Chapter 13

Role of Inventory
Management
 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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 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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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

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 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 for autos are a dependent demand item
• Independent
• Demand for items used by external customers
• Cars, appliances, computers, and houses are
examples of independent demand inventory

Copyright 2011 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

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 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

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 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 2011 John Wiley & Sons, Inc. 13-10

 ABC Classification
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

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 ABC Classification
TOTAL % OF TOTAL % OF TOTAL
PART VALUE VALUE QUANTITY % CUMMULATIVE
9 $30,600 35.9 6.0 6.0
8 16,000 18.7 5.0 11.0
2 14,000 16.4 4.0
A 15.0
1 5,400 6.3 9.0 24.0
4 4,800 5.6 6.0 B 30.0
3 3,900 4.6 10.0 40.0
6 3,600 4.2 18.0 58.0
5 3,000 3.5 13.0 71.0
10 2,400 2.8 12.0 C 83.0
7 1,700 2.0 17.0 100.0
$85,400

Example 10.1
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 ABC Classification

% OF TOTAL % OF TOTAL
CLASS ITEMS VALUE QUANTITY
A 9, 8, 2 71.0 15.0
B 1, 4, 3 16.5 25.0
C 6, 5, 10, 7 12.5 60.0

Example 10.1
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 Economic Order Quantity
(EOQ) Models
• EOQ
• optimal order quantity that will minimize
total inventory costs
• Basic EOQ model
• Production quantity model

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 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

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

Copyright 2011 John Wiley & Sons, Inc. 13-17

 EOQ Cost Model

Deriving Qopt Proving equality of

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

Copyright 2011 John Wiley & Sons, Inc. 13-18

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

CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost =
Q

Optimal order Order Quantity, Q

Qopt

Copyright 2011 John Wiley & Sons, Inc. 13-19

 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 2011 John Wiley & Sons, Inc. 13-20

 Production Quantity Model
• 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

Inventory
level

Maximum
Q(1-d/p) inventory
level

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

0
Begin End Time
order order
Order
receipt receipt
receipt period

Copyright 2011 John Wiley & Sons, Inc. 13-22

 Production Quantity Model

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

Co D CcQ d
TC = + 1- p
Q 2

Copyright 2011 John Wiley & Sons, Inc. 13-23

 Production Quantity Model

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

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

C oD C c Q d
TC = + 1- p = $1,329
Q 2

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

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 Production Quantity Model

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

Maximum inventory level = Q 1 - = 2,256.8 1 -

= 1,772 gallons

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 Solution of EOQ Models With Excel

The optimal order

size, Q, in cell D8

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 Solution of EOQ Models With Excel

The formula for Q

in cell D10

=(D4*D5/D10)+(D3*D10/2)*(1-(D7/D8))

=D10*(1-(D7/D8))

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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

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 Quantity Discount Model
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 2011 John Wiley & Sons, Inc. 13-30
 Quantity Discount

QUANTITY PRICE
Co = $2,500
1 - 49 $1,400
Cc = $190 per TV
50 - 89 1,100
D = 200 TVs per year
90+ 900

2CoD 2(2500)(200)
Qopt = = = 72.5 TVs
Cc 190

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

For Q = 90
C oD CcQ
TC = + + PD = $194,105
Q 2
Copyright 2011 John Wiley & Sons, Inc. 13-31
 Quantity Discount Model With Excel

=IF(D10>B10,D10,B10) =(D4*D5/E10)+(D3*E10/2)+C10*D5

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 Reorder Point
• Inventory level at which a new order is placed

R = dL
where

d = demand rate per period

L = lead time

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 Reorder Point

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

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 Safety Stock
• 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
• P(Demand during lead time <= Reorder Point)

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 Variable Demand With Reorder Point

Q
Inventory level

Reorder
point, R

0
LT LT
Time

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 Reorder Point With Safety Stock
Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time

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 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

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 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 2011 John Wiley & Sons, Inc. 13-39

 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

The reorder point

formula in cell E7

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 Order Quantity for a
Periodic Inventory System

Q = d(tb + L) + zd tb + L - I

where
d = average demand rate
tb = the fixed time between orders
L = lead time
d = standard deviation of demand

zd tb + L = safety stock

I = inventory level

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 Periodic Inventory System

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 Fixed-Period Model With
Variable Demand
d = 6 packages per day
d = 1.2 packages
tb = 60 days
L = 5 days
I = 8 packages
z = 1.65 (for a 95% service level)

Q = d(tb + L) + zd tb + L - I
= (6)(60 + 5) + (1.65)(1.2) 60 + 5 - 8
= 397.96 packages

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 Fixed-Period Model with Excel

Formula for order

size, Q, in cell D10

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