Managing Facilitating Goods

Replenishment
order

Factory
Production
Delay

Replenishment Replenishment
order
order

Wholesaler

Distributor

Shipping
Delay
Wholesaler
Inventory

Retailer

Shipping
Delay
Distributor
Inventory

Customer
order

Customer

Item Withdrawn

Retailer
Inventory

Learning Objectives
Discuss the role of information technology in managing
inventories.
Describe the functions and costs of an inventory system.
Determine the order quantity.
Determine the reorder point and safety stock for inventory
systems with uncertain demand.
Design a continuous or periodic review inventory-control
system.
Conduct an ABC analysis of inventory items.
Determine the order quantity for the single-period inventory
case.
Describe the rationale behind the retail discounting model.

Role of Inventory in Services

Decoupling inventories
Seasonal inventories
Speculative inventories
Cyclical inventories
In-transit inventories
Safety stocks

Considerations in Inventory Systems

Type of customer demand
Planning time horizon
Replenishment lead time
Constraints and relevant costs

Relevant Inventory Costs

Ordering costs
Receiving and inspections costs
Holding or carrying costs
Shortage costs

Inventory Management
Questions
What should be the order quantity
(Q)?
When should an order be placed,
called a reorder point (ROP)?
How much safety stock (SS) should
be maintained?

Inventory Models
Economic Order Quantity (EOQ)
Special Inventory Models
With Quantity Discounts
Planned Shortages
Demand Uncertainty - Safety Stocks
Inventory Control Systems
Continuous-Review (Q,r)
Periodic-Review (order-up-to)
Single Period Inventory Model

Units on Hand

Inventory Levels For EOQ Model

Q
D

Time

Annual Costs For EOQ Model

900
700
600

Holding Cost
Ordering Cost
Total Cost

500
400
300
200
100

Order Quantity, Q

140

120

100

80

60

40

20

0
0

Annual Cost, $

800

EOQ Formula
Notation
D = demand in units per year
H = holding cost in dollars/unit/year
S = cost of placing an order in dollars
Q = order quantity in units
Total Annual Cost for Purchase Lots
EOQ

TCp S ( D / Q) H (Q / 2)
EOQ

2 DS
H

Annual Costs for Quantity

Discount Model
22,000
C = $20.00

C = $19.50

C = $18.75

Annual Cost, $

21000

20000

2000

1000

100

200

300

400

Order quantity, Q

500

600

700

Inventory Levels For Planned

Shortages Model
Q-K

Q
TIME

-K
T1

T2
T

Formulas for Special Models

Quantity Discount Total Cost Model
TCqd CD S ( D / Q) I (CQ / 2)

Model with Planned Shortages

D
(Q K ) 2
K2
TCb S H
B
Q
2Q
2Q
Q
*

2 DS H B

H
B

H
K Q

H B
*

Values for Q* and K* as A

Function of Backorder Cost
B

Q*

2DS
H

0 B

2DS H B

H
B

B 0

undefined

K*
0

H
Q*
H B

Q*

Inventory Levels

Demand During Lead Time

Example
L 3
15
.

u=3

u=3

15
.

15
.

15
.

u=3

u=3

d L 12

ROP

ss

Four Days Lead Time

Demand During Lead time

Safety Stock (SS)

Demand During Lead Time (LT) has
Normal Distribution with
- Mean(d L ) ( LT )
- Std . Dev.( L ) LT
SS with r% service level
SS zr LT
Reorder Point

ROP SS d L

Continuous Review System (Q,r)

Amount used during first lead time

Reorder point, ROP

Average lead time usage, dL

Safety stock, SS

d1

Order quantity, EOQ

Inventory on hand

EOQ

d3
d2 EOQ

First lead
time, LT1

Order 1 placed

LT2

LT3

Time
Order 2 placed

Shipment 1 received

Order 3 placed

Shipment 2 received

Shipment 3 received

Periodic Review System

(order-up-to)

