Supply Chain Management

By
Dr. Asif Mahmood
drasif@uet.edu.pk
Chapter 5: Managing Economies of Scale in a Supply
Chain: Cycle Inventory
 Inventory
Inventory: a stock or store of goods
Independent Demand
 Independent demand –
finished goods, items that are A Dependent Demand
ready to be sold
 Demand is uncertain. B(4) C(2)
E.g. a computer
D(2) E(1) D(3) F(2)

 Dependent demand – components of finished

products
 Demand is certain.
 E.g. parts that make up the computer
 Types of Inventories
• Raw materials & purchased parts
• Partially completed goods called
work in progress
• Finished-goods inventories
– (manufacturing firms) or
• Merchandise
– (retail stores)

• Replacement parts, tools, & supplies

• Goods-in-transit to warehouses or
customers
Role of Inventory in the Supply
Chain
Improve Matching of Supply
and Demand
Improved Forecasting

Reduce Material Flow Time

Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

Figure Error! No text of
 Functions of Inventory
• Meet anticipated demand
• Smooth production requirements
• Decouple operations
• Protect against stock-outs
• Take advantage of order cycles
• Help hedge against price increases
• Permit operations
• Take advantage of quantity discounts
Level of customer service vs costs of ordering
and carrying inventory
 Inventory Counting Systems
• Periodic System
Physical count of items made at periodic intervals
• Perpetual Inventory System
System that keeps track of removals from inventory continuously, thus
monitoring current levels of each item
• Two-Bin System
Two containers of inventory; reorder when the first is empty
• Universal Product Code
Bar code printed on a label that has information about the item to
which it is attached
• Point-of-sale (POS) systems 0
A system that electronically records actual sales.
214800 232087768
Such demand information is very useful for enhancing forecasting and
inventory management
 Key Inventory Terms
• Lead time: time interval between ordering and
receiving the order
• Inventory Costs
– Purchase costs: the amount paid to a vendor or supplier
to buy the inventory
– Holding (carrying) costs: cost to carry an item in
inventory for a length of time, usually a year
– Ordering costs: costs of ordering and receiving
inventory (set up cost…)
– Shortage costs: costs when demand exceeds supply
• Inventory turnover: Ratio of annual cost of goods sold
to average inventory investment
 Classification Systems
ABC Approach
Classifying inventory according to some
measure of importance and allocating
control efforts accordingly.
A - very important
B - mod. important High
A
C - least important Annual
$ value B
of items

Low C
Low High
Percentage of Items
 ABC Classification Example
Annual Unit Cost Annual $
Item Demand ($) Value Classification
1 1,000 4300 4,300,000 A
2 5,000 720 3,600,000 A
3 1,900 500 950,000 B
4 1,000 710 710,000 B
5 2,500 250 625,000 B
6 2,500 192 480,000 B
7 400 200 80,000 C
8 500 100 50,000 C
9 200 210 42,000 C
10 1,000 35 35,000 C
11 3,000 10 30,000 C
12 9,000 3 27,000 C
 How Much to Order: EOQ Models
1. Economic order quantity (EOQ) model
– The order size that minimizes total annual
cost
The Inventory Cycle

The Inventory Cycle—Example

 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q
 Total Cost

Cost Minimization Goal

Linear and positive Non-linear and inverse

Carrying and ordering

costs are equal

Q/2*H=D/Q*S
U-Shaped Solve for Q…
Minimum Total Inventory Cost

The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.

