Inventory Management

AT3D Quantec
Group 5 Written Report
Group Members:
Alcantara, Hannah Denisse C.
Cepillo, Christian Adrian D.
De La Vega, Nikko U.
Medalla, Jefferson G.
Pangilinan, John Paul G.
Ramos, Aldrin P.
Introduction

Inventory is one of the most expensive and important assets to many companies, representing
as much as 50% of total invested capital. Managers have long recognized that good inventory
control is crucial. On one hand, a firm can try to reduce costs by reducing on-hand inventory
levels. On the other hand, customers become dissatisfied when frequent inventory outages,
called stockouts occur. Thus companies, must make the balance between low and high
inventory levels. As you would expect, cost minimization is the major factor in obtaining this
delicate balance.

Inventory is any stored resource that is used to satisfy a current or a future need. Raw
materials, work-in-process, and finished goods are examples of inventory. Inventory levels for
finished goods are a direct function of demand.

Functions of Inventory

Inventory control serves several important functions and adds a great deal of flexibility to the
operation of the firm. Consider the following five uses of inventory:

1. The decoupling function one of the major functions of inventory is to decouple

manufacturing processes within the organization. If you did not store inventory, there
could be many delays and inefficiencies.
2. Storing resources agricultural and seafood products often have definite seasons over
which they can be harvested or caught, but the demand for these products is somewhat
constant during the year. In these and similar cases, inventory can be used to store
these resources. In a manufacturing process, raw, materials can be stored by
themselves, in work-in-process, or in the finished product. In the same sense, labor can
be stored in inventory. In general, any resource, physical or otherwise, can be stored in
inventory.
3. Irregular Supply and Demand when the supply or demand for an inventory is irregular,
storing certain amounts in inventory can be important
4. Quantity Discount another use of inventory is to take of advantage of quantity
discounts. Many suppliers offer discounts for large orders. There are, however, some
disadvantages of buying in large quantities. You will have higher storage costs and
higher costs due to spoilage, damaged stock, theft, insurance, and so on. Furthermore,
by investing in more inventory, you will have less cash to invest elsewhere.
5. Avoiding Stockouts and Shortages another important function of inventory is to avoid
shortages or stockouts. If you are repeatedly out of stock, customers are likely, to go
 elsewhere to satisfy their needs. Lost goodwill can be an expensive price to pay for not
having the right item at the right time.

Types of Inventory

Raw material - Purchased but not processed

Work-in-process - Undergone some change but not completed and a function of cycle time
for a product.

Maintenance/repair/operating (MRO) - Necessary to keep machinery and processes

productive

Finished goods - Completed product awaiting shipment

Control of Service Inventories - Can be a critical component of profitability, Losses may come
from shrinkage or pilferage

Applicable techniques include:

1. Good personnel selection, training, and discipline

2. Tight control on incoming shipments

3. Effective control on all goods leaving facility

Holding, ordering and Setup Costs

Ordering Cost Factors Carrying Cost Factors

1. Developing and sending purchase 1. Cost of capital
2. Taxes
orders
3. Insurance
2. Processing and inspecting incoming
4. Spoilage
inventory 5. Theft
3. Bill paying 6. Obsolescence
4. Inventory inquiries 7. Salaries and wages for warehouse
5. Utilities, phone bills, and so on for the
employees
purchasing department 8. Utilities and building costs for the
6. Salaries and wages for purchasing
warehouse
department employees 9. Supplies such as forms and paper for
7. Supplies such as forms and paper for
the warehouse
the purchasing department
 Ordering costs are generally independent of the size of the order, and many of these
involve personnel time. An ordering cost is incurred each time an order is placed. The time
to process the paperwork, pay the bill, and so forth, does not depend on the number of units
ordered

Holding costs varies as the size of inventory varies.

Economic Order Quantity

The economic order quantity (EOQ) is one of the oldest and most commonly known
inventory control techniques. Research on its dates back to a 1915 publication by Ford W.
Harris. This technique is still used by a large number of organizations today. It is relatively
easy to use, but it does make a number of assumptions. Some of the most important
assumptions follows:

1. Demand is known and constant

2. The lead time that is, the time between the placement of the order and the receipt of
the order is known and constant.
3. The receipt of inventory is instantaneous. In other words, the inventory from an older
arrives in one batch, at one point in time.
4. The purchase cost per unit is constant throughout the year. Quantity discounts are not
possible.
5. The only variable costs are the cost of placing an order, ordering cost, and the cost of
holding or storing inventory over time, holding or carrying cost. The holding cost per unit
per year and the ordering cost per order are constant throughout the year.
6. Orders are placed so that stockouts or shortages are avoided completely.
Order Cycle Time
When this assumptions are not met, adjustments must be made to the EOQ model. With
these asssumptions, inventory usage has a sawtooth shape.

