Quantitative Analysis for Management

Thirteenth Edition, Global Edition

Chapter 6
Inventory Control Models

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Learning Objectives (1 of 2)
After completing this chapter, students will be able to:
6.1 Understand the importance of inventory control.
6.2 Understand the various types of inventory related
decisions.
6.3 Use the economic order quantity (EOQ) to determine
how much to order.
6.4 Compute the reorder point (ROP) in determining when
to order more inventory.
6.5 Handle inventory problems that allow noninstantaneous
receipt.
6.6 Handle inventory problems that allow quantity
discounts.
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Learning Objectives (2 of 2)
After completing this chapter, students will be able to:
6.7 Understand the use of safety stock.
6.8 Compute single period inventory quantities using
marginal analysis.
6.9 Understand the importance of ABC analysis.
6.10 Describe the use of material requirements planning in
solving dependent-demand inventory problems.
6.11 Discuss just-in-time inventory concepts to reduce
inventory levels and costs.
6.12 Discuss enterprise resource planning systems.

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Chapter Outline
6.1 Importance of Inventory Control
6.2 Inventory Decisions
6.3 Economic Order Quantity: Determining How Much to Order
6.4 Reorder Point: Determining When to Order
6.5 EOQ Without the Instantaneous Receipt Assumption
6.6 Quantity Discount Models
6.7 Use of Safety Stock
6.8 Single-Period Inventory Models
6.9 ABC Analysis
6.10 Dependent Demand: The Case for Material Requirements
Planning
6.11 Just-in-Time Inventory Control
6.12 Enterprise Resource Planning
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Introduction (1 of 3)
• Inventory is an expensive and important asset
• Any stored resource used to satisfy a current or future
need
– Raw materials
– Work-in-process
– Finished goods
• Balance high and low inventory levels to minimize costs

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Introduction (2 of 3)
• Lower inventory levels
– Can reduce costs
– May result in stockouts and dissatisfied customers
• All organizations have some type of inventory planning and
control system
• Determine what goods/services are produced or
purchased

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Introduction (3 of 3)
FIGURE 6.1 Inventory Planning and Control

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Importance of Inventory Control (1 of 3)
• Five uses of inventory
1.The decoupling function
2.Storing resources
3.Irregular supply and demand
4.Quantity discounts
5.Avoiding stockouts and shortages
• Decoupling Function
– Reduces delays and improves efficiency
– A buffer between stages

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Importance of Inventory Control (2 of 3)
• Storing resources
– Seasonal products stored to satisfy off-season demand
– Materials stored as raw materials, work-in-process, or
finished goods
– Labor can be stored as a component of partially
completed subassemblies
• Irregular supply and demand
– Not constant over time
– Inventory used to buffer the variability

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Importance of Inventory Control (3 of 3)
• Quantity discounts
– Lower prices may be available for larger orders
– Higher storage and holding costs
– More cash invested
• Avoiding stockouts and shortages
– Stockouts may result in lost sales
– Dissatisfied customers may choose to buy from
another supplier
– Loss of goodwill

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Inventory Decisions
• Two fundamental decisions
1.How much to order
2.When to order
• Major objective is to minimize total inventory costs
1.Cost of the items (purchase cost or material cost)
2.Cost of ordering
3.Cost of carrying, or holding, inventory
4.Cost of stockouts

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Inventory Cost Factors (1 of 2)
TABLE 6.1 Inventory Cost Factors
ORDERING COST FACTORS CARRYING COST FACTORS
Developing and sending purchase orders Cost of capital
Processing and inspecting incoming inventory Taxes
Bill paying Insurance
Inventory inquiries Spoilage
Utilities, phone bills, and so on for the
Theft
purchasing department
Salaries and wages for purchasing department
Obsolescence
employees
Supplies such as forms and paper for the Salaries and wages for warehouse employees
purchasing department
Blank Utilities and building costs for the warehouse
Blank Supplies such as forms and paper for the warehouse

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Inventory Cost Factors (2 of 2)
• Ordering costs are generally independent of order quantity
– Many involve personnel time
– The amount of work is the same no matter the size of
the order
• Holding costs generally vary with the amount of inventory
or order size
– Labor, space, and other costs increase with order size
– Cost of items purchased can vary with quantity
discounts

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Economic Order Quantity (1 of 2)
• Economic order quantity (EOQ) model
– One of the oldest and most commonly known inventory
control techniques
– Easy to use
– A number of important assumptions
• Objective is to minimize total cost of inventory

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Economic Order Quantity (2 of 2)
• Assumptions:
1. Demand is known and constant over time
2. Lead time is known and constant
3. Receipt of inventory is instantaneous
4. Purchase cost per unit is constant
5. The only variable costs are ordering cost and holding
or carrying cost, and these are constant throughout
the year
6. Orders are placed so that stockouts or shortages are
avoided completely

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Inventory Usage Over Time
FIGURE 6.2 Inventory Usage over Time

