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Chapter

Inventory Control

17-2

OBJECTIVES

Inventory System Defined


Inventory Costs
Independent vs. Dependent Demand
Single-Period Inventory Model
Multi-Period Inventory Models: Basic
Fixed-Order Quantity Models
Multi-Period Inventory Models: Basic
Fixed-Time Period Model
Miscellaneous Systems and Issues

17-3

Inventory System

Inventory is the stock of any item or


resource used in an organization and
can include: raw materials, finished
products, component parts, supplies,
and work-in-process
An inventory system is the set of
policies and controls that monitor levels
of inventory and determines what levels
should be maintained, when stock
should be replenished, and how large
orders should be

17-4

Purposes of Inventory

1. To maintain independence of operations


2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size

17-5

Inventory Costs

Holding (or carrying) costs


Costs for storage, handling,
insurance, etc
Setup (or production change) costs
Costs for arranging specific
equipment setups, etc
Ordering costs
Costs of someone placing an order,
etc
Shortage costs
Costs of canceling an order, etc

17-6

Independent vs. Dependent Demand

Independent Demand (Demand for the final endproduct or demand not related to other items)

Finished
product

E(1
)

Component parts

Dependent
Demand
(Derived demand
items for
component
parts,
subassemblies,
raw materials,
etc)

17-7

Inventory Systems

Single-Period Inventory Model


One time purchasing decision (Example:
vendor selling t-shirts at a football game)
Seeks to balance the costs of inventory
overstock and under stock
Multi-Period Inventory Models
Fixed-Order Quantity Models
Event triggered (Example: running out of
stock)
Fixed-Time Period Models
Time triggered (Example: Monthly sales
call by sales representative)

17-8

Single-Period Inventory Model

C
Cuu
P
P
C
Coo C
Cuu

This
Thismodel
modelstates
statesthat
thatwe
we
should
shouldcontinue
continueto
toincrease
increase
the
thesize
sizeof
ofthe
theinventory
inventoryso
so
long
longas
asthe
theprobability
probabilityof
ofnot
not
selling
sellingthe
thelast
lastunit
unitadded
addedisis
equal
equalto
toor
orless
lessthan
thanthe
theratio
ratio
of:
of:Cu/Co+Cu
Cu/Co+Cu

Where :
Co Cost per unit of demand over estimated
Cu Cost per unit of demand under estimated
P Probability that the unit will not be sold

17-9

Single Period Model Example

Our college basketball team is playing in a


tournament game this weekend. Based on our
past experience we sell on average 2,400
shirts with a standard deviation of 350. We
make $10 on every shirt we sell at the game,
but lose $5 on every shirt not sold. How many
shirts should we make for the game?
Cu = $10 and Co = $5; P $10 / ($10 + $5) = .667
Z.667 = .432 (use NORMSDIST(.667) or Appendix E)
therefore we need 2,400 + .432(350) = 2,551 shirts

17-10

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 1)

Demand for the product is constant


and uniform throughout the period
Lead time (time from ordering to
receipt) is constant
Price per unit of product is constant

17-11

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 2)

Inventory holding cost is based on


average inventory
Ordering or setup costs are constant
All demands for the product will be
satisfied (No back orders are allowed)

17-12

Basic Fixed-Order Quantity Model and Reorder Point Behavior

4. The cycle then repeats.

1. You receive an order quantity Q.


Number
of units
on hand

2. Your start using


them up over time.

R = Reorder point
Q = Economic order quantity
L = Lead time

Time

L
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.

17-13

Cost Minimization Goal

By
Byadding
addingthe
theitem,
item,holding,
holding,and
andordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichin
in
turn
inventory order point that
turnis
isused
usedto
tofind
findthe
theQ
Qopt
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs
Total Cost
C
O
S
T

Holding
Costs
Annual Cost of
Items (DC)
Ordering Costs
QOPT
Order Quantity (Q)

17-14

Basic Fixed-Order Quantity (EOQ) Model Formula

Total
Annual =
Cost

Annual
Annual
Annual
Purchase + Ordering + Holding
Cost
Cost
Cost

D
Q
D
Q
TC
TC == DC
DC ++ SS++ H
H
Q
22
Q

TC=Total
TC=Totalannual
annual
cost
cost
DD=Demand
=Demand
CC=Cost
=Costper
perunit
unit
QQ=Order
=Orderquantity
quantity
SS=Cost
=Costof
ofplacing
placing
an
anorder
orderor
orsetup
setup
cost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
H=Annual
H=Annualholding
holding
and
andstorage
storagecost
cost
per
perunit
unitof
ofinventory
inventory

