07-Dec-22

Operations and Supply Chain Management

S13-16: INVENTORY MANAGEMENT

Prof. Vivek Roy

Indian Institute of Management Kashipur

Inventory management

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What Is Inventory?
• Stock of items kept to meet future demand

• Purpose of inventory management

• how many units to order
• when to order

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Supply Chain Inventories—Make-

to-Stock Environment
• Raw materials
• Purchased parts and
supplies
• Work-in-process
(partially completed)
products (WIP)
• Items being
transported
• Tools and equipment

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Opposing Views of Inventory

• Why We Want to Hold Inventories

• Why We Not Want to Hold Inventories

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Why We Want to Hold Inventories

• Improve customer service
• Reduce certain costs such as
• ordering costs
• stockout costs
• acquisition costs
• start-up quality costs
• Contribute to the efficient and effective operation of the production
system

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Why We Want to Hold Inventories

• Finished Goods
• Essential in produce-to-stock positioning strategies
• Necessary in level aggregate capacity plans
• Products can be displayed to customers
• Work-in-Process
• Necessary in process-focused production
• May reduce material-handling & production costs
• Raw Material
• Suppliers may produce/ship materials in batches
• Quantity discounts and freight/handling $$ savings

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Why We Do Not Want to Hold Inventories

• Certain costs increase such as

• carrying costs
• cost of customer responsiveness
• cost of coordinating production
• cost of diluted return on investment
• reduced-capacity costs
• large-lot quality cost
• cost of production problems

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The Key Objective of Inventory

Supply

Demand

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Two Forms of Demand

Dependent
Demand for items used to produce final
products
Tires stored at a Goodyear plant are an
example of a dependent demand item
Independent
Demand for items used by external
customers
Cars, appliances, computers, and houses
are examples of independent demand
inventory

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Purposes of Inventory

To maintain To allow flexibility

To meet variation in
independence of in production
product demand
operations scheduling

To provide a
safeguard for To take advantage
variation in raw of economic
material delivery purchase order size
time

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Inventory Management Vs. Inventory Control

• Where does Inventory Policy falls?

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Inventory Policy

Inventory policy addresses two questions

concerning replenishment of inventory:

• When to order?

• How much to Order?

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Formulating Inventory Policy:

Inventory Costs Minimization
Holding (or carrying) costs
• Costs for storage, handling,
insurance, and so on
Setup (or production
change) costs
• Costs for arranging specific
equipment setups, and so on

Costs

Ordering costs Shortage costs

• Costs of placing an order • Costs of running out

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Inventory Policy Systems –

Comparison
Single-period inventory
model
• One-time purchasing decision
(e.g., 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 (e.g., running out of
stock)
• Fixed-time period models
• Time triggered (e.g., monthly sales call
by sales representative)
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Multi-Period Models
Fixed-order quantity models
- Also called the economic
order quantity, EOQ, and Q-
model
- Event triggered
- Perpetual system

Fixed–time period models

- Also called the periodic system,
periodic review system, fixed-
order interval system, and P-mode
- Time triggered
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Multi-Period Models –
Comparison
Fixed-Order Quantity
• Inventory remaining must be
continually monitored
• Has a smaller average inventory
• Favors more expensive items
• Is more appropriate for
important items
• Requires more time to maintain
– but is usually more automated
• Is more expensive to implement
Fixed-Time Period
• Counting takes place only at
the end of the review period
• Has a larger average inventory
• Favors less expensive items
• Is sufficient for less-important
items
• Requires less time to maintain
• Is less expensive to implement

• Also known as Continuous • Also known as Periodic

Review Systems Review Systems
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Fixed–Order Quantity and Fixed–Time Period

Differences

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Multi-Period Models – Process

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Fixed-Order Quantity Models

• Model I: Basic EOQ

• Model II: EOQ for Production Lots

• Model III: EOQ with Quantity Discounts

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Model I: Basic EOQ

• Typical assumptions made
• Annual Demand (D), Holding Cost (H) and Ordering Cost (S) can be estimated
• Average Inventory Level is the fixed order quantity (Q) divided by 2 which
implies
• no safety stock
• orders are received all at once
• demand occurs at a uniform rate
• no inventory when an order arrives
• . . . more

