p
   


   
 

p
   
   
 
Learning Objectives:
Introduction to Inventory Management.
The Effect of Demand Uncertainty:
Economic Order Quantity
Reorder Points
Service levels
(s,S) Policy
Periodic Review Policy
Supply Contracts
Risk Pooling
Centralized vs. Decentralized Systems.
Practical Issues in Inventory Management.

p
 

2

2




2




2



2



 
2
2



 

 

 

 

 

 

p
   

rhere do we hold inventory?

 
 
   


Types of Inventory

p


  
 p
 
    !  "!#
 p
 

p
   

rhy do we hold inventory?

G $  
 %

Short life cycles for a number of products.

Presence of many competing products.

      &  

& '
   

'

   '
( $   '
   
  '
 
  &  
   '
 !)'
*   '


p
   

[y effectively managing inventory:

$
 +,--
 
 

 '
.
 
 / 
 
 
  
 '
0
    
123 '

p 456708   %

1----  '

499 '
94(
 '
44---'
   G 77'4 2-3


 '
p
 
G +,'7 %,-3p 
 
'

p
   

[y not managing inventory successfully:

p 4557:p;     

  <" =!,4557#'
p 4559:>/  $   
 &    $

 <" ==4?4559#'
p 4559: 
@  '
  
  

   
  <
" =( 4559#'

Objectives of Inventory Management

$
/ 
 


$
/        
 

 
/ 

   
 '

'

G   p
 
The inventory policy is affected by:


 
 
 >

)

!A

Service level
Minimize costs

p
  

Cost Structure:

Order costs
  '
  '
'
>'
oolding Costs

p   
rarehouse rental, heat & lights
    * 
 $
! 

Losses due to Pilferage, Spoilage, Damage, or

! 

 
> /
Two major questions are of interest in formulating
and solving the economic order quantity (EOQ)
model.

oow much should be ordered when the inventory

for a given item is to be replenished?
rhen the order for a given item should be
placed?

||

 
> /
(
  !B%


       '
!      "

& #'
      '
Total carrying cost is a linear function of carrying cost
rate and quantity ordered.
p
      " & 
 #'
 
 
   
"/
#'


!





|

 







Number
of units
on hand









 


R = Reorder point
Q = Economic order quantity
L = Lead time

Time










 

 












|

Cost Minimization Goal

[y adding the item, holding, and ordering costs
together, we determine the total cost curve, which in
turn is used to find the Qopt inventory order point that
minimizes total costs
Total Cost
C
O
S
T

oolding
Costs
Annual Cost of
Items (DC)
Ordering Costs
QOPT
Order Quantity (Q)

[asic Fixed-Order Quantity (EOQ)

Model Formula
Total
Annual =
Cost

Annual
Annual
Annual
Purchase " Ordering " Holding
Cost
Cost
Cost

$

!%
&
$%
"

#
"

o



TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost
per unit of inventory

Deriving the EOQ

Using calculus, we take the first derivative of

the total cost function with respect to Q, and
set the derivative (slope) equal to zero, solving
for the optimized (cost minimized) value of Qopt

$#
'(

$
)'*

#
%)
*+!
&


&

o
(

o
%
re also need a
reorder point to
tell us when to
place an order

  
   

& ,


&







'
)

,
&
,


'
)

EOQ Example (1) Problem Data

Given the information below, what are the EOQ and
reorder point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
oolding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15

EOQ Example (1) Solution

^


.

'|///
)'|/)




 0/

|///
 3 





40

 3 


12




90 units

 5
 3

 

 


 5  3


'5

)

|2 |1

20 u n its

In summary, you place an optimal order of 90 units. In

the course of using the units to meet demand, when
you only have 20 units left, place the next order of 90
units.

