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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
MANAGING INVENTORIES
CHAPTER 12
DAVID A. COLLIER
AND
JAMES R. EVANS
OM
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Can you cite any experiences in which the lack of
appropriate inventory at a retail store has caused you
as the customer to be dissatisfied?

• Inventory is any asset held for future use or sale.
• The expenses associated with financing and
maintaining inventories are a substantial part of the
cost of doing business (i.e., cost of goods sold).
• Inventory Management involves planning,
coordinating, and controlling the acquisition, storage,
handling, movement, distribution, and possible sale of
raw materials, component parts and subassemblies,
supplies and tools, replacement parts, and other assets
that are needed to meet customer wants and needs.
Chapter 12 Managing Inventories

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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Basic Inventory Concepts
• Raw materials, component parts,
subassemblies, and supplies are inputs to
manufacturing and service-delivery processes.
• Work-in-process (WIP) inventory consists of
partially finished products in various stages of
completion that are awaiting further processing.
• Finished goods inventory is completed
products ready for distribution or sale to
customers.
Chapter 12 Managing Inventories
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Basic Inventory Concepts
• Cycle inventory (order or lot size
inventory) is inventory that results from
purchasing or producing in larger lots than are
needed for immediate consumption or sale.
• Safety stock inventory is an additional
amount of inventory that is kept over and
above the average amount required to meet
demand.
Chapter 12 Basic Inventory Concepts
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Inventory managers deal with two
fundamental decisions:
1. When to order items from a supplier
or when to initiate production runs if
the firm makes its own items
2. How much to order or produce each
time a supplier or production order is
placed
Chapter 12 Managing Inventories
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Inventory Management Decisions & Costs
Four categories of inventory costs:
• Ordering costs or setup costs are
incurred as a result of the work involved in
placing purchase orders with suppliers or
configuring tools, equipment, and machines
within a factory to produce an item.
• Inventory-holding costs or inventory-
carrying costs are the expenses associated
with carrying inventory.
Chapter 12 Managing Inventories
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Inventory Management Decisions & Costs
• Shortage costs or stockout costs are
the costs associated with a SKU being
unavailable when needed to meet
demand.
• Unit cost is the price paid for purchased
goods or the internal cost of producing
them.
Chapter 12 Managing Inventories
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning

Characteristics of Inventory Systems
• Number of items: each item is identified by
its stock-keeping unit (SKU).
• A stock-keeping unit (SKU) is a single item
or asset stored at a particular location.
• Maintaining data integrity on thousands of
SKUs is difficult but must be done. The quality
of inventory model decisions is related to the
quality of information used in the model(s).
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Nature of Demand
• Independent demand is demand for an SKU that is
unrelated to the demand for other SKUs and needs to be
forecast.
• Dependent demand is demand directly related to the
demand for other SKUs and can be calculated without
needing to be forecast.
• Deterministic demand is when uncertainty is not
included in its characteristics.
• Stochastic demand incorporates uncertainty by using
probability distributions.
• Static demand is stable demand.
• Dynamic demand varies over time.
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Characteristics of Inventory Systems
• Number of time periods in planning
horizon: short or long planning horizon such as
days, weeks, months, quarters, and years.
• Size of time periods: hours, days, weeks,
months, quarters.
• The lead time is the time between placement
of an order and its receipt.

