LOGO

Logistics and Supply Chain Management

Lecture:
Inventory Management

1
 LOGO
Outline
Reasons for Holding Stocks
 Aggregate Stockholdings
 Buffering Supply and Demand
 Types of Stock: Raw material, WIP, Finished goods
 Cost of Carrying Stock: Unit, Reorder, Holding, and Shortage Cost
Economic Order Quantity (EOQ)
 Finding the order size
 Finding the time to place orders
 Sensitivity Analysis
 Weakness of EOQ approach
Uncertain Demand and Safety Stock
Periodic Review Systems
Effort of Stock Control
 ABC Analysis
 Vendor Manage Inventory
2
 LOGO
REASONS FOR HOLDING STOCK

Question: When and how much an organization should

buy materials.
Ideally, materials move smoothly and continuously
through a supply chain
=> When materials stop moving they form stocks. All
organizations hold stocks of some kind.
STOCKS:
supplies of goods and materials that are held by an
organization.
INVENTORY:
a list of things held in stock.
3
 LOGO
Buffering Supply and Demand
• Many organizations cannot reduce them.
Ex: - Farmers grow one crop of hay a year,
and then store it to feed animals
throughout the year.

- A distiller stores whisky in barrels for

at least three years before selling it.

- A video store buys copies of videos and

keeps them in stock until people want to
hire them.

These organizations do not want to eliminate stocks,

but they want to control them properly.
Stocks give a buffer between variable and uncertain supply and demand.
4
 LOGO

■ They allow operations to continue smoothly and avoid

disruptions.
To be more specific, stocks:
● act as a buffer between different parts of the supply chain
● allow for demands that are larger than expected, or at unexpected times
● allow for deliveries that are delayed or too small
● take advantage of price discounts on large orders
● allow the purchase of items that are going out of production
● allow for seasonal operations
● make full loads and reduce transport costs
● give cover for emergencies
● can be profitable when inflation is high.

5
 LOGO
Types of Stock
● Raw materials – the materials, parts and components
that have been delivered to an organization, but are not yet
being used.

● Work in process – materials that have started,

but not yet finished their journey through the production
process.
● Finished goods – goods that have finished
the process and are waiting to be shipped out to customers.

Some stock items do not fall easily into these categories, and
we can define two additional types:
● Spare parts for machinery, equipment, and so on
● Consumables such as oil, fuel, paper, and so on
6
Types of stock (cont.) LOGO

7
 LOGO

Independent Demand System

8
 LOGO

Three basic questions

1. What items should we stock?

2. When should we place an order?
3. How much should we order?

9
 Costs of Carrying Stock LOGO

1. Unit cost: the price for an item charged by the supplier,

or the cost to the organization of acquiring one unit of the item.
2. Reorder cost (Ordering cost):
the cost of placing a repeat order for an item
(Estimately, Reorder cost =
the total annual cost of the purchasing dept.
the number of orders it sends out.)
3. Holding cost: the cost of holding one unit of an item
in stock for a unit period of time
(including: construction, storage space, loss,
handling, special treatment, such as refrigeration,
administration, insurance, and obsolescence)

4. Shortage cost (Stockout cost): occurs when an item

is needed but it cannot be supplied from stock.
Ex.: Lost sales, costs of expediting (extra setup, transportation, etc.)
and the costs of interrupted production

Note: The total cost of holding stock is around 25% of its value a year 10
 LOGO

Example

Janet is a purchasing clerk at Overton Travel

Group. She earns £16,000 a year, with other
employment costs of £3,000, and has a budget of
£6,200 for telephone, communications, stationery
and postage. In a typical month Janet places 100
orders. When goods arrive there is an inspection
that costs about £15 an order. The cost of
borrowing money is 9%, the obsolescence rate is
5% and insurance and other costs average 4%.

How can Overton estimate their reorder and

holding costs?
11
 LOGO
Solution
The total number of orders a year:12 mon.×100order/mon.= 1200 orders/yr.
 The reorder cost includes all costs that occur for an order:
■ salary = £16,000/1200ord./yr = £13.33 an order
■ employment costs = £3000/1200ord/yr = £2.50 an order
■ expenses = £6200/1200ord./yr = £5.17 an order
■ inspection = £15 an order
So the reorder cost is 13.33 + 2.50 + 5.17 + 15 = £36 an order.
 Holding costs include all costs that occur for holding stock:
■ borrowing = 9%
■ obsolescence = 5%
■ insurance and taxes = 4%
So the holding cost is 9 + 5 + 4 = 18% of inventory value a year.

