Purchasing and Supply Chain Management

by W.C. Benton

Chapter Five
Inventory Management
 Learning Objectives
1. To learn the relationship between the purchasing
function and inventory control.

2. To learn the primary reasons for holding inventory.

3. To identify the necessary requirements for

effective inventory management.

4. To learn about ABC analysis.

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 Learning Objectives
5. To identify the cost components of the classical
EOQ model.

6. To learn the basic assumptions of the EOQ model.

7. To learn about quantity discounts.

8. To learn about service levels.

9. To identify the differences between fixed-order-

quantity and variable-order inventory systems.
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 Purchasing Raw Materials
and Component Parts
• The purchasing function is taking on increasing
importance in today’s industrial economy.
• Since materials constitute the largest single
percentage of their purchasing dollars, profit
oriented firms have turned to professionally
operated purchasing departments to make sure they
are getting full value for their outlays on materials
• The purchasing professional must be able to make
profitable buying decisions under these conditions.
The purchasing professional person must make
profitable inventory management decisions.

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 Inventory Management
• Inventory is the life blood of any business. Most
firms store thousands of different items.
• The type of business a firm is in will usually
determine how much of the firm’s assets are
invested in inventories.
• Hospitals carry beds, surgical instruments, food,
pharmaceuticals, and other miscellaneous items.
• Manufacturing firms carry office supplies, raw
materials, component parts, finished products, and
many other industry-related items.

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 Dependent Versus
Independent Demand
• In order to manage the various types of inventory, attributes of the
items first must be analyzed in terms of cost, lead time, past usage,
and the nature of demand.

• The nature of demand is perhaps the most important attribute. The

nature of demand can be either independent or dependent.

• Independent demand is unrelated to the demand for other items.

In other words, an independent item must be forecasted
independently.

• Dependent demand is directly derived from demand for another

inventoried item demand
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 Dependent Versus
Independent Demand
• In order to manage the various types of inventory, attributes
of the items first must be analyzed in terms of cost, lead time,
past usage, and the nature of demand.

• The nature of demand is perhaps the most important

attribute. The nature of demand can be either independent or
dependent.

• Independent demand is unrelated to the demand for other

items. In other words, an independent item must be
forecasted independently. Dependent demand is directly
derived from demand for another inventoried item demand.
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Inventory Management Overview
• Management of inventories is a major interest of purchasing
managers.
• In many industries, the investment in inventories comprises a
substantial share of the firm’s assets.
• If the productivity of the inventory asset can be enhanced, the
improvement will go directly to the bottom line.
• How does the purchasing professional know how much
inventory to carry?
• How does the purchasing professional know when to place a
replenishment order?
• Specifically, what guidelines should be used for making
purchasing decisions?
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 Inventory Decisions
• In the area of inventory management, the
purchasing professional should make explicit
decisions regarding the following:

1. What to stock. The purchasing professional, at the very minimum,

must meet the requirements and needs of the manufacturer on
distribution operation.

2. How much to invest. The purchasing professional must first review

the level of capital support for inventory. This decision is usually made
at the vice president level.

3. How much service to offer. What level of protection against stockouts

is acceptable for the competitive environment? It is impossible to
achieve a service level of 100 percent
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 Inventory Decisions

• As can be seen, none of these decisions is

independent of the other. Moreover, combining
these decisions is complex and may be closely
correlated with the industry and the type of firm
within the industry.

• In the case of a manufacturing firm, you must

consider whether the production process is make to
order, make to stock, or some hybrid of the two.

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Production Processing Strategy

• In this section, the production processing

strategy is divided into two categories:
1. continuous systems
2. intermittent systems

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 Production-Inventory Taxonomy
• The taxonomy is based on continuous systems producing
standardized products through an assembly line, while
intermittent systems are used to produce non standardized
products through a job shop.

• Another subcategory (not shown in the taxonomy) associated

with continuous systems is pure inventory systems.

• Pure inventory systems are distribution stocking points, such

as warehouses or distributors.

• The purchasing manager must have a clear understanding of

the role of inventory in the materials management system.

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 ABC Classification of
Inventory Items
• The inventory items that are the most important for a specific
industry or firm should be items that account for the greatest
dollar value.

