Lec07 – item inventory Production Planning and Inventory

Control Class 2024

management
How Much to Order at One Time

• Objectives:
• Maximize customer service.
• Minimize sum of all costs involved.
• Decision rules for determining what lot size to
order at one time:
• lot-for-lot
• fixed order quantity (FOQ)
• economic order quantity (EOQ)
• order n periods of supply
Lot-for-Lot

• In lot-for-lot,
• only required amount is ordered
• order quantities change as requirements change
• no unused lot-size inventory is created.
• Lot-for-lot is used
• for dependent and independent demand items
• for expensive components (A items)
• for perishable items
• in a lean environment.
Fixed Order Quantity

• Fixed order quantity

• Is a technique that causes orders to be generated for
specific amounts
• is quick and simple
• often is based on what seems reasonable
• leads to inventory buildup
• does not always produce the best results.
Order n Periods of Supply

• The required amount to satisfy demand for a

certain number of periods is ordered.
• No unused lot-size inventory is created.
• It is used for
• dependent and independent demand items
• inexpensive components (C items).
EOQ Manages Cost Tradeoffs
Inventory carrying costs Ordering costs

But ordering in
Ordering in small small quantities
quantities minimizes requires more
inventory carrying orders and
costs. increases order
costs.

The EOQ model manages tradeoffs by balancing

ordering costs and inventory carrying costs.
Assumptions

• EOQ is based on the following assumptions:

• Demand is relatively constant and known.
• Items are produced or purchased in lots or batches.
• Order preparation costs and inventory carrying costs are
constant and known.
• Replacement occurs all at once.
EOQ Calculation Process

• Calculate annual ordering cost.

• Calculate annual inventory carrying cost.
• Calculate total annual cost.
• Evaluate alternative order quantities.
• Calculate EOQ.
 Step 1: Annual Ordering Cost

Annual ordering cost = number of orders x cost per order ($)

A (annual demand) 8,000 units

Number of orders = = = 10 orders
Q (lot size) 800 units

S (cost per order) = $25

Annual ordering cost = 10 orders  $25 per order = $250

 Step 2: Annual Inventory Carrying Cost
Annual inventory carrying cost = average inventory  carrying cost
(a) Determine average inventory (Q/2) in units

Q (lot size) 800 units

Average inventory = = = 400 units
2 2
800
(Average inventory)

Units in stock
Given:
Q
400
Cost per unit (c) = $10
Carrying cost rate (i) = .25

Time
(b) Determine carrying cost in dollars
Q
Inventory carrying cost =  c  i = 400  $10  .25 = $1,000
2
Step 3: Total Annual Cost

Total annual cost = annual ordering cost + annual carrying cost

Total annual cost = $250 + $1,000 = $1,250

not equal

Conclusions:
• Annual ordering cost does not equal annual carrying cost.
• The EOQ is the quantity at which the two costs are equal.
• We need to look further into identifying the EOQ.
Step 4: Evaluate Alternative Order Quantities
Evaluation of EOQ data
Annual Order Order Cost per Carrying Ordering Carrying
Total
demand costs quantity unit cost rate cost cost
cost
(A) (S) (Q) (c) (i) (AS/Q) (Qci/2)
8000 25 200 10 0.25 1000 250 1250

8000 25 300 10 0.25 667 375 1042

8000 25 400 10 0.25 500 500 1000

8000 25 500 10 0.25 400 625 1025

8000 25 600 10 0.25 333 750 1083

8000 25 700 10 0.25 286 875 1161

8000 25 800 10 0.25 250 1000 1250

8000 25 900 10 0.25 222 1125 1347

8000 25 1000 10 0.25 200 1250 1450

 EOQ: Cost and Quantity Relationships
1600

1400

EOQ
1200

1000
Cost in dollars

800
Ordering costs

600
Carrying costs

Total cost
400

200

0
0 200 400 600 800 1000 1200
Order quantity
Total cost = carrying costs + ordering costs
 Economic Order Quantity Formula
The EOQ is based on the following mathematical relationship:

1600
Inventory carrying cost = ordering cost
1400

EOQ
1200 Qic AS
Cost in dollars

1000
=
2 Q
800
Ordering costs
600 Carrying costs
Total cost
400

Solving for Q gives the formula for EOQ.

