Chapter 12

Inventory Management

Slides prepared by Laurel Donaldson Douglas College

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives
LO 1 LO 2 LO 3

Define the term inventory, list major reasons for holding inventory, and discuss the objectives of inventory management. List the main requirements for effective inventory management, and describe A-B-C classification and perform it. Describe the basic EOQ model, the economic production quantity model, the quantity discount model, and the planned shortage model and solve typical problems. Describe how to determine the reorder point and solve typical problems. Describe the fixed order interval model and solve typical problems. Describe the single period model and solve typical problems.

LO 4 LO 5 LO 6

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Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
Introduction Requirements for Effective Inventory Management Fixed Order Quantity/Reorder Point Model (FOQRP) FOQRP: Determining the Reorder Point Fixed Order Interval Model The Single Period Model

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Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Inc. All rights reserved.What Is Inventory? Stock of items kept to meet future demand Decisions of inventory management how many units to order when to order 4 LO 1 Copyright © 2010 by The McGraw-Hill Companies. .

Dependent demand is certain. LO 1 Copyright © 2010 by The McGraw-Hill Companies.Inventory Independent Demand A ‡Retail items. 5 . All rights reserved. Inc. ‡finished goods. ‡supplies and parts. ‡some raw materials C(2) B(4) D(2) E(1) D(3) F(2) Dependent Demand ‡Manufactured parts Independent demand is uncertain.

Inc. tools. . All rights reserved.Types of Inventories Raw materials & purchased parts Partially completed items called work in process (WIP) Finished-goods (or merchandise) Spare parts. & supplies 6 LO 1 Copyright © 2010 by The McGraw-Hill Companies.

.Functions of Inventory To take advantage of quantity discounts To hedge against price increases To wait while in transit To protect against stockouts To smooth production requirements To decouple operations 7 LO 1 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. Inc.

. All rights reserved.Objective of Inventory Control To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds Level of customer service (not understock) Fill rate Costs of ordering and carrying inventory (not overstock) Inventory turnover 8 LO 1 Copyright © 2010 by The McGraw-Hill Companies. Inc.

Effective Inventory Management A reliable forecast of demand Knowledge of lead times Reasonable estimates of Holding costs Ordering costs Shortage costs Quantity Costs Control A classification system A system to keep track of inventory 9 LO 2 Copyright © 2010 by The McGraw-Hill Companies. . All rights reserved. Inc.

Inc.Safely Storing Inventory Warehouse Management System (WMS) computer software that controls the movement and storage of materials within a warehouse. and processes the associated transactions Warehouse/storeroom concerns Security Safety Obsolescence 10 LO 2 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. .

Inc. . thus providing current levels of each item 11 LO 2 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved.Inventory Counting Systems Periodic counting Physical count of items made at periodic intervals Perpetual (or continual) tracking keeps track of removals from and additions to inventory continuously.

Inc. reorder when the first is empty Bar Code A number assigned to an item or location.Inventory Replenishment Fixed Order Quantity/Reorder Point Model An order of a fixed size is placed when the amount on hand drops below a minimum quantity called the reorder point Two-Bin System Two containers of inventory. All rights reserved. 214800 232087768 12 . LO 2 Copyright © 2010 by The McGraw-Hill Companies. made of a group of vertical bars of different thickness that are readable by a scanner Universal Product Code (UPC) Radio Frequency Identification (RFID)0 technology that uses a RFID tag attached to the item that emits radio waves to identify items.

.Forecasting Demand Lead time time interval between ordering and receiving the order Point of Sale (POS) system Software for electronically recording actual sales at the time and location of sale 13 LO 2 Copyright © 2010 by The McGraw-Hill Companies. Inc. All rights reserved.

All rights reserved. Inc. .Inventory Costs Ordering or Setup costs Holding (carrying) costs Shortage costs Inventory costs 14 LO 2 Copyright © 2010 by The McGraw-Hill Companies.

and material handling Setup costs Time spent preparing equipment for the job by adjusting machine. . changing tools. Inc. All rights reserved. etc Shortage costs costs when demand exceeds supply. inspection. often unrealized profit per unit 15 LO 2 Copyright © 2010 by The McGraw-Hill Companies.Inventory Costs Holding (carrying) costs cost to carry an item in inventory Ordering costs costs determining order quantity. and fixed cost portion of receiving. preparing purchase orders.

