11-1 Inventory Management

Operations Management

William J. Stevenson

8th edition
11-2 Inventory Management

CHAPTER
11

Inventory
Management

Operations Management, Eighth Edition, by William J. Stevenson

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
11-3 Inventory Management

Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
11-4 Inventory Management

Types of Inventories
 Raw materials & purchased parts
 Partially completed goods called
work in progress
 Finished-goods inventories
 (manufacturing firms)
or merchandise
(retail stores)
11-5 Inventory Management

Types of Inventories (Cont’d)

 Replacement parts, tools, & supplies

 Goods-in-transit to warehouses or customers
11-6 Inventory Management

Functions of Inventory

 To meet anticipated demand

 To smooth production requirements
 To decouple operations
 To protect against stock-outs
11-7 Inventory Management

Functions of Inventory (Cont’d)

 To take advantage of order cycles

 To help hedge against price increases
 To permit operations
 To take advantage of quantity discounts
11-8 Inventory Management

Objective of Inventory Control

 To achieve satisfactory levels of customer

service while keeping inventory costs within
reasonable bounds
 Level of customer service
 Costs of ordering and carrying inventory
11-9 Inventory Management

Why Inventory Control?

11-10 Inventory Management

Why Inventory Control?

Inadequate inventory control can result in both:
-understocking
-overstocking

Two fundamental decisions:

timing (when to order)
size (how much to order)
11-11 Inventory Management

Effective Inventory Management

 A system to keep track of inventory
 A reliable forecast of demand
 Knowledge of lead times
 Reasonable estimates of
 Holding costs
 Ordering costs
 Shortage costs
 A classification system
11-12 Inventory Management

Inventory Counting Systems

 Periodic System
Physical count of items made at periodic
intervals. Order is placed for variable amount
after fixed passage of time.

 Perpetual (Continuous) Inventory System

System that keeps track
of removals from inventory
continuously, thus monitoring
current levels of each item.
Constant amount is ordered when
inventory declines to predetermined
level
11-13 Inventory Management

Inventory Counting Systems (Cont’d)

 Two-Bin System - Two containers of

inventory; reorder when the first is empty
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0

214800 232087768
11-14 Inventory Management

Key Inventory Terms

 Lead time: time interval between ordering

and receiving the order
 Holding (carrying) costs: cost to carry an
item in inventory for a length of time,
usually a year
 Ordering costs: costs of ordering and
receiving inventory
 Shortage costs: costs when demand exceeds
supply
11-15 Inventory Management

ABC Classification System

Figure 11.1
Classifying inventory according to some
measure of importance and allocating control
efforts accordingly.
A - very important
B - mod. important
High
C - least important A
Annual
$ value B
of items

Low C
Few Many
Number of Items
11-16 Inventory Management

ABC Classification
 A items
 15-20% of items that account for 75-80% of
annual inventory value
 B items
 30-40% of items that account for 15% of
annual inventory value
 C items
 40-50% of items that account for 10-15% of
annual inventory value
11-17 Inventory Management

ABC Classification
11-18 Inventory Management

ABC Classification System

Item Annual Unit cost Annual
Classification
no. demand ($) value ($)
8 1,000 4,000 4,000,000 A
5 3,900 700 2,730,000 A
3 1,900 500 950,000 B
6 1,000 915 915,000 B
1 2,500 330 825,000 B
4 1,500 100 150,000 C
12 400 300 120,000 C
11 500 200 100,000 C
9 8,000 10 80,000 C
2 1,000 70 70,000 C
7 200 210 42,000 C
10 9,000 2 18,000 C
11-19 Inventory Management

Cycle Counting

 A physical count of items in inventory

 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be performed?
 Who should do it?
11-20 Inventory Management

The Inventory Cycle

Figure 11.2

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
11-21 Inventory Management

The Inventory Cycle

11-22 Inventory Management

Economic Order Quantity Models

 Economic order quantity model

 Economic production model
 Quantity discount model
11-23 Inventory Management

Assumptions of EOQ Model

 Only one product is involved

 Annual demand requirements known
 Demand is even throughout the year
 Lead time does not vary
 Each order is received in a single delivery
 There are no quantity discounts
11-24 Inventory Management

The Inventory Cycle

Figure 11.2

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
11-25 Inventory Management

Carrying Cost
Annual carrying cost is computed by multiplying the
average amount of inventory on hand by the cost to
carry one unit for one year.

