Copperbelt University

School of Business
BS 343
Inventory Management

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 Types of Inventory

Raw materials
Bought out items
Work-in-Progress
Finished Good Inventory
Maintenance, Repair and Operating Supplies (MROs)
Tools inventory
Miscellaneous inventory-stationaries and others
consumables

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 Why do we care?
At the firm level:
• 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.

Higher Profits

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 Inventory Terminology
Demand-it is the number of items (products) required
per unit time. The demand may be deterministic or
probabilistic in nature.
Order-cycle-the time between two successive orders.
Lead time-the length of time between placing an order
and receipt of items.
Safety stock-also called buffer stock. It is stock kept
to carter for unforeseen circumstances in the lead time.
Re-order level (ROL)-it is the point at which
replenishment action is initiated.
Re-order quantity-is the quantity to be ordered at the
ROL. It is normally equal to the EOQ. 5
 Inventory Terminology
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 (this is ordering cost in
production set-ups)

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 Functions of Inventory
To meet anticipated customer demand. These inventories are referred to as
anticipation stocks because they are held to satisfy expected demand. Such
inventories are typical in retail establishments.
To smooth production requirements. Firms that experience seasonal patterns in
demand often build up inventories during preseason periods to meet overly high
requirements during seasonal periods.
To decouple operations. manufacturing firms may use inventories as buffers
between successive operations to maintain continuity of production that would
otherwise be disrupted by events such as breakdowns of equipment and accidents
that cause a portion of the operation to shut down temporarily. The buffers permit
other operations to continue temporarily while the problem is resolved.
To take advantage of quantity discounts , because purchases in larger quantities
may reduce the cost of goods or their delivery.
To hedge against inflation and upward price changes.
To reduce the risk of stockouts. Delayed deliveries and unexpected increases in
demand increase the risk of shortages. Delays can occur because of weather
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conditions, supplier stockouts, deliveries of wrong materials, quality problems,
and so on.
 Functions of Inventory
• To take advantage of order cycles. To minimize purchasing and inventory
costs, a firm often buys in quantities that exceed immediate requirements.
This necessitates storing some or all of the purchased amount for later use.
Similarly, it is usually economical to produce in large rather than small
quantities.
• To permit operations. The fact that production operations take a certain
amount of time (i.e., they are not instantaneous) means that there will
generally be some work-in-process inventory. In addition, intermediate
stocking of goods—including raw materials, semifinished items, and
finished goods at production sites, as well as goods stored in warehouses—
leads to pipeline inventories throughout a production-distribution system.
Little's Law can be useful in quantifying pipeline inventory. It states that the
average amount of inventory in a system is equal to the product of the
average rate at which inventory units leave the system (i.e., the average
demand rate) and the average time a unit is in the system. Thus, if units are
in the system for an average of 10 days, and the demand rate is 5 units per
day, the average inventory is 50 units: 5 units/ day 10 days 50 units.
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 Opposing Views of Inventory

Why We Want to Hold Inventories

Why We Not Want to Hold Inventories

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 Why We Want to Hold Inventories

Improve customer service

Reduce certain costs such as
ordering costs
stockout costs
acquisition costs
start-up quality costs
Contribute to the efficient and effective operation of
the production system

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 Why We Want to Hold Inventories

Finished Goods
Essential in produce-to-stock positioning strategies
Necessary in level aggregate capacity plans
Products can be displayed to customers
Work-in-Process
Necessary in process-focused production
May reduce material-handling & production costs
Raw Material
Suppliers may produce/ship materials in batches
Quantity discounts and freight/handling $$ savings

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Why We Do Not Want to Hold Inventories

Certain costs increase such as:

Pilferage costs
Inventory obsolescence
Insurance
Heating and Cooling costs
cost of diluted return on investment
reduced-capacity costs e.g warehousing
WIP
These costs are collective called Carrying or Holding
Costs
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 Managing Inventory

Two systems for managing inventory;

How inventory items can be classified (called
ABC analysis ) and
How accurate inventory records can be
maintained.