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Inventory Costs in the Q
Average inventory level =
EOQ Situation 2
• Annual ordering cost is number of orders per year times
cost of placing each order
• Annual carrying cost is the average inventory times
carrying cost per unit per year
TABLE 6.2 Computing Average Inventory
Blank Blank INVENTORY LEVEL Blank
DAY BEGINNING ENDING AVERAGE
April 1 (order received) 10 8 9
April 2 8 6 7
April 3 6 4 5
April 4 4 2 3
April 5 2 0 1

Maximum level April 1 = 10 units

Total of daily averages = 9 + 7 + 5 + 3 + 1 = 25
Number of days = 5
Average inventory level = 25÷5 = 5 units
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Inventory Costs in the EOQ Situation (1 of 3)
Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year
Annual  Number of 
   Ordering cost 
Ordering   orders placed    
   per order 
cost  per year 
 
 Annual demand   Ordering cost  D
    Co
 Number of units   per order  Q
 in each order 
 
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Inventory Costs in the EOQ Situation (2 of 3)
Q = number of pieces to order
EOQ = Q* = optimal number of pieces to order
D = annual demand in units for the inventory item
Co = ordering cost of each order
Ch = holding or carrying cost per unit per year
Annual  Carrying cost 
 Average   
holding     per unit
 inventory   

cost  per year 
Order quantity
  (Carrying cost per unit per year)
2
Q
 Ch
2
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Inventory Costs in the EOQ Situation (3 of 3)
FIGURE 6.3 Total Cost as a Function of Order Quantity

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Finding the EOQ (1 of 2)
• When the EOQ assumptions are met, total cost is
minimized when
Annual ordering cost = Annual holding cost
D Q
Co  Ch
Q 2 Thus
Solving for Q
Q 2Ch  2DCo
2DCo
2DCo EOQ  Q  *

Q 
2
Ch
Ch
2DCo
Q
Ch
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Finding the EOQ (2 of 2)
• Equation summary

D
Annual ordering cost  Co
Q
Q
Annual holding cost  Ch
2
2DCo
EOQ  Q * 
Ch

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Sumco Pump Company (1 of 5)
• Sells pump housings to other companies
• Reduce inventory costs by finding optimal order quantity
Annual demand = 1,000 units
Ordering cost = $10 per order
Average carrying cost per unit per year = $0.50

2DCo 2(1,000)(10)
Q 
*
  40,000  200 units
Ch 0.50

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Sumco Pump Company (2 of 5)
• Total cost

D Q
TC  Co  Ch
Q 2
1,000 200
 (10)  (0.5)
200 2
 $50 + $50  $100

Number of orders per year = (D÷Q) = 5

Average inventory (Q÷2) = 100

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Sumco Pump Company (3 of 5)

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Sumco Pump Company (4 of 5)
PROGRAM 6.1A Input Data and Excel QM Formulas for the
Sumco Pump Company Example

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Sumco Pump Company (5 of 5)
PROGRAM 6.1B Excel QM Solution for the Sumco Pump
Company Example

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Purchase Cost of Inventory Items (1 of 2)
• Total inventory cost can be written to include the cost of
purchased items
– Annual purchase cost is constant at D × C no matter
the order policy, where
C is the purchase cost per unit
D is the annual demand in units
• The average dollar level of inventory

(CQ )
Average dollar level 
2

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 Purchase Cost of Inventory Items (2 of 2)
• Carrying cost often expressed as an annual percentage of
the unit cost or price of the inventory
• New variable

I  (Annual inventory holding charge as a percentage of unit price or cost)

Cost of storing inventory for one year = Ch = IC

Thus
2DCo
Q *

IC

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Sensitivity Analysis with the EOQ Model (1 of
2)

• The EOQ model assumes all values are know and fixed
over time
• Values are estimated or may change
• Sensitivity analysis determines the effects of these
changes
• Because the EOQ is a square root, changes in the inputs
result in relatively minor changes in the order quantity

2DCo
EOQ  Q  *

Ch

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Sensitivity Analysis with the EOQ Model (2 of
2)

• Sumco Pump example

2(1,000)(10)
EOQ   200 units
0.50

• Increase Co to $40

2(1,000)(40)
EOQ   400 units
0.50

• In general, the EOQ changes by the square root of the

change to any of the inputs

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 Reorder Point: Determining When To Order
• Next decision is when to order
• Time between placing an order and its receipt is called the
lead time (L) or delivery time
• On hand and on order inventory must be available to meet
demand during lead, the inventory position
• Generally expressed as a reorder point (ROP)

ROP  (Demand per day)  (Lead time for a new order in days)
 d L

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Reorder Point Graphs
FIGURE 6.4 Reorder Point Graphs

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Procomp’s Computer Chips (1 of 2)
• Annual demand = 8,000
• Daily demand = 40 units
• Delivery in three working days

ROP  d  L  40 units per day  3 days

 120 units

• An order for the EOQ (400) is placed when the inventory

reaches 120 units
• The order arrives 3 days later just as the inventory is depleted

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Procomp’s Computer Chips (2 of 2)
• Annual demand = 8,000
• Daily demand = 40 units Now 12 days
• Delivery in three working days
ROP  d  L  40 units per day  12 days
 480 units
 Inventory   Inventory   Inventory 
   
 position   on hand   on order 
480  80  400
• New order placed when inventory = 80 and one order is in
transit
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EOQ Without Instantaneous Receipt
• When inventory accumulates over time, the
instantaneous receipt assumption does not apply
– Daily demand rate must be taken into account
– Production run model
FIGURE 6.5 Inventory Control and the Production Process

