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Inventory Management

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Inventory meaning Independent demand VS Dependent demand Types of inventory Functions of inventory Objectives of inventory Requirements for effective inventory management. Inventory model
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Basic EOQ model EPQ model Fixed Time period model Re-order model Single period model

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Is the stock of any item or resources used in an organization An inventory system is the set of policies and controls that monitor levels of inventory and determine
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what level should be maintained, when stock should be replenished and how large order should be.

In mfg inventory refers to items that contribute to or become part of a firm’s product output In service inventory refers to the tangible goods to be sold and the supplies necessary to administer the service


a stock or store of goods

Independent Demand

Dependent Demand







Independent demand is uncertain. Dependent demand is certain.

Independent vs dependent

Independent demand – finished goods, items that are ready to be sold

E.g. a computer

Dependent demand – components of finished products

E.g. parts that make up the computer

Types of Inventories
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Raw materials & purchased parts Partially completed goods called work in progress Finished-goods inventories

(manufacturing firms) or merchandise (retail stores)

Types of Inventories

Replacement parts, tools, & supplies Goods-in-transit to warehouses or customers

Functions of Inventory
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To meet anticipated demand To smooth production requirements To decouple operations To protect against stock-outs

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Functions of Inventory (Cont’d)
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To take advantage of order cycles To hedge against price increases To permit operations To take advantage of quantity discounts

Objective of Inventory Control

To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds
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Level of customer service

Costs of ordering and carrying inventory Inventory turnover is the ratio of average

cost of goods sold to average inventory investment.

Effective Inventory Management
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A system to keep track of inventory A reliable forecast of demand Knowledge of lead times Reasonable estimates of
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Holding costs Ordering costs Shortage costs

A classification system

Inventory Counting Systems

Periodic System
Physical count of items made at periodic intervals

Perpetual Inventory System
System that keeps track of removals from inventory continuously, thus monitoring current levels of each item

Inventory Counting Systems

Two-Bin System - Two containers of inventory; reorder when the first is empty Universal Bar Code - Bar code printed on a label that has information about the item to which it is attached 0
214800 232087768

Key Inventory Terms

Lead time: time interval between ordering
and receiving the order

Holding (carrying) costs: cost to carry an
item in inventory for a length of time, usually a year

Ordering costs: costs of ordering and receiving inventory Shortage costs: costs when demand
exceeds supply

ABC Classification System
Classifying inventory according to some measure of importance and allocating control efforts accordingly. A - very important B - mod. Important C - least important High
Annual $ value of items Low Low

Percentage of Items

Economic Order Quantity Models

Economic order quantity (EOQ) model

The order size that minimizes total annual cost

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Economic production model Quantity discount model

Assumptions of EOQ Model
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Only one product is involved Annual demand requirements known Demand is even throughout the year Lead time does not vary Each order is received in a single delivery There are no quantity discounts

The Inventory Cycle
Quantity on hand

Usage rate

Profile of Inventory Level Over Time

Reorder point

Receive order

Place Receive order order

Place Receive order order


Lead time

Total Cost
Annual Annual Total cost = carrying + ordering cost cost TC = Q H 2 + DS Q

et differentiate TC with respect to Q. Setting the result =0, & solving Q TC/dQ= d QH/2 +d DS/Q = H/2- DS/Q2 H/2- DS/Q2 = 0 or DS/Q2 = H/2 or Q2 H= 2DS or Q= √2DS/H Note the second derivative is positive which indicates a minimum has been obtai

Cost Minimization Goal
The Total-Cost Curve is U-Shaped
Annual Cost

Q D TC = H + S 2 Q

Ordering Costs
QO (optimal order quantity)

Deriving the EOQ
Using calculus, we take the derivative of the total cost function and set the derivative (slope) equal to zero and solve for Q.


2DS = H

2(Annual Demand)(Order or Setup Cost) Annual Holding Cost

Minimum Total Cost
The total cost curve reaches its minimum where the carrying and ordering costs are equal. Q H 2 = DS Q

Economic Production Quantity (EPQ)
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Production done in batches or lots Capacity to produce a part exceeds the part’s usage or demand rate Assumptions of EPQ are similar to EOQ except orders are received incrementally during production

Economic Run Size

Q0 =

2DS p H p− u

Derivation of EPQ
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Annual carrying cost = I max* H/2 , Imax= Q/P ( p - u) where p = production and u= usage rate and Q/P is the run time or no of days. Annual carrying cost= QH(p-u)/2p Set up cost = DS/Q As we know the optimum size Q or EPQ occurs in the trade off between carrying cost and order cost. In other words when Carrying cost = Order cost. QH (p-u)/2p = DS/Q Q = √ 2DSp/H(p-u)

When to Reorder with EOQ Ordering

Reorder Point - When the quantity on hand of an item drops to this amount, the item is reordered Safety Stock - Stock that is held in excess of expected demand due to variable demand rate and/or lead time. Service Level - Probability that demand will not exceed supply during lead time.

