Operations Management
Dr. Ron TibbenLembke
Purposes of Inventory
Meet anticipated demand
Demand variability
Supply variability
Decouple production & distribution
permits constant production quantities
Take advantage of quantity discounts
Hedge against price increases
Protect against shortages
2006 13.81 1857 24.0% 446 801 58 1305 9.9
US Inventory, GDP ($B)

2,000
4,000
6,000
8,000
10,000
12,000
14,000
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
Business Inventories US GDP
US Inventories as % of GDP
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
Year
%
o
f
G
D
P
Source: CSCMP, Bureau of Economic Analysis
Two Questions
Two main Inventory Questions:
How much to buy?
When is it time to buy?
Also:
Which products to buy?
From whom?
Types of Inventory
Raw Materials
Subcomponents
Work in progress (WIP)
Finished products
Defectives
Returns
Inventory Costs
What costs do we experience because
we carry inventory?
Inventory Costs
Costs associated with inventory:
Cost of the products
Cost of ordering
Cost of hanging onto it
Cost of having too much / disposal
Cost of not having enough (shortage)
Shrinkage Costs
How much is stolen?
2% for discount, dept. stores, hardware,
convenience, sporting goods
3% for toys & hobbies
1.5% for all else
Where does the missing stuff go?
Employees: 44.5%
Shoplifters: 32.7%
Administrative / paperwork error: 17.5%
Vendor fraud: 5.1%
Inventory Holding Costs
Category % of Value
Housing (building) cost 4%
Material handling 3%
Labor cost 3%
Opportunity/investment 9%
Pilferage/scrap/obsolescence 2%
Total Holding Cost 21%
Inventory Models
Fixed order quantity models
How much always same, when changes
Economic order quantity
Production order quantity
Quantity discount
Fixed order period models
How much changes, when always same
Economic Order Quantity
Assumptions
Demand rate is known and constant
No order lead time
Shortages are not allowed
Costs:
S  setup cost per order
H  holding cost per unit time
EOQ
Time
Inventory
Level
Q*
Optimal
Order
Quantity
Decrease Due to
Constant Demand
EOQ
Time
Inventory
Level
Q*
Optimal
Order
Quantity
Instantaneous
Receipt of Optimal
Order Quantity
EOQ
Time
Inventory
Level
Q*
Lead Time
Reorder
Point
(ROP)
EOQ
Time
Inventory
Level
Q*
Lead Time
Reorder
Point
(ROP)
Average
Inventory Q/2
Total Costs
Average Inventory = Q/2
Annual Holding costs = H * Q/2
# Orders per year = D / Q
Annual Ordering Costs = S * D/Q
Annual Total Costs = Holding + Ordering
Q
D
S
Q
H Q TC *
2
* ) ( + =
How Much to Order?
Annual Cost
Order Quantity
Holding Cost
= H * Q/2
How Much to Order?
Annual Cost
Order Quantity
Holding Cost
= H * Q/2
Ordering Cost
= S * D/Q
How Much to Order?
Annual Cost
Order Quantity
Total Cost
= Holding + Ordering
How Much to Order?
Annual Cost
Order Quantity
Total Cost
= Holding + Ordering
Optimal Q
Optimal Quantity
Q
D
S
Q
H *
2
* +
Total Costs =
2
*
2 Q
D
S
H
Take derivative
with respect to Q =
Solve for Q:
2
2 Q
DS H
=
Set equal
to zero
0 =
H
DS
Q
2
2
=
H
DS
Q
2
=
Adding Lead Time
Use same order size
Order before inventory depleted
R = * L where:
= demand rate (per day)
L = lead time (in days)
both in same time period (wks, months,
etc.)
H
DS
Q
2
=
d
d
A Question:
If the EOQ is based on so many
horrible assumptions that are never
really true, why is it the most
commonly used ordering policy?
Benefits of EOQ
Profit function is very shallow
Even if conditions dont hold
perfectly, profits are close to optimal
Estimated parameters will not throw
you off very far
Sensitivity
Suppose we do not order optimal Q*, but
order Q instead.
