INVENTORY MANAGEMENT

Operations Management
Dr. Ron Lembke
Purposes of Inventory

 Meet anticipated demand

 Demand variability
 Supply variability
 Decouple production & distribution
 permits constant production quantities
 Take advantage of quantity discounts
 Hedge against price increases
 Protect against shortages
2006 13.81 1857 24.0% 446 801 58 1305 9.9
2007
 US Inventory, GDP ($B)
14,000

12,000

10,000

8,000

6,000

4,000

2,000

9 84 9 86 9 88 9 90 9 92 9 94 9 96 9 98 0 00 0 02 0 04
1 1 1 1 1 1 1 1 2 2 2

Business Inventories US GDP

 US Inventories as % of GDP
25.0%

20.0%

15.0%
% of GDP

10.0%

5.0%

0.0%

9 84 9 86 9 88 9 90 9 2 94 96 9 8 00 0 02 0 4
1 1 1 1 19 19 19 19 20 2 20
Year

Source: CSCMP, Bureau of Economic Analysis

Two Questions
Two main Inventory Questions:
 How much to buy?

 When is it time to buy?

Also:
Which products to buy?
From whom?
Types of Inventory
 Raw Materials
 Subcomponents
 Work in progress (WIP)
 Finished products
 Defectives
 Returns
Inventory Costs
What costs do we experience because we carry
inventory?
Inventory Costs
Costs associated with inventory:
 Cost of the products

 Cost of ordering

 Cost of hanging onto it

 Cost of having too much / disposal

 Cost of not having enough (shortage)

Shrinkage Costs
 How much is stolen?
 2% for discount, dept. stores, hardware, convenience,
sporting goods
 3% for toys & hobbies
 1.5% for all else
 Where does the missing stuff go?
 Employees: 44.5%
 Shoplifters: 32.7%
 Administrative / paperwork error: 17.5%
 Vendor fraud: 5.1%
Inventory Holding Costs
Category % of Value
Housing (building) cost 4%
Material handling 3%
Labor cost 3%
Opportunity/investment 9%
Pilferage/scrap/obsolescence 2%
Total Holding Cost 21%
Inventory Models
 Fixed order quantity models
 How much always same, when changes
 Economic order quantity
 Production order quantity
 Quantity discount
 Fixed order period models
 How much changes, when always same
Economic Order Quantity
Assumptions
 Demand rate is known and constant

 No order lead time

 Shortages are not allowed

 Costs:

 S - setup cost per order

 H - holding cost per unit time
 EOQ
Inventory
Level

Q* Decrease Due to
Optimal Constant Demand
Order
Quantity

Time
 EOQ
Inventory
Level

Q* Instantaneous
Optimal Receipt of Optimal
Order Order Quantity
Quantity

Time
EOQ

Inventory
Level
Q*

Reorder
Point
(ROP)

Time

Lead Time
EOQ

Inventory
Level
Q*
Average
Inventory Q/2
Reorder
Point
(ROP)

Time

Lead Time
Total Costs
 Average Inventory = Q/2
 Annual Holding costs = H * Q/2
 # Orders per year = D / Q
 Annual Ordering Costs = S * D/Q
 Cost of Goods = D * C
 Annual Total Costs = Holding + Ordering + CoG
Q D
TC (Q)  H *  S *  C * D
2 Q
 How Much to Order?

Annual Cost

Holding Cost
= H * Q/2

Order Quantity
 How Much to Order?

Annual Cost

Ordering Cost
= S * D/Q

Holding Cost
= H * Q/2

Order Quantity
 How Much to Order?
Total Cost
Annual Cost = Holding + Ordering

Order Quantity
 How Much to Order?
Total Cost
Annual Cost = Holding + Ordering

Optimal Q Order Quantity

 Optimal Quantity

Q D
Total Costs = H *  S * C*D
2 Q
Take derivative H D Set equal
with respect to Q = S* 2 0 to zero
2 Q
Solve for Q:

