Inventory Management Economic Order Quantity JIT and the

Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints Prepared by Douglas Cloud Pepperdine University 24 -1

Objectives 1. Describe the. After just-in-case inventory studying this managementchapter, model. you should 2. Discuss just-in-time (JIT) be able to: inventory management. 3. Explain the basic concepts of constrained optimization. 4. Define theory of constraints, and tell how it can be used to manage inventory. 24 -2

Just-in-Case Inventory Management Three types of inventory costs can be readily identified with inventory: (1) The cost of acquiring inventory. (2) The cost of holding inventory. (3) The cost of not having inventory on hand when needed. 24 -3

Economic Order Quantity 1. Ordering Costs: The costs of placing and receiving an order. Examples: Clerical costs, documents, insurance for shipment, and unloading. 2. Carrying Costs: The costs of carrying inventory. Examples: Insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, and storage. 24 -4

Economic Order Quantity 3. Stock-Out Costs: The costs of not having sufficient inventory. Examples: Lost sales, costs of expediting (extra setup, transportation, etc. ) and the costs of interrupted production. 4. Setup Costs: The costs of preparing equipment and facilities so they can be used to produce a particular product or component. Examples: Setup labor, lost income (from idled facilities), and test runs. 24 -5

Traditional Reasons for Carrying Inventory 1. To balance ordering or setup costs and carrying costs 2. Demand uncertainty 3. Machine failure 4. Defective parts 5. Unavailable parts 6. Late delivery of parts 7. Unreliable production processes 8. To take advantage of discounts 9. To hedge against future price increases 24 -6

Economic Order Quantity TC = PD/Q + CQ/2 The total Theordering The cost The known of number placing The annual cost of units of carrying (or setup) and receiving ordered demand one an each unittime of stock for carrying ordercost (oran theorder cost is ofplaced one year setting (orup thealot size for production) run) 24 -7

An EOQ Illustration EOQ = 2 PD/C D = 25, 000 units Q = 500 units P = $40 per order C = $2 per unit EOQ = (2 x 25, 000 x $40) / $2 EOQ = 1, 000 EOQ = 1000 units 24 -8

When to Order or Produce Reorder point = Rate of usage x Lead time Example: Assume that the average rate of usage is 4 units per day for a component. Assume also that the time required to place and receive an order is 10 days. What is the reorder point? Reorder point = 4 x 10 = 40 units Thus, an order should be placed when inventory drops to 40 units. 24 -9

The Reorder Point Reorder point = Rate of usage x Lead time Inventory (units) (EOQ) 1000 800 600 Reorder Point 400 200 0 2 4 6 8 10 Days 12 14 16 18 20 24 -10

Demand Uncertainty and Reordering To avoid running out of parts, organizations often choose to carry safety stock. Safety stock is extra inventory carried to serve as insurance against fluctuations in demand. Example: If the maximum usage of the VCR part is 120 units per day, the average usage is 100 units per day, and the lead time is four days, the safety stock is 80. Maximum usage Average usage Difference Lead time Safety stock 120 -100 20 x 4 80 24 -11

Example Involving Setups Expedition Company manufactures edgers. The manager is trying to determine the size of the production run. The controller has supplied the following information: Average demand for edgers: 720 per day Maximum demand for edgers: 780 per day Annual demand for edgers: 180, 000 Unit carrying cost: $4 Setup cost: $10, 000 Lead time: 22 days 24 -12

Example Involving Setups EOQ = 2 PD/C EOQ = (2 x 180, 000 x $10, 000)/$4 EOQ = 900, 000 EOQ = 30, 000 edgers 24 -13

Example Involving Setups Safety stock: Maximum usage Average usage Difference Lead time Safety stock 780 720 60 x 22 1, 320 Reorder point = (Average usage x Lead time) + Safety stock Reorder point = (720 x 22) + 1, 320 Reorder point = 17, 160 edgers 24 -14

JIT Inventory Management Setup and Carrying Costs: The JIT Approach JIT reduces the costs of acquiring inventory to insignificant levels by: 1. Drastically reducing setup time 2. Using long-term contracts for outside purchases Carrying costs are reduced to insignificant levels by reducing inventories to insignificant levels. 24 -15

