Operations Management

Inventory Management

Dr. Ramesh Krishnan

IIM Kozhikode
[email protected]
 Purposes of Inventory

• To provide a selection of goods for anticipated demand and to

separate the firm from fluctuations in demand
• To provide a safeguard for variation in raw material delivery time
(Supply)
• To decouple or separate various parts of the production process
(Postponement)
• To take advantage of quantity discounts
• To allow flexibility in production scheduling (Bottleneck)
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
Single period inventory
A Retailer Selling Christmas Tree
A Retailer Selling Christmas Tree
A Retailer Selling Christmas Tree
A Retailer Selling Christmas Tree
A Retailer Selling Christmas Tree
A Retailer Selling Christmas Tree
 350000

For each of the production quantity of 8k, 10k, 12k, 14k, 16k or
18k units, we have to calculate the profit for all possible demand quantity.
Then by multiplying the demand probability with the profit calculated, calculate expected profit
for each production quantity & choose the max profit giving production quantity.
Production Production
Prob. Demand Profit Prob. Demand Profit
Quantity Quantity
8000 .11 8000 260000 10000 .11 8000 140000
8000 .11 10000 260000 10000 .11 10000 350000
8000 .28 12000 260000 10000 .28 12000 350000
8000 .22 14000 260000 10000 .22 14000 350000
8000 .18 16000 260000 10000 .18 16000 350000
8000 .1 18000 260000 10000 .1 18000 350000
Avg Profit (Profit * Prob.) 260000 Avg Profit (Profit * Prob.) 330400
….
 Managing Uncertainty in Demand:
The Newsvendor Problem

• Short life cycle products

• Stochastic demand
• Single ordering opportunity
• Timing of order: before the realization of random demand
• Trade-off: stocking more vs less
 The Newsvendor Problem
notations and assumption
• 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 = 𝑝 /𝑢𝑛𝑖𝑡
• 𝑂𝑟𝑑𝑒𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝑄, decision variable
• 𝐷𝑒𝑚𝑎𝑛𝑑 − −𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 𝑟𝑎𝑛𝑑𝑜𝑚 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒, 𝑋 ∈ [𝑎, 𝑏]
• 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑐𝑜𝑠𝑡 = 𝑐/𝑢𝑛𝑖𝑡
• 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑣/𝑢𝑛𝑖𝑡
• 𝑆𝑡𝑜𝑐𝑘𝑜𝑢𝑡 𝑐𝑜𝑠𝑡 = 𝐵/𝑢𝑛𝑖𝑡
• 𝐴𝑠𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛: 𝑝 > 𝑐 > 𝑣 ≥ 0, 𝐵 ≥ 0

𝑝𝑥 − 𝑐𝑄 + 𝑣(𝑄 − 𝑥), 𝑥 ≤ 𝑄
• 𝑃𝑟𝑜𝑓𝑖𝑡, 𝜋 𝑥, 𝑄 = ቊ
(𝑝 − 𝑐)𝑄 − 𝐵(𝑥 − 𝑄), 𝑥 > 𝑄
The Newsvendor Problem: Marginal Analysis

34 1-34
 The Newsvendor Problem: Service Level

• 𝑈𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘𝑖𝑛𝑔 𝑐𝑜𝑠𝑡, 𝑐𝑢 =
𝑡ℎ𝑒 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑛𝑜𝑡 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑎 𝑢𝑛𝑖𝑡 𝑡ℎ𝑎𝑡 𝑐𝑜𝑢𝑙𝑑 ℎ𝑎𝑣𝑒 𝑏𝑒𝑒𝑛 𝑠𝑜𝑙𝑑
𝑐𝑢 = 𝑝 − 𝑐 + 𝐵,
• 𝑂𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘𝑖𝑛𝑔 𝑐𝑜𝑠𝑡, 𝑐𝑜 =
𝑡ℎ𝑒 𝑙𝑜𝑠𝑠 𝑖𝑛𝑐𝑢𝑟𝑒𝑑 𝑤ℎ𝑒𝑛 𝑎 𝑢𝑛𝑖𝑡 𝑖𝑠 𝑜𝑟𝑑𝑒𝑟𝑒𝑑 𝑏𝑢𝑡 𝑛𝑜𝑡 𝑠𝑜𝑙𝑑
𝑐𝑜 = 𝑐 − 𝑣

