Inventory Management

Outline
 Functions of Inventory
 Types of Inventory
 Inventory Management
 ABC Analysis
 Record Accuracy
 Cycle Counting
 Control of Service Inventories
 Outline – Continued
 Inventory Models
 Independent vs. Dependent Demand
 Holding, Ordering, and Setup Costs
 Outline – Continued
 Inventory Models for Independent
Demand
 The Basic Economic Order Quantity (EOQ)
Model
 Minimizing Costs
 Reorder Points
 Production Order Quantity Model
 Quantity Discount Models
 Functions of Inventory
1. To decouple or separate various parts of
the production process
2. To immune the firm from fluctuations in
demand
3. To take advantage of quantity discounts
4. To hedge against inflation
 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
 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
 Inventory Management
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 unimportant
ones.
 ABC Analysis

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class

#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A

72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

23%
#10867 30% 350 42.86 15,001 6.4% B

#10500 1,000 12.50 12,500 5.4% B

 ABC Analysis
A Items
Percent of annual dollar usage

80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items Figure 12.2
 ABC Analysis
 Policies employed may include
 More emphasis on supplier development for A
items
 Tighter physical inventory control for A items
 More care in forecasting A items
 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
 Cycle Counting
 Items are counted and records updated on a periodic basis
 Often used with ABC analysis
to determine cycle
 Has several advantages
 Eliminates shutdowns and interruptions
 Eliminates annual inventory adjustment
 Trained personnel audit inventory accuracy
 Allows causes of errors to be identified and corrected
 Maintains accurate inventory records
 Cycle Counting Example
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)

Item Number of Items

Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
77/day
 Independent Versus
Dependent Demand
 Independent demand - the demand
for item is independent of the
demand for any other item in
inventory.
 Dependent demand - the demand for
item is dependent upon the demand
for some other item in the inventory.
 Holding Costs
Cost (and range) as
a Percent of
Category Inventory Value
Housing costs (building rent or depreciation, 6%
operating costs, taxes, insurance) (3 - 10%)
Material handling costs (equipment lease or 3%
depreciation, power, operating cost) (1 - 3.5%)
Labor cost 3%
(3 - 5%)
Investment costs (borrowing costs, taxes, and 11%
insurance on inventory) (6 - 24%)
Pilferage, space, and obsolescence 3%
(2 - 5%)
Overall carrying cost 26%

Table 12.1
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
e bu s in e s s , location,
Housing costs (building rent
e r a b ly dor
e pe nding on th h ig h t e ch it6%
em s
s vary con s id s o m e
depreciation,
Holding costoperating ra
costs,
lly g re ate than 15%,
taxes,
r (3 - 10%)
tes . G e n e
and interest ra sts greater than 50%.
insurance)
Material holding co costs (equipment lease or
have handling 3%
depreciation, power, operating cost) (1 - 3.5%)
Labor cost 3%
(3 - 5%)
Investment costs (borrowing costs, taxes, 11%
and insurance on inventory) (6 - 24%)
Pilferage, space, and obsolescence 3%
(2 - 5%)
Overall carrying cost 26%
Table 12.1
Inventory Models for Independent
Demand
Need to determine when and how much
to order
 Basic economic order quantity
 Production order quantity
 Quantity discount model
 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent.
2. Lead time is known and constant.
3. Receipt of inventory is instantaneous and
complete.
4. Quantity discounts are not possible.
5. Only variable costs are setup and holding.
6. Stock outs can be completely avoided.
 Inventory Usage Over Time

Usage rate Average

Order quantity inventory on
= Q (maximum hand
Inventory level

inventory level) Q
2

Minimum
inventory

0
Time
 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal order Order quantity
Table 11.5 quantity (Q*)
 Calculation for EOQ

• Develop an expression for setup or ordering cost.

• Develop an expression for holding cost.

• Set setup cost equal to holding cost.

• Solve the equation for optimal order quantity.

