OPERATIONS MANAGEMENT

MEM-803
Dr. M Fahad
Associate Professor (IMD)
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1-2

Inventory Management
 Inventory
 Any stored resource used to satisfy a current or future need.
 Raw materials
 Work in Process
 Finished Goods
 MROs

 Main uses include:

 The decoupling function
 Storing resources
 Irregular supply and demand
 Quantity discounts
 Avoiding stockouts and shortages
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Inventory Management
 Inventory
 Following types of inventories are commonly used in industries
 Buffer
 Provides protection in the event of an abrupt demand change (downstream)
 Safety
 Protects from incapability in the upstream processes or suppliers
 Cycle
 Used for producing variety of products on the same equipment
 Anticipation
 Used to cope with seasonal demand rise
 Pipeline
 Occurs when the point of supply and point of demand are at a distance
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Inventory Models
 Inventory Models are used to
 Determine rules that management can use to minimize the costs
associated with maintaining inventory and meeting customer
demand.
 Answer the following questions

1. When should an order be placed for a product?

2. How large should each order be?

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Inventory Models
ABC Classification
Classifying inventory according to some measure of importance
and allocating control efforts accordingly.
A - very important
 are those 20 % or so of high-usage-value items
which account for around 80 % of the total usage High
value. A
Annual
B- mod. Important $ value B
 the next 30 % of items which often account for of items
around 10 % of the total usage value. C
Low
C - least important Low High
 comprising around 50 % of the total types of Percentage of Items
items stocked, probably only account for around
10 % of the total usage value of the operation.
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Inventory Models
Silicon Chips, Inc., maker of superfast DRAM chips, wants to categorize its 10
major inventory items (shown below) using ABC analysis.
Stock Annual Volume Unit Cost Annual % of $ % of Class
Number (Units) ($) Volume ($) Volume Volume
01036 100 8.5 850/- 0.37 1.2 C
01307 1200 0.42 504/- 0.2 14.0 C
10286 1000 90.0 90,000/- 38.8 11.7 A
10500 1000 12.5 12,500/- 5.4 11.7 B
10572 250 0.6 150/- 0.06 2.9 C
10867 350 42.86 15001/- 6.5 4.1 B
11526 500 154.0 77,000/- 33.2 5.8 A
12760 1550 17.0 26,350/- 11.3 18.1 B
12572 600 14.17 8502/- 3.7 7.0 C
14075 2000 0.6 1200/- 0.52 23.4 C
Total 8550 232,057/-
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Inventory Models

ABC Classification
 Other criteria than annual dollar volume may be
used
 Anticipated engineering changes
 Delivery problems
 Quality problems
 High unit cost
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Inventory Models

ABC Classification
 Policies employed may include
 More emphasis on supplier development for A items
 Tighter physical inventory control for A items
 More care in forecasting A items
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Inventory Models

 Independent demand
the demand for item is independent of the
demand for any other item in inventory
 Dependent demand
the demand for item is dependent upon the
demand for some other item in the inventory
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Inventory Models
Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
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Inventory Models
 Cost Components
 Unit Purchasing Cost
 This cost is simply the cost associated with purchasing a single unit.
 Typically, the unit purchasing cost includes the labor cost, overhead
cost, and raw material cost.
 Ordering and Setup Cost
 These costs do not depend on the size of the order.
 They typically include things like paperwork, billing or machine
setup time if the product is made internally.
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Inventory Models
 Holding or Carrying Cost
 This is the cost of carrying one unit of inventory for one time period.
 The holding costs usually includes storage cost, insurance cost, taxes
on inventory and others.
 Stockout or Shortage Cost
 When a customer demands a product and the demand is not met on
time, a stockout, or shortage, is said to occur.
 If they will accept delivery at a later date, we say the demands are
back-ordered.
 If they will not accept late delivery, we are in the lost sales case.
These costs are often harder to measure than other costs.
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Inventory Models
Holding or Carrying Cost
Cost (and Range) as a
Percent of Inventory
Category Value
Housing costs (including rent or depreciation, operating 6% (3 - 10%)
costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and insurance 11% (6 - 24%)
on inventory)
Pilferage, scrap, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
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Inventory Models
Inventory Models for Independent Demand

