Inventory management

MSc. Do Thi Thu Ha

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Learning outcomes

 Know how to classify inventory

types
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 Have a thorough understanding

of how to manage inventory by
different methods
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Contents
Definitions

Inventory costs
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ROP

EOQ model

ABC analysis

Inventory turnover
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What is inventory?
Stock of items kept to meet future demand.

Inventory types:
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 Raw materials

 Purchased parts and supplies

 Work-in-process

 Finished goods
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Inventory classifications
You eat 1 egg a day and buy eggs by the dozen.
→ Buy a new container of eggs every 12 days
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Cycle stock (base stock)

Safety stock (buffer stock)

Pipeline stock (in-transit stock)

Speculative stock
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Psychic stock
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Inventory management
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Timing Quantity

Inventory costs Inventory purposes

 Smooth-out variations in operation
performances
1. Ordering cost
 Avoid stock out or shortage
2. Carrying cost (or Holding cost)
 Safeguard against price changes and
3. Stock-out cost (or shortage cost)
inflation
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 Take advantage of quantity discounts

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Ordering cost per order

British Gas is the largest UK energy and home services company. They supply
gas and electricity, boilers and boiler cover as well as other home services. The
company expands its pipelines every now and then. Installation of pipelines
involves the use of specialized high-quality pipes, customized valves and other
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spares and loose tools.

British Gas has only a few suppliers who produce these customized tools. The UK
government regulations require the company to advertise in three national and
two international newspapers before placing a purchase order, this will cost
£200,000. The suppliers have to modify their own production plans and they
charge an amount of £2 million regardless of the size of order. The opportunity cost
of staff time spent on drafting the tender documents is estimated at £250,000.
Related legal costs are £50,000. In each procurement, British Gas hires a firm for
inspection at a flat fee of £100,000. Bank charges an amount of £3,000 as
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documentation charges.
How much does an order of British Gas costs?
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Carrying cost or Holding cost

 Cost of holding an item in inventory for a period of time
 Approximate percentage of the value of an item: 25% – 26%.
Carrying cost
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→ Vary from product to product

components

Obsolescence Inventory Storage Handling Insurance Interest

Taxes
costs shrinkage costs costs costs costs

Opportunity cost
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Specialized storage Costs for keeping

requirements result in “products” alive
higher costs
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Trade-off between Carrying and Ordering costs
Ordering cost for a year CO = no. of orders
per year × ordering cost per order
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= sum of expenses related to

servicing an order
Costs

Carrying cost for 1 order Ch= average

inventory × carrying costs per unit

average inventory = ½ order size

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Order quantity
Note: Assume that as many orders as inventories
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Ordering cost and Carrying cost

Suppose weekly demand is 100 units, order cost per order is £80,
the value of an item is £50 and carrying cost is 20% of the value of
an item.
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a)If we place one order per year for the product, how much will
the ordering cost for a year and carrying cost for 1 order be?
b)If we place one order per week, how much will those costs be?

Co for a year = number of orders per year × Co per order

Ch for 1 order = ½ order size × Ch per unit

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a) Ordering cost = £80 b) Ordering cost = £4160

Carrying cost = £26000 Carrying cost = £500
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Stock out (or Shortage cost)

Customer agrees to wait for the item
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Customer chooses other products with the

same objectives
Possible
consequences
Customer bakes orders the items
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Customer cancels the order, buy products

from a competitor and maybe is no longer a
customer
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Trade-off between
Carrying and Stockout costs
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Carrying Stockout
cost cost
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When to order?
Fixed order quantity system Fixed time period system
(Continuous system) (Fixed order interval/ Periodic system)
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 Orders placed with a constant size in  Orders placed for variable amount at
different time period specific time intervals

+ Inventory level continuously monitored. + Proactive occasion.

– Costly. – Less direct control.
Reorder point – ROP ROP = (DD x RC) + SS
The level of inventory at which
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a replenishment is placed DD: average daily demand (units)

RC: length of the replenishment cycle (days)
SS: safety stock
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ROP = (DD x RC) + SS
ROP – Reorder point DD: average daily demand
RC: length of the replenishment cycle (days)
SS: safety stock

Demand for chicken soup at a supermarket is

always 900 packs a month. The shelves are
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restocked with chicken soup after 4 days

calculating from the moment an order is sent.
The manager always leaves an on-hand
inventory of at least 10 packs.
What is the reorder point?
What is the meaning of the result?
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Note: Assuming a month has 30 days

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How much to order?

