Inventory Management

Prema Mahale
 Inventory

Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
 Inventory Models

 Independent demand – finished goods,

items that are ready to be sold
 E.g. a computer
 Dependent demand – components of
finished products
 E.g. parts that make up the computer
 Types of Inventories

 Raw materials & purchased parts

 Partially completed goods called
work in progress
 Finished-goods inventories
 (manufacturing firms)
or merchandise
(retail stores)

 Replacement parts, tools, & supplies

 Goods-in-transit to warehouses or
customers
 Functions of Inventory

 To meet anticipated demand

 To smooth production requirements
 To decouple operations
 To protect against stock-outs

 To take advantage of order cycles

 To help hedge against price increases
 To permit operations
 To take advantage of quantity discounts
 Objective of Inventory Control

 To achieve satisfactory levels of customer

service while keeping inventory costs within
reasonable bounds
 Level of customer service
 Costs of ordering and carrying inventory

Inventory turnover is the ratio of

average cost of goods sold to
average inventory investment.
 Effective Inventory Management

 A system to keep track of inventory

 A reliable forecast of demand
 Knowledge of lead times
 Reasonable estimates of
 Holding costs (Carrying cost)
 Ordering costs
 Shortage costs
 A classification system
 Key Inventory Terms

 Lead time: time interval between ordering and

receiving the order
 Holding (carrying) costs: cost to carry an item

in inventory for a length of time, usually a year

 Ordering costs: costs of ordering and receiving

inventory
 Shortage costs: costs when demand exceeds
supply
 Cycle Counting

 A physical count of items in inventory

 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be performed?
 Who should do it?
 Economic Order Quantity Models

 Economic order quantity (EOQ) model

 The order size that minimizes total annual
cost

 Economic production model

 Quantity discount model
 Assumptions of EOQ Model

 Only one product is involved

 Annual demand requirements known
 Demand is even throughout the year
 Lead time does not vary
 Each order is received in a single delivery
 There are no quantity discounts
 The Inventory Cycle

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time
 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + D
TC =
2
Cc Q
Co
 Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q + D
2 Cc Q Co
Annual Cost

Ordering Costs

Order Quantity (Q)

QO (optimal order quantity)
 Deriving the EOQ

Using calculus, we take the derivative of the total cost function

and set the derivative (slope) equal to zero and solve for Q.

2DS 2( Annual Demand )(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost

The total cost curve reaches its minimum where

the carrying and ordering costs are equal.
Q = D
2
Cc Q
C o
 Total cost = Annual carrying cost + Annual
Ordering cost + purchase price
 = Q/2 Cc + D/Q Co + D*C
Example: 1 – Discussed in class
Solution
Total cost with EOQ
Compare the Total cost in current policy and
EOQ quantity.
Example 2 : discussed in the class
Total Costs with Purchasing Cost

Annual Annual
TC = carrying + ordering + Purchasing
cost
cost cost
Q + D Co + CD
TC = Cc
2 Q
Total Costs with PD

Cost
Adding Purchasing cost TC with PD
doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity
When to Reorder with EOQ Ordering

 Reorder Point - When the quantity on hand

of an item drops to this amount, the item
is reordered
 Safety Stock - Stock that is held in excess of
expected demand due to variable demand
rate and/or lead time.
 Service Level - Probability that demand will
not exceed supply during lead time.
 Determinants of the Reorder Point

 The rate of demand

 The lead time

 Demand and/or lead time variability

 Stockout risk (safety stock)

 Inventory Counting Systems

 Periodic System
Physical count of items made at periodic intervals
 Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
Re-order Point :
 Safety Stock

 Safety stock reduces risk of stockout during lead time

The amount of safety stock that is appropriate for a given

situation depends on the following factors:
 1. The average demand rate and average lead time

 2. Demand and lead time variability

 3. The desired service level

 When to Reorder

 Reorder point
 When the quantity on hand of an item drops to this amount, the item is
reordered.
 Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

13-34
 Inventory Counting Systems (Cont’d)

 Two-Bin System - Two containers of inventory;

reorder when the first is empty
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0

214800 232087768
 Practice Example: 1

 A local distributor for a national tire company expects to sell

approximately 9,600 steelbelted radial tires of a certain size and
tread design next year. Annual carrying cost is $16 per tire, and
ordering cost is $75. The distributor operates 288 days a year.
a. What is the EOQ?
b. How many times per year does the store reorder?
c. What is the length of an order cycle?
d. What will the total annual cost be if the EOQ quantity is
ordered?
ANS: a. 300tires b. 32 orders
c. 9 working days ( 0.031 yr) d. $ 4800
 Example 2:

