Mgt-501

2ND Midterm

INTRODUCTION TO OPERATION MANAGEMENT

The Operating Environment

Customers

Suppliers
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Types of inventory

Q
Vendor 1

Vendor 1

Inventory

Inventory

Cycle Inventory:

Safety Stock:

Pipeline (Transit) Inventory:

Anticipation (Seasonal) Inventory:

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Classification of inventories:

One way of classification inventories is by how it is created. In this context, there are 4
types of inventories for an item.

 Cycle Inventory:
 Safety Inventory:
 Pipeline (Transit) Inventory:
 Anticipation (Seasonal Inventory:

Cycle inventory: the proportion of total inventory that varies directly with lot is
called CI. Lot size (Q) explains how much to order at a time and how frequently to
order.

 Ordering large quantities so as to reduce the number of orders that must be placed
each year increases it.

 Lot size, Q varies directly with elapsed time ( or cycle) between orders. If a lot is
ordered every 5 weeks, the average lot size must equal five weeks, demand.

 The longer the time between orders for a given item, the grater the cycle
inventory must be.

 At the beginning of the interval, the CI is at its max or Q, whereas, at the end of
interval (just before a new lot arrives) CI drops to its minimum or 0.

 The average cycle inventory (ACI) = (Q + 0) / 2

Example : Lot size of an item is 100 units and the ordering cycle average 2 months .
what are the item’s annual demand and cycle inventory?

Solution : Annual Demand : 6 x 100 = 600

CI = 100+0/2 = 50

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(2) Safety Stock - companies hold safety stock to avoid customer service problems and
the hidden cost of unavailable components. Having the item available when the problem
occurs allows subsequent operations to continue

To create safety stock, a firm places an order form delivery earlier than when the item is
typically needed. The replenishment order therefore arrives ached of time, giving a
cushion against uncertainty.

e.g suppose the average lead-time from a supplier is 3 weeks but a firm orders 5 weeks in
advance just to be safe . This policy creates a safety stock equal to 2 weeks of supply (5-
3)

(3) Anticipation inventory – anticipation inventory basically refers to inventory that is

used to absorb uneven rates of demand or supply which business often faces.
Manufactures of air conditioners e.g. can experience 90% of their annual demand just 3
months of a year.

Such uneven demand may lead a manufacture to stockpile anticipation inventory during
periods of low demand so that levels don’t have to be increased much when demand
peaks.

Pipeline inventory – pipeline inventory basically refers to inventory moving from point to
point in the materials flow system. Materials move from suppliers to a plant, from one
operation to the next in the plant, from the plant to a DC or customer, and from the DC to
a retailer. Pipeline inventory consist of orders that have been placed but not yet
received.

Pipeline inventory between two points, for either transportation or production, can be
measured as the average demand during the lead-time, DL, which is the average demand
for the item per period (d) times the number of periods in the lead time (LT) to move
between two points , or

Pipeline Inventory = DLT = d * LT

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Inventory management

How should inventory levels be measured and evaluated?

Holding inventory may prove to be useful at times but costs are associated with
doing so. This is why mangers closely monitor measures of inventory to keep
them at acceptable levels.

There are 3 (three) basis ways of measuring inventories. All the three methods
involve a physical count.

The three methods are:

1. Average aggregate inventory value
2. Weeks of supply
3. Inventory turnover

1. Average aggregate inventory value:

Average aggregate inventory value = (# of units of item A) (value of each unit) +
(# of units of item B)(value of each unit)

It is average since it usually represents inventory investment over some period of

time ( i.e. a month or quarter)

Manufacturing firms typically have about 25% of their assets in inventory whereas
retailers and wholesalers average about 75%.

2. Weeks of supply: It is an inventory measure obtained by dividing the

average aggregate inventory value by the sales per week.

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Weeks of supply = average aggregate inventory value / weekly sales at cost

N. B: although numerator includes the value of all items (RM, WIP, FG) the
denominator represents only the finished goods of sold.

4. Inventory turnover (or turns) : an inventory measure obtained by

dividing annual sales at cost by the average aggregate inventory value
maintained during the year.

Inventory turnover = Annual sales at cost / average aggregate inventory value

The typical inventory level is 6 to 7 turns per year. However, it can settle for
only 3 turns per year for high-tech firms while it can be high as 40 turns per
year for an automobile firm.

Problem:
A company averaged $2 million in inventory last year, and the cost of good
sold was $ 10 million. If the company has 52 business weeks per year, how
many weeks of supply were held in inventory? What was the inventory
turnover?

Elucidation

Relevant costs:
Inventory Holding Cost

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Ordering/ Set-Up Cost
Purchasing Cost
Transpiration Cost

Two different demand categories:

Independent demand
 Demand for a product comes from an external source (market)
 Demand for a product is not related to demand for other products
 Demand for a product has to be forecasted / estimated
e.g How many bicycles will be sold next week?

Important considerations
What to order?
How much to order?
When to order?

Dependent demand
 Demand for an item is related to the demand for another item (see Bill of
materials (BOM) for a lamp below)
 Demand for an item can be calculated, need not be forecasted.
e.g. If 100 bicycles need to be sold, we need to produces 100 farmers, 200
wheels, 100 saddles etc

Simplified product structure for a lamp

Lamp

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Base Shade Socket

assembly assembly

Shaft Plate Hub Screws Holder Socket Wiring

assembly

Tubing
Wire Terminals

A
1 week

B 11 weeks E 1 week
(1) (4)

C 1week D 5 weeks
(1) (1)

Three Basic Questions in the Management of Independent Demand Inventories:

 What to order?
 When to order?
 How much to order?

