Chapter 11

Inventory
Management

Types of Inventories
Raw materials & purchased parts
Incoming students

Work in progress
Current students

Finished-goods inventories
(manufacturing firms) or merchandise (retail
stores)
Graduating students

Replacement parts, tools, & supplies

Goods-in-transit to warehouses or customers
Students on leave

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

Inventory performance measures

and levers
Inventory level
Low or high

Customer service levels

Can you deliver what customer wants?
Right goods, right place, right time, right quantity

Inventory turnover
Cost of goods sold per year / average inventory investment

Inventory costs, more will come

Costs of ordering & carrying inventories

Decisions: Order size and time

4

Inventory Counting Systems

A physical count of items in inventory

Periodic/Cycle Counting System:

Physical count of items made at
periodic intervals
How much accuracy is needed?
When should cycle counting be performed?
Who should do it?

Continuous Counting System

System that keeps track of
removals from inventory
continuously, thus monitoring
current levels of each item

Inventory Counting Systems (Contd)

Two-Bin System - Two containers of inventory;
reorder when the first is empty
Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached

0
214800 232087768

RFID: Radio frequency identification

6

Key Inventory Terms

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

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
8

ABC Classification System

Classifying inventory according to some
measure of importance and allocating control
efforts accordingly.
Importance measure= price*annual sales

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

High
Annual
$ volume
of items

A
B
C

Low
Few

Many

Number of Items

Inventory Models
Fixed Order Size - Variable Order Interval Models:
1. Economic Order Quantity, EOQ
2. Economic Production Quantity, EPQ
3. EOQ with quantity discounts
All units quantity discount
3.1. Constant holding cost
3.2. Proportional holding cost

4. Reorder point, ROP

Lead time service level
Fill rate

Fixed Order Interval - Variable Order Size Model

5. Fixed Order Interval model, FOI

Single Order Model

6. Newsboy model

10

1. EOQ Model
Assumptions:

Only one product is involved

Annual demand requirements known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single delivery
Infinite production capacity
There are no quantity discounts

11

The Inventory Cycle

Profile of Inventory Level Over Time

Usage
rate

Quantity
on hand
Reorder
point

Receive
order

Place Receive
order order

Place Receive
order order

Time

Lead time

12

Average inventory held

Length of an inventory cycle
From one order to the next = Q/D

Inventory held over entire inventory cycle

Area under the inventory level = Q (Q/D)

Average inventory held

= Inventory held over a cycle / cycle length
= Q/2

13

Total Cost

Annual
Annual
Total cost = carrying + ordering
cost
cost
TC =

Q
H
2

DS
Q

14

Figure 11-4

15

Cost Minimization Goal

Annual Cost

The Total-Cost Curve is U-Shaped

Q
D
TC H S
2
Q

Ordering Costs
QO (optimal order quantity)

Order Quantity
(Q)

16

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.
Q OPT =

2DS
=
H

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost

The total cost curve reaches its minimum where

the carrying and ordering costs are equal.

Total cost(Q EOQ) 2 DSH

17

EOQ example
Demand, D = 12,000 computers per year.
Holding cost, H = 100 per item per year. Fixed cost, S =
$4,000/order.
Find EOQ, Cycle Inventory, Optimal Reorder Interval and
Optimal Ordering Frequency.

EOQ = 979.79, say 980 computers

Cycle inventory = EOQ/2 = 490 units
Optimal Reorder interval, T = 0.0816 year = 0.98 month
Optimal ordering frequency, n=12.24 orders per year.

18

Optimal Quantity is robust

19

Total Costs with Purchasing Cost

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

DS
Q

PD

Note that P is the price.

20

Cost

Total Costs with PD

Adding Purchasing cost

doesnt change EOQ

TC with PD

TC without PD

PD

EOQ

Quantity

21

2. Economic Production Quantity

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
This corresponds to producing for an order with
finite production capacity

22

Economic Production Quantity Assumptions

Only one item is involved

Annual demand is known
Usage rate is constant
Usage occurs continually

Production rate p is constant

Lead time does not vary
No quantity discounts

23

Usage

Production
& Usage

Production
& Usage

Economic Production Quantity

Usage
In
v

en

to
ry

Le
v

el

24

Average inventory held

p-D
Q/p

(Q/p)(p-D)

Time

Q/D
Average inventory held=(1/2)(Q/p)(p-D)
Total cost=(1/2)(Q/p)(p-D)H+(D/Q)S
Q

2 DS
H

p
pD

25

EPQ example
Demand, D = 12,000 computers per year.
p=20,000 per year. Holding cost, H = 100 per
item per year. Fixed cost, S = $4,000/order.
Find EPQ.

