Inventory Management

INVENTORY COSTS
Purchase Cost
• It is the unit purchase price - from an external source
• It is unit production cost – produced internally
• Unit production cost includes direct labour, direct material and factory
overhead

Order/Setup Cost
• Expense of issuing a purchase order to an outside supplier or from internal
production setup costs
•  Vary directly with number of orders or setups
• Order cost includes transportation cost, and cost for requisition, analysing
vendors, writing purchase orders, transportation cost to transport the
order quantity, receiving materials, inspecting materials, following up
orders and doing the process necessary to complete the transaction

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Holding Cost or Carrying Cost
•  It is the cost associated with investing in inventory and maintaining the
physical investment in storage
• It contains capital costs, taxes, insurance, handling, storage, shrinkage,
obsolescence, and deterioration

Stockout Costs
• Economic consequence of an external or an internal shortage
• External shortage – when customer’s order is not filled
• Internal Shortage – When an order of a group or department is not filled  
• External shortages can incur backorder cost, present profit loss and
future profit loss
• Internal shortage can result in lost production and delay in completion
date

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 Holding Costs
Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 -
operating costs, taxes, insurance) 10%)
Material handling costs (equipment lease or 3% (1 -
depreciation, power, operating cost) 3.5%)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 -
insurance on inventory) 24%)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%

© 2014 Pearson Education, Inc. 12 - 4

 Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT
pe n d
deINVENTORYing o n OF
CATEGORY
c on s idera b ly VALUE
osts va r y r at . (3 -
es6%
Housing ing c(building
Holdcosts int
rent or depreciation,
n , and e r es t
ss , lo c a tio h tech
t he b usine
operating costs, taxes, insurance)
a n 1 5% , so me hig 10%)
ally g r e er th
at(equipment lease in org costs gre r -
ate(1
G ne r
Materialehandling costs
v e h old
3%
depreciation, em
power,noperating
h io it s h a
cost) 3.5%)
and f a s
Labor cost (receiving,
% . warehousing, security) 3% (3 - 5%)
than 4 0
Investment costs (borrowing costs, taxes, and 11% (6 -
insurance on inventory) 24%)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%

© 2014 Pearson Education, Inc. 12 - 5

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INDEPENDENT DEMAND SYSTEMS: DETERMINISTIC MODELS

• A major reason for studying inventory is to enable an organization to
buy or produce items in economic lot sizes

• Economic lot sizing often applied when organization want to maintain a

regular inventory of items which have a fairly uniform, independent
demand

• To determine an optimum inventory policy, information on the following

parameters is required
 Demands,
 Appropriate inventory costs and
 Lead times

• Inventory policy find answers for –

 how many and
 when to order
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Inventory Control System: Fixed order size systems

• The stock level is reviewed

with each transaction

• Whenever the inventory

position reaches a
predetermined point, an
order for a fixed number of
units is placed

• The two parameters of the

system are – Reorder point
and Size of the order

• This system also is termed

a Q-system
 Inventory Models for Independent
Demand: Fixed order size systems

1. Basic economic order quantity

(EOQ) model
2. Production order quantity model
3. Quantity discount model

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Economic Order Quantity (EOQ) – Single Item
EOQ - The order quantity that minimizes the total inventory
cost

Notations Used
R – annual demand in units
P – purchase cost of an item
C – ordering cost per order
H = PF – holding cost per unit per year
Q – lot size or order quantity in units
F – annual holding costs as a fraction of unit cost
TC – total annual cost

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 Basic EOQ Model
Important assumptions
1. Demand is known, constant, continuous and independent
2. Lead time is known and constant
3. Receipt of inventory(entire lot) is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering) and holding
6. Stockouts can be completely avoided.
7. There is sufficient space and capital to procure the desired
quantity
8. The item is a single product; it does not interact with any
other inventory item
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 Inventory Usage Over Time

Total order received

Average
Order Usage rate inventory
quantity = Q on hand
Inventory level

(maximum Q
inventory
level) 2

Minimum
inventory 0
Time

© 2014 Pearson Education, Inc. Classical Inventory model 12 - 11

 Minimizing Costs
Objective is to minimize total costs

Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
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Total annual cost = purchase cost + order cost + holding cost

Replenishment order arrives just as the last item leaves the inventory which
restores the inventory level to the amount ordered

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Example 1: Fixed Order Size System

• ABC company purchases 8000 units of a product
each year at a unit cost of Rs 10.00. The order cost is
Rs 30.00 per order, and the holding cost per unit per
year is Rs 3.00.

• What are the economic order quantity, the total

annual cost, the number of orders to place in one
year, the reorder point when the lead time is two
weeks?
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Solution
2CR 2(30)8000
Q*    400units
H 3
TC (Q * )  PR  HQ *  10(8000)  3(400)  Rs81,200
R 8000
m *   20orders / year
Q 400
RL 8000(2)
B   307.7units
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Example 2: A local distributor for a national tire company
expects to sell approximately 9600 steel belted radial tires of
certain size and tread design next year. Annual carrying cost is
$16 per tire, ordering cost is $75. the distributor operates 288
days a year.
1. What is the EOQ
2. How many time s per year does the store reorder
3. What is the length of an order cycle
4. What is the total annual cost if the EOQ quantity is ordered.

