Inventory Management

INVENTORY
KEEPING INVENTORY
INVENTORY CONTROL
ABC ANALYSIS
EOQ MODELS
 Inventory

 An Inventory consists of usable but idle resources

such as men, machine, materials or money.
 When the resources involved is material, the
inventory is also called ‘stock’.
 Inventory

 Inventory generally refers to the materials in stock. It is

also called the idle resource of an enterprise. Inventories
represent those items which are either stocked for sale or
they are in the process of manufacturing or they are in
the form of materials, which are yet to be utilized. The
interval between receiving the purchased parts and
transforming them into final products varies from
industries to industries depending upon the cycle time of
manufacture. It is, therefore, necessary to hold
inventories of various kinds to act as a buffer between
supply and demand for efficient operation of the system.
Thus, an effective control on inventory is a must for
smooth and efficient running of the production cycle
with least interruptions
 Inventory

 Inventory comes in many shapes and sizes such as

 Raw materials – purchased items or extracted materials
transformed into components or products
 Components – parts or subassemblies used in final
product
 Work-in-process – items in process throughout the plant
 Finished goods – products sold to customers
 Distribution inventory – finished goods in the
distribution system
 Reasons for Keeping Inventories

 To stabilize production: The demand for an item

fluctuates because of the number of factors, e.g.,
seasonality, production schedule etc. The inventories
(raw materials and components)should be made
available to the production as per the demand failing
which results in stock out and the production
stoppage takes place for want of materials. Hence,
the inventory is kept to take care of this fluctuation
so that the production is smooth.
 Reasons for Keeping Inventories

 To take advantage of price discounts: Usually the

manufacturers offer discount for bulk buying and to gain
this price advantage the materials are bought in bulk
even though it is not required immediately. Thus,
inventory is maintained to gain economy in purchasing.
 To meet the demand during the replenishment
period: The lead time for procurement of materials
depends upon many factors like location of the source,
demand supply condition, etc. So inventory is
maintained to meet the demand during the procurement
(replenishment) period.
 Reasons for Keeping Inventories

 To prevent loss of orders (sales):In this

competitive scenario, one has to meet the delivery
schedules at 100 per cent service level, means they
cannot afford to miss the delivery schedule which
may result in loss of sales. To avoid the organizations
have to maintain inventory.
 To keep pace with changing market
conditions: The organizations have to anticipate
the changing market sentiments and they have to
stock materials in anticipation of non-availability of
materials or sudden increase in prices.
 Inventory Control

Inventory control is a planned approach of determining what to order,

when to order and how much to order and how much to stock so that
costs associated with buying and storing are optimal without
interrupting production and sales. Inventory control basically deals with
two problems:
(i) When should an order be placed? (Order level), and
(ii) How much should be ordered? (Order quantity).

These questions are answered by the use of inventory models. The

scientific inventory control system strikes the balance between the loss
due to non-availability of an item and cost of carrying the stock of an
item. Scientific inventory control aims at maintaining optimum level of
stock of goods required by the company at minimum cost to the
company.
 Objectives of Inventory Control
1. To ensure adequate supply of products to customer and avoid shortages
as far as possible.
2. To make sure that the financial investment in inventories is minimum
(i.e., to see that the
working capital is blocked to the minimum possible extent).
3. Efficient purchasing, storing, consumption and accounting for materials
is an important
objective.
4. To maintain timely record of inventories of all the items and to
maintain the stock within the
desired limits
5. To ensure timely action for replenishment.
6. To provide a reserve stock for variations in lead times of delivery of
materials.
7. To provide a scientific base for both short-term and long-term planning
of materials.
 Benefits of Inventory Control

1. Improvement in customer’s relationship because of the

timely delivery of goods and service.
2. Smooth and uninterrupted production and, hence, no stock
out.
3. Efficient utilization of working capital. Helps in minimizing
loss due to deterioration,
obsolescence damage and pilferage.
4. Economy in purchasing.
5. Eliminates the possibility of duplicate ordering.
 Inventory Costs

 Cost of placing the order: Every time that an

order is placed to replenish stock, a number of
transactions is needed which incurs costs to the
company. These include the clerical tasks of
preparing the order and all the documentation
associated with it, arranging for the delivery to be
made, arranging to pay the supplier for the delivery
and the general costs of keeping all the information
which allows us to do this.
 Inventory Costs

 Price discount costs: In many industries suppliers

offer discounts on the normal purchase price for large
quantities; alternatively they might impose extra costs
for small orders.
 Stock-out costs: If we misjudge the order-quantity
decision and our inventory runs out of stock, there will
be costs to us incurred by failing to supply our customers.
If the customers are external, they may take their
business elsewhere; if internal, stock-outs could lead to
idle time at the next process, inefficiencies and
eventually, again, dissatisfied external customers.
 Inventory Costs

