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Lecture Outline

Elements of Inventory Management Inventory Control Systems Economic Order Quantity Models Quantity Discounts Reorder Point Order Quantity for a Periodic Inventory System

What Is Inventory?
Stock of items kept to meet future demand Purpose of inventory management
how many units to order when to order

Water Tank Analogy for Inventory

Inventory Level Supply Rate

Inventory Level

Buffers Demand Rate from Supply Rate

Demand Rate

Inventory-A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state.
Inventory System- A set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be

Reasons for Inventories

Improve customer service Economies of purchasing Economies of production Transportation savings Unplanned shocks (labor strikes, natural disasters, surges in demand, etc.) To maintain independence of supply chain

Types of Inventory
Raw materials Purchased parts and supplies Work-in-process (partially completed) products (WIP) Items being transported Tools and equipment

Why We Want to Hold Inventories Finished Goods

Essential in produce-to-stock positioning strategies Necessary in level aggregate capacity plans Products can be displayed to customers

Necessary in process-focused production May reduce material-handling & production costs

Raw Material
Suppliers may produce/ship materials in batches Quantity discounts and freight/handling $$ savings

Zero Inventory?
Reducing amounts of raw materials and purchased parts and subassemblies by having suppliers deliver them directly. Reducing the amount of works-in process by using just-in-time production. Reducing the amount of finished goods by shipping to markets as soon as possible.

Inventory and Quality Management

Customers usually perceive quality service as availability of goods they want when they want them Inventory must be sufficient to provide high-quality customer service in TQM

Inventory and Supply Chain Management

Bullwhip effect
demand information is distorted as it moves away from the end-use customer higher safety stock inventories to are stored to compensate

Seasonal or cyclical demand Inventory provides independence from vendors Take advantage of price discounts Inventory provides independence between stages and avoids work stop-pages


Current trends in inventory management

Two Forms of Demand

Demand for items used to produce final products Tires stored at a Goodyear plant are an example of a dependent demand item Demand for items used by external customers Cars, appliances, computers, and houses are examples of independent demand inventory


Independent and Dependent Demand Inventory Management

Independent demand
Uncertain / forecasted Continuous Review / Periodic Review

Dependent demand
Requirements / planned Materials Requirements Planning / Just in Time

Nature of Inventory: Functional Roles of Inventory

Transit / pipeline Buffer Seasonal Decoupling Lot Sizing or Cycle Support Capacity related inventory

Why We Do Not Want to Hold Inventories Certain costs increase such as carrying costs cost of customer responsiveness cost of coordinating production cost of diluted return on investment reduced-capacity costs large-lot quality cost cost of production problems

Inventory Costs
Carrying cost
cost of holding an item in inventory

Ordering cost
cost of replenishing inventory

Shortage cost
temporary or permanent loss of sales when demand cannot be met

Inventory Costs
Costs associated with ordering too much (represented by carrying costs) Costs associated with ordering too little (represented by ordering costs) These costs are opposing costs, i.e., as one increases the other decreases . . . more

Balancing Carrying against Ordering Costs

Annual Cost ($)
Higher Minimum Total Annual Stocking Costs Total Annual Stocking Costs Annual Carrying Costs Annual Ordering Costs Smaller EOQ Larger Order Quantity


Inventory Costs


The sum of the two costs is the total stocking cost (TSC) When plotted against order quantity, the TSC decreases to a minimum cost and then increases This cost behavior is the basis for answering the first fundamental question: how much to order It is known as the economic order quantity (EOQ)

Economic Order Quantity (EOQ) Models

optimal order quantity that will minimize total inventory costs

Basic EOQ model Production quantity model

Behavior of EOQ Systems

As demand for the inventoried item occurs, the inventory level drops When the inventory level drops to a critical point, the order point, the ordering process is triggered The amount ordered each time an order is placed is fixed or constant When the ordered quantity is received, the inventory level increases

Assumptions of Basic EOQ Model

Demand is known with certainty and is constant over time No shortages are allowed Lead time for the receipt of orders is constant Order quantity is received all at once

Model I: Basic EOQ

Assumptions (continued)
Stock out, customer responsiveness, and other costs are inconsequential acquisition cost is fixed, i.e., no quantity discounts Annual carrying cost = (average inventory level) x (carrying cost) = (Q/2)Cc Annual ordering cost = (average number of orders per year) x (ordering cost) = (D/Q) Co . . . more

Model I: Basic EOQ

Total annual stocking cost (TSC) = annual carrying cost + annual ordering cost = (Q/2)C + (D/Q)S The order quantity where the TSC is at a minimum (EOQ) can be found using calculus (take the first derivative, set it equal to zero and solve for Q)

EOQ Cost Model (cont.)

