Why ‘Inventory Management’ is important?

• Inventory is any stored resource that is used to satisfy a

current or future need
• Raw materials, work-in-process, and finished goods are
examples of inventory
• Inventory is one of the most expensive assets of many
companies.
• In some cases, it may represent as much as 40% of total
invested capital
• Two basic questions in inventory management are (1) how
much to order (or produce), and (2) when to order (or
produce).
 Basic Functions of Inventory
Basic Functions of Inventory are:

1. If product demand is high in summer, a firm

might produce during winter (Decoupling)
2. Inventory can be a hedge against price
changes and inflation
3. Another use of inventory is to take advantage
of quantity discounts (when buying)
(Many suppliers offer discounts for large orders)
Role of Inventory in the Supply Chain
Improve Matching of Supply
Improve Matching of Supply
and Demand
and Demand

Improved Forecasting

Cost
Cost Reduce Material Flow Time Availability
Availability
Efficiency
Efficiency Responsiveness
Responsiveness
Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand
Economies of Scale Variability Seasonal Variability

Cycle Inventory Safety Inventory Seasonal Inventory

 Cycle Inventory
Cycle inventory is the average inventory that builds up in the supply
chain because a stage of the supply chain either produces or
purchases in lots that are larger than those demanded by the
customer.

Inventory

Time t
Cycle
Cycle inventory
inventory == lot
lot size/2
size/2 == Q/2
Q/2
 Independent Demand
• Demand from outside the organization
• Unpredictable  usually forecasted

Demand for tables . . .

 Dependent Demand
• Tied to the production of another item
• Relevant mostly to manufacturers

Once we decide how many tables we want to

make, how many legs do we need?
 Two “Classic” Systems for
Independent Demand Items
• Periodic review systems
• Continuous (perpetual) review systems

Factors
– Order quantity (Q)
– Restocking level (R)
– Inventory level when reviewed (I)
 Periodic Review System
(Orders at regular intervals)

Inventory
level

2 4 6 Time
 Continuous Review System
(Orders when inventory drops to R)

How is the reorder

Q point ROP established?

Inventory
level

L-T Time
lead time to get
a new order in
 Comparison of Periodic and
Continuous Review Systems
Periodic Review Continuous Review
• Fixed order intervals • Varying order intervals
• Variable order sizes • Fixed order sizes (Q)
• Convenient to • Allows individual review
administer frequencies
• Orders may be • Possible quantity
combined discounts
• Inventory position • Lower, less-expensive
only required at safety stocks
review
 Inventory Related Costs:
Holding, Ordering and Set-up Costs
• Holding Costs are the costs associated with holding or
“carrying” inventory over time.

• Some example holding costs are:

– building rent or depreciation,
– building operating cost,
– taxes on building, insurance on building,
– material handling equipment leasing or depreciation,
– equipment operating cost, handling manpower cost,
– taxes on inventory, insurance, etc.
 Inventory Related Costs:
Ordering and Set-up Costs…
• Ordering Costs include, cost of supplies, order processing,
clerical cost, etc.
– The ordering cost is valid if the products are purchased NOT
produced internally.
• Set-up cost is the cost to prepare a machine for
manufacturing an order.
– Set-up cost is highly correlated with set-up time.
– Machines that traditionally have taken long hours to set up
Are Now being set up in less than a minute by employing
FMSs or CIM systems.
– Reducing set up times is an excellent way to Reduce
Inventory. (Japanese car manufacturers!!)
 Questions to answer?

• In the independent demand situation, we

should be interested in answering:

– a) When to place an order for an item, and

– b) How much of an item to order.
Independent Demand Inventory Models

• There are Four Basic Independent Demand

Inventory Models:
1) Economic Order Quantity (EOQ) Model (the most
known model).
2) Production Order Quantity Model.
3) Back order inventory model.
4) Quantity discount model.
 Economic Order Quantity (EOQ)
Model
• EOQ model makes a number of assumptions:
1-) Demand is known and constant.
2-) Lead time (the time between placement of order and
receipt of the order) is constant and known.
3-) Orders arrive in one batch at a time, and they arrive in one
point in time.
4-) Quantity discounts are not possible.
5-) The costs include only setup cost (or ordering cost when
buying) and holding cost.
6-) Orders are always placed at the right times. Therefore,
stock outs (or shortages) can be completely avoided.
For EOQ Model, the graph of inventory usage over time:

Q = order quantity
Inventory (That is also equal to the
Level Maximum Inventory)
Usage
Rate Minimum Inventory = 0

Average
Inventory
Level
Time
0

When inventory level reaches 0, a new order is

placed and received.
 Objective: Minimize total cost

• The objective of inventory model is to

minimize total cost.

• If we minimize the setup and holding costs,

we will be able to minimize total cost.

• As the quantity ordered (Q) increases,

holding cost increases, and setup cost
decreases.
 Where the total cost is
minimum?
Total
Annual Cost
Cost
Annual
Holding
Minimum Cost
Total
Cost
Setup Cost
Order Quantity
(Ordering
Cost) (Q)
Optimal Order
Quantity (Q*)

Optimal order quantity (Q*) occurs at a point where setup cost is

equal to the total (annual) holding cost.
 Finding the optimum…
Optimal order quantity (Q*) occurs at a point where setup
cost is equal to the total (annual) holding cost.

By using this fact, we can write an equation for Q*:

D: Annual Demand in units for the inventory item.

S: Setup cost (or the ordering cost) for each order.

Notice: (Setup cost for production, order cost for buying).

H: Annual Holding cost of inventory per unit.

 Finding the optimum…

There will be (D/Q) times of ordering in a

whole year.

Therefore, Annual Setup Cost = (D/Q) . S

Average Annual Holding Cost = (Average Inventory) . H

= (Q/2) . H
 Finding the optimum…
We get optimum point by setting:

Annual Setup Cost = Annual Holding Cost

(D/Q) . S = (Q/2) . H

Therefore,
Q2 = 2DS / H
Q* = [2DS / H]1/2

Q* value is also called as the EOQ.