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a. Continuous Review System/Q-System/Fixed Order Quantity System :

*Ordering quantity (Q) remains same
*Time interval between orders varies

b. Periodic Review System / P-System

*Ordering quantity (Q) varies
*Time interval between orders remains same

How Much To Order?

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Suppose Annual Demand = 1200 Units

Case 1:

Order Quantity (Q) = 300 Units

Number Of Orders Per Year = 1200/300 = 4
Average Inventory Level = (Max + Min)/2 = (300 + 0) / 2 =150

Case 2:

Order Quantity (Q) = 100 Units

Number Of Orders Per Year = 12
Average Inventory Level = 50

In General:
Annual Demand: D
Order Quantity: Q
Number Of Orders Per Year (D/Q)
Average Inventory Level :(Q/2)

350

300

250

200

150

100

50

Suppose The Related Costs For The Example Are:

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S = $ 100 Per Order (Ordering Cost)
H = $ 6 Per Unit Per Year (Holding Cost)
C= $ 30 Per Unit (Item Cost), Regardless Of How Many Are Purchased.

For Both Cases,

Annual Purchasing Cost = 1200 X $ 300 =

Variable Costs:
Case 1
Annual Ordering Cost = 4 * 100 = $400
Annual Holding Cost = 150 * 6 = $900
Annual Total Variable Cost = $1300

Case 2
Annual Ordering Cost =1200
Annual Holding Cost= 300
Annual Total Variable Cost = 1500
Note The Behavior Of Ordering Cost Vs Holding Costs In The Above Cases.
What Order Quantity Will Yield The Lowest Annual Total Variable Cost?
# In General
Annual Purchasing Cost = Annual Demand * Item Cost ( D X C)
Annual Ordering Cost = # Of Orders * Ordering Cost[( D/Q) * S]
Annual Holding Cost = Avg. Inventory Level * Holding Cost/Unit/Year [ (Q/2) * H]

2500

2000

1500

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1000

500

100 200 300 400 500 600

The Order Quantity , Q , that produces the lowest Annual Total Variable Cost is obtained
when Annual Ordering Cost = Annual Holding Cost

[D/Q]*S = [Q/2]*H
or
Q2 = [2*D*S]/H
Or
Q* = 2* D*S/H Henceforth, we’ll call Q* the EOQ

For the example , the optimal values are:

EOQ =

Annul Ordering Cost =

Annual Holding Cost =

Annual Total Variable Cost =

Determination of cost parameters:

Holding cost per unit Vs. Holding Rate per $1
H = Holding cost of one unit of an item in inventory per year
h = holding rate of one dollar’s worth of inventory , usually expressed as a percentage,
e.g. 35%

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H = holding rate ( h) * cost of one unit of the item ( c ),
e.g. if a tire costs $ 45 and h is 0.35, then the cost of carrying this for one year is
The inventory carrying cost is estimated from
Storage costs: fixed & variable cost
Cost of money tied in inventory
Obsolescence, insurance, Taxes, etc.

Ordering cost / set-up cost

Ordering cost for purchased items (cost of placing an order to the vendor), which can be
estimated by:
 Following the “cost” of a typical” order
 Accumulating the pertinent costs during the year and dividing by the
total number of orders process during the year.

Set-up cost for manufactured items ( cost of changing the machine configuration,
cleaning, preparing and loading the machine, i.e. , setting up the process for the next time
to be manufactured) . the set-up cost is estimated from the cost of direct labor time
involved and the associated overhead.

Hoe would the set-up times in a paint factory?

Will it be different going from light to darker colors?
Will it be different going from water base to oil base?

Quantity Discounts
Usually vendors provide discounts if purchases are made in large quantities of a certain
time or when a group of items are combined. Furthermore, economics of scale also exist
in transportation costs when large volumes are shipped.

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Examples:
D = 1600 units/ year
S = $ 10
h = 20%
Suppose the vendor gives the following discounts:

Quantity purchased prices

1 – 799 units $ 1.00 per unit
800 – 1599 units $ 0.98
1600 & more $ 0.97

EOQ is 400 units at $ 1.00 and close to 400 units at other costs.
How many should we buy at a time?
Price Order Annual Annual Annual Annual
Quantity Purchasing Ordering Holding Total Cost
Cost Cost Cost

How to choose the best order quantity

1. Calculate the EOQ for the lowest cost. If it is within the discount range, that the
best choice that will yield the annual total cost
2. If the EOQ is not within discount range for the lowest cost, calculate the EOQ for
other cost options. Compare the Annual Total Costs for each cost using either the
EOQ (if it is within the discount range), or the minimum quantity necessary to
obtain the discount. Choose the quantity that results in lowest annual total Cost

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Example:
D = 750 Discount Range:
S = $ 160 per order
h = 30%

Price Order Annual Annual Annual Annual

Quantity Purchasing Ordering Holding Total Cost
Cost Cost Cost

When to Order
So far we have studied the components behind how much to order. Equally important is
the timing of orders. Namely, the determination of when the order should be placed,
referred to as the “ Re-Order Point (ROP)’. Usually, ROP is stated in units of inventory,
however, it can also be stated in terms of time. Clearly he major factors influencing this
decision are lead-time and how well we know the demand during lead-time.
The following situations are possible :
Lead time Demand
Constant constant
Constant Varies

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Varies Constant
Varies Varies
When the demand and lead time (LT) are constant, we should place the order when we
have just enough inventories to cover the demand during the lead time (DLT). For
example if the lead time is 2 weeks and the demand is 25 units per week, then we should
place another order when we have 50 units left in stock.

ROP = Demand During Lead Time

ROP = ( Demand per period) * ( # of periods in LT)

Another example:
D = 1200 units (100 units per month)
Q = 300 units
Lead Time = 1 month
When should we place the order?

Let’s develop the ROP based on the assumption that demand follows a normal
distribution.

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