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Inventory
Operations
Management  One of the most expensive assets
of many companies representing as
much as 50% of total invested
capital
Inventory Management  Operations managers must balance
inventory investment and customer
service

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Functions of Inventory Types of Inventory

1. To decouple or separate various  Raw material
parts of the production process  Purchased but not processed
 Work-in-process
2. To decouple the firm from
 Undergone some change but not completed
fluctuations in demand and
 A function of cycle time for a product
provide a stock of goods that will
provide a selection for customers  Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
3. To take advantage of quantity productive
discounts  Finished goods
4. To hedge against inflation  Completed product awaiting shipment

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Inventory Management ABC Analysis

 Divides inventory into three classes
 How inventory items can be based on annual dollar volume
classified  Class A - high annual dollar volume
 How accurate inventory records  Class B - medium annual dollar
can be maintained volume
 Class C - low annual dollar volume
 Used to establish policies that focus
on the few critical parts and not the
many trivial ones
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ABC Analysis ABC Analysis

Percent of annual dollar usage

Percent of Percent of
A Items
80 – Item
Stock
Number of
Items
Annual
Volume Unit
Annual
Dollar
Annual
Dollar
70 – Number Stocked (units) x Cost = Volume Volume Class

60 – #10286 20% 1,000 $ 90.00 $ 90,000 38.8% 72% A

50 – #11526 500 154.00 77,000 33.2% A

40 – #12760 1,550 17.00 26,350 11.3% B

30 –
#10867 30% 350 42.86 15,001 6.4% 23% B
20 – B Items
#10500 1,000 12.50 12,500 5.4% B
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100 Silicon Chips, Inc., maker of superfast DRAM chips,

wants to categorize its 10 major inventory items using
Percent of inventory items Figure 12.2
ABC analysis.
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ABC Analysis ABC Analysis

Item
Percent of
Number of Annual Annual
Percent of
Annual
 Other criteria than annual dollar
Stock
Number
Items
Stocked
Volume
(units) x
Unit
Cost =
Dollar
Volume
Dollar
Volume Class volume may be used
#12572 600 $ 14.17 $ 8,502 3.7% C
 Anticipated engineering changes
#14075 2,000 .60 1,200 .5% C

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

 Delivery problems
#01307 1,200 .42 504 .2% C  Quality problems
#10572 250 .60 150 .1% C  High unit cost

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ABC Analysis Record Accuracy

 Accurate records are a critical
 Policies employed may include ingredient in production and inventory
systems
 More emphasis on supplier
development for A items  Allows organization to focus on what
is needed
 Tighter physical inventory control for
A items  Necessary to make precise decisions
about ordering, scheduling, and
 More care in forecasting A items shipping
 Incoming and outgoing record
keeping must be accurate
 Stockrooms should be secure
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Cycle Counting Cycle Counting Example

 Items are counted and records updated Cole’s Trucks, Inc., a builder of high-quality refuse trucks, has about
on a periodic basis 5,000 items in its inventory. It wants to determine how many items to
cycle count each day.
 Often used with ABC analysis to 5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C items
determine cycle 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)
 Has several advantages
Item Number of Items
 Eliminates shutdowns and interruptions Class Quantity Cycle Counting Policy Counted per Day
 Eliminates annual inventory adjustment A 500 Each month 500/20 = 25/day

 Trained personnel audit inventory accuracy B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
 Allows causes of errors to be identified and
corrected 77/day
 Maintains accurate inventory records
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Control of Service Independent Versus

Inventories Dependent Demand
 Can be a critical component of
profitability  Independent demand - the
demand for item is independent
 Losses may come from shrinkage or of the demand for any other
pilferage
item in inventory
 Applicable techniques include
1. Good personnel selection, training, and
 Dependent demand - the
discipline demand for item is dependent
2. Tight control on incoming shipments upon the demand for some
3. Effective control on all goods leaving
other item in the inventory
facility
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Holding, Ordering, and Inventory Models for

