CHAPTER 5: INVENTORY

TRUE/FALSE
1

Inventory is comprised of those stocks of items, merchandise, articles, necessities, etc. used to support
production and operations, as well as all activities that maintain the processes of the organization,
and that provide customer services.
ANS: T

One of the seven classes of inventory situations is order repetition (e.g., static vs. dynamic) situations.
ANS: T

Lead time is the interval between demand for units by customers and payment for the sales.
ANS: F

The pure dynamic case of inventory models is also called a one-period model.
ANS: F

Inventory is made internally or purchased externally. The decision is based on quality factors alone.
ANS: F

Buffer stock is stock carried to prevent outages when supply exceeds expectations.
ANS: F

Contingency planning for cancellations is better production management than reacting to cancellations
after the fact.
ANS: T

OPP is best when the demand distribution is unknown or unstable.

ANS: F

Lead time is the interval between order placement and receipt.

ANS: T

The book lists five main kinds of inventory costs: ordering, set-ups, carrying stock, out-of-stock, and
costs of running the inventory system.
ANS: F

Freshness dating puts pressure on operations to make and deliver products as much before the freshness
date as possible. This results in a decrease in the amount of inventory being carried.
ANS: F

Each unhappy customer represents a loss of goodwill, defined as the termination of the revenue
generation of that customer.
ANS: T

Backorder costs include the effects of word-of-mouth praise on obtaining new customers.
ANS: F

Systems involving many stock-keeping units are dependent upon having an organized information
system.
ANS: T

Total carrying costs for the job shop may tend to be higher than those of the flow shop because costs of
materials are greater since they are purchased in smaller quantities.
ANS: T

Order point policies define the stock level at which an order will be placed.
ANS: T

The two major types of applications of order point policies are the perpetual inventory system and the
periodic inventory system.
ANS: T

The economic production quantity (EPQ) is the fixed amount to order, whereas the economic order
quantity is the fixed amount to produce whenever the order point is reached.
ANS: F

The most important requirement for EOQ and EPQ is consistency of independent demand over time with
relatively smooth and regular withdrawal patterns of units from stock.
ANS: T

EOQ calls for JIT order quantities when there is extreme reduction of the cost of ordering, extreme
reduction of the cost of setting up jobs, and very low costs of carrying inventory.
ANS: F

Minimum total variable cost is associated with an order quantity Q =

.

where

is referred to as

ANS: T
1

The maximum total variable cost always occurs at the cross point of the following two lines on a graph:
the total carrying cost as a function of ordering quantity, Q and the total ordering cost as a function
of Q.
ANS: F

EPQ models can provide continuous delivery of product instead of delivery in batches.
ANS: T

The EPQ triangle is divided into two right triangles. The upward slope of the left side of the triangle
represents the net rate of accumulation of the stock on hand.
ANS: T

Set-up costs are the cost of labor to do the set-up work for the new production run and the cost of lost
production created by facility shut down during changeover.
ANS: T

Just in time is the interval between reordering and receiving that order and readying the units for use.
ANS: F

Expediting is the process of keeping track of the state of an order and doing what is necessary to
facilitate keeping the delivery of that order on schedule.
ANS: T

Lead times are usually fixed.

ANS: F

Expediting cannot control lead times.

ANS: F

Perpetual inventory systems continuously record inventory received from suppliers and withdrawn by
employees.
ANS: T

Perpetual inventory systems were more popular than periodic inventory systems before inventory
information was digitized and put online.
ANS: F
3

Inventory management encompasses the widest spectrum of activities related to materials.

ANS: T

Web-based tools provide real-time tracking of shipments from the time of order to delivery.
ANS: T

Choosing a larger order size may indicate an intuition that in the future, prices will fall.
ANS: F

Lack of coordination diminishes buying power and loses the knowledge-based benefits of the centralized
system.
ANS: T

MULTIPLE CHOICE
1 Which one choice is not part of the seven classes of inventory situations?
a.make or buy decisionsc.inventory reduction decisionsb.order repetitiond.lead-time distributions
ANS: C
1 Static inventory models are best explained by
a.how much to order in a one-shot decision.b.how much to order in a fixed amount as required
repetitively over a long time.c.maintaining stock on-hand for every practical reason that materials are
needed.d.ordering additional stock to prevent outages arising from unexpected demands.
ANS: A
1 Dynamic inventory models apply to inventories that are used for _____.
a.flow shopsb.intermittent flow shopsc.batch work that occurs fairly regularlyd.all of the above
ANS: D
1 Which considerations play a major role in deciding whether to make or buy inventory?
a.costc.both a and b b.quality requiredd.neither a nor b
ANS: C
1 Signing a contract to supply a given number of units converts _____ from a risk to a _____.
a.cost estimation; gamblec.demand; gambleb.demand; certaintyd.analysis; reality
ANS: B

