Operations Management

Module 8
Inventory Planning and Control

Independent Demand
Inventory Management
Acknowledgement
 The concepts and ideas presented in the following
slides are based on concepts and ideas in the books
mentioned in your sessions plan and material freely
available on the internet, journals and other sources.
These have been put together for teaching, easy
understanding and study purposes only. The concepts
or ideas do not belong to the undersigned.
 Therefore,
 Read from Books
 Thank You
 Prof. Pintoo Shome
Learning Outcomes
After going through this module students shall be
able to do / answer questions such as,
 Explain the difference between dependent and
independent demand inventory?
 Why is inventory necessary? Why is it a
‘necessary evil’?
 List and explain the types of inventory found in
an organisation and why is it important to
control?
 Describe a few examples of Single and Multi-
period demand?
 Find inventory using single period inventory
model.
 Learning Outcomes (contd.)
 Find Economic Order Quantity in order to
optimise cost for a multi-period inventory
situation?

 Explain uncertainty of demand / supply and take

care of these in our inventory decisions?
 What are the different inventory management
policies and systems? How and when do we use
these?
 When do we use Q or T models in inventory
management based on their merits and
demerits?
 How to classify items of inventory and how to
use these effectively to design inventory policies
of organisations dealing with thousands of items?
Definition
Inventory is the stock of any item or
resource in an organisation.

Inventory System is the set of policies

and controls that monitor levels of
inventory and determine what levels
should be maintained, when stock gets
replenished, and how large orders
should be.
Purposes of Inventory
1) To maintain independence of operation
2) To meet variation in product demand
3) To allow flexibility in production
scheduling
4) To safeguard against delivery time
variations
5) To take advantage of economic
purchase order size
Type of Inventory

 It is very important to first

understand whether we are dealing
with dependent or independent
demand inventory.

 The basic approaches and methods of

dealing with these are different.
Independent vs Dependent
Demand Inventory

Example:
 Demand for 500 cars per day is an
independent demand
 Demand for 2000 wheels, 500
engines, 500 windscreens or 3000
wheel mounting bolts arise from the
demand for the cars and are
Dependent demands
Independent vs. Dependent
Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Finished
product
Dependent
Demand
(Derived demand
items for
E(1 component
) parts,
subassemblies,
Component parts raw materials,
etc)
Independent vs Dependent
Demand Inventory
 Distinction lies in whether the
various items are unrelated to each
other or not.
 Conceptually, dependent demand is a
straightforward computational
exercise tackled by MRP systems
whereas independent demand is
influenced by several factors which
have nothing to do with any other
item
Inventory Costs
(A necessary evil – lower the better)

 Holding or carrying costs

 Setup or production change costs
 Ordering Costs
 Shortage Costs
Our aim is to minimise the Total
Incremental Costs arising out of the
combined effects of the above costs
Inventory Systems
 Single-Period Inventory Model
◼ One time purchasing decision (Example:
vendor selling t-shirts at a football game)

◼ Seeks to balance the costs of inventory

overstock and under stock
 Multi-Period Inventory Models
◼ Fixed-Order Quantity Models
 Event triggered (Example: running out
of stock)
◼ Fixed-Time Period Models
 Time triggered (Example: Monthly
sales call by sales representative)
Single-Period Inventory Model
This model states that we

Cu should continue to increase

P
the size of the inventory so
long as the probability of
Co + Cu selling the last unit added is
equal to or greater than the
ratio of: Cu/Co+Cu

