Part II

Inventory Costs
Ordering policies

1
  Demand Forecasts and Lead-Time
Information
 Inventories are used to satisfy demand
requirements, so it is essential:
1. To have reliable estimates of the amount and
timing of demand.
2. To know how long it will take for orders to be
delivered.
3. The time between submitting an order and
receiving it (lead time )might vary

2
• Greater the potential variability, the greater
the need for additional stock to reduce the
risk of a shortage between deliveries. Thus,
there is a crucial link between forecasting and
inventory management.

3
  Inventory Costs
• Four Basic costs associated with inventory are
1. Purchase cost
2. Holding, or carrying, costs
3. Ordering costs
4. setup costs
5. Shortage costs

4
 1.Purchase cost
• Purchase cost is the amount paid to a vendor
or supplier to buy the inventory.
• It is typically the largest of all inventory costs

5
 2. Holding or carrying costs
• This cost relates to physically having items in
storage. Costs include:
• Interest, insurance, taxes , depreciation, and
warehousing costs (heat, light, rent, security).
• They also include opportunity costs
• It is the variable portion of cost
• Holding costs are stated in either as a
percentage of unit price or as a dollar amount
per unit.
6
 3. Ordering costs

• Costs of ordering and receiving inventory

• These costs vary with the actual placement of
an order. They include:
• Determining how much is needed, preparing
invoices, inspecting for quality and quantity and
moving the goods to storage
• Ordering costs are generally expressed as a
fixed dollar amount per order, regardless of
order size.
7
 4.setup costs
• When a firm produces its own inventory instead of
ordering it from a supplier , setup costs are similar to
ordering costs
• It includes cost involved in preparing equipment for a
job by adjusting the machine, changing cutting tools
etc.
• It is expressed as a fixed charge per production run,
regardless of the size of the run.

8
 5.Shortage costs
• Shortage costs result when demand exceeds the
supply of inventory on hand.
• These costs can include the opportunity cost of not
making a sale, loss of customer goodwill, late
charges, backorder costs, and similar costs, cost of
lost production or downtime
• Shortage cost are difficult to measure, and they may
be subjectively estimated.

9
  Classification System
• items held in inventory are not of equal importance
in terms of dollars invested, profit potential, sales or
usage volume, or stock out penalties
• Allocate control efforts according to the relative
importance of various items

10
 A-B-C approach of classification
• A-B-C approach classifies inventory items according
to some measure of importance, usually annual
dollar value
• Generally three classes of items are used:
• A (very important), about 10-20% of the number of
items but about 60–70% of the annual dollar value
• B (moderately important) about 35 percent
• C (least important) about 50-60% of the number of
items but about 10–15% of the annual dollar value

11
 cycle counting
• Another application of the A-B-C concept is as
a guide to Cycle counting, which is a physical
count of items in inventory
• It reduces discrepancies between inventory
records and the actual inventory on hand
• Accuracy is important to avoid disruptions in
operations, poor customer service, and
unnecessarily high inventory carrying costs

12
 Types of stock
• Cycle stock The amount of inventory needed
to meet expected demand.
• Safety stock Extra inventory carried to reduce
the probability of a stockout due to demand
and/ or lead time variability.

13
  INVENTORY ORDERING POLICIES

Two basic issues of inventory management

1. How much to order
2. When to order
• To address these issues four classes of models are
used :
1. EOQ (economic order quantity)
2. ROP (reorder point)
3. fixed-order-interval
4. single-period models
14
 1.EOQ (economic order quantity)

• Economic order quantity (EOQ) model

determines how much to order
• EOQ models identify the optimal order
quantity by minimizing the sum of certain
annual costs that vary with order size and
order frequency

EOQ model 15
 Order size models
A. The basic economic order quantity model.
B. The economic production quantity model.
C. The quantity discount model.

EOQ/Order size models 16

 A. The Basic EOQ Model.
• It is used to identify a fixed order size that will minimize
the sum of the annual costs of holding inventory and
ordering inventory
• Unit purchase price of items in inventory is not generally
included in the total cost
• Inventory ordering and usage occur in cycles
• cycle begins with receipt of an order of Q units
• These units are withdrawn at a constant rate over time
When the quantity on hand is just sufficient to satisfy
demand during lead time, an order for Q units is
submitted to the supplier
EOQ/Order size models/the basic EO 17
Q model
• The optimal order quantity reflects a balance
between carrying costs and ordering costs:
• As order size varies, one type of cost will
increase while the other decreases.
• For example, if the order size is relatively small,
the average inventory will be low, resulting in
low carrying costs However, a small order size
will necessitate frequent orders, which will
drive up annual ordering costs.
EOQ/Order size models/the basic EO 18
Q model
• Annual carrying cost =(Q/2)H
• Annual ordering cost =(D/Q)S
• where
• Q= Order quantity in units
• H = Holding (carrying) cost per unit per year
• D= Demand, usually in units per year
• S=Ordering cost per order

EOQ/Order size models/the basic EO 19

Q model
 Formulas

EOQ/Order size models/the basic EO 20

Q model
 Example 1

EOQ/Order size models/the basic EO 21

Q model
 Example 2

EOQ/Order size models/the basic EO 22

Q model
B . Economic Production Quantity (EPQ)
• Generally the capacity to produce a part
exceeds the part’s usage or demand rate
• In this way inventory will continue to grow.
• It is better to periodically produce such items
in batches, or lots, instead of producing
continually
• There is no ordering cost but with every
production run (batch) there are setup costs

EOQ/Order size models/ Economic pr 23

oduction Quantity EPQ
 formula

EOQ/Order size models/ Economic pr 24

oduction Quantity EPQ
EOQ/Order size models/ Economic pr 25
oduction Quantity EPQ
 Example

EOQ/Order size models/ Economic pr 26

oduction Quantity EPQ
EOQ/Order size models/ Economic pr 27
oduction Quantity EPQ
 C. The Quantity Discount Model.
• Quantity discounts are price reductions for
larger orders offered to customers to induce
them to buy in large quantities
• Buyer must weigh the potential benefits of
reduced purchase price and fewer orders that
will result from buying in large quantities
against the increase in carrying costs caused
by higher average inventories

EOQ/Order size models/ Quantity Dis 28

count Model
The buyer’s goal with quantity discounts is to select
the order quantity that will minimize total cost

• Total cost is the sum of carrying cost, ordering

cost, and purchasing (i.e., product) cost:

29
Example

30
31
Part II concluded

32