Managing

Inventory

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory is the stock of any

item or resource used in an
organization.

Upendra Kachru

WHAT IS
INVENTORY?

OPERATIONS MANAGEMENT

Water Tank Analogy for Inventory

Inventory Level
Supply Rate

Inventory Level

Buffers Demand Rate

from Supply Rate

Demand Rate
Upendra Kachru

OPERATIONS MANAGEMENT

Reasons To NOT Hold Inventory

Carrying cost
Financially calculable

Takes up valuable factory space

Especially for in-process inventory

Inventory covers up problems

That are best exposed and solved
Driver for increasing inventory turns (finished goods) and lean
production/Just in time for work in process

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory Hides Problems

Bad
Design
Poor
Quality

Lengthy
Setups
Inefficient
Layout

Upendra Kachru

Machine
Breakdown

Unreliable
Supplier

OPERATIONS MANAGEMENT

To Expose Problems:
Reduce Inventory Levels

Bad
Design
Poor
Quality

Lengthy
Setups
Inefficient
Layout
Upendra Kachru

Machine
Breakdown

Unreliable
Supplier

OPERATIONS MANAGEMENT

Remove Sources of Problems

and Repeat the Process
Poor
Quality

Lengthy
Setups
Bad
Design

Upendra Kachru

Inefficient
Layout

Machine
Breakdown

Unreliable
Supplier

OPERATIONS MANAGEMENT

Consumes capital
Requires storage space
Incurs taxes
Requires insurance
Can become lost, stolen,
damaged, outdated, or obsolete
Must be counted, sorted, verified,
stored, retrieved, moved, issued,
and protected

Upendra Kachru

OPERATIONS MANAGEMENT

INVENTORY PROFILE
Inputs

Raw
Materials

Orders Being Worked

Orders in Temporary Storage

Orders Waiting to be Worked

Orders Being Inspected
Outputs

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Productive

InProcess
Inventory
(WIP)
Nonproductive

Finished
Goods

OPERATIONS MANAGEMENT

Cost of Inventory at Different Stages

Inventory Costs are additive

Upendra Kachru

OPERATIONS MANAGEMENT

RAW MATERIALS INVENTORY PROFILE

Inputs

Surplus / Idle
Excess Stock
Safety Stock
Working Stock

Nonproductive

Productive

Outputs
Upendra Kachru

OPERATIONS MANAGEMENT

Inventory Objectives
Balancing Objectives

Maximize
Customer
Service
Operating
Efficiency

Upendra Kachru

1. Provide customer service

2. Support plant efficiency
3. Minimize inventory investment
Minimize
Inventory
Investment

OPERATIONS MANAGEMENT

MULTI PERIOD
INVENTORY
MODELS

Upendra Kachru

OPERATIONS MANAGEMENT

Multi-Period Inventory Models

Inventory Level
Q

Fixed-Order Quantity Models (Q): Event triggered

(Example: running out of stock)
Fixed-Time Period Models (T): Time triggered (Example:
Monthly sales call by sales representative)

Time

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T1

T2

OPERATIONS MANAGEMENT

Q and P Systems
Continuous Review System (Q)
A system designed to track the remaining inventory
of an item each time a withdrawal is made, to determine
whether it is time to replenish
Periodic Review System (P)
A system in which an items inventory position is
reviewed periodically rather than continuously

Upendra Kachru

OPERATIONS MANAGEMENT

Comparison of Q and P Systems

Continuous Review System (EOQ)
Individual review frequencies
Possible quantity discounts
Lower, less-expensive safety stocks
Periodic Review System (P)
Convenient to administer
Orders may be combined
Inventory position only required at review

Upendra Kachru

OPERATIONS MANAGEMENT

Fixed order Quantity and Fixed-Time

Period Differences
Feature

Fixed-order quantity Model

Fixed-Time Period Model

Order quantity

The same amount ordered each time

When to place order

Reorder point when inventory position Reorder when the review period
dips to a predetermined level
arrives

Record keeping

Each time a withdrawal or addition is Counted only at review period.

made

Size of inventory

Less than fixed-time period model

Time to maintain

Higher due
keeping

Type of items

Higher-priced, critical, or important

items.

