Manufacturing

Planning and Control

MPC 6th Edition
Chapter 11

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Order Point Inventory

Control Methods
Order point methods are used to determine
appropriate order quantities and timing for
individual independent-demand product
items that are characterized by random
customer demand.
Performed well, these inventory management
functions can provide appropriate levels of
customer service without excess levels of
inventory and/or cost.
11-2

AgendaOrder Point
Inventory Control Methods

11-3

Basic Concepts

Inventory supports both independent- and

dependent-demand items
Independent-demand

inventoriesprimarily
influenced by factors outside of company
decisions (e.g. random variation)
Demand forecasts estimate the average usage rate
and pattern of variation

Dependent-demand

inventoriesinfluenced
mainly by internal factors within the firms control
11-4

11-5

Inventory Management
Issues

Routine inventory decisionshow much to

order and when to order
Inventory

control decision rules can simplify

these decisions

11-6

Parameters:

Q Order a fixed quantity Q.

S : Order up to a fiexed expected opening

inventory quantity S

R : Place an order when the inventrory

drops to R level.

T : Place order every (T) period

11-7

Inventory Management
Issues

Determining Inventory System Performance

Inventory

turnover (annual sales divided by

average inventory investment)
Fill rate (percentage of units available when
requested by customers)

Allows comparison of different systems and

evaluation of system changes

11-8

Inventory Management
Issues
Implementing Changes in Managing
Inventorymaking the appropriate changes at
the right time is critical
More formalized change management system
is required as the scope of the business
increases

11-9

Inventory-Related Costs

Incremental costsdoes the cost represent an actual expenditure or lost

profit? Does the cost actually vary with the decision being made?
11-10

Economic Order Quantity

(EOQ) Model

Describes the relationship between cost of

ordering, cost of carrying inventory, and the
order quantity

A
Q
TAC ( )C P ( )C H
Q
2
Total Costs
Ordering Costs

Inventory
Holding Costs
11-11

Determining the EOQ

Graphical Method
A = 1,250
Cp = 6.25
CH = 25
TAC=(1,250/Q)6.25+(Q/2)25

TAC curve shows clear minimum

value at Q=25

11-12

Determining the EOQ

Deriving the EOQ Formula
Derivative of TAC
with respect to Q
Set derivative
equal to zero and
solve for Q

Economic time between orders (TBO)

TBO

EOQ
D

11-13

TV Retailer example:

_________
EOQ = 2*Cp*A/CH

If A = 1250 units/year
Cp = 6.25 $/order (or setting up)
CH = 25 $/unit/year
______________
EOQ = 2*6.25*1250/25 = 25
When we buy tvs we should buy them in lots of 25.

11-14

Number of Orders NO = Demand/EOQ =

1250/25 = 50 orders/year (once a week)
Time between orders TBO (weeks)
TBO = EOQ/Acerage weekly demand
Decision Rule: Q,T. Buy 25 every weak
Total Annual Cost TAC = (A/Q)* Cp +
(Q/2)*CH=1250/25*6.25+25/2*25=625

11-15

Example

A major equipment producer sells 4000 units of its

$90/unit product per year. Ordering costs are $30
and holding costs are 8% of the product unit value
per year. Each items requires 5 square meters for
storage (product cannot be piled on top of each
other) and there is currently space in the
warehouse. The space available is of size 20 by 40
meters to store the items.
a) What lot size should he use?
b) What is the total annual cost?
c) Does he need additional space? How much, if
any?
11-16

Example (Cont.)
________________
a) Q* = 2*4000*30/(.08*90) = 182.6
b) TSC = 4000/182.6*30 +
182.6/2*(.08*90) = 652.6 + 652.6

c) Area = 182.6*5 = 912.9

Area

= 20*40 = 800
Additional area needed = 112.9 m2

11-17

Example

a)
b)

For a manufacturing operation, parts are

needed at a rate of 180 parts per day.
Set up costs is $150 and the carrying
cost is $0.25 per unit per year. The firm
operates 250 days per year.
What is the economic lot size?
What is the total stocking cost?

