Inventory Management

⚫Inventory meaning
⚫Independent demand VS Dependent demand
⚫Types of inventory
⚫Functions of inventory
⚫Objectives of inventory
⚫Requirements for effective inventory management.
⚫Inventory model
⚫ Basic EOQ model
⚫ EPQ model
⚫ Quantity discount model
⚫ Re-order model
⚫ Single period model

4/1/2022
 Inventory
Independent Demand
• a stock or store of goods

A Dependent Demand

B(4) C(2)

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

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Independent demand is uncertain.
Dependent demand is certain.
 Independent vs dependent
• 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

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 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

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 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

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 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. 4/1/2022
 Effective Inventory Management

• A system to keep track of inventory

• A reliable forecast of demand
• Knowledge of lead times
• Reasonable estimates of
– Holding costs
– Ordering costs
– Shortage costs
• A classification system

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 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

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 Inventory Counting Systems
• 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
0
to which it is attached
• RFID - Radio Frequency Identification
21480 23208

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 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
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inventory
 ABC Classification System
Classifying inventory according to some measure of importance
and allocating control efforts accordingly.
A - very important
B - mod. Important
High A
C - least important
Annual
$ value B
of items

C
Low
Low High
Percentage of Items

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 Economic Order Quantity Models

• Economic order quantity (EOQ) model

– The order size that minimizes total annual cost

• Economic production model

• Quantity discount model

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 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

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 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
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order order
Lead time
 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost

Q D
TC = H + S
2 Q

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 Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Annual Cost

Ordering Costs

QO (optimal order
quantity)
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 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.

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 Minimum Total Cost
The total cost curve reaches its minimum where
the carrying and ordering costs are equal.

Q D
H = S
2 Q

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 Example
• A local distributor for a national tire company expects to sell
approximately 9600 tires of a certain size. Annual carrying
costs are $16 per tire and ordering costs are $75. The
distributor operates 288 days a year.
– What is the EOQ?
– How many times per year does the store reorder?

– What is the length of an order cycle?

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 Solution

• EOQ= √ 2DS/H = √ 2*9600*75/16 = 300 tires.

• Number of orders per year D/EOQ =

9600/300 = 32

• Length of order cycle = EOQ/ D = 300/9600 =

1/32 of a year, which is 1/32 *288= 9 days

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 Economic Production Quantity (EPQ)

• Production done in batches or lots

• Capacity to produce a part exceeds the part’s
usage or demand rate
• Assumptions of EPQ are similar to EOQ except
orders are received incrementally during
production
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Economic Run Size

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 Derivation of EPQ
• Annual carrying cost = I max*H/2 ,
• Imax= Q(p-u)/p where p = production and u= usage rate and
• Q/p is the run time or no of days.
• Annual carrying cost=
• Set up cost =
• As we know the optimum size Q or EPQ occurs in the trade off between
carrying cost and order cost. In other words when
• Carrying cost = Order cost.
•
• =

• Q= √
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 Problem:
• A toy manufacturer uses 48000 rubber wheels per year for its popular
truck series. The firm makes its own wheels which it can produce at a
rate of 800 per day. The toy trucks are assembled uniformly over the
entire year. carrying cost is $1 per wheel a year. set up cost for
production run of wheels is $45. The firm operates 240 days per year.
Determine each of the following.

• Optimum run size

• Minimum total annual cost for carrying and setup
• Cycle time for the optimal run size
• Run time.
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 Solutions
• D= 48000 wheel per year
• S= $45
• H= $1 per wheel per year
• p= 800 wheels per day
• u= 48000 wheels per 240 days or 200 wheels per day.
• Q = 2*48000*45 * 800/800-200 = 2400 wheels. Where
• TC min = Carrying cost + set up cost = (I max/2)*H + DS/Q
• I max= Q(p-u)/p = 2400(800-200)/800 = 1800 wheels.
• TC=1800/2*1 +(48000*45)/2400=900+900=$1800
• Cycle time= Q/u= 2400 wheels/200 wheels/day= 12 days
• Run time=Q/p= 2400/800 wheels per day= 3 days

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 Quantity Discount Model
● Price reductions for large orders.
● TC=Carrying cost + Ordering cost+ Purchasing cost
● TC=QH/2+DS/Q+PD where P= unit price.
● The maintenance department of a large hospital uses about 816 cases of liquid cleanser
annually. Ordering costs are $12 and carrying costs are $4 per case a year and the new price
schedule indicate the orders of less than 50 cases will cost $20 per case,50-79 cases will cost
$18 per case, 80-99 cases will cost $17 per case and larger order will cost $16 per case.
Determine the optimum order quantity and the total cost

