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Purposes of Inventory

**I Meet anticipated demand
**

G Demand variability

G Supply variability

**I Decouple production & distribution
**

G permits constant production quantities

I Take advantage of quantity discounts

I Hedge against price increases

I Protect against shortages

Two Questions

**Two main Inventory Questions:
**

I How much to buy?

I When is it time to buy?

Also:

Which products to buy?

From whom?

Types of Inventory I Raw Materials I Subcomponents I Work in progress (WIP) I Finished products I Defectives I Returns .

Inventory Costs What costs do we experience because we carry inventory? .

Inventory Costs Costs associated with inventory: I Cost of the products I Cost of ordering I Cost of hanging onto it I Cost of having too much / disposal I Cost of not having enough (shortage) .

convenience. stores.7% G Administrative / paperwork error: 17. dept.5% for all else I Where does the missing stuff go? G Employees: 44.5% G Shoplifters: 32. Shrinkage Costs I How much is stolen? G 2% for discount.1% . sporting goods G 3% for toys & hobbies G 1. hardware.5% G Vendor fraud: 5.

Inventory Holding Costs Category % of Value Housing (building) cost 4% Material handling 3% Labor cost 3% Opportunity/investment 9% Pilferage/scrap/obsolescence 2% Total Holding Cost 21% .

Inventory Models I Fixed order quantity models G How much always same. when always same . when changes G Economic order quantity G Production order quantity G Quantity discount I Fixed order period models G How much changes.

setup cost per order G H .holding cost per unit time . Economic Order Quantity Assumptions I Demand rate is known and constant I No order lead time I Shortages are not allowed I Costs: G S .

EOQ Inventory Level Q* Decrease Due to Optimal Constant Demand Order Quantity Time .

EOQ Inventory Level Q* Instantaneous Optimal Receipt of Optimal Order Order Quantity Quantity Time .

EOQ Inventory Level Q* Optimal Order Quantity Time .

EOQ w Lead Time Inventory Level Q* Optimal Order Quantity Time Lead Time .

EOQ Inventory Level Q* Reorder Point (ROP) Time Lead Time .

EOQ Inventory Level Q* Average Inventory Q/2 Reorder Point (ROP) Time Lead Time .

Total Costs I Average Inventory = Q/2 I Annual Holding costs = H * Q/2 I # Orders per year = D / Q I Annual Ordering Costs = S * D/Q I Annual Total Costs = Holding + Ordering Q D TC (Q) = H * + S * 2 Q .

How Much to Order?

Annual Cost

Holding Cost

= H * Q/2

Order Quantity

How Much to Order?

Annual Cost

Ordering Cost

= S * D/Q

Holding Cost

= H * Q/2

Order Quantity

**How Much to Order?
**

Total Cost

Annual Cost = Holding + Ordering

Order Quantity

How Much to Order? Total Cost Annual Cost = Holding + Ordering Optimal Q Order Quantity .

Optimal Quantity Q D Total Costs = H* +S* 2 Q .

Optimal Quantity Q D Total Costs = H* +S* 2 Q Take derivative H D with respect to Q = −S* 2 2 Q .

Optimal Quantity Q D Total Costs = H* +S* 2 Q Take derivative H D Set equal with respect to Q = −S* 2 =0 to zero 2 Q .

Optimal Quantity Q D Total Costs = H* +S* 2 Q Take derivative H D Set equal with respect to Q = −S* 2 =0 to zero 2 Q Solve for Q: H DS = 2 2 Q .

Optimal Quantity Q D Total Costs = H* +S* 2 Q Take derivative H D Set equal with respect to Q = −S* 2 =0 to zero 2 Q Solve for Q: H DS 2 2 DS = 2 Q = 2 Q H .

Optimal Quantity Q D Total Costs = H* +S* 2 Q Take derivative H D Set equal with respect to Q = −S* 2 =0 to zero 2 Q Solve for Q: H DS 2 2 DS 2 DS = 2 Q = Q= 2 Q H H .

etc. Adding Lead Time I Use same order size 2 DS Q= H I Order before inventory depleted I R = d * L where: G d = demand rate (per day) G L = lead time (in days) G both in same time period (wks.) . months.

why is it the most commonly used ordering policy? . A Question: I If the EOQ is based on so many horrible assumptions that are never really true.

