Solving Inventory

Management Problems

Henry C. Co
Technology and Operations Management,
California Polytechnic and State University
Inventory
Inventory: stockpiles of raw materials,
components, semi-finished or finished goods
waiting to be processed, transported or used
at a point of the supply chain.
Reasons to have inventories
l Improving service level,
l Reducing overall logistics costs,
l Coping with randomness in demand and lead times
l Making seasonal items available all year
l Speculating on price patterns, etc.
Annual inventory holding cost can be 30% of
the value of the materials kept in stock, or
even more.
Ghiani, p. 121

Inventory Management Problems 2

Relevant Cost
Procurement costs
Holding costs
Shortage costs
Obsolescence costs

Ghiani, p. 122

Inventory Management Problems 3

Inventory Management Models
Deterministic vs. stochastic models
Fast- vs. slow-moving items
No. of stocking points
No. of commodities
Instantaneous resupply v. non-instantaneous
resupply
Discrete vs. continuous; finite vs. infinite
horizon; shortage allowed/disallowed etc.

The Economic Order Quantity model you learned in TOM 301 is an

example of a “single stocking point, single-commodity, instantaneous
resupply, shortage not allowed, continuous model with infinite
horizon.”
Ghiani, p. 123

Inventory Management Problems 4

The EOQ Model in TOM 301
The total cost curve reaches its
minimum where the carrying and
ordering costs are equal.
EOQ represents trade-off between fixed
cost associated with production or
procurement against inventory holding
costs.
D= Rate of demand, units/year
S= Fixed cost of procurement, $/order
v = Variable cost of procurement.
H= $/unit/year holding cost
Q= Quantity ordered, units

Inventory Management Problems 5

Instantaneous Resupply

Ghiani, p. 129

Inventory Management Problems 6

 The Classical EOQ Model
The total cost curve reaches its
minimum where the carrying and
ordering costs are equal.
Annual Cost

Q D
TC = H + S
2 Q

Ordering Costs

Order Quantity (Q)

(optimal order quantity)
QO
Inventory Management Problems 7
 Using calculus, we take the derivative
of the total cost function (TC) and set
the derivative (slope) equal to zero
and solve for Q.

2DS 2(Annual Demand)(Or der or Setup Cost)

Q OPT = =
H Annual Holding Cost

Inventory Management Problems 8

Try This!
Al-Bufeira Motors manufactures spare parts for aircraft
engines in Saudi Arabia. Its component Y02PN,
produced in a plant located in Jiddah, has a demand of
220 units per year and a unit production cost of $1200.
Manufacturing this product requires a time-consuming
set-up that costs $800. The current annual interest rate
p is 18%, including warehousing costs. Shortages are
not allowed.

Ghiani, p. 123

Inventory Management Problems 9

Non-instantaneous Resupply
(Batch Production Model)

Ghiani, p. 126
Suppose production rate = p= 200
units/day, and demand rate = d = 80
units/day.
Since p>d, inventory will increase at
__________ (p-d) units/day.
Suppose current inventory is 0.
l In 10 days, the inventory level would be
10 days * 120 unit/day = _____ units.
l In 20 days, the inventory level would be
20 days * 60 unit/day = _____ units.
l etc.

Inventory Management Problems 11

The machine produces a batch, then stops, then
resumes production at some later time when the
inventory of this item is low. This is call batch
production.
Batch production is very common in industry.
l When a machine is used to produce two or more
products, one product at a time.
l One decision the production manager has to make is
when to start producing each product, and when to stop.
The run time is the amount of time the machine is
producing a batch.
l Producing at 200 units/day, if we want to produce
2,000 units per batch, the run time is _____ days.

Inventory Management Problems 12

Maximum Inventory Level
If current inventory level is 0, what is the inventory
at the end of the run time?
l Since inventory will be rising at (200- 80 =120)
units/day, the inventory level will be _____ units in 10
days.
l The inventory at the end of the run time is the
maximum inventory. It is equal to (p-d)*t = _____
units.
The machine produced 2,000 units in 10 days, and
the maximum inventory level is only 1,200. Why?
After completing a batch, how long will it take to
deplete the inventory?
l Answer: It will take (p-d)*t/d = _____ days to deplete
the inventory. This is the off-time.

Inventory Management Problems 13

Number of Runs Per Year
If annual = D = 24,000 units, how
many runs do we produce each year?
l Answer: Since we are producing Q =
2,000 units per batch, there will be D/Q =
_____ batches per year.
l In other words, there are D/Q = 12 cycles
per year. In each cycle, there is a period
of time the machine is producing the
product (the run time), and a period to
allow the inventory to deplete (the off
time).

