Managing Facilitating Goods

Replenishment Replenishment Replenishment Customer

order order order order

Factory Wholesaler Distributor Retailer Customer

Production
Delay Shipping Shipping Item Withdrawn
Delay Delay

Wholesaler Distributor Retailer

Inventory Inventory Inventory
Learning Objectives
• Discuss the role of information technology in managing
inventories.
• Describe the functions and costs of an inventory system.
• Determine the order quantity.
• Determine the reorder point and safety stock for inventory
systems with uncertain demand.
• Design a continuous or periodic review inventory-control
system.
• Conduct an ABC analysis of inventory items.
• Determine the order quantity for the single-period inventory
case.
• Describe the rationale behind the retail discounting model.
Role of Inventory in Services
• Decoupling inventories
• Seasonal inventories
• Speculative inventories
• Cyclical inventories
• In-transit inventories
• Safety stocks
Considerations in Inventory Systems

• Type of customer demand

• Planning time horizon

• Replenishment lead time

• Constraints and relevant costs

Relevant Inventory Costs
• Ordering costs

• Receiving and inspections costs

• Holding or carrying costs

• Shortage costs
Inventory Management Questions
• What should be the order quantity
(Q)?
• When should an order be placed,
called a reorder point (ROP)?
• How much safety stock (SS) should
be maintained?
Inventory Models
• Economic Order Quantity (EOQ)
• Special Inventory Models
With Quantity Discounts
Planned Shortages
• Demand Uncertainty - Safety Stocks
• Inventory Control Systems
Continuous-Review (Q,r)
Periodic-Review (order-up-to)
• Single Period Inventory Model
Inventory Levels For EOQ Model
Units on Hand

0
Q Time
D
Annual Costs For EOQ Model

900
800
700
Annual Cost, $

600
Holding Cost
500
Ordering Cost
400 Total Cost
300
200
100
0
0

20

40

60

80

100

120

140
Order Quantity, Q
EOQ Formula
• Notation
D = demand in units per year
H = holding cost in dollars/unit/year
S = cost of placing an order in dollars
Q = order quantity in units
• Total Annual Cost for Purchase Lots
TCp  S ( D / Q)  H (Q / 2)
• EOQ
2 DS
EOQ 
H
 Annual Costs for Quantity
Discount Model
22,000
C = $20.00 C = $19.50 C = $18.75

21000

20000

2000

1000

0 100 200 300 400 500 600 700

Order quantity, Q
 Inventory Levels For Planned
Shortages Model
Q-K

0 TIME

-K
T1 T2
T
Formulas for Special Models
• Quantity Discount Total Cost Model
TCqd  CD  S ( D / Q)  I (CQ / 2)
• Model with Planned Shortages
D (Q  K ) 2 K2
TCb  S  H B
Q 2Q 2Q
2 DS  H  B 
Q 
*
 
H  B 
 H 
K Q 
* *

 H  B
 Values for Q* and K* as A
Function of Backorder Cost
B Q* K* Inventory Levels

B  2DS 0
0
H

2DS  H  B   H 
0 B    Q*
 H  B 
0
H  B 

B 0 undefined Q* 0
 Demand During Lead Time
Example
L  3

  15
.   15
.   15
.   15
.

+ + + =

u=3 u=3 u=3 u=3 

d L  12 ROP
ss

Four Days Lead Time Demand During Lead time

Safety Stock (SS)
• Demand During Lead Time (LT) has
Normal Distribution with
- Mean(d L )   ( LT )
- Std . Dev.( L )   LT
• SS with r% service level
SS  zr LT
• Reorder Point
ROP  SS  d L
 Continuous Review System (Q,r)
Amount used during first lead time
Inventory on hand