H DS 2 DS 2 DS
 2 Q 
2
Q
2 Q H H
Adding Lead Time
 Use same order size
2 DS
Q
H
 Order before inventory depleted
 R = d * L where:

d = average demand rate (per day)
 L = lead time (in days)
 both in same time period (wks, months, etc.)
A Question:
 If the EOQ is based on so many horrible
assumptions that are never really true, why is it the
most commonly used ordering policy?
 Profit function is very shallow
 Even if conditions don’t hold perfectly, profits are
close to optimal
 Estimated parameters will not throw you off very far
Quantity Discounts
 How does this all change if price changes
depending on order size?
 Holding cost as function of cost:
 H=I*C
 Explicitly consider price:

2DS
Q
I C
Discount Example

D = 10,000 S = $20 I = 20%

Price Quantity EOQ

c = 5.00 Q < 500 633
4.50 501-999 666
3.90 Q >= 1000 716
 Discount Pricing

Total Cost

Price 1 Price 2 Price 3

X 633
X 666
X 716

500 1,000 Order Size

 Discount Pricing

Total Cost

Price 1 Price 2 Price 3

X 633
X 666
X 716

500 1,000 Order Size

Discount Example
Order 666 at a time:
Hold 666/2 * 4.50 * 0.2= $299.70
Order 10,000/666 * 20 = $300.00
Mat’l 10,000*4.50 = $45,000.00 45,599.70

Order 1,000 at a time:

Hold 1,000/2 * 3.90 * 0.2= $390.00
Order 10,000/1,000 * 20 = $200.00
Mat’l 10,000*3.90 = $39,000.00 39,590.00
Discount Model
1. Compute EOQ for next cheapest price
2. Is EOQ feasible? (is EOQ in range?)
If EOQ is too small, use lowest possible Q to get
price.
3. Compute total cost for this quantity
4. Repeat until EOQ is feasible or too big.
5. Select quantity/price with lowest total cost.
INVENTORY MANAGEMENT
-- RANDOM DEMAND
Random Demand

 Don’t know how many we will sell

 Sales will differ by period
 Average always remains the same
 Standard deviation remains constant
Impact of Random Demand

How would our policies change?

 How would our order quantity change?

 How would our reorder point change?

Mac’s Decision
 How many papers to buy?
 Average = 90, st dev = 10
 Cost = 0.20, Sales Price = 0.50
 Salvage = 0.00
 Cost of overestimating Demand, CO
 CO = 0.20 - 0.00 = 0.20
 Cost of Underestimating Demand, CU
 CU = 0.50 - 0.20 = 0.30
Optimal Policy

G(x) = Probability demand <= x

Optimal quantity:
Cu
Pr(D  Q) 
C o  Cu
Mac: G(x) = 0.3 / (0.2 + 0.3) = 0.6
From standard normal table, z = 0.253
=Normsinv(0.6) = 0.253
Q* = avg + zs = 90+ 2.53*10 = 90 +2.53 = 93
Optimal Policy
 If units are discrete, when in doubt, round up
 If u units are on hand, order Q - u units
 Model is called “newsboy problem,” newspaper
purchasing decision
 By time realize sales are good, no time to order more
 By time realize sales are bad, too late, you’re stuck
 Similar to the problem of # of Earth Day shirts to
make, lbs. of Valentine’s candy to buy, green beer,
Christmas trees, toys for Christmas, etc., etc.
Random Demand –
Fixed Order Quantity

 If we want to satisfy all of the demand 95% of the

time, how many standard deviations above the
mean should the inventory level be?
 Probabilistic Models
Safety stock = x m
x
From statistics, z 
L
Safety stock & Safety stock = zs
Therefore, z = L
sL
From normal table z.95 = 1.65
Safety stock = zsL= 1.65*10 = 16.5
R = m + Safety Stock
=350+16.5 = 366.5 ≈ 367
Random Example
 What should our reorder point be?
 demand over the lead time is 50 units,
 with standard deviation of 20
 want to satisfy all demand 90% of the time
 (i.e., 90% chance we do not run out)
 To satisfy 90% of the demand, z = 1.28
 Safety stock = zσL= 1.28 * 20 = 25.6
 R = 50 + 25.6 = 75.6
St Dev Over Lead Time

