MATERIALS

MANAGEMENT

Module 9
July 22, 2014
Inventories and their Management

“Inventories”= ?
New Car Inventory Sitting in Parking Lots
 Types of Inventory

1. Materials

• A. Raw material

• B. WIP

• C. Finished Goods
 Types of Inventory
1. Components
• A. Subassemblies
• B. Purchased parts that “go into”

2. Distribution inventories
• A. Sometimes called
“pipeline” inventories
• B. In a warehouse or in transit

3. “MRO”
• A. Maintenance items
• B. Repair parts
• C. Operating supplies
 A Material-Flow Process
Production Process

Work in
process

Raw Work in Finished

Materials process goods
Work in
Vendors process Custome
What is inventory and
Inventory management?
• Inventory: a stock of materials used to facilitate production or
to satisfy customer demand

• Managing the flow of goods into, through, and out of an organization

Inventory
• One of the most expensive assets of many companies
representing as much as 50% of total invested capital
• Operations managers must balance inventory investment
and customer service
Purpose of Inventories
• To protect against uncertainties

• in demand
• supply
• lead times
• schedule changes
• Reduction: shorten throughput times
Types of Inventory
• External
• Internal
Types of Inventory (external)

Pipeline inventory
inbound or outbound

stock in transit
Types of Inventory (internal)
Raw Material
product which has not yet
undergone any transformation

Work-in-process (WIP)
inventory which has already undergone
some transformation but not yet completed

Finished Goods
inventory which has undergone all transformations
and is ready to be passed on to the customer
Negative Aspects of Inventory
• Financial cost of carrying too much inventory

• Risk of obsolescence or damage

• Large inventories hide operational problems

 Holding (or Carrying) Cost
• 1. Cost to carry one unit of stock for one unit of time, e.g., $2 /
unit / year
• A. Varies with the inventory level

• 2. Notation: H

• 3. Components:
• A. Capital costs or Opportunity costs
• B. Storage cost
• C. Insurance & Taxes
• D. Risk costs
• a. Pilferage & Obsolescence

• 4. Sometimes derived from:

• A. holding cost “rate”, e.g., 25% per year
• B. Multiplied by the unit value
Inventory Cost Structures
How the 35 percent carrying cost is distributed

• Cost of Capital—9-20 percent

• Obsolescence—2-5 percent
• Storage—2-5 percent
• Material Handling—1-3 percent
• Shrinkage—1-3 percent
• Taxes & Insurance—1-3 percent

Source: Mark Williams, APICS Instructor Listserv, 22 January 2001

Inventory Cost Structures
• Shrinkage
• “…’shrinkage’…cost U.S. retailers about $41.6 billion last year.”
This is more than the combined total from other crimes such as
robberies, auto theft and larceny.

Source: Wall Street Journal, 11 July 2007, p. B4.

Inventory Cost Structures
• Stock out cost (back order or lost sales)
• record maintenance
• lost income
• customer dissatisfaction
• Typically expressed as a fixed cost per backorder or as a function
of aging of backorders.
Hidden Costs of Inventory
• Longer lead times
• Reduced responsiveness
• Underlying problems are hidden rather than being exposed
and solved
• Quality problems are not identified immediately
• No incentive for improvement of the process
Two Forms of Demand
• Independent demand (this chapter)
• finished goods, spare parts,
• based on market demand
• requires forecasting
• managed using ‘replenishment philosophy’, i.e. reorder when
reach a pre-specified level.
 Two Forms of Demand
• Dependent demand (next chapter)
• parts that go into the finished products
• dependent demand is a known function of independent demand
• calculate instead of forecast
• Managed using a ‘requirements philosophy’, i.e. only ordered as
needed for higher level components or products.
 Independent vs. Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Finished
product
Dependent
Demand
(Derived demand
items for
component
E parts,
subassemblies,
(1 raw materials,
etc)
Component parts )
Basic Inventory Management Issues
And Decisions

1. For which items should inventory be carried?

2. Where should inventory be stored?
3. What is the right inventory level for each product?
4. How can we control inventories?
5. How can we evaluate inventory performance?

Inventory Decisions Involve Trade-Offs!

Inventory Systems
• 1. An inventory system provides the structure and
operating policies for maintaining and controlling goods to
be stocked in inventory.

• 2. The system is responsible for ordering, tracking, and

receiving goods.

