OM323 Final Exam Study Guide PDF

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OM12 Inventory Management (1) *inventory isn’t always a physical product 2 main functions of inventory management: 1.) Match level of customer service- right goods/right place/right time/right quantity a. Measure effectiveness through customer satisfaction 2.) Cost of ordering/carrying inventories  

Within an organization: Input (RM)  Transformation (WIP)  Between organizations: Goods-in-transit

Output (FG)

Objective of inventory management: achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds 2 basic issues/decisions for inventory management: 1.) When to order 2.) How much to order Independent demand item: items ready to be sold/used ROI= Profit after tax / total assets Functions of Inventory: 1.) Meet anticipated demand- referred to as anticipation stocks because they’re held to satisfy expected demand 2.) To smooth production requirements- seasonal inventories where firms experience seasonal patterns in demand often build up inventories during preseason 3.) To decouple operations- inventories used as buffers between successive operations to maintain continuity of production that’s disrupted by equipment breakdowns/accidents. a. This is particularly useful in supply chains to insulate RM from deliverers and suppliers to FG inventory 4.) Reduce risk of stockout- hold safety stock, inventory in excess of demand to compensate for variabilities in demand/lead time 5.) Take advantage of order cycles- buying in quantities that exceed immediate requirements, store the rest a. This enables a firm to buy/produce economic lot sizes without having to match demand, resulting in periodic order cycles. 6.) Permit operations- there’s usually WIP inventory and pipeline inventory. a. Little’s law: the average amount of inventory is equal to the product of the average demand rate and the average time a unit is in the system b. Little’s law is useful for quantifying pipeline inventory 7.) Take advantage of quantity discounts Costs of Holding Inventory - Average ~30% of item cost o Opportunity cost of the investment (interest) which is the largest element o Warehousing, insurance, taxes o Breakages, spoilage, theft o Devaluation o Rework o



Price protection and returns in some industries

Inventory turnover= annual COGS/inventory

o



Days of supply or days of inventory on hand= inventory/daily COGS o



Indicates how many times a year inventory is sold, higher is better because it implies more efficient use of inventories

Indicates the expected number of days of sales that can be supplied from existing inventory

Service level: percent of demand fulfilled from the stock

Requirements for effective management: 1. System to keep track of inventory on hand and on order 2. Reliable forecast of demand that includes an indication of possible forecast error 3. Knowledge of LT and variability 4. Reasonable estimates for Holding costs, ordering costs and shortage costs 5. A classification system for inventory items Inventory Counting/Holding System:  Periodic system: physical count to decide how much to order each time o Be careful of shortages between review sessions  Perpetual inventory system: continuous review, keeps track of removals on a continuous basis – a system can provide info on the current inventory level o 2 bin system : system uses 2 containers for inventory- one where you draw out inventory, the other is what you use while you’re waiting for the replenishment of the order  Universal product code (UPC): scans at supermarkets  Point of Sale(POS): electronically record items at the time of sale Lead time: the time between order placed and receiving it. The greater the risk of variability, the greater the need for additional stock to reduce the risk of shortage Purchase cost: amount paid to vendor/supplier to buy the inventory Holding/Carrying Cost: physically having the item in storage such as interest, taxes, depreciation - Stated as a percent of unit price or dollar amount- 30% Ordering cost: costs of ordering/handling, labor etc Setup costs: fixed charge per production run regardless the size of the run Shortage costs: results when demand exceeds the supply of inventory on hand Classification Systems:  A-B-C: classifies inventory items according to some measure of importance (usually price) o A items (most important) get the most attention, C items are least important o The problem: each item gets multiplied by unit price to get annual $ value, the $ are in descending order, 1015% are the top in A, bulk is in C  Cycle Counting o Physical count of inventory, this reduces discrepancies between the amounts indicated by inventory records and actual on hand.  How much accuracy is needed?  When should cycle counting be performed?  Who should do it?  Cycle stock: inventory intended to meet demand EOQ Model (single price): NON perishable - Identifies the optimal order quantity to minimize annual costs that vary with size and order frequency Assumptions: - Only one product is involved - Lead time is known and constant - Demand is known and constant

