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MATERIAL MANAGEMENT
-INVENTORY-

Learning Objectives

When you complete this chapter you should be

able to:
1. Understand types of inventory , inventory
function and inventory classification system
2. Explain and use the EOQ model:
- basic EOQ
- EPQ
- Discount quantity model
3. Compute a reorder point (ROP) and safety
stock (SS)

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INVENTORY
•Inventory
•A stock or store of goods

•Independent demand items

•Items that are ready to be sold or used

TYPES OF INVENTORY
• Raw materials and purchased parts
• Work-in-process (WIP)
• Finished goods (FG) inventories or merchandise
• Maintenance and repairs (MRO) inventory, tools and
supplies
• Goods-in-transit to warehouses or customers (pipeline
inventory)

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INVENTORY FUNCTIONS
Inventories serve a number of functions such as:
1. To meet anticipated customer demand
2. To smooth production requirements
3. To decouple operations
4. To protect against stockouts
5. To take advantage of order cycles
6. To hedge against price increases
7. To take advantage of quantity discounts

INVENTORY MANAGEMENT
Management has two basic functions
concerning inventory:
1. Establish a system for tracking items in
inventory – bar code, RFID

2. Make decisions about

•When to order
•How much to order

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EFFECTIVE INVENTORY MANAGEMENT

Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
• holding costs (warehouse rental/manpower)
• ordering costs (transportation/currency)
• shortage costs (backlog)
5. A classification system for inventory items

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ABC CLASSIFICATION SYSTEM

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

• A items (very important)

• 10 to 20 percent of the number of items in inventory and
about 60 to 70 percent of the Annual Volume Value (AVV)

• B items (moderately important)

• about 20 to 25 percent of the AVV

• C items (least important)

• 50 to 60 percent of the number of items in inventory but only
about 10 percent of the AVV

Tutorial ABC Classification

Calculate Annual Volume

Value

Annual Demand x
Cost/unit

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Annual Cost/Unit Annual

Items Demand (RM) Volume Value
SAGA 3,000 50
WIRA 4,000 12
GEN2 1,500 45
LENEO 6,000 10
RIA 1,000 20
MYVI 500 500
ALZA 300 1,500
LIMO 600 20
BENZ 1,750 10
EZORA 2,500 5

Rearrange the annual volume value from highest to lowest

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Start to classify using A =60 to 70 percent of the AVV

B= 20 to 25 percent of the AVV
C= less than 10 percent of the AVV
Annual
Annual Cost/Unit Volume
Items Demand (RM) Value %
ALZA 300 1,500
MYVI 500 500
SAGA 3,000 50
GEN2 1,500 45
LENEO 6,000 10
WIRA 4,000 12
RIA 1,000 20
BENZ 1,750 10
EZORA 2,500 5
LIMO 600 20

Calculate percentage annual volume value

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HOW MUCH TO ORDER: 3 Models

1. The basic Economic Order Quantity model

(EOQ)
2. The economic Production Order Quantity
model (POQ)
3. The Quantity Discount model

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1. Basic EOQ Model

The basic EOQ model is used to find a fixed order quantity
that will minimize total annual inventory costs

Assumptions
Only one product is involved
Annual demand requirements are known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single delivery
There are no quantity discounts

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THE INVENTORY CYCLE

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time

Inventory Usage Over Time

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TOTAL ANNUAL INVENTORY COST

Total Cost  Annual Holding Cost  Annual Ordering Cost
Q D
 H  S
2 Q
where
Q  Order quantity in units
H  Holding (carrying) cost per unit
D  Demand, usually in unit per year
S  Ordering cost

Holding/Carrying cost – insurance, storage, store workers, rental

warehouse, Tax, material handling
Ordering cost – clerk (admin), documents, shipment (transportation)

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GOAL: TOTAL COST MINIMIZATION

Q D
TC  H S
2 Q
Curve for total
cost of holding
and setup
Q
Minimum
total cost
H
2
Annual cost

Holding cost
curve

D
Ordering (or setup) S
cost curve Q
Optimal Order quantity
Table 11.5
Q* order
quantity

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DERIVING EOQ
• Using calculus, we take the derivative of the total cost function and set the
derivative (slope) equal to zero and solve for Q.
• The total cost curve reaches its minimum where the carrying and ordering
costs are equal.

