Inventory Management

Graeme Warren
Copyright Graeme Warren 1
Introduction
• Inventory is a stock of goods.
• Management of inventories of independent
demand items, i.e., items that can be sold,
used, or are otherwise stand-alone in nature.
• Dependent demand items are components or
spare parts of independent demand items.
Coverage in Chapter 12.

Copyright Graeme Warren 2
Importance, Types of Inventory
• Effective management of inventory is essential. There are stock
outs, with lost sales and possibly lost customers if a firm has to little
inventory. Too much inventory is a waste and reduces the firm’s
financial performance. The inventory of some firms is huge,
representing a significant investment. For most merchandisers,
inventory is one of the largest assets. For some firms, having
enough inventory (and the right type of inventory in the right
locations) to enable its competitive priorities is essential.
• Inventory may be classified by type. The most important types are:
raw materials and purchased parts, partially finished goods (also
called work in process or work in progress (WIP)), finished goods,
spare parts and maintenance supplies, tools, miscellaneous
supplies. The text also includes pipeline inventory, i.e., goods in
transit, as a separate class of inventory, but these goods can be
otherwise classified as raw materials, purchased parts, finished
goods inventory, etc.

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Functions of Inventory
• Satisfying anticipated customer demand.
• To smooth production of products that experience seasonal demand because
the firm cannot produce fast enough during the season.
• To decouple operations. The idea here is to prevent bottlenecks from being
idle due to disruptions at other machines through the use of inventory buffers.
Other strategies are available.
• To protect against stock outs. Safety stock is inventory carried to protect
against variability in demand and variability in delivery lead time.
• To exploit order cycles. Production or order quantities will generally be
optimized to balance ordering and carrying costs. The use of economic lot sizes
leads to order cycles or periodic orders.
• To beat price increases. The idea here is to stockpile in anticipation of a price
increase by a supplier.
• To permit operations. Every production system will have some work in process
(WIP). Inventory cannot be eliminated entirely.
• To exploit quantity discounts.

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Objectives & Decisions
The objectives of inventory management are:
• To ensure that the level of customer service is
satisfactory. This involves having the right goods
available at the right location and the right time to
satisfy the customer.
• To balance order and carrying costs.

The two fundamental decisions that must be made in
inventory management are:
• The order size.
• The order timing.

Copyright Graeme Warren 5
Measures of Performance
• Inventory turnover, defined as follows:

=




Higher inventory turns are desirable. Inventory turns will vary by industry and profit
margin.

• Weeks of supply, defined as follows:

=




Generally speaking we want to minimize weeks of supply, but it cannot go to zero
(because we need some inventory to “lubricate” the production system).

• Inventory on hand.
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Requirements for
Effective Inventory Management
• A system to track inventory levels (orders, backorders, and
inventory on hand). There are two basic types:
– Periodic systems, in which inventory is periodically counted for the
purpose of placing of orders. The main advantage of a periodic system
is that multiple orders can be placed at the same time, allowing for
efficient shipping.
– Perpetual systems, which track every addition to, and every removal
from inventory. When a target inventory is reached, an order is
automatically generated. Perpetual systems are easily implemented
using point-of-sale (POS) systems that can scan merchandise bar codes
or RFID tags.
• A forecast of demand, to include estimates of the mean and
standard deviation of demand per period.
• Estimates of the mean and standard deviation of delivery lead time,
per supplier, per item.

Copyright Graeme Warren 7
Requirements for Effective
Inventory Management contin.
• Estimates of the inventory carrying, ordering, and shortage costs.
– Carrying (a.k.a. holding) costs include the cost of storing inventory, including real-estate taxes,
insurance, lost interest on the value of the inventory, spoilage, pilferage, obsolescence,
warehousing costs, and material handling costs. According to the class text, annual carrying
costs range from 20% to 40% of the value of an item, depending upon the type of item.
– Ordering costs include the cost of placing an order, administration, setting up a production
facility to manufacture an order (if applicable), quality assurance, storage, and handling of the
order upon delivery.
– Shortage costs occur when there is a stock out. They are difficult to estimate and include loss
of a sale, loss of customer goodwill, and perhaps permanent loss of the customer.
• An inventory classification system that recognizes the relative importance of different items (or
stock-keeping units (SKUs). The ABC approach can be used, where
– Class A items (typically 60-70% of the value of the inventory, but usually only about 10-20% of
the total number of items in inventory) are “very important.”
– Class B items (typically 25-40% of the value of the inventory, and accounting for about 20-40%
of the total number of items in inventory) are “moderately important.”
– Class C items (typically only 10-15% of the value of the inventory, but as much as 60% of the
total number of items in inventory) are “least important.”
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Mathematical Models
Prototype inventory models, namely:
• A continuous- (a.k.a. perpetual) review model.
and
• A periodic-review model.

We will not consider the EPQ model (p. 570-573)
or quantity discounts (p. 573-577).