Setup Costs Independent Demand
 Holding costs - the costs of holding Need to determine when and how
or “carrying” inventory over time much to order
 Ordering costs - the costs of
placing an order and receiving  Basic economic order quantity
goods
 Production order quantity
 Setup costs - cost to prepare a
machine or process for  Quantity discount model
manufacturing an order
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Basic EOQ Model Inventory Usage Over Time

Important assumptions
Usage rate Average
Order inventory
1. Demand is known, constant, and

Inventory level
quantity = Q on hand
independent (maximum
Q
inventory
2. Lead time is known and constant level) 2

3. Receipt of inventory is instantaneous and

complete Minimum
inventory
4. Quantity discounts are not possible
5. Only variable costs are setup and holding Time
6. Stockouts can be completely avoided
Figure 12.3
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Minimizing Costs The EOQ Model

Annual setup cost =
D
Q
S

Objective is to minimize total costs Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)
Curve for total D = Annual demand in units for the Inventory item
cost of holding S = Setup or ordering cost for each order
and setup H = Holding or carrying cost per unit per year
Minimum
total cost Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)
Annual cost

Holding cost
curve Annual demand Setup or order
=
Number of units in each order cost per order
Setup (or order)
cost curve = D (S)
Q
Optimal Order quantity
Table 11.5 order
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The EOQ Model

Annual setup cost =
D
Q
S The EOQ Model
Annual setup cost =
D
Q
S
Q Q
Annual holding cost = H Annual holding cost = H
Q = Number of pieces per order 2 Q = Number of pieces per order 2
Q* = Optimal number of pieces per order (EOQ) Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the Inventory item D = Annual demand in units for the Inventory item
S = Setup or ordering cost for each order S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year H = Holding or carrying cost per unit per year

Annual holding cost = (Average inventory level) Optimal order quantity is found when annual setup cost
x (Holding cost per unit per year) equals annual holding cost

D Q
Order quantity S = H
= (Holding cost per unit per year) Q 2
2
Solving for Q*
2DS = Q2H
= Q (H) Q2 = 2DS/H
2
Q* = 2DS/H
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An EOQ Example An EOQ Example

Sharp, Inc., a company that markets painless hypodermic needles to
hospitals, would like to reduce its inventory cost by determining the optimal Determine optimal number of needles to order
number of hypodermic needles to obtain per order.
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
D = 1,000 units S = $10 per order
S = $10 per order H = $.50 per unit per year
H = $.50 per unit per year

2DS Expected Demand D

Q* = number of = N =
Order quantity
=
Q*
H orders
2(1,000)(10) 1,000
N= = 5 orders per year
Q* = = 40,000 = 200 units 200
0.50

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An EOQ Example An EOQ Example

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

Number of working Total annual cost = Setup cost + Holding cost

Expected days per year D Q
time between = T = TC = S + H
orders N Q 2
250 1,000 200
T= = 50 days between orders TC = ($10) + ($.50)
5 200 2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100
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Reorder Points Reorder Point Curve

 EOQ answers the “how much” question Q*

Inventory level (units)

 The reorder point (ROP) tells when to
order
Slope = units/day = d
Demand Lead time for a
ROP = per day new order in days
ROP
(units)
=dxL
D
d = Number of working days in a year
Time (days)
Figure 12.5 Lead time = L
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Reorder Point Example Production Order Quantity

An Apple store has a demand (D) for 8,000 iPhones per year. The firm Model
operates a 250-day working year. On average, delivery of an order takes
3 working days, but has been known to take as long as 4 days. The store  Used when inventory builds up over
wants to calculate the reorder point without a safety stock and then with
a one-day safety stock.
a period of time after an order is
placed
Demand = 8,000 DVDs per year
250 working day year  Used when units are produced and
Lead time for orders is 3 working days sold simultaneously
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
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Production Order Quantity Production Order Quantity

Model Model
Q = Number of pieces per order p = Daily production rate Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days t = Length of the production run in days

Maximum Total produced during Total used during

Annual inventory Holding cost inventory level = the production run – the production run
holding cost = (Average inventory level) x per unit per year
= pt – dt