EPQ = EOQ*sqrt(p/(p-D))
=979.79*sqrt(20/8)=1549 computers
26

3. All unit quantity discount

Cost/Unit
$3

$2.96

$2.92

Two versions
Constant H
Proportional H

5,000 10,000
Order Quantity
27

3.1.Total Cost with Constant Carrying Costs

Total Cost

TCa
TCb
TCc

Decreasing
Price

Annual demand*discount

EOQ

Quantity

28

3.1.Total Cost with Constant Carrying Costs

Total Cost

TCa
TCb
TCc

Decreasing
Price

Annual demand*discount

EOQ

Quantity

29

Example Scenario 1
Total Cost

Price a > Price b > Price c

TCa
TCb
TCc

Q*=EOQ

Quantity

30

Example Scenario 2
Total Cost

Price a > Price b > Price c

TCa
TCb
TCc

EOQ

Q*

Quantity

31

Example Scenario 3

Total Cost

Price a > Price b > Price c

TCa
TCb
TCc

EOQ

Q*

Quantity

32

Example Scenario 4

Total Cost

Price a > Price b > Price c

TCc
TCa
TCb

Q*=EOQ

Quantity

33

Total Cost

3.1. Finding Q with all units discount with

constant holding cost
Note all the price ranges have the same EOQ.
Stop if EOQ=Q1 is in the lowest cost range (highest
quantity range), otherwise continue towards
quantity break points which give lower costs

2 DS
Q1
H

Quantity

34

All-units quantity discounts

Constant holding cost
A popular shoe store sells 8000 pairs per year. The
fixed cost of ordering shoes from the distribution
center is $15 and holding costs are taken as
$12.5 per shoe per year. The per unit purchase
costs from the distribution center is given as
C3=60, if 0 < Q < 50
C2=55, if 50 <= Q < 150
C1=50, if 150 <= Q

where Q is the order size. Determine the optimal

order quantity.
35

Solution

There are three ranges for lot sizes in this problem:

(0, q2=50),
(q2=50, q1=150)
(q1=150,infinite).
2(15)(8000)
EOQ
138.6
Holding costs in all there ranges of shoe prices
12.5
are given as H=12.5,
EOQ is not feasible in the lowest price range because
138.6 < 150.
The order quantity q1=150 is a candidate with cost
TC(150)=8000(50)+8000(15)/150+(12.5)(150)/2
=401,900
Let us go to a higher cost level of (q2=50, q1=150).
EOQ=138.6 is in the appropriate range, so it is another candidate
with cost
TC(138.6)=8000(55)+8000(15)/138.6+(12.5)(138.6)/2
=441,732
Since TC(150) < TC(132.1), Q=150 is the optimal solution.
Remark: In these computations, we do not need to compute
TC(50), why? Because TC(50) >= TC(132.1).

36

Total Cost

3.2. Summary of finding Q with all units

discount with proportional holding cost
Note each price range has a different EOQ.
Stop if Q1=EOQ of the lowest price feasible
Otherwise continue towards higher costs until an EOQ
becomes feasible.
In each price range, evaluate the lowest cost.
Lowest cost is either at an EOQ or price break quantity

Pick the minimum cost among all evaluated

2 DS
Q1
H1

Example: Q1
feasible stop

1
Quantity

37

Total Cost

3.2. Finding Q with all units discount with

proportional holding cost

2 DS
Q1
H1

1
Q2

2 DS
H2

Example: Q1 infeasible, Q2
feasible, Break point 1 is
selected since TC1 < TC2
Quantity

38

Total Cost

3.2. Finding Q with all units discount with

proportional holding cost
Stop if 1 is feasible, otherwise
continue towards higher costs until a
EOQ becomes feasible. Evaluate
cost at all alternatives

1
Quantity

39

All-units quantity discounts

Proportional holding cost
A popular shoe store sells 8000 pairs per year. The
fixed cost of ordering shoes from the distribution
center is $15 and holding costs are taken as
25% of the shoe costs. The per unit purchase
costs from the distribution center is given as
C3=60, if 0 < Q < 50
C2=55, if 50 <= Q < 150
C1=50, if 150 <= Q

where Q is the order size. Determine the optimal

order quantity.
40

Solution

There are three ranges for lot sizes in this problem:

(0, q2=50),
(q2=50, q1=150)
(q1=150,infinite).
2(15)(8000)
Holding costs in there ranges of shoe prices
EOQ2
132.1
are given as
13.75
H3=(0.25)60=15,
2(15)(8000)
H2 =(0.25)55=13.75
EOQ1
138.6
12.5
H1 =(0.25)50=12.5.
EOQ1 is not feasible because 138.6 < 150.
The order quantity q1=150 is a candidate with cost
TC(150)=8000(50)+8000(15)/150+(0.25)(50)(150)/2
=401,900
Let us go to a higher cost level of (q2=50, q1=150).
EOQ2=132.1 is in the appropriate range, so it is another candidate with
cost
TC(132.1)=8000(55)+8000(15)/132.1+(0.25)(55)(132.1)/2
=441,800
Since TC(150) < TC(132.1), Q=150 is the optimal solution.
We do not need to compute TC(50) or EOQ3, why?

