Chapter 13

Inventory Management

Operations Management - 6th Edition

Roberta Russell & Bernard W. Taylor, III

Beni Asllani
Copyright 2009 John Wiley & Sons, Inc. University of Tennessee at Chattanooga
 Lecture Outline

 Elements of Inventory Management

 Inventory Control Systems
 Economic Order Quantity Models
 Quantity Discounts
 Reorder Point
 Order Quantity for a Periodic Inventory
System

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 What Is Inventory?

 Stock of items kept to meet future

demand
 Purpose of inventory management
 how many units to order
 when to order

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 Inventory and Supply Chain
Management
 Bullwhip effect
 demand information is distorted as it moves away
from the end-use customer
 higher safety stock inventories to are stored to
compensate
 Seasonal or cyclical demand
 Inventory provides independence from vendors
 Take advantage of price discounts
 Inventory provides independence between
stages and avoids work stoppages

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 Inventory and Quality
Management in the Supply Chain

 Customers usually perceive quality

service as availability of goods they want
when they want them
 Inventory must be sufficient to provide
high-quality customer service in QM

Copyright 2009 John Wiley & Sons, Inc. 13-5

 Types of Inventory

 Raw materials
 Purchased parts and supplies
 Work-in-process (partially completed)
products (WIP)
 Items being transported
 Tools and equipment

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 Two Forms of Demand
 Dependent
 Demand for items used to produce
final products
 Tires stored at a Goodyear plant are
an example of a dependent demand
item
 Independent
 Demand for items used by external
customers
 Cars, appliances, computers, and
houses are examples of independent
demand inventory

Copyright 2009 John Wiley & Sons, Inc. 13-7

 Inventory Costs

 Carrying cost
 cost of holding an item in inventory
 Ordering cost
 cost of replenishing inventory
 Shortage cost
 temporary or permanent loss of sales
when demand cannot be met

Copyright 2009 John Wiley & Sons, Inc. 13-8

 Inventory Control Systems

 Continuous system (fixed-

order-quantity)
 constant amount ordered
when inventory declines to
predetermined level
 Periodic system (fixed-time-
period)
 order placed for variable
amount after fixed passage of
time

Copyright 2009 John Wiley & Sons, Inc. 13-9

 ABC Classification
 Class A
 5 – 15 % of units
 70 – 80 % of value
 Class B
 30 % of units
 15 % of value
 Class C
 50 – 60 % of units
 5 – 10 % of value

Copyright 2009 John Wiley & Sons, Inc. 13-10

 ABC Classification: Example
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120

Copyright 2009 John Wiley & Sons, Inc. 13-11

 ABC Classification:
Example (cont.)
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 11.0
2 14,000 16.4 4.0
A40 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 B60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 % OF TOTAL
18.0 % OF TOTAL
180 58.0
CLASS ITEMS VALUE QUANTITY
5 3,000
7 3.510 13.0 170 71.0
10 2,400
A 9, 8,2.8
2 12.0
71.0 C 83.0
8 320 50 15.0
7 1,700
B 1, 4,2.0
3 17.0
16.5 100.0
25.0
9
C 5107
6, 5, 10, 12.5 60 60.0
$85,400
10 20 120
Example 10.1

Copyright 2009 John Wiley & Sons, Inc. 13-12

 Economic Order Quantity
(EOQ) Models

 EOQ
 optimal order quantity that will
minimize total inventory costs
 Basic EOQ model
 Production quantity model

Copyright 2009 John Wiley & Sons, Inc. 13-13

 Assumptions of Basic
EOQ Model

 Demand is known with certainty and

is constant over time
 No shortages are allowed
 Lead time for the receipt of orders is
constant
 Order quantity is received all at once

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 Inventory Order Cycle
Order quantity, Q
Demand Average
rate inventory
Inventory Level

Q
2

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt

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 EOQ Cost Model
Co - cost of placing order D - annual demand
Cc - annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
C oD CcQ
Total cost = +
Q 2

Copyright 2009 John Wiley & Sons, Inc. 13-16

 EOQ Cost Model

Deriving Qopt Proving equality of

costs at optimal point
Co D CcQ
TC = +
Q 2 Co D CcQ
=
TC CoD
Cc Q 2
=– +
Q Q2
2 2CoD
Q = 2
C0 D Cc Cc
0=– +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc

