Chapter 6: Inventory Control
Inventory
• Any stored resource used to satisfy a current or
future need (raw materials, work-in-process,
finished goods, etc.)
• Represents as much as 50% of invested capitol
at some companies
• Excessive inventory levels are costly
• Insufficient inventory levels lead to stockouts
Inventory Planning and Control
For maintaining the right balance between high and low
inventory to minimize cost
Main Uses of Inventory
1. The decoupling function
2. Storing resources
3. Irregular supply and demand
4. Quantity discounts
5. Avoiding stockouts and shortages
Inventory Control Decisions
Objective: Minimize total inventory cost
Decisions:
• How much to order?
• When to order?
Components of Total Cost
1. Cost of items
2. Cost of ordering
3. Cost of carrying or holding inventory
4. Cost of stockouts
5. Cost of safety stock (extra inventory held to
help avoid stockouts)
Economic Order Quantity (EOQ):
Determining How Much to Order
• One of the oldest and most well known
inventory control techniques
• Easy to use
• Based on a number of assumptions
Assumptions of the EOQ Model
1. Demand is known and constant
2. Lead time is known and constant
3. Receipt of inventory is instantaneous
4. Quantity discounts are not available
5. Variable costs are limited to: ordering cost
and carrying (or holding) cost
6. If orders are placed at the right time,
stockouts can be avoided
Inventory Level Over Time
Based on EOQ Assumptions
Minimizing EOQ Model Costs
• Only ordering and carrying costs need to be
minimized (all other costs are assumed
constant)
• As Q (order quantity) increases:
– Carry cost increases
– Ordering cost decreases (since the number
of orders per year decreases)
EOQ Model Total Cost
At optimal order quantity (Q*):
Carrying cost = Ordering cost
Finding the Optimal Order Quantity
Parameters:
Q* = Optimal order quantity (the EOQ)
D = Annual demand
Co = Ordering cost per order
Ch = Carrying (or holding) cost per unit per yr
P = Purchase cost per unit
Two Methods for Carrying Cost
Carry cost (Ch) can be expressed either:
1. As a fixed cost, such as
Ch = $0.50 per unit per year
2. As a percentage of the item’s purchase cost
(P)
Ch = I x P
I = a percentage of the purchase cost
EOQ Total Cost
Total ordering cost = (D/Q) x Co
Total carrying cost= (Q/2) x Ch
Total purchase cost = P x D
= Total cost
Note:
• (Q/2) is the average inventory level
• Purchase cost does not depend on Q
Finding Q*
Recall that at the optimal order quantity (Q*):
Carry cost = Ordering cost
(D/Q*) x Co = (Q*/2) x Ch
Rearranging to solve for Q*:
Q* = ( 2 DCo / Ch )
EOQ Example: Sumco Pump Co.
Buys pump housing from a manufacturer and
sells to retailers
D = 1000 pumps annually
Co = $10 per order
Ch = $0.50 per pump per year
P = $5
Q* = ?
Using ExcelModules for Inventory
• Worksheet for inventory models in
ExcelModules are color coded
– Input cells are yellow
– Output cells are green
• Select “Inventory Models” from the
ExcelModules menu, then select “EOQ”
Average Inventory Value
After Q* is found we can calculate the average
value of inventory on hand
Average inventory value = P x (Q*/2)
Calculating Ordering and
Carrying Costs for a Given Q
• Sometimes Co and Ch are difficult to estimate
• We can use the EOQ formula to calculate the
value of Co or Ch that would make a given Q
optimal:
Co = Q2 x Ch/(2D)
Ch = 2DCo/Q2
Sensitivity of the EOQ Formula
• The EOQ formula assumes all inputs are know
with certainty
• In reality these values are often estimates
• Determining the effect of input value changes
on Q* is called sensitivity analysis
Sensitivity Analysis for Sumco
• Suppose Co = $15 (instead of $10), which is a
50% increase
• Assume all other values are unchanged
• The new Q* = 245 (instead of 200), which is a
22.5% increase
• This shows the nonlinear nature of the formula
Reorder Point:
Determining When to Order
• After Q* is determined, the second decision is
when to order
• Orders must usually be placed before
inventory reaches 0 due to order lead time
• Lead time is the time from placing the order
until it is received
• The reorder point (ROP) depends on the lead
time (L)
Reorder Point (ROP)
ROP = d x L
Sumco Example Revisited
• Assume lead time, L = 3 business days
• Assume 250 business days per year
• Then daily demand,
d = 1000 pumps/250 days = 4 pumps per day
ROP = (4 pumps per day) x (3 days)
= 12 pumps
Economic Production Quantity:
Determining How Much to Produce
• The EOQ model assumes inventory arrives
instantaneously
• In many cases inventory arrives gradually
• The economic production quantity (EPQ)
model assumes inventory is being produced at
a rate of p units per day
• There is a setup cost each time production
begins
Inventory Control With Production
Determining Lot Size or EPQ
Parameters
Q* = Optimal production quantity (or EPQ)
Cs = Setup cost
D = annual demand
d = daily demand rate
p = daily production rate
Average Inventory Level
• We will need the average inventory level for
finding carrying cost
• Average inventory level is ½ the maximum
Max inventory = Q x (1- d/p)
Ave inventory = ½ Q x (1- d/p)
Total Cost
Setup cost = (D/Q) x Cs
Carrying cost = [½ Q x (1- d/p)] x Ch
Production cost = P x D