ABC Classification System Classifying inventory according to some measure of importance and allocating control efforts accordingly.least important A items should receive more attention! High (70-80) A B C Low (15-20) Annual $ value of items Low (5-10) High (50-60) Percentage of Items 16 LO 2 Copyright © 2010 by The McGraw-Hill Companies.mod. All rights reserved. important C . Inc. A .very important B . .

00 42.2% .000 100 1.00 154.500 8.000 77.50 .00 17. .4% 5. All rights reserved.000 12.000 600 2.000 26.1% A 72% B 23% C 5% 17 LO 2 Copyright © 2010 by The McGraw-Hill Companies.200 250 $ 90.5% .3% 6.4% .8% 33.200 850 504 150 38.60 $ 90.350 15.17 . Inc.500 1.86 12.42 .Example: A-B-C Classification Item Number 8 10 2 5 3 1 7 9 6 4 Annual Demand x Unit Cost = Annual Dollar Volume (ADV) % of Total ADV 1.2% 11.550 350 1.60 8.7% .4% 3.000 500 1.50 14.

. Inc.Cycle Counting Regular actual count of the items in inventory on a cyclic schedule Cycle counting management How much accuracy is needed? When kind of counting cycle should be used? Who should do it? 18 LO 2 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved.

Fixed Order Quantity/Reorder Point Model: Determining Economic Order Quantity economic order quantity (EOQ) The order size that minimizes total inventory control cost basic economic order quantity (EOQ) economic production quantity (EPQ) EOQ with quantity discount LO 3 EOQ with planned shortage 19 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. . Inc.

2. . All rights reserved. Shortage is not allowed 20 LO 3 Copyright © 2010 by The McGraw-Hill Companies. Lead time does not vary 5. There are no quantity discounts 7. Only one product is involved . Inc. Demand is even throughout the year 4. Annual demand requirements known 3.Assumptions of EOQ Model 1. Each order is received in a single delivery 6.

Quantity decreases by demand rate (d) LT Time LT 3. The cycle then repeats. Inc. place another order (size = Q). Q Quantity on hand Q Q R 2. R = Reorder point Q = Economic order quantity LT = Lead time LO 3 21 Copyright © 2010 by The McGraw-Hill Companies.Inventory Cycles with EOQ 1. Order received after lead time (LT) expires. When quantity reaches reorder point quantity (R). when 0 on hand. You receive an order (size = Q) 4. All rights reserved. .

. All rights reserved.EOQ: Minimizing Total Costs Total cost = Holding + Ordering Costs Total cost is minimized at Q0 where holding = ordering cost A N N U A L C O S T Total Cost Holding Costs Ordering Costs QO LO 3 Order Quantity (Q) 22 Copyright © 2010 by The McGraw-Hill Companies. Inc.

All rights reserved.Basic Economic Order Quantity (EOQ) Total Annual = Cost Annual Annual Holding + Ordering Cost Cost TC = Total annual cost Q = Order quantity (units) H = Annual holding cost per unit D = Annual Demand S = Ordering (or setup) cost per order Q0 = EOQ Q D TC ! H  S 2 Q 2DS 2(Annual Demand) (Order or Setup Cost) QO = = H Annual Holding Cost 23 LO 3 Copyright © 2010 by The McGraw-Hill Companies. . Inc.

000 units H Q 2 Qo = 2(10. Inc.EOQ Example 1 A phone company has annual demand of 10.000/500 = 12.000) (75) (6) TC = (500)(6) 2 + (10. number of orders per year and the order cycle time. and ordering cost of $75. . Total Cost. H = $6 per unit 2DS QH DS S = $75 Qo = TC = + D = 10.000)(75) 500 Qo = 500 units TC = $1500 + $1500= $3000 Length of order cycle = 250 days/(D/Qo) Orders per year = D/Qo = 250/20 = 10.000.5 days = 20 orders/year 24 LO 3 Copyright © 2010 by The McGraw-Hill Companies. A component has annual holding cost of $6 per unit. All rights reserved. Calculate EOQ.

