Inventory Management

Dr. Anurag Tiwari

IIM Rohtak
What is Inventory Management?

 Raw Material and Purchased parts

 Partially completed goods, called work in progress.
 Finished goods inventory
 Tools and supplies
 Maintenance and repair (MRO) inventory
 Goods-in-transit to warehouses, distributors, or customers
 Function of Inventory
 Inventories serve a number of functions
 To meet anticipated customer demand
 To smooth production requirements
 To decouple operations
 To reduce the risk of stock out
 To take advantage of order cycles
 To hedge against price increase
 To permit operations
 To take advantage of quantity discount
 Objective of Inventory

 Inadequate control of inventories can result in both under-and overstocking of items.

 Under stocking results in missed deliveries, lost sales, dissatisfied customer, and
production bottleneck.
 Overstocking unnecessary take up space and ties up funds that might be more productive
elsewhere.
 Inventory Management has two main concern:
 Level of customer services, that is to have the right goods, in sufficient quantitates, in the right
place at the right time.
 The cost of ordering and carrying inventories.
 Requirement for Effective Inventories
Management
 To be effective, management must have the following:
 A system to keep track of the inventory on hand and on order.
 A reliable forecast of demand that includes an indication of possible forecast error.
 Knowledge of lead times and lead time variability.
 Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
 A classification system for inventory items.
 Inventory counting System

 Inventory counting systems can be periodic or perpetual.

 Under a periodic system, a physical count of items in inventory is made at periodic, fixed
interval in order to decide how much to order of each item.
 A perpetual inventories system (also known as continuous review system) keeps track of
removals from inventories on a continuous basis, so the system can provide information on the
current level of inventory for each item.
 Perpetual system ranges from very simple to very sophisticated.
 A two-bin-system , a very elementary system, uses two containers for inventory.
 Items are withdrawn from the first bin until its contents are exhausted.
 It is then time to reorder.
 The second bin contains enough stock to satisfy expected demand until the order is filled.
 Inventory counting System

 Supermarket , discount stores, and department stores have always been major users of
periodic counting system.
 Most have switched to computerized checkout systems using a laser scanning device that
reads a universal product code(UPC), or bar code, printed on an item tag or on packaging.
 Points of sale (POS) systems electronically record actual sales, knowledge of actual sales
can generally enhance forecasting and inventory management
 By relaying information about actual demand in real time, these system enable
management to make unnecessary changes to restocking decisions.
 Inventory Costs

 Four basic costs associated with inventories:

 Purchase Cost
 Holding or carrying cost
 Ordering costs
 Shortage costs
 Classification System

 ABC Analysis
 ABC analysis is an inventory categorization method which consists in dividing
items into three categories (A, B, C):
 A being the most valuable items,
 C being the least valuable ones.
 This method aims to draw managers’ attention on the critical few (A-items) not
on the trivial many (C-items).
 The ABC analysis

The ABC approach states that a company should rate items from A to C, basing its
ratings on the following rules:
 A-items are goods which annual consumption value is the highest; the top 70-
80% of the annual consumption value of the company typically accounts for
only 10-20% of total inventory items.
 B-items are the interclass items, with a medium consumption value; those 15-
25% of annual consumption value typically accounts for 30% of total inventory
items.
 C-items are, on the contrary, items with the lowest consumption value; the
lower 5% of the annual consumption value typically accounts for 50% of total
inventory items.
 The ABC analysis

 The annual consumption value is calculated with the formula:

(Annual demand) x (item cost per unit)

 Through this categorization, the supply manager can identify inventory hot spots,
and separate them from the rest of the items, especially those that are numerous
but not that profitable.
 The ABC analysis

Steps for the classification of items:

1. Find out the unit cost and the usage of each material over a given period;
2. Multiply the unit cost by the estimated annual usage to obtain the net value;
3. List out all the items and arrange them in the descending value (Annual Value);
4. Accumulate value and add up number of items and calculate percentage on
total inventory in value and in number;
5. Draw a curve of percentage items and percentage value;
6. Mark off from the curve the rational limits of A, B and C categories.
 ABC analysis