EOQ Example (2) Problem Data

Determine the economic order quantity
and the reorder point given the following

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
oolding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15

EOQ Example (2) Solution

 *+! &

$ #
&
o

 '| / / / /
)'| / )
&  4 0 | 1
 
 

| 0/

its

|////
 3 

&
& 5 25
 3 

40

 3 

-

& 
, &  5  2 5
   3 


'| /

) &  5  2 5
 
2 7 4

Place an order for 366 units. rhen in the course of

using the inventory you are left with only 274 units,
place the next order of 366 units.

its

!B%!
!B 
Example:
     
    
  1----'       

  +?-     
     1-3    
  +4-'
*
       
C
D=20,000yds
s=$50
i=0.20
c=10

!B%( $



EOQ = Q* = 2V50V20000/(0.20V10)
= 1000 yds.

!B%( $


The company must order 1000 yards when ever it
orders. At this EOQ
Annual order processing costs
=50V(20000/ )
= 50V(20000/1000)
= $1000
Annual Carrying Costs
=(0.20V10)V( /2)
= (0.20V10)V(1000/2)
= $1000

!B%( $


Annual TIC*= Annual order processing costs +
Annual carrying costs
= $1000 + $1000
= $2000
Annual TC* = Annual order processing costs +
Annual carrying costs + Item
Costs
= $1000+$1000+10V20000
= $202000



 G  
Most companies treat the world as if it were
predictable:
  
 
  

 
 
 
  '

 
   
  
  
 '
Recent technological advances have increased the
level of demand uncertainty:
'
p  
'



 
The three principles of all forecasting techniques:

  '

 / 
'
(  
'

 
  0

Fashion items have short life cycles, high variety

of competitors.
SnowTime Sporting Goods

) 

'
!   '
;     
 
  
 
 
'

 494--
 
   '

  
> 




0














 

  



'

 
 
   





































 

0
 


 

 


Production cost per unit (C): $80

Selling price per unit (S): $125
Salvage value* per unit (V): $20
Fixed production cost (F): $100,000
Q is production quantity, D demand
Profit =

 . D. $E 
 

F
 $/ 
    
 


 
  
Scenario One:

41---A 
 
  49---A'
G41?"41---#. 6-"41---#. 4-----G
+77---Scenario Two:

41---A 
 
  44---A'
G41?"44---#. 6-"41---#. 4-----E
1-"4---#G+99?--

 
; 

 & 

$
/

 '
B %&  &
  
 
 C

C
Question: rill this quantity be less than, equal
to, or greater than average demand?
Average demand is 13,100.
Look at marginal cost Vs. marginal profit

p$A  %

  G41?.6-G+7?
p   %
  G6-.1-G+2-

So Snow Time should make less than average

demand.

 
$













 

 
$

ofit

Exp


t d

ofit




d

u ntit


 
%p
 !
 

    



   
'

& 


 '
(
  '

-p  




&   
&
 
 '

&   
  
   

  '
(&  
 
   '
( &  
 'p 
      '

  
[uyers and suppliers usually agree on supply
contracts. These contracts are very powerful tools
that can used to ensure adequate supply and
demand for goods.
In a supply contract the buyer and seller may agree
on:

  

 '
 

 
$

& '


'

&'
 '

'

  

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20
Manufacturer

Manufacturer DC

Retail DC

Stores



   


















t

0


 

$

xpected Profit











Orde r Qua ntity

$

E




  " '#


& 41--- '
8$+7,---- 
  
#'
 +77----"G41---"6-.9?#.
4-----#'
 +54----"7,----E77----#'
p

 



 







 

 




  " 8#

;.;  '


 .   '
0!
/ '
B .$ '
 '

  

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20
Manufacturer

Manufacturer DC

Retail DC

Stores


;;G+??#

[uy-[ack Contracts:
Suppose the manufacturer offers to buy back
unsold jackets from the retailer for $55.

