Ops management lecture 8 inventory management

Chapter eight

Inventory management

Learning objectives

• Identify and describe classification systems,

particularly ABC analysis

• Understand the importance of record accuracy

• Explain cycle counting

• Discuss the impact of independent and

dependent demand on inventory

• Identify the costs involved in inventory holding

• Define the term ‘inventory’

• List reasons for holding inventory

Learning objectives (cont.)

• Discuss the main requirements for effective inventory management

• Describe and use basic economic order quantity models

• Understand periodic and perpetual review systems

• Describe and use the quantity discount model and reorder point model

• Appreciate the need for buffer stock in inventory management

• Appreciate the need for keeping inventory

• Explain the importance of service levels in inventory management.

8.1 Introduction

• Inventory = stockpile or store of goods

• Type of business determines inventory

type

• Inventory: one of the most expensive

assets

• Good indicator – number of times

inventory is turned.

8.2 The nature and importance of

holding inventory • ROI

• Larger the reduction in holding inventory,

the higher the ROI

• Manufacturing organisations hold:

– Raw materials

– WIP

– Finished goods

– Replacement parts


holding inventory (cont.) COMMON REASONS FOR KEEPING

INVENTORY

Decouple production process

There is an insecure supply of raw materials

To distance organisation from uncertain demand

To facilitate wide variety of products

To take advantage of supplier discounts

To avoid price increases

Items are in transit

To smooth production requirements

To prevent stock-outs occurring

To take advantage of ordering cycles


holding inventory (cont.)

• Objective function of inventory control

– Satisfaction of customers

– Management of inventory costs

Two types of stockholding

Overstocking – too much inventory – large

funds tied up

Understocking – too little inventory – late

deliveries



• Inventory types:

– Inventory of raw materials – not yet

transformed into finished goods

– WIP inventory – in process but not completed

– Maintenance, repair and operating inventory –

machine parts etc.

– Finished goods inventory – goods that are

ready for delivery



• Control and turnover of inventory

• Lower the turnover the poorer the

performance of the inventory control function





Average world wide trends:-

ITR = 3 or 4 times

Lean manufacturing as much as 30 times!


holding inventory (cont.) If we assume the following:-

R250,000 of average inventory = FGI

R250,000 of average inventory = RMI

R500,000 of average inventory = WIP

R2,000,000 labour and overhead costs to transform raw materials

to finished goods

R2,500,000 = Purchasing materials cost

R750,000 – cost of carrying FGI

R2,000,000 labour and overhead costs to transform raw materials

to finished goods

Calculate TWIP,TRM & TFGI



ASSUMPTIONS

R250,000 = FGI

R250,000 = RMI

R500,000 = WIP

R2,500,000 = Purchasing

materials cost


R2,000,000 labour and overhead

costs to transform raw materials

to finished goods



ASSUMPTIONS

R250,000 = FGI

R250,000 = RMI

R500,000 = WIP


materials cost




to finished goods


holding inventory (cont.) ASSUMPTIONS

R250,000 = FGI

R250,000 = RMI

R500,000 = WIP


materials cost




to finished goods


holding inventory (cont.) ASSUMPTIONS

R250,000 = FGI

R250,000 = RMI

R500,000 = WIP


materials cost




to finished goods



• Methods utilised to reduce stocks

• Reduction in line and store stock

• A two-bin system

• SILS (Supplier in-line sequencing) – all needed

parts delivered to operative

• Kanbans – cards or similar for each operating

station to communicate demand

• Milk runs – daily trips by suppliers

• Supplier sub-assembly of components on the

organisation premises

8.3 Requirements for effective

inventory management

• Two basic functions:

• Keeping track of the entire inventory

• Deciding how much to order and when


inventory management (cont.) • Counting systems for inventory:

• Periodic counting system – daily, weekly, monthly

inventory counts

– Small retail outlets

– Results determine next order quantity

• Perpetual counting system:

– System updated every time an item is removed

• Batch perpetual system

• Online perpetual system

• Barcode systems

8.3 Requirements for effective inventory

management (cont.)

• Forecasting demand and information regarding lead

time

• Costs incurred when inventory is carried out:

• Holding cost – cost incurred for the actual storage

of inventory over a specific time period

• Ordering cost - cost associated with ordering and

receipt of goods such as suppliers, forms and

clerical support

• Shortage cost – Cost incurred when demand

exceeds supply


management (cont.)

• HOLDING COST

• Cost of insurance against theft/fire damage

• Cost of interest for loans to build warehouse and stock it

• Cost of depreciation of goods held in inventory

• Obsolescence costs due to newer/better products coming

into market

• Opportunity costs because money is tied up in stock and

can, therefore not be used for other, more profitable items

• Usually expressed as a % of the selling price of product


management (cont.)

• HOLDING COST

TV sells for R5000.

Holding cost is 4% of

selling price per annum.

How much will it cost

organisation to hold 1 TV

in stock for 1 year?


management (cont.)

