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Tata McGraw
 Chapter 17

Inventory Control
 17-3

OBJECTIVES
• Inventory System Defined
• Inventory Costs
• Independent vs. Dependent Demand
• Single-Period Inventory Model
• Multi-Period Inventory Models: Basic
Fixed-Order Quantity Models
• Multi-Period Inventory Models: Basic
Fixed-Time Period Model
• Miscellaneous Systems and Issues
 17-4

Inventory System

• Inventory is the stock of any item or

resource used in an organization and
can include: raw materials, finished
products, component parts, supplies,
and work-in-process
• An inventory system is the set of
policies and controls that monitor levels
of inventory and determines what levels
should be maintained, when stock
should be replenished, and how large
orders should be
 17-5

Purposes of Inventory

1. To maintain independence of operations

2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size
 17-6

Inventory Costs

• Holding (or carrying) costs

– Costs for storage, handling,
insurance, etc
• Setup (or production change) costs
– Costs for arranging specific
equipment setups, etc
• Ordering costs
– Costs of someone placing an order,
etc
• Shortage costs
– Costs of canceling an order, etc
 17-7

Independent vs. Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Finished
product
Dependent
Demand
(Derived demand
items for
E(1 component
) parts,
subassemblies,
Component parts raw materials,
etc)
 17-8

Inventory Systems

• Single-Period Inventory Model

– One time purchasing decision (Example:
vendor selling t-shirts at a football game)
– Seeks to balance the costs of inventory
overstock and under stock
• Multi-Period Inventory Models
– Fixed-Order Quantity Models
• Event triggered (Example: running out of
stock)
– Fixed-Time Period Models
• Time triggered (Example: Monthly sales
call by sales representative)
 17-9

Single-Period Inventory Model

This model states that we

Cu should continue to increase

the size of the inventory so
P long as the probability of
Co  Cu selling the last unit added is
equal to or greater than the
ratio of: Cu/Co+Cu

Where :
Co  Cost per unit of demand over estimated
Cu  Cost per unit of demand under estimated
P  Probability that the unit will be sold
 17-10

Single Period Model Example

• Our college basketball team is playing in a

tournament game this weekend. Based on our
past experience we sell on average 2,400 shirts
with a standard deviation of 350. We make $10
on every shirt we sell at the game, but lose $5
on every shirt not sold. How many shirts should
we make for the game?
Cu = $10 and Co = $5; P ≤ $10 / ($10 + $5) = .667

Z.667 = .432 (use NORMSDIST(.667) or Appendix E)

therefore we need 2,400 + .432(350) = 2,551 shirts
 17-11

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 1)

• Demand for the product is constant

and uniform throughout the period

• Lead time (time from ordering to

receipt) is constant

• Price per unit of product is constant

 17-12

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 2)

• Inventory holding cost is based on

average inventory

• Ordering or setup costs are constant

• All demands for the product will be

satisfied (No back orders are allowed)
 17-13

Basic Fixed-Order Quantity Model and Reorder Point Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
 17-14

Cost Minimization Goal

By adding the item, holding, and ordering costs

together, we determine the total cost curve, which in
turn is used to find the Qopt inventory order point that
minimizes total costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
 17-15

Basic Fixed-Order Quantity (EOQ) Model Formula

TC=Total annual
cost
Total Annual Annual Annual D =Demand
Annual = Purchase + Ordering + Holding C =Cost per unit
Cost Cost Cost Cost Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time

D Q H=Annual holding

TC = DC + S + H and storage cost

Q 2
per unit of inventory
 17-16

Deriving the EOQ

Using calculus, we take the first derivative of

the total cost function with respect to Q, and
set the derivative (slope) equal to zero,
solving for the optimized (cost minimized)
value of Qopt
2DS 2(Annual D em and)(Order or Setup Cost)
Q OPT = =
H Annual Holding Cost
_
We also need a R eorder point, R = d L
reorder point to _
tell us when to d = average daily demand (constant)
place an order
L = Lead time (constant)
 17-17