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Model I: Basic EOQ

• Assumptions (continued)
• Stockout, customer responsiveness, and other costs are inconsequential
• acquisition cost is fixed, i.e., no quantity discounts
• Annual Holding Cost = (Average Inventory Level) x (Holding Cost) =
(Q/2)H
• Annual Ordering Cost = (Average Number of Orders per Year) x
(Ordering Cost) = (D/Q)S
• . . . more

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Model I: Basic EOQ

EOQ = 2 DS / C

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Example: Basic EOQ

Zartex Co. produces fertilizer to sell to wholesalers. One raw
material – calcium nitrate – is purchased from a nearby supplier at
$22.50 per ton. Zartex estimates it will need 5,750,000 tons of
calcium nitrate next year.
The annual carrying cost for this material is 40% of the
acquisition cost, and the ordering cost is $595.
a) What is the most economical order quantity?
b) How many orders will be placed per year?
c) How much time will elapse between orders?

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Example: Basic EOQ

• Economical Order Quantity (EOQ)

D = 5,750,000 tons/year
H = .40(22.50) = $9.00/ton/year
S = $595/order

EOQ = 2(5,750,000)(595)/9.00

= 27,573.135 tons per order

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Example: Basic EOQ

• Total Annual Stocking Cost (TSC)

TSC = (Q/2)H + (D/Q)S

= (27,573.135/2)(9.00)
+ (5,750,000/27,573.135)(595)
= 124,079.11 + 124,079.11
= $248,158.22 Note: Total Holding Cost
equals Total Ordering Cost

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Example: Basic EOQ

• Number of Orders Per Year
= D/Q
= 5,750,000/27,573.135
= 208.5 orders/year
• Time Between Orders Note: This is the inverse
of the formula above.
= Q/D
= 1/208.5
= .004796 years/order
= .004796(365 days/year) = 1.75 days/order

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Basic EOQ with Re-order Point

Always order Q units when Inventory is consumed at a
inventory reaches reorder constant rate, with a new
point (R). order placed when the
reorder point (R) is reached
once again.

Inventory arrives after

lead time (L). Inventory is
raised to maximum level
(Q).

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Basic EOQ with Re-order Point

Average Daily Demand

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Basic EOQ with Re-order Point

The optimal order
quantity (Qopt) occurs
where total costs are at
their minimum

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Example 20.2

Excel: Economic
Order Quantity
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Establishing Safety Stock Levels

Safety stock – refers to the amount of inventory carried
in addition to expected demand.

• Safety stock can be determined based on many different criteria.

A common approach is to simply keep a certain number

of weeks of supply.

A better approach is to use probability.

•Assume demand is normally distributed.

•Assume we know mean and standard deviation.
•To determine probability, we plot a normal distribution for expected demand and
note where the amount we have lies on the curve.
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Fixed-Order Quantity Model with

Safety Stock
Demand is variable, but
follows a known
distribution/

After the reorder is placed, demand

during the lead time may be higher
than expected, consuming some (or
all) of the safety stock/

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Example 20.4
• Daily demand for a certain product is normally distributed, with a mean of 60 and
a standard deviation of 7. The source of supply is reliable and maintains a
constant lead time of six days. The cost of placing the order is $10 and annual
holding costs are $0.50 per unit. There are no stock-out costs, and unfilled orders
are filled as soon as the order arrives. Assume sales occur over the entire 365
days of the year. Find the order quantity and reorder point to satisfy a 95 percent
probability of not stocking out during the lead time.

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Example 20.4: Daily demand for a certain product is normally distributed, with a mean of 60 and a standard
deviation of 7. The source of supply is reliable and maintains a constant lead time of six days.
The cost of placing the order is $10 and annual holding costs are $0.50 per unit. There are
no stock-out costs, and unfilled orders are filled as soon as the order arrives. Assume sales
occur over the entire 365 days of the year. Find the order quantity and reorder point to satisfy a
95 percent probability of not stocking out during the lead time.

For 95%
probability,
z = 1.64.