17-15

Deriving the EOQ

Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative of
of
the
the total
total cost
cost function
function with
with respect
respect to
to Q,
Q, and
and
set
set the
the derivative
derivative (slope)
(slope) equal
equal to
to zero,
zero,
solving
solving for
for the
the optimized
optimized (cost
(cost minimized)
minimized)
value
value of
of Q
Qopt
opt
QQOPT
=
OPT =

2DS
2DS =
=
HH

We
Wealso
alsoneed
needaa
reorder
reorderpoint
pointto
to
tell
tellus
uswhen
whento
to
place
placean
anorder
order

2(Annual
2(AnnualDemand)(Order
Demand)(Orderor
orSetup
SetupCost)
Cost)
Annual
AnnualHolding
HoldingCost
Cost
__

Reorder
Reorder point,
point, R
R == ddLL

d = average daily demand (constant)


L = Lead time (constant)

17-16

EOQ Example (1) Problem Data

Given
Giventhe
theinformation
informationbelow,
below,what
what are
arethe
theEOQ
EOQ and
and
reorder
reorderpoint?
point?

Annual Demand = 1,000 units


Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15

17-17

EOQ Example (1) Solution

Q
=
QOPT
OPT =

2DS
2DS =
=
H
H

2(1,000
2(1,000)(10)
)(10) = 89.443 units or 90 units
= 89.443 units or 90 units
2.50
2.50

1,000
units
//year
1,000
units
year = 2.74 units / day
dd ==
= 2.74 units / day
365
days
/
year
365 days / year
__

Reorder
Reorderpoint,
point, RR==dd LL==2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18or
or 20
20units
units

In
Insummary,
summary,you
youplace
placean
anoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have20
20units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90
units.
units.

17-18

EOQ Example (2) Problem Data

Determine
Determine the
the economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following
following

Annual Demand = 10,000 units


Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15

17-19

EOQ Example (2) Solution

2DS
2(10,000
)(10)
2DS
2(10,000
)(10) = 365.148 units, or 366 units
Q
=
=
QOPT
=
= 365.148 units, or 366 units
OPT =
H
1.50
H
1.50

10,000
units
//year
10,000
units
year = 27.397 units / day
dd==
= 27.397 units / day
365
days
/
year
365 days / year
__

R
R ==dd LL==27.397
27.397units
units//day
day(10
(10days)
days)==273.97
273.97or
or 274
274units
units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin
in the
thecourse
courseof
of
using
usingthe
theinventory
inventoryyou
you are
areleft
left with
with only
only274
274units,
units,
place
placethe
thenext
next order
orderof
of366
366units.
units.

17-20

Fixed-Time Period Model with Safety Stock Formula

qq==Average
Averagedemand
demand++Safety
Safetystock
stockInventory
Inventorycurrently
currentlyon
onhand
hand
qq==dd(T
(T++L)
L)++ZZTT++LL--II
Where
Where::
qq==quantitiy
quantitiyto
tobe
beordered
ordered
TT==the
thenumber
numberof
ofdays
daysbetween
betweenreviews
reviews
LL==lead
leadtime
timein
indays
days
dd==forecast
forecast average
averagedaily
dailydemand
demand
zz==the
thenumber
numberof
ofstandard
standarddeviations
deviationsfor
foraaspecified
specifiedservice
serviceprobabilit
probabilityy
T + L ==standard
standarddeviation
deviationof
ofdemand
demandover
overthe
thereview
reviewand
andlead
leadtime
time
T+L

II==current
currentinventory
inventorylevel
level(includes
(includesitems
itemson
onorder)
order)

17-21

Multi-Period Models: Fixed-Time Period Model:


Determining the Value of sT+L

T+T+LL ==

T+
L
T+L
i i 11

22

ddi
i

Since
Sinceeach
eachday
dayisisindependent
independentand
anddd isisconstant,
constant,
22
T+T+LL == (T
+
L)

(T + L)dd

The standard deviation of a sequence


of random events equals the square
root of the sum of the variances

17-22

Example of the Fixed-Time Period Model

Given
Given the
the information
information below,
below, how
how many
many units
units
should
should be
be ordered?
ordered?
Average daily demand for a product is
20 units. The review period is 30 days,
and lead time is 10 days. Management
has set a policy of satisfying 96 percent
of demand from items in stock. At the
beginning of the review period there are
200 units in inventory. The daily
demand standard deviation is 4 units.