= Total cost
As in the EOQ model:
• The production cost does not depend on Q
• The function is nonlinear
Finding Q*
• As in the EOQ model, at the optimal quantity Q*
we should have:
Setup cost = Carrying cost
(D/Q*) x Cs = [½ Q* x (1- d/p)] x Ch
Rearranging to solve for Q*:
Q* = ( 2 DCs /[Ch (1 d / p )]
EPQ for Brown Manufacturing
Produces mini refrigerators (has 167 business
days per year)
D = 10,000 units annually
d = 1000 / 167 = ~60 units per day
p = 80 units per day (when producing)
Ch = $0.50 per unit per year
Cs = $100 per setup
P = $5 to produce each unit
Length of the Production Cycle
• The production cycle will last until Q* units
have been produced
• Producing at a rate of p units per day means
that it will last (Q*/p) days
• For Brown this is:
Q* = 4000 units
p = 80 units per day
4000 / 80 = 50 days
Quantity Discount Models
• A quantity discount is a reduced unit price based
on purchasing a large quantity
• Example discount schedule:
Four Steps to Analyze
Quantity Discount Models
1. Calculate Q* for each discount price
2. If Q* is too small to qualify for that price,
adjust Q* upward
3. Calculate total cost for each Q*
4. Select the Q* with the lowest total cost
Brass Department Store Example
Sells toy cars
D = 5000 cars annually
Co = $49 per order
Ch = $0.20 per car per year
Quantity Discount Schedule
Use of Safety Stock
• Safety stock (SS) is extra inventory held to
help prevent stockouts
• Frequently demand is subject to random
variability (uncertainty)
• If demand is unusually high during lead time,
a stockout will occur if there is no safety stock
Use of Safety Stock
Determining Safety Stock Level
Need to know:
• Probability of demand during lead time
(DDLT)
• Cost of a stockout (includes all costs directly
or indirectly associated, such as cost of a lost
sale and future lost sales)
ABCO Safety Stock Example
• ROP = 50 units (from previous EOQ)
• Place 6 orders per year
• Stockout cost per unit = $40
• Ch = $5 per unit per year
• DDLT has a discrete distribution
Analyzing the Alternatives
• With uncertain DDLT this becomes a
“decision making under risk” problem
• Each of the five possible values of DDLT
represents a decision alternative for ROP
• Need to determine the economic payoff for
each combination of decision alternative
(ROP) and outcome (DDLT)
Stockout and Additional
Carrying Costs
Additional
Stockout Cost Carrying Cost
ROP = DDLT 0 0
ROP < DDLT $40 per unit
0
short per year
ROP > DDLT $5 per unit per
0
year
Safety Stock With
Unknown Stockout Costs
• Determining stockout costs may be difficult or
impossible
• Customer dissatisfaction and possible future
lost sales are difficult to estimate
• Can use service level instead
Service level = 1 – probability of a stockout
Hinsdale Co. Example
• DDLT follows a normal distribution
(μ = 350, σ = 10)
• They want a 95% service level (i.e. 5%
probability of a stockout)
SS = ?
Safety Stock and the Normal
Distribution
Calculating SS
From the standard Normal Table,
Z = 1.645 = X – 350 so X= 366.45
10
and, SS = 16.45 (which could be rounded
to17)
ABC Analysis
• Recognizes that some inventory items are
more important than others
• A group items are considered critical (often
about 70% of dollar value and 10% of items)
• B group items are important but not critical
(often about 20% of dollar value and 20% of
items)
• C group items are not as important (often
about 10% of dollar value and 70% of items)
VED Analysis
- VED stands for vital, essential and desirable.
- relates to the classification of maintenance spare parts and
denotes the essentiality of stocking spares.
- spares are split into three categories in order of importance. From
the view-points of functional utility, the effects of non-availability
at the time of requirement or the operation, process, production,
plant or equipment and the urgency of replacement in case of
breakdown.
- spares are so important that their non-availability renders the
equipment or a number of equipment in a process line completely
inoperative, or even causes extreme damage to plant, equipment or
human life.
SDE Analysis
S:
Refers to scarce items, items which are in short supply. Usually
these are raw materials, spare parts and imported items.
D:
Stands for difficult items, items which are not readily available in
local markets and have to be procured from faraway places, or
items for which there are a limited number of suppliers; or items
for which quality suppliers are difficult to get.
E:
Refer to items which are easily available in the local markets.
FSN Analysis
Here the items are classified into fast-moving (F), slow-
moving (S) and Non-moving (N) items on the basis of
quantity and rate of consumption. The non-moving items
(usually, not consumed over a period of two years) are of
great importance. It is found that many companies maintain
huge stocks of non-moving items blocking quite a lot of
capital.
Moreover, there are thousands of such items. Scrutiny of
these items is made to determine whether they could be used
or to be disposed off. The classification of fast and slow
moving items helps in arrangement of stocks in stores and
their distribution and handling methods.
