Inventory Management

for Independent Demand
Chapter 12
MGMT 326
Foundations
of Operations
Introduction
Strategy
Managing
Projects
Quality
Assurance
Facilities
& Work
Design
Products &
Processes
Product
Design
Process
Design
Managing
Quality
Statistical
Process
Control
Just-in-Time & Lean Systems
Facility
Layout
Capacity
and
Location
Linear
Program-
ming
Managing
Inventory
Planning
& Control
Chapter Outline
 Basic concepts
 Objectives of inventory management
 Dependent and independent demand
 ABC inventory analysis
 Inventory costs
 Item costs
 Holding costs
 Order or setup costs
 Shortage costs
Chapter Outline (2)
 Inventory policy
 Fixed order quantity method
 Economic order quantity – the optimal
fixed order quantity
 Reorder point
 Reorder point when demand is constant
 Reorder point when demand is variable
 Economic production quantity – the
optimal production quantity
Objectives of
Inventory Management
 Maintain good customer service
 Minimize inventory investment, consistent
with the required level of customer service

Types of Demand
Dependent Demand
 Demand for raw materials, component
parts, and subassemblies used to make a
finished product
 Both the amount of demand and the date
required depend on the production schedule
Types of Demand (2)
Independent Demand
 Any demand that is not used to meet a production
schedule is called independent demand
 Examples of independent demand: finished goods;
retail and distributor inventories; service inventories;
maintenance, repair, and operating (MRO)
inventories
 MRO includes fuels, repair parts, office supplies,
cleaning supplies
Dependent and Independent Demand:
Types of Inventory
Dependent demand:
used to meet a
production schedule
in manufacturing
Independent demand:
not used to meet a
production schedule
Work-in-process
(WIP)
Raw materials
Component parts
Manufacturer
Service Company
Finished goods
MRO
Retail or
distributor
inventories
Service
inventories
MRO
ABC Inventory Analysis
 For an inventory item, the annual usage in dollars is
(annual demand)x(cost per unit).
 Annual demand is also called annual usage in units.
 ABC inventory analysis divides inventory items into 3
categories:
 A items usually account for at least 60% of annual usage
and should be controlled most closely
 B items require a moderate level of control. A and B items
should account for at least 80% of annual usage.
 C items require less control than other items. These items
are those with the least usage that were not classified as
A and B items
© Wiley 2007
The AAU Corp. is considering doing an ABC analysis on
its entire inventory but has decided to test the
technique on a small sample of 15 of its SKU’s. The
annual usage and unit cost of each item is shown below
Steps in ABC Analysis
1. Compute Annual Usage in Dollars for each
item.
2. Compute Total Annual Usage.
3. Compute the percentage of Annual Usage
for each item.
4. Sort the list of items by the percentage of
Annual Usage in Dollars, from largest to
smallest.
Steps in ABC Analysis (2)
5. Calculate the Cumulative Percentage of
Annual Usage in Dollars for the first item,
first 2 items, first 3 items, etc. For the last
item, the cumulative % should be 100%.
6. Using Cumulative % as a guide, assign the
items to A, B, and C categories.

© Wiley 2007
© Wiley 2007
Relevant Inventory Costs
Measurable Cost of Inventory =
Item
Costs
Holding
Costs
Order Costs for
purchased items
OR
Setup Costs for
items made by
your company
Shortage costs:
Administrative
& transportation
costs related to
back orders
+ + +
Shortages and back orders result in lost sales and lost
goodwill. These costs are relevant but hard to measure.
Item Costs
 Item costs
 For purchased items, the item cost is the
purchase price, plus shipping
 For work in process, the item cost is the
cost of materials and labor used in the item
 For finished goods, the item cost is the
cost of goods sold.

Inventory Holding Costs
 Inventory holding costs include capital costs,
storage costs, and risk costs
 Capital costs:
 If inventory is financed with borrowed money, the
capital cost is the interest rate paid
 If inventory is financed from retained earnings,
the capital cost is the opportunity cost of not
putting the money into other investments
 Storage costs: the costs of space, people,
and equipment used in inventory storage

Inventory Holding Costs (2)
 Risk costs: cost of taxes and insurance
on inventory, damage, obsolescence,
and theft
 Inventory holding costs are usually
computed as a percentage of item costs

Ordering and Setup Costs
 For purchased items, ordering costs are
the fixed costs associated with placing
an order with a supplier
 For items made internally, setup costs
are used instead of order costs. The
setup cost is the cost of work that must
be done before production actually
begins.

Shortage Costs
 Administrative and transportation costs
related to back orders
 Lost good will and lost sales due to
product shortages – hard to measure

Inventory Management Policies
 An inventory management policy should
determine
 How much to order
 When to order
Fixed Order Quantity Method
 An inventory policy for independent
demand. Based on the following rules:
1. Order the same amount, Q, each time
 Q is called the order quantity
2. Place an order when the amount in
inventory gets down to the reorder point,
R
 Compute Q and R for each item.
Fixed Order Quantity Method (2)
Relevant Costs
 Assume
 Quantity discounts are not available
 Orders are placed early enough that
shortages do not occur
 Relevant costs
 Order costs
 Inventory holding costs
Fixed Order Quantity Method (3)
Annual Inventory Cost
Figure 12.2, page 430
Given:
D = annual demand = 10,400
Weekly demand = 200
L = lead time = 1 week
Q = order quantity = 600
Average inventory
= (Q/2) = 600/2 = 300

