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Inventory Management

Inventory Management

Inventory: A quantity of goods/materials in the control of a firm and hold for a time in a relatively idle state awaiting its intend use or sale Inventory Management: To determine an optimal level of holding such idle resources through certain procedures/rules on the decisions of when/how much to order for procurement or production

How Much? When!

Conflicting Pressures on Inventory Levels

Pressures for Small Inventories Interest or opportunity cost Storage and handling cost Property taxes Insurance premiums Shrinkage costs: pilferage, obsolescence, and deterioration Pressures for Large Inventories Customer service Ordering or setup cost Labor and facility utilization Transportation cost Cost of purchased items

Inventory Management (II)

Major objectives of inventory management: 1. Minimizing total inventory management cost under given constraints 2. Satisfying desired customer service level

Functions of Inventory

1. To prevent fluctuation in demand 2. To meet seasonal demand change 3. To protect variation in supply 4. To obtain economy of scale in procurement/production 5. To maintain independence of operations 6. To smooth production process 7. To provide flexibility for production planning and scheduling

Type of Inventory
Inventory types: 1. RM/purchased parts/subassemblies 2. Work-in-process 3. Finished goods

Inventory: Purposetheand Types material Purpose: Buffering against any uncertainty in work flow process from
purchasing to finished goods shipping through providing a buffer between successive work flow stages. Types: Operation Type Manufacturing Inventory Type Purchased RMs and Parts Buffered Flows Between Purchasing and manufacturing operations

Finished Goods Services Delivery: Supplies

Between Successive Production Operations

Between production and Sales Between Purchasing and Services delivery

Wholesale/ Retail

Finished goods Stock

Between Distribution and Final Sales

Costs Constraints and Customer Service

Relevant costs in inventory management: 1. Fixed costs: purchase ordering cost/production setup cost 2. Variable costs: holding cost/shortage cost/purchase cost Major constraint in inventory management: 1. Supply constraint 2. Internal constraint 3. Marketing constraint

Inventory Management
Costs affected by inventory decisions

Ordering (or setup costs) Clerical costs Transportation and receiving costs Cost incurred in setting up production Order follow-up cost

Inventory holding cost Space costs Storage costs Cost of capital invested Insurance costs Taxes on investment values Costs of spoilage

Stockout or shortage costs Expediting costs Rush shipment costs Possible loss Loss of profit Potential loss of customer

Costs of purchased items on which price discounts are offered based on Total dollar values of purchase order for items

Inventory Costs
Interest or opportunity Cost Storage and Handling Costs Taxes, Insurance, and Shrinkage Customer Service Cost Ordering Cost/Setup Cost Labor and Equipment Cost Transportation Costs Payments to Suppliers

Customer Service in Inventory Management

Customer Service: measured by the availability of items when needed a performance measure of inventory management Customer may be: purchaser of FG/distribution/another plant or shop where next operation is performed Customer Service Level: a target level for keeping initial delivery schedules and backorders

Service Level and Safety Stock

Service level: an inventory management performance criterion measured by ---the percentage of stock-out occurrence defined as service level=1-P(percentage of stock-out) Safety stock: a quantity of inventory which have been set aside to reduce the probability of stockout or to improve the service level.

Service Level and Safety Stock

Safety Stock is: A Quantity of Inventory which have been set aside to reduce the Probability of StockOut, or to improve the Service Level. The General Relationship Between Safety Stock and Services Level is:

The ABC Classification Method

A small percentage of the items that would account for a large percent of the total values of annual usage- these are called A items A large percentage of the item that would account for a small percentage of the total value of annual usage- these are called C items Items in between A and C items- these are called B items A typical relationship among A, B and C items is:

ABC Analysis
100 90 Class A 80 70 60 50 40 30 20 10 0 10 Figure 15.2 20 30 40 50 60 70 80 90 100 Class B Class C

Percentage of dollar value

Percentage of items

See ABC Classification Example on your Supplement (p.15-8)

Reading Article about 80/20 Rule on p. 15-11.

