Chapter 10

CHAPTER 10
INVENTORY MANAGEMENT
Learning Objectives
After reading this chapter, you will be able to

describe the purpose of inventory;
explain different types of inventory cost;
describe fixed order quantity models and fixed time period models;
compute economic order quantity, economic order period and safety stock;
describe simple applications of inventory control methods.
Inventory refers to stock of any item or resource used in an organization. Inventory

is available in both manufacturing and service organizations. Manufacturing
inventory includes raw materials, finished products, component parts, supplies and
work-in-process. In services, inventory generally refers to the tangible goods to be
sold and the supplies necessary to provide and administer the service. An inventory
management system is the set of policies and control mechanism that monitor levels
of inventory and determines the levels of inventory to be maintained, size of the order
and time of order placement.
PURPOSE OF INVENTORY
Firms keep inventory due to following reasons.
1. To maintain independence of operations

Inventory between the operations provide independence to carry out operations. For
example, raw material stock gives flexibility to carry out manufacturing activities
without depending on the schedules of purchasing department.
2. To cope up with uncertainties in product demand

Product demand is not known precisely due to uncertainties of the market.
Companies use safety or buffer stocks to cope up uncertainties in product demand.
Inventory Management 151
3. To safeguard delays in shipment

When material is ordered from a vendor, supplies can be delayed due to variety of
reasons such as variations in shipping time and shortages of material at the vendor's
plant. Usually organizations keep safety stocks to safeguard the situation.
4. To allow flexibility in production scheduling

A stock of inventory provides opportunities for large lot sizes under high setup cost.
Inventory is useful to adjust the capacity under high demand situations,
5. To take advantage of economic purchase order size

There are certain costs incurred in placing orders: documentation, phone calls,
postage, and so on. Therefore, larger the each order is, the fewer the number of orders
that need to be placed. In addition to that, larger orders reduce the number of
shipments and hence reduce the total transport cost. There is a possibility to get
quantity discounts through larger orders.
6. To get price advantages

If there are possibilities for future price escalation, organizations purchase items
more than their present requirements and keep them in inventory for future use.
NEGATIVE ASPECTS OF INVENTORY
1. Poor quality of products

Large inventories can prohibit meaningful feedback on the quality of the product.
With large inventories, there is usually a long delay between the production of an
item and its use. Thus, when problems are discovered, it is usually too late to
investigate and correct the problem.
2. Hiding operational problems

Operational problems such as delays in order processing and production backlogs are
hidden by the excessive inventories. These problems reduce the level of performance
of the operation system.
3. Risk of damage
There is some risk of damage to goods held in inventory. Often, warehouse workers
have to move and replace large quantities of inventory just to find a specific item.
When each time an item is handled, there is some chance that it will be damaged.
152 Operations Management: Concepts and Applications
4. Risk of product obsolescence and depreciation

Large inventories are associated with a risk of product obsolescence and losses due to
depreciation.
5. Cost of maintaining inventory

In maintaining inventory, it is required to track and keep records. This needs
additional effort and cost.
INVENTORY COSTS
In making inventory decisions such as order quantity and order frequency the
following costs must be considered.
1 . Holding (or carrying) costs

This includes the costs for storage facilities, handling, insurance, pilferage, damages,
obsolescence, depreciation, taxes, and the opportunity cost of capital. High holding
costs tend to favour low inventory levels and frequent replenishment.
2. Ordering costs
These costs refer to the administrative costs to prepare the purchase or production
order. The costs associated with maintaining the system need to track orders and
receiving orders are also included in ordering costs.
3. Setup (or production changeover) costs

