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Inventory Management

Why do we have inventories?

 Inventory is one of the most expensive assets of    

many companies. It represents as much as 40% of total invested capital. Inventory is any stored resource that is used to satisfy a current or future need. Raw materials, work-in-process, and finished goods are examples of inventory. Two basic questions in inventory management are (1) how much to order (or produce), and (2) when to order (or produce).

Basic Functions of Inventory

Basic Functions of Inventory are:
1. If product demand is high in summer, a firm might produce during winter (Decoupling). 2. Inventory can be a hedge against price changes and inflation. 3. Another use of inventory is to take advantage of quantity discounts (when buying).
(Many suppliers offer discounts for large orders)

ABC Analysis
 ABC analysis divides on-hand inventory into

three classifications on the basis of dollar (TL) volume.  It is also known as Pareto analysis. (which is named after principles dictated by Pareto).  The idea is to focus resources on the critical few and not on the trivial many.  (Annual Dollar Volume of an Item) = (Its Annual Demand) x (Its Cost per unit)

ABC Analysis
 Class A items are those on which the annual dollar

volume is high.

They represent 70-80% of total inventory costs, but they account for only 15% of total inventory items.

 Class B items are those on which annual dollar

volume is medium.

They represent 15-25% of total dollar value, and they account for 30% of total inventory items on the average.

 Class C items are low dollar volume items.  They represent only the 5% of total dollar volume, but they include as many as 50-60% of total inventory items.

ABC Analysis
Percent of Annual Dollar Volume


Class A Items Class C Items


Percent of Inventory Items 20 50 100

ABC Analysis
Some of the Inventory Management Policies that may be based on ABC analysis include:
a) Class A items should have tighter inventory control. b) Class A items may be stored in a more secure area. c) Forecasting Class A items may warrant more care.

Cycle Counting of Inventory

 Inventory records must be verified through a

continuing audit.  Such audits are known as (periodical) cycle counting.. (e.g., counting items at supermarket).  Cycle counting uses inventory classifications developed by ABC analysis.

That is: Class A items are counted frequently, perhaps once a month. Class B items are counted less frequently, perhaps once a quarter. Class C items are counted perhaps once every six months.

Just-in-Time Inventory
 Just in Time Inventory is the minimum inventory that

is necessary to keep a system perfectly running.  With just in time (JIT) inventory, The exact amount of items arrive at the moment they are needed, Not a minute before OR not a minute after.  To achieve JIT inventory, Managers should Reduce the Variability Caused by some Internal and External Factors.

(Goldratts boys scout example Apply the pace of the slowest boy).

 Existence of Inventory hides the variability.  What causes variability?


What causes variability?

 Most variability is caused by tolerating waste


(1) For example, employees or machines produce units that do not conform to standards. These are waste. And they cause variability. (2) Or, engineering drawings are inaccurate, Again resulting in loss of production And consecutively resulting in Variability.


What causes variability?...

 These are the internal (controllable) factors that  


cause Variability. However, Some of the variability is caused by some external factors. For example, customer demands may change due to some external factors (such as competitors actions or promotions) In summary, To achieve JIT inventory, Managers must begin with Reducing Inventory. Reducing Inventory uncovers the Rocks located along the way on a river, And the water stream becomes more clear.

Rocks located along the way


Output Others Waiting


Move Time

Queue Time Lead Time

Set-up Time

Run Time

Cycle Time

The section called Others are the Rocks on the river. Those rocks include Quality Variability, In-transit Delays, Machine Breakdowns, Large Lot-sizes, Inaccurate drawings, Employee attendance variability.

Just-In-Time Production
 JIT production means  (1) Elimination of Waste,  (2) Synchronized Manufacturing, and  (3) Little Inventory.  Reducing the order batch size can be a major help in

reducing inventory.  Average Inventory = (Maximum Inventory + Minimum Inventory) / 2  Average Inventory drops as the inventory re-order quantity drops because the maximum inventory level drops.

Kanban System
 Moreover, the smaller the lot size, the fewer the     

problems are hidden. One way to achieve small lot sizes is to Move Inventory through the shop Only as needed. This is called a pull system. In this system, Ideal Lot size is 1. Japanese call this system as Kanban system. Kanban is a Japanese word for Card. A card is used to signal the need for material in a work center.