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 ABC Analysis
ABC analysis divides on-hand inventory into three classifications on the
basis of annual dollar volume.
ABC analysis is an inventory application of what is known as the Pareto
principle (named after Vilfredo Pareto, a 19th-century Italian economist).
The Pareto principle states that there are a “critical few and trivial many.”
The idea is to establish inventory policies that focus resources on the few
critical inventory parts and not the many trivial ones.
It is not realistic to monitor inexpensive items with the same intensity as
very expensive items.
Class A items may represent only about 15% of the total inventory items,
but they represent 70% to 80% of the total dollar usage.
Class B items represent about 30% of inventory items and 15% to 25% of
the total value. Those with low annual dollar volume are
Class C items represent only 5% of the annual dollar volume but about
55% of the total inventory items.
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 Criteria for ABC classification

Annual dollar volume classification. For instance,

High shortage or holding cost,
Anticipated engineering changes,
Delivery problems, or quality problems may dictate
upgrading items to a higher classification.

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 Inventory Counting Systems

Periodic system
Perpetual system (continuous review system)

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 Periodic system
The physical count of items in inventory is made at
periodic, fixed intervals (e.g., weekly, monthly) in order
to decide how much to order of each item.
Many small retailers use this approach: A manager
periodically checks the shelves and stockroom to
determine the quantity on hand. Then the manager
estimates how much will be demanded prior to the next
delivery period and bases the order quantity on that
information.

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 Advantages & disadvantages

An advantage of this type of system is that orders for

many items occur at the same time, which can result
in economies in processing and shipping orders.
The disadvantage of periodic reviews is a lack of
control between reviews.
Another disadvantage is the need to protect against
shortages between review periods by carrying extra
stock.

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 Perpetual inventory system

This system keeps track of removals from inventory on a continuous basis,

so the system can provide information on the current level of inventory for
each item.
When the amount on hand reaches a predetermined minimum, a fixed
quantity, Q, is ordered.

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 Advantages & disadvantages
An main advantage of this system is the control provided
by the continuous monitoring of inventory withdrawals.
Another advantage is the fixed-order quantity;
management can determine an optimal order quantity.
One disadvantage of this approach is the added cost of
record keeping. Moreover, a physical count of inventories
must still be performed periodically to verify records
because of possible errors, pilferage, spoilage, and other
factors that can reduce the effective amount of inventory.
Bank transactions such as customer deposits and
withdrawals are examples of continuous recording of
inventory changes.
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 Record Accuracy

Two-bin system
Point of sale (POS) systems

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 Two-bin system
A two-bin system , a very elementary system, uses two containers for inventory.
Items are withdrawn from the first bin until its contents are exhausted. It is then time
to reorder.
Sometimes an order card is placed at the bottom of the first bin.
The second bin contains enough stock to satisfy expected demand until the order is
filled, plus an extra cushion of stock that will reduce the chance of a stockout if the
order is late or if usage is greater than expected.
The advantage of this system is that there is no need to record each withdrawal from
inventory;
The disadvantage is that the reorder card may not be turned in for a variety of
reasons (e.g., misplaced, the person responsible forgets to turn it in).
Supermarkets, discount stores, and department stores have always been major users
of periodic counting systems.
Today, most have switched to computerized checkout systems using a laser
scanning device that reads a universal product code (UPC) , or bar code, printed on
an item tag or on packaging. 26
 Point-of-sale (POS) systems
Electronically record actual sales.
Knowledge of actual sales greatly enhance forecasting and inventory
management:
By relaying information about actual demand in real time, these systems
enable management to make any necessary changes to restocking decisions.
These systems are being increasingly emphasized as an important input to
effective supply chain management by making this information available to
suppliers.
UPC (universal product code) scanners represent major benefits to
supermarkets.
In addition to their increase in speed and accuracy, these systems give
managers continuous information on inventories, reduce the need for
periodic review and order-size determinations, and improve the level of
customer service by indicating the price and quantity of each item on the
customer's receipt. 27
 Cycle Counting
Cycle counting uses inventory classifications developed through ABC analysis.
With cycle counting procedures, items are counted, records are verified, and
inaccuracies are periodically documented.
The cause of inaccuracies is then traced and appropriate remedial action taken to
ensure integrity of the inventory system.
A items will be counted frequently, perhaps once a month
B items will be counted less frequently, perhaps once a quarter; and
C items will be counted perhaps once every 6 months. Example 2 illustrates how to
compute the number of items of each classification to be counted each day.

