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52 Instructor’s Resource Manual
LEARNING OBJECTIVES
1. List the reasons for and against having inventory.
2. Learn the basic types of inventory.
3. Apply the continuous review and periodic review systems. Describe other important
inventory systems.
LECTURE OUTLINE
I. Inventory Equilibrium
Inventory is the physical stock of any item or resources used in an organization. An
inventory management system comprises the policies and procedures that monitor levels of
inventory and determine when to place an order. The objective of an inventory system is to
specify when items should be ordered and what quantity of each item should be ordered.
A. Reasons to Carry Inventory
i. Setup and ordering cost—Producing an item involves two steps: setting up
the materials and resources necessary to produce the item and doing the
actual processing or transformation of the item.
1. Setup and ordering cost is the cost in time and/or money to prepare
all necessary materials and resources for production.
2. Processing cost is the cost in time and/or money to machine,
assemble, or transform an item.
ii. Customer service and variation in demand—Although demand can be
predicted, it cannot be predicted with great accuracy. Businesses often
carry buffer inventory so that there is a higher customer service level—
that is, less chance that the store is out of stock.
iii. Labor and equipment utilization—Organizations will often produce extra
inventory in order to keep equipment and people occupied.
iv. Transportation cost—Transportation cost is closely linked to the size of
the order. When large items or large quantities of smaller items are
shipped, it is much more efficient to have an entire truckload (or some
other vehicle) than to have a partial load.
v. Costs of materials/quantity discounts—Companies can pass along the
reduction in costs of producing larger orders by offering quantity
discounts as an incentive to increase order size.
B. Reasons to Reduce Inventory
i. Storage and handling—The greater the amount of inventory carried, the
more storage and handling is necessary. There is a cost associated with
owning, renting, and maintaining extra space to hold extra inventory.
Operations and Supply Chain Management for the 21st Century 53
Problem-Solving Tip
Average Inventory
The formula assumes that inventory fluctuates between zero and the order quantity. This
means the company is planning on having zero units on the shelf when the next
replenishment order arrives. If the company uses safety stock, it is planning on having the
safety stock quantity on hand when the replenishment order arrives. In this case, add the
safety stock quantity to the quantity given by the formula.
Teaching Tip
Reorder Point versus Periodic Review
To demystify this concept, point out that it is something most of us use regularly. For
example, my family consumes many bottles of milk per week. If I buy milk from
dairy and I go to the dairy to buy more milk any time that the amount of milk in my
refrigerator reaches one half-gallon bottle or less, then I am using a reorder point
system. My reorder point for milk is one bottle. If I buy milk at the grocery store, and
any time I am going to the store I assess the amount of milk in my refrigerator and
then figure out how much milk to buy, then I am using a periodic review system.
A. Continuous review systems consist of two components: the order quantity Q and the
reorder point R:
i. When the inventory position drops to or below the quantity R, then an
order for a quantity Q is placed.
ii. Inventory position is on-hand inventory plus outstanding orders, minus
any backorder quantities (items promised to a customer but not yet
delivered).
iii. The goal for the inventory system is to minimize total annual inventory
cost.
1. Total inventory cost = annual ordering cost + annual holding cost,
as demonstrated in Figure 6.4.
2. Economic order quantity (EOQ) is the order quantity that
minimizes the total annual cost of ordering and holding inventory
for a particular item.
a. The EOQ answers the question of how much to order.
b. Solved Example 1 demonstrates how to determine an
optimal order quantity.
Problem-Solving Tip
Economic Order Quantity Solved Problem
In Part 1, 5,000/1,000 is the number of orders that will be placed. Because the annual
demand is 5,000 and the order quantity is 1,000, we will place five orders.
The value $0.20 is the item cost ($1.00) times the 20 percent carrying rate. This is the
cost of carrying 1 unit for 1 year.
Operations and Supply Chain Management for the 21st Century 55
Problem-Solving Tip
Setting the Safety Stock and R
Think of the Z value simply as “the number of standard deviations required to achieve a
desired probability.” For example, Z of 1.28 standard deviations equates to a probability
of .8997, or 88.9 percent.