● EOQ= √ 2DS/H = √ 2*816*12/4= 70 cases

● TC= QH/2+DS/Q+PD= 70*4/2+816*12/70+18*816=$14968

● TC 80= 14154

● TC 100= 13325 …. Is the lowest so 1000 case is the optimal order size.
• When carrying costs are expressed as a
percentage of price …..
• Surge electric uses 4000 switches a year. Switches price are as follows 1-
499, 90 cents each:500-999, 85 cents each and 1000 or more 80 cents.
Order cost is $30 and carrying costs are 40% of purchase price per unit.
Determine optimum order qty and TC.
• Given D=400 S=30 H=.40P
Range Unit Price H
1-499 .9 .4*.9=.36
500-999 .85 .4*.85=.34
1000 or more .8 .4*.8=.32
• Minimum point= √ 2DS/H = √
2*4000*30/.32=866
• But 866 will cost .85 each rather than .8
each,866 is not a feasible. Next try .85 for
each
• Minimum point = √ 2DS/H = √
2*4000*30/.34=840 switches– this is feasible
is it falls in .85 per switch range
• TC 840= QH/2+DS/Q+PD=840/2*.34+4000/840*30+.85*4000=3686
• TC 1000= QH/2+DS/Q+PD=1000/2*.32+4000/1000*30+.8*4000=3480
• Thus minimum cost order size is 1000.
 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.

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 Determinants of the Reorder Point

• The rate of demand

• The lead time
• Demand and/or lead time variability
• Stock out risk (safety stock)

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 Safety Stock
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock reduces risk of Safety stock

stockout during lead time LT 4/1/2022
Time
 Reorder Point

Service level
Risk of
a stockout
Probability of
no stockout
ROP Quantity
Expected
demand Safety
stock
0 z z-scale
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 Problem: when demand and LT are constant

• John takes two – a- day vitamins, which are delivered to his

home by a route man seven days after an order is called in. At
what point should John telephone his order in.
• Solution:
• Usage = 2 vitamin per day
• Lead time= 7 days

• ROP= Usage* Lead-time = 2 vitamin per day* 7 days = 14 vitamins.

• Thus John should reorder when 14 vitamin tablets are left.

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 When demand and LT variability are
present
• ROP= Expected demand during LT+ ZσdLT

• Where Z= no of std deviation and σdLT= std deviation lead time demand
• A manager of construction supply house determined from historical records that
demand for sand during lead time averages 50 tons. In addition, suppose the
manager determined the demand during lead time could be described by a
normal distribution that has a mean of 50 tons and std deviation of 5 tons. Assume
that manager is willing to accept a stock out risk of no more than 3%.

• Find i, Safety stock ii. What reorder point should be used?

• SS=1.88*5=9.4 tons

• ROP=50+9.4=59.4

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 Single Period Model
• Model for ordering of perishables and other
items with limited useful lives
• Shortage cost: generally the unrealized profits
per unit
• CS = revenue-cost per unit
• Excess cost: difference between purchase cost
and salvage value of items left over at the end
of a period
• Ce =cost per unit- salvage value 4/1/2022
 Single Period Model
• Continuous stocking levels
– Identifies optimal stocking levels
– Optimal stocking level balances unit shortage and
excess cost
• Discrete stocking levels
– Service levels are discrete rather than continuous
– Desired service level is equaled or exceeded

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 Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit
Ce C
s
Service Level

Quantity

S point
Balance
o
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 Example
• Ce = $0.20 per unit
• Cs = $0.60 per unit

Cs

• Service level = = .6/(.6+.2)

• Service level = .75
Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25

4/1/2022
 Problem:

• A basket of fruits are delivered weekly to Jenny’s shop.

Demand varies uniformly between 300 kgs and 500 kgs per
week. Jenny pays 20 cent/kg and charges 80 cents/kg .
Unsold fruits has no salvage value and can not be carried over
into the next week due to spoilage. Find the optimal stocking
level and its stock out risk.

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 Solution: When demand is uniform

• Cs = revenue per unit - cost per unit = $ .80- $. 20 = $. 60 per unit

• Ce = cost per unit – salvage value per unit = $ .20 - $0 = $.20
• SL= Cs/Cs+ Ce = .60/.60+.20 = .75
• Thus the optimum stocking level must satisfy demand 75 % of the time.
For the uniform distribution, this will be at a point equal to the minimum
demand plus 75% of the difference between maximum and minimum
demands.
• S = 300+ .75(500-300) = 300+ .75*200 = 450 kgs.

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 Operations Strategy

• Too much inventory

– Tends to hide problems

– Easier to live with problems than to eliminate

them

– Costly to maintain

• Wise strategy
– Reduce lot sizes 4/1/2022