Annual inventory However, Q = total produced = pt ; thus t = Q/p

level = (Maximum inventory level)/2
Maximum Q Q d
inventory level = p p –d =Q 1–
p p
Maximum Total produced during Total used during
inventory level = the production run – the production run
Maximum inventory level Q d
= pt – dt Holding cost = (H) = 1– H
2 2 p

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Production Order Quantity Production Order Quantity

Model Example
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate Nathan Manufacturing, Inc., makes and sells specialty
D = Annual demand
hubcaps for the retail automobile aftermarket. Nathan’s
Setup cost = (D/Q)S forecast for its wire-wheel hubcap is 1,000 units next year,
Holding cost = 1/2 HQ[1 - (d/p)] with an average daily demand of 4 units. However, the
production process is most efficient at 8 units per day. So
(D/Q)S = 1/2 HQ[1 - (d/p)] the company produces 8 per day but uses only 4 per day.
2DS The company wants to solve for the optimum number of
Q2 =
H[1 - (d/p)] units per order. ( Note: This plant schedules production of
2DS this hubcap only as needed, during the 250 days per year
Q* = the shop operates.)
H[1 - (d/p)]
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Production Order Quantity Quantity Discount Models

Example
 Reduced prices are often available when larger
quantities are purchased
D =1,000 units p = 8 units per day
S = $10 d = 4 units per day  Trade-off is between reduced product cost and
H = $0.50 per unit per year increased holding cost
2DS Total cost = Setup cost + Holding cost + Product cost
Q* =
H[1 - (d/p)] D Q
TC = S+ IP + PD
2(1,000)(10) where Q 2
Q* = = 80,000 Q = Quantity ordered
0.50[1 - (4/8)]
D = Annual demand in units
= 282.8 or 283 hubcaps S = Setup or ordering cost per order
P = Price per unit
I = Holding cost per unit per year expressed as a percent of price P
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Quantity Discount Models Quantity Discount Models

A typical quantity discount schedule Steps in analyzing a quantity discount
STEP 1: Starting with the lowest possible purchase price in
Discount Discount
Number Discount Quantity Discount (%) Price (P) a quantity discount schedule and working toward the
highest price, keep calculating Q* until the first feasible
1 0 to 999 no discount $5.00
EOQ is found. The first feasible EOQ is a possible best
2 1,000 to 1,999 4 $4.80 order quantity, along with all price-break quantities for
3 2,000 and over 5 $4.75 all lower prices.
STEP 2: Calculate the total annual cost TC for each of the
Table 12.2 possible best order quantities determined in Step 1.
Select the quantity that has the lowest total cost.

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Quantity Discount Example Quantity Discount Example

Chris Beehner Electronics stocks toy remote control flying • First we calculate the Q * for the lowest possible price of
drones. Recently, the store has been offered a quantity $96
discount schedule for these drones. This quantity schedule is
show below. Furthermore, setup cost is $200 per order, annual
demand is 5,200 units, and annual inventory carrying charge
as a percent of cost, I , is 28%. What order quantity will
minimize the total inventory cost?
• Calculate Q * for the next-higher price of $98:

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Probabilistic Models and

Quantity Discount Example Safety Stock
• Total Cost Computations for Chris Beehner  Used when demand is not constant or
Electronics certain
 Use safety stock to achieve a desired
service level and avoid stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short

x the probability x the stockout cost/unit
Total cost = Setup cost + Holding cost + Product cost
x the number of orders per year
D Q
TC = S+ IP + PD
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Safety Stock Example Safety Stock Example

David Rivera Optical has determined that its reorder point for
eyeglass frames is 50 (d * L) units. Its carrying cost per frame per ROP = 50 units Stockout cost = $40 per frame
year is $5, and the stockout (or lost sale) cost is $40 per frame. The Orders per year = 6 Carrying cost = $5 per frame per year
store has experienced the following probability distribution for
inventory demand during the lead time (reorder period). The Safety Additional
Stock-out Cost Total Cost
Stock Holding Cost
optimum number of orders per year is six. How much safety stock
should David Rivera keep on hand?
Number of Units Probability
30 .2
40 .2
ROP → 50 .3
60 .2
70 .1 Annual stockout costs = the sum of the units short x the probability x
the stockout cost/unit x the number of orders per year
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Probabilistic Demand Probabilistic Example