1 _____ methods are applicable when demand distributions are predictable.

a.Moving Averagec.Weighted MAb.OPPd.Exponential Smoothing
ANS: B
4

1 Sensitivity analysis is defined as

a.a diagnostic, analytic method for analyzing the effects of changing factors such as inventory costs to
determine the effects.b.a family of parts or products run on the same line.c.a good production
management reaction to order cancellations after the fact.d.adaptation to a shift from continuous
demand to sporadic demand.
ANS: A
1

As lead times get _____, inventory systems become _____ sensitive to problems that can arise in
the supply chain.
a.shorter; morec.longer; lessb.longer; mored.shorter; hyper
ANS: B
1 One of the major inventory costs for EOQ modeling is
a.rented storage space.d.ordering.b.labor.e.pilferage.c.maintenance.
ANS: D
1

Total inventory carrying costs are costs that depend upon the average number of units stocked
, the cost per unit
, and _____.
a.TC, total inventory costsb.Q, the number of units per orderc. , the number of orders
placedd.applicable carrying cost interest rate
ANS: D
1 What factors below have a direct effect on carrying costs?
a.pilferaged.damageb.obsolescencee.all of the abovec.deterioration
ANS: E
1

Accepting discounts by buying at least a certain amount of material involves _____ costs that may
make taking the discount _____. The analysis of total costs with and without the discount is
essential.
a.extra; profitablec.less; profitableb.extra; unprofitabled.less; unprofitable
ANS: B
1 If a buyer is willing to wait to have an order filled, the company creates a
a.backorder.c.outage cost.b.outstanding ticket.d.systematic cost.
ANS: A
1

Processing costs that are associated with running the inventory system are referred to as _____
costs.
a.carryingc.systemicb.backorderd.stock-keeping
ANS: C
1

The cost of ordering materials for the _____ is often higher than for the flow shop because of
_____.
a.job shop; high variety and small quantitiesb.synchronized shop; JIT requirementsc.project system;
union relationsd.custom shop; the vendor release arrangement
ANS: A
1

The best definition of a reorder point is

5

a.the optimal interval between orders with order quantity fixed.b.the stock-on-hand level at which
successive new orders must be placed.c.the optimal order size when the interval between orders is
fixed.d.the trigger for expediting an order for more stock.
ANS: B
1 _____ is the fixed amount to order from an outside vendor.
a.Economic order quantityc.Economic lot sizeb.Perpetual inventory reorder pointd.Periodic inventory
reorder point
ANS: A

Where CC is total variable carrying cost and OC is total variable ordering cost, the equation for
total variable cost is:
a.
c.
b.
d.
1
ANS: C

What is the generic name of the model that is the foundation equation for all inventory models of the
OPP type? This name applies to most flow shops, job shops, flexible processing, and projects.
a.economic lot size modelc.just-in-time inventory modelb.square root inventory modeld.economic order
point model
ANS: B
1

Identify reasons that account for a producer storing output for batch delivery to certain customers at
specific times.
a.lack of storage space at the buyers siteb.delivery economicsc.Vendor releasing agreements between
supplier and buyer.d.all of the above
ANS: D
1 One or more components of lead time is(are) the _____.
a.amount of time required to recognize the need to reorderb.interval for doing whatever clerical work is
needed to prepare the orderc.mail, e-mail, EDI, or telephone intervals to communicate with supplier to
place the orderd.delivery time including loading, transit, and unloading transporterse.all of the above
ANS: E
1 _____ is extra stock so that when demand is heavier than expected, orders can still be filled.
a.Bufferc.EOQb.EPQd.ELS
ANS: A
1

The _____ model involves more than one total cost equation, but only one line segment is applicable
in each cost breaks range.
a.EOQc.quantity discountb.ELSd.static inventory
ANS: C
25 Accept a quantity discount _____.
a.alwaysb.only when it actually lowers total costsc.neverd.only when it actually raises total costs
ANS: B
25 _____ costs are not changed by the order size or frequency of ordering, so they are not included in the
inventory policy model.
a.Fixedc.Overheadb.Variabled.Order
ANS: A