17-23

Example of the Fixed-Time Period Model: Solution (Part 1)

T+T+LL ==

(T
(T++ L)
L) ==
22
dd

30
30++10
10 44 == 25.298
25.298
22

The
The value
value for
forz
z isis found
found by
byusing
using the
theExcel
Excel
NORMSINV
NORMSINVfunction,
function, or
oras
as we
we will
will do
do here,
here, using
using
Appendix
Appendix D.
D. By
Byadding
adding 0.5
0.5 to
to all
all the
the values
values in
in
Appendix
Appendix D
D and
and finding
finding the
the value
value in
in the
the table
table that
that
comes
comes closest
closest to
to the
the service
service probability,
probability,the
the z
z
value
value can
can be
be read
read by
by adding
adding the
thecolumn
column heading
heading
label
label to
to the
the row
rowlabel.
label.
So,
So,by
byadding
adding0.5
0.5to
tothe
thevalue
valuefrom
fromAppendix
AppendixDDof
of0.4599,
0.4599,
we
wehave
haveaaprobability
probabilityof
of0.9599,
0.9599,which
whichisisgiven
givenby
byaazz==1.75
1.75

17-24

Example of the Fixed-Time Period Model: Solution (Part 2)

qq==dd(T
(T++L)
L)++ZZTT++LL --II
qq==20(30
20(30++10)
10)++(1.75)(25.
(1.75)(25.298)
298)--200
200
qq==800
80044.272
44.272--200
200==644.272,
644.272,or
or645
645units
units

So,
So, to
to satisfy
satisfy 96
96 percent
percent of
of the
the demand,
demand,
you
you should
should place
place an
an order
order of
of 645
645 units
units at
at
this
this review
review period
period

17-25

Price-Break Model Formula

Based on the same assumptions as the EOQ model,


the price-break model has a similar Qopt formula:

Q OPT

2DS
2(Annual Demand)(Order or Setup Cost)
=
=
iC
Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory


C = cost per unit
Since C changes for each price-break, the formula
above will have to be used with each price-break cost
value

17-26

Price-Break Example Problem Data


(Part 1)

A
Acompany
company has
has aa chance
chance to
to reduce
reduce their
theirinventory
inventory
ordering
ordering costs
costs by
by placing
placing larger
largerquantity
quantity orders
orders using
using
the
the price-break
price-breakorder
orderquantity
quantity schedule
schedule below.
below. What
What
should
should their
theiroptimal
optimal order
orderquantity
quantity be
be ifif this
this company
company
purchases
purchases this
this single
single inventory
inventoryitem
item with
with an
an e-mail
e-mail
ordering
ordering cost
cost of
of $4,
$4, aa carrying
carrying cost
cost rate
rate of
of 2%
2%of
of the
the
inventory
inventory cost
cost of
of the
the item,
item, and
and an
an annual
annual demand
demand of
of
10,000
10,000 units?
units?
Order Quantity(units) Price/unit($)
0 to 2,499
$1.20
2,500 to 3,999 1.00
4,000 or more .98

17-27

Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of C


Annual Demand (D)= 10,000 units
Cost to place an order (S)= $4

Carrying cost % of total cost (i)= 2%


Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not


Interval from 0 to 2499, the
Qopt value is feasible

Q OPT =

2DS
=
iC

2(10,000)(4)
= 1,826 units
0.02(1.20)

Q OPT =

2DS
=
iC

2(10,000)(4)
= 2,000 units
0.02(1.00)

Interval from 4000 & more, the


Q OPT =
Qopt value is not feasible

2DS
=
iC

2(10,000)(4)
= 2,020 units
0.02(0.98)

Interval from 2500-3999, the


Qopt value is not feasible

17-28

Price-Break Example Solution (Part 3)

Since
Sincethe
thefeasible
feasiblesolution
solution occurred
occurredin
inthe
thefirst
firstpricepricebreak,
values occur
break,itit means
means that
thatall
all the
theother
othertrue
trueQ
Qopt
opt values occur
at
at the
thebeginnings
beginningsof
ofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?
Because
Becausethe
thetotal
total annual
annualcost
costfunction
functionis
is
aau
ushaped
shapedfunction
function

Total
annual
costs

So
So the
thecandidates
candidates
for
forthe
thepricepricebreaks
breaks are
are1826,
1826,
2500,
2500,and
and4000
4000
units
units
0