Calculate EOQ. Inc. A component has annual holding cost of $6 per unit.EOQ Example 2a A phone company has annual demand of 15. number of orders per year and the order cycle time. .000.000)(75) (612)(6) 2(15.000/612 25 = 10 days = 25 orders/year Copyright © 2010 by The McGraw-Hill Companies.000 units Q H 2 (15. H = $6 per unit 2DS QH DS S = $75 Qo = TC = + D = 15. and ordering cost of $75. Total Cost.000) (75) TC = + 612 2 Qo = (6) Qo = 612 units EOQ is 22% more than 500 TCmin = $1836 + $1838 = $3674 Total cost is 22% more than $3000 LO 3 Length of order cycle = 250 days/(D/Qo) Orders per year = D/Qopt = 250/25 = 15. All rights reserved.

H = $6 per unit S = $75 D = 15. A component has annual holding cost of $6 per unit.000. .000) (75) (6) Qo = 2DS H QH DS TC = + 2 Q Qo = 612 units Total cost is only an extra 2% more if still use EOQ of 500 LO 3 What if we still use EOQ of 500? What is total cost? TC = (15.000)(75) (500)(6) + 500 2 TC = $1500 + $2250 = $3750 26 Copyright © 2010 by The McGraw-Hill Companies. and ordering cost of $75. Inc.EOQ Example 2b A phone company has annual demand of 15.000 units Qo = 2(15. All rights reserved.

Robust Model The EOQ model is robust It works even if all parameters and assumptions are not met The total cost curve is relatively flat near the EOQ (especially to the right) 27 LO 3 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. . Inc.

Inc.Economic Production Quantity (EPQ) Production done in batches or lots production capacity > usage or demand rate for a part for the part Assumptions of EPQ similar to EOQ except orders are received incrementally during production 28 LO 3 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. .

Economic Production Quantity (EPQ) 29 LO 3 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. . Inc.

I max ! . Run length ! .Economic Production Quantity (EPQ) ¨ Annual ¸ ¨ Annual ¸ © ¹ © ¹ ¨ I max ¸ ¨D¸ TC ! © Holding ¹  © Setup ¹ ! © ¹ H  © ¹S ©Q¹ ª 2 º ª º © Cost ¹ © Cost ¹ ª º ª º Q Q Q Cycle length ! .

All rights reserved.p  d d p p TC = Total annual cost Q = Order quantity (units) H = Annual holding cost per unit D = Annual Demand S = Ordering (or setup) cost per order LO 3 Q0 ! 2 DS ¨ p © H © pd ª ¸ ¹ ¹ º Q0 = Optimal run or order quantity p = Production rate d = Usage or demand rate Imax = Maximum inventory level 30 Copyright © 2010 by The McGraw-Hill Companies. . Inc.

Calculate the EPQ.55 per bag. Production is 50. Demand is 20. the cycle length and optimal production run length.55 ª 50G  20G º 31 LO 3 Copyright © 2010 by The McGraw-Hill Companies.000. 5 days per week. All rights reserved.000)(200) ¨ 50G ¸ Q0 ! ¹ ! 77.000 per day. The setup cost is $200 and the annual holding cost rate is $. produces reusable shopping bags. the total cost.000 bags per day p = 50. .55 per bag S = $200 D = 20.EPQ Example Holdit Inc.850 © . 50 weeks per year.000 bags x 50 wks x 5 days d = 20. Inc.000 bags per day. H = $0.000 bags per day 2 DS ¨ p ¸ © Q0 ! © pd ¹ ¹ H ª º 2(5.

produces reusable shopping bags.000 bags per day. Demand is 20. 5 days per wk.000 bags x 50 wks x 5 days d = 20.EPQ Example Holdit Inc.55 per bag. Setup cost is $200 and annual holding cost rate is $. Calculate total cost.000 bags per day ¨D¸ ¨ I max ¸ TC ! © ¹ H  © ¹S ©Q¹ ª 2 º ª º I max Q ! . 50 wks per yr. H = $0.000 bags per day p = 50.55 per bag S = $200 D = 20. Production is 50.000 per day.