• 3. There are two essential questions to answer that define

a policy:
• 1. How much or what quantity of an item to order
• 2. When should an order for that item be placed?
Two Types of Systems
• 1. Continuous review system: an inventory system that
always orders the same quantity of items but has
differing periods of time between orders

Q Q Q

T1 T2
• 2. Periodic review system: an inventory system that
has a fixed time between orders but has different order
quantities from order to order

Q1 Q2 Q3

T T
Order or Setup Cost

• 1. Cost to place an order or to initiate a

production run, e.g., $10 / order
• A. A fixed cost
• 2. Notation: S
• 3. Components:
• Order Cost -> Time of personnel, receiving,
inspection, etc.
• Setup Cost -> Opportunity cost, waste, etc.
Shortage Cost

• 1. Also known as stockout cost

• A. Occurs when inventory not sufficient to meet demand
• 2. Could result in:
• A. Back order
• B. Lost sale
• 3. Direct, and indirect, dollar consequences:
• A. Downtime of operations
• B. Premiums for expediting
• C. Extra transportation and handling
• D. Lost of customer goodwill
EOQ
• 1. You want to review your inventory continually

• 2. You want to replenish your inventory when the level

falls below a minimum amount, and order the same Q
each time

• 3. Typical of a retail item, or a raw material item in a

manufacturer
How to Determine Q
• Use the “EOQ” formula

2DS
Q
• D = Demand
H
• S = Order or Setup Cost
• H = Holding Cost
 EOQ Assumptions
• 1. For the Square Root Formula to Work Well:

• A. Continuous review of the inventory position

• B. Demand is known & constant …

no safety stock is required

• C. Lead time is known & constant

• D. No quantity discounts are available

• E. Ordering (or setup) costs are constant

• F. All demand is satisfied (no shortages)

• G. The order quantity arrives in a single shipment

EOQ Inventory Behavior
Inventory Level
Starts at Q
Q
Inventory Depletes Process Repeats
at Constant Rate

Reorder Point Hit

R
0
Inventory Runs Out &
Order of Size Q Arrives
Where the EOQ formula comes from:

• Find the Q that minimizes

the total annual inventory related costs:
• Annual number of orders: N = D / Q
1. Annual Ordering Cost: S x (D / Q)

• Average Inventory: Q / 2
2. Annual Carrying Cost: H x Q / 2
How the costs behave:
Annual
cost ($)

Order Quantity, Q
How the costs behave:
Annual
cost ($)

SD
Ordering Cost = Q

Order Quantity, Q
How the costs behave:
Annual
cost ($)

HQ
Carrying Cost =
2

SD
Ordering Cost = Q

Order Quantity, Q
How the costs behave:

Annual
cost ($) Total Cost
Slope = 0

Minimum Carrying Cost

total cost

Ordering Cost

Optimal order Order Quantity, Q

Qopt
How the Costs Behave
• Total Cost (TC)
Q D
TC  H  S
2 Q
• 1. Total Cost Function Has Slope of Zero at Best
(Optimal) Value of Q
• 2. Taking First Derivative of TC and Setting Equal to Zero
Gives the Square Root Equation
 Example: Papa Joe’s Pizza
(Atlanta store)

• Uses 18,000 pizza cartons / year

• Ordering lead time is 1 month

Decisions:
• 1. How many cartons should Papa
Joe order? i.e., Q

• 2. When should Papa Joe order? R

Data:

• Inventory carrying cost is

$ .022 carton / year

• Ordering cost is $10 / order

EOQ for Papa Joe’s
2  10  18,000
EOQ   4,045.2
0.022
Q  4,045
TC (4,045)  180,000 / 4,045  0.011 4,045
 $88.99 / year
TC (4,000)  180,000 / 4,000  0.011 4,000
 $89.00 / year
Reorder Point

R
0

Lead Time
Reorder Point Calculation
• 1. D x L = demand during lead time

• 2. Set reorder point, R, equal to

demand during lead time
• 3. R = D x L

• 4. For Papa Joe’s

• A. R = (18,000 cartons / yr) x (1 / 12 yr)

= 1,500 cartons

• 5.State Inventory Policy As:

• A. Order 4,000 cartons When the Inventory Level Reaches 1,500

cartons
Variable Demand &
Safety Stock

Q
R

Order
Order Demand du
Placed
Received lead time
Stockout
The Relationship Between
SS, R, & L
1. R = enough stock to cover:

A. What you expect to happen during a lead time

plus

B. What might happen during the lead time

C. R = dL + SS
EOQ with Discounts
• Many companies offer discounted pricing for items that
they sell.
Procedure:
• Arrange the prices from lowest to highest. Starting with
the lowest price, calculate the EOQ for each price until
a feasible EOQ is found.
• If the first feasible EOQ is for the lowest price, this quantity is
optimal and should be used.
• If not, proceed until feasible EOQ found.
• If feasible EOQ found, check ALL breakpoints above the value
of the feasible Q
EOQ w/ Quantity Discounts
• Example C  $3.00
• D = 16,000 boxes of (2)(16, 000)(5)
gloves/year
Q  461.9
(0.25)(3)
• S = $5/order
Not Feasible
• h = 0.25 (25% of cost)
C  $4.00
• C = cost per unit
• $5.00 for 1 to 99 boxes (2)(16, 000)(5)
• $4.00 for 100 to 499 boxes
Q  400
(0.25)(4)
• $3.00 for 500+ boxes
Feasible
 EOQ w/ Quantity Discounts
For Q = 400
16,000 400
TC = (5) + (0.25)(4) + (4)(16,000) = $64,400
400 2
For Q = 500