Upendra Kachru

to

perpetual

Quantity varies each time order is

placed

Larger than fixed-order quantity

model

record

OPERATIONS MANAGEMENT

EOQ Model - The Inventory Cycle

The inventory cycle determines when an order should be placed and how much
should be ordered so as to minimize average annual variable costs.
Profile of Inventory Level Over Time

Usage
rate

Quantity
on hand

Reorder
point

Receive
order

Place
order

Receive
order

Place
order

Receive
order

Lead time
Upendra Kachru

OPERATIONS MANAGEMENT

Time

The EOQ Model - Assumptions

The basic assumptions in the EOQ Model are as
follows:
The rate of demand for the item is deterministic and is a
constant D units per annum independent of time.
Lead time is zero or constant and it is independent of
both demand as well as the quantity ordered.
Price per unit of product is constant
Inventory holding cost is based on average inventory
Ordering or setup costs are constant

Upendra Kachru

Prof. Upendra Kachru

OPERATIONS MANAGEMENT

19

EOQ Model: Cost of Inventory

Total Cost
C
O
S
T

Annual Cost of
Items (DC)
Holding
Costs (H)

Ordering Costs (A)

QOPT
Order Quantity (Q)

Upendra Kachru

OPERATIONS MANAGEMENT

20

EOQ Model: Minimizing Cost

Q
Average inventory level:
2

Q
vr
HQ
2

Holding cost per unit:

D
2D

A
Ordering cost per unit:
Q

By adding the item, holding, and ordering costs together, we

determine the total cost curve, which in turn is used to find the
Qopt inventory order point that minimizes total costs
Upendra Kachru

OPERATIONS MANAGEMENT

The EOQ Formula

QOPT

2DA
2DA
=
=

rv
H

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost
We also need a
reorder point to tell
us when to place an
order

Upendra Kachru

R eo rd er p o in t, R = d L
_

d = average daily demand (constant)

L = Lead time (constant)

OPERATIONS MANAGEMENT

EOQ Formula Total Annual Cost

Total
Annual =
Cost

Annual
Purchase +
Cost

TC =

Upendra Kachru

Annual
Ordering +
Cost

Annual
Holding
Cost

P*D + D*A / Q + Q*v*r / 2

TC=Total annual cost

D =Demand
P =Cost per unit
Q =Order quantity
A =Cost of placing an
order or setup cost
R =Reorder point
L =Lead time
H = v*r =Annual holding
and storage cost per
unit of inventory

OPERATIONS MANAGEMENT

EOQ Model Problem

A company, for one of its class A items, placed 8 orders each for a lot of 150
numbers, in a year. Given that the ordering cost is Rs. 5,400.00, the
inventory holding cost is 40 percent, and the cost per unit is Rs. 40.00. Find
out if the company is making a loss in not using the EOQ Model for order
quantity policies.
What are your recommendations for ordering the item in the future? And
what should be the reorder level, if the lead time to deliver the item is 6
months?
D = Annual demand
= 8*150 = 1200 units
v = Unit purchase cost
= Rs. 40.00
A = Ordering Cost
= Rs. 5400.00
r = Holding Cost
= 40%

Upendra Kachru

OPERATIONS MANAGEMENT

QEOQ = (2*5400*1200)/(0.40*40)
Using the Economic Order Equation:

TC= =
2*5400*1200*0.40*40

QEOQ = (2*A*D /r*v) = 900 units.

Minimum Total Annual Cost (TC) = 2*A*D*r*v = Rs. 14,400.00
The Total annual Cost under the present system = Rs. 45,000.00
The loss to the company = Rs. 45,000 Rs. 14,400 = Rs.
30,600.00
Reorder Level = Ro = L*D = (6/12)* 1200 = 600 units
The company should place orders for economic lot sizes of 900 units in
each order.
It should have a reorder level at 600 units.
= Rs. (1200*5400/150 +
0.40*40*150/2) = Rs.
(43,800 + 1200)
Upendra Kachru

