Inventory Management

Outline (1 of 2)

• Global Company Profile: Amazon.com

• The Importance of Inventory
• Managing Inventory
• Inventory Models
• Inventory Models for Independent Demand
Outline (2 of 2)

• Probabilistic Models and Safety Stock

• Single-Period Model
• Fixed-Period (P) Systems
Inventory Management at Amazon.Com (1 of 3)

• Amazon.com started as a “virtual” retailer – no inventory,

no warehouses, no overhead – just computers taking
orders to be filled by others
• Growth has forced Amazon.com to become a world
leader in warehousing and inventory management
Inventory Management at Amazon.Com (2 of 3)

1. Each order is assigned by computer to the closest

distribution center that has the product(s)
2. A “flow meister” at each distribution center assigns work
crews
3. Technology helps workers pick the correct items from
the shelves with almost no errors
4. Items are placed in crates on a conveyor, bar code
scanners scan each item 15 times to virtually eliminate
errors
Inventory Management at Amazon.Com (3 of 3)

5. Crates arrive at central point where items are boxed and

labeled with new bar code
6. Gift wrapping is done by hand at 30 packages per hour
7. Completed boxes are packed, taped, weighed and
labeled before leaving warehouse in a truck
8. Order arrives at customer within 1 - 2 days
Learning Objectives (1 of 2)

12.1 Conduct an ABC analysis

12.2 Explain and use cycle counting
12.3 Explain and use the EOQ model for independent
inventory demand
12.4 Compute a reorder point and explain safety stock
Learning Objectives (2 of 2)

12.5 Apply the production order quantity model

12.6 Explain and use the quantity discount model
12.7 Understand service levels and probabilistic inventory
models
Inventory Management

The objective of inventory management is to strike a

balance between inventory investment and customer
service
Importance of Inventory

• One of the most expensive assets of many companies

representing as much as 50% of total invested capital
• Less inventory lowers costs but increases chances of
running out
• More inventory raises costs but always keeps customers
happy
Functions of Inventory

1. To provide a selection of goods for anticipated demand

and to separate the firm from fluctuations in demand
2. To decouple or separate various parts of the production
process
3. To take advantage of quantity discounts
4. To hedge against inflation
Types of Inventory
• Raw material
– Purchased but not processed
• Work-in-process (WIP)
– Undergone some change but not completed
– A function of cycle time for a product
• Maintenance/repair/operating (MRO)
– Necessary to keep machinery and processes productive
• Finished goods
– Completed product awaiting shipment
Figure 12.1 The Material Flow Cycle
Managing Inventory

1. How inventory items can be classified (ABC analysis)

2. How accurate inventory records can be maintained
ABC Analysis (1 of 5)

• Divides inventory into three classes based on annual

dollar volume
– Class A - high annual dollar volume
– Class B - medium annual dollar volume
– Class C - low annual dollar volume
• Used to establish policies that focus on the few critical
parts and not the many trivial ones
ABC Analysis (2 of 5)
Figure 12.2 Graphic Representation of ABC Analysis
ABC Analysis (3 of 5)

ABC Calculation
ABC Analysis (4 of 5)

• Other criteria than annual dollar volume may be used

– High shortage or holding cost
– Anticipated engineering changes
– Delivery problems
– Quality problems
ABC Analysis (5 of 5)

• Policies employed may include

1. More emphasis on supplier development for A items

2. Tighter physical inventory control for A items
3. More care in forecasting A items
Record Accuracy (1 of 2)

• Accurate records are a critical

ingredient in production and
inventory systems
– Periodic systems require
regular checks of inventory
▪ Two-bin system
– Perpetual inventory tracks
receipts and subtractions
on a continuing basis
▪ May be semi-automated
Record Accuracy (2 of 2)

• Incoming and outgoing record keeping must be accurate

• Stockrooms should be secure
• Necessary to make precise decisions about ordering,
scheduling, and shipping
Cycle Counting

• Items are counted and records updated on a periodic

basis
• Often used with ABC analysis
• Has several advantages

1. Eliminates shutdowns and interruptions

2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records
Cycle Counting Example

5,000 items in inventory, 500 A items, 1,750 B items, 2,750

C items
Policy is to count A items every month (20 working days), B
items every quarter (60 days), and C items every six
months (120 days)

Cycle Counting Number Of Items Counted

Item Class Quantity Policy Per Day
A 500 Each month 500 twentieths
500 20 = 25=day
25 a day

B 1,750 Each quarter 1,750

1,750sixtieths
60 = 29= day
29 a day.