𝑐𝑢
𝐹 𝑄∗ = , 𝑐𝑟𝑖𝑡𝑖𝑐𝑎𝑙 𝑓𝑟𝑎𝑐𝑡𝑖𝑙𝑒,
𝑐𝑢 +𝑐𝑜

0 < 𝐹 𝑄∗ < 1

• 𝐹 𝑄 ∗ gives the service level 1 (cycle service level)---probability that the firm ends the season having
satisfied all the demand
 Managing Uncertainty at Sportmart
The manager at Sportmart, a sporting goods store, has to decide on the
number of skis to be purchased for the winter season. Based on past
demand data and weather forecasts for the year, management has forecast
demand to be normally distributed, with a mean of 350 and a standard
deviation of 100. Each pair of skis costs c = $100 and sells for p = $250.
Any unsold skis at the end of the season are disposed of for $85. Assume
that it costs $5 to hold a pair of skis in inventory for the season. How many
skis should the manager order to maximize expected profits?

1-37
 Managing Uncertainty at Sportmart
• p= $250
• c= $100
• v= $80
• 𝑐0 = $20
• 𝑐𝑢 = $150
• 𝜇 = 350
• 𝜎 = 100
∗ 𝑐𝑢 150
• 𝐹 𝑄 = = = 0.88235 = 𝐶𝑆𝐿∗
𝑐𝑢 +𝑐𝑜 170
• 𝑄 ∗ =468.68
• Excel, 𝑄 ∗ = NORMINV(𝐶𝑆𝐿∗ , 𝜇, 𝜎)
1-38
Multi Period Inventory
 Role of Cycle Inventory
in a Supply Chain
• Cycle inventory is held to
– Take advantage of economies of scale
• A fixed cost is incurred each time an order is placed or produced
• The supplier offers price discounts based on the quantity purchased per lot
• The supplier offers short-term price discounts or holds trade promotions
– Reduce costs in the supply chain
• Lower cycle inventory
– Lowers working capital requirements
– Lowers inventory holding costs
 Inventory Costs
➢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
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance 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
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%
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
 Inventory Usage Over Time

Total order received

Average
Order quantity Usage rate inventory on
= Q (maximum hand
Inventory level

inventory
Q
level)
2

Minimum
inventory 0
Time
Economies of Scale to Exploit Fixed Costs
Objective is to minimize total costs

Total cost of
holding and setup
(order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
 Minimizing Costs
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)
x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
æ Dö
= ç ÷S
èQø
 Minimizing Costs D
Annual setup cost = S
Q
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)
x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
æ Dö
= ç ÷S
èQø
 Minimizing Costs D
Annual setup cost = S
Q
Q
Q = Number of pieces per order Annual holding cost = H
2
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 holding cost = (Average inventory level)
x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2
æQö
= ç ÷H
è2ø
 Minimizing Costs D
Annual setup cost = S
Q
Q
Q = Number of pieces per order Annual holding cost = H
2
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

Optimal order quantity is found when annual setup

cost equals annual holding cost

æ Dö æQ ö Solving for Q* 2DS = Q 2 H

ç ÷S = ç ÷ H 2DS
èQø è2ø Q2 =
H
2DS
Q* =
H
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H

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

Expected Demand D
number of = N = =
orders Order quantity Q*

1,000
N= = 5 orders per year
200
 An EOQ Example
Determine optimal time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected time Number of working days per year

between =T =
orders Expected number of orders

250
T= = 50 days between orders
5
 An EOQ Example
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 inventory cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
= ($10) + ($.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
 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 per Lead time for a new

ROP = day order in days

ROP = d x L

d= D
Number of working days in a year
 Reorder Point Curve
Q*
Stock is replenished as order arrives

Inventory level (units) Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 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 x 3 days = 96 units
= 32 units per day x 4 days = 128 units
 Production Order Quantity Model
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
Q

Production Usage Production Usage Production

and usage only and usage only and usage
Qp
Cumulative
production

Imax

Amount
on hand

Time
Production Order Quantity Model
Q = Number of units per order p = Daily production rate
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) x
holding cost per unit per year

Annual inventory = (Maximum inventory level)/2

level

Maximum Total produced during Total used during

inventory level = the production run – the production run

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

Maximum = Total produced during – Total used during

inventory level the production run the production run

= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level =p –d = Q 1–
p p p

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
Production Order Quantity Model
Q = Number of units per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Setup cost = (D / Q)S

