On-Line Lesson

Inventory Management

 

Lesson 1-Introduction

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Types of Inventory

 

To accommodate the functions of inventory, firms maintain four types:

 

1.      Raw Material Inventory:  these are materials that are purchased from suppliers and have not yet been processed.

 

2.      Work-In-Process Inventory (WIP):  these are raw materials that have undergone some processing but are not yet complete.  For example, pies fresh from the oven but not yet packaged would be considered WIP.

 

3.      Maintenance/Repair/Operating (MRO):  these are the supplies necessary to keep machinery and processes productive.

 

4.      Finished Goods Inventory:  these are items that have been completed through the production process and are thus ready for sale to the end user.

 

 

ABC Analysis

 

ABC analysis is a method of categorizing inventory into three groups (A, B, and C) according to annual cost to the company.  To determine annual dollar volume for ABC analysis, we measure the annual demand of each inventory item times the cost per unit..  class A items are those on which the annual dollar volume is high.  Although such items may represent only about 15% of the total inventory items, they represent 70% to 80% of the total dollar usage.  Class B items are those inventory items of medium annual dollar volume.  These items may represent about 20% to 30% of the total volume.  Class C items are those with low annual dollar volume and may represent only 5% of the annual dollar volume.

 

 

Example – ABC Analysis

 

Jacqueline Johnson’s company has compiled the following data on a small set of products:

 

 

For the above data, the annual cost, annual demand volume percentage, and annual dollar volume percentage were calculated.  Using the annual dollar volume percentage as the criteria for classifying the inventory, the following ABC analysis is the result:

 

 

So, items 4 and 1 would be classified as A with a combined annual dollar volume of 62%.  Items 5 and 2 would be classified as B with a combined annual dollar volume of 25%, And finally, item 3 is classified as C.

 

Click here to see an Excel Version of ABC analysis

 

 

Basic Economic Order Quantity (EOQ) Model

 

The basic EOQ model, when calculated, provides that order quantity that minimizes the total cost for the respective item.  Total cost is defined as follows:

 

Total Cost = Annual Purchasing Cost + Annual Ordering Cost + Annual Holding Cost

 

The assumptions of this model are:

 

·        Demand is known, constant, and independent

·        Lead time (time from order placement until order is received) is known and constant

·        Receipt of inventory is instantaneous and complete

·        Quantity discounts are not possible

·        The only variable costs are the cost of setting up or placing an order and the cost of holding inventory over time

·        Stockouts (shortages) are not allowed

 

The following variables are used in the basic EOQ model:

 

            Q = Number of pieces per order

            Q* = EOQ

            D = Annual demand In units for the inventory item

            S = Ordering cost per order

            H = Holding cost per unit per year

            N = Expected number of orders per year

            T = Expected time in between orders

            d = Daily demand

            L = Lead time in days

            ROP = Reorder point in units

            TC = Total annual inventory cost

 

The formula for calculating the EOQ is:

 

 

The expected number of orders is:

 

 

The expected time between orders is :

 

           

 

The total annual inventory cost for the EOQ is:

 

           

 

The re-order point (in units) is:

 

           

 

 

Example – Basic EOQ Model

 

Betsy Mccollum is the purchasing agent for Central Valve company, which sells industrial valves and fluid control devices.  One of Centra’s most popluar valves is the Western, which has an annual demand of 4,000 units.  The cost of each valve is $90, and the inventory carrying cost estimated to be 10% of the cost of each valve.  Betsy has made a study of the ocsts involved in placing an order for any of the valves that Central stocks, and she has concluluded that the average ordering cost is $25 per order.  Furthermore, it takes about 5 working days for an order to arrive from the supplier.  During this time, the demand per week for valves is approximately 80 (assume 5 working days per week).  The holding cost/unit/year is 10% X $90 = $9.

 

a.      What is the EOQ?

 

            units

 

b.      What is the re-order point?

 

            units

 

c.      What is the total annual cost?

 

           

 

d.      What is the optimal number of orders per year?

 

             orders

 

 

Production Order Quantity Model

 

In this model, inventory arrives (or is received) over time which is different than the basic EOQ model that receives one replenishment instantaneously.  So, the inventory replenishment is like a production process that produces product over a give time period.  In addition to the variables for the basic EOQ model, the following new variables apply:

 

            p = Daily production rate

            t = Length of the production run in days

 

The production order quantity is calculated as follows:

           

 

 

Example – Production Order Quantity Model

 

Jan Kottas is the owner of a small company that produces electric knives used to cut fabric.  The annual demand is 8,000 for knives, and Jan produces the knives in batches.  On average, Jan can produce 150 knives per day; during the production process, demand has been about 40 knives per day.  The cost to set up the production process is $100, and it costs Jan $0.80 to carry a knife for one year.  How many knives should Jan produce in each batch?

 

 

 knives

 

 

 

Quantity Discount Model

 

The quantity discount model applies when price breaks are offered.  For example, if an order for 1 to 99 units costs $100/unit and an order for the same item for 100 to 199 units costs $90/units, then a price break exists.  In order to determine what the order quantity should be the following process should be applied:

 

1.      Calculate the EOQ for each price break and determine if feasible (the EOQ is feasible if it falls within the order quantity range for that respective price)

2.      For each EOQ calculated in Step 1, perform the following.  If the EOQ is not feasible and the EOQ is above the price break order quantity range range, then lower the order quantity so that it is at the top end of the order quantity range for that price.  If the EOQ is not feasible and the EOQ is below the price break order quantity range, the raise the order quantity to the bottom end of the price break order quantity range for that price.

3.      Calculate the total annual inventory cost for all feasible EOQ’s or adjusted order quantities calculated previously.  Select that order quantity with the lowest total annual inventory cost.

 

 

Example – Quantity Discount Model

 

McLeavey Manufacturing has a demand for 1,000 pumps each year.  The cost of a pump is $50/unit.  It costs McLeavey $40 to place an order, and carrying cost is 25% of unit cost.  If pumps are ordered in quantities of 200, McLeavey can get a 3% discount.  Should McLeavey order 200 pumps at a time and take the 3% discount?

 

Step 1 – Calculate EOQs for all price breaks:

 

(feasible because it falls between 1 and 200)

 

 

(not feasible because it is not greater than 200)

 

Step 2 – Adjust not feasible EOQ’s

 

            EOQ at $50 is feasible, so it remains at 80 units.

            EOQ at $48.5 is not feasible, so adjust up to 201.

 

Step 3 – Calculate total costs for order quantities

 

 

So, select to order 201 units/order at a price of $48.50/unit.