41

Types of inventories (stocks) by function

Deterministic demand case
Anticipation stock
For known future demand

Cycle stock
For convenience, some operations are performed occasionally and
stock is used at other times
Why to buy eggs in boxes of 12?

Pipeline stock or Work in Process

Stock in transfer, transformation. Necessary for operations.
Students in the class

Stochastic demand case

Safety stock
Stock against demand variations

42

4. When to Reorder with EOQ Ordering

Reorder Point - When the quantity on hand of
an item drops to this amount, the item is
reordered. We call it ROP.

Safety Stock - Stock that is held in excess of

expected demand due to variable demand rate

and/or lead time. We call it ss.

(lead time) Service Level - Probability that

demand will not exceed supply during lead time.

We call this cycle service level, CSL.

43

Optimal Safety Inventory Levels

inventory
An inventory cycle

Q
ROP
time
Lead Times
Shortage
44

Quantity

Safety Stock

Maximum probable demand

during lead time
Expected demand
during lead time

ROP
Safety stock
LT

Time

45

Inventory and Demand during Lead Time

ROP

Inventory

0
LT

Demand
During LT

Upside
down

Inventory=
ROP-DLT

ROP

DLT: Demand
During LT

0
46

0
ROP

Upside
down

Shortage=
DLT-ROP

ROP

Shortage
LT
Demand
During LT

Shortage max{0, ( DLT ROP)}

DLT: Demand During LT

Shortage and Demand during Lead Time

47

Cycle Service Level

Cycle service level: percentage of cycles with shortage
For example consider 10 cycles :
11 0 111 0 1 0 1
CSL
Write 0 if a cycle has shortage, 1 otherwise
10
CSL 0.7
CSL 0.7 Probability that a single cycle has sufficient inventory
[Sufficient inventory] [Demand during lead time ROP]

48

DLT : Demand during lead time

LT and demand may be uncertain.
D Average demand per period

D2 Variance of demand
L Average lead time in number of periods
2
LT
Variance of lead time

Expected value of the demand during lead time

LT

E ( Di ) ( L)( D)
i 1

Variance of the demand during lead time

LT

2
2
Var ( Di ) L D D 2 LT
DLT
i 1

49

Reorder Point

Service level

Risk of
a stockout

Probability of
no stockout
Expected
demand
0

ROP

Quantity

Safety
stock
z

z-scale

ROP = E(DLT) + z DLT

50

Finding safety stock from cycle service

level CSL
Note we use normal density for the demand
during lead time
2
CSL P( DLT ROP) P( Normal ( L D, DLT
) ROP)

ROP L D
P( z
)
DLT

z : Standard normal variable

ROP L D
normsinv(CSL)
DLT
ROP L D ss DLT normsinv(CSL)
The excel function normsinv has default values of 0 and 1 for the mean and
standard deviation. Defaults are used unless these values are specified.

51

Example: Safety inventory vs. Lead time

variability
D = 2,500/day; D = 500
L = 7 days; CSL = 0.90
Normsinv(0.9)=1.3, either from table or Excel
If LT=0, DLT=sqrt(7)*500=1323
ss=1323*normsinv(0.9)=1719.8
ROP=(D)(L)+ss=17500+1719.8
If LT=1, DLT=sqrt(7*500*500+2500*2500*1)=2828
ss=2828*normsinv(0.9)=3676
ROP=(D)(L)+ss=17500+3676

52

Expected shortage per cycle

First let us study shortage
during the lead time
Expected shortage E (0, max( DLT ROP))

( D ROP) f

( D)dD where f D is pdf of DLT.

D ROP

Ex:

d1 9 with prob p1 1/4

ROP 10, D d 2 10 with prob p2 2/4 , Expected Shortage?

d 11 with prob p 1/4
3
3

Expected shortage max{0, ( d i ROP )} pi

i 1

11

(d ROP)}P( D d )

d 10

1
2
1 1
max{0, (9 - 10)} max{0, (10 - 10)} max{0, (11 - 10)}
4
4
4 4

53

Expected shortage per cycle

Ex:
ROP 10, D Uniform(6,12), Expected Shortage?
D 12

1 10 2

1
1 D2
1 12 2
Expected shortage ( D 10) dD
10 D

10(12)
10(10)
6
6 2
6 2
6 2

D 10
D 10
172 - 170 2
12

If we assume that DLT is normal,

ROP D L
Let z
then E (max(0, DLT ROP )) DLT E ( z ) use Table 11 - 3.
DLT

54

Example: Finding expected shortage per cycle

Suppose that the demand during lead time has
expected value 100 and stdev 30, find the
expected shortage if ROP=120.
z=(120-100)/30=0.66.
E(z)=0.153 from Table 11-3.
Expected shortage = 30*0.153=4.59

