11-1 Inventory Management

CHAPTER
11

Inventory
Management

Operations Management, Eighth Edition, by William J. Stevenson

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
11-2 Inventory Management

Inventory: a stock or store of goods Independent Demand

A Dependent
Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
TYPES OF INVENTORIES

• Raw materials & purchased parts

• Partially completed goods called
work in progress
• Finished-goods inventories
• (manufacturing firms)
or merchandise
(retail stores)
11-4 Inventory Management

TYPES OF INVENTORIES (CONT’D)

• Replacement parts, tools, & supplies
• Goods-in-transit to warehouses or customers
11-5 Inventory Management

FUNCTIONS OF INVENTORY
• To meet anticipated demand

• To smooth production requirements

• To decouple operations

• To protect against stock-outs

11-6 Inventory Management

FUNCTIONS OF INVENTORY (CONT’D)

• To take advantage of order cycles

• To help hedge against price increases
• To permit operations
• To take advantage of quantity discounts
11-7 Inventory Management

OBJECTIVE OF INVENTORY CONTROL

• To achieve satisfactory levels of customer service while keeping

inventory costs within reasonable bounds
• Level of customer service
• Costs of ordering and carrying inventory
11-8 Inventory Management

EFFECTIVE INVENTORY MANAGEMENT

• A system to keep track of inventory

• A reliable forecast of demand
• Knowledge of lead times
• Reasonable estimates of
• Holding costs
• Ordering costs
• Shortage costs
• A classification system
11-9 Inventory Management

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
11-10 Inventory Management

INVENTORY COUNTING SYSTEMS (CONT’D)

• Two-Bin System - Two containers of 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
11-11 Inventory Management

KEY INVENTORY TERMS

• Lead time: time interval between ordering and receiving the order
• 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
• Shortage costs: costs when demand exceeds supply
11-12 Inventory Management

ABC CLASSIFICATION SYSTEM

Figure 11.1
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
Few Many
Number of
Items
11-13 Inventory Management

CYCLE COUNTING
• A physical count of items in inventory
• Cycle counting management
• How much accuracy is needed?
• When should cycle counting be performed?
• Who should do it?
11-14 Inventory Management

ECONOMIC ORDER QUANTITY MODELS

• Economic order quantity model
• Economic production model
• Quantity discount model
11-15 Inventory Management

ASSUMPTIONS OF EOQ MODEL

• Only one product is involved
• Annual demand requirements known
• Demand is even throughout the year
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts
11-16 Inventory Management

THE INVENTORY CYCLE

Figure 11.2

Profile of Inventory Level Over

Q Usage Time
Quantity rate
on hand

Reorder
point

Tim
Receive Place Receive Place Receive e
order order order order order
Lead
time
11-17 Inventory Management

TOTAL COST

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q
11-18 Inventory Management

COST MINIMIZATION GOAL

Figure 11.4C
The Total-Cost Curve is U-Shaped
Annual Cost

Ordering Costs

Order Quantity
QO(optimal order
quantity) (Q)
11-19 Inventory Management

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.
11-20 Inventory Management

MINIMUM TOTAL COST

The total cost curve reaches its minimum where the carrying and
ordering costs are equal.
11-21 Inventory Management

ECONOMIC PRODUCTION QUANTITY (EPQ)

• Production done in batches or lots

• Capacity to produce a part exceeds the part’s usage or demand rate
• Assumptions of EPQ are similar to EOQ except orders are received
incrementally during production
11-22 Inventory Management

ECONOMIC PRODUCTION QUANTITY ASSUMPTIONS

• Only one item is involved
• Annual demand is known
• Usage rate is constant
• Usage occurs continually
• Production rate is constant
• Lead time does not vary
• No quantity discounts
11-23 Inventory Management

ECONOMIC RUN SIZE

11-24 Inventory Management

TOTAL COSTS WITH PURCHASING COST

Annual Annual Purchasing

TC +
carrying + ordering cost
= cost cost
Q + DS + PD
TC = H
2 Q
11-25 Inventory Management