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 Example

A firm has about 5,000 items in its inventory. It wants to

determine how many items to cycle count each day. The firm
hires a consultant and determines that it has 500 A items,
1,750 B items, and 2,750 C items. Company policy is to
count all A items every month (every 20 working days), all B
items every quarter (every 60 working days), and all C items
every 6 months (every 120 working days). The firm then
allocates some items to be counted each day.

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 SOLUTION

ITEM QUANTITY CYCLE-COUNTING POLICY NUMBER OF ITEMS

CLASS COUNTED PER DAY
A 500 Each month (20 working days) 500/20 = 25 items
B 1,750 Each quarter (60 working days) 1,750/60 = 29 items
C 2,750 Every 6 months (120 working 2,750/120 = 23 items
days)
Total = 77 items

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 Advantages of Cycle counting
Eliminates the shutdown and interruption of production
necessary for annual physical inventories.
Eliminates annual inventory adjustments.
Trained personnel audit the accuracy of inventory.
Allows the cause of the errors to be identified and remedial
action to be taken.
Maintains accurate inventory records.

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 Control of Service Inventories
Extensive inventory is held in wholesale and retail businesses,
making inventory management crucial.
In the food-service business, control of inventory is often the
difference between success and failure.
Moreover, inventory that is in transit or idle in a warehouse is lost
value. Similarly, inventory damaged or stolen prior to sale is a loss.
In retailing, inventory that is unaccounted for between receipt and
time of sale is known as shrinkage
Shrinkage occurs from damage and theft (pilferage) as well as from
sloppy paperwork.
Retail inventory loss of 1% of sales is considered good, with losses
in many stores exceeding 3%.
Inventory has substantial impact on firm’s
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 Techniques for service inventory control
Good personnel selection, training, and discipline: These are very necessary in
food-service, wholesale, and retail operations, where employees have access to
directly consumable merchandise.
Tight control of incoming shipments: This task is being addressed by many firms
through the use of Universal Product Code (or bar code) and radio frequency ID
(RFID) systems that read every incoming shipment and automatically check tallies
against purchase orders.
Effective control of all goods leaving the facility: This job is accomplished with
bar codes, RFID tags, or magnetic strips on merchandise, and via direct
observation. Direct observation can be done by personnel stationed at exits (as at
wholesale stores) and in potentially high-loss areas or can take the form of one-
way mirrors and video surveillance.

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 Two Fundamental Inventory Decisions

Inventory control is a planned approach of

determining what to order, when to order and how
much to order.
How much to order of each material when orders are
placed with either outside suppliers or production
departments within organizations (Order Quantity)
When to place the orders (Order Level)

The questions are answered using inventory models.

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Independent Demand Inventory Systems

Demand for an item carried in inventory is

independent of the demand for any other item in
inventory
Finished goods inventory is an example
Demands are estimated from forecasts and/or
customer orders

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 Dependent Demand Inventory Systems

Items whose demand depends on the demands for

other items
For example, the demand for raw materials and
components can be calculated from the demand for
finished goods
The systems used to manage these inventories are
different from those used to manage independent
demand items

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 Independent vs. Dependent Demand

Independent Demand
(finished goods and spare parts)

A Dependent Demand
(components)

B(4) C(2)

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

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 Inventory Costs

Costs associated with ordering too much (represented

by carrying costs)
Costs associated with ordering too little (represented
by ordering costs)
These costs are opposing costs, i.e., as one increases
the other decreases
. . . more

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 Inventory Costs (continued)

The sum of the two costs is the total stocking cost

(TSC)
When plotted against order quantity, the TSC
decreases to a minimum cost and then increases
This cost behavior is the basis for answering the first
fundamental question: how much to order
It is known as the economic order quantity (EOQ)

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Balancing Carrying against Ordering Costs

Annual Cost ($)

Higher

Minimum
Total Annual
Stocking Costs
Total Annual
Stocking Costs
Annual
Carrying Costs
Lower