55

Fill rate
Fill rate is the percentage of demand filled from the
stock
In a cycle
Fill rate = 1-(Expected shortage during LT) / Q

For normally distributed demand

Expected shortage per cycle
Demand per cycle
E( z)
1 DLT
Q
Expected number of units short per year D * (1 Fill rate)
Fill rate 1

DLT E ( z )
Q

56

Example: computing the fill rate

Suppose that the demand during lead time has
expected value 100 and stdev 30, find the
expected shortage if ROP=120. Compute the fill
rate if order sizes are 200. Compute the annual
expected shortages if there are 12 order cycles
per year.
Expected shortage per cycle=4.59 from the last
example.
Fill rate = 1-4.59/20=0.7705
Annual expected shortage=12*4.59=55.08.
57

Determinants of the Reorder Point

The rate of demand

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

58

5. 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
Items from same supplier may yield savings in:
Ordering
Packing
Shipping costs

May be practical when inventories cannot be closely

monitored
59

FOI compared against variable order interval

models

A single order must cover the demand until the next

order arrives. Exposure to random demand during not
only lead time but also before.
Requires higher safety stock than variable order interval
models.
May provide savings in set up / ordering costs.

60

6. How many to order for the winter?

Parkas at L.L. Bean

61

Parkas at L.L. Bean

Cost per parka = c = $45

Sale price per parka = p = $100
Discount price per parka = $50
Holding and transportation cost = $10

Salvage value per parka = s = $40

Profit from selling parka = p-c = 100-45 = $55

Underage cost=$55
Cost of overstocking = c-s = 45-40 = $5
Overage cost=$5

62

6. Single Period Model

Single period model: model for ordering of
perishables and other items with limited useful
lives
Shortage cost: generally the unrealized profits
per unit, $55 for L.L.Bean. We call this underage.
Excess cost: difference between purchase cost
and salvage value of items left over at the end of
a period, $5 for L.L.Bean. We call this overage.

63

Parkas at L.L. Bean

Expected demand = 10 (00) parkas
Expected profit from ordering 10 (00) parkas = $499
The underage and overage probabilities after ordering
1100 parkas
P(D>1100):Probability of underage
P(D<1100):Probability of overage

64

Optimal level of product availability

p = sale price; s = outlet or salvage price; c = purchase price
CSL = Probability that demand will be at or below reorder point
At optimal order size,
Expected Marginal Benefit from raising order size =
=P(Demand is above stock)*(Profit from sales)=(1-CSL*)(p - c)
Expected Marginal Cost =
=P(Demand is below stock)*(Loss from discounting)=CSL*(c - s).
Let Co= c-s; Cu=p-c, then the optimality condition is
(1-CSL*)Cu = CSL* Co,
CSL* = Cu / (Cu + Co)

65

Parkas at L.L. Bean

Additional Expected
Expected
Expected Marginal
100s
Marginal Benefit Marginal Cost Contribution
11th
5500.49 = 2695 500.51 = 255 2695-255 = 2440
12th

5500.29 = 1595 500.71 = 355 1595-355 = 1240

13th

5500.18 = 990

500.82 = 410 990-410 = 580

14th

5500.08 = 440

500.92 = 460 440-460 = -20

15th

5500.04 = 220

500.96 = 480 220-480 = -260

16th

5500.02 = 110

500.98 = 490 110-490 = -380

17th

5500.01 = 55

500.99 = 495 55-495 = -440

66

Order Quantity for a Single Order

Co = Cost of overstocking = $5
Cu = Cost of understocking = $55
Q* = Optimal order size
CSL P ( Demand Q * )

Cu
55

0.917
Cu Co 55 5

See the next slide.

If the demand is normally distributed,

Cu

Q norminv
, mean _ demand , stdev _ demand
Cu C o

67

Optimal Order Quantity

without Normal Demands
1.2
0.917

1
0.8
0.6

Cumulative
Probability

0.4
0.2
0

Optimal Order Quantity = 13(00)

68

Operations Strategy
Too much inventory
Tends to hide problems
Easier to live with problems than to eliminate them
Costly to maintain

Wise strategy

Reduce lot sizes

Reduce set ups
Reduce safety stock
Aggregate negatively correlated demands
Remember component commonality
Delayed postponement

69