A company produces 2000 units of TV sets in a year. It

requires a equal no. of subpart for production which costs Rs.
10 and cost to hold it in stock for a year is Rs. 2.40. Cost of
placing an order is Rs. 150.
Calculate i) EOQ, ii) Annual total variable inventory cost,
iii) Inventory cycle, iv) no. of orders and v)rupee value of
EOQ.
 Example : 3
i) Determine the EOQ and the total variable cost for the
following
Annual demand : 25 units
Unit Price : Rs. 2.50
Order Cost : Rs. 4.00
Storage rate : 1% per year
Interest rate : 12% per year
obsolescence rate : 7% per year
ii) Compute the order quantity and the total variable cost that
would result if an incorrect price of Rs. 1.60 were used for the
item.
ANS i) 20 and Rs. 10
ii) 25 and Rs. 8
 Reorder Point

ROP = Demand during lead time

ROP = Demand or consumption rate x Lead time

(Demand / Consumption rate in demand per day or per week or

per month as per the lead time given )
 Quantity discount
 Price reduction for larger orders offered to customers to
induce them to buy in large quantities
Total Cost  Carrying Cost  Ordering Cost  Purchasing Cost
Q D
 H  S  PD
2 Q
where
P  Unit price

13-43
Adding PD does not change EOQ

13-44
The total-cost curve
with quantity discounts
is composed of a
portion of the total-cost
curve for each price

13-45
 The maintenance department of a large hospital uses about 816
cases of liquid cleanser annually. Ordering costs are $12,
carrying costs are $4 per case a year, and the new price
schedule indicates that orders of less than 50 cases will cost
$20 per case, 50 to 79 cases will cost $18 per case, 80 to 99
cases will cost $17 per case, and larger orders will cost $16 per
case. Determine the optimal order quantity and the total cost.

 Ans : TC 100 = ( 100 / 2 ) 4 + ( 816 / 100 ) 12 + 16(816) =

$13,354
 Therefore, because 100 cases per order yields the lowest
total cost, 100 cases is the overall optimal order quantity.

13-46
 Surge Electric uses 4,000 toggle switches a year. Switches
are priced as follows: 1 to 499, 90 cents each; 500 to 999,
85 cents each; and 1,000 or more, 80 cents each. It costs
approximately $30 to prepare an order and receive it, and
carrying costs are 40 percent of purchase price per unit on
an annual basis. Determine the optimal order quantity and
the total annual cost.

 Ans:

13-47
 ABC Classification System

Classifying inventory according to some

measure of importance and allocating
control efforts accordingly.
A - very important
High
B - mod. important A
Annual
C - least important $ value
B
of items

C
Low

Low High
Percentage of Items
ABC Analysis
Calculate the total spending per year

Item number Unit cost Annual demand Total cost per year

101 5 48,000 240,000

102 11 2,000 22,000
103 15 300 4,500
104 8 800 6,400
105 7 4,800 33,600
106 16 1,200 19,200
107 20 18,000 360,000
108 4 300 1,200
109 9 5,000 45,000
110 12 500 6,000
Total usage 737,900

Total cost per year: Unit cost * total cost per year
 Calculate the usage of item in total usage

Total cost per Usage as a %

Item number Unit cost Annual demand
year of total usage

101 5 48,000 240,000 32,5%

102 11 2,000 22,000 3%
103 15 300 4,500 0,6%
104 8 800 6,400 0,9%
105 7 4,800 33,600 4,6%
106 16 1,200 19,200 2,6%
107 20 18,000 360,000 48,8%
108 4 300 1,200 0,2%
109 9 5,000 45,000 6,1%
110 12 500 6,000 0,8%
Total usage 737,900 100%

Usage as a % of total usage = usage of item/total usage

 Sort the items by usage

Item Cumulative Unit Annual Total cost per Usage as a % Cumulative % of

number % of items cost demand year of total usage total

107 10% 20 18,000 360,000 48,8% 48,8%

101 20% 5 48,000 240,000 32,5% 81,3%

109 30% 9 5,000 45,000 6,1% 87,4%

105 40% 7 4,800 33,600 4,6% 92%

102 50% 11 2,000 22,000 3,0% 94,9%

106 60% 16 1,200 19,200 2,6% 97,5%

104 70% 8 800 6,400 0,9% 98,4%

110 80% 12 500 6,000 0,8% 99,2%

103 90% 15 300 4,500 0,6% 99,8%

108 100% 4 300 1,200 0,2% 100%

Total usage 737,900 100%