Inventory

Management

Inventory
Inventory is the stock of any item or
resource used in an organization.
Inventory include: raw materials, finished
products, component parts, supplies, and
work-in-process

Purposes of Inventory
1. To maintain independence of operations
2. To meet variation in product demand
3. To allow flexibility in production scheduling
4. To provide a safeguard for variation in raw
material delivery time
5. To take advantage of economic purchaseorder size/Quantity discounts

Types of Inventory
Raw materials
Purchased parts and supplies
Work-in-process (partially completed) products
(WIP)
Items being transported
Tools and equipment

Inventory Costs
Holding (or carrying) costs

Costs
for
storage,
handling,
insurance,
obsolescence, depreciation, opportunity cost of
capital,etc
Holding costs tend to favor low inventory levels
and frequent replenishment

Ordering costs

Costs of placing an order, etc

Shortage costs

temporary or permanent loss of sales when demand

cannot be met

Two Forms of Demand

Dependent
Demand for items used to produce final
products
Tires for autos are a dependent demand item
Independent
Demand for items used by external customers
Cars, appliances, computers, and houses are
examples of independent demand inventory

Independent vs. Dependent

Demand
Independent Demand (Demand for the final
end-product or demand not related to other
items)
Finishe
d
product

E(1)

Component
parts

Dependent
Demand
(Derived
demand items
for
component
parts,
subassemblie
s,

The Role of Inventory In Supply Chain

Management
Since demand is usually not known with certainty, it is
not possible to produce exactly the amount demanded
So an additional amount of inventory, called safety or
buffer is kept on hand to meet variations in product
demand
The bullwhip effect: The distortion of demand
information as it moves away from end-user customer
This effect causes distributers, manufacturers and
suppliers to stock increasingly higher safety stocks

Inventory and Quality Management

Level of customer service: The ability to meet effectively
internal or external customer demand in a timely and efficient
manner
Customer for finished goods perceive quality service as
availability of goods they want at the time when they want
them
To provide this level of quality customer service, the tendency
is to maintain large stocks of all types of items
However, there is a cost associated with carrying items in
inventory, which creates a trade-off between the quality level
of customer service and the cost of that service

Conti..
As the level of inventory increases to provide better
customer service, inventory costs increase, whereas
quality-related customer service costs, such as lost sales
and loss of customers decrease
The conventional approach to inventory management is
to maintain a level of inventory that reflects a
compromise between inventory costs and customer
service
But according to the contemporary zero defects
philosophy of quality management, the long term benefits
of quality in terms of large market share outweigh lower
shot-term production-related costs such as inventory
costs

Inventory Control System

An inventory system is the set of policies
and controls that monitor levels of inventory
and determines what levels should be
maintained,
when
stock
should
be
replenished, and how large orders should be
There are two basic inventory systems:
Continuous system
Periodic system

Continuous Inventory Systems

In a continuous inventory system, a continual
record of the inventory level for every item is
maintained
It is also referred to as a perpetual system or
a fixed-order-quantity system
Whenever the inventory at hand decreases to a
predetermined level, referred to as the
reorder point, a new order is placed to
replenish the stock of inventory

Continuous Inventory Systems

The order that is placed is for a fixed amount
that minimizes the total inventory costs
This amount of order placed is called the
economic order quantity
Continuous
inventory
systems
often
incorporate information technology tools to
improve the speed and accuracy of data entry.
E.g. Barcodes

Continuous Inventory Systems

Since inventory level is continuously
monitored, so management always knows the
inventory status
This is advantageous for critical items such as
replacement parts or raw material supplies
However, maintaining a continual record of the
amount of inventory on hand can also be
costly

Periodic Inventory Systems

It is also referred to as fixed-time-period system
or periodic review system
In a periodic inventory system, the inventory on
hand is counted at specific time intervals-every
week or at the end of each month
After the inventory in stock is determined, an
order is placed for an amount that will bring
inventory back up to a desired level
Since inventory level is not monitored at all
during the time interval between orders, little or
no record keeping is required