Q = DS
H
2 Q
TC = 2 (Q/2)H = 2 (D/Q)S
 Deriving the EOQ

Using calculus, we take the derivative of

the total cost function and set the
derivative (slope) equal to zero and solve
for Q.
2DS 2( Annual Demand )(Order or Setup Cost )
Q OPT = =
H Annual Holding Cost

Length of order cycle = Q0/D

 Example 1
• A local distributor for a national tire company
expects to sell approximately 9,600 steel-
belted radial tires of a certain size and tread
design next year. Annual carrying costs are
$16 per tire, and ordering costs are $75. The
distributor operates 288 days a year.
a.What is the EOQ? (300 tires)
b.How many times per year does the store
reorder? (32)
c.What is the length of an order cycle? (nine
working days)
 Example 2

• Piddling Manufacturing assembles

television sets. It purchases 3,600 black
and white pictures tubes a year at $65
each. Ordering costs are $31, and annual
carrying costs 20% of the purchase price.
Compute the optimal quantity and the total
annual cost of ordering and carrying the
inventory.
• Q0 = 131 picture tubes
• TC = $852+$852 = $1,704
 Reorder Point
:Under Certainty (Constant Demand and Lead Time Model

Reorder Point - When the quantity on hand of an item drops

to this amount, the item is reordered
• ROP = Demand (per day or week) X Lead time (day or week)
Example
Tingly takes Two-a-Day vitamins, which are delivered to his home by a
routeman seven days after an order is called in. At what point should
Tingly reorder?
Usage = 2 vitamins a day
Lead time = 7 days
Solution:
ROP = Usage x Lead time
= 2 vitamins per day x 7 days
= 14 vitamins
 Reorder Point: Under Uncertainty

• Demand or lead time uncertainty creates the possibility that

demand will be greater than available supply
• To reduce the likelihood of a stockout, it becomes necessary to
carry safety stock
– Safety stock
• Stock that is held in excess of expected demand due to variable
demand and/or lead time

–.
Expected Demand
ROP = + Safety Stock
during Lead time
 The ROP based on a normal
Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale

Service Level = 100%- Stock-out risk

 Fixed-Order-Interval Model
Orders are placed at fixed time intervals
Benefits
• Tight control of inventory items
• Items from same supplier may yield savings in:
– Ordering
– Packing
– Shipping costs
• May be practical when inventories cannot be closely
monitored
Disadvantages
• Requires a larger safety stock
 Single-Period Model
Single-period model
Model for ordering of perishables and other items with limited useful lives
Shortage cost
Generally, the unrealized profit per unit
Cshortage = Cs = Revenue per unit – Cost per unit
Excess cost
Difference between purchase cost and salvage value of items left over
at the end of the period
Cexcess = Ce = Cost per unit – Salvage value per unit

• The goal of single-period model is to identify the order quantity that will
minimize the long-run excess and shortage costs
 Optimal Stocking Level (So)
Order Cycle Service Level - Probability that demand
will not exceed supply during lead time.
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit
Service level = 100 percent – Stockout risk
Ce Cs

Min Demand Seesaw Max Demand

Potential Profit would come
Service Level with additional quantity

Potential Loss would incur Demand

Quantity
with additional quantity uncertainty
So
Balance point (Both Costs are equal)
 Example
• Sweet cider is delivered weekly to Pappy’s Produce Stand. Demand varies uniformly
between 300 liters and 500 liters per week. Pappy pays 20 cents per liter for the
cider and charges 80 cents per liter for it. Unsold cider has no salvage value and
cannot be carried over into the next week due to spoilage. Find the optimal stocking
level and its stock-out risk for that quantity.
• Ce = $0.20 per unit
• Cs = $0.60 per unit
• Service level = Cs/(Cs+Ce) = .6/(.6+.2)
• Service level = .75
Ce Cs
So = 300+0.75(500-300)
= 450
Service Level = 75%

Min Demand Max Demand

=300 =500
Quantity
Stockout risk = 1.00 – 0.75 = 0.25
 Supply Chain Strategy
• Too much inventory
– Tends to hide problems
– Makes easier to live with problems than to
eliminate them
– Costly to maintain
• Wise strategy
– Reduce lot sizes
– Reduce safety stock
 Exercises
• Economic Order Quantity Demand for the Deskpro computer at Best
Buy is 1 ,000 units per month. Best Buy incurs a fixed order
placement, transportation, and receiving cost of $4,000 each time an
order is placed. Each computer costs Best Buy $500 and the retailer
has a holding cost of 20 percent. Evaluate the number of computers
that the store manager should order in each replenishment lot.
• Solution page 270