Inventory Level

Usage rate
Order quantity = Q
(maximum inventory level)

Average
Q inventory
=
2

ROP
(Reorder point)
Lead time = L Time
 ROP
(Reorder point)

Lead time = L
Time

Total cost of holding and setup (ordering)

Order Cycle Time

Minimum total cost

Order quantity

Holding cost
Annual cost

Setup (or ordering) cost curve

Order Cycle Time

Optimal order quantity (Q*)

Objective is to minimize total costs

EOQ Model
Q = Order quantity
D = Annual Demand
S = Ordering/setup cost
H = Holding/carrying cost
P = Unit cost of product
 Q
Average Inventory
2

2 DS
Q*
H
EOQ =
D
Annual ordering cost S
Q

Q
Annual carrying cost H
2

D Q
Total inventory cost(TIC) ordering cost carrying cost S H
Q 2

D Q
Total Cost (TC) ordering cost carrying cost Product cost S H PD
Q 2

Q = Order quantity
D = Annual Demand
Demand D
Expected number of orders N
Order quantity Q

Order Cycle Time (i.e., the time between th e recepit of orders)

Number of working days per year

N
Number of working days per year

D
Q

EOQ Model (Example 12.2)

Sharp, Inc., a company that markets painless needles to hospitals, would like to reduce its inventory cost by
determining the optimal number of hypodermic needles to obtain per order. The annual demand is 1000 units; the
ordering cost is $10 per order; the carrying cost per unit per year is $0.5; and the unit price of product is $10. The
number of working days per year is 250 days. In order to minimize the annual total cost,

D hypodermic
(1) how many = 1,000 unitsneedles should be ordered each time?
S = $10 per order
H = $.50 per unit per year
(2) how many orders should be placed per year?
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

(3) what is the expected time between orders?

D = 1,000 units Q* = 200 units

S = $10 per order N = 5 orders per year
H = $.50 per unit per year
Number of working days per years = 250 days

(4) how much is the optimal annual total inventory cost?

D = 1,000 units Q* = 200 units

S = $10 per order

TotalHannual
= $.50 cost = Setup
per unit cost + Holding cost
per year

D Q* 1,000 200
TC = S + TCH= 200
($10) +
2
($.50
Q* 2
TC = (5)($10) + (100)($.50)

= $50 + $50

= $100
 (5) how much is the optimal annual total cost?
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year
P = $10 per unit per product

Total annual cost = Setup cost + Holding cost + Product cost

D Q*
TC = S + H + PD
Q* 2
1,000 200
TC = ($10) + ($.50) +(1000)($10)
200 2
TC = (5)($10) + (100)($.50) + (1000)($10)

= $50 + $50 + $10,000

Reorder Points
= $10,100
Once the order quantity is determined, the next decision is when to order. The time between
placing an order and its receipt is called the lead time (L) or delivery time. Inventory must be
available during this period to met the demand. When to order is generally expressed as a
reorder point (ROP) the inventory level at which an order should be placed. The slope of
the graph is the daily inventory usage. Expressed in units demanded per day, d. If an order
is placed when the inventory level reaches the ROP, the new inventory arrives at the same
instant the inventory is reaching 0

ROP = (Demand per day) (Lead time for a new order in days)

=dxL

Where d = Demand per year/Number of working days in a year

Example

An apple distributor has a demand for 8,000 iPods per year. The firm operates a 250-day working year. On average,
delivery of an order takes 3 working days. What is the reorder points (ROP)?

Demand = 8,000 iPods per year

250 working day year

Lead time for orders is 3 working days

 d= Demand per year
Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L

= 32 units per day x 3 days = 96 units

Safety Stock

If demand or the lead time are uncertain, the exact ROP will not be known with certainty. To
prevent stockouts, it is necessary to carry extra inventory called safety stock. Safety stock
can prevent stockouts when demand is unusually high. Safety stock can be implemented by
adjusting the ROP.

Minimum demand during lead time

Inventory level Maximum demand during lead time
Expected demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5

ROP

Example 12.5: A computer components manufacturerSafety stock 10,000

uses approximately 16.5 blank
unitsCDs annually. The CDs are
used at a safety rate during the 250 workdays that the plant operates. The price of each blank CD is $7.00 and the
annual carrying cost is $0.5 per unit per
Place year. The
order
Lead timeordering cost is $50. The lead time for ordering these CDs is ten
Receive order
days. In addition, due to poor supplier delivery, the company has decided to maintain a safety stock of 1000 units.
Tim
e
(1) The optimal order size each time the inventory needs to be replenished.
 D = 10,000 per year 2 DS
Q*
H
P = $7.00
2 10,000 50

H = $0.5 per unit per year 0.5
1415
S = $50 per order

L = 10 days
(2) Number of workdays between each purchase order placed (order cycle time).
available workdays
Safety stock = 1000 units
D
Q*
Available working days = 250 days
250

10000
1415
35.4 days

(3) Average inventory level of CDs

Q*
SS
Since the safety stock is used, the average inventory level 2
increases by the amount of safety stock 1415
1000
2
1708 units
(4) Maximum inventory level of CDs
(5) Reorder point in units
The maximum
Q * SS
inventory level
ROP d * L SS
increases by the 1415 1000
10000
(7) Annual
amountcarrying
of safety Q* 2415
(holding) cost
units 1415 10 1000
Carrying cost increases
stock 2 SS H 1000 0. 5 $
250 854
2 1400 units
(8) Total inventory cost
(6) Annual setup/Ordering cost
TAC $353 $854
D $ 10000
S 1207
Setup/Ordering cost does not
50 $353
change
Q* 1415

When safety stock is used,

optimal holding cost optimal setup/carrying cost

Safety Stock
ROP = d x L + ss
Q
Average Inventory SS
2

Max Inventory Q SS

Q
Annual carrying cost SS H
2

D Q
TAC ordering cost carrying cost S SS H
Q 2

Independent demand - the demand for item is independent of the demand for any other item in
inventory and demand is beyond control of the organization

Dependent demand - the demand for item is dependent upon the demand for some other item
in the inventory and demand is driven by demand of another item