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Annual Carrying Cost for Production Run
Model (1 of 3)
• Setup cost replaces ordering cost
– Model variables

Q = number of pieces per order, or production run

Cs = setup cost
Ch = holding or carrying cost per unit per year
p =daily production rate
d =daily demand rate
t = length of production run in days

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Annual Carrying Cost for Production Run
Model (2 of 3)
• Maximum inventory level
(Total produced during the production run)
− (Total used during production run)
= (Daily production rate)(Number of days production)
− (Daily demand)(Number of days production)
= (pt) − (dt)
Q
Since Total produced = Q = pt and t =
p
Q Q  d
Maximum inventory level  pt – dt  p – d  Q  1– 
p p  p
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Annual Carrying Cost for Production Run
Model (3 of 3)
• Average inventory is one-half the maximum

Q d
Average inventory   1– 
2 p

and
Q d
Annual holding cost   1–  Ch
2 p

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Annual Setup Cost for Production Run
Model
• Setup cost replaces ordering cost

D
Annual setup cost  Cs
Q

becomes

D
Annual ordering cost  Co
Q

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Determining the Optimal Production
Quantity
• Set setup costs equal to holding costs and solve for the
optimal order quantity
Annual holding cost = Annual setup cost
Q d D
 1– C
 h  Cs
2 p Q

Solving for Q, we get

2DCs
Q* 
 d
Ch  1– 
 p

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Production Run Model
• Equation summary

Q d
Annual holding cost  1 –  Ch
2 p
D
Annual setup cost  Cs
Q
2DCs
Optimal production quantity Q  *

 d
Ch  1 – 
 p

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Brown Manufacturing (1 of 4)
• Produces commercial refrigeration units in batches

Annual demand = D = 10,000 units

Setup cost = Cs = $100
Carrying cost = Ch = $0.50 per unit per year
Daily production rate = p = 80 units daily
Daily demand rate = d = 60 units daily

1. How many units should Brown produce in each batch?

2. How long should the production part of the cycle last?

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Brown Manufacturing (2 of 4)
Q
1. 2DCs 2. Production cycle 
Q 
*
p
 d
Ch  1 – 
 p 4,000
  50 days
2  10,000  100 80
Q* 
 60 
0.5  1 – 
 80 
2,000,000
  16,000,000
 
0.5 1
4
 4,000 units

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Brown Manufacturing (3 of 4)
PROGRAM 6.2A Excel QM Formulas and Input Data for the
Brown Manufacturing Problem

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Brown Manufacturing (4 of 4)
PROGRAM 6.2B Excel QM Solutions for the Brown
Manufacturing Problem

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Quantity Discount Models (1 of 5)
• Quantity discounts are commonly available
• Basic EOQ model is adjusted by adding in the purchase or
materials cost
Total cost = Material cost + Ordering cost + Holding cost
D Q
Total cost  DC + Co + Ch
Q 2
where
D = annual demand in units
Co = ordering cost of each order
C = cost per unit
Ch = holding or carrying cost per unit per year
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Quantity Discount Models (2 of 5)

Holding cost per unit is based on cost, so

Ch = IC
where
I = holding cost as a percentage of the unit cost (C)

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Quantity Discount Models (3 of 5)
• Discount schedule and EOQs might not align
• Buying at the lowest unit cost may not result in lowest total
cost

TABLE 6.3 Quantity Discount Schedule

DISCOUNT DISCOUNT DISCOUNT

NUMBER QUANTITY DISCOUNT (%) COST ($)
1 0 to 999 0 5.00
2 1,000 to 1,999 4 4.80
3 2,000 and over 5 4.75

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Quantity Discount Models (4 of 5)
FIGURE 6.6 Total Cost (TC) Curve for the Quantity Discount
Model

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Quantity Discount Models (5 of 5)
• Steps in the process
2DCo
1. For each discount price (C), compute EOQ 
IC
2. If EOQ < Minimum for discount, adjust the quantity to
Q = Minimum for discount
D Q
3. For each EOQ or adjusted Q, compute Total cost  DC + Co + Ch
Q 2
4. Choose the lowest-cost quantity

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Brass Department Store (1 of 5)
• Toy race cars
• Quantity discounts available
Step 1 – Compute EOQs for each discount
(2)(5,000)(49)
EOQ1 = = 700 cars per order
(0.2)(5.00)

(2)(5,000)(49)
EOQ2 = = 714 cars per order
(0.2)(4.80)

(2)(5,000)(49)
EOQ3 = = 718 cars per order
(0.2)(4.75)
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Brass Department Store (2 of 5)
Step 2 – Adjust quantities below the allowable discount
range
– The EOQ for discount 1 is allowable
– The EOQs for discounts 2 and 3 are outside the
allowable range, adjust to the possible quantity
closest to the EOQ
Q1 = 700
Q2 = 1,000
Q3 = 2,000