12
 LOGO
Costs of Carrying Stock (cont.)

Cost Flow Assumption

In practice, the most common costing is based on the amount
paid and can use:

● FIFO (first in, first out): assumes that stock is sold in

the order it was bought, so the remaining stock is valued at
the current replacement cost

● LIFO (last in, first out): assumes that the latest stock is used
first, so the remainder is valued at earlier acquisition costs

● Average cost: uses a moving average cost over some

periods.

13
 LOGO
Example

A company bought the following numbers of an item. In July it had 8 units

in stock. What was the value of this stock?
Month Jan Feb Mar Apr May Jun Jul
Number bought 6 4 5 8 3 2 8
Unit price 21 19 18 22 24 26

Solution
No right answer to this, it depends on the conventions that we choose to use.
■ FIFO assumes that the remaining units are the last that were bought, and the
value of the last eight units is
(2×26) + (3×24) + (3×22) = 190
■ LIFO assumes that the first units bought are still in stock, and the value of these
first eight units is
(6×21) + (2×19) = 164
■ Current replacement cost gives a value of
(8×26) = 206
■ A three-month moving average gives a unit price of (22+24+26)/3 = 24, and a
value of (8×24) = 192.

14
 ECONOMIC ORDER QUANTITY (EOQ) LOGO

Finding the Order Size

 The EOQ: remains the best way of tackling a wide range of inventory
problems.

 Imagine a single item, held in stock to meet a constant demand of D per

unit time. Assume that we know:
 unit cost (U)
 reorder cost (R)
 holding cost (H)
 no shortages are allowed.

 The item is bought in batches from a supplier who delivers after a

constant lead time (L).

 Find the best order quantity (Q) and always place orders of this size.
There is no point in carrying spare stock, so we time orders to arrive just
as existing stock runs out. Then we get a series of stock cycles.

15
 Finding the Order Size (cont.) LOGO
Inventory (Stock) level

Usage rate Avg.

Order inventory
quantity = Q on hand
(max. inventory
level) Q
2

Min.
inventory

0
Stock Cycle Time
 LOGO
Finding the Order Size (cont.)

At some point an order of size Q arrives. This is used

at a constant rate, D, until no stock is left.
We can find the total cost for the cycle
(= unit cost + reorder cost + holding cost + shortage cost)
No shortages are allowed, so we can ignore
shortages cost, and the cost of buying the item is
constant regardless of the ordering policy.
The cost per unit time (Variable cost) is
C = total reorder costs + total holding costs

= RD/Q + HQ/2

17
 Variation of Cost with Order Sizes LOGO

Optimal Order Quantity is when the Total Cost curve is at its

lowest . This occurs when the Ordering Cost = Holding Cost
Cost
Curve of Total Cost
of Holing
and Ordering

Minimum
Total
Cost

Holding Cost Curve

Ordering Cost Curve

Optimal Order Quantity

Order
Quantity
 LOGO
Finding the Order Size (cont.)
 From the graph:
● the total holding cost rises linearly with order size
● the total reorder cost falls as the order quantity increases
● large infrequent orders give high total holding costs and low total
reorder costs
● small frequent orders give low total holding costs and high total
reorder costs
● adding the two costs gives a total cost curve that is an asymmetric ‘U’
shape with a distinct minimum
● this minimum cost shows the optimal order size – which is the
economic order quantity, EOQ.
D = demand
R = reorder cost 2 RD
H = holding cost Q 
H
Economic order quantity Q:
Q
(Stock) cycle length T 
D
19
 Example LOGO

John Pritchard buys stationery for Penwynn Motors.

The demand for printed forms is constant at 20 boxes
a month. Each box of forms costs £50, the cost of
processing an order and arranging delivery is £60,
and holding cost is £18 a box a year.

What are the economic order quantity, cycle length

and costs?

20
 LOGO
Solution

Listing the values we know in consistent units:

 D = 20unit/mon. × 12mon. = 240 units a year
 U = £50 a unit
 R = £60 an order
 H = £18 a unit a year.
■ Substituting these values into the economic order quantity gives:
= 40 units

■ Then the variable cost is:

C = total reorder costs + total holding costs
= RD/Q + HQ/2 = 60 × 240/40 + 18 × 40/2
= 360 + 360 = £720 a year
(You can see that the total reorder costs equal the total holding
costs. This is always true if we order the economic order
quantity, so we can simplify the calculation to twice the total
holding cost or C = HQ = 18 × 40 = £720)

21
 LOGO
Solution

■ The fixed cost of buying boxes is the number of boxes bought a

year, D, times the cost of each box, U.
total cost = fixed cost + variable cost
= UD + C
= 50 × 240 + 720 = £12,720 a year
■ We buy 40 boxes at a time, and use 20 boxes a month, so the
stock cycle length is 2 months.
stock cycle length: T = Q/D
T = Q/D
= 40/240 = 1/6 years or 2 months
The best policy, with total costs of £12,720 a year, is to order 40
boxes of paper every 2 months.