 Economic order quantity (EOQ)

 Economic production quantity (EPQ)
 Quantity discount model
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Inventory Models
 For the basic EOQ model to hold, certain assumptions are
required:
1. Only one product is involved.
2. Demand (D) is deterministic and occurs at a constant rate.
3. The purchasing cost (c) does not depend on the size of the
order.
4. If an order of any size (say Q units) is placed, an ordering
and setup cost S is incurred.
5. The replenishment time for each order is zero.
6. No shortages are allowed.
7. The cost per unit-year of holding inventory is H.
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Inventory Models

Inventory
Level
Q*

Average Inventory = Q/2

Reorder Point

Time

Lead Time
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Inventory Models
Q D
TC  H  S
2 Q
Cost

Q
Holding Cost H
2

D
Ordering Cost S
Q

Q*

Order Quantity (Q)

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Inventory Models

Q D
Total Costs = H* S*
2 Q
Take derivative with
H D
respect to Q =
S* 2 0
2 Q

H DS 2 DS 2 DS
 2 Q 
2
Q
2 Q H H
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Inventory Models
An Airlines uses 500 taillights per year. Each time an order for taillights
is placed, an ordering cost of $5 is incurred. Each light cost 40¢, and the
holding cost is 8¢/light/year. Assume that demand occurs at a constant
rate and shortages are not allowed. What is the EOQ? How many
orders will be placed each year? How much time will elapse between
the placement of orders?
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Inventory Models
 S = $5, H = $0.08/light/year, and D = 500 lights/year.

2(5)(500)
Q*   250
0.08

500
No. of Orders   2 / year
250
1
Time between orders   0.5 year  6months
2
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Inventory Models
A company works 50 weeks/year and has demand for an item which is
constant at 100 units/week. The cost of each unit is $20 and the
company aims for a 20% return on capital invested. Annual warehouse
costs are estimated to be 5% of the value of goods stored. The
purchasing department costs $45,000/year and sends out an average
of 2000 orders. Determine the optimal order quantity for the item, the
optimal time between orders and the minimum annual cost of carrying
the item. If an order arrives 1 week after its placement, determine the
reorder level.
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Inventory Models
 S = 45,000/2000 = $22.5/order
 H = (20% + 5%) x C = 0.25 x 20 = $5/unit.year
2(22.5)(50 100)
Q*   212.1
5
212.1
Time between orders   0.042 year  2.1weeks
5000

S  D H Q
Total cos t  C  D  
Q 2
 C  D  2.H .S .D  $101,060.6 / year
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Inventory Models
 S = 45,000/2000 = $22.5/order
 H = (20% + 5%) x C = 0.25 x 20 = $5/unit.year

Re order Level  L  D  100units

 That is, place an order of 212 units when the stock level reaches 100 units.
 What if the Lead Time is assumed to be 3 weeks?
Re order Level  L  D  300units
Re order Level  300  212  88units
Order is placed when the stock level reaches 88 units
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Inventory Models
Economic Production Quantity Model
1. Only one product is involved.
2. Demand (D) is deterministic and occurs at a constant rate.
3. The purchasing cost (c) does not depend on the size of the
order.
4. If an order of any size (say Q units) is placed, an ordering and
setup cost S is incurred.
5. Inventory builds up over a period of time after an order is
placed.
6. No shortages are allowed.
7. The cost per unit-year of holding inventory is H.
8. Used when units are produced and sold simultaneously
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Inventory Models
Economic Production Quantity (EPQ) Model