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 Brass Department Store (3 of 5)
Step 3 – Compute total cost for each quantity

TABLE 6.4 Total Cost Computations for Brass Department

Store
ANNUAL ANNUAL ANNUAL
ORDER MATERIAL ORDERING CARRYING
DISCOUNT UNIT PRICE QUANTITY COST COST COST TOTAL
NUMBER (C) (Q) ($) = DC ($) = (D÷Q)Co ($) = (Q÷2)Ch ($)
1 $5.00 700 25,000 350.00 350.00 25,700.00

2 4.80 1,000 24,000 245.00 480.00 24,725.00

3 4.75 2,000 23,750 122.50 950.00 24,822.50

Step 4 – Choose the alternative with the lowest total cost

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Brass Department Store (4 of 5)
PROGRAM 6.3A Excel QM Formulas and Input Data for the
Brass Department Store Quantity Discount Problem

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Brass Department Store (5 of 5)
PROGRAM 6.3B Excel QM Solutions for the Brass
Department Store Quantity Discount Problem

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Use of Safety Stock (1 of 4)
• If demand or the lead time are uncertain, the exact ROP
will not be known with certainty
• Safety stock can help prevent stockouts
• Can be implemented by adjusting the ROP

ROP = (Average demand during lead time) + Safety stock

ROP = (Average demand during lead time) + SS

where
SS = safety stock

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Use of Safety Stock (2 of 4)
FIGURE 6.7 Use of Safety Stock

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Use of Safety Stock (3 of 4)
• Objective is to choose a safety stock amount the
minimizes total holding and stockout costs
• If variation in demand and holding and stockout costs are
known, payoff/cost tables could be used to determine
safety stock
• More general approach is to choose a desired service
level based on satisfying customer demand

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Use of Safety Stock (4 of 4)
• Set safety stock to achieve a desired service level

Service level = 1 − Probability of a stockout

or
Probability of a stockout = 1 − Service level

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Safety Stock with the Normal Distribution
ROP = (Average demand during lead time) + ZsdLT
where
Z = number of standard deviations for a given service
level
sdLT = standard deviation of demand during the lead time
Thus Safety stock = ZsdLT

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Hinsdale Company (1 of 8)
• Item A3378 has normally distributed demand during lead
time
Mean = 350 units, standard deviation = 10
• Stockouts should occur only 5% of the time

μ = Mean demand = 350

σdLT = Standard deviation =
10
X = Mean demand + Safety
stock
X 
ZSS = Safety stock = X − μ = Zσ

FIGURE 6.8 Safety Stock and the Normal Distribution
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Hinsdale Company (2 of 8)
X   SS
• From Appendix A we find Z = 1.65  
 
ROP = (Average demand during lead time) + ZsdLT
= 350 + 1.65(10)
= 350 + 16.5 = 366.5 units (or about 367 units)

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Calculating Lead Time Demand and
Standard Deviation (1 of 4)
• Three situations to consider
– Demand is variable but lead time is constant
– Demand is constant but lead time is variable
– Both demand and lead time are variable

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Calculating Lead Time Demand and
Standard Deviation (2 of 4)
1. Demand is variable but lead time is constant

ROP  dL  Z  d L  

where

d  average daily demand

 d  standard deviation of daily demand
L  lead time in days

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Calculating Lead Time Demand and
Standard Deviation (3 of 4)
2. Demand is constant but lead time is variable

ROP  dL  Z  d L 

where

L  average lead time

 L  standard deviation of lead time
d  daily demand

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Calculating Lead Time Demand and
Standard Deviation (4 of 4)
3. Both demand and lead time are variable

ROP  dL  Z L d2  d 2 L2

– The most general case

– Can be simplified to the earlier equations

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Hinsdale Company (3 of 8)
• Determine safety stock for three other items

• For SKU F5402, d = 15,  d = 3, L = 4

• Desired service level = 97%

– For a 97% service level, Z = 1.88


ROP  dL  Z  d L 
 15(4) + 1.88(3 4)  15(4) + 1.88(6)
 60 + 11.28  71.28

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Hinsdale Company (4 of 8)
• For SKU B7319, d = 25, L = 6,  L = 3
• Desired service level = 98%
– For a 98% service level, Z = 2.05

ROP  dL  Z  d L 
 25(6) + 2.05(25)(3)  150 + 2.05(75)
 150 + 153.75  303.75

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Hinsdale Company (5 of 8)
• For SKU F9004, d = 20,  d = 4, L = 5,  L = 2
• Desired service level = 94%
– For a 94% service level, Z = 1.55

ROP  dL  Z L d2  d 2 L2
 (20)(5) + 1.55 5(4)2 + (20)2 (2)2
 100 + 1.55 1680
 100 + 1.55(40.99)  100 + 63.53  163.53

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Service Levels, Safety Stock, and Holding
Costs
• As service levels increase
– Safety stock increases at an increasing rate
• As safety stock increases
– Annual holding costs increase