Annual carrying cost = Q H

2
where
Q = order quantity in units
H = annual holding cost per unit
11-26 Inventory Management

Carrying cost

Q
H
Annual cost

Order quantity (Q)

Carrying costs are linearly related to order size

11-27 Inventory Management

Ordering cost
Annual ordering cost will decrease as order size
increases because the larger the order size, the fewer
orders are needed.

Annual ordering cost = D S

Q
where
D = demand, usually units per year
S = ordering cost
11-28 Inventory Management

Ordering cost
Annual cost

D
S
Q

Order quantity (Q)

Ordering costs are inversely and non-linearly related to order size

11-29 Inventory Management

Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q
11-30 Inventory Management

Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q D
TC  H  S
Annual Cost

2 Q

Carrying Costs

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)
11-31 Inventory Management

Deriving the EOQ

Using calculus, we take the derivative of the

total cost function and set the derivative
(slope) equal to zero and solve for Q.

2DS 2(Annual Demand)(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost
11-32 Inventory Management

Minimum Total Cost

The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.

2DS 2(Annual Demand)(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost

To determine the order size at a minimum total

cost.
11-33 Inventory Management

Example 1
A tyre distributor expects to sell 9,600 tyres next
year. Annual carrying cost is RM16 per tyre and
ordering cost is RM75. The distributor operates
288 days per year.
a) What is the EOQ?

b) How many times per year does the store order?

c) What is the length of an order cycle?

d) What is the total annual cost if the EOQ is

ordered?
11-34 Inventory Management

Example 1
D = 9,600 tyres per year
H = RM16 per unit per year
S = RM75
2 DS 2(9,600)(75)
a ) Q    300 tyres
H 16

b) Number of orders per year: D 9,600

  32 times
Q 300

c) Time between orders: Q 300 tyres 1

  of a year
D 9,600 tyres / year 32
1
  288  9 working days
32
11-35 Inventory Management

Example 2
Taiko Manufacturing assembles security monitors.
It purchases 3,600 CRT a year at $65 each.
Ordering costs are $31 and annual carrying costs
are 20% of purchase price.
a) Compute EOQ
b) Total annual cost.
11-36 Inventory Management

Example 2
D = 3,600 CRT per year
S = $31
H = 0.20($65) = $13

2 DS 2(3,600)(31)
a ) Q    131 CRT
H 13
b) Total annual cost: Q H  D
S 
131
(13) 
3,600
(31)
2 Q 2 131

 $1,704
11-37 Inventory Management

Economic Production Quantity (EPQ)

 Production done in batches or lots

 Capacity to produce a part exceeds the part’s
usage or demand rate
 Assumptions of EPQ are similar to EOQ
except orders are received incrementally
during production
 Normally applies to a firm which is both a
producer and user
11-38 Inventory Management

Economic Production Quantity Assumptions

 Only one item is involved

 Annual demand is known

 Usage rate is constant

 Usage occurs continually

 Production rate is constant

 Lead time does not vary

 No quantity discounts
 11-39 Inventory Management

Economic Production Quantity

Production Usage Production Usage Production Usage
and usage only and usage only and usage only

Run size, Qo

Cumulative
production
Maximum
inventory,
Imax

Amount on
hand

Time
EOQ with incremental inventory replenishment
11-40 Inventory Management

Economic Run Size

 I max   D
TC min   H    S
 2   Q 
2 DS p Imax = maximum
Q 
H p u inventory
Q H = annual carrying
Cycle time  cost
u
Q D = demand per year
Run time 
p S = setup cost
Q
I max   p  u p = production rate
p
u = usage rate
11-41 Inventory Management

Example 3
A toy manufacturer uses 48,000 rubber wheels per year.
The firm makes its own wheels, which it can produce at
a rate of 800 per day. The carrying cost is $1 per wheel
a year. Setup cost is $45. The firm operates 240 days
per year. Determine the:
a) Optimal run size
b) Minimum total annual cost for carrying and setup
c) Cycle time for the optimal run size
d) Run time
11-42 Inventory Management

