Associate Professor NED University of Engineering and Technology

Dr. Rameez Khalid, PMP

Learning Objectives
Objectives of inventory management Periodic and Perpetual review systems A-B-C approach EOQ model Economic Production Quantity model Quantity Discount model Reorder Point model

Inventory
Inventory: a stock or store of goods
Independent Demand

Dependent Demand

B(4)

C(2)

D(2)

E(1)

D(3)

F(2)

Independent demand is uncertain. Dependent demand is certain.

Types of Inventories
Raw materials & purchased parts Partially completed goods called work in progress (WIP) Finished-goods inventories

(manufacturing firms) or merchandise (retail stores)

Types of Inventories
Replacement parts, tools, & supplies Goods-in-transit to warehouses or customers

Functions of Inventory
To meet anticipated demand To smooth production requirements To decouple operations To protect against stock-outs To take advantage of order cycles To help hedge against price increases To permit operations To take advantage of quantity discounts

Objective of Inventory Control

To achieve satisfactory levels of customer service while keeping inventory costs within reasonable bounds
Level of customer service Costs of ordering and carrying inventory

Inventory turnover is the ratio of:

average cost of goods sold to average inventory investment.

Effective Inventory Management

A system to keep track of inventory A reliable forecast of demand Knowledge of lead times Reasonable estimates of
Holding costs Ordering costs Shortage costs

A classification system

Inventory Counting Systems

Periodic System (T or P System) Physical count of items made at periodic intervals Perpetual Inventory System (Q System) System that keeps track of removals from inventory continuously, thus monitoring current levels of each item

Key Inventory Terms

Lead time: time interval between ordering and receiving the order Holding (carrying) costs: cost to carry an item in inventory for a length of time, usually a year Ordering costs: costs of ordering and receiving inventory Shortage costs: costs when demand exceeds supply

ABC Classification System

Classifying inventory according to some measure of importance and allocating control efforts accordingly.

% Annual $ Usage

A - very important B - mod. important C - least important

Class A B C

% $ Vol 80 15 5

% Items 15 30 55

100 80 60 40 20 0

A B 0 C

50 100 % of Inventory Items

Inventory Classifications
Inventory

Process stage

Number & Value

Demand Type

Other

Raw Material WIP Finished Goods

A Items B Items C Items

Independent Dependent

Maintenance Dependent Operating

Inventory Models
Fixed order-quantity models
Economic order quantity (EOQ) Economic production quantity (EPQ) or Production order quantity (POQ) Quantity discount Help answer the inventory planning questions!

Probabilistic models Fixed order-period models

Economic Order Quantity Models

Economic order quantity (EOQ) model
The order size that minimizes total annual cost

Economic production model Quantity discount model

The Inventory Cycle

Profile of Inventory Level Over Time

Q
Quantity on hand

Usage rate

Reorder point

Time Receive order Place order Receive order Place order Receive order

Lead time

Total Cost
Annual carrying cost Q H 2 Annual + ordering cost + DS Q

Total cost =

TC =

Cost Minimization Goal

The Total-Cost Curve is U-Shaped
Annual Cost

TC

Q H 2

D S Q

Holding Costs

Ordering Costs
QO(optimal order quantity)

Order Quantity (Q)

Deriving the EOQ

Using calculus, we take the derivative of the total cost function and set the derivative (slope) equal to zero and solve for Q.
2DS = H 2( Annual Demand )(Order or Setup Cost ) Annual Holding Cost

Q OPT =

Minimum Total Cost

The total cost curve reaches its minimum where the carrying and ordering costs are equal.

Q H 2

DS Q

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EOQ
A local distributor for a national tire company expects to sell approx. 9,600 steel-belted radial tires of a certain size and tread design next year. Annual carrying cost is $16 per tire, and ordering cost is $75. The distributor operates 288 days a year.
a. EOQ? b. How many Orders? c. Length of an order cycle? d. Total Annual Cost? a. 300 tires; b. 32; c. 9 working days; d. $4800

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Economic Production Quantity (EPQ)

Production done in batches or lots Capacity to produce a part exceeds the parts usage or demand rate Assumptions of EPQ are similar to EOQ except orders are received incrementally during production

EOQ EPQ Model When To Order

Inventory Level

Optimal Order Quantity (Q*) Reorder Point (ROP)

