Unit 2

UNIT – II
INVENTORY MANAGEMENT
“Almost all quality improvement comes via simplification of

design, manufacturing, layout, process and procedures”
- Tom Peters-
Dr Sripriyan Karuthapandi
Department of Mechanical Engineering
PSG College of Technology, Coimbatore
INVENTORY MANAGEMENT AND FORECASTING: Introduction to inventory and multi
order opportunities, Inventory policy- Periodic review policy, Continuous review policy, Effect of
demand uncertainty. Risk pooling, centralized and decentralized system, managing inventory in the
supply chain, forecasting-The Role of Forecasting in a Supply Chain, Risk Management in
Forecasting, case studies. (CO2)
(8)
2
Introduction
◼ In any business or organization, all functions are interlinked and connected
to each other and are often overlapping. Some key aspects like supply chain
management, logistics and inventory form the backbone of the business
delivery function.
◼ Inventory management is a very important function that determines the
health of the supply chain as well as the impacts the financial health of the
balance sheet.
◼ Every organization constantly strives to maintain optimum inventory to be able
to meet its requirements and avoid over or under inventory that can impact the
financial figures.
◼ Inventory is always dynamic. Inventory management requires constant and
careful evaluation of external and internal factors and control through
planning and review. Most of the organizations have a separate department
or job function called inventory planners who continuously monitor,
control and review inventory and interface with production, procurement and
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finance departments.
Functions of Inventory…
Independent demand inventories are managed according to two decisions:
❖ order size and
❖ order timing
Order time
❖ Single order period

❖ Multi order period ❖ Deterministic
❖ Risk
❖ People
Total cost ❖ Transportation
❖ Inspection
❖ Space + power
❖ Cost of items (ci) ❖ Rejection
❖ People
❖ Order cost (co) ❖ Follow up
❖ Special requirements
❖ Delay
❖ Cost of capital “i”
❖ Holding (or) carrying cost (cc) ❖ Loss of customer goodwill
❖ Loss of profit
❖ Loss of opportunity
❖ Backorder (or) shortage cost ❖ Cost of additional capacity 4
❖ Rescheduling
Model - 1
Single item with continuous demand and instantaneous replenishment without shortage
Deterministic

KEY TAKEAWAYS
❖ Inventory management is the entire process of managing inventories from raw materials to finished products.
❖ Inventory management tries to efficiently streamline inventories to avoid both gluts and shortages.
❖ Two major methods for inventory management are just-in-time (JIT) and materials requirement planning (MRP). 5
Functions of Inventory
Functions of Inventory
Why Is Inventory Required?
❖ To meet anticipated demand
◼ Uncertainty in customer demand
❖ To smooth production requirements
◼ Shorter product lifecycles
❖ To protect against stock-outs ◼ More competing products
❖ To take advantage of order cycles
◼ Uncertainty in supplies
❖ To take advantage of quantity discounts ◼ Quality/Quantity/Costs/Delivery Times
◼ Delivery lead times
◼ Incentives for larger shipments
Centre for Monitoring Indian Economy 6

Types of inventory
7
Types of inventory…
◼ Cycle inventory – Regular demand / ex. CI Material
◼ Safety inventory - to protect against supply-and-demand uncertainties, low delivery

reliability, and poor-quality components.
safety stock can avoid:
❖ Stock-outs (when an order cannot be filled from existing inventory)
❖ Backorders
❖ Making the customer wait until the next production cycle
❖ Causing the customer to go elsewhere to find the product
8
Types of inventory…
◼ Pipeline inventory
❖ Inventory moving from point to point in the materials flow system.
❖ any good shipped by a seller but not yet received by a buyer.
❖ Pipeline inventory = DL = dL
❖ When the stock is in transit but yet to be received by the purchaser
customer, then the journal entry will be:
◼ Decoupling inventory
❖ any inventory set aside to meet purchase orders in the case of inventory production
slowing or stopping.
◼ Anticipation inventory
◼ Seasonal inventory
◼ Speculation inventory
◼ Dead inventory
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Estimating Inventory Levels - Example
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Why Is Inventory Important?
◼ GM’s production and distribution network in the world.
◼ in 1984
◼ 20,000 supplier plants
◼ 133 parts plants
◼ 31 assembly plants
◼ 11,000 dealers
◼ Freight transportation costs: $4.1 billion (60% for material shipments)

◼ GM inventory valued at $7.4 billion (70%WIP; Rest Finished Vehicles)
◼ After Implement in SCM
◼ Decision tool to reduce:
◼ combined corporate cost of inventory and transportation.
◼ 26% annual cost reduction by adjusting:
◼ Shipment sizes (inventory policy)

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◼ Routes (transportation strategy)

Success mantra
❖ Ensure a continuous supply of raw materials to facilitate

uninterrupted production.
❖ Maintain sufficient stocks

of raw materials in periods of short supply
and anticipate price changes.
❖ Maintain sufficient finished goods

inventory for smooth sales operation,
and efficient customer service.
❖ Minimize the carrying cost and time.
❖ Control investment in inventories and keep it at an optimum level.
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What if we over react?
◼ Unnecessary tying down of firm’s funds and loss of profit.
◼ Excessive carrying costs.
◼ Risk of liquidity- difficult to convert into cash.
◼ Physical deterioration of inventories while in storage due to mishandling and improper storage facilities.
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What if we over react?
Role of Inventory
◼ To supply and support the balance of demand and supply.
◼ To effectively cope with the forward and reverse flows in
the supply chain.
Optimization Models
❖ Mixed Integer Linear Programming (MILP) - Mathematical modeling /optimization areas such as production planning, transportation,
network design, etc.
❖ Stochastic Modeling - Mathematical approach / representing data or predicting outcomes in situations by randomness. Example : unknown
parameters like quality of the input materials, reliability of the machines and competence within the employees.
❖ Uncertainty
❖ Bi-level Optimization - Real life situations / multiple parties make decisions one after the other, which influences their respective profit.14
Methods of valuation
An inventory valuation allows a company to provide a monetary value for items that
make up its inventory.
Methods:-
◼ First In First Out (FIFO) Method.
◼ Last In First Out (LIFO) Method.
◼ Weighted Average Cost/price Method.
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FIFO Method
❖ Based on the assumption that the goods that are received first are issued first.
❖ For purpose of assigning costs and not exactly for purpose of physical flow of goods.
❖ Goods sold, thus, consist of earliest lots and are valued at the price paid for such lots.
❖ The ending inventory consists of latest lots and is valued at the price paid for such lots.
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FIFO Method
ABC Ltd. Provides you with the following information :
- 1.1.2018 Opening Stock 100 units @ Re 1.