The production system should be setup for each production order. Each setup incurs
certain cost. The larger the production lot sizes the lower the total setup cost.
4. Shortage costs
Shortage costs occur due to stock out of products or raw material. Shortage cost
includes lost profits and lateness penalties. Shortage may cause customer
dissatisfaction leading to loss of customers, which can be considered as a cost but
difficult to quantify.
INDEPENDENT VERSUS DEPENDENT DEMAND
Inventories may contain items that have either dependent demand or independent
demand. In independent demand inventories, demand for an item is independent of
the demand for any other item carried in the inventory. Finished goods delivered to
customers are considered as independent demand items. Demand for dependent

demand items depends on the other items in the inventory. For example, demand for
wheels and seats, which are components, are dependent on the demand for cars.
Quantities of independent items to be produced are based on the realized orders
or sales forecast. This chapter mainly considers the issues related to independent
demand. Requirements of dependent demand items are derived from the demand of
independent items. Order quantity and order point decisions for dependent demand
items are different from those independent demand inventories; these decisions will be
discussed in Chapter 11.
INVENTORY MANAGEMENT SYSTEMS
An inventory management system provides a set of rules and policies for planning
and controlling inventory. To maintain appropriate level of inventory, decision rules
are needed to answer the questions such as:
1. When should an order be placed to replenish the inventory?
2. How much should be ordered?
3. What level of safety stock to be maintained?
Various types of inventory control models incorporate different rules to decide
when and how many to order. In managing independent inventory, there are two
basic inventory control models:
1. Fixed order quantity model
2. Fixed time period model
In addition to above models, single period inventory models are used for the items
with a short selling period.
Fixed Order Quantity Model
The Fixed order quantity model places orders for same quantity of material at each
order. It initiates an order when the inventory level reaches a specified reorder level
(i.e. order placement is event triggered). This event may take place at any time
depending on the demand for the items considered. Inventory position must be
continuously monitored to check whether it has reached to the reorder level. Thus,
the fixed order quantity model is a perpetual system, which requires that every time a
withdrawal from inventory or an addition to inventory is made, records must be
updated and also known as continuous review system.
Fixed order quantity models attempt to determine the quantity to be ordered (Q)
and reorder level (R). Inventory position is equal to the on-hand plus on-order minus
back order quantities. The fixed order quantity model is implemented something like
this: When the inventory position drops to R, place an order of Q items. Quantity to
be ordered is determined so that total cost is minimum and it is referred to as
economic order quantity.
In deriving formulae for economic order quantity (EOQ) and reorder level,
fixed order quantity models have following assumptions.
Demand for the product is constant and uniform throughout the period.
Lead time (time from ordering to receipt) is constant.
Price per unit of product is constant.
Inventory holding cost is based on average inventory.
Ordering or setup costs are constant.
All demands for the product will be satisfied (No shortages are allowed).
Figure 10.1 shows the pattern of variation of inventory for fixed order quantity
model. When the inventory position drops to reorder level R, order of quantity Q is
placed. This order is received at the end of time period L.
Inventory
Position
Q Q Q
L L Time
Figure 10.1: Variation of Inventory for Fixed Order Quantity Model
In deriving formula for economic order quantity, it is required to develop the

relationship between variables interest and total cost, since the objective of economic
order quantity is to minimize the total cost. Total annual cost of the items in the
inventory can be given as follows:
Total annual cos t Annual purchase cos t Annual ordering cos t

Annual holding cos t
Annual purchase cost = Annual demand Cost per unit = D C
Annual ordering cost = Number of orders per year Cost of each order
D
S
Q
Annual holding cost = Average inventory Annual holding cost per unit of
inventory
Q
= H
2
Then total annual cost is given by,
D Q
TC DC S H
Q 2
where,
TC = Total annual cost
D = Demand
C = Cost per unit
Q = Order quantity
S = Cost of placing an order or setup cost
R = Reorder point
L = Lead time
H = Annual holding cost per unit of average inventory
It can be noted that total annual cost varies with the order quantity. Figure 10.2
shows the variation of costs with order quantity Q.
Cost
Total Cost
Holding Cost
Annual cost of
items
Annual ordering
cost
Q (OPT) Order Qty (Q)
Figure 10.2: Variation of Cost with Quantity Order
Deriving EOQ Calculus Method

Order quantity Qopt is the point at which the total cost is a minimum. The total cost is
minimal at the point where the slope of the curve is zero. Using calculus, taking the
derivative of the total cost with respect to Q and setting this equal to zero will results,
D Q
TC DC S H
Q 2
For minimum TC,
dTC DS H
0 2 0
dQ Q 2
Qopt 2 DS
H
2 Annual demand Order or setup cos t

Qop t =
Annual holding cos t per unit of inventory
This quantity is known as the Economic Order Quantity (EOQ).
Deriving the EOQ - Graphical Method