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•Example
  3: Inventory cost function is given as
Y = 5 - 400x + 20,000
Y = Total cost ($), X = units of inventory, a) Find the
amount of inventory that results in lowest Total cost. b)
The lowest total cost

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 Example 4: Sharp, Inc. a company that markets painless
hypodermic needles to hospitals, would like to reduce its
inventory cost by determining the optimal number of
hypodermic needles to obtain per order. The annual demand is
1,000 units; the setup or ordering cost is $10 per order; and the
holding cost per unit per year is $ 50. a) Determine optimal
number of needles to order b) Determine the expected number
of orders placed during the year(M), c) the expected time
between the orders(T) d) Determine the combined annual
ordering and holding cost.

© 2014 Pearson Education, Inc. 12 - 18

 Example 4: Sharp, Inc. a company that markets painless
hypodermic needles to hospitals, would like to reduce its
inventory cost by determining the optimal number of
hypodermic needles to obtain per order. The annual demand is
1,000 units; the setup or ordering cost is $10 per order; and the
holding cost per unit per year is $ 50. a) Determine optimal
number of needles to order b) Determine the expected number
of orders placed during the year(M), c) the expected time
between the orders(T) d) Determine the combined annual
ordering and holding cost.

R = 1,000 units
C = $10 per order
H = $.50 per unit per year

* 2(1,000)(10)
Q0 / Q = = 40,000 =200 units
0.50
© 2014 Pearson Education, Inc. 12 - 19
 Determine expected number of orders
R = 1,000 units Q*/Q0 = 200 units
C = $10 per order
H = $.50 per unit per year

Expected Demand
number of = M = = R/ Q0
orders Order quantity

1,000
M= = 5 orders per year
200

© 2014 Pearson Education, Inc. 12 - 20

 Determine optimal time between orders
R = 1,000 units Q* = 200 units
C = $10 per order m = 5 orders/year
H = $.50 per unit per year

Expected Number of working days per year

time between = T =
orders Expected number of orders

250
T= = 50 days between orders
5

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 Determine the total annual cost
R = 1,000 units Q*/Q0 = 200 units
C = $10 per order M = 5 orders/year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

T C = (R/Q)C + (Q/2)H
= (1000/200)($10) + (200/2)($.50)
= (5)($10) + (100)($.50)
= $50 + $50 = $ 100

© 2014 Pearson Education, Inc. 12 - 22

 The EOQ Model
When including actual cost of material P = $10

Total annual cost = Setup cost + Holding cost + Product cost

= (R/Q)C + (Q/2)H + RP
= $50 + $50 + (1000)($10)
= $10,100

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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
Only to
2%order
less than
R = 1,000 units 1,500 units Q* =the200 units
total cost of
C = $10 per order N =$125
5 orders/year
when the
H = $.50 per unit per year = 50 quantity
T order days was
200
TC = (R/Q)C + (Q/2)H
= (1500/200)($10) + (200/2)($.50)
= $ 75 + $50 =$125

1,500 244.9
= ($10) + ($.50)
244.9 2
=6.125($10) +122.45($.50)
=$61.25 +$61.22 =$122.47
© 2014 Pearson Education, Inc. 12 - 25
 Reorder Points
▶ EOQ answers the “how much” question
▶ The reorder point (ROP) tells “when” to order
▶ Lead time (L) is the time between placing and
receiving an order
Demand Lead time for a new
ROP = per day order in days

=rxL

r= R
Number of working days in a year

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 Reorder Point Curve
Q*
Resupply takes place as order arrives
Inventory level (units)

Slope = units/day = r

ROP
(units)

Time (days)
Lead time = L
© 2014 Pearson Education, Inc. 12 - 27
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days, may take 4

R
r=
Number of working days in a year
= 8,000/250 = 32 units

ROP = r x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units

© 2014 Pearson Education, Inc. 12 - 28

EOQ SENSITIVITY
▶ Determines how the output of a model will be influenced by
changes or errors in the input data(parameters)
▶ If an input can assume a wide range of values without
appreciably affecting the output – the model is Insensitive
▶ If a small change in an input can appreciably affect the output
– the model is sensitive
▶ The sensitivity of the model will dictate the precision of
parameters required for the model.
▶ The EOQ model assumes that the annual demand R, holding
cost H, and the ordering cost C are deterministic and without
variation.
▶ Errors by management in determining these parameters will
cause variations in output(EOQ and total variable cost)
▶ In EOQ sensitivity the impact of estimation errors is analyzed
© 2014 Pearson Education, Inc. 12 - 29
EOQ SENSITIVITY
Usefulness
▶ How errors in estimation could affect decisions and resulting
cost
▶ Input parameters may change over time, so sensitivity analysis
can help in deciding at what point it will be necessary to revise
inventory decisions
▶ The effect of adjusting the order quantity to above or below
EOQ to take account of factors such as capacity limitations,
transportation efficiencies or packaging restrictions