 Working capital costs: Soon after we receive a

replenishment order, the supplier will demand
payment for their goods. Eventually, when (or after)
we supply our own customers, we in turn will receive
payment. However, there will probably be a lag
between paying our suppliers and receiving payment
from our customers. During this time we will have to
fund the costs of inventory. This is called the
working capital of inventory.
 Inventory Costs

 Storage costs: These are the costs associated with

physically storing the goods. Renting, heating and
lighting the warehouse, as well as insuring the inventory,
can be expensive, especially when special conditions are
required such as low temperature or high security.
 Obsolescence costs: When we order large quantities,
this usually results in stocked items spending a long time
stored in inventory. Then there is a risk that the items
might either become obsolete (in the case of a change in
fashion, for example) or deteriorate with age (in the case
of most foodstuffs).
ABC analysis
What is ABC analysis?

 ABC analysis is an inventory

categorization method which
consists in dividing items into three
categories (A, B, C):
 A being the most valuable items,
 C being the least valuable ones.
 This method aims to draw managers’
attention on the critical few (A-items)
not on the trivial many (C-items).
 The ABC analysis
The ABC approach states that a company
should rate items from A to C, basing its
ratings on the following rules:
 ABC classification is a method for determining
level of control and frequency of review of
inventory items
 A Pareto analysis can be done to segment items
into value categories depending on annual dollar
volume
 A Items – typically 20% of the items accounting
for 80% of the inventory value-use Q system
 B Items – typically an additional 30% of the items
accounting for 15% of the inventory value-use Q
or P
 C Items – Typically the remaining 50% of the
items accounting for only 5% of the inventory
value-use P
The ABC analysis
The AAU Corp. is considering doing an ABC analysis on its
entire inventory but has decided to test the technique on a
small sample of 15 of its SKU’s. The annual usage and unit
cost of each item is shown below

© Wiley 2010
(A) First calculate the annual dollar
volume for each item

© Wiley 2010
B) List the items in descending order based on annual dollar
volume. (C) Calculate the cumulative annual dollar volume
as a percentage of total dollars. (D) Classify the items into
groups

© Wiley 2010
Graphical solution For Example showing the
ABC classification of materials
 The A items (106 and 110) account for 60.5% of the value and 13.3% of the items
 The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the items
 The C items make up the last 14.5% of the value and 60% of the items
 How might you control each item classification? Different ordering rules for each?

© Wiley 2010
 Percentage
Percentage
value of
of items
annual usage

Close day to
Class A items About 20% About 80%
day control

Regular
Class B items About 30% About 15%
review

Infrequent
Class C items About 50% About 5%
review
Step 1

Calculate the total spending per year

Item number Unit cost Annual demand Total cost per year
101 5 48,000 240,000
102 11 2,000 22,000
103 15 300 4,500
104 8 800 6,400
105 7 4,800 33,600
106 16 1,200 19,200
107 20 18,000 360,000
108 4 300 1,200
109 9 5,000 45,000
110 12 500 6,000
Total usage 737,900

Total cost per year: Unit cost * total cost per year
Step 2

Calculate the usage of item in total usage

Usage as a
Item Unit Annual Total cost
% of total
number cost demand per year
usage
101 5 48,000 240,000 32,5%
102 11 2,000 22,000 3%
103 15 300 4,500 0,6%
104 8 800 6,400 0,9%
105 7 4,800 33,600 4,6%
106 16 1,200 19,200 2,6%
107 20 18,000 360,000 48,8%
108 4 300 1,200 0,2%
109 9 5,000 45,000 6,1%
110 12 500 6,000 0,8%
Total usage 737,900 100%

Usage as a % of total usage = usage of item/total usage

Step 3
Sort the items by usage
Item Cumulative Unit Annual Total cost per Usage as a % Cumulative % of
number % of items cost demand year of total usage total

107 10% 20 18,000 360,000 48,8% 48,8%

101 20% 5 48,000 240,000 32,5% 81,3%

109 30% 9 5,000 45,000 6,1% 87,4%

105 40% 7 4,800 33,600 4,6% 92%

102 50% 11 2,000 22,000 3,0% 94,9%

106 60% 16 1,200 19,200 2,6% 97,5%

104 70% 8 800 6,400 0,9% 98,4%

110 80% 12 500 6,000 0,8% 99,2%

103 90% 15 300 4,500 0,6% 99,8%

108 100% 4 300 1,200 0,2% 100%

Total usage 737,900 100%

Step 4

Results of calculation

Percentage of Percentage
Cathegory Items Action
items usage (%)

Class A 107, 101 20% 81,6% Close control

109, 105, 102, Regular

Class B 40% 16,2%
106 review

104, 110, 103, Infrequent

Class C 40% 2,5%
108 review
 Assignment
PART UNIT COST ANNUAL USAGE

1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
Inventory Models for
Independent Demand
Need to determine when and how
much to order

