Operations and Project Management Module

Inventory Management
Operations
managers
make decisions
in four distinct
areas:
Process
Quality
Capacity
Inventory

In the first module on operations, we discussed that operations managers

make decisions in four distinct areas:

Process (Module 2)
Quality (Module 3)
Capacity (Module 4)
Inventory

This module concentrates on the fourth and final area, inventory decisions.
Inventory management is a key operations management responsibility
because it greatly affects capital requirements, costs, and customer service.

Introduction to Inventory
Inventory is a
stock of
materials used
to facilitate
production or to
satisfy
customer
demand.

Inventory is a stock of materials used to facilitate production or to satisfy

customer demand. Inventory is a necessary evil from a financial point of
view as it is idle capital waiting somewhere in the process. However,
virtually no organization can operate without inventory.
The main purpose of inventory is to decouple or separate the different stages
of operations and supply chain.
The four main reasons to carry inventory are to:

There are
different types
of inventory
within each
operations
system.

Protect against uncertainties in supply, demand, and lead time

Allow for economic production and purchase, as in discounts for buying in
bulk
Cover anticipated changes in demand, as in a level strategy or supply
Provide for transit, as in pipeline inventories

Types of Inventory
There are different types of inventory within each operations system, such as:

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Raw materials or purchased parts inventories waiting to enter the

transformation process
Work-in-process inventories in some intermediate stage of transformation
Finished goods inventories already completed by the transformation
process
Maintenance, repair, and operating supply inventories for the continuous

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The four types

of inventory
costs to
consider are:
Item cost
Ordering or
setup cost
Carrying or
holding cost
Stock out
cost

operation of the processes

Inventory Costs
The four types of inventory costs to consider are:

Item cost
Ordering or setup cost
Carrying or holding cost
Stock out cost

Item cost is the direct cost for obtaining an item. It includes the purchase cost
for external orders and the manufacturing cost for internal orders.
Ordering or setup cost includes the paperwork costs like preparing and
sending purchase orders, transportation costs, receiving costs, etc.
Carrying or holding cost is associated with keeping items in the inventory.
The main components of carrying costs are:
Component
Capital
Storage
Obsolescence

Different
demand
patterns
require
different
approaches to
inventory
management.

Description
Cost of lost opportunity of investing in inventory at the
market rate or internal rate of return
Includes the costs associated with buildings, utilities,
insurance, and handling
Includes:
Outdated products, especially for high-tech
gadgets
Deteriorated products for perishable products
Lost product due to theft and breakage

Stock out cost reflects the consequences of running out of stock.

Demand Patterns
Different demand patterns require different approaches to inventory
management. The most important demand characteristic is whether it is
independent or dependent.

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Independent demand is subject to market forces and randomness dictated

by the final customer. It is usually used for finished goods and spare
parts. This type of demand requires forecasting and is managed using a
replenishment philosophy for example, reordering when inventory
reaches a pre-specified level.

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Managing
independent
demand
involves
replenishment
or ordering
decisions.
The first
question is how
much to order.
The most
common
method for
making this
decision is the
economic order
quantity.

Dependent demand is a function of independent demand and is calculated

instead of forecasted. This is usually used for parts going into the finished
products or work in process.

Independent Demand
Managing independent demand involves replenishment or ordering decisions,
including how much to order and when to order it.
Economic order quantity. The first question is how much to order. The most
common method for making this decision is the economic order quantity.
The main objective of this method is to find the order quantity that minimizes
the total cost of managing the inventory.
Note: Economic order quantity must be calculated separately for each item or
product in the inventory.
The economic order quantity assumptions include a constant demand rate,
constant lead time, fixed setup time, no stockouts, lot ordering, no discounts,
and a single product.
The diagram below illustrates the economic order quantity.

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Within the assumptions made, the economic order quantity formula

minimizes the sum of holding and ordering costs. It is widely used
and very robust. For example, it works well in a lot of situations,
even when its assumptions dont hold exactly.

Where:
Q = Lot size, units
S = Cost per order placed, or setup cost, dollars per order
D = Demand rate, units per year
i = Carrying rate, percent of value per year
C = Unit cost, dollars per unit
There is a trade-off between frequency of ordering and size of the
order and the inventory level when the economic order quantity lot
size is chosen. Specifically:

The second question

is when to reorder.
There are two
approaches to
determine the
reorder point
continuous and
periodic review
systems.

Frequent orders of small lot sizes lead to a lower average inventory

size because you have a higher ordering cost and a lower holding
cost.

Fewer orders of large lot sizes lead to a larger average inventory

size because you have a lower ordering cost and a higher holding
cost.

Key point: The economic order quantity method determines the

optimal quantity that an inventory system has to order for
replenishment.
The second question that inventory managers have to answer is when
to reorder. There are two approaches to determine the reorder point
continuous and periodic review systems.
The first approach to determine the reorder point is the continuous
review system. In this approach, the stock position drops to the
reorder point and a fixed quantity is ordered. The time between
orders will vary depending on actual demand.

