Inventory Management

(Part 1)
Jurusan Teknik Industri
Fakultas Teknologi Industri
Universitas Katolik Parahyangan
2023
References

1. Tersine, Richard J., Principles of Inventory and Materials Management, 4th ed.,
Prentice-Hall Inc., 1994 (Outline 1,2,3)

2. Fogarty, F.W., J.H. Blackstone, Jr, and T.R. Hoffmann, Production and Inventory
Management, 2nd ed., South-Western Publishing Co., 1991. (Outline 4, 5)
Outline

1 • Introduction

2 • Deterministic Inventory Models

3 • Quantity Discount

4 • Order Release Decisions

5 • Joint Replenishment
Inventory (1)
q The stock on hand of materials at a given time (a tangible asset which
can be seen, measured, and counted)

q An itemized list of all physical assets

q The value of the stock of goods owned by an organization at a

particular time (for financial and accounting records)
Inventory (2)
The effective management of materials is crucial to the performance of
many organizations
1. Finance is influenced through liquidity and return on investment

2. Production through efficiency and cost of operations

3. Marketing through sales and customer relations

Types of Inventory
q Supplies
Are inventory items consumed in the normal functioning of an organization that are not a
part of the final product (MRO – Maintenance, Repair and Operating)

q Raw Material
Is item purchased from supplier to be used as inputs the production process.

q In-Process Goods/Work in Processs

Is partially completed product.

q Finished Goods
Functions of Inventory
1. Gives protection from unanticipated occurrences à uncertainty à
supply and demand are difficult to synchronize perfectly.

2. Enable an organization to reduce the lead time in meeting demand.

3. Enables organization to take advantage of cost reducing alternatives

à purchase in economic quantities.
Functional Classification (1)
q Working stock: part of inventory available for normal demand in a given period.

q Safety stock: an extra quantity of a product which is stored in the warehouse to prevent
an out-of-stock situation.

q Anticipation stock: the stock of components, material, or goods kept at hand by a

company or business to meet demand or to meet the shortfall caused by erratic production.
Functional Classification (2)
q Pipeline stock: stock that is currently in transit between locations and has not yet been
purchased by the consumer.

q Decoupling stock: any inventory set aside to meet purchase orders in the case of
inventory production slowing or stopping, usually because slow production and stoppage,
not unseen fluctuations in demand.

q Psychic stock: the inventory used for display to stimulate demand for items.
Properties of Inventory (1)

1. Demand
• Units taken from inventory.
• Categorized by size, rate, and pattern (how units are withdrawn).

2. Replenishment
• Units put into inventory
• Categorized according to size, pattern (instantaneous, uniform, etc.), lead
time.
Properties of Inventory (2)

3. Constraint
• Is limitation placed on inventory system: space, capital, facility, etc.

4. Cost
• What is sacrificed for keeping or not keeping inventory.
Inventory Costs (1)

1. Order (setup) cost

Is the expense of issuing a purchase order to an outside supplier or from internal production
setup cost.

2. Purchase cost
Is the unit purchase price (external source) or unit production cost (internal source).
Is modified for different quantity levels when a supplier offers quantity discounts.
Inventory Costs (2)

3. Holding (carrying) cost

Cost associated with investing in inventory à capital cost, taxes, insurance, handling storage,
breakage, etc.

4. Stock out cost

Occurs when a demand is not filled à backorder, lost sales
Outline

1 • Introduction

2 • Deterministic Inventory Models

3 • Quantity Discount

4 • Order Release Decisions

5 • Joint Replenishment
Independent vs Dependent Demand

Independent demand
Does not depend on demand for another items à machine spare parts

Dependent demand
Depends primarily on the demand for other items à subassemblies,
component parts, raw materials.
Deterministic Inventory Models

All of the parameter and variables are known or can be calculated with
certainty.

1. Economic Order Quantity (EOQ)

2. Economic Production Quantity (EPQ)
3. EOQ with Quantity Discount
Economic Order Quantity (EOQ) - 1
§ EOQ is the order size that minimizes the total inventory cost for
independent demand items

§ Required parameters: demands, appropriate inventory costs and lead times

§ There are two types:

1. Deterministic models: all parameter and variables are known or can be
calculated with certainty
2. Stochastic models: where some or all of the variables are probabilistic
Economic Order Quantity (EOQ) - 2
§ The two fundamental questions posed to any inventory system are
how many and when to order

§ EOQ assumptions:
1. The demand rate is known, constant and continous.
2. The lead time is known and constant.
3. The entire lot size is added to inventory at the same time (instantaneously).
4. No stock out are permitted.
5. The cost structure is fixed.
6. There is sufficient capacity, space and capital to produce the desire quantity.
7. The item is a single product.
Economic Order Quantity (EOQ) - 3
Economic Order Quantity (EOQ) - 4
• EOQ minimizes the total inventory cost

