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Chapter 7

:
Inventory Decision Making

Learning Objectives 

After reading this chapter, you should be able to do the following:
Understand the fundamental differences among approaches to managing inventory. Appreciate the rationale and logic behind the Economic Order Quantity (EOQ) approach to inventory decision making, and be able to solve some problems of a relatively straightforward nature. Understand alternative approaches to managing inventory --- JIT, MRP, and DRP.
Management of Business Logistics, 7th Ed. 2

Chapter 7

Learning Objectives

Realize how variability in demand and order cycle length affects inventory decision making. Know how inventory will vary as the number of stocking points decreases or increases. Recognize the contemporary interest in and relevance of time-based approaches to inventory management.
Management of Business Logistics, 7th Ed. 3

Chapter 7

Learning Objectives

Make needed adjustments to the basic EOQ approach to respond to several special types of applications.

Chapter 7

Management of Business Logistics, 7th Ed.

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Management of Business Logistics. 5 Chapter 7 . investment in inventory also increased. Traditionally.Fundamental Approaches to Managing Inventory     Basic issues are simple…how much to order and when to order. conflicts were usually present…as customer service levels increased. Recent emphasis is on increasing customer service and reducing inventory investment. Additional issues are…where to store inventory and what items to order. 7th Ed.

6 Chapter 7 . the firm can achieve higher levels of customer service without actually increasing inventory:  More responsive order processing  Ability to strategically manage logistics data  More capable and reliable transportation  Improvements in the location of inventory Management of Business Logistics. that is. 7th Ed.Fundamental Approaches to Managing Inventory  Four factors might permit this apparent paradox.

Relationship between Inventory and Customer Service Level Figure 7-1 Chapter 7 Management of Business Logistics. 7th Ed. 7 .

7th Ed.  For many manufacturing processes.  Independent demand is unrelated to the demand for another product. demand is dependent. 8 Chapter 7 .  For many end-use items.Key Differences among Approaches to Managing Inventory  Dependent versus Independent Demand  Dependent demand is directly related to the demand for another product. demand is independent. Management of Business Logistics.

Alternatively. JIT.Key Differences among Approaches to Managing Inventory   Of the inventory management processes in this chapter. Chapter 7 Management of Business Logistics. 9 . 7th Ed. MRP and MRPII are generally associated with items having dependent demand. DRP and the EOQ models are generally associated with items exhibiting independent demand.

relying on customer demand to “pull” product through a logistics system. MacDonald’s is an example. 7th Ed. Management of Business Logistics.Key Differences among Approaches to Managing Inventory  Pull versus Push  Pull approach is a “reactive” system. and uses inventory replenishment to anticipate future demand. 10 Chapter 7 .  Push approach is a “proactive” system. Catering businesses are examples of push systems.

7th Ed. and apply more to independent demand situations. 11 Chapter 7 . Management of Business Logistics. and apply more to dependent demand situations.Key Differences among Approaches to Managing Inventory  Pull versus Push  Pull systems respond quickly to sudden or abrupt changes in demand. involve one-way communications.  Push systems use an orderly and disciplined master plan for inventory management.

On the Line: American Cancer Society      ACS constructed a world class automated order fulfillment center in Atlanta. Order cycle time was reduced to five business days. Chapter 7 Management of Business Logistics. The new center saved $8 million in the first year alone. 7th Ed. Centralized storage reduced waste and obsolescence of educational materials. 12 . Centralized shipment reduced freight rates.

000 units.  Just as the 4.000 units arrives and a new cycle begins.Fixed Order Quantity Approach (Condition of Certainty): Inventory Cycles  In this example.000th unit is sold. each cycle starts with 4. 7th Ed. the next order of 4.000 units:  Demand is constant at the rate of 800 units per day.  When inventory falls below 1. an order is placed for an additional 4. 13 . Chapter 7 Management of Business Logistics.500 units.  After 5 days the inventory is completely used.

7th Ed. 14 .Fixed Order Quantity Model under the Condition of Certainty Figure 7-2 Chapter 7 Management of Business Logistics.

independent of order quantity or time. Management of Business Logistics. Constant cost. 15 . No limits on capital availability. No inventory in transit costs. 7th Ed. A constant and known replenishment time. known and infinite rate of demand on one item of inventory.Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model  Simple EOQ Model Assumptions       Chapter 7 Continuous. constant. Satisfaction of all demand.