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When demand is random, the reorder point must take into account
the service level or fill rate.

The reorder point is defined as mean lead time demand plus the
safety or buffer stock. In the equation below, R is the reorder point,
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m is mean lead time demand, and s is the safety or buffer stock.

R=m+s
The second approach to determine the reorder point is the periodic
review system. In this approach, the stock position is reviewed at
fixed intervals and an amount is ordered equal to target inventory
minus stock position. The amount ordered at each review period will
vary depending on actual demand.
For example, a soda truck visits the grocery store on the same days
every week. After each interval review, the inventory is brought up
to the target level.
Considerations when choosing an approach. The choice between
continuous and periodic systems should be based on:

Timing of replenishment
Type of record keeping
Cost of the item

Note: The periodic system should be used when inventory orders

must be regularly scheduled and also when multiple items are
ordered from the same supplier.
ABC inventory management. Inventory managers use both
approaches for different items in their inventories. One way to
distinguish between these items is ABC inventory management. The
ABC inventory concept is based on the significant few and the
insignificant many. The purpose is to set priorities for effort used to
manage different items.

The concept should be used to carefully control the significant A

items using continuous review systems and to spend less effort and
cost on the B and C items by using periodic reviews.

Classification of items as A, B, or C is based on usage as follows:

If the classification is
A
B
C

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Then usage is
20% of units, 80% of dollars
30 % units, 15% of dollars
50 % of units, 5% of dollars

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Dependent Demand
Dependent demand
is a function of
independent demand
and is calculated
instead of
forecasted. This is
usually used for parts
going into the
finished products or
work in process
(WIP).

Dependent demand is a function of independent demand and is

calculated instead of forecasted. This is usually used for parts going
into the finished products or work in process (WIP). The primary tool
determining the dependent demand in production is materials
requirement planning.
Materials requirement planning is based on the concept of dependent
demand. Dependent demand items in a manufacturing firm are:
Raw materials
Purchased parts
WIP
A materials requirement planning system translates the master
production schedule and other sources of demand into the
requirements for all subassemblies, components, and raw materials
necessary to produce required assemblies or parent products. This
process of translating the master schedule or demand schedule into
the product requirements given by bills of materials is called MRP
explosion.

Krajewski, L., Ritzman, L., & Malhotra, M. (2007).

Operations management: Processes and value chains.
Upper Saddle River, NJ: Pearson-Prentice Hall.

By exploding the master schedule through the bills of materials, it is

possible to derive demand for component parts and raw materials.
The materials requirement planning system can then be used to plan
and control capacity, and it can be extended to enterprise resource
planning throughout a manufacturing firm.

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The following characteristics pertain to materials requirement planning

systems:

A materials
requirement
planning system is
an information
system used to
plan and control
manufacturing.

A materials requirement planning system is an information system

used to plan and control manufacturing. There are three types of
materials requirement planning systems:
Type of System
I MRP
II MRPII
III ERP

The three
principles of a
materials
requirement
planning system
are inventory,
priorities, and
capacity.

Description
An inventory control system
Manufacturing resource planning system
Enterprise resource planning system

There are three principal functions of a materials requirement

planning system:
1. Inventory function, which includes:
Ordering the right part
Ordering in the right quantity
Ordering at the right time
2. Priorities function, which includes:
Ordering with the right due date
Keeping the due date valid
3. Capacity function, which includes:
Having a complete load
Having an accurate or valid load
Having an adequate time span for visibility of future loads

A materials
requirement
planning record
displays all
periods or time
buckets that exist
within the master
production
schedule.

A materials requirement planning record displays all periods or time

buckets that exist within the master production schedule. The time
buckets can be in units of quarters, months, weeks, or days.

The total span of time buckets is called the planning horizon. For
example, if the materials requirement planning system represents three
months of production, the materials requirement planning records will
display three monthly time buckets or 12 weekly time buckets.

The total span of

time buckets is
called the
planning horizon.

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A materials
requirement
planning record
consists of:
Gross receipts
Scheduled
receipts
Projected on
hand
Net
requirements
Planned order
receipt
Planned order
release

A materials requirement planning record consists of the following

items:
Item
Gross receipts
Scheduled receipts
Projected on hand
Net requirements
Planned order receipt
Planned order release

Description
Anticipated future usage of or demand for
the item during each period
Existing replenishment orders that are
due in at the beginning of the period
Projected inventory status for the item at
the beginning of each period
Gross requirements minus scheduled
receipts minus projected on hand
Planned receipt of replenishment orders
at the beginning of the period
Release of planned replenishment orders
for the item using a lead-time offset

The following scenario is an example of how to develop a materials

requirement planning record using the following information:
Product A consists of subassemblies B and C.
It takes one unit of B and two units of C to make one unit of A.
At the beginning of time period 1, we have 100 units of A, 150 units of
B, and 80 units of C in stock.
The gross requirements of item A are 200 for period 4 and 250 for
period 5.
The lead time for items A and C is 1 week, and for item B it is 2
weeks.