Percentage of Percentage value of

items annual usage

Close day to day

Class A items About 20% About 80% control

Class B items About 30% About 15% Regular review

Infrequent
Class C items About 50% About 5%
review
 ABC analysis Example

Percentage
Percentage of
value of annual
items
usage
Close day to
Class A items About 20% About 80%
day control

Regular
Class B items About 30% About 15%
review
Infrequent
Class C items About 50% About 5%
review
 ABC analysis Example
 Calculate the total spending per year

Item number Unit cost Annual demand Total cost per year
101 5 48,000 240,000
102 11 2,000 22,000
103 15 300 4,500
104 8 800 6,400
105 7 4,800 33,600
106 16 1,200 19,200
107 20 18,000 360,000
108 4 300 1,200
109 9 5,000 45,000
110 12 500 6,000
Total usage 737,900

Total cost per year: Unit cost * total cost per year
 ABC analysis Example
 Calculate the usage of item in total usage
Usage as a
Item Annual Total cost per
Unit cost % of total
number demand year
usage
101 5 48,000 240,000 32,5%
102 11 2,000 22,000 3%
103 15 300 4,500 0,6%
104 8 800 6,400 0,9%
105 7 4,800 33,600 4,6%
106 16 1,200 19,200 2,6%
107 20 18,000 360,000 48,8%
108 4 300 1,200 0,2%
109 9 5,000 45,000 6,1%
110 12 500 6,000 0,8%
Total usage 737,900 100%

Usage as a % of total usage = usage of item/total usage

 ABC analysis Example
 Sort the items by usage

Item Unit Annual Total cost per Usage as a % of Cumulative % of

number cost demand year total usage total

107 20 18,000 360,000 48,8% 48,8%

101 5 48,000 240,000 32,5% 81,3%

109 9 5,000 45,000 6,1% 87,4%

105 7 4,800 33,600 4,6% 92%

102 11 2,000 22,000 3,0% 94,9%

106 16 1,200 19,200 2,6% 97,5%

104 8 800 6,400 0,9% 98,4%

110 12 500 6,000 0,8% 99,2%

103 15 300 4,500 0,6% 99,8%

108 4 300 1,200 0,2% 100%

Total usage 737,900 100%

 ABC analysis Example
 Results of calculation

Percentage of Percentage usage

Cathegory Items Action
items (%)

Class A 107, 101 20% 81,6% Close control

109, 105, 102, Regular

Class B 40% 16,2%
106 review

104, 110, 103, Infrequent

Class C 40% 2,5%
108 review
 Example
 A manager has obtained a list of units costs and estimated annual demands for 10
inventories items on an A-B-C basis,

Item Number Annual Demand Unit Cost ($)

1 25 360
2 10 70
3 24 500
4 15 100
5 7 70
6 10 1,000
7 2 210
8 10 4,000
9 80 10
10 5 200
 Inventories Ordering Policies

Each item should receive a treatment corresponding to its class:

 A-items should have tight inventory control, more secured storage areas and
better sales forecasts; re-orders should be frequent, with weekly or even daily
reorder; avoiding stock-outs on A-items is a priority.
 B-items benefit from an intermediate status between A and C; an important
aspect of class B is the monitoring of potential evolution toward class A or, in
the contrary, toward the class C.
 Reordering C-items is made less frequently; a typically inventory policy for
C-items consist of having only 1 unit on hand, and of reordering only when an
actual purchase is made; this approach leads to stock-out situation after each
purchase which can be an acceptable situation, as the C-items present both low
demand and higher risk of excessive inventory costs.
 Inventories Ordering Policies

 Inventory ordering policies address the two basic issues of inventory management, which
are how much to order and when to order.
 Inventory that is intended to meet expected demand is known as cyclic stock
 While inventory that is held to reduce the probability of experiencing a stock out due to
demand and/or lead time variability is known as safety stock.
Role of cycle inventory 
 Why do companies hold inventory? Why
might they avoid doing so?
 Why?
 To take advantage of economic purchase order size : economy of scale (cycle
inventory)
 To meet anticipated customer demand
 To account for differences in production timing (smoothing)
 To protect against uncertainty (demand surge, price increase, lead time slippage)
 To maintain independence of operations (buffering)
 Why Not
 Requires additional space
 Opportunity cost of capital
 Spoilage / obsolescence
The role of cycle inventory in a supply chain