TOTAL COSTS WITH PD

Figure 11.7
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without
PD

P
D

0 EOQ Quantit
y
11-26 Inventory Management

TOTAL COST WITH CONSTANT CARRYING COSTS

Figure 11.9

TC
Total Cost

aTC
b
Decreasing
TCc Price

CC a,b,c

O
C

EO Quantity
Q
11-27 Inventory Management

WHEN TO REORDER WITH EOQ ORDERING

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

amount, the item is reordered
• Safety Stock - Stock that is held in excess of expected demand due to
variable demand rate and/or lead time.
• Service Level - Probability that demand will not exceed supply during
lead time.
11-28 Inventory Management

DETERMINANTS OF THE REORDER POINT

• The rate of demand
• The lead time
• Demand and/or lead time variability
• Stockout risk (safety stock)
11-29 Inventory Management

SAFETY STOCK
Figure 11.12
Quantit

Maximum probable demand

during lead time
y

Expected demand
during lead time

RO
P
Safety stock reduces risk of Safety stock
stockout during lead time L Tim
T e
11-30 Inventory Management

REORDER POINT
Figure 11.13

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantit
Expected
y
demand Safety
stock
0 z z-scale
11-31 Inventory Management

FIXED-ORDER-INTERVAL MODEL
• Orders are placed at fixed time intervals
• Order quantity for next interval?
• Suppliers might encourage fixed intervals
• May require only periodic checks of inventory levels
• Risk of stockout
11-32 Inventory Management

FIXED-INTERVAL 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
11-33 Inventory Management

FIXED-INTERVAL DISADVANTAGES

• Requires a larger safety stock

• Increases carrying cost
• Costs of periodic reviews
11-34 Inventory Management

SINGLE PERIOD MODEL

• Single period model: model for ordering of perishables and other items
with limited useful lives
• Shortage cost: generally the unrealized profits per unit
• Excess cost: difference between purchase cost and salvage value of
items left over at the end of a period
11-35 Inventory Management

SINGLE PERIOD MODEL

• Continuous stocking levels

• Identifies optimal stocking levels
• Optimal stocking level balances unit shortage and excess cost

• Discrete stocking levels

• Service levels are discrete rather than continuous
• Desired service level is equaled or exceeded
11-36 Inventory Management

OPERATIONS STRATEGY

• Too much inventory

• Tends to hide problems
• Easier to live with problems than to eliminate them
• Costly to maintain

• Wise strategy
• Reduce lot sizes
• Reduce safety stock
11-37 Inventory Management
11-38 Inventory Management

Chapter 13
Managing the Systems
Development Life Cycle
11-39 Inventory Management

Objectives for Chapter 13

• Identify the key stages in the SDLC
• How a firm’s business strategy shapes its information system
• The relationship between strategic systems planning and
legacy systems
• What transpires during systems analysis
• The TELOS model for assessing project feasibility
• Cost-benefit analysis issues related to information systems
projects
• The role of accountants in the SDLC
11-40 Inventory Management

The Systems Development

Life Cycle (SDLC)
• A logical sequence of activities used to:
– identify new systems needs
– develop new systems to support those needs
• A model for reducing risk through planning,
execution, control, and documentation
• The SDLC model may be shown in five
stages.
– We’ll look at the first two in this chapter and the
remaining three in chapter 14.
11-41 Inventory Management
Systems Development Life Cycle
Business
Needs and
Strategy
Legacy Situation
Business Requirements

1. Systems Strategy
- Assessment Feedback:
- Develop Strategic Plan User requests for New Systems
System Interfaces, Architecture
and User Requirements
High Priority Proposals undergo
Additional Study and Development

2. Project Initiation
- Feasibility Study
- Analysis
- Conceptual Design
- Cost/Benefit Analysis Feedback:
User requests for System
Selected System Proposals go Improvements and Support
forward for Detailed Design