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 Hinsdale Company (6 of 8)
TABLE 6.5 Safety Stock for SKU A3378 at Different Service
Levels
SERVICE LEVEL (%) Z VALUE FROM NORMAL CURVE TABLE SAFETY STOCK (UNITS)
90 1.28 12.8
91 1.34 13.4
92 1.41 14.1
93 1.48 14.8
94 1.55 15.5
95 1.65 16.5
96 1.75 17.5
97 1.88 18.8
98 2.05 20.5
99 2.33 23.3
99.99 3.72 37.2

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Calculating Annual Holding Cost with
Safety Stock
• Under standard assumptions of EOQ
– Average inventory = Q÷2
– Annual holding cost = (Q÷2)Ch
• With safety stock
 Holding cost of 
 Total annual    Holding cost of 
  regular   
 holding cost   inventory   safety stock 
 
Where
Q
THC  Ch  (SS)Ch THC = total annual holding cost
2
Q = order quantity
Ch = holding cost per unit per
year
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SS = safety stock
Hinsdale Company (7 of 8)
FIGURE 6.9 Service Level Versus Annual Carrying Costs

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Hinsdale Company (8 of 8)
FIGURE 6.9 Service Level Versus Annual Carrying Costs

This graph was developed

for a specific case, but the
general shape of the curve
is the same for all cases

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Using Excel QM for Safety Stock Problems
(1 of 2)

PROGRAM 6.4A Excel QM Formulas and Input Data for the

Hinsdale Safety Stock Problem

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Using Excel QM for Safety Stock Problems
(2 of 2)

PROGRAM 6.4B Excel QM Solutions for the Hinsdale

Safety Stock Problem

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Single-Period Inventory Models
• Some products have no future value beyond the current
period
– News vendor problems or single-period inventory
models
• Marginal analysis uses marginal profit (MP) and
marginal loss (ML)
– With a manageable number of states of nature and
alternatives, use discrete distributions
– When there are a large number of alternatives or states
of nature, use normal distribution

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Marginal Analysis with Discrete
Distributions (1 of 2)
• Stock an additional unit only if the expected marginal profit
for that unit exceeds the expected marginal loss
P = probability that demand will be greater than or
equal to a given supply (or the probability of selling
at least one additional unit)
1 − P = probability that demand will be less than supply (or
the probability that one additional unit will not sell)

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Marginal Analysis with Discrete
Distributions (2 of 2)
• The expected marginal profit = P(MP)
• The expected marginal loss = (1 − P)(ML)
• The optimal decision rule

Stock the additional unit if P(MP) ≥ (1 − P)ML

• With some basic manipulation

P(MP) ≥ ML − P(ML)
ML
P(MP) + P(ML) ≥ ML or P
ML + MP
P(MP + ML) ≥ ML

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Steps of Marginal Analysis with Discrete
Distributions
ML
1. Determine the value of for the problem
ML + MP

2. Construct a probability table and add a cumulative

probability column
3. Keep ordering inventory as long as the probability (P) of
selling at least one
ML
additional unit is greater than
ML + MP

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Café du Donut (1 of 5)
• Café buys donuts each day for $4 per carton of 2 dozen
donuts
• Cartons not sold are thrown away at the end of the day
• If a carton is sold, the total revenue is $6
• The marginal profit per carton is

MP = Marginal profit = $6 − $4 = $2
• Marginal loss ML = $4 since doughnuts cannot be returned
or salvaged

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Café du Donut (2 of 5)
TABLE 6.6 Café du Donut’s Probability Distribution

DAILY SALES PROBABILITY (P) THAT DEMAND

(CARTONS OF DOUGHNUTS) WILL BE AT THIS LEVEL
4 0.05
5 0.15
6 0.15
7 0.20
8 0.25
9 0.10
10 0.10
Blank Total 1.00

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Café du Donut (3 of 5)
ML
Step 1. Determine the value of for the decision rule
ML + MP

ML $4 4
P = = = 0.67
ML + MP $4 + $2 6
P  0.67

Step 2. Add a new column to the table to reflect the

probability that doughnut sales will be at each level
or greater

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Café du Donut (4 of 5)
TABLE 6.7 Marginal Analysis for Café du Donut
DAILY SALES PROBABILITY (P) THAT PROBABILITY (P) THAT
(CARTONS OF DEMAND WILL BE AT DEMAND WILL BE AT THIS
DOUGHNUTS) THIS LEVEL LEVEL OR GREATER
4 0.05 1.00 ≥ 0.66
5 0.15 0.95 ≥ 0.66
6 0.15 0.80 ≥ 0.66
7 0.20 0.65
8 0.25 0.45
9 0.10 0.20
10 0.10 0.10
Blank Total 1.00 Blank

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Café du Donut (5 of 5)
Step 3. Keep ordering additional cartons as long as the
probability of selling at least one additional carton is
greater than P, the indifference probability

P at 6 cartons = 0.80 > 0.67

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Marginal Analysis with the Normal
Distribution
• Find four values
1. The average or mean sales for the product, μ
2. The standard deviation of sales, σ
3. The marginal profit for the product, MP
4. The marginal loss for the product, ML

X * = optimal stocking level

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Steps of Marginal Analysis with the Normal
Distributions
ML
1. Determine the value of for the problem
ML + MP

