Engineering

Management
MSE407
Manufacturing Systems

Chapter 6
Single-Stage Inventory Control
 Learning Objectives
 Single-stage production systems
 Independent-demand items
 Explain economic order quantity (EOQ) concept
 Explain models available for guiding inventory
planning decisions in various production and
distribution environments
 Present a more technical explanation of trade-offs
associated with inventory control
 Explain decision models for determining optimal
policies

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Types of Inventory

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 Inventory & inventory system

 Inventory is the set of items that an organization holds

for later use by the organization
 An inventory system is a set of policies that monitors
and controls inventory
• How much of each item should be kept
• When low items should be replenished
• How many items should be ordered or made when
replenishment is needed

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 Basic types of inventory

 Independent demand

 Dependent demand

 Supplies

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 Independent Demand
 Independent demand items are those items that we
sell to customers

 Dependent demand items are those items whose

demand is determined by other items.
• Demand for a car translates into demand for four
tires, one engine, one transmission, and so on.
• The items used in the production of that car (the
independent demand item) are the dependent demand
items

 Supplies are items such as copier paper, cleaning

materials, and pens that are not used directly in the
production of independent demand items

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 Why hold Inventory

1. To decouple work centers

2. To meet variations in demand
3. To allow flexible production schedules
4. As a safeguard against variations in delivery time
5. To get a lower price

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 Uses of Inventory

 Anticipation or seasonal inventory

 Safety stock: buffer demand fluctuations
 Lot-size or cycle stock: take advantage of quantity
discounts or purchasing efficiencies
 Pipeline or transportation inventory
 Speculative or hedge inventory protects against some
future event, e.g. labor strike
 Maintenance, repair, and operating (MRO) inventories

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 Inventory Management Objectives
 Provide desired customer service level:
• Percentage of orders shipped on schedule
• Percentage of line items shipped on schedule
• Percentage of dollar volume shipped on schedule
• Idle time due to material and component shortages
 Provide for cost-efficient operations:
• Buffer stock for smooth production flow
• Maintain a level work force
• Allowing longer production runs & quantity
discounts
 Minimize inventory related investments:
• Inventory turnover
• Weeks (or days) of supply
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 Customer Service Level Examples
 Percentage of Orders Shipped on Schedule
• Good measure if orders have similar value. Does not capture
value.
• If one company represents 50% of your business but only 5% of
your orders, 95% on schedule could represent only 50% of value
 Percentage of Line Items Shipped on Schedule
• Recognizes that not all orders are equal, but does not capture $
value of orders.
• More expensive to measure.
• Ok for finished goods.
• A 90% service level might mean shipping 225 items out of the
total 250 line items totaled from 20 orders scheduled
 Percentage Of Dollar Volume Shipped on Schedule
• Recognizes the differences in orders in terms of both line items
and $ value

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 Inventory Investment Measures
Example
The Coach Motor Home Company has annual cost of goods sold of
$10,000,000. The average inventory value at any point in time is $384,615.
Calculate inventory turnover and weeks/days of supply.

 Inventory Turnover:
annual cost of goods sold $10,000,000
Turnover    26 turns
average inventory value $384,615

 Weeks/Days of Supply:

average inventory value $384,615

Weeks of Supply    2 weeks
average weekly COGS $10,000,000/52

$384,615
Days of Supply   10 days
$10,000,000/260

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 Relevant Inventory Costs

Item Cost Cost per item plus any other direct costs
associated with getting the item to the plant

Holding Capital, storage, and risk cost typically stated as a

Costs % of the unit value,
e.g. 15-25%

Ordering Fixed, constant dollar amount incurred for

Cost each order placed

Shortage Loss of customer goodwill, back order

Costs handling, and lost sales

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 Determining Order Quantities

Lot-for-lot Order exactly what is needed

Fixed-order Order a predetermined amount each time an

quantity order is placed-Q System

Min-max When on-hand inventory falls below a

system predetermined minimum level, order enough
to refill up to maximum level
Order n Order enough to satisfy demand for the next
periods n periods

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 Examples of Ordering Approaches
Lot for Lot Example
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 0 0 0 0 0 0 0
Order Placement 40 70 65 60 55 85 75 85

Fixed Order Quantity Example with Order Quantity of 200

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 160 90 25 165 110 25 150 65
Order Placement 200 200 200

Min-Max Example with min.= 50 and max.= 250 units

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 180 110 185 125 70 165 90 165
Order Placement 220 140 180 160

Order n Periods with n = 3 periods

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 135 65 0 140 85 0 85 0
Order Placement 175 200 160
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 Three Mathematical Models for
Determining Order Quantity

 Economic Order Quantity (EOQ or Q System)

• An optimizing method used for determining order
quantity and reorder points
• Part of continuous review system which tracks
on-hand inventory each time a withdrawal is made
 Economic Production Quantity (EPQ)
• A model that allows for incremental product
delivery
 Quantity Discount Model
• Modifies the EOQ process to consider cases where
quantity discounts are available
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 Economic Order Quantity
EOQ Assumptions:
 Demand is known & constant
- no safety stock is required
 Lead time is known &
constant
 No quantity discounts are
available
 Ordering (or setup) costs are
constant
 All demand is satisfied (no
shortages)
 The order quantity arrives in a
single shipment