At the optimal order quantity, the total annual holding cost is equal to the total annual
ordering cost.
Q D
Solving, H S
2 Q
Qopt 2 DS
H
2 Annual demand Order or setup cos t
Economic Order Quantity (EOQ) =
Annual holding cos t per unit of inventory
At the reorder point, the inventory should fulfill the demand during lead time and the
reorder point R is,
R dL
where, d = Average daily (weekly) demand

L = Lead time in days (weeks)
Example 10.1: Economic Order Quantity and the Reorder Point

Find the economic order quantity and reorder point for following data.
Annual Demand = 1,000 units
Cost to place an order = Rs. 2000
Holding cost per unit per year = 20% of price
Lead time = 7 days
Cost per unit = Rs. 2500
Solution
2DS 2 1000 2000

Qopt = = 89.44 units
H 2500 0.2
The reorder point is
1000
R dL 7 19.18 units = 20 units (round up to avoid stock outs)
365
The inventory policy is as follows: When the inventory position drops to 20 units
place an order for 89 units.
The total annual cost will be
D Q
TC DC S H
Q 2
1000
10002500 2000 89 500
89 2
= Rs. 2,544,721.91
Fixed Order Model with Quantity Discounts

Suppliers usually offer quantity discounts for large purchase quantities. Economic
order quantity can deviate from the previously derived Qopt due to the cost savings
gained through quantity discounts.
Example 10.2: Economic Order Quantity with Quantity Discounts

The supplier offers quantity discounts and discounted prices are as follows.
Quantity Unit Price
0 500 units 35 cents
500 1000 units 33 cents
1000 and above 31 cents
Assume demand is 1000 per year; cost of placing an order is Rs. 8 and annual
holding cost is 20 percent of unit price. What is the economic order quantity?
Solution
Find Qoptimal for different ranges of order quantities.
2DS 2 1000 8
Qopt(0) = = 478 units
H 0.2 0.35
2DS 2 1000 8
H 0.2 0.33
2DS 2 1000 8
H 0.2 0.31
440
420
TC (0)
400
Total Cost (TC)
380 TC (1)
360 TC (2)
340
320
300
100 200 300 400 500 600 700 800 900 1,000 1,100 1,200
Order Quantity (Q)
Figure 10.3: Cost Variation with Quantity Discounts
Only Qopt (0) is realisable. Since others are not fallen into the corresponding unit cost
range, Qopt (1), Qopt (2) are not realisable. But there are two price breaks (Q = 500, Q =
1000) above the optimal realisable quantity, (Q = 478). There is a possibility that the
total costs at these price breaks are lower than the cost at Qopt(0) (Q = 478). Therefore
the total cost should be calculated for quantities 478, 500 and 1000 to determine the
economic order quantity.
D Q
TC DC S H
Q 2
1000 478
TC 478 1000 0.35 8 0.2 0.35 383.47
478 2
1000 500
TC 500 1000 0.33 8 0.2 0.33 362.50
500 2
1000 1000
TC 1000 1000 0.31 8 0.2 0.31 349
1000 2
Total cost is minimum at 1000. Hence the economic order quantity is 1000
units.
Fixed Order Quantity Model with Consumption during Production

Basic economic order quantity model assumes that the quantity ordered would be
received in one lot, but there are deviations from this situation. In many situations of
production environment, production of inventory items and usage of those items take
place simultaneously. Figure 10.4 shows the variation of inventory for this situation.
It can be observed that maximum inventory is less than the order quantity Q. If the
production rate p and the demand rate d (<p), it can be proved that average inventory
is equal to (1-d/p) Q/2.
Modified total cost equation
D d Q
TC DC S 1 H
Q p 2
By replacing H by (1 d/p) H, Qoptimal can be written