 A lot or batch size is the quantity that a stage of a SC either produces or purchases
at a time.
 The lot size is usually larger than the quantities demanded by the customer.
 Cycle inventory is the average inventory in a SC due to this difference.
  The role of cycle inventory in a supply
chain
 Example: Consider a computer store selling an average of D=4 printers a day but
ordering Q=80 printers from the manufacturer each time
 Cycle Inventory = Lot Size/2=Q/2=40
 Average flow time=cycle inventory/demand rate=40/4=10
 Inventory turnover, inventory coverage
On-Hand Inventory

Demand Rate
Q

Average Cycle Inventory

Q/2

Time
 Two Decisions in Inventory Management

 When is it time to reorder?

 If it is time to reorder, how much?
 Models of Inventory Management in SCM

 The Single-Period Model

 Fixed Order Quantity Model
 Fixed Time Period Model
 A Single-Period Inventory Model

 One time ordering decision such as selling t-shirts at a football game, newspapers, fresh
bakery products. Objective is to balance the cost of running out of stock with the cost of
overstocking. The unsold items, however, may have some salvage values.
 Computer that will be obsolete before the next order
 Perishable product
 Seasonal products such as bathing suits, winter coats, etc.
 Newspaper and magazine
 Trade-offs in a Single-Period Models

Loss resulting from the items unsold

ML= Purchase price - Salvage value

Profit resulting from the items sold

MP= Selling price - Purchase price

Trade-off
Given costs of overestimating/underestimating demand
and the probabilities of various demand sizes
how many units will be ordered?
 Trade-offs in a Single-Period Models

Cost  per unit of demand overestimated

=Cost per unit of demand underestimating
By introducing the probabilities, the expected marginal cost equation becomes
P
Where P is the probability that the unit will not be sold and 1-P is the probability of it being sold .
Then, Solving for P, we obtain
P
 Example

 A hotel near the university always fills up on the evening before the football games.
 History shown that when the hotel is fully booked, the number of last minute cancellation
has a mean of 5 and standard deviation of 3.
 The average room rate is 80$. When the hotel is overbooked,
 The policy is to find a room in a nearby hotel and pay for the room for the customer.
 This usually cost the hotel approximately 200$ since the rooms are booked on such a late
notice are expensive.
 How many rooms should the hotel overbook?
 Solutions

  
The cost of underestimating the number of cancellation is $180 and cost of overestimating
cancelation is 200$
 = =0.2857
 Using NORMSINV(Cummulative standarized normal distribution )(.2857) from Excel
gives a Z-Score -0.56599.
 The negative values indicates that we should overbooked by a value less than the average
of 5.
 The actual value should be –(.56599)*(3)=-1.69797, or 2 reservation less than 5.
 The hotel should overbook three reservation on the evening prior to football match
 Fixed Order Quantity and Fixed Time
Period Differences
Feature Fixed Order Quantity Model Fixed Time Period Model
Order Quantity Constant Varies (Varies each time order is
placed)
When to place When inventory position drops to the When the review period arrives
reorder level
Record Keeping Each time a withdraw or addition is made Counted only at review period

Size of Inventory Less than fixed time period model Larger than fixed order quantity
model
Time to maintain Higher due to perpetual recordkeeping Efficient, since multiple items can
be ordered at the same time

Types of Items Higher priced, critical, or important items Typically used with lower cost
items.
 Economies of scale to exploit fixed costs:
Economic Order Quantity Model
  Economies of scale to exploit fixed costs:
Economic Order Quantity Model
Time Between Orders
(Cycle Time)T=Q/D
On-Hand Inventory

Demand Rate
Q

Average Cycle Inventory

Q/2

Reorder
point R

Time
Place Order Receive Order

Lead
Time
Estimating Cycle Inventory Related Costs in
Practice
 Inventory Holding Cost
 Obsolescence cost
 Handling cost
 Occupancy cost
 Miscellaneous costs
 Theft, security, damage, tax, insurance
Estimating Cycle Inventory Related Costs in
Practice
 Ordering Cost
 Buyer time
 Transportation costs
 Receiving costs
 Other costs
 Economies of Scale
to Exploit Fixed Costs
• Lot sizing for a single product (EOQ)
D = Annual demand of the product
S = Fixed cost incurred per order
C = Cost per unit
H = Holding cost per year as a fraction of product cost
• Basic assumptions
– Demand is steady at D units per unit time
– No shortages are allowed
– Replenishment lead time is fixed
 Lot Sizing for a Single Product
Annual material cost  CD
D
Number of orders per year 
Q