16 Chapter 7 .Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model  Simple EOQ Model Variables         R = annual rate of demand Q = quantity ordered (lot size in units) A = order or setup cost V = value or cost of one unit in dollars W = carrying cost per dollar value in percent S = VW = annual storage cost in $/unit per year t = time in days TAC = total annual costs in dollars per year Management of Business Logistics. 7th Ed.

17 . 7th Ed.Figure 7-3 Inventory Carrying Cost Chapter 7 Management of Business Logistics.

7th Ed. 18 .Figure 7-4 Order or Setup Cost Chapter 7 Management of Business Logistics.

19 .Figure 7-5 Inventory Costs Chapter 7 Management of Business Logistics. 7th Ed.

7th Ed.Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model TAC = QVW + AR 2 Q or TAC = QS + AR 2 Q First term is the average carrying cost Second term is order or setup costs per year Chapter 7 Management of Business Logistics. 20 .

7th Ed. 21 .Figure 7-6 Sawtooth Model Chapter 7 Management of Business Logistics.

. 7th Ed.Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model TAC = QVW + AR 2 Q or TAC = QS + AR 2 Q Solving for Q gives the following expressions: Q= √ 2 RA or Q = VW or S √ 2RA VW or Q = √ 2RA S 22 Chapter 7 Management of Business Logistics.

7th Ed. A = $200 per order Q= √ 2 RA VW or S or Q= √ 2RA VW or Q= √ 2RA S √ 2*3600*$200 √ 2*3600*$200 $100*25% Q = 240 units Chapter 7 $25 Q = 240 units 23 Management of Business Logistics. . S (or VW)= $25. W = 25%.Fixed Order Quantity Approach (Condition of Certainty): Simple EOQ Model Where R = 3600 units V = $100.

24 . 7th Ed.Figure 7-7 Sawtooth Models Chapter 7 Management of Business Logistics.

25 .Table 7-1 Total Costs for Various EOQ Amounts Chapter 7 Management of Business Logistics. 7th Ed.

26 . 7th Ed.Figure 7-8 Graphical Representation of the EOQ Example Chapter 7 Management of Business Logistics.

EOQ doesn’t do well when demand is not constant. Newer techniques will ultimately take the place of EOQ. EOQ doesn’t handle multiple locations as well as a single location. Minor adjustments can be made to the basic model.Fixed Order Quantity Approach (Condition of Certainty)  Summary and Evaluation of the Fixed Order Quantity Approach:      EOQ is a popular inventory model. 27 . 7th Ed. Chapter 7 Management of Business Logistics.

28 Chapter 7 . Examine out Figure 7-9.  Demand is often affected by exogenous factors---weather. etc. Management of Business Logistics.  Note the variability in lead times and demand. 7th Ed.  Lead times often vary regardless of carrier intentions.Fixed Order Quantity Approach (Condition of Uncertainty)   Uncertainty is a more normal condition. forgetfulness.

Figure 7-9 Fixed Order Quantity Model under Conditions of Uncertainty Chapter 7 Management of Business Logistics. 29 . 7th Ed.

7th Ed. Chapter 7 Management of Business Logistics. the reorder point becomes the average daily demand during lead time plus the safety stock.  Examine Figure 7-9 again. 30 .Fixed Order Quantity Approach (Condition of Uncertainty)  Reorder Point – A Special Note  With uncertainty of demand.

no inventory in transit costs. one item and no interaction among the inventory items. 7th Ed. Management of Business Logistics. constant cost/price. no limit on capital availability.Fixed Order Quantity Approach (Condition of Uncertainty)  Uncertainty of Demand Affects Simple EOQ Model Assumptions:       a constant and known replenishment time. independent of order quantity or time. infinite planning horizon. 31 Chapter 7 .

06 0. 32 . 7th Ed.24 0.06 0.01 Management of Business Logistics.01 0.Table 7-2 Probability Distribution of Demand during Lead Time Demand 100 units 110 120 130 140 Probability 0.24 150 160 Chapter 7 0.38 0.

