Page 239 - DMGT501_OPERATIONS_MANAGEMENT

Unit 9: Inventory Planning and Control

9.2.3 Set up (or Production Change) Costs Notes

In the case of sub-assemblies, or finished products that may be produced in-house, ordering cost
is actually represented by the costs associated with changing over equipment from producing
one item to producing another. This is usually referred to as set up costs.

Set up costs reflect the costs involved in obtaining the necessary materials, arranging specific

equipment setups, filling out the required papers, appropriately charging time and materials,
and moving out the previous stock of materials, in making each different product. If there were
no costs or loss of time associated in changing from one product to another, many small lots
would be produced, permitting reduction in inventory levels and the resultant savings in costs.
9.2.4 Shortage or Stock-out Costs

When the stock of an item is depleted, an order for that item must either wait until the stock is
replenished or be canceled. There is a trade-off between carrying stock to satisfy demand and the
costs resulting from stock out. The costs that are incurred as result of running out of stock are
known as stock out or shortage costs. As a result of shortages, production as well as capacity can

be lost, sales of goods may be lost, and finally customers can be lost.
In this context, it is important to understand the difference between dependent and independent
demand. In manufacturing, inventory requirements are primarily derived from dependent
demand; however, in retailing the requirements are basically dependent on independent
demand.
Inventory systems are predicated on whether demand is derived from an end item or is related
to the item itself. Because independent demand is uncertain, extra inventory needs to be carried
to reduce the risk of stocking out.

To determine the quantities of independent items that must be produced, firms usually use a

variety of techniques, including customer surveys, and forecasting. However, a balance is
sometimes difficult to obtain, because it may not be possible to estimate lost profits, the effects of

lost customers, or penalties for delayed order fulfillment.

Where the unfulfilled demand for the items can be satisfied at a later date (back order case), in

such a case, the cost of back orders are assumed to vary directly with the shortage quantity (in
rupee value) and the cost involved in the additional time required to fulfill the backorder ( / /

year). However, if the unfulfilled demand is lost, the cost of shortages is assumed to vary directly
with the shortage quantity ( /unit shortage). Frequently, the assumed shortage cost is little more
than a guess, although it is usually possible to specify a range of such costs.

9.3 Inventory Control by Classification Systems
It is useful to visualize the inventory of a medium sized business organization. The inventory would
comprise thousands of items, each item with different usage, price, lead time and specifications.

There could be different procurement and technical problems associated with different items. In
order to escape this quagmire, many selective inventory management techniques are used.

9.4 Inventory Control

Recent industry reports show that inventory costs as a percent of total logistics costs are increasing.
Despite this rise, many organizations have not taken full advantage of ways to lower inventory
costs. There are a number of proven strategies that will provide payoff in the inventory area, both

in customer service and in financial terms.

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