EOQ Example (1) Problem Data

Given the information below, what are the EOQ and

reorder point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
 17-18

EOQ Example (1) Solution

2DS 2(1,000 )(10)

Q OPT = = = 89.443 units or 90 units
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year

_
Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In summary, you place an optimal order of 90 units. In

the course of using the units to meet demand, when
you only have 20 units left, place the next order of 90
units.
 17-19

EOQ Example (2) Problem Data

Determine the economic order quantity

and the reorder point given the following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15
 17-20

EOQ Example (2) Solution

2DS 2(10,000 )(10)

Q OPT = = = 365.148 units, or 366 units
H 1.50

10,000 units / year

d= = 27.397 units / day
365 days / year

_
R = d L = 27.397 units / day (10 days) = 273.97 or 274 units

Place an order for 366 units. When in the course of

using the inventory you are left with only 274 units,
place the next order of 366 units.
 17-21

Fixed-Time Period Model with Safety Stock Formula

q = Average demand + Safety stock – Inventory currently on hand

q = d(T + L) + Z  T + L - I

Where :
q = quantitiy to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probability
 T + L = standard deviation of demand over the review and lead time
I = current inventory level (includes items on order)
 17-22

Multi-Period Models: Fixed-Time Period Model:

Determining the Value of sT+L

T+ L

  
2
 T+ L = di
i 1

Since each day is independent and  d is constant,

 T+ L = (T + L) d 2

• The standard deviation of a sequence

of random events equals the square
root of the sum of the variances
 17-23

Example of the Fixed-Time Period Model

Given the information below, how many units

should be ordered?
Average daily demand for a product is
20 units. The review period is 30 days,
and lead time is 10 days. Management
has set a policy of satisfying 96 percent
of demand from items in stock. At the
beginning of the review period there are
200 units in inventory. The daily
demand standard deviation is 4 units.
 17-24

Example of the Fixed-Time Period Model: Solution (Part 1)

 T+ L = 2
(T + L) d = 30 + 10 4 = 25.298
2

The value for “z” is found by using the Excel

NORMSINV function, or as we will do here, using
Appendix D. By adding 0.5 to all the values in
Appendix D and finding the value in the table that
comes closest to the service probability, the “z”
value can be read by adding the column heading
label to the row label.
So, by adding 0.5 to the value from Appendix D of 0.4599,
we have a probability of 0.9599, which is given by a z = 1.75
 17-25

Example of the Fixed-Time Period Model: Solution (Part 2)

q = d(T + L) + Z  T + L - I

q = 20(30 + 10) + (1.75)(25.298) - 200

q = 800  44.272 - 200 = 644.272, or 645 units

So, to satisfy 96 percent of the demand,

you should place an order of 645 units at
this review period
 17-26

Price-Break Model Formula

Based on the same assumptions as the EOQ model,

the price-break model has a similar Qopt formula:

2DS 2(Annual Demand)(Order or Setup Cost)

Q OPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since “C” changes for each price-break, the formula

above will have to be used with each price-break cost
value
 17-27

Price-Break Example Problem Data

(Part 1)

A company has a chance to reduce their inventory

ordering costs by placing larger quantity orders using
the price-break order quantity schedule below. What
should their optimal order quantity be if this company
purchases this single inventory item with an e-mail
ordering cost of $4, a carrying cost rate of 2% of the
inventory cost of the item, and an annual demand of
10,000 units?
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
 17-28

Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of “C”
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DS 2(10,000)(4)

Qopt value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,020 units
iC 0.02(0.98)
 17-29

Price-Break Example Solution (Part 3)

Since the feasible solution occurred in the first price-

break, it means that all the other true Qopt values occur
at the beginnings of each price-break interval. Why?