Benefits of EOQ I Profit function is very shallow I Even if conditions don’t hold perfectly. profits are close to optimal I Estimated parameters will not throw you off very far .

order 150 (50% over): 0.66) =1.5*(1. I Percentage profit loss given by: TC (Q) 1 Q * Q = + TC (Q*) 2 Q Q * I Should order 100.08 an 8%cost increase .5 + 0. but order Q instead. Sensitivity I Suppose we do not order optimal Q*.

Quantity Discounts I How does this all change if price changes depending on order size? I Holding cost as function of cost: G H=I*C I Explicitly consider price: 2DS Q= I ∗C .

90 Q >= 1000 716 .000 S = $20 I = 20% Price Quantity EOQ c = 5.00 Q < 500 633 4.50 501-999 666 3. Discount Example D = 10.

000 Order Size . Discount Pricing Total Cost Price 1 Price 2 Price 3 X 633 X 666 X 716 500 1.

000 Order Size . Discount Pricing Total Cost Price 1 Price 2 Price 3 X 633 X 666 X 716 500 1.

90 = $39.50 * 0.00 Mat’l 10.00 Order 10.2= $299.70 Order 1. Discount Example Order 666 at a time: Hold 666/2 * 4.70 Order 10.000/2 * 3.000 * 20 = $200.000.000 at a time: Hold 1.590.000.000/666 * 20 = $300.000*4.2=$390.90 * 0.000/1.599.00 45.000*3.00 Mat’l 10.00 .00 39.50 = $45.

Is EOQ feasible? (is EOQ in range?) If EOQ is too small. Repeat until EOQ is feasible or too big. Compute EOQ for next cheapest price 2. use lowest possible Q to get price. Select quantity/price with lowest total cost. Compute total cost for this quantity 4. 3. 5. . Discount Model 1.

Random Demand .Inventory Management -.

Random Demand I Don’t know how many we will sell I Sales will differ by period I Average always remains the same I Standard deviation remains constant .

Impact of Random Demand How would our policies change? I How would our order quantity change? I How would our reorder point change? .

20 I Underage: CU = 0. Sales Price = 0.50 .30 .0.50 I Salvage = 0.0.00 = 0.20. Mac’s Decision I How many papers to buy? I Average = 90. st dev = 10 I Cost = 0.00 I Overage: CO = 0.20 .20 = 0.

3) = 0.6) = 0.3 / (0. z = 0. Optimal Policy F(x) = Probability demand <= x Optimal quantity: Cu P(unit sold)= Co + Cu Mac: F(Q) = 0.6 From standard normal table.253 =Normsinv(0.2 + 0.253 Q* = avg + zσ σ = 90+ 2.53 = 93 .53*10 = 90 +2.

” newspaper purchasing decision I If units are discrete. when in doubt. order Q .u units . Optimal Policy I Model is called “newsboy problem. round up I If u units are on hand.

3654 0 0 2 4 6 8 10 12 14 16 18 20 22 Mac’s sales are roughly normally distributed . Example: Mac’s Newsstand 6 5 Probability 4 Demand <= 9 3 = 1+0+0+0+3+ 1+2+2+4+6 2 = 19 / 52 1 =0.

25 ∗ MAD . update exponentially: MADt = α Dt − Dt −1 + (1 − α )MADt −1 σ ≈ 1.74 I In the future.73 I Standard Deviation = 4. Mac Continued I Calculate average sales = 11.

holding cost I Solve like a regular newsboy . G salvage = cost . Multiple Periods I For multiple periods.

Random Demand I If we want to satisfy all of the demand 95% of the time. how many standard deviations above the mean should the inventory level be? .

5 ≈ 367 .5 = 366.65 Safety stock = zσ = 1. Probabilistic Models Safety stock = x −µ x −µ From statistics.65*10 = 16. z = σ Safety stock Therefore.95 = 1. z = & Safety stock = zσ σ From normal table z.5 ROP = µ + Safety Stock =350+16.

6 I R = 50 + 25.28 * 20 = 25.6 . z = 1. Random Example I What should our reorder point be? G demand over the lead time is 50 units.6 = 75.28 Safety stock = zσ = 1. G with standard deviation of 20 G want to satisfy all demand 90% of the time I To satisfy 90% of the demand.