Inventory Management Problems 14

Average Inventory
What is the average inventory level?
l During the run time, the inventory level rises from
0 to the maximum level of (p-d)*t = _____ units.
l During the off time, the inventory level drops from
a maximum of (p-d)*t units to 0.
l The average inventory level therefore = _____
units.
Since p*t = Q, then t = Q/p. We can rewrite
the expression for the average inventory as
(p-d)*t/2 = (p-d)*(Q/p)/2 = (1-d/p)Q/2.

Inventory Management Problems 15

Tradeoff
What is the average inventory if the batch size
equals the annual demand D = 24,000 units?
How many batches do we have to run per
year?
l Answer: The average inventory = (1-d/p)Q/2 =
_____ units. We need to run one batch per year.
What is the average inventory if the batch size
equals the weekly demand of 480 units
(assuming 50 weeks/year)? How many
batches do we have to run per year?
l Answer: _____ units; Run _____ batches per year.

Inventory Management Problems 16

Optimal Tradeoff
Suppose the cost to carry one unit of inventory for
one year is H. Since the average inventory level is
(1-d/p)Q/2, the annual inventory-carrying cost is
H*(1-d/p) Q/2.
Suppose the cost to set-up the machine to produce a
batch is S. Since we need to run D/Q batches per
year, the annual set-up cost is S*D/Q.
Adding the two costs, we have H*(1-d/p) Q/2 +
S*D/Q. Using calculus, the optimal batch size is

Inventory Management Problems 17

Try This!
Golden Food distributes tinned foodstuff in Great Britain.
In a warehouse located in Birmingham, the demand
rate d for tomato purée is 400 pallets a month. The
value of a pallet is c = ￡2500 and the annual interest
rate p is 14.5% (including warehousing costs). Issuing
an order costs ￡30. The replenishment rate r is 40
pallets per day. Shortages are not allowed.

Ghiani, p. 126

Inventory Management Problems 18

Quantity Discounts-On-All-Units

Ghiani, p. 133

Inventory Management Problems 19

Try this!
Maliban runs more than 200 stationery outlets in Spain.
The firm buys its products from a restricted number of
suppliers and stores them in a warehouse located near
Sevilla. Maliban expects to sell 3000 boxes of the Prince
Arthur pen during the next year. The current annual
interest rate p is 30%. Placing an order costs €50. The
supplier offers a box at €3, if the amount bought is less
than 500 boxes. The price is reduced by 1% if 500–
2000 boxes are ordered. Finally, if more than 2000
boxes are ordered, an additional 0.5% discount is
applied.

Ghiani, p. 134

Inventory Management Problems 20

Single Period Stochastic Models

Short product life cycles / Long lead times

l Computers
l Apparel
Fresh products
l Fresh food, newspapers
Services
Airline industry
These models have the objective of properly
balancing the cost of Underage – having not
ordered enough products vs. Overage –
having ordered more than we can sell
These models apply to problems like:
l Planning initial shipments of ‘High-Fashion’ items
l Amount of perishable food products
l Item with short shelf life (like the daily
newspaper)
Because of this last problem type, this class
of problems is typically called the “Newsboy”
problem

Inventory Management Problems 22

Stochastic Model 1: The Newsboy Model
At the start of each day, a newsboy must
decide on the number of papers to purchase.
Daily sales cannot be predicted exactly, and
are represented by the random variable, D.
The newsboy must carefully consider these
costs:
l cU: underage cost (when D≥S). This is the unit
opportunity cost; for example, unit revenue r -
unit cost c, i.e., (r-c)
l cO: overage cost (when D≤S). This is the unit cost
of overstocking; for example, unit cost c - unit
salvage value u, i.e., (c-u).

Inventory Management Problems 23

The objective is to Minimize the expected cost:
cu E[max{D-S, 0}] + co E[max{S-D, 0}]
Solving for Q, the optimal order quantity S
satisfies the following condition:

Equation (4-36) can be rewritten as:

r −c r −c r −c cu
= = =
r − u r − u + (c − c) (r − c )(c − u ) cu + c0
Ghiani, p. 141-142

Inventory Management Problems 24

Graphical Representation

Inventory Management Problems 25

Uniform Demand Between [A,B]

S* − A cu
Solve =
B − A cu + co
cu
S = A+ (B − A) ⋅
*

cu + co
r −c
= A+ (B − A) ⋅
r −u
Inventory Management Problems 26
Try this on Excel!
Emilio Tadini & Sons is a hand-made shirt retailer,
located in Rome (Italy), close to Piazza di Spagna. This
year Mr. Tadini faces the problem of ordering a new
bright color shirt made by a Florentine firm.
l He assumes that the demand is uniformly distributed between 200
and 350 units.
l The purchasing cost is c = €18 while the selling price is r = €52
and the salvage value is u = €7. Thus co = 34 and cu = 11.

cu
S * = A+ (B − A) ⋅ = 200 + (350 − 200 ) ⋅
34
= 313
cu + co 34 + 11
r −c 52 − 18
= A+ (B − A) ⋅ = 200 + (350 − 200 ) ⋅ = 313
r −u 52 − 7

Hence, Mr. Tadini should order S = 313 units.

