Inventory

Inventory Planning and Control
Operations Management: Theory and Practice, 3e

Inventory Planning
Independent demand items
• Finished goods and spare parts typically belong to
independent demand items in manufacturing organisations
• Two attributes characterise and distinguish independent
demand items:
– Timing of demand: Independent demand items have a
continuous demand
– Uncertainty of demand: There is considerable element of
uncertainty in the demand in the case of independent
demand items
• Inventory planning of independent demand items must
address the following two key questions:
– How much?
– When?
Types of Inventory
• Seasonal Inventory: Seasonality in demand is absorbed
using inventory
• Decoupling Inventory: Complexity of production control
is reduced by splitting manufacturing into stages and
maintaining inventory between these stages
• Cyclic Inventory: Periodic replenishment causes cyclic
inventory
• Pipeline Inventory: Exists due to lead time
• Safety Stock: Used to absorb fluctuations in demand due
to uncertainty

Decoupling Inventory
An illustration
Production System without any decoupling inventory
1 2 3 4 5 6 7 8 9 10
1 4 5 8 9
Stage 2
Stage 1 3 Stage 3
2 7 6 10
Decoupling Inventory

Cyclic, Pipeline and Safety Stocks
A graphical illustration
Cyclic
Stock
Quantity
Pipeline inventory
Safety stock
L
Time
Cyclic inventory, pipeline inventory and safety stocks are critically linked to
“how much” and “when” decisions in inventory planning

Inventory Types
Example
A manufacturer of transformers requires
copper(both in plate and wire form) as a key
ingredient. The average weekly requirement of
copper is 200 tonnes. The lead time for the
supply of is two weeks. If the manufacturer
places monthly orders of copper, analyse the
various types of inventory in the system?
Order quantity Q ?
Cyclic inventory ?
Pipeline inventory ?
Inventory Types
Example Solution
A manufacturer of transformers requires copper(both in plate and wire form)
as a key ingredient. The average weekly requirement of copper is 200 tonnes.
The lead time for the supply of is two weeks. If the manufacturer places
monthly orders of copper, analyse the various types of inventory in the
system?
Solution
Order Quantity Q = 1 month requirement = 200 x 4 = 800 tonnes.
Cyclic inventory in the system = Q /2 = 800 /2 = 400 tonnes.
Lead Time = 2 weeks
Average weekly demand µ = 200 tonnes
Pipeline inventory = L x µ = 200 x 2 = 400 tonnes.

Costs in Inventory Planning
Carrying Cost
• Interest for short-term borrowals for working
capital
• Cost of stores and warehousing
• Administrative costs related to maintaining
and accounting for inventory
• Insurance costs, cost of obsolescence,
pilferage, damages and wastage
• All these costs are directly related to the level
of inventory
Computation of Carrying Cost
An illustration
Sl. No. Item of Expenditure (Annual) Amount (₹)
1 Stationary 75,000.00
2 Insurance premium 375,000.00
3 Establishment expenses & Overheads 275,000.00
4 Salary of Stores Personnel 1,100,000.00
Total expenditure 1,750,000.00
Average Value of the inventory in Stores 35,000,000.00

Warehousing cost (in % inventory value) 5.00%
a Cost of warehousing 5.00%

b Cost of capital (assumed) 15.00%
c Obsolescence (estimated historically) 2.00%
d Damages, spoilage etc. (estimated historically) 1.00%
Carrying cost (%) 23.00%

Ordering Cost
• Search and identification of appropriate sources
of supply
• Price negotiation, contracting and purchase
order generation
• Follow-up and receipt of material
• Eventual stocking in the stores after necessary
accounting and verification
• A larger order quantity will require less number
of orders to meet a known demand & vice versa
Cost of carrying and cost of ordering are fundamentally two opposing cost structures
inOperations
inventory planning
Management: Theory and Practice, 3e
Computation of Ordering Cost
An illustration
Sl. No. Item of Expenditure (Annual) Amount (₹)
1 Stationary 80,000.00
2 Telephone 40,000.00
3 Other communication Expenses 60,000.00
4 Salary of Purchase Department Personnel 1,100,000.00
5 Inwards Goods Inspection Section Expenses 350,000.00

