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.

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 Learning Objectives
 Describe the basic EOQ model and its
assumptions and solve typical problems.

12-2
 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.
12-3
 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

12-4
 Types of Inventories
 Raw materials & purchased parts
 Partially completed goods called
work in progress
 Finished-goods inventories
 (manufacturing firms)
or merchandise
(retail stores)

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Types of Inventories (Cont’d)
 Replacement parts, tools, & supplies
 Goods-in-transit to warehouses or
customers

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 Functions of Inventory

 To meet anticipated demand

 To smooth production requirements
 To decouple operations
 To protect against stock-outs

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 Functions of Inventory (Cont’d)

 To take advantage of order cycles

 To help hedge against price increases
 To permit operations
 To take advantage of quantity
discounts

12-8
Objective of Inventory Control
 To achieve satisfactory levels of
customer service while keeping
inventory costs within reasonable
bounds
 Level of customer service
 Costs of ordering and carrying inventory

Inventory turnover is the ratio of

average cost of goods sold to
average inventory investment.
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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

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 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

12-11
 Inventory Counting Systems
(Cont’d)
 Two-Bin System - Two containers of
inventory; reorder when the first is
empty
 Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached 0

214800 232087768

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 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

12-13
 ABC Classification System
Figure 12.1

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
12-14
 ABC Classification

Annual unit Percentage of total

Item Unit cost ($) Usage in dollar
usage dollar usage
PA 01 5,000 1.50 7,500 2.94
PA 02 1,500 8.00 12,000 4.71
PA 03 10,000 10.50 105,000 41.22
PA 04 6,000 2.00 12,000 4.71
PA 05 7,500 0.50 3,750 1.47
PA 06 6,000 13.60 81,600 32.03
PA 07 5,000 0.75 3,750 1.47
PA 08 4,500 1.25 5,625 2.21
PA 09 7,000 2.50 17,500 6.87
PA 10 3,000 2.00 6,000 2.36
Total 254,725 100
 ABC Classification

Percentage of total dollar usage

45.0
41.2
40.0
35.0 32.0
30.0
25.0
20.0
15.0
10.0 6.9
4.7 4.7
5.0 2.9 2.4 2.2 1.5 1.5
0.0
PA 03 PA 06 PA 09 PA 02 PA 04 PA 01 PA 10 PA 08 PA 05 PA 07

Class Class
Class B C
A
 Cycle Counting

 A physical count of items in

inventory
 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be
performed?
 Who should do it?
ABC Classification

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ABC Classification

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 ABC Classification

Unit Usage in Percentage of total

Item Usage
Cost($) dollar dollar usage

K34 50 1200

K35 20 400

K36 72 300

M10 160 400

M20 40 600

Z45 60 1600

F14 40 160
 Cycle Counting

 A physical count of items in

inventory
 Cycle counting management
 How much accuracy is needed?
 When should cycle counting be
performed?
 Who should do it?

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 Economic Order Quantity
Models

 Economic order quantity (EOQ)

model
 The order size that minimizes total
annual cost
 Economic production model
 Quantity discount model

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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

12-23
 The Inventory Cycle
Figure 12.2

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

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 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q

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 Cost Minimization Goal
Figure 12.4C

The Total-Cost Curve is U-Shaped

Q D
TC  H  S
Annual Cost

2 Q

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)

12-26
 Deriving the EOQ

Using calculus, we take the derivative

of the total cost function and set the
derivative (slope) equal to zero and
solve for Q.
2DS 2( Annual Demand )(Order or Setup Cost )
Q OPT = =
H Annual Holding Cost

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EOQ Practice Problem

12-28
Solution

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