D
Annual ordering cost    S
Q
Q Q
Annual holding cost    H   hC
2 2

 D Q
Total annual cost, TC  CD    S   hC
Q  2 
Lot Sizing for a Single Product
 Lot Sizing for a Single Product

• The economic order quantity (EOQ)

2 DS
Optimal lot size, Q* 
hC

• The optimal ordering frequency

D DhC
n*  
Q* 2S
Lot Sizing for a Single Product

Reorder point = dL
Where d is Average daily Demand(Constant)
L =Lead Time in days
 EOQ Example

 Best Buy Retail chain selling Deskpro computers

Annual demand, D = 1,000 x 12 = 12,000 units
Order cost per lot, S = $4,000
Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2

2 12,000  4,000
Optimal order size  Q*   980
0.2  500
 EOQ Example

Q * 980
Cycle inventory    490
2 2
D
Number of orders per year   12.24
Q*

D  Q*
Annual ordering and holding cost  S  hC  97,980
Q*  2 

Q* 490
Average flow time    0.041  0.49 month
2 D 12,000
 EOQ Example

 If Q=1100 is used instead of 980 (10% increase) annual cost increase to $98,930,
a 0.67% increase;
 We don’t have to use EOQ exactly, a convenient value near the EOQ is ok.
 If the demand in a month increases to 4000 unites (an increase by a factor 4 (k=4)
 EOQ figure doubles (increases by k )
 Number of orders per year doubles
 Average flow time decreases by a factor of 2 (decreases by k )
 EOQ Example

 Lot size reduced to Q = 200 units

D  Q*
Annual inventory - related costs  S  hC  250,000
Q*  2 
 Lot Size and Ordering Cost

 In order to have Q* = 200, how much should the ordering cost be reduced?
 Desired lot size, Q* = 200
 Annual demand, D = 1,000 × 12 = 12,000 units

 Unit cost per computer, C = $500

 Holding cost per year as a fraction of inventory value, h = 0.2

hC (Q*)2 0.2  500  2002

S   166.7
2D 2 12,000
 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?
 What is the total annual cost if the EOQ quantity is ordered?
 Fixed Order Quantity Model With Safety
Stock
 A fixed order-quantity system perpetually monitors the inventory level and places a new
order when stock reaches some level R
 The amount of safety stock depends on the service level desired,
 The quantity to be ordered, Q is calculated in the usual way considering the demand,
shortage cost, holding cost.
 The key difference between a fixed-order quantity model where demand is known and one
where demand is uncertain is computing the reorder point.
 The reorder point is =
R=dL+zℓ
 R= Reorder Point
 d= Average daily demand
 L= Lead Time in days
 Z=Number of standard deviation for a specified service probability
 ℓ=Standard deviation of usage during lead time
  Computing ,

    Average Daily demand

 =
 The standard deviation of the daily demand is

 Example

 Daily demand for a certain product is normally distributed with a mean of 60 and standard
deviation of 7.
 The source of supply is reliable and maintains a constant lead time of 6 days.
 The cost of placing order is $10 and annual holding costs are $0.50 per unit.
 There are no stock out costs, and unfilled orders are filled as soon as order arrives.
 Assume sales occurs over the entire 365 days of the year.
 Find the order point to satisfy a 95 percent probability of not stocking out during the lead
time.
 Fixed Time Period Model

  A fixed time period system, inventory model is counted only at particular times.
 Fixed-time order models generate order quantities that vary from period to period
depending on the usage rates.
 This require higher level of safety stock than a fixed order quantity system.
 In a fixed time period system, reorders are placed at the time of review(T) and the safety
stock that must be reordered is
 Safety stock= z
 Where L is constant lead time L,
 Fixed Time Period Model

 Order
  Quantity = Average demand over the vulnerable Period +Safety Stock-Inventory
Currently on hands(Plus on order, if any)
 q=+ z
 Where q=Quantity to be order
 T= The number of days between reviews
 L= Lead time in days
 Forecast average daily demand
 Z=number of standard deviation
 =Standard deviation of demand over the review and lead time
 I= current inventory level
 Example

 Dailey demand for a product is 10 unit with a standard deviation of 3 units.