1826

2500

4000

Order Quantity

17-29

Price-Break Example Solution (Part 4)

Next,
values into the total cost
Next,we
weplug
plugthe
thetrue
trueQ
Qopt
opt values into the total cost
annual
annualcost
costfunction
functionto
todetermine
determinethe
thetotal
total cost
costunder
under
each
eachprice-break
price-break

D
Q
D
Q iC
TC
=
DC
+
S
+
TC = DC +
S+
iC
Q
2
Q
2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
==$12,043.82
$12,043.82
TC(2500-3999)=
TC(2500-3999)=$10,041
$10,041
TC(4000&more)=
TC(4000&more)=$9,949.20
$9,949.20

Finally,
, which is this
Finally,we
weselect
select the
theleast
least costly
costlyQ
Qopt
opt, which is this
problem
problem occurs
occursin
in the
the4000
4000 &&more
more interval.
interval. In
In summary,
summary,
our
ouroptimal
optimal order
orderquantity
quantityis
is4000
4000units
units

17-30

Miscellaneous Systems:
Optional Replenishment System

Maximum Inventory Level, M

q=M-I
Actual Inventory Level, I

M
I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

17-31

Miscellaneous Systems:
Bin Systems

Two-Bin System

Order One Bin of


Inventory
Full

Empty

One-Bin System

Order Enough to
Refill Bin
Periodic Check

17-32

ABC Classification System

Items kept in inventory are not of equal


importance in terms of:

dollars invested

60

% of
$ Value 30

profit potential

sales or usage volume % of

Use

30

A
B

60

stock-out penalties

So, identify inventory items based on percentage of total


dollar value, where A items are roughly top 15 %, B
items as next 35 %, and the lower 65% are the C items

17-33

Inventory Accuracy and Cycle Counting

Inventory accuracy refers to how


well the inventory records agree
with physical count
Cycle Counting is a physical
inventory-taking technique in which
inventory is counted on a frequent
basis rather than once or twice a
year

17-34

Question Bowl

Which of the following is a reason why


firms keep a supply of inventory?
a. To maintain independence of
operations
b. To meet variation in product demand
c. To allow flexibility in production
scheduling
d. To take advantage of economic
purchase order size
e. All of the above
Answer: e. All of the above (Also can include to provide
a safeguard for variation in raw material delivery
time.)

17-35

Question Bowl

An Inventory System should


include policies that are related
to which of the following?
a. How large inventory purchase
orders should be
b. Monitoring levels of inventory
c. Stating when stock should be
replenished
d. All of the above
e. None of the above

Answer: d. All of the above

17-36

Question Bowl

Which of the following is an


Inventory Cost item that is related
to the managerial and clerical
costs to prepare a purchase or
production order?
a. Holding costs
b. Setup costs
c. Carrying costs
Answer: e. None of the
d. Shortage costs
e. None of the above above (Correct answer
is Ordering Costs.)

17-37

Question Bowl

Which of the following is


considered a Independent
Demand inventory item?
a. Bolts to a automobile
manufacturer
b. Timber to a home builder
c. Windows to a home builder
d. Containers of milk to a grocery
store
e. None of the above
Answer: d. Containers of milk to a grocery store

17-38

Question Bowl

If you are marketing a more expensive


independent demand inventory item,
which inventory model should you
use?
a. Fixed-time period model
b. Fixed-order quantity model
c. Periodic system
d. Periodic review system
e. P-model

Answer: b. Fixed-order quantity model

17-39

Question Bowl

If the annual demand for an inventory


item is 5,000 units, the ordering costs
are $100 per order, and the cost of
holding a unit is stock for a year is
$10, which of the following is
approximately the Qopt?
a. 5,000 units
b. $5,000
c. 500 units
d. 316 units
Answer: d.
e. None of the above

316

units
(Sqrt[(2x1000x10
0)/10=316.2277)

17-40

Question Bowl

The basic logic behind the ABC


Classification system for inventory
management is which of the
following?
a. Two-bin logic
b. One-bin logic
c. Pareto principle
d. All of the above
e. None of the above

Answer: c. Pareto principle

17-41

Question Bowl

A physical inventory-taking
technique in which inventory is
counted frequently rather than
once or twice a year is which of
the following?
a. Cycle counting
b. Mathematical programming
c. Pareto principle
d. ABC classification
e. Stockkeeping unit (SKU)

Answer: a. Cycle counting

17-42

End of Chapter