Inventory Management
12
Inventory
Independent Demand
A Dependent Demand
B(4) C(2)
D(2) E(1) D(3) F(2)
Independent demand is uncertain.
Dependent demand is certain.
Inventory Models
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
Types of Inventories
Raw materials & purchased parts
Partially completed goods called
work in progress
Finished-goods inventories
(manufacturing firms)
or merchandise (retail stores)
Types of Inventories (Cont’d)
Replacement parts, tools, & supplies
Goods-in-transit to warehouses or
customers
Functions of Inventory
To meet anticipated demand
To smooth production
requirements
To protect against stock-outs
Functions of Inventory (Cont’d)
To help hedge against price
increases
To permit operations
To take advantage of quantity
discounts
Objective 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
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
Inventory Counting Systems
Periodic System
Physical count of items made at
periodic intervals
Perpetual Inventory System
System that keeps track of removals
from inventory continuously, thus
monitoring current levels of each item
Inventory Counting Systems (Cont’d)
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
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
ABC Classification System
Classifying inventory according to some
measure of importance and allocating
control efforts accordingly.
A - very important
B-
High
mod. important A
Annual
C - least important $ value
of items
B
Low C
Low High
Percentage of Items
Economic Order Quantity
Models
Economic order quantity (EOQ) model
The order size that minimizes total
annual cost
Economic production model
Quantity discount model
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
Inventory Level = 0 when new order just
arrived
There are no quantity discounts
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
Total Cost
Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q
Cost Minimization Goal
Q D
TC = H + S
Annual Cost
2 Q
Ordering Costs
Order Quantity (Q)
QO (optimal order quantity)
Minimum Total Cost
The total cost curve reaches its
minimum where the
Carrying Cost = Ordering Cost
Q = DS
H
2 Q
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.
2DS 2(Annual Demand)(Order or Setup Cost)
Q OPT = =
H Annual Holding Cost
Economic Production Quantity
(EPQ)
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
12-21
Quantity Discount Model
Quantity discount
Price reduction offered to customers for
placing large orders
Total Cost = Carrying Cost + Ordering Cost + Purchasing Cost
Q D
= H + S + PD
2 Q
where
P = Unit price
12-22
Quantity Discounts
12-23
Quantity Discounts
12-24
EPQ: Inventory Profile
Q
Production Usage Production Usage Production
and usage only and usage only and usage
Q*
Cumulative
production
Imax
Amount
on hand
Time
12-25
EPQ (Economic Production
Quantity) Assumptions
Same as the EOQ except: inventory arrives in
increments & is drawn down as it arrives
EPQ Equations
D I MAX
Adjusted total cost: TC EPQ = S + H
Q 2
d
Maximum inventory: I MAX = Q1 −
p
2 DS
EPQ =
Adjusted order quantity: d
H 1 −
p
EPQ Example
Annual demand = 18,000 units
Production rate = 2500 units/month
Setup cost = $800
Annual holding cost = $18 per unit
Lead time = 5 days
No. of operating days per month = 20
EPQ Example Solution
18,000
d= = 1500 units / month; p = 2500 units / month
12
2 DS 2 ×18,000 × 800
Q= = = 2000 units
d 1500
H 1 − 18 × 1 −
p 2500
d 1500
I MAX = Q1 − = 2000 × 1 − = 800 units
p 2500
D I 18,000 800
TC = S + MAX H = × 800 + ×18
Q 2 2000 2
= 7,200 + 7,200 = 14,400
EPQ Example Solution (cont.)
The reorder point:
1500
R = dL = × 5 = 375 units
20
With safety stock of 200 units:
1500
R = dL + SS = × 5 + 200 = 575 units
20
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.
Determinants of the Reorder Point
The rate of demand
The lead time
Demand and/or lead time variability
Stockout risk (safety stock)
Safety Stock
reduce risk of stockout during lead time
Reorder Point
The ROP based on a normal
Distribution of lead time demand
Service level
Risk of
a stockout
Probability of
no stockout
ROP Quantity
Expected
demand Safety
stock
0 z z-scale
Fixed
Quantity
Fixed time
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
Excess cost: difference between
purchase cost and salvage value of
items left over at the end of a period
Single Period Model
Continuous stocking levels
Identifies optimal stocking levels
Optimal stocking level balances unit
shortage and excess cost
Discrete stocking levels
Service levels are discrete rather than
continuous
Desired service level is equaled or
exceeded
Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit
Ce Cs
Service Level
Quantity
So
Balance point
Example 15
Ce = $0.20 per unit
Cs = $0.60 per unit
Service level = Cs/(Cs+Ce) = .6/(.6+.2)
Service level = .75
C Cs
e
Service Level = 75%
Quantity
Stockout risk = 1.00 – 0.75 = 0.25
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 safety stock