- 2.1.2018 Purchased 400 units @ Rs 1.50.
- 3.1.2018 Issued 450 units.
-4.1.2018 Purchase 500 units @ Re 2.06.
- 5.1.2018 issued 300 units.
REQUIRED : Compute the value of inventory and cost of goods sold as on 5.1.2018 assuming:-
(a) periodic system under FIFO method; and

(b) Perpetual system.
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STOCK LEDGER UNDER FIFO METHOD
DATE RECEIPTS ISSUES BALANCE

Quality Rate (Rs) Amt. (Rs) Quality Rate (Rs) Amt. (Rs) Quality Rate (Rs) Amt. (Rs)
1-1-20118 _ _ _ _ _ 100 1.00 100
2-1-2018 100 1.00 100
400 1.50 600 _ _ _
400 1.50 600
3-1-2018 100 1.00 100
_ _ _ 50 1.50 75
350 1.50 525
4-1-2018 50 1.50 75
500 2.06 1030 _ _ _
500 2.06 1,030
5-1-2018 50 1.50 75
_ _ _ 2.06
250 2.06 515 250 515
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2a… PERPETUAL SYSTEM
Closing inventory calculated as residual figures:-
- Opening inventory 100

- Add: Purchases (Rs. 600+Rs.1,030) 1,630
- Less: Cost of good sold
(Rs. 515+75+525+100) 1,215
- Ending inventory (A+B-C) Rs. 515
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2b… PERIODIC SYSTEM
Cost of goods sold is calculated as residual figures:-

- Add: Purchase(Rs600+1030) 1,630
- Less: Ending inventory
(250 x Rs 2.06) 515
- Cost of goods sold (A+B-C) Rs 1,215
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LIFO Method
❖ Based on assumption that goods that are received last are issued first.
❖ Assumption made for purposes of assigning costs and not for actual physical flow of goods.
❖ Flows of goods and costs may not coincide.
❖ Goods sold, thus, consist of the latest lots and are valued at the price paid for such lots.
❖ The ending inventory consists of the earliest lots and is valued as such.
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LIFO Method
ABC Ltd. Provides you with the following information :
- 1.1.20 18 Opening Stock 100 units @ Re 1.

- 2.1.20 18 Purchased 400 units @ Rs 1.50.
- 3.1.20 18 Issued 450 units.
-4.1.20 18 Purchase 500 units @ Re 2.06.
- 5.1.2018 Issued 300 units.
REQUIRED : Compute the value of inventory and cost of goods sold as on 5.1.2018 assuming:-
(a) Perpetual system; and

(b) periodic system under LIFO method.
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1…STOCK LEDGER UNDER LIFO METHOD
DATE RECEIPTS ISSUES BALANCE
Quality
Quality Rate (Rs) Amt. (Rs) Quality Rate (Rs) Amt. (Rs) Rate (Rs) Amt. (Rs)
1-1-2018 _ _ _ _ _ 100 1.00 100

1.50 600 _ 100 1.00 100
2-1-2018 400 _ _
400 1.50 600
400 1.50 600
3-1-2018 _ _ _
50 1.00 50 50 1.00 50
50 1.00 50
4-1-2018 500 2.06 1030 _ _ _
500 2.06 1,030
50 1.00 50
5-1-2018 _ _ _ 300 2.06 618
200 2.06 412
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2a… PERPETUAL SYSTEM
Closing inventory calculated as residual figures:-

- Add: Purchases (Rs 600+Rs.1,030) 1,630
- Less: Cost of good sold
(Rs 600+50+618) 1,215
- Ending inventory (A+B-C) Rs 462
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2b… PERIODIC SYSTEM
Cost of goods sold is calculated as residual figures:-

- Add: Purchase(Rs 600+1030) 1,630
- Less: Ending inventory
(150 x Rs 2.06) 462
- Cost of goods sold (A+B-C) Rs. 1,268
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CAMPARISION BETWEEN FIFO & LIFO
BASIS OF DISTINCTION FIFO LIFO
Basic assumption Goods received first are issued first. Goods received last are issued first.
Cost of goods sold represents cost of earlier Cost of goods sold represents cost of recent
Cost of goods sold
purchases. purchases.
Ending inventory represents cost of recent Ending inventory represents cost of earlier
Ending inventory
purchases. purchases.
In case of rising prices Income tax liability is increased . Income tax liability is reduced.
Distortion in balance Balance sheet shows the ending inventory at a Balance sheet is distorted because ending
value nearer the current market price. inventory is understated at old costs.
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WEIGHTED AVERAGE PRICE METHOD
❖ Based on the assumption that each issue of goods consists of a due proportion of the earlier lots and is
valued at weighted average price.
❖ Weighted average price is calculated by dividing the total cost of goods in stock by the total quantity of
goods in stock.
❖ This weighted price is used for pricing the issues until a new lot is received when a new weighted average
price would be calculated.
❖ This method evens out the effect of widely varying prices of different lots that make up stocks.
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WEIGHTED AVERAGE PRICE METHOD
Units available Units sold Per unit cost Total Cost in Rs,
Opening inventory 100 -- 1.00 100

