Lecture Engineering economics - Chapter 9: Minimum cost analysis

Upon completion of this lesson, the successful participant will be able to: Minimum cost concepts, Economic Order Quantity (EOQ) analysis methods, Just‐in‐time (JIT) purchasing quantities based on EOQ, setup time reduction, push and pull inventory scheduling and EOQ.

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Chapter 9 – Unit 1

Minimum Cost Analysis

IET 350 Engineering Economics

Learning Objectives – Chapter 9

Upon completion of this chapter you should understand:

Minimum cost concepts

Economic Order Quantity (EOQ) analysis methods

Just‐in‐time (JIT) purchasing quantities based on EOQ

Setup time reduction

Push and pull inventory scheduling and EOQ

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Learning Objectives – Unit 1

Upon completion of this unit you should understand:

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Basis for understanding and applying techniques such as:

Economic purchase quantity analysis

Economic production quantity analysis

Just‐in‐time purchasing

Just‐in‐time scheduling

Inventory reduction

Capacity maximization

Cost minimization as related to quality, maintenance and

design

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Minimum Cost Analysis

Cost analysis problems frequently include opposing costs.

Changes to a variable may cause some costs to increase

while other costs decrease

Example J increasing production quantities reduce cost

associated with setup but increase costs associated with

holding and storing inventory

Objective of minimum cost analysis is to find the point at

which total costs are minimized

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Minimum Cost Analysis

Breakeven, isocost and make/buy analysis techniques apply

to situations where cost increase relative to a key variable

(output quantity)

Minimum cost analysis techniques apply to situations where y q pp y

some costs increase and some costs decrease relative to a

key variable (typically output quantity).

Concept of minimum cost occurs frequently when designing

and manufacturing products

“It is not enough to design a technically good product; it

must be economical as well.”

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Minimum cost analysis is typically used in the manufacturing

process in the following areas:

Amount and type of quality control

Amount of raw material and/or components in each

purchase order.

Scheduling delivery frequency of materials from vendors

Determination of the equipment setup and scheduling of

production

Determination of the production lot size

Response and delivery times to customers 7

End Unit 1 Material

Go to Unit 2 Economic Order Quantity

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Economic Order Quantity

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Upon completion of this chapter you should understand:

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Inventory and Minimum Cost

Technique for minimizing inventory costs is known as

Economic Order Quantity (EOQ) analysis

Economic Order Quantity analysis is applied to:

Production lot (batch) quantity determination

Purchase quantities for raw materials or components

used in the product from outside suppliers

Purchase quantities for supplies required for the

organization’s operation

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Inventory and Minimum Cost

Just‐in‐time (JIT) is an economic order quantity concept of

having inventory and supplies available just before they are

required rather than holding large quantities in inventory

Large inventories are sometimes known as just‐in‐case.g j

Just‐in‐time is a philosophy that requires a fundamental shift

in how manufacturing organizations operate

Known and predictable quality is mandatory

Just‐in‐time also requires a fundamental change in many

manufacturing methods to allow quick and inexpensive

changeover of equipment to produce different parts

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Determination of inventory levels is a critical decision for

manufacturing organizations:

Inventory represents significant costs and investment of

financial resources

Lack of inventory leads to customer dissatisfaction and

potential loss of sales

Inventory must be ordered, scheduled and monitored

which requires personnel resources

Levels of in‐process inventory significantly affects the

operation of the production area

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Inventory EOQ

Determination of EOQ requires minimizing opposing costs.

Increasing order quantities and the resulting inventory:

Ordering/setup costs are lower since fewer orders per

time period are required.p q

Holding (storage) cost of inventory increases due to

higher levels including the requirement of more space

Funds used to purchase the inventory have a cost (ROI)

Inventory is readily available for immediate sale

Loss due to scrapping inventory due to obsolescence

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Inventory EOQ

Determination of EOQ requires minimizing opposing costs.

Decreasing order quantities and the resulting inventory:

Ordering/setup costs are higher since more orders per

time period are required.p q

Holding (storage) cost of inventory decreases due to

lower levels including the requirement for less space

Funds used to purchase the inventory have a cost (ROI)

Potential for lost sales due to lack of inventory

Less chance of loss of inventory due to obsolescence

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Inventory EOQ – Factors

Order Cost J costs associated with obtaining quotations and

placing the order for materials, supplies or components

Setup Cost J costs associated with the setup or changeover

of production equipment for each production batch (lot).p q p p ( )

Holding (Storage) Cost J costs associated with:

Value of warehouse space

Cost of the investment (ROI)

Other costs such as insurance, spoilage, damage,

materials handling and related storage costs

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Total Inventory Cost = Order Cost + Storage Cost

17 Example problem from Bowman text page 351

Annual Storage or Holding Cost J uses average inventory/year:

( )( )

Q Holding Cost = H PV

2

⎛ ⎞

⎝ ⎠

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( )( )

where: Q = Units/order (EOQ)

H = Holding costs/year (%)

PV = Part Value ($/unit)

2

⎜ ⎟

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Annual Setup Cost:

( )

AU Setup Cost = SU

Q

⎛ ⎞

⎜ ⎟

⎝ ⎠

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( )

where: Q = Units/order (EOQ)

AU = Annual Usage (units/year)

SU = Setup Cost ($/setup)

Q

⎜ ⎟

⎝ ⎠

EOQ occurs when Annual Storage Cost = Annual Setup Cost :

H PV = SU

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( )( ) ( )( )

solving for Q

2 AU SU EOQ = Q =

H PV

This EOQ equation yields an exact mathematical solution

( )( ) ( )( )