Copyright Graeme Warren 9
Continuous-Review Model Regime
The operating regime for the continuous-review model is as follows:
• An order (for Q units) is placed whenever the quantity of inventory
on hand reaches the re-order point, R.
• The order quantity Q is fixed and the time between orders is
variable (an order is placed when the inventory hits the re-order
point).
• The order size Q is optimized to balance carrying and ordering
costs.
• Example: used by some to buy gas for their vehicle: they go to the
gas station when the amber light (the re-order point R has been
reached) comes on, and fill up their tanks (i.e., Q is a tank of gas).
• Observe that a continuous-review system is focused on each type of
inventory in isolation.

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Periodic-Review Model Regime
The periodic-review model operates as follows:
• an order for a variable number of units is placed every
OI time units. The time between orders is therefore
fixed.
• Orders are placed for whatever is needed to restock to
a target inventory level.
• Notice that a periodic-review system can order
multiple product types whenever an order is placed.
• Many retail firms use periodic-review systems, placing
orders on a fixed weekly or biweekly basis for
numerous types of items from a supplier.

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Contrast of Continuous-Review and
Periodic-Review Models
Continuous-review
model

Periodic-review
model

Time between orders

Variable
(order when inventory
reaches the re-order point)


Fixed

Order size

Fixed

Variable
(order whatever is needed
at the fixed order times)

Copyright Graeme Warren 12
Pros and Cons of Continuous-Review
and Periodic-Review Models
• Pros of the continuous-review system: total carrying and ordering costs
are minimized.
• Cons of the continuous-review system: the model does not factor
inventory monitoring costs in the calculation of the optimal order
quantity. Monitoring is required to determine when the re-order point is
reached. Continuous-review systems can be expensive to implement in
practice due to the cost of monitoring, and the cost of shipping a single
type of item. Applications are usually limited to high-value items.
Nevertheless, it is often useful to know what the economic order quantity
is to design alternative inventory management systems.
• Pros of periodic-review systems: the fixed order interval allows for
efficient and routine shipping of multiple item types. This is a significant
consideration when freight costs are high…
• Cons of periodic-review systems: safety stock has to be carried to protect
against stock outs. Recall that in the periodic review model that orders can
only be placed at fixed order intervals, exposing the firm to greater stock
out risk because it cannot order whenever it needs to.

Copyright Graeme Warren 13
Continuous-Review Model Math
The key parameters needed to operate a continuous review system are:
• The order size Q, which we’ll set equal to the economic order size, EOQ .
• The re-order point R.

The notation we’ll assume is as follows:
• H is the annual carrying cost (in $/unit/year).
• D is the annual demand (in units).
• S is the flat order cost (in $). Note that it does not depend upon the size of the order.
• Q is an order quantity (in units).
• EOQ is the optimal order quantity a.k.a. economic order quantity or EOQ (in units).
• TBO is the time between orders.
• C is the total cost (in $).
• R is the reorder point (in units).
• L is the delivery lead time.

is the standard deviation of demand during the delivery lead time.

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Continuous-Review Model Math contin.
Copyright Graeme Warren 15
TBO TBO TBO
Q
Q
R
ORDERS PLACED
time
Inventory
Continuous-Review Model Math contin.
=

2
+

Copyright Graeme Warren 16
Order Quantity
Cost
Carrying Cost
Total Cost
Order Cost
EOQ
Continuous-Review Model Math contin.

=

2

2
= 0

2

2
= 2
−3
> 0
Celebrated EOQ formula:
=
2

Copyright Graeme Warren 17
Continuous-Review Model Math contin.
Time between orders: = /
Reorder point: = . +

where z=NORM.INV(1-ltsl,0,1)
Copyright Graeme Warren 18
Example 1
A company buys an item with a demand of 64 units/week. It costs $50 to order the item (irrespective of the
quantity ordered). Holding costs are $13/unit/year. The delivery lead time is 2 weeks and the standard
deviation of demand during the delivery lead time is 12 units. Suppose that a lead time service level of 95%
is desired. Assume 52 weeks per year. Design a continuous-review inventory strategy for this setting, and
compute the total annual carrying and holding costs.

Solution: for this problem we have = 64 × 52 = 3328 units, = $50, = $13 unit/year; = 2 weeks;

= 12 units. For this data we compute the optimal order quantity:

=
2

=
2 64 × 52 50
13
= 160

We calculate z=NORM.INV(1-.95,0,1) = 1.645.

The re-order point is then:

= . +.

= 64 × 2 + 1.645 × 12 = 128 +19.74 = 147.74
which we will round to 148 units. Note that the safety stock is 19.74 units.

The time between orders is TBO = EOQ/D = 160/(6452) = 0.048 years = 2.5 weeks.
The total annual order and holding costs of the system is:
=

2
+

=
160
2
13 +
3328
160
50 = 1,040 + 1,040 = $2,080/

Copyright Graeme Warren 19
Example 1 Visualization
Copyright Graeme Warren 20
Two- Bin System
• A two-bin system is an example
of a continuous-review system.
• The system works by storing
inventory in two bins. When a bin
is empty an order is placed. The
inventory in the second bin is
used while waiting for the order
to arrive.
• The amount of inventory in a bin
(and hence the order size) should
be EOQ.
• Reorder point R = EOQ.
Copyright Graeme Warren 21
This image was taken from the Geography project collection. See this
photograph's page on the Geography website for the photographer's
contact details. The copyright on this image is owned by Michael
Patterson and is licensed for reuse under the Creative Commons
Attribution-ShareAlike 2.0 license. Downloaded from WikiMedia
Commons.