Company Illustration
Kellogg’s Direct Store Delivery
This insert describes a replenishment system in which Kellogg’s representatives deliver
material directly to the shelves of retail stores, rather than shipping to retailers’
distribution centers and relying on retail employees to perform inventory management
tasks. This insert brings up a good opportunity to discuss the EOQ system and the related
inventory cost models presented earlier. Deliveries to stores are typically in small
quantities, but they seem to make business sense here. Clearly, there are inventory-related
costs and benefits not accounted for by traditional models. Traditional models are a
starting point, but they should not be applied slavishly.
Problem-Solving Tip
Setting the Order Period to Match the EOQ
Why is 52 in the denominator of the denominator? Dividing the EOQ over the demand
gives us P in years. We must multiply this by 52 to convert it to weeks.
Teaching Tip
Two-Bin System
A two-bin system is essentially a reorder point system in which the reorder point is the
number of items that fit in one bin. These are typically used for lower-value items. A box
of candy on a retailer’s shelves with another box behind it is a good example.
58 Instructor’s Resource Manual
iii. Can-order systems are a variation of the periodic review system that
reviews the inventory position at fixed time intervals and places orders to
bring the inventory up to an expected target level, but only if the inventory
position is below a minimum quantity, similar to the reorder point in a
continuous review system.
iv. Base stock system is a type of inventory system that issues an order
whenever a withdrawal is made from inventory.
v. Newsvendor problem is a technique that determines how much inventory
to order when handling perishable products or items that have a limited
life span.
1. Products that are handled with this technique include perishable
items and items with a limited life span. Shortage cost is the lost
profit from not being able to make a sale, plus any loss of customer
goodwill.
2. Excess cost is the difference between the purchase cost of an item
and its salvage or discounted value.
Teaching Tip
Newsvendor Model
Strictly speaking, the model applies to items where only one order is placed for the entire
selling period, at the end of which the items can only be sold for their salvage value, as
noted in the text. However, the general concept applies widely. For other types of items
(where there is no finite selling period), stockout costs will occur in the same way they do
for the newsvendor model if customers buy from a competitor when the item in question
is out of stock. Overstock costs are costs associated with carrying excessive inventory
(i.e., physical storage, capital costs, risk of damage, and obsolescence).
F. Inventory accuracy
i. The amount of inventory in the system (i.e., the computer) often differs
from the amount of physical inventory that is on hand.
ii. Several common approaches for minimizing the problem of inaccurate
inventory include the following:
1. Control the number of people who handle inventory or the
associated transactions.
2. Place inventory in a locked and secured location.
3. Use cycle counting, whereby employees physically count a
percentage of the total number of items stocked in inventory and
correct any errors that are found.
Company Illustration
Preventing Stockouts from Turning up the AC Repair
This insert describes an inventory management system for managing service parts (i.e.,
spares). Service parts are exceedingly difficult because the cost of a stockout (down time)
is typically high but it is very difficult to predict demand. In other words, predicting the
timing and nature of breakdowns is nearly impossible for many types of equipment.
Operations and Supply Chain Management for the 21st Century 59
ADDITIONAL PROBLEM
The table below contains cost per unit and estimated usage for 20 items in the inventory of a
local branch of Janson Elevator, a firm that distributes and services elevators. Conduct ABC
analysis on the inventory. Assign an ABC code to each item. What type of system should be
used to manage item 8679? How does that differ from the system that should be used to manage
8116? Items 5489 and 4218 are critical for elevator operation. If a customer needs one of these
items (typically due to a breakdown) and does not have it, then all of the elevators in the
customer’s building must be shut down until the part arrives and can be installed/replaced. Item
3136 has a shelf life of only 1 week. Should 5489, 4218, and 3136 be managed in the same way
as 8116? Explain.
