AMITY GLOBAL

BUSINESS SCHOOL Stevenson

Chandigarh

13
Inventory
Management
 Learning Objectives
• Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory management.
• Discuss the nature and importance of service
inventories
• Discuss periodic and perpetual review systems.
• Discuss the objectives of inventory management.
• Describe the A-B-C approach and explain how it is
useful.

12-2
 Learning Objectives
• Describe the basic Economic Order Quantity
(“EOQ”) model and its assumptions, and solve
typical problems.
• Describe the Economic Production Quantity
(“EPQ”) model and solve typical problems.
• Describe the quantity discount model and solve
typical problems.
• Describe reorder point models and solve
typical problems.

12-3
 Inventory Models
• Independent demand – finished goods,
items that are ready to be sold
– E.g. a computer
• Dependent demand – components of
finished products
– E.g. parts that make up the computer

12-4
 Inventory Independent Demand
Inventory: a stock or store of goods

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
12-5
 Types of Inventories
• Raw materials & purchased parts
• Partially completed goods called
work in progress
• Finished-goods inventories
– (manufacturing firms)
or merchandise
(retail stores)

• Replacement parts, tools, & supplies

• Goods-in-transit to warehouses or
customers (pipeline inventory)
12-6
 Functions of Inventory

• To meet anticipated demand

• To smooth production
requirements
• To decouple operations
• To protect against stock-outs

12-7
 Functions of Inventory (Cont’d)

• To take advantage of order cycles

• To help hedge against price increases
• To permit operations
• To take advantage of quantity
discounts

12-8
 Objective of Inventory Control
• To achieve satisfactory levels of
customer service while keeping
inventory costs within reasonable
bounds
– Level of customer service
– Costs of ordering and carrying inventory

Inventory turnover is the ratio of average cost

of goods sold to average inventory investment.

12-9
Effective Inventory Management
• A system to keep track of inventory
• A reliable forecast of demand
• Knowledge of lead times
• Reasonable estimates of
– Holding costs
– Ordering costs
– Shortage costs
• A classification system
12-10
 Inventory Counting Systems
• Periodic System
Physical count of items made at periodic
intervals
• Perpetual Inventory System
System that keeps track of removals from
inventory continuously, thus
monitoring current levels of
each item

12-11
 Inventory Counting Systems
(Cont’d)
• Two-Bin System - Two containers of
inventory; reorder when the first is
empty
• Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached 0

214800 232087768

12-12
 Key Inventory Terms
• Lead time: time interval between
ordering and receiving the order
• Holding (carrying) costs: cost to carry
an item in inventory for a length of
time, usually a year
• Ordering costs: costs of ordering and
receiving inventory
• Shortage costs: costs when demand
exceeds supply
12-13
 ABC Classification System

Classifying inventory according to some

measure of importance and allocating
control efforts accordingly.
A - very important
B - mod. important High
A
C - least important Annual
$ value B
of items

Low C
Low High
Percentage of Items
12-14
Economic Order Quantity Models

• Economic order quantity (EOQ) model

– The order size that minimizes total annual
cost

• Economic production model

• Quantity discount model

12-15
 Assumptions of EOQ Model

• Only one product is involved

• Annual demand requirements known
• Demand is even throughout the year
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts

12-16
 The Inventory Cycle

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
12-17
 Total Cost

Annual Annual
Total cost = carrying + ordering
cost cost
Q + DS
TC = H
2 Q

Q is Order Quantity (in units)

H is Holding (Carrying) cost per unit
D is Demand, usually in units per year
S is Ordering Cost per order

12-18
 Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q D
TC  H  S
Annual Cost

2 Q

Carrying Costs

Ordering Costs
Order Quantity
QO (optimal order quantity)
(Q)

12-19
 Deriving the EOQ

Using calculus, we take the derivative of

the total cost function and set the
derivative (slope) equal to zero and solve
for Q.
2DS 2(Annual Demand)(Order or Setup Cost )
Q OPT = =
H Annual Holding Cost

12-20
 Minimum Total Cost

The total cost curve reaches its

minimum where the carrying and
ordering costs are equal.

Q = DS
H
2 Q

12-21
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EOQ Example
• A local distributor for a national tire company expects
to sell approximately 9,600 steel-belted radial tires of
a certain size and tread design next year. Annual
carrying cost is $16 per tire, and ordering cost is $75.
The distributor operates 288 days a year.
– What is the EOQ?
– How many times per year does the store reorder?
– What is the length of an order cycle (time between orders)?
– What is the total annual cost if the EOQ quantity is ordered?

12-22
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EOQ Example

12-23
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EOQ Example
Piddling Manufacturing assembles security monitors. It purchases
3,600 black-and-white cathode ray tubes a year at $65 each. Ordering
costs are $31, and annual carrying costs are 20 percent of the purchase
price. Compute the optimal quantity and the total annual cost of
ordering and carrying the inventory.