850 .p  d p I max 77.

710 bags ! 50.710 ¸ TC ! © ¹200 ! $25.30000 ! 46. All rights reserved.850 º 32 LO 3 Copyright © 2010 by The McGraw-Hill Companies. Inc.690 ¹(.55)  © ª 2 º ª 77.000 ¨ 5million ¸ ¨ 46. .

The setup cost is $200 and the annual holding cost rate is $. produces reusable shopping bags. 50 weeks per year.000 bags per day.EPQ Example Holdit Inc.850 Run length ! ! 1. . H = $0.000 77. Calculate cycle length and optimal production run length.850 Cycle length ! ! every 3.000 bags x 50 wks x 5 days d = 20. Inc.000 per day.55 per bag.000 33 LO 3 Copyright © 2010 by The McGraw-Hill Companies. Run length ! d p 77. 5 days per week.89 days 20.56 days per order 50.55 per bag S = $200 D = 20. Production is 50. All rights reserved. Demand is 20.000 bags per day Q Q Cycle length ! .000 bags per day p = 50.

Inc. .EOQ with Quantity Discounts Price reductions are often offered as incentive to buy larger quantities Weigh benefits of reduced purchase price against increased holding cost Annual holding cost Q H 2 Annual ordering cost D S Q + Purchasing cost + RD TC = + + TC = R = per unit price of the item D = annual demand LO 3 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved.

. All rights reserved.Total Cost with Purchase Cost Cost Adding Purchasing cost TC with PD doesn¶t change EOQ TC without PD PD 0 LO 3 EOQ Quantity 35 Copyright © 2010 by The McGraw-Hill Companies. Inc.

All rights reserved.Total Cost with Quantity Discounts 36 LO 3 Copyright © 2010 by The McGraw-Hill Companies. . Inc.

Inc. .Best Purchase Quantity Procedure begin with the lowest unit price compute the EOQ for each price range stop when find a feasible EOQ Is EOQ for the lowest unit price feasible? Yes: it is the optimal order quantity No: compare total cost at all break quantities larger than feasible EOQ The quantity that yields the lowest total cost is optimum 37 LO 3 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved.

Example: Quantity Discounts Below is a quantity discount schedule for an item with an annual demand of 10.000 units that a company orders regularly at an ordering cost of $4.000 or more . All rights reserved.499 $1. The annual holding cost is 2% of the purchase price per year. Inc.999 1.00 4.98 38 LO 3 Copyright © 2010 by The McGraw-Hill Companies. .20 2. Order Quantity(units) Price/unit($) 0 to 2.500 to 3. Determine the optimal order quantity.

LO 3 Copyright © 2010 by The McGraw-Hill Companies.000)(4) QO = = = 2.999 1.Example: Quantity Discounts D = 10. the Qo value is feasible Qo value is NOT feasible Qo value is NOT feasible 39 .000 units H 0. 2DS 2(10.98 2(10.020 units H 0.500 to 3.00 4.20.20 2.02(0.826 units = QO = 0.000 units H = .98) Interval from 4000 & up.000)(4) 2DS = 1.00.02(1. 1.499 $1.000 or more .98 Order Quantity Price/unit($) 0 to 2. All rights reserved.20) H Interval from 0 to 2499.02(1. Inc.000)(4) QO = = = 2. 0.00) Interval from 2500-3999.02R S = $4 R = $1. 2DS 2(10.

All rights reserved. 40 .Quantity Discount Models 1st range total cost curve 2nd range total cost curve Annual cost EOQ 3rd range total cost curve EOQs (not feasible) 1st break quantity 2nd break quantity 0 LO 3 2500 4000 Quantity Copyright © 2010 by The McGraw-Hill Companies. Inc.

