F O U R T H E D I T I O N

Inventory Systems forIndependent Demand

© The McGraw-Hill Companies, Inc., 2003

chapter 16

DAVIS

AQUILANO

CHASE

PowerPointPresentation

byCharlieCook

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–2

Chapter ObjectivesChapter ObjectivesChapter ObjectivesChapter Objectives

• Introduce the different types of inventories that exist in a company and provide a rationale for why companies maintain inventories.

• Identify the various costs associated with carrying and maintaining inventories.

• Define the classical inventory models and the conditions necessary for them to be applicable.

• Show how economic order quantity is calculated for each of the different inventory models.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–3

Chapter Objectives (cont’d)Chapter Objectives (cont’d)Chapter Objectives (cont’d)Chapter Objectives (cont’d)

• Introduce the single-period inventory model and the concept of yield management with respect to service operations.

• Present some of the current inventory management trends and issues that exist in companies today.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–4

Managerial IssuesManagerial IssuesManagerial IssuesManagerial Issues

• Inventory is no longer viewed as an asset• Product life cycles are becoming shorter

increasing the likelihood of product obsolescence.

• Inventory concealing other problems.• The high costs of inventory storage.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–5

Definition of InventoryDefinition of InventoryDefinition of InventoryDefinition of Inventory

• Inventory–The stock of any item or resource used in an

organization, includes raw materials, finished goods, and work-in-process.

• Inventory Management System–The set of policies and controls that monitors

levels of inventory and determines:• What levels should be maintained.

• When stock should be replenished.

• How large orders should be.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–6

Types of InventoryTypes of InventoryTypes of InventoryTypes of Inventory

• Raw Materials–Vendor-supplied items that have not had any

labor added by the firm receiving the items.

• Finished Goods–Completed products that are still in the

possession of the firm that manufactured them.

• Work-in-Process (WIP)–Items that have been partially processed but are

still incomplete.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–7

Reason for Maintaining InventoryReason for Maintaining InventoryReason for Maintaining InventoryReason for Maintaining Inventory

• To protect against uncertainty:–Shortages of raw materials.–Work-in-process variations.–Changes in demand for finished products.

• To support a strategic plan–As a cyclic demand buffer for a level-output

strategy.

• To take advantage of economies of scale–Large quantity purchases reduce the average

total unit costs related to fixed ordering, setup costs, and transportation costs.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–8

Inventory CostsInventory CostsInventory CostsInventory Costs

• Holding and Carrying Costs–Storage costs (facility, insurance, taxes, utilities)–Capital costs (opportunity costs)–Obsolescence/shrinkage costs (depreciated

value)

• Setup or Ordering Costs• Shortage (or Stockout) Costs• Purchase Costs• Transportation Costs

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–9

Independent versus Dependent Independent versus Dependent DemandDemand

Independent versus Dependent Independent versus Dependent DemandDemand

• Independent Demand–The demand that pertains to the requirements

for end products (external market demand).

• Dependent Demand–The requirements for components that are

directly dependent on the demand for the end products in which they are used.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–10

Types of Inventory SystemsTypes of Inventory SystemsTypes of Inventory SystemsTypes of Inventory Systems

• Fixed-Order Quantity–A system where the order quantity remains

constant but the time between orders varies.• Preferred for important or expensive items

because average inventory is lower.

• Provides a quicker response to stockouts

• Is more expensive to maintain due to inventory record-keeping costs.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–11

Types of Inventory SystemsTypes of Inventory SystemsTypes of Inventory SystemsTypes of Inventory Systems

• Fixed-Time Period–A system where the time period between orders

remains constant but the order quantity varies.• Has larger average inventory to prevent stockouts.

• Useful when purchasing multiple items from one vendor to save on costs.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–12

Comparison of Comparison of Fixed-Order Fixed-Order

Quantity and Fixed-Quantity and Fixed-Time Period Time Period Reordering Reordering

Inventory SystemsInventory Systems

Comparison of Comparison of Fixed-Order Fixed-Order

Quantity and Fixed-Quantity and Fixed-Time Period Time Period Reordering Reordering

Inventory SystemsInventory Systems

Exhibit 16.1Exhibit 16.1

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–13

Basic Inventory ModelsBasic Inventory ModelsBasic Inventory ModelsBasic Inventory Models