Purchase 400 1.50 600
Sale -- 450 -- --
Purchase 500 -- 2.06 1030
Sale -- 300 -- --
Total 1000 750 1730
1. The weighted-average cost per unit is Rs. 1730/1000 = Rs. 1.73

2. Ending inventory is 250 units (1000 – 750) at Rs. 1.73 = Rs. 432.5
3. Cost of goods sold (i.e. 750 units at Rs. 1.73) = Rs. 1297.5
FIFO
LIFO Purchase Rs 1,630
Purchases Rs 1,630
Cost of goods sold Rs 1,215
Cost of good sold Rs 1,215 28
Ending inventory Rs 462 Ending inventory Rs 515
Inventory management
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Inventory Expectations
Not only external customers make demands on the inventories but internal customers
such as top management, finance, manufacturing also have different expectation.
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Inventory Expectations…
Inventory Decisions
❖ How much to order? That is to say, what is the optimal quantity of an item that
should be ordered whenever an order is placed?
❖ When should the order to be placed?
❖ How much safety stock should be kept? (buffer stock) 31
Basic inventory cost trade-off
Inventory management involves trade-offs between conflicting
objectives such as cost minimization and service level maximization.
The trade-off analysis of cycle stock investment and workload.
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Selective Control Techniques
Following are the methods in practice:
❖ ABC Analysis
❖ VED Analysis (Vital, Essential and Desirable status of inventory items)
❖ SAP Analysis (Scarce, Availability and Plenty status of inventory item is used for planning and forecasting of inventory
requirement)
❖ FSN Analysis (Fast, Slow or Normal determines the consumption pattern of an item)
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Economic Lot Size (ELS)
◼ ELS is the quantity of material or units of a manufactured good that can be produced or purchased within the
lowest unit cost range. It is determined by reconciling the decreasing unit cost of larger quantities with the
associated increasing unit cost of handling, storage, insurance, interest, etc

◼ A manufacturer must determine the production lot size that will result in minimum production and storage
cost.
D = Annual Demand in Units for the Inventory Item

S = Setup or Ordering Cost per Order
H = Holding or Carrying Cost per Unit per Year
p = production rate
d = daily demand
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Economic lot size (or) Economic batch quantity
D
P-D

P = production rate
D = daily demand
P>D
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Economic Lot Size (ELS) …
ELS - Total Annual Cost
ELS – Production Time per Lot
ELS - Time Between Orders (TBO)
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Economic Lot Size (ELS) model Example
A plant manager of a chemical plant must determine the lot size for a particular chemical that has a steady
demand of 30 barrels per day. The production rate is 190 barrels per day, annual demand is 10,500 barrels,
setup cost is $200, annual holding cost is $0.21 per barrel, and the plant operates 350 days per year.
a. Determine the Economic Production Lot Size (ELS)

b. Determine the Total Annual Setup and Inventory Holding Cost for this item (Total Annual Cost)
c. Determine the time between orders (TBO), or cycle length, for the ELS
d. Determine the Production Time per Lot
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Economic Lot Size (ELS) model Example …
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Time varying demand problem Solution
Da =10,000 Units 1. Lot for lot
Co = Rs 300 per order TC = Oder cost + carrying cost
Cc = Rs 4 per unit per year or TC = 12x300 + 1/3 x (5000) = 5266.66 rupees
Rs 1/3 per unit per month
Month Demand
2. Part period balancing heuristic
Jan 400
Feb 600 TC = Oder cost + carrying cost
March 1000 Q = 400 unit Avg. inventory = 200 unit Cc = 200/3 = 66.66 rupees
April 800 Q = 1000 unit Avg. inventory = 800 + 300 units Cc = 1100/3 = 366.66 rupees (make an Oder)
May 1200
June 900
Q = 1000 unit Avg. inventory = 500 units Cc = 500/3 = 166.666 rupees (make an Oder)
Q = 1800 unit Avg. inventory = 1300 + 400 units Cc = 1700/3 = 566.66 rupees
July 800
Aug 1000 Q = 1200 unit Avg. inventory = 600 units Cc = 600/3 = 200.00 rupees (make an Oder)
Sep 1200 Q = 2100 unit Avg. inventory = 1500 + 450 units Cc = 1950/3 = 650 rupees
Oct 700 Q = 700 unit Avg. inventory = 350 units Cc = 350/3 = 116.66 rupees
Nov 600 Q = 1300 unit Avg. inventory = 950 + 300 units Cc = 1250/3 = 416.66 rupees (make an
Oder) 40
Dec 800
Month Order
(No. quality Total cost for part period balancing
order)
Jan + Feb 1000 TC =10 x 300 + 1/3 ( 800 + 300 + 500 + 400 + 600 + 450 + 400 + 500 + 600+ 950 + 300 + 400)
March 1000 = 3000 + 2066.66
April 800
May 1200
TC = 5066.66 Rupees
June 900
July 800
Aug 1000
Sep 1200
Oct + Nov 1300
Dec 800
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Solution for Silver meal heuristic
3. Silver meal heuristic
Month Order TC = 366.66 Rupees
(No. order) quality Q = 400 unit Co = Rs 300 per order
Avg. inventory = 200 unit Cc = 200/3 = 66.66 rupees
Jan + Feb 1000
March + April 1800 Q = 1000 unit Co = Rs 300 per order TC = 666.66 Rupees
May + June 2100 Avg. inventory = 800 + 300 unit Cc = 1100/3 = 366.66 rupees
July 800 For per period avg. cost = 333.33 rupees
Aug 1000 Q = 2000 unit Co = Rs 300 per order TC =1500 Rupees
Sep + Oct 1900 Avg. inventory = 1800 + 1300 + 500 unit Cc = 3600/3 = 1200 rupees
For per period avg. cost = 500 rupees
Nov + Dec 1400
Q = 1000 unit Co = Rs 300 per order TC = 466.66 Rupees
Avg. inventory = 500 unit Cc = 500/3 = 166.66 rupees
Q = 1800 unit Co = Rs 300 per order

