ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

ME 391A: DESIGN, PLANNING AND CONTROL OF

PRODUCTION SYSTEM

UNIT 3 INVENTORY SYSTEMS

Learning outcomes

 Cost factors relevant to operations and inventory control

 EOQ with shortages and uniform productions

 EOQ with quantity discount

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

1 Inventory Systems
Inventory plays multiple roles in a company’s operations. For this reason,
companies develop inventory management objectives and performance
measures to evaluate how well they are handling their inventory investment.
1.1 Types of Inventory
Inventory comes in many shapes and sizes, as shown below.

Most manufacturing firms have the following types of inventory.

Raw materials are the purchased items or extracted materials that are
transformed into components or products. For example, gold is a raw material
that is transformed into jewelry.
Components are parts or subassemblies used in building the final product. For
example, a transformer is a component in an electronic product.
Work-in-process (WIP) refers to all items in process throughout the plant.
Since products are not manufactured instantaneously, there is always some WIP
inventory flowing through the plant.
After the product is completed, it becomes finished goods - the bicycles,
stereos, CDs, and automobiles that the company sells to its customers.
Distribution inventory consists of finished goods and spare parts at various
points in the distribution system—for example, stored in warehouses or in
transit between warehouses and consumers.

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

1.2 Different ways of using inventory

Companies have different kinds of inventory. They also use inventory for
different purposes. Different ways of using inventory are:
a) Anticipation Inventory or Seasonal Inventory is built in anticipation of
future demand, planned promotional programs, seasonal fluctuations,
plant shutdowns, and vacations. Companies build anticipation inventory
to maintain level production throughout the year. For example, the toy
industry builds toys throughout the year in anticipation of high seasonal
sales in December.
b) Fluctuation Inventory or Safety Stock is carried as a cushion to protect
against possible demand variation, ―just in case‖ of unexpected demand.
Fluctuation inventory or safety stock is also called buffer stock or reserve
stock.
c) Lot-size Inventory or Cycle Stock results when a company buys or
produces more than is immediately needed. The extra units of lot-size
inventory are carried in inventory and depleted as customers place orders.
Cycle stock also occurs when making products and the process has a
minimum greater than is needed.
d) Transportation or Pipeline Inventory is in transit between the
manufacturing plant and the distribution warehouse. Transportation
inventory are items that are not available for satisfying customer demand
until they reach the distribution warehouse, so the company needs to
decide between using slower, inexpensive transportation or faster, more
expensive transportation.
e) Speculative or Hedge Inventory is a buildup to protect against some
future event such as a strike, a price increase, or the scarcity of a product
that may or may not happen. A company typically builds speculative
inventory to ensure a continuous supply of necessary items.

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

f) Maintenance, Repair, and Operating (MRO) Inventory includes

maintenance supplies, spare parts, lubricants, cleaning compounds, and
daily operating supplies such as pens, pencils, and note pads. MRO items
support general operations and maintenance but are not part of the
product the company builds.
1.3 Objectives of Inventory Management
1.3.1 Customer Service
Customer service is a company’s ability to satisfy the needs of its customers.
Customer service measures the effectiveness of the company’s inventory
management. Customers can be either external or internal: any entity in the
supply chain is considered a customer. The performance of any company in
customer satisfaction can be measured using the following criterias:
a) Percentage of Orders Shipped on Schedule
b) Percentage of Line Items Shipped on Schedule
c) Percentage of Volume Shipped on Schedule
d) Idle Time Due to Material and Component Shortages
1.3.2 Cost-Efficient Operations
Companies can achieve cost-efficient operations by using inventory in the
following ways:
a) First, companies use work-in-process (WIP) inventory to buffer
operations.
b) Second, inventories allow manufacturing organizations to maintain a
level workforce throughout the year despite seasonal demand for
production.
c) Third, by building inventory in long production runs, the setup cost is
spread over a larger number of units, decreasing the per unit setup cost.
d) Fourth, a company that is willing to acquire inventory can buy in larger
quantities at a discount.
1.3.3 Minimum Inventory Investment
Dr. Kailash Chaudhary, MBM Engineering College Jodhpur
ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

A company can measure its minimum inventory investment by its inventory

turnover, i.e., by the level of customer demand satisfied by the supply on hand.
The inventory turnover can be calculated as:
annual cost of goods sold
Inventory turnover 
average inventory amount