Annual cost ($) Slope = 0 Minimum total cost Carrying Cost = CcQ 2

Total Cost

Ordering Cost =


Optimal order Qopt

Order Quantity, Q

EOQ Cost Model

Co - cost of placing order Cc - annual per-unit carrying cost D - annual demand Q - order quantity CoD Q CcQ 2 CcQ 2

Annual ordering cost =

Annual carrying cost = Total cost = CoD + Q

EOQ Cost Model

Deriving Qopt Proving equality of costs at optimal point CoD CcQ = Q 2 Q2 2CoD = Cc 2CoD Cc

Co D CcQ TC = + Q 2
CoD Cc TC = + Q2 2 Q C0D Cc 0= + Q2 2 Qopt = 2CoD Cc

Qopt =

EOQ Example
Cc = $0.75 per yard Qopt = Qopt = Co = $150 D = 10,000 yards

2CoD Cc
2(150)(10,000) (0.75)

CoD CcQ TCmin = + Q 2

(150)(10,000) (0.75)(2,000) = + 2,000 2

Qopt = 2,000 yards

Orders per year = D/Qopt = 10,000/2,000 = 5 orders/year

TCmin = $750 + $750 = $1,500

Order cycle time = 311 days/(D/Qopt) = 311/5 = 62.2 store days

EOQ Lot Size Choice

There is a trade-off between lot size and inventory level.
Frequent orders (small lot size): higher ordering cost and lower holding cost. Fewer orders (large lot size): lower ordering cost and higher holding cost.

Reorder Point
Level of inventory at which a new order is placed R = dL
where d = demand rate per period L = lead time

Reorder Point: Example

Demand = 10,000 yards/year Store open 311 days/year Daily demand = 10,000 / 311 = 32.154 yards/day Lead time = L = 10 days R = dL = (32.154)(10) = 321.54 yards

Variable Demand with a Reorder Point

Q Inventory level

Reorder point, R

0 LT Time LT

Reorder Point With Variable Demand

R = dL + zd L
where d = average daily demand L = lead time d = the standard deviation of daily demand z = number of standard deviations corresponding to the service level probability zd L = safety stock

Reorder Point for a Service Level

Probability of meeting demand during lead time = service level transport Probability of a stockout

Safety stock zd L dL Demand

Safety Stocks
Safety stock
buffer added to on hand inventory during lead time

an inventory shortage

Service level
probability that the inventory available during lead time will meet demand

Reorder Point with a Safety Stock

Inventory level

Reorder point, R

Safety Stock

0 LT Time LT

P-System Periodic Review Method

an alternative to ROP/Q-system control is periodic review method Q-system - each stock item reordered at different times - complex, no economies of scope or common prod./transport runs P-system - inventory levels for multiple stock items reviewed at same time - can be reordered together higher carrying costs - not optimum, but more practical

Using P-System audit inventory level at interval (T) quantity to place on order is difference between max. quantity (M) and amount on hand at time of review management task - set optimal T and M to balance stock availability and cost In ABC analysis, which items would use Psystem???

Model III: EOQ with Quantity Discounts

Under quantity discounts, a supplier offers a lower unit price if larger quantities are ordered at one time This is presented as a price or discount schedule, i.e., a certain unit price over a certain order quantity range This means this model differs from Model I because the acquisition cost (ac) may vary with the quantity ordered, i.e., it is not necessarily constant

Under this condition, acquisition cost becomes an incremental cost and must be considered in the determination of the EOQ The total annual material costs (TMC) = Total annual stocking costs (TC) + annual acquisition cost
TC = (Q/2) Co + (D/Q) Cc + (D) ac

Quantity Discounts
Price per unit decreases as order quantity increases
CoD CcQ TC = + + PD Q 2 where P = per unit price of the item D = annual demand

Quantity Discount Model (cont.)