7th Ed.Table 7-3 Possible Units of Inventory Short or in Excess during Lead Time with Various Reorder Points Actual Demand 100 100 0 110 -10 120 -20 130 -30 140 -40 150 -50 160 -60 Chapter 7 110 10 0 -10 -20 -30 -40 -50 Reorder Points 120 130 140 20 30 40 10 20 30 0 10 20 -10 0 10 -20 -10 0 -30 -20 -10 -40 -30 -20 150 50 160 60 40 30 20 10 0 -10 50 40 30 20 10 0 33 Management of Business Logistics. .

0 -7.06 120 130 0.2 -2.01 0.0 100 110 0.4 160 0.4 -4.8 150 0.6 -0.5 -0.2 7.3 1.5 2.4 -2.8 3.24 0.3 -0.4 -0. 7 Ed.6 0 -3.8 2.6 3. -0.6 -3.2 th 0 -0.6 9.8 7.0 -0.2 Management of Business Logistics.38 -4.Table 7-3 Possible Units of Inventory Short or in Excess during Lead Time with Various Reorder Points Actual Demand Probability Reorder Points 100 0.24 0.4 0 4.8 -2.6 130 0.4 0 4.6 110 0.8 0.8 -11.6 2.4 1.4 140 150 0.1 0 120 0.06 -9.01 Chapter 7 -0.6 11.6 160 0.4 -7.2 0.8 -1.2 140 0.1 0 34 .4 -1.

Table 7-4 Calculation of Lowest-Cost Reorder Point Dmnd (e) (VW) (g) G=gw GR/Q TAC 100 0.50 3.8 $8 $120 0.8 $20 10.50 20.9 $97.1 $2. 35 .9 $39 $585 140 10.8 150 20.1 $1 $15 0.50 $750 Chapter 7 Management of Business Logistics.1 160 30.50 $750 0. 7th Ed.8 $108 130 3.0 $270 $502.0 $0 $0 $4500 $3015 $1620 $4500 $3018 $1640 $682.0 0 30 $300 110 0.1 $201 120 0.50 $390 $517.

A = $200 per order.Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model Where R = 3600 units V = $100. W = 25%. 7th Ed. G = 8 Q= √ 2 R(A + G) VW √ 2 * 3600 * ($200 + 8) $100 * 25% Q = approximately 242 units Chapter 7 Management of Business Logistics. 36 .

A = $200 per order.Fixed Order Quantity Approach (Condition of Certainty): Expanded EOQ Model Where R = 3600 units V = $100. G = 8. W = 25%.8 TAC = QVW + AR + eVW + GR 2 Q Q TAC = (242*$100*25%) + (200*3600) + (10. 7th Ed. e = 10.8*$100*25%) + (8*3600) 2 242 242 TAC = TAC = $3025 + $2975 + $270 + $119 $6389 (New value for TAC when uncertainty introduced) Management of Business Logistics. Q = 242. 37 Chapter 7 .

 The greater the dispersion of the probability distribution. the greater the cost disparity.  Inventory carrying costs of safety stock Results may or may not be significant. 38 Chapter 7 .  In text example.5%. Management of Business Logistics. TAC rose $389 or approximately 6. 7th Ed.Fixed Order Quantity Approach (Condition of Uncertainty): Conclusions   Following costs will rise to cover the uncertainty:  Stockout costs.

Figure 7-10 Area under the Normal Curve Chapter 7 Management of Business Logistics. 39 . 7th Ed.

40 . 7th Ed.Table 7-5 Reorder Point Alternatives and Stockout Possibilities Chapter 7 Management of Business Logistics.

41 Chapter 7 .Fixed Order Interval Approach      A second basic approach Involves ordering at fixed intervals and varying Q depending upon the remaining stock at the time the order is placed. Management of Business Logistics. 7th Ed. Less monitoring than the basic model Examine Figure 7-11. Amount ordered over each five weeks in the example varies each week.