2DS
Qopt
d
H 1
p
Inventory
level
Maximum Inventory
(1-d/p) Q
Average
Inventory level
(1-d/p) Q/2
Order Begin Time

receipt order End order
period receipt receipt
Figure 10.4: Fixed Order Quantity Model with Consumption during Production
Time
Example 10.3: Fixed Order Quantity Model with Consumption during Production
Time
Find the economic order quantity and reorder point, given
Annual Demand = 1,000 units
Holding cost per unit per year = Rs. 250
Lead time = 2 weeks
Production rate = 80 units per week
Assume that the plant operates 50 business weeks per year.
Solution
1000
Demand rate, d 20 units per week
50
2 DS
Qopt
d
H 1
p
2 1000 1000
Qopt
20
2501
80
Qopt 103.28 units
Reorder point is,

R d L 20 units / week 2 weeks 40 units
Safety Stock for Fixed Order Quantity Model
The Fixed-order quantity model continuously monitors the inventory level and places
a new order when stock reaches reorder point, R. The fixed order quantity model
assumes that demand and lead time are constants. But, in actual practice these are not
constants and fluctuate due to uncertainties in the environment. If there is increase in
demand or lead time more than the normal, there can be stock out as shown in
Figures 10.5 and 10.6. It should be noted that the danger of stock out in this model
occurs only during the lead time, between the time an order is placed and the time it
is received.
In many situations, demand and lead time are not constants but vary from day to
day. Safety stock must therefore be maintained to provide some level of protection
against stock outs. Safety stock can be defined as the amount of inventory carried in
addition to the expected demand.
Safety stock can be determined based on many different criteria. Some mangers
follow simple deterministic approach to decide the level of safety stock. This simply
states that a certain number of weeks of supply to be kept in safety stock (e.g.
maintain 2 weeks supply as safety stock). Probabilistic approach is more scientific
method in determining safety stock, which considers the probability of running out of
stock.
Inventory
level
Normal dem and
Increased demand
Time
Stock out
Figure 10.5: Stock-out due to Demand Uncertainty
Inventory
level
Time
Normal lead time Stock out
Increased lead time
Figure 10.6: Stock-out due to Lead Time Uncertainty
Assuming that demand and lead time follow the standard normal distribution, safety
stock (SS) is given as,
SS z DL
DL is given by
DL L D 2 d 2 L 2
where,
L = Lead time in days
d = Demand per day
z = Number of standard deviations for a specified probability of not stocking outs
(Probability of meeting demand is known as service level)
DL = Standard deviation of demand during lead time and review period
D = Standard deviation of daily demand
L = Standard deviation of lead time
With safety stock, inventory position at reorder point should carry the demand during
lead time and safety stock. Thus, the reorder point is given by,
R d L SS
where,
d = Average daily demand
SS = Safety stock
Example 10.4: Safety Stock for Fixed Order Quantity Models

A company orders a product with an average daily demand of 100 units.
Average lead time of shipment is 5 days. The company wishes to maintain a
safety stock so that orders are met with of 0.95 service level. Standard
deviations of daily demand and lead time are 20 units and 2 days respectively.
Determine the safety stock and reorder point.
Solution
Safety stock is given by,
SS z DL
2 2
DL L D d 2 L
L = 5 days
d = 100 units
D = 20 units
L = 2 days
Service level (Probability of not stocking out) = 0.95
Corresponding z is found from standard normal distribution as shown in Figure 10.6

(Z values for standard normal distribution curve are given in appendix).
P- Service level
P=0.95
Z = 1.64
Figure 10.6: Z Value for Given Service Level
z = 1.64
DL 5 202 1002 2 2
DL 2000 40000 42000 204.94
SS 1.64 204.93 336.1
R d L SS
R 100 5 336 836
Safety stock is 336 units and the reorder point is 836 units.
Fixed Time Period Model
In the fixed time period model, inventory is reviewed only at fixed time intervals
such as every week or every month, and orders are placed for enough items to bring
inventory levels backup to some predetermined level. Figure 10.6 illustrates the fixed
time inventory model.
Place Place
Inventory order order
position
Place
order
Safety L L L
stock
T T T Time
Figure 10.6: Variation of Inventory for Fixed Time Period Model
In this model, maximum inventory level is given by,
Maximum Inventory level = Demand for review period and lead time + Safety Stock
I max D( T L ) SS
where,
Imax = Maximum inventory level
D = Annual demand
T = Review period (in years)
L = Lead time
SS = Safety stock
Order quantity varies depends on the inventory and is computed by,
Order quantity = Maximum inventory level - Current inventory position
In deriving formula for economic order period, it is required to develop the

relationship between variables interest and total cost, since the objective of economic
order quantity is to minimize the total cost.
Total annual cost of the items in the inventory can be given as follows:
Total annual cost = Annual purchase cost + Annual ordering cost + Annual holding
cost
Annual purchase cost = Annual demand Cost per unit = D C