Kanban System
 Sending a card authorizes the previous work

center to send its finished batch to the subsequent work center.  Batches are typically very small. Such a system requires tight schedules and frequent set-ups for machines.  On the other hand, Small batches allow a very limited amount of faulty material, less damages, less space occupation, less material handling, less accidents, etc.

Inventory Related Costs: Holding, Ordering and Set-up Costs

 Holding Costs are the costs associated with holding

or carrying inventory over time.  It includes costs related to storage; such as insurance, extra staffing, interest, and so on.  Some example holding costs are:

building rent or depreciation, building operating cost, taxes on building, insurance on building, material handling equipment leasing or depreciation, equipment operating cost, handling manpower cost, taxes on inventory, insurance, etc.

Inventory Related Costs: Ordering and Set-up Costs

 Ordering Costs include, cost of supplies, order

processing, clerical cost, etc.

The ordering cost is valid if the products are purchased NOT produced internally.

 Set-up cost is the cost to prepare a machine for

manufacturing an order.

Set-up cost is highly correlated with set-up time. Machines that traditionally have taken long hours to set up Are Now being set up in less than a minute by employing FMSs or CIM systems. Reducing set up times is an excellent way to Reduce Inventory.

Inventory Models
 Demand for an item is either dependent on the    

demand for other items or it is independent. For example, demand for refrigerator is independent of the demand for cars. But, demand for auto tires is certainly dependent on the demand of cars. We will deal with the Independent Demand Situation. In the dependent demand situation we use Material Requirement Planning (MRP) systems.

What to answer?
 In the independent demand situation, we

should be interested in answering:


a) When to place an order for an item, and b) How much of an item to order.


Independent Demand Inventory Models

 There are Four Basic Independent Demand

Inventory Models:
1) Economic Order Quantity (EOP) Model (the most known model). 2) Production Order Quantity Model. 3) Back order inventory model. 4) Quantity discount model.


Economic Order Quantity (EOQ) Model

 EOQ model makes a number of assumptions: 1-) Demand is known and constant. 2-) Lead time (the time between placement of order and receipt of the order) is constant and known. 3-) Orders arrive in one batch at a time, and they arrive in one point in time. 4-) Quantity discounts are not possible. 5-) The costs include only setup cost (or ordering cost when buying) and holding cost. 6-) Orders are always placed at the right times. Therefore, stock outs (or shortages) can be completely avoided.

With these assumptions in EOQ Model, the graphic of inventory usage over time is as follows:
Q = order quantity (That is also equal to the Maximum Inventory)
Usage Rate Q

Inventory Level

Minimum Inventory = 0

Average Inventory Level Time 0

When inventory level reaches 0, a new order is placed and received.


Objective: Minimize total cost

 The objective of inventory models is to

minimize total cost.

 If we minimize the setup and holding costs,

we will be able to minimize total cost.

 As the quantity ordered (Q) increases,

holding cost increases, and setup cost decreases.


Where the total cost is minimum?

Annual Cost Total Cost Annual Holding Cost

Minimum Total Cost

Optimal Order Quantity (Q*)

Setup Cost (Ordering Cost)

Order Quantity (Q)

Optimal order quantity (Q*) occurs at a point where setup cost is equal to the total (annual) holding cost.

Finding the optimum

Optimal order quantity (Q*) occurs at a point where setup cost is equal to the total (annual) holding cost. By using this fact, we can write an equation for Q* as follows: D: Annual Demand in units for the inventory item. S: Setup cost (or the ordering cost) for each order.
Notice: (Setup cost for production, order cost for buying).

H: Annual Holding cost of inventory per unit.


Finding the optimum

There will be (D/Q) times of ordering in a whole year. Therefore, Annual Setup Cost = (D/Q) . S
Average Annual Holding Cost = (Average Inventory) . H
= (Q/2) . H


Finding the optimum

We get optimum point by setting: Annual Setup Cost = Annual Holding Cost (D/Q) . S = (Q/2) . H Therefore, Q2 = 2DS / H Q* = [2DS / H]1/2 Q* value is also called as the EOQ.

