Inventory Management

Lec- 6 & 7
 Learning Objectives
• Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory management.
• Discuss the nature and importance of service
inventories
• Discuss periodic and perpetual review systems.
• Discuss the objectives of inventory management.
• Describe the A-B-C approach and explain how it is
useful.
 Learning Objectives
• Describe the basic Economic Order Quantity
(“EOQ”) model and its assumptions, and solve
typical problems.
• Describe the Economic Production Quantity
(“EPQ”) model and solve typical problems.
• Describe the quantity discount model and solve
typical problems.
• Describe reorder point models and solve typical
problems.
 Inventory
Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
 Inventory Models
• Independent demand – finished goods, items
that are ready to be sold
– E.g. a computer

• Dependent demand – components of finished

products
– E.g. parts that make up the computer
 Importance of Inventory
• One of the most expensive assets of many companies representing as
much as 30%-50% of total invested capital
• Operations managers must balance inventory investment and customer
service

Too much stock:

•Cost of storing stock: risk of obsolescence/deterioration, higher holding cost
• Capital cost: loss of interest of capital tied up
• Reduced working capital available for alternative investment
Too little stock:
• Disappointed customers, lost sales
• Higher costs: making emergency orders and reordering more frequently

Aim: hold just right amount of stock – not too much or too little
and achieve minimum cost overall
 Types of Inventories
• Raw materials & purchased parts
• Partially completed goods called
work in progress
• Finished-goods inventories
– (manufacturing firms)
or merchandise
(retail stores)

• Replacement parts, tools, & supplies

• Goods-in-transit to warehouses or customers
(pipeline inventory)
 Functions of Inventory

• To meet anticipated demand

• To smooth production requirements
• To decouple operations
• To protect against stock-outs
 Functions of Inventory (Cont’d)

• To take advantage of order cycles

• To hedge against price increases
• To permit operations
• To take advantage of quantity discounts
 Inventory Counting Systems
• Periodic System
Physical count of items made at periodic
intervals

• Perpetual Inventory System

System that keeps track of removals from
inventory continuously, thus
monitoring current levels of
each item
Inventory Counting Systems (Cont.)
 Two-Bin System - Two containers of
inventory; reorder when the first is empty

 Universal Product Code - Bar code

printed on a label that has
information about the item 0
to which it is attached
214800 232087768
 Effective Inventory Management
• A system to keep track of inventory
• A reliable forecast of demand
• Knowledge of lead times
• Reasonable estimates of
– Holding costs
– Ordering costs
– Shortage costs
• A classification system
 Key Inventory Terms
• Lead time: time interval between ordering
and receiving the order
• Holding (carrying) costs: cost to carry an
item in inventory for a length of time,
usually a year
• Ordering costs: costs of ordering and
receiving inventory
• Shortage costs: costs when demand
exceeds supply
 ABC Classification System

Classifying inventory according to some

measure of importance and allocating
control efforts accordingly.
A - very important
B - mod. important High
A
C - least important Annual
$ value B
of items

Low C
Low High
Percentage of Items
 Economic Order Quantity Models

• Economic order quantity (EOQ) model

– The order size that minimizes total annual cost
• Economic production model
• Quantity discount model
 Assumptions of EOQ Model

• Only one product is involved

• Annual demand requirements known
• Demand is even throughout the year
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts
• Stock outs can be completely avoided
 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + D S
TC = H
2 Q

Q is Order Quantity (in units)

H is Holding (Carrying) cost per unit
D is Demand, usually in units per year
S is Ordering Cost per order
 Minimum Total Cost

The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.

Q = D S
H
2 Q
 The EOQ Model
2
DS
2
(Annu
)
(
Ord
)
Q
= =
OPT
H Ann

Optimal order quantity is found when annual setup cost

equals annual holding cost
 EOQ Example
• A local distributor for a national tire company expects to
sell approximately 9,600 steel-belted radial tires of a
certain size and tread design next year. Annual carrying
cost is $16 per tire, and ordering cost is $75. The
distributor operates 288 days a year.
– What is the EOQ?
– How many times per year does the store reorder?
– What is the length of an order cycle (time between orders)?
– What is the total annual cost if the EOQ quantity is ordered?
EOQ Example
 EOQ Example
Piddling Manufacturing assembles security monitors. It
purchases 3,600 black-and-white cathode ray tubes a year at $65
each. Ordering costs are $31, and annual carrying costs are 20
percent of the purchase price.

Compute the optimal quantity and the total annual cost of

ordering and carrying the inventory.
Solution
 Example
The demand for a product is constant at 200
units per month. It costs £10 to place an
order and the costs of holding one unit in
stock for one month is £5.