25 Good inventory policy maintains the _____ necessary stock on-hand.

a.maximumc.both a and bb.minimumd.neither a nor b
ANS: B
25 _____ also include the expense of storing inventory.
7

a.Inventory carrying costsc.Diversification strategiesb.Set-up costsd.both a and c

ANS: A
25 Obsolescence may be the most important component of carrying cost because it happens so _____ and
so _____.
a.often; slowc.seldom; slowb.often; fastd.seldom; fast
ANS: B
25 Deterioration affects the carrying cost of a broad range of products including
a.food.c.chemicals.b.adhesives.d.all of the above
ANS: D
25 Extra expenses for taking a quantity discount should be compared to the savings obtained from the
discount. Extra expenses include
a.carrying cost.c.both a and bb.storage space.d.neither a nor b
ANS: C
25 Lead time is the interval that elapses between recognition that an order should be placed and _____.
a.the delivery of that orderc.receipt of raw materials b.availability for use by productiond.completion of
cross-docking
ANS: B
25 Expediting is part of the _____ function.
a.P/OMc.HRb.accountingd.finance
ANS: A
25 Expediting is used to control and improve lead times in
a.the plant.b.the office.c.with outside suppliers and shippers.d.all of the above
ANS: D

25 Lead times are usually _____.

a.fixedc.constantb.variabled.static
ANS: B
25 _____ inventory systems continuously record inventory received from suppliers and withdrawn by
employees.
a.Physicalc.Yearlyb.Perpetuald.Weekly
ANS: B
25 _____ inventory systems were more popular than _____ inventory systems before inventory information
was digitized and put online.
a.Periodic; physicalc.Periodic; perpetualb.Physical; periodicd.Perpetual; periodic
ANS: C
25 Accept a quantity discount only when it _____ the total costs.
a.raisesc.keeps constantb.lowersd.either a or b
ANS: B

SHORT ANSWER
1. Define Inventory.
ANS:
Inventory is those stocks or items used to support production (raw materials and work in process items),
supporting activities (maintenance, repair, and operating supplies), and customer service (finished goods
and spare parts).
2. Explain the main difference between static and dynamic inventory models.
ANS:
Order repetition is the key to the explanation: static inventory models have no (or low) repetition. They
portray one-shot ordering situations, such as toys for Christmas ordered from Indonesia. On the other
hand, dynamic inventory models permit placing orders repetitively over long periods of time. For
example, buying gasoline to keep the company truck fleet running.
3. What is buffer stock?
ANS:
Buffer stock is stock carried to prevent outages when demand exceeds expectations. Basic inventory
methods dealing with order point policy (OPP) make assumptions about the demand distribution that
gets translated into buffer stock levels. To exemplify, buffer stock is also called safety stock because it
provides an extra margin of safety during a lead time period or between ordering intervals.
4. What are the six inventory costs discussed in this chapter.
ANS:
The six costs are:
1. Costs of ordering
9

2. Costs of setups and changeovers

3. Costs of carrying inventory
4. Costs of discounts
5. Out-of-stock costs
6. Costs of running the inventory system
5. Can discounts have a cost? Discuss.
ANS:
Accepting discounts by buying at least a certain amount of material involves extra costs that may make
taking the discount unprofitable. An appropriate inventory cost analysis must be used to determine
whether a discount that is offered should be taken. The extra costs for taking the discount and buying
more are compared to the savings obtained from the discount.
7. What are order point policies?
ANS:
Order point policies define the stock level at which an order will be placed. In other words, as
withdrawals decrease the number of units on hand, a particular stock level is reached. The number of
units, called the reorder point (RP) triggers an order for more stock. This order is placed with the
appropriate supplier with an understanding about the lead time.
8. What is the main difference between perpetual and periodic inventory system?
ANS:
The perpetual inventory system continuously records inventory withdrawals. Most often it is used online
and in real time. In the periodic inventory system, the order size is determined by the amount of stock
on-hand when the record is read. The interval between reading the record is fixed and the amount
ordered varies with the periodic system. The interval between orders is variable and the order is of fixed
size with the perpetual system.
9. What are EOQ and EPQ? How are they different?
ANS:
The EOQ or economic order quantity is a fixed amount of inventory to order while the EPQ or economic
lot size is a fixed amount to produce. Both are order point policies and levels are based on the square
root mathematical structure. Key requirements for both the OPP models are the consistency of
independent demand over time with relatively smooth and regular withdrawal patterns of units from
stock.

