inventory management

Operations and Project Management Module Inventory Management

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

Inventory is a stock of materials used to facilitate production or to satisfy customer demand. There are different types of inventory within each operations system.

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

Inventory Management Version 1.0 1 of 14

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.

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 Description Capital Cost of lost opportunity of investing in inventory at the

market rate or internal rate of return Storage Includes the costs associated with buildings, utilities,

insurance, and handling Obsolescence 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.

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.


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.


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

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: 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. 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,


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 Then usage is

A 20% of units, 80% of dollars B 30 % units, 15% of dollars C 50 % of units, 5% of dollars


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 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.


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

The following characteristics pertain to materials requirement planning systems:

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 Description

I MRP An inventory control system II MRPII Manufacturing resource planning system III ERP 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. 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.


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 Description

Gross receipts Anticipated future usage of or demand for the item during each period

Scheduled receipts Existing replenishment orders that are due in at the beginning of the period

Projected on hand Projected inventory status for the item at the beginning of each period

Net requirements Gross requirements minus scheduled receipts minus projected on hand

Planned order receipt Planned receipt of replenishment orders at the beginning of the period

Planned order release 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 = 2Stock= 150 units

C (2) (Component)

Lead Time = 1Stock = 80 units


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.


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.


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 sub-assemblies B and C.


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.


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.



Complete the exercises on your myFranklin Web site.

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

Return to the Grad Success Prep Program available through your myFranklin Web site and do the exercises for this module.

inventory management

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