Inventory Management

12 – 1
 Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 Undergone some change but not completed
 A function of cycle time for a product
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
productive
 Finished goods
 Completed product awaiting shipment
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 Inventory

 One of the most expensive assets

of many companies representing as
much as 50% of total invested
capital
 Operations managers must balance
inventory investment and customer
service

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 Functions of Inventory
1. To decouple or separate various
parts of the production process
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
4. To hedge against inflation
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 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
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 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

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 Inventory Models for
Independent Demand
Need to determine when and how
much to order

 Basic economic order quantity

 Production order quantity
 Quantity discount model

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 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
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 Inventory Usage Over Time

Usage rate Average

Order inventory
quantity = Q
Inventory level

on hand
(maximum
inventory Q
level) 2

Minimum
inventory

Time

Figure 12.3
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 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 quantity
Table 11.5 order
quantity 12 – 10
 The EOQ Model
Annual setup cost =
D
Q
S

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

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

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

Q
= ( H)
2

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 The EOQ Model
Annual setup cost =
D
Q
S
Q
Annual holding cost = H
Q = Number of pieces per order 2
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

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
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 Robust Model

 The EOQ model is robust

 It works even if all parameters
and assumptions are not met
 The total cost curve is relatively
flat in the area of the EOQ

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 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
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
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 An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2
1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

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 An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2 Only 2% less
1,500 244.9 than the total
TC = ($10) + ($.50) cost of $125
244.9 2
when the
TC = $61.24 + $61.24 = $122.48 order quantity
was 200

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 Numerical Problem
Problem : Henry Crounch’s law office had
traditionally ordered ink rifills 60 units at a
time.The firm estimates that carrying cost
is 40% of the $10 unit cost and that annual
demand is about 240 units per year. The
assumption of the basic EOQ model are
thought to apply. For what value of
ordering cost would the action be optimal.

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 Numerical Problem
Problem : Whole nature Foods Sells a gluten-
free product for which the annual demand is
5000 boxes.At the moment it is paying $ 6.40
for each box; carrying cost is 25% of the unit
cost; ordering cost are $ 25. A new supplier
has offered to sell the same item for $ 6.00 , if
Whole Nature buys at least 3,000 boxes per
order. Should the firm stick with the old
supplier , or take advantage of the new
supplier.

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 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

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 Reorder Point Example

Problem: Annual demand or notebook binders at

Meyer’s Stationary shop is 10,000 units.Brad Meyers
operates his business 300 days per year and finds that
deliveries from the supplier takes 5 working
days.Calculate the reorder point for the notebook
binders.

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 Reorder Point Example

Problem: Southeastern Bell stocks a certain switch

connector at its central warehouse for supplying field
service offices. The yearly demand for these connectors
is 15,000 units.South eastern estimates its annual
holding cost for this item to be $ 25 per unit. The cost to
place and process an order from the supplier is $ 75 .
The company operates 300 days per year , and the lead
time to receive an order from the supplier is 2 working
days.
a)Find the EOQ
b)Find the annual holding cost
c)Find the annual ordering cost
d)What is the reorder point. 12 – 22
 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

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 Production Order Quantity
Model
Part of inventory cycle during
which production (and usage)
is taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time

Figure 12.6

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Production Order Quantity
Model
Q= Number of pieces per order p = Daily production rate
H= Holding cost per unit per year d = Daily demand/usage rate
D= Annual demand

2DS
Q* = H[1 - (d/p)]

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 Production Order Quantity
Model
When annual data are used the equation becomes

2DS
Q* =
annual demand rate
H 1–
annual production rate

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 Production Order Quantity
Example

Problem : Leonard Presby Inc has an annual demand

rate of 1000 units but can produce at an average
production rate of 2000 units . Setup cost is $ 10 ;
carrying cost is $ 1. What is the optimal number of
units to be produced each time.

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 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 QH
TC = S+ + PD
Q 2

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 Quantity Discount Models
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

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 Quantity Discount Models
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
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 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars order
(.2)(4.75)
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 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP

2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars order
(.2)(4.75) 2,000 — adjusted
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 Quantity Discount Example
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
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 Numerical Problem
Problem : Rocky Mountain Tire Centre sells
20,000 go-cart tires per year. The ordering
cost for each order is $ 40 , and the holding
cost is 20% of the purchase price of the tires
per year. The purchase price is $ 20 per tire if
fewer than 500 tires are ordered, $ 18 per tire
if 500 or more – but fewer than 1000- tires are
ordered, and $ 17 per tire if 1000 or more are
ordered. How many tires Rocky mountain
order each time it places an order.