 The review period is 30 days, and lead time is 14 days .
 Management has set a policy of satisfying 98 percent of demand from item in stock.
 At the beginning of this review period there are 150 units in the inventory.
 How many units should be ordered.
 Inventory Turn Calculation

  Inventory Turn =
 Average inventory value=(
 C=Cost per unit
 SS=safety Stock
 Inventory Turn= =
 EBQ (Economic Batch Quantity)

 Economic Batch Quantity (EBQ), also known as the optimum production quantity (EPQ),
is the order size of a production batch that minimizes the total cost.
 Whereas EOQ is suitable for determining the order size when the parts, materials or
finished goods are ready to be delivered by external suppliers when the order is placed,
 EBQ is used to determine the size of a production run (i.e. batch size) when the
manufacturing takes place internally and any raw materials or parts required for
production are either acquired internally or are supplied incrementally by other companies
according to the production requirement.
 EBQ (Economic Batch Quantity)

  Formula

 Economy Batch Quantity:

 Where:
 Cs is the setup cost of a batch
 D is the annual demand
 P is the annual production capacity
 Ch is the annual cost of holding one unit of finished inventory
 EBQ (Economic Batch Quantity)

 The formula for calculating EBQ is very similar to EOQ with one notable difference in the
denominator. 
 The cost of holding in EBQ formula is decreased by the amount of inventory that will be
produced and sold on the same day therefore not contributing to the annual cost of holding
the inventory.
 Economies of Scale to
Exploit Quantity Discounts
 Lot size-based discount – discounts based on quantity ordered in a single lot
 Volume based discount – discount is based on total quantity purchased over a
given period (e.g. year)
 Two common schemes
 All-unit quantity discounts
 Marginal unit (incremental) quantity discount or multi-block tariffs
 Quantity Discounts

 Two basic questions

1. What is the optimal purchasing decision for a buyer seeking to maximize
profits? How does this decision affect the supply chain in terms of cost, lot
sizes, cycle inventories, and flow times?
2. Under what conditions should a supplier offer quantity discounts? What are
appropriate pricing schedules that a supplier seeking to maximize profits
should offer?
 All-Unit Quantity Discounts

 Pricing schedule has specified quantity break points q0, q1, …, qr, where q0 = 0
 If an order is placed that is at least as large as qi but smaller than qi+1, then each unit
has an average unit cost of Ci
 Unit cost generally decreases as the quantity increases, i.e., C0 > C1 > … > Cr
 Objective is to decide on a lot size that will minimize the sum of material, order,
and holding costs
All-Unit Quantity Discounts
 All-Unit Quantity Discounts

 Step 1: Evaluate the optimal lot size for each price Ci,0 ≤ i ≤ r as follows
2 DS
Qi 
hCi
 Step 2: We next select the order quantity Q*i for each price Ci

1. qi  Qi  qi 1
2. Qi  qi
3. Qi  qi 1

• Case 3 can be ignored as it is considered for Qi+1

qi  Qi  qi 1
• For Case 1 if
Qi  qi , then set Q*i = Qi

• If , then a discount is not possible. Set Q*i= qi to qualify for the discounted price of Ci
 All-Unit Quantity Discounts

 Suppose fixed order cost were reduced to $4

 Without discount, Q* would be reduced to 1265 units
 With discount, optimal lot size would still be 10001 units
 What is the effect of such a discount schedule?
 Retailers are encouraged to increase the size of their orders
 Average inventory (cycle inventory) in the supply chain is increased
 Average flow time is increased
 Is an all-unit quantity discount an advantage in the supply chain?
 Why Quantity Discounts?

 Coordination in the supply chain

 Commodity products
 Products with demand curve
 2-part tariffs
 Volume discounts
 Coordination for
Commodity Products
 D = 120,000 bottles/year
 SR = $100, hR = 0.2, CR = $3
 SS = $250, hS = 0.2, CS = $2

Retailer’s optimal lot size = 6,324 bottles

Retailer cost = $3,795; Supplier cost = $6,009
Supply chain cost = $9,804