;;G+??#









 
  



3
 


";;G+??#











t  
ft



3
 t t

'

 ";;G+??#











  





 


 ";;G+??#














  





 


;..; ";G??#

;
Under buy back at $55:
8G+?496--'
 8G+7,45--'
G?496--E7,45--G+56?,--'

|

  " 8#

Revenue-Sharing Contracts:
In revenue-sharing contracts, buyer shares some
of its revenue with the seller, in turn for a discount
on the wholesale price.
In this type a contract, manufacturer agrees to
reduce the whole price from $80 to $60, and in
return, the retailer provides 15% of the product
revenue to the manufacturer.

  

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$60

Selling Price=$125
Salvage Value=$20
Manufacturer

Manufacturer DC

Retail DC

Stores


"+2- 

4?3#









    



3
  

"+2- 

4?3#











    



3
  



 "+2-

 4?3#













  





 


 "+2-

 4?3#












 





 


 .
.   "
+2- 4?3#
Under this RS Contract:
8G+?-791?'
 8G+7649,?'
G?-791?E7649,?G+56?,--'

'

  

2
 
2
  

 

2



 









 


 


 








 




  



  " 8#

0!
/ %
;
  
 



  /   
 
  '
p  
  
+5-G+41?.+9? 
  +4?G+9?.
+1-'

  

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20
Manufacturer

Manufacturer DC

Retail DC

Stores
|

























 



 


 


  


 






















 






 


  

2
 
  
2  
 
 2

  
 

 















 








 




  





  %-p  


  

 & 
/ 

/ '

;; 
    


A
  '

  % 

Example: Demand for a movie newly released

video cassette typically starts high and
decreases rapidly

[lockbuster purchases a copy from a studio for

$65 and rent for $3


 4-

* 
 11

  

Retailers cannot justify purchasing enough to

cover the peak demand

p 45561-3



  

 

  % 

Starting in 1998 [lockbuster entered a revenue

sharing agreement with the major studios

 +6

;9-.7?3  


Even if [lockbuster keeps only half of the rental

income, the breakeven point is 6 rental per copy
The impact of revenue sharing on [lockbuster
was dramatic

  ,?3 


 
1?3943"1 
 * 
 ?3

#

! 

Quantity Flexibility Contracts


  

  
  
   & 
Sales Rebate Contracts

  

 
 
 


 & 

'

 
%p p
 

Production cost per unit (C): $80

Selling price per unit (S): $125
Salvage value per unit (V): $20
Fixed production cost (F): $100,000
Q is production quantity, D demand
Profit =

 . D. $E 
 

 
$

Profit

Expected Profit






Order Quantity

p p
 

Suppose that one of the jacket designs is a

model produced last year.
Some inventory is left from last year.
Assume the same demand pattern as before
If only old inventory is sold, no setup cost.
Question: If there are 7000 units remaining, what
should SnowTime do? rhat should they do if
there are 10,000 remaining?

" #


 
 

 '
p

'
 " #'p
 

 '
   ..

'
  

 
$ 
  
  '


Consider these two systems:



*

a
6
*



!

a
6
!

#

a
6
*
#



a
6
!



For the same service level, which system will

require more inventory? rhy?
For the same total inventory level, which
system will have better service? rhy?
rhat are the factors that affect these answers?

 %
p
 !
 

Centralizing inventory control reduces

both safety stock and average inventory
level for the same service level.

rhat other kinds of risk pooling will we

see?

Risk Pooling:
Types of Risk Pooling

Risk Pooling Across Markets

Risk Pooling Across Products
Risk Pooling Across Time
Daily order up to quantity is:
LTVAVG + z V AVG V LT

*
|/

||

|

|

$


|0

 /!) /

rhat is the effect on:

C


C
!
C
>
C
  C

 / 

Centralized Decision:
#







'

 
  p
 


  
 
 
 
 "453#'
)
 -G 
"4-3#'
p

 ",3#'
G
 
  
 
"23#'
  
  


"23#'
!'

 
p
  

p 

;
 

  
 
"42'13#'

"4?3#'
p

 "4-',3#'
(   "5'23#'
  
 
  
 "2'23#'
   -G"?'43#'
!'

'

End of the Session

Thank You

'|