2,750 one hundred and

C 2,750 Every 6 months 120 = 23= 23
2,750twentieths daya day.

Blank Blank Blank 77 Total

day is 77
aday.
Control of Service Inventories

• Can be a critical component of profitability

• Losses may come from shrinkage or pilferage
• Applicable techniques include

1. Good personnel selection, training, and discipline

2. Tight control of incoming shipments
3. Effective control of all goods leaving facility
Inventory Models (1 of 2)

• Independent demand - the demand for item is

independent of the demand for any other item in
inventory
• Dependent demand - the demand for item is dependent
upon the demand for some other item in the inventory
Inventory Models (2 of 2)

• Holding costs - the costs of holding or “carrying”

inventory over time
• Ordering cost - the costs of placing an order and
receiving goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
– May be highly correlated with setup time
Holding Costs (1 of 2)
Table 12.1 Determining Inventory Holding Costs

Cost (And Range) As A

Percent Of Inventory
Category Value
Housing costs (building rent or depreciation, operating 6% (3 - 10%)
costs, taxes, insurance)
Material handling costs (equipment lease or depreciation, 3% (1 - 3.5%)
power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and insurance 11% (6 - 24%)
on inventory)
Pilferage, space, and obsolescence (much higher in 3% (2 - 5%)
industries undergoing rapid change like tablets and smart
phones)
Overall carrying cost 26%
Holding Costs (2 of 2)

Holding costs vary considerably depending on the

business, location, and interest rates. Generally greater
than 15%, some high tech and fashion items have holding
costs greater than 40%.
Inventory Models for Independent Demand

Need to determine when and how much to order

1. Basic economic order quantity (EOQ) model
2. Production order quantity model
3. Quantity discount model
Basic EOQ Model

Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering) and holding
6. Stockouts can be completely avoided
Figure 12.3 Inventory Usage over Time
Minimizing Costs (1 of 6)

Objective is to minimize total costs

Figure 12.4 Costs as a Function of Order Quantity: Total costs

Minimizing Costs (2 of 6)

• By minimizing the sum of setup (or ordering) and holding

costs, total costs are minimized
• Optimal order size Q* will minimize total cost
• A reduction in either cost reduces the total cost
• Optimal order quantity occurs when holding cost and
setup cost are equal
Minimizing Costs (3 of 6)
Q = Number of units per order
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year) ×

(Setup or order cost per order)
 Annual demand   Setup or order 
=    
 Number of units in each order   cost per order 
D
=  S
Q 
Minimizing Costs (4 of 6)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year) ×

(Setup or order cost per order)
 Annual demand   Setup or order 
=   
 Number of units in each order   cost per order 
D
Annual setup cost =   S
Q 
Minimizing Costs (5 of 6)

Annual holding cost = (Average inventory level) ×

(Holding cost per unit per year)
 Order quantity 
=  (Holding cost per unit per year)
 2 
Q 
Annual holding cost =   H
2
Minimizing Costs (6 of 6)

Optimal order quantity is found when annual setup cost

equals annual holding cost

Solving for Q* 2DS = Q 2H

2DS
Q =
2

H
D Q  Q* =
2DS
  S =  H
Q  2 H
An EOQ Example (1 of 6)

Determine optimal number of needles to order

D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2 DS
Q* =
H

2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
An EOQ Example (2 of 6)
Determine expected number of orders
D = 1,000 units
S = $10 per order
I = $.50 per unit per year
Q* =200 units

Demand D
Expected number of = N = =
Order quantity Q 
orders
1,000
N= = 5 orders per year
200
An EOQ Example (3 of 6)
Determine optimal time between orders
D = 1,000 units
S = $10 per order
I = $.50 per unit per year
Q* =200 units
N = 5 orders/year