OPERATIONS MANAGEMENT

Cost

Total Costs with Purchasing Cost

Adding Purchasing cost
doesnt change EOQ

TC with
Purchasing
Cost
TC without
Purchasing
Cost

Purchasing Cost

0
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EOQ

Quantity
OPERATIONS MANAGEMENT

Total Cost with Constant Carrying Costs

Total Cost

TCa
TCb

Decreasing
Price

TCc

CC a,b,c
OC

EOQ
Upendra Kachru

Quantity
OPERATIONS MANAGEMENT

EOQ Model with Quantity Discounts

Quantity discounts, which are price incentives to purchase
large quantities, create pressure to maintain a large
inventory.
For any per-unit price level, P, the total cost is:

Total annual cost = Annual holding cost + Annual ordering or

setup cost + Annual cost of materials
Q
C=
(H) +
2

Upendra Kachru

D
(A) + PD
Q

OPERATIONS MANAGEMENT

Total cost curves with

purchased materials added

Quantity Discounts

PD for
P = Rs.4.00

First
price
break
0

PD for
P = Rs.3.50

PD for
P = Rs.3.00

Total cost (Rupees)

Total cost (Rupees)

C for P = Rs.4.00
C for P = Rs.3.50
C for P = Rs.3.00

First
price
break

Second
price
break

100
200
Purchase quantity (Q)

Upendra Kachru

300

EOQs and price break

quantities
EOQ 4.00
EOQ 3.50
EOQ 3.00

Second
price
break

100
200
Purchase quantity (Q)

OPERATIONS MANAGEMENT

300

Finding Q with Quantity Discounts

Step 1. Beginning with the lowest price, calculate
the EOQ for each price level until a feasible EOQ
is found. It is feasible if it lies in the range
corresponding to its price.
Step 2. If the first feasible EOQ found is for the
lowest price level, this quantity is the best lot size.
Step 3. Otherwise, calculate the total cost for the
price break quantity at each lower price level. The
quantity with the lowest total cost is optimal.

Upendra Kachru

OPERATIONS MANAGEMENT

Problem
A supplier for Apollo Hospital has introduced
quantity discounts to encourage larger order
quantities of a special catheter. The price
schedule is:
Order Quantity
0 75
76 499
500 or more

Price per Unit

Rs. 60.00
Rs. 58.80
Rs. 57.00

Annual demand (D) = 936 units

Ordering cost (A) = Rs. 45
Holding cost (H) = rv = 25% of unit price

Upendra Kachru

OPERATIONS MANAGEMENT

Step 1: Start with lowest price level:

EOQ 57.00 =

EOQ 58.80 =
EOQ 60.00 =

2DS
H

2DS
H
2DS
H

2(936)(45)
0.25(57.00)

2(936)(45)
0.25(58.80)

=
=

2(936)(45)
0.25(60.00)

= 77 units
Not feasible

= 76 units
= 75 units

Feasible

Feasible

These quantities are feasible because they lie in the

range corresponding to its price.

Upendra Kachru

OPERATIONS MANAGEMENT

 Step 2: The first feasible EOQ of 75 does not correspond to the lowest price level.
Therefore compare its total cost with the price break quantities (300 and 500 units) at
the lower price levels (Rs.58.80 and Rs.57.00)

D
Q
C=
(rv) +
(A) + PD
Q
2
75
C75 =
[(0.25)(Rs. 60.00)] +
2
= Rs. 57,284
300
C300 =
[(0.25)(Rs. 58.80)] +
2
= Rs. 57,382

936
(Rs. 45) + Rs. 60.00(936)
75
936
(Rs. 45) + Rs. 58.80(936)
300

936
500
C500 =
[(0.25)(Rs.57.00)] +
(Rs.45) + Rs. 57.00(936)
500
2
= Rs. 56,999

Upendra Kachru

The best purchase quantity is 500 units,

which qualifies for the deepest discount.
OPERATIONS MANAGEMENT

QUANTITY DISCOUNTS
Advantages

Disadvantages

Lower unit cost

Higher holding costs

Lower ordering costs

Fewer stockouts
Price increase hedge

Upendra Kachru

Larger inventory investment

Older stock
Slow inventory turnover

OPERATIONS MANAGEMENT

Fixed-Time Period Models

In many retail merchandising systems, a fixed-time
period system is used. Sales people make routine
visits to customers and take orders. Inventory,
therefore, is counted only at particular times.
Fixed-time period models generate order quantities
that vary from period to period, depending on the
usage rates.

