Inventory Management

Prof Sarbjit Singh Oberoi

IMT Nagpur
Lecture Outline

Elements of Inventory Management

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

The word inventory was first recorded in

1601. The French term inventaire, or
"detailed list of goods," dates back to
1415. Inventory management is primarily
about specifying the size and placement
of stocked goods. Inventory management
is required at different locations within a
facility or within multiple locations of a
supply network to protect the regular and
planned course of production against the
random disturbance of running out of
materials or goods.
What Is Inventory?

Stock of items kept to meet future demand

Purpose of inventory management
how many units to order
when to order
Types of Inventory

Raw materials
Purchased parts and supplies
Work-in-process (partially completed) products (WIP)
Items being transported
Tools and equipment
Inventory System

An inventory system is the set of policies and controls

that monitor levels of inventory and determine what
levels should be maintained , when stock should be
replenished, and how large order should be
Objectives of inventory

To satisfy expected customer demand (anticipation

inventory).
To provide a buffer between successive operations
(decoupling inventory or work-in-process inventory).
To satisfy periods of seasonal high demand (seasonal
inventory).
Objectives of inventory
(Continued)
To act as buffer between various
elements of supply chain
To minimize the total cost by ordering
the economic order quantity (cycle
stock).
To avoid stock outs (safety stock or
buffer stock).
To protect against price increases and
take advantage of quantity discount
Advantages of having large
inventory
The economies of production with large run sizes.
The smooth and efficient running of the business.
The economies of transportation.
The advantage of price discounts by bulk purchasing
Advantages of having large
inventory (continued)
Faster and adequate service to the customers.
Profit from speculation in the market where prices are
expected to rise.
Disadvantages of Inventory

Blockage of money
Warehouse rent
Deterioration
Obsolesce
Huge Carrying cost
Accounting
Physical handling
Scope of Inventory
Management
The scope of inventory management also
concerns the fine lines between
replenishment lead time, carrying costs of
inventory, asset management, inventory
forecasting, inventory valuation,
inventory visibility, future inventory price
forecasting, physical inventory, available
physical space for inventory, quality
management, replenishment, returns and
defective goods and demand forecasting
Inventory and 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 stop-
pages
Two Forms of Demand

Dependent
Demand for items used to produce
final products
Tires stored at a Goodyear plant are
an example of a dependent demand
item
Independent
Demand for items used by external
customers
Cars, appliances, computers, and
houses are examples of independent
demand inventory
Inventory and Quality
Management
Customers usually perceive quality service as
availability of goods they want when they want them
Inventory must be sufficient to provide high-quality
customer service in TQM
Inventory Models

Deterministic models
Probabilistic/stochastic models
Deterministic models

These are the inventory models in which demand is

assumed to be fixed for a subsequent period of time.
Probabilistic models

These are the inventory models in which demand is a

random variable having known probabilistic distribution.
Here the future demand is determined by collecting
data from the past experience.
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
Inventory Control Systems

Continuous system (fixed-

order-quantity)
constant amount ordered
when inventory declines to
predetermined level
Periodic system (fixed-time-
period)
order placed for variable
amount after fixed passage of
time
ABC Analysis

In this all item are categorized into three categories ,

namely, A, B and C on the basis of their consumption or
usage value
Consumption Value=unit price of an item X no. of units
consumed per annum
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: Example
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
 ABC Classification:
Example (cont.)
TOTAL % OF TOTAL % OF TOTAL
PART PART
VALUE UNIT
VALUECOSTQUANTITY
ANNUAL USAGE
% CUMMULATIVE
9 1
$30,600 $ 60
35.9 6.0 90 6.0
8 16,000
2 18.7
350 5.0 40 11.0
2 14,000 16.4 4.0
A 15.0
3 30 130
1 5,400 6.3 9.0 24.0
4 4
4,800 5.680 6.0 B60 30.0
3 5
3,900 4.630 10.0 100 40.0
6 6
3,600 4.220 % OF TOTAL
18.0 % OF TOTAL
180 58.0
CLASS ITEMS VALUE QUANTITY
5 3,000
7 3.510 13.0 170 71.0
10 2,400
A 9, 8,2.8
2 12.0
71.0 C 83.0
8 320 50 15.0
7 1,700
B 1, 4,2.0
3 17.0
16.5 100.0
25.0
9
C 5107
6, 5, 10, 12.5 60 60.0
$85,400
10 20 120
Example 10.1
ABC Classification: Example
PART UNIT Rs. No. of units/year
1 5 1,000
2 10 10
3 7 5
4 750 100
5 5 2,000
6 1 150
7 8 1,500
8 6 10,000
9 30 20
10 4 9,000
VED Analysis

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VED Analysis

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VED Analysis

As we have seen that ABC analysis depends upon the

consumption value. But there are items which are
critical for the organization.
Some of the materials are important by their absence
In addition to the intrinsic or market value of materials
, which is invested in the materials, there is some times
a nuisance value to the materials.