Avg. inventory = 1300 + 400 unit Cc = 1700/3 = 566.66 rupees TC = 866.66 Rupees
For per period avg. cost = 433.33 rupees
Q = 3000 unit Co = Rs 300 per order

Avg. inventory = 2500 + 1600 + 600 unit Cc = 4700/3 = 1566.66 rupees TC = 1866.66 Rupees
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For per period avg. cost = 622.22 rupees
Month Demand
Total cost for Silver meal heuristic
TC = 7 x 300 + 1/3 ( 800 + 300 + 1300 + 400 + 1500 + 450 + 400 + 500 + 1300 + 350 + 1100 + 400)
Jan 400 = 2100 + 2933.33
TC = 5033.33 Rupees
Feb 600
Month Order
March 1000 (No. order) quality
Jan + Feb 1000
April 800 March + 1800
April
May 1200
May + June 2100
June 900
July 800
July 800
Aug 1000
Aug 1000 Sep + Oct 1900
Sep 1200 Nov + Dec 1400
Oct 700
Nov 600
Dec 800
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Economic Lot Size (ELS) scheduling model
Objective
❖ Same cycle time for all items

❖ Need to be a same Q*
i j k
Qty Changeover time
Setup time
Time
t1
t2
t3

T
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Total cost = item cost + order cost + carrying cost
Economic Lot Size (ELS) scheduling model
i j k
Qty Changeover time

Setup time
Time
t1
t2
t2
45
Economic Lot Size (ELS) scheduling model - example
i j k
Qty Changeover time

Setup time
Time
t1
t2
t2
T
46
Economic Lot Size (ELS) scheduling model – example…

Q1 = D1 x T = 216.3
Q2 = D2 x T = 360.5 T = 83,138.43/-
Q3 = D3 x T = 144.2

Q1 = D1 x T = 1027.5
Q2 = D2 x T = 1712.5 T = 2,06,039.1/-
Q3 = D3 x T = 6850
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Multiple Order Opportunities
What is inventory management
The objective of inventory is to achieve satisfactory levels of
customer service while keeping inventory costs within reasonable
bounds.
Level of customer service: (1) in-stock (fill) rate (2) number of

back orders (3) inventory turnover rate: the ratio of average cost
of goods sold to average inventory investment
Inventory cost: cost of ordering and carrying trade-off
An Example
❖ Deterministic
❖ Random
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Multiple Order Opportunities…
When-to-order: deterministic demand and deterministic lead time
Assume constant demand per period is d.
Lead times is L for a new order in terms of periods.
Then
ROP =dL
Note that in our previous EOQ model, we assume L= 0
so the reorder point is ROP = 0.
When-to-order: stochastic demand and stochastic lead time

ROP = Expected demand during lead time + Safety stock
ROP = dL + zσ dLT σ σ √L
dLT= d
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The inventory system operates continuously with many repeating periods or cycles.
The lead time for a new order is L days and L is a random variable in general, reflecting the variation of delivery time.
The daily demand is D (i = 1, . . . , L) within the lead time, where the Ds are also random variables, , reflecting the
variation of demand over time.
New orders can be placed based on one of the following two basic classes of reorder policies:
❖ Event-driven: These are reorder policies that are driven by reorder point (ROP)—continuous review
policy: in which inventory is reviewed every day and a decision is made about whether and how much to order.
❖ Time-driven: These are reorder policies that are driven by time —periodic review policy: in which inventory
is reviewed at regular intervals and an appropriate quantity is ordered after each review.
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REASONS
– To balance annual inventory holding costs and annual fixed order costs.
– To satisfy demand occurring during lead time.
– To protect against uncertainty in demand.
TWO POLICIES
• Continuous review policy

– inventory is reviewed continuously
– an order is placed when the inventory reaches a particular level or reorder point.
– inventory can be continuously reviewed (computerized inventory systems are used)
• Periodic review policy

– inventory is reviewed at regular intervals
– appropriate quantity is ordered after each review.
– it is impossible or inconvenient to frequently review inventory and place orders if necessary.
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If demand is constant & instantaneous
Continuous review policy: (Q, R) order-reorder
replenishment
◼policy
Daily demand is random and follows a normal distribution.
◼ Every time the distributor places an order from the manufacturer, the distributor
pays a fixed cost, K, plus an amount proportional to the quantity ordered.
◼ Inventory holding cost is charged per item per unit time.
◼ Inventory level is continuously reviewed, and if an order is placed, the order
arrives after the appropriate lead time.
◼ If a customer order arrives when there is no inventory on hand to fill the
order (i.e., when the distributor is stocked out), the order is lost.
◼ The distributor specifies a required service level.
(Q, R)-policy: Whenever the inventory level reaches the reorder

point R, place an order of Q to bring the inventory position to the
order-up-to level R + Q;
Example Q can be chosen using the EOQ quantity. Decide the reorder level R, Decide the reorder quantity52Q
Continuous review policy: (Q, R) order-reorder policy - Example
A distributor of TV sets that orders from a manufacturer and sells to retailers. Fixed ordering cost = Rs. 4,500. Cost of
a TV set to the distributor = Rs. 250. Annual inventory holding cost = 18% of product cost. Replenishment lead time =
2 weeks. Expected service level = 97%
Month Sept Oct Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug
Sales 200 152 100 221 287 176 151 198 246 309 98 156
Average monthly demand = 191.17

Standard deviation of monthly demand = 66.53
Average weekly demand = Average Monthly Demand/4.3

Standard deviation of weekly demand = Monthly standard deviation/√4.3
Parameter Average weekly Standard deviation Average demand Safety Reorder
demand of weekly demand during lead time stock point
Value 44.58 32.08 89.7 85.3 174.9 53
◼ Average lead time, AVGL
Weekly holding cost =
◼ Standard deviation, STDL.
◼ Reorder Level, R:
Optimal order quantity =
Average inventory level = 679/2 + 85.3 = 424.8
ROP = dL + z σ √L d
Amount of safety stock=
= 44.85 x 2 + 1.88 x 32.08 x √2
= 89.7 + 85.3
= 174.9 Order Quantity =
order-up-to level R + Q = 175 + 679 = 855.