2. Locate P on the normal distribution (Appendix A) and find

the associated Z-value

X *
–
3. Find X using the relationship Z =
*


to solve for the resulting stocking policy

X * =  + Z

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Newspaper Example (1 of 7)
• Chicago Tribune m = 60 papers a day, s = 10
• Marginal loss ML = 20 cents
• Marginal profit MP = 30 cents
Step 1. Stock the Tribune as long as the probability of
selling the last unit is at least ML÷(ML + MP)

ML 20 cents 20
= = = 0.40
ML + MP 20 cents + 30 cents 50

Let P = 0.40

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Newspaper Example (2 of 7)
Step 2. Using the normal distribution in Figure 6.10 find the
appropriate Z value
Z = 0.25 standard deviations from the mean
FIGURE 6.10 Joe’s Stocking Decision for the Chicago
Tribune

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Newspaper Example (3 of 7)
• Chicago Tribune m = 60 papers a day, s = 10

Step 3.
X * – 60
0.25 =
10
or
X * = 60 + 0.25(10) = 62.5, or 62 newspapers

Joe should order 62 newspapers since the

probability of selling 63 newspapers is slightly
less than 0.40
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Newspaper Example (4 of 7)
FIGURE 6.10 Joe’s Stocking Decision for the Chicago
Tribune

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Newspaper Example (5 of 7)
• The procedure is the same when P > 0.50
• Chicago Sun-Times
• ML = 40 cents, MP = 10 cents, m = 100, s = 10

Step 1.

ML 40 cents 40
= = = 0.80
ML + MP 40 cents + 10 cents 50

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Newspaper Example (6 of 7)
Step 2. Using the normal distribution in Figure 6.11 find the
appropriate Z value for 0.80 and multiply by −1
Z = −0.84 standard deviations from the mean
FIGURE 6.11 Joe’s Stocking Decision for the Chicago Sun-
Times

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Newspaper Example (7 of 7)
• Chicago Sun-Times m = 100 papers a day, s = 10

Step 3. X * – 100
0.84 =
10
or
X * = 100 − 0.84(10) = 91.6, or 91 newspapers

Joe should order 91 copies of the

Chicago Sun-Times every day

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ABC Analysis (1 of 3)
• The purpose is to divide the inventory into three groups
based on the overall inventory value of the items
• Group A items account for the major portion of inventory
costs
– Typically 70% of the dollar value but only 10% of the
quantity of items
– Forecasting and inventory management must be done
carefully
– Mistakes can be expensive

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ABC Analysis (2 of 3)
• Group B items are more moderately priced
– May represent 20% of the cost and 20% of the quantity
– Moderate levels of control
• Group C items are very low cost but high volume
– It is not cost effective to spend a lot of time managing
these items
– Simple control policies and loose control

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 ABC Analysis (3 of 3)
TABLE 6.8 Summary of ABC Analysis

INVENTORY DOLLAR INVENTORY ARE QUANTITATIVE CONTROL

GROUP USAGE (%) ITEMS (%) TECHNIQUES USED?
A 70 10 Yes
B 20 20 In some cases
C 10 70 No

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Dependent Demand: The Case for Material
Requirements Planning (1 of 2)
• Inventory models discussed so far have assumed item
demand was independent
• In many situations items demand is dependent on demand
for one or more other items
• In these situations material requirements planning
(MRP) can be employed effectively

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Dependent Demand: The Case for Material
Requirements Planning (2 of 2)
• Benefits of MRP
1. Increased customer service and satisfaction
2. Reduced inventory costs
3. Better inventory planning and scheduling
4. Higher total sales
5. Faster response to market changes and shifts
6. Reduced inventory levels without reduced customer
service

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Material Structure Tree (1 of 4)
• The first step is to develop a bill of materials (BOM)
• BOM identifies components, descriptions, and the number
required for production of one unit of the final product
• Material structure tree developed from the BOM
– Demand for product A is 50 units
– Each A requires 2 units of B and 3 units of C
– Each B requires 2 units of D and 3 units of E
– Each C requires 1 unit of E and 2 units of F

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Material Structure Tree (2 of 4)
FIGURE 6.12 Material Structure Tree for Item A

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Material Structure Tree (3 of 4)
• The demand for B, C, D, E, and F is completely dependent
on the demand for A
• The material structure tree has three levels
• Items above a level are called parents
• Items below any level are called components
• The number in parenthesis beside each item shows how
many are required for each unit of the parent

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Material Structure Tree (4 of 4)
• We can use the material structure tree and the demand for
Item A to compute demands for the other items
Part B: 2 × number of A’s = 2 × 50 = 100

Part C: 3 × number of A’s = 3 × 50 = 150

Part D: 2 × number of B’s = 2 × 100 = 200

Part E: 3 × number of B’s + 1 × number of C’s = 3 ×

100 + 1 × 150 = 450

Part F: 2 × number of C’s = 2 × 150 = 300

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Gross and Net Material Requirements Plan
(1 of 4)

• A gross material requirements plan is constructed after the

materials structure tree is complete
– Time schedule
– Shows when an item must be ordered
– Shows when there is no inventory on hand
– Shows when the production of an item must be started
in order to satisfy the demand for the finished product
at a particular date