200

0 2AS
0 200 400 600 800 1000 1200 EOQ =
Order quantity ic
 EOQ Sample Calculation
For example, if
A = 8,000 units
S = $25 per order
i = 25% = 0.25
c = $10 per unit

EOQ = √ 2×8,000 units×$25

0.25 × $10 = 400 units
Problem 7.1

A = 100,000 units
S = $32 per order
i = 20% = .20
c = $8 per unit

2AS
EOQ =
ic
Problem 7.1 Solution

A = 100,000 units
S = $32 per order
i = 20% = .20
c = $8 per unit

EOQ = √ 2 x 100,000 units x $32

0.2 x $8 = 2,000 units
EOQ Lot Sizing Control

• Of the following, what can be controlled?

• annual demand
• cost of carrying inventory
• unit cost
• ordering cost

2AS
EOQ =
ic
When to Place an Order

• If an order is placed late, there is the possibility of a

stockout.
• If an order is placed early, there will be extra
inventory and cost.
• A system is needed to tell when to order.
• Common systems include
• order point system
• periodic review system.
 Order Point System
Quantity

OP
DDLT
SS

LT Time

• Order point = demand during lead time + safety stock

• OP = DDLT + SS
Key Assumptions

• Order quantities usually are fixed.

• Intervals between replenishments are not constant.
• Demand is stable and shows random variation.
Problem 7.2

• Order point calculation

• demand = 100 units per week
• lead time = 4 weeks
• safety stock = 100 units
• order point = DDLT + SS
• order point = ?
 Problem 7.2 Solution
 Order point calculation
− demand = 100 units per week
− lead time = 4 weeks
− safety stock = 100 units
− order point = DDLT + SS
= 100 (4) + 100
= 500 units
Problem 7.3

• SKU lead time = 4 weeks

• average demand = 200 units per week
• safety stock = 1 week’s demand
• order quantity = 2,000 units

Calculate the order point.

Problem 7.3 Solution

• Order point calculation

• demand = 200 units per week
• lead time = 4 weeks
• order quantity = 2,000 units
• safety stock = 200 units

• order point = DDLT + SS

= 200 (4) + 200
= 1,000 units
Safety Stock

• Safety stock is used to prevent a stockout.

• The amount of safety stock carried depends on
• variability of demand during the lead time
• frequency of ordering
• desired service level
• length of the lead time
• ability to forecast and control lead times.
Service Levels

• The cost of carrying safety stock plus the cost of a

stockout should be at a minimum.
• Costs of a stockout:
• cost of backorder
• cost of lost sales
• cost of lost customers
• All are difficult to calculate.
• Management should state the acceptable number
of stockouts per year.
 Problem 7.4
Calculation of safety stock for a target service level

10-month demand: 10,000 units Order quantity: 100 units MAD: 160 units

Step 1: Number of orders per 10-month period Stockouts: 5 per

total demand 10-month period
Number of orders per 10 months =
order quantity

Step 2: Target service level

n stockouts per 100 orders = 100 – n orders with no stockouts

100 – n
Service level = = service level percent
100

Step 3: Safety stock level

Safety factor service level % = from safety factor table

Problem 7.4 Solution

Step 1: Number of orders per 10-month period

Number of orders per 10 months = total demand

order quantity
10,000
= = 100 orders
100

Step 2: Target service level

5 stockouts per 100 orders = 95 orders with no stockouts

100 – 5
Service level = = .95 or 95%
100
Problem 7.4 Solution (cont.)

Step 3: Safety stock level

Safety factor 95% service level = 2.06 (see safety factor table)

Safety stock = safety factor × MAD

= 2.06 × 160 units = 330 units

Determining When the Order Point is Reached

• Three basic systems:

• two-bin system
• kanban
• perpetual inventory record system
Two-Bin System

• Quantity equal to order point quantity is put in bin

2.
• When bin 1 is used up, bin 2 is used while bin 1 is
replenished.