Upendra Kachru

OPERATIONS MANAGEMENT

Fixed-Period Model
Answers how much to order
Orders placed at fixed intervals
Inventory brought up to target amount
Amount ordered varies

No continuous inventory count

Possibility of stock-out between intervals

Useful when vendors visit routinely

Example: P&G rep. calls every 2 weeks
Upendra Kachru

OPERATIONS MANAGEMENT

Fixed-Period Model:
When to Order?
Inventory Level

Period
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Target maximum

Time
OPERATIONS MANAGEMENT

Fixed-Period Model:
When to Order?
Inventory Level

Period
Upendra Kachru

Target maximum

Period

Time
OPERATIONS MANAGEMENT

Fixed-Period Model:
When to Order?
Inventory Level

Period
Upendra Kachru

Target maximum

Period

Time
OPERATIONS MANAGEMENT

Fixed-Period Model:
When to Order?
Inventory Level

Period
Upendra Kachru

Target maximum

Period

Period

Time

OPERATIONS MANAGEMENT

Fixed-Period Model:
When to Order?
Inventory Level

Period
Upendra Kachru

Target maximum

Period

Period

Time

OPERATIONS MANAGEMENT

Fixed-Period Model:
When to Order?
Inventory Level

Period
Upendra Kachru

Target maximum

Period

Period

Time

OPERATIONS MANAGEMENT

T = Time between orders

d Average period usage

Average Order Quantity d T A
L = Lead Time

I = Existing Inventory
Q = Order Size

Q d T d L I
Q d( T L) I

Total Annual Cost = Purchase Cost + Ordering

Cost + Holding Cost

T C P D (D A/Q)
(H Q/2)
Upendra Kachru

OPERATIONS MANAGEMENT

Upendra Kachru

OPERATIONS MANAGEMENT

Order Quantity = Average demand over the

vulnerable period + safety stock - Inventory
currently on hand

Accounting for Safety Stock:

Q d(T L) I SS
Q d(T L) I z T L
Where
z = Number of standard deviations for a specified service probability
T + L= Standard deviation of demand over the review and lead time
Upendra Kachru

OPERATIONS MANAGEMENT

Fixed Order Period

Standard deviation of demand over T+L =

T L T L
T = Review period length (in days)
= std dev per day
Order quantity =

q d (T L) z T L I
Upendra Kachru

OPERATIONS MANAGEMENT

Two-Bin System
When the first bin is empty,
stock is taken from the second
bin and an order is placed.
There should be enough stock
in the second bin to last until
more stock is delivered.

Upendra Kachru

OPERATIONS MANAGEMENT

Single-Period Inventory Model

Single-Period Inventory Models are a
special case of periodic inventory systems.
One time purchasing decision
Seeks to balance the costs of inventory
overstock and under stock

It is used for a wide variety of service and

manufacturing applications

Upendra Kachru

OPERATIONS MANAGEMENT

Single-Period Inventory Model

The model identifies two penalty costs which are incurred
regardless of a decision:
Cost of Overage
CO = Purchase Price - Salvage Value = c - s

For each item overstocked the vendor incurs a penalty cost

Cost of Underage
CU = Selling Price - Purchase Price = p - c

For each item understocked the vendor incurs a penalty

(opportunity) cost

Upendra Kachru

OPERATIONS MANAGEMENT

Single-Period Inventory Model

If we know the probability that the unit will be sold is P; the
expected marginal cost equation can be represented as:
P (Co) < (1- P) Cu
Here (1-P) is the probability of the unit not being sold. Solving for P, we
obtain
P < [Cu / (Co + Cu)]

This equation states that we should continue to increase the

size of the order as long as the probability of selling what we
order is equal to or less than the Ratio Cu/ (Co + Cu).