7th Ed. 42 .Figure 7-11 Fixed Order Interval Model (with Safety Stock) Chapter 7 Management of Business Logistics.

then safety stock model should be used Chapter 7 Management of Business Logistics. 7th Ed. If demand or lead time varies. basic EOQ or fixed order interval model best. 43 .Summary and Evaluation of EOQ Approaches to Inventory Management  Four basic inventory models:     Fixed quantity/fixed interval Fixed quantity/irregular interval Irregular quantity/fixed interval Irregular quantity/irregular interval   Where demand and lead time are known.

Summary and Evaluation of EOQ Approaches to Inventory Management   Relationship to ABC analysis  “A” items suited to a fixed quantity/irregular interval approach. 7th Ed. Management of Business Logistics. Importance of trade-offs  Familiarity with EOQ approaches assists the manager in trade-offs inherent in inventory management. 44 Chapter 7 .  “C” items best suited to a irregular quantity/fixed interval approach.

MRPII. DRP. MRP.Summary and Evaluation of EOQ Approaches to Inventory Management   New concepts  JIT. the SKUs at each. and their strategic positioning. and ECR also take into account a knowledge and understanding of applicable logistics trade-offs. 7th Ed. Management of Business Logistics. 45 Chapter 7 . QR. Number of DCs  The issue of inventory at multiple locations in a logistics network raises some interesting questions concerning the number of DCs.

Additional Approaches to Inventory Management  Three approaches to inventory management that have special relevance to supply chain management:  JIT (Just in Time)  MRP (Materials Requirements into Planning)  DRP (Distribution Resource Planning) Chapter 7 Management of Business Logistics. 7th Ed. 46 .

Time-Based Approaches to Replenishment Logistics: JIT

Definition and Components of JIT Systems - designed to manage lead times and eliminate waste.  Kanban - refers to the informative signboards on carts in a Toyota system of delivering parts to the production line. Each signboard details the exact quantities and necessary time of replenishment.  JIT operations - Kanban cards and light warning system communicate possible production interruptions.  Fundamental concepts - JIT can substantially reduce inventory and related costs.
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Chapter 7

Time-Based Approaches to Replenishment Logistics: JIT

Definition and Components of JIT Systems designed to manage lead times and eliminate waste.  Goal is zero inventory, and zero defects.  Similarity to the two-bin system - one bin fills demand for part, the other is used when the first is empty.  Reduces lead times through requiring small and frequent replenishment.
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Chapter 7

Time-Based Approaches to Replenishment Logistics: JIT

JIT is a widely used and effective strategy for managing the movement of parts, materials, semi-finished products from points of supply to production facilities. Product should arrive exactly when a firm needs it, with no tolerance for early or late deliveries. JIT systems place a high priority on short, consistent lead times.
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Chapter 7

JIT versus EOQ Approaches to Inventory Management

Six major differences:  First, JIT attempts to eliminate excess inventories for both buyer and seller.  Second, JIT systems involve short production runs with frequent changeovers.  Third, JIT minimizes waiting lines by delivering goods when and where needed.
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Chapter 7

51 Chapter 7 .JIT versus EOQ Approaches to Inventory Management    Fourth. JIT uses short. JIT requires a strong. Fifth. Management of Business Logistics. emphasizing quality and win-win outcomes for both partners. 7th Ed. consistent lead times to satisfy inventory needs in a timely manner. JIT relies on high-quality incoming products and on exceptionally high-quality inbound logistics operations. mutual commitment between buyer and seller. Sixth.

Table 7-6 EOQ versus JIT Attitudes and Behaviors Chapter 7 Management of Business Logistics. 7th Ed. 52 .

53 . more frequent production runs  Minimize waiting lines by delivering materials when and where needed  Short. 7th Ed. consistent lead times through proximate location  Quality stressed throughout supply chain  Win-win relationships necessary to a healthy supply chain Chapter 7 Management of Business Logistics.Time-Based Approaches to Replenishment Logistics: JIT  JIT versus Traditional Inventory Management  Reduces excess inventories  Shorter.

Ryder handles all inbound logistics for Saturn. GM increased production by 100%. 54 Chapter 7 .Time-Based Approaches to Replenishment Logistics: JIT  Examples of JIT Successes:     Apple Computer’s increase in IT from 10 weeks to 2 weeks resulted in 18-month $20 million payback on plant. Management of Business Logistics. Norfolk Southern mini-train hauls direct from one GM plant to another without switching delays. but inventories increased by only 6%. 7th Ed.

