Inventory Management

Lecture # 11

Dr. Muhammad Hammad A. K.

1
Chapter 12 – Independent
Demand Inventory Management

Operations Management
by
R. Dan Reid & Nada R. Sanders
2nd Edition © Wiley 2005

PowerPoint Presentation by R.B. Clough - UNH

Inventories in the Supply Chain
Independent vs. Dependent
Demand
 Independent demand items are finished
goods or other items sold to someone
outside the company
 Dependent demand items are materials
or component parts used in the
production of another item (e.g.,
finished product)
 Types of Inventory:
How Inventory is Used
 Anticipation or seasonal inventory
 Safety stock: buffer demand fluctuations
 Lot-size or cycle stock: take advantage of quantity
discounts or purchasing efficiencies
 Pipeline or transportation inventory
 Speculative or hedge inventory protects against
some future event, e.g. labor strike
 Maintenance, repair, and operating (MRO)
inventories
Objectives of Inventory
Management
 Provide acceptable level of customer
service (on-time delivery)
 Allow cost-efficient operations
 Minimize inventory investment
 Relevant Inventory Costs
Item Cost Cost per item plus any other direct costs
associated with getting the item to the
plant
Holding Capital, storage, and risk cost typically
Costs stated as a % of the unit value,
e.g. 15-25%
Ordering Fixed, constant dollar amount incurred
Cost for each order placed

Shortage Loss of customer goodwill, back order

Costs handling, and lost sales
 Order Quantity Strategies
Lot-for-lot Order exactly what is needed for the
next period
Fixed-order Order a predetermined amount each
quantity time an order is placed
Min-max When on-hand inventory falls below a
system predetermined minimum level, order
enough to refill up to maximum level
Order n Order enough to satisfy demand for
periods the next n periods
 Examples of Ordering Approaches
Lot for Lot Example
1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 0 0 0 0 0 0 0
Order Placement 40 70 65 60 55 85 75 85

Fixed Order Quantity Example with Order Quantity of 200

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 160 90 25 165 110 25 150 65
Order Placement 200 200 200

Min-Max Example with min.= 50 and max.= 250 units

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 180 110 185 125 70 165 90 165
Order Placement 220 140 180 160

Order n Periods with n = 3 periods

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 135 65 0 140 85 0 85 0
Order Placement 175 200 160
 Three Mathematical Models for
Determining Order Quantity
 Economic Order Quantity (EOQ or Q System)
 An optimizing method used for determining order
quantity and reorder points
 Part of continuous review system which tracks on-
hand inventory each time a withdrawal is made
 Economic Production Quantity (EPQ)
 A model that allows for incremental product delivery
 Quantity Discount Model
 Modifies the EOQ process to consider cases where
quantity discounts are available
 Economic Order Quantity
 The Economic Order
Quantity (EOQ) is the
number of units that a
company should add to
inventory with each
order to minimize the
total costs of inventory—
such as holding costs,
order costs, and
shortage costs
 EOQ Assumptions
 Known & constant demand
 Known & constant lead time
 Instantaneous receipt of material
 No quantity discounts
 Only order (setup) cost & holding cost
 No stockouts
Inventory Holding Costs
Reasonably Typical Profile

% of
Category Inventory Value
Housing (building) cost 6%
Material handling costs 3%
Labor cost 3%
Inventory investment costs 11%
Pilferage, scrap, & obsolescence 3%
Total holding cost 26%
EOQ Model
Annual Cost

Order Quantity
EOQ Model
Annual Cost

Holding Cost

Order Quantity
 Why Order Cost Decreases
 Cost is spread over more units
Example: You need 1000 microwave ovens
1 Order (Postage $ 1000 Orders (Postage
0.35) $350)
Purchase Order PurchaseOrder
Purchase Order
PurchaseOrder
Order
Description
Purchase Qty.
Description Qty. Description Qty.
Microwave 1000 Description
Microwave
Description Qty.1
Qty.
Microwave 11
Microwave
Microwave 1
Order
quantity
EOQ Model
Annual Cost

Holding Cost
Order (Setup) Cost

Order Quantity
 EOQ Model
Annual Cost

Total Cost Curve

Holding Cost
Order (Setup) Cost

Order Quantity
Total annual costs = annual ordering costs + annual holding costs
EOQ Model
Annual Cost

Total Cost Curve

Holding Cost
Order (Setup) Cost

Optimal Order Quantity

Order Quantity (Q*)
 EOQ Formula Derivation
D= Annual demand (units)
C= Cost per unit ($) Total cost = (Q/2) x I x C + S x (D/Q)
Q= Order quantity (units) inv carry cost order cost
S= Cost per order ($)
I = Holding cost (%) Take the 1st derivative:
H= Holding cost ($) = I x C
d(TC)/d(Q) = (I x C) / 2 - (D x S) / Q²