Upendra Kachru

OPERATIONS MANAGEMENT

The Classical Newsvendors Problem

A newspaper vendor is faced with the problem of deciding
how many newspapers to order daily so as to maximize the
daily profit.
Daily demand (d) for newspapers is a random variable.
No reordering is possible during a day,
If the newsvendor orders fewer papers than customers demand
he or she will lose the opportunity to sell some papers.
If supply exceeds demand, the vendor will be stuck with papers
which cannot be sold.

Upendra Kachru

OPERATIONS MANAGEMENT

Demand Data
Based on observations over several weeks, the vendor has established
the following probability distribution of daily demand:
Demand
d

Probability
P(d)

Cumulative Prob.
F(d) = P(D d)

35 or less
36
37
38
39
40
41
42
43
44
45
46 or more

0.00
0.05
0.07
0.08
0.15
0.15
0.20
0.15
0.10
0.03
0.02
0.00

0.00
0.05
0.12
0.20
0.35
0.50
0.70
0.85
0.95
0.98
1.00
1.00

The vendor purchases daily papers at Rs.2 and sells them at Rs. 5
apiece. Leftover papers are valueless and are discarded (i.e. no
salvage value).
Upendra Kachru

OPERATIONS MANAGEMENT

Assume that there is already a policy in place to order a certain number of papers
daily, say 38.
Consider the decisions:
D1 : Continue the present policy: Stock 38 papers.
D2 : Order one more paper: Stock 39 papers.
The possible events are:
E1 : The 39th paper sells (i.e. demand 39 = demand > 38).
E2 : The 39th paper does not sell (i.e. demand 39 = demand 38).

Upendra Kachru

OPERATIONS MANAGEMENT

Item 39 will not sell on a given day only if demand on that

day is for 38 or fewer items:
P(D 38) = F(38) = 0.20.

The probability that an item will not sell is the cumulative

probability associated with the previous item. Item 39 will
sell on a given day only if demand on that day is for 39 or
more items:
P(D 39) = 1 - P(D 38) = 1 - F(38) = 1 0.2 = 0.80.

The expected payoff is:

Rs. 3(0.8) + (- Rs. 2)(0.2) = Rs. 2.

Upendra Kachru

This implies an increase in profit of

Rs. 2.00 as compared to the
alternative decision which has a
payoff of Rs. 0.00. He should stock
the 39th paper.

OPERATIONS MANAGEMENT

Worked
Example
After prayers at the Siababa temple
on Thursdays, people go to a vendor
to eat food. The vendor has
collected data over a few months
that show, on an average, 100 meals
were sold with a standard deviation
of 10 meals.
If our vendor wants to be 90
percent sure of not running out of
food each Thursday, how many
meals should he prepare?
Upendra Kachru

OPERATIONS MANAGEMENT

Problem and Solution

F(0.9)= +1.282

f(z)

z*

If we assume that the distribution is normal and the vendor prepared food for
exactly 100 persons, the risk of food running out would be 50 percent. The demand
would be expected to be less than 100 meals 50 percent of the time, and greater
than 100 the other 50 percent.
To be 90 percent sure of not falling short, he needs to prepare more food.
From the standard normal distribution, we can find out that he needs to have
additional food to cover 1.282 standard deviations.

In order to ensure that he is 90 percent sure having sufficient food:

The number extra food required would be 1.282 x 10 = 12.82, or 113 meals.
Upendra Kachru

OPERATIONS MANAGEMENT

Inventory Control by Classification

Systems
The inventory of a medium sized business organization would
comprise thousands of items, each item with different usage,
price, lead time and specifications. There could be different
procurement and technical problems associated with different
items.
In order to escape this quagmire many selective inventory
management techniques are used.