6 Other expenses & Overheads 200,000.00
Total Expenditure 1,830,000.00
No. of purchase orders generated 600.00

Average Cost of Ordering 3,050.00

Shortage Cost
• Costs arising out of pushing the order back
and rescheduling the production system to
accommodate these changes
• Rush purchases, uneven utilisation of available
resources and lower capacity utilisation
• Missed delivery schedules leading to customer
dissatisfaction and loss of good will
• The effects of shortage are vastly intangible, it
is indeed difficult to accurately estimate
Inventory Control for deterministic demand:
EOQ Model
Demand during the planning period =D

Order quantity =Q
The cost of ordering per order =
Co
Inventory carrying cost per unit per unit time = C c
Q
The average inventory carried by an organisation=
2
Q 
The cost associated with carrying inventory =  * C c 
2 
D 
The total ordering cost is given by  * C o 
Q 
Total cost of the plan =
Total cost of carrying inventory + Total cost of ordering
Q  D 

TC(Q) =  * C c  +  * C o

2  Q 
Inventory Control for deterministic demand:
EOQ Model…
When the total cost is minimum, we obtain the most economic

order quantity (EOQ). By taking the first derivative of with
respect to Q and equating it to zero we can obtain the EOQ
Differentiating total cost equation with respect to Q we obtain,
dTC (Q) C c C o D
= − 2
dQ 2 Q
The second derivative is positive and hence we obtain the
minimum cost by equating the first derivative to zero.
2C o D
Denoting EOQ by Q* , we obtain the expression of Q* as: Q *
=
Cc
D
The optimal number of orders =
Q*
Q*
Time between orders =
D
EOQ Model
A graphical representation
Sum of the two costs
Cost of Inventory
Total cost of carrying
Minimum Cost
Total cost of ordering
Economic Level of Inventory

Order Qty.

Issues in using EOQ Model
Model assumptions
1. The demand is known with certainty
2. Demand is continuous over time
3. There is an instantaneous replenishment of items
4. The items are sourced from an outside supplier
5. Assumptions about order quantity
a) There are no restrictions in the quantity that we can order
b) There are no preferred order quantities for the items
c) No price discount is offered when the order size is large
• Despite this, the EOQ model could be applied with suitable

modifications because it is robust
• Assumptions 3, 4 and 5 can be addressed with required modifications
• Relaxing assumption 1 will result in shortages due to difficulty in
estimating demand
Practice Numerical

Practice Numerical 1 Solution

Inventory Planning Models
Example 1 (EOQ)
Mean of weekly demand : 200
Unit cost of the raw material : Rs. 300/-
Ordering cost : Rs. 460/- per order
Carrying cost percentage : 20% per annum
Lead time for procurement : 2 weeks
EOQ ?
Time between orders = ?
Pipeline Inventory = ?

Example 1 (EOQ) Solution
Mean of weekly demand : 200
Unit cost of the raw material : Rs. 300/-
Ordering cost : Rs. 460/- per order
Carrying cost percentage : 20% per annum
Lead time for procurement : 2 weeks
EOQ Model
Weekly demand = 200
Number of weeks per year = 52
Annual demand, D = 200*52 = 10,400
Carrying cost, Cc = Rs. 60.00 per unit per year
2Co D 2 * 460 *10,400
Economic Order Quantity = = = 399.33  400
Cc 60
Time between orders = 400 = 2 = 2 weeks
10400 52
Pipeline Inventory = 2 x 200 = 400

