Chapter 13

Inventory
Management

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 13: Learning Objectives
 You should be able to:
1. Define the term inventory, list the major reasons for holding
inventories, and list the main requirements for effective
inventory management
2. Discuss the nature and importance of service inventories
3. Explain periodic and perpetual review systems
4. Explain the objectives of inventory management
5. Describe the A-B-C approach and explain how it is useful
6. Describe the basic EOQ model and its assumptions and solve
typical problems
7. Describe the economic production quantity model and solve
typical problems
8. Describe the quantity discount model and solve typical problems
9. Describe reorder point models and solve typical problems
10. Describe situations in which the single-period model would be
appropriate, and solve typical problems
Instructor Slides 13-2
 Inventory
Inventory
 A stock or store of goods
Independent demand items
 Items that are ready to be sold or used

Inventories are a vital part of business: (1)

necessary for operations and (2) contribute to
customer satisfaction
A “typical” firm has roughly 30% of its
current assets and as much as 90% of its
working capital invested in inventory

Instructor Slides 13-3

 Types of Inventory
 Raw materials and purchased parts
 Work-in-process (WIP)
 Finished goods inventories or merchandise
 Tools and supplies
 Maintenance and repairs (MRO) inventory
 Goods-in-transit to warehouses or customers
(pipeline inventory)

Instructor Slides 13-4

 Objectives of Inventory Control
Inventory management has two main concerns:
1. Level of customer service
 Having the right goods available in the right quantity in the
right place at the right time
2. Costs of ordering and carrying inventories

 The overall objective of inventory management is to

achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds
1. Measures of performance
2. Customer satisfaction
 Number and quantity of backorders
 Customer complaints

3. Inventory turnover

Instructor Slides 13-5

 Inventory Management
Management has two basic functions
concerning inventory:
1. Establish a system for tracking items in
inventory
2. Make decisions about
When to order
How much to order

Instructor Slides 13-6

 Effective Inventory Management
 Requires:
1. A system keep track of inventory
2. A reliable forecast of demand
3. Knowledge of lead time and lead time variability
4. Reasonable estimates of
 holding costs
 ordering costs
 shortage costs
5. A classification system for inventory items

Instructor Slides 13-7

Q= 100

Per day sales

qty= 5 unit

Lead Time= 2
days

ROP = 2X5
= 10 unit

Lead Time = 2 days

Instructor Slides 8
 Inventory Counting Systems
Periodic System
Physical count of items in inventory made at
periodic intervals
Perpetual Inventory System
 System that keeps track of removals from
inventory continuously, thus monitoring
current levels of each item
An order is placed when inventory drops to a
predetermined minimum level
 Two-bin system
 Two containers of inventory; reorder
when the first is empty

Instructor Slides 13-9

 Demand Forecasts and Lead Time
 Forecasts
 Inventories are necessary to satisfy customer demands,
so it is important to have a reliable estimates of the
amount and timing of demand
 Point-of-sale (POS) systems
 A system that electronically records actual sales
 Such demand information is very useful for enhancing
forecasting and inventory management
Lead time
 Time interval between ordering and receiving the order

Instructor Slides 13-10

 Inventory Costs
 Purchase cost
 The amount paid to buy the inventory
 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
 Setup costs
 The costs involved in preparing equipment for a job
 Analogous to ordering costs
 Shortage costs
 Costs resulting when demand exceeds the supply of
inventory; often unrealized profit per unit
Instructor Slides 13-11
 ABC Classification System
 A-B-C approach
 Classifying inventory according to some measure of
importance, and allocating control efforts accordingly
 A items (very important)
 10 to 20 percent of the number of items in inventory and
about 60 to 70 percent of the annual dollar value
 B items (moderately important)
 C items (least important)
 50 to 60 percent of the number
of items in inventory but only
about 10 to 15 percent of the
annual dollar value

Instructor Slides 13-12

 Cycle Counting
 Cycle counting
 A physical count of items in inventory
 Cycle counting management
 How much accuracy is needed?
 A items: ± 0.2 percent
 B items: ± 1 percent
 C items: ± 5 percent
 When should cycle counting be performed?
 Who should do it?

Instructor Slides 13-13

 How Much to Order: EOQ Models
Economic order quantity models identify the
optimal order quantity by minimizing the sum
of annual costs that vary with order size and
frequency
1. The basic economic order quantity model
2. The economic production quantity model
3. The quantity discount model

Instructor Slides 13-14

 Basic EOQ Model
 The basic EOQ model is used to find a fixed
order quantity that will minimize total
annual inventory costs
 Assumptions:
1. Only one product is involved
2. Annual demand requirements are known
3. Demand is even throughout the year
4. Lead time does not vary
5. Each order is received in a single delivery
6. There are no quantity discounts

Instructor Slides 13-15

 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

Instructor Slides 13-16

 Annual demand = 100 unit, Each time we order Q= 2 unit,
How many order we place in a year? Number of order = 100/2
= 50 times, Per order we have to pay 10 taka, ordering cost=
500 taka. If we increase order qty to 10, number of order =
100/10 = 10, Ordering cost = 10 X 10 = 100
Cost
Total cost = Holding
cost + Ordering cost

