Chapter 12 - Inventory Management

Operations
Management
Chapter 12 –
Inventory Management
© 2008 Prentice Hall, Inc. 12 – 1

Inventory
 One of the most expensive assets of

many companies representing as much
as 50% of total invested capital

Functions of Inventory
1. To decouple or separate various parts of the production
process. For example if firm’s supplies fluctuate, extra
inventory may be necessary to decouple production
process from supplies
2. To decouple the firm from fluctuations in demand and

provide a stock of goods that will provide a selection for
customers
3. To take advantage of quantity discounts, because

purchases in larger quantities may reduce the cost of
goods or their delivery
4. To hedge against inflation and upward price changes

Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 Undergone some change but not completed
 During most of the time the product being made is in fact
sitting idle
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes productive
 Finished goods
 Completed product awaiting shipment
Inventory Management
 How inventory items can be classified
 How accurate inventory records can be

maintained

ABC Analysis
 Divides inventory into three classes
based on annual dollar volume
 Class A - high annual dollar volume
 Class B - medium annual dollar volume
 Class C - low annual dollar volume

ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4% B

ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C
#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $232,057 100.0%

ABC Analysis
Percent of annual dollar usage
A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |
10 20 30 40 50 60 70 80 90 100
Percent of inventory items Figure 12.2

Independent Versus
Dependent Demand
 Independent demand - the demand for
item is independent of the demand for
any other item in inventory
 Dependent demand - the demand for item

is dependent upon the demand for some
other item in the inventory

Holding, Ordering, and Setup Costs
 Holding costs - the costs of holding or
“carrying” inventory over time
 Ordering costs - the costs of placing an

order and receiving goods
 Setup costs - cost to prepare a machine

or process for manufacturing an order

Inventory Models for Independent
Demand
Need to determine when and how much to
order
 Basic economic order quantity
 Production order quantity
 Quantity discount model

Basic EOQ Model
Important assumptions
1. Demand is known, constant, and
independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided

Inventory Usage Over Time
Usage rate Average

Order inventory
quantity = Q
Inventory level
on hand
(maximum
inventory Q
level) 2
Minimum
inventory
0
Time
Figure 12.3
Minimizing Costs
Objective is to minimize total costs
Curve for total

cost of holding
and setup
Minimum
total cost
Annual cost
Holding cost
curve
Setup (or order)

cost curve
Optimal order Order quantity
Table 11.5 quantity (Q*)
The EOQ Model D
Annual setup cost = S
Q
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)
Annual demand Setup or order

=
Number of units in each order cost per order
D
= (S)
Q

The EOQ Model
D
Annual setup cost =
S
Q
Q = Number of pieces per order Q
Annual holding cost = H
Q* = Optimal number of pieces per order (EOQ) 2
Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)
Order quantity
= (Holding cost per unit per year)
2
= Q (H)
2

The EOQ Model
D
Annual setup cost = S
Q
Q = Number of pieces per order Q
Annual holding cost = H
Q* = Optimal number of pieces per order (EOQ) 2
Optimal order quantity is found when annual setup cost equals annual
holding cost
D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H

An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year
2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50

An EOQ Example
D = 1,000 units Q* = 200 units
S = $10 per order
Expected Demand D
number of = N = =
orders Order quantity Q*
1,000
N= = 5 orders per year
200

An EOQ Example
S = $10 per order N = 5 orders per year
Number of working
Expected days per year
time between = T =
orders N
250
T= = 50 days between orders
5

An EOQ Example
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days
Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = ($10) + ($.50)
200 2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100

Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to order
Demand Lead time for a

ROP = per day new order in days
=dxL
D
d = Number of working days in a year

Reorder Point Curve
Q*
Inventory level (units)
Slope = units/day = d
ROP
(units)
Time (days)
Figure 12.5 Lead time = L
Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
D
d=
Number of working days in a year
= 8,000/250 = 32 units
ROP = d x L
= 32 units per day x 3 days = 96 units

Production Order Quantity Model
 Used when inventory builds up over a
period of time after an order is placed
 Used when units are produced and sold

simultaneously

Part of inventory cycle during

which production (and usage)
is taking place
Inventory level
Demand part of cycle with

no production(only usage
Maximum takes place)
inventory
t Time
Figure 12.6

Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days
Annual inventory Holding cost

= (Average inventory level) x
holding cost per unit per year
Annual inventory
= (Maximum inventory level)/2
level
Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt

t = Length of the production run in days
Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p
Maximum Q Q d
inventory level = p –d =Q 1–
p p p
Q d
Holding cost = Maximum inventory level (H) = 1– H
2 2 p

D = Annual demand
Setup cost = (D/Q)S

1
Holding cost = 2 HQ[1 - (d/p)]
1
(D/Q)S = 2 HQ[1 - (d/p)]
2DS
Q =
2
H[1 - (d/p)]
2DS
Q*p =
H[1 - (d/p)]

Example
D = 1,000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year
2DS
Q* =
H[1 - (d/p)]
2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283