Fixed ordering cost (doesn’t vary or depend on order size) – by ordering larger quantities at a time you save on these costs - Holding cost of inventory The Inventory Cycle:  Amt of inventory on hand -

S m all Q Finding the minimum cost:

Per unit

Q0= how much to order to minimize fixed costs and holding costs Annual carrying cost= (Q/2)H - The avg amount of inventory on hand times the cost to carry one unit a year Annual ordering cost= (D/Q)S - D=demand and S=ordering cost per year Total Cost= Annual carrying cost+ annual ordering cost Length of order cycle= Q/D

Quantity Discount Model (price breaks) Assumptions: o Demand is known and constant o Purchase price depends on the quantity ordered o Tradeoffs: Ordering costs vs. inventory vs. purchase costs EOQ with purchase cost -- P= unit price

)

Step 3: calculate TC @ Price break for P=$1.70

Quantity Discounts (when carrying costs are stated as a percentage of unit price, the minuimum points don’t ilne up. Question #16

Step 4: Pick the smallest TC! Which in this case is an order of 70

What happens when demand is uncertain? Last class we assume demand is known and constant for EOQ model Single Period Model (newsboy)- Perishables:

Goal: identify order Q, or stocking level, that will minimize the long-run excess and shortage costs Assumptions: - Uncertain demand - Single order opportunity/ single selling season o Perishables (fruit, fresh vegies) or items with limited useful life (newspaper, spare parts of specialized equipment) o You don’t carry items into the next period o Sometimes there is a cost associated with leftover goods - Trade off: Cost of excess vs. cost of shortage - 2 ways to find S0 balance point: 1.) S0=Ce + (Cs-Ce)*SL 2.) S0= mean + Z*SD Normal distribution: area represents probability - Z score : number of SD from the mean - Z =(X-mean)/SD - Z can be negative and positive Service level: probability that demand will not exceed supply during lead time (no stockout) Service level= 1- stockout risk  If service level= 95%, Means 95% of demand won’t > supply in lead time, So optimal stocking level must satisfy 95% of the time It’s NOT 95% demand won’t be satisfied

risk of

service level expected demand



a stockout

order

quantity

Shortage cost z 0 CS = revenue/unit – cost/unit (+ loss of goodwill?)  Excess cost CE = cost/unit – salvage/unit  If Ce> Cs then you’ll want to order more and more as costs get higher so you can really reduce the chance of excess  Order quantity= expected demand+ z*standard deviation of demand (to maintain service level)  When zCs  Demand > S0, shortage, Cs on right end Demand expected demand, it will arrive at maximum probable demand, use up safety stocks 

Assume any variability in demand rate or lead time can be described by a normal distribution:

ROP=expected demand over LT + safety stock Stock risk , Z , safety stock , ROP, overall means adding less inventory ROP: variable d and constant LT

where safety stock= the STD of demand over LT ROP: variable LT and constant d

ROP: variable d and variable LT

ROP: constant d and constant LT ROP=d*LT Fixed Order Interval (FOI): how much to order  Orders are placed at fixed time intervals  Reasons to use this model: o Supplier’s might want you to order at the same time o Grouping orders from the same suppliers can save on costs o Some circumstances don’t lend themselves to continuously monitoring inventory position  If demand is variable, order size will vary with each cycle  Requires only periodic checks of inventory  Most common with variable demand and constant LT

 

The higher than normal demand causes a shorter time between orders but the fixed interval method is that it will be a larger order size. FOI results in tight control and a larger amount of safety stock

Amt to order= expected demand during protection interval + safety stock – amt on hand at reorder time

Fixed Quantity

Fixed Interval

Amount to order(Q)= OI= order interval (time between orders) A= amt on hand at reorder time