Inventory on Hand

Review period
Target inventory level, TIL

RP

RP

RP

First order quantity, Q1

Q3

Q2

d3

d1

Amount used during

first lead time

d2

Safety stock, SS

First lead time, LT1

LT2

LT3
Time

Order 1 placed

Order 2 placed

Shipment 1 received

Order 3 placed

Shipment 2 received Shipment 3 received

Inventory Control Systems

Continuous Review System
2 DS
H
ROP SS LT
EOQ

SS zr LT

Periodic Review System

RP EOQ /
TIL SS ( RP LT )
SS zr RP LT

Percentage of inventory items (SKUs)

100

90

80

70

60

50

30

20

10

40

100
90
80
70
60
50
40
30
20
10
0
0

Percentage of dollar volume

ABC Classification of Inventory

Items

Inventory Items Listed in

Descending Order of Dollar Volume
Unit cost
($)

Monthly
Sales
(units)

Computers
Entertainment center

3000
2500

50
30

150,000
75,000

Television sets
Refrigerators
Monitors

400
1000
200

60
15
50

Stereos
Cameras
Software
Computer disks
CDs

150
200
50
5
20

60
40
100
1000
200

Inventory Item

Totals

Percent of
Dollar
Dollar
Volume ($)
Volume

Percent of
SKUs

Class

74

20

24,000
15,000
10,000

16

30

9,000
8,000
5,000
5,000
4,000

10

50

100

100

305,000

Single Period Inventory Model

Newsvendor Problem Example
D = newspapers demanded
p(D) = probability of demand
Q = newspapers stocked
P = selling price of newspaper, $10
C = cost of newspaper, $4
S = salvage value of newspaper, $2
Cu = unit contribution: P-C = $6
Co = unit loss: C-S = $2

Single Period Inventory Model

Expected Value Analysis
p(D)

.028
.055
.083
.111
.139
.167
.139
.111
.083
.055
.028

2
3
4
5
6
7
8
9
10
11
12

4
12
20
28
36
36
36
36
36
36
36

2
10
18
26
34
42
42
42
42
42
42

Expected Profit

$31.54

$34.43

Stock Q
8
0
8
16
24
32
40
48
48
48
48
48
$35.77

10

-2
6
14
22
30
38
46
54
54
54
54

-4
4
12
20
28
36
44
52
60
60
60

$35.99

$35.33

Single Period Inventory Model

Incremental Analysis
E (loss on last sale)
P ( revenue) (unit revenue) P (loss) (unit loss)
E (revenue on last sale)

P( D Q)Cu P( D Q)Co

1 P( D Q) C

P ( D Q) Co

Cu
P ( D Q)
Cu Co

(Critical Fractile)

where:
Cu = unit contribution from newspaper sale ( opportunity cost of underestimating demand)
Co = unit loss from not selling newspaper (cost of overestimating demand)
D = demand
Q = newspaper stocked

Critical fractile for the

newsvendor problem
P(D<Q)
(Co applies)

Probability

P(D>Q)
(Cu applies)

0.722

10

New spaper demand, Q

12

14

Retail Discounting Model

S = current selling price

D = discount price
P = profit margin on cost (% markup as decimal)
Y = average number of years to sell entire stock of dogs at
current price (total years to clear stock divided by 2)
N = inventory turns (number of times stock turns in one year)
Loss per item = Gain from revenue
S D = D(PNY)

S
D
(1 PNY )

Topics for Discussion

Discuss the functions of inventory for different
organizations in the supply chain.
How would one find values for inventory costs?
How can information technology create a competitive
advantage through inventory management?
How valid are the assumptions for the EOQ model?
How is a service level determined for inventory items?
What inventory model would apply to service capacity
such as seats on an aircraft?

Interactive Exercise
The class engages in an estimation of the
cost of a 12-ounce serving of Coke in
various situations (e.g., supermarket,
convenience store, fast-food restaurant,
sit-down restaurant, and ballpark).
What explains the differences?