Economic Order Quantity EOQ
Annual costs

EOQ model determines:

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 The point at which the sum of

carrying cost and ordering
cost are minimized
TC
 The point at which carrying
cost equal ordering cost
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Q* Order quantity
= EOQ
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Basic EOQ assumptions

1. A continuous, constant, and known rate of demand
2. A constant and known replenishment or lead time
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3. A constant purchase price that is independent of the

order quantity
4. All demand is satisfied
5. No inventory in transit
6. Only one item in inventory or no interaction between
inventory items
7. An infinite planning horizon
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8. Unlimited capital availability

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EOQ cost model
If Q units are ordered:
TC (Q ) = annual ordering cost + annual holding cost + annual
purchasing cost
Annual ordering cost = ordering cost per order × orders per year = Co × D/Q
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Annual holding cost = holding cost per unit × average inventory = Ch × Q/2

Annual purchasing cost = P × D

 D: the number of units demanded per year
𝑪𝟎 𝑫 𝑪𝒉 𝑸  Q: the quantity ordered each time the
⇒ 𝑻𝑪 = + + 𝑷𝑫
𝑸 𝟐 inventory level = 0

Then: 𝐶0 𝐷 𝐶ℎ 𝑄 2𝐶0 𝐷  Co: cost of placing 1 order

= 2
⇒ 𝑄 =
𝑄 2 𝐶ℎ  Ch: annual holding cost/unit
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 P: purchase cost/unit
𝟐𝑪𝟎 𝑫
⇒ 𝑬𝑶𝑸 = 𝑸∗ = Problem is to find Q* that minimizes the annual
𝑪𝒉
inventory total cost.
 18 EOQ model - Practice
A building materials supplier obtains its bagged cement from a single supplier. Demand is
reasonably constant throughout the year and last year the company sold 2000 tons of this
product. It estimates the costs of placing an order at around £25 each time an order is placed
and the annual cost of holding inventory is 20% of the purchase cost. The company purchases
the cement at £60 per ton.
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a) How much should the company order at a time?

b) How many orders should be placed each year?
c) How much time will elapse between the placements of orders (what is the cycle length)?

➢ D: the number of units demanded 𝑪𝟎 𝑫 𝑪𝒉 𝑸

per year. 𝟐𝑪𝟎 𝑫 ⇒ 𝑻𝑪 = + + 𝑷𝑫
⇒ 𝑸∗ = 𝑸 𝟐
➢ Q: the quantity ordered each time 𝑪𝒉
the inventory level = 0.
➢ Co: cost of placing 1 order. No. of orders per year = D/Q*
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➢ Ch: annual holding cost/unit. Time between orders (Cycle) = Q*/D

➢ P: purchase cost/unit
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ABC analysis
 The ABC analysis states that a
company should rate items from
A to C, based on:
• Sales volume in money (high to
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Standards of evaluation

low value
• Sales volume in units (high to low
quantity)
• Fastest-selling items (high to low
speed of selling)
• Item profitability (bring most to
least revenue)
• Item importance (high to low
protective level)
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• Fragileness level
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ABC analysis Flowers
50 $0.50
Sally who owns a grocery store is fairly profitable, but would like
to focus on the items that create more revenue.
Apples
Squashes
150
30
$0.10
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$0.25
Toothbrushes
100 $4.00

Magazines
200
$1.00
Balloons
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Stools
Paper towels 400
100
$15.00 200 $1.50 $1.00
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Inventory turnover
 A ratio showing how many times a company's inventory is sold and
replaced over a period of time
 Inventory turnover measures how fast a company is selling inventory
and is generally compared against industry averages
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 Beginning inventory: The value of goods, inputs or materials available

for use or sale at the beginning of an inventory accounting period
 Ending inventory: The value of goods available for sale at the end of
the accounting period.

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
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𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑒𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
2
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Inventory turnover – Example

The Hegemony Toy Company is reviewing its inventory levels.
The related information is $8,150,000 of cost of goods sold in the
past year, and the average inventory of $1,630,000.
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 Calculate the inventory turnover and determine the days

number that the inventory of Hegemoney is on hand.
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