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 The Economic Order Quantity Model

Assumptions:
 Production is instantaneous. There is no capacity
constraint and the entire lot is produced simultaneously.
 Delivery is immediate. There is no time lag between
production and availability to satisfy demand.
 Demand is deterministic. There is no uncertainty about the
quantity or timing of demand.
 Demand is constant over time. In fact, it can be
represented as a straight line, so that if annual demand is
365 units this translates into a daily demand of one unit.
 A production run incurs a constant setup cost.
Regardless of the size of the lot or the status of the factory,
the setup cost is the same.
 Products can be analyzed singly. Either there is only a
single product or conditions exist that ensure reparability of
products.
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 Notation

 D = Demand rate (in units per year).

 c = Unit production cost, not counting setup or
inventory costs (in dollars per unit).
 A = Constant setup (ordering) cost to produce
(purchase) a lot (in dollars).
 h = Holding cost
 Q = Lot size (in units); this is the decision variable

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 The model
Inventory versus time in the EOQ model

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 The model

Q

 Average inventory level: 2
Q
h
2 hQ
 
 The holding cost per unit: D 2D
A

 The setup cost per unit: Q

c
 The production cost per unit:

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 Economic order quantity
AD hQ
Cost / Time   CD 
Q 2

dCost / Time  AD h
 2
 0  first order condition
dQ Q 2

d 2Cost / Time 2 AD
2
 3  0 for Q  0 (second order condition)
dQ Q
Where:
2 AD A= Fixed cost to place an order

Q  D= Demand rate in units per time
h C= Unit purchase cost of product
h = Inventory holding cost
Τ = lead-time for order delivery 21
 Total Annual Inventory Cost with
EOQ Model
 Total annual cost= annual ordering cost + annual holding costs

D Q 2DS

TCQ   S   H; and Q * 
Q 2 H

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 Continuous (Q) Review System
Example
A computer company has annual demand of 10,000. They want to
determine EOQ for circuit boards which have an annual holding cost (H)
of $6 per unit, and an ordering cost (S) of $75. They want to calculate TC
and the reorder point (R) if the purchasing lead time is 5 days.

2DS 2 * 10,000 * $75

 EOQ (Q) Q   500 units
H $6
 Reorder Point (R)
10,000
R  Daily Demand x Lead Time  * 5 days  200 units
250 days
 Total Inventory Cost (TC)

 10,000   500 
TC   $75   $6  $1500  $1500  $3000
 500   2 

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 Economic Production Quantity (EPQ)

 Same assumptions as the EOQ except: inventory arrives in

increments & is drawn down as it arrives

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 EPQ Equations

 D   IMAX 
 Total cost: TCEPQ   S   H
Q   2 

Maximum inventory:

 d
• d=avg. daily demand rate IMAX  Q1 
• p=daily production rate  p
 Calculating EPQ
2DS
EPQ 
 d
H
 1  
 p

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 Quantity Discount Model

 Same as the EOQ, except:

• Unit price depends upon the quantity ordered
 Use the total cost equation:

 D  Q 
TC QD   S    H   PD
Q   2 

Unit Price X Demand

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 Quantity Discount Procedure

 Calculate the EOQ at the lowest price

 Determine whether the EOQ is feasible at that price
• Will the vendor sell that quantity at that price?
 If yes, stop – if no, continue
 Check the feasibility of EOQ at the next higher price

 Continue to the next slide ...

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 QD Procedure (continued)

 Continue until you identify a feasible EOQ

 Calculate the total costs (including total item cost) for
the feasible EOQ model
 Calculate the total costs of buying at the minimum
quantity required for each of the cheaper unit prices
 Compare the total cost of each option & choose
the lowest cost alternative
 Any other issues to consider?

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 Quantity Discount Example
Collin’s Sport store is considering going to a different hat supplier. The
present supplier charges $10 each and requires minimum quantities of 490
hats. The annual demand is 12,000 hats, the ordering cost is $20, and the
inventory carrying cost is 20% of the hat cost, a new supplier is offering hats
at $9 in lots of 4000. Who should he buy from?
 EOQ at lowest price $9. Is it feasible?

2 DS 2(12,000)( 20)
EOQ$9    516 hats
h $1.80
 Since the EOQ of 516 is not feasible, calculate the total cost (C) for each
price to make the decision

 4000 hats at $9 each saves $9,320 annually. Space?