Annual ordering cost = Number of orders per year Cost of each order
D S
S
DT T
Annual holding cost = Average inventory Annual holding cost per unit
DT SS
= H
2
Then total annual cost is given by,
S DT SS
TC DC H
T 2
where,
TC = Total annual cost
D = Annual demand
C = Cost per unit
T = Order period (Review period)
S = Cost of placing an order or setup cost
L = Lead time
H = Annual holding cost per unit of inventory
SS = Safety stock
For economic order period,

d TC S DH
0 2 0
dT T 2
2S
Economic order period = Toptimal
DH
Example 10.5: Fixed Time Period Model

Find the economic order period and the order quantity for the following data.
Annual demand = 7,500 units
Holding cost per unit per year = Rs. 7.7
Safety stock = 200 units
Current inventory level = 250 units
Lead time = 1 month
Solution
2S 2 800
Toptimal 0.1665 years 2 months
DH 7500 7.7
Economic order period is two months.
Order quantity = Demand for review period & lead time + Safety St ock -
Current inventory position
2 1
= 7500 200 250 = 1200 units
12
Order quantity is 1627 units.
Safety Stock for Fixed Time Period Model
In a fixed time period system, stock out can occur at any point of the review period.
Therefore safety stock should be enough to protect the demand uncertainties during
the review period. Since the items ordered at the review point are received after the
lead time period (L), the safety stock should protect demand uncertainties during the
lead time in addition to review period (i.e. the safety stock should protect demand
uncertainties during T+L period). Since the safety stock protects demand uncertainty
for longer period, the level of safety stock in fixed time period systems is higher
compare to the fixed order quantity systems.
Safety Stock (SS) is given by,

SS z D T L
D(T+L) is expressed as,
D T L T L D 2 d 2 L 2
where,
T = Review Period
d = Demand per day
z = Number of standard deviations for a specified probability of not stocking
outs
D(T+L) = Standard deviation of demand over lead time and review period
D = Standard deviation of daily demand
L = Standard deviation of lead time
Example 10.6: Safety Stock for Fixed Time Period Models

Calculate the level of safety stock for the previous example assuming inventory is
maintained according to the fixed time period model and the review period is 30
days.
Solution
SS z D T L
L = 5 days
d = 100 units per day
D = 20 units
L = 2 days
T = 30 days
Probability of not stocking out = 0.95
z = 1.64
D T L T L D 2 d 2 L 2
D T L 30 520 2 100 2 2 2 14000 40000 54000 232.38
SS 1.64 232.38 381.1
Safety stock is 381units.
Comparison of Fixed Order Quantity Model and Fixed Time Period

Model
The inventory control models discussed above have their own characteristics.
Selection of the suitable inventory control model depends on these characteristics.
Table 10.1 shows some basic differences of the inventory control models.
Table 10.1: Comparison of Inventory Control Models
Characteristic Fixed Order Quantity Model Fixed Time Period Model

Order quantity Constant (usually economic Variable (fills up to
order quantity) predetermined inventory level)
Order placement When inventory position When the review period arrives
drops to the reorder level
Record keeping & Each time a withdrawal or Counted only at review period.
maintenance addition is made. Record keeping and
Recordkeeping and maintenance cost is low due to
maintenance cost is high periodic review
Size of inventory Less than fixed-time period Larger than fixed-order quantity
model due to the less safety model due to higher safety
stock stock
Chance for stock Low (Stock out can occur High (Stock out can occur at
out only during lead time) any time)
Type of item High-priced items (to Low-priced and non-critical