© 2014 Pearson Education, Inc. 12 - 30

EOQ SENSITIVITY ANALYSIS
Notations
▶ TVC – total annual variable cost or total relevant cost
▶ Q - order quantity with parameter errors
▶ Q0 – economic order quantity

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EOQ SENSITIVITY ANALYSIS

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 Sensitivity of the total variable cost per year to
errors in input parameters

When the inputs are measured erroneously, the above equation

becomes

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▶ This shows that for single parameter variations, the effect on
total cost is the same irrespective of the parameter (C, R, or H)
▶ Errors in parameters are dampened when translated into their
impact on total incremental cost
▶ For example, if the ordering cost is in error by 40% on the
high side ( Xc = 1.4) it results in only an 18.3% increase over
the theoretically possible minimum total variable cost

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 Sensitivity of the total variable cost per year to rounding in
EOQ

Fairly sizable lot size errors result in comparatively small increases in total variable
costs
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▶ As shown in fig. 4, the cost penalty is greater
for errors of underestimation than errors of
overestimation
▶ This indicates the general desirability for
estimates to be on the high side to avoid the
larger cost penalty for low estimates

© 2014 Pearson Education, Inc. 12 - 37

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

TABLE 12.2 A 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

© 2014 Pearson Education, Inc. 12 - 38

 Quantity Discount Models
Total annual cost = Setup cost + Holding cost + Product cost

= (R/Q)C + (Q/2)H + PR

where Q = Quantity ordered P = Price per unit

R = Annual demand in units H = Holding cost per unit per year
C = Ordering or setup cost per order

Because unit price varies, holding cost (H) is

expressed as a percent (F) of unit price (P)

© 2014 Pearson Education, Inc. 12 - 39

 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 lowest possible quantity 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
© 2014 Pearson Education, Inc. 12 - 40
Example: Wohl’s discount store stocks toy race cars. Recently,
the stores has been given a quantity discount schedule for these
cars. This quantity schedule is shown below.
TABLE 12.2 A 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

Furthermore, ordering cost is $ 49 per order, annual demand is

5000 race cars, and inventory carrying charge, as percent of cost,
I, is 20%. What order quantity will minimize the total inventory
cost.

© 2014 Pearson Education, Inc. 12 - 41

 Quantity Discount Models
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
Order quantity Figure 12.7

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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)
© 2014 Pearson Education, Inc. 12 - 43
 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
© 2014 Pearson Education, Inc. 12 - 44
 Quantity Discount Example
TABLE 12.3 Total Cost Computations for Wohl’s Discount Store
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

Choose the price and quantity that gives the

lowest total cost
Buy 1,000 units at $4.80 per unit

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▶ a) A Producer of photo equipment buys lenses from
suppliers at $100 each. The producer requires 125
lenses per year, and the ordering cost is $18 per order.
Carrying cost per unit-year (based on average inventory)
is estimated to be $20 each. The supplier offers a 6
percent discount for purchases of 50 lenses and an 8
percent discount for purchases of 100 or more lenses at
one time. What is the most economical amount to order
at a time?

© 2014 Pearson Education, Inc. 12 - 46

BATCH-TYPE PRODUCTION SYSTEMS
• Multiple products are produced on the same equipments
in batches
• These products share and even compete for common
production capacity as individual items

Planning batch production involves

1. Determining the order of production
2. Batch size
Batch production system may not seek optimum production
level, but allocate production capacity to items in relation to
their demands, production rates and existing inventory

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BATCH-TYPE PRODUCTION SYSTEMS
Economic Production Quantity (EPQ) – Single items
• Finite replenishment rate or no instantaneous supply
• Production cost
• Setup cost
• Size of production run (order) to be determined
• Production run that minimizes the total inventory cost
is the economic production quantity

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Notations
R – annual demand in units
P – unit production cost
Q – size of production run
p – production rate
r – demand rate
C – setup cost per production run
H – holding cost per unit per year
B – Reorder level

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 Example 1: A toy manufacturer uses 48000 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 s production run of
wheels is $45. the firm operates 240 days per year. Determine the
i) optimal run size ii) minimum total annual cost for carrying and
setup iii) Cycle time for the optimal run size iv) Run time

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References
• Richard J Tersine, Principles of Inventory and
Materials Management, PTR Prentice-Hall.

• Martin K Starr and D W Miller, Inventory

Control: Theory and Practice, Prentice-Hall.

• Edward A Silver, David F Pyke, and Rein

Peterson, Inventory Management and
Production Planning and Scheduling, John
Wiley.