1.

0 Introduction

Since the 20th century, an emphasis has been put on continuous increase in efficiency of

business activities. The development of operational research methods and their implementation

with the use of modern information technologies has contributed to reducing corporate costs.

One of the ways of how to achieve their reduction is the optimization of logistics activities,

which also includes inventory management theory (Bowerson and Closs 1996).

The current market situation could be described as a competitive environment resulting from

frequent economic changes and intensive relationship networking within the supply chains

(Bazan, Jaber and Zanoni 2016). The concept of Supply Chain Management first appeared in the

mid-1990s (Sixta and Žižka 2009). Kuncová (2009) states that the supply chain management is

currently one of the most developing areas. For most companies, entering these supply chains

has been becoming a routine, gradually imposed by the market and the conditions of such

companies. An essential condition in this context is to use the latest technologies for a quick

information and data interchange between customers and suppliers. Mutual cooperation and

collaboration of the supply chain members, including sharing information, are the driving factors

ensuring a higher competitiveness in the market as well as a larger scope of activities in the

market both for the companies and the whole chains (Lee, Chan and Langevin 2016). Due to the

continuously growing customers´ demands, the limiting and decisive factor is not only the price

or quality of the product, but also lead time, services provided by the producer and/or the

customers´ relationship to the company and the product(s). As a result of these requirements,

companies currently engage more in the supply chains and their mutual cooperation can generate

far more benefits than their mutual competitiveness (Basl, Majer, Šmíra 2003). The main

objective of the supply chain management is to stay one step ahead of the competitors and a
great emphasis is also put on the information involving demand (the number of items sold,

sellers´ expectations, predicting customers´ behaviour, various marketing actions, and

competition). An important role of the inventory theory is to satisfy the demand and determine

its further development as well as to ensure an adequate quantity of the goods (Daněk and Plevný

2005).

In the supply chain, inventory (or stock) has an important role from a commercial point of view.

There is a wide range of factors affecting the supply chain, such as the stock level throughout the

whole supply chain (and not only in a particular entity), costs related to storing and maintaining

the inventory, in particular their minimization in the whole supply chain, and at the same time,

the pursuit of maximum demand satisfaction (Samal and Pratihar 2014). Inventory management

is an important element both in the management of individual companies and the supply chains

as such. Regardless of whether the inventory refers to raw materials, material, semi-finished or

finished products, it is an element which influences the operations of companies and supply

chains, and should therefore be given adequate attention. Owing to frequent uncertainties in the

market development, fluctuating demand or production and changes in lead times, the inventory

management as such may be very complicated (Emmett 2008). There is no universal model, with

a wide range of factors affecting the inventory stock, and thus the situation here is closely related

to the ability to predict the future consumption induced by future demand (Bartmann and

Beckamann 1992). The future demand varies in the course of time and is covered by the

production, which, by contrast, remains constant, and any changes that do occur are step changes

rather than incremental ones. In this case, the inventory serves to compensate for the differences

between the productive potential and the demand volume (Lukáš 2009).
1.1 Inventory Theory

Inventory theory is a mathematical concept which may be defined as the sub-specialty

within operations research and operations management that is concerned with the design of

production/inventory systems to minimize costs. It studies the decisions faced by engineering

firms and the military in connection with manufacturing, warehousing, supply chains, spare

part allocation and so on and provides the mathematical foundation for logistics. The inventory

control problem is the problem faced by a firm that must decide how much to order in each time

period to meet demand for its products. The problem can be modeled using mathematical

techniques of optimal control, dynamic programming and network optimization. The study of

such models is part of inventory theory.

1.1.1 Inventory Model

Inventory model is a mathematical model that helps business in determining the optimum level

of inventories that should be maintained in a production process, managing frequency of

ordering, deciding on quantity of goods or raw materials to be stored, tracking flow of supply of

raw materials and goods to provide uninterrupted service to customers without any delay in

delivery.

There are two types of Inventory model widely used in management.

i. Fixed Reorder Quantity System

ii. Fixed Reorder Period System.

1.1.1.1 Fixed Reorder Quantity System.

Fixed Reorder Quantity System is an Inventory Model, where an alarm is raised immediately

when the inventory level drops below a fixed quantity and new orders are raised to replenish the

inventory to an optimum level based on the demand. The point at which the inventory is ordered

for replenishment is termed as Reorder Point. The inventory quantity at Reorder Point is termed

as Reorder Level and the quantity of new inventory ordered is referred as Order Quantity.

Average Demand (DAv): It is the average number of order requests made per day.

Average Lead Time (TL): The time required to manufacture goods or product.

Average Lead Time Demand (DL): Average number of orders requested during the Lead Time

Average Lead Time Demand (DL) = Average Demand (DAv) X Average Lead Time (TL)

Safety Stock (S): It is the extra stock that is always maintained to mitigate any future risks

arising due to stock-outs because of shortfall of raw materials or supply, breakdown in machine

or plant, accidents, natural calamity or disaster, labour strike or any other crisis that may the stall

the production process.

The quantity of safety stock is often derived by analyzing historical data and is set to an

optimized level by evaluating carefully the current cost of inventory and losses that may be

incurred due to future risk.

Reorder Level (RL): Reorder level is the inventory level, at which an alarm is triggered

immediately to replenish that particular inventory stock. Reorder level is defined, keeping into

consideration the Safety Stock to avoid any stock-out and Average Lead Time

Demand because even after raising the alarm, it would take one complete process cycle (Lead

Time) till the new inventories arrive to replenish the existing inventory.

