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FOR MANAGEMENT
Lecture 10
Inventory Control
April 2008
1
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
2
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)
3
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
4
Types of Inventory
• Typical items carried in inventory can include:
» raw materials
» purchased parts
» components
» Sub-assemblies
» work-in-progess
» finished goods and supplies
5
Basic components of inventory
• Planning phase
• Forecasting
• Feedback measurements
6
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
7
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
8
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?
9
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
12
Inventory Management for
Independent Demand
• Answers two basic questions:
13
Inventory Models
Help answer the inventory planning questions.
16
Inventory Usage Over Time
Order quantity
Usage
= Q (maximum Average
inventory level) Rate
Inventory
(Q*/2)
Inventory Level
Minimum
inventory
0
Time
17
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
Inventory
Level
Optimal Average
Order Inventory
Quantity (Q*/2)
(Q*)
Reorder
Point
(ROP)
Time
Lead Time
19
EOQ Model Equations
21
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
23
Example 2
Reorder points
yr ot nev nI
L L
28
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?
29
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
30
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.
31
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?
32