Chapter 13

Inventory Management
 Inventory management

• Inventory management is a systematic approach to

obtaining, storing, and profiting from non-capital assets
(raw materials and finished goods). The right stock, at
the right levels, in the right place, at the right time, and at
the right cost.
 Types of Inventory

• Independent demand
– Finished goods, Items
that are ready to be sold.

-Computer.

• Dependent demand
– Components of finished
products

-Parts that make up the

computer.
 Inventory Types
Inventory: A stock or store of goods.
Independent Demand

A Dependent Demand

B(4) C(2)

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

Independent demand is uncertain.

Dependent demand is certain.
 Importance of Inventory Management
• One of the most expensive assets of many companies representing as
much as 30%-50% of total invested capital.

Too much stock:

•Cost of storing stock: risk of obsolescence/deterioration, higher
holding cost
• Capital cost: loss of interest of capital tied up
• Reduced working capital available for alternative investment
Too little stock:
• Disappointed customers, lost sales.
• Higher costs: making emergency orders and reordering more
frequently.

Aim: Hold just right amount of stock – not too much or too little and
achieve minimum cost overall.
 Types of Inventories
• Raw materials & purchased parts.
• Partially completed goods called work in progress.
• Finished-goods inventories.
• Replacement parts, tools, & supplies.
• Goods-in-transit to warehouses or customers (pipeline
inventory).
 Functions of Inventory

• To permit operations.
• To decouple operations.
• To meet anticipated demand.
• To protect against stock-outs.
• To hedge against price increases.

• To take advantage of order cycles.

• To smooth production requirements.
• To take advantage of quantity discounts.
 Inventory Counting Systems
• Periodic System: Physical count of items made at
periodic intervals (Weekly, Monthly).

• Perpetual Inventory System: System that keeps

track of removals from inventory continuously, thus
monitoring current levels of each item.
 Inventory Counting Systems (Cont.)
• Two-Bin System- Two containers of inventory; reorder
when the first is empty.

• Universal Bar Code- Bar code

printed on a label that has
0
information about the item
to which it is attached.
214800 232087768
 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.

Inventory turnover is the ratio of average cost

of goods sold to average inventory investment.
 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
 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.
 Inventory Models

• Economic order quantity (EOQ) model.

– The order size that minimizes total annual cost
• Economic production model.
• Quantity discount model.
 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.
• Stock outs can be completely avoided.
 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
 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
 Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Annual Cost

Carrying Costs

Ordering Costs
Order Quantity
QO (optimal order quantity)
(Q)
 Minimum Total Cost

The total cost curve reaches its

minimum where the carrying and
ordering costs are equal.

Q = DS
H
2 Q
 The EOQ Model

Optimal order quantity is found when annual

setup cost equals annual holding cost.
 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.
 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?
EOQ Example
 Example

The demand for a product is constant at 200

units per month. It costs £10 to place an
order and the costs of holding one unit in
stock for one month is £5.

-What should the order quantity be to

minimize total monthly costs and what is this
cost?
Solution
Economic Production Quantity (EPQ)

• Assumptions of EPQ are similar to EOQ except

orders are received incrementally during
production.
• Production done in batches or lots.
• Capacity to produce a part exceeds the part’s
usage or demand rate.
 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.
Economic Run Size

p is production or delivery rate

u is usage rate
 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.
EPQ Example
 EOQ Refresher

•  
Quantity Discount Model
 Total Costs with Purchasing Cost

Annual Annual Product/

TC = carrying + ordering + Purchasing
cost cost cost

Q D
TC = H + S + PD
2 Q
 Total Costs with PD
Cost

Adding Purchasing cost

doesn’t change EOQ TC with PD

TC without PD

PD

0 EOQ Quantity
 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.
Quantity Discount Example
 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
 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.
 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.
 Determinants of the Reorder Point

• The lead time.

• The rate of demand.

• Demand and/or lead time variability.

• Stockout risk (safety stock).

If demand and lead time are both constants, then

ROP = dxLT
 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.
 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 stock out) 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.
 Safety Stock

Safety stock reduces risk of stock out during lead time

 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 stock out is the complement of service

level; a customer service level of 95 percent implies a
stock out risk of 5 percent.
 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 stock out.
• Fill rate – The percentage of demand filled by
the stock on hand.
 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.
 Fixed-Interval Disadvantages

• Increases carrying cost.

• Costs of periodic reviews.
• Requires a larger safety stock.
 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.
 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
 Example
• Ce = $0.20 per unit
• Cs = $0.60 per unit
• Service level = Cs/(Cs+Ce) = .6/(.6+.2)
• Service level = .75
Ce Cs

Service Level = 75%

Quantity

Stock out risk = 1.00 – 0.75 = 0.25

 Operations Strategy

• Too much inventory:

– Costly to maintain.
– Tends to hide problems.

– Easier to live with problems than to eliminate them.

• Wise strategy:
– Reduce lot sizes.
– Reduce safety stock.
 Lecture Takeaways
 Basics of Inventory Management.
 Types of Inventory.
 Functions of Inventory.
 Inventory counting systems.
 A-B-C classification system.
 Different inventory models (EOQ, EPQ, Quantity
Discounts) and its assumptions.
 Basics of Re-order point, Safety Stock, Service Level.
 Try these at home:
 Examples: 2-7, 15-16 (skip So), 17,18.
 Solved Problem: 1-3 (Pages: 595- 597).
 Practice Problem: 3, 4(a,b,c),6,7 (a),9,10,11
(a,b,c), 13,14,15 (Pages 602- 604).