• Fixed-Order-Quantity Model Assumptions:–Demand for the product is known, constant, and

uniform throughout the period.–Lead time (L), which is the time from ordering to

receipt, is constant.–Price per unit of product is constant (no quantity

discounts).–Ordering or setup costs are constant–All demands for the product are known with

certainty, no back orders or stockouts.–There is no interaction with other products.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–14

Basic Fixed-Order Quantity ModelBasic Fixed-Order Quantity ModelBasic Fixed-Order Quantity ModelBasic Fixed-Order Quantity Model

Exhibit 16.2Exhibit 16.2

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–15

Fixed-Order-Quantity ModelFixed-Order-Quantity ModelFixed-Order-Quantity ModelFixed-Order-Quantity Model

TC = Total Annual CostD = Annual demand in unitsC = Cost per unitQ = Quantity to be order (the optimum is termed

the economic order quantity—EOQ)S = Setup or ordering costH = Annual holding cost per unit

Total annual cost =Annual purchase cost + Annual ordering cost + Annual holding cost

HQ

SQ

DDCTC

2

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–16

Annual Product Cost, Based on Size of Annual Product Cost, Based on Size of OrderOrder

Annual Product Cost, Based on Size of Annual Product Cost, Based on Size of OrderOrder

Exhibit 16.3Exhibit 16.3

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–17

Fixed-Order-Quantity Model (cont’d)Fixed-Order-Quantity Model (cont’d)Fixed-Order-Quantity Model (cont’d)Fixed-Order-Quantity Model (cont’d)

• Economic Order Quantity–The optimal quantity to order taking into

consideration both the cost to carry inventory and the cost to order the item.

–Minimizes total inventory cost

H

DSEOQ

2

D = Annual demand in unitsS = Setup or ordering costH = Annual holding cost per unit

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–18

Fixed-Order-Quantity Model (cont’d)Fixed-Order-Quantity Model (cont’d)Fixed-Order-Quantity Model (cont’d)Fixed-Order-Quantity Model (cont’d)

• Reorder Point–The point in time by which stock must be

ordered to replenish inventory before a stockout occurs.

LdR

delivery and order placing between periods time of NumberL

(constant) period time per demand Average d

point Reorder R

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–19

Basic Inventory ModelsBasic Inventory ModelsBasic Inventory ModelsBasic Inventory Models

• Fixed Order Quantity Model with Usage–Considers a supplier that will provide an order

quantity over a period of time rather than all at once.

HISQDDCTC 2max

pQdpI max

d = the constant demand rate for the item in productionp = production rate of the process

(p - d) = inventory that accumulates each time period(Q/p) = number of time periods required to fill the order

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–20

Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)

• Fixed Order Quantity Model with Usage (cont’d)

p

QHdpS

Q

DDCTC

2

dp

p

H

DSEOQ

2

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–21

Fixed Order Quantity Model withFixed Order Quantity Model withUsage during Production TimeUsage during Production Time

Fixed Order Quantity Model withFixed Order Quantity Model withUsage during Production TimeUsage during Production Time

Exhibit 16.4Exhibit 16.4

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–22

Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)

• Fixed-Time-Period Model–Inventory is counted at fixed intervals.–Ceiling (par) inventory is established.–Safety stock level is established.–Order quantity to return inventory to ceiling

level varies based on on-hand inventory less safety stock at time inventory is counted.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–23

Fixed-Time Period Inventory ModelFixed-Time Period Inventory ModelFixed-Time Period Inventory ModelFixed-Time Period Inventory Model

Exhibit 16.5Exhibit 16.5

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–24

Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)Basic Inventory Models (cont’d)

• Quantity-Discount Model–Addresses price discounts associated with

minimum order quantities.–Two types of quantity discounts

• Incremental discounts which apply increasing discounted unit prices as orders reach or exceed certain quantity levels of units.