Table : Service Level & Safety Factor, z
Service
90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%
Level
z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88 2.05 2.33 3.08
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Periodic Review Policy
❖ Inventory level is reviewed periodically at regular intervals
❖ An appropriate quantity is ordered after each review
❖Two Cases:
Short Intervals (e.g. Daily)
❑ Define two inventory levels s and S
❑ During each inventory review, if the inventory position falls below s,
order enough to raise the inventory position to S.
❑ (s, S) policy
Longer Intervals (e.g. Weekly or Monthly)

❑ May make sense to always order after an inventory level review.
❑ Determine a target inventory level, the base-stock level
❑ During each review period, the inventory position is reviewed
❑ Order enough to raise the inventory position to the base-stock level.
❑ Base-stock level policy
❖ Base stock is the amount of inventory that a business needs to keep on hand in order to fulfill customer orders
with a delay no greater than expected by customers.
❖ If inventory levels drop below the base stock level, reordering delays will likely result in the loss of customers.
Periodic Review Policy
Periodic review policy: (s, S) policy I
The periodic review policy is similar to the continuous review policy except that the former is triggered by time, which
causes two major differences
❖ The fixed order cost plays no role here, as presumably the fixed cost is used to determine the cycle time.
Decision to make: how much to order.
❖ This level of IP should be enough to protect the warehouse against shortages until the next order arrives, which is
after r + L days, and hence the current order should be enough to cover the demand during a period of r + L (or
said differently, the IP should be enough to cover the demand during the lead time and the order period).
❖ Let r be the review period (or order interval). For every period, place an order to bring the inventory to some
desired replenishment position S.
❖ Therefore the safety-stock is usually higher in periodic review policy
ROP = Expected demand during lead time + Safety stock

ROP = d x (L + r) + zσ dLT σ dLT= σ √(L + r)
d
Periodic Review Policy Base-Stock Level Policy
◼ Determine a target inventory level, the base-stock level
◼ Each review period, review the inventory position is reviewed and order enough
to raise the inventory position to the base-stock level
◼ Assume:
r = length of the review period
L = lead time
AVG = average daily demand
STD = standard deviation of this daily demand.
Inventory level as a function of time in a periodic review policy
◼ Average demand during an interval of r + L days =
◼ Safety Stock=
◼ Average inventory = ((r x AVG)/2) +

Periodic Review Policy Base-Stock Level Policy - Example
◼ Assume:
◼ distributor places an order for TVs every 3 weeks
◼ Lead time is 2 weeks
◼ Base-stock level needs to cover 5 weeks
◼ Average demand = 44.58 x 5 = 222.9

◼ Safety stock =
◼ Base-stock level = 223 + 136 = 359
◼ Average inventory level =
◼ Distributor keeps 5 = (203.17/44.58) weeks of supply.
The advantage of the continuous review system:
❖Provide real-time updates of inventory counts
❖Make easier to know when to order
❖Provide accurate accounting
The disadvantage of the continuous system:

❖Involves additional cost
The advantage of the periodic review system:
❖Reduce time for business owner to analyze inventory counts
❖Allows the business owner having more time to run another aspect of the business
❖Simple to administer
❖Save labor cost for counting
The disadvantage of the periodic review system:

It may not provide an accurate inventory count when there is a high volume of sale
It may also make accounting inaccurate
There is little control over inventory movement
Multiple Order Opportunities…k
Safety stock model
Qty
Problem (without back order)
Demand Probability D = 10,000 units
ROL
100 0.1 Co = Rs 300
ROL
150 0.2 Cc = Rs 4/unit/year ROL
200 0.4 Cs = Rs 2.5/unit
Time
250 0.2 Lead time Lt = 1 week
300 0.1 σt = 50
x p(x) x.p(x) x2 x2p(x)
E(LTD) = 200 100 0.1 10 10000 1000
ROL = 250 150 0.2 30 22500 4500
TC = Rs 5200 Q star 200
250
0.4
0.2
80
50
40000
62500
16000
12500
TC 300

0.1

30
200
90000

9000
43000
TC = Rs 4900
TC = 4900 + (250 – 200)* 4 σ 3000
= Rs 5100/- Expected value, E(X), or mean μ E(X)=μ=∑xP(x)

The formula of the variance σ2 =∑(x−μ)2P(x)
Safety stock model
Problem (without back order) x p(x) x.p(x) x2 x2p(x)
100 0.1 10 10000 1000
Demand Probability 150 0.2 30 22500 4500
200 0.4 80 40000 16000
100 0.1 250 0.2 50 62500 12500
300 0.1 30 90000 9000
150 0.2
200 43000
200 0.4
E(LTD) = 200 σ 3000
250 0.2
ROL = 250
300 0.1 TC = Rs 5200
Q star
D = 10,000 units
TC
Co = Rs 300
TC = Rs 4900
Cc = Rs 4/unit/year TC = 4900 + (250 – 200)* 4
Cs = Rs 2.5/unit = Rs 5100/-
Lead time Lt = 1 week
σt = 50
Safety stock model
Problem (without back order) x p(x) x.p(x) x2 x2p(x)
100 0.1 10 10000 1000
Demand Probability 150 0.2 30 22500 4500
200 0.4 80 40000 16000
100 0.1 250 0.2 50 62500 12500
300 0.1 30 90000 9000
150 0.2
200 43000
200 0.4
E(LTD) = 200 σ 3000
250 0.2
ROL = 250
300 0.1 TC = Rs 5200
Q star
D = 10,000 units
TC
Co = Rs 300
TC = Rs 4900
Cc = Rs 4/unit/year TC = 4900 + (250 – 200)* 4
Cs = Rs 2.5/unit = Rs 5100/-
Lead time Lt = 1 week
σt = 50
Risk Pooling
Definition : Inventory risk pooling is the concept that the variability in demand for raw materials and /or product is
reduced by aggregating demand across multiple products. When properly employed, a business can use risk pooling to
maintain lower inventory levels while still avoiding stockout conditions.
Risk pooling is an important concept in supply chain management. The idea of risk pooling is executed by a centralized
distribution system which caters to the requirements of all the markets in a given region instead of separate warehouse
allocated for different markets
Case questions:
- Understanding the concept of centralized and decentralized ware houses; which is better? Why?
- Concept of Risk pooling- advantages
- Different ways to implement the risk pooling in a supply chain
Risk Pooling …
Questions:
Q1: For the same service level, which system will require more inventory?
Q2: For the same total inventory level, which system will have better service?
Risk Pooling …
Centralized Vs Decentralized
Factory Factory
Decentralized
Warehouse – I
Centralized Decentralized
Warehouse – I
Warehouse – II
Warehouse - II
Market-I
Market-I
Market-II Market-II
Risk Pooling …
What is Risk Pooling?
The idea behind risk pooling is to redesign the supply chain, the production process, or
the product to either reduce the uncertainty the firm faces or to hedge uncertainty
so that the firm is in a better position to mitigate the consequence of uncertainty.
Lead Time Pooling
Location pooling
Product pooling
Lead Time pooling
Capacity pooling
Capacity Pooling
Risk Pooling …
Advantages / Disadvantages
Advantages Disadvantages Summary Risk Pooling