.949.20 Therefore the optimal order quantity is 4000 units 41 LO 3 Copyright © 2010 by The McGraw-Hill Companies.82 TC(2500-3999)= $10.041 TC(4000&more)= $9.20) = $12.02*1. All rights reserved.043. Inc.20) + (10000/1826)*4+(10000*1.Example: Quantity Discounts Q TC = H 2 + DS Q + RD TC(0-2499) = (1826/2)(0.

.EOQ with Planned Shortages Assumptions: all shorted demand is back-ordered back-orders incur shortage costs shortage cost is proportional to waiting time all other basic EOQ assumptions 42 LO 3 Copyright © 2010 by The McGraw-Hill Companies. Inc. All rights reserved.

EOQ with Planned Shortages ¨ Annual ¸ ¨ Annual ¸ ¨ Annual ¸ © ¹ © ¹ © ¹ TC ! © Holding ¹  © Ordering ¹  © Back Order ¹ © Cost ¹ © Cost ¹ © Cost ¹ ª º ª º ª º ¨ .

. Inc.ordered per order cycle H ! annual holding cost per unit D ! annual demand S ! ordering (or setup) cost per order 43 LO 3 Copyright © 2010 by The McGraw-Hill Companies.Q  Qb 2 ¸ ¨ Qb2 ¸ ¨D¸ ¹ © ¹ TC ! © © ¹ © 2Q ¹ H  © Q ¹ S  © 2Q ¹ B ª º ª º ª º Q! 2 DS ¨ H  B ¸ ¹ © H ª B º B ! back  order cost per unit per year Qb ! quantity back . All rights reserved.

Ordering cost from the manufacturer is $10 per order. round to 1. Inc.86. round to 3 units.65. Holding cost per unit per year is $200. Determine order quantity and back-order quantity per order cycle. Back-order cost per unit per year is estimated to be $500. 44 LO 3 Copyright © 2010 by The McGraw-Hill Companies.Example: EOQ with Planned Shortage Annual demand for a refrigerator is 50 units. ªH Bº ª 200  500 º Allow inventory to drop to zero. order 3 units. D = 50 Q! H = $200 B = $500 S = $10 2 DS ¨ H  B ¸ © ¹! H ª B º 2(50)(10) ¨ 200  500 ¸ © ¹ ! 2. 200 ª B º ¨ H ¸ ¨ 200 ¸ Qb ! Q © ! 3© ¹ ¹ ! 0. When another unit is demanded. All rights reserved. .

Concept Check Which of the following is FALSE about EOQ? A. It determines how many to order. . The EOQ always results in the lowest total cost. The model is robust and works even if all assumptions are not exact. B. Inc. 45 LO 3 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. The model minimizes total cost by balancing carrying and order costs. D. C.

. Demand can be variable for EPQ but not for EOQ. EPQ is used mainly for producing batches. Inc. D. C. All rights reserved. B. and EOQ is for receiving orders. A different formula is used.Concept Check Which is NOT a difference between EOQ and EPQ? A. Quantity is received gradually in EPQ. 46 LO 3 Copyright © 2010 by The McGraw-Hill Companies.

Lead time for the receipt of orders is constant 47 LO 3 Copyright © 2010 by The McGraw-Hill Companies. No shortages are allowed C. All rights reserved. . Inc. Demand is known with certainty and is constant over time B.Concept Check Which is NOT an assumption of both EOQ and EPQ? A. Order quantity is received all at once D.

48 LO 4 Copyright © 2010 by The McGraw-Hill Companies.What·s next? EOQ models give HOW MANY to order Now look at WHEN to order Reorder Point (ROP) ROP = d v LT d = Demand rate (units per day or week) LT = Lead time (in days or weeks) Note: Demand and lead time must have the same time units. Inc. . All rights reserved.

Inc. .000 units Days per year = 365 Lead time = 7 days 1. place the next order.18 or 20 units When inventory level reaches 20 units.Example: ROP Annual Demand = 1. All rights reserved.000 units/year d= = 2.74 units/day 365 days/year ROP = d L = 2.74 units/day (7days) = 19. 49 LO 3 Copyright © 2010 by The McGraw-Hill Companies.