EOQ
Reorder point, ROP

d3
Average lead time usage, dL
d1
d2 EOQ

Safety stock, SS First lead

time, LT1 LT2 LT3

Time
Order 1 placed Order 2 placed Order 3 placed

Shipment 1 received Shipment 2 received Shipment 3 received

 Periodic Review System
(order-up-to)
Inventory on Hand
Review period

RP RP RP
Target inventory level, TIL

First order quantity, Q1

Q2 Q3

d1 d3
Amount used during
first lead time

d2

Safety stock, SS First lead time, LT1

LT2 LT3

Time
Order 1 placed Order 2 placed Order 3 placed

Shipment 1 received Shipment 2 received Shipment 3 received

Inventory Control Systems
• Continuous Review System
2 DS
EOQ 
H
ROP  SS   LT
SS  zr LT

• Periodic Review System

RP  EOQ / 
TIL  SS   ( RP  LT )
SS  zr RP  LT
ABC Classification of Inventory
Items
Percentage of dollar volume
100
90
80
70
60
50
40
30
20 A B C

10
0
0

10

20

30

40

50

60

70

80

90

100
Percentage of inventory items (SKUs)
 Inventory Items Listed in
Descending Order of Dollar Volume
Monthly Percent of
Unit cost Sales Dollar Dollar Percent of
Inventory Item ($) (units) Volume ($) Volume SKUs Class

Computers 3000 50 150,000 74 20 A

Entertainment center 2500 30 75,000

Television sets 400 60 24,000

Refrigerators 1000 15 15,000 16 30 B
Monitors 200 50 10,000

Stereos 150 60 9,000

Cameras 200 40 8,000
Software 50 100 5,000 10 50 C
Computer disks 5 1000 5,000
CDs 20 200 4,000

Totals 305,000 100 100

Single Period Inventory Model
Newsvendor Problem Example
D = newspapers demanded
p(D) = probability of demand
Q = newspapers stocked
P = selling price of newspaper, $10
C = cost of newspaper, $4
S = salvage value of newspaper, $2
Cu = unit contribution: P-C = $6
Co = unit loss: C-S = $2
 Single Period Inventory Model
Expected Value Analysis
Stock Q
p(D) D 6 7 8 9 10

.028 2 4 2 0 -2 -4
.055 3 12 10 8 6 4
.083 4 20 18 16 14 12
.111 5 28 26 24 22 20
.139 6 36 34 32 30 28
.167 7 36 42 40 38 36
.139 8 36 42 48 46 44
.111 9 36 42 48 54 52
.083 10 36 42 48 54 60
.055 11 36 42 48 54 60
.028 12 36 42 48 54 60

Expected Profit $31.54 $34.43 $35.77 $35.99 $35.33

 Single Period Inventory Model
Incremental Analysis
E (revenue on last sale)  E (loss on last sale)

P ( revenue) (unit revenue)  P (loss) (unit loss)

P( D  Q)Cu  P( D  Q)Co

1 P( D  Q)C u  P( D  Q)Co

Cu
P ( D  Q)  (Critical Fractile)
Cu  Co
where:
Cu = unit contribution from newspaper sale ( opportunity cost of underestimating demand)
Co = unit loss from not selling newspaper (cost of overestimating demand)
D = demand
Q = newspaper stocked
Critical fractile for the
newsvendor problem
P(D<Q)
(Co applies)

P(D>Q)
(Cu applies)
Probability

0.722

0 2 4 6 8 10 12 14
New spaper demand, Q
Retail Discounting Model
• S = current selling price
• D = discount price
• P = profit margin on cost (% markup as decimal)
• Y = average number of years to sell entire stock of “dogs” at
current price (total years to clear stock divided by 2)
• N = inventory turns (number of times stock turns in one year)
Loss per item = Gain from revenue
S – D = D(PNY)

S
D
(1  PNY )
 Topics for Discussion
• Discuss the functions of inventory for different
organizations in the supply chain.
• How would one find values for inventory costs?
• How can information technology create a competitive
advantage through inventory management?
• How valid are the assumptions for the EOQ model?
• How is a service level determined for inventory
items?
• What inventory model would apply to service capacity
such as seats on an aircraft?
Interactive Exercise
The class engages in an estimation of the
cost of a 12-ounce serving of Coke in
various situations (e.g., supermarket,
convenience store, fast-food restaurant,
sit-down restaurant, and ballpark).
What explains the differences?