JIT Inventory Management Due-Date Performance: The JIT Solution Lead times are reduced so that the company can meet requested delivery dates and to respond quickly to customer demand. Lead times are reduced by: ü reducing setup times ü improving quality ü using cellular manufacturing 24 -16

JIT Inventory Management Avoidance of Shutdown: The JIT Approach § Total preventive maintenance to reduce machine failures § Total quality control to reduce defective parts § The use of the Kanban system is also essential 24 -17

What is the Kanban System? A card system is used to monitor work in process q A withdrawal Kanban q A production Kanban q A vendor Kanban The Kanban system is responsible for ensuring that the necessary products are produced in the necessary quantities at the necessary time. 24 -18

Withdrawal Kanban Item no. _____________ 15670 T 07 Preceding Process Circuit Board CB Assembly Item name___________________ TR 6547 PC Computer Type_________________ 8 Box Capacity___________ Subsequent Process Box Type________________________ C Final Assembly 24 -19

Production Kanban Item no. _____________ 15670 T 07 Preceding Process Circuit Board CB Assembly Item name___________________ TR 6547 PC Computer Type__________ 8 Box Capacity___________ Box Type_______________ C 24 -20

Vendor Kanban 15670 T 07 Name of Receiving Company Item no. __________ Circuit Board Electro PC Item name___________________ 8 Box Capacity__________ Receiving Gate A Box Type__________ _ 75 _ 8: 30 A. M. , 12: 30 P. M. , 2: 30 P. M. Time to Deliver_____________________ Gerry Supply Name of Supplier_____________________ 24 -21

The Kanban Process (7) Withdrawal Store Lot with P-Kanban CB Assembly (5) Attach W-Kanban (6) Signal Remove (4) P-Kanban Attach to Post Production Ordering Post CB Stores (1) Remove W-Kanban Attach to Post (2), (3) Withdrawal Post Final Assembly 24 -22

JIT Inventory Management Discounts and Price Increases: JIT Purchasing Versus Holding Inventories v Careful vendor selection v Long-term contracts with vendors § Prices are stipulated (usually producing a significant savings) § Quality is stipulated § The number of orders placed are reduced 24 -23

JIT Limitations • Patience in implications is needed. • Time is required. • JIT may cause lost sales and stressed workers. • Production may be interrupted due to an absence of inventory. 24 -24

Linear Programming The unit contribution margins are $300 and $600 for X and Y, respectively. Z = $300 X + $600 Y Total contribution margin This equation is called the objective function, the function to be optimized. 24 -25

Linear Programming Internal constraints: X + Y 80 X + 3 Y 120 2 X + Y 90 External constraints: X 60 Y 100 24 -26

Linear Programming X + Y 80 X + 3 Y 120 2 X + Y 90 X 60 Y 100 X 0 Y 0 24 -27

Multiple Constrained Resource 160 140 120 100 80 60 40 X 60 2 X + Y 90 Y 100 X + Y 80 X + 3 Y 120 20 20 40 60 80 100 120 140 24 -28

Multiple Constrained Resource 160 140 120 100 80 60 40 20 B C D A 20 40 60 80 100 120 140 24 -29

Linear Programming Corner Point X-Value Y-Value Z = $300 X + $600 Y A 0 0 $ 0 B 0 40 24, 000 C 30 30 27, 000 D 45 0 13, 500 C is the optical solution! 24 -30

Theory of Constraints Three Measures of Systems Performance: ü Throughput (Sales revenue – Unit-level variable expenses)/Time ü Inventory ü Operating expenses 24 -31

Five-Step Method for Improving Performance 1. Identify an organization’s constraints. 2. Exploit the binding constraints. 3. Subordinate everything else to the decisions made in Step 2. 4. Elevate the organization’s binding constraints. 5. Repeat the process as a new constraint emerges to limit output. 24 -32

The Drum-Buffer-Rope System Materials Initial Process Rope Process A Process B Time Process C Final Process Finished Goods Buffer Drummer Process 24 -33

New Constraint Set: Schaller Co. 160 140 120 100 80 60 40 X 60 2 X + Y 90 Y 100 X + 3 Y 240 X + Y 80 20 20 40 60 80 100 120 140 160 200 220 24 -34

New Constraint Set: Schaller Co. 160 140 120 100 80 60 40 B C 20 D A 20 40 60 80 100 120 140 160 200 220 24 -35

End of Chapter 24 -36

24 -37