2 DS 2(annual demand)(order cost)

Q*  
H annual per unit holding cost
Optimal order quantity is found when annual
setup/order cost equals annual holding cost

Solving for Q*

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EOQ Example
Determine optimal number of needles to order (Q*)
D = 1,000 units per year
S = RM10 per order
H = RM0.50 per unit per year

2DS
Q* =
H

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Determine expected number of orders (N)

D = 1,000 units per year Q* = 200 units
S = RM10 per order
H = RM0.50 per unit per year

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

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Determine time expected between orders (T)

D = 1,000 units per year Q* = 200 units
S = RM10 per order N = 5 orders per year
H = RM0.50 per unit per year

Number of working
Expected days per year
time between = T =
orders N

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Determine Minimum Total Inventory Cost (TC)

D = 1,000 units per year Q* = 200 units
S = RM10 per order N = 5 orders per year
H = RM0.50 per unit per year T = 50 days

Total annual inventory cost = Holding cost +Ordering cost

Q D
TC  H S
2 Q

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TUTORIAL EOQ
Sep 2014

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Assignment EOQ

Mac 2017

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Assignment

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2. Production Order Quantity (POQ)

Assumptions

Only one product is involved

Annual demand requirements are known
Usage rate is constant
Usage occurs continually, but production occurs
periodically
The production rate is constant
Lead time does not vary
There are no quantity discounts
Components based product – motorcycle, electronics
Factory produces the components 12-26

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POQ 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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POQ TOTAL INVENTORY COST

TC = Carrying/Holding Cost + Setup Cost

I  D
  max  H  S
 2  Q
where
I max  Maximum inventory
Q
p = Production rate  p  u 
u = Usage rate p
Setup cost – preparing machine for production,
clean-up cost, adjustment cost, test run

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POQ
2 DS p
Q*p 
H p u

Production rate of the components must be higher

than the usage rate of the components
p>u
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Maximum Inventory Level

Total Inventory Cost for POQ

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Production of components Assembly of components

(Producion rate) (Usage Rate)

p > u
Always provided Can be found using D,
must have working days
per year

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POQ Model Example

D = 1,000 units per year p = 8 units per day

S = RM10
H = RM0.50 per unit per year
Note: D = 1,000 units and operation day 250 days

u=

2 DS p
Q *p  =
H p u

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Tutorial POQ
MODENAS is a Malaysian motor manufacturer. At its
largest manufacturing facility, in Gurun, the company
produces subcomponents at a rate of 300 per day, and
it uses these subcomponents at a rate of 12,500 per
year (of 250 working days). Holding costs are RM 2 per
item per year, and ordering/setup costs are RM 30 per
order.

a. What is the economic order/run quantity?

b. How many production runs per year will be made?

c. What will be the maximum inventory level?

d. What is the annual cost of ordering and holding

inventory?
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Order

Produce/run

Production of components Assembly of components

(Usage of components to assemble)

p > u
Can be found using D,
Always provided
must have working days
per year

Run length = Q*
Order cycle = Q*
p
u

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Assignment POQ
Mac 2016

c. What will be the maximum inventory

level?

d. What is the total inventory cost?

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3. QUANTITY DISCOUNT MODELS

 Reduced prices are often available when
larger quantities are purchased
 Trade-off is between reduced product cost
and increased holding cost

Total Inventory cost = Ordering cost + Holding cost + Production cost

D Q H
TC = S+ + PD
Q 2

P – Price per unit

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QD

12-38

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QD Models

Steps in analyzing a quantity discount

1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost

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QD Example

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Calculate Q* for every discount

2DS
Q* =
H
1-199
Q1* =

200 to 599
Q2* =

600 & over

Q3* =

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D QH
TC = S+ + PD
Q 2

Annual Annual Annual

Ordering Holding Product
P Q* Cost Cost Cost Total

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QD Tutorial 1 Mac 2017

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Calculate Q* for every discount

2DS
Q* =
1-49 H
Q1* =

50 to 99
Q2* =

100 & more

Q3* =

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Calculate Q* for every discount