Number of working days per year

Expected time between orders = T =
Expected number of orders

250
T= = 50 days between orders
5
An EOQ Example (4 of 6)
Determine the total annual cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S+ H
Q 2
1,000 200
= ( $20 ) + ( $.50 )
200 2
= (5)($10) + (100)($.50)
= $50 + $50 = $100
The EOQ Model

When including actual cost of material P

Total annual cost = Setup cost + Holding cost + Product
cost

D Q
TC = S + H + PD
Q 2
Robust Model

• The EOQ model is robust

• It works even if all parameters and assumptions are
not met
• The total cost curve is relatively flat in the area of the
EOQ
An EOQ Example (5 of 6)
Determine optimal number of needles to order
D = 1,000 units Q1,000 = 200 units
S = $10 per order T = 50 days
H = $.50 per unit per year Q1,500 = 244.9 units
N = 5 orders/year

Ordering old Q* Ordering new Q*

D Q
TC = S+ H 1,500 244.9
Q 2 = ($10) + ($.50)
244.9 2
1,500 200
= ($10) + ($.50) = 6.125($10) + 122.45($.50)
200 2
= $75 + $50 = $125 = $61.25 + $61.22 = $122.47
An EOQ Example (6 of 6)

Only 2% less than the total cost of $125 when the order
quantity was 200
Reorder Points

• EOQ answers the “how much” question

• The reorder point (ROP) tells “when” to order
• Lead time (L) is the time between placing and receiving
an order
 Demand  Lead time for a new 
ROP =   
 per day  order in days 

ROP = d x L
D
d=
Number of working days in a year
Reorder Point Curve
Figure 12.5 The Reorder Point (ROP)
Reorder Point Example

Demand = 8,000 iPhones per year

250 working day year
Lead time for orders is 3 working days, may take 4

D
d=
Number of working days in a year
= 8,000 / 250 = 32 units
ROP = d x L
= 32 units per day × 3 days = 96 units
= 32 units per day × 4 days = 128 units
Production Order Quantity Model (1 of 5)

1. Used when inventory builds up over a period of time

after an order is placed
2. Used when units are produced and sold simultaneously

Figure 12.6 Change in Inventory Levels over Time for the

Production Model
Production Order Quantity Model (2 of 5)
Q = Number of units per order p = Daily production
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in
days

(Annual inventory
holding cost ) = ( Average inventory level )  ( Holding cost
per unit per year )
( level )
Annual inventory = (Maximum inventory level ) / 2

( Maximum
inventory level
) (
= Total produced during
the production run
) (
− Total used during
the production run
)
= pt − dt
Production Order Quantity Model (3 of 5)

( Maximum
inventory level
)(= Total produced during
the production run
) ( − Total used during
the production run
)
= pt − dt
However, Q = total produced = pt ; thus t = Q/p

 Maximum  Q  Q   d
 inventory level  = p p − d p = Q  1− p 
       

Maximum inventory level Q  d  

Holding cost = (H ) = 1−  H
2
  p  
2 
Production Order Quantity Model (4 of 5)

Setup cost = ( D / Q )S

Holding cost = HQ 1 −
2 
1
( )
d
p

D 1   d 
HQ 1 −  
Q
S =
2
  p 

2 2 DS 2 DS
Q = Q *p =
  d    d 
H 1−   H 1−  
  p    p 
Production Order Quantity Example

D = 1,000 units
S = $10
H = $0.50 per unit per year * 2 DS
Q =
p = 8 units per day
p H
1− d p( )
d = 4 units per day *= 2(1,000)(10)
Qp

0.50 1−( 4 8) 
20,000
= = 80,000
0.50(1 2)

= 282.8 hubcaps, or 283 hubcaps

Production Order Quantity Model (5 of 5)

Note:
D 1,000
d = 4 = =
Number of days the plant is in operation 250

When annual data are used the equation becomes:

* 2 DS
Qp =
 Annual demand rate 
H 1 − 
 Annual production rate 
Quantity Discount Models (1 of 4)

• Reduced prices are often available when larger quantities

are purchased
• Trade-off is between reduced product cost and increased
holding cost

Table 12.2 A Quantity Discount Schedule

Price Range Quantity Ordered Price Per Unit P

Initial price 0 to 119 $100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96
Quantity Discount Models (2 of 4)
Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S+ IP + PD
Q 2

where Q = Quantity ordered P = Price per unit

D = Annual demand in units I = Holding cost per unit per
S = Ordering or setup cost per year expressed as a
order percent of price P
2DS
Q* =
IP
Because unit price varies, holding cost is expressed as a percent (I) of
unit price (P)
Quantity Discount Models (3 of 4)

Steps in analyzing a quantity discount

1. Starting with the lowest possible purchase price,

calculate Q* until the first feasible EOQ is found. This is
a possible best order quantity, along with all price-break
quantities for all lower prices.
2. Calculate the total annual cost for each possible order
quantity determined in Step 1. Select the quantity that
gives the lowest total cost.
Quantity Discount Models (4 of 4)
Figure 12.7 EOQs and Possible Best Order Quantities for the Quantity
Discount Problem with Three Prices in Table 12.2 (see slide 55)
Quantity Discount Example (1 of 2)

Calculate Q* for every discount 2DS

starting with the lowest price Q =
*

IP
2(5,200)($200)
Q$96 * = = 278 drones / order
(.28)($96)

Infeasible – calculate Q* for next-higher price

2(5,200)($200)
Q$98 * = = 275 drones / order
(.28)($98)
Feasible
Quantity Discount Example (2 of 2)
Table 12.3 Total Cost Computations for Chris Beehner Electronics

Annual Annual Annual

Order Unit Ordering Holding Product Total Annual
Quantity Price Cost Cost Cost Cost
275 $98 $3,782 $3,773 $509,600 $517,155
1,500 $96 $693 $20,160 $499,200 $520,053

Choose the price and quantity that gives the lowest total cost
Buy 275 drones at $98 per unit
Quantity Discount Variations

• All-units discount is the most popular form

• Incremental quantity discounts apply only to those
units purchased beyond the price break quantity
• Fixed fees may encourage larger purchases
• Aggregation over items or time
• Truckload discounts, buy-one-get-one-free offers,
one-time-only sales
Probabilistic Models and Safety Stock

• Used when demand is not constant or certain

• Use safety stock to achieve a desired service level and
avoid stockouts

ROP = d × L + ss

Annual stockout costs = The sum of the units short for each
demand level × The probability of that demand level × The
stockout cost/unit × The number of orders per year
Safety Stock Example (1 of 2)

ROP = 50 units
Orders per year = 6
Stockout cost = $40 per frame
Carrying cost = $5 per frame per year
Number Of Units Probability
30 .2
40 .2
ROP → 50 .3
60 .2
70 .1
Blank 1.0
Safety Stock Example (2 of 2)

Safety Additional Total

Stock Holding Cost Stockout Cost Cost

20 20(20)($5)
times $5 == $100
$100 $0 $100

10 10(10)($5)
times $5 == $ .50
$50 (10)(.1)
10 = ($40)(6)
times 0.1 = $240
times $40 times 6 = $240. $290

0 $0
10(10)(.2)($40)(6) + (20)(.1)($40)(6)
times 0.2 times $40 = 0.1
times 6 + 20 times $960 $960
times $40 times 6 = $960.