Part of inventory cycle during

which production (and usage) is
taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time
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Inventory Models
Economic Production Quantity (EPQ) Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory = (Average inventory level) x Holding cost

holding cost per unit per year

Average inventory = (Maximum inventory level)/2

level

Maximum = Total produced during – Total used during the

inventory level the production run production run
= pt – dt
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Inventory Models
Economic Production Quantity (EPQ) Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum = Total produced during – Total used during the

inventory level the production run production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level =p –d =Q 1–
p p p

Maximum inventory level Q d

Holding cost = ( )(H) = 1– H
2 2 p
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Inventory Models
Economic Production Quantity (EPQ) Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Setup cost = (D/Q)S

Holding cost = 1/2 HQ[1 - (d/p)]

(D/Q)S = 1/2 HQ[1 - (d/p)]

2DS
Q2 = H[1 - (d/p)]
2DS 2DS p
Q* = =
H[1 - (d/p)] H p-d
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Inventory Models
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. Determine
a. Optimal run size.
b. Minimum total annual cost for carrying and setup.
c. Cycle length (time) for the optimal run size.
d. Run time.
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Inventory Models
D = 48,000 wheels per year 2DS p
S = $45 Q*= H p-d
H = $1per wheel per year
p = 800 wheels per day 2(48000)45 800
Q*= 1 = 2400 Wheels
800-200
d = 200 wheels per day

Maximum Q* Q* d = 2400 1 – 200

inventory level =p –d = Q* 1–
p p p 800

Q max= 1800 Wheels

Maximum inventory level Qmax d
Holding cost = ( )(H) = 2 1 – H = $900/-
2 p

Setup cost =(D/Q)S = (48000/2400)45 = $900/-

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Inventory Models

Total Cost = Setup cost + Holding Cost = $1800/-

Cycle Length = Q*/d = 12 days

Run Time = Q*/p = 3 days

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Inventory Models
 Up to now, we have assumed that the annual purchase
cost does not depend on the order size.
 In real life, however, suppliers often reduce the unit
purchasing price for large orders. Such price reductions
are referred to as quantity discounts.
 The approach used previously is no longer valid and we
need a new approach to find the optimal quantity.
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Inventory Models

TCU1

TCU2

Cost
c1, if Q  Qd
c c1  c2
c2 , if Q  Qd

Quantity

SD HQ
TCU 1 (Q)  Dc1   , Q Q d
Q 2
TCU (Q) 
SD HQ
TCU 2 (Q)  Dc2   , Q Q d
Q 2
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Inventory Models
TCU1 TCU1

TCU2
Cost

TCU2

Cost
Q* Q*

Qd Qd
Qd
Zone 1 Zone 2 Zone 3
Zone 1 Zone 2 Zone 3
Quantity
Quantity

If Qd is in Zone 1 or 3, use Q*
If Qd is in Zone 2, use Q* = Qd
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Inventory Models
 LubeCar specializes in fast automobile oil change. The garage buys car oil in
bulk at $3 per gallon. A discount price of $2.5 is available on the purchase
of 1000 gallons. The garage services approximately 150 cars per day and
each oil change takes 1.25 gallons. LubeCar stores bulk oil at the cost of
$0.02 per gallon per day. Cost of placing an order is $20. Lead time for
delivery is 2 days. Determine the optimal inventory policy.
 Solution
 Demand (D) = 150 x 1.25 = 187.5 gallons/day
 Holding cost (H) = $0.02/gallon.day
 Lead Time = 2 days
 C1 = $3, C2 = $ 2.5, Qd = 1000 gallons
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Inventory Models
 Solution
2 S  D 2  20 187.5
Q*    612.37 gallons
H 0.02