 Basic economic order quantity

 Production order quantity
 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 and holding
6. Stockouts can be completely avoided
 Inventory Usage Over Time

Usage rate Average

Order inventory
quantity = Q on hand
Inventory level

(maximum
Q
inventory
level) 2

Minimum
inventory

0
Time

Figure 12.3
 D
The EOQ Model Annual setup cost =
Q
S

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 or ordering 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

= D (S)
Q
 D
The EOQ Model Annual setup cost =
Q
S
Q
Annual holding cost = H
2
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 holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

= Q (H)
2
 D
The EOQ Model Annual setup cost =
Q
S
Q
Annual holding cost = H
2
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
Optimal order quantity is found when annual setup cost
equals annual holding cost

D Q
S = H
Q 2
Solving for Q* 2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
Economic order quantity (EOQ) is the order quantity that minimizes total inventory
holding costs and ordering costs. EOQ typically applies only when demand for a
product is constant over a given period of time and each new order is delivered in full
when inventory reaches zero.
Economic Order Quantity(EOQ)
Economic Order Quantity(EOQ)
 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 optimal number of needles to order
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= 200 = 5 orders per year
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected time days per year
between orders =T=
N

250
T= 5 = 50 days between orders
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = Q S + 2 H

1,000 200
TC = 200 ($10) + 2 ($.50)

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

 Example- EOQ model (Assignment)

 A local distributor for a national tire company expects to sell

approximately 9600 steel-belted radial tires of a certain size
and tread design next year. Annual carring cost is $ 16 per
tire, and ordering cost is $ 75. The distributor operates 288
days a year.
 (a) What is the EOQ?
 (b) How many times per year does the store reorder?
 (c) What is the length of an order cycle?
 (d) What is the total annual cost if the EOQ quantity is
ordered?
 Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to
order
Demand Lead time for a
ROP = per day new order in days
=dxL
D
d= Number of working days in a year
 Reorder Point Curve

Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days

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

 Production Order Quantity Model

 Used when inventory builds up over a

period of time after an order is placed
 Used when units are produced and sold
simultaneously
 Economic Production Quantity (EPQ)

 Production done in batches or lots. Even in assembly

operations, portions of the work are done in batches.
 Capacity to produce a part exceeds the part’s usage or
demand rate
 As long as production continious, inventory will
continue to grow.
 This makes sense to periodically produce such items in
batches or lots instead of producing continually.
 Assumptions of EPQ are similar to EOQ except orders
are received incrementally during production
Economic Production Quantity Assumptions

 Only one item is involved

 Annual demand is known
 Usage rate is constant
 Usage occurs continually
 Production rate is constant
 Lead time does not vary
 No quantity discounts
 Production Order Quantity Model
Q = Number of pieces 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 pieces 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 pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand
Setup cost = (D/Q)S
1
Holding cost = HQ[1 - (d/p)]
2
1
(D/Q)S = HQ [1 - (d/p)]
2
Q2 = 2DS
H[1 - (d/p)]

Q* 2DS
p=
H[1 - (d/p)]
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* = H[1 - (d/p)]

2(1,000)(10)
Q* = 0.50[1 - (4/8)] = 80,000

= 282.8 or 283 hubcaps

 Example- Run size

 A toy manufacturer uses 48000 rubber wheels per year for

its popular damp truck series. The firm makes its own
wheels which it can produce at the rate of 800 per day. The
toy trucks are assembled uniformly over the entire year.
Carring cost is $ 1 per wheel a year. Setup cost for a
production run of wheels is $ 45. The firm operates 240
days per year. Determine

 (a) Optimal run size

 (b) Minimum total annual cost for carring and setup
 (c) Cycle time for the optimal run size
 (d) Run time
 Quantity Discount Models

 Reduced prices are often available when larger

quantities are purchased
 Trade-off is between reduced product cost and
increased holding cost
Total cost = Setup cost + Holding cost + Product cost

D Q
TC = S + 2 H + PD
Q
 Quantity Discount Models

Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

 Quantity Discount Models
Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify, choose the
smallest possible order size to get the discount
3. Compute the total cost for each Q* or adjusted
value from Step 2
4. Select the Q* that gives the lowest total cost
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
 Quantity Discount Example
2DS
Q* =
Calculate Q* for every discount IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
 Quantity Discount Example

Annual Annual Annual

Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Table 12.3

Choose the price and quantity that gives the lowest total cost
Buy 1,000 units at $4.80 per unit
EOQ examples 4
Production Order Quantity (POQ)
Examples
Examples 2
Examples 3
 References

 Operation Research- Hira and Gupta

 Operation Management-Slack, Chambers and
Johnston
 Schaum’s Oulines Operation Research-Richard
Brondson
 Operation Research- Winston
 Operation Research-Heizer
Thank You