Percentage profit loss given by:
Should order 100, order 150 (50% over):
0.5*(1.5 + 0.66) =1.08 an 8%cost increase
(
+ =
*
*
2
1
*) (
) (
Q
Q
Q
Q
Q TC
Q TC
Quantity Discounts
How does this all change if price
changes depending on order size?
Holding cost as function of cost:
H = I * C
Explicitly consider price:
Q=
2DS
I C
Discount Example
D = 10,000 S = $20 I = 20%
Price Quantity EOQ
c = 5.00 Q < 500 633
4.50 501999 666
3.90 Q >= 1000 716
Discount Pricing
Total Cost
Order Size
500 1,000
Price 1 Price 2 Price 3
X 633
X 666
X 716
Discount Pricing
Total Cost
Order Size
500 1,000
Price 1 Price 2 Price 3
X 633
X 666
X 716
Discount Example
Order 666 at a time:
Hold 666/2 * 4.50 * 0.2= $299.70
Order 10,000/666 * 20 = $300.00
Matl 10,000*4.50 = $45,000.00 45,599.70
Order 1,000 at a time:
Hold 1,000/2 * 3.90 * 0.2=$390.00
Order 10,000/1,000 * 20 = $200.00
Matl 10,000*3.90 = $39,000.00 39,590.00
Discount Model
1. Compute EOQ for next cheapest price
2. Is EOQ feasible? (is EOQ in range?)
If EOQ is too small, use lowest possible
Q to get price.
3. Compute total cost for this quantity
4. Repeat until EOQ is feasible or too big.
5. Select quantity/price with lowest total
cost.
Inventory Management
 Random Demand
Master of the Obvious?
If you focus on the things the
customers are buying its a little
easier to stay in stock
James Adamson CEO, Kmart Corp.
3/12/02
Fired Jan, 2003
Random Demand
Dont know how many we will sell
Sales will differ by period
Average always remains the same
Standard deviation remains constant
Impact of Random
Demand
How would our policies change?
How would our order quantity change?
How would our reorder point change?
Macs Decision
How many papers to buy?
Average = 90, st dev = 10
Cost = 0.20, Sales Price = 0.50
Salvage = 0.00
Overage: C
O
= 0.20  0.00 = 0.20
Underage: C
U
= 0.50  0.20 = 0.30
Optimal Policy
F(x) = Probability demand <= x
Optimal quantity:
Mac: F(Q) = 0.3 / (0.2 + 0.3) = 0.6
From standard normal table, z = 0.253
=Normsinv(0.6) = 0.253
Q* = avg + zo = 90+ 2.53*10 = 90 +2.53 = 93
P(unit sold) =
C
u
C
o
+ C
u
Optimal Policy
Model is called newsboy problem,
newspaper purchasing decision
If units are discrete, when in doubt,
round up
If u units are on hand, order Q  u
units
Multiple Periods
For multiple periods,
salvage = cost  holding cost
Solve like a regular newsboy
Random Demand
If we want to satisfy all of the
demand 95% of the time, how many
standard deviations above the mean
should the inventory level be?
Probabilistic Models
Safety stock = x
From statistics,
From normal table z
.95
= 1.65
Safety stock = zo = 1.65*10 = 16.5
ROP = + Safety Stock
Therefore, z =
Safety stock
& Safety stock = zo
o
=350+16.5 = 366.5 367
z =
x
o
Random Example
What should our reorder point be?
demand over the lead time is 50 units,
with standard deviation of 20
want to satisfy all demand 90% of the time
To satisfy 90% of the demand, z = 1.28
R = 50 + 25.6 = 75.6
Safety stock = z o = 1.28 * 20 = 25.6
St Dev Over Lead Time
What if we only know the average daily
demand, and the standard deviation of
daily demand?
Lead time = 4 days,
daily demand = 10,
standard deviation = 5,
What should our reorder point be, if z =
3?