3. In-house Development 4. Commercial Packages

- Construct - Configure
- Deliver - Test
- Roll-out

New and Revised Systems

Enter into Production

5. Maintenance & Support

- User help desk
- Configuration Management
- Risk Management & Security
11-42 Inventory Management

Overview of Phases 1 and 2

• Phase 1 - Systems Strategy
– understand the strategic needs of the organization
– examine the organization’s mission statement
– analyze competitive pressures on the firm
– examine current and anticipated market conditions
– consider the information systems’ implications
pertaining to legacy systems
– consider concerns registered through user feedback
– produce a strategic plan for meeting these various and
complex needs
– produce a timetable for implementation
11-43 Inventory Management

Overview of Phases 1 and 2

• Phase 2 - Project Initiation
– assess systems proposals for consistency with the
strategic systems plan
– evaluate feasibility and cost-benefit characteristics of
proposals
– consider alternative conceptual designs
– select a design to enter the construct phase of the
SDLC
– examine whether the proposal will require in-house
development, a commercial package, or both
11-44 Inventory Management

Systems Development Participants

• Systems Professionals: analyze problems in
current systems and formulate solutions
– systems analysts
– systems designers
– programmers
• End Users: primary users of the system
– addressing their needs is critical to success
• Stakeholders: individuals who have an
interest in the system but are not end users
11-45 Inventory Management

Systems Steering Committee

• Usually includes the CEO, CFO, CIO, senior
management from user areas and computer services,
and internal auditors
• Typical responsibilities:
– provide guidance
– resolve conflicts
– review projects and assigning priorities
– budget and allocate funds
– review the status of projects
– determine whether projects should be continued
11-46 Inventory Management

Phase 1
Systems Strategy
11-47 Inventory Management

Assessing Strategic
Information Needs
• Strategic systems planning involves the
allocation of resources at the macro level.
– usually a time frame of three to five years
• Key inputs in developing a sound systems
strategy include:
– strategic business needs of the organization
– situations involving legacy systems
– end user feedback
11-48 Inventory Management

Strategic Business Needs

• Vision and mission
– systems strategy requires an understanding of top
management’s vision, which has shaped the
organization’s business strategy
• Industry and competency analysis
– industry analysis: the driving forces that affect the
industry and their organization’s performance, such as
important trends, significant risks, and potential
opportunities
– competency analysis: a complete picture of the
organization’s effectiveness as seen via four strategic
filters: resources, infrastructure, products/services, and
customers
11-49 Inventory Management

Legacy Systems
• Use legacy components to help develop an
architecture description.
11-50 Inventory Management

End User Feedback

• Identifying user needs is fundamental to everything
else
• During phase 1, pertains to substantial perceived
problems rather than minor systems modifications
• Has five key phases at this point in the SDLC:
– recognize problems
– define problems
– specify systems objectives
– determine feasibility and contributions of projects
•may entail prioritizing individual projects
– preparing a formal project proposal
11-51 Inventory Management

End User Feedback:

Recognizing the Problem
• The need for a new, improved information system
is manifested through various symptoms.
– Symptoms may seem vague and innocuous or go
unrecognized initially.
• The point at which the problem is recognized is
often a function of management’s philosophy.
– reactive management - responds to problems only
when they reach a crisis state
– proactive management - alert to subtle signs of
problems and aggressively looks for ways to improve
11-52 Inventory Management

End User Feedback:

Defining the Problem
• Managers and end users should…
– avoid leaping to a single definition of a problem
– keep an open mind and gather facts before deciding
– learn to intelligently interact with systems professionals
• An interactive process between managers/end
users and systems professionals is necessary to
arrive at an accurate problem definition.
– The next three stages of the end user feedback process
involve this interactive process.
11-53 Inventory Management

End User Feedback:

