Chapter 04

Inventory Management
Outline
 Definition
 Functions of Inventory
 Types of Inventory
 Inventory Management
 ABC Analysis
 Record Accuracy
 Cycle Counting
 Control of Service Inventories
Outline – Continued
 Inventory Models
 The Basic Economic Order Quantity (EOQ) Model
 Reorder Points
 Quantity Discount Models
 Probabilistic Models and Safety Stock
 Fixed-Period (P) Systems
Learning Objectives
When you complete this chapter you should be able to:

1. Conduct an ABC analysis

2. Explain and use cycle counting
3. Explain and use the EOQ model
4. Compute a reorder point and safety stock
5. Explain and use the quantity discount model
6. Understand probabilistic inventory models
 Inventory
 Inventory is stock of any item or resource
 Inventory system is set of policies to control,
maintaining and order replenishment.
 One of the most expensive assets of many
companies representing as much as 50% of
total invested capital for critical & costly item
 Operations managers must balance
inventory investment and customer service
 Functions of Inventory
1. To decouple or separate various parts of the
production process
2. To decouple the firm from fluctuations in demand
and provide a stock of goods that will provide a
selection for customers
3. To take advantage of quantity discounts
4. To protect against inflation
Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 Undergone some change but not completed
 A function of cycle time for a product
 Maintenance/repair/operating (MRO) spare parts
 Necessary to keep machinery and processes productive
 Finished goods
 Completed product awaiting shipment
The Material Flow Cycle
Cycle time

95%

Input Wait for

5%
Wait to Move Wait in queue Setup Run Outp
inspection be moved time for operator time time

Figure 4.1
 Inventory Management
 How inventory items can be classified
 How accurate inventory records can be maintained
 How much and when to order
 Inventory system
Inventory system involves;
 ABC Analysis
 Record accuracy
 Cycle counting
 ABC Analysis
 Divides inventory into three classes based on annual
dollar volume, unit cost, quality and delivery problems
 Class A - high annual dollar volume
 Class B - medium annual dollar volume
 Class C - low annual dollar volume
 Used to establish policies that focus on the few critical
parts and not the many trivial ones
 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

23%
#10867 30% 350 42.86 15,001 6.4% B

#10500 1,000 12.50 12,500 5.4% B

ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

ABC Analysis
Percent of annual dollar usage

80 – A Items
70 –
60 –
50 –
40 – B Items
30 –
20 –
C Items
10 –
0 –
| | | | | | | | |
|

10 20 Percent
30 of inventory
40 50items60 70 80 90
Figure 4.2
100
 ABC Analysis
 Policies employed may include
 More emphasis on supplier development for A items
 Tighter physical inventory control for A items
 More care in forecasting A items
Record Accuracy
 Accurate records are a critical ingredient in production and
inventory systems
 Allows organization to focus on what is needed
 Necessary to make precise decisions about ordering,
scheduling, and shipping
 Incoming and outgoing record keeping must be accurate
 Stockrooms should be secure from non registered use, theft..
 Cycle Counting
 Items are counted and records updated on a periodic basis
 Often used with ABC analysis to determine cycle
 Has several advantages
 Eliminates shutdowns and interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and corrected
 Maintains accurate inventory records
Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C items
Policy is to count A items every month (20 working days), B items
every quarter (60 days), and C items every six months (120 days)

Item Number of Items

Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
77/day
 Inventory Management Models
 Two main inventory management models
1. Single Period inventory model for service like air flight
booking, purchase of fashion items and hotel rooms…
2. Multiple inventory models for parts and products; can
be fixed order quantity model (Q- model) and fixed
time period model (P- model)
 Fixed order quantity model vs fixed
time period model
Features Q Model T Model

Order quantity Q amount, constant Q Varies

When to place order R when inventory drop T when review period
to R level arrives
Record keeping Each time withdrawal Counted only in review
or addition be made period

Size of inventory Less than P model Larger than Q model

Time to maintain Higher due to Less record keeping

perpetual record
keeping
Type of inventory Higher priced, critical Low priced components
components

Table 4.1
Inventory Costs;
Holding, Ordering/Setup and Shortage Costs
 Holding costs - the costs of holding or “carrying”
inventory over time
 Ordering costs - the costs of placing an order and
receiving goods. Setup costs - cost to prepare a
machine or process for manufacturing an order
 Shortage costs – cost of lost profit, lost customer
will, lateness penalty…

s id e ra b l y d e p ending
o ld in g c o s ts vary con n te re s t r a t e s.
H l o c ation, a n d i
b u s in e s s , h i g h tech
on the r than 15 % , s o m e
e ra lly g r e a te th a n 5 0%.
G en ng c ost s g r e a te r
s h a v e h o l d i
item
Inventory Models for
Independent Demand
Need to determine when and how much to order
 Basic economic 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. Stock outs can be completely avoided
 Inventory Usage Over Time
Usage rate Average
Order quantity inventory
= Q (maximum on hand
Inventory level

inventory Q
level)
2

Minimum
inventory

0
Time

Figure 4.3
Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
quantity (Q*)
Figure 4.4
The EOQ Model Annual setup cost =
D
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 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
The EOQ Model Annual setup cost =
D
Q
Q
S