7th Ed.Figure 7-12 The Orderly Pickup Concept Chapter 7 Management of Business Logistics. 55 .

Management of Business Logistics. 56 Chapter 7 . and records designed to translate a master production schedule into time-phased net inventory requirements for each component item needed to implement this schedule. demand. MRPs re-plan net requirements based on changes in schedule.Time-Based Approaches to Replenishment Logistics: MRP   A Materials Requirements Planning (MRP) system consists of a set of logically related procedures. 7th Ed. decision rules. etc.

components. Management of Business Logistics. 7th Ed.  Plan manufacturing activities.  Maintain lowest possible inventory level. delivery schedules. 57 Chapter 7 .Time-Based Approaches to Replenishment Logistics: MRP  Goals of an MRP:  Ensure the availability of materials. and purchasing activities. and products for planned production.

7th Ed. 58 .Time-Based Approaches to Replenishment Logistics: MRP  Key elements of an MRP:  Master production schedule  Bill of materials file  Inventory status file  MRP program  Outputs and reports Chapter 7 Management of Business Logistics.

7th Ed.Figure 7-13 An MRP System Customer Orders Master Production Schedule Bill of Material File Demand Forecasts MRP Program Output and Reports Inventory Status File Chapter 7 Management of Business Logistics. 59 .

Figure 7-14 Relationship of Parts to Finished Product: MRP Egg Timer Example 1 Egg Timer 2 Ends 1 Bulb 1 Gram of Sand 3 Supports Chapter 7 Management of Business Logistics. 60 . 7th Ed.

.Table 7-7 Inventory Status File: MRP Egg Timer Example Product Egg Timers Ends Supports Bulbs Sand Chapter 7 Gross Req. 1 2 1 1 1 Lead Time 1 5 1 1 4 61 Management of Business Logistics. 7th Ed. Inventory 1 2 3 1 1 0 0 2 0 0 Net Req.

7th Ed. 62 .Master Schedule: MRP Egg Timer Example Figure 7-15 Chapter 7 Management of Business Logistics.

 Minimize or eliminate inventories.  Identification of process problems. 7th Ed. Management of Business Logistics.  Coordination of materials ordering. 63 Chapter 7 .Time-Based Approaches to Replenishment Logistics: MRP  Principal advantages of MRP:  Maintain reasonable safety stock.  Production schedules based on actual demand.  Most suitable for batch or intermittent production schedules.

 Frequently become quite complex.  Difficult to make changes once operating.  Not usually as sensitive to short-term fluctuations in demand. Management of Business Logistics. 64 Chapter 7 . 7th Ed.  May not work exactly as intended.  Ordering and transportation costs may rise.Time-Based Approaches to Replenishment Logistics: MRP  Principal shortcomings of MRP:  Computer intensive.

DRP starts with customer demand and works backwards toward establishing a realistic system-wide plan for ordering the necessary finished products. 7th Ed. 65 .Time-Based Approaches to Replenishment Logistics: Distribution Resource Planning    MRP sets a master production schedule and “explodes” into gross and net requirements. Then DRP works to develop a time-phased plan for distributing product from plants and warehouses to the consumer. Chapter 7 Management of Business Logistics.

7th Ed.  Current inventory level for each SKU. 66 .  Target safety stock.  Recommended replenishment quantity.Time-Based Approaches to Replenishment Logistics: Distribution Resource Planning  DRP develops a projection for each SKU and requires17:  Forecast of demand for each SKU.  Lead time for replenishment. Chapter 7 Management of Business Logistics.

Q=3800. SS=1956. 7th Ed. .Table 7-8 DRP Table for Chicken Noodle Soup Month Week CN Soup 1 974 Columbus Distribution Center–Distribution Resource Planning January 2 974 February 4 974 March 8 1002 3 974 5 989 6 1002 7 1002 9 1061 Current BOH=4314. LT=1 Forecast Schedule 0 0 3800 0 0 0 Receipt BOH-End 3340 2366 5192 4218 3229 2227 3800 5025 0 0 4023 0 0 2962 3800 67 Planned Order Chapter 7 0 3800 0 0 0 3800 Management of Business Logistics.