Example 2 (EOQ)
A two wheeler component manufacturing unit uses
large quantities of a component made of steel.
Although these are production items, the demand is
continuous and inventory planning could be done
independent of the production plan. The annual
demand for the component is 2500 boxes. The
company procures the item from a supplier at the
rate of Rs 750 per box. The company estimates the
cost of carrying inventory to be 18 % per unit per
annum and the cost of ordering as Rs 1080 per order.
The company works for 250 days in a year. How
should the company design an inventory control
system for this item ? What is the overall cost of the
plan ?
Example 2 (EOQ) Solution
A two wheeler component manufacturing unit uses large quantities of a component
made of steel. Although these are production items, the demand is continuous and
inventory planning could be done independent of the production plan. The annual
demand for the component is 2500 boxes. The company procures the item from a
supplier at the rate of Rs 750 per box. The company estimates the cost of carrying
inventory to be 18 % per unit per annum and the cost of ordering as Rs 1080 per
order. The company works for 250 days in a year. How should the company design an
inventory control system for this item ? What is the overall cost of the plan ?
Solution
Annual demand for the item (D) = 2,500 boxes
Number of working days = 250
The average daily demand = 2500/250 = 10 boxes
Unit cost of the item (Cu) = Rs 750 per box
Inventory-carrying cost, Cc = 18 % per unit per annum = iCu = 0.18x750
= Rs 135 per unit per year
Cost of ordering (Co) = Rs 1080 per order
The “how much “ decision :
Economic Order Quantity = 2Co D = 22*x460 *10
1080 ,400 = 200 Boxes
x 2500
= 399.33  400
Cc 135 60
Number of orders to be placed = D/ Q* = 2500 / 200 = 12.5 ~ 13
The “when” decision:
Time between orders = Q*/D = 200/2500 = 0.08 year = 0.08 x 250 =20 days.
Total cost of the plan =TC(Q*)=(Q*/2)xCc+(D/Q)xCo
=(200/2)x135 +(2500/200)x1080 = Rs 27,000
Practice Numerical 2

Practice Numerical 2 Solution



Practice Numericals
Q 1. Demand for the Child Cycle at Best Buy is 500 units per month.
Best Buy incurs a fixed order placement, transportation, and
receiving cost of Rs. 4,000 each time an order is placed. Each cycle
costs Rs. 500 and the retailer has a holding cost of 20 percent.
Evaluate the number of computers that the store manager should
order in each replenishment lot?
Q2. ABC Ltd. uses EOQ logic to determine the order quantity for its
various components and is planning its orders. The Annual
consumption is 80,000 units, Cost to place one order is Rs. 1,200,
Cost per unit is Rs. 50 and carrying cost is 6% of Unit cost. Find
EOQ, No. of order per year, Ordering Cost and Carrying Cost and
Total Cost of Inventory.

Practice Numericals Continued
Q3. Midwest Precision Control Corporation is trying to decide
between two alternate Order Plans for its inventory of a certain item.
Irrespective of the plan to be followed, demand for the item is
expected to be 1,000 units annually. Under Plan 1st, Midwest would
use a teletype for ordering; order costs would be Rs. 40 per order.
Inventory holding costs (carrying cost) would be Rs. 100 per unit per
annum. Under Plan 2nd order costs would be Rs. 30 per order. And
holding costs would 20% and unit Cost is Rs. 480. Find out EOQ
and Total Inventory Cost than decide which Plan would result in the
lowest total inventory cost?

Practice Numericals Continued
Q4. A local TV repairs shop uses 36,000 units of a part each year (A
maximum consumption of 100 units per working day). It costs Rs.
20 to place and receive an order. The shop orders in lots of 400
units. It cost Rs. 4 to carry one unit per year of inventory.
Requirements:
(1) Calculate total annual ordering cost
(2) Calculate total annual carrying cost
(3) Calculate total annual inventory cost
(4) Calculate the Economic Order Quantity
(5) Calculate the total annual cost inventory cost using EOQ
inventory Policy
(6) How much save using EOQ
(7) Compute ordering point assuming the lead time is 3 days

Continuous Review (Q) System
An illustration
Inventory Position
Q Physical Inventory
Inventory Level
ROP
Mean Demand during LT

SS
Safety Stock
L Time
Periodic Review (P) System
An illustration
Inventory Position
Physical Inventory
QR Q2R Q3R
Order Up to Level
S
Inventory Level
SS
Safety Stock
R 2R 3R
L
Time

Example (Q System)
Q System
Standard deviation of weekly demand = 40
Lead time, L = 2 weeks
Mean demand during L,  (L) = 2* 200 = 400
 (L)
Standard deviation of demand during L, = 2 * 40 = 56.57
For a service level of 95%, SS = Z *  ( L) = 1.645*56.57 = 93.05  93
ROP =  (L) + Z *  ( L)= 400 + 93 = 493
Using EOQ as the fixed order quantity, Q system can be designed

as follows: As the inventory level in the system reaches 493,
place an order for 400 units. This will ensure in the long run a
service level of 95%.