ABC Classification Examples

A wholesaler has ten items in a product line. The item number, selling price, and estimated annual volume in units are:
item 1001 3080 0053 4197 3683 4421 2222 5376 2121 0070 Selling price $3.00 15.00 4.60 2.56 21.00 0.65 4.49 6.38 4.21 5.44 Annual usage in units 10,000 350 4,000 5,000 200 10,500 12,500 4,400 750 2,000 Total= Annual Usage in Values 30,000 5,250 18,400 12,800 4,200 6,825 56,125 28,072 3,157.5 10,880 175,709.50

The first step in categorizing the item is to estimate the dollar value of annual usage for each item (multiply the selling price by the estimated annual usage). Then, they should be arranged in descending order. The result of these two steps are:
Item Value of annual usage $56,125.00 30,000.00 28,072.00 18,400.00 12,800.00 10,880.00 6,825.00 5,250.00 4,200.00 3,157.50 Cumulative value of Cumulative percent annual usage of value of annual usage $ 56,125.00 31.9 % 86,125.00 49.0 A 114,197.00 65.0 132,597.00 75.5 145,397.00 82.7 156,277.00 88.9 B 163,352.00 92.8 168,352.00 95.8 C 172,552.00 98.2 175,709.50 100.0

2222 1001 5376 0053 4197 0070 4421 3080 3683 2121

Assume the wholesaler wants to construct the ABC classification with A items representing 75% of the sales, B using the table above the classification would be:
Item A 2222 1001 5376 0053 Item B 4197 0070 Item C 4421 3080 3683 2121

Classification of Inventory Control Models

Demand Characteristics: 1. Independent Demand Item (finished goods): demand of an item is independent to others usually with high uncertainty uncontrollable and external determined 2. Dependent Demand Item (RM/part/ subassembly): demand of an item is dependent on other items requirements usually with certainty controllable and internal determined

Types of Demand

Independent Demand

When items demand is influenced by market conditions and is not related to (i.e. independent of) production decisions for any other item Only end items can qualify in manufacturing Demand must be forecast (uncontrollable) When items demand derives from (i.e. depends on) the production decisions for its parent All intermediate and purchased items in manufacturing Demand should be derived (can be controlled)

Dependent Demand

Some items can be viewed as both independent and dependent demand items!

Classification of Inventory Control Models

Single item inventory vs. multiple-item inventory Single stage inventory vs. multi-stage Static demand vs. dynamic demand Stochastic demand vs. determined demand

Five Types of Inventory Control System for Independent Demand Items

1. Fixed Order Quantity (Q)- Reorder Point (R) System: (Q,R)

Continue review on inventory status (It),

2. Fixed Order Interval (T)- Maximum Level (M) System: (T,M)

Periodical review at fixed time interval (T) Place an order at end of each period with a quantity that build On- Hand Inventory up to M

3. Hybrid System: Combination of Fixed Order Interval (T) and Reorder Point System (R) (Several Possible Combinations). 4. Time-Phased Order Point System: (MRP Application on Independent Demand Items) 5. Single-Period Model: for Perishable Items (Newspaper/ Flower)

Basic Fixed-Order Quantity Model

Economic Order Quantity

Receive order On-hand inventory (units) Inventory depletion (demand rate)

Q 2

Average cycle inventory

Figure 15.3

1 cycle


Fixed-Interval Inventory System (T,M) System

Continuous Review
IP Order received Order received IP Order received

Order received

On-hand inventory




Order placed L TBO TBO Order placed L TBO Figure 15.7 Order placed L


Periodic Review Systems

T On-hand inventory IP

Order received


Order received Q3 OH


Order received

IP1 IP3 IP2 Order placed


Order placed

Figure 15.12



Protection interval

Fixed Order Quantity System

A perceptual system (sometimes called a fixed quantity or Q/R system) is one that used a fixed reorder point (R) and a fixed order quantity (Q). The time between orders varies depending on when the inventory reaches the reorder point.