Unit Annual
Item Cost ($) Volume
1316 7.00 20,000
1411 6.20 200
2433 5.50 500,000
2536 0.03 16,000
3136 200.00 200
3341 275.00 500
4218 26.00 400
4699 28.00 80
5308 19.00 5,000
5386 0.32 1,000,000
5489 307.00 50
5576 31.00 12,000
6079 7.10 50
6500 77.00 10,000
6578 22.00 700
6899 15.00 11,000
8116 0.05 20,000
8340 0.78 12,000
8679 50.00 16,000
9305 10.00 30,000
Solution to Problem
The mathematical analysis needed to solve this problem appears in the table below. Note that
some of the items with high unit cost (such as 5576) are not A items because of their low
volumes.
Item 8679 is in the A category. It should be managed with a reorder point system. Item 8116 is
categorized as C. A periodic review system with a long review period (e.g., quarterly) would be
more appropriate for this item. Even though 5489, 4218, and 3136 are C items on the basis of
purely numerical analysis, they need to be managed more intensively (i.e., like A items) because
of their special nature. In many companies they would be assigned A codes or another code to
indicate this.
60 Instructor’s Resource Manual
Le 19. — Une lettre de Louise, pleine d’intérêt pour toi : rien que
cœur, esprit, charme d’un bout à l’autre, façon de dire qui ne se dit
nulle part que dans ces rochers de Rayssac. La solitude fait cela ; il
y vient des idées qui ne ressemblent à rien du monde, inconnues,
jolies comme des fleurs ou des mousses. Charmante Louise, que je
l’aime ! Je la trouve cette fois d’un calme, d’un désabusé qui
m’étonne, elle si illusionnée d’ordinaire. Je vais joindre l’autre
Louise, qui ressemble tant à celle-ci, ne trouves-tu pas ? et qui prie
aussi et fait prier pour ta guérison. « L’autre jour, m’écrit-elle (Louise
de Rayssac), j’étais à la Platée, paroisse de ma tante ; je
m’approchai d’une sainte fille qui habite cette église depuis le matin
jusqu’au soir, et qui est en grande vénération de sainteté. Je
soulevai un coin de son voile noir et lui dis bien bas : « Pardon,
mademoiselle, je voudrais vous demander des prières pour un jeune
homme malade, frère de la personne que j’aime le plus au monde. »
— « Eh bien ! je prierai », me dit-elle, avec cet air de modestie qui
donne encore plus de confiance à ma recommandation. — Je ne l’ai
pas revue. »
N’est-ce pas un joli trait pieux, mon ami, cette jeune fille quêtant
pour toi des prières avec un air d’intérêt céleste ? Elle est
charmante. Les anges lui auraient donné.
ENCORE A LUI
A MAURICE MORT, A MAURICE AU CIEL
Où l’éternité réside
On retrouve jusqu’au passé.
Le 30. — Qu’il faisait bon ce matin dans la vigne, cette vigne aux
raisins-chasselas que tu aimais ! En m’y voyant, en mettant le pied
où tu l’avais mis, la tristesse m’a rempli l’âme. Je me suis assise à
l’ombre d’un cerisier, et là, pensant au passé, j’ai pleuré. Tout était
vert, frais, doré de soleil, admirable à voir. Ces approches d’automne
sont belles, la température adoucie, le ciel plus nuagé, des teintes
de deuil qui commencent. Tout cela, je l’aime, je m’en savoure l’œil,
m’en pénètre jusqu’au cœur, qui tourne aux larmes. Vu seule, c’est
si triste ! Toi, tu vois le ciel ! Oh ! je ne te plains pas. L’âme doit
goûter d’ineffables ravissements,
Il pleut ; cette pluie, qui reverdit prés et bois, tombe sur la terre
qui te couvre et dissout tes restes au cimetière, là-bas, à Andillac.
Qu’on est heureux de penser qu’il y a dans l’homme quelque chose
que n’atteint pas la destruction !
« Il est des créatures que vous retirez de ce monde pour de
légères faiblesses ; c’est par amour et pour leur sauver de nouvelles
chutes. » — Si on ne savait que cette pensée est de Shakspeare, on
la croirait de Fénelon. Oh ! je sais à qui je l’applique.