Fixed Order Quantity Method (4)
Notation
 Q = order quantity
 D = annual demand for the item
 S = cost of placing one order
 H = inventory holding cost per unit per year
(commonly called holding cost)
 L = lead time (time between order placement and
order receipt)
 R = reorder point
 TC = annual cost of placing orders
+ annual cost of holding inventory
Fixed Order Quantity Method (5)
Costs
 Annual cost of placing orders =

 Annual cost of holding inventory =

 Total annual cost =
Economic Order Quantity
 The economic order quantity (EOQ) is
the fixed order quantity (Q) that
minimizes the total annual costs of
placing orders and holding inventory
(TC).
Economic Order Quantity
Assumptions
 Demand (D) is known and constant
 H is known and constant
 Order costs (S) are constant
 The order quantity arrives in a single
shipment
 No quantity discounts are available
 All demand will be met (no shortages)

 We want to minimize TC
 D, S, and H are constant. TC is a function of Q.
1
2 2
D Q H
TC S H DS Q
Q Q
= + = +
Economic Order Quantity (3)
*
2DS
Q
H
=
*
*
2
D Q
TC S H
Q
= +
Let Q
*
be the economic order quantity. Then
For Q
*
, annual order cost = annual inventory cost
*
*
2
D Q
S H
Q
=
Simple Reorder Point
 Use this method when daily demand is
constant.
 R = reorder point
 d = daily demand (may have to compute
this)
 L = lead time (Caution: if lead time is given
in weeks, convert this to days. A week may
be 5, 6, or 7 days).
 R = dL
Reorder Point with Safety Stock
 Safety stock (SS) is extra inventory that is kept to
meet unexpected demand.
Reorder point without
safety stock
Reorder point
with safety stock
Reorder Point with Safety Stock (2)
How much safety stock (SS) ?

 Reorder point with safety stock:
 Service level is the probability of having enough
inventory to meet demand during lead time
 The probability of a stockout is (1 - service level)
 Demand during lead time is normally distributed
with mean and standard deviation o
dL

SS L d R + =
demand daily average = d
L d
Reorder Point with Safety Stock (2)
How much safety stock (SS) ?
 z is the number of standard deviations required to
meet the desired service level
 SS = zo
dL

 Reorder point with safety stock: R = + zo
dL


L d
Reorder Point with Safety Stock
Example
Given
 D = annual demand = 10,000
 N = number of business days per year = 250
 The company operates 5 days per week
 = average daily demand
 o
dL
= standard deviation of demand during lead time = 20
 L = lead time = 1 week
 Service level = 96%
Find: reorder point with safety stock: R = + zo
dL

L d
d
Computing Reorder Point
with Safety Stock
1. If average daily demand ( ) is not given,
compute it.
Note: = D/N and D =
= 10,000/250 = 40
2. If the lead time is given in weeks or
months, compute lead time in days.
L = 1 week = 1(5) = 5 days
Note: 1 week is the number of days per week that
the company operates. This may be 5, 6, or 7.

d
d
d d N
Computing Reorder Point
with Safety Stock (2)
3. Find the z value for the service level
(96%)
Probability of
a stockout =
1 – service
level = 4%
z
50% 46%
L d
Appendix B gives
this area.
Computing Reorder Point
with Safety Stock (3)
3. Find the z value for the service level (96%) (cont.)
(a) Write the service level as a decimal
96% = 0.9600
(b) Subtract 0.5000 from the service level
0.9600 – 0.5000 = 0.4600
(c) Use the table in Appendix B, page 652, to find
the area that is closest to 0.4600
The closest area in the table is 0.4599, which
occurs when z = 1.75
Use z = 1.75
Computing Reorder Point
with Safety Stock (4)
4. Compute R
R = L+ zo
dL

= 40(5) + 1.75(20) = 200 + 35
= 235
Note: If the computation gives a fractional
value, round up to nearest integer.
Example: Computed R = 210.2  R = 211

d
Economic Production Quantity
 Key question: How many units of a part or
product should be made at one time?
 The economic production quantity (EPQ) is
the production quantity (lot size) that
minimizes the total annual cost of setups
and holding inventory.


Economic Production Quantity (2)
Notation
 Q = Amount to make (lot size)
 D = annual demand for the item
 d = daily demand for the item
 p = daily production rate
 S = cost of one setup
 H = inventory holding cost per unit per year
(commonly called holding cost)
 TC = annual cost of setups
+ annual cost of holding inventory
 The EPQ is the quantity that minimizes TC
Economic Production Quantity (3)
Assumption: Daily demand < daily production.
When the item is being made, some is sold or used to
make a product. The remainder goes into inventory.
When production stops, the inventory is used until
there is no inventory left. Then production resumes.
Ending inventory
= beginning
inventory
+ production
- sales or usage
Economic Production Quantity (4)
 Length of production run = Q/p
 During production, d units are sold or used each day. (p – d)
units go into inventory.
|
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.
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÷ = ÷ =
p
d
Q d p 1 ) (
p
Q
I
MAX
Maximum inventory:
Total cost: |
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+ |
.
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= H
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I
S
Q
D
TC
MAX
EPQ
Economic production
quantity (EPQ):
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.
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\
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÷
=
p
d
1 H
2DS
EPQ
EOQ vs. EPQ
 When to use economic order quantity (EOQ):
 Demand is independent
 Compute how much to order (order quantity)
 When to use economic production quantity
(EPQ):
 Parts or products will be produced: demand is
dependent
 Compute how much to make at one time
(production lot size)