Note:
D 1,000
d=4= =
Number of days the plant is in operation 250
When annual data are used the equation becomes
2DS
Q* =
annual demand rate
H 1–
annual production rate

Quantity Discount Models
 Reduced prices are often available when larger
quantities are purchased
 Trade-off is between reduced product cost and

increased holding cost
Total cost = Setup cost + Holding cost + Product cost

D Q
TC = S+ H + PD
Q 2

PROBLEM

A typical quantity discount schedule
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75
Table 12.2

Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount

Quantity Discount Examples
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)
2(5,000)(49)
(.2)(4.80)
2(5,000)(49)
(.2)(4.75)

Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
(.2)(5.00)
2(5,000)(49)
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
(.2)(4.75) 2,000 — adjusted

Total cost curve for discount 2

Total cost
curve for
discount 1
Total cost $
Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b
1st price 2nd price

break break
0 1,000 2,000
Figure 12.7
Order quantity
Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total cost

Annual Annual Annual

Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700
2 $4.80 1,000 $24,000 $245 $480 $24,725
3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50
Table 12.3
Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit
Fixed-Period (P) Systems
 Orders placed at the end of a fixed period
 Inventory counted only at end of period
 Order brings inventory up to target level
 Only relevant costs are ordering and holding
 Lead times are known and constant
 Items are independent from one another

Target quantity (T)
Q4
Q2
On-hand inventory
Q1 P
Q3
Time Figure 12.9

 Inventory is only counted at each

review period
 May be scheduled at convenient times
 Appropriate in routine situations
 May result in stockouts between
periods
 May require increased safety stock

PROBLEM
• A company manufactures in batches; the manufactured
items are placed in stock. Specifically, the firm is
questioning how best to manage a specific wooden crate
for shipping live seafood, which is sold primarily by the
mail/phone order marketing division of the firm. The firm
has estimated that carrying cost is $4 per unit per year.
Other data for the crate are: annual demand 60,000 units;
setup cost $300. The firm currently plans to satisfy all
customer demand from stock on hand. Demand is known
and constant.
•
• a. What is the cost minimizing size of the manufacturing
batch?
• b. What is the total cost of this solution?

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Operations

© 2008 Prentice Hall, Inc. 12 – 1

 One of the most expensive assets of

© 2008 Prentice Hall, Inc. 12 – 2

2. To decouple the firm from fluctuations in demand and

3. To take advantage of quantity discounts, because

4. To hedge against inflation and upward price changes

 How accurate inventory records can be

© 2008 Prentice Hall, Inc. 12 – 5

© 2008 Prentice Hall, Inc. 12 – 6

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

© 2008 Prentice Hall, Inc. 12 – 7

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

© 2008 Prentice Hall, Inc. 12 – 8

© 2008 Prentice Hall, Inc. 12 – 9

 Dependent demand - the demand for item

© 2008 Prentice Hall, Inc. 12 – 10

 Ordering costs - the costs of placing an

 Setup costs - cost to prepare a machine

© 2008 Prentice Hall, Inc. 12 – 11

© 2008 Prentice Hall, Inc. 12 – 12

© 2008 Prentice Hall, Inc. 12 – 13

Usage rate Average

Curve for total

Setup (or order)

Annual setup cost = (Number of orders placed per year)

Annual demand Setup or order

© 2008 Prentice Hall, Inc. 12 – 16

Annual holding cost = (Average inventory level)

© 2008 Prentice Hall, Inc. 12 – 17

© 2008 Prentice Hall, Inc. 12 – 18

© 2008 Prentice Hall, Inc. 12 – 19

© 2008 Prentice Hall, Inc. 12 – 20

© 2008 Prentice Hall, Inc. 12 – 21

Total annual cost = Setup cost + Holding cost

© 2008 Prentice Hall, Inc. 12 – 22

Demand Lead time for a

© 2008 Prentice Hall, Inc. 12 – 23

© 2008 Prentice Hall, Inc. 12 – 25

 Used when units are produced and sold

© 2008 Prentice Hall, Inc. 12 – 26

Part of inventory cycle during

Demand part of cycle with

© 2008 Prentice Hall, Inc. 12 – 27

Annual inventory Holding cost

Maximum Total produced during Total used during

© 2008 Prentice Hall, Inc. 12 – 28

Maximum Total produced during Total used during

© 2008 Prentice Hall, Inc. 12 – 29

Setup cost = (D/Q)S

© 2008 Prentice Hall, Inc. 12 – 30

© 2008 Prentice Hall, Inc. 12 – 31

When annual data are used the equation becomes

© 2008 Prentice Hall, Inc. 12 – 32

 Trade-off is between reduced product cost and

Total cost = Setup cost + Holding cost + Product cost

© 2008 Prentice Hall, Inc. 12 – 33