Introduction to

MATERIALS MANAGEMENT

Inventory
Management

Copyright © 2017 by Pearson Education, Inc.Introduction to Materials Management, 8e All Rights ReservedChapman, Arnold, Gatewood, and Clive

Copyright © 2017 by Pearson Education, Inc.

All Rights Reserved
 Item Inventory Management

• Relative importance of inventory items (ABC analysis)

• How to control individual inventory items (ABC
inventory control)
• How much to order at one time (EOQ)
• When to place an order (ROP)

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Inventory and the Flow of Materials

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
Common Inventory Classifications
• Raw materials
• Not yet entered into the production process
• Work-in-process (WIP)
• Finished goods
• Distribution inventories
• Maintenance, repair, and operating supplies
(MRO)
 Items that do not become part of the
product
 Example – cleaning and repair supplies

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Inventory Functions
• Anticipation
▪ Anticipation of future demand, such as
seasonality or promotional
• Safety Stock (buffer/fluctuation inventory)
▪ Buffer against issues including
▪ Quality problems
▪ Lead time fluctuations
▪ Equipment or supply problems
▪ Spike in demand

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Inventory Functions (continued)
• Lot-size inventory
▪ Replenishment occurs in lots that are in excess of
immediate demand
▪ Economy of bulk purchase
▪ Economy of scale in bulk production
• Hedge inventory
▪ Hedge against price changes, purchase inventory when
prices are low
• Decoupling Inventory
▪ Inventory held between operations to allow independence
(like WIP buffer inventory before the constraint)

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Inventory Functions (continued)
• Transportation inventory
▪ Needed due to the transit time (e.g. plant to
customer)
▪ Does not depend on the shipment size
▪ Formula:
• I = tA/ 365
• (I = average annual inventory in transit, t = transit
time, A = annual demand)
• How to reduce I?
• If t = 10 days, A = 5200 units, calculate I
▪ I = 5200 X 10/365 = 142.5 units

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Types of Inventory and Rationales
1. Procurement (purchase discounts), production (long production run), and
transportation (freight rate discounts)
2. Demand- and supply-side uncertainties

3. Inventory costs associated with goods in motion during transportation time

period.

4. Inventory costs associated with goods in process during manufacture or assembly of a

complex product.

5. Seasonality in raw materials supply (e.g. production, transportation), in demand for

finished product, or in both

6. Inventory hold in anticipation that an unusual event (e.g. strikes, significant price
increase, extreme weather)
©2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8
 Objectives of Inventory Management

Maximize customer service Low-cost plant operation Minimize total inventory

investment
Have adequate inventory of the Economical inventory production,
right type to meet customer storage, and movement
demand

Introduction to Materials Management, 8e

Chapman, Arnold, Gatewood, and Clive
Inventory Costs
• Item Cost
• These could include such things as
transportation, custom duties, and
insurance. The inclusive cost is often
called the landed cost.
• For an item manufactured in-house, the
cost includes direct material, direct labor,
and factory overhead.
• Carrying Costs
• Order (Ordering) Costs
Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.
Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Inventory Costs (continued)

• Order Costs
• Setup and teardown cost
• Purchase order cost
• Lost capacity cost
• Production control cost
• Stockout Costs
• Capacity-associated Costs – overtime, hiring, training,
layoffs etc.- avoided by leveling production

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
Ordering Cost

Question: Given the following annual costs, calculate

the average cost of placing one order.
• Production control salaries = $60,000
• Supplies and operating expenses for production
control department = $15,000
• Cost of setting up work centers for an order = $120
• Orders placed each year = 2000
Ordering Cost
• Solution:
Operations
Leveling
•By leveling production,
manufacturing can
continually produce an
amount equal to the
average demand. The
advantage of this
strategy is that the costs
of changing production
levels are avoided.
 Carrying Costs

Carrying Costs
• Cost of capital
• Storage costs
• Risk, such as obsolescence, pilferage, or damage

The carrying cost is usually defined as a percentage of the dollar value of inventory
per unit of time (usually one year).

Textbooks tend to use a figure of 20–30% in manufacturing industries, Usually 25%

Problem on Carrying Costs

• A company carries an average annual inventory of

$2,000,000. If it estimates the cost of capital is 10%,
storage costs are 7%, and risk costs are 6%, what does
it cost per year to carry this inventory?
Solution

• Total cost of carrying inventory = 10% + 7% +

6% = 23%
• Annual cost of carrying inventory = 0.23 *
$2,000,000 = $460,000
The annual cost of carrying inventory