An Inventory model has the following characteristics:
Annual Demand (D) = 1000 units Ordering (Setup) cost (S)= $10 per order; Holding cost per unit per year (H) = $.50 Assume that there are 270 working days in a year (excluding holidays and weekends).

a) Find the Economic Order Quantity (Q*) for this inventory model. b) How many orders should be placed during one year? c) What is the expected time between two consecutive orders? d) What is the total annual cost of this inventory model?

Answers: a) EOQ= Q* = [2(1000)10 / .50]1/2 = 200 units b) Expected number of orders placed during the year (N) = D / Q* = 1000 / 200 = 5 times. c) Expected time between orders (T) = (Working days in a year) / N = 270 / 5 = 54 days. d) Total Annual Cost = Annual Setup Cost + Annual Holding Cost
= = = DS / Q* + (Q*) H / 2 1000 (10) / 200 + (200) (.50) / 2 $100


Proof of Optimality by Using Derivation

If we take the derivative of Total Cost (TC) function, based on the order quantity (Q), we get the following: TC = DS / Q + (Q)H / 2 dTC/dQ = (- DS / Q2) + (H / 2)


Proof of Optimality by Using Derivation

As a mathematic rule, if we set this derived equation equal to zero, we get the optimal (minimum) point of the total cost function: Therefore, dTC/dQ = (- DS / Q2) + (H / 2) = 0 From here, (- DS / Q2) = - H / 2 Q2 = 2DS / H Q* = [2DS / H]1/2

Proof of Optimality by Using Derivation

 One more check is needed for the optimality

of Q.  That is we take the second derivative of the total cost function based on Q.  If the second derivative is positive, the Q* value is a real optimum. (Rule)  In fact, second derivative is equal to 2DS / Q3 which is a positive value (It is a real optimum)


Considering the Reorder Point

 So far, we only decided how much to order

(That is Q*).  Now, we should find what time to order.  We assumed that firm will wait until its inventory reaches to zero before placing an order.  And, we also assumed that the Orders will receive immediately.  However, there is a time between placement and receipt of an order.

Considering the Reorder Point

 This is called LEAD TIME or delivery time.  Here, we will use the term Reorder Point

(ROP) for when to order.  ROP (in units) = (Demand Per Day) x (Lead time for a new order in days)


Reorder Point

ROP = d . L Q* ROP (units) Time (Days) Slope = d (units/day)

L = Lead Time

When the inventory level reaches the ROP, a new order is required. It will take a time that is equal to the Lead Time (L) to receive the new order.


Reorder Point
 Here, Demand per day (d) is found by the

following equation:

d = D / Number of working days in a year

 This ROP equation assumes that demand is

uniform and constant.

 If this is not the case, an extra (safety) stock

is added (because of uncertainty).


 Annual demand for an item is D = 8000/year.  This year there will be 200 working days in a

 Delivery of an order for this item takes 3

working days (L = 3 days).


a) Find the demand per day for this item. b) What is the ROP for this item?


a) Demand per day for this item (d) = 8000 / 200 = 40 units / day. b) ROP = d . L = 40 . 3 = 120 units.
When inventory level becomes 120 units, an Order should be placed.


Production Order Quantity Model

 In EOQ Model, We assumed that the entire

order was received at one time.  However, Some Business Firms may receive their orders over a period of time.  Such cases require a different inventory model.  Here, we take into account the daily production rate and daily demand rate.


Production Order Quantity Model..

Production occurs at a rate of p Maximum Inventory

Demand occurs at a rate of d

Time t


Production Order Quantity Model..

Since this model is especially suitable for production environments, It is called Production Order Quantity Model. Here, we use the same approach as we used in EOQ model. Lets define the following: p: Daily Production rate (units / day) d: Daily demand rate (units / day) t: Length of the production in days. H: Annual holding cost per unit

Production Order Quantity Model..

