ME 1103

Introduction to Industrial Engineering

Lecture on -
“Inventory Management”

© 2008 Prentice Hall, Inc. 12 – 1

 Inventory management
Inventory is stock or store of goods
• Inventory management is a core operations
management activity.
• Good inventory management is important for the
successful operation of most businesses and
their supply chains.
• Operations, marketing, and finance have interests
in good inventory management.
• Bad inventory management hampers operations,
diminishes customer satisfaction, and increases
operating costs.

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 Types of Inventories
• Raw materials & purchased parts
• Partially completed goods called
work-in-process (WIP)
• Finished-goods inventories
– Completed product awaiting shipment
– (manufacturing firms) or merchandise
(retail stores)
• Replacement parts, tools, & supplies
• Goods-in-transit to warehouses or
customers
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 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

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 Functions of Inventory
• To meet anticipated demand

• To keep production running

• To protect against stock-outs

• To help hedge against price increases

• To take advantage of quantity discounts

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 Effective Inventory
Management
To be effective, management must have the following:
• A system to keep track of inventory on hand and on
order
• A reliable forecast of demand
• Knowledge of lead times and its variability
• Reasonable estimates of:
– Inventory Holding (carrying) costs
– Ordering costs
– Shortage costs
• A classification system for inventory items

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 Inventory Counting Systems
• Periodic System
Physical count of items made at periodic
intervals
• Perpetual (continual) 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
Perpetual inventory system ranges between
very simple to very sophisticated such
as:
• Two-Bin System - Two containers of
inventory; reorder when the first is empty
• Universal Bar Code (UBC)- Bar code
printed on a label that has
information about the item
to which it is attached 0

214800 232087768

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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
inventory (shipping cost, preparing invoices, cost
of inspecting goods upon arrival for quality and
quantity, moving the goods to temporary storage)
• Setup costs: cost to prepare a machine or
process for manufacturing an order
• Shortage costs: costs when demand exceeds
supply (the opportunity cost of not making a sale,
loss of customer goodwill, late charges, the cost
of lost of production or downtime)
© 2008 Prentice Hall, Inc. 12 – 9
 Classification system
• An important aspect of inventory management is
that items held in inventory are not of equal
importance in terms of dollar invested, profit
potential, sales or usage volume, or stockout
penalties.
• For instance, a producer of electrical equipment
might have electric generators, coils of wire, and
miscellaneous nuts and bolts among items
carried in inventory. It would be unrealistic to
devote equal attention to each of these items.
Instead, a more reasonable approach would
allocate control efforts according to the relative
importance of various items in inventory. This
approach is called A-B-C classification approach.

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 ABC Analysis
Divides inventory into three classes
based on annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar
volume
Class C - low annual dollar volume
Used to establish policies that focus on
the few critical parts and not the many
trivial ones

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

Low C
Few Many
Number of Items
© 2008 Prentice Hall, Inc. 12 – 12
 ABC Classification system
Material Classification

A – close or strict control

B – moderate control
C – loose control

A Class A: 10-15% contributes 60-70% value

Co
st

B Class B: 20-30% contributes 20-30% value

C Class C: 60-70% contributes 5-10% value

Quant
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ity 12 – 13
 ABC Classification Example-1
Example
The annual dollar value of 12 items has been calculated based on annual demand and unit
cost. The annual dollar values were then arrayed from highest to lowest to simplify
classification of items. It is reasonable to classify the first two items as A, the next three items
as B and the remainder are C items.
Item number Annual demand Unit cost Dollar value classification
8 1000 4000 4,000,000 A
5 3900 700 2,730,000 A
3 1900 500 950,000 B
6 1000 915 915,000 B
1 2500 330 825,000 B
4 1500 100 150,000 C
12 400 300 120,000 C
1 500 200 100,000 C
9 8000 10 80,000 C
2 1000 70 70,000 C
7 200 210 42,000 C
10 9000 2 18,000 C
total 10,000,000
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 ABC Analysis Example-2
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

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 ABC Analysis Example-2
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

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 Independent Versus
Dependent Demand

Independent demand - the demand for

item is independent of the demand for
any other item in inventory
Dependent demand - the demand for
item is dependent upon the demand
for some other item in the inventory

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 Inventory Models for
Independent Demand

Need to determine when and how

much to order

Basic economic order quantity

Production order quantity
Quantity discount model

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 Basic EOQ Model
or Supply Model
Economic Order Quantity (EOQ)
EOQ is the order size that minimizes total cost
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided

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 Inventory Usage Over Time

Usage rate Average

Order inventory
Inventory level

quantity = Q on hand
(maximum Q
inventory
level) 2

Minimum
inventory

0
Time

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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 order order
Lead time
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 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
quantity (Q*)
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 The EOQ Model
Annual setup cost =
D
Q
S

Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory
item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per
year)
x (Setup or order cost per order)
Annual demand Setup or order
= Number of units in each order
cost per order

= D (S)
Q

© 2008 Prentice Hall, Inc. 12 – 23

 The EOQ Model
Annual setup cost =
D
Q
S
Q
Annual holding cost = H
Q = Number of pieces per order 2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory
item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)

Order quantity
= 2 (Holding cost per unit per
year)

= Q (H)
2

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 Total Cost
The total annual cost associated with carrying and
ordering inventory when Q units are ordered each
time is:
Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
Where 2 Q
Q = quantity to be ordered
H = holding cost per unit (carrying cost per unit) Note that D and
D = annual demand H must be in the
same units, e.g.,
S = ordering (setup cost) per order months, years
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 Cost Minimization Goal
The Total-Cost Curve is U-Shaped
Annual Cost

Holding
cost

Ordering Costs

Q* (optimal order quantity) Order Quantity

(Q)

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 Deriving the EOQ
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory
item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Optimal order quantity is found when annual setup cost
equals annual holding cost

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
© 2008 Prentice Hall, Inc. 12 – 27
 An EOQ Example-1
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50

© 2008 Prentice Hall, Inc. 12 – 28

 An EOQ Example-1
Determine optimal number of needles to order
D = 1,000 units Q*= 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand D
number of = N = Order quantity
orders = Q*
1,000
N= = 5 orders per year
200

© 2008 Prentice Hall, Inc. 12 – 29

 An EOQ Example-1
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected days per year
time between = T =
N
orders
250
T= = 50 days between orders
5

© 2008 Prentice Hall, Inc. 12 – 30

 An EOQ Example-1
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per yearT = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = ($10) + ($.50)
200 2

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

© 2008 Prentice Hall, Inc. 12 – 31
 An EOQ Example-2
❖ A local distributor for a national tire company
expects to sell approximately 9600 steel-belted
radial tires of a certain size and tread design next
year. Annual carring 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 is the total annual cost if the EOQ
quantity is ordered?

© 2008 Prentice Hall, Inc. 12 – 32

 An EOQ Example-2
(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 is the total annual cost if the EOQ quantity is order?

© 2008 Prentice Hall, Inc. 12 – 33

 An EOQ Example-3
Piddling manufacturing assembles security monitors.
It purchases 3600 black and white cathode ray tubes
a year at $ 65 each. Ordering costs are $ 31, and
annual carring costs are 20 percent of the purchase
price.
(a) Compute the optimal quantity
(b) What is the carring cost?
(c) What is the ordering cost?
(d) Calculate the total annual cost ?

© 2008 Prentice Hall, Inc. 12 – 34

 An EOQ Example-3
(a) Compute the optimal quantity

(b) What is the carring cost?

(c) What is the ordering cost?

(d) Calculate the total annual cost ?

© 2008 Prentice Hall, Inc. 12 – 35