2 Cost factors relevant to operations and inventory control

Inventory management policies have cost implications. Decisions about how
much inventory to hold affect item costs, holding costs, ordering costs, and
stockout (shortage) costs.
1. Item Costs: The item costs of a purchased item include the price paid for
the item and any other direct costs for getting the item to the plant, such
as inbound transportation, insurance, duty, or taxes. For an item built by
the manufacturing company, the item costs include direct labor, direct
materials, and factory overhead.
2. Holding Costs: Holding costs include the variable expenses incurred by
the firm for the volume of inventory held. As inventory increases, so do
the holding costs. We can determine unit holding costs by examining
three cost components: capital costs, storage costs, and risk costs. Annual
holding costs are typically stated in either per unit (Rs. 10 per unit per
year) or as a percentage of the item value (25 percent of the unitvalue).
The cost of the capital is the interest rate the company pays to borrow
money to invest in inventory. Storage costs usually include the cost of
space, workers, and equipment. Risk costs include obsolescence, damage
or deterioration, theft, insurance, and taxes.
3. Ordering Costs: Ordering costs are fixed costs for either placing an
order with a supplier for a purchased component or raw material or for
placing an order to the manufacturing organization for a product built in-
house. For a purchased item, the ordering costs include the cost of the

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

clerical work to prepare, release, monitor, and receive orders and the
physical handling of the goods. The ordering costs are considered
constant regardless of the number of items or the quantities ordered.
4. Shortage Costs: Companies incur shortage costs when customer demand
exceeds the available inventory for an item. Suppose a customer places an
order through website for a product, but that product is out of stock. One
of two things happens. Either customer waits until the product is available
or customer decides to buy the product from another company and the
result for the first company is a lost sale.

3 Determination of Order Quantities

The objectives of inventory management are to provide the desired level of
customer service, enable cost-efficient operations, and minimize the inventory
investment. To achieve these objectives, a company must first determine how
much of an item to order at a time. Inventory management and control are done
at the level of the individual item or stock-keeping unit (SKU). An SKU is a
specific item at a particular geographic location. The Common Ordering
Approaches are:
3.1 Lot-for-lot
It is ordering exactly what is needed. The orders are placed as per the ordering
needs, which ensures no possibility of leftover inventory. Lot-for-lot is used
when demand is not constant and the manufacturer has the information about
the expected needs.
3.2 Fixed-order quantity
It specifies the number of units to order each time an order is placed for a
certain item. The quantity may be arbitrary, or it may be the result of how the
item is packaged or prepared. The advantage of this system is that it is easily
understood; the disadvantage is that it does not minimize inventory costs.
3.3 Min-max system

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

It involves placing an order when the on-hand inventory falls below a

predetermined minimum level. The quantity ordered is the difference between
the quantity available and the predetermined maximum inventory level. With
this system, both the time between orders and the quantity ordered can vary.
3.4 Order n periods
It means that the order quantity is determined by summing company’s
requirements for the next n periods. For example, the order is placed enough
each time to satisfy the company’s requirements for the next three periods. A
concern with this system is determining the number of periods to include in the
order.

4 Mathematical Models For Determining Order Quantity

4.1 Economic Order Quantity (EOQ)
It is an optimizing method used for determining order quantity and reorder
points. EOQ is a continuous review system, used to keep track of the inventory
on hand each time stock is added or withdrawn. If the withdrawal reduces the
inventory level to the reorder point or below, the company makes a
replenishment order. Thus, EOQ indicates when to place a replenishment order
and determines the order quantity that minimizes annual inventory cost.
Following are the assumptions for the basic EOQ model:
a) Demand for the product is known and constant. This means that the
demand for every time period is known and that this amount never
changes.
b) Lead time is known and constant. It is the amount of time it takes from
order placement until it arrives at the manufacturing company. Because
the company knows how long it takes for the replenishment order to
arrive, it can determine when the order to be placed. By finding the
reorder point, company schedules the arrival of the replenishment

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

quantity just as company’s inventory level reaches zero. The minimum

inventory level with the basic EOQ should be zero.
c) Quantity discounts are not considered: the cost of all units is the same,
regardless of the quantity ordered.
d) Ordering and setup costs are fixed and constant: the amount to place an
order is always the same, regardless of the size of the order.
e) Since the company knows demand with certainty, the assumption is that
all demand is met. The basic model does not permit back orders, but more
advanced models are less rigid.
f) The quantity ordered arrives at once. Since the order is scheduled to
arrive just as the company runs out of inventory, the maximum inventory
level equals the economic order quantity.
Figure shows the basic workings of the EOQ model. The inventory
replenishment process begins when the inventory reaches the reorder point. This
is the point at which company places an order for Q units, which are timed to
arrive just as company’s inventory level reaches zero. The inventory goes from
zero to Q and then is depleted at a constant rate. Once the inventory reaches the
reorder point, the process begins again.