Average Holding Cost = (Average Inventory) . H = (Max. Inventory / 2) . H In the period of production: Max. Inventory = (Total Produced) = px t

(Total Used) dxt

Here, Q is the total units that are produced. Therefore, Q=pxt and t=Q/p

Production Order Quantity Model..

If we replace the values of t in the Max. Inventory formula: Max. Inventory = p (Q/p) - d (Q/p) = Q - dQ/p = Q (1 d/p) Annual Holding Cost = (Max. Inventory / 2) . H = Q/2 (1 d/p) . H Annual Setup Cost = (D/Q) . S

Production Order Quantity Model..

Now we will set: Annual Holding Cost = Annual Setup Cost Q/2 (1 d/p) . H = (D/Q) . S

2 S Q ! d H 1  p

2 DS d 1 p

This formula gives us the optimum production quantity for the Production Order Quantity Model. It is used when inventory is consumed as it is produced.

Backorder Inventory Model

In this model, we assume that stock outs (and backordering) are allowed. In addition to previous assumptions, we assume that sales will not be lost due to a stock out. Because, we will back order any demand that can not be fulfilled.
B: Backordering cost per unit per year b: The amount backordered at the time the next order arrives Q b: Remaining units after the backorder is satisfied


Backorder Inventory Model

(Q - b)

Q T1 0 b b T2



Backorder Inventory Model

Total Annual Cost = Annual Setup Cost + Annual Holding Cost + Annual Backordering Cost Annual Setup (Ordering) Cost = (D/Q) . S Annual Holding Cost = (Average Inventory Level) . H Average Inventory = Level = Average inventory level during in stock period (Q b) / 2 . Proportion of time there is inventory in stock T1 / T

Backorder Inventory Model

By using the graphical ratios, we know that: T1 / T = (Q b) / Q Therefore, if we replace T1/T in the above equation we get Average Inventory Level = (Q b)2 / 2Q (Q b)2 ---------- . H 2Q

Annual Holding Cost =

Backorder Inventory Model

Annual Backordering Cost = (Average Backordering) . B Average Backordering = (Average number of stock outs during out of stock period) x (Proportion of time inventory is on backorder) Average Backordering = b / 2 .T2 / T

By using the graphical ratios, we know that: T2 / T = b / Q Therefore, if we replace T2/T in the above equation we get: Average Backordering = b2 / 2Q and b2 Annual Backordering Cost = ---------- . B 2Q

Backorder Inventory Model

DS (Q b)2 b2 Total Cost (TC) = ------- + ---------- . H + --------- . B Q 2Q 2Q We find optimum order quantity (Q*) and optimum backordering quantity (b*) by taking the derivatives of dTC/dQ = 0 and dTC / db = 0 and then putting the values in their places. We find that:

2 S H  B * Q ! H B

Q H b* ! H

Quantity Discount Model

A quantity discount is simply a reduced price (P) for an item when it is purchased in LARGER quantities. A typical quantity discount schedule is as follows:
Alternative Quantity Discount (%) 1 0-999 0 2 1000-1999 4 3 20005 Discount (unit) Price $5.00 $4.80 $4.75


Quantity Discount Model

 Since the unit cost for the Third discount is

the lowest, We might be tempted to order 2000 or more units.  However, this quantity might not be the one that minimizes the Total Cost.  Remember that, As the quantity goes up, the holding cost increases.  Here, there is a trade off between reduced product price (P) and increased holding cost (H).

Quantity Discount Model

Total Cost = Setup Cost + Holding Cost + Product Price (Cost) Total Cost = DS / Q+ QH / 2 + PD where P is the price per unit To determine the minimum Total Cost, we perform the following process which includes 4 steps: Step 1: Assume that I: is a percentage value, and I . P represents the holding cost as a percentage of price per unit (P).

Quantity Discount Model

 For each discount alternative, calculate a

value of Q* = [2DS / IP]1/2  Here, instead of using a value of H, the holding cost is equal to I . P  That is, If the item is expensive (such as a Class A Item), Its holding cost will be higher.  Since the price of item (P) is a factor in Annual Holding Cost, we can no longer assume that the holding cost is constant (such as H) when price changes.