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
Probabilistic Demand (1 of 3)
Figure 12.8 Probabilistic Demand for a Hospital Item
Probabilistic Demand (2 of 3)

Use prescribed service levels to set safety stock when the

cost of stockouts cannot be determined

ROP = demand during lead time + Z dLT

Where Z = Number of standard deviations

 dLT = Standard deviation of demand during lead time
Probabilistic Demand (3 of 3)
Probabilistic Example (1 of 4)
 = Average demand = 350 kits

 dLT = Standard deviation of demand during lead time =

10 kits

Stockout policy = 5% (service level = 95%)

Using Appendix I, for an area under the curve of 95%, the Z = 1.645

Safety stock = Z dLT = 1.645(10) = 16.5 kits

Reorder point = Expected demand during lead time + Safety stock

= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
Other Probabilistic Models (1 of 4)

• When data on demand during lead time is not available,

there are other models available

1. When demand is variable and lead time is constant

2. When lead time is variable and demand is constant
3. When both demand and lead time are variable
Other Probabilistic Models (2 of 4)

Demand is variable and lead time is constant

ROP = (Average daily demand × Lead

time in days) + Z dLT

where  dLT =  d Lead time

 d = Standard deviation of demand per day
Probabilistic Example (2 of 4)
Average daily demand (normally distributed) = 15
Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28 From Appendix I

ROP = (15 units  2 days ) + Z dLT

= 30 + 1.28 ( 5 ) ( 2)
= 30 + 9.02 = 39.02  39

Safety stock is about 9 computers

Other Probabilistic Models (3 of 4)

Lead time is variable and demand is constant

ROP = (Daily demand × Average lead time

in days) + Z × (Daily demand) ×  LT

where  LT = Standard deviation of lead time in days

Probabilistic Example (3 of 4)

Daily demand (constant) = 10

Average lead time = 6 days
Standard deviation of lead time =  LT = 1

Service level = 98%, so Z (from Appendix I) = 2.055

ROP = (10 units × 6 days) + 2.055(10 units)(1)
= 60 + 20.55 = 80.55
Reorder point is about 81 cameras
Other Probabilistic Models (4 of 4)

Both demand and lead time are variable

ROP = (Average daily demand
× Average lead time) + Z dLT

where  d = Standard deviation of demand per day

 LT = Standard deviation of lead time in days
( Average lead time   d 2 )
 dLT =
+ Average daily demand) 2 2LT
Probabilistic Example (4 of 4)
Average daily demand (normally distributed) = 150
Standard deviation =  d = 16

Average lead time 5 days (normally distributed)

Standard deviation =  LT = 1 day

Service level = 95%, so Z = 1.645 (from Appendix I)

ROP = (150 packs  5 days) + 1.645 dLT

 dLT = ( 5 days 16 ) + (150

2 2
 12 ) = ( 5  256 ) + ( 22,500 1)
= (1,280 ) + ( 22,500 ) = 23,780  154
ROP = (150  5) + 1.645(154)  750 + 253 = 1,003 packs
Single-Period Model

• Only one order is placed for a product

• Units have little or no value at the end of the sales period

Cs = Cost of shortage = Sales price/unit – Cost/unit

Co = Cost of overage = Cost/unit – Salvage value

Cs
Service level =
Cs + Co
Single-Period Example (1 of 2)
Average demand =  = 120 papers / day

Standard deviation =  = 15 papers

Cs = cost of shortage = $1.25 – $.70 = $.55

Co = cost of overage = $.70 – $.30 = $.40

Cs
Service level =
Cs + Co
.55
=
.55 + .40
.55
= =.579
.95
Single-Period Example (2 of 2)

From Appendix I, for the area .579, Z  .20

The optimal stocking level

= 120 copies + (.20) ( )

= 120 + (.20)(15) = 120 + 3 = 123 papers

The stockout risk = 1 − Service level

= 1 − .579 = .422 = 42.2%
Fixed-Period (P) Systems (1 of 3)

• Fixed-quantity models require continuous monitoring

using perpetual inventory systems
• In fixed-period systems orders placed at the end of a
fixed period
• Periodic review, P system
Fixed-Period (P) Systems (2 of 3)

• Inventory counted only at end of period

• Order brings inventory up to target level
– Only relevant costs are ordering and holding
– Lead times are known and constant
– Items are independent of one another
Fixed-Period (P) Systems (3 of 3)
Figure 12.9 Inventory Level in a Fixed-Period (P) System
Fixed-Period Systems

• Inventory is only counted at each review period

• May be scheduled at convenient times
• Appropriate in routine situations
• May result in stockouts between periods
• May require increased safety stock
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