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

Since the basic model assumes certainty about demand and lead time, the
reorder point is set equal to demand during lead time, or
R = dL
where R = reorder point
d = average daily demand
L = lead time in days
As no quantity discounts are considered in the basic EOQ model, so the annual
item cost remains constant regardless of the quantity ordered each time. Given
that, our total costs are:
Total annual cost = annual ordering costs + annual holding costs
D  Q 
TC  S    H 
EOQ Q   2 
Where
TC  total annual cost
D  annual demand
Q  quantity to be ordered
H  annual holding cost
S  ordering or setup cost

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

EOQ is calculated as:

2DS
EOQ 
H
where Q = optimal order quantity
D = annual demand
S = ordering or setup cost
H = holding cost
When to Order:
The Reorder Point
• Without safety stock:
R  dL
where R  reorder point in units
d  daily/weekly demand in units
L  lead time in days/weeks
• With safety stock:
R  dL  SS
where SS  safety stock in units

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

Example
Weekly demand = 240 units
No. of weeks per year = 52
Ordering cost = Rs. 50
Unit cost = Rs. 15
Annual carrying charge = 20%
Lead time = 2 weeks
Solution:
D  52  240  12,480 units/year
H  0.2  15  Rs. 3 per unit per year

2DS 2 12,480  50
Q   644.98  645 units
H 3
 D   Q   12,480   645 
TC   S    H     50     3
 Q   2   645   2 
 967.44  967.5  Rs. 1,934.94
R  dL  240  2  480 units

4.2 Quantity Discount Model

The basic EOQ model assumes that no quantity discounts are available. In real
life, however, quantity discounts are often available, so we need to modify the
basic model for these situations. Quantity discounts are price incentives to
encourage a company to buy in larger quantities. Whenever the price per unit is
not fixed but varies based on the size of order, the total annual cost formula for
any inventory policy used must include the cost of material:

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

D  Q 
TC   S    H   CD
EOQ  Q   2 
Where
TC  total annual cost
D  annual demand
Q  quantity to be ordered
H  annual holding cost
S  ordering or setup cost
C  unit price
Quantity Discount Procedure
1. Calculate the order quantity using the basic EOQ model and the cheapest
price possible.
2. Determine whether the order quantity is feasible. That is, if we order this
quantity will the supplier charge us the price we used to determine our order
quantity? If this is a feasible order quantity, you are done. Otherwise, go to Step
3.
3. If the EOQ quantity found in Step 1 was infeasible, calculate the EOQ for the
next higher price.
4. Check again to determine if this quantity is feasible. If it is not feasible,
repeat Step 3. If it is feasible, move on to Step 5.
5. Calculate the total annual costs associated with your feasible order quantity.
You must include ordering, holding, and material costs.
6. Calculate the total annual costs associated with buying the minimum quantity
required to qualify for any prices that are lower than the price at which the
feasible solution was found.
7. Compare the total annual costs of buying these minimum quantities to receive
the cheaper price against the cost of the feasible Q.
8. Recommend whichever order policy has the lowest total annual cost.

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

Example
KC company operates its own laboratory on-site. The lab maintains an
inventory of test kits for a variety of procedures. KC company uses 780 kits
each year. Ordering costs are Rs. 15 and holding costs are Rs. 3 per kit per year.
The new price list indicates that orders of fewer than 73 kits will cost Rs. 60 per
kit, 73 through 144 kits will cost Rs. 56 per kit, and orders of more than 144 kits
will cost Rs. 53 per kit. Determine the optimal order quantity and the total cost.
Solution:
The first step is to calculate the common Q.
2DS 2 x 780 x 15
EOQ    89 kits
H 3
This quantity qualifies for a price of Rs. 56 per kit. Since it is not the lowest
possible price, we calculate the total cost at this price and compare it to the total
cost at any lower price breaks. The total cost when ordering 89 kits is
 D   Q   780   89 
TC   S    H     15     3   (56  780)
 Q   2   89   2 
 Rs. 43945
Total cost when ordering 145 kits is
 D   Q   780   145 
TC   S    H     15     3   (53  780)
 Q   2   145   2 
 Rs. 41638
Therefore, KC company should order 145 kits at a time since it will save Rs.
2307 each year (Rs. 43945 – Rs. 41638).

Review Questions
1) Describe the importance of inventory system in a manufacturing industry.
2) Explain various types of inventory with suitable examples.
3) Discuss about the different ways of using inventory.
4) What is the objectives of inventory management ?

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur

ME 391A DESIGN, PLANNING AND CONTROL OF PRODUCTION SYSTEM UNIT 3

5) Discuss about the cost factors relevant to operations and inventory

control.
6) Compare the common ordering approaches with suitable examples.
7) Explain Economic Order Quantity (EOQ) along with its assumptions.
8) Discuss about the Quantity Discount Model.
9) Write the Quantity Discount procedure.

Dr. Kailash Chaudhary, MBM Engineering College Jodhpur