Chapter 21
Inventory Management: Economic
Order Quantity, JIT, and the Theory
of Constraints
COPYRIGHT 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
Study Objectives
1. Describe the just-in-case inventory
management model.
2. Discuss just-in-time (JIT) inventory
management.
3. Explain the basic concepts of
constrained optimization.
4. Define the theory of constraints, and tell
how it can be used to manage inventory.
2
Just-in-Case Inventory
Management
Three types of inventory costs can be readily
identified with inventory:
The cost of acquiring inventory.
The cost of holding inventory.
The cost of not having inventory on hand when
needed.
Just-in-Case Inventory
Management
Ordering Costs: The costs of placing and
receiving an order.
Examples: Clerical costs, documents, insurance for
shipment, and unloading.
Just-in-Case Inventory
Management
Stock-Out Costs: The costs of not having
sufficient inventory.
Examples: Lost sales, costs of expediting (extra setup,
transportation, etc.) and the costs of interrupted
production.
Just-in-Case Inventory
Management
Just-in-Case Inventory
Management
Economic Order Quantity
TC = PD/Q + CQ/2
Where
TC = The total ordering (or setup) and carrying cost
P = The cost of placing and receiving an order (or the
cost of setting up a production run)
Q = The number of units ordered each time an order is
placed (or the lot size for production)
D = The known annual demand
C = The cost of carrying one unit of stock for one year
7
Just-in-Case Inventory
Management
Economic Order Quantity illustrated
Assume
P = $40 per order
D = 25,000 units
C = $2 per unit
EOQ =
2DP C
= (2 25,000 50) $2
= 1,000,000
= 1,000
8
Just-in-Case Inventory
Management
When to Order or Produce
Example: Assume that the average rate of usage is
100 parts per day. Assume also that the
lead time is 4 days. What is the reorder
point?
Just-in-Case Inventory
Management
10
Just-in-Case Inventory
Management
Demand Uncertainty and Reordering
Maximum usage
Average usage
Difference
Lead time
Safety stock
120
(100)
20
4
80
11
Just-in-Case Inventory
Management
12
13
14
16
17
Vendors
Careful selection; consider more than price
Close to production facility
Establish more extensive supplier
involvement
18
Basic Concepts of
Constrained Optimization
Every firm faces limited resources and
limited demand for each product.
External constraints (e.g., market demand)
Internal constraints (e.g., machine or labor
time availability)
Basic Concepts of
Constrained Optimization
Linear Programming
A method that searches among possible solutions until
the optimal solution is identified
Example: Two products, X and Y,
provide contribution
margins of $300 and
$600, respectively.
The objective is to
maximize total
contribution margin.
21
Basic Concepts of
Constrained Optimization
Linear Programming
22
Basic Concepts of
Constrained Optimization
Internal constraints:
X+Y 80
X + 3Y 120
2C + Y 90
External constraints:
X 60
Y 100
Linear Programming
X+Y
X + 3Y
2C + Y
X
Y
X
Y
80
120
90
60
100
0
0
23
Basic Concepts of
Constrained Optimization
24
Basic Concepts of
Constrained Optimization
Linear Programming
Corner Point
X-Value
Y-Value
Z = $300X + $600Y
40
24,000
30
30
27,000
45
13,500
Theory of Constraints
Measures of Systems Performance
Throughput*
The rate at which an organization generates money
through sales
Inventory
The money the organization spends in turning
materials into throughput
Operating expenses
The money the organization spends in turning
inventories into throughput
Sales - Unit-level
Rev
Var Exp
*Throughput =
Time
26
Theory of Constraints
Five-Step Method for Improving Performance
Identify an organizations constraints.
Exploit the binding constraints.
Subordinate everything else to the decisions
made in Step 2.
Elevate the organizations binding constraints.
Repeat the process as a new constraint
emerges to limit output.
27
Theory of Constraints
28
Theory of Constraints
29
Theory of Constraints
30
COST MANAGEMENT
Guan Hansen Mowen
End Chapter 21
31