Example 3
D = 48,000 wheels per year
H = $1 per wheel per year
S = $45
p =800 wheels per day
u = 48,000 wheels per 240 days, or 200
wheels per day.
2 DS p 2(48,000)(45) 800
a) Q    2,400 wheels
H p u 1 800  200

b) TCmin =  I max  D
  H  S
 2  Q
Q 2400
I max   ( p  u )  (800  200)
p 800
 1,800 wheels
 1800  48000
TC   ($1)  ($45)  $1,800
 2  2400
11-43 Inventory Management

Example 3
Q 2400 wheels
c) Cycle time  
u 200 wheels per day
 12 days
A run of wheels will be made every 12 days

Q 2400 wheels
d ) Run time  
p 800 wheels per day
 3 days
Each run requires 3 days to complete
11-44 Inventory Management

Quantity Discounts
 Quantity discounts are price reductions for large orders
offered to customers to induce them to buy in large
quantities. For example:

Order Quantity Price per box

1 to 44 $2.00
45 to 69 1.70
70 or more 1.40
11-45 Inventory Management

Total Costs with Purchasing Cost

Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost

Q + DS + PD
TC = H
2 Q
11-46 Inventory Management

Total Costs with PD

Figure 11.7
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity
11-47 Inventory Management

Total Cost with Constant Carrying Costs

Figure 11.9

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
11-48 Inventory Management

Quantity Discount: Example

QUANTITY PRICE
H = $15
1 - 49 $1,400 S = $190 per computer
50 - 89 1,100 D = 200 units
90+ 900
11-49 Inventory Management

When to Reorder with EOQ Ordering

 Reorder Point - When the quantity on hand

of an item drops to this amount, the item is
reordered
 Safety Stock - Stock that is held in excess of
expected demand due to variable demand
rate and/or lead time.
11-50 Inventory Management

Determinants of the Reorder Point

 The rate of demand

 The lead time

 Demand and/or lead time variability

 Stockout risk (safety stock)

11-51 Inventory Management

Reorder Point (ROP)

 ROP can be expressed in terms of quantity.
 For example, a firm should place an order a
component when the number of components left is
50 units.
 ROP= d x LT

where, d = demand rate (units per day or week)

LT = lead time in days or weeks
11-52 Inventory Management

Reorder Point: Example

Demand = 10,000 yards/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
yards/day
Lead time = LT = 10 days

R = dLT = (32.154)(10) = 321.54 yards

11-53 Inventory Management

Safety Stock
Figure 11.12
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock reduces risk of Safety stock

stockout during lead time LT Time
11-54 Inventory Management

Fixed-Order-Interval Model

 Orders are placed at fixed time intervals

 Order quantity for next interval?

 Suppliers might encourage fixed intervals

 May require only periodic checks of

inventory levels
 Risk of stockout
11-55 Inventory Management

Fixed-Interval Benefits

 Tight control of inventory items

 Items from same supplier may yield savings
in:
 Ordering
 Packing
 Shipping costs
 May be practical when inventories cannot be
closely monitored
11-56 Inventory Management

Fixed-Interval Disadvantages

 Requires a larger safety stock

 Increases carrying cost

 Costs of periodic reviews

11-57 Inventory Management

Single Period Model

 Single period model: model for ordering of

perishables and other items with limited
useful lives
 Shortage cost: generally the unrealized
profits per unit
 Excess cost: difference between purchase
cost and salvage value of items left over at
the end of a period
11-58 Inventory Management

Single Period Model

 Continuous stocking levels

 Identifies optimal stocking levels
 Optimal stocking level balances unit shortage
and excess cost
 Discrete stocking levels
 Service levels are discrete rather than
continuous
 Desired service level is equaled or exceeded
11-59 Inventory Management

Operations Strategy

 Too much inventory

 Tends to hide problems
 Easier to live with problems than to eliminate
them
 Costly to maintain

 Wise strategy
 Reduce lot sizes
 Reduce safety stock