Periodic Inventory Systems

Disadvantage is less direct control
Results in larger inventory levels to guard
against unexpected stock outs early in the
fixed period
Also requires that a new order quantity be
determined each time a periodic order is made
Used in college library, small retail stores,
drug stores, grocery stores, and offices

The ABC Classification System

The ABC system is a method for classifying
inventory according to several criteria including its
dollar value to the firm
About 5 % - 15% of all inventory item account for
70% to 80% of the total dollar value of inventory.
These are classifies as class A items

B items represent approximately 30% of total

inventory units but only about 15% of the total
inventory dollar value

C items account for 50% - 60% of all inventory units

but represent only 5% - 10% of total dollar value

The ABC Classification System

In ABC analysis each class of inventory requires a
different levels of inventory monitoring and controlthe higher the value of the inventory, the tighter the
control
Class A items require tight inventory control,
minimized safety stocks, accurate demand forecasting
and detailed record keeping
B and C items require less stringent inventory control
Since carrying costs are usually lower for C items,
higher inventory levels can sometimes be maintained
with larger safety stocks

The ABC Classification System

A items require a continuous control system,
while for B and C items periodic review system
with less monitoring
Items kept in inventory are not of equal
importance in terms of:
Dollars

invested

Profit

potential

Sales

or usage volume

Stock-out

penalties

Illustration of ABC
The
maintenance
department
for
a
small
manufacturing firm has responsibility for maintaining
an inventory of spare parts for the machinery it
services. The parts inventory, unit cot and annual
usage Part
are as follow: Unit Cost $
Annual Usage
1

60

90

350

40

30

130

80

60

30

100

20

180

10

170

320

50

510

60

10

20

120

The department manager wants to classify the

inventory parts according to the ABC system to
determine which stocks of parts should most
closely be monitored
Part

Total
Value

% of Total
Value

% of Total
Quantity

%
Cumulativ
e

30,600

35.9

6.0

6.0

16,000

18.7

5.0

11.0

14, 000

16.4

4.0

15.0

5,400

6.3

9.0

24.0

4,800

5.6

6.0

30.0

3,900

4.6

10.0

40.0

3,600

4.2

18.0

58.0

3,000

3.5

13.0

71.0

10

2,400

2.8

12.0

83.0

1,700

2.0

17.0

100.0

Conti..
ABC Classification of the items:
Class

Items

% of Total
Value

% of Total
Quantity

9, 8, 2

71

15

1, 4, 3

16.5

25

6, 5, 10, 7

12.5

60

The Basic EOQ Model

In a continuous system, when inventory
reaches a specific level, referred to as the
reorder point, a fixed amount is ordered
The most widely used and traditional means of
determining how much to order in a
continuous system is the Economic Order
Quantity (EOQ) Model
The function of EOQ Model is to determine
the optimal order size that minimizes total
inventory costs

The Basic EOQ Model - Assumptions

1. Demand is known with certainty
and is constant over time
2. No shortages are allowed
3. Lead time for the receipt of orders
is constant
4. The order quantity is received all at
once

Basic Fixed-Order Quantity Model and

Reorder Point Behavior
1. You receive an order quantity Q.

Number
of units
on hand

4. The cycle then repeats.

R
L

L
3. When you reach down to
Time a level of inventory of R,
R = Reorder point
you place your next Q
Q = Economic order quantity sized order.
L = Lead time

2. Your start using

them up over time.