Financial Impact of Supply Chain Decisions 2 kinds of Expenses (1) COGS: incurred in order to make the product or service (2) SG&A or operating expenses: associated with selling the product and running the company Category Costs Examples Cost of goods sold Direct materials Price paid to purchase materials (including shipping) Direct labor Wages of production employees (including fringe benefits) Overhead Indirect materials, indirect labor, depreciation of equipment and buildings, mfg. or facility IS, utilities cost SG&A Selling Advertising and market research costs, sales salaries and commissions

Administrative

Executive and clerical salaries, office rent and expenses, R&D and legal costs

Supply Chain design affects both the I/S and B/S:  Income statement o Determines COGS – DM, DL, MOH, Facility OH  DM are price paid to purchase materials, includes shipping  DL are wages of production employess, includes Fringe benefits if we have- paid vacation, health insurance  MOH is a “catchall” category that includes all other manufacturing costs that are not directly assignable to a specific unit produced Indirect material: cleaner  Indirect labor: supervisor  Depreciation  Cost of leaser  Utility and IS used for manufacturing  Facility overhead includes the same sorts of operations costs in service firms.  indirect materials and labor  facility lease and maintenance  utilities  depreciation  information systems  furniture and fixtures in the front and back office o Direct impact to revenue through product availability, if you don’t have enough inventory or production capacity to meet demand, sales suffer o Direct materials and direct labor are examples of variable costs. These are costs that vary directly with changes in the volume of output or activity levels. o Overhead is an example of a semi-fixed cost. These costs remain relatively constant over a range of activity, but may increase in steps as volumes exceed capacity thresholds. 

Balance Sheet o Drives inventories in current assets: RM  WIP  FG = Total Investment  Services don’t really have WIP or FG o Contributes to PPE in fixed assets

Inventory challenge:  Understand the role investors play in the SC  Translate operating decisions into investor and accounting language  Make tradeoffs and inventory decisions 

RM Inventory: o Cycle stock= Q/2 --- this tells us how much RM we need to have o





Safety stock

--- use the LT quotes from suppliers

o In transit stock --- assumes you take ownership once the RM ships WIP Inventory: o WIP units= expected demand x ag production LT o Assume a production LT of one week o This includes the time to complete full order plus planning and prep FG Inventory: o Cycle stock= Q/2 --- how much you need to be able to sell everything  Based on a production batch size of one week o o

Safety stock --- assume a total LT exposure of 2 weeks Pre-build stock: when there’s seasonality changes (aggregate planning)

Estimating demand and LT distributions:  We use a PERT distribution to estimate the normal distribution of product demand  Mean= (min * 4 * most likely + max) /6  STD= (max-min)/6 o Weekly STD= STD of demand per year/ (sqrt(number of weeks per year))  standard deviations can’t be added/divided the way that means can. Because uncertainties “pool” when combined.  Risk pooling: applies to forecasting the demand for different varieties of the same product. you can’t just divide or add STD the same way you’d divide or add the mean because the variations kind of depend on each other and there will be more uncertainty o SD don't sum due to risk pooling If you need to have many styles of one product, there’s more necessity for safety stock due to the greater difficulty of predicting demand for each individual style. o Safety stock for n varieties = (safety stock without variety+ √ n  carrying cost rate includes the opportunity cost of the capital invested in inventory plus the costs of storage space, insurance, and losses from theft, deterioration, or obsolescence.  Fixed cost of placing an order: function of the time it takes employees to determine appropriate order quantity, prepare order, receive and inspect shipment and enter it into the information systems

Expected demand comes from marketing

 

Min= expected demand – 10% of expected demand Max= expected demand + 10% of expected demand

Translating product demand into RM demand:  Estimate product demand with the PERT distribution  Calculate RM demand: o Mean material demand= BOM quantity x mean product demand  BOM= how many we need of a product o STD of material demand= BOM quantity x STD of product demand Calculating product demand: -

In order to get an initial estimate of the demand parameters for your product, you should forecast what you believe to be the most likely, worst case, and best case demand scenarios for each year

Assuming a PERT distribution, we get: mean demand= (worst case + 4 × most likely + best case) / 6 standard deviation demand = (best case − worst case) / 6

Demand estimates is annual, Lead time is in weeks/days, Conversion mean per week = (mean per year) / (number of weeks per year=52) standard deviation per week = (standard deviation per year) /