Ghiani, p. 142

Inventory Management Problems 27

Download Excel worksheet

Inventory Management Problems 28

Another Example …
The buyer for Needless Markup, a famous “high end”
department store, must decide on the quantity of a
high-priced women’s handbag to procure in Italy for the
following Christmas season.
l The unit cost of the handbag to the store is $28.50 and the
handbag will sell for $150.00.
l Any handbags not sold by the end of the season are purchased by
a discount firm for $20.00.
l In addition, the store accountants estimate that there is a cost of
$.40 for each dollar tied up in inventory, as this dollar invested
elsewhere could have yielded a gross profit.
l Assume that this cost is attached to unsold bags only. Suppose
that the sales of the bags are equally likely to be anywhere from
50 to 250 handbags during this season.
Based on this, how many bags should the buyer
purchase?
Example from Nahmias, Production and Operations Analysis

Inventory Management Problems 29

Equation (4-36) does not account for inventory-holding cost!

Inventory Management Problems 30

Distribution of Demand Is Normal

Inventory Management Problems 31

Example
Every week, the owner of a newsstand
purchases a number of copies of The
Computer Journal.
l Weekly demand for the Journal is normally
distributed with mean 10 and standard
deviation 5.
l He pays 25 cents for each copy and sells
each for 75 cents.
Question:
How many copies should he order?
Example from Nahmias, Production and Operations Analysis

Inventory Management Problems 32

 Using NORMSINV

Inventory Management Problems 33

 Using NORMINV

Inventory Management Problems 34

 Using Table

Inventory Management Problems 35

Stochastic Model 2
(s, S) Policy for Single Period :
l If there is an initial inventory q0 and a fixed reorder cost k,
the optimal replenishment policy can be obtained as
follows. If q0 ≥S, no reorder is needed.
l Otherwise, the best policy is to order S −q0, provided that
the expected revenue associated with this choice is greater
than the expected revenue associated with not producing
anything.
Hence, two cases can occur:
(i) if the expected revenue ρ(S) − k − cq0 associated
with reordering is greater than the expected revenue
ρ(q0) − cq0 associated with not reordering, then S −
q0 units have to be reordered;
(ii) otherwise, no order has to be placed.

Ghiani, p. 142

Inventory Management Problems 36

Stochastic Model 3
In reorder point policy (fixed order quantity), inventory
level monitored continuously. As soon as its net value
I(t) (amount in stock - unsatisfied demand + orders
placed but not yet received) reaches a reorder point l, a
constant quantity q is ordered.

Ghiani, p. 143

Inventory Management Problems 37

Stochastic Model 4
In the reorder cycle policy (periodic review policy) stock
level is reviewed periodically at time instants ti (ti+1 = ti
+ T , T≥0). At time ti, qi = S − I (ti) units are ordered.
The order-up-to-level S represents the maximum
inventory level in case lead time tl is negligible.

Ghiani, p. 145

Inventory Management Problems 38

Stochastic Model 5
The (s, S) inventory policy is a natural extension of the (s, S)
policy illustrated for the one-shot case. At time ti , S −I(ti)
items are ordered if I(ti) < s. If s is large enough (s → S), the
(s, S) policy is similar to the reorder cycle inventory method.
On the other hand, if s is small (s → 0), the (s, S) policy is
similar to a reorder level policy with a reorder point equal to s
and a reorder quantity q ≈ S.

Ghiani, p. 147

Inventory Management Problems 39

Stochastic Model 6
The two-bin policy is a variant of the reorder point inventory
method where no demand forecast is needed, and the
inventory level does not have to be monitored continuously.
The items in stock are assumed to be stored in two identical
bins. As soon as one of the two becomes empty, an order is
issued for an amount equal to the bin capacity.
Browns supermarkets make use of the two-bin policy for tomato juice bottles. The capacity of
each bin is 400 boxes, containing 12 bottles each. In a supermarket close to Los Alamos
(New Mexico, USA) the inventory level on 1 December last was 780 boxes of 12 bottles each.
Last 6 December, the inventory level was less than 400 boxes and an order of 400 boxes was
issued (see Table 4.2). The order was fulfilled the subsequent day.

Ghiani, p. 147-148

Inventory Management Problems 40

Simulation of the (S, S) Policy
Excel Worksheet

The (s, S) policy is a good compromise between the

reorder level and the reorder cycle policies.
Unfortunately, parameters T , S and s are difficult to
determine analytically. Therefore, simulation is often
used in practice.

Inventory Management Problems 41

Homework

The Ortiz County Hospital Blood Bank Case