Where :
Co = Cost per unit of demand over estimated
Cu = Cost per unit of demand under estimated
P = Probabilit y that the unit will be sold
 Example 1 : The street corner newspaper
vendor
 Assume that a newspaper vendor has to decide
on optimum product availability, CSL*, that is,
corresponding optimum no. of papers, O*, to
stock so that his profits are maximised. He buys
each paper at Rs. 2 and sells at Rs. 4. Unsold
paper can be disposed of at Rs. 1 as wastepaper.
His avg. daily demand is 500 with a std.
deviation of 100 papers every day.
 What is his Optimum Product Availability CSL*?
 What is the optimum no. of papers O* to be
kept in stock corresponding to this CSL*?
Ex 1 : Solution
 p = 4; c = 2; s = 1;
 Co = c – s = 2 – 1= 1
 Cu = p – c = 4 - 2 = 2
 CSL* = Cu / (Cu +Co) = 2 / (2+1) = 2 / 3 =
0.6667
 Z = 0.4308 corresponding to a CSL* (probability
of 0.6667 from normal distribution table) or in
Excel, = NORMSINV(probability) , returns the z
value
 O* = Avg demand + optimum safety stock = 500
+ z σ = 500 + 0.43 x 100 = 543
 In Excel, =NORMINV(probability, mean, std. dev),
returns the O* value directly
Example 2
 The manager at Sportmart a sporting goods
store has to decide on the number of skis to
purchase for the winter season. Based on past
demand data and weather forecasts for the
year, management has forecast demand to be
normally distributed, with a mean of µ = 350
and a standard deviation of σ = 100. Each pair
of skis costs c = $100 and retails at p = $250.
Any unsold skis at the end of the season are
disposed of for $85. Assume that it costs $5 to
hold a pair of skis in inventory for the season.
How many skis should the manager order to
maximize expected profits?
Single Period Model Examples
 Overbooking of airline flights.
Cost of underestimating number of
cancellations results in revenue loss.
Cost of overestimating cancellations results
in loss due to compensations to customers
who are unable to board the flight.
 Any type of one time order, for example,
items that become obsolete after a certain
period of time, say the daily newspaper.
Multi-period Inventory Models
TWO General Types of Multi-period
models
 Fixed Order Quantity Models
Normally known as Q-models or EOQ
models ( Event triggered)
 Fixed Time Period Models
Known as T – models (Time
triggered)
Each has advantages/ disadvantages
 Comparison between Q –model (EOQ)
and T- model (Periodic Review)
Feature Q- Model
Fixed order quantity model
Order quantity Constant (same amount
ordered every time)
When to place R - when inventory position
order drops to the reorder level
Record keeping Each time a withdrawal or
addition takes place
Size of Inventory Less than fixed time period
model
Time to maintain Higher due to perpetual record
keeping
Type of items Higher priced, critical or
important items
P- Model
Fixed time period model
Q- variable (varies each
time the order is placed)
T – order is placed when
the review period arrives
Counted only at review
period
Larger than fixed order
quantity model
Comparatively lower
Comparatively lower priced
less critical items
Basic Economic Order Quantity Model
(EOQ)
 Assumptions:

1. Ordering in batch from supplier.

2. Only one product is involved.
3. Constant demand rate. Demand is spread
evenly throughout the year.
4. Constant lead time. Lead time does not vary
much for a long enough time.
5. Single delivery for each order.
6. A single flat unit price from the supplier.
 The Inventory Cycle
Profile of Inventory Level Over Time

Order/batch size
Q Demand
rate D

Reorder
point

Receive Place Receive Place Receive Time

order order order order order

Order lead time

Order cycle time

Reorder Point

Reorder point refers to the inventory

level at which a new order should be
placed to avoid future shortage.

Reorder point (ROP) = demand during ordering lead time

= lead time (L) X demand rate (d)
Costs
Fixed order cost
allocated per unit
time

Average carrying
cost per unit time

EOQ= 2 DS
H

SD H EOQ
Optimal cost + = 2 DSH
EOQ 2
=
Total Cost
Independent
Q D
TC = H + S + PD of Q
2 Q
Cost

Adding variable ordering TC with PD

cost doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity
Key Points
 In deciding EOQ, the trade off is between fixed order
cost and holding cost. Ordering at EOQ, the fixed
ordering cost per unit time equals the carrying cost per
unit time.

 The total cost reveals a U-shape in order size. It is

minimized at EOQ.

 Unit ordering cost P does not affect EOQ, because

demand is constant.

 EOQ increases with demand rate and fixed ordering cost,

and decreases with carrying cost rate.