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Gross and Net Material Requirements Plan
(2 of 4)

• Lead times are required for each item

Item A – 1 week Item D – 1 week
Item B – 2 weeks Item E – 2 weeks
Item C – 1 week Item F – 3 weeks

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Gross Material Requirements Plan
FIGURE 6.13 Gross Material Requirements Plan for 50 Units
of A

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Gross and Net Material Requirements Plan
(3 of 4)

• A net material requirements plan can be constructed from

the gross materials requirements plan and on-hand
inventory information

TABLE 6.9 On-Hand Inventory

ITEM ON-HAND INVENTORY
A 10
B 15
C 20
D 10
E 10
F 5

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Gross and Net Material Requirements Plan
(4 of 4)

• Using this data we can construct a plan that includes:

– Gross requirements
– On-hand inventory
– Net requirements
– Planned-order receipts
– Planned-order releases
• The net requirements plan is constructed like the gross
requirements plan

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Net Material Requirements Plan (1 of 7)
FIGURE 6.14(a) Net Material Requirements Plan for 50 Units of A
Week
Item 1 2 3 4 5 6 Lead Time

A Gross Blank Blank Blank Blank Blank 50 1 Week

On-Hand 10 Blank Blank Blank Blank Blank 10 Blank

Net Blank Blank Blank Blank Blank 40 Blank

Order Receipt Blank Blank Blank Blank Blank 40 Blank

Order Release Blank Blank Blank Blank 40 Blank Blank

B Gross Blank Blank Blank Blank 80A Blank 2 Weeks

On-Hand 15 Blank Blank Blank Blank 15 Blank Blank

Net Blank Blank Blank Blank 65 Blank Blank

Order Receipt Blank Blank Blank Blank 65 Blank Blank

Order Release Blank Blank 65 Blank Blank Blank Blank

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Net Material Requirements Plan (2 of 7)
FIGURE 6.14(b) Net Material Requirements Plan for 50 Units of A
Week
Item 1 2 3 4 5 6 Lead Time

C Gross Blank Blank Blank Blank 120A Blank 1 Week

On-Hand 20 Blank Blank Blank Blank 20 Blank Blank

Net Blank Blank Blank Blank 100 Blank Blank

Order Receipt Blank Blank Blank Blank 100 Blank Blank

Order Release Blank Blank Blank 100 Blank Blank Blank

D Gross Blank Blank 130B Blank Blank Blank 1 Week

On-Hand 10 Blank Blank 10 Blank Blank Blank Blank

Net Blank Blank 120 Blank Blank Blank Blank

Order Receipt Blank Blank 120 Blank Blank Blank Blank

Order Release Blank 120 Blank Blank Blank Blank Blank

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Net Material Requirements Plan (3 of 7)
FIGURE 6.14(c) Net Material Requirements Plan for 50 Units of A
Week
Item 1 2 3 4 5 6 Lead Time

E Gross Blank Blank 195B 100C Blank Blank 2 Weeks

On-Hand 10 Blank Blank 10 0 Blank Blank Blank

Net Blank Blank 185 100 Blank Blank Blank

Order Receipt Blank Blank 185 100 Blank Blank Blank

Order Release 185 100 Blank Blank Blank Blank Blank

F Gross Blank Blank Blank 200C Blank Blank 3 Weeks

On-Hand 5 Blank Blank Blank 5 Blank Blank Blank

Net Blank Blank Blank 195 Blank Blank Blank

Order Receipt Blank Blank Blank 195 Blank Blank Blank

Order Release 195 Blank Blank Blank Blank Blank Blank

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Two or More End Products (1 of 2)
• Most manufacturing companies have more than one end
item
• A second product AA has
this material structure tree
• If we require 10 units of AA, the gross requirements for
parts D and F are

Part D: 3 × number of AA’s = 3 × 10 = 30

Part F: 2 × number of AA’s = 2 × 10 = 20

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Two or More End Products (2 of 2)
• The lead time for AA is one week
• The gross requirement for AA is 10 units in week 6 and
there are no units on hand
• This new product can be added to the MRP process
– The addition of AA will only change the MRP schedules
for the parts contained in AA
• MRP can also schedule spare parts and components
– These have to be included as gross requirements

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Net Material Requirements Plan (4 of 7)
FIGURE 6.15a Net Material Requirements Plan, Including AA

Week

Item Inventory 1 2 3 4 5 6 Lead Time

AA Gross Blank Blank Blank Blank Blank 10 1 Week
Blank On-Hand: 0 Blank Blank Blank Blank Blank 0 Blank
Blank Net Blank Blank Blank Blank Blank 10 Blank
Blank Order Receipt Blank Blank Blank Blank 10 10 Blank
Blank Order Release Blank Blank Blank Blank Blank Blank Blank
A Gross Blank Blank Blank Blank Blank 50 1 Week
Blank On-Hand: 10 Blank Blank Blank Blank Blank 10 Blank
Blank Net Blank Blank Blank Blank Blank 40 Blank
Blank Order Receipt Blank Blank Blank Blank Blank 40 Blank
Blank Order Release Blank Blank Blank Blank 40 Blank Blank

