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  1. Chapter 7: Inventory Decision Making

  2. Learning Objectives - After reading this chapter, you should be able to do the following: • Understand the fundamental differences among approaches to managing inventory. • Appreciate the rationale and logic behind the Economic Order Quantity (EOQ) approach to inventory decision making, and be able to solve some problems of a relatively straightforward nature. • Understand alternative approaches to managing inventory --- JIT, MRP, and DRP. Management of Business Logistics, 7th Ed.

  3. Learning Objectives • Realize how variability in demand and order cycle length affects inventory decision making. • Know how inventory will vary as the number of stocking points decreases or increases. • Recognize the contemporary interest in and relevance of time-based approaches to inventory management. Management of Business Logistics, 7th Ed.

  4. Learning Objectives • Make needed adjustments to the basic EOQ approach to respond to several special types of applications. Management of Business Logistics, 7th Ed.

  5. Fundamental Approaches to Managing Inventory • Basic issues are simple…how much to order and when to order. • Additional issues are…where to store inventory and what items to order. • Traditionally, conflicts were usually present…as customer service levels increased, investment in inventory also increased. • Recent emphasis is on increasing customer service and reducing inventory investment. Management of Business Logistics, 7th Ed.

  6. Fundamental Approaches to Managing Inventory • Four factors might permit this apparent paradox, that is, the firm can achieve higher levels of customer service without actually increasing inventory: • More responsive order processing • Ability to strategically manage logistics data • More capable and reliable transportation • Improvements in the location of inventory Management of Business Logistics, 7th Ed.

  7. Figure 7-1 Relationship between Inventory and Customer Service Level Management of Business Logistics, 7th Ed.

  8. Key Differences among Approaches to Managing Inventory • Dependent versus Independent Demand • Dependent demand is directly related to the demand for another product. • Independent demand is unrelated to the demand for another product. • For many manufacturing processes, demand is dependent. • For many end-use items, demand is independent. Management of Business Logistics, 7th Ed.

  9. Key Differences among Approaches to Managing Inventory • Of the inventory management processes in this chapter, JIT, MRP and MRPII are generally associated with items having dependent demand. • Alternatively, DRP and the EOQ models are generally associated with items exhibiting independent demand. Management of Business Logistics, 7th Ed.

  10. Key Differences among Approaches to Managing Inventory • Pull versus Push • Pull approach is a “reactive” system, relying on customer demand to “pull” product through a logistics system. MacDonald’s is an example. • Push approach is a “proactive” system, and uses inventory replenishment to anticipate future demand. Catering businesses are examples of push systems. Management of Business Logistics, 7th Ed.

  11. Key Differences among Approaches to Managing Inventory • Pull versus Push • Pull systems respond quickly to sudden or abrupt changes in demand, involve one-way communications, and apply more to independent demand situations. • Push systems use an orderly and disciplined master plan for inventory management, and apply more to dependent demand situations. Management of Business Logistics, 7th Ed.

  12. On the Line: American Cancer Society • ACS constructed a world class automated order fulfillment center in Atlanta. • Order cycle time was reduced to five business days. • Centralized storage reduced waste and obsolescence of educational materials. • Centralized shipment reduced freight rates. • The new center saved $8 million in the first year alone. Management of Business Logistics, 7th Ed.

  13. Fixed Order Quantity Approach (Condition of Certainty): Inventory Cycles • In this example, each cycle starts with 4,000 units: • Demand is constant at the rate of 800 units per day. • When inventory falls below 1,500 units, an order is placed for an additional 4,000 units. • After 5 days the inventory is completely used. • Just as the 4,000th unit is sold, the next order of 4,000 units arrives and a new cycle begins. Management of Business Logistics, 7th Ed.

  14. Figure 7-2 Fixed Order Quantity Model under the Condition of Certainty Management of Business Logistics, 7th Ed.

  15. Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model • Simple EOQ Model Assumptions • Continuous, constant, known and infinite rate of demand on one item of inventory. • A constant and known replenishment time. • Satisfaction of all demand. • Constant cost, independent of order quantity or time. • No inventory in transit costs. • No limits on capital availability. Management of Business Logistics, 7th Ed.

