Lesson 12: Inventory management

Operations

Management
Maintenance/repair/operating (MRO)
Inventory
Types of inventory
An inventory is a stock of an item or idle resource held
for future usage in an organization (to satisfy present or
future demand).
Raw Materials: Vendor-supplied items that have not had any labor added
by the firm receiving the items.

Finished Goods: Completed products that are still in the possession of
the firm that manufactured them.

Work-in-Process (WIP): Items that have been partially processed but are
still incomplete.
Inventory management
Why inventory is important
Is one of the most expensive assets of
many companies (50%)
Inventory management must balance
inventory investment and customer service

Set of policies and controls that monitors levels of
inventory and determines:
What to keep? how much to keep? How much do we
have? (inventory control)
What to order? how large orders should be? When
should be replenished?
How much does this cost?
1. To separate (in time, in space, in technology)
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 discounts and hedge
against changes in price or supply
interruptions
Rationales for inventory
Based on the Pareto principle (20-80)
Divides inventory into three classes
based on annual dollar volume
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 (care in forecasting, physical inventory
control and procurement)
ABC analysis
ABC analysis (Example)
Bookers Book Bindery wants to divider SKUs into three
classes, according to their dollar usage.
ABC analysis (Example)
Items are counted and records updated on a
periodic basis
ABC analysis: cycle counting
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).
A museum of natural history opened a gift shop which
operates 52 weeks per year.
Managing inventories has become a problem.
Top-selling SKU is a bird feeder.
Sales are 18 units per week, the supplier charges $60 per
unit.
Ordering cost is $45.
Annual holding cost is 25 percent of a feeders value.
The aim of inventory management
Compute the optimal order size. How
frequently will orders be placed? How
many orders per year?
Compute the relevant costs.
Independent demand: the demand for this item is
independent of the demand for any other item in
inventory.
Holding costs are the costs of holding or
carrying inventory over time.
Fixed costs (per order or batch): Ordering costs
(the costs of placing a single order and receiving
goods) or Setup costs (cost to prepare a machine
or process for manufacturing an order).
the Economic Order Quantity (EOQ)
model : glossary
1. Demand rate is known, uniform, and
independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Price is constant. Quantity discounts do not
exist
5. Only setup/ordering cost and holding cost
are considered. They are constant over time.
6. No stockouts
Assumptions underlying the EOQ model

Maximum
inventory Q
Average
inventory
on hand
Q
2
Minimum
inventory
I
n
v
e
n
t
o
r
y

l
e
v
e
l

Time (t)
0
The EOQ model: usage of inventory
Order quantity
Q
S(t)
Time Between Orders
(replenishment period)
The EOQ formula
The single-item EOQ formula finds the minimum point of the following
cost function:

Total Cost (in a period) = purchase (or production) cost + ordering (setup)
cost + holding cost



Purchase cost: purchase unit price annual demand quantity. p D
Ordering cost: Each order has a fixed cost S, and we need to order D/Q
times per period.
Holding cost: the average quantity in stock is Q/2 and the holding cost
per unit per period is H (sometimes H = i x P, where i is an interest rate).

H
The EOQ formula
To determine the minimum point of the total cost curve, differentiate the
total cost with respect to Q and set to 0:
Solving for Q gives Q* (the optimal order quantity)
A museum of natural history opened a gift shop which
operates 52 weeks per year.
Managing inventories has become a problem.
Top-selling SKU is a bird feeder.
Sales are 18 units per week, the supplier charges $60 per
unit.
Ordering cost is $45.
Annual holding cost is 25 percent of a feeders value.
Inventory management: the Economic
Order Quantity (EOQ) model
Compute the optimal order size. How
frequently will orders be placed? How
many orders per year?
Compute the relevant costs.
Using the formula for EOQ we get

We begin by computing the annual demand and the holding cost
D =
18 units/week 52 weeks/year = 936 units
N= = 12.5 orders
936
75
TBO =
75
18
= 4.2 weeks
TRC= (H) + (S) =
Q
2
D
Q
15 + 45 = $562 + $562 = $1124
75
2
936
75
H = 0.25 $60/unit) = $15
SOLUTION

Let us return to the bird feeder example. If the lead time is
constant at two weeks. Determine the reorder point.
Reorder point
The reorder point (ROP) tells when to order
ROP =
18 x 2 = 36 units
Inventory control systems
R = 25 x 4 = 100 cases
= 10 + 200 0 = 210 cases > R
IP = OH + SR BO
EXAMPLE
Demand for chicken soup at a supermarket is 25 cases a day. Supply
lead time is 4 days. Now the on-hand inventory is 10 cases. No
backorders currently exist but there is an order in the pipeline for 200
cases. What is the reorder point? What is the inventory position?
Should a new order be placed?
Continuous review (Q) system
Tracks inventory position (IP)
Reorder point system (ROP)
Fixed order quantity system (FOQ EOQ)
Reorder point for variable demand
Safety stock is used to achieve a desired service level and avoid
stockouts
Reorder point = Average demand during lead time + Safety stock
d = average demand per week (or day or months)
L = constant lead time in weeks (or days or months)
Z = number of standard deviations
s
dLT
= standard deviation of demand during lead time

dLT
= L
The order quantity remains constant (Q*)
but the time between orders (TBO) varies.
Let us return to the bird feeder example. The average demand is 18 units per
week with a standard deviation of 5 units per week. The lead time is constant
at 2 weeks. Determine the safety stock and reorder point if management
wants a 90 percent cycle-service level*.
*For service level based upon individual unit shortages see J.G. Monks
(1996) Operations management 2
nd
ed. pp. 262-264
SOLUTION
Average demand
during lead time
Service level = 90%
Probability
of stockout
(1.0 0.90 = 0.10)
Z
dLT
R dL
Safety stock = z
dLT
= 1.28 x 7.07 = 9 units
2 x 18 + 9 = 45 units Reorder point = d L + Safety stock =
In this case,
d
= 5, d = 18 units, and L = 2 weeks, so
Consult the body of the Normal Distribution for 0.90 (90% service level).
The closest number is 0.8997, which corresponds to z = 1.28.

dLT
=
d
L = 5 2 = 7.07