Specifying System Objectives
• The strategic objectives of the firm and the
operational objectives of the information
systems must be compatible.
• At this point, the objectives only need to be
defined in general terms.
11-54 Inventory Management

End User Feedback:

Preliminary Project Feasibility-TELOS
• Technical feasibility - is the technology necessary
available?
• Economic feasibility - are the funds available and
appropriate for the system?
• Legal feasibility - does the system fall within legal
boundaries?
• Operational feasibility - can procedural changes be
made to make the system work?
• Schedule feasibility - can the project be completed
by an acceptable time period?
11-55 Inventory Management

End User Feedback:

Preparing a Formal Project Proposal
• A systems project proposal provides
management with a basis for deciding
whether or not to proceed with the project.
• It summarizes the findings of the study and
makes a general recommendation.
• It outlines the linkage between the objectives
of the proposed system and the business
objectives of the firm.
11-56 Inventory Management

Strategic Systems Plan

• After collecting input, the steering committee and
systems professionals evaluate the pros and cons
of each proposal.
• Assessing each potential project’s:
– benefits
– costs
– strategic impact
• Development will proceed on proposals with the
greatest potential for supporting the organization’s
business objectives at the lowest cost.
11-57 Inventory Management

Relationship between Benefits,

Costs, and Strategic Impact
11-58 Inventory Management

Create an Action Plan:

the Balanced Scorecard
• The next step is to translate strategy into action
• Many companies have found the balanced scorecard
(BSC) a useful tool for this step.
• The BSC recommends viewing an organization using
four perspectives:
– learning and growth
– internal business process
– customer
– financial
11-59 Inventory Management

The Balanced Scorecard

Primary objective: capture information on orthogonal dimensions
that are important to every organization
financial: how do we look to our shareholders?
customer: how do we look to our customers?
internal business process: what must we excel at?
learning and growth: can we continue to improve?
Second objective: prevent the proliferation of reports and
information. Concentrate only on critical success factors to
which everyone in the organization will pay attention.
11-60 Inventory Management

BSC for On-Line Banking

11-61 Inventory Management

Phase 2
Project Initiation
11-62 Inventory Management

Project Initiation
• The second phase in SDLC involves:
– understanding of users’ needs and problems
– proposing multiple alternative solutions
– assessing alternatives in terms of feasibility and
cost-benefit characteristics
– selecting the best option and proceeding to the
construct phase
– examining whether the selected option will require
in-house development, a commercial package, or
both
11-63 Inventory Management

Systems Analysis
• A business problem must be fully
understood before a solution can be
formulated.
– A defective analysis will lead to a defective
solution.
• System analysis is a two-step process
– survey of current systems
– analysis of users’ needs
11-64 Inventory Management

Survey of Current Systems

• Advantages:
– allows aspects of the old system which should be
kept to be identified
– aids in planning the implementation of the new
system
– may allow conclusive determination of the cause of
the reported problem symptoms
• Disadvantages:
– the current physical tar pit
– can stifle new ideas
11-65 Inventory Management

The Survey Step

• Fact-gathering techniques include observing,
participating, interviewing, and reviewing documents.
• Facts must be gathered regarding:
– data sources and data stores
– users
– processes
– data flows
– controls, especially audit trails
– transaction volumes
– error rates
– resource costs
– bottlenecks and redundant operations
11-66 Inventory Management

The Analysis Step

• Systems analysis is an intellectual process that is
commingled with fact gathering.
• A formal systems analysis report, prepared and presented
to the steering committee, contains:
– reasons for system analysis
– scope of study
– problem identified with current system
– statement of user requirements
– resource implications
– recommendations
11-67 Inventory Management

The Conceptualization Phase

• Purpose: produce alternative conceptual
solutions that satisfy the requirements
identified during systems analysis
• How much detail?
– enough to highlight the differences between
critical features of competing systems rather
than their similarities
11-68 Inventory Management
Alternative Conceptual Designs for
a Purchasing System
11-69 Inventory Management