Annual
Ordering Costs
Order Quantity
Smaller EOQ Larger
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 Fixed Order Quantity Systems

Behavior of Economic Order Quantity (EOQ)

Systems
Determining Order Quantities
Determining Order Points

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 Behavior of EOQ Systems

As demand for the inventoried item occurs, the

inventory level drops
When the inventory level drops to a critical point, the
order point, the ordering process is triggered
The amount ordered each time an order is placed is
fixed or constant
When the ordered quantity is received, the inventory
level increases
. . . more

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 Determining Order Quantities

Basic economic order quantity-EOQ Model I

Trial and Error Approach
Production order quantity-EOQ Model II
Quantity discount model-EOQ Model III

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 Example – illustrating the trial and
error approach

• Estimated annual requirement, D =1200unit

• Purchasing cost per unit, P(K) =50
• Ordering cost (per order),O(K) =37.50
• Carrying cost per unit,c(K) =1
 Total cost in the various orders
Order size(Q) 1200 600 400 300 240 200 150 120 100

Average 600 300 200 150 120 100 75 60 50

inventory(Q/2)
No.of orders 1 2 3 4 5 6 8 10 12
(A/Q)
Annual carrying 600 300 200 150 120 100 75 60 50
Cost (K)(cQ/2)

Annual 37.5 75 112.5 150 187.5 225 300 375 450

ordering cost
(K)(OA/Q)
Total annual 637.5 375 312.5 300 307.5 325 375 435 500
costs (K)
 Inference from the TC table
Order Total cost
1.For single order(once in year) 637.5
2.12 order (once in a month) 500
3.4 order(once in every 3 month) 300
i.e.the third option is the most economic
 Model I: Basic EOQ

Typical assumptions made

annual demand (D), carrying cost (C) and ordering
cost (S) can be estimated
average inventory level is the fixed order quantity
(Q) divided by 2 which implies
no safety stock
orders are received all at once
demand occurs at a uniform rate
no inventory when an order arrives
. . . more
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Inventory Usage Over Time

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 Model I: Basic EOQ

Assumptions (continued)
Stockout, customer responsiveness, and other costs
are inconsequential
acquisition cost is fixed, i.e., no quantity discounts
Annual carrying cost = (average inventory level) x
(carrying cost) = (Q/2)C
Annual ordering cost = (average number of orders per
year) x (ordering cost) = (D/Q)S
. . . more

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 Model I: Basic EOQ

Total annual stocking cost (TSC) = annual carrying

cost + annual ordering cost = (Q/2)C + (D/Q)S
The order quantity where the TSC is at a minimum
(EOQ) can be found using calculus (take the first
derivative, set it equal to zero and solve for Q)

EO Q = 2 DS / C

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 Example: Basic EOQ

Zartex Co. produces fertilizer to sell to wholesalers. One

raw material – calcium nitrate – is purchased from a
nearby supplier at K22.50 per ton. Zartex estimates it
will need 5,750,000 tons of calcium nitrate next year.
The annual carrying cost for this material is 40% of the
acquisition cost, and the ordering cost is K595.
a) What is the most economical order quantity?
b) How many orders will be placed per year?
c) How much time will elapse between orders?
d) What will the total annual cost (TSC) be if the EOQ
quantity is ordered.
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 Example: Basic EOQ

Economical Order Quantity (EOQ)

D = 5,750,000 tons/year
C = 0.40(22.50) = K9.00/ton/year
S = K595/order
EOQ = 2D S /C
EOQ = 2(5,750,000)(595)/9.00
= 27,573.135 tons per order

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 Example: Basic EOQ
Number of Orders Per Year
= D/Q
= 5,750,000/27,573.135
= 208.5 orders/year
Time Between Orders (T) Note: This is the inverse
= Q/D of the formula above.
= 1/208.5
= 0.004796 years/order
= 0.004796(365 days/year) = 1.75 days/order
Or T = number of working days/number of orders per year
= 365/208.5= 1.75 days per order 53
 Example: Basic EOQ

Total Annual Stocking Cost (TSC)

