the interval, the cycle inventory is
at its maximum or Q. At the end of the interval, just before a new lot arrives, cycle inventory drops to its
minimum or 0.

B. SAFETY STOCK INVENTORY – protects against uncertainties in demand, lead time, and supply

C. ANTICIPATION INVENTORY – used to absorb uneven rates of demand or supply, which businesses
often face

D. PIPELINE INVENTORY – inventory moving from point to point in the materials flow system. It consists
of orders that have been placed but not yet received.

ESTIMATING INVENTORY LEVEL

Example
A plant makes monthly shipments of electric drills to a wholesaler in average lot sizes of 280 drills.
The wholesaler’s average demand is 70 drills per week, and the lead time from the plant is three
weeks. On average, how much cycle inventory and pipeline inventory does the wholesaler carry?

ANSWER:
The wholesaler’s cycle inventory is 140 drills, whereas the pipeline inventory (inventory in transit)
averages 210 drills.

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INVENTORY REDUCTION TACTICS

LEVERS – basic tactics for reducing inventory

 PRIMARY LEVER is one that must be activated if inventory is reduced.
 SECONDARY LEVER reduces the penalty cost of applying the primary lever and the need for
having inventory in the first place.

ABC ANALYSIS - It is the process of dividing items into three classes according to their dollar usage so
that the manager can focus on the items that have the highest dollar value.

Control of Service Inventories can be a critical component of profitability. Losses may come from
shrinkage or pilferage. Applicable techniques include:

1. Good personnel selection, training, and discipline

2. Tight control on incoming shipments
3. Effective control on all goods leaving facility

Independent versus Dependent Demand

 Independent demand - the demand for item is independent of the demand for any
other item in inventory
 Dependent demand - the demand for item is dependent upon the demand for some
other item in the inventory

Inventory Models for Independent Demand

1. Basic Economic Order Quantity (EOQ

ECONOMIC ORDER QUANTITY (EOQ) is the lot size that minimizes total annual
inventory holding and ordering costs
 The approach to determining the EOQ is based on the following assumptions:

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 o The demand rate for the item is constant and known with
certainty.
o There are no constraints on the size of each lot.
o The only two relevant costs are the inventory holding cost and
fixed cost per lot for ordering or setup.
o Decisions for one item can be made independently of decisions
for other items.
o There is no uncertainty in lead time or supply

CALCULATING THE EOQ

Where: D = annual demand

S = Annual Ordering/Set-up cost
H = Annual Holding Cost

 Annual Holding Cost

= (Average cycle inventory)(Unit holding cost)
 Annual Ordering Cost
= (Number of orders/year)(Ordering or setup cost)
 Average Number of Orders Per Year
= Annual demand
Lot size

 Total Cost
= Annual holding cost + Annual ordering or set up cost
or C = Q (H) + D (S)
2 Q

Where C = total cost per year

Q = lot size, in units
H = cost of holding one unit in inventory for a year, often calculated as the
proportion of the item’s value
D = annual demand, in units per year
S = cost of ordering or setting up one lot, in dollars per lot
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  TIME BETWEEN ORDERS (TBO) for a particular lot size is the average elapsed
time between receiving (or placing) replenishment orders of Q units
o When we use EOQ the TBO can be expressed in various ways for the same
time period:

Formula for determining TBO in years:

Formula in determining TBO in months, weeks and days:

Example:

A museum of natural history opened a gift shop two years ago. Managing inventories
has become a problem. Low inventory turnover is squeezing profit margins and causing
cash-flow problems.
One of the top selling items in the container group at the museum’s gift shop is a
birdfeeder. Sales are 18 units per week, and the supplier charges $60 per unit.
The cost of placing an order with the supplier is $45. Annual holding cost is 25% of a
feeder’s value, and the museum operates 52 weeks per year. Management chose 390-
unit lot size so that new orders could be placed less frequently. What is the annual cost of
the current policy of using 390-unit lot size?

SOLUTION:

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For the birdfeeder in the previous example, calculate the EOQ and its total cost. How
frequently will orders be placed if the EOQ is used?

First, compute the EOQ......then the Annual cost which is as follows:

Now, to compute how frequent orders will be made, we first determine the time between
orders which is as follows:

So, given those TBOs in year, month, weeks and days, how frequent will the museum order
birdfeeders? Answer : Approximately 12 times a year.

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2. Production order quantity
3. Quantity discount model

UNDERSTANDING THE EFFECT OF CHANGES

 A change in the Demand Rate. Because D is in the numerator, the EOQ increases
in proportion to the square root of the annual demand.
 A change in the Setup Costs. Because S is in the numerator,
increasing S increases the EOQ and, consequently, the average cycle inventory.
Conversely, reducing S reduces the EOQ, allowing smaller lot sizes to be produced
economically.
 A Change in the Holding Costs. Because H is in the denominator, the EOQ
declines when H Conversely, when H declines, the EOQ increases.
 Errors in Estimating D, H, and S. Total cost is fairly insensitive to errors even
when estimates are wrong by a large margin.
Inventory Control Systems
 Continuous Review (Q) System
o sometimes called a reorder point (ROP) system or fixed order
quantity system
o tracks the remaining inventory of an item each time a withdrawal is
made to determine whether it is time to reorder.
o reviews are done frequently or continuously

INVENTORY POSITION (IP) - measures the item’s ability to satisfy future demand.
It includes scheduled receipts (SR), which are orders that have been placed but not
yet received (also called open orders), plus on-hand inventory
(OH) minus backorders (BO).
Inventory Position = On-hand inventory + Scheduled receipts – Backorders
IP = OH + SR - BO

A. Selecting the Reorder Point When Demand is Certain

Reorder point , R
-predetermined minimum level
- R equals demand during lead time, with no added allowance for safety stock

R = Average demand during lead time

Example:

Demand for chicken soup at a supermarket is 25 cases a day and the lead time is
four days. The shelves were just restocked with chicken soup, leaving an on-hand
inventory of only 10 cases. There are no backorders, but there is one open order for
200 cases. Should a new order be placed?

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 B. Selecting the Reorder Point When the Demand is Uncertain

o This approach will create a safety stock, or stock held in excess of
expected demand to buffer against uncertain demand

R = Average demand during lead time + Safety stock

 Finding the Safety Stock
o We compute the safety stock by multiplying the number of standard
deviations from the mean needed to implement the cycle-service
level, z, by the standard deviation of demand during lead time
probability distribution, σL

Example:

Records show that the demand for dishwasher detergent during the lead time is
normally distributed, with an average of 250 boxes and σL = 22. What safety stock
should be carried for a 99 percent cycle-service level? What is R?

Solution:

 Periodic Review (P) System

o sometimes called a fixed interval reorder system or periodic
reorder system in which an item’s inventory position is reviewed
periodically rather than continuously.

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  Hybrid System
1.
a. Optional Replenishment System
 Sometimes called the optional review, min-max, or (s, S) system
 Much like the P system
 It is used to review the inventory position at fixed time intervals and, if the
position has dropped to (or below) a predetermined level, to place a
variable-sized order to cover expected needs
b. Base-Stock System
 Issues a replenishment order, Q, each time a withdrawal is made, for
the same amount as the withdrawal

*** END of LESSON***

REFERENCES
Textbooks
Chase, Richard,et.al. Production and Operations management: Manufacturing and Services 8th ed.
Irwin/McGrwa-Hill. Boston

Stevenson, William J. (2018). Operations management thirteenth edition. McGraw Hill Education,
2 Penn Plaza, New York, NY 10121.

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