Sacramento State



INVENTORY MANAGEMENT

TYPES OF INVENTORY

Raw materials and components

Semi-finished (work-in-process) goods

Finished products

Maintenance, repair, and operating (MRO) supplies

Goods-in-transit (pipeline inventory)

FUNCTIONS OF INVENTORY

1. Reduce the lead time between the request and meeting of a demand.

2. Allow the supply-production-distribution subsystems to work independently and efficiently.

3. Absorb unforeseen events or forecast errors.

3. Take advantage of cost-reducing opportunities (e.g., quantity discount, joint orders, and economies of scale).

4. To smooth production requirements

BASIC INVENTORY SYSTEMS FOR INDEPENDENT DEMAND

1. Perpetual (fixed-order quantity) system -- Order the same amount of stock every time the inventory level reaches a certain point (reorder point).

2. Periodic (fixed-order interval) system -- Order stocks on a fixed-time cycle.

EVALUATION OF INVENTORY SYSTEMS

1. Inventory Turnover = Annual Cost of Goods Sold

Average Inventory Value

It is generally assumed that a larger inventory turnover is desirable. But an organization should not consider the financial aspect of inventory alone. The effect of inventory on operations and customer service should also be considered.

2. Days of inventory on hand

INVENTORY COSTS

1. Purchase (or acquisition) price/cost ($ P/unit).

2. Ordering or setup costs ($ S/order).

5. Carrying or holding costs ($ H/unit-year) -- capital cost, taxes, insurance, storage, obsolescence, deterioration, etc.

4. Shortage or stock out costs ($ B/unit of stock out) -- backorder cost, lost sales, good-will erosion.

PRACTICAL CONSIDERATION IN INVENTORY MANAGEMENT

1. Inventory catalog -- Identification of all inventory items.

Part name, part number, manufacturer(s), unit cost, substitute part number, purchase lead time, safety stock, order quantity, etc.

2. ABC analysis -- Determination of the relative importance of each item with respect to inventory value.

Group the inventory items in three or more classes based on annual dollar usage followed by non-cost factors.

A items --15-25% of items represent 75% of total inventory value.

B items -- 20-30% of items represent 20% of total inventory value.

C items -- 50-60% of items represent 5% of total inventory value.

3. Inventory counting

Periodic physical counting system

Cycle counting system

INVENTORY MODELS FOR INDEPENDENT DEMANDS

Questions: (a) When to order?

(b) How much to order?

1. Deterministic Models

Basic Fixed-Order Quantity Model

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1

Sensitivity of the EOQ Model

Studies have shown that the EOQ model is not sensitive to errors or changes in the values of carrying and ordering costs, but is very sensitive to changes in demand. Therefore, the demand forecast should be evaluated and updated periodically when the EOQ model is used in practice.

2. Probabilistic Models

Sources of Uncertainty

a. Demand

} Lead Time Demand

b. Lead Time

Safety Stock (Buffer Stock)

Safety stock is the extra inventory held beyond the average demand in an order cycle.

Methods of Establishing Safety Stock

a. Through the use of a rule of thumb.

Examples: Safety Stock = 3 weeks of average demand

b. Based on comparison between carrying cost and shortage cost.

c. Based on service considerations, e.g., probability of no stock out in an order cycle, expected number of units short in a year, etc.

Use Actual Demand or Sales Data

|Possible Demand During Lead Time |Number of Occurrence (Frequency) |Probability of Occurrence |Cumulative Probability |

|10 |2 | | |

|11 |3 | | |

|12 |3 | | |

|13 |5 | | |

|14 |2 | | |

|15 |2 | | |

|16 |3 | | |

|(Possible) Reorder Point |Safety Stock |Probability of Not Stocking Out |Probability of Stock Out |

| | |(Service Level) | |

|10 | | | |

|11 | | | |

|12 | | | |

|13 | | | |

|14 | | | |

|15 | | | |

|16 | | | |

Use the normal probability distribution

Assume that the demand during lead time has a normal distribution with mean of 100 and standard deviation of 20. If the reorder point is 130, what is the corresponding service level (i.e. probability of not stocking out)?

Assume that the standard deviation of lead time demand is 20 units and the lead time demand is close to a normal distribution. For a service level of 80 percent, what is the required amount of safety stock? What is the expected number of units short in an order cycle?

COMPARISON OF INVENTORY SYSTEMS

Fixed-Order Quantity System

➢ Provides an effective, meaningful order size.

➢ Safety stock is needed during one lead time period only.

➢ Pays less attention to slow-moving items, e.g., spare parts.

➢ Requires continuous monitoring of inventory level.

Fixed-Order Interval System

➢ Requires only periodic monitoring of inventory level.

➢ Safety stock is needed against stock out during one lead time plus one order cycle.

➢ Ideal for using combined (joint) orders.

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