•Question: A company makes and sells a seasonal

product. Based on a sales forecast of 2000, 3000,
6000, and 5000 per quarter, calculate a level
production plan, quarterly ending inventory, and
average quarterly inventory.
•If inventory carrying costs are $3 per unit per quarter,
what is the annual cost of carrying inventory? Opening
and ending inventories are zero.
Copyright © 2017 by Pearson Education, Inc.
All Rights Reserved
The annual cost of carrying inventory
• Average Inventory = (inventory at beginning of period + inventory at end of period)/2
 Inventory Costs
Major Types of Costs
Emphasis of inventory cost analysis should be placed on the variable components of these costs.
Inventory Costs
• Inventory Carrying Cost
– Inventory carrying costs incurred by inventory at rest and waiting to be used. Four major components: Capital
cost, Storage space cost, Inventory service cost, and Inventory risk cost.
• Ordering and Setup Cost
– Ordering cost refers to expense of placing an order, excluding the cost of the product itself. Setup cost refers to
the expense of changing/modifying a production/assembly process to facilitate line changeovers.
• Expected Stockout Cost
– The cost associated with not having a product/materials available to meet customer/production demand. Most
organizations hold safety stock or buffer stock, to minimize the possibility of a stockout and costs of lost sales.
• In-transit Inventory Carrying Cost
– Generally, carrying inventory in transit costs less than in warehouses. But, in-transit inventory carrying cost
becomes especially important on global moves since both distance & time increase.

©2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2
0
 Approaches to Managing
Inventory
• Fundamental Approaches: Fixed order quantity & Fixed order
interval EOQ Additional Approaches: JIT, MRP, DRP, and VMI

©2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or
21
duplicated, or posted to a publicly accessible website, in whole or in part.
 Inventory Management Approaches
Managing inventory involved four fundamental questions:
• How much should inventory be ordered?
• When should inventory be ordered?
• Where should inventory be held?
• What specific line items should be available at specific locations?

©2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2
2
 Inventory Management Approaches
Cost vs. Service Tradeoff Considerations
Regardless of the approach selected, inventory decisions must consider the basic tradeoff
between cost and service.

Source Figure 9.4: Robert A. Novack, Ph.D. Used with permission.

©2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or
23
duplicated, or posted to a publicly accessible website, in whole or in part.
 Economic Order Quantity (Fixed Order Quantity)
• Minimizes the total costs of carrying and
ordering
• Assumptions
1.Demand is relatively constant and known
2.The item is purchased in lots or batches
3.Preparation costs and ordering costs are
constant and known
4.Replacement occurs all at once

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
Inventory Management Approaches (1 of 3)
Fixed Order Quantity EOQ Approach: Condition of Certainty
In fixed order quantity EOQ model, inventory is reordered when the amount on hand reaches the
reorder point. The reorder point quantity depends on the time it takes to get the new order and on the
demand for the item during this lead time.

Source Figure 9.5: John J. Coyle, DBA. Used with permission.

©2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
25
Re-Order Point
• Certainty
Re-order = Lead time x Average Usage
• Uncertainty
Re-order = (Lead time x Average Usage) + Safety Stock
Graphical
Representation
of EOQ
Mathematical Formulation
• The EOQ model can be developed in standard mathematical form, using the following variables:

where
• R = Annual rate of demand (units)
• Q = Quantity ordered (units)
• A = Cost of placing an order ($ per order)
• V = Value or cost of one unit of inventory ($ per order)
• W = Carrying cost per dollar value of inventory per year (% of product value)
• S = VW = Inventory carrying cost per unit per year ($ per unit per year)
• t = Time (days)
• TAC = Total annual cost ($ per year) =
Example - EOQ
Inventory Costs
and EOQ
 Example Problem
The annual demand is 10,000 units, the ordering
cost $30 per order, the carrying cost 20%, and the
unit cost $15. The order quantity is 600 units.
Calculate:
a. Annual ordering cost
b. Annual carrying cost
c. Total annual cost

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Example Problem - Solution
A = 10,000 units
S = $30 It’s a good
idea to write
c = $15 these down
i = 20% (.20) every time

Q = 600 units A
x S
a. Annual ordering cost = Q
= (10,000/600) x $30
= $500

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Example Problem - Solution
(continued)
b. Annual carrying cost =
Q
= (600/2) x $15 x .20 x c x i
= $900 2

c. Total annual cost

= cost of ordering + cost of carrying
= $500 + $900
= $1,400

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Trial-and-Error Method

Figure 10.2 Costs for different lot sizes

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Quantity Discounts

• A discount is given for orders over a certain

volume
• Must consider
▪ Purchase cost
▪ Ordering cost (usually annual)
▪ Carrying cost (also annual)
• Compare the total cost of discount quantity with
the total cost of EOQ

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Quantity Discounts
• Encourages buying more than normal
• Will increase the amount of inventory
▪ Increases inventory carrying cost
▪ Decreases ordering costs

• Savings from lower unit cost (due to the discount

offered on the purchase price) must be enough to
offset higher carrying cost

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved
 Quantity Discount - Example
An item has an annual demand of 25,000 units, a unit cost of $10, an order
preparation cost of $10, and a carrying cost of 20%. It is ordered on the
basis of an EOQ, but the supplier has offered a discount of 2% on orders of
1,000 units or more.
Should the offer be accepted?

Introduction to Materials Management, 8e Copyright © 2017 by Pearson Education, Inc.

Chapman, Arnold, Gatewood, and Clive All Rights Reserved