 EOQ model is cost-robust. If order a quantity deviates

from EOQ at a certain amount within the EOQ zone, the
resulting total cost is very close to the optimal total cost.
Key Points from EOQ Model
 The Economic Lot Size Model
Total inventory cost is insensitive to order quantities
• Changes in order quantities have a relatively small
impact on annual setup costs and inventory holding
costs
• Consider a decision maker that places an order quantity
Q that is a multiple b of the optimal order quantity Q*
• Table 3-1 presents the impact of changes in b on total
system cost

Sensitivity Analysis

b 0.5 0.8 0.9 1 1.1 1.2 1.5 2

Increase in cost 25.0% 2.5% 0.5% 0 0.4% 1.6% 8.0% 25.0%

To Reduce the EOQ Cost
Reducing
Reduce the fixed Smaller
EOQ Cost ordering EOQ
cost

Reducing Reduced
average
carrying inventory
cost

 To reduce total cost, the fixed ordering

cost has to be reduced. This is exactly
what JIT is doing!
 Fixed Time Period Model

Inventory
On hand q2 L
L q1 L q3

Safety
Stock
T T T
Review Period
Stock out
Fixed-Time Period Model with Safety Stock Formula
q = Average demand + Safety stock – Inventory currently on hand

q = d(T + L) + Z  -I
T+L
Where :
q = quantitiy to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probability
 T+L = standard deviation of demand over thereview and lead time
I = current inventorylevel (includes items on order)
Multi-Period Models: Fixed-Time
Period Model:
Determining the Value of T+L

 ( )
T+ L 2
 T+ L = di
i =1

Since each day is independent and  d is constant,

 T+ L = (T + L) d 2

 The standard deviation of a sequence of

random events equals the square root of
the sum of the variances
Example of the Fixed-Time Period
Model
Given the information below, how many units
should be ordered?

Average daily demand for a product is 20

units. The review period is 30 days, and lead
time is 10 days. Management has set a policy
of satisfying 96 percent of demand from items
in stock. At the beginning of the review
period there are 200 units in inventory. The
daily demand standard deviation is 4 units.
Example of the Fixed-Time Period
Model: Solution (Part 1)
 T+ L = (T + L) d =
2
( 30 + 10 )( 4 ) 2 = 25.298

The value for “z” is found by using the Excel

NORMSINV function, or using Tables for Normal
Distributions.

In Excel, =NORMSINV(p) returns the z value where p

denotes the service level
Example of the Fixed-Time Period
Model: Solution (Part 2)
q = d(T + L) + Z  T + L - I

q = 20(30+ 10) + (1.75)(25.298) - 200

q = 800 + 44.272 - 200 = 644.272,or 645 units

So, to satisfy 96 percent of the demand,

you should place an order of 645 units at
this review period
Miscellaneous Systems:
Optional Replenishment System
Maximum Inventory Level, M

q=M-I

Actual Inventory Level, I

M
I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

Miscellaneous Systems:
Bin Systems
Two-Bin System

Order One Bin of

Inventory
Full Empty
One-Bin System

Order Enough to
Refill Bin
Periodic Check
Inventory Classification
Systems
 ABC Classification based on several
relevant factors
 VED Classification (Vital, Essential,
Desirable)
 SDE Classification (Scarce, Difficult to
obtain, Easy to obtain)
 Other methods also may be used
depending on items and purpose
 Note: The Service Level decision is
primarily based on these classifications
ABC Classification System
 Items kept in inventory are not of
equal importance in terms of:
◼ rupees invested
◼ profit potential
◼ sales or usage volume
◼ stock-out penalties

So, identify inventory items based on percentage of total

rupee value, where “A” items are roughly top 10 %, “B”
items as next 25 %, and the lower 65% are the “C” items
Inventory Accuracy and Cycle
Counting Defined

 Inventory accuracy refers to how

well the inventory records agree
with physical count
 Cycle Counting is a physical
inventory-taking technique in
which inventory is counted on a
frequent basis rather than once
or twice a year
End of Module (Acknowledgement)

 The concepts and ideas presented in the above slides

are based on concepts and ideas in the books
mentioned in your sessions plan and material freely
available on the internet, journals and other sources.
These have been put together for teaching, easy
understanding and study purposes only. The concepts
or ideas do not belong to the undersigned.
 Therefore,
 Read from Books and Practice Problems
 Thank You
 Prof. Pintoo Shome