11-18

Example (cont.)

a)

b)

__________________
Q* = 2*150/0.25 = 7348.5
TAC = 7348.5/2*.25 +
250*180/7348.5*150 = 918.6 + 918.6
= 1837.1

11-19

Order Timing Decisions

Q,R rule
When

stock reaches predetermined inventory

level (R), a fixed quantity (Q) is ordered
Order point is influenced by demand rate,
replenishment lead time, uncertainty of demand
rate and replenishment lead time, and
acceptable level of customer service
Safety stock is the difference between average
demand during lead time and the reorder point
11-20

Safety Stock in a Q,R

system
Order
quantity (Q)

Inventory level

Reorder point

Safety stock
R

Time
Lead time
11-21

Determining the Safety

Stock in a Q,R system

Stockout probabilityspecify an acceptable

risk of stocking out during any given
replenishment cycle
Carry

stock sufficient to satisfy expected

demand with this probability

Customer service leveldefine an acceptable

level of customer service (percent of demand
met from inventory)

SL 100 (100 / Q)

d max

P(d )(d R)

d R 1

11-22

Stockout Probability
With a lead time
of one day, 95%
of cycles will
experience
demand for 7 or
fewer units

Safety stock of 7
units will provide 5%
chance of stockout
during a one day
lead time
Sum of demand
probability is
0.05 (5%)
11-23

Customer Service Level

A reorder point
of 5 units has a
35% chance of
stockout, with
an average of
0.56 units short
each cycle

Sum = 0.35

11-24

Discrete Distribution ex:

Problem :
Demand during lead time discrete distribution:
Probability
Deman

0.05
20

0.15
21

0.2
22

0.3
23

0.1
24

0.15
25

0.05
26

What is the probability of demand to be less than 22?

.2 = % 20

What is the probability of demand to exceed 22?

.3 + .1 + .15 + .05 = .6 =% 60

What is the expected demand during lead time?

(.05)20 + (.15)21 + (.2)22 + (.3)23 + (.1)24 + (.15)25 + (.05)26 = 22.9 units
11-25

Olaslk
Talep

0.05
20

0.15
21

0.2
22

0.3
23

0.1
24

0.15
25

0.05
26

If we take our reorder point as 22, what is our expected units short (the
demand that cant be filled)?
If demand is 20, 21, or 22, we dont have any units short

We have shortage, only if demand is 23, 24 or 25

Expected units short= (.3)23 + .1(24) + .15(25) + .05(26) = 1.15

If the order quantity is 23, what would be our customer service level ?
1 1.15/23 = .95 = 95 %
11-26

Safety Stock with

Continuous Distributions

Reorder point

Probability of
at least one
stockout
during cycle

Expected
number of
stockouts per
cycle

11-27

Probability of Stocking Out

R = davg + S
(average deman during lead time davg
+ Safety Stock S)
S = Z d
R = davg + Zd
Z, standart deviation multiple corresponding to
relevant stockout probablility according to normal
distribution
(Example% 5 Stockout = 95% SL Z=1,645).
d ... Standard deviation in demand, during lead time
11-28

Probability of Stocking Out

Probability of demand
between 3.5 and 6.5 units
is 0.6827. Probability of
stockout when safety
stock is 1 unit is 0.3173
(1 0.6827)

Safety stock = Zd
Reorder point = mean demand during replenishment lead time + Zd
Z = appropriate value from standard normal table
d = standard deviation of demand during replenishment lead time

11-29

Example
Q = 5;

d = 1.5;

Stockout Probability = % 5 -> SL = 95%

R = d + Z d = 5 + 1.645*1.5 = 5 + 2.5
= 7.5
Result: Reorder Point =8 ;
Order Quantity Q=5
Safety Stock= 3
11-30

Customer Service Criterion

Calculate E(Z) using
the desired service
level (SL) and
reorder quantity (Q)

Find the calculated

E(Z) in the chart to
determine the Z
value
Safety stock = Zd
11-31

Customer Service Criterion

Annual stockout quantity=
Stockout probability* annual demand
(1 SL) * D
This value is equal to stockout quantity per
order (d E(Z)) * number of orders per year
(1 SL) * D = d E(Z) [D/Q]
(1-SL) = d E(Z)/Q
E(Z) = Q(1- SL)/d
11-32