I What should our reorder point be. G standard deviation = 5. and the standard deviation of daily demand? G Lead time = 4 days. if z = 3? . St Dev Over Lead Time I What if we only know the average daily demand. G daily demand = 10.

St Dev Over LT I If the average each day is 10. then the average demand over the lead time must be 40. I What is the standard deviation of demand over the lead time? I Std. and the lead time is 4 days. Dev. ≠ 5 * 4 .

St Dev Over Lead Time I Standard deviation of demand = = Lσ = 4 ∗ 5 = 10 I R = 40 + 3 * 10 = 70 .

on average I Service levels easier to estimate . Service Level Criteria I Type I: specify probability that you do not run out during the lead time G Chance that 100% of customers go home happy I Type II: proportion of demands met from stock G 100% chance that this many go home happy.

Two Types of Service Cycle Demand Stock-Outs 1 180 0 Type I: 2 75 0 8 of 10 periods 3 235 45 80% service 4 140 0 5 180 0 Type II: 6 200 10 1.450 55 .395 / 1.450 = 7 150 0 96% 8 90 0 9 160 0 10 40 0 Sum 1.

so z = 2.05 * 25 = 151 . then R = 100 + 2.98. and σ = 25.05 if µ = 100. Type I Service I α = desired service level I We want F(R) = α I R=µ+σ*z Example: α = 0.

8 P. = (1.02 R = 126 -.β) / σ Example: EOQ = 100.A very different answer .β) EOQ I L(z) = EOQ (1. Type II Service I β = desired service level I Number of mad cust.98 L(z) = 100 * 0. β = 0. 835: z = 1.2 / 25 = 0.

still need to double- check I Annual physical inventory. Inventory Recordkeeping Two ways to order inventory: I Keep track of how many delivered. sold I Go out and count it every so often If keeping records. or I Cycle Counting .

g. Cycle Counting I Physically counting a sample of total inventory on a regular basis I Used often with ABC classification G A items counted most often (e.. daily) I Advantages G Eliminates annual shut-down for physical inventory count G Improves inventory accuracy G Allows causes of errors to be identified .

Fixed- Fixed-Period Model I Answers how much to order I Orders placed at fixed intervals G Inventory brought up to target amount G Amount ordered varies I No continuous inventory count G Possibility of stockout between intervals I Useful when vendors visit routinely G Example: P&G rep. calls every 2 weeks .

Fixed- Fixed-Period Model: When to Order? Inventory Level Target maximum Period Time .

Fixed- Fixed-Period Model: When to Order? Inventory Level Target maximum Period Period Time .

Fixed- Fixed-Period Model: When to Order? Inventory Level Target maximum Period Period Time .

Fixed- Fixed-Period Model: When to Order? Inventory Level Target maximum Period Period Period Time .

Fixed- Fixed-Period Model: When to Order? Inventory Level Target maximum Period Period Period Time .

Fixed- Fixed-Period Model: When to Order? Inventory Level Target maximum Period Period Period Time .

11) = q = d (T + L) + zσ T + L − I . Fixed Order Period I Standard deviation of demand over T+L = σ T + L = T + Lσ I T = Review period length (in days) I σ = std dev per day I Order quantity (12.

B class. ABC Analysis I Divides on-hand inventory into 3 classes G A class. C class I Basis is usually annual $ volume G $ volume = Annual demand x Unit cost I Policies based on ABC analysis G Develop class A suppliers more G Give tighter physical control of A items G Forecast A items more carefully .

Classifying Items as ABC % Annual $ Usage 100 80 60 A 40 20 B C 0 0 50 100 150 % of Inventory Items .

% ABC 206 26.000 207 7.000 $ 36 $936.000 55 110.000 019 2. ABC Classification Solution Stock # Vol. Cost $ Vol.000 4 80.316.000 10 70.000 Total 1.000 144 20.000 .000 105 200 600 120.

000 $ 36 $936. Cost $ Vol.000 71.000 10 70.000 8.1 A 105 200 600 120.1 A 019 2.3 C Total 1.4 B 144 20.000 9.000 6. % ABC 206 26.000 55 110.0 .316.000 5.000 4 80. ABC Classification Solution Stock # Vol.1 B 207 7.000 100.

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