16,000 500
TC = (5) + (0.25)(3) + (3)(16,000) = $48,347.5
500 2
Decision: Buy with Q = 500 for
Lowest Possible Cost
EPQ

• You want to review your inventory continually

• You want to replenish your inventory when the level falls

below a minimum amount, and order the same Q each
time

• Your replenishment does NOT occur all at once

• Typical of a WIP item, typical of manufacturing

Illustration - -
Papa Joe’s Pizza
• Joe orders in batches of Q = 4000 cartons at a time

• He uses a “low bid” vendor (cheap)

• It takes about 1 month to get the order in
• Due to limited staffing, only 1000 cartons can be made and sent
to Joe each week

How is the inventory build up different

than the Base Case (EOQ scenario)?
EPQ Inventory Behavior

Inventory Level
Production Stops at Imax
Starts at Imax
Imax
Inventory Depletes
Process Repeats
at Constant Rate

Reorder Point Hit

Inventory Produced
R (Prepare Production Run) at Constant Rate
0
Inventory Runs Out &
Production Begins

Major Difference: Maximum Inventory Level

EPQ Equations

 D   IMAX 
• Total cost: TC   S    H
Q   2 

• Maximum inventory:
 d
• d =avg. daily demand rate I MAX  Q 1  
• p =daily production rate  p

• Calculating EPQ: 2DS

Q
 d
H 1  
 p
EPQ Example
And when should Papa Joe reorder his
cartons ?
R = Demand during the resupply lead time
=dxL
Other Types of Inventory Systems
Variations on the basic types of continuous and
periodic reviews:
• ABC Systems
• Bin Systems
• Can Order Systems
• Base Stock Systems
• The Newsvendor Problem
ABC Systems
• 1. ABC systems: inventory systems that utilize some
measure of importance to classify inventory items and
allocate control efforts accordingly

• 2. They take advantage of what is commonly called the

80/20 rule, which holds that 20 percent of the items
usually account for 80 percent of the value.
• A. Category A contains the most important items.
• B. Category B contains moderately important items.
• C. Category C contains the least important items.
ABC Systems
• 1. A items make up only 10 to 20 percent of the total
number of items, yet account for 60 to 80 percent of
annual dollar value.
• 2. C items account for 50 to 70 percent of the total
number of items, yet account for only 10 to 20 percent of
annual dollar value.
• 3. C items may well be of high importance, but because
they account for relatively little annual inventory cost, it
may be preferable to order them in large quantities and
carry excess safety stock.
Bin Systems
• 1. Bin system: a type of inventory system that uses
either one or two bins to hold a quantity of the item being
inventoried; an order is placed when one of two bins is
empty or a line on a single bin is reached

Demand
Can Order & Base Stock Systems
• 1. Can order system: a type of inventory system that
reviews the inventory position at fixed time intervals and
places orders to bring the inventory up to an expected
target level, but only if the inventory position is below a
minimum quantity, similar to the reorder point in a
continuous review system
• 2. Base stock system: a type of inventory system that
issues an order whenever a withdrawal is made from
inventory
“Newsvendor” Problem
• 1. Order inventory for only a one-time stocking of an item
the “Single-Period” Inventory model

• 2. Examples:
• A. Xmas tree lots
• B. Newspaper stands

• 3. Objective: maximize profit

• 4. Why not just stock as many units as possible?

 Example:

Tee shirts are purchased in multiples of 10 for a charity event

for $8 each. When sold during the event the selling price is
$20. After the event their salvage value is just $2.
From past events the organizers know the probability of
selling different quantities of tee shirts within a range
from 80 to 120:

Customer Demand 80 90 100 110 120

Prob. Of Occurrence .20 .25 .30 .15 .10

How many tee shirts should they

buy and have on hand for the event?
Payoff Table: Setup

Demand
Purchase 80 90 100 110 120
Qty
80
90
100
110
120
 Payoff Table: Cell Calculations

Profit = Revenues – Costs + Salvage

• Revenues = Selling Price (p)  Amount Sold
• Costs = Purchase Price (c)  Purchase Qty
• Salvage = Salvage Value (s)  Amount Leftover

Amount Sold = min (Demand, Purchase Qty)

Amount Leftover = max (Purchase Qty – Demand, 0)
 Payoff Table: Cell Calculations

Let Q = Purchase Qty and D = Demand

Case 1. Q ≤ D
Profit = [p  Q] – [c  Q] + [s  0] = (p – c) Q

Case 2. Q > D
Profit = [p  D] – [c  Q] + [s  (Q – D)]
 Payoff Table: Cell Calculations

Have p = $20, c = $8, and s = $2.