Systems Evaluation and Selection

• A critical juncture in the SDLC
– a formal mechanism for selecting the one
system from the set of alternative
conceptual designs that will go forward for
construction
– an optimization process that seeks to
identify the best system
– a structured decision-making process that
reduces uncertainty and risk
11-70 Inventory Management

The Role of Accountants

• Accountants ensure that the following are
considered during evaluation and selection:
– only escapable costs are used in calculations of cost
savings benefits
– reasonable interest rates are used in measuring
present values of cash flows
– one-time and recurring costs are completely and
accurately reported
– realistic useful lives are used in comparing competing
projects
– intangible benefits are assigned reasonable financial
values
11-71 Inventory Management

Detailed Feasibility Study

• Similar to the preliminary project
feasibility analysis (TELOS), but now
more detailed and oriented to deciding
on a specific system design. Examine:
– technical feasibility
– economic feasibility
– legal feasibility
– operational feasibility
– schedule feasibility
11-72 Inventory Management

Cost-Benefit Analysis:
Identify Costs
11-73 Inventory Management

Cost-Benefit Analysis:
Identify Benefits—Tangible
11-74 Inventory Management

Cost-Benefit Analysis:
Identify Benefits—Intangible
11-75 Inventory Management

Comparing Costs and Benefits

• Two methods commonly used for evaluating the
costs and benefits of information systems:
– Net Present Value Method: deduct the present value of
costs from the present value of benefits over the life of the
project.
•The optimal choice is the project with the greatest net present
value.
– Payback Method: do break-even analysis of total costs
(one-time costs plus present value of recurring costs) and
total benefits (present value of benefits). After the
break-even point, the system earns future profits.
•The optimal choice is the project with the greatest future profits.
11-76 Inventory Management

How Should We Get the System?

• Once the optimal system is selected, decide
how to acquire it:
– develop the system in-house: best for systems that
need to meet unique and proprietary business
needs
– purchase commercial software: best for systems
that are expected to support “best industry
practices”
– a mix of the first two approaches: make in-house
modifications, to varying degrees, of a commercial
system to meet the organization’s unique needs
11-77 Inventory Management

Announcing the New System

Project…
• can be the most delicate aspect of the SDLC.
• End user support is critical to success.
• All end users need to be made to understand
the objectives of the new system.
• End users and managers who view the new
system as a potential benefit to their jobs,
rather than a threat, are more likely to
cooperate with the project.
11-78 Inventory Management

Why are Accountants Involved

with SDLC?
• The creation of an information system
consumes significant resources and has
financial resource implications.
• The quality of accounting information
systems and their output rests directly on
the SDLC activities that produce them.
11-79 Inventory Management

How are Accountants Involved

with SDLC?
• As end users who must provide a clear
picture of their problems and needs
• As members of the development team
• As auditors who must ensure that the
system is designed with appropriate internal
controls and computer audit techniques.
11-80 Inventory Management

The Accountant’s Role in

Systems Strategy
• Auditors should routinely review the
organization’s systems strategy.
• Careful systems planning is a
cost-effective way to reduce the risk of
creating unneeded, unwanted, inefficient,
and ineffective systems.
• Both internal and external auditors have
vested interests in this outcome.
11-81 Inventory Management

The Accountant’s Role in

Conceptual Design
• Accountants should be responsible for the
conceptual system…
– and the systems professionals for the physical
system.
• If important accounting considerations are not
conceptualized at this point, they may be
overlooked, exposing the organization to
potential financial loss.
• The auditability of a system depends in part on
its design characteristics.
11-82 Inventory Management

The Accountant’s Role in

Systems Selection
• Economic feasibility is a primary concern to
accountants. Accountants should ensure that:
– use only escapable costs in calculations of cost-savings
benefits
– use reasonable interest rates in measuring present
values of cash flows
– one-time v. recurring costs are accurately reported
– use realistic useful lives in comparing competing projects
– intangible benefits are assigned reasonable financial
values