Inventory Management:
Economic Order Quantity,
JIT, and the Theory of
Constraints
20
20-1
Just-in-Case Inventory Management
1
• 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)?
20-2
Just-in-Case Inventory Management
1
Total ordering and carrying cost can be
described as:
TC  PD / Q  CQ / 2
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
20-3
Just-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
EOQ  2 DP / C
20-4
Just-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
20-5
JIT 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.
20-6
JIT 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
20-7
JIT 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
20-8
JIT 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.
20-9
JIT Inventory Management
2
• 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
20-10
JIT Inventory Management
2
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
20-11
Basic Concepts of
Constrained 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.
20-12
Basic Concepts of
Constrained Optimization
3
Linear Programming
Linear 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
20-13
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
20-14
organization spends
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
20-15