minimize holding cost and items
capital tied-up)
Critical or important items
(to minimize stock out of
critical or important items)
Single Period Inventory Model
Some inventory situations involve placing to cover only one demand period or very
short selling season. Items such as holiday decoration, Christmas trees, newspapers,
and magazines are good examples. These products typically have a high value for a
relatively short period; then value diminishes dramatically an either or some
minimum scale value. This type of inventory model is called single period or news
boy problem.
The single period model is designed for products that share the following
characteristics.
They are sold at their regular prices only during a single-time period.
Demand for these products is highly variable but follows a known probability
distribution.
Salvage value of these products is less than its original cost so the seller loses
money when they are sold for their salvage value.
Example 10.7: Single Period Inventory Model
A product is providing to sell at Rs.100 per unit and its cost is constant at Rs.70 per
unit. Demand is replaced to range between 40 and 60 units for the period. Each
unsold unit has a salvage value of Rs 20. Based on the past demand data, the seller
has determined the probability of selling different quantities as follows.
Demand (Products) Probability

40 0.20
45 0.25
50 0.30
55 0.15
60 0.10
Determine how many products should be ordered to maximize the sellers expected
profits.
Solution
Based on the information provided develop a payoff table to determine expected

profit with each possible order quantity.
In calculating payoff, there are three possible outcomes,
when the number of products ordered equals the number of shirts demanded,
Pay off = demand (selling price unit cost)
e.g. demand = 50 and number of product ordered = 50

Pay off = 50(100-70) = Rs.1500
when the number products is less than demand,

Pay off = number of products ordered (selling price unit cost)
e.g. demand = 50 and number of products ordered = 40

Pay off = 40(100-70) = Rs. 1200
when the number of products ordered exceeds the demand,

Pay off = number of products demanded x (selling price unit cost)
(products of ordered products demanded) x (unit cost salvage value)
e.g. demand = 50 and products ordered = 60

Pay off = 50 (100-70) (60-50)(70-20) = Rs. 1000
Pay off Table
Probability of
0.20 0.25 0.30 0.15 0.10
occurrence
Customer demand 40 45 50 55 60
Number of product Expected
ordered profit
40 1200 1200 1200 1200 1200 1200
45 950 1350 1350 1350 1350 1270*
50 700 1100 1500 1500 1500 1240
55 450 850 1250 1650 1650 1090
60 200 600 1000 1400 1800 880
The seller should select the order quantity of 45 units with the highest
expected profit (i.e. Rs 1270).
APPLICATIONS OF INVENTORY CONTROL MODELS
Practitioners use some simple systems based on the inventory control models
presented above. Following are three simple systems used in practice.
Two-Bin System
Two-bin system of inventory control is a simple application of fixed order quantity
model. In the two bin system, items are used from one bin and the second bin
provides an amount large enough to ensure demand during the replenishment lead
time. Ideally the second bin would contain an amount equal to the reorder point (R)
calculated earlier. Items are withdrawn from a large bin until the large bin is empty.
When the large bin is empty, an order is placed to replenish the items and the items
are drawn from the second bin, a smaller one. When the inventory is replenished, the
both bins are filled with the items. The order quantity is the amount needed to fill
both bins. The re-order point is the amount needed to fill the second bin.
One -Bin System

One-bin inventory system is a simple application of fixed time period model. The
items are filled in a bin and drawn when the demand arises. At fixed periods (such as
weekly or monthly) the inventory is brought up to its predetermined maximum level.
Optional Replenishment System

Optional replenishment system is another version of fixed time period model. In this
system inventory is reviewed at fixed time interval, but replenishment orders are
placed if the inventory level has dropped below a predetermined level. This system
establish a minimum order size and avoid small orders because each order takes time
and cost.
ABC INVENTORY PLANNING
When an organizations inventory items are listed by their value of usage (their usage
is multiplied by their individual value), generally a small number of items accounts
for a high value of usage, and large number of items account for low value of usage.
This phenomenon is known as the Pareto law, sometime referred to as 80/20 rule.
ABC classification scheme divides inventory items into three groupings:
Class A items are those of high-value items which account for around 80 per cent
of the total stock value. Generally there are 20 per cent of inventory items in this
category.
Class B items are those of medium value, usually the next 30 per cent of items
which account for around 10 per cent of the total stock value.
Class C items are those low-value items comprising around 50 per cent of
inventory items. These items value around 10 percent of the total stock value.
In controlling inventory, class A items should receive the attention first. One of
the major costs of inventory is annual carrying costs; money is invested largely in
class A. In managing inventory of class A items, more savings can be achieved
through tight control and sound operating practices with a reasonable amount of time
and effort. Fixed order quantity systems are more suitable for managing these
inventory items. Fixed time period model is suitable to manage the inventory of class
B and class C items. Class B items can be reviewed in shorter time period while
larger time period for class C items.
Example 10.8: ABC Classification