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Net Material Requirements Plan (5 of 7)
FIGURE 6.15b Net Material Requirements Plan, Including AA

Week
Item Inventory 1 2 3 4 5 6 Lead Time
B Gross Blank Blank Blank Blank 80A Blank 2 Weeks
Blank On-Hand: 15 Blank Blank Blank Blank 15 Blank Blank
Blank Net Blank Blank Blank Blank 65 Blank Blank
Blank Order Receipt Blank Blank Blank Blank 65 Blank Blank
Blank Order Release Blank Blank 65 Blank Blank Blank Blank
C Gross Blank Blank Blank Blank 120A Blank 1 Week
Blank On-Hand: 20 Blank Blank Blank Blank 20 Blank Blank
Blank Net Blank Blank Blank Blank 100 Blank Blank
Blank Order Receipt Blank Blank Blank Blank 100 Blank Blank
Blank Order Release Blank Blank Blank 100 Blank Blank Blank

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Net Material Requirements Plan (6 of 7)
FIGURE 6.15c Net Material Requirements Plan, Including AA

Week
Item Inventory 1 2 3 4 5 6 Lead Time
D Gross Blank Blank 130B Blank 30AA Blank 1 Week
Blank On-Hand: 10 Blank Blank 10 Blank 0 Blank Blank
Blank Net Blank Blank 120 Blank 30 Blank Blank
Blank Order Receipt Blank Blank 120 Blank 30 Blank Blank
Blank Order Release Blank 120 Blank 30 Blank Blank Blank
E Gross Blank Blank 195B 100C Blank Blank 2 Weeks
Blank On-Hand: 10 Blank Blank 10 0 Blank Blank Blank
Blank Net Blank Blank 185 100 Blank Blank Blank
Blank Order Receipt Blank Blank 185 100 Blank Blank Blank
Blank Order Release 185 100 Blank Blank Blank Blank Blank

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Net Material Requirements Plan (7 of 7)
FIGURE 6.15d Net Material Requirements Plan, Including AA

Week

Item Inventory 1 2 3 4 5 6 Lead Time

F Gross Blank Blank Blank 200C 20AA Blank 3 Weeks
Blank On-Hand: 5 Blank Blank Blank 5 0 Blank Blank
Blank Net Blank Blank Blank 195 20 Blank Blank
Blank Order Receipt Blank Blank Blank 195 20 Blank Blank
Blank Order Release 195 20 Blank Blank Blank Blank Blank

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Just-in-Time Inventory Control (1 of 2)
• Organizations have tried to have less in-process inventory
on hand to achieve greater efficiency in the production
process
• This is known as JIT inventory
– The inventory arrives just in time to be used during the
manufacturing process
• One technique of implementing JIT is a manual procedure
called kanban

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Just-in-Time Inventory Control (2 of 2)
• Kanban in Japanese means “card”
• Dual-card kanban system
– Conveyance, or C-kanban
– Production, or P-kanban
• Simple systems but require considerable discipline
• Little inventory to cover variability
• Schedule must be followed exactly

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The Kanban System
FIGURE 6.16 The Kanban System

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4 Steps of Kanban (1 of 2)
1. Full containers along with their
C-kanban card are taken from
the storage area to a user area,
typically on a manufacturing line (arrow 1).

2. During the manufacturing process, parts in the container

are used up by the user. When the container is empty,
the empty container along with the same C-kanban card
is taken back to the storage area (arrow 2). Here the user
picks up a new full container, detaches the P-kanban
card from it, attaches his or her C-kanban card to it, and
returns with it to the user area.

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4 Steps of Kanban (2 of 2)
3. The detached P-kanban card
is then attached to an empty
container in the storage area and then—and only then—
is the empty container taken back to the upstream
producer area (arrow 3).

4. This empty container is then refilled with parts and taken

with its P-kanban card back to the storage area (arrow 4).
This kanban process continuously cycles throughout the
day. Kanban is sometimes known as a “pull” production
system.

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Some Kanban Rules
• Minimum of two containers are required
• No containers are filled without the appropriate P-kanban
• Each container must hold exactly the specified number of
parts or items
• Only those parts that are needed are produced

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Enterprise Resource Planning (1 of 3)
• MRP has evolved to include
– Labor hours
– Material cost
– Other resources related to production
– Refered to as MRP II and resource replaces the word
requirements
• Sophisticated software was developed, systems became
known as enterprise resource planning (ERP) systems

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Enterprise Resource Planning (2 of 3)
• Objective of ERP System is to reduce costs by integrating
all of the operations of a firm
– From supplier of materials needed through the
organization to invoicing the customer
– Data entered only once
– Central database quickly and easily accessed by
anyone in the organization
• Benefits include
– Reduced transaction costs
– Increased speed and accuracy of information

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Enterprise Resource Planning (3 of 3)
• Drawbacks to ERP
– Software is expensive to buy and costly to customize
– The implementation of an ERP system may require a
company to change its normal operations
– Employees are often resistant to change
– Training employees on the use of the new software can
be expensive

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