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory Classification Systems

Vilfredo Paretos 80-20 rule.
The Pareto Rule is based on focusing efforts where the payoff
is highest; i.e. high-value, high-usage items must be tracked
carefully and continuously.
Typically only 20 percent of all the items account for 80
percent of the total rupee usage, while the remaining 80
percent of the items typically account for remaining 20
percent of the rupee value.
The large value items constitute only 20 percent, the Pareto
Rule makes analysis the task of inventory analysis relatively
easier.
Upendra Kachru

OPERATIONS MANAGEMENT

TYPICAL ABC INVENTORY ANALYSIS

PERCENT OF
RUPEE VALUE

ABC Analysis is based on the Pareto Rule

A
80
60
40

B
20

PERCENT OF
ITEMS

20
40
60

Upendra Kachru

A = HIGH VALUE ITEMS

B = MEDIUM VALUE ITEMS
C = LOW VALUE ITEMS

OPERATIONS MANAGEMENT

ABC Analysis
Divides on-hand inventory into 3 classes
A class, B class, C class
Basis is usually annual Re. volume
Re. volume = Annual demand x Unit cost
Policies based on ABC analysis
Develop class A suppliers more
Give tighter physical control of A items
Forecast A items more carefully

Upendra Kachru

OPERATIONS MANAGEMENT

RELATIVE ANALYSIS OF ABC

CLASSIFICATIONS

Item

Degree of

Type of Records

Lot Sizes

Control
A

Tight

Accurate / Complete

Frequency of

Size of Safety

Review

Stocks

Low

Continuous

Small

Moderate

Good

Medium

Occasional

Moderate

Loose

Simple

Large

Infrequent

Large

Upendra Kachru

OPERATIONS MANAGEMENT

ABC EXCEPTIONS
1. Difficult Procurement Items
2. Short Shelf Life
3. Large Storage Space Requirements
4. Items Operational Criticality
5. Likelihood of Theft

6. Difficult Forecast Items

Upendra Kachru

OPERATIONS MANAGEMENT

Other Classification Systems

Title

Basis

Main Uses

ABC (Level of Usage)

Value of consumption

raw material components and workin progress inventories

HML (High, medium, low

usage)

Unit price of the material

Mainly to control purchase.

FSND (Fast, Slow moving,

Non moving, Dead )

Consumption pattern of the

component

Control obsolescence.

SDE (Scarce, difficult, easy

to obtain items)

Problems faced in
procurement

Lead time analysis and purchasing

strategies

GOLF (Government,
Ordinary, Local, Foreign)

Source of the material

Procurement strategies

VED (Vital, Essential,

(Desirable)
SOS (Seasonal, Offseasonal)
XYZ ( Value of Stock)

Upendra Kachru

Criticality of the component

Nature of suppliers
Value of items in storage

To determine the stocking levels of

spare parts.
Seasonal items like agriculture
products
To review the inventories and their
use scheduled intervals.

OPERATIONS MANAGEMENT

Inventory Metrics
Average Inventory Investment: The rupee value of a
companys average level of inventory is one of the most
common measures of inventory.
Inventory Turnover Ratio: It is a ratio that measures how
many times during a year the inventory turns around.
Inventory turnover = annual cost of
goods sold/average inventory
investment

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory Metrics
Days of Inventory: This measure is an indication of
approximately how many days of sales can be supplied solely
from inventory.
Days of inventory = avg. inventory
investment/ (annual cost of gods
sold/days per year)
Days of inventory = days per year/
inventory turnover rate

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory Tracking
Track additions and removals
Bar-coding
Point of use or point of sale (POS)
RFID

Physical count of items

Periodic intervals
Cycle count
Find and correct errors
Upendra Kachru

OPERATIONS MANAGEMENT

Classical Inventory Problems

Ever - increasing storage space needs

Slow-moving materials
Disposition of scrap, obsolete, & surplus
materials
Transaction recording errors
Misplaced materials

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory System Improvement

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

Standardize Stock Items

Reduce Lead Times
Reduce Cycle Times
Use Fewer Suppliers
Inform Suppliers of Expected Demand
Contract for Minimum Annual Purchases
Buy on Consignment
Consider Transportation Costs
Order Economical Quantities
Control Access to Storage Areas
Obtain Better Forecasts

Upendra Kachru

OPERATIONS MANAGEMENT

Inventory System Improvement

12. Dispose of Excess Stock
13. Improve Record Accuracy (cycle count)
14. Improve Capacity Planning
15. Minimize Setup Times
16. Simplify Product Structures
17. Multishift operations
18. Continuous Improvement

Upendra Kachru

OPERATIONS MANAGEMENT
Prof. Upendra Kachru

Click

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to

edit

company

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