Annual service level 50 LO 4 Copyright © 2010 by The McGraw-Hill Companies. . Lead time service level 2b. Service Level 2a. Variability of demand and lead time 2. All rights reserved. Inc.Fixed Order Quantity/Reorder Point Model Reorder Point = Expected demand + Safety Stock (ROP) during lead time Safety Stock 1.

When to Reorder with EOQ Ordering Reorder Point ± When inventory level drops to this amount. Inc. Safety Stock .Stock that is held in excess of expected demand due to variability of demand and/or lead time. Annual service level: percentage of annual demand filled. . All rights reserved. the item is reordered. 51 LO 4 Copyright © 2010 by The McGraw-Hill Companies. Service Level ± Probability demand will not exceed supply. Lead time service level: probability that demand will not exceed supply during lead time.

Determinants of the Reorder Point Rate of demand Demand and/or lead time variability Lead time Stockout risk (safety stock) ROP ! Expected demand  Safety stock during lead time 52 LO 4 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. . Inc.

Inc. All rights reserved.Safety Stock Quantity Safety stock reduces risk of stockout during lead time Maximum probable demand during lead time Expected demand during lead time ROP Safety stock LT LO 4 Copyright © 2010 by The McGraw-Hill Companies. Time 53 .

Inc.Reorder Point The ROP based on a normal Distribution of lead time demand Safety Stock = z.WdLT z = Safety factor. All rights reserved. number of standard deviations above expected demand WdLT = The standard deviation of demand during lead time LO 4 Copyright © 2010 by The McGraw-Hill Companies. 54 .

Demand During Lead Time 55 LO 4 Copyright © 2010 by The McGraw-Hill Companies. Inc. All rights reserved. .

All rights reserved. number of standard deviations above expected demand WdLT = The standard deviation of demand during lead time 56 LO 5 Copyright © 2010 by The McGraw-Hill Companies.WdLT z = Safety factor. . Inc.ROP with Lead Time Service Level variable demand during a lead time ROP = expected demand during lead time + safety stock ROP = + z.

of demand during lead time (demand and lead time measures in same time units) Wd = standard deviation of demand per day WdLT = Wd LT 57 LO 5 Copyright © 2010 by The McGraw-Hill Companies. dev. All rights reserved. Inc. .ROP with Lead Time Service Level variable demand and constant lead time ROP = (average demand x lead time) + z x st.

of demand in lead time (demand and lead time measures in same time units) Wd= standard deviation of demand per day WLT= standard deviation of lead time WdLT = (average lead time x Wd2) + (average daily demand) 2WLT2 58 LO 5 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. dev. Inc. lead time) + z x st. .ROP with Lead Time Service Level both demand and lead time are variable ROP = (avg. demand x avg.

From Table 12-3 (p434). Inc.5 = 366.5 § 367 A new order should be placed when inventory level reaches 367 units.65 (10) = 350 + 16. 59 . All rights reserved. z for 95% = 1. LO 5 Copyright © 2010 by The McGraw-Hill Companies.Example 1: ROP with Lead Time Service Level Calculate the ROP required to achieve a 95% service level for a product with average demand of 350 units per week and a standard deviation of demand during lead time of 10. Lead time averages one week.65 ROP = 350 + ZWdLT = 350 + 1.

28 ROP = (15 units x 2 days) + ZWdLT = 30 + 1.28 ( 2) (5) = 30 + 8. 60 . Inc. z for 90% = 1. All rights reserved.96 § 39 Safety stock is about 9 units and a new order should be placed when inventory level reaches 39 units. From Table 12-3 (p434).Example 2: ROP with Lead Time Service Level Calculate the ROP and amount of safety stock required to achieve a 90% service level for a product with variable demand that averages 15 units per day with a standard deviation of 5.96 = 38. Lead time is consistently 2 days. LO 5 Copyright © 2010 by The McGraw-Hill Companies.

with a standard deviation of 2.65Wdlt = (150 x 5) + 1. Lead time averages 5 days. The company wants no more than 5% stockouts.65 (154) = 1.65 ROP = (150 units x 5 days) + 1. Inc. All rights reserved.004 units Place a new order when inventory level reaches 1004 units 61 LO 5 Copyright © 2010 by The McGraw-Hill Companies. z for 95% = 1. service level = 1 ± 5% = 95% From Table 12-3 (p434). .Example 3: ROP with Lead Time Service Level Calculate the ROP for a product that has an average demand of 150 units per day and a standard deviation of 16.65 (5 days x 162) + (1502 x 12) = 750 + 1.