TSC = (Q/2)C + (D/Q)S
= (27,573.135/2)(9.00)
+ (5,750,000/27,573.135)(595)
= 124,079.11 + 124,079.11
= K248,158.22
Note: Total Carrying Cost
equals Total Ordering Cost

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 Example: Basic EOQ

Total Annual Stocking Cost (TSC)

TSC = (Q/2)C + (D/Q)S
= (27,573.135/2)(9.00)
+ (5,750,000/27,573.135)(595)
= 124,079.11 + 124,079.11
= K248,158.22
Note: Total Carrying Cost
equals Total Ordering Cost

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 Model II: EOQ for Production Lots

Used to determine the order size, production lot, if an

item is produced at one stage of production, stored in
inventory, and then sent to the next stage or the
customer
Differs from Model I because orders are assumed to
be supplied or produced at a uniform rate (p) rate
rather than the order being received all at once
. . . more

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Production Order Quantity Model

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 Model II: EOQ for Production Lots

It is also assumed that the supply rate, p, is greater

than the demand rate, d.
We derive the model by setting ordering
cost=Carrying cost and solve for optimal Q.
Q=number of units per order
c=carrying cost per unit per year
p=daily production rate
d=daily demand rate or usage rate
t=length of the production run in days

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 Model II: EOQ for Production Lots

1. (Annual inv. carrying cost)=(Average Inv. Level) x

(carrying cost per unit per year)
2. Ave. inv. Level=Max inv. Level/2
3. (Max Inv. Level)=(Total Pro.during prodn time=pt)-
(Total demand during prodn time=dt)
4. However, Q=total produced=pt, thus t=Q/p
5. Max. Inve. Level=p(Q/p)-d(Q/p)=Q(p-d)/p
6. S=(D/Q)s and Cc=1/2 [(Q)(p-d)/p]C
7. Solve for the model: S=Cc; solve for Q we
have….see next slide.
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 Model II: EOQ for Production Lots

It is also assumed that the supply rate, p, is greater

than the demand rate, d
The change in maximum inventory level requires
modification of the TSC equation
TSC = (Q/2)[(p-d)/p]C + (D/Q)S
The optimization results in

2 DS  p 
EOQ =  
C p − d

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 Example: EOQ for Production Lots

HE Co. buys coal from Creek Coal Co. to

generate electricity. Creek Coal Co can supply coal at
the rate of 3,500 tons per day for K10.50 per ton. HE
Co. uses the coal at a rate of 800 tons per day and
operates 365 days per year.
HE Co.’s annual carrying cost for coal is 20% of
the acquisition cost, and the ordering cost is K5,000.
a) What is the economical production lot size?
b) What is HE Co.’s maximum inventory level for
coal?
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 Example: EOQ for Production Lots

Economical Production Lot Size

d = 800 tons/day; D = 365(800) = 292,000 tons/year
p = 3,500 tons/day
S = $5,000/order C = .20(10.50) = $2.10/ton/year
EOQ = (2D S /C )[p/(p-d)]
EOQ = 2(292,000)(5,000)/2.10[3,500/(3,500-800)]
= 42,455.5 tons per order

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 Example: EOQ for Production Lots

Maximum Inventory Level

= Q(p-d)/p
= 42,455.5(3,500 – 800)/3,500
= 42,455.5(.771429)
= 32,751.4 tons Note: HEC will use 23%
of the production lot by the
time it receives the full lot.

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 Example: EOQ for Production Lots

Total Annual Stocking Cost (TSC)

TSC = (Q/2)((p-d)/p)C + (D/Q)S
= (42,455.5/2)((3,500-800)/3,500)(2.10)
+ (292,000/42,455.5)(5,000)
= 34,388.95 + 34,388.95
= K68,777.90
Note: Total Carrying Cost
equals Total Ordering Cost

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Model III: EOQ with Quantity Discounts

Under quantity discounts, a supplier offers a lower

unit price if larger quantities are ordered at one time
This is presented as a price or discount schedule, i.e.,
a certain unit price over a certain order quantity range
This means this model differs from Model I because
the acquisition cost (ac) may vary with the quantity
ordered, i.e., it is not necessarily constant
. . . more

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Model III: EOQ with Quantity Discounts