• In the all-units approach, discounts are applied to all units with the unit cost determined by the size of the purchase order.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–25

Total Cost Curves for a Total Cost Curves for a Quantity-Discount ModelQuantity-Discount ModelTotal Cost Curves for a Total Cost Curves for a Quantity-Discount ModelQuantity-Discount Model

Exhibit 16.6Exhibit 16.6

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–26

Total Cost Calculations in a Total Cost Calculations in a Quantity-Discount ModelQuantity-Discount Model

Total Cost Calculations in a Total Cost Calculations in a Quantity-Discount ModelQuantity-Discount Model

Exhibit 16.7Exhibit 16.7

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–27

Inventories and Service LevelsInventories and Service LevelsInventories and Service LevelsInventories and Service Levels

• Determining Safety Stock Levels–Variation in product demand.–Variability in the lead time required to replenish

the item.–The desired level of service that the company

wants to provide its customers.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–28

The Impact of Variation, Lead Time, and Service The Impact of Variation, Lead Time, and Service Level on the Amount of Safety Stock (SS) Level on the Amount of Safety Stock (SS)

RequiredRequired

The Impact of Variation, Lead Time, and Service The Impact of Variation, Lead Time, and Service Level on the Amount of Safety Stock (SS) Level on the Amount of Safety Stock (SS)

RequiredRequired

Exhibit 16.8Exhibit 16.8

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–29

Economic Order Quantity Models in Economic Order Quantity Models in Relation to the Real WorldRelation to the Real World

Economic Order Quantity Models in Economic Order Quantity Models in Relation to the Real WorldRelation to the Real World

• Costs are difficult to measure.• Demand is not constant.• Lack of focus on lot sizing and inventory

control.• Need to focus on reducing setup costs to

reduce EOQs and total costs.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–30

Effect of Reduced Setup Costs Effect of Reduced Setup Costs on Order Size and Total Costson Order Size and Total Costs

Effect of Reduced Setup Costs Effect of Reduced Setup Costs on Order Size and Total Costson Order Size and Total Costs

Exhibit 16.9Exhibit 16.9

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–31

Perishable InventoryPerishable InventoryPerishable InventoryPerishable Inventory

• Single-Period Inventory Model–Product is only viable for sale during a single

time period.–Demand for the product is highly variable, but

follows a known probability distribution.–The scrap value of the product or the value of

the product after the time period has elapsed is less than the initial cost of the product.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–32

Inventory Management in ServicesInventory Management in ServicesInventory Management in ServicesInventory Management in Services

• Yield Management or Revenue Management–Goal is maximizing capacity utilization by selling

all of a service capacity for some price that exceeds the service’s variable costs per unit of service.

–A large proportion of capacity is sold in advance for reduced prices; some capacity is held for last-minute customers willing to pay full prices.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–33

Additional Issues in Additional Issues in Inventory ManagementInventory Management

Additional Issues in Additional Issues in Inventory ManagementInventory Management

• Determining Realistic Costs–Accounting data is usually expressed in

averages; marginal costs are needed to determine proper lot sizes.

–Carrying and ordering costs are not constant.–Some costs (e.g., obsolescence) are subjective.

• Inventory Accuracy–Shrinkage, misidentification, and misplaced

items create inventory inaccuracies.

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–34

Cost to Place Orders versus the Number Cost to Place Orders versus the Number of Orders Placed: Linear Assumption and of Orders Placed: Linear Assumption and

Normal RealityNormal Reality

Cost to Place Orders versus the Number Cost to Place Orders versus the Number of Orders Placed: Linear Assumption and of Orders Placed: Linear Assumption and

Normal RealityNormal Reality

Exhibit 16.10Exhibit 16.10

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–35

ABC Inventory PlanningABC Inventory PlanningABC Inventory PlanningABC Inventory Planning

• ABC Analysis–A method for grouping items by dollar volume to

identify those items to be monitored closely.–Follows the Pareto principle.–“A” items: high dollar volume (15%)–“B” items: moderate dollar volume (35%)–“C” items: low dollar volume (50%)

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–36

Annual Usage of Inventory by ValueAnnual Usage of Inventory by ValueAnnual Usage of Inventory by ValueAnnual Usage of Inventory by Value

Exhibit 16.11Exhibit 16.11

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–37

ABC Grouping of Inventory ItemsABC Grouping of Inventory ItemsABC Grouping of Inventory ItemsABC Grouping of Inventory Items

Exhibit 16.12Exhibit 16.12

Fundamentals of Operations Management 4e © The McGraw-Hill Companies, Inc., 2003 16–38

Current Trends in Current Trends in Inventory ManagementInventory Management

Current Trends in Current Trends in Inventory ManagementInventory Management

• Inventory is a liability, not an asset.• Average amount of inventory relative to annual

sales is decreasing.• Firms are focusing on reducing setup and

order costs, resulting in smaller economic order quantities.

• Firms are working more closely with vendors to reduce product throughput times and, consequently, lead times.