Cornerstones of cost management 3rd edition hansen mowen chapter 20

JUST-IN-CASE INVENTORY MANAGEMENT• Just-in-case inventory management: a traditional inventory model based on anticipated demand • Three types of inventory costs can be readily identif

INVENTORY MANAGEMENT: ECONOMIC

ORDER QUANTITY, JIT, AND THE THEORY

OF CONSTRAINTS

CHAPTER 20

4 Define the theory of constraints, and tell

how it can be used to manage inventory

JUST-IN-CASE INVENTORY MANAGEMENT

• Just-in-case inventory management: a

traditional inventory model based on

anticipated demand

• Three types of inventory costs can be

readily identifies with inventory

• The cost of acquiring inventory

• The cost of holding inventory

• The cost of not having inventory on hand when

JUST-IN-CASE INVENTORY MANAGEMENT

• Ordering costs: costs of placing and

receiving an order

• Examples: costs of processing an order

(clerical costs and documents), insurance

for shipment, and unloading costs

JUST-IN-CASE INVENTORY MANAGEMENT

• Setup costs: costs of preparing

equipment and facilities so they can be

used to produce a particular product or

component

• Examples: wages of idled production

workers, the cost of idled production

facilities (lost income), and the costs of

JUST-IN-CASE INVENTORY MANAGEMENT

• Carrying costs: costs of holding

inventory

• Examples: insurance, inventory taxes,

obsolescence, opportunity cost of capital

tied up in inventory, handling costs, and

storage

JUST-IN-CASE INVENTORY MANAGEMENT

• Stock-out costs: costs of not having a

product available when demanded by a

customer

• Examples: lost sales (both current and

future), the costs of expediting (increased

transportation charges, overtime, and so

on), and the costs of interrupted

EXHIBIT 20.1—TRADITIONAL REASONS FOR

CARRYING INVENTORY

JUST-IN-CASE INVENTORY MANAGEMENT

Economic Order Quantity: A Model for

Balancing Acquisition and Carrying Costs

• 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)?

JUST-IN-CASE INVENTORY MANAGEMENT

Minimizing Total Ordering and Carrying Costs

• Assuming that demand is known, the total ordering (or

setup) and carrying cost can be described by the following

equation

TC = PD/Q + CQ/2

= Ordering (or setup) cost + Carrying cost

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

JUST-IN-CASE INVENTORY MANAGEMENT

• The objective of inventory management is

to identify the order quantity that

minimizes the total cost, called the

economic order quantity

C DP

JUST-IN-CASE INVENTORY MANAGEMENT

When to Order or Produce

• Reorder point: point in time when a new order

should be placed

• Lead time: 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

JUST-IN-CASE INVENTORY MANAGEMENT

When to Order or Produce

• If 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 is extra inventory carried to serve as

insurance against fluctuations in demand

Reorder point = (Average rate of usage × Lead time) +

Safety stock

EXHIBIT 20.2—THE REORDER POINT

EXHIBIT 20.3—EOQ AND REORDER POINT

ILLUSTRATED

JIT INVENTORY MANAGEMENT

Setup and Carrying Costs: The JIT/Lean

Approach

• Long-term contracts: negotiating long-term

contracts for the supply of outside materials will

obviously reduce the number of orders and the

associated ordering costs

• Continuous replenishment: a manufacturer assumes

the inventory management function for the retailer

• Electronic data interchange (EDI): allows suppliers

access to a buyer’s online database

JIT INVENTORY MANAGEMENT

Due-Date Performance: The JIT (Lean)

Solution

• Measure of a firm’s ability to respond to customer

needs

• Lead times are reduced so that the company can

meet requested delivery dates and to respond

quickly to the demands of the market

• Lead times are reduced by reducing setup times,

improving quality, and using cellular manufacturing

JIT INVENTORY MANAGEMENT

Avoidance of Shutdown and Process

Reliability: The JIT/Lean Approach

• Total preventive maintenance: zero machine

failures

• Total quality control: the problem of defective

parts is solved by striving for zero defects

• The Kanban system: ensure that parts or materials are available when needed

JIT INVENTORY MANAGEMENT

The Kanban System

• Withdrawal Kanban specifies the quantity that a

subsequent process should withdraw from the

preceding process

• A production Kanban specifies the quantity that

the preceding process should produce

• A vendor Kanban is used to notify suppliers to

deliver more parts; it also specifies when the parts

are needed

EXHIBIT 20.4—WITHDRAWAL KANBAN

EXHIBIT 20.5—PRODUCTION KANBAN

EXHIBIT 20.6—VENDOR KANBAN

EXHIBIT 20.7—THE KANBAN PROCESS

JIT INVENTORY MANAGEMENT

Discounts and Price Increases: JIT

Purchasing Versus Holding Inventories

• Negotiate long-term contracts with a few chosen

suppliers located close to the production facility

and establish more extensive supplier involvement

• Stipulate prices and acceptable quality levels

• Reduce dramatically the number of orders placed,

which helps to drive down the ordering cost

JIT INVENTORY MANAGEMENT

JIT’s 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

BASIC CONCEPTS OF CONSTRAINED

OPTIMIZATION

• Every firm faces limited resources and

limited demand for each product

• External constraints: limiting factors imposed

on the firm from external sources, such as

market demand

• Internal constraints: limiting factors found

within the firm, such as machine or labor time

availability

BASIC CONCEPTS OF CONSTRAINED

OPTIMIZATION

• Loose constraints: constraints whose

limited resources are not fully used by a

product mix are

• Binding constraint: a product mix that

uses all of the limited resources of a

constraint

• Constrained optimization is choosing the

optimal mix given the constraints faced by

BASIC CONCEPTS OF CONSTRAINED

OPTIMIZATION

One Binding Internal Constraint

• The function to be optimized (maximized in the case of contribution margin) is called

the objective function

BASIC CONCEPTS OF CONSTRAINED

OPTIMIZATION

Multiple Internal Binding Constraints

• Linear programming model: expresses a

constrained optimization problem as a linear objective

function subject to a set of linear constraints

• All constraints, taken together, are referred to as the

constraint set

• A feasible solution is a solution that satisfies the

constraints in the linear programming model

• Linear programming is a method that searches among

EXHIBIT 20.8—CONSTRAINT DATA:

SCHALLER COMPANY

EXHIBIT 20.9—GRAPHICAL SOLUTION

THEORY OF CONSTRAINTS (TOC)

• Goal is to make money now and in the

future by managing constraints

• Recognizes that the performance of any

organization (system) is limited by its

constraints

• Focuses on the system-level effects of

continuous improvement

THEORY OF CONSTRAINTS (TOC)

Operational Measures

• TOC focuses on three operational measures of

systems performance

• Throughput: rate at which an organization generates

money through sales

Throughput = (Sales revenue – Unit level variable

expenses)/Time

• Inventory: all the money the organization spends in

turning materials into throughput

• Operating expenses: all the money the organization

THEORY OF CONSTRAINTS (TOC)

Five Step Method for Improving

Performance

• Identify an organization’s constraints

• Exploit the binding constraints

• Subordinate everything else to the decisions made

in Step 2

• Elevate the organization’s binding constraints

• Repeat the process as a new constraint emerges

to limit output

EXHIBIT 20.10—DRUM-BUFFER-ROPE

SYSTEM: GENERAL DESCRIPTION

EXHIBIT 20.11—DRUM-BUFFER-ROPE:

SCHALLER COMPANY

EXHIBIT 20.12—NEW CONSTRAINT SET:

SCHALLER COMPANY

END OF CHAPTER 20