Holding cost = 21 HQ éë1- d p ùû ( )
D
Q
S = 21 HQ éë1- d p ùû ( )
2DS
Q2 =
(
H éë1- d p ùû )
2DS
Q *p =
(
H éë1- d p ùû )
Production Order Quantity Example
D = 1,000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year

2DS
Q *p =
( )
H éë1- d p ùû

2(1,000)(10)
Q *p =
0.50éë1- (4 8)ùû

20,000
= = 80,000
0.50(1 2)
= 282.8 hubcaps, or 283 hubcaps
Practice Problems
 EOQ Model (Basic Deterministic Model)
Scenario: A hardware store sells screws and wants to determine the optimal order quantity. The following details are
provided:
• Annual demand: 10,000 units
• Ordering cost: $50 per order
• Holding cost: $0.10 per unit per year
• Purchase price: $1 per screw
Tasks:
1. Calculate the Economic Order Quantity (EOQ).
2. Determine the total annual cost of inventory (including ordering and holding costs) if the store orders at EOQ.
3. How many orders will the store place annually?
Quantity Discounts
 Exploit Quantity Discounts
• Two common schemes
– All-unit quantity discounts
– Marginal unit quantity discount or multi-block tariffs
All-Unit Quantity Discounts (1 of 6)
• Pricing schedule has specified quantity break points
q0 , q1, , qr , where q0 = 0
• If an order is placed that is at least as large as qi but
smaller than qi +1, then each unit has an average unit
cost of Ci
• Unit cost generally decreases as the quantity increases,

i.e., C0  C1   Cr
• Objective is to decide on a lot size that will minimize the sum
of material, order, and holding costs
All-Unit Quantity Discounts (2 of 6)

Average Unit Cost with All Unit Quantity Discounts

All-Unit Quantity Discounts (3 of 6)
Step 1: Evaluate the optimal lot size for each price Ci ,0  i  r
as follows

2DS
Qi =
hCi
All-Unit Quantity Discounts (4 of 6)
Step 2: We next select the order quantity Q*i for each price Ci

1. qi  Qi  qi +1
2. Qi  qi
3. Qi  qi +1
• Case 3 can be ignored as it is considered for Qi +1
• For Case 1 if q  Q  q , then set Q = Q
i i i +1
*
i i

• If Qi  qi , then a discount is not possible

• Set Qi = qi to qualify for the discounted price of Ci
All-Unit Quantity Discounts (5 of 6)
Step 3: Calculate the total annual cost of ordering Q i units

D   Qi* 
Total annual cost, TCi =  * S +   hCi + DCi
 Qi   2 

Step 4: Select Qi* with the lowest total cost TCi

 All-Unit Quantity Discount
Example (1 of 3)
Order Quantity Unit Price
0–4,999 $3.00
5,000–9,999 $2.96
10,000 or more $2.92

q0 = 0, q1 = 5,000, q2 = 10,000
C0 = $3.00, C1 = $2.96, C2 = $2.92

D = 120,000 year, S = $100 lot, h = 0.2

 All-Unit Quantity Discount
Example (2 of 3)
Step 1

2DS 2DS 2DS

Q0 = = 6,325; Q1 = = 6,367; Q2 = = 6,411
hC0 hC1 hC2

Step 2

Ignore i = 0 because Q0 = 6,325 > q1 = 5,000

For i = 1, 2

Q1* = Q1 = 6,367; Q2* = q2 = 10,000

 All-Unit Quantity Discount Example (3 of 3)
Step 3

D   Q1* 
TC1 =  * S +   hC1 + DC1 = $358,969; TC2 = $354,520
 Q1   2 

Lowest total cost is for i = 2

Order Q * 2 = 10,000 bottles per lot at $2.92 per bottle

Practice Problem
 EOQ with Quantity Discounts
Scenario: A manufacturer buys metal rods from a supplier who offers the following discounts:
• Orders below 500 units: $12 per rod
• Orders between 500–999 units: $11 per rod
• Orders of 1000 units or more: $10 per rod
Other details:
• Annual demand: 5000 rods
• Ordering cost: $100 per order
• Holding cost: 20% of unit price per year
Tasks:
* Calculate the EOQ for each price level.
* Determine which order quantity minimizes the total cost, considering both price and inventory costs.