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VED Analysis

The investment in these materials may be small but for

non-availability of the item the costs or losses the
company going to involve will be very high,
The degree of criticality can be stated as whether the
material is vital to the process of production, or
essential to the process of production or desirable for
the production
This classification is known as VED analysis, V stands for
vital, E stands for essential and D stands for desirable
items

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SDE Analysis

The SDE analysis is based upon the availability

of items and is very useful in the context of
scarcity of supply.
S refers to scarce items , generally imported,
and those which are in short supply.
D refers to difficult items, which are available
indigenously but are difficult items to
procure.
E refers to items which are easy to acquire
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 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
Order quantity, Q
Demand
rate
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
placed receipt placed receipt
 EOQ Cost Model

Co - cost of placing order D - annual demand

Cc - annual per-unit carrying cost Q - order quantity

Co D
Annual ordering cost =
Q
CcQ
Annual carrying cost =
2
CoD CcQ
Total cost = +
Q 2
 EOQ Cost Model

Deriving Qopt Proving equality of

costs at optimal point
CoD CcQ
TC = +
Q 2 Co D CcQ
=
TC -CoD Cc Q 2
= +
Q Q2 2
2CoD
-C0D Cc Q2 =
Cc
0= +
Q2 2
2CoD
2CoD Qopt =
Qopt = Cc
Cc
 EOQ Cost Model (cont.)
Annual
cost ($) Total Cost
Slope = 0
CcQ
Minimum Carrying Cost =
2
total cost

CoD
Ordering Cost = Q

Optimal order Order Quantity, Q

Qopt
 EOQ Example
Cc = $0.75 per yard Co = $150 D = 10,000 yards

2CoD CoD CcQ

Qopt = TCmin = +
Cc Q 2
2(150)(10,000) (150)(10,000) (0.75)(2,000)
Qopt = (0.75) TCmin = 2,000 + 2

Qopt = 2,000 yards TCmin = $750 + $750 = $1,500

Orders per year = D/Qopt Order cycle time = 311 days/(D/Qopt)

= 10,000/2,000 = 311/5
= 5 orders/year = 62.2 store days
Case1

Zen Bicycle Ltd buys 3,000 seat

covers for its bicycle from an outside
supplier per annum. The ordering
cost is Rs 10 per order and the
carrying cost is Rs 6 unit per year.
The company has 300 working days
per year. Find the a) EOQ b) number
of orders per year, c) total inventory
cost, d) number of inventory cycles
in a year, and e) the duration of an
inventory cycle.
CaseII

Yantra India Ltd is a supplier of

speedometers to speed auto Ltd-
manufacturers of 60 cc two-wheelers. It
supplies 20,000 speedometers to Speed
Auto annually. At Speed Auto, the ordering
cost per order is Rs 5 and the carrying cost
is 2.5% of the average inventory value. The
price of a single unit is 200. The company
presently has a policy of placing 10 orders
every year. Advise the management of
Speed Auto as to whether it should continue
with its present policy or switch over to
EOQ model
CaseIII

ABC manufacturing company

purchases 9000 parts of a machine
for its annual requirements ordering
one month usage at a time . Each
part costs Rs. 20. The ordering cost
per order is Rs. 15 and the carrying
charges are 15% of the average
inventory per year. You have been
asked to suggest a more economical
purchasing policy for company.
What advice would you offer , and
how much would it save per year?
Production Quantity
Model
An inventory system in which an 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
Assumptions continued

The demand of the item is not high enough to warrant

continuous production. Therefore items are produced in
lots or batches.
 Production Quantity Model
(cont.)
Inventory
level

Maximum
Q(1-d/p) inventory
level

Average
Q inventory
(1-d/p)
2 level

0
Begin End Time
order order
Order
receipt receipt
receipt period
 Production Quantity Model
(cont.)
p = production rate d = demand rate

Maximum inventory level = Q - Q d

p

=Q1- d 2CsD
p
Qopt = d
Q d Cc 1 -
Average inventory level = 1- p
2 p

CsD CcQ d
TC = Q + 2 1 - p
 Production Quantity Model:
Example
Cc = $0.75 per yard Cs = $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day

2CsD 2(150)(10,000)
Qopt = = = 2,256.8 yards
Cc 1 - d 0.75 1 -
32.2
p 150

CsD CcQ d
TC = Q + 2 1 - p = $1,329

Q 2,256.8
Production run = = = 15.05 days run
p 150
 Production Quantity Model:
Example (cont.)