Example
Q = 5; d = 1.5

SL = 95%

E(Z) = Q(1 - .05)/d = 5*.05/1.5

= .167
From the normal distribution table Z = 0.6
R = d + Zd = 5 + 0.6*1.5 = 5 + 0.9 = 5.9
Order Q=5, once inventory drops to 5.9 (6)
11-33

Example:
D = Annual demand 1000
LT=15 days
Q = 200
Service Level = 95 % (.95)
Annual number of days= 250 d=50 units
Average daily demand=1000/250 = 4 /day
R = d + Z d = 4*15 + Z(50)
E(Z)=(1-.95)200/50 = 0.2 from tables
Z = 0.49
R = 4(15) + 0.49*50 = 84.5
11-34

Example (Cont.)
Policy:
When inventory level gets to 85 or less then order 200.
What is the expected number of units short per order?
E(Z) d = 0.2 * 50 = 10
How many orders per year?
(1000/200)= 5
Total number of units short?
10*5 = 50 (Service level is 95%; 950/1000)

11-35

Time Period Correction

Factor

Variations in demand and lead time complicate

the calculations
When standard deviation of
demand is measured over a
different time period than
the lead time, correction is
required

When both demand and

lead time vary, additional
adjustments are required
2

d D m

d L D L2

Safety Stock Z D m

D average demand per period

lead time
demand period

L average lead time in periods

2
D

11-36

Forecast Error Distribution

Safety stock can be based on forecast error
rather than historical demand variation
Standard deviation = 1.25 MAD

MAD

mean absolution deviation

11-37

Multi-Item Management
Management attention should be focused on
the most important items
ABC analysis segments the inventoried items
according to annual cost volume usage
(unit cost x annual usage)
A items are the most important

This

small percentage of items usually makes

up a majority of annual cost volume usage

B and C items are progressively less critical

11-38

ABC Analysis

3 classes
A

Basic classification parameter is annual cost

$

class, B class, C class

volume = Annual demand x Unit cost

Result of ABC analysis

A

class material is important

Accurate Ccunting of A class material is more
important
Forecasts regarding class A materials are of more
signaficance
11-39

ABC Analizi
Dollar Usage
Category # of items % of items % of $ use
A
15
11
84%
B
25
15
15
C
88
74
1
Total
128
100
100

11-40

ABC Analysis - Criticality

Criticality
Category # of items % of items % of $ use
I
5
4
40%
II
48
39
56
III
75
57
4
Total
128
100
100

11-41

ABC Analysis Two sided

view
Dollar Usage
A
B
C
Total

Criticality
I
II
III Total
2
12 1
15
1
19 5
25
2
17 69 88
5
48 75 128

11-42

ABC Analysis Combined

Combined
#
Category of items
AA
14
BB
16
CC
98
Total
128

%
%
of items of $ use
11
78%
13
12
76
10
100
100

11-43

Inventory management policies

according to multi-criteria ABC analysis
AA

BB

CC

Counting
Frequency

monthly

Every six
months

yearly

Order quantity

Low
quatity

EOQ

Large quantity

Safety stock

High for
critical
items

High for
critical items

Low or none

Every 6
months

yearly

Reclassification Every 6
months

11-44

Principles
The difference between dependent and independent
demand must serve as the first basis for determining
appropriate inventory management procedures.
Organizational criteria must be clearly established
before we set safety stock levels and measure
performance.
A sound basic independent demand system must be
in place before attempting to implement advanced
techniques.

11-45

Principles
Savings in inventory-related costs can be
achieved by a joint determination of the order
point and order quantity parameters.
All criteria should be taken into account in
classifying inventory items for management
priorities.
The functions of inventory are useful principles to
apply in determining whether or not inventory
reductions can be made.

11-46

Quiz Chapter 11

Order point methods are generally used for _____________

demand items.
Cycle stock is are a result of manufacturing lot sizes?
(True/False)
Stock produced for upcoming promotional events would be
considered _______________ stock.
The two main decisions when managing independent
demand items are _______________ and ______________.
A measurement that relates inventory levels to product sales
volume is ___________ _____________.
The three types of costs associated with holding inventory
are ____________, ______________, and ____________.
11-47