• To determine the usage value of an item, multiply the unit cost by

annual sales volume. If a particular item costs $100 and 150 are
sold in one year, then its usage value is $100 × 150, or $15,000.

• With only these two data points (sales and costs), you can not only
rank all of your inventory items by importance, but also take the
first step toward controlling independent demand and distribution
inventories.
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 ABC Classification of
Inventory Items
• If you analyze what sells the most and what cost the
most, a predictable pattern will emerge with most
distribution inventories.

1. Certain items are demanded by a great many customers.

2. Most items are only demanded by certain customers.

3. Some items are demanded by few customers.

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• The following procedure is one
way of implementing an ABC
analysis.
1. Calculate the annual dollar
value for each item.
2. List all items in descending
order.
3. Develop a cumulative
percentage of the items that
reflect roughly 60–80 percent
of the total cost.
4. Determine the percentage of
the items that represent
roughly 60–80 percent of the
total cost. These are
considered A items.

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 Independent Demand
• In this section, we are concerned with the control
of end items. The inventory management concepts
covered in this section are also applicable to
retailing and distribution.

There are five primary functions of inventories:

1. Pipeline inventory. The supply pipelines of the entire
system require a considerable investment in inventory. If
the system’s volume is 1,000 units per week and it takes
one day to transport from the supplier to the plant, there
are 1/7 × 1,000, or about 143, units in transit on the
average.

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 Independent Demand
2. Cycle stocks. When units are transported from one
location point to another, how many units do we
transport at one time? For example, say we place
an order once each three weeks following a review
of sales and projected needs.

1. Once the order is received, there is a two-day order

processing delay at the suppliers plus three days for
transit and receipt. Assume that the average unit
sales volume is five units per week or 15 units in the
three-week order period.

1. Thus, the buyer must have no less than 15 units of

cycle stock on hand when an order is placed, for an
average cycle stock level of 15/2 = 7.5 units.
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 Independent Demand

3. Seasonal inventories. If demand follows a seasonal

pattern, inventories can be accumulated during low
sales periods and depleted during high usage periods to
avoid problems associated with adjusting capacity.

4. Safety stocks. Safety stocks are designed to absorb

random demand uncertainties.

5. Decoupling. Stocks of inventories at major stocking

points throughout the system make it possible to carry
on each activity independently. That is, the presence of
inventories allows for each work center to begin at the
same starting time.

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 Costs in an Inventory System
• The objective of an inventory
system is the minimization of
total operating costs. The
unavoidable costs of operating
pure inventory systems are
ordering costs, stockout costs,
and holding costs.

• To illustrate the cost behavior of

a fixed-order-size system, let’s
look at the simple classical
economic lot size model (EOQ).
The EOQ derives the optimal lot
size for purchasing by minimizing
the cost components involved
(ordering costs and holding cost).

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 The EOQ Model
• Once the most economical order quantity is known,
several other measures can be taken:

1. The expected number of orders during the year, NO = A/Q

1. The expected time between orders, TBO = 1/NO = Q/A

1. The reorder point, R = (A/12) * L, where L is expressed in

months. If L is expressed in weeks, R = (A/52) * L.

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 The EOQ Model
• The minimum total cost per year is obtained by
substituting Q* for Q in equation (1). The classical
EOQ model assumes the following:
1. Constant demand.
2. Constant lead time.
3. Constant unit price.
4. Fixed order cost per order.
5. Fixed holding cost per unit.
6. Instantaneous replenishment.
7. No stockouts allowed.
8. No demand uncertainty.
9. Quantity discounts are not available

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 Quantity Discounts
• From time to time, buying firms receive discounted
price schedules from their suppliers.

• This usually means that the price per unit is lower if

larger orders are purchased. It may or may not be to
the buyer’s advantage to accept the quantity discount.

• The buyer must be careful not to compromise the

economies of his or her firm’s cost structure.

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 Quantity Discounts
• The classical EOQ model assumes that the per-unit
material price is fixed. The quantity discount condition
invalidates the total cost curve.

• Quantity discounts induce a discontinuous total cost

curve.

