Inventory Management

Concept
Inventory Management
 Inventory Management

The objective of inventory

management is to strike a balance
between inventory investment and
customer service
 Importance of Inventory

 One of the most expensive assets

of many companies representing as
much as 50% of total invested
capital
 Operations managers must balance
inventory investment and customer
service
 Functions of Inventory
1. To decouple or separate 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 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
 Managing Inventory

1. How inventory items can be

classified
2. How accurate inventory records
can be maintained
 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, Ordering, and
Setup Costs
 Holding costs - the costs of holding
or “carrying” inventory over time
 Ordering costs - the costs of
placing an order and receiving
goods
 Setup costs - cost to prepare a
machine or process for
manufacturing an order
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or 6% (3 - 10%)
depreciation, operating costs, taxes,
insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Inventory Models for
Independent Demand
Need to determine when and how
much to order

1. Basic economic order quantity

2. Production order quantity
3. 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. Stockouts can be completely avoided
 Inventory Usage Over Time

Usage rate Average

Order inventory
Inventory level

quantity = Q on hand
(maximum
Q
inventory
level) 2

Minimum
inventory

0
Time
 Minimizing Costs
Objective is to minimize total costs
Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (or order)

cost
Optimal order Order quantity
quantity (Q*)
 The EOQ Model
Annual setup cost =
D
Q
S

Q = Number of pieces per order

Q* = Optimal number of pieces 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

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
 The EOQ Model
Annual setup cost =
D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal number of pieces 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

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 Model
Annual setup cost =
D
Q
S
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal number of pieces 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

Optimal order quantity is found when annual setup cost

equals annual holding cost

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H
2(1,000)(10)
Q* = = 40,000 = 200 units
0.50
 An EOQ Example
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 Demand D
number of = N = =
orders Order quantity Q*
1,000
N= = 5 orders per year
200
 An EOQ Example
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 days per year
time between = T =
orders N
250
T= = 50 days between orders
5
 An EOQ Example
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 T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = ($10) + ($.50)
200 2

TC = (5)($10) + (100)($.50) = $50 + $50 = $100

 Robust Model

 The EOQ model is robust

 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

D Q
TC = S + H
Q 2
1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 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 = S + H
Q 2 Only 2% less
1,500 244.9 than the total
TC = ($10) + ($.50) cost of $125
244.9 2
when the
TC = $61.24 + $61.24 = $122.48 order quantity
was 200
 Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells “when” to
order
Demand Lead time for a
ROP = per day new order in days
=dxL
D
d = Number of working days in a year
 Reorder Point Curve
Q*
Inventory level (units)

Resupply takes place as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days
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
 Used when inventory builds up
over a period of time after an
order is placed
 Used 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 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
 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
 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
1
(D/Q)S = 2 HQ[1 - (d/p)]

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

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

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

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

= 282.8 or 283 hubcaps

 Production Order Quantity
Model
Note:
D 1,000
d = 4 = Number of days the plant is in operation = 250

When annual data are used the equation becomes

2DS
Q* =
annual demand rate
H 1–
annual production rate
 Quantity Discount Models
 Reduced prices are often available when
larger quantities are purchased
 Trade-off is between reduced product cost
and increased holding cost

Total cost = Setup cost + Holding cost + Product cost

D Q
TC = S+ H + PD
Q 2
 Quantity Discount Models
A typical quantity discount schedule

Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

 Quantity Discount Models
Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify,
choose the smallest possible order size
to get the discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
Quantity Discount Models
Total cost curve for discount 2
Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75)
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted
 Quantity Discount Example
Annual Annual Annual
Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit
Fixed-Period (P) Systems
Target quantity (T)

Q4
Q2
On-hand inventory

Q1 P
Q3

Time
 Probabilistic Demand

Minimum demand during lead time

Inventory level

Maximum demand during lead time

Mean demand during lead time

ROP = 350 + safety stock of 16.5 = 366.5

ROP 
Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)

Safety stock 16.5 units

0 Lead
time Time
Place Receive
order order