22
 LOGO

Annual demand, which of Southwest Apparel Company about denim to

produce jeans, is 6500 yards. The ordering costs (including delivery) are
$30 and annual carrying costs are $3 per yard. The lead time required to
receive an order of denim from the textile mill is a constant 5 weeks.
Determine the following:

a. Economic order quantity (Company work 5 days per week, 52 weeks

per year), total annual inventory cost.
 Finding the Time to Place Orders LOGO

Lead time

 When an organization buys materials, there is a lead time

between placing the order and having the materials arrive in
stock.

 This is the time taken to prepare an order, send it to the

supplier, allow the supplier to make or assemble the materials
and prepare them for shipment, ship the goods back to the
customer, allow the customer to receive and check the
materials and put them into stock.

 Depending on circumstances, this lead time can vary between

a few minutes and months or even years.

24
 LOGO
Finding the Time to Place Orders (cont.)
● Suppose:
* the lead time, L: constant
* the demand, D: constant
Place an order when the stock level falls to LD, and this point is called the
reorder level (ROL).
Reorder level = lead time demand = lead time × demand
ROL = LD

25
Example
Demand for an item is constant at 20 units a week, the reorder costLOGO
is
£125 an order and holding cost is £2 an unit a week.
If suppliers guarantee delivery within 2 weeks, what is the best ordering
policy for the item?
Solution
Listing the variables in consistent units:
 D= 20 units a week
 R = £125 an order
 H= £2 a unit a week
 L = 2 weeks
Substituting these gives:

= 50 units

 Reorder level = lead time × demand = LD = 2 × 20 = 40 units

 The best policy is to place an order for 50 units whenever stock falls to 40 units.

26
 Sensitivity Analysis LOGO

Cheng Tau Hang notices that demand for an item his company supplies
is constant at 500 units a month. Unit cost is $100 and shortage
costs are known to be very high.
The purchasing department sends out an average of 3000 orders a
year, and their total operating costs are $180,000.
Any stocks have financing charges of 15%, warehouse charges of 7%
and other overheads of 8% a year.
The lead time is constant at one week.

Find a good ordering policy for the item.

What is the reorder level if the lead time increases to 3 weeks?
What range of order size keeps variable costs within 10% of optimal?
What is the variable cost if orders are placed for 200 units at a time?

Solution: Text book : page 264 + 265 27

LOGO
LOGO
 LOGO
UNCERTAIN DEMAND & SAFETY STOCK

Demand varies more widely. We will illustrate one approach where

the demand is normally distributed.
• Safety stocks: additional stocks → to add a margin of safety.
• REORDER LEVEL = lead time demand + safety stock = LD + SS

30
 UNCERTAIN DEMAND & SAFETY STOCK LOGO
(cont.)

Service level: the probability that a demand is met directly from stock.
Cycle-service level: Service level as the probability of not running out of
stock in a stock cycle.

Suppose that:
Demand for an item is normally distributed with a mean of D per unit
time and standard deviation of σ. If the lead time is constant at L, the
lead-time demand is normally distributed with mean of LD.
The lead-time demand has a variance of σ2L and standard deviation of
σ√L.
● demand in a single period has mean D and variance σ2,
● demand in L periods has mean LD and variance Lσ2.

when lead-time demand is normally distributed the safety stock is:

SAFETY STOCK = Z × standard deviation of lead-time demand
= Zσ√L
31
 Example LOGO

Associated Kitchen Furnishings runs a retail shop to sell a range of

kitchen cabinets.
The demand for cabinets is normally distributed with a mean of 200
units a week and a standard deviation of 40 units.
The reorder cost, including delivery, is £200, holding cost is £6 per
unit a year and lead time is fixed at 3 weeks.

• Describe an ordering policy that gives the shop a 95% cycle-service

level.
• What is the cost of holding the safety stock in this case?
• How much does the cost rise if the service level is set at 97%?