 Annual set up cost
D
Annual setup cost = S
Q
Using the following variables we can determine set up cost and holding cost
 Q = Number of pieces per order
 Q* = Optimal number of units per order (EOQ)
 D = Annual demand in units for the inventory item
 S = Setup or ordering cost for each order
 H = Holding or carrying cost per unit per year

1. Annual setup cost = (Number of orders placed per year)

x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

D
= (S)
Q
 Annual Holding Cost

2. Annual holding cost = (Average inventory level)

x (Holding cost per unit per year)

Order quantity
(Holding cost per unit per year)
2

Q
= (H)
2
 The EOQ ModelAnnual setup cost = D
S
Q
Q
Annual holding cost = H
2

3. Optimal order quantity is found when annual setup cost equals

annual holding cost

D Q
S = H
Q 2
4. Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
 An EOQ Example
Sharp inc a company that makes painless hypodermic needles to
hospitals, would like to reduce its inventory cost by determining the
optimal number of hypodermic needles to obtain per order.
The annual demand is 1000 units; the setup or ordering cost is $10 per
order, and the holding cost per unit per year is $.50.

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
Related problems : 11.5 to 11.15, exclude 11.10, 11.11 and 11.14
Determination of the expected Number of
orders placed during the year
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected number Demand

of orders D
N= Order quantity Q*

1,000
N= 200 = 5 orders per year
 Expected time between orders
Sharp inclusive have 250 working days per year.
Determine optimal number of needles to order
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected time days per year
between orders T= N

250
T= 5 = 50 days between orders

Related problems : 11.12,11.13,11.15

 Total Annual cost
• Total Annual Cost = setup (order) cost + Holding cost

D Q
S + H
Q 2

Related Exercise : 11.12, 11.13, 11.14

 Robust Model
 The EOQ model is a robust model.
 That means it gives satisfactory answers even
with substantial variations in its parameters.
 It works even if all parameters and assumptions
are not met
 The total cost curve is relatively flat in the area
of the EOQ
 An EOQ Example
Management underestimated demand by 50%
D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

1,500 200
TC = 200 ($10) + ($.50) = $75 + $50 = $125
2

Total annual cost increases by only 25%

 An EOQ Example
Actual EOQ for new demand is 244.9 units
D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = SQ + H 2
Only 2% less than the
1,500 244.9 total cost of $125
TC = ($10) + ($.50) when the order
244.9 2 quantity was 200

TC = $61.24 + $61.24 = $122.48

 Reorder Points
 ROP : is the inventory level at which the order should
be placed.
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to order

Demand Lead time for a new

ROP = per day order in days
=dxL
D
d= Number of working days in a year

Lead Time : In purchasing system it is the time between

placing an order and receiving it.
 Reorder Point Curve
Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Reorder Point Example
An Apple distributor has a demand of 8,000 iPods per year. The firm operate a
250 days working year. On average delivery of an order takes 3 working days.
Calculate the reorder point for the firm.

D
d= Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L

= 32 units per day x 3 days = 96 units

 Production Order Quantity Model

 it is an economic order quantity technique

applied to production orders.
 This model is applicable under two situations
1. When inventory continuously builds up over a
period of time after an order is placed.
2. When units are produced and sold
simultaneously
 Production Order Quantity Model

Part of inventory cycle during which

production (and usage) is taking
place
Inventory level

Demand part of cycle with

no production
Maximum
inventory

t Time
Production Order Quantity Model
Q = Number of units per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand rate or 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 the Total inventory used

= –
inventory level production run during the production
run
Q = pt – dt
Production Order Quantity Model

Maximum Total produced during the Total used during the

= –
inventory level production run production run
= pt – dt

However, Q = total produced = pt ; thus t = Q/p

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

Holding cost = Maximum inventory level (H) = Q 1– d H

2 2 p
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

Holding cost =1 HQ[1 - (d/p)]
2
(D/Q)S = HQ 1 [1 - (d/p)]
2
2DS
Q = 2
H[1 - (d/p)]

2DS
Q* = H[1 - (d/p)]
p
 Production Order Quantity
Example
Annual demand D = 1,000 units p = 8 units per day
Set up cost S = $10 d = 4 units per day
Holding cost = $0.50 per unit per year

2DS
Q* = H[1 - (d/p)]

Q* = 2(1,000)(10) = 80,000
0.50[1 - (4/8)]

= 282.8 hubcaps