HANSEN & MOWEN

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HANSEN & MOWENHANSEN & MOWEN

Cost ManagementCost ManagementACCOUNTING AND CONTROLACCOUNTING AND CONTROL

Inventory Management: EOQ, JITInventory Management: EOQ, JITand the Theory of Constraintsand the Theory of Constraints

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Three types of inventory costs can be readily identified with inventory:

(1) The cost of acquiring inventory.

(2) The cost of holding inventory.

(3) The cost of not having inventory on hand when needed.

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

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1. Ordering Costs: The costs of placing and receiving an order.

Examples: Clerical costs, documents, insurance for shipment, and unloading.

2. Setup Costs: The costs of preparing equipment and facilities so they can be used to produce a particular product or component.

Examples: Setup labor, lost income (from idled facilities), and test runs.


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3. 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.

4. Carrying Costs: The costs of carrying inventory.Examples: Insurance, inventory taxes,

obsolescence, opportunity cost of capital tied up in inventory, and storage.


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Traditional Reasons for Carrying InventoryTraditional Reasons for Carrying InventoryTraditional Reasons for Carrying InventoryTraditional Reasons for Carrying Inventory

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Economic Order Quantity

TC = PD/Q + CQ/2

The total ordering (or setup) and carrying cost

The cost of placing and receiving an order (or

the cost of setting up a production run)

The known annual demand

The number of units ordered each time an order is placed (or the lot size for production)

The cost of carrying one unit of stock for one

year


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An EOQ Illustration

EOQ = 2PD/C

D = 25,000 units

Q = 500 units

P = $40 per order

C = $2 per unit

EOQ = (2 x 25,000 x $40) / $2

EOQ = 1,000,000

EOQ = 1,000 units


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Reorder point = Rate of usage x Lead time

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?

Reorder point = 4 x 100 = 400 units

Thus, an order should be placed when inventory drops to 400 units.

When to Order or Produce


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The Reorder PointThe Reorder PointThe Reorder PointThe Reorder Point

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Demand Uncertainty and Reordering

To avoid running out of parts, organizations often choose to carry safety stock. Safety stock is extra inventory carried to serve as insurance against fluctuations in demand.

Example: If the maximum usage of the VCR part is 120 units per day, the average usage is 100 units per day, and the lead time is four days, the safety stock is 80.

Maximum usage 120Average usage -100Difference 20Lead time x 4Safety stock 80


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EOQ and Reorder Point IllustratedEOQ and Reorder Point IllustratedEOQ and Reorder Point IllustratedEOQ and Reorder Point Illustrated

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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.

Setup and Carrying Costs: The JIT Approach

JIT Inventory ManagementJIT Inventory Management 2

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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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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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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.

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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Withdrawal KanbanWithdrawal KanbanWithdrawal KanbanWithdrawal Kanban


Production KanbanProduction KanbanProduction KanbanProduction Kanban

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Vendor KanbanVendor KanbanVendor KanbanVendor Kanban


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The Kanban ProcessThe Kanban ProcessThe Kanban ProcessThe Kanban Process


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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 LimitationsJIT 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.


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Basic Concepts of Constrained OptimizationBasic Concepts of Constrained Optimization 3

Every firm faces limited resources and limited demand for each product.

External constraints, such as market demand

Internal constraints, such as machine or labor time availability

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

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Linear ProgrammingThe unit contribution margins are $300 and

$600 for X and Y, respectively.

Z = $300X + $600 Y

Total contribution margin

This equation is called the objective This equation is called the objective function, the function to be optimized.function, the function to be optimized.


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Internal constraints:

X + Y 80

X + 3Y 120

2X + Y 90

External constraints:

X 60

Y 100


Linear Programming

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X + Y 80

X + 3Y 120

2X + Y 90

X 60

Y 100

X 0

Y 0

Linear Programming


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160

140

120

100

80

60

40

20

20 40 60 80 100 120 140

Y 100

X 60

X + Y 80

X + 3Y 120

2X + Y 90


D

CB

A

Graphical SolutionGraphical SolutionGraphical SolutionGraphical Solution

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Linear Programming

Corner Point X-Value Y-Value Z = $300X + $600Y

A 0 0 $ 0

B 0 40 24,000

C 30 30 27,000

D 45 0 13,500

C is the optimal solution!


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Throughput Inventory Operating expenses

Three Measures of Systems Performance:

(Sales revenue – Unit-level variable expenses)/Time

Theory of ConstraintsTheory of Constraints 4

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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.

Five-Step Method for Improving Performance


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Drum-Buffer-Rope System: General DescriptionDrum-Buffer-Rope System: General DescriptionDrum-Buffer-Rope System: General DescriptionDrum-Buffer-Rope System: General Description


Continued

Continued from left

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Drum-Buffer-Rope System: Drum-Buffer-Rope System: Schaller Company Schaller Company

Drum-Buffer-Rope System: Drum-Buffer-Rope System: Schaller Company Schaller Company


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New Constraint Set: Schaller CompanyNew Constraint Set: Schaller CompanyNew Constraint Set: Schaller CompanyNew Constraint Set: Schaller Company


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