Use the z value in the appropriate ROP formula. Use a table to find the z value associated with E(z) 3. ROP ! expected demand during lead time  zW dLT SLannual = annual service level E(z) = standardized expected number of units short during an order cycle. All rights reserved. Calculate Q(1  SLannual ) E( z) ! W dLT 2. .ROP Using Annual Service Level 1. Inc. 62 LO 5 Copyright © 2010 by The McGraw-Hill Companies.

Min/Max model similar to fixed order-quantity/reorder point (ROP) model difference: if at order time. Inc. then order quantity = max ± Q on hand (max $ EOQ + ROP) 63 LO 5 Copyright © 2010 by The McGraw-Hill Companies. . Q on hand < min (ROP). All rights reserved.

Inventory Models EOQ/ROP model Order size constant. safety stock. and amount on hand demand or lead time can be variable 64 LO 5 Copyright © 2010 by The McGraw-Hill Companies. time between orders changes Fixed Order Interval/Order up to Level Model orders placed at fixed time intervals determine how much to order to bring inventory level up to a predetermined point (order up to level) used widely for retail consider expected demand during lead time. All rights reserved. . Inc.

Inc.Comparing Inventory Models EOQ/ROP Fixed Interval/ Order up to 65 LO 5 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. .

Fixed Order Interval: Benefits and Disadvantages Benefits grouping items from same supplier can reduce ordering/shipping costs practical when inventories cannot be closely monitored Disadvantages requires a larger safety stock increases carrying cost costs of periodic reviews 66 LO 5 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved. . Inc.

Inc. .Fixed Order Interval/Order up to Level Model Determining the order interval Total Annual Inventory Cost: ¨ D j . «. n 67 LO 5 Copyright © 2010 by The McGraw-Hill Companies. j = 1. n i = annual holding cost rate Dj = annual demand of SKUj .i  ( S  ns)© ¹ © 2 ¹ ª OI º ª º * Optimal Order Interval: 2 ( S  ns ) OI ! i DjRj § OI = order interval (in fraction of a year) S = fixed ordering cost per purchase order s = variable ordering cost per SKU included in the order (line item) (assume s is the same for every SKU) n = n number of SKUs purchased from the supplier Rj = unit cost of SKUj . «. j = 1.OI ¸ ¨ 1 ¸ TC = § © ¹ R j . All rights reserved..

Fixed Order Interval/Order up to Level Model Determining the Order up to Level Q ! I max  Amount on hand I max ¨ Expected demand ¸ © ¹ ¨ Safety ¸ ! © during protection ¹  © © Stock ¹ ! ¹ º © interval ¹ ª ª º ! d .

OI  LT  zW d OI  LT
= Average daily or weekly or monthly demand OI = Order interval (length of time between orders LT = Lead time in days or weeks or months z = Safety factor; # of standard deviations above expected demand Wd = Standard deviation of daily or weekly or monthly demand
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Example: Fixed Order Interval Model
Average daily demand for a product is 20 units, with a standard deviation of 4 units. The order interval is 30 days, and lead time is 10 days. Desired service level is 99%. If there are currently 200 units on hand, how many should be ordered?

I max ! d

OI  LT  zW d
= =

OI  LT

I max= 20 (30 + 10) + (2.32) (4) 30 + 10
800 + 2.32 (25.298) 858.7 or 859 units stock up to level

Amount to order = 859 ± 200 = 659 units 69
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Coordinated Periodic Review Model determines an order interval (OI) and order up to level for reviewing every stock keeping unit (SKU) calculate a multiple (mi ) of OI for each SKUi use this to determine the optimal OI for each SKUi To use: Compare on hand inventory of each SKU to its ROP (forecast demand for next OI + lead time + safety stock) if on hand is less: order a quantity that brings the on hand level to SKU¶s order up-to level the order up-to level is enough for the next OI + LT. Inc. . 70 LO 5 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved.