• ORDERING COST

• Set up costs – cost of setting machinery for

manufacturing

• Labour cost

• Lost time for production

• Operations manager must ensure all procedures and

processes running efficiently to reduce ordering costs


management (cont.)

• SHORTAGE COST – Cost of losing a sale due to unavailability of a product

– The loss of goodwill of the customer

– The cost of lost production

– Downtime cost of lost production

– Estimation of these costs is difficult


inventory management (cont.) • Classification systems for inventory

• ABC analysis

• Pareto principle: 80/20

Critical few; trivial many

Use management effort to control critical

few i.e. top 20% in value!

Don’t always use monetary value of

inventory item

• H. Ford Dickie , developed ABC in 1951

• Class discussion

(see Table 8.2 on page 202 of the textbook)


inventory management (cont.)

• Need for accurate inventory records

• Usually accuracy is between 1 & 3%



• Cycle counting – confirm accuracy of inventory

records by continuous audit

• Counted on a continuous rather than batch

basis

• Rules most often used:

– Count after a busy period

– Count when the balance shows zero stock

– Use ABC analysis to determine frequency of count

– Count when inventory records show a positive balance

but a stock out occurs



• Cycle counting – CLASS EXERCISE

CLASS INVENTORY

HOLDING

POLICY ITEMS TO BE

COUNTED/DAY

A

B

C



• Cycle counting – CLASS EXERCISE

CLASS INVENTORY

HOLDING

POLICY ITEMS TO BE

COUNTED/DAY

A

2750

20

WORKING

DAYS

B

3500

60

WORKING

DAYS

C

5000

120

WORKING

DAYS



ADVANTAGES OF CYCLE COUNTING

Ensures accuracy of inventory records

Enhances detection of errors and ensures remedial action

taken timeously

No need to close plant to facilitate cycle counting

Only trained warehouse personnel should do counts – this

minimises errors



• How to control service inventory

• Pilferage

• Inventory shrinkage

• Measures:

• Bar coding shipments

• Magnetic tags

• Staff selection



•Advantages and

disadvantages of holding

inventory

• see Table 8.5 on page 206

8.4 Economic order quantity

models

• Used to decide how much to order

• There are 3 models:

• The basic EOQ model

• The economic production quantity model

• The quantity discount model

BASIC EOQ MODEL

• Developed by FW Harris at Westinghouse

in 1915

• This same model and a number of

variations are still used throughout industry

today

• A number of assumptions have to be made

BASIC EOQ MODEL

Assumptions • No stock outs should happen if orders for inventory are

placed at correct time

• There is a known and constant lead time that never varies

• Only two types of variable cost will incur: set up cost (cost

of placing order) and holding cost

• All demand is independent, constant, known and never

varies

• No discounts for quantity will be given

• The entire inventory will be received at once and complete

• There will be only one product involved and no interaction

will take place with other products

8.4 Economic order quantity models

Q = order size in units

H = holding cost

D = annual demand

Q = order size

S = cost per order

Q0 = Optimal order quantity

EOQ – Basic Model

•Class exercise

EOQ – Basic Model

•Most limiting factor of the

basic EOQ model is

assumption that demand will

always be constant

•Therefore more flexible

continuous (Q or fixed order)

system is used

EOQ – Continuous Model

• Mistake many managers make is to ignore

inventory quantities that are already on

order

• This system monitors inventory on hand on

a continuous basis after each inventory

transaction

• When inventory reaches reorder point

(RoP) an order for a fixed quantity is

placed.

Continuous Model

R = m + s

s = zσ

R = reorder point

m = mean demand over

a specific lead time

s = safety inventory

Z = no of std dev for a

given service level

Σ = std dev of demand

over leadtime

####

D

P

C

H

EOQ

(warehouse space, refrig., ins., etc.)

Try different order quantities:

Costs with EOQ

BASIC EOQ MODEL

500.00

1,100.00Total:

Average Annual Fixed Order Cost:

1,000.00Average Annual Purchase Cost:

50.00

50.00Average Annual Holding Cost:Annual Holding Cost per Unit

Fixed Cost per Order

Purchase Cost per Unit

Since the demand will be satisfied with the unit purchase cost any way, it is discarded from the model. The cost in consideration is reduced to

2 types: Holding Cost and Ordering Cost. The tradoff between these costs is optimized at the minimum point of the Total Cost Curve, i.e. EOQ.

EOQ is the level of the inventory where ordering cost and carrying cost remains equal.

(optimal order quantity)

Economic Order Quantity 400.00

Annual Demand Quantity of the Product

0.25

20.00

1.00

1,000

0.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

450.00

Inventory LevelCosts by Order Quantity

Holding Cost

Ordering Cost

Total Cost

OTHER MODELS

•Please read p 217 - 227

Class discussion

•What is the link between

inventory and supply

management?

Summary

•Nature and importance of

holding inventory

•Effective inventory system

•EOQM.

Education

Ops management lecture 8 inventory management