Policy – place a new

order for 936 units
whenever stock falls
to 388 units on hand.
This results in a 95%
probability of not
stocking out during
the lead time.
Excel: Reorder
Point 48

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Use NORMINV fn. To calculate in excel 49

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Model II: EOQ for Production Lots

• Used to determine the order size, production lot, if an item is
produced at one stage of production, stored in inventory, and then
sent to the next stage or the customer
• Differs from Model I because orders are assumed to be supplied or
produced at a uniform rate (p) rate rather than the order being
received all at once
• . . . more

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Model II: EOQ for Production Lots

• It is also assumed that the supply rate, p, is greater
than the demand rate, d
• The change in maximum inventory level requires
modification of the TSC equation
• TSC = (Q/2)[(p-d)/p]H + (D/Q)S
• The optimization results in

2DS  p 
EOQ =  
H p  d 
C

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Example: EOQ for Production Lots

Highland Electric Co. buys coal from Cedar Creek Coal Co. to
generate electricity. CCCC can supply coal at the rate of 3,500 tons
per day for $10.50 per ton. HEC uses the coal at a rate of 800 tons
per day and operates 365 days per year.
HEC’s annual holding cost for coal is 20% of the acquisition cost,
and the ordering cost is $5,000.
a) What is the economical production lot size?
b) What is HEC’s maximum inventory level for coal?

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Example: EOQ for Production Lots

• Economical Production Lot Size
d = 800 tons/day; D = 365(800) = 292,000 tons/year
p = 3,500 tons/day
S = $5,000/order
H = .20(10.50) = $2.10/ton/year EOQ = (2DS/C)[p/(p-d)]
H

EOQ = 2(292,000)(5,000)/2.10[3,500/(3,500-800)]

= 42,455.5 tons per order

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Example: EOQ for Production Lots

• Total Annual Stocking Cost (TSC)

TSC = (Q/2)((p-d)/p)H + (D/Q)S

= (42,455.5/2)((3,500-800)/3,500)(2.10)
+ (292,000/42,455.5)(5,000)
= 34,388.95 + 34,388.95
= $68,777.90 Note: Total Carrying Cost
equals Total Ordering Cost

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Example: EOQ for Production Lots

• Maximum Inventory Level

= Q(p-d)/p
= 42,455.5(3,500 – 800)/3,500
= 42,455.5(.771429)
= 32,751.4 tons
Note: HEC will use 23%
of the production lot by the
time it receives the full lot.

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Model III: EOQ with Quantity Discounts (Price

Break)
• Under quantity discounts, a supplier offers a lower unit price if larger
quantities are ordered at one time
• This is presented as a price or discount schedule, i.e., a certain unit
price over a certain order quantity range
• This means this model differs from Model I because the acquisition
cost (ac) may vary with the quantity ordered, i.e., it is not necessarily
constant
• . . . more

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Model III: EOQ with Quantity Discounts

To find the EOQ, the following procedure is used:

1. Compute the EOQ using the lowest acquisition cost.

• If the resulting EOQ is feasible (the quantity can be purchased at the
acquisition cost used), this quantity is optimal and you are finished.
• If the resulting EOQ is not feasible, go to Step 2
2. Identify the next higher acquisition cost.

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Model III: EOQ with Quantity Discounts /

Price Breaks CONTD…
3. Compute the EOQ using the acquisition cost from Step 2.
• If the resulting EOQ is feasible, go to Step 4.
• Otherwise, go to Step 2.
4. Compute the TMC for the feasible EOQ (just found in Step 3) and its
corresponding acquisition cost.
5. Compute the TMC for each of the lower acquisition costs using the
minimum allowed order quantity for each cost.
6. The quantity with the lowest TMC is optimal.