12-24
Economic Production Quantity (EPQ)
• Production done in batches or lots
• Capacity to produce a part exceeds the
part’s usage or demand rate
• Assumptions of EPQ are similar to EOQ
except orders are received incrementally
during production

12-25
 Economic Production Quantity
Assumptions
• Only one item is involved
• Annual demand is known
• Usage rate is constant
• Usage occurs continually
• Production rate is constant
• Lead time does not vary
• No quantity discounts

12-26
 Economic Run Size
2 DS p p is production or delivery rate
Qp 
H p u u is usage rate

12-27
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EPQ Example
A toy manufacturer uses 48,000 rubber wheels per year for
its popular dump truck series. The firm makes its own
wheels, which it can produce at a rate of 800 per day. The
toy trucks are assembled uniformly over the entire year.
Carrying cost is $1 per wheel a year. Setup cost for a
production run of wheels is $45. The firm operates 240
days per year. Determine the:
•Optimal run size
•Minimum total annual cost for carrying and setup
•Cycle time for the optimal run size
•Run time

12-28
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EPQ Example

12-29
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EPQ Example

12-30
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
EOQ Refresher

12-31
Total Costs with Purchasing Cost

Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost

Q + DS + PD
TC = H
2 Q

12-32
 Total Costs with PD
Cost

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD

PD

0 EOQ Quantity

12-33
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Quantity Discount Example
The maintenance department of a large hospital
uses about 816 cases of liquid cleanser annually.
Ordering costs are $12, carrying costs are $4 per
case a year, and the new price schedule indicates
that orders of less than 50 cases will cost $20
per case, 50 to 79 cases will cost $18 per case, 80
to 99 cases will cost $17 per case, and larger
orders will cost $16 per case. Determine the
optimal order quantity and the total cost.

12-34
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Quantity Discount Example

12-35
 AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Quantity Discount Example
• The 70 cases can be bought at $18 per case because 70 falls in the range
of 50 to 79 cases. The total cost to purchase 816 cases a year, at the rate
of 70 cases per order, will be

 Because lower cost ranges exist, each must be checked against the
minimum cost generated by 70 cases at $18 each. In order to buy at
$17 per case, at least 80 cases must be purchased. (Because the TC
curve is rising, 80 cases will have the lowest TC for that curve's feasible
region.) The total cost at 80 cases will be

 To obtain a cost of $16 per case, at least 100 cases per order are
required, and the total cost at that price break will be

12-36
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Quantity Discount Example
Order Quantity Total Cost
70 14,968
80 14,154
100 13,354
100 cases per order yields the lowest total
cost, 100 cases is the overall optimal order
quantity.

With Quantity Discounts, purchase quantity

will be equal to or greater optimal
economic quantity.

12-37
 When to Reorder with EOQ
Ordering
• Reorder Point - When the quantity on
hand of an item drops to this amount,
the item is reordered
• Safety Stock - Stock that is held in
excess of expected demand due to
variable demand rate and/or lead time.
• Service Level - Probability that demand
will not exceed supply during lead time.

12-38
 Determinants of the Reorder
Point
• The rate of demand
• The lead time
• Demand and/or lead time variability
• Stockout risk (safety stock)

If demand and lead time are both

constants, then ROP = dxLT

12-39
 Safety Stock

Safety stock reduces risk of

stockout during lead time 12-40
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Reorder Point Example
Rahim takes Two-a-Day vitamins, which are
delivered to his home seven days after an
order is called in. At what point should
Rahim reorder?

Rahim should reorder when 14 vitamin tablets are

left, which is equal to a seven-day supply of two
vitamins a day.
12-41
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Safety Stock
When variability is present in demand or lead time, it creates the possibility
that actual demand will exceed expected demand. Consequently, it becomes
necessary to carry additional inventory, called safety stock , to reduce the
risk of running out of inventory (a stockout) during lead time. The reorder
point then increases by the amount of the safety stock:

For example, if expected demand during lead time is 100 units, and the
desired amount of safety stock is 10 units, the ROP would be 110 units

12-42
AMITY GLOBAL
BUSINESS SCHOOL Chandigarh
Service Level
• Order cycle service level can be defined as the
probability that demand will not exceed supply during
lead time (i.e., that the amount of stock on hand will be
sufficient to meet demand).
• A service level of 95 percent implies a probability of 95
percent that demand will not exceed supply during lead
time.
• The risk of a stockout is the complement of service level;
a customer service level of 95 percent implies a stockout
risk of 5 percent.

12-43
Reorder Point

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale

12-44
 Fixed-Order-Interval Model

• Orders are placed at fixed time intervals

• Order quantity for next interval?
• Suppliers might encourage fixed
intervals
• May require only periodic checks of
inventory levels
• Risk of stockout
• Fill rate – the percentage of demand
filled by the stock on hand
12-45
 Fixed-Interval Benefits

• Tight control of inventory items

• Items from same supplier may yield
savings in:
– Ordering
– Packing
– Shipping costs
• May be practical when inventories
cannot be closely monitored

12-46
 Fixed-Interval Disadvantages

• Requires a larger safety stock

• Increases carrying cost
• Costs of periodic reviews

12-47
 Single Period Model
• Single period model: model for ordering of
perishables and other items with limited
useful lives
• Shortage cost: generally the unrealized
profits per unit

• Excess cost: difference between purchase

cost and salvage value of items left over at
the end of a period

12-48
 Optimal Stocking Level
Cs Cs = Shortage cost per unit
Service level =
Cs + Ce Ce = Excess cost per unit

Ce Cs

Service Level

Quantity

So
Balance point

12-49
 Example
• Ce = $0.20 per unit
• Cs = $0.60 per unit
• Service level = Cs/(Cs+Ce) = .6/(.6+.2)
• Service
Ce level = .75 C s

Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25

12-50
 Operations Strategy
• Too much inventory
– Tends to hide problems
– Easier to live with problems than to
eliminate them
– Costly to maintain
• Wise strategy
– Reduce lot sizes
– Reduce safety stock

12-51