Topics

 Inventory
 Types, Purpose, Costs
 Single period inventory models
 Multi-period inventory models
 Fixed order quantity models
 Fixed time-period models
 Miscellaneous systems & issues
 Optional replenishment, two-bin & one-bin systems
 ABC Analysis
 Record Accuracy
 Cycle Counting
Inventory
 Inventory is the stock of any item or resource
used in an organization
 One of the most expensive assets of many
companies representing as much as 50% of total
invested capital
 Operations managers must balance inventory
investment and customer service
Types of Inventory
 Raw material
 Purchased but not processed

 Work-in-process
 Undergone some change but not completed
 A function of cycle time for a product

 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
productive
 Finished goods
 Completed product awaiting shipment
Material Flow Cycle
Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
Purposes of Inventory
1. To maintain independence of operations

2. To allow flexibility in production scheduling

3. To decouple the firm from fluctuations in

demand and provide a stock of goods that will
provide a selection for customers
Purposes of Inventory
4. To provide a safeguard for variation in raw
material delivery time

5. To take advantage of economic purchase-order

size

6. To take advantage of quantity discounts

7. To hedge against inflation

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
 Independent vs. Dependent Demand
Independent Demand (Demand for the final end-
product or demand not related to other items)
Finished
product

Dependent
Demand
(Derived demand
items for
E(1) component
parts,
subassemblies,
Component parts raw materials,
etc)
Independent vs. Dependent Demand
 Independent demand
 demand for item is independent of the
demand for any other item in inventory
 Dependent demand
 demand for item is dependent upon the
demand for some other item in the
inventory
Inventory System
 Set of policies and controls that
 monitor levels of inventory
 determines what levels should be maintained,
when stock should be replenished, and how large
orders should be
Inventory Systems
 Single-Period Inventory Models
 Multi-Period Inventory Models
Single-Period Models
 One time purchasing decision
 Vendor selling t-shirts at a football game
 Perishable items
 Newspaper boy selling at a street corner
 Overbooking airline flights
 Seeks to balance the costs of inventory overstock and under
stock
 Two types
 Discrete probability distributions
 Continuous probability distributions
Single-Period Model : Example 1
Discrete probability distribution of demand of mangoes (in no.
of cases) given. How much to stock each day?
Cost Price/case= Rs.20; Selling Price/case= Rs.50
If not sold the same day, the mangoes are spoilt
Demand (No. of Cases) Probability
10 0.15
11 0.20
12 0.40
13 0.25
 Expected Value
 Marginal Analysis
Single-Period Model: Example 2
Continuous probability distribution
A college basketball team is playing in a tournament game.
Based on past experience, they sell on average 2,400 shirts
with a standard deviation of 350. They make Rs.100 on
every shirt sold at the game, but lose Rs.50 on every shirt
not sold. How many shirts should be made for the game?

MP = Rs.100 and ML = Rs.50; P* = 50 / (100 + 50) = .333

Z.667 = .432 (use NORMSINV(.667) or Z table)

therefore we need 2,400 + .432(350) = 2,551 shirts
Multi-Period Models
 Ensures item available on ongoing basis
 Quantity & order timing important
 Two types:
 Fixed-Order Quantity Models (Q-model)
 Event triggered (Example: running out of stock)
 Fixed-Time Period Models (P-model)
 Time triggered (Example: Monthly sales call by sales
representative)
Q-model vs. P-model
 Q-model
 Constant order quantity (Q)
 Order placed: Reorder level (R)
 Perpetual system
 Continuous record keeping
 Higher time to maintain
 Less inventory than P-model
 P-model
 Variable order quantity (q)
 Order placed: Review period T
Fixed-Order Quantity Model:
Assumptions
 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
Fixed-Order Quantity Model:
Assumptions
 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)
 Basic EOQ Model
1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
2. Your start using them L L
up over time. 3. When you reach down to a level
Time of inventory of R, you place your
R = Reorder point next Q sized order.
Q = Economic order quantity
L = Lead time
Costs in EOQ TC=Total annual
cost
Total Annual Annual Annual D =Demand
Annual = Purchase + Ordering + Holding C =Cost per unit
Cost Cost Cost Cost Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
D Q H=Annual holding