Compute Profit when Q = 90 and D = 110.

Profit = [p  Q] – [c  Q] + [s  0] = (p – c) Q = 12(90) = 1080

Compute Profit when Q = 100 and D = 100.

Profit = [p  Q] – [c  Q] + [s  0] = (p – c) Q = 12(100) = 1200

Compute Profit when Q = 110 and D = 80.

Profit = [p  D] – [c  Q] + [s  (Q – D)]
= 20(80) – 8(110) + 2(30) = 1600 – 880 + 60 = 780
Payoff Table Values

Demand
Purchase 80 90 100 110 120
Qty
80 960 960 960 960 960
90 900 1080 1080 1080 1080
100 840 1020 1200 1200 1200
110 780 960 1140 1320 1320
120 720 900 1080 1260 1440
Getting the Final Answer
• 1. For Each Purchase Quantity:
• A. Calculated the Expected Profit
• 2. Choose Purchase Quantity With Highest Expected
Profit.
• 3. Expected Profit for a Purchase Quantity:
• A. Multiply Each Payoff by Its Probability, Then Sum
• 4. Example:
• A. For Purchase Quantity = 100
• B. Expected Profit = (840)(0.2) + (1020)(0.25) + (1200)(0.3) +
(1200)(0.15) + (1200)(0.1) =$1083
=$C$3*MIN($B14,C$12)-$C$2*$B14+$C$4*MAX($B14-C$12,0)
=SUMPRODUCT($C$7:$G$7,C14:G14)
Newsvendor and Overbooking
• 1. Approximately 50% of Reservations Get Cancelled at
Some Point in Time.
• 2. In Many Cases (car rentals, hotels, full fare airline
passengers) There is No Penalty for Cancellations.
• 3. Problem:
• A. The company may fail to fill the seat (room, car) if the passenger
cancels at the very last minute or does not show up.
• 4. Solution:
• A. Sell More Seats (rooms, cars) Than Capacity (Overbook)
• 5. Danger:
• A. Some Customers May Have to be Denied a Seat Even Though
They Have a Confirmed Reservation.
• B. Passengers Who Get Bumped Off Overbooked Domestic Flights
Receive :
• a. Up-to $400 if arrive <= 2 hours after their original arrival time
• b. Up-to $800 if arrive >= 2 hours after their original arrival time
Overbooking at Hyatt

• 1. The Cost of Denying a Room to the Customer with a

Confirmed Reservation is $350 in Ill-Will (Loss of Goodwill)
and Penalties.
• 2. Average Revenue From a Filled Room is $159.
• 3. Average Number of No Shows Per Night is 8.5
• 4. How Many Rooms Should be Overbooked (Sold in
Excess of Capacity)?
Overbooking at Hyatt
No Shows Probability No Shows Probability
0 0.0002 11 0.0853
1 0.0017 12 0.0604
2 0.0074 13 0.0395
3 0.0208 14 0.0240
4 0.0443 15 0.0136
5 0.0752 16 0.0072
6 0.1066 17 0.0036
7 0.1294 18 0.0017
8 0.1375 19 0.0008
9 0.1299 20 0.0003
10 0.1104

• How to Approach Problem?

• Payoff Table Would Be Huge (21 by 21 = 441 Cells)
Overbooking at Hyatt
• New Trick
• Use Critical Ratio
• Optimal Overbooking Ratio:
Cu
Cu  Co
• Cu = Cost of Underage
• Co = Cost of Overage
• For Hyatt: Cu = $159 and Co = $350
• Critcal Ratio is then:

Cu 159
  0.3124
Cu  Co 159  350
Overbooking at Hyatt
• Look at Cumulative Probabilities of “No Shows”
Cumulative
• Find First Number of “No Shows”
No Shows Probability
That Exceeds Critical Ratio
0 0.0002
• For Critical Ratio of 0.3124 1 0.0019
First Number of “No Shows” 2 0.0093
3 0.0301
With Cumulative Probability
4 0.0744
That Exceeds is 7 5 0.1496
• Overbooking by 7 Rooms Is 6 0.2562
Optimal Decision 7 0.3856
8 0.5231
9 0.6530
10 0.7634
…
Summary
• What are the types of inventory
• What are the basic inventory decisions
• What are the basic inventory questions to solve
• What are holding costs
• Understand the shortage costs
• EOQ
• EPQ
• Other types of inventory control