Inventory Management

Lecture Outline

Elements of Inventory Management

Inventory Control Systems
Economic Order Quantity Models
Quantity Discounts
Reorder Point
Order Quantity for a Periodic Inventory System

What Is Inventory?
Stock of items kept to meet future demand
Purpose of inventory management
how many units to order
when to order

Importance of Inventory
Balance the advantages and
disadvantages of small and large
inventories
Pressures for small inventories

Inventory holding cost

Cost of capital
Storage and handling costs
Taxes, insurance, and shrinkage

Importance of Inventory
Pressures for large inventories

Customer service
Ordering cost
Setup cost
Labor and equipment utilization
Transportation cost
Payments to suppliers

Reasons for Holding Inventory

To meet anticipated customer demand

To protect against stock outs
To take advantage of economic order cycles
To maintain independence of operations
To allow for smooth and flexible production
operations
To guard against price increases

In Short,
Buffer against uncertainty in..
Supply (Raw material inventories)
Production process ( Work in process inventories)
&
Demand (Finished good inventories)

Supply Chain Management

Bullwhip effect

demand information is distorted as it moves away

from the end-use customer
higher safety stock inventories to are stored to
compensate

Seasonal or cyclical demand

Inventory provides independence from vendors
Take advantage of price discounts
Inventory provides independence between
stages and avoids work stoppages

Inventory Management
To have the correct inventory at the right place
at the right time to minimize system costs while
satisfying customer service requirements
Raw material/WIP/Finished goods

Inventory Policy
The strategy, approach, or set of techniques
used to determine how to manage inventory

Quality Management in the Supply Chain

Customers usually perceive quality service as
availability of goods they want when they want
them
Inventory must be sufficient to provide highquality customer service in QM

Type of Inventory

Process
stage

Raw Materials
WIP
Finished Goods

Demand
Type

Independent
Dependent

Purpose

Cycle
Safety
Seasonal
Pipeline

Others

Spares
Consumable

Independent vs. Dependent

Demand
Independent Demand
(demand for item is independent
of demand for any other item)

Dependent Demand
(demand for item is dependent
upon the demand for some
other item)

Independent vs. Dependent

Demand..
Item

Materials With
Independent Demand

Materials With
Dependent Demand

Demand
Source

Company Customers

Parent Items

Material
Type

Finished Goods

WIP & Raw Materials

Method of
Estimating
Demand
Planning
Method

Forecast & Booked

Customer Orders
EOQ & ROP

Calculated

MRP

Inventory Type : Purpose

Seasonal stocks
These are accumulated to absorb seasonal fluctuations in supply
or demand.

Cycle stocks
Due to fixed transportation and handling charges or set up
requirements, it is economical to order or produce large quantities
at a time.

Safety stocks
These are built as a hedge against uncertainties in supply or
demand.

Pipeline stocks
Inventories in-transit.

Inventory Costs

Carrying cost
cost of holding an item in inventory

Ordering cost
cost of replenishing inventory

Shortage cost
temporary or permanent loss of sales when
demand cannot be met

What are these costs made of? How to estimate these?

Terms used in Inventory

Material cost = C (per unit of product)

Fixed ordering cost = S (a fixed cost of receiving one order)

Holding cost = H (% of C)

carrying one unit in inventory for a specified period of time i.e. Rs. H/Unit/Year

Quantity in a lot or batch size = Q

Quantity is either produced or purchased at a time

Demand per unit time = D

Demand in one 1 year, d = average demand per week, So, D = d *52 / years

Inventory Cost
Holding Costs (H)
Obsolescence
Insurance
Extra staffing
Interest
Pilferage
Damage
Warehousing
etc.

Ordering Costs (S)

Supplies
Forms
Order processing
Clerical support
etc.
Setup Costs (S)
Clean-up costs
Re-tooling costs
Adjustment costs
etc.

Inventory Cost
Holding cost (H)

Cost of Capital
Obsolescence cost
Handling cost

Occupancy cost

Vary with quantity of product received , ZERO otherwise

Vary with quantity of product stored, ZERO otherwise

Miscellaneous costs

Theft, security, damage, tax, insurance

Inventory Cost
Ordering cost (S)

Buyer time

Time of buyer for placing extra order, ZERO otherwise

Internet and communication has reduced this cost significantly

Receiving costs

Administrative work such as purchase order matching with updating

inventory records

Quantity dependent should not be included here

Transportation costs

Fixed cost should be included here

Shortage Costs
When occurs,
possibilities..

company

faces

two

It can meet the shortage with some type

of rush, special
handling or priority
shipment
It cannot meet the shortage at all

So. It depends on
How company handles the problem ?

