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QUANTITATIVE METHODS

FOR MANAGEMENT

Lecture 10
Inventory Control

April 2008
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Learning Objectives
When you complete this chapter, you should
be able to explain:
• the purpose of inventory
• the costs involved in inventory
• independent and dependent demand
• EOQ Model

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Outline
• Functions of inventory
- Types of inventory
• Inventory Models
- Independent versus dependent demand
- Holding, ordering, set up costs..
• Inventory Models for independent demand
- Basic Economic Order Quantity (EOQ) Model
- Minimizing costs
- Reorder points (ROP)

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What is Inventory?
• Inventory is one of the most expensive and
important assets to many companies,
representing 50% of total invested capital.
Managers have long recognised that good
inventory control is crucial.

• Definition of inventory

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Types of Inventory
• Typical items carried in inventory can include:
» raw materials
» purchased parts
» components
» Sub-assemblies
» work-in-progess
» finished goods and supplies

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Basic components of inventory
• Planning phase

• Forecasting

• Controlling of the inventory levels

• Feedback measurements

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Functions of Inventory
• To provide a stock of goods that will provide a
‘selection’ for customers
• To take advantage of quantitative discounts
• To care for against inflation and upward price
changes
• Seasonal inventory
• Safety inventory

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Where do we keep inventory
• Retail
• Wholesale/distributor
• Warehouse
• Producer
• Input supplier
- kept closer to the customer if quick
response to demand for finished goods is
needed
- kept further down the chain if more
customisation is needed
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Inventory decisions
Two fundamental decisions that have to be made
when controlling inventory are:
i. How much to order
ii. When to order
The purpose of all inventory models and
techniques is to determine rationally how much to
order and when to order.
What is the objective of inventory?

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Inventory Costs
• Purchasing costs – cost incurred when purchasing a
unit of an item.
• Holding costs – associated with holding or
‘carrying’ inventory over time.
• Ordering costs – associated with costs of placing
order and receiving goods.
• Setup costs – cost to prepare a machine or process
• Stockouts costs – penalty costs for running out of
stock.
• Safety stock – extra stock kept at hand in order to
avoid stockouts. 10
Disadvantages of Inventory
• BUT maintaining inventory incurs costs such as:
» Ordering costs (setup cost – flat charge
for delivery and admin)
» Unit costs (charge per item)
» Holding costs (insurance, interest lost on
capital, cost of storage)
» Shortage costs (cost of placing an order
for immediate delivery, cost of lost trade,
loss of goodwill)

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Independent v/s Dependent Demand
• Independent demand – demand for item
is independent of demand for any other
item
• Dependent demand – demand for item is
dependent upon the demand for some
other items

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Inventory Management for
Independent Demand
• Answers two basic questions:

1. how much should we order?

2. when should we order?

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Inventory Models
Help answer the inventory planning questions.

• Fixed order-quantity models


- Economic Order Quantity (EOQ): one of the
oldest and most commonly known inventory
control techniques.
- Quantity discount: a reduced cost for an item
when it is purchased in larger quantities.
• Probabilistic models
• Fixed order-period models
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Economic Order Quantity (EOQ)
Assumptions
• Known and constant demand.
• Known and constant lead time (time between the
placement of the order and the receipt of the order)
• Instantaneous receipt of material: the inventory from
an order arrives in one batch, at one point in time.
• No quantity discounts.
• The only variable costs are the cost of placing an
order (ordering cost) and the cost of holding (holding
or carrying cost)
• No stockouts: if orders are placed at the right time,
shortages can be avoided completely.
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EOQ Objective
• To determine the quantity to order which will
minimise the total annual inventory cost
Total annual inventory cost = annual inventory
holding costs + annual ordering/setup costs

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Inventory Usage Over Time

Order quantity
Usage
= Q (maximum Average
inventory level) Rate
Inventory
(Q*/2)
Inventory Level

Minimum
inventory
0
Time
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EOQ Model (How Much to Order?)