 What if we only know the average daily demand,

and the standard deviation of daily demand?
 Lead time = 4 days,
 daily demand = 10,
 standard deviation = 5,
 What should our reorder point be, if z = 3?
St Dev Over LT
 If the average each day is 10, and the lead time is 4
days, then the average demand over the lead time
must be 40.
d * L  10 * 4  40
 What is the standard deviation of demand over the
lead time?
 Std. Dev. ≠ 5 * 4
St Dev Over Lead Time
 Standard deviation of demand =

 L  Ldays  day
 45  10
R  d * L  z L  d * L  z Ldays  day
 R = 40 + 3 * 10 = 70
Service Level Criteria
 Type I: specify probability that you do not run out
during the lead time
 Probability that 100% of customers go home happy
 Type II: proportion of demands met from stock
 Percentage that go home happy, on average
 Fill Rate: easier to observe, is commonly used
 G(z)= expected value of shortage, given z. Not
frequently listed in tables

Q
G( z)  1  Fill Rate 
L
Two Types of Service
Cycle Demand Stock-Outs
1 180 0 Type I:
2 75 0
8 of 10 periods
3 235 45
4 140 0 80% service
5 180 0
6 200 10 Type II:
7 150 0 1,395 / 1,450 =
8 90 0 96%
9 160 0
10 40 0
Sum 1,450 55
FIXED-TIME PERIOD
MODELS
Fixed-Time Period Model
 Every T periods, we look at inventory on hand and
place an order
 Lead time still is L.
 Order quantity will be different, depending on
demand
 Fixed-Time Period Model:
When to Order?

Inventory Level Target maximum

Period Time
 Fixed-Time Period Model: :
When to Order?

Inventory Level Target maximum

Period Period Time

 Fixed-Time Period Model:
When to Order?

Inventory Level Target maximum

Period Period Time

 Fixed-Time Period Model:
When to Order?

Inventory Level Target maximum

Period Period Period Time

 Fixed-Time Period Model:
When to Order?

Inventory Level Target maximum

Period Period Period Time

 Fixed-Time Period Model:
When to Order?

Inventory Level Target maximum

Period Period Period Time

Fixed Order Period
 Standard deviation of demand over T+L =

 T  L  T  L
 T = Review period length (in days)
 σ = std dev per day
 Order quantity (12.11) =

q  d (T  L)  z T  L  I
 Inventory Recordkeeping

Two ways to order inventory:

 Keep track of how many delivered, sold

 Go out and count it every so often

If keeping records, still need to double-check

 Annual physical inventory, or

 Cycle Counting
Cycle Counting
 Physically counting a sample of total inventory
on a regular basis
 Used often with ABC classification
 A items counted most often (e.g., daily)
 Advantages
 Eliminates annual shut-down for physical inventory
count
 Improves inventory accuracy
 Allows causes of errors to be identified
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 rep. calls every 2 weeks
ABC Analysis
 Divides on-hand inventory into 3 classes
 A class, B class, C class
 Basis is usually annual $ volume
 $ volume = Annual demand x Unit cost
 Policies based on ABC analysis
 Develop class A suppliers more
 Give tighter physical control of A items
 Forecast A items more carefully
 Classifying Items
as ABC

% Annual $ Volume Items %$Vol %Items

100 A 80 15
B 15 30
80
C 5 55
60
40 A
20
B C
0
0 50 100 150

% of Inventory Items
ABC Classification Solution

Stock # Vol. Cost $ Vol. % ABC

206 26,000 $ 36 $936,000 71.1
105 200 600 120,000 9.1
019 2,000 55 110,000 8.4
144 20,000 4 80,000 6.1
207 7,000 10 70,000 5.3
Total 1,316,000 100.0
ABC Classification Solution

Stock # Vol. Cost $ Vol. % ABC

206 26,000 $ 36 $936,000 71.1 A
105 200 600 120,000 9.1 A
019 2,000 55 110,000 8.4 B
144 20,000 4 80,000 6.1 B
207 7,000 10 70,000 5.3 C
Total 1,316,000 100.0