Fixed Order Quantity System

The inventory behavior is:

(d) Q R Q

SS= 0

Fixed Order Quantity System

Where: R= reorder point = (d*L) + SS
Q= economic order quantity = EOQ =
2* DS H

D= annual demand (expressed in units/ year) L= reorder lead time (expressed as a fraction of a year) S= ordering cost (expressed as $ per order) C= item cost (expressed in $ per unit) F= inventory holding cost fraction (expressed as a fraction of item cost per year) H= holding cost = (C*F) The total annual cost (TC) for a purchased item managed with a perpetual inventory system can be calculated as follows: TC= (cost of the item) + (ordering cost) + (inventory holding cost) D*C + ( Q/2)*H + (D/Q)*S

Economic Order Quantity

Example 15.2 3000

Annual cost (dollars)

Total cost =

Q D (H) + (S) 2 Q

Holding cost =

Q (H) 2

Ordering cost =
0 | 50 | 100 | 150 | 200 | 250 | 300 | 350 | 400

D (S) Q

Lot Size (Q)

Economic Order Quantity

Total cost = HC + OC Annual cost (dollars)

Holding cost (HC) Ordering cost (OC)

Figure 15.4

Lot Size (Q)

See Example on Your Supplement

P. 15-15.

Example of Determining Economic Order Quantity

An importer/distributor or toys uses a standard, corrugated cardboard box for shipping orders to customers. These boxes are used at the rate of 120,000 per year. Each box costs $0.30, and the estimated annual holding cost is 60% of the purchase price. It requires 20 minutes (or 0.33 hours) to prepare an order for this item. The wage rate of the inventory and purchasing clerks is $5.00 per hour. D=120,000; C=0.30; F=0.60; H=0.3x0.6=0.18 Problem: Determine how many boxes should be ordered from the supplier each time. Solution: S= (1/3) x $5= $1.65 EOQ= 2.D.S/H = 2x120,000x1.65/0.18 = 1,483 1,500

Problem: If lead time is one day and there are 250 working days during the year, what is the reorder point?
Solution: d= 120,000/250= 480, L=1, SS=0 R= d.L + SS= (480X1) + 0 = 480

Problem: What is the total annual cost of this reordering system? Solution: TC = D.C + (D/Q).S + (Q/2).H = (120,000)(0.3) + (120,000/1,483)1.65+(1483/2)X0.18 = $36,267


Economic Order Quantity

1. Demand rate is constant 2. No constraints on lot size 3. Only relevant costs are holding and ordering/setup 4. Decisions for items are independent from other items 5. No uncertainty in lead time or supply 6. One Time delivery.

Fixed Order Quantity System with Gradual Replenishment

The inventory behavior is:

Fixed Order Quantity System with Gradual Replenishment

EPQ= economic production quantity = P-d H Where D= annual demand (expressed in units/ year) S= ordering cost (expressed as $ per order) C= item cost (expressed in $ per unit) F= inventory holding cost fraction (expressed as a fraction of item cost per year) P= production rate (expressed in units per period) d= usage rate (expressed in units per period)


TC = [D*C] + ( D )*S + ( )*H*( P-d )

Q 2 P

Special Inventory Models

On-hand inventory

Production quantity Demand during production interval


Maximum inventory


pd Q Imax = (p d) = Q p p

Production and demand
Demand only


Figure E.1

See Example on Your Supplement

P. 15-17.

Example of Determining Economic Production Quantity

A manufacturer of steel products uses a large, special bolt as a fastener in all products in a particular product line. The usage rate of this item is 2000 per day. There are 250 working days in the year.

It takes 30 minutes to prepare a manufacturing order for this bolt. The clerks make $5.00 per hour.
It takes one hour to change the tooling to begin a production run for the bolt. The setup personnel make $9.00 per hour. The production run is 5000 units per day. C=1.30; F=25%; H=(1.3x25%)=0.325; d= 2,000; D=2,000x250=500,000 Problem: What is the economic production quantity for this item assuming a manufacturing cost of $1.30 and an annual holding cost of 25% of the manufacturing cost? S: (0.5x5) + (1x9)= $11.50, P=5,000 EPQ= (2.D.S)x P/H.(P-d) = (2x500,000x11.50)x5,000/0.325X(5,000-2,000) 7,680

Problem: If lead time is 1.5 days, what is the reorder point? Solution: L= 1.5; SS=0 R = d.L +SS = 2,000X1.5+0 = 3,000

Periodic Systems

Periodic Systems
T= economic order interval = L= reorder lead time (expressed as a fraction of a year) S= ordering cost (expressed as a fraction of a year) D= annual demand (expressed in units/year) C= item cost (expressed in $ per unit) F= inventory holding cost fraction (expressed as a fraction of item cost per year) Order quantity = Q= d(L+T) + SS It = M- It (M= (Base-Level) = d(L+T) + SS It = [On-Hand] + [On-Order] [Back Order])

