Inventory Management: Types, Strategies, and EOQ Analysis
Inventory: A stock of materials used to satisfy customer demand or to support the production of services or goods.
Types of Inventory:
- Raw materials (RM): Basic materials used in production.
- Work-in-process (WIP): Partially completed goods.
- Finished goods (FG): Completed products ready for sale.
Pressures for Small Inventories:
- Temporary monetary investment: Tied-up capital could be used elsewhere.
- Inventory holding cost (or carrying cost): Costs associated with storing and maintaining inventory.
- Cost of capital: Opportunity cost of investing in inventory.
- Storage and handling costs: Costs of warehousing, transportation, and handling.
- Taxes, insurance, and shrinkage: Costs associated with protecting and managing inventory.
Shrinkage: Pilferage, obsolescence, deterioration.
Usually, an item’s holding cost per period of time is expressed as a percentage of its value.
Pressures for Large Inventories:
- Customer service: Meeting customer demand and avoiding stockouts.
- Ordering cost: Cost of placing and receiving orders.
- Setup cost: Cost of preparing production equipment for a new batch.
- Labor and equipment utilization: Maintaining production efficiency and avoiding idle resources.
- Transportation cost: Cost of shipping and receiving inventory.
- Payments to suppliers: Maintaining good relationships with suppliers and securing favorable terms.
Types of Inventory:
- Cycle Inventory: The portion of total inventory that varies directly with lot size.
- Safety Stock Inventory: Surplus inventory that protects against uncertainties in demand, lead time, and supply changes.
- Anticipation Inventory: Inventory used to absorb uneven rates of demand or supply.
- Pipeline Inventory: Inventory created when an order for an item is issued but not yet received.
Average demand during lead time = Dl
Average demand per period = d
Number of periods in the item’s lead time = L
Pipeline inventory = Dl = dL
ABC Analysis:
- Stock-keeping unit (SKU): A unique identifier for each item in inventory.
- Identify the classes: Categorize inventory items based on their value and importance.
- A Pareto chart: A visual representation of the Pareto principle (80/20 rule) applied to inventory.
Economic Order Quantity (EOQ):
- Developed in 1913 by F.W. Harris.
- Answers the question ‘How much do I order?’
- Used for independent demand items.
- Objective: To find the order quantity (Q) that minimizes total annual inventory holding and ordering costs.
- Must be calculated separately for each SKU.
- Widely used and very robust (i.e., works well in a lot of situations, even when its assumptions don’t hold exactly).
- Is the lot size that minimizes total annual inventory holding and ordering costs.
Assumptions:
- Demand rate for the item is constant and known with certainty.
- No constraints are placed on the size of each lot.
- The only two relevant costs are the inventory holding cost and the fixed cost per lot for ordering or setup.
- Decisions for one item can be made independently of decisions for other items.
- 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.
There is a trade-off between frequency of ordering (or the size of the order) and the inventory level.
- Frequent orders (small lot size) lead to a lower average inventory size, and higher ordering cost and lower holding cost.
- Fewer orders (large lot size) lead to a larger average inventory size, and lower ordering cost and higher holding cost.
Calculating EOQ:
- Annual holding cost: (average cycle inventory) x (unit holding cost)
- Annual ordering cost: (number of orders per year) x (ordering or setup cost)
- Total annual cycle-inventory cost: annual holding cost + annual ordering or setup cost
C = Q/2 x H + D/Q x S
Where:
- c = total annual cycle inventory cost.
- Q = lot size, in units.
- H = cost of holding one unit in inventory for a year, often expressed as a percentage of the item’s value.
- D = annual demand, in units per year.
- S = cost of ordering or setting up one lot in dollars per lot.
THE EOQ FORMULA: raiz cuadrada 2DS/H
Time between orders expressed in months: EOQ/D (12 months/year)
Inventory Control Systems: Two important questions: How much? When?
Nature of demand:
- Independent demand
Two inventory control systems:
- Continuous review (Q) system
- Periodic review (P) system
Continuous review (Q) system:
- Also called reorder point system or fixed order-quantity system.
- An order is placed when the inventory position reaches a predetermined level called reorder point (R).
- Inventory position (IP) = on-hand inventory + scheduled receipts – backorders
- An order must be placed when there is enough stock to satisfy demand from the time the order is placed until the new stock arrives (called lead time).
- Reorder point = Average demand during lead time + Safety stock
- = dL + safety stock
- where: d = average demand per week or day or month. L = constant lead time in weeks or days or months.
1. Choose an appropriate service-level policy:
- Select service level or cycle-service level.
- Protection interval.
2. Determine the distribution of demand during lead time:
3. Determine the safety stock and reorder point levels:
Advantages of Q systems:
- Review frequency may be individualized.
- Fixed lot sizes can result in quantity discounts.
- Lower safety stocks.
Advantages of P systems:
- Convenient.
- Orders can be combined.
- Only need to know IP when review is made.