Since Q* < Qd

SD HQ
TCU 2 (Q)  TCU 1 (Q*)  Dc1    574.75
Q 2
SD HQ
TCU 2 (Q)  Dc2    574.75
Q 2
Q  10564.25

Re order Po int  LxD  2 x 187.5  375 gallons

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Inventory Models
 The maintenance department of a large hospital uses about 816 cases
of liquid cleanser annually. Ordering costs are $12, carrying costs are
$4 per case a year, and the new price schedule indicates that orders
of less than 50 cases will cost $20 per case, 50 to 79 cases will cost
$18 per case, 80 to 99 cases will cost $17 per case, and larger orders
will cost $16 per case. Determine the optimal order quantity and the
total cost.
 Solution
 Demand (D) = 816/year
 Holding cost (H) = $4/case.year, S = $12/order
 Lead Time = 2 days
 C1 = $20 (Q<50), C2 = $ 18 (50≤Q<80), C3 = $ 17 (80≤Q<100),
C4 = $ 16 (100≤Q)
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Inventory Models
 Solution
2 S  D 2  816 12
Q*    70cases
H 4
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Inventory Models
 Solution
2 S  D 2  816 12
Q*    70cases
H 4

SD HQ
TCU 70(Q)  Dc2    $14,968 / 
Q 2
SD HQ
TCU 80(Q)  Dc3    $14,154 / 
Q 2
SD HQ
TCU 100(Q)  Dc4    $13,354 / 
Q 2
Q*  100cases
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Inventory Models
 A machine shops holds an inventory of special drill bits for a variety of
procedures. The average usage of drill bits is 780 per year. Ordering
costs are $15 and holding costs are $3 per bit per year. The new price
list indicates that orders of fewer than 73 bits will cost $60 per bit, 73
through 144 bits will cost $56 per bit, and orders of more than 144
bits will cost $53 per bit. Determine the optimal order quantity and the
total cost.
 Solution
 Demand (D) = 780/year
 Holding cost (H) = $3/bit.year, S = $15/order
 C1 = $60 (Q<73), C2 = $56 (73≤Q≤144), C3 = $53 (145≤Q)
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Inventory Models
 Solution
2S D 2  780  15
Q*    89bits
H 3

SD HQ
TCU 73(Q )  Dc2    $43,945 / 
Q 2
SD HQ
TCU 145(Q )  Dc3    $41,638 / 
Q 2

Q*  145bits
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Inventory Models
Safety Stock
 Used when demand is not constant or certain
 Use safety stock to achieve a desired service level and avoid
stockouts
ROP = d x L + ss
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Inventory Models
Safety Stock
Order-cycle service level
 Probability that demand during lead time does not exceed on-hand
inventory
 On-hand stock is adequate to meet demand.
 A service level of 95 percent implies
 demand does not exceed supply 95% of the time.
 If the company places 20 orders annually, the demand will not exceed the on-
hand quantity in 19 of the 20 replenishment lead times.
 Stockout risk = (1 – the order-cycle service level), or 5% in the preceding
example.
Annual stockout costs = the sum of the units short x the probability x the
stockout cost/unit x the number of orders per year
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Inventory Models
David Rivera Optical has determined that its reorder point for eyeglass frames
is 50 (d * L) units. Its carrying cost per frame per year is $5, and stockout (or
lost sale) cost is $40 per frame. The store has experienced the following
probability distribution for inventory demand during the lead time (reorder
period). The optimum number of orders per year is six.
ROP = 50 units Number of Units Probability
Stockout cost = $40 per frame
30 .2
Orders per year = 6
Carrying cost = $5 per frame 40 .2
per year ROP  50 .3
60 .2
70 .1
1.0
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Inventory Models
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Safety Additional Total

Stock Holding Cost Stockout Cost Cost

20 (20)($5) = $100 $0 $100

10 (10)($5) = $50 (10)(.1)($40)(6) = $240 $290

0 $0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
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Inventory Models

Use prescribed service levels to set safety stock when the cost of
stockouts cannot be determined
ROP = demand during lead time + Zsdlt
where Z = number of standard deviations
sdlt = standard deviation of demand during
lead time
Safety Stock (SS) depends upon following factors
 The average demand rate and average lead time.
 Demand and lead time variability.
 The desired service level.
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Inventory Models