See Example on Your Supplement

P. 15-19.

Example of Determining Economic Order Interval

An auto parts store carrier a universal gasoline filter. The store sells 4000 units of this item annually. The cost of this filter from the supply house is $0.50 and the annual holding cost is 20% of the unit value. The cost of preparing a purchase order is $8.00. D=4,000; C=0.5; F=20%; H=0.5X0.2=0.1 Problem: If the store is open 51 weeks per year, how many weeks should there be between orders? S=$8.00 T= 2.S/H.D = 2x8/0.1x4,000 =0.2 (Years) x 51 =10.2 (Weeks)

Problems: If the lead time is one week, what is the quantity to be ordered if 110 units are currently on hand at the end of a reorder interval?
D=4,000/51=78, L=1; It=110, SS=0 Q=d(T+L)+SS-It =78(10.2+1)+0-110770 Problem: How many orders should be placed each year? N= 51/10.2 =5 (Orders)

Hybrid System
A hybrid inventory system has a combination of a fixed order interval and a fixed reorder point. Examples of hybrid systems are:
Place an order every 4 weeks unless the inventory drops below 100 units. Then, place the order immediately Place a order every 4 weeks unless the inventory on hand is more than 250 units. Then, wait another week to place the order

Summary Of Basic Inventory Models

Decision When to order
How much to order

Perpetual System (Q,R) R= d*L + SS

Periodic System (T,M)





2*D*S H

Q = d* (L+T)+SS - It

( )
P P-d

Inventory Control System

Continuous Review (Q,R) System fixed-order quantity system for independent demand item:

When a withdrawal brings Inventory down to the reorder point (R), place an order for Q (fixed) units R= average demand during the lead time + safety stock (safety stock = z* L) Review the inventory every P time periods- place an order (Q) equal to (T-IP), where T is the target inventory. Here Q varies, and time between orders (TBO) is fixed. Same four assumptions, but again allow for uncertain demand.

Periodic Review (P) System periodic reorder system.

Inventory Control Models Comparison

Fixed Order Quantity [Q,R] vs. Fixed Order Periods [T,M]
Fixed Order Quantity Order Quantity Q is fixed (order same) Fixed Order Period Q is variable (order different)

Order Time
Initiated By Control Point Operating Cost Implementation Data Managing

Variable, anytime when on-hand reaching R

Event triggered (when IR) Continuous review on inventory Very high Difficult Difficult and time consuming

Fixed at T (period)
Time triggered (when tT) Periodical review only Low Easy Easy and simple

Factors to Consider When Determining which System to Use

Factors favoring a Fix-Order Quantity system: 1. high cost items 2. items that have high stockout costs 3. items that have discount price based on order quantity 4. items that have relatively more irregular demand patterns

Factors to Consider When Determining which System to Use

Factors favoring a fix Order-Period system: 1. low cost items 2. items that have low stockout costs 3. items that have discount price based on dollar value 4. items that have relatively regular demand patterns 5. items that can be purchased from the same supplier 6. items that their values will change period-by-period

Comparison of Q and P Systems

P Systems

Convenient to administer Orders may be combined IP only required at review

Q Systems

Individual review frequencies Possible quantity discounts Lower, less-expensive safety stocks

Inventory Control System (II)

Comparative Advantage of Two Systems Periodic review system Administration is convenient Standardized routes for transportation systems Easier to combine orders to same supplier May help with price break or paperwork May reduce suppliers shipping costs Continuous review system Tailoring Q to costs for each item Easier for quantity discounts or capacity limitations Less safety stock Hybrid systems Optional replenishment system Base stock system Special case of Q and P system Single- bin system Two- bin system

Basis for Setting the Order Point

In the fixed order quantity system, the ordering process is trigged when the inventory level drops to a critical point the order point This starts the lead time the item--lead time is the time to complete all activities associated with placing filling and receiving the order. During the lead time customers continue to draw down the inventory so during this period that the inventory is vulnerable to stock-out ( run out of inventory) Customer service level is the probability that a stock out will not occur during the lead time (DDLT). The order point is set based on: the demand during lead time and the desired customer service level

Basis for Setting the Order Point (II)

Order point = expected demand + safety stock The amount of safety stock needed is based on the degree of uncertainty in the DDLT and the customer service level desired If there is variability in the DDLT the DDLT is expressed as a distribution discrete /continuous DDLT distribution is appropriate when the demand is very high.