❖ Reduce demand variability
❖ Reduce expected inventory ❖ Creates distance between
❖ Risk-pooling strategies are most effective
Location Pooling when demands are negatively correlated
❖ investment needed to achieve a target service inventory and customers
level because then the uncertainty with total
demand is much less than the uncertainty
❖ Reduction in demand variability
❖potentially degrades product with any individual item/location
Product Pooling ❖ Better performance in terms of matching supply
functionality
and demand
❖ Risk-pooling strategies do not help reduce
❖ Decrease lead time ❖ Extra costs of operating pipeline inventory
Lead Time
❖ Keep inventory closer to customer distribution center
Pooling ❖ Reduce inventory investment ❖ Additional transportation costs
❖ Risk-pooling strategies can be used to
Capacity Pooling ❖ Accommodate demand uncertainty ❖large costs to have flexibility reduce inventory while maintaining the same
service or they can be used to increase
service while holding the same inventory
Risk Pooling …
Warehouse one Market one
Supplier
Warehouse one Market one
Market one
Supplier Warehouse one
Market one
Questions:
Q1: For the same service level, which system will require more inventory?
Q2: For the same total inventory level, which system will have better service?
Risk Pooling – Example
Electronic equipment manufacturer and distributor / 2 warehouses for distribution in New York and New
Jersey (partitioning the northeast market into two regions) / Customers (that is, retailers) receiving items
from warehouses (each retailer is assigned a warehouse) / Warehouses receive material from Chicago /
Current rule: 97 % service level / Each warehouse operate to satisfy 97 % of demand (3 % probability of
stock-out)
Current distribution systems:

Warehouse One Market One
New York
Supplier
Chicago
Warehouse Two Market Two

New Jersey
Risk Pooling – Example…
Problems: New Idea :
- over 7 years ago ❖ Replace the 2 warehouses with a single warehouse (located some suitable
-1,500 products place) and try to implement the same service level 97 %
❖ Delivery lead times may increase
-10,000 customers in Northeast.
❖ But may decrease total inventory considerably.
Considering an alternative logistics strategy ❖ Why?
Z =1.89 Compare the total inventories of two systems
Co =Rs 60/order LT=1 week
Cc =Rs 0.27/unit/week
New idea: aggregating warehouses into one
i.e. Centralized distribution

system Market
Supplier Warehouse One
Market
Two
Risk Pooling – Example …
Compare the total inventories of two systems
Historical Data
PRODUCT A
Week 1 2 3 4 5 6 7 8
New York 33 45 37 38 55 30 18 58
New Jersey 46 35 41 40 26 48 18 55
Total 79 80 78 78 81 78 36 113
PRODUCT B
Week 1 2 3 4 5 6 7 8
New York 0 3 3 0 0 1 3 0
New Jersey 2 4 3 0 3 1 0 0
Total 2 6 3 0 3 2 3 0
COMPARE THE TOTAL INVENTORIES OF TWO
Summary of SYSTEMS
Historical Data
Standard Avg
Average Coefficient of Safety Max Avg Inventory TC
Statistics Product Deviation ROP Q inventory
Demand Variation Stock Inventory (without ss) per week
of Demand reduction
New York A 39.3 13.2 0.34 24.95 65 132 197 66 131.5 42.42
New York B 1.125 1.36 1.21 2.57 4 25 29 12.5 6.769
New Jersey A 38.6 12 0.31 22.68 62 131 193 65.5 41.488
New Jersey B 1.25 1.58 1.26 2.99 5 24 29 12 24.5 7.1713
Total (aggreg.) A 77.9 20.71 0.27 39.14 118 186 304 93 29.28 60.807
Total (aggreg.) B 2.375 1.9 0.80 3.59 6 33 39 16.5 32.65 9.7428
Savings in
Average inventory for Product A: Inventory Average inventory for Product B:
❖ At NJ warehouse is about 88 units ❖ At NJ warehouse is about 15 units
❖ At New York warehouse is about 91 units ❖ At New York warehouse is about 14 units
❖ In the centralized warehouse is about 132 units ❖ In the centralized warehouse is about 20 units
❖ Average inventory reduced by about 36 percent ❖ Average inventory reduced by about 45 percent
❖ % of reduction of inventory A = (91+88-132)/132 =36%
❖ % of reduction of inventory B = (14+15-20)/20 =45%
Important Observations about risk pooling
• Centralizing inventory control reduces both safety stock and average inventory level for the same service
level.
i.e., benefit from aggregating demand decreases when demands from two (or more) markets are positive
correlated
Centralized vs. Decentralized Market One