Single Period Model Single period model model for ordering of perishables and other items with limited useful lives Shortage cost Cs generally the unrealized profits per unit Revenue per unit ± Cost per unit Excess cost Ce cost per unit . All rights reserved.salvage per unit for items left over at the end of a period GOAL = find order quantity (stock level) that minimizes total excess and shortage costs. 71 LO 6 Copyright © 2010 by The McGraw-Hill Companies. . Inc.

Inc. .Single Period Model Continuous stocking levels Identifies optimal stocking levels Optimal stocking level balances unit shortage and excess cost Discrete stocking levels Desired service level is equaled or exceeded Compare service level to cumulative probability of demand 72 LO 6 Copyright © 2010 by The McGraw-Hill Companies. All rights reserved.

. All rights reserved.Optimal Stocking Level Cs Service level (SL) = Cs + Ce Ce Cs = Shortage cost per unit Ce = Excess cost per unit Cs Service Level Quantity Balance point So = Optimum stocking level (i.. Inc. order quantity So 73 LO 6 Copyright © 2010 by The McGraw-Hill Companies.e.

6+.75 = 0. Inc.25 74 LO 6 Copyright © 2010 by The McGraw-Hill Companies.20 per unit Cs = $0. All rights reserved.2) Service level = .6/(.00 ± 0.Example 1: Single Period Model Ce = $0.75 Ce Cs Service Level = 75% Quantity Stockout risk = 1.60 per unit Service level = Cs/(Cs+Ce) = . .

75 LO 6 Copyright © 2010 by The McGraw-Hill Companies.983 is $343. so Cs ! .99.406($500  Cs ) Number of Failures Cs  $500 Cumulative Probability Cs = $343.17 to $1.677($500  Cs ) 2 Cs  $500 SL between 3 .135 1 Optimum stock . 4 . Part failures can be modeled by a Poisson distribution with a mean of 2 failures during the useful life of the equipment.947 The range of shortage cost 5 .047. Inc.99.17 0 . . The Poisson table (App. All rights reserved.677 ! .677.406. so Cs ! . B. Estimate the range of shortage cost for which stocking 2 units of this spare part is optimal. then .406 Cs level = 2.0: Cs ! .Example 2: Single Period Model A company usually carries 2 units of a spare part that costs $500 and has no salvage value.047. Table C) Cs is unknown Ce = $500 provides these values for a mean of 2.857 Cs = $1.

Review: Inventory Models EOQ models used to determine order size Simple model for many types of inventory Trade-off between carrying and ordering costs Quantity discount model adds purchasing costs and compares total cost for various order sizes (that is still a feasible EOQ) EPQ models used to determine production lot size Used when producing and depleting items at same time Trade-off between carrying and setup costs Consider production and usage rate 76 Copyright © 2010 by The McGraw-Hill Companies. . Inc. All rights reserved.

but not continuous monitoring Single-Period Model Determines at what quantity (when) to re-order Used when can¶t carry goods to next period (e. and amount on hand Demand or lead time can be variable Need more safety stock. perishables) Trade-off cost of shortages & of excess (wasted) inventory 77 Copyright © 2010 by The McGraw-Hill Companies. . All rights reserved. safety stock.g..Review: Inventory Models ROP (reorder point) Determines at what quantity (when) to re-order Consider expected demand during lead time and safety stock Trade-off cost of carrying safety stock & risk of stockout Fixed Order Interval Model Used when orders placed at fixed time intervals ± determine how much to order Used widely for retail Consider expected demand during lead time. Inc.

. Describe the A-B-C approach and perform it. Single Period Model. 78 Copyright © 2010 by The McGraw-Hill Companies.Learning Checklist Define the term inventory and list the major reasons for holding inventories. ROP. Inc. List the main requirements for effective inventory management. Fixed Order Interval Model. Discuss the objectives of inventory management. EPQ. All rights reserved. Describe Basic Inventory Control Systems Be able to describe and solve problems using: EOQ.

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