10

PROBLEMS
1

Enviroguard Pest Control uses termite chemicals that cost $500 per gallon. Use is constant at 1/3
gallon per week. Carrying cost rate is considered to be 12 percent per year, and the cost of an
order is $125. What is the optimal EOQ for the reagent?
ANS:
D = 1/3 gal/wk 52 wks/yr = 17.33 gal/yr
Qo =

= 8.5 gallons

Continuing with the information about Enviroguard in another problem, the company could make
this chemical in-house at the rate of 1/8 = 0.125 gallon per day, at a cost of $300 per gallon.
The setup cost is $150. Using a 7-day week, the daily demand, d, is 1/21 = 0.0477.
Compare using the EOQ and the EPQ systems. What course of action do you recommend?
ANS:
EOQ:
D = 1/3 gal/wk 52 wks/yr = 17.33 gal/yr
Qo =

= 8.5 gallons

Total cost = purchase cost + holding costs + ordering cost

= $500(17.33) + 8.5(0.12)($500)/2 + (17.33/8.5)($125) = $9,175.
EPQ:
Qo =

= 15.31 gallons.

Total cost = $300(17.33) + [15.3(0.12)$300(0.125-0.048)]/[2(0.125)] + [$150(17.33/15.3)] =

$5,539
Making its own chemicals is $3,636 cheaper. However, do-it-yourself has technical issues.
1

Water testing at the olympic-size city pool requires a chemical that costs $400 per gallon. Use is
constant at 1/3 gallon per week. Carrying cost rate is considered to be 10 percent per year, and
the cost of an order is $100. What is the optimal EOQ for the reagent?
ANS:
D = 1/3 gal/wk 52 wks/yr - 17.33 gal/yr
Qo =

= 9.3 gallons

11

Continuing with the information about the city pool chemical testing in another problem, the city
could make this reagent at the rate of 1/4 gallon per day, at a cost of $500 per gallon. The setup
cost is $125. Using a 7-day week, the daily demand, d, is 1/21 = 0.0477.
Compare using the EOQ and the EPQ systems. What course of action do you recommend?
ANS:
EOQ = D = 1/3 gal/wk 52 wks/yr - 17.33 gal/yr
Qo =

= 9.3 gallons

Total cost = purchase cost + holding costs + ordering cost

= $400(17.33) + 9.3(0.10)($400)/2 + (17.33/9.3)($100) = $7,304.
EPQ:
Qo =

= 10.35 gallons.

Total cost = $500(17.33) + [10.35(0.10)$500/2](0.202/0.25) + (17.33/10.35)($125) = $9,083

Buy the chemical to test the water in the pool and save about $1,800 with no technical hassle either.
1

Daisys dog supply sells popular dog vitamins which have an expected demand of 15,000 jars per
year (or 60 bottles per day with 250 sales days per year). Lead time from the distributor is three
days. It has been determined that demand in any 3-day period exceeds 200 bottles only once out
of every 100 three-day periods. This outage level (of 1 in 100 LT periods) is considered
acceptable by Daisy as well as production and marketing VPs. The economic order quantity has
been derived as 2,820 jars. Set up the perpetual inventory system.
ANS:
Order 2,820 bottles when inventory levels reach 200 bottles. This meets the acceptable outage level
for Daisy. Only one out of 100 times will the company be unable to fill and order. Further, there will
be 15,000/2820 = 5.32 orders per year and that means that 18.8 years will elapse between out-ofstock occurrences.

12

The annual demand for an item is 2400 units. The inventory holding cost is $ 12.00 per unit per
year. The demand is continuous and constant, that is, 200 units/month. The item is
purchased in three lots. The size of the first lot is 800 units, the size of the second lot is
1000 units and the size of the third lot is 600 units. Find the total anual cost of holding
inventory.
ANS: 5,000.
Demand per month = 200 = 2,400/12.
The first lot (800) is sufficient to meet the demand of first four months. The average inventory
during these four months will be 400 (= 800/2).
The second lot (1,000) meets the demand for next five months. The average inventory during
these five months will be 500 (= 1,000/2).
The third lot (600) meets the demand of the last three months. The average inventory during
these three months will be 300 (= 600/2).
Inventory Holding Cost per unit per month = $ 1.00. (Annual Cost is $ 12.00; Four month cost
is $4; Five month cost is $5; Three month cost is $3).
Annual Inventory Holding Cost = 400*4*1.0 + 500*5*1.0 + 300*3*1.0 = 1,600 + 2,500 + 900
= $5,000