A centralized Systems
system :
Warehouse
• Safety stock : ↓ Inbound cost↓
• Service level : ↑(with the same total safety stock) Outbound↑ Market One
• Overhead costs :↓
• Lead time :↑
• Transportation costs: inbound↓, outbound↑.
Introduction echelon inventory
Introduction : Inventory is commonly defined as the

total amount of goods held in stock at a location. There
are three main categories of inventory based on the type
of material.
❖ Finished Goods Inventory
❖ Intermediate or work in progress (WIP) inventory
❖ Raw Material Inventory
Introduction echelon inventory …
Planned inventories include:
❖ Safety Stock
❖ Cycle Stock
❖ Anticipation Stock
❖ Pipeline or In-Transit Inventory
❖ Strategic Inventory
Unplanned (or excess) inventories include :
❖ Overly High Sales Plan
❖ Product Returns
❖ Inventory at Wrong Location
❖ Inventory in Wrong Package
❖ Off-Spec Material which can be Converted to Sellable Material
❖ Off- Spec Material which should be disposed of
❑ Experimental Product
❑ New Product Information
Introduction echelon inventory ….
Echelon – what it is?
❖ An echelon is a level or some height. In inventory it is synonymous with the various levels at which
inventory is held, viz., Factory warehouse, Distributor’s warehouse, and at retailer level.
❖ If Inventory is planned at each level – echelon – independent, it can lead to very high inventory build-up.
❖ Problem in modern “Supply Chain Management” : costs can be minimized for the chain as a whole,
rather than adding up the minimum inventory costs at each locations or echelons, based on EOQs.
❖ In traditional inventory models : often use normal distributions (only forecast accuracy, single location, and don’t
consider up- and down-stream SKU-L’s).
❖ Multi-Echelon Inventory optimization moves beyond traditional assumptions for demand behaviour and
demand variability. (It considers impact of upstream and downstream inventory to delivering customer
service)
❖ Built to deliver the best possible service levels – at minimum inventory holding – for each SKU.
COMMON PROBLEMS
❖The network carries excess inventory in the form of redundant safety stock.
❖End-customer service failures occur even when adequate inventory exists in the network
❖External (outsourcing) suppliers deliver unreliable performance, because they have received unsatisfactory
demand projections.
❖Internal allocation decisions can be erroneous.
Overview
NETWORK TOPOLOGY
Echelon Inventory
A serial supply chain The warehouse echelon inventory
Reorder Point with Echelon Inventory

• Le = echelon lead time,
– lead time between the retailer and the distributor plus the lead time
between the distributor and its supplier, the wholesaler.
• AVG = average demand at the retailer
Reorder point
• STD = standard deviation of demand at the retailer
4-Stage Supply Chain Example
◼ Average weekly demand faced by the retailer is 45
◼ Standard deviation of demand is 32
◼ At each stage, management is attempting to maintain a service level of 97% (z=1.88)
◼ Lead time between each of the stages, and between the manufacturer and its suppliers is 1 week
Costs and Order Quantities

Reorder Points at Each Stage
K LD H Q
❖ For the retailer, R=1*45+1.88*32*√1 = 105
Retailer 250 45 1.2 137
❖ For the distributor, R=2*45+1.88*32*√2 = 175
Distributor 200 45 0.9 141 ❖ For the wholesaler, R=3*45+1.88*32*√3 = 239
Wholesaler 205 45 0.8 152 ❖ For the manufacturer, R=4*45+1.88*32*√4 = 300
Manufacturer 500 45 0.7 255

Echelon inventory
Forecasting in supply chain
Role of Forecasting in a Supply Chain
◼The basis for all strategic and planning decisions in a supply chain
◼Used for both push and pull processes
Examples:
◼ Production : scheduling, inventory, aggregate planning
◼ Marketing : sales force allocation, promotions, new production introduction
◼ Finance : plant/equipment investment, budgetary planning
◼ Personnel : workforce planning, hiring, layoffs
◼ All of these decisions are interrelated
Characteristics of Forecasts
• Forecasts are always wrong. Should include expected value and measure of error.
• Long-term forecasts are less accurate than short-term forecasts (forecast horizon is important)
• Aggregate forecasts are more accurate than disaggregate forecasts
Forecasting in supply chain…
◼ QUALITATIVE METHODS – judgmental methods
◼Forecastsgenerated subjectively by the forecaster
◼Educated guesses
Type Characteristics Strengths Weaknesses
One person's opinion can dominate the
Executive opinion A group of managers meet & come up with a forecast Good for strategic or new-product forecasting
forecast
Uses surveys & interviews to identify customer It can be difficult to develop a good
Market research Good determinant of customer preferences
preferences questionnaire
Excellent for forecasting long-term product
Seeks to develop a consensus among a group of
Delphi method demand, technological changes, and scientific Time consuming to develop
experts
advances
◼ QUANTITATIVE METHODS – based on mathematical modeling:

Forecasts generated through mathematical modeling
Time Series Models:

❖Assumes information needed to generate a forecast is contained in a time series of data
❖Assumes the future will follow same patterns as the past
❖Statistical Time Series Models are very useful for short range forecasting problems such as weekly sales .
Causal Models or Associative Models
❖Explores cause-and-effect relationships
❖Uses leading indicators to predict the future
❖Housing starts and appliance sales
Sales SOME COMMON METHODS
Year
per year Methods Forecast values Remarks
E 25 2015 Simple Average F = 27

st Average F = 26.25 Only last four values
32 2016
i Average F = 28 Increasing trend in last two values
m 24 2017 Decreasing trend in last two values
Average F = 26
at 28 2018 Average F = 27 Avg. of last three values
io
n 26 2019 Weighted average F = 26.833
Weighted Average on last three values
method
27 2020
Average F = 26 Remove 32, Avg. rest of values
? 2021 Simple average
-- F=30 Other methods
Level (constant) Constant Noise Weighted average
F=a+ε Moving average

