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CHAPTE R

11 Inventory Management

Introduction to Operations Management


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What is inventory?
An

inventory is an idle stock of material used to facilitate production or to satisfy customer needs

Introduction to Operations Management


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Why do we need inventory?


Economies

of scales in ordering or production - cycle stock


trade-off setup cost vs carrying cost

Smooth

production when requirements have predictable variability - seasonal stock


trade-off production adjustment cost vs carrying cost

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Why do we need inventory? (contd)


Provide

immediate service when requirements are uncertain (unpredicatable variability) -safety stock
trade-off shortage cost versus carrying cost

Decoupling

of stages in production/distribution systems -decoupling stock


trade-off interdependence between stages vs carrying cost
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Why do we need inventory? (contd)


Production

is not instantaneous, there is always material either being processed or in transit - pipeline stock
trade-off cost of speed vs carrying cost

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Why carrying inventory


As

you can see from the above list, there are economic reasons, technological reasons as well as management/operations reasons.

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Why carrying inventory is costly?


Traditionally,

carrying costs are

attributed to:
Opportunity cost (financial cost) Physical cost (storage/handling/insurance/theft/obs olescence/)

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Inventory Management
Independent Demand

Dependent Demand

B(4)

C(2)

D(2)

E(1)

D(3)

F(2)

Independent demand is uncertain. Dependent demand is certain.


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Types of Inventories
Raw

materials & purchased parts Partially completed goods called work in progress Finished-goods inventories
(manufacturing firms) or merchandise (retail stores)

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Types of Inventories (Contd)


Replacement

parts, tools, & supplies Goods-in-transit to warehouses or customers

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Inventory Counting Systems


Periodic

System

Physical count of items made at periodic intervals


Perpetual

Inventory System

System that keeps track of removals from inventory continuously, thus monitoring current levels of each item

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Inventory Counting Systems (Contd)


Two-Bin

System - Two containers of

inventory; reorder when the first is empty Universal Bar Code - Bar code printed on a label that has information about the item to which it is attached 0
214800 232087768

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ABC Classification System


Classifying inventory according to some measure of importance and allocating control efforts accordingly.

A - very important B - mod. important C - least important

High
Annual $ volume of items Low Few Many

B C

Number of Items
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What are we tackling in inventory management?


All

models are trying to answer the following questions for given informational, economic and technological characteristics of the operating environment: How much to order (produce)? When to order (produce)? How often to review inventory? Where to place/position inventory?

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The inventory models


The

quantitative inventory management models range from simple to very complicated ones. However, there are two simple models that capture the essential tradeoffs in inventory theory
The newsboy (newsvendor) model The EOQ (Economic Ordering Quantity) model

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The Newsboy Model


The

newsboy model is a single-period stocking problem with uncertain demand: Choose stock level and then observe actual demand.
Tradeoff: overstock cost versus opportunity cost (lost of profit because of under stocking)

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The Newsboy Model


Shortage

cost (Cs) - the opportunity cost for lost of sales as well as the cost of losing customer goodwill.
Cs = revenue per unit - cost per unit

Excess

cost (Ce) - the over-stocking cost (the cost per item not being able to sell)
Ce = Cost per unit - salvage value per unit

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The Newsboy Model


In

this model, we have to consider two factors (decision variables): the supply (X), also know as the stock level, and the demand (Y). The supply is a controllable variable in this case and the demand is not in our control. We need to determine the quantity to order so that long-run expected cost (excess and shortage) is minimized.
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The Newsboy Model


Let

X = n and P(n) = P(Y>n). The question is: Based on what should we stock this n-th unit? The opportunity cost (expected loss of profit)for this n-th unit is P(n) Cs The expected cost for not being able to sell this n-th unit (expected loss)
(1-P(n))Ce
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The Newsboy model


Stock

the n-th unit if P(n)Cs > (1-P(n))Ce

Do

not stock if P(n)Cs < (1-P(n))Ce

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The Newsboy model


The

equilibrium point occurs at

P(n)Cs = (1-P(n)) Ce

Solving the equation


P(n) = Ce/(Cs + Ce)

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Newsboy model
Service

level is the probability that demand will not exceed the stocking level and is the key to determine the optimal stocking level. our notation, it is the probability that YX(=n), which is given by
P(Yn) = 1 - P(n) = Cs/(Cs + Ce)
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In

Example (p.564)
Demand for long-stemmed red roses