Table 10.2 lists a number of stock items according to decreasing value of usage.
Table 10.3 groups these items into ABC classification and Pareto chart of ABC
classification is given in Figure 10.7.
Table 10.2: Annual Usage of Inventory by Value
Unit Value Annual Value Percentage of Total

Item Number Annual Usage
(Rs.) (Rs.) Value
P101 8,050 150 12,075,000 32.6
P301 1,095 956 10,468,200 28.2
P109 830 600 4,980,000 13.4
P121 211 1,500 3,165,000 8.5
P107 655 325 2,128,750 5.7
P205 25 5,000 1,250,000 3.4
P302 400 300 1,200,000 3.2
P256 435 150 652,500 1.8
P191 100 640 640,000 1.7
P408 89 354 315,060 0.9
P246 375 50 187,500 0.5
P369 112 75 84,000 0.2
P296 150 25 37,500 0.1
37,062,010 100.0
Table 10.3: ABC Grouping of Inventory Items
Annual Value Percentage of

Classification Item Numbers
(Rs.) Total
27,523,200
A P101, P301, P109 74
7,743,750
B P121, P107, P205, P302, 21
P256, P191, P408, P246, P369, 1,916,560
C 5
P296
Total 37,062,010 100
80 A items
70
60
50
% of total
40
inventory value
30
B items
20
10 C items
0
23 54 100
% of total list of different stock items
Figure 10.6: ABC Inventory Classification
CHAPTER HIGHLIGHTS
Inventory control models discussed in this chapter mainly focuses on

independent demand items.
Two main inventory control models are used for managing inventory: fixed order
quantity models and fixed time period models.
Economic order quantity is a trade off between holding cost and order cost.
Safety stocks are maintained to cope up with demand and lead time uncertainties.
Price breaks are considered to decide the economic order quantity.
ABC classification is useful to decide the most appropriate inventory model.
DISCUSSION QUESTIONS
1. Why are inventories necessary? Discuss.

2. Name two purpose of carrying these inventories: (a) finished goods, (b) in-
process, and (c) raw materials.
3. Compare and contrast fixed order quantity inventory systems with fixed order
period inventory systems.
4. What are the assumptions of the basic EOQ model and to what extent do they limit the
usefulness of the model.
5. What are the purposes of safety stock? How will the use of safety stock affect
the EOQ?
6. Explain the following terms and discuss their importance in inventory
management.
a) Economic order quantity
b) Reorder point
c) Safety stock
7. Explain following applications in inventory management and indicate their
advantages.
a) Two bin system.
b) ABC inventory classification system.
PROBLEMS
1. A maintenance department of a manufacturing plant needs to plan inventories

for frequently used maintenance part, a bearing. Under consideration is the order
point and order quantity for this item. Average demand per week is 15 bearings
and average lead time is 5 weeks. The plant operates under a policy of carrying
50 percent of expected demand during lead time as safety stock across all items
in the same class as this bearing. Order cost is Rs. 1000 per order and holding
cost is Rs. 25 per year per item. Determine
a) re-order level and
b) economic order quantity.
2. Mihiri fast-food uses 300 breakfast paper cartons per day. The outlet plans to be
open 365 days a year. A box of 10 cartons costs Rs. 50; ordering cost is Rs. 180
per order and holding cost is 10% of cost per day. Delivery lead time is one day.
Currently cartons are ordered every 14 days. Do you accept the current ordering
system? If not, what is your proposed system? What is the amount of savings
due to new system?
3. A grocery store carries a particular brand of fruit drink which has following
details.
Sales: 10 cases per week
Ordering cost: Rs. 2,000 per order
Inventory holding cost: 30% of cost per case per year
Item cost: Rs. 6,000 per case
a) How many cases should be ordered at a time?
b) How often will the drink be ordered?
c) What is the total annual cost?
Suppose that the grocery store is offered a price discount of 5% if 50 or more