Annual holding cost = H

Q = Number of pieces per order 2
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
The EOQ Model Annual setup cost =
D
Q
Q
S

Annual holding cost = H

Q = Number of pieces per order 2
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
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 = = 5 orders per year
200
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= = 50 days between orders
5
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 = S + H
Q 2

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

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

 Robust Model
 The EOQ model is robust
 It works even if all parameters and assumptions are not met
 The total cost curve is relatively flat in the area of the EOQ
 An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2

1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2

1,500 244.9
TC = ($10) + ($.50)
244.9 2 Only 2% less than the total
cost of $125 when the
TC = $61.24 + $61.24 = $122.48 order quantity was 200
Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to order

Demand Lead time for a new

ROP = per day 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)
Figure 4.5 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

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 + Q H + PD 2
Quantity Discount Models
A typical quantity discount schedule

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

Table 4.2
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
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)
1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
2,000 — adjusted
Quantity Discount Models
Total cost curve for discount 2
Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a and must
be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Figure 4.6
Order quantity
Quantity Discount Example
Discoun Order Annual Annual Annual
t Unit Quantit Product Ordering Holding
Number Price y Cost Cost Cost Total
1 $5.00 $25,000 $350 $25,700
700 $350
2 $4.80 $24,000 $480 $24,725
1,000 $245
3 $4.75 $23.750 $950 $24,822.50
2,000 $122.50
Table 4.3

Choose the price and quantity that gives the lowest total cost
Buy 1,000 units at $4.80 per unit
Probabilistic Models and Safety Stock
 Used when demand is not constant or certain
 Use safety stock to achieve a desired service
level and avoid stock outs

ROP = d x L + ss
 Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Safety Additional Total

Stock Holding Cost Stockout Cost Cost

(20)($5) = $100 $0
20 $100

(10)($5) = $ 50 $240
10 $290

$0 $960
0 $960

Based on total cost of holding and stock out

A safety stock of 20 frames gives the lowest total cost
ROP new = 50 + 20 = 70 frames
Probabilistic Demand

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
Probabilistic Demand
Use prescribed service levels to set safety stock
when the cost of stockouts cannot be determined

ROP = demand during lead time + ZsdLT

where Z= number of standard

deviations
sdLT = standard deviation of
demand during lead time
Probabilistic Example
Average demand = m = 350 kits
Standard deviation of demand during lead time = sdLT = 10 kits
5% stock out policy (service level = 95%)
Using Appendix I, for an area under the curve of 95%, the Z = 1.65

Safety stock = ZsdLT = 1.65(10) = 16.5 kits

Reorder point = expected demand during lead time +

safety stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
Probabilistic Example
Average daily demand (normally distributed) = 15
Standard deviation = 5
Lead time is constant at 2 days Z for 90% = 1.28
From Appendix I
90% service level desired

ROP = (15 units x 2 days) + Zsdlt

= 30 + 1.28(5)( 2)
= 30 + 9.02 = 39.02 ≈ 39

Safety stock is about 9 iPods

Probabilistic Example
Z for 98% = 2.055
Daily demand (constant) = 10 From Appendix I
Average lead time = 6 days
Standard deviation of lead time = sLT = 3
98% service level desired

ROP = (10 units x 6 days) + 2.055(10 units)(3)

= 60 + 61.65 = 121.65

Reorder point is about 122 cameras

Probabilistic Example
Average daily demand (normally distributed) = 150
Standard deviation = sd = 16
Average lead time 5 days (normally distributed)
Standard deviation = sLT = 1 day
95% service level desired
Z for 95% = 1.65
From Appendix I
ROP = (150 packs x 5 days) + 1.65sdLT
= (150 x 5) + 1.65 (5 days x 162) + (1502 x 12)
= 750 + 1.65(154) = 1,004 packs
Fixed-Period (P) Systems
 Orders placed at the end of a fixed period
 Inventory counted only at end of period
 Order brings inventory up to target level
 Only relevant costs are ordering and holding
 Lead times are known and constant
 Items are independent from one another
Fixed-Period (P) Systems
Target quantity (T)

Q4
Q2
On-hand inventory

Q1 P
Q3

Time Figure 4.8

 Fixed-Period (P) Example
3 jackets are back ordered No jackets are in stock
It is time to place an order Target value = 50

Order amount (Q) = Target (T) - On-hand

inventory - Earlier orders not yet received
+ Back orders (safety/shortage stock)
Q = 50 - 0 - 0 + 3 = 53 jackets
Fixed-Period Systems
 Inventory is only counted at each review period
 May be scheduled at convenient times
 Appropriate in routine situations
 May result in stock outs between periods
 May require increased safety stock