Minimum demand during lead time

Inventory level

Maximum demand during lead time

Mean demand during lead time

ROP = dL + safety stock
ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time

Safety stock

0 Lead
time Time
Place Receive
order order
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Inventory Models

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP Quantity

demand

Safety
stock
0 z
Number of
standard deviations
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Inventory Models
Suppose that the owner of the campus café has determined that demand
for tea during lead time averages 500 cups. Ahmed, the owner, believes
the demand during lead time can be described by a normal distribution
with a mean of 5000 cups and a standard deviation of 30 cups. Ahmed
is willing to accept a stockout risk of approximately 4 percent. Calculate
how much safety stock Ahmed should hold. Also determine the reorder
point.
Find the appropriate z value associated with the order-cycle service level
(1 – 0.04 = 0.9600)
Using Appendix I, for an area under the curve of 96%, the Z = 1.75

Safety stock = Zsdlt = 1.75(30) = 52.5 cups

Reorder Point = 500 + 52.5 = 552.5 cups

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Inventory Models
A hospital stocks a resuscitation kit that has a normally distributed
demand during the reorder period. The mean (average) demand during
the reorder period is 350 kits, and the standard deviation is 10 kits. The
hospital administrator wants to follow a policy that results in stockouts
only 5% of the time.
(a) What is the appropriate value of Z?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?
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Inventory Models

Average demand = d = 350 kits

Standard deviation of demand during lead time = sdlt = 10 kits
5% stockout policy (service level = 95%)

Using Appendix I, for an area under the curve of 95%, the Z = 1.65

Safety stock = Zsdlt = 1.65(10) = 16.5 kits

Reorder point = expected demand during lead time +

safety stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
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Inventory Models

When data on demand during lead time is not available,

there are other models available

1. When demand is variable and lead time is constant

2. When lead time is variable and demand is constant
3. When both demand and lead time are variable
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Inventory Models
Demand is variable and lead time is constant
ROP = (dx LT) + Z sd LT

Lead time is variable and demand is constant

ROP = (dx LT) + Z d sLT
Both demand and lead time are variable
ROP = (dx LT) + Z d sdLT
where sd = standard deviation of demand per day
sLT = standard deviation of lead time in days
sdLT = (average lead time x sd2)
+ (average daily demand) 2slt2
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Inventory Models
A hotel uses an average of 50 jars of a special sauce each
week. Weekly usage of sauce has a standard deviation of 3
jars. The manager is willing to accept no more than a 10
percent risk of stockout during lead time, which is two weeks.
Assume the distribution of usage is normal.
a. Determine the value of z.
b. Determine the ROP.
d = 50, sd = 3, LT = 2 weeks, risk = 10%, service level = 90%

Z = 1.28 (for 90% service level)

ROP = 50x2 + 1.28x3x 2 = 105.43 Jars

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Inventory Models
The hotel uses approximately 600 bars of soap each day, and this tends
to be fairly constant. Lead time for soap delivery is normally distributed
with a mean of six days and a standard deviation of two days. A service
level of 90 percent is desired.
a. Find the ROP.
b. How many days of supply are on hand at the ROP?

d = 600, LT = 6 days, sLT = 2 days, risk = 10%, service level = 90%

Z = 1.28 (for 90% service level)
a) ROP = 600x6 + 1.28x2x600 = 5136

b) Days = ROP/d = 5136/600 = 8.56 days

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Inventory Models
The hotel also replaces broken glasses at a rate of 25 per day. In the
past, this quantity has tended to vary normally and have a standard
deviation of three glasses per day. Glasses are ordered from a supplier
whose lead time is normally distributed with an average of 10 days and
a standard deviation of 2 days. What ROP should be used to achieve a
service level of 95 percent?

d = 25/day, LT = 10 days, sd = 3/day, sLT = 2 days, service level = 95%

Z = 1.65 (for 95% service level)
ROP = 25x10 + 1.65x 10(3)2x(25)2(2)2 = 334 glasses