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Model III: EOQ with Quantity Discounts

• Under this condition, acquisition cost becomes an incremental cost
and must be considered in the determination of the EOQ
• The total annual material costs (TMC) = Total annual stocking costs
(TSC) + annual acquisition cost

TSC = (Q/2)H + (D/Q)S + DC

• . . . more

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Model III: EOQ with Quantity Discounts /

Price Breaks CONTD…
• OVERALL, Price varies with the order size
• To find the lowest-cost, calculate the order quantity for each price
and see if the quantity is feasible
1. Sort prices from lowest to highest and calculate the order quantity for each
price until a feasible order quantity is found
2. If the first feasible order quantity is the lowest price, this is best; otherwise,
calculate the total cost for the first feasible quantity and calculate total cost at
each price lower than the first feasible order quantity

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Example 20.8: Price Break (or Quantity

Discount)
• Annual Demand (D) = 10,000
• Order Cost (S) = $20
• Holding Cost (H) is 20 percent of cost
• Cost (C) per unit…
• Scheme 1: 0-499 units cost $5.00
• Scheme 2: 500-999 units cost $4.50
• Scheme 3: 1,000 units and up cost $3.90

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Example 20.8: Price Break (or Quantity

Discount)
• Annual demand = 10,000
• Order cost = $20
• Hold cost is 20 percent of cost
• Cost per unit…
• Cost per unit…
• Scheme 1: 0-499 units cost $5.00
• Scheme 2: 500-999 units cost $4.50
• Scheme 3: 1,000 units and up cost $3.90

C = $5.00 Q = 632 TCQ=499 = $50,650

C = $4.50 Q = 667 TCQ=667 = $45,600
C = $3.90 Q = 716 TCQ=1,000 = $39,590
• Order 1,000 is optimal

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Inventory Models with QD / PB

20-64
Exhibit 20.9

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Example 2: EOQ with QD / PB

A-1 Auto Parts has a regional tire warehouse in Atlanta. One
popular tire, the XRX75, has estimated demand of 25,000 next year.
It costs A-1 $100 to place an order for the tires, and the annual
holding cost is 30% of the acquisition cost. The supplier quotes these
prices for the tire:

Q C
1 – 499 $21.60
500 – 999 20.95
1,000 + 20.90
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Example 2: EOQ with QD / PB

• Economical Order Quantity
EOQ i = 2DS/C
Hii

EOQ3 = 2(25,000)100/(.3(20.90) = 893.00

This quantity is not feasible, so try ac = $20.95
EOQ 2 = 2(25,000)100/(.3(20.95) = 891.93
This quantity is feasible, so there is no reason to try ac = $21.60

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Example: EOQ with QD / PB

• Compare Total Annual Material Costs (TMCs)
TMC = (Q/2)H + (D/Q)S + DC
Compute TMC for Q = 891.93 and ac = $20.95
TMC2 = (891.93/2)(.3)(20.95) + (25,000/891.93)100
+ (25,000)20.95
= 2,802.89 + 2,802.91 + 523,750
= $529,355.80
… more

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Example: EOQ with Quantity Discounts

Compute TMC for Q = 1,000 and ac = $20.90
TMC3 = (1,000/2)(.3)(20.90) + (25,000/1,000)100
+ (25,000)20.90
= 3,135.00 + 2,500.00 + 522,500
= $528,135.00 (lower than TMC2)

The EOQ is 1,000 tires

at an acquisition cost of $20.90.

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Multi-Period Models –
Comparison
Fixed-Order Quantity
• Inventory remaining must be
continually monitored
• Has a smaller average inventory
• Favors more expensive items
• Is more appropriate for
important items
• Requires more time to maintain
– but is usually more automated
• Is more expensive to implement
Fixed-Time Period
• Counting takes place only at
the end of the review period
• Has a larger average inventory
• Favors less expensive items
• Is sufficient for less-important
items
• Requires less time to maintain
• Is less expensive to implement

• Also known as Continuous • Also known as Periodic

Review Systems Review Systems
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Fixed-Time Period Model

• Inventory is counted only at particular times
• Such as every week or every month
• Desirable when vendors make routine visits to customers and take
orders for their complete line of products
• Or when buyers want to combine orders to save transportation costs
• Order quantities that vary from period to period, depending on the
usage rates
• Generally require higher levels of safety stock

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Fixed-Time Period Model

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Fixed–Time Period Model with Safety Stock

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Fixed-Time Period Model

Time periods
are equal, but Reorder quantity varies,
ending depending upon ending
inventory inventory level. Beginning
varies. inventory is always the
same. 73

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Example 20.5

• Daily demand for a product is 10 units, with a standard deviation of 3 units. The
review period is 30 days, and the lead time is 14 days. Management has set a
policy of satisfying 98 percent of demand from items in stock. At the beginning of
this review period, there are 150 units in inventory. How many units should be
ordered?