Use prescribed service levels to set safety 1. Memphis Regional Hospital stocks a “code blue”
stock when the cost of stockouts cannot be resuscitation kit that has a normally distributed demand
determined during the reorder period. The mean (average) demand
during the reorder period is 350 kits, and the standard
deviation is 10 kits. The hospital administrator wants to
ROP = demand during lead time + Zsdlt
follow a policy that results in stockouts only 5% of the time.
where Z = number of standard deviations (a)What is the appropriate value of Z ?
sdlt = standard deviation of demand (b)How much safety stock should the hospital maintain?
during lead time
(c)What reorder point should be used?

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Probabilistic Example

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Probabilistic Example Other Probabilistic Models

Average demand = m = 350 kits When data on demand during lead time is
Standard deviation of demand during lead time = sdlt = 10 kits
5% stockout policy (service level = 95%) not available, there are other models
available
Using Appendix I, for an area under the curve
of 95%, the Z = 1.645 1. When demand is variable and lead
time is constant
Safety stock = Zsdlt = 1.645(10) = 16.45 kits
2. When lead time is variable and
Reorder point = expected demand during lead time demand is constant
+ safety stock
3. When both demand and lead time
= 350 kits + 16.45 kits of safety
stock
are variable
= 366.45 or 367 kits
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Other Probabilistic Models Probabilistic Example

Demand is variable and lead time is constant
The average daily demand for Lenovo laptop
computers at a Circuit Town store is 15, with
ROP = (average daily demand a standard deviation of 5 units. The lead time
x lead time in days) + Zsdlt
is constant at 2 days. Find the reorder point if
management wants a 90% service level (i.e.,
risk stockouts only 10% of the time). How
much of this is safety stock?

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Probabilistic Example Other Probabilistic Models

Average daily demand (normally distributed) = 15
Standard deviation = 5 Lead time is variable and demand is constant
Lead time is constant at 2 days
90% service level desired Z for 90% = 1.28
From Appendix I ROP = (daily demand x average lead time in
days) + (Z x daily demand x slt
ROP = (average daily demand x lead time in days) + Zsdlt
ROP = (15 units x 2 days) + Zsdlt
= 30 + 1.28(5)( 2) where slt = standard deviation of lead time in days

=30 +9.05= 39.05

Safety stock is about 9 units

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Probabilistic Example Probabilistic Example

Z for 98% = 2.055
The Circuit Town store sells about 10 digital cameras Daily demand (constant) = 10 From Appendix I
a day (almost a constant quantity). Lead time for Average lead time = 6 days
camera delivery is normally distributed with a mean Standard deviation of lead time = slt = 1
98% service level desired
time of 6 days and a standard deviation of 1 day. A
98% service level is set. Find the ROP. ROP = (daily demand x average lead time in days)
+ (Z x daily demand x slt

ROP = (10 units x 6 days) + 2.055(10 units)(1)

= 60 + 20.55 = 80.55
Reorder point is about 81 units

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Other Probabilistic Models Probabilistic Example

Both demand and lead time are variable
The Circuit Town store’s most popular item is six-
packs of 9-volt batteries. About 150 packs are sold
ROP = (average daily demand per day, following a normal distribution with a
x average lead time) + Zsdlt standard deviation of 16 packs. Batteries are ordered
from an out-of-state distributor; lead time is
where sd = standard deviation of demand per day normally distributed with an average of 5 days and a
slt = standard deviation of lead time in days standard deviation of 1 day. To maintain a 95%
sdlt = (average lead time x sd2)
service level, what ROP is appropriate?
+ (average daily demand) 2slt2

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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 = (average daily demand x average lead time) + Zsdlt

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
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