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

d 32.2
Maximum inventory level = Q 1 - = 2,256.8 1 -
p 150
= 1,772 yards
Case I

Singhvi Bottlers (p) Ltd is the sole bottler of

pepsi at Nagpur. The annual demand of Pepsi
at Nagpur is 200,000 bottles. The CC of the
inventory of bottled Pepsi is Rs 10 per bottle
per year. The set-up cost per bottling run is
Rs. 1000. The rate of production is 1,000
bottles per day and the rate of demand is 600
bottles per day. Find the optimum size of a
bottling run, i.e., the number of bottles that
should be manufactured in one production
run.
Case II

A manufacturing company needs 2,500 units

of a particular component every year. The
company buys it at a rate of $ 30 per unit.
The order processing cost for this part is
estimated at $15 and the cost of carrying a
part in stock comes to about $4 per year.
The company can manufacture this part
internally. It saves 20% of the price of the
product. However, it estimates a set-up cost
of $250 per production run.
Continued

The annual production rate would be 4800

units. However, the inventory holding costs
remain unchanged.
Determine the EOQ and the number of
optimal orders placed in a year.
Determine the optimum production lot size
and the average duration of the production
run.
Should the company manufacture the
component internally or continue to purchase
it from the supplier?
Quantity Discounts

Price per unit decreases as order

quantity increases
CoD CcQ
TC = + + PD
Q 2

where

P = per unit price of the item

D = annual demand
 Quantity Discount Model (cont.)
ORDER SIZE PRICE
0 - 99 $10 TC = ($10 )
100 199 8 (d1)
200+ 6 (d2) TC (d1 = $8 )

TC (d2 = $6 )
Inventory cost ($)

Carrying cost

Ordering cost

Q(d1 ) = 100 Qopt Q(d2 ) = 200

 Quantity Discount: Example
QUANTITY PRICE
Co = $2,500
1 - 49 $1,400 Cc = $190 per computer
50 - 89 1,100 D = 200
90+ 900

2CoD 2(2500)(200)
Qopt = = = 72.5 PCs
Cc 190

For Q = 72.5 Co D CcQopt

TC = + 2 + PD = $233,784
Qopt

For Q = 90 CoD CcQ

TC = + 2 + PD = $194,105
Q
Examples
Consider the following case, where
D=10,000 units, Holding cost = 20% cost per unit, Ordering cost= Rs. 20
Price break
0-499 Rs. 5
500-999 Rs. 4.50
1000 &above Rs. 3.90
What quantity should be ordered?
Example

Derive the optimal order quantity

with the following data
D=600 units per year, ordering cost=
Rs 800, carrying cost = 20%
Price break
0<q=<500 Rs 39
500<q=< 1000 Rs 29
1000< q Rs 28
Example

D= 200 items , carrying cost = 20%, ordering cost=Rs100

Price break
0-2999 Rs 10
3000-5000 Rs 9.25
5000 & above Rs 8.75
Shortage Model (Assumptions)

Demand rate is uniform at a rate of D units per unit

time
Production is instantaneous
Lead time is zero
Shortages are allowed and are backlogged
Q= total quantity Ordered
 Example

A dealer supplies you the following information with

regard to a product dealt in by him: Annual demand =
12,000 units, ordering cost = $ 50 per order, inventory
carrying cost is 30% per unit per year of purchase cost
$25 per unit. The dealer is considering the possibility of
allowing some back-orders to occur for the product. He
has estimated that the annual cost of back-ordering the
product will be $4 per unit.
1. What should be the optimum number of units of the
product he should buy in one lot?
2. What quantity of the product should he allow to be
backordered?
3. How much additional cost will he have to incur on
inventory if he does not permit backordering?
Example

A manufacturer has to supply his

customer 24,000 units of his
product every year. The demand is
fixed and known. The customer has
no storage space and so the
manufacturer fails to supply, the
penalty is Rs .20 per unit per
month. The inventory carrying cost
is Rs .10 per unit per month and the
set up cost is Rs 350 per production
run. Find the optimum lot-size for
the manufacturer.