Determinants of the Reorder Point
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The rate of demand The lead time Demand and/or lead time variability Stock out risk (safety stock)

Safety Stock
Quantity Maximum probable demand during lead time Expected demand during lead time

ROP Safety stock reduces risk of stockout during lead time Safety stock
LT Time

Reorder Point

Service level Probability of no stockout Expected demand 0

Risk of a stockout

Safety stock z



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For constant Demand & Lead Time ROP= d L d= Average daily demand L = Lead Time

ROP with safety stock

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When demand is uncertain ? Of saftey stock comes Reorder point is ROP= d L+zσL d= Average daily demand L= Lead time Z= number of std deviation σL = Std deviation of usage during lead time zσL = amount of safety stock

ROP with safety stock
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d = ∑d /n Standard deviation of daily demand is σd = √ ∑(di-d) 2/n

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σd refers to one day if lead time extends over several days we can use statistical premises that the std deviation of a series of independent occurrences is equal to the square root of the sum of the σL = √ σ21+ σ22+ σ23+….+ σ2L To find out Z use formula NORMSINV() or see


Daily demand for a certain product is normally distributed with a mean of 60 and standard deviation of 7.The source of supply is reliable and maintains a constant lead time of six days.The cost of placing the order is $10 and annual holding cost are $.50 per unit.There are no stock out cost and unfilled orders are filled as soon as order arrives.Assume sales occur over the the entire 365 days of a year.Find the order quantity and rop to satisfy a 95% probability of not stocking out during lead time.

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d=60 S= $10 H= $.50 L=6 D= 60*365 σd = 7

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EOQ = √2DS/H = √2*60*365*10/.5= √876000= 936 units ROP= d L+zσL = 60*6 +1.64*17.15=388 units σL = √ σ21+ σ22+ σ23+….+ σ2L σL = √ 6*72 =17.15

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Fixed-Order-Interval Model
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Orders are placed at fixed time intervals Fixed time period model generates order quantities that vary from period to period, depending on usage rate This generally requires higher safety stock FOIMQ = Average demand over the vulnerable
period+Safety Stock- Inventory currently on hand

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Q= d(T+L) + zσT+L -I T= Number of days b2n reviews, σT+L = std deviations of demand over the review and lead time


Daily demand for a product is 10 units with a standard deviation of 3 units.The review period is 30 days and lead time is 14 days.Mgt has set a policy of satisfying 98 % demand from items in stock.At the beginning of this review period there are 150 units in inventory.How many units should be ordered?

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Q= d(T+L) + zσT+L -I = 10(30+14) +2.05 √(T+L) σ2d –150 =10*44+2.05 √(30+14)(3)2-150 440+2.05*19.9-150=331 units

Fixed-Interval Benefits
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Tight control of inventory items Items from same supplier may yield savings in:
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Ordering Packing Shipping costs

May be practical when inventories cannot be closely monitored

Fixed-Interval Disadvantages
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Requires a larger safety stock Increases carrying cost Costs of periodic reviews

Single Period Model

model for ordering of perishables and other items with limited useful lives Shortage cost: generally the unrealized profits per unit Excess cost: difference between purchase cost and salvage value of items left over at the end of a period

Single Period Model

Continuous stocking levels
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Identifies optimal stocking levels Optimal stocking level balances unit shortage and excess cost

Discrete stocking levels

Service levels are discrete rather than continuous Desired service level is equaled or exceeded

Optimal Stocking Level
Service level =

Cs Cs + Ce

Cs = Shortage cost per unit Ce = Excess cost per unit

Service Level Quantity Balance point

Ce = $0.20 per unit  Cs = $0.60 per unit  Service level = Cs/(Cs+Ce) = Ce Cs .6/(.6+.2)  Service level = .75

Service Level = 75%


Stockout risk = 1.00 – 0.75 = 0.25

Operations Strategy

Too much inventory
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Tends to hide problems Easier to live with problems than to eliminate them Costly to maintain Reduce lot sizes Reduce safety stock

Wise strategy
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