Calculating service level:

√ number of weeks per year

-

-

Assume carrying cost=30% Shortage cost = loss of gross margin  opportunity costs Cost of excess Ce here is for non-perishable products Excess cost equals the holding/carrying cost “the cost to carry the excess inventory until the firm can collect enough convincing estimate that demand has actually decreased, and reacted to that conclusions by decreasing inventories.” -Assume takes two month Use same service level for raw materials and finished goods

service level = Cs / (Cs + Ce) Ce = COGS per unit × annual carrying cost rate / 6

(annual/6=2 month)

Cs = Revenue per unit – COGS per unit Using the standard normal table (or Excel function), service level translates to a z-value

Calculating finished goods units -

Total finished goods inventory will consist of three types:

(1) cycle stock that accumulates due to the periodic completion and gradual depletion of production orders (2) safety stock that is carried to protect against uncertainty in demand for the end product (3) pre-build stock that is produced in advance during a low season in order to meet product demand during a high season. (only apply to seasonable products)

-

Q= average production batch size (assume one week worth of demand for manufacturing firms safety stock LT= one week; one week of “exposure” to uncertainty in demand – an unexpected spike in demand early in a week will produced in the following week. Pre build stock are for seasonal products

FIG cycle stock in units = (average demand per week) / 2 FIG cycle stock in dollar = FGI cycle stock in units* COGS per unit FIG safety stock in units =

z σ d √ ¿ (assume LT = 1 week for finished goods)

FIG safety stock in dollar = FIG safety stock in units * COGS per unit P FIG pre-build stock = from aggregate plan (assume 0 for now)

Calculating work in process units -

Production lead time (assume to be one week) : time to complete a full order and includes planning and preparation time Throughput time: time for only a single unit to proceed through the process

work in process units =

´d

work in process in dollars =

× average production lead time (assume 1 week in manufacturing)

´d × ( total material cost + COGS) 2

´d = mean demand

------------------------------------------------------------------------Raw materials inventory will consist of three types: (1) cycle stock that accumulates due to the periodic receipt and gradual depletion of orders from suppliers (2) safety stock that is carried to protect against uncertainties in supplier lead times and in the demand for the material (3) in-transit stock that has been shipped by the supplier but has not yet arrived at your facility.

Calculating raw materials units: -

Translate the product demand to the demand for raw materials

We must first calculate the demand and lead time parameters for each raw material: Bill of materials (BOM) = how many units of each material go into the end product

´d = Mean demand for raw material A = BOM quantity × mean demand for product

D/ ❑

σd

= Standard deviation of demand for raw material = BOM quantity × standard deviation for product

Using PERT distribution for lead time: LT = Mean lead time for material A = (worst case + 4 × most likely + best case) / 6 ❑

σ¿

= Standard deviation of lead time for material A = (best case − worst case) / 6

We can now use the equations to calculate raw materials cycle stock, safety stock, and in-transit stock for each raw material: Q = raw material A EOQ =

√

2 DS H

raw material A cycle stock in unit= Q/2 Q : find Q from EOQ (selected order size for the material which should be determined by the EOQ) Or from quantity discounts offer by suppliers

raw material A safety stock in unit =

z √ ´¿ σ2d+ d´ 2 σ ¿2

raw material A safety stock in dollar = raw material A safety stock in unit × COGS raw material A in-transit stock units =

´d × average transit time

The total raw materials units for A =cycle stock + safety stock + in-transit stock

Estimating inventory investment: -

Value of Raw material use purchase price (including inbound freight) Value of Finished Goods use COGS per unit since DL and OH costs have been added during production

-

Value of WIP use the average of DM cost and COGS per unit since on average WIP will be halfway

Multiplying the inventory units by their corresponding dollar values we get: raw materials investment = raw materials units A× cost per material A + raw materials units B × cost per material B finished goods investment = total finished goods units × COGS per unit work in process investment = work in process units × (direct materials + COGS per unit) / 2 direct material (include shipping) = material cost for A +...