Cost Minimization Goal

By
Byadding
addingthe
theitem,
item,holding,
holding,and
andordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichin
in
turn
inventory order point that
turnis
isused
usedto
tofind
findthe
theQ
Qopt
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs
Total Cost
C
O
S
T

Holding
Costs

Ordering Costs
QOPT
Order Quantity (Q)

EOQ Cost Model

- cost of placing order
- annualdemand
demand
CC
DD- annual
o -o cost of placing order
- orderquantity
quantity
c - annual per-unit carrying cost
CC
QQ- order
c - annual per-unit carrying cost
oD
CC
oD
Annualordering
orderingcost
cost==
Annual
QQ
cQ
CC
cQ
Annualcarrying
carryingcost
cost==
Annual
22
oD
cQ
CC
CC
oD
cQ
Totalcost
cost==
Total
++ 2
Q
Q
2

EOQ Cost Model

Deriving Qopt
TC =

Co D
Q
Co D

CcQ
2

Cc
TC
=
+
Q2
Q
2
0=
Qopt =

C0 D
Q2

2CoD
Cc

Cc

Proving equality of
costs at optimal
point
Co D
CcQ
=
Q
2
Q

2
Qopt =

2CoD
Cc
2CoD
Cc

EOQ Cost Model

Annual
cost ($)

Total Cost
Slope = 0
Cc Q

Carrying Cost = 2

Minimum
total cost

Co D

Ordering Cost = Q
Optimal order
Qopt

Order Quantity, Q

EOQ Example

Cc = $0.75 per gallon

Qopt =
Qopt =

Co = $150 D = 10,000 gallo

2CoD

TCmin =

Cc
2(150)(10,000)
(0.75)

TCmin =

CoD
Q

CcQ
+
2

(150)(10,000) (0.75)(2,000)
+
2,000
2

Qopt = 2,000 gallons TCmin = $750 + $750 = $1,500

Orders per year =

D/Qopt

Order cycle time =

= 10,000/2,000
= 5 orders/year

311 days/(D/Qopt)

= 311/5
= 62.2 store days

Sum 1
The ePaint stocks paint in its warehouse and sells it
online on its Internet Website. The store stocks
several brands of paints; however, its biggest seller
is Sharman-Wilson Ironcoat paint. The company
wants to determine the optimal order size and total
inventory cost for Ironcoat paint given an estimated
annual demand of 10,000 gallons of paint, an annual
carrying cost of $0.75 per gallon, and an ordering
cost of $150 per order. They would also like to know
the number of orders that will be made annually and
time between orders (i.e. order cycle)

Sum 2
Electronic Village stocks and sells a particular
brand of personal computer. It costs the store
$450 each time it places and order with the
manufacturer for the personal computers. The
annual cost of carrying the PCs in inventory is
$170. the store manager estimates that annual
demand for the PCs will be 1200 units.
Determine the optimal order quantity, total
minimum cost and order cycle time.

Sum 3
The EastCoasters Bicycle Shop operates 364 days a year,
closing only on Christmas Day. The shop pays $300 for a
particular bicycle purchased from the manufacturer. The
annual holding cost per bicycle is estimated to be 25% of the
dollar value of inventory. The shop sells an average of 18
bikes per week. The ordering cost for each order is $250.
Determine the optimal order quantity and the total minimum
cost.

The Production Quantity Model

In this EOQ model the assumption that orders
are received all at once is relaxed
The order quantity is received gradually is
over time and the inventory level is depleted at
the same time it is being replenished
This situation is commonly found when the
inventory user is also the producer as in a
manufacturing operation where a part is
produced to use in larger assembly

Sum 4
Assume that the epaint Store has its own
manufacturing facility in which it produces Ironcoat
paint. The ordering cost is the cost of setting up the
production process to make paint. The manufacturing
facility remains open for the same number of days as
the store is open and produces 150 gallons of paint per
day. Determine the optimal order size, total inventory
cost, the length of time to receive an order, the number
of orders per year and the maximum inventory level.

Sum 5
I-75 Discount Carpets manufactures Cascade
carpet, which it sells in its adjoining showroom
store near the interstate. Estimated annual
demand is 20,000 yards of carpet with an annual
carrying cost of $2.75 per yard. The
manufacturing facility operates 360 days and
produces 400 yards of carpet per day. The cost
of setting up the manufacturing process for a
production run is $720. determine the optimal
order size, total inventory cost, length of time to
receive an order and maximum inventory level.