2 AU SU EOQ = Q =

H PV

This EOQ equation yields an exact mathematical solution

Frequently it is advantageous to modify the actual quantity

ordered to better reflect schedule or customer requirements

Often firms maintain a safety stock to account for unexpected

orders or delays in delivery. However, safety stock adds cost

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This EOQ equation yields an exact mathematical solution for

( ) ( )

( )( )

2 AU EOQ = Q = PO

H PV

This EOQ equation yields an exact mathematical solution for

purchased raw materials, components or supplies

The Setup Cost per order (SU) is replaced with the Purchase

Cost per order (PO)

Like EOQ for manufactured parts, EOQ for ordered items is

adjusted within reason to account for specific situations

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Example Problem 9.1

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Example Problem 9.1 Solution

End Unit 2 Material

Go to Unit 3 Just‐In‐Time Purchasing

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Just‐In‐Time Purchasing

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Just‐In‐Time Purchasing

Successful just‐in‐time ordering is based on EOQ analysis

Philosophy J if the cost of executing the purchase order (PO)

is reduced, the order frequency (f) increases and the quantity

per order (Q) decreases

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per order (Q) decreases

Result J reduced stored inventory and shorter response time

to the customer

Reduced inventory requires less space allowing for

conversion to productive purposes

Objective J extend J‐I‐T philosophy to all purchased

materials and supplies

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J‐I‐T purchasing implementation:

Work with vendors to establish long‐range ordering plans

under a single purchase order with more frequent

deliveries and smaller quantities per delivery.q p y

Utilize single vendors and establish long‐term relationships.

Long‐term commitments generally result in:

Investment by vendor yielding lower costs to the vendor

and customer

Higher‐quality products with less variation. Quality

assurance responsibilities are transferred to the vendor

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Just‐In‐Time Purchasing

As suppliers and customers become “partners,” costs decrease,

quality increases, and schedules become more synchronized.

The results of this effort are better profits for both the supplier

and customer as well as higher customer satisfaction

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J‐I‐T purchasing requires the vendor (supplier) to make

similar changes in their production system:

Producing large quantities, storing inventory and shipping

small frequent quantities will increase costs to the vendor

resulting in higher costs to the customer

Quantity Discounts and EOQ

Suppliers frequently offer quantity discounts for minimum

order quantities or order dollar value

Buyers must consider the effect on total cost if the EOQ is

ordered or if the quantity needed for the discount is ordered.q y

Total cost is determined by totaling for the EOQ and for each

discount quantity:

Storage cost

Ordering (acquisition) cost

Material Cost

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Example Problem 9.2 Solution

EOQ Concerns and Limitations

Lumpy demand J usage and demand are not linear or

constant.

Minimum order quantity J suppliers may require minimum

order quantities which are more than the EOQ.q Q

Transportation costs J should be factored into the ordering

cost. More frequent smaller orders may result in increased

total shipping costs

Unit loads J there may be a standard quantity such as a

pallet load which is different than EOQ

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Just‐In‐Time History

First examples of J‐I‐T can be found in the grocery industry in

the United States

Dairy and bakery companies began providing home

delivery in the late 1800s J small, frequent deliveries y , q

when the item was needed

Grocery stores in the 1950s were receiving non‐

perishable items on a two week delivery schedule J

small delivery quantities minimizing inventory on‐hand

Japanese auto industry adapted inventory techniques used

by the U.S. grocery industry in the 1970s

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Go to Unit 4 Setup Time and Inventory

Scheduling

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Setup Time and Inventory Scheduling

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Key element of J‐I‐T in the production environment is

minimum setup or changeover times

If setup time can be reduced, setup costs are decreased

resulting in lower EOQ.g Q

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Figure 9‐2 Revised RL 12‐40

Setup Costs

Push and Pull Inventory and EOQ

Pull inventory system:

Supplier waits for customer order to begin assembling the

final product

Replenishment components are requested from prior

department in the manufacturing sequence J pulled

from the prior step

Sequence repeats backward through the manufacturing

process until raw material inventory is reached

Order to replenish the materials and components issued

to replenish the inventory J pulled from the supplier.

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Push and Pull Inventory and EOQ

Push inventory system:

Supplier forecasts the customer needs

Product is produced in advance of customer’s needs

Product is pushed through the manufacturing sequence

and placed in finished goods inventory until needed

Push inventory system typically used when changeover

times are high

EOQ minimum cost analysis can be used to implement the

preferable pull system

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Benefits of J‐I‐T purchasing, EOQ and quick changeover:

Reduced inventory levels

Increased productivity

Increased inventory turnover

Reduced costs

Increased ROI

Reduced customer delivery times

Increase the organization’s overall financial results

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Conclusions on J‐I‐T

41 Figure 9‐3 Inventory Improvement Cycle

Minimum Cost Applications

Maintenance costs J implementation of preventive

maintenance policies that balance opposing costs of

inspection and preventive replacement with costs associated

with equipment downtime

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Electrical conductor sizing J balance opposing costs of

reducing resistance by increasing conductor diameter with

additional cost of larger conductor

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Fluid flow and pipe sizing J balance opposing costs of

increasing pipe diameter to reduce flow resistance with

additional cost of larger pipe

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Heat transfer and insulation thickness J balance opposing

costs of increasing insulation thickness to reduce heat loss

with additional cost of thicker insulation

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Structural design J balance opposing costs of increasing

column spacing reduce number of columns with additional

cost of heavier column cross‐section

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End Chapter 9 Material

Student Study Guide Ö Chapter 9

Homework Assignment Ö Problem Set 9

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