Quantity Discount Model

 Step 2: For any discount alternative,  If the calculated optimum order quantity (Q*) is too

low to qualify for the discount range,  Then, Adjust the order quantity upward to the lowest quantity that will qualify for the particular discount alternative.  Step 3: Using the total cost (TC) equation above, compute a total cost for every order quantity (Q). Use the adjusted Q values.  Step 4: Select the discount alternative which has the minimum Total Cost (TC).

 Consider the quantity discount schedule

given in the beginning (above).  Assume that the Ordering (Setup) Cost (S) is $49 per each order.  Annual Demand (D) is 5000 units, and  Inventory carrying charge is a percentage (I=0.20) of product cost (P).  Question: What order quantity will minimize the total inventory cost.

Answer: Step 1: Compute Q* for every discount range.
Q !
Q !
* 2

* 1

2 DS ! IP
2 S ! I
2 S ! I

2(5000)( 49) ! 700units / order (.2)(5)

2(5000)( 49) ! 714units / order (.2)( 4.8)
2(5000)( 49) ! 718units / order (.2)(4.75)

Q !
* 3

Step 2: Adjust values of Q* that are below allowable discount ranges. - For Q1, allowable range is 0-999. Since Q1* = 700 is between 0 and 999, It does not have to be adjusted. - For Q2, allowable range is 1000-1999. Since Q2* = 714 is not in the allowed range, we adjust it to the lowest allowable value, That is Q2* = 1000. - For Q3, allowable range is 2000-. Since Q3* = 718 is not in the allowed range, we adjust it to the lowest allowable value, That is Q3* = 2000.


Step 3: Compute total cost for each of the order quantities (Q*):

5000 x Unit price

$49 x (5000 / 700)

(Average Inventory x Holding Cost) =

(Q / 2) x (I x P) = (700 / 2) x (5 x 0,20)

Step 4: An Order quantity of 1000 units will minimize the total cost. However, if the third discount cost is lowered to $4.65, selecting this discount alternative (2000 units) would be the optimum solution.


Probabilistic Models
 So far we assumed that demand is constant

and uniform.
 However, In Probabilistic models, demand is

specified as a probability distribution.

 Uncertain demand raises the possibility of a

stock out (or shortage). (Why?)


Probabilistic Models
One method of reducing stock outs is to hold extra inventory (called Safety Stock). In this case, we change the ROP formula to include that safety stock (ss). ROP = d . L d = daily demand, and

L = Order Lead Time

Now it will be as follows: ROP = d . L + (ss) where (ss) is the safety stock

AMP Ltd. company determined its ROP = 50 units. Its holding cost (H) is $5 per unit per year. Its stock out cost (B) is $40 per unit. Probability of stock out is based on the following probability distribution:

Question: Find the Level of Safety Stock (ss) that minimizes the total additional holding cost and Stock out costs (annually).

 Stock out cost is an expected cost; That is:


Possible stock outs per year is actually the number of orders per year (D/Q). Since it is not known (or not given) assume that it is 6 times / year. For zero safety stock, there is no additional holding cost for extra (safety) stock. But there are stock out costs for two levels: 1) If demand is 60 units at the ROP, Then a shortage of 10 units will occur. (Because, ROP is 50 units) 2) If demand is 70 units at the ROP, Then a shortage of 20 units will occur.

Results of the example

The safety stock with the lowest total cost is (ss = 20) units. Therefore, ROP = 50 + 20 = 70 units.


Finding A Safety Stock Level

 Managers may want to limit the possibility of

stock out only to a small percentage, say 5%.  If demand level is assumed to be a normal distribution,  By using mean and standard deviation of the normal distribution,  We can determine a safety stock that is necessary for %95 service level.


 The SAC company carries an inventory item

that has a normally distributed demand.

 The mean demand is (Q = 350) units and

standard deviation is (W = 10).


We use the properties of a standardized normal curve to get a z value that corresponds to the.95 of the curve.

x : mean demand + safety stock x-Q z = -----W Using a standard Normal table we find z = 1.65 for 95% confidence.

Therefore, x-Q ss z = ------ = ---- = 1.65 W W ss = 16.5 units Reorder point is elevated up by 16.5 units.