TC = DC + S + H and storage cost

per unit of inventory
Q 2
Costs in EOQ

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT Order Quantity (Q)

Costs in EOQ
 Total cost curve
 By adding the item, holding, and ordering costs
 Used to find the Qopt
 Goal: Cost Minimization
 Optimal Order Quantity (EOQ or Qopt or Q*)
 Take the first derivative (slope) of the total cost function with
respect to Q
 Set the derivative equal to zero,

 Solve for Q
EOQ Model
2D S 2(A nnual D em and)(O rder or Setup Cost)
Q O PT = =
H A nnual H olding Cost

_
R eo rd er p o in t, R = d L
_
d = average daily demand (constant)
L = Lead time (constant)
EOQ Model
 In deciding optimal lot size, the tradeoff is
between
 setup (order) cost and
 holding cost.

 If demand increases by k, optimal lot size

increases by √k
 Holding cost per year as a fraction of product cost
(H = hC)
EOQ Example 1
A company markets hypodermic needles to hospitals.
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
EOQ Example 1
Determine number of orders N
D = 1,000 units Q* = 200 units

Expected
Demand D
number of orders = N = = =
Order quantity Q*

1,000
N= = 5 orders per year
200
EOQ Example 1
Determine expected time between orders
If there are 250 working days in the year
N= 5 orders per year

Expected time Number of working

days per year
between =T=
orders N

250
T= = 50 days between orders
5
Reorder Point Curve
Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
EOQ Example 1

Determine Reorder Point (R)

If lead time= 10 days

Daily Demand = 1,000/250 = 4 units/ day

R = 4 units per day x 10 days = 40 units

EOQ Example 1
Determine total annual costs
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

TC = D S + Q H
Q 2

1,000 200
TC = 200 ($10) + 2 ($.50)

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

EOQ Model
 Model is robust

 Works even if all parameters and assumptions

are not met
 Total cost curve is relatively flat in the area of
the EOQ
 To make it economically feasible to reduce lot
size, the fixed cost associated with each lot
would have to be reduced
EOQ Example 2
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

TC = D S + Q H
Q 2

1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

EOQ Example 2
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D S + Q
TC = H
Q 2

1,500 244.9 Only 2% less than the

TC = ($10) + ($.50)
244.9 2 total cost of $125
when the order
TC = $61.24 + $61.24 = $122.48 quantity was 200
Probabilistic Models
 Used when demand is not constant or certain
 Use safety stock to achieve a desired service
level and avoid stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short x the probability x
the stockout cost/unit
x the number of orders per year
Safety Stock Example 1
ROP = 50 units Stockout cost = $40 per unit
Orders per year = 6 Carrying cost = $5 per unit per year

Number of Units Probability

30 .2
40 .2
ROP  50 .3
60 .2
70 .1
1.0
Safety Stock Example 1
ROP = 50 units Stockout cost = $40 per unit
Orders per year = 6 Carrying cost = $5 per unit per year

Safety Additional Total

Stock Holding Cost Stockout Cost Cost

20 (20)($5) = $100 $0 $100

10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 units gives the lowest total cost

ROP = 50 + 20 = 70 units
Safety Stock Example 2
 When cost of stockouts cannot be determined
 Use prescribed service levels to set safety stock
 Assume demand during lead time normally distributed

ROP = demand during lead time + ZsdLT

where Z = number of standard deviations

sdLT = standard deviation of demand during lead time
Safety Stock Example 2

Minimum demand during lead time

Inventory level

Maximum demand during lead time

Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5

ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 units)

Safety stock 16.5 units

0 Lead
time Time
Place Receive
order order
Safety Stock Example 2

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? units Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
Safety Stock Example 2
Average demand = m = 350 units
Standard deviation of demand during lead time = sdLT = 10 units
5% stockout policy (service level = 95%)

For an area under the curve of 95%, the Z = 1.65

Safety stock = ZsdLT = 1.65(10) = 16.5 units

Reorder point = expected demand during lead time + safety stock

= 350 units + 16.5 units of safety stock
= 366.5 or 367 units
Fixed-Period (P) Systems
 Orders placed at the end of a fixed period
 Inventory counted only at end of period
 Order brings inventory up to target level
 Only relevant costs are ordering and holding
 Lead times are known and constant
 Demand is independent
Fixed-Period (P) Systems
Target quantity (QT)