ORDER SIZE 0 - 99 100 199 200+ PRICE $10 8 (d1) 6 (d2)

TC = ($10 ) TC (d1 = $8 ) TC (d2 = $6 )

Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt

Q(d2 ) = 200

Model III: EOQ with Quantity Discounts

To find the EOQ, the following procedure is used: 1. Compute the EOQ using the lowest acquisition cost.
If the resulting EOQ is feasible (the quantity can be purchased at the acquisition cost used), this quantity is optimal and you are finished. If the resulting EOQ is not feasible, go to Step 2

2. Identify the next higher acquisition cost.

Model III: EOQ with Quantity Discounts

3. Compute the EOQ using the acquisition cost from Step 2.
If the resulting EOQ is feasible, go to Step 4. Otherwise, go to Step 2.

4. Compute the TMC for the feasible EOQ (just found in Step 3) and its corresponding acquisition cost. 5. Compute the TMC for each of the lower acquisition costs using the minimum allowed order quantity for each cost. 6. The quantity with the lowest TMC is

Quantity Discount: Example

QUANTITY 1 - 49 50 - 89 90+ Qopt = For Q = 72.5 PRICE $1,400 1,100 900 2CoD = Cc

Co = $2,500 Cc = $190 per computer D = 200

2(2500)(200) = 72.5 PCs 190

CcQopt Co D TC = + 2 + PD = $233,784 Qopt CcQ CoD TC = + 2 + PD = $194,105 Q

For Q = 90

Hybrid Inventory Models

Base stock model
Start with a certain inventory level Whenever a withdrawal is made, an order of equal size is placed Ensures that inventory maintained at an approximately constant level Appropriate for very expensive items with small ordering costs

Miscellaneous Systems:

Bin Systems
Two-Bin System

Ful l One-Bin System Periodic Check

Empt y

Order One Bin of Inventory when one is emptied Order Enough to Refill Bin (e.g. check book)

ABC Classification
Typical observations
A small percentage of the items (Class A) make up a large percentage of the inventory value A large percentage of the items (Class C) make up a small percentage of the inventory value

These classifications determine how much attention should be given to controlling the inventory of different items

Classifying Inventory Items

ABC Classification (Pareto Principle) A Items: very tight control, complete and accurate records, frequent review B Items: less tightly controlled, good records, regular review C Items: simplest controls possible, minimal records, large inventories, periodic review and reorder

ABC Classification
Class A
5 15 % of units 70 80 % of value

Class B
30 % of units 15 % of value

Class C
50 60 % of units 5 10 % of value

Track carefully (e.g. continuous review) Sophisticated forecasting to assure correct levels

Track less frequently (e.g. periodic review) Accept risks of too much or too little (depending on the item)


+Class B
Class A

+Class C

Percentage of dollar value

80 70 60 50 40

20 10 0 10 20 30 40 50 60 70 80 90 100

Percentage of items

ABC Classification: Example

1 2 3 4 5 6 7 8 9 10

$ 60 350 30 80 30 20 10 320 510 20

90 40 130 60 100 180 170 50 60 120

ABC Classification: Example (cont.)


9 8 2 1 4 3 6 5 10 7

$30,600 1 16,000 2 14,000 3 5,400 4 4,800 5 3,900 3,600 6 CLASS 3,000 7 2,400 A 8 1,700 B 9 C $85,400


35.9 6.0 $ 60 18.7 5.0 350 16.4 4.0 30 6.3 9.0 80 5.6 6.0 30 4.6 10.0 4.2 % OF TOTAL 18.0 20 VALUE ITEMS 3.5 13.0 10 12.0 9, 8,2.8 2 71.0 320 17.0 1, 4,2.0 3 16.5 510 6, 5, 10, 7 12.5


6.0 90 11.0 40 A 15.0 130 24.0 60 30.0 B 100 40.0 % 58.0 180 OF TOTAL QUANTITY 71.0 170 C 83.0 50 15.0 100.0 25.0 60 60.0 120
Example 10.1