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Probabilistic Models and
Safety Stock
 Used when demand is not constant or
certain
 Use safety stock to achieve a desired
service level and avoid stockouts

ROP = d x L + ss

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 Probabilistic Demand

Minimum demand during lead time

Inventory level

Maximum demand during lead time

Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5

ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)

Safety stock 16.5 units

0 Lead
time Time
Figure 12.8 Place Receive
order order
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Probabilistic Demand

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
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 Probabilistic Demand
Use prescribed service levels to set safety
stock when the cost of stockouts cannot be
determined

ROP = demand during lead time + Zdlt

where Z = number of standard

deviations
dlt = standard deviation of
demand during lead time

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 Probabilistic Example
Average demand =  = 350 kits
Standard deviation of demand during lead time = dlt = 10 kits
5% stockout policy (service level = 95%)

For an area under the curve of 95%, the Z =

1.65

Safety stock = Zdlt = 1.65(10) = 16.5 kits

Reorder point = expected demand during lead

time + safety stock
= 350 kits + 16.5 kits of safety
stock
= 366.5 or 367 kits
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 Numerical Problem
What safety stock should Ron
Satterfield Corporation maintain if
mean Sales are 80 during the reorder
point, the standard deviation is 7, and
Ron can tolerate stockouts 10% of the
time?( z at an area of .9 = 1.28)

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 Other Probabilistic Models
When data on demand during lead time is
not available, there are other models
available

1. When demand is variable and lead

time is constant
2. When lead time is variable and
demand is constant
3. When both demand and lead time
are variable

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 Other Probabilistic Models
Demand is variable and lead time is constant

ROP = (average daily demand

x lead time in days) + Zdlt

where d = standard deviation of demand per day

dlt = d lead time

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 Numerical Problem
The daily demand for 52 inch plasma
TVs at Sarahs Discount Emporium is
normally distributed , with an average
of 5 and a standard deviation of 2
units. The lead time for receiving a
shipment of new TVs is 10 days and is
fairly constant. Determine the reorder
level and safety stock for a 95%
service level.( z at an area of .95 = 1.65)

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 Numerical Problem
Daily demand for a certain product is normally
distributed with a mean of 60 and a standard
deviation of 7.The source of supply is reliable
and maintains a constant lead time of six days.
The cost of placing the order is $10 and annual
holding costs are $0.50 per unit. There are no
stockouts costs and unfilled orders are filled as
soon as the order arrives .Assume sales occur
over the entire 365 days of the year. Find the
order quantity and reorder point to satisfy a 95
percent probability of not stocking out during
the lead time.( z at an area of .95 = 1.65)

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 Other Probabilistic Models
Lead time is variable and demand is constant

ROP = (daily demand x

average lead time in days) +
Z x (daily demand) x lt

where lt = standard deviation of lead time in days

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 Numerical Problem
The demand at Arnold Palmer Hospital for
a specialized surgery pack is 60 per week,
virtually every week. The lead time from
McKesson , its main supplier , is normally
distributed , with a mean of 6 weeks for
this product and a standard deviation of 2
weeks .A 90 % weekly service level is
desired. Find the ROP.( Z at an area of .9 =
1.28).

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 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
 Used to establish policies that focus
on the few critical parts and not the
many trivial ones
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VED Analysis

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VED Analysis

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12 – 50
 FSN Analysis

F – Fast Moving
S – Slow Moving
N- Non Moving

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 Policy Implications of
Selective Inventory Control
ABC Analysis
-A class Items need rigorous control
-B class items – relaxed
control(periodic review)
- C class items- simple rules of
thumb

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 Policy Implications of
Selective Inventory Control
VED Analysis
-V class Items call for high level of
service
- E class Items call for medium level
of service
-D class Items call for tolerable level
of service

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 Policy Implications of
Selective Inventory Control
FSN Analysis
F – Most inventory Models apply
to this class
S – (Spare parts etc)
N- Non Moving dead stock(optimal
stock disposal rules)

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 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

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 Fixed-Period Systems

 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

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 Fixed-Period (P) Systems
Target maximum (T)

Q4
Q2
On-hand inventory

Q1 P
Q3

Time Figure 12.9

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Fixed-Time Period Model

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 Fixed-Time period Model
with Safety Stock
In a fixed-time period system,reorders are
placed at the time of the review(T), and
the safety stock that must be reordered is
Safety Stock=z*T+L
Order Quantity=Average demand over
the vulenerable period+Safety Stock-
Inventory currently on hand(plus on order
if any)
q= Average demand * (T+L)+z*T+L - I
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 Numerical Problem
Daily demand for a product is 10 units with a
standard deviation of 3 units. The reveiw
period is 30 days, and lead time is 14 days.
Management has set a policy of satisfying 98
percent of demand from items in stock. At
the beginning of this review period there are
150 units of inventory. How many units
should be ordered?

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 Example
Daily demand for a product is 10 units
with a standard deviation of 3 units.
The review period is 30 days and the
lead time is 14 days. Management has
a set a policy of satisfying 98 percent
of demand from items in stock. At the
beginning of this review period, there
are 150 units in inventory. How many
units should be ordered. .( Z at an area
of .98 = 2.05).
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Example

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 Example
A company currently has 200 units of a product
on hand that it orders every two weeks when the
salespersons visits its premises. Demand for the
product averages 20 units per say with a
standard deviation of 5 units. Lead time for the
product to arrive is seven days. Management has
a goal of a 95 percent probability of not stocking
out for this product. The sales person is due to
come in late this afternoon when 180 units are
left in stock (assuming that 20 are sold
today).How many units should be ordered?( Z at
an area of .95 = 1.64).
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