Because the total annual cost function is

Total a “u” shaped function
annual
costs So the candidates
for the price-
breaks are 1826,
2500, and 4000
units

0 1826 2500 4000 Order Quantity

 17-30

Price-Break Example Solution (Part 4)

Next, we plug the true Qopt values into the total cost
annual cost function to determine the total cost under
each price-break
D Q
TC = DC + S+ iC
Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000&more)= $9,949.20

Finally, we select the least costly Qopt, which is this

problem occurs in the 4000 & more interval. In
summary, our optimal order quantity is 4000 units
 17-31

Miscellaneous Systems:
Optional Replenishment System

Maximum Inventory Level, M

q=M-I

Actual Inventory Level, I

M

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

 17-32

Miscellaneous Systems:
Bin Systems

Two-Bin System

Order One Bin of

Inventory
Full Empty
One-Bin System

Order Enough to
Refill Bin
Periodic Check
 17-33

ABC Classification System

• Items kept in inventory are not of equal

importance in terms of:
60
– dollars invested % of
$ Value 30 A
– profit potential 0 B
– sales or usage volume % of 30 C
Use 60
– stock-out penalties

So, identify inventory items based on percentage of total

dollar value, where “A” items are roughly top 15 %, “B”
items as next 35 %, and the lower 65% are the “C” items
 17-34

Inventory Accuracy and Cycle Counting

• Inventory accuracy refers to how

well the inventory records agree
with physical count
• Cycle Counting is a physical
inventory-taking technique in which
inventory is counted on a frequent
basis rather than once or twice a
year
 17-35

Question Bowl

Which of the following is a reason why

firms keep a supply of inventory?
a. To maintain independence of
operations
b. To meet variation in product demand
c. To allow flexibility in production
scheduling
d. To take advantage of economic
purchase order size
e. All of the above

Answer: e. All of the above (Also can include to

provide a safeguard for variation in raw material
delivery time.)
 17-36

Question Bowl

An Inventory System should

include policies that are related
to which of the following?
a. How large inventory purchase
orders should be
b. Monitoring levels of inventory
c. Stating when stock should be
replenished
d. All of the above
e. None of the above

Answer: d. All of the above

 17-37

Question Bowl

Which of the following is an Inventory

Cost item that is related to the
managerial and clerical costs to
prepare a purchase or production
order?
a. Holding costs
b. Setup costs
c. Carrying costs
d. Shortage costs Answer: e. None of the
e. None of the above above (Correct answer
is Ordering Costs.)
 17-38

Question Bowl

Which of the following is

considered a Independent
Demand inventory item?
a. Bolts to a automobile
manufacturer
b. Timber to a home builder
c. Windows to a home builder
d. Containers of milk to a grocery
store
e. None of the above

Answer: d. Containers of milk to a grocery store

 17-39

Question Bowl

If you are marketing a more expensive

independent demand inventory item,
which inventory model should you
use?
a. Fixed-time period model
b. Fixed-order quantity model
c. Periodic system
d. Periodic review system
e. P-model

Answer: b. Fixed-order quantity model

 17-40

Question Bowl

If the annual demand for an inventory item

is 5,000 units, the ordering costs are
$100 per order, and the cost of holding
a unit is stock for a year is $10, which
of the following is approximately the
Qopt?
a. 5,000 units
b. $5,000
c. 500 units
d. 316 units Answer: d. 316
e. None of the above
units
(Sqrt[(2x1000x10
0)/10=316.2277)
 17-41

Question Bowl

The basic logic behind the ABC

Classification system for inventory
management is which of the
following?
a. Two-bin logic
b. One-bin logic
c. Pareto principle
d. All of the above
e. None of the above

Answer: c. Pareto principle

 17-42

Question Bowl

A physical inventory-taking
technique in which inventory is
counted frequently rather than
once or twice a year is which of
the following?
a. Cycle counting
b. Mathematical programming
c. Pareto principle
d. ABC classification
e. Stockkeeping unit (SKU)

Answer: a. Cycle counting

 17-43

End of Chapter 17