Annual Cost

ur ve
st C
a l Co r ve
Tot t Cu
Minimu C os
m total i n g
ld
cost Ho

Order (Setup) Cost Curve

Optimal Order quantity


Order
Quantity (Q*) 18
EOQ Model (When To Order)

Inventory
Level
Optimal Average
Order Inventory
Quantity (Q*/2)
(Q*)

Reorder
Point
(ROP)

Time
Lead Time
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EOQ Model Equations

ptimal Order Quantity =Q* = 2×D ×Co


Ch
D
=N =
pected Number of Orders
Q*
Working Days /Year
pected Time Between Orders =T =
N
D D = Demand per year
d=
Working Days /Year Co = Setup (order) cost
per order
ROP = d × L
Ch = Holding (carrying)
cost
d = Demand per day 20
Finding the EOQ
Four steps for finding the optimum inventory:
• Develop an expression for the ordering cost.
• Develop an expression for the holding cost.
• Set the ordering cost equal to the carrying
cost.
• Solve this equation for the optimum desired.

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Example 1
A company that sells pump housings to other
manufacturers, would like to reduce its inventory
cost by determining the optimal number of pump
housings to obtain per order. The annual demand is
1,000 units, the ordering cost is £10 per order and
the average holding cost per unit per year is £0.50.
i. Calculate the optimal number of units per order.
ii. Evaluate the total inventory cost.
iii. The expected number of orders.
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Fixed Period Model
• Answers how much to order
• Orders placed at fixed intervals
– Inventory brought up to target amount
– Amount ordered varies
• No continuous inventory count
– Possibility of stockout between intervals
• Useful when vendors visit routinely
– Example: P&G representative calls every 2
weeks
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Example 2

A wholesaler has a steady demand for 50 items of a


given product each month. The purchase cost of each
item is $6 and the holding cost for this item is
estimated to be 20% of the stock value per annum.
Every order placed by the wholesaler costs $10 in
administration charges regardless of the number
ordered.
Given this information, you are required to evaluate all
the relevant costs and attempt to determine the most
economic order quantity for this item of goods. 24
Example 3
The Managing Director at Littlewoods, has asked you to
devise ordering policies at the central warehouse for all the
major drug items required by their stores. Consider a
single item of stock: the Becotide inhaler for asthma
sufferers. Assume that there is a constant demand for this
item of 400 per week. Each inhaler costs $3 to purchase.
It is estimated that it costs an average of $2 per week to
store 100 inhalers in the warehouse. Each order placed to
the suppliers costs $12 in administration fees. Using this
information, what is the optimum order quantity and order
frequency for this product? Sketch a graph indicating the
total costs, holding costs and order costs.
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Reorder point: Determining when to
order
• In most simple, inventory models, it is assumed
that receipt of an order is instantaneous. That is,
we assume that a firm waits until its inventory
level for a particular item reaches 0, places an
order and receives the items in stock
immediately.
• However, the time between the placing and
receipt of an order , called the lead time or
delivery time, is often a few days or even a few
weeks. 26
Reorder point: Determining when to
order
• Thus, the when to order decision is usually
expressed in terms of e reorder point (ROP),
the inventory level at which an order should
be placed. The reorder point, ROP, is given
as
• ROP = (demand per day) * (lead time for a
new order in days)
=d*L
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• The figure illustrates the situation where
reordering occurs L time units before delivery is
expected.

Reorder points
yr ot nev nI

L L

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Procomp’s demand for computer chips is
8,000 yearly. The firm has a weekly demand
of 280 units. On the average, delivery of an
order takes three working days.
Calculate the ROP?

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Probabilistic Models
• Answer how much & when to order
• Allow demand to vary
– Follows normal distribution
– Other EOQ assumptions apply
• Consider service level & safety stock
– Service level = 1 - Probability of stockout
– Higher service level means more safety stock
• More safety stock means higher ROP

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Safety Stock
• Safety stock is additional stock that is kept on
hand.
• If, for example, safety stock for an item is 50
units, you are carrying an average of 50 units
more of inventory during the year.
• When demand is unusually high, you dip into the
safety stock instead of encountering a stockout.
• Thus, the main purpose of safety stock is to
avoid stockouts when the demand is higher than
expected.
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Safety Stock
• The Hinsdale Company carries an inventory item
that has a normally distributed demand during the
reorder point. The mean demand is 350 units and
the standard deviation is 10. Hinsdale follow a
policy that results in stockouts occurring only 5%
of the time.
How much safety stock should be maintained?

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