1
Kanban

• Kanban = card or signal

• Used to achieve just-in-time production
• Used as visual signal to indicate replenishment is
required
• Examples include card, light, or container

Examples:
Paper card

Light Container
Perpetual Inventory Record

Order quantity = 500 units

Part number 426254
Order point = 100 units
On
Date Received Issued On hand Allocated Available
order

01 500 500
02 500 400 100
03 500 500 400 100
04 500 400 100 0 100
05 500 600 600
Periodic Review System
Periodic review versus order point system

Order point Periodic review

Characteristic
system system

Interval between Varies depending Fixed and

orders on actual usage constant

Order quantity Usually fixed Varies by period

The periodic review system also is called the fixed reorder

cycle inventory model and fixed-interval order system.
Uses of the Periodic Review System

• The periodic review system is used when

• products are perishable, with short shelf life
• receiving deliveries of many items from one source at
one time is economical
• tracking and posting transactions of many small issues
from inventory are costly
• ordering costs are low; short-interval ordering is not an
issue.
Periodic Review System
Units in stock

Target level (T)

Q1 Q2 Q3
 Periodic Review Example
D = demand per working day = 300 ÷ 5 = 60/day
R = review period = 20 days
L = lead =
2 days
SS = safety stock = 3
days’ supply = 180 units

T = target level = D
(R+L) + SS
=
60 (20 + 2) + 180 = 1,500 units

I = inventory on hand = 260 units

Q = order quantity = T–I

=
1,500 – 260 = 1,240 units
Problem 7.5

•T = D (R + L) + SS
• Order quantity = T–I
Problem 7.5 Solution

• T = D (R + L) + SS
= (10) (6 + 2) + 10
= 90 cases

• Order quantity = T–I

= 90 – 35
= 55 cases
ABC Inventory Control

Objective:
Application of different levels of control based on the
relative importance of items.

Key questions
• What is the importance of the inventory items?
• How are they to be controlled?
Principles of ABC Inventory Control

• A small number of items will represent the most

critical values.
• ABC inventory control separates the most
significant items from the less important.
• It is used to determine the degree and level of
control required.
ABC Classification

• A items
20 percent of the items account for
80 percent of the total dollar usage
• B items
30 percent of the items account for
15 percent of the total dollar usage
• C items
50 percent of the items account for
5 percent of the total dollar usage
ABC Process

Establish the item characteristics that influence the

results of inventory management:
• annual dollar usage
• scarcity of material
• quality problems

Classify items into groups based on the criteria

established.

Apply a degree of control in proportion to the

importance of the group.
Example of ABC Analysis: Step 1
Part number annual usage analysis
Annual Annual Annual
Part number unit usage unit cost dollar usage
1 1,100 $2 $ 2,200
2 600 40 24,000
3 100 4 400
4 1,300 1 1,300
5 100 60 6,000
6 10 25 250
7 100 2 200
8 1,500 2 3,000
9 200 2 400
10 500 1 500
Total $38,250
ABC Classification Calculation Steps

• Rank part numbers by annual dollar usage in descending

order.
• Calculate cumulative dollar usage: add the dollar usage of
each part number to the cumulative total for the preceding
part. (Part 2’s cumulative usage is $24,000.)
• Calculate the cumulative percentage of dollar usage in the
same way. (Part 2’s cumulative percentage of dollar usage is
63 percent.)
• Calculate the cumulative percentage of items in ascending
order. Because there are 10 parts, each part number
accounts for 10 percent of the cumulative total.
Example of ABC Analysis: Step 2
Ranking of part numbers by annual usage
Part Annual Cumulative Cumulative Cumulative
number dollar dollar usage percent percent of items
usage dollar usage
2 24,000 24,000 63 10
5 6,000 30,000 78 20
8 3,000 33,000 86 30
1 2,200 35,200 92 40
4 1,300 36,500 95 50
10 500 37,000 97 60
3 400 37,400 98 70
9 400 37,800 99 80
6 250 38,050 99 90
7 200 38,250 100 100
 Problem 7.6
Item number Annual Cumulative Cumulative Cumulative Class
dollar dollar usage percent dollar percent of
usage usage items
Problem 7.6 Solution
Item number Annual Cumulative Cumulative Cumulative Class
dollar dollar usage percent dollar percent of
usage usage items
8 241,873 241,873 48.37 10 A
2 156,127 398,000 79.60 20 A
5 42,749 440,749 88.15 30 B
7 19,562 460,311 92.06 40 B
1 13,189 473,500 94.70 50 B
10 10,112 483,612 96.72 60 C
4 8,493 492,105 98.42 70 C
6 5,589 497,694 99.54 80 C
9 1,962 499,656 99.93 90 C
3 344 500,000 100.00 100 C
500,000
 Control Based on ABC Classification