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Example 20.5: Daily demand for a product is 10 units, with a standard deviation of 3
units. The review period is 30 days, and the lead time is 14 days. Management has
set a policy of satisfying 98 percent of demand from items in stock. At the beginning
of this review period, there are 150 units in inventory.
How many units should be ordered?

Excel: Fixed
Time Period
Model
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Inventory Turn Calculation

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Example: Average Inventory

Calculation—Fixed–Order Quantity Model

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Inventory Policy Systems –

Comparison
Single-period inventory
model
• One-time purchasing decision
(e.g., 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 (e.g., running out of
stock)
• Fixed-time period models
• Time triggered (e.g., monthly sales call
by sales representative)
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Single Period Inventory Model

Consider the problem of

deciding how many newspapers
to put in a hotel lobby
Too few papers and some
Too many papers and the
customers will not be able
price paid for papers that
to purchase a paper, and
were not sold during the
profits associated with
day will be wasted,
these potential sales are
lowering profit.
lost.

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Solving the Newsvendor Problem

• Consider how much risk we are willing to take of running out of
inventory.
• Let a MEAN of 90 Newspapers and a SD of 10 papers have been
observed selling each Monday.
• Assume that the probability distribution associated of sales is normal,
stocking 90 papers yields a 50 percent chance of stocking out. (??)

• OBJECTIVE: Assume we want an 80 percent surety of not running out.

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NORMAL DISTRIBUTION

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Solving the Newsvendor Problem

• From Chart, we see that we need
approximately 0.85 Standard Deviation (SD)
of extra papers to be 80 percent sure of not
stocking out.
• Alternatively, Using Excel, “=NORMSINV(0.8)” =
0.84162 (SD)
• Final Value = 90 + 0.84162 (10) = 90 + 9

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Let’s Complicate the Formulation

based on Overage / Underage Costs

Where:
Co = Overage cost per unit
Cu = Underage cost per unit
P = probability that a given unit will be sold

• We should increase the size of the inventory so long as

the probability of selling the last unit added is equal to or
greater than the ratio

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Including Potential Profit and Loss in

Newsperson Problem

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Single Period Model Applications

Overbooking of airline flights

Ordering of clothing and other fashion items

One-time order for events – e.g., t-shirts for a

concert

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Inventory Management
• Inventory accuracy: refers to how well the inventory records agree
with physical count
• How much error is acceptable?
• Cycle counting: a physical inventory-taking technique in which
inventory is counted on a frequent basis rather than once or twice a
year
1. When the record shows a low/zero balance on hand
2. When record shows a positive balance but there has been a backorder
3. After some specified level of activity
4. To signal a review based on the importance of the item

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Inventory Planning and Accuracy

• Maintaining inventory takes time and costs money
• Makes sense to focus on most important inventory items
• Villefredo Pareto found that 20 percent of the people controlled 80 percent
of the wealth
• Broadened and known as Pareto principle
• Most inventory control situations involve so many items that it is not
practical to model each item
• ABC inventory classification scheme divides inventory items into three
groupings
A. High dollar volume
B. Moderate dollar volume
C. Low dollar volume

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Annual Usage of Inventory by Value and ABC

Grouping of Inventory Items

20-88
Exhibit 20.11 A and B

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ABC Inventory Classification Graphically

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Exhibit 20.11 C

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Summary
• Inventory is expensive mainly due to storage, obsolescence, insurance, and the value of
the money invested
• The basic decisions are: (1) when should an item be ordered, and (2) how large should
the order be
• The main costs relevant to these models are(1) the cost of the item itself, (2) the cost to
hold an item in inventory, (3) setup costs, (4) ordering costs, and (5) costs incurred when
an item runs short
• An inventory system provides a specific operating policy for managing items to be in
stock
• Single-period model—When an item is purchased only one time and it is expected that it will be
used and then not reordered
• Multiple-period models—When the item will be reordered and the intent is to maintain the item
in stock
• There are two basic types of multiple-period models, with the key distinction being what triggers
the timing of the order placement

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Thank You

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