Under this condition, acquisition cost becomes an

incremental cost and must be considered in the
determination of the EOQ
The total annual material costs (TMC) = Total annual
stocking costs (TSC) + annual acquisition cost

TSC = (Q/2)C + (D/Q)S + (D)ac

. . . more

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 Model III: EOQ with Quantity Discounts

To find the EOQ, the following procedure is used when

carrying costs are expressed as a percentage of unit price:
1. Compute the EOQ using the lowest acquisition cost.
If the resulting EOQ is feasible (the quantity can be
purchased at the acquisition cost used), this quantity
is optimal and you are finished.
If the resulting EOQ is not feasible, go to Step 2
2. Identify the next higher acquisition cost.

67
 Model III: EOQ with Quantity Discounts

3. Compute the EOQ using the acquisition cost from

Step 2.
If the resulting EOQ is feasible, go to Step 4.
Otherwise, go to Step 2.
4. Compute the TMC for the feasible EOQ (just found
in Step 3) and its corresponding acquisition cost.
5. Compute the TMC for each of the lower acquisition
costs using the minimum allowed order quantity for
each cost.
6. The quantity with the lowest TMC is optimal.

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Example: EOQ with Quantity Discounts

A-1 Auto Parts has a regional tyre warehouse in

Atlanta. One popular tyre, the X75, has estimated
demand of 25,000 units next year. It costs A-1 K100
to place an order for the tyres, and the annual carrying
cost is 30% of the acquisition cost. The supplier
quotes these prices for the tyre:
Q ac
1 – 499 K21.60
500 – 999 20.95
1,000 + 20.90

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Calculate EOQ for each of the acquisition costs

2𝐷𝑆 2×25000×100
EOQ20.90 = = = 892.999
𝐶 20.90(0.3)

2𝐷𝑆 2×25000×100
EOQ20.95 = = = 891.93
𝐶 20.95(0.3)

2𝐷𝑆 2×25000×100
EOQ21.60 = = = 878.4
𝐶 21.60(0.3)

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Example: EOQ with Quantity Discounts

Compare Total Annual Material Costs (TMCs)

TMC = (Q/2)C + (D/Q)S + (D)ac
Compute TMC for Q = 891.93 and ac = K20.95
TMC2 = (891.93/2)(.3)(20.95) + (25,000/891.93)100
+ (25,000)20.95
= 2,802.89 + 2,802.91 + 523,750
= K529,355.80
… more

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 Example: EOQ with Quantity Discounts

Compute TMC for Q = 1,000 and ac = K20.90

TMC3 = (1,000/2)(.3)(20.90) + (25,000/1,000)100
+ (25,000)20.90
= 3,135.00 + 2,500.00 + 522,500
= K528,135.00 (lower than TMC2)
The EOQ is 1,000 tires
at an acquisition cost of K20.90.

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 Model III: EOQ with Quantity Discounts

To find the EOQ, the following procedure is used when

carrying costs are constant:
1. Compute the common EOQ, and then identify the
price range in which the EOQ is feasible.
If the EOQ is feasible in the lowest price range,
that is the optimal EOQ.
If the EOQ is feasible in a higher price range,
compute the total cost for the feasible EOQ and for
the price break quantity for all lower unit costs.
Compare the total costs; the EOQ that yields the
lowest total cost is the optimal EOQ.
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 Example: EOQ with Quantity Discounts
A-1 Auto Parts has a regional tyre warehouse in
Atlanta. One popular tyre, the X75, has estimated
demand of 25,000 units next year. It costs A-1 K100
to place an order for the tyres, and the annual carrying
cost is K10 per unit. The supplier quotes these prices
for the tyre:
Q ac
1 – 499 K21.60
500 – 999 20.95
1,000 + 20.90

Determine the optimal EOQ 74

 Calculate common EOQ

2𝐷𝑆 2×25000×100
EOQ = = = 707
𝐶 10

707 falls in the range of 500-999

The total cost for purchasing 707 tyres will be
TMC = (Q/2)C + (D/Q)S + (PD)
= (707/2)10+(25000/707)100+(20.95 x 25000)
= 3535+3536+523750
= K530,821
Because lower price range exist, it must be checked
against the minimum total cost generated at EOQ
707. 75
 Model III: EOQ with Quantity Discounts