Periodic-Review Model Math
The key parameters needed to operate a periodic-review
system are:
• The time between orders (OI), and
• The amount to order.

We assume the notation used for the continuous-review
model, adding the following:
• OI = time between orders (in days).
• A= the amount of inventory on hand at time of ordering (in
units).
• d = the mean demand per day (in units).

= the standard deviation of daily demand (in units).

Copyright Graeme Warren 22
Periodic-Review Model Math contin.
Copyright Graeme Warren 23
Orders Placed
Order Interval (OI)
Time
Inventory
T

Periodic-Review Model Math contin.
Deciding the order interval:
• May be decided by supplier
• =

Define the protection interval P as the sum of the order interval
and the delivery lead time, i.e.:

= +

The protection interval is so named because every order that is
placed has to cover demand until the next order can be placed
and delivered.


Copyright Graeme Warren 24
Periodic-Review Model Math contin.
The amount that must be ordered is the expected
demand during the protection interval, plus safety stock,
less the amount on hand at reorder time.

= . +



We assume that demand during the protection interval is
normally distributed. z is then the familiar deviate for
which the upper tail of the standard normal distribution is
1-pisl (where pisl is the desired protection interval service
level). That is, z=NORM.INV(1-pisl,0,1).

Copyright Graeme Warren 25
Example 2
A company buys an item with a demand of 64 units/week. It costs $50 to order the item (irrespective of the
quantity ordered). Holding costs are $13/unit/year. The delivery lead time is 2 weeks and the standard
deviation of daily demand is 2 units. Suppose that a protection interval service level of 99% is desired.
Assume 52 weeks per year. Design a periodic-review inventory strategy for this setting.

Solution: We have = 64 units; = 64 × 52 = 3328 units, = $50, = $13 unit/year; = 2 weeks;

= 2 units. For this data we compute the optimal order quantity:
=
2

=
2 64 × 52 50
13
= 160
Suppose that the supplier is flexible and will deliver as requested. In this case we are able to calculate the
order interval (OI):
=

=
160
3328
= 0.048 years = 2.5 weeks

Then we have = + = 2.5 +2 = 4.5 weeks.

The amount to order, at the fixed re-order times (every 2.5 weeks) will be (assuming there are A units on
inventory on hand at that time):

= 64 4.5 + 2.326 2 4.5 − = 288 + 9.9 − ≈ 298 −

since z=NORM.INV(1-.99,0,1) = 2.326.

The target inventory level, which will be denoted by T, is 298 units.

Copyright Graeme Warren 26
Single-Period Model
• The single-period model is also called the newsvendor
problem.
• Informal description: a newsvendor must decide how many
papers to buy from the newspaper company. She faces the
challenge of buying too few and foregoing profit versus
buying too many, and having to throw away unsold
newspapers at the end of the day.
• Let’s throw in some numbers: suppose she can buy the
newspapers for $0.10, and sell them for $1.00. How many
should she buy at the start of the day assuming that
demand for the newspaper is normally distributed with a
mean of 100 newspapers and a standard deviation of 15
newspapers?

Copyright Graeme Warren 27
Single-Period Model
The single-period model generalizes (and is applicable) to any inventory
system in which products age, become obsolete, or otherwise unusable at the
end of the period. The class text identifies applications in bakeries, produce,
printed media, and seafood. It is precisely the fact that the product is
valueless at the end of the period that makes the inventory problem a single-
period problem.

Suppose the following notation:



the shortage cost (i.e., the lost profit per unit =
Revenue/unit – Cost/unit)

the excess cost (i.e., Cost/unit – Salvage cost/unit)

mean period demand

standard deviation of period demand

Copyright Graeme Warren 28
Single-Period Model
The service level is the probability that demand will not exceed the stocking level, and is calculated as
follows (details are beyond the scope of the course):

=


+

The optimal stock level at the start of the period for which demand is assumed to be normally
distributed with a mean of

and a standard deviation of

can be calculated using the Microsoft Excel
2010 formula =NORM.INV(Service Level,

,

)

We are now in a position to help out our newsvendor. In her problem

=$1.00-$0.10=$0.90,

=$0.10,

=100, and

=15. So,

=


+

=
0.90
0.90 + 0.10
= 0.9

And so her optimal stocking level should be =NORM.INV(0.9, 100,15) = 119.2, or 119 newspapers!

Copyright Graeme Warren 29
Operations Strategy
• Inventory management processes offer
substantial scope for significant improvement
(because of the cost of maintaining inventory).
• The benefits accruing from lean initiatives,
improvement in supply chain management,
and the use of an IT system to track inventory
should be pursued.

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FIN
Copyright Graeme Warren 31