Number of Orders = D / Q To optimize: set d(TC)/d(Q) = 0

Ordering costs = S x (D / Q)
DS/ Q² = IC / 2
Average inventory
units = Q / 2 Q²/DS = 2 / IC
$ = (Q / 2) x C
Q²= (DS x 2 )/ IC
Cost to carry
average inventory = (Q / 2) x I x C Q = sqrt (2DS / IC)
= (Q /2) x H
Economic Order Quantity
2 D S
EOQ 
H
D= Annual demand (units)
S= Cost per order ($)
C= Cost per unit ($)
I = Holding cost (%)
H= Holding cost ($) = I x C
 EOQ Model Equations
2 D S
Optimal Order Quantity  Q * 
H
D
Expected Number Orders  N 
Q*
Working Days / Year
Expected Time Between Orders  T 
N
D
d D = Demand per year
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP  d  L
d = Demand per day
L = Lead time in days
EOQ
Example
You’re a buyer for SaveMart.

SaveMart needs 1000 coffee makers per

year. The cost of each coffee maker is
$78. Ordering cost is $100 per order.
Carrying cost is 40% of per unit cost. Lead
time is 5 days. SaveMart is open 365
days/yr.

What is the optimal order quantity & ROP?

SaveMart EOQ
2 D S
EOQ 
H
D= 1000
2 1000  $100
S= $100 EOQ 
C= $ 78 $31.20
I= 40%
H= CxI
H= $31.20 EOQ = 80 coffeemakers
 SaveMart ROP
ROP = demand over lead time
= daily demand x lead time (days)
=dxl

D = annual demand = 1000

Days / year = 365
Daily demand = 1000 / 365 = 2.74
Lead time = 5 days

ROP = 2.74 x 5 = 13.7 => 14

 SaveMart
Average (Cycle Stock) Inventory

Avg. CS = OQ / 2
= 80 / 2 = 40 coffeemakers
= 40 x $78 = $3,120

Inv. CC = $3,120 x 40% = $1,248

Note: unrelated to reorder point

Economic Order Quantity
2 D S
EOQ 
H
D= Annual demand (units)
S= Cost per order ($)
C= Cost per unit ($)
I = Holding cost (%)
H= Holding cost ($) = I x C
 2 D S
EOQ 
H
What if …
1. Interest rates go up ?
2. Order processing is automated ?
3. Warehouse costs drop ?
4. Competitive product is introduced ?
5. Product is cost-reduced ?
6. Lead time gets longer ?
7. Minimum order quantity imposed ?
The EOQ Formula
Minimize the TC by ordering the EOQ:

2DS
EOQ 
H
When to Order:
The Reorder Point
 Without safety stock:
R  dL
where R  reorder point in units
d  daily/weekly demand in units
L  lead time in days/weeks

 With safety stock:

R  dL  SS
where SS  safety stock in units
EOQ Example
 Weekly demand = 240 units
 No. of weeks per year = 52
 Ordering cost = $50
 Unit cost = $15
 Annual carrying charge = 20%
 Lead time = 2 weeks
EOQ Example Solution
D  52  240  12,480 units / year
H  0.2 15  $3 per unit per year
2DS 2 12,480  50
Q   644.98  645 units
H 3
 D   Q   12,480   645 
TC   S    H     50     3
 Q   2   645   2 
 967.44  967.5  $1,934.94

R  dL  240  2  480 units

EPQ (Economic Production
Quantity) Assumptions
 Same as the EOQ except: inventory arrives in
increments & is drawn down as it arrives
 EPQ Equations
 D   I MAX 
 Adjusted total cost: TCEPQ   S    H
Q   2 

 d
 Maximum inventory: I MAX  Q1  
 p

2 DS
EPQ 
 Adjusted order quantity:  d
H 1  
 p
EPQ Example
 D=Annual demand = 18,000 units
 p=Production rate = 2500 units/month
 S=Setup cost = $800
 H=Annual holding cost = $18 per unit
 L=Lead time = 5 days
 No. of operating days per month = 20
EPQ Example Solution
18,000
d  1500 units / month; p  2500 units / month
12
2 DS 2 18,000  800
Q   2000 units
 d  1500 
H 1   18  1  
 p  2500 

 d  1500 
I MAX  Q1    2000  1    800 units
 p  2500 
D  I   18,000   800 
TC   S    MAX H     800    18 
Q   2   2000   2 
 7,200  7,200  14,400
EPQ Example Solution (cont.)
 The reorder point:

1500
R  dL   5  375 units
20

 With safety stock of 200 units:

1500
R  dL  SS   5  200  575 units
20
Quantity Discount Model
Assumptions
 Same as the EOQ, except:
 Unit price depends upon the quantity
ordered
 Adjusted total cost equation:
 D  Q 
TCQD   S    H   PD
Q   2 
Quantity Discount Procedure
 Calculate the EOQ at the lowest price
 Determine whether the EOQ is feasible at
that price
 Will the vendor sell that quantity at that price?
 If yes, stop – if no, continue
 Check the feasibility of EOQ at the next
higher price

 Continue to the next slide ...