Shortage Costs
Permanent
Lost profits due to unsatisfied demand
Lost profits of future sales

Temporary (CB)
Backordered, so not necessarily lost
Special clerical & paperwork costs
Extraordinary transportation cost to customer

Inventory policy considerations:

Customer demand: known/random

Replenishment lead time: known/random
Product variety (# of SKUs)
Length of planning horizon
Costs: Order costs Vs Inventory costs
Service level requirements

Inventory management policies/ control systems:

Periodic review policy
No tracking of inventory position on a regular basis.
Inventory position is reviewed after a fixed period,
Based on a pre-specified order up to level the firm decides the
order size.

Continuous review policy

As soon as the inventory position goes down a certain prespecified level the order is placed.

Since most firms have real time inventory information

systems in place, the continuous review policy would be the
focus.

ABC Analysis

Stock-keeping units (SKU)

Identify the classes so management can
control inventory levels
A Pareto chart

ABC Classification
Class A
5 15 % of units
70 80 % of value

Class B
30 % of units
15 % of value

Class C
50 60 % of units
5 10 % of value

ABC Classification
PART

1
2
3
4
5
6
7
8
9
10

UNIT COST

$ 60
350
30
80
30
20
10
320
510
20

ANNUAL USAGE

90
40
130
60
100
180
170
50
60
120

TOTAL VALUE

(60 * 90) 5400

ABC Classification
PART

9
8
2
1
4
3
6
5
10
7

TOTAL
VALUE

$30,600
16,000
14,000
5,400
4,800
3,900
3,600
3,000
2,400
1,700
$85,400

% OF TOTAL
VALUE

35.9
18.7
16.4
6.3
5.6
4.6
4.2
3.5
2.8
2.0

% OF TOTAL
QUANTITY

6.0
5.0
4.0
9.0
6.0
10.0
18.0
13.0
12.0
17.0

% CUMMULATIVE

A
B
C

6.0
11.0
15.0
24.0
30.0
40.0
58.0
71.0
83.0
100.0

ABC Classification

CLASS
A
B
C

ITEMS
9, 8, 2
1, 4, 3
6, 5, 10, 7

% OF TOTAL
VALUE

% OF TOTAL
QUANTITY

71.0
16.5
12.5

15.0
25.0
60.0

ABC Problem
Bookers Book Bindery divides SKUs into three classes, according to
their dollar usage.
Calculate the usage values of the following SKUs and determine which is
most likely to be classified as class A.
SKU Number

Description

Boxes

Quantity Used
per Year

Unit Value
($)

500

3.00

Cardboard
(square feet)

18,000

0.02

Cover stock

10,000

0.75

Glue (gallons)

75

40.00

Inside covers

20,000

0.05

Reinforcing tape
(meters)

3,000

0.15

Signatures

150,000

0.45

Seating arrangement (E)

1
1

1
1

1
2

2
1

1
2

1
1

1
1

1
1

1
2

1
1

1
1

Seating arrangement (F)

1

1
1

1
1

1
1

1
1

1
1

1
1

1
1
1

1
1

1
1

1
1

Top margin:
Name:
Roll No.:
Group#: (1 or 2)
-------------------------------------------------------------------

Economic Order Quantity

(EOQ) Models
EOQ
optimal order quantity that will minimize
total inventory costs

Basic EOQ model

Production quantity model

Assumptions of Basic EOQ Model

Demand is known with certainty and is constant
over time
No shortages are allowed
Lead time for the receipt of orders is constant
Order quantity is received all at once

Inventory Order Cycle

Inventory Level

Order quantity, Q

Demand
rate

Average
inventory

Q
2

Reorder point, R

Lead
time
Order Order
placed receipt

Lead
time
Order Order
placed receipt

Time

EOQ Cost Model

S - cost of placing order
H - annual per-unit carrying cost

D - annual demand
Q - order quantity

Annual ordering cost =

SD
Q

Annual carrying cost =

HQ
2

Total cost =

SD
Q +

HQ
2

EOQ Cost Model

Deriving Qopt
SD
HQ
TC = Q + 2
SD
TC
= Q2 +
Q

H
2

SD
H
0 = Q2 + 2
Qopt =

2SD
H

Proving equality of
costs at optimal point
SD
HQ
Q = 2
2SD
Q = H
2

Qopt =

2SD
H

EOQ Cost Model

Annual
cost ($)

Total Cost
Slope = 0
HQ
Carrying Cost = 2

Minimum
total cost

SD
Ordering Cost = Q
Optimal order
Qopt

Order Quantity, Q

EOQ Example
H = $0.75 per gallon
Qopt =

2SD
H

Qopt =

2(150)(10,000)
(0.75)