  16. Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model • Simple EOQ Model Variables • R = annual rate of demand • Q = quantity ordered (lot size in units) • A = order or setup cost • V = value or cost of one unit in dollars • W = carrying cost per dollar value in percent • S = VW = annual storage cost in $/unit per year • t = time in days • TAC = total annual costs in dollars per year Management of Business Logistics, 7th Ed.

  17. Figure 7-3 Inventory Carrying Cost Management of Business Logistics, 7th Ed.

  18. Figure 7-4 Order or Setup Cost Management of Business Logistics, 7th Ed.

  19. Figure 7-5 Inventory Costs Management of Business Logistics, 7th Ed.

  20. Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model TAC = QVW + AR or TAC = QS+ AR 2Q2Q First term is the average carrying cost Second term is order or setup costs per year Management of Business Logistics, 7th Ed.

  21. Figure 7-6 Sawtooth Model Management of Business Logistics, 7th Ed.

  22. Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model TAC = QVW + AR or TAC = QS+ AR 2Q2Q Solving for Q gives the following expressions: Q= √2 RAor Q = √2RA or Q = √2RA VW or S VW S Management of Business Logistics, 7th Ed.

  23. Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model Where R = 3600 units V = $100; W = 25%; S (or VW)= $25; A = $200 per order Q= √2 RA or Q = √2RA or Q = √2RA VW or SVWS √ 2*3600*$200√2*3600*$200 $100*25% $25 Q = 240 units Q = 240 units Management of Business Logistics, 7th Ed.

  24. Figure 7-7 Sawtooth Models Management of Business Logistics, 7th Ed.

  25. Table 7-1 Total Costs for Various EOQ Amounts Management of Business Logistics, 7th Ed.

  26. Figure 7-8 Graphical Representation of the EOQ Example Management of Business Logistics, 7th Ed.

  27. Fixed Order Quantity Approach (Condition of Certainty) • Summary and Evaluation of the Fixed Order Quantity Approach: • EOQ is a popular inventory model. • EOQ doesn’t handle multiple locations as well as a single location. • EOQ doesn’t do well when demand is not constant. • Minor adjustments can be made to the basic model. • Newer techniques will ultimately take the place of EOQ. Management of Business Logistics, 7th Ed.

  28. Fixed Order Quantity Approach (Condition of Uncertainty) • Uncertainty is a more normal condition. • Demand is often affected by exogenous factors---weather, forgetfulness, etc. • Lead times often vary regardless of carrier intentions. • Examine out Figure 7-9. • Note the variability in lead times and demand. Management of Business Logistics, 7th Ed.

  29. Figure 7-9 Fixed Order Quantity Model under Conditions of Uncertainty Management of Business Logistics, 7th Ed.

  30. Fixed Order Quantity Approach (Condition of Uncertainty) • Reorder Point – A Special Note • With uncertainty of demand, the reorder point becomes the average daily demand during lead time plus the safety stock. • Examine Figure 7-9 again. Management of Business Logistics, 7th Ed.

  31. Fixed Order Quantity Approach (Condition of Uncertainty) • Uncertainty of Demand Affects Simple EOQ Model Assumptions: • a constant and known replenishment time. • constant cost/price, independent of order quantity or time. • no inventory in transit costs. • one item and no interaction among the inventory items. • infinite planning horizon. • no limit on capital availability. Management of Business Logistics, 7th Ed.

  32. Table 7-2 Probability Distribution of Demand during Lead Time Management of Business Logistics, 7th Ed.

  33. Table 7-3 Possible Units of Inventory Short or in Excess during Lead Time with Various Reorder Points Management of Business Logistics, 7th Ed.

  34. Table 7-3 Possible Units of Inventory Short or in Excess during Lead Time with Various Reorder Points Management of Business Logistics, 7th Ed.

  35. Management of Business Logistics, 7th Ed.

  36. Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model Where R = 3600 units V = $100; W = 25%; A = $200 per order; G = 8 Q= √2 R(A + G) VW √ 2 * 3600 * ($200 + 8) $100 * 25% Q = approximately 242 units Management of Business Logistics, 7th Ed.

  37. Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model Where R = 3600 units V = $100; W = 25%; A = $200 per order; G = 8; Q = 242; e = 10.8 TAC = QVW + AR + eVW + GR 2 Q Q TAC = (242*$100*25%) + (200*3600) + (10.8*$100*25%) + (8*3600) 2 242 242 TAC = $3025 + $2975 + $270 + $119 TAC = $6389 (New value for TAC when uncertainty introduced) Management of Business Logistics, 7th Ed.