Example (P System)
P System
Using the time between orders derived from the EOQ model as the basis
for review period
Review period, R = 2 weeks
Mean demand during (L + R),  ( L+ R) = 200*(2 + 2) = 800
Standard deviation of demand during (L + R), ( L+ R) = 2 + 2 * 40 = 80
For a service level of 95%,
SS =Z *  ( L+ R) = 1.645*80 = 131.6  132
Order up to level, S =  ( L+ R) + Z *  ( L+ R) = 800 + 132 = 932
The P system can be designed as follows: The inventory level in the

system is reviewed every two weeks and an order is placed to
restore the inventory level back to 932 units. This will ensure a
service level of 95%.

Estimation of Safety Stock
From empirical Data – An example
Demand Exceeding Lower Class
Demand
Frequency Cumulative Cumulative
during LT
Frequency Percentage
0-30 2 114 100.00%
31-60 5 112 98.25%
61-90 11 107 93.86%
91-120 20 96 84.21%
121-150 25 76 66.67%
151-180 30 51 44.74%
181-210 13 21 18.42%
211-240 5 8 7.02%
241-270 2 3 2.63%
271-300 1 1 0.88%
300 - - - -

Frequency Ogave of weekly
demand
100
Demand exceeding lower class (%)
95
90
85
80
75
70
65
60
55
50
45
40
35
30
25
20
15
10
5
0
0 30 60 90 120 150 180 210 240 270 300
Demand during LT

What is the right safety stock?
• Avg. demand during LT = 143

• For 90% service level
– Demand = 203
– Safety stock = 203 - 143= 60
• For 95 % service level
– Demand = 224
– Additional Safety stock (over the 90% service
level) = 224 - 203 = 21

Computing safety stock
Using Normal Distribution
Let the demand during lead time

follow a Normal distribution
Mean demand during lead-time =  (L)
Standard deviation of
demand during lead-time =  (L )
Desired service level = (1 −  )
Z  *  L out = 
The probability of a stock
Standard normal variate
corresponding to an area of (1 −  )
covered on the left side of
the normal curve = Z
Safety stock (SS) is given by SS = Z *  ( L)

Periodic & Continuous Review Systems:
A comparison
Criterion Continuous Review (Q) Periodic Review (P) System
System
How much to Fixed order qty: Q S = μ(L+R) + Zα × σ(L+R)
order QR = S – IR
When to ROP = μ(L) + Zα×σ(L) Every R periods

order
Safety stock SS = Zα×σ(L) SS = Zα×σ(L+R)
Salient • Implemented using two • More safety stock

aspects
bin system • More responsive to demand
• Suited for medium and • Ease of implementation
low value items
Selective Control of Inventories
Alternative Classification Schemes
• ABC Classification (on the basis of consumption value)
• XYZ Classification (on the basis of unit cost of the item)
– High Unit cost (X Class item)
– Medium Unit cost (Y Class item)
– Low unit cost (Z Class item)
• FSN Classification (on the basis of movement of inventory)
– Fast Moving
– Slow Moving
– Non-moving
• VED Classification (on the basis of criticality of items)
– Vital
– Essential
– Desirable
• On the basis of sources of supply
– Imported
– Indigenous (National Suppliers)
– Indigenous (Local Suppliers)
ABC Classification Scheme

ABC Classification
A graphical illustration
100%
90%
Class C
80%
Consummption value (%)
Class B
70%
60%
Class A
50%
40%
30%
20%
10%
0%
0%
0%
10
20
30
40
50
60
70
80
90
10
No. of items (% )

Inventory Planning for Single Period Demand
Let Co = Cost of over stocking per unit