12,000 490
C$10   $20    $2  $1012,000   $120,980
490 2
12,000 4000
C$9   $20    $1.80   $912,000   $111,660
4000 2 29
 Periodic Review Systems

 Orders are placed at specified, fixed-time intervals (e.g.

every Friday), for a order size (Q) to bring on-hand
inventory (OH) up to the target inventory (TI), similar to the
min-max system.
 Advantages are:
• No need for a system to continuously monitor item
• Items ordered from the same supplier can be reviewed
on the same day saving purchase order costs
 Disadvantages:
• Replenishment quantities (Q) vary
• Order quantities may not qualify for quantity discounts
• On the average, inventory levels will be higher than Q
systems-more stockroom space needed
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 Single Period Inventory Model

 The SPI model is designed for products that share the following
characteristics:
• Sold at their regular price only during a single-time period
• Demand is highly variable but follows a known probability distribution
• Salvage value is less than its original cost so money is lost when these
products are sold for their salvage value
 Objective is to balance the gross profit of the sale of a unit with
the cost incurred when a unit is sold after its primary selling
period

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 Single Period Inventory Example
Tee shirts are purchase in multiples of 10 for a charity event for $8 each. When
sold during the event the selling price is $20. After the event their salvage value
is just $2. From past events the organizers know the probability of selling
different quantities of tee shirts within a range from 80 to 120

Payoff Table
Prob. Of Occurrence .20 .25 .30 .15 .10
Customer Demand 80 90 100 110 120
# of Shirts Ordered Profit
80 $960 $960 $960 $960 $960 $960
90 $900 $1080 $1080 $1080 $1080 $1040
Buy 100 $840 $1020 $1200 $1200 $1200 $1083
110 $780 $ 960 $1140 $1320 $1320 $1068
120 $720 $ 900 $1080 $1260 $1440 $1026

Sample calculations:
Payoff (Buy 110)= sell 100($20-$8) –((110-100) x ($8-$2))= $1140
Expected Profit (Buy 100)= ($840 X .20)+($1020 x .25)+($1200 x .30) +
($1200 x .15)+($1200 x .10) = $1083

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 ABC Inventory Classification

 ABC classification is a method for determining level

of control and frequency of review of inventory items
 A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
 A Items – typically 20% of the items accounting for
80% of the inventory value-use Q system
 B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use Q or P
 C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value-use P

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 Justifying Smaller Order Quantities

 JIT or “Lean Systems” would recommend reducing order

quantities to the lowest practical levels
 Benefits from reducing Q’s:
• Improved customer responsiveness (inventory = Lead time)
• Reduced Cycle Inventory  Increase Inventory Turns
• Reduced raw materials and purchased components
 Justifying smaller EOQ’s:
 Reduce Q’s by reducing setup time (S). “Setup reduction” is a
well documented, structured approach to reducing S

2DS
Q
H

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 Inventory Record Accuracy
 Inaccurate inventory records can cause:
• Lost sales
• Disrupted operations
• Poor customer service
• Lower productivity
• Planning errors and expediting

 Two methods are available for checking record accuracy

• Periodic counting-physical inventory
• Cycle counting-daily counting of pre-specified items
provides the following advantages:
• Timely detection and correction of inaccurate records
• Elimination of lost production time due to unexpected
stock outs
• Structured approach using employees trained in cycle
counting
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 Summary
 Inventory has several categories and is used to support
daily operations.
 Inventory management intends to provide a desired service
level, to allow cost efficient operations, and to minimize
inventory investment.
 Inventory performance is measured by turns/supply.
 Inventory costs include item cost, holding cost, ordering
cost, and shortage cost.
 Order Q’s can be determined by using L4L, fixed order Q’s,
min-max, order n periods, quantity discounts, and single
period systems.
 Ordering decisions can be improved by analyzing total cost

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 Summary (continued)

 Smaller lot sizes increase flexibility and reduce

response time.
 Safety stock can be added to reorder point calculations
to meet desired service level.
 Inventory decisions about perishable products can be
made by using the single-period inventory model.
 ABC analysis can be used to assign the appropriate
level of control and review frequency based on the
annual dollar volume of each item.
 Cycle counting of pre-specified items is an accepted
method for maintaining inventory records

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 Interactive Workshop (1 of 5)
 Inventory is:

a) The set of items that an organization holds for later

use by the organization.
b) The set of policies that monitors and controls
inventory.
c) A tool used to balance capacity and demand
d) All of the above

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 Interactive Workshop (2 of 5)
 The types of costs associated with inventory are:

a) Holding costs, selling costs, ordering costs, and

shortage costs
b) Holding costs, buying costs, ordering costs, and
shortage costs
c) Holding costs, stocking costs, ordering costs, and
shortage costs
d) Item cost, holding cost, ordering costs, and
shortage costs

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 Interactive Workshop (3 of 5)
 One of the assumptions of EOQ model is:

a) Delivery is intermediate
b) Production is intermediate and constant
c) Demand is constant over time
d) A production run incurs variable setup costs

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 Interactive Workshop (4 of 5)
 One of the advantages of periodic review systems is:

a) No need for a system to continuously monitor item

b) Replenished quantity (Q) vary
c) Order quantities may quality for quantity discounts
d) Inventory levels will be higher than (Q)

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 Interactive Workshop (5 of 5)
 ABC classification is a method for:

a) Determining level of inventory and production of

inventory items
b) Determining level of control and frequency of review
of inventory items
c) Determining level of production and frequency of
review of inventory items
d) None of the above

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 Homework Assignment
 Page 216 problems
• 6.1
• 6.2
• 6.3
• 6.7
 Read Chapter 7
• Pages 221-262

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Questions? Comments?

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