Copyright 2009 John Wiley & Sons, Inc. 13-17

 EOQ Cost Model (cont.)
Annual
cost ($) Total Cost
Slope = 0

CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost =
Q

Optimal order Order Quantity, Q

Qopt

Copyright 2009 John Wiley & Sons, Inc. 13-18

 EOQ Example
Cc = $0.75 per gallon Co = $150 D = 10,000 gallons

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = TCmin = +
(0.75) 2,000 2

Qopt = 2,000 gallons TCmin = $750 + $750 = $1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt)

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
Copyright 2009 John Wiley & Sons, Inc. 13-19
 Production Quantity
Model
 An inventory system in which an order is
received gradually, as inventory is
simultaneously being depleted
 AKA non-instantaneous receipt model
 assumption that Q is received all at once is relaxed
 p - daily rate at which an order is received over
time, a.k.a. production rate
 d - daily rate at which inventory is demanded

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 Production Quantity Model
(cont.)
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q
(1-d/p) inventory
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period

Copyright 2009 John Wiley & Sons, Inc. 13-21

 Production Quantity Model
(cont.)
p = production rate d = demand rate

Q
Maximum inventory level = Q - d
p
d
=Q1-
p 2CoD
Qopt = d
Q d Cc 1 - p
Average inventory level = 1-
2 p

CoD CcQ d
TC = + 1- p
Q 2

Copyright 2009 John Wiley & Sons, Inc. 13-22

 Production Quantity Model:
Example
Cc = $0.75 per gallon Co = $150 D = 10,000 gallons
d = 10,000/311 = 32.2 gallons per day p = 150 gallons per day

2 C oD 2(150)(10,000)
Qopt = = = 2,256.8 gallons
32.2
Cc 1 - d 0.75 1 -
p 150

Co D Cc Q d
TC = + 1- p = $1,329
Q 2

Q 2,256.8
Production run = = = 15.05 days per order
p 150

Copyright 2009 John Wiley & Sons, Inc. 13-23

 Production Quantity Model:
Example (cont.)

D 10,000
Number of production runs = = = 4.43 runs/year
Q 2,256.8

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 gallons

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 Solution of EOQ Models with
Excel

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 Solution of EOQ Models with
Excel (Con’t)

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 Solution of EOQ Models with OM
Tools

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 Quantity Discounts

Price per unit decreases as order

quantity increases

CoD CcQ
TC = + + PD
Q 2
where

P = per unit price of the item

D = annual demand

Copyright 2009 John Wiley & Sons, Inc. 13-28

 Quantity Discount Model (cont.)
ORDER SIZE PRICE
0 - 99 $10 TC = ($10 )
100 – 199 8 (d1)
200+ 6 (d2)
TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

Copyright 2009 John Wiley & Sons, Inc. 13-29
 Quantity Discount: Example
QUANTITY PRICE
Co = $2,500
1 - 49 $1,400
Cc = $190 per TV
50 - 89 1,100
D = 200 TVs per year
90+ 900

2 Co D 2(2500)(200)
Qopt = = = 72.5 TVs
Cc 190

For Q = 72.5
C oD CcQopt
TC = + + PD = $233,784
Qopt 2

For Q = 90
Co D Cc Q
TC = + + PD = $194,105
Q 2
Copyright 2009 John Wiley & Sons, Inc. 13-30
 Reorder Point

Level of inventory at which a new order

is placed
R = dL
where
d = demand rate per period
L = lead time

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 Reorder Point: Example

Demand = 10,000 gallons/year

Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
gallons/day
Lead time = L = 10 days

R = dL = (32.154)(10) = 321.54 gallons

Copyright 2009 John Wiley & Sons, Inc. 13-32

 Safety Stocks
 Safety stock
 buffer added to on hand inventory during lead
time
 Stockout
 an inventory shortage
 Service level
 probability that the inventory available during
lead time will meet demand

Copyright 2009 John Wiley & Sons, Inc. 13-33

 Variable Demand with
a Reorder Point
Q
Inventory level

Reorder
point, R

0
LT LT
Time

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 Reorder Point with
a Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
Copyright 2009 John Wiley & Sons, Inc. 13-35
 Reorder Point With
Variable Demand

R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock

Copyright 2009 John Wiley & Sons, Inc. 13-36

 Reorder Point for
a Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd L

dL R
Demand
Copyright 2009 John Wiley & Sons, Inc. 13-37
 Reorder Point for
Variable Demand
The paint store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day

For a 95% service level, z = 1.65

R = dL + z d L Safety stock = z d L
= 30(10) + (1.65)(5)( 10) = (1.65)(5)( 10)
= 326.1 gallons = 26.1 gallons

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 Determining Reorder Point with
Excel

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