QD Procedure (continued)

 Continue until you identify a feasible EOQ

 Calculate the total costs (including total item
cost) for the feasible EOQ model
 Calculate the total costs of buying at the
minimum quantity required for each of the
cheaper unit prices
 Compare the total cost of each option &
choose the lowest cost alternative
 Any other issues to consider?
QD Example
 Annual Demand = 5000 units
 Ordering cost = $49
 Annual carrying charge = 20%
 Unit price schedule:
Quantity Unit Price
0 to 999 $5.00
1000 to 1999 $4.80
2000 and over $4.75
QD Example Solution
 Step 1
2  5,000  49
QP $4.75   718 not feasible 
0.2  4.75

2  5,000  49
QP $4.80   714 not feasible 
0.2  4.80

2  5,000  49
QP $5.00   700  feasible 
0.2  5.00
 QD Example Solution (Cont.)
 Step 2
5,000 700
TCQ 700   49   0.2  5.00  5.00  5000  $25,700
700 2

5,000 1000
TCQ 1000   49   0.2  4.80  4.80  5000  $24,725
1000 2

5,000 2000
TCQ  2000   49   0.2  4.75  4.75  5000  $24,822.50
2000 2
What if Demand is Uncertain?
Safety Stock and Service Level
 Order-cycle service level is the
probability that demand during lead
time won’t exceed on-hand inventory.
 Risk of a stockout = 1 – (service level)
 More safety stock means greater service
level and smaller risk of stockout
Safety Stock and Reorder
Point
 Without safety stock:
R  dL
where R  reorder point in units
d  daily demand in units
L  lead time in days

 With safety stock:

R  dL  SS
where SS  safety stock in units
ABC Inventory Classification
 ABC classification is a method for determining
level of control and frequency of review of inventory
items
 A Pareto analysis can be done to segment items into
value categories depending on annual dollar volume
 A Items – typically 20% of the items accounting for
80% of the inventory value-use Q system
 B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use Q or P
 C Items – Typically the remaining 50% of the items
accounting for only 5% of the inventory value-use P
ABC Example: the table below shows a solution to an ABC analysis. The
information that is required to do the analysis is: Item #, Unit $ Value, and
Annual Unit Usage. The analysis requires a calculation of Annual Usage $ and
sorting that column from highest to lowest $ value, calculating the cumulative
annual $ volume, and grouping into typical ABC classifications.

Item Annual Usage ($) Percentage of Total $ Cumulative Percentage of Total $ Item Classification
106 16,500 34.4 34.4 A
110 12,500 26.1 60.5 A
115 4500 9.4 69.9 B
105 3200 6.7 76.6 B
111 2250 4.7 81.3 B
104 2000 4.2 85.5 B
114 1200 2.5 88 C
107 1000 2.1 90.1 C
101 960 2 92.1 C
113 875 1.8 93.9 C
103 750 1.6 95.5 C
108 600 1.3 96.8 C
112 600 1.3 98.1 C
102 500 1 99.1 C
109 500 1 100.1 C
Inventory Record Accuracy
 Inaccurate inventory records can cause:
 Lost sales
 Disrupted operations
 Poor customer service
 Lower productivity
 Planning errors and expediting

 Two methods are available for checking record accuracy

 Periodic counting-physical inventory
 Cycle counting-daily counting of pre-specified items provides the
following advantages:
 Timely detection and correction of inaccurate records
 Elimination of lost production time due to unexpected stock outs
 Structured approach using employees trained in cycle counting
 Assignment
1. Demand for the Child Cycle at Best Buy is 500 units per month. Best
Buy incurs a fixed order placement, transportation, and receiving cost of
Rs. 4,000 each time an order is placed. Each cycle costs Rs. 500 and
the retailer has a holding cost of 20 percent. Evaluate the number of
computers that the store manager should order in each replenishment
lot?
2. ABC Ltd. uses EOQ logic to determine the order quantity for its various
components and is planning its orders. The Annual consumption is
80,000 units, Cost to place one order is Rs. 1,200, Cost per unit is Rs.
50 and carrying cost is 6% of Unit cost. Find EOQ, No. of order per
year, Ordering Cost and Carrying Cost and Total Cost of Inventory.
 A local TV repairs shop uses 36,000 units of a part each year (A
maximum consumption of 100 units per working day). It costs Rs. 20
to place and receive an order. The shop orders in lots of 400 units. It
cost Rs. 4 to carry one unit per year of inventory.

(1) Calculate total annual ordering cost

(2) Calculate total annual carrying cost
(3) Calculate total annual inventory cost
(4) Calculate the Economic Order Quantity
(5) Calculate the total annual cost inventory cost using EOQ inventory Policy
(6) How much save using EOQ
(7) Compute ordering point assuming the lead time is 3 days