Time

Lead Time

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EPQ Model Inventory Levels

Inventory Level Level

Production portion of cycle Demand portion of cycle with no supply

Supply Begins

Supply Ends

Time

EPQ Model Inventory Levels

Inventory Level

Inventory level with no demand

Imax Max. Inventory Q(1- u/p)

Q*

Production Portion of Cycle

Time

Supply Begins

Supply Ends

Demand portion of cycle with no supply

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Economic Run Size

Q0

p 2DS H p u

EPQ Model Equations

Optimal Order Quantity = Q* = p Maximum inventory level

Imax = Q*
Setup Cost = D Q * S

( ) ( )
1 u p D = Demand per year S = Setup cost H = Holding cost u = Demand per day p = Production per day

2*D*S u H* 1 p

Holding Cost = 0.5 * H * Q 1 - u p

( )

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EPQ
A toy manufacturer uses 48,000 rubber wheels per year for its popular dump truck series. The firm makes its own wheels, which it can produce at a rate of 800 per day. The toy trucks are assembled uniformly over the entire year. Carrying cost is $1 per wheel a year. Setup cost for a production run of wheels is $45. The firm operates 240 days per year.
a. EPQ or POQ or Optimal Run Size? b. Minimum Total Annual Cost? c. Cycle Time? d. Run Time? a. 2400 wheels; b. $1800; c. 12 days; d. 3 days

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Quantity Discount Model

Answers how much to order & when to order Allows quantity discounts
Reduced price when item is purchased in larger quantities Other EOQ assumptions apply

Trade-off is between lower price & increased holding cost Buyers Goal:
Select the order quantity that will minimize the total cost.

Total Costs with Purchasing Cost

Annual Annual TC = carrying + ordering + Purchasing cost cost cost TC = Q H 2 + DS Q + PD

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Total Costs with PD

Cost

Adding Purchasing cost doesnt change EOQ

TC with PD

TC without PD

PD

EOQ

Quantity

Case1: Constant Holding Costs

TCa
Total Cost Decreasing Price

TCb TCc

HC a,b,c OC
EOQ Quantity

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Quantity Discount
When D = 816 cases per year, S =$12, and H=$4 per case per year, determine for the following discounts:
a. b. Optimal Order Quantity? Total Cost? Range 1 to 49 50 to 79 80 to 99 100 or more Price $20 18 17 16

a. 100 cases; b. TC100=$13354

Quantity Discount

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Case2: Holding Cost as Percentage of Purchase Price

Quantity Discount
When D = 4000 switches per year, S =$30, and H=0.40P per unit per year, determine for the following discounts:
a. b. Optimal Order Quantity? Total Cost? Range 1 to 499 500 to 999 1000 or more Price $0.90 0.85 0.80

a. 1000 switches; b. TC1000=$3480

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Case2: Holding Cost as Percentage of Purchase Price

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When to Reorder with EOQ Ordering

Reorder Point - When the quantity on hand of an item drops to this amount, the item is reordered Safety Stock - Stock that is held in excess of expected demand due to variable demand rate and/or lead time. Service Level - Probability that demand will not exceed supply during lead time.

Determinants of the Reorder Point

The rate of demand The lead time Demand and/or lead time variability Stockout risk (safety stock)

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ROP and Safety Stock

Quantity

ROP = d x LT
Maximum probable demand during lead time Expected demand during lead time

ROP =
Expected Demand during Lead time + Safety Stock

Safety stock
LT

Safety stock reduces risk of stockout during lead time

Time

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Fixed-Order-Interval Model
Orders are placed at fixed time intervals Order quantity for next interval? Suppliers might encourage fixed intervals May require only periodic checks of inventory levels Risk of stockout Fill rate the percentage of demand filled by the stock on hand

Fixed Period Model When to Order?

Inventory Level Target maximum

Time Period Period Period

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Fixed-Interval Model
Benefits: Items from same supplier may yield savings in:
Ordering Packing Shipping costs

May be practical when inventories cannot be closely monitored Disadvantages: Requires a larger safety stock Increases carrying cost Costs of periodic reviews

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REFERENCES
Operations Management William J. Stevenson Operations Management Barry Render & Jay Heizer

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