Total cost at EOQ 1000 will be

TMC1000 = (Q/2)C + (D/Q)S + (PD)

= (1000/2)10+(25000/1000)100+20.9 x 25000
= 5000+2500+517500
= K525,000

Therefore, 1000 is the optimal order quantity as it yields

the lowest total cost.
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 REORDER POINT ORDERING

Applicable only when demand and lead time are

both constant 77
Reorder Point Curve

78
 REORDER POINT ORDERING

Four determinants of the reorder point quantity:

1. The rate of demand (usually based on a forecast)
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to
management

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 Example-Computing the ROP when usage and
lead time are constant
Peggy takes Two-a-Day vitamins, which are delivered to her home by a
routeman 7 days after an order is called in. At what point should Peggy
reorder?

Solution
Demand = 2 vitamins a day
Lead time = 7 days
ROP = d × LT
= 2 vitamins per day × 7 days = 14 vitamins
Thus, Peggy should reorder when 14 vitamin tablets are left, which is
equal to a seven-day supply of two vitamins a day. 80
 Probability Models and Safety Stock

All inventory models we have discussed so far make the

assumption that demand and production are constant and
certain.
We now relax that assumption and consider a probabilistic
situation where:
1. Demand or lead time is unknown but can be specified by
means of probability distribution.
A key issue is to maintain an adequate service level in the
face of uncertain demand.
Recall that ROP=d x L; the inclusion of safety stock
changes the expression to
81
ROP= d x LT + ss
 82
Safety stock reduces risk of stockout during lead time
 SAFETY STOCK
The amount of safety stock that is appropriate for a given
situation depends on the following factors:
The average demand rate and average lead time
Demand and lead time variability
The desired service level
For a given order cycle service level, the greater the variability
in either demand rate or lead time, the greater the amount of
safety stock that will be needed to achieve that service level.
Similarly, for a given amount of variation in demand rate or
lead time, achieving an increase in the service level will
require increasing the amount of safety stock. 83
The ROP based on a normal distribution of lead time demand
84
 Probability Models and Safety Stock

When the estimate of expected demand during lead time

and its standard deviation are available. The formula is

ROP = Expected demand during lead time + zσdLT

where
z = Number of standard deviations
σdLT = The standard deviation of lead time demand

85
 Example 8-Computing the ROP and Safety Stock When the Mean and Standard
Deviation of Lead Time Demand Are Given

Suppose that the manager of a construction supply house

determined from historical records that demand for sand
during lead time averages 50 tons. In addition, suppose the
manager determined that demand during lead time could be
described by a normal distribution that has a mean of 50
tons and a standard deviation of 5 tons. Assuming a stockout
risk of no more than 3 percent:
a. What value of z is appropriate?
b. How much safety stock should be held?
c. What reorder point should be used?
86
 Solution
Expected lead time demand = 50 tons
σdLT = 5 tons
Risk = 3% (service level 100%-3%=97%)
a. Using a service level of 97%, value of z = +1.88.
b. Safety stock = zσdLT = 1.88(5) = 9.40 tons.
c. ROP = Expected lead time demand + Safety stock
= 50 + 9.40 = 59.40 tons
87
 Probability Models and Safety Stock

When data on lead time demand are not readily

available, data are generally available on daily or
weekly demand, and on the length of lead time.
Using those data, determine whether demand
and/or lead time is variable, if variability exists in
one or both, and the related standard deviation(s).
One of the following formulas can be used:

88
 Probability Models and Safety Stock

If only demand is variable and lead time is constant, then

Safety stock (σdLT) = σd 𝐿𝑇, and the reorder point is
𝑅𝑂𝑃 = 𝑑ҧ × 𝐿𝑇 + 𝑍𝜎𝑑 𝐿𝑇
where
𝑑ҧ = Average daily or weekly demand
σd = Standard deviation of demand in days or weeks
LT = Lead time in days or weeks

89
 Example

The average daily demand for Lenovo laptop

computers at a Circuit Town store is 15, with a
standard deviation of 5 units. The lead time is
constant at 2 days. Find the reorder point if
management wants a 90% service level. How much of
this is safety stock?