than 50 cases were ordered. Should the grocery take this discount offer?
4. Annual demand for a product is 13,000 units. It has been estimated that that the
weekly demand is 250 units with a standard deviation of 50 units. The cost of
placing an order is Rs 1000, and the time from ordering to receipt is 5 weeks.
The annual inventory carrying cost is Rs 15 per unit. To provide a 98% service
probability, what must the reorder point be? Suppose the production manager is
told to reduce the safety stock of this item by 100 units. If this is done, what will
the new service probability be?
5. Shakthi Food Products Ltd. (SFPL) produces a cereal which is manufactured

from green-gram. SFPL wanted to decide an order quantity, to meet the annual
demand at the lowest cost. The price of green-gram depends on the quantity
ordered. The price break details and other data are as follows:
Price of the green-gram : Rs. 82 per kg up to 2499 kg.

Rs. 81 per kg for orders between 2500 and 5000 kg.
Rs. 80 per kg for orders greater than 5000 kg.
Annual demand : 50,000 kg per year
Holding cost : 25% per unit per year of the price of the green-
gram
Ordering cost : Rs. 3,000 / order
a) Calculate the best quantity that SFPL should purchase.
b) Graphically represent the variation of total cost with order quantity.

Chapter 10

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Chapter 10

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CHAPTER 10

After reading this chapter, you will be able to

Inventory refers to stock of any item or resource used in an organization. Inventory

Firms keep inventory due to following reasons.

1. To maintain independence of operations

2. To cope up with uncertainties in product demand

3. To safeguard delays in shipment

4. To allow flexibility in production scheduling

5. To take advantage of economic purchase order size

6. To get price advantages

NEGATIVE ASPECTS OF INVENTORY

1. Poor quality of products

2. Hiding operational problems

4. Risk of product obsolescence and depreciation

5. Cost of maintaining inventory

1 . Holding (or carrying) costs

3. Setup (or production changeover) costs

INDEPENDENT VERSUS DEPENDENT DEMAND

customers are considered as independent demand items. Demand for dependent

INVENTORY MANAGEMENT SYSTEMS

Fixed Order Quantity Model

Figure 10.1: Variation of Inventory for Fixed Order Quantity Model

In deriving formula for economic order quantity, it is required to develop the

Total annual cos t Annual purchase cos t Annual ordering cos t

Then total annual cost is given by,

Q (OPT) Order Qty (Q)

Figure 10.2: Variation of Cost with Quantity Order

Deriving EOQ Calculus Method

For minimum TC,

2 Annual demand Order or setup cos t

This quantity is known as the Economic Order Quantity (EOQ).

Deriving the EOQ - Graphical Method

where, d = Average daily (weekly) demand

Example 10.1: Economic Order Quantity and the Reorder Point

2DS 2 1000 2000

The reorder point is

Fixed Order Model with Quantity Discounts

Example 10.2: Economic Order Quantity with Quantity Discounts

Find Qoptimal for different ranges of order quantities.

Figure 10.3: Cost Variation with Quantity Discounts

Fixed Order Quantity Model with Consumption during Production

Modified total cost equation

By replacing H by (1 d/p) H, Qoptimal can be written

Order Begin Time

Qopt 103.28 units

Reorder point is,

Safety Stock for Fixed Order Quantity Model

Figure 10.5: Stock-out due to Demand Uncertainty

Increased lead time

Figure 10.6: Stock-out due to Lead Time Uncertainty

Example 10.4: Safety Stock for Fixed Order Quantity Models

Service level (Probability of not stocking out) = 0.95

Corresponding z is found from standard normal distribution as shown in Figure 10.6

Figure 10.6: Z Value for Given Service Level

DL 2000 40000 42000 204.94

SS 1.64 204.93 336.1

R 100 5 336 836

Fixed Time Period Model

Figure 10.6: Variation of Inventory for Fixed Time Period Model

In this model, maximum inventory level is given by,

Order quantity = Maximum inventory level - Current inventory position

In deriving formula for economic order period, it is required to develop the

Annual purchase cost = Annual demand Cost per unit = D C

Then total annual cost is given by,