Holding Cost

Ordering cost

Q (optimal) QTY

Instructor Slides 17
 Total Annual Cost

Total Cost Annual Holding Cost  Annual Ordering Cost

Q D
 H  S
2 Q
where
Q Order quantity in units
H Holding (carrying) cost per unit, usually per year
D Demand, usually in units per year
S Ordering cost per order

Instructor Slides 13-18

 If annual demand is 100 and each time we order 5
unit, how many order in a year? Ans: 100/5 = 20,
If we order 2 unit each time, how many order? Ans
100/2 = 50 , If we pay 10 taka for each order?
Cost

Total cost

Holding cost

Ordering cost

Quantity

Instructor Slides 19
 Goal: Total Cost Minimization

The Total-Cost Curve is U-Shaped

Annual Cost

Q D
TC  H  S
2 Q

Holding Costs

Ordering Costs

Order Quantity
QO (optimal order quantity) (Q)

Instructor Slides 13-20

 Deriving EOQ
 Using calculus, we take the derivative of the total
cost function and set the derivative (slope) equal
to zero and solve for Q.
 The total cost curve reaches its minimum where
the carrying and ordering costs are equal.

2 DS 2(annual demand)(or der cost)

QO  
H annual per unit holding cost

Instructor Slides 13-21

 Economic Production Quantity
(EPQ)
 The batch mode is widely used in production. In
certain instances, the capacity to produce a part
exceeds its usage (demand rate)
 Assumptions
1. Only one item is involved
2. Annual demand requirements are known
3. Usage rate is constant
4. Usage occurs continually, but production occurs periodically
5. The production rate is constant
6. Lead time does not vary
7. There are no quantity discounts

Instructor Slides 13-22

 EPQ: Inventory Profile
Q
Production Usage Production Usage Production
and usage only and usage only and usage
Qp
Cumulative
production
Imax

Amount
on hand

Time

Instructor Slides 13-23

 EPQ – Total Cost
TC min Carrying Cost  Setup Cost
I  D
 max  H  S
 2  Q
where
I max Maximum inventory
Qp
 p  u 
p
p Production or delivery rate
u Usage rate

Instructor Slides 13-24

 EPQ

2 DS p
Qp 
H p u

Instructor Slides 13-25

 Quantity Discount Model
Quantity discount
 Price reduction for larger orders offered to
customers to induce them to buy in large
quantities
Total Cost Carrying Cost  Ordering Cost  Purchasing Cost
Q D
 H  S  PD
2 Q
where
P Unit price

Instructor Slides 13-26

 Quantity Discounts

Adding PD does not change EOQ

Instructor Slides 13-27

 Quantity Discounts

The total-cost curve

with quantity discounts
is composed of a
portion of the total-cost
curve for each price

Instructor Slides 13-28

 When to Reorder
 Reorder point
 When the quantity on hand of an item drops to this
amount, the item is reordered.
 Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to
management

Instructor Slides 13-29

 Uncertainty, 1= Lead Time, 2=
Demand
QTY

ROP= 50

Time
Lead Time
If LT= 5 days, Daily demand= 10 unit, Reorder
30
Point = 50 unit
 Reorder Point: Under Certainty

ROP d LT
where
d Demand rate (units per period, per day, per week)
LT Lead time (in same time units as d )
In a grocery store demand of bottled water is 70
bottles weekly. The supplier takes around 5 days
on average to deliver the order. What is the ROP ?
D= 70/7 = 10 /days , ROP = 10X5 =50 unit

Instructor Slides 13-31

 Reorder Point: Under Uncertainty
 Demand or lead time uncertainty creates the
possibility that demand will be greater than
available supply
 To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
 Safety stock
 Stock that is held in excess of expected demand due
to variable demand and/or lead time

Expected demand
ROP   Safety Stock
during lead time

Instructor Slides 13-32

 Safety Stock

Instructor Slides 13-33

 Safety Stock?
 As the amount of safety stock carried
increases, the risk of stockout decreases.
 This improves customer service level
 Service level
 The probability that demand will not exceed supply
during lead time
 Service level = 100% - Stockout risk

Instructor Slides 13-34

 How Much Safety Stock?
The amount of safety stock that is
appropriate for a given situation depends
upon:
1. The average demand rate and average lead
time
2. Demand and lead time variability
3. The desired
Expectedservice
demandlevel
ROP   z dLT
during lead time
where
z Number of standard deviations
 dLT The standard deviation of lead time demand
Instructor Slides 13-35
 Reorder Point: Demand
Uncertainty

ROP d LT  z d LT
where
z Number of standard deviations
d Average demand per period (per day, per week)
 d The stdev. of demand per period (same time units as d )
LT Lead time (same time units as d )
Note: If only demand is variable, then  dLT  d LT

Instructor Slides 13-36

 Reorder Point: Lead Time
Uncertainty

ROP d LT  zd LT

where
z Number of standard deviations
d Demand per period (per day, per week)
 LT The stddev. of lead time (same time units as d )
LT Average lead time (same time units as d )
Note: If only lead time is variable, then  dLT d LT

Instructor Slides 13-37

 Reorder Point: Lead Time and
Demand Uncertainty

Instructor Slides 13-38