Q4
Q2
On-hand inventory

Q1 T
Q3

Time
Fixed-Period (P) Example
3 jackets are back ordered No jackets are in stock
It is time to place an order Target value = 50

Order amount (Q) = Target quantity (QT) -

On-hand inventory - Earlier orders not yet
received + Back orders
Q = 50 - 0 - 0 + 3 = 53 jackets
P Systems with Safety Stock
Safety Stock = ZsT+L
Time of review = T
Constant lead time = L
Order quantity = Average demand over vulnerable period +
Safety Stock - Inventory on hand or on order

_
q = d (T+L) + ZsT+L - I
P Systems with Safety Stock Example
Daily demand = 10 units; Standard deviation = 3 units
Review period = 30 days; Lead time = 14 days
Policy: to satisfy 98% demand from stock (z= 2.05)
Inventory on hand = 150
sT+L = (T+L) sd2 = [(30+14)(3)2] = 19.90
_
q = d (T+L) + ZsT+L – I
= 10 (30+14) + 2.05 (19.90) – 150 = 331 units
Fixed-Period Systems
 Inventory is only counted at each review period
 May be scheduled at convenient times
 Appropriate in routine situations
 May result in stockouts between periods
 May require increased safety stock
Miscellaneous Systems
 Problems with inventory models
 Obtaining cost data difficult
 Assumptions unrealistic
 Miscellaneous systems
 Simple practical systems
 Helps maintain adequate control over inventory items
 Ensures adequate records of stock on hand are kept
Optional Replenishment System
Maximum Inventory Level, M

q=M-I

Actual Inventory Level, I

M

Q = minimum acceptable order quantity

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

Bin Systems
Two-Bin System

Order One Bin of

Inventory
Full Empty
One-Bin System

Order Enough to
Refill Bin
Periodic Check
ABC Analysis
 Divides inventory into three classes based on
annual dollar volume
 Class A - high annual dollar volume
 Class B - medium annual dollar volume
 Class C - low annual dollar volume

 Used to establish policies that focus on the few

critical parts and not the many trivial ones
ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

ABC Analysis
A Items
80 –
Percent of annual dollar usage

70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
ABC Analysis
 Other criteria than annual dollar volume may be
used
 Anticipated engineering changes
 Delivery problems
 Quality problems
 High unit cost
ABC Analysis
 Policies employed may include
 More emphasis on supplier development for A items
 Tighter physical inventory control for A items
 More care in forecasting A items
Record Accuracy
 Accurate records are a critical ingredient in
production and inventory systems
 Match inventory records with actual count
 Organizations can focus on what is needed
 Necessary to make precise decisions about
ordering, scheduling, and shipping
 Incoming and outgoing record keeping must
be accurate
 Stockrooms should be secure
Record Accuracy
 Ensure accuracy by
 Keeping storeroom locked
 Conveying importance of accurate records to all
 Cycle counting
Cycle Counting
 Items are counted and records updated on a
periodic basis
 Often used with ABC analysis
to determine cycle
 Advantages
 Eliminates shutdowns & interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and
corrected
 Maintains accurate inventory records
Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items,
2,750 C items
Policy is to count A items every month (20 working
days), B items every quarter (60 days), and C items every
six months (120 days)
Item Number of Items
Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
77/day
Inventory Control in Services
 Inventory in services?
 Inventory can be critical for
profitability
 Retailing
 Auto-replacement parts
 Food-service
Inventory Control in Services
Department Store Inventory
 SKU identifies inventory item, its manufacturer & cost
 Large number of SKUs
 Calculate EOQ for each?
 Purchase from distributors
 Aggregates over manufacturers
 Faster replenishment
 Shrinkage
 Damage
 Pilferage
Inventory Control in Services
Auto Replacement parts
 Find order quantity of wide variety of items
 Franchised new car dealers purchase mostly from
manufacturers
 Many alternate uses of funds
 Use software packages provided by manufacturers
 Forecasting to find usage rate
Inventory Control in Services
Inventory accuracy & control through
1. Good personnel selection, training, and
discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving facility