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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Characteristics of Inventory Systems
• A stockout is the inability to satisfy demand for
an item. When a stockout happens, the item is
either back-ordered or a sale is lost.
• A backorder occurs when a customer is willing
to wait for an item.
• A lost sale occurs when the customer is
unwilling to wait and purchases the item
elsewhere.
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Inventory Management Infrastructure
ABC inventory (Pareto) analysis gives
managers useful information to identify the
best methods to control each category of
inventory (see Exhibits 12.2 to 12.4).
A vital few SKUs represent a high
percentage of the total dollar inventory
value.
Chapter 12 ABC Inventory Analysis
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
ABC Inventory (Pareto) Analysis
• ―A‖ items account for a large dollar value but
relatively small percentage of total items (e.g.,
10% to 30 % of items, yet 60% to 80% of total
dollar usage).
• ―C‖ items account for a small dollar value but a
large percentage of total items (e.g., 5% to 15% of
items, yet about 50% of total dollar usage). These
can be managed using automated computer
systems.
• ―B‖ items are between A and C.
Chapter 12 ABC Inventory Analysis
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
• In a fixed quantity system (FQS), the order
quantity or lot size is fixed; the same amount, Q,
is ordered every time.
• The process of triggering an order is based on the
inventory position.
• Inventory position (IP) is the on-hand quantity
(OH) plus any orders placed but which have not
arrived (scheduled receipts, or SR), minus any
backorders (BO).
IP = OH + SR – BO [12.1]
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Fixed Quantity System
• When inventory falls at or below a certain value, r,
called the reorder point, a new order is placed.
• Reorder point depends on the lead time and
nature of demand—oftentimes, the reorder point is
selected using the average demand during the
lead time (µ
L
).
r = µ
L
= (d) (L) [12.2]
• Where d is average demand per unit of time and L
is the lead time expressed in the same units of
time.
Chapter 12 Managing Inventories
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Exhibit 12.6 Fixed Quantity System (FQS) under Stable Demand
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
The Economic Order Quantity (EOQ) model is a classic
economic model developed in the early 1900s that minimizes
total cost, which is the sum of the inventory-holding cost and
the ordering cost.
Cost of storing one unit in inventory for the year (denoted
by C
h
), is given by C
h
= (I) (C ), where I is annual
inventory-holding charge, C is unit cost of the inventory
item, and Q is the number of units in inventory.
Chapter 12 Managing Inventories
[12.4]
annual inventory
holding cost
average
inventory
annual holding
cost per unit
=
( )


=
1

2

QC
h

( )
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Optimal Order Quantity: order quantity that minimizes
the total cost.

Q* is the quantity that minimizes the total cost and is
known as the economic order quantity, or EOQ.
Chapter 12 Managing Inventories




Q* =

2DC
o

C
h

[12.7]
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
• Only a single item (SKU) is considered.
• The entire order quantity (Q) arrives in
the inventory at one time. No physical
limits are placed on the size of the order
quantity, such as shipment capacity or
storage availability.
• Only two types of costs are relevant—
order/setup and inventory holding costs.
Chapter 12 Key Assumptions of the EOQ Model
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
• No stockouts are allowed.
• The demand for the item is deterministic
and continuous over time. This means
that units are withdrawn from inventory
at a constant rate proportional to time.
For example, an annual demand of 365
units implies a monthly demand of
365/12 and a daily demand of one unit.
• Lead time is constant.
Chapter 12 Key Assumptions of the EOQ Model (continued)
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Exhibit 12.9 Chart of Holding, Ordering, and Total Costs

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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Fixed Period Systems
An alternative to a fixed order quantity system is a
fixed period system (FPS)—sometimes called a
periodic review system—in which the inventory position
is checked only at fixed intervals of time, T, rather than
on a continuous basis.
Two principal decisions in a FPS:
1. The time interval between reviews (T), and
2. The replenishment level (M)
Chapter 12 Managing Inventories
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Fixed Period Systems (no uncertainty)
Economic time interval: T = Q*/D [12.11]
Optimal replenishment level:
M = d (T + L) [12.12]
Where d = average demand per time period
L = lead time in the same time units
M = demand during the lead time plus
review period
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OM, Ch. 12 Managing Inventories
©2009 South-Western, a part of Cengage Learning
Single-Period Inventory Model
• Applies to inventory situations in which one
order is placed for a good in anticipation of a
future selling season where demand is
uncertain.
• At the end of the period, the product has either
sold out or there is a surplus of unsold items to
sell for a salvage value.
• Sometimes called a newsvendor problem,
because newspaper sales are a typical example
of the single-period inventory problem.
Chapter 12 Special Models for Inventory Management