2DS
Q* =
1-69 H
Q1* =

70 to 139
Q2* =

140 & more

Q3* =

45

D QH
TC = S+ + PD
Q 2

Annual Annual
Ordering Holding Annual
P Q* Cost Cost Product Cost Total

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Annual Annual
Ordering Holding Annual
P Q* Cost Cost Product Cost Total

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Example: QD Models with I

Toy store has been given a quantity discount. Ordering

Cost is RM49 per order, annual demand is 5000 toy cars
and inventory carrying charge as a percent of cost, I is
20% or 0.2. What order quantity will minimize the total
inventory cost?
Discount
Discount Quantity Price (P)
0 to 999 $5.00
1,000 to 1,999 $4.80

2,000 and over $4.75

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Discount Discount Price

Quantity (P)
0 to 999 $5.00
1,000 to 1,999 $4.80
2,000 and over $4.75

Calculate Q* for every discount 2DS

Q* =
IP
0 to 999
Q1* =

1,000 to 1,999
Q2* =

2,000 & over

Q3* =

49

D QH
TC = S+ + PD
Q 2

Annual Annual Annual

Unit Ordering Holding Product
Price Q* Cost Cost Cost Total

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QD Tutorial
Oct 2016

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D QH
TC = S+ + PD
Q 2

Annual Annual Annual

Unit Ordering Holding Product
Price Q* Cost Cost Cost Total

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WHEN TO REORDER: REORDER POINT

ROP (SIGNAL)
• When the quantity on hand of an item drops to this
amount, the item is reordered.

• Determinants of the reorder point

1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

Lead time – length of time between order

and stock arrives (days)

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REORDER POINT (ROP): Under Certainty without

safety stock
ROP  d  LT (without safety stock)
where
d  Demand rate (units per period, per day, per week)
LT  Lead time (in same time units as d )

Supplier tip top – reliable

Demand consistent u
Annual Demand (D)
d
Number of working days in a year
12-56

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Example ROP

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REORDER POINT: with safety stock

• Demand or lead time uncertainty creates the possibility that
demand will be greater than available supply
• To reduce the likelihood of a stockout, it becomes necessary to
carry safety stock

Safety stock certainty

• Stock that is held in excess of expected demand due to
variable demand and/or lead time
ROP  d (LT)  Safety Stock
ROP  d ( LT )  z dLT
Supplier problem– not reliable
Demand not consistent
12-58

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How Much Safety Stock? (3 conditions)

12-59

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Q*

ROP

SS

LT

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Condition 1: Demand & Lead Time constant, d &

LT

ROP =(d x LT)+ ZdLT

where dLT = standard deviation of demand during Lead Time

Daily demand, d =60 units

Lead time, LT = 6 days
Standard deviation demand during lead time, dLT = 10
units (benda)
95% service level desired z=1.645

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Condition 2:Demand Variable, LT constant,

when variable use average demand, d & d

Where = average daily demand (variable)

d= standard deviation of demand per day
(benda)

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for 90% Z = 1.28

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Where = Average Lead Time (Variable Lead Time)

LT= standard deviation of lead time in days (masa)

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Z= 2.055

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Condition 1: d & LT constant, Std Dev demand during Lead time (benda)

Demand
variable, Std
Dev = benda

Condition 2

Condition 3

Lead Time
variable, Std
Dev = masa

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ROP Tutorial Jun 2018

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ROP Tutorial
Oct 2016

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ROP Tutorial
Jan 2018

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EOQ & ROP Example

Perodua Auto Shop services and repairs a Perodua brand automobile. The company uses
oil filters throughout the year. The shop operates 52 weeks per year and weekly demand
is 150 filters. The company estimates that the ordering costs is RM20 and the lead time
is two weeks. The annual holding cost rate is RM3 per oil filter.

a. Determine the economic order quantity.

b. What is the number of order placed per year?
c. Calculate total annual cost.

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Determine the reorder point.

The company estimates that the demand and lead time is described by a
normal distribution with a standard deviation of 50 filters. The
company is willing to accept a stockout risk of approximately 2.5%,
calculate the safety stock. (Given, number of standard deviation, z, at
2.5% stockout risk is 1.96)

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