Total annual cost (TC) = Order cost + Purchased cost + Holding cost

R = annual demand in units

P = purchase cost of an item
C = ordering cost per order
Q = lot size or order quantity in units
H = P x F = holding cost per unit per year
F = annual holding cost as a fraction of unit cost
Economic Order Quantity (EOQ) - 5
• Order size

• Number of orders during year

• Order interval
Economic Order Quantity (EOQ) - 6
EOQ Example - 1

The Williams Manufacturing Company purchases 8000 units of a

product each year at a unit cost of $10.00. The order cost is $30.00 per
order, and the holding cost per unit per year is $3.00. What are the
economic order quantity, the total annual cost and the number of
orders to place in one year
Calculate the EOQ!
EOQ Example - 2
Reorder point (B)
When to order?

R = annual demand in units; L = lead time

Example: What is the reorder point when the lead time is two weeks?
Economic Production Quantity (EPQ) - 1
• The EOQ formulation assumes that the entire order for an item is received into
inventory at a given time (instantaneously)
• If the item is produced in-house instead of purchased externally, then the
assumption that the entire order is received into inventory at one time
(instantaneously) is often not true
• Frequently, items are produced and added to inventory gradually rather than all
at once
• The economic production quantity (EPQ) is used
• In this case, purchased cost will be replaced by production cost and order cost
replaced by setup cost
Economic Production Quantity (EPQ) - 2

Where production (p) is greater than demand (r)

Economic Production Quantity (EPQ) - 3
Total annual cost = production cost + setup cost + holding cost

Where:
R = annual demand in units
P = unit production cost
Q = size of production run or production order quantity (unit)
p = production rate (unit/period)
r = demand rate (unit/period)
C = setup cost per production run
H = holding cost per unit per year
Economic Production Quantity (EPQ) - 4

EPQ = Q* = Minimum TC (Q*) =

Optimum length of production run =

Production reorder point in units = B =

Where L is the scheduling and production setup time in days and r is

the daily demand rate
EPQ Example - 1

The demand for an item is 20000 units per year, and there are 250
working days per year. The production rate is 100 units per day, and
the lead time is 4 days. The unit production cost is $50.00, the holding
cost is $10.00 per unit per year, and the setup cost is $20.00 per run.

What are the economic production quantity, the number of runs per
year, the reorder point, and the minimum total annual cost?
EPQ Example - 2
Production reorder point in units
B = r x L = 80 units/day x 4 days = 320 units
Outline
1 • Introduction

2 • Deterministic Inventory Models

3 • Quantity Discount

4 • Order Release Decisions

5 • Joint Replenishment
Quantity Discounts - 1

q Supplier offers lower unit prices on order for larger quantities as an

economic incentive to buyers to purchase in large order.

q Seller benefit: reducing per unit order processing and setup cost

q Buyer benefit: reducing ordering costs and paying lower unit price, but
at the cost of having more inventories.
Quantity Discounts - 2

Two general types of quantity discount:

1. All unit discount
Purchasing larger quantities results in a lower unit price for the entire lot.

2. Incremental discount
Apply the lower unit price only to units purchased above specifies quantity.
Thus, an item within the same lot can have multiple unit price.
All-Units Quantity Discounts - 1
q Buyer is presented with a price schedule consisting j quantity ranges such that the
unit price is equal for all units in an order and decreases with increasing order size.
q The unit purchase cost is defined as follows:

q Where U1< U2< .... <Uj is the sequence of integer quantities at which price break
occur. U0 is min quantity, Uj+1 is max quantity.
q Ci denotes the unit purchase cost applicable to orders whose lot size falls in the
interval Ui to Ui+1 with C0> C1> .... >Cj
All-Units Quantity Discounts - 2
Procedure:
1. Starting with the lowest unit cost, calculate the EOQ at each unit cost until
a valid EOQ is obtained.

2. Calculate the total annual cost for the valid EOQ and all price-break
quantitites larger than the valid EOQ (a price break quantity is the lowest
quantity for which the price discount is available).

3. Select the quantity with the lowest total cost in step 2.

All-Units Quantity
Discounts - 3
Example - 1

The Smith Co. Purchase 8000 units of a product each year. The
supplier offers the units for sale at $10 per unit for orders up to 500
unit and $9.0 per unit for orders of 500 or more. Holding cost is 30% of
per unit cost. Ordering cost is $30 per order.

What is EOQ?
Example - 2
Example - 3
Question?