CHAPTER 10

Inventory
Management

UiTMK/Chapter 10 1
 Introduction
 Inventory is any stock or stored resources of any
item that are used by organization to satisfy
current or future needs. They maybe items that
are purchased from others, or those produced
internally.

 The objective of inventory management is to

strike a balance between inventory investment
and customer service.

UiTMK/Chapter 10 2
 The Functions of Inventory
• To ”decouple” or separate various parts of
the production process
• To provide a stock of goods that will provide
a “selection” for customers
• To take advantage of quantity discounts
– Supplies usually offer discount to encourage bulk
buying
• To hedge against inflation and upward price
changes
– Buy more and stock up more when price is low
UiTMK/Chapter 10 3
 Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 Undergone some change but not completed
 A function of cycle time for a product
 Maintenance/repair/operating (MRO)
 Necessary to keep machinery and processes
productive
 Finished goods
 Completed product awaiting shipment
UiTMK/Chapter 10 4
 Techniques of inventory
1. ABC Analysis
2. Record accuracy
3. Cycle Counting
4. Control of Service Inventories

UiTMK/Chapter 10 5
 1. ABC Analysis
 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 parts and not the many
trivial ones

UiTMK/Chapter 10 6
 Classifying Items as ABC
% Annual $ Usage Class % $ Vol % Items
100 A 80 15
B 15 30
80 C 5 55
60
A
40
B
20 C
0
0 50 100
% of Inventory Items
UiTMK/Chapter 10 7
 ABC Analysis

 Other criteria than annual dollar

volume may be used
 Anticipated engineering changes
 Delivery problems
 Quality problems
 High unit cost

UiTMK/Chapter 10 8
 2. Record Accuracy
 Accurate records are a critical ingredient in
production and inventory systems
 Allows organization to focus on what is needed
 Necessary to make precise decisions about
ordering, scheduling, and shipping
 Incoming and outgoing record keeping must be
accurate
 Stockrooms should be secure

UiTMK/Chapter 10 9
 3. Cycle Counting
 Items are counted and records updated on a
periodic basis
 Often used with ABC analysis
to determine cycle
 Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records
UiTMK/Chapter 10 10
4. Control of Service Inventories
 Can be a critical component
of profitability
 Losses may come from
shrinkage or pilferage
 Applicable techniques include
1. Good personnel selection, training, and discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving facility

UiTMK/Chapter 10 11
 Independent versus
Dependent Demand
• Independent demand - demand for item
is independent of demand for any other
item
• Dependent demand - demand for item is
dependent upon the demand for some
other item

UiTMK/Chapter 10 12
 Inventory Costs
• Holding costs - associated with holding
or “carrying” inventory over time
• Ordering costs - associated with costs
of placing order and receiving goods
• Setup costs - cost to prepare a
machine or process for manufacturing
an order

UiTMK/Chapter 10 13
Cont…
• Holding (Carrying) • Ordering Costs
Costs – Supplies
– Obsolescence – Forms
– Insurance – Order processing
– Extra staffing – Clerical support
– Interest • Setup Costs
– Pilferage – Clean-up costs
– Damage – Re-tooling costs
– Warehousing – Adjustment costs

UiTMK/Chapter 10 14
 Inventory Models
• Fixed order-quantity models
– Economic order quantity
• is the quantity level that results in the least total
annual inventory cost.
– Production order quantity
– Quantity discount

UiTMK/Chapter 10 15
 Assumption of EOQ model
 Demand is known, constant and independent
 Lead time is known and constant
 Receipt of inventory is instantaneous and
complete. Orders are delivered as whole units at
a single point in time.
 Quantity discounts are not possible
 The only variable costs are setup cost and
holding cost
 Shortages can be completely avoided if orders
are placed at the right time
UiTMK/Chapter 10 16
 EOQ Model Equations
Economic Order Quantity 2 ×D ×S
= Q* =
H
Number of Orders =N =
D
Q*
Time Between Orders Working Days Per Year
= T =
(Reorder cycle) N

