Inventory

Management
 Learning Objectives
Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory
management.
Discuss the nature and importance of service
inventories
Discuss periodic and perpetual review systems.
Discuss the objectives of inventory management.
Describe the A-B-C approach and explain how it is
useful.

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 Learning Objectives
Describe the basic EOQ model and its
assumptions and solve typical problems.
Describe the economic production quantity
model and solve typical problems.
Describe the quantity discount model and solve
typical problems.
Describe reorder point models and solve typical
problems.
Describe situations in which the single-period
model would be appropriate, and solve typical
problems.
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 Inventory
Stock of items kept to meet future demand
Purpose of inventory management
how many units to order
when to order

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 Inventory
Independent Demand

A Dependent Demand

B(4) C(2)

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

Independent demand is uncertain.

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Dependent demand is certain. 5
 Inventory
Independent demand finished goods, items
that are ready to be sold
E.g. a computer
Dependent demand components of finished
products
E.g. parts that make up the computer

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 Types of Inventory
Raw materials purchased items or extracted
materials transformed into components or
products
Components parts or subassemblies used in
final product
Work-in-process items in process throughout
the plant
Finished goods products sold to customers
Distribution inventory finished goods in the
distribution system

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 Types of Inventory

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

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 Objectives of Inventory Control
To achieve satisfactory levels of customer
service while keeping inventory costs within
reasonable bounds
Level of customer service
Costs of ordering and carrying inventory

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

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 ABC Classification System
Classifying inventory according to some
measure of importance and allocating
control efforts accordingly.
A - very important High
A
Annual
B - mod. important $ value B
of items
C - least important C
Low
Low High
Percentage of Items

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 Economic Order Quantity Models
Economic order quantity (EOQ) model
The order size that minimizes total annual cost
Economic production model
Quantity discount model

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 Assumptions of EOQ Model
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
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
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 EOQ
D: Annual demand
S: Setup or Order Cost H hC
C: Cost per unit
h: Holding cost per year as a
fraction of product cost 2 DS
H: Holding cost per unit per year Q*
Q: Lot Size, Q*: Optimal Lot Size
n*: Optimal order frequency
H
Material cost is constant and therefore
DhC
n*
is not considered in this model

2S

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 Total Cost
Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q

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 EOQ
The Total-Cost Curve is U-Shaped
Q D
TC H S
2 Q
Annual Cost

Ordering Costs

Order Quantity (Q)

QO (optimal order quantity)

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 EOQ

2DS 2( Annual Demand )(Order or Setup Cost )

Q OPT = =
H Annual Holding Cost

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 Economic Production Quantity (EPQ)
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

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 Economic Production Quantity
Assumptions
Only one item is involved
Annual demand is known
Usage rate is constant
Usage occurs continually
Production rate is constant
Lead time does not vary
No quantity discounts

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 Economic Run Size
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

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 Economic Run Size

2DS p
Q0
H p u

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 p = production rate d = demand rate

Maximum inventory level = Q - Q d

p

=Q1- d 2SD
p
Qopt = d
Q d H 1-
Average inventory level = 1- p
2 p

SD HQ d
TC = Q + 2 1 - p

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H = $0.75 per yard S = $150 D = 10,000 yards
d = 10,000/311 = 32.2 yards per day p = 150 yards per day

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

SD HQ d
TC = Q + 2 1 - p = $1,329

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 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

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 Quantity Discounts
Cost/Unit Total Material Cost

$3
$2.96
$2.92

5,000 10,000 5,000 10,000

Order Quantity Order Quantity

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 Quantity Discounts
Step 1: Calculate the EOQ for the lowest price. If it is
feasible (i.e., this order quantity is in the range for that
price), then stop. This is the optimal lot size. Calculate
total cost (TC ) for this lot size.
Step 2: If the EOQ is not feasible, calculate the TC for this
price and the smallest quantity for that price.
Step 3: Calculate the EOQ for the next lowest price. If it is
feasible, stop and calculate the TC for that quantity and
price.
Step 4: Compare the TC for Steps 2 and 3. Choose the
quantity corresponding to the lowest TC.
Step 5: If the EOQ in Step 3 is not feasible, repeat Steps 2,
3, and 4 until a feasible EOQ is found.

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 Quantity Discounts

Order quantity Unit Price

0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92

q0 = 0, q1 = 5000, q2 = 10000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120000 units/year, S = $100/lot, h = 0.2

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 Quantity Discounts

Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]

= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410
Not feasible (6410 < 10001)
Calculate TC2 using C2 = $2.92 and q2 = 10001
TC2 = (120000/10001)(100)+(10001/2)(0.2)(2.92)+(120000)(2.92)
= $354,520
Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]
=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367
Feasible (5000<6367<10000) Stop
TC1 = (120000/6367)(100)+(6367/2)(0.2)(2.96)+(120000)(2.96)
= $358,969
TC2 < TC1 The optimal order quantity Q* is q2 = 10001

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 Total Costs with Purchasing Cost

Annual Annual Purchasing

TC = carrying + ordering + cost
cost cost
Q + DS + CD
TC = H
2 Q

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 Total Costs with PD
Cost

Adding Purchasing cost TC with material

doesnt change EOQ cost

TC without PD

PD

0 EOQ Quantity
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 When to Reorder with EOQ Ordering
Reorder Point - When the quantity on hand of
an item drops to this amount, the item is
reordered
Safety Stock - Stock that is held in excess of
expected demand due to variable demand
rate and/or lead time.
Service Level - Probability that demand will
not exceed supply during lead time.

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 Determinants of the Reorder Point
The rate of demand
The lead time
Demand and/or lead time variability
Stockout risk (safety stock)

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 Safety Stock
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock
LT Time
Safety stock reduces risk of
stockout
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 ROP

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale

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 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
Risk of stockout
Fill rate the percentage of demand filled by
the stock on hand
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 Fixed-Interval Benefits
Tight control of inventory items
Items from same supplier may yield savings in:
Ordering
Packing
Shipping costs
May be practical when inventories cannot be
closely monitored

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 Fixed-Interval Disadvantages
Requires a larger safety stock
Increases carrying cost
Costs of periodic reviews

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