April 2008

Learning Objectives
When you complete this chapter, you should be able to explain: • the purpose of inventory • the costs involved in inventory • independent and dependent demand • EOQ Model

• • Functions of inventory - Types of inventory Inventory Models - Independent versus dependent demand - Holding, ordering, set up costs.. Inventory Models for independent demand - Basic Economic Order Quantity (EOQ) - Minimizing costs - Reorder points (ROP)



What is Inventory? • Inventory is one of the most expensive and important assets to many companies. Managers have long recognised that good inventory control is crucial. representing 50% of total invested capital. • Definition of inventory 4 .

Types of Inventory • Typical items carried in inventory can include: » raw materials » purchased parts » components » Sub-assemblies » work-in-progess » finished goods and supplies 5 .

Basic components of inventory • Planning phase • Forecasting • Controlling of the inventory levels • Feedback measurements 6 .

Functions of Inventory • • • • • To provide a stock of goods that will provide a ‘selection’ for customers To take advantage of quantitative discounts To care for against inflation and upward price changes Seasonal inventory Safety inventory 7 .

Where do we keep inventory • • • • • Retail Wholesale/distributor Warehouse Producer Input supplier .kept further down the chain if more customisation is needed 8 .kept closer to the customer if quick response to demand for finished goods is needed .

Inventory decisions Two fundamental decisions that have to be made when controlling inventory are: i. What is the objective of inventory? 9 . How much to order ii. When to order The purpose of all inventory models and techniques is to determine rationally how much to order and when to order.

• Holding costs – associated with holding or ‘carrying’ inventory over time.Inventory Costs • Purchasing costs – cost incurred when purchasing a unit of an item. • Safety stock – extra stock kept at hand in order to avoid stockouts. • Ordering costs – associated with costs of placing order and receiving goods. 10 . • Setup costs – cost to prepare a machine or process • Stockouts costs – penalty costs for running out of stock.

cost of storage) » Shortage costs (cost of placing an order for immediate delivery. cost of lost trade. loss of goodwill) 11 . interest lost on capital.Disadvantages of Inventory • BUT maintaining inventory incurs costs such as: » Ordering costs (setup cost – flat charge for delivery and admin) » Unit costs (charge per item) » Holding costs (insurance.

Independent v/s Dependent Demand • Independent demand – demand for item is independent of demand for any other item • Dependent demand – demand for item is dependent upon the demand for some other items 12 .

Inventory Management for Independent Demand • Answers two basic questions: 1. how much should we order? 2. when should we order? 13 .

• Fixed order-quantity models . • Probabilistic models • Fixed order-period models 14 .Inventory Models Help answer the inventory planning questions. .Quantity discount: a reduced cost for an item when it is purchased in larger quantities.Economic Order Quantity (EOQ): one of the oldest and most commonly known inventory control techniques.

Economic Order Quantity (EOQ) Assumptions • Known and constant demand. at one point in time. 15 . • Known and constant lead time (time between the placement of the order and the receipt of the order) • Instantaneous receipt of material: the inventory from an order arrives in one batch. • The only variable costs are the cost of placing an order (ordering cost) and the cost of holding (holding or carrying cost) • No stockouts: if orders are placed at the right time. • No quantity discounts. shortages can be avoided completely.

EOQ Objective • To determine the quantity to order which will minimise the total annual inventory cost Total annual inventory cost = annual inventory holding costs + annual ordering/setup costs 16 .

Inventory Usage Over Time Order quantity = Q (maximum inventory level) Usage Rate Minimum inventory Inventory Level Average Inventory (Q*/2) 0 Time 17 .

EOQ Model (How Much to Order?) Annual Cost e urv st C o rve al C u Tot tC Cos g din l Ho Minimu m total cost Order (Setup) Cost Curve Optimal Order Quantity (Q*) Order quantity 18 .

EOQ Model (When To Order) Inventory Level Optimal Order Quantity (Q*) Reorder Point (ROP) Lead Time Average Inventory (Q*/2) Time 19 .