D D = Demand per year

d = Working Days Per Year S = Setup/Ordering Cost (RM per order)
H = Carrying/Holding cost (annual basis)
d = Demand per day
L = Lead time in days
UiTMK/Chapter 10 ss = Safety Stock 17
Reorder Point (without safety stock) = d x L

Reorder Point (with safety stock) = (d x L) + ss

Total ordering cost = (D/Q) x S

Total Carrying Cost = (Q/2) x H

Total annual cost = DxS + Q xH

(without ss) Q 2

Total annual cost = D x S + Q +ss x H

(with ss) Q 2
18
UiTMK/Chapter 10
 Cont…
• Lead time – the length of time between the time
order is placed and the time the inventory or
stock arrived or received
• Reorder point – the level that signals the need to
reorder inventory. It indicates the time for the
form to place new order.
• Safety stock – a buffer stock or additional stocks
maintain by the firm to meet the unexpected
increase in demand or uncertainties in delivery
time

UiTMK/Chapter 10 19
Production Order Quantity
Model
 Used when inventory builds up over
a period of time after an order is
placed
 Used when units are produced and
sold simultaneously

UiTMK/Chapter 10 20
 Production Order Quantity
Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory Holding cost

= (Average inventory level) x
holding cost per unit per year

Annual inventory
= (Maximum inventory level)/2
level

Maximum Total produced during Total used during

= –
inventory level the production run the production run

= pt – dt

UiTMK/Chapter 10 21
 Production Order Quantity
Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum Total produced during Total used during

= –
inventory level the production run the production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level = p –d =Q 1–
p p p

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
UiTMK/Chapter 10 22
 Production Order Quantity
Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand

Setup cost = (D/Q)S

1
Holding cost = 2 HQ[1 - (d/p)]
1
(D/Q)S = 2 HQ[1 - (d/p)]
2DS
Q =
2
H[1 - (d/p)]
2DS
Q*p =
H[1 - (d/p)]
UiTMK/Chapter 10 23
 Quantity Discount Model
 Reduced prices are often available when
larger quantities are purchased.
 The concern – to determine the best order
size/to select the order quantity that would
minimized the total annual inventory costs
 Answers how much to order &
when to order

UiTMK/Chapter 10 24
Total annual cost – without ss
= (D/Q x S) +(Q/2 x H) + (P x D)

Total annual cost – with ss

= (D/Q x S)+ (Q/2+ss) x H + (P x D)

Total Purchase Cost = P x D

P = cost of item/price
D = demand per year

UiTMK/Chapter 10 25
 Steps involve for discount model

 Compute EOQ for each price,until a

feasible EOQ is found
 Compute TAIC for feasible EOQ
 Then calculate the TAIC for the next lower
price breaks
 Repeat procedure in step 3 until you found
the quantity that result in lowest TAIC

UiTMK/Chapter 10 26
 Exercise 1:
• The owner of a bakery received a price list from a vendor
who supplies flour. The bakery uses approximately 5000
bags of flour every year. The annual holding cost for each
bag of flour is 30% of purchase cost and the ordering cost
is RM10 per order.
 
Quantity (bag) Purchase Cost per
bag(RM)
1 - 499 3.30
500 – 999 3.10
> 1000 2.90

Determine an order quantity that will minimize the total cost

UiTMK/Chapter 10 27
 Probabilistic Models

• Answer how much & when to order

• Allow demand to vary
– Follows normal distribution
– Other EOQ assumptions apply
• Consider service level & safety stock
– Service level = 1 - Probability of stockout
– Higher service level means more safety stock
• More safety stock means higher ROP

UiTMK/Chapter 10 28
 Fixed Period Model
• Only one order is placed for a product
• Units have little or no value at the end of
the sales period

UiTMK/Chapter 10 29