St Dev Over LT
If the average each day is 10, and the
lead time is 4 days, then the average
demand over the lead time must be
40.
What is the standard deviation of
demand over the lead time?
Std. Dev. 5 * 4
St Dev Over Lead Time
Standard deviation of demand =
R = 40 + 3 * 10 = 70
= Lo
=  = 4 5 10
Service Level Criteria
Type I: specify probability that you
do not run out during the lead time
Chance that 100% of customers go
home happy
Type II: proportion of demands met
from stock
100% chance that this many go home
happy, on average
Service levels easier to estimate
Two Types of Service
Cycle Demand StockOuts
1 180 0
2 75 0
3 235 45
4 140 0
5 180 0
6 200 10
7 150 0
8 90 0
9 160 0
10 40 0
Sum 1,450 55
Type I:
8 of 10 periods
80% service
Type II:
1,395 / 1,450 =
96%
Type I Service
o = desired service level
We want F(R) = o
R = + o * z
Example: o = 0.98, so z = 2.05
if = 100, and o = 25, then
R = 100 + 2.05 * 25 = 151
Type II Service
 = desired service level
Number of mad cust. = (1 ) EOQ
L(z) = EOQ (1 ) / o
Example: EOQ = 100,  = 0.98
L(z) = 100 * 0.2 / 25 = 0.8
P. 835: z = 1.02
R = 126  A very different answer
Inventory Recordkeeping
Two ways to order inventory:
Keep track of how many delivered, sold
Go out and count it every so often
If keeping records, still need to double
check
Annual physical inventory, or
Cycle Counting
Cycle Counting
Physically counting a sample of total
inventory on a regular basis
Used often with ABC classification
A items counted most often (e.g., daily)
Advantages
Eliminates annual shutdown for
physical inventory count
Improves inventory accuracy
Allows causes of errors to be identified
FixedPeriod Model
Answers how much to order
Orders placed at fixed intervals
Inventory brought up to target amount
Amount ordered varies
No continuous inventory count
Possibility of stockout between intervals
Useful when vendors visit routinely
Example: P&G rep. calls every 2 weeks
FixedPeriod Model:
When to Order?
Time
Inventory Level
Target maximum
Period
FixedPeriod Model:
When to Order?
Time
Inventory Level
Target maximum
Period Period
FixedPeriod Model:
When to Order?
Time
Inventory Level
Target maximum
Period Period
FixedPeriod Model:
When to Order?
Time
Inventory Level
Target maximum
Period Period Period
FixedPeriod Model:
When to Order?
Time
Inventory Level
Target maximum
Period Period Period
FixedPeriod Model:
When to Order?
Time
Inventory Level
Target maximum
Period Period Period
Fixed Order Period
Standard deviation of demand over T+L =
T = Review period length (in days)
= std dev per day
Order quantity (12.11) =
o o L T
L T
+ =
+
I z L T d q
L T
+ + =
+
o ) (
ABC Analysis
Divides onhand inventory into 3 classes
A class, B class, C class
Basis is usually annual $ volume
$ volume = Annual demand x Unit cost
Policies based on ABC analysis
Develop class A suppliers more
Give tighter physical control of A items
Forecast A items more carefully
Classifying Items
as ABC
0
20
40
60
80
100
0 50 100 150
% of Inventory Items
% Annual $ Usage
A
B
C
ABC Classification Solution
Stock # Vol. Cost $ Vol. % ABC
206 26,000 $ 36 $936,000
105 200 600 120,000
019 2,000 55 110,000
144 20,000 4 80,000
207 7,000 10 70,000
Total 1,316,000
ABC Classification Solution
Stock # Vol. Cost $ Vol. % ABC
206 26,000 $ 36 $936,000 71.1 A
105 200 600 120,000 9.1 A
019 2,000 55 110,000 8.4 B
144 20,000 4 80,000 6.1 B
207 7,000 10 70,000 5.3 C
Total 1,316,000 100.0
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