A (1)
(End Product)
Lead Time = 1
Stock = 100 units

B (1)
(Component)
Lead Time = 2
Stock= 150 units

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C (2)
(Component)
Lead Time = 1
Stock = 80 units

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Stage A. The first stage in developing a complete materials requirement

plan for a five-week period is to develop a plan for end product A.
A.1 There are 100 units at hand. We need to produce 200 units in week 4
and 250 units in week 5.

A.2 Since there are 100 units of product A on hand:

The net requirement for week 4 becomes 100 instead of 200.

The net requirement for week 5 it becomes 250.

Therefore, we need to plan for receiving orders at the amount of 100 in

week 4 based on the net requirements and 250 in week 5.

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A.3 The lead time for Item A is 1 week.

A.4 Plan for the order release of 100 units in week 3 and 250 units in
week 5.

Stage B. The second stage is to look at the requirements for item B.

There are 150 units of B on hand.
B.1 The requirements for item B are dependent on item As order release
dates. Item B should be ready at those dates.
B.2 There is no need to order any item B for week 3 since there is
enough in stock to cover the request. This leaves 50 on hand for
week 4.
B.3 The net requirement for item B for week 4 is 200 units. Plan for
receiving orders in the amount of 200 units in week 4.
B.4 Since item B has a two-week lead time, we have to plan for an order
release of 200 units in week 2 to cover the production scheduled in
week 4.

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Stage C. The third stage is to look at the requirements for item C. There
are 80 units of item C on hand.
C.1 The requirements for item C are dependent on item As order
release. Item C needs to be ready at these dates. It takes two units
of item C to produce a unit of item A.
C.2 Since there are 80 units in stock, the net requirement for week 3 is
120 units and 500 units for week 4.
C.3 Plan for receiving orders in the amount of 120 units in week 3 and
500 units in week 4.
C.4 Since item C has a one-week lead time, plan for an order release of
120 units in week 2 and 500 units in week 3.

The combined material requirement plan for item A includes its subassemblies B and C.

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Conclusion. This plan provides a road map for the production planner
for the next five weeks of production. Using this plan, schedulers
prepare detailed schedules for work centers.
If the capacity is not enough, the operations managers should decide
whether to increase the capacity, outsource, or reject the order.

Summary
Inventory management comprises one of the four decision areas for
operations managers. Inventory management is a key operations
management responsibility because it greatly affects capital
requirements, costs, and customer service.
Inventory is a stock of materials used to facilitate production or to
satisfy customer demand. Inventory is a necessary evil from a financial
point of view as it is idle capital waiting somewhere in the process.
However, virtually no organization can operate without inventory.
The main purpose of inventory is to decouple or separate the different
stages of operations and supply chain.
The four main reasons to carry inventory are to:
Protect against uncertainties in supply, demand, and lead time
Allow for economic production and purchase as in discounts for
buying in bulk
Cover anticipated changes in demand as in a level strategy or supply
Provide for transit as in pipeline inventories

There are different types of inventory within each operations system.

The four types of inventory costs to consider are:
Item cost
Ordering or setup cost
Carrying or holding cost
Stock out cost

Different demand patterns require different approaches to inventory

management. The most important demand characteristic is whether it is
independent or dependent.

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Within independent demand, the first question is how much to order.

The most common method for making this decision is the economic
order quantity. The main objective of this method is to find the order
quantity that minimizes the total cost of managing the inventory. The
second question that inventory managers have to answer is when to
reorder. There are two approaches to determine the reorder point
continuous and periodic review systems.
Inventory managers use both approaches for different items in their
inventories. One way to distinguish between these items is ABC
inventory management. The ABC inventory concept is based on the
significant few and the insignificant many. The purpose is to set
priorities on effort used to manage different items.
Dependent demand is a function of independent demand and is
calculated instead of forecasted. This is usually used for parts going
into the finished products or work in process (WIP). The primary tool
determining the dependent demand in production is materials
requirement planning. Materials requirement planning is based on the
concept of dependent demand.
Dependent demand items in a manufacturing firm are:
Raw materials
Purchased parts
WIP
Under dependent demand, a materials requirement planning system is
an information system used to plan and control manufacturing. There
are three types of materials requirement planning systems MRP,
MRPII, and ERP.
The three principles of a materials requirement planning system are
inventory, priorities, and capacity.
A materials requirement planning record displays all periods or time
buckets that exist within the master production schedule.
The total span of time buckets is called the planning horizon.

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A materials requirement planning record consists of:

Gross receipts
Scheduled receipts
Projected on hand
Net requirements
Planned order receipt
Planned order release

Complete the
exercises on your
myFranklin Web
site.

Inventory Management

Return to the Grad Success Prep Program available through your

myFranklin Web site and do the exercises for this module.

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