Solution: Text book, page 269

32
 LOGO
Solution
Listing the values we know:
D = 200 units a week = 10,400 units a year H = £6 a unit a year
σ = 40 units L = 3 weeks
R = £200 an order
Substituting these values gives:
■ Q = √(2RD/H) = √(2 × 200 × 200 × 52/6) = 833 (to the nearest integer)
■ Reorder level = LD + safety stock = 600 + safety stock
■ For a 95% service level Z = 1.64 standard deviations from the mean. Then:
■ safety stock = Zσ√L = 1.64 × 40 × √3 = 114 (to the nearest integer)
The best policy is to order 833 units whenever stock falls to 600 + 114 =
714 units. On average orders will arrive when there are 114 units left.
The holding cost of safety stock:
= safety stock × holding cost = 114 × 6 = £684 a year
■ If the service level is set at 97%, Z becomes 1.88 and:
■ safety stock = Zσ√L = 1.88 × 40 × √3 = 130
The cost of holding this is:
= safety stock × holding cost = 130 × 6 = £780 a year
 LOGO
PERIODIC REVIEW SYSTEMS

EOQ analysis uses a fixed order quantity for

purchases, so an order of fixed size is placed
whenever stock falls to a certain level.
Periodic review approach:
orders varying amounts at regular intervals.
Question:
 How long should the interval between orders be?
 What is the target stock level?

34
LOGO

35
 LOGO
PERIODIC REVIEW SYSTEMS (cont.)
 Assume that the demand for each period is normally distributed with a
mean D and standard deviation σ, and that both the order period (T)
and lead time (L) are fixed.
 target stock level = mean demand over (T+L) + safety stock
= D(T+L) + Zσ√(T+L)
 order quantity = target stock level – stock on hand

36
 LOGO

Computing Safety Stock

 Order-cycle service level is the probability
that demand during lead time will not exceed
on-hand inventory
 A 95% service level means the stockout risk
is 5%, and has a z-score Z95=1.645

Area = .45

Area Stockout!
left of y-axis = .50 Tail Area = .05

0
Z95 = 1.645 z
 LOGO

Normal distribution
service levels and
unit normal loss function
http://www.baskent.edu.tr/~kilter
 LOGO
Example

Demand for an item has a mean of 200 units a week and

standard deviation of 40 units.
Stock is checked every four weeks and lead time is
constant at two weeks.
Describe a policy that will give a 95% service level. If the
holding cost is £2 a unit a week, what is the cost of the
safety stock with this policy?

What is the effect of a 98% service level?

Solution: Text book, page 273

39
 LOGO
Solution

Listing the values given:

D = 200 units; T = 4 weeks
σ = 40 units; L = 2 weeks
H = £2 a unit a week

 For a 95% service level, Z is 1.64 (from a standard package or tables). Then:

■ safety stock = Zσ√(T+L) = 1.64 × 40 × √6 = 161units (to the nearest integer)

■ target stock level = D(T+L) + safety stock = 200 × 6 + 161 = 1361units.

 When it is time to place an order, the policy is to find the stock on hand, and place
an order for:

■ order size = target stock level – stock on hand = 1361 – stock on hand.
If, for example, there are 200 units in stock, we place an order for
1361 – 200 = 1161 units.
■ The safety stock is not normally used, so the holding cost:
= safety stock × holding cost = 161 × 2 = £322 a week.
 Solution ( cont) LOGO

If the service level is increased to 98%, Z = 2.05. Then:

■ safety stock = Zσ√(T+L)
= 2.05 × 40 × √6 = 201 units
■ target stock level = D(T+L) + safety stock
= 200×6 + 201 = 1401 units
■ cost of the safety stock is safety stock × holding cost
= 201unit × 2£/unit/wk = £402 a week.
 LOGO
EFFORT OF STOCK CONTROL

ABC analysis

Vendor managed inventory

42
 ABC Analysis LOGO

 An ABC analysis puts items into categories that show the amount of
effort worth spending on inventory control. This is a standard Pareto
analysis or ‘rule of 80/20’, which suggests that 20% of inventory items
need 80% of the attention, while the remaining 80% of items need
only 20% of the attention. ABC analyses define:

● A items as expensive and needing special care

● B items as ordinary ones needing standard care
● C items as cheap and needing little care.

Category % of items Cumulative % of use Cumulative % of

% of items by value use by value
A 10 10 70 70
B 30 40 20 90
C 60 100 10 100

43
ABC Analysis (cont.) LOGO

44
Example

LOGO

Sorting
Example

LOGO

Sorting

330+50

330/500