Reorder Level (RL) = Safety Stock (S) + Average Lead Time Demand (DL)

Order Quantity (O): Order quantity is the Demand (Order requests) that needs to be delivered

to the customer.

Minimum Level: At least Safety Stock has to be always maintained to avoid any future stock-

outs as per the standard practices of inventory management.

Minimum Level (LMin) = Safety Stock (S)

Maximum Level: The maximum level that can be kept in stock is safety stock and the demand

(the quantity ordered).

Maximum Level (LMax) = Safety Stock (S) + Order Quantity (O)

Example: The order quantity of an Item is 600 Units. The safety Stock is 200 Units. The

Average Lead Time is 5 Days and average consumption per days is 40 units.

Order Quantity (O) = 600 Units

Safety Stock (S) = 200 Units

Average Lead Time (TL) = 5 Days

Average Demand ( DAv ) = 40 Units

Average Lead Time Demand (DL) = Demand (DAv) X Lead Time (TL) = 200 Units

Reorder Level (RL) = Safety Stock (S) + Average Lead Time Demand (DL) = 400 Units

Minimum Level (LMin) = Safety Stock (S) = 200 Units

Maximum Level (LMax) = Safety Stock (S) + Order Quantity (O) = 800 Units

Fixed Reorder Period System.

Fixed Reorder Period System is an Inventory Model of managing inventories, where an alarm is

raised after every fixed period of time and orders are raised to replenish the inventory to an

optimum level based on the demand. In this case replenishment of inventory is a continuous

process done after every fixed interval of time.

Regular Intervals (R): Regular Interval is the fixed time interval at the end of which the

inventories would be reviewed and orders would be raised to replenish the inventory

Inventory on Hand (It): Inventory on hand is the Inventory level measured at any given point

of time.

Maximum Level (M): It is the maximum level of inventory allowed as per the production

guidelines. The maximum level is derived by analysing historical data.

Order Quantity: In this system, inventory is reviewed at regular intervals (R), inventory on

hand (It) is noted at the time of review and order quantity is placed for a quantity of (M) – (It).

Order Quantity (O) = (M) – (It).

Figure 1: Inventory Model: Fixed Reorder Period System

Example: Inventory is replenished at every regular interval of 5 days. The maximum allowable

inventory is 800 Units. The inventory reviewed on Day-5, Day-10, Day -15 and Day -20 were

387 Units, 201 Units, 498 Units and 127 Units respectively.

Regular Intervals (R) = 5 Days

Maximum Level (M) = 800 Units

Inventory on Hand: I5 = 387 Units, I10 = 201 Units, I15 = 498 Units and I20 = 127 Units

Order Quantity (O) = (M) – (It).

Order Quantity (O5) = 800 – 387 = 413 Units

Order Quantity (O10) = 800 – 201 = 599 Units

Order Quantity (O15) = 800 – 498 = 302 Units

Order Quantity (O15) = 800 – 127 = 673 Units

1.1.2 Dynamic Programming

Dynamic programming is a method for solving a complex problem by breaking it down into a

collection of simpler sub-problems, solving each of those sub-problems just once, and storing

their solutions – ideally, using a memory based data structure. A dynamic programming

algorithm will examine the sub-problems which has been solved previously and will combine

their solutions, making sure that it gives the best solution for the given problem. Therefore,

Dynamic programming algorithms are often used for optimization.

A very powerful method for optimization of a system that can be separated into stages is

dynamic programming. The main concept of this technique lies in the principle of optimality

which can be stated as follows:

An optimal policy has the property that whatever the initial state and the initial decision are, the

remaining decisions must constitute an optimal policy with regard to the state resulting from the

first decision.

Many engineering systems are in the form of individual stages, or can be broken into stages, so

the idea of breaking up a complex problem into simpler sub-problems so that optimization could

be carried out systematically by optimizing the sub-problems.

1.1.3 Network Optimization

A supply chain network optimization empowers companies to compare the current state of their

supply chains to multiple “what-if” scenarios. They can then develop concise, strategic plans and

goals based on sound metrics. The end in mind of a supply chain optimization is to provide

results that enable companies to move forward in a secure manner.

When considering a Supply Chain Network Optimization project, assess your comfort level with

your knowledge about your company’s current network, and what you will need to know – going

forward – to make highly confident decisions. Many components of a supply chain network may

seem intuitive at the micro level, but when considered as a part of the whole, those pieces may

not be the ones driving the overall direction and costs. Only by conducting a Supply Chain

Network Optimization project will those individual mechanisms, their links and influences be

measured and understood collectively.

Supply chain network optimization provide the ability to determine the costs and benefits of

adapting a company’s overall network in response to such changes

While these adaptations are often focused on improving service levels and reducing working

capital across the end-to-end distribution network, many companies fail to align their network

optimization programs with long-term business strategies and implement them in isolation

1.1.3.1 Applications of Network Optimization

i. Reduce overall supply chain costs, including working capital, production, distribution

and transportation

ii. Reduce inventory (raw materials, WIP, and finished goods)

iii. Enhance profit margins (e.g., business unit, channel, and product, etc.)

iv. Develop an ongoing capability to evaluate business and environmental changes that

affect the supply chain

v. Improve flexibility