Ops Reading P.177-185: Inventory Concepts

OPS Reading p.177-185: INVENTORY CONCEPTS

Inventory is created when items, including materials, parts, or finished goods, are received faster than they’re consumed, used, or sold.
Considered more generally, items can also include customer orders waiting to be processed (ORDER BACK-LOG) or customers waiting in a service process.

Pressures for Low Inventories

Two main pressures for low inventory:

1. Inventory represents a temporary monetary investment in goods on which a firm must PAY interest (rather than receiving interest)
2. As inventory increases, the total time required for items to pass through the process, aka throughput time, increases

Inventory holding cost (carrying cost): the variable cost of keeping items on hand
- includes interest, storage, handling, taxes, insurance, shrinkage

Holding costs are usually measured as a % of the inventory’s value.

The annual cost to maintain one unit in inventory is typically 20-40% of that unit’s value.

Pressures for High Inventories

There are various pressures for high inventories:

1. Customer service
2. Ordering cost
3. Setup cost
4. Labor and Equipment utilization
5. Transportation cost
6. Purchasing cost discounts

Customer Service

Creating finished goods inventory can speed delivery and improve on-time delivery.

Also, inventory reduces the potential for stockouts and backorders, which are key concerns for wholesalers and retailers
- stockout = item that is typically stocked is not available to satisfy immediate demand; results in immediate loss of sale
- backorder = customer order cannot be filled right away, but will be filled later; customer may deem this as ok immediately, but can take business elsewhere the next day

Ordering Cost

Each time a firm places a new order, it incurs a fixed ordering cost (doesn’t matter the size or type of item)
- i.e. time on paperwork, followup, receiving

Setup Cost

Includes labor and time to make the changeover, cleaning, and new tools/fixtures.

Labor and Equipment Utilization

By creating more invnetory, management can increase workforce productivity and facility utilization in three ways, all of which relate to reduce variability:

1. Placing larger, less frequent orders reduces the number of unproductive setups
2. Holding inventory reduces the chance of costly rescheduling of production orders (we will have the components to make the order)
3. Building inventory improves resource utilization by stabilizing the output rate for industries when demand is cyclical or seasonal

• The firm uses inventory built during slack periods to handle extra demand in peak; this minimizes need for extra shifts, hiring, layoffs, overtime, and additional equipment

Identifying Critical Inventory Items with ABC ANALYSIS

Stock Keeping Unit (SKU): an individual item or product that has an identifying code and is held in inventory somewhere along the supply chain

ABC Analysis: the method of dividing items into THREE CLASSES according to their DOLLAR USAGE so that managers can focus on important items

Example of a class breakdown:
Class A Items
- about 20% of items

Class B Items

Class B Items
- about 50% of items

The goal of ABC analysis is to identify the inventory levels of CLASS A ITEMS and enable management to control them tightly by using inventory control levers.

How to Perform an ABC Analysis

1. Determine an item’s DOLLAR USAGE by multiplying the annual demand rate for one item by the dollar value (cost) of one unit

2. Rank the items on the basis of dollar usage

3. Class A items should be somewhat higher or lower than 20% of all items, but they normally account for the bulk of the dollar usage

Implications to draw from ABC Analysis

Class A items
- should be directed by the manager to be reviewed frequently in order to reduce the average lot size and keep inventory records current

Class B items
- candidates for systems where purchase or replenishment decisions can be programmed

Class C items
- inventory holding costs tend to be low for these items, so you can actually have high inventory lots of these items in order to have safety stock
- a visual system may suffice for these items

ECONOMIC ORDER QUANTITY (EOQ)

To balance the pressures to keep inventories low enough to avoid excess inventory holding costs, but high enough to reduce the frequency of orders and setups, we can use EOQ.

EOQ: the lot size that minimizes the total annual inventory holding and ordering costs

Determining the EOQ rests on some assumptions:

1. The demand rate for the item is constant and known with certainty
2. There are no constraints on the size of each lot
3. The only two relevant costs are the inventory holding cost and the fixed cost per lot for ordering or setup
4. Decisions for one item can be made independently of decisions for other items
5. There is no uncertainty in lead time or supply. The lead time is constant and known with certainty. The amount received is exactly what was ordered, and it arrives all at once rather than piecemeal.

The EOQ will be optimal when ALL FIVE assumptions are satisfied.

Nonetheless, the EOQ is often a reasonable approximation of the appropriate lot size even when several assumptions do not apply.

Guidelines:

DO NOT USE THE EOQ IF:

1. You use the “make-to-order” strategy and your customer specifies that the entire order be delivered in one shipment
2. The order size is constrained by capacity limitations (i.e. amount of testing equipment)

MODIFY THE EOQ IF:

1. Significant quantity discounts are given for ordering large orders
2. Replenishment of the invnetory occurs as items are used or sold as soon as they’re finished, without waiting until the entire batch or order has been completed

USE THE EOQ IF:

1. You follow a “make-to-stock” strategy and the item has relatively stable demand
2. Your carrying cost per unit and setup or ordering costs are known and relatively stable

CALCULATING THE EOQ

1. Formulate the Total Cost for any order size (Q) for a specific part of product

2. Derive the EOQ, which is the Q that minimizes total cost.