Assume that annual demand for a part is 15,000 units, the ordering cost is $30 per order and the
annual holding cost of carrying inventory in stock is 50% of the cost of the unit. A quantity
discount will reduce the unit price from $5.00 for an order placed between 0 to 599 units to
$4.50 for an order of the size of 600 units or more. Using a price-break (also known as
price or quantity discount) inventory model, what is the optimal order quantity?
Answer: 632.46
Using the price $ 4.50, the EOQ is 632.46.
This is greater than 599, the quantity at which price break occurs.
Therefore, 632.46 is the optimal quantity.
Total Annual Order Cost = $ 711.51
Total Annual Inventory Holding Cost: $ 711.51
Total Item Cost = $67,500
Total Annual Cost = $ 68,923.02

13

Assume that annual demand for a part is 45,000 units, the ordering cost is $15.00 per order and
the annual holding cost of carrying inventory in stock is 10% of the cost of the unit. A quantity
discount will reduce the unit price from $5.00 for an order placed between 0 to 2,499 units to
$4.85 for an order of the size of 2,500 units or more. Using a price-break (also known as price
or quantity discount) inventory model, what is the optimal order quantity?
Answer: Quantity = 2,500
See calculations below using Excel program.

Q u a n tity R a n g e
F irs t
Se c o n d

M in

M ax

Ite m C o s t

In v H o ld in g
C o s ts

In v H o ld in g
F o rm u la

EO Q

2 ,4 9 9

$ 5 .0 0

$ 0 .5 0

=0 .1 * 5

1 6 4 3 .1 7

2 ,5 0 0

N o L im it

$ 4 .8 0

$ 0 .4 8

=0 .1 * 4 .8

1 6 7 7 .0 5

Fin d th e b e s t q u a n tity
Q u a n tity R a n g e
F irs t
Se c o n d

to o rd e r
Best Q
1643
2500

O rd e r C o s t
$ 4 1 0 .7 9
$ 2 7 0 .0 0

In v C o s t
$ 4 1 0 .7 9
$ 6 0 0 .0 0

14

Y e a rly C o s t
Ite m C o s t
$ 2 2 5 ,0 0 0 .0 0
$ 2 1 6 ,0 0 0 .0 0

E O Q F o rm u la
=( ( 2 * 4 5 0 0 0 * 1 5 ) / 0
.5 ) ^0 .5
=( ( 2 * 4 5 0 0 0 * 1 5 ) / 0
.4 8 ) ^0 .5

F e a s ib ility
F e a s ib le
N o t F e a s ib le

T o ta l C o s t
$ 2 2 5 ,8 2 1 .5 8
$ 2 1 6 ,8 7 0 .0 0

Consider the data given in the following table and identify the appropriate category for item D
in an ABC classification.

It e m S t c o k
N um ber

A nnual
V o lu m e
( U n it s )

U n it C o s t

389

6 .5 5

2564

9 .3 1

551

1 2 .8 7

121

4 .1 2

76

7 .1 0

353

2 .1 2

382

1 .2 8

92

1 .2 7

487

6 .5 8

960

3 .6 1

ANS: The appropriate category for item D is C category.

It e m S t c o k
N um ber

A nnual
V o lu m e
(U n it s )

U n it C o s t

A nnual
D o lla r
V o lu m e

2564

9 .3 1

2 3 8 7 0 .8 4

P e rce n ta ge
of A nnual
D o lla r
V o lu m e
5 6 .0 8 %

551

1 2 .8 7

7 0 9 1 .3 7

960

3 .6 1

487

6 .5 8

389

C u m u la t iv e %
5 6 .0 8 %

Cate go ry
A

1 6 .6 6 %

7 2 .7 4 %

3 4 6 1 .7 8

8 .1 3 %

8 0 .8 8 %

3 2 0 2 .6 6

7 .5 2 %

8 8 .4 0 %

6 .5 5

2 5 4 5 .0 2

5 .9 8 %

9 4 .3 8 %

353

2 .1 2

7 4 8 .3 2

1 .7 6 %

9 6 .1 4 %

76

7 .1 0

5 3 9 .8 7

1 .2 7 %

9 7 .4 1 %

121

4 .1 2

4 9 8 .3 4

1 .1 7 %

9 8 .5 8 %

382

1 .2 8

4 8 8 .9 6

1 .1 5 %

9 9 .7 3 %

92

1 .2 7

1 1 6 .8 4
4 2 5 6 3 .9 9

0 .2 7 %

1 0 0 .0 0 %

15