What should the order quantity be to

minimize total monthly costs and what is
this cost?
Solution
Economic Production Quantity (EPQ)
• Production done in batches or lots
• Capacity to produce a part exceeds the
part’s usage or demand rate
• Assumptions of EPQ are similar to EOQ
except orders are received incrementally
during production
 Economic Production Quantity Assumptions
• Only one item is involved
• Annual demand is known
• Usage rate is constant
• Usage occurs continually
• Production rate is constant
• Lead time does not vary
• No quantity discounts
 Economic Run Size
2 DS p p is production or delivery rate
Q 
p
H p u u is usage rate

12-28
 EPQ Example
A toy manufacturer uses 48,000 rubber wheels per year for its
popular dump truck series. The firm makes its own wheels,
which it can produce at a rate of 800 per day. The toy trucks are
assembled uniformly over the entire year. Carrying cost is $1 per
wheel a year. Setup cost for a production run of wheels is $45.
The firm operates 240 days per year. Determine the:
• Optimal run size
• Minimum total annual cost for carrying and setup
• Cycle time for the optimal run size
• Run time
EPQ Example
 EOQ Refresher
•  
Quantity Discount Models
 Total Costs with Purchasing Cost

Annual Annual Purchasing

TC = carrying + ordering + cost
cost cost

Q + DS + PD
TC = H
2 Q
 Total Costs with PD
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity
 Quantity Discount Example
The maintenance department of a large hospital
uses about 816 cases of liquid cleanser annually.
Ordering costs are $12, carrying costs are $4 per
case a year, and the new price schedule indicates
that orders of less than 50 cases will cost $20 per
case, 50 to 79 cases will cost $18 per case, 80 to
99 cases will cost $17 per case, and larger orders
will cost $16 per case. Determine the optimal
order quantity and the total cost.
Quantity Discount Example
 •
Quantity Discount Example
The 70 cases can be bought at $18 per case because 70 falls in the range of 50
to 79 cases. The total cost to purchase 816 cases a year, at the rate of 70 cases
per order, will be

 Because lower cost ranges exist, each must be checked against the
minimum cost generated by 70 cases at $18 each. In order to buy at
$17 per case, at least 80 cases must be purchased. (Because the TC
curve is rising, 80 cases will have the lowest TC for that curve's feasible
region.) The total cost at 80 cases will be

 To obtain a cost of $16 per case, at least 100 cases per order are
required, and the total cost at that price break will be
Quantity Discount Example
Order Quantity Total Cost
70 14,968
80 14,154
100 13,354

100 cases per order yields the lowest total

cost, 100 cases is the overall optimal order
quantity.

With Quantity Discounts, purchase quantity

will be equal to or greater optimal economic
quantity.
When to Reorder with EOQ Ordering
• Reorder Point - When the quantity on hand
of an item drops to this amount, the item
is reordered
• Safety Stock - Stock that is held in excess of
expected demand due to variable demand
rate and/or lead time.
• Service Level - Probability that demand will
not exceed supply during lead time.
Determinants of the Reorder Point
• The rate of demand
• The lead time
• Demand and/or lead time variability
• Stockout risk (safety stock)

If demand and lead time are both constants,

then ROP = d x LT
 The Inventory Cycle

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 Reorder Point Example
Rahim takes Two-a-Day vitamins, which are
delivered to his home seven days after an order
is called in. At what point should Rahim reorder?

Rahim should reorder when 14 vitamin tablets are left,

which is equal to a seven-day supply of two vitamins a
day.
 Safety Stock

Safety stock reduces risk of

stockout during lead time 12-44
 Safety Stock
When variability is present in demand or lead time, it creates the possibility that
actual demand will exceed expected demand. Consequently, it becomes necessary
to carry additional inventory, called safety stock , to reduce the risk of running out
of inventory (a stockout) during lead time. The reorder point then increases by the
amount of the safety stock:

For example, if expected demand during lead time is 100 units, and the desired
amount of safety stock is 10 units, the ROP would be 110 units
 Service Level
• Order cycle service level can be defined as the probability
that demand will not exceed supply during lead time (i.e., that
the amount of stock on hand will be sufficient to meet
demand).
• A service level of 95 percent implies a probability of 95
percent that demand will not exceed supply during lead time.
• The risk of a stockout is the complement of service level; a
customer service level of 95 percent implies a stockout risk of
5 percent.
Reorder Point

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
 Fixed-Order-Interval Model

• Orders are placed at fixed time intervals

• Order quantity for next interval?
• Suppliers might encourage fixed intervals
• May require only periodic checks of
inventory levels
• Risk of stockout
• Fill rate – the percentage of demand filled
by the stock on hand
 Fixed-Interval Benefits

• Tight control of inventory items

• Items from same supplier may yield savings
in:
– Ordering
– Packing
– Shipping costs
• May be practical when inventories cannot
be closely monitored
 Fixed-Interval Disadvantages

• Requires a larger safety stock

• Increases carrying cost
• Costs of periodic reviews
 Single Period Model
• Single period model: model for ordering of
perishables and other items with limited
useful lives
• Shortage cost: generally the unrealized
profits per unit

• Excess cost: difference between purchase

cost and salvage value of items left over at
the end of a period
 Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit

Ce Cs

Service Level

Quantity

So
Balance point
 Example
• Ce = $0.20 per unit
• Cs = $0.60 per unit
• Service level = Cs/(Cs+Ce) = .6/(.6+.2)
C C
• Service
e
level = .75 s

Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25

 Operations Strategy
• Too much inventory
– Tends to hide problems
– Easier to live with problems than to eliminate
them
– Costly to maintain
• Wise strategy
– Reduce lot sizes
– Reduce safety stock