S = $150

Qopt = 2,000 gallons

Orders per year = D/Qopt
= 10,000/2,000
= 5 orders/year

D = 10,000 gallons

SD
HQ
TCmin = Q + 2
TCmin =

(150)(10,000) (0.75)(2,000)
+
2,000
2

TCmin = $750 + $750 = $1,500

Order cycle time = 311 days/(D/Qopt)
= 311/5
= 62.2 store days

Production Quantity Model

Order is received gradually, as inventory is
simultaneously being depleted
AKA non-instantaneous receipt model
assumption that Q is received all at once is relaxed

p - daily rate at which an order is received over

time, a.k.a. production rate
d - daily rate at which inventory is demanded

Production Quantity Model

Inventory
level

Q(1-d/p)

Maximum
inventory
level

Q
(1-d/p)
2

Average
inventory
level

0
Order
receipt period

Begin
End
order order
receipt receipt

Time

Production Quantity Model

p = production rate

d = demand rate

Maximum inventory level = Q - Q d

p
=Q1- d
p
Average inventory level =

TC =

Q
d
1 p
2

SD
HQ
d
+
1
Q
2
p

2SD
Qopt =

d
H 1p

Production Quantity Model

S = $0.75 per gallon
H = $150
d = 10,000/311 = 32.2 gallons per day

2SD
Qopt =

TC =

H 1-

D = 10,000 gallons
p = 150 gallons per day

2(150)(10,000)
d
p

SD
HQ
d
+
1
Q
2
p

Q
Production run =
p

32.2
0.75 1 150

= 2,256.8 gallons

= $1,329

2,256.8
= 150

= 15.05 days per order

Production Quantity Model

Number of production runs =

10,000
D
=
= 4.43 runs/year
2,256.8
Q

d
Maximum inventory level = Q 1 p

= 2,256.8 1 -

= 1,772 gallons

32.2
150

Quantity Discounts
Price per unit decreases as order
quantity increases
HD
SQ
TC = Q + 2 + PD
where
P = per unit price of the item
D = annual demand

Quantity Discount Model

ORDER SIZE
1 - 49
50 89
90+

PRICE
$1400
$1100
$900

TC = ($1400)
TC ($1100)

Inventory cost ($)

TC ($900)

Carrying cost

Ordering cost
Q1 = 49

Qopt=72.5

Q2= 90

Quantity Discount
QUANTITY

PRICE

1 - 49
50 - 89
90+

$1,400
1,100
900

Qopt =

2SD
H

S = $2,500
H = $190 per TV
D = 200 TVs per year
2(2500)(200)
= 72.5 TVs
190

For Q = 72.5

HQopt
SD
TC = Q
+
+ PD = $233,784
2
opt

For Q = 90

HQ
SD
TC = Q + 2

+ PD = $194,105

Reorder Point

Inventory level at which a new order is placed

R = dL
where
d = demand rate per period
L = lead time

Reorder Point
Demand = 10,000 gallons/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154
gallons/day
Lead time = L = 10 days
R = dL = (32.154)(10) = 321.54 gallons

Safety Stock
Safety stock
buffer added to on hand inventory during lead time

Stockout
an inventory shortage

Service level
probability that the inventory available during lead
time will meet demand
P(Demand during lead time <= Reorder Point)

Inventory level

Variable Demand With Reorder Point

Q

Reorder
point, R

LT

LT
Time

Inventory level

Reorder Point With Safety Stock

Reorder
point, R

Safety Stock

LT

Time

LT

Reorder Point With Variable Demand

R = dL + zd L
where
d = average daily demand
L = lead time
d = the standard deviation of daily demand
z = number of standard deviations
corresponding to the service level
probability
zd L = safety stock

Reorder Point For a Service Level

Probability of
meeting demand during
lead time = service level

Probability of
a stockout
Safety stock
zd L
dL
Demand

Reorder Point For Variable Demand

The paint store wants a reorder point with a 95%
service level and a 5% stockout probability
d = 30 gallons per day
L = 10 days
d = 5 gallons per day
For a 95% service level, z = 1.65
R = dL + z d L

Safety stock = z d L

= 30(10) + (1.65)(5)( 10)

= (1.65)(5)( 10)

= 326.1 gallons

= 26.1 gallons

Order Quantity for a

Periodic Inventory System
Q = d(tb + L) + zd
where

Fixed periodicity between two orders, T = tb + L

d
tb
L
d
zd

tb + L - I

= average demand rate

= the fixed time between orders
= lead time
= standard deviation of demand

tb + L = safety stock
I = inventory level

Derivation of optimal ordering frequency (N)

To determine optimum N (or T):

We know that minimum cost occurs at,

Periodic Inventory System

Fixed-Period Model With

Variable Demand
d
d
tb
L
I
z

= 6 packages per day

= 1.2 packages
= 60 days
= 5 days
= 8 packages
= 1.65 (for a 95% service level)

Q = d(tb + L) + zd

tb + L - I

= (6)(60 + 5) + (1.65)(1.2)
= 397.96 packages

60 + 5 - 8