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11 Inventory Management
What is inventory?
An
inventory is an idle stock of material used to facilitate production or to satisfy customer needs
Smooth
immediate service when requirements are uncertain (unpredicatable variability) -safety stock
trade-off shortage cost versus carrying cost
Decoupling
is not instantaneous, there is always material either being processed or in transit - pipeline stock
trade-off cost of speed vs carrying cost
you can see from the above list, there are economic reasons, technological reasons as well as management/operations reasons.
attributed to:
Opportunity cost (financial cost) Physical cost (storage/handling/insurance/theft/obs olescence/)
Inventory Management
Independent Demand
Dependent Demand
B(4)
C(2)
D(2)
E(1)
D(3)
F(2)
Types of Inventories
Raw
materials & purchased parts Partially completed goods called work in progress Finished-goods inventories
(manufacturing firms) or merchandise (retail stores)
System
Inventory System
System that keeps track of removals from inventory continuously, thus monitoring current levels of each item
inventory; reorder when the first is empty Universal Bar Code - Bar code printed on a label that has information about the item to which it is attached 0
214800 232087768
High
Annual $ volume of items Low Few Many
B C
Number of Items
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models are trying to answer the following questions for given informational, economic and technological characteristics of the operating environment: How much to order (produce)? When to order (produce)? How often to review inventory? Where to place/position inventory?
quantitative inventory management models range from simple to very complicated ones. However, there are two simple models that capture the essential tradeoffs in inventory theory
The newsboy (newsvendor) model The EOQ (Economic Ordering Quantity) model
newsboy model is a single-period stocking problem with uncertain demand: Choose stock level and then observe actual demand.
Tradeoff: overstock cost versus opportunity cost (lost of profit because of under stocking)
cost (Cs) - the opportunity cost for lost of sales as well as the cost of losing customer goodwill.
Cs = revenue per unit - cost per unit
Excess
cost (Ce) - the over-stocking cost (the cost per item not being able to sell)
Ce = Cost per unit - salvage value per unit
this model, we have to consider two factors (decision variables): the supply (X), also know as the stock level, and the demand (Y). The supply is a controllable variable in this case and the demand is not in our control. We need to determine the quantity to order so that long-run expected cost (excess and shortage) is minimized.
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X = n and P(n) = P(Y>n). The question is: Based on what should we stock this n-th unit? The opportunity cost (expected loss of profit)for this n-th unit is P(n) Cs The expected cost for not being able to sell this n-th unit (expected loss)
(1-P(n))Ce
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Do
P(n)Cs = (1-P(n)) Ce
Newsboy model
Service
level is the probability that demand will not exceed the stocking level and is the key to determine the optimal stocking level. our notation, it is the probability that YX(=n), which is given by
P(Yn) = 1 - P(n) = Cs/(Cs + Ce)
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In
Example (p.564)
Demand for long-stemmed red roses at a small flower shop can be approximated using a Poisson distribution that has a mean of four dozen per day. Profit on the roses is $3 per dozen. Leftover are marked down and sold the next day at a loss of $2 per dozen. Assume that all marked down flowers are sold. What is the optimal stocking level?
Example (solutions)
Cs = $3, Ce = $2 Opportunity cost is P(n)Cs Expected loss for overstocking (1 - P(n)) Ce P(Y n) = Cs/(Cs + Ce) = 3/((3+2) = 0.6 From the table, it is between 3 and 4, round up give you optimal stock of 4 dozen.
Usage rate
Receive order
Place order
Receive order
Place order
Receive order
The cost per order = S + cQ The length of order cycle = Q/D unit time
The average inventory level = Q/2 Thus the inventory carrying cost
= S + cQ + HQ2/(2D) Thus the total cost per unit time is dividing the above expression by Q/D, I.e., TC = {S + cQ + HQ2/(2D)} {D/Q}
= DS/Q + cD + HQ/2
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Total Cost
TC =
Q H 2
DS Q
Annual Cost
Q OPT =
2DS = H
Total Costs
Cost Adding Purchasing cost doesnt change EOQ TC with PD
TC without PD
PD
EOQ
Introduction to Operations Management
Quantity
34
TCb TCc
Decreasing Price
CC a,b,c
OC EOQ
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Quantity
is a variant of the EOQ model. Quantity discount is another form of economies of scale: pay less for each unit if you order more. The essential trade-off is between economies of scale and carrying cost.
To tackle the problem, there will be a separate (TC) curve for each discount quantity price. The objective is to identify an order quantity that will represent the lowest total cost for the entire set of curves in which the solution is feasible. There are two general cases: The holding cost is constant The holding cost is a percentage of the purchasing price.
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cost = S Purchase cost = ciQ, if the order quantity Q is in the range where unit cost is ci. Carrying cost = (Q/2)h(Q/D)
TC
2DS Q0 h
The questions is: Is this Q0 a feasible solution to our problem?
steps:
1. Compute the EOQ. 2. If the feasible EOQ is on the lowest price curve, then it is the optimal order quantity. 3. If the feasible EOQ is on other curve, find the total cost for this EOQ and the total costs for the break points of all the lower cost curves. Compare these total costs. The point (EOQ point or break point) that yields the lowest total cost is the optimal order quantity.
