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Inventory Management: Inventory Management: Economic Order Quantity, Economic Order Quantity,

JIT, and the Theory of JIT, and the Theory of ConstraintsConstraints

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Just-in-Case Inventory ManagementJust-in-Case Inventory Management

• To develop an inventory policy that deals with the tradeoff between acquisition costs and carrying costs, two basic questions must be addressed:• How much should be ordered (or produced) to

minimize inventory costs?• When should the order be placed (or the setup

done)?

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Just-in-Case Inventory ManagementJust-in-Case Inventory Management 1

Total ordering and carrying cost can be described as:

2// CQQPDTC Where:

TC = the total ordering and carrying cost

P = the cost of placing and receiving an order

Q=the number of units ordered each time an order is placed

D = the known annual demand

C = the cost of carrying one unit of stock for one year

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Just-in-Case Inventory ManagementJust-in-Case Inventory Management 1

The objective of inventory management is to identify the order quantity that minimizes the total

cost – called the Economic Order Quantity

CDPEOQ /2

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Just-in-Case Inventory ManagementJust-in-Case Inventory Management 1

When to Order or Produce

Reorder point: the point in time when a new order should be placed

Lead time: the time required to receive the economic order quantity once an order is place or a setup is initiated

Reorder point: Rate of usage * Lead time

Because the demand for a product is not known with certainty, the possibility of a stock-out exits. Safety stock can help avoid this.

Safety stock: extra inventory carried to serve as insurance against fluctuations in demand

Reorder point: (Average rate of usage * Lead time) + Safety stock

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JIT Inventory ManagementJIT Inventory Management 2

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.

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JIT Inventory ManagementJIT Inventory Management 2

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:

• Reducing setup times

• Improving quality

• Using cellular manufacturing

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JIT Inventory ManagementJIT Inventory Management 2

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

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JIT Inventory ManagementJIT Inventory Management 2

What is the Kanban System?

A card system is used to monitor work in process

• A withdrawal Kanban

• A production Kanban

• A vendor Kanban

The Kanban system is responsible for ensuring that the necessary products are produced in the necessary quantities at the necessary

time.

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JIT Inventory ManagementJIT Inventory Management

• Discounts and Price Increases: JIT Purchasing versus Holding Inventories• Careful vendor selection• Long-term contracts with vendors

• Prices are stipulated (usually producing a significant savings)

• Quality is stipulated• The number of orders placed are reduced

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JIT Inventory ManagementJIT Inventory Management

JIT Limitations:

1. Patience in implications is needed

2. Time is required

3. JIT may cause lost sales and stressed workers

4. Production may be interrupted due to an absence of inventory

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Basic Concepts of Basic Concepts of Constrained OptimizationConstrained Optimization 3

• Every firm faces limited resources and limited demand for each product• External constraints – market demand• Internal constraints – machine or labor time

availability

Constrained optimization is choosing the optimal mix given the constraints faced by the firm.

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Basic Concepts of Basic Concepts of Constrained OptimizationConstrained Optimization 3

Linear ProgrammingLinear programming model: expresses a constrained optimization

problem as a linear objective function subject to a set of linear constraints

A feasible solution is a solution that satisfies the constraints in the linear programming model.

Linear programming is a method that searches among possible solutions until it finds the optimal solution.

See Cornerstone 20-4

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Theory of Constraints (TOC)Theory of Constraints (TOC) 4

• Goal – to make money now and in the future by managing constraints

• Recognizes that the performance of any organization is limited by its constraints

• TOC focuses on three operational measures of systems performance• Throughput = (sales revenue – unit level variable

expenses)/time• Inventory is all the money the organization spends

in turning materials into throughput• Operating expenses defined as all the money the

organization spends in turning inventories into throughput and represent all other money that an organization spends

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Theory of Constraints (TOC)Theory of Constraints (TOC) 4

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