Quantity Discounts
A quantity discount is a price discount on an
item if predetermined numbers of units are
ordered
Determining if an order size with a discount is
more cost effective than optimal Q is the main
task
When a discount price is available, it is
associated with a specific order size, which may
be different from the optimal order size and the
customer must evaluate the trade off between
possibly higher carrying costs with the discount

Quantity Discounts
Price per unit decreases as order
quantity increases
TC =

CoD
Q

CcQ
2

+ PD

where
P = per unit price of the item
D = annual demand

Inventory cost ($)

Quantity Discount Model

ORDER SIZE
0 - 99
100 199
(d1)
200+
(d2)

PRICE
$10
8
6

TC = ($10 )
TC (d1 = $8 )
TC (d2 = $6 )

Carrying cost

Ordering cost
Q(d1 ) = 100 Qopt

Q(d2 ) = 200

Sum 6
Avtek, a distributor of audio and video
equipment, wants to reduce a large stock of
televisions. It has offered a local chain of
stores a quantity discount pricing schedule,
as follows:Quantity
Price
1-49

$1,400

50-89

1,100

90+

900

The annual carrying cost for the stores for a

TV is $190, the ordering cost is &2,500, and
annual demand for this particular model TV is
estimated to be 200 units. The chain wants to
determine if it should take advantage of this

Quantity Discount
QUANTITY

PRICE

1 - 49
50 - 89
90+

$1,400
1,100
900

Qopt =

2CoD

Cc

For Q = 72.5
TC =

Co D

For Q = 90
TC =

Co D

Qopt

Co =$2,500
Cc =$190 per TV
D = 200 TVs per year
2(2500)(200)
190

CcQopt
2
CcQ
2

= 72.5 TVs

+ PD = $233,784

+ PD = $194,105

Sum 7
The bookstore at Tech purchases jackets emblazoned with the
school name and logo from a vendor. The vendor sells the
jackets to the store for $38 a piece. The cost to the bookstore
for placing an order is $120 and the annual carrying cost is
25% of the cost of jacket. The bookstore manager estimates
that 1700 jackets will be sold during the year. The vendor has
offered bookstore the following volume discount schedule.
What is the bookstores optimal order quantity?
Order Size

Discount

1-299

0%

300-499

2%

500-799

4%

800+

5%

Reorder Point
The Reorder Point is the determinant of
when to order in a continuous inventory system,
i.e. the inventory level at which a new order is
placed
Reorder point for basic EOQ model with
constant demand and a constant lead time is:
R = dL
Where
d = demand rate per period (daily demand)
L = Lead Time

Example of Reorder Point with

Constant Demand and Lead Time
The ePaint Store is open 311 days per year. If
annual demand is 10,000 gallons of Ironcoat
paint and the lead time to receive an order is
10 days. Determine the reorder point for paint.

Stockout, Safety Stock and Service Level

Stockout: An inventory shortage
Safety Stock: A buffer added to the inventory on hand
during lead time

Service Level: the service level is the probability that

the amount of inventory on hand during the lead time is
sufficient to meet the expected demand-i.e. that the
customer will e served

For E.g. A service level of 90% means that there is a

0.90 probability that the demand will be met during the
lead time, and the probability that a stockout will occur
is 10%

Inventory level

Variable Demand With Reorder Point

Q

Reorder
point, R

LT

LT
Time

Inventory level

Reorder Point With Safety Stock

Reorder
point, R

Safety Stock

LT

Time

LT

Reorder Point With Variable Demand

R = dL + zd L
where
d=
L=
d =
z=
zd

average daily demand

lead time
the standard deviation of daily demand
number of standard deviations
corresponding to the service level
probability
L= safety stock

Reorder Point For a Service Level

Probability of
meeting demand during
lead time = service level

Probability of
a stockout
Safety stock
zd L
dL
Demand

Reorder Point For Variable

Demand

The paint store wants a reorder point with a

95% service level and a 5% stockout
probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day