EOQ Model Equations Ch D ptimal Order Quantity =Q* = 2× ×Co D Q* pected Number of Orders N = = Working Days /Year pected Time Between Orders =T = N d= D D = Demand per year Co = Setup (order) cost per order Ch = Holding (carrying) cost d = Demand per day Working Days /Year ROP = d × L 20 .

Finding the EOQ Four steps for finding the optimum inventory: • Develop an expression for the ordering cost. 21 . • Develop an expression for the holding cost. • Set the ordering cost equal to the carrying cost. • Solve this equation for the optimum desired.

would like to reduce its inventory cost by determining the optimal number of pump housings to obtain per order. ii. The expected number of orders.000 units. 22 . Evaluate the total inventory cost. Calculate the optimal number of units per order. The annual demand is 1. i.50. the ordering cost is £10 per order and the average holding cost per unit per year is £0.Example 1 A company that sells pump housings to other manufacturers. iii.

Fixed Period Model • Answers how much to order • Orders placed at fixed intervals – Inventory brought up to target amount – Amount ordered varies • No continuous inventory count – Possibility of stockout between intervals • Useful when vendors visit routinely – Example: P&G representative calls every 2 weeks 23 .

Every order placed by the wholesaler costs $10 in administration charges regardless of the number ordered.Example 2 A wholesaler has a steady demand for 50 items of a given product each month. you are required to evaluate all the relevant costs and attempt to determine the most economic order quantity for this item of goods. The purchase cost of each item is $6 and the holding cost for this item is estimated to be 20% of the stock value per annum. 24 . Given this information.

It is estimated that it costs an average of $2 per week to store 100 inhalers in the warehouse. Consider a single item of stock: the Becotide inhaler for asthma sufferers. Using this information. holding costs and order costs. what is the optimum order quantity and order frequency for this product? Sketch a graph indicating the total costs. Assume that there is a constant demand for this item of 400 per week. Each order placed to the suppliers costs $12 in administration fees. has asked you to devise ordering policies at the central warehouse for all the major drug items required by their stores. Each inhaler costs $3 to purchase. 25 .Example 3 The Managing Director at Littlewoods.

it is assumed that receipt of an order is instantaneous. we assume that a firm waits until its inventory level for a particular item reaches 0. That is. is often a few days or even a few weeks. called the lead time or delivery time. 26 . • However. inventory models.Reorder point: Determining when to order • In most simple. the time between the placing and receipt of an order . places an order and receives the items in stock immediately.

the when to order decision is usually expressed in terms of e reorder point (ROP). is given as • ROP = (demand per day) * (lead time for a new order in days) =d*L 27 . the inventory level at which an order should be placed.Reorder point: Determining when to order • Thus. ROP. The reorder point.

• The figure illustrates the situation where reordering occurs L time units before delivery is expected. Reorder points yr o nev n t I L L 28 .

Calculate the ROP? 29 .000 yearly. delivery of an order takes three working days.Procomp’s demand for computer chips is 8. On the average. The firm has a weekly demand of 280 units.

Probabilistic Models • Answer how much & when to order • Allow demand to vary – Follows normal distribution – Other EOQ assumptions apply • Consider service level & safety stock – Service level = 1 .Probability of stockout – Higher service level means more safety stock • More safety stock means higher ROP 30 .

• When demand is unusually high. you are carrying an average of 50 units more of inventory during the year. for example. • If. you dip into the safety stock instead of encountering a stockout. 31 . • Thus. safety stock for an item is 50 units. the main purpose of safety stock is to avoid stockouts when the demand is higher than expected.Safety Stock • Safety stock is additional stock that is kept on hand.

Safety Stock • The Hinsdale Company carries an inventory item that has a normally distributed demand during the reorder point. The mean demand is 350 units and the standard deviation is 10. Hinsdale follow a policy that results in stockouts occurring only 5% of the time. How much safety stock should be maintained? 32 .

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