68 .Figure 7-16 Combining DRP Tables Chapter 7 Management of Business Logistics. 7th Ed.

As locations increase. The square root law (SRL) states that total safety stock can be approximated by multiplying the total inventory by the square root of the number of future facilities divided by the current number of facilities. Management of Business Logistics. 7th Ed. but not in the same ratio as the growth in facilities.Inventory at Multiple Locations – The Square Root Law (SQL)    Used to reduce inventory at multiple locations. 69 Chapter 7 . inventory also increases.

7th Ed. 70 .Inventory at Multiple Locations – The Square Root Law   X2= (X1) * √(n2/n1) Where:  n1 = number of existing facilities  n2 = number of future facilities  X1 = total inventory in existing facilities  X2 = total inventory in future facilities Chapter 7 Management of Business Logistics.

000) * √(2/8) X2 = 20.000 units Chapter 7 Management of Business Logistics.000 units Eight facilities shrinking to two Using the square root law:   X2 = (40. 71 .Square Root Law Example    Current distribution 40. 7th Ed.

770 8.2361 3.4142 1.729 7.0000 17.7958 5.Table 7-9 Example Impacts of Square Root Law on Logistics Inventories Warehouses 1 2 3 4 5 10 15 √n 1. 7th Ed.374 18.494 6.7321 2.687 12.0000 2.0000 1.4721 4.8730 Total Av Inv 3.047 % Change --141% 173% 200% 224% 316% 387% 20 23 25 Chapter 7 4. .1623 3.632 19.425 447% 480% 500% 72 Management of Business Logistics.885 5.285 15.

7th Ed.Four Directions for Replenishment Logistics Figure 7-17 Chapter 7 Management of Business Logistics. 73 .

 Real-time information available by SKU. compressed time horizons.Time-Based Approaches to Replenishment Logistics: Quick Response (QR)  Structure of QR  Shorter.  Seamless. cross-docking and effective store receipt and distribution systems. integrated logistics networks with rapid transportation. 74 . 7th Ed. Chapter 7 Management of Business Logistics.

Time-Based Approaches to Replenishment Logistics: Quick Response (QR)  Structure of QR  Partnership relationships present among supply chain members.  Redesign of manufacturing processes to reduce lot sizes. 75 . Chapter 7 Management of Business Logistics. 7th Ed. changeover times and enhanced flexibility.  Commitment to TQM.

7th Ed.Figure 7-18 Basic Elements of Quick Response (QR) Chapter 7 Management of Business Logistics. 76 .

Time-Based Approaches to Replenishment Logistics: Efficient Consumer Response (ECR)  Structure of ECR   Grocery industry estimates U. 77 Chapter 7 . consumer-driven system in which distributors and suppliers work together as business allies to maximize consumer satisfaction and minimize cost.S. 7th Ed. savings at approximately $30 billion. Accurate information and high-quality products flow through a paperless system between manufacturing and check-out counter with minimum degradation or interruption…” Management of Business Logistics. “Ultimate goal is a responsive.

78 .Figure 7-19 Efficient Consumer Response: Broad Operating Capabilities Tailored to Each Unique Partner Chapter 7 Management of Business Logistics. 7th Ed.

Chapter 7: Summary and Review Questions Students should review their knowledge of the chapter by checking out the Summary and Study Questions for Chapter 7. This is the last slide for Chapter 7 .

7th Ed. 80 .Figure A7-1 Sawtooth Model Modified for Inventory in Transit Chapter 7 Management of Business Logistics.

81 .Figure A7-2 EOQ Costs Considering Volume Transportation Rate Chapter 7 Management of Business Logistics. 7th Ed.

Annual Cost.Table 7A-1 Annual Savings. 7th Ed. 82 . and Net Savings by Various Quantities Using Incentive Rates Chapter 7 Management of Business Logistics.

7th Ed.Figure A7-3 Net Savings Function for Incentive Rate Chapter 7 Management of Business Logistics. 83 .

End of Chapter 7 and 7A Slides Inventory Decision Making .