K – period moving average (0, σ^2)
2-period moving average
Moving wieghted average
4-period moving average
Types
For period t + 1
▪ Moving average For period t For period t
▪ Exponential smoothing
▪ Method for date with trends
Ft+1 = αDt + (1-α)Ft
Sales
Year F – Forecast
per year
D – Demand
E 25 2015
TIME SERIES MODELS α(Alpha) – Smoothing constant
st 32 2016
i Exponential smoothing
m 24 2017
at 28 2018
io
Forecast in the year 2021
26 2019
n
27 2020
F7 (2021) = αD6 + (1-α)F6 F1 = ?
F6 (2020) = αD5 + (1-α)F5
? 2021 α=?
----------------------------------------
-----------------------------------------
Forecast in the year 2021 Assume F1 = 27 (From simple average)
F7 (2021) = αD6 + (1-α)F6 Smoothing constant (α) = 0.2
F6 (2020) = αD5 + (1-α)F5
---------------------------------------- F2 = 26.6 F3 = 27.68 F4 = 26.944
-----------------------------------------
F2 (2016) = αD1 + (1-α)F1 F5 = 27.1552 F6 = 26.92416
Equation F7 = 26.97
F7 (2021) = αD6 + (1-α)F6
The smoothing factor “α” is a

=
αD6 + (1-α) [αD5 + (1-α) F5] value between 0 and 1, where α
closer to 1 means more weigh to
= αD6 + (1-α) αD5 + (1-α)^2 F5 the recent observations and
hence more rapidly changing
forecast.
= αD6 + (1-α) αD5 + (1-α)^2 D4 + ………….. α(1-α)^5 D1 + (1-α)^6 F1
=
α + (1-α) α + α (1-α)^2 + ………….. α(1-α)^(n-1)
=
0.2+ 0.16 + 0.17 + ………….. 0.05
SEASONAL MODELS PROBLEM
(SEASONAL SERIES WITH INCREASING TREND)
Winter’s Method
Increasing in trend ------ Level
------ Trends
(slope)
------ Seasonality
1 2 3
53 58 62 Forecast made in period t for any future period t + p
22 25 27
37 40 44 Ft+1 = (at + bt) x ct+1
45 50 56
157 173 189
Seasonal index
a = 0.2 x 156 + 0.8 (156 + 4) = 159.43
Risk Pooling …
Demand Forecasts
The three principles of all forecasting techniques:
❖ Forecasting is always wrong
❖ The longer the forecast horizon the worst is the forecast
❖ Aggregate forecasts are more accurate
The Effect of Demand Uncertainty

❖ Most companies treat the world as if it were predictable:
– Production and inventory planning are based on forecasts of demand made far in advance of the
selling season
– Companies are aware of demand uncertainty when they create a forecast, but they design their planning
process as if the forecast truly represents reality
❖ Recent technological advances have increased the level of demand uncertainty:

– Short product life cycles
– Increasing product variety

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Unit 2

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UNIT – II

“Almost all quality improvement comes via simplification of

❖ Single order period

◼ Delivery lead times

◼ Incentives for larger shipments

Centre for Monitoring Indian Economy 6

◼ Safety inventory - to protect against supply-and-demand uncertainties, low delivery

◼ 133 parts plants

◼ Freight transportation costs: $4.1 billion (60% for material shipments)

◼ combined corporate cost of inventory and transportation.

◼ 26% annual cost reduction by adjusting:

◼ Shipment sizes (inventory policy)

◼ Routes (transportation strategy)

❖ Ensure a continuous supply of raw materials to facilitate

❖ Maintain sufficient stocks

❖ Maintain sufficient finished goods

❖ Minimize the carrying cost and time.

❖ Control investment in inventories and keep it at an optimum level.

◼ Unnecessary tying down of firm’s funds and loss of profit.

◼ Excessive carrying costs.

◼ Risk of liquidity- difficult to convert into cash.

◼ Last In First Out (LIFO) Method.

◼ Weighted Average Cost/price Method.

- 1.1.2018 Opening Stock 100 units @ Re 1.

(a) periodic system under FIFO method; and

DATE RECEIPTS ISSUES BALANCE

Closing inventory calculated as residual figures:-

- Opening inventory 100

Cost of goods sold is calculated as residual figures:-

❖ Flows of goods and costs may not coincide.

ABC Ltd. Provides you with the following information :

- 1.1.20 18 Opening Stock 100 units @ Re 1.

(a) Perpetual system; and

1-1-2018 _ _ _ _ _ 100 1.00 100

Closing inventory calculated as residual figures:-

- Opening inventory 100

Cost of goods sold is calculated as residual figures:-

Opening inventory 100 -- 1.00 100

1. The weighted-average cost per unit is Rs. 1730/1000 = Rs. 1.73

Economic Lot Size (ELS)

D = Annual Demand in Units for the Inventory Item

ELS - Total Annual Cost

ELS – Production Time per Lot

ELS - Time Between Orders (TBO)

a. Determine the Economic Production Lot Size (ELS)

Q = 1800 unit Co = Rs 300 per order

Q = 3000 unit Co = Rs 300 per order

Qty Changeover time

Total cost = item cost + order cost + carrying cost

Qty Changeover time

Total cost = item cost + order cost + carrying cost

Level of customer service: (1) in-stock (fill) rate (2) number of

Inventory cost: cost of ordering and carrying trade-off

When-to-order: stochastic demand and stochastic lead time

• Continuous review policy

• Periodic review policy

(Q, R)-policy: Whenever the inventory level reaches the reorder

Average monthly demand = 191.17

Average weekly demand = Average Monthly Demand/4.3

Average inventory level = 679/2 + 85.3 = 424.8

order-up-to level R + Q = 175 + 679 = 855.

Longer Intervals (e.g. Weekly or Monthly)

ROP = Expected demand during lead time + Safety stock