  38. Fixed Order Quantity Approach (Condition of Uncertainty): Conclusions • Following costs will rise to cover the uncertainty: • Stockout costs. • Inventory carrying costs of safety stock • Results may or may not be significant. • In text example, TAC rose $389 or approximately 6.5%. • The greater the dispersion of the probability distribution, the greater the cost disparity. Management of Business Logistics, 7th Ed.

  39. Figure 7-10 Area under the Normal Curve Management of Business Logistics, 7th Ed.

  40. Table 7-5 Reorder Point Alternatives and Stockout Possibilities Management of Business Logistics, 7th Ed.

  41. Fixed Order Interval Approach • A second basic approach • Involves ordering at fixed intervals and varying Q depending upon the remaining stock at the time the order is placed. • Less monitoring than the basic model • Examine Figure 7-11. • Amount ordered over each five weeks in the example varies each week. Management of Business Logistics, 7th Ed.

  42. Figure 7-11 Fixed Order Interval Model (with Safety Stock) Management of Business Logistics, 7th Ed.

  43. Summary and Evaluation of EOQ Approaches to Inventory Management • Four basic inventory models: • Fixed quantity/fixed interval • Fixed quantity/irregular interval • Irregular quantity/fixed interval • Irregular quantity/irregular interval • Where demand and lead time are known, basic EOQ or fixed order interval model best. • If demand or lead time varies, then safety stock model should be used Management of Business Logistics, 7th Ed.

  44. Summary and Evaluation of EOQ Approaches to Inventory Management • Relationship to ABC analysis • “A” items suited to a fixed quantity/irregular interval approach. • “C” items best suited to a irregular quantity/fixed interval approach. • Importance of trade-offs • Familiarity with EOQ approaches assists the manager in trade-offs inherent in inventory management. Management of Business Logistics, 7th Ed.

  45. Summary and Evaluation of EOQ Approaches to Inventory Management • New concepts • JIT, MRP, MRPII, DRP, QR, and ECR also take into account a knowledge and understanding of applicable logistics trade-offs. • Number of DCs • The issue of inventory at multiple locations in a logistics network raises some interesting questions concerning the number of DCs, the SKUs at each, and their strategic positioning. Management of Business Logistics, 7th Ed.

  46. Additional Approaches to Inventory Management • Three approaches to inventory management that have special relevance to supply chain management: • JIT (Just in Time) • MRP (Materials Requirements Planning) • DRP (Distribution Resource Planning) Management of Business Logistics, 7th Ed.

  47. Time-Based Approaches to Replenishment Logistics: JIT • Definition and Components of JIT Systems - designed to manage lead times and eliminate waste. • Kanban - refers to the informative signboards on carts in a Toyota system of delivering parts to the production line. Each signboard details the exact quantities and necessary time of replenishment. • JIT operations - Kanban cards and light warning system communicate possible production interruptions. • Fundamental concepts - JIT can substantially reduce inventory and related costs. Management of Business Logistics, 7th Ed.

  48. Time-Based Approaches to Replenishment Logistics: JIT • Definition and Components of JIT Systems - designed to manage lead times and eliminate waste. • Goal is zero inventory, and zero defects. • Similarity to the two-bin system - one bin fills demand for part, the other is used when the first is empty. • Reduces lead times through requiring small and frequent replenishment. Management of Business Logistics, 7th Ed.

  49. Time-Based Approaches to Replenishment Logistics: JIT • JIT is a widely used and effective strategy for managing the movement of parts, materials, semi-finished products from points of supply to production facilities. • Product should arrive exactly when a firm needs it, with no tolerance for early or late deliveries. • JIT systems place a high priority on short, consistent lead times. Management of Business Logistics, 7th Ed.

  50. JIT versus EOQ Approaches to Inventory Management • Six major differences: • First, JIT attempts to eliminate excess inventories for both buyer and seller. • Second, JIT systems involve short production runs with frequent changeovers. • Third, JIT minimizes waiting lines by delivering goods when and where needed. Management of Business Logistics, 7th Ed.