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Example
The maintenance department of a large hospital uses about 816 cases of liquid cleanser annually. Ordering costs are $12, carrying cost are $4 per case a year, and the new price schedule indicates that orders of less than 50 cases will cost $20 per case, 50 to 79 cases will cost $18 per case, 80 to 99 cases will cost $17 per case, and larger orders will cost $16 per case. Determine the optimal order quantity and the total cost.
Example (solutions)
1. The common EOQ: = {2(816)(12)/4} = 70
2.
= 816(12)/70 + 18(816) + 4(70)/2 = 14,968 3. Total cost at 80 cases per order TC = 816(12)/80 + 17(816) + 4(80)/2 = 14,154 Total cost at 100 cases per order TC = 816(12)/100 + 16(816) + 4(100)/2 =13,354
The minimum occurs at the break point 100. Thus order 100 cases each time
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Using the same argument as in the constant holding cost case, Let TCi be the total cost when the unit quantity is ci.
TCi = rciQ/2 + DS/Q + ciD
Therefore EOQ = {2DS/(rci)} In this case, the carrying cost will decrease with the unit price. Thus the EOQ will shift to the right as the unit price decreases.
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1. Beginning with the lowest price, find the EOQs for each price range until a feasible EOQ is found. 2. If the EOQ for the lowest price is feasible, then it is the Optimal order quantity. 3. Same as step (3) in the constant carrying case.
Example (p.549)
Surge Electric uses 4000 toggle switches a year. Switches are priced as follows: 1 to 499 at $0.9 each; 500 to 999 at $.85 each; and 1000 or more will be at $0.82 each. It costs approximately $18 to prepare an order and receive it. Carrying cost is 18% of purchased price per unit on an annual basis. Determine the optimal order quantity and the total annual cost.
Solution
D = 4000 per year; S = 18 ; h = 0.18 {price} Step 1. Find the EOQ for each price, starting with the lowest price EOQ(0.82) = {2(4000)(18)/[(0.18)(0.82)]} = 988
(Not feasible for the price range).
EOQ(0.85)= 970 (feasible for the range 500 to 999) Step 2. Feasible solution is not on the lowest cost curve Step 3. TC(970) = 970(.18)(.85)/2 + 4000(18)/970 + .85(4000) = 3548 TC(1000) = 1000(.18)(.82)/2 + 4000(18)/1000 + .82(4000) = 3426
Thus the minimum total cost is 3426 and the minimum cost order size is 1000 units per order.
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We
have settled the problem of how much to order. The next decision problem is when to order.
Reorder point
In the EOQ model, we assume that the delivery of goods is instantaneous. However, in real life situation, there is a time lag between the time an order is placed and the receiving of the ordered goods. We call this period of time the lead time. Demand is still occurring during the lead time and thus inventory is required to meet customer demand. This is why we need to consider when to order!
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When to reorder
We
Safety Stock
Quantity
ROP
Safety stock
LT
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Time
When to reorder
In
general, we need to consider the following four factors when deciding when to order:
The rate of demand (usually based on a forecast) The length of lead time. The extent of demand and lead time variability. The degree of stock-out risk acceptable to management.
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When to reorder
We
The demand rate and lead time are constant Variable demand rate and constant lead time.
Reorder Point
ROP
Safety stock
Quantity
z-scale
lead time is constant. In this case, we need extra buffer of safety stock to insure against stock-out risk. Since it cost money to carry safety stocks, a manager must weigh carefully the cost of carrying safety stock against the reduction in stock-out risk (provided by the safety stock)
other words, he needs to trade-off the cost of safety stock and the service level. Service level = 1 - stock-out risk ROP = Expected lead time demand + safety stock = d (LT) + z
Where is the standard deviation of the lead time demand = {LT} d
Example (solution)
Z = 2.055 (from normal distribution table)
Thus ROP = 400 (3) + 2.055 (3) d = 1200 + 32.03 = 1232 The safety stock is approximately 32 washcloths, providing a service level of 98%.
Fixed-order-interval model
In
the EOQ/ROP models, fixed quantities of items are ordered at varying time interval. However, many companies ordered at fixed intervals: weekly, biweekly, monthly, etc. They order varying quantity at fixed intervals. We called this class of decision models fixed-orderinterval (FOI) model.
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FOI model
Why
Is
it optimal?
What
FOI model
Assuming
FOI model
Order quantity
Safety stock
Time OI LT
Receive order
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FOI model
We
use the following notations OI = Length of order interval A = amount of inventory on hand LT = lead time d = Standard deviation of demand
FOI model
Amount
to order
= d(OI LT) z d OI LT A
Example (p.560)
The following information is given for a FOI system. Determine the amount to order. d = 30 units per day, d = 3 units per day, LT = 2 days; OI = 7 days Amount on hand = 71 units, Desired serve level = 99%.