Level of control
Two general rules: Tight

Level of control
• Have plenty of low-
value items.
Normal
• Focus control effort Least
on A items. possible

A B C
Item classification
 Auditing Inventory Records
Auditing methods
Periodic inventory
• Physical inventory count of
all inventory.
• Supports appraisal of
inventory value for the
annual financial statements.
• For the benefit of
stakeholders in the
company.
Cycle counting
• Counting is continual.
• Updates records but also finds
and prevents causes of error.
• Items are counted in cycles,
some more frequently than
others.
• For the benefit of operations
improvement and customer
service.
Periodic Inventory Audit

Periodic inventory audit

Drawbacks:
• Production is disrupted.
• Labor and paperwork are expensive.
• Counters often are inexperienced and error
prone.
• Accuracy, as a result, can suffer.
• No priority for improving inventory control
processes.
Cycle Counting

Cycle counting

Key features of cycle counting:

• It occurs continually throughout the year.
• Counting occurs every day.
• It uses trained and dedicated staff.
• All items are counted a predetermined number
of times a year depending on their
importance.
Cycle Counting Advantages

Cycle counting

Advantages
• Timely detection and correction of problems
• Little or no loss of production time
• Higher level of counting accuracy
• Determination and elimination of causes of
error
Count Frequency: ABC System

• Classify items by their importance into A, B, and C

categories.
• Establish rules for count frequency of each
classification.
• Establish count schedule.
Count Frequency Schedule Example

Classificatio Number Count Number

n of items frequency of counts
A 2,000 12 24,000

B 3,000 4 12,000

C 5,000 2 10,000

Total counts 46,000

Workdays per year 250

Counts per day 184

Problem 7.7

Number Count Number

Classification
of items frequency of counts
A 1,100 12

B 1,650 4

C 2,250 2

Total counts

Workdays per year 250

Counts per day
Problem 7.7 Solution

Classificatio Number Count Number

n of items frequency of counts
A 1,100 12 13,200

B 1,650 4 6,600
C 2,250 2 4,500

Total counts 24,300

Workdays per year 250

Counts per day 98

 Problem 7.8
Solve for EOQ and determine number of orders per year.

A= 12,000 boxes
S= $20
i = 25% = 0.25
c= $7.50

2AS 2 x12,0 0units x $20

E OQ = = =506units
ic .25 x $7.50
Orders per year =
Problem 7.8 Solution

A= 12,000 boxes
S= $20
i = 25% = 0.25
c= $7.50

2AS 2 x 12,000 units x $20

EOQ = =
ic .25 x $7.50
= 506 boxes

annual demand 12,000

Orders per year = =
order quantity 506
= 23.7
 Problem 7.9
Solve for target level of inventory and determine the
order quantity.
Target level
= D (R + L) + SS
=

Order quantity
=
 Problem 7.9 Solution
Solve for target level of inventory and determine the
order quantity.
Target level
= D (R + L) + SS
= 200 (2+1) + 400 = 1,000

Order quantity
= 1000  600 = 400
Problem 7.10
Determine the number of cycle counts per day.

Number Count Number of

Classification
of items frequency counts
A 1,900 24

B 3,000 4

C 5,100 1

Total counts

Workdays per year

Counts per day

Problem 7.10 Solution

Number Count Number of

Classification
of items frequency counts
A 1,900 24 45,600

B 3,000 4 12,000

C 5,100 1 5,100

Total counts 62,700

Workdays per year 250

Counts per day 251