For a 95% service level, z = 1.65

R = dL + z d L

Safety stock = z d L

= 30(10) + (1.65)(5)( 10)

= (1.65)(5)( 10)

= 326.1 gallons

= 26.1 gallons

Sum 8 (Reorder Point with Variable Demand)

Kellys Tavern serves Shamrock draft beer to its
customers. The daily demand for beer is normally
distributed, with an average of 20 gallons and a
standard deviation of 4 gallons. The lead time required
to receive an order of beer from the local distributor is
12 days. Determine the safety stock and reorder point
if the restaurant wants to maintain a 90% service level.
What would be the increase in the safety stock if a
95% service level were desired?

Sum 9
The amount of denim used daily by the Southwest
Apparel Company in its manufacturing process to
make jeans is normally distributed with an average of
4000 yards of denim and a standard deviation of 600
yards. The lead time required to receive an order of
denim from the textile mill is constant 7 days.
Determine the safety stock and reorder point if the
company wants to limit the probability of a stock out
and work stoppage to 5%? What level of service would
a safety stock of 2000 yards provide?

Order Quantity For Periodic Inventory System

A periodic inventory system is one in which the time between
the orders is constant and the order size varies
Small retailers often use this system of inventory management;
E.g. Drugstore
In this case the vendors who provide stock of materials make
periodic visits-every few weeks or every month-and count the
stock of inventory on hand
If the inventory is exhausted or at some predetermined reorder
point, a new order will be placed for an amount of inventory that
will bring the inventory level back up to the desired level

Order Quantity For Periodic Inventory System

In periodic inventory system, usually the manager does
not monitor the inventory level between vendor visits
but instead will rely on the vendor to take inventory
Since the items are generally of low value, larger safety
stocks will not pose a significant cost
However, if the inventory becomes exhausted early in
the time period between visits, resulting in a stockout
that will not be remedied until the next scheduled order

Order Quantity
System

For

Periodic

Inventory

If the demand rate and lead time are constant, then

the fixed-period model will have a fixed-order quantity
that will be made at specified time intervals, which is
same as the fixed-order (basic EOQ) model
But the fixed-period model reacts differently than the
fixed-order model when the demand is variable

Order Quantity for a

Periodic Inventory System
Q = d(tb + L) + zd

tb + L - I

where
d
tb
L
d
zd

=
=
=
=

average demand rate

the fixed time between orders
lead time
standard deviation of demand

tb + L = safety stock
I = inventory level

Periodic Inventory System

Fixed-Period Model With

Variable Demand
d
d
tb
L
I
z

=
=
=
=
=
=

6 packages per day

1.2 packages
60 days
5 days
8 packages
1.65 (for a 95% service level)

Q = d(tb + L) + zd

tb + L - I

= (6)(60 + 5) + (1.65)(1.2)
= 397.96 packages

60 + 5 - 8

Sum 10
KVS Pharmacy fills prescriptions for a popular
childrens antibiotic, Amoxycilin. The daily demand
for Amoxycilin is normally distributed with a mean of
200 ounces and a standard deviation of 80 ounces. The
vendor for the pharmaceutical firm that supplies the
drug calls the drugstores pharmacist every 30 days
and checks the inventory of Amoxycilin. During a call
the druggist indicated the store had 60 ounces of the
antibiotic in stock. The lead time to receive an order is
four days. Determine the order size that will enable the
drug store to maintain a 99% service level.

Sum 11
Food Place Market stocks frozen pizzas in a refrigerated
display case. The average daily demand for the pizzas is
normally distributed, with a mean of 8 pizzas and a
standard deviation of 2.5 pizzas. A vendor for a packaged
food distributor checks the markets inventory of frozen
foods every 10 days. During a particular visit there were
no pizzas in stock. The lead time to receive an order is 3
days. Determine the order size for this order period that
will result in a 98% service level. During the vendors
following visit there were 5 frozen pizzas in stock. What
is the order size for the next order period?