Determine R and Safety Stock

R= Average Demand during Lead-time + Safety Stock = d*L + SS SS = determined by desired Service Level (%) and Standard deviation of (d*L) = z* L Example: Service Level = 95%, = 5%, z=1.96; = 1%, z= 2.33) Given: (d*L)=250, L=22, = 1%, z= 2.33 SS= z* L = 2.33*22 = 51 R = (d*L) + SS = 250 + 51 = 301 300

Determine R and Safety Stock R = Average Demand during Lead Time + Safety Stock = d*L + SS SS = determined by desired Service Level (%) and Standard deviation of (d*L) = z*L Example: Service Level = 95% = 5% z = 1.96 = 1% z = 2.33 Given: (d*L) = 250 L = 22 = 1% z = 2.33 SS = z* L = 2.33*22 = 51 R = (d*L) + SS = 250 +51 = 301 ~300

Reorder Point / Safety Stock

Safety Stock/R Safety stock = zL = 2.33(22) = 51.3 = 51 boxes Cycle-service level = 85%

Reorder point = ADDLT + SS = 250 + 51 = 301 boxes Average demand during lead time zL
Example 15.5

Probability of stockout (1.0 0.85 = 0.15)

A Quantity Discount Schedule

Order Quantity
1-99 100-199

Price per Unit

$ 4.00 $ 3.50

200 and over

$ 3.00

Example: EOQ with Discount Price

Given: D=1000, S=2000, F=20% Supplier offered a price discount:

If the order quantity: Q < 2000; pay 100/unit If the order quantity: Q > 2000; pay 80/unit

What is the most economic order quantity that minimizes the total cost?

Example: EOQ with Discount Price (II)

1. assume you normally order less than 2000, then H=? Q*= ? TC=? 2. if you order Q=2000 to obtain the discount price then: H=? Q*=? TC=? Savings=

Example: EOQ with Discount Price

Given: D= 10,000 S= $2,000 F= 20% Supplier offered a price discount: If order quantity: Q 2000 You pay $100/unit If order quantity: Q> 2000 You pay $80/unit What is the most economic order quantity that minimize the total cost? Assume you normally order less than 2000, Then H= C1*F = $100 * 0.20 = $20,
So, Q*= = 1,414 (<2,000) 20 TC= (10,000 *100) + (1414/2)*20 + (10,000/1414)* 2000 = $1,028,284


If you order (just) Q= 2000 to obtain the discount price ($80), Then H= C2*F= $80*0.20 = $16, with Q* = 2,000 TC= (10,000*80)+2000/2*16 + 10,000/2000*2000= 826,000 Savings: 1,028,284-826,000=$202.284

TC P1=100






Special Inventory Models

Quantity Discounts
C for P = $4.00 C for P = $3.50 C for P = $3.00
Total cost (dollars) Total cost (dollars) Figure E.3

EOQ 4.00 EOQ 3.50 EOQ 3.00

PD for P = $4.00

PD for P = $3.50

PD for P = $3.00

First price break


Second price break

300 0

First price break

Second price break


100 200 Purchase quantity (Q)

100 200 Purchase quantity (Q)

(a) Total cost curves with purchased materials added

(b) EOQs and price break quantities

Sensitivity of EOQ Model to Changes

Sensitivity of EOQ Model ( Effect of changes)

Due to Square-Root effect, the EOQ model is relatively insensitive to small changes from model parameter. For change in the demand rate (D) or Order Cost (S): -D (or S) is the numerator, EOQ varies directly as the square root of D (or S) For Change in the holding cost (h): -H is in the denominator, so if H decreases, EOQ increases Errors in estimating D, H and S

Errors such as overestimating ordering cost may be offset by other errors such as overestimating holding cost. The square root also reduces the effect of errors. If one misses a cost or demand estimate by 10%, the effect on total cost is often undetectable