• Assuming the discount applies to all units (and not just

in incremental units beyond the discount point), the
minimum total cost point will be either at the point of
discontinuity or at the traditional EOQ point compared
with the original price.
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 Quantity Discounts
• A five-step method can easily be used for determining the
minimum cost order quantity:
1. Calculate the economic order quantity using the minimum unit prices. If this
quantity falls within the range for which the vendor offers the discount price, it
is a valid economic order quantity and will result in the minimum cost for the
particular item.

1. If the EOQ calculated in step 1 is not valid (i.e., is less than the break quantity),
find the total annual cost for each price break quantity.

1. Calculate an EOQ for each unit price.

1. Calculate the total annual cost for each valid EOQ determined in step 3.

1. The minimum cost order quantity is that associated with the lowest cost in
either step 2 or step 4.
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 Safety Stock
• When there is uncertainty in demand, safety stock must be
considered. Safety stocks are extra inventory held to protect
against randomness in demand or lead time.

• Safety stock is needed to cover the demand during the

replenishment lead time in case actual demand is greater than
expected demand.
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• The safety stock adjusted reorder point is
• ROP = (Expected demand during lead time) + (Safety stock)
• = DDLT + Z√(Lead time expressed as some multiple of forecast
interval) * (Standard deviation of demand)
• = DDLT + Z√L * σd
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 Dependent Demand Systems
• Order-point (statistical inventory control) techniques are
based on the assumption of uniform requirements per unit
time. If this assumption of the demands is unrealistic, these
techniques can lead to inappropriate inventory decisions.

• For components of assembled products, the demands are not

usually constant per unit time, and depletion is anything but
gradual. Inventory depletion for component parts tends to
occur in discrete “lumps”

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 Dependent Demand Systems
• Customer demand is fairly uniform but, because of
the build schedules, the requirements for the
components are “lumpy.”

• The build schedule shows periods of zero

requirements before a requirement of 50
component parts is encountered.

• This requirement sequence, very common to

component parts, is not handled well with traditional
non-time-phased order-point techniques.

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 Dependent Demand Systems
• MRP systems utilize substantially better information
on future requirements than is possible by the
traditional non-time-phased order-point system.

• MRP systems are helpful for companies with

assembled products that have component
requirements dependent on the final product.

• The system provides information to better

determine the quantity and timing of component
parts and purchase orders than is possible with the
non-time-phased order-point system.

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 The Material Requirements Concept
• The MRP concept provides the basis for projecting future
inventories in a manufacturing operation.

• MRP can help improve the traditional non-time-phased order-

point system because it allows the operating manager to plan
requirements (raw material, component parts) to meet the
final assembly schedule.

• That is, MRP provides a plan for component and subassembly

availability that allows certain end products to be scheduled
for final assembly in the future.

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 The General Lot-Sizing Problem
• The general lot-sizing problem for time-phased requirements
for a component part involves converting the requirements
over the planning horizon (the number of periods into the
future for which there are requirements) into planned orders
by batching the requirements into lots.

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 Quantity Discounts
for the Variable Demand Case
• It has been shown in the previous section that MRP
provides time-phased requirements to determine
planned orders using lot-sizing procedures.

• The general lot-sizing problem is to batch requirements

to minimize the sum of ordering and carrying cost each
time an order is to be placed.

• Up until now, conditions for quantity discounts have

not been discussed.

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 Quantity Discounts
for the Variable Demand Case
• The safety stock should be set to achieve a prespecified service
level. Setting safety stock so as to achieve a prespecified service
level enables fair comparison of the alternative lot-sizing
procedures. The service level, S, is defined as

• S = (The number of units required that were in inventory)/(The

number of units required)

• If a discount is available, there is a price differential (lower price)

for ordering an increased number of units. In this chapter, the
discount applies to all units provided an amount at least as big as
the discount quantity is purchased.

• In situations where discounts are not available, the price per unit is
constant regardless of the number of units ordered.
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 Illustration of Various
Variable-demand Lot-sizing Models
• There has been a significant amount of attention given to the
variable-demand order size lot-sizing problem.

• Both developmental and comparative literature will be discussed in

this section.

• Among the better-known lot-sizing methods for the single item,

nondiscount, time-phased, certain-demand models are
(1) lot for lot,
(2) economic order quantity,
(3) periodic order quantity,
(4) least unit cost,
(5) McLaren’s order moment,
(6) Silver-Meal, and
(7) the Wagner-Whitin dynamic programming algorithm.

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