Cu = Cost of under stocking per unit
Q = Optimal number of units to be stocked
d = Single period demand
P(d  Q) = The probability of the single period
demand being at most Q units
Cu
P(d  Q) 
Cu + C o

Single Period Demand Model
Example
Selling price per box of the item : Rs. 1300.00
Cost of production : Rs. 1000.00
Cost of under stocking, Cus : Rs. 300.00
Salvage value : Rs. 800.00
Cost of over stocking, Cos : Rs. 200.00
As per equation 18.11, the optimal quantity to stock is obtained as:
Cus 300
P(d  Q)  = P(d  Q)   0.60
Cus + C os 200
On examination of the cumulative probability values in the last

column of the demand table, a value of Q = 300 satisfies this
requirement. Therefore, the manufacturer should plan for an
inventory of 300 boxes for sale during the festival

Inventory Planning & Control
Highlights
• Every organization carries five different types of inventory:
– Cyclic stock, Pipeline inventory, Safety stock, Decoupling inventory,
Seasonal inventory.
• Inventory planning is done in order to minimize the total
cost of the plan. The costs include
– Cost of carrying inventory
– Cost of ordering
– Cost of shortages
• The key decisions in any inventory planning scenario is to
answer the “how much” and the “when” questions.
• The EOQ model is useful for inventory planning in the case
of multi-period deterministic demand situations.
Highlights…
• The EOQ model is robust to model parameters and could be
suitably modified to incorporate some real life situations
such as quantity discounts and non-zero lead time for
supply.
• Service level is a useful concept for modeling inventory
planning in the case of stochastic demand. Safety stocks can
be built commensurate to the desired service level.
• A fixed order quantity (Q system) or continuous review
system of inventory planning and control is useful for B class
and C class items of inventory.
– A popular application of the continuous review system in
organizations is the two-bin system.
Highlights…
• A fixed order interval or a periodic review system (P
system) is useful for planning and control of high
value and A class items.
– The P system is more responsive to changes in demand
patterns than the Q system.
• Selective control of inventories is achieved through
alternative classification methodologies. The ABC,
VED and XYZ classifications are often used by
organizations
• The news vendor model is useful for inventory
planning in the case of single period demand

Inventory

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Inventory Planning and Control

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Cyclic inventory in the system = Q /2 = 800 /2 = 400 tonnes.

Lead Time = 2 weeks

Average weekly demand µ = 200 tonnes

Pipeline inventory = L x µ = 200 x 2 = 400 tonnes.

Operations Management: Theory and Practice, 3e

Average Value of the inventory in Stores 35,000,000.00

a Cost of warehousing 5.00%

Operations Management: Theory and Practice, 3e

4 Salary of Purchase Department Personnel 1,100,000.00

5 Inwards Goods Inspection Section Expenses 350,000.00

No. of purchase orders generated 600.00

Operations Management: Theory and Practice, 3e

Demand during the planning period =D

When the total cost is minimum, we obtain the most economic

Total cost of carrying

Total cost of ordering

Economic Level of Inventory

Operations Management: Theory and Practice, 3e

• Despite this, the EOQ model could be applied with suitable

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Time between orders = ?

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Mean Demand during LT

Operations Management: Theory and Practice, 3e

Using EOQ as the fixed order quantity, Q system can be designed

Operations Management: Theory and Practice, 3e

The P system can be designed as follows: The inventory level in the

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

• Avg. demand during LT = 143

Operations Management: Theory and Practice, 3e

Let the demand during lead time

Safety stock (SS) is given by SS = Z *  ( L)

Operations Management: Theory and Practice, 3e

When to ROP = μ(L) + Zα×σ(L) Every R periods

Salient • Implemented using two • More safety stock

Operations Management: Theory and Practice, 3e

Operations Management: Theory and Practice, 3e

Let Co = Cost of over stocking per unit

Operations Management: Theory and Practice, 3e

As per equation 18.11, the optimal quantity to stock is obtained as:

On examination of the cumulative probability values in the last

Operations Management: Theory and Practice, 3e

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