90
 Solution

Average daily demand (normally distributed) == 15

Lead time in days (constant) =2
Standard deviation of daily demand = σd = 5
Service level = 90%
Z-value for 90% = 1.28
Safety stock = 𝑍𝜎𝑑 𝐿𝑇 = 1.28(5) 2 = 9.05
𝑅𝑂𝑃 = 𝑑ҧ × 𝐿𝑇 + 𝑍𝜎𝑑 𝐿𝑇
= 15 × 2 + 9.05
=39.05 = 39

91
 Probability Models and Safety Stock
If only lead time is variable and demand is constant, then
σdLT = d σLT,
and the reorder point is
ROP = 𝑑 × 𝐿𝑇+ zd σLT
where
d = Daily or weekly demand
𝐿𝑇 = Average lead time in days or weeks
σLT = Standard deviation of lead time in days or weeks

92
 Example

The Circuit Town store sells about 10

digital cameras a day (almost a constant
quantity). Lead time for camera delivery is
normally distributed with a mean time of 6
days and a standard deviation of 1 day. A
98% service level is set. Find the ROP.

93
 Solution

Daily demand = 10
Average lead time = 6 days
Standard deviation of lead time = σLT =1 day
Service level = 98%, so Z-value is 2.055

ROP = 𝑑 × 𝐿𝑇+ zd σLT

= 10 × 6 + 2.055(10)(1)
= 60 + 20.55 = 80.55 = 81
94
 Probability Models and Safety Stock
If both demand and lead time are variable,
then
σdLT = 𝐿𝑇𝜎 2 𝑑 + 𝑑ҧ 2 𝜎 2 𝐿𝑇
and the reorder point is
ROP= 𝑑ҧ × 𝐿𝑇 + 𝑧 𝐿𝑇𝜎 2 𝑑 + 𝑑ҧ 2 𝜎 2 𝐿𝑇

Note: Each of these models assumes that

demand and lead time are independent 95
 Example-ROP for variable Demand and LT
The Circuit Town store’s most popular item is six-packs of
9-volt batteries. About 150 packs are sold per day,
following a normal distribution with a standard deviation
of 16 packs. Batteries are ordered from an out-of-state
distributor; lead time is normally distributed with an
average of 5 days and a standard deviation of 1 day. To
maintain a 95% service level, what ROP is appropriate?

96
 Solution
𝑑ҧ = 150 packs, σd = 16 packs, 𝐿𝑇 = 5 days,
σLT = 1 day, Service level = 95%, so Z =1.65

σdLT = 5(16)2 + 1502 (12 ) = 154.2

ROP = 𝑑ҧ × 𝐿𝑇 + 𝑧 𝐿𝑇𝜎 2 𝑑 + 𝑑ҧ 2 𝜎 2 𝐿𝑇
=150 x 5 + 1.65(154.2) = 1,004 packs

97
 Example -Computing the ROP When Demand is Variable

A restaurant uses an average of 50 jars of a special sauce

each week. Weekly usage of sauce has a standard
deviation of 3 jars. The manager is willing to accept no
more than a 10 percent risk of stockout during lead time,
which is two weeks. Assume the distribution of usage is
normal.
a. Which of the given formulas is appropriate for this
situation? Why?
b. Determine the value of z.
c. Determine the ROP.
98
 Solution
𝑑ҧ = 50 jars per week LT = 2 weeks
σd = 3 jars per week service level is 90%
a. Because only demand is variable (i.e., has a standard
deviation), Formula 𝑅𝑂𝑃 = 𝑑ҧ × 𝐿𝑇 + 𝑍𝜎𝑑 𝐿𝑇 is appropriate.
b. using a service level of 90%, z = +1.28.
c. ROP = 𝑑ҧ × 𝐿𝑇 + zσ𝑑 𝐿𝑇
=50 × 2 + 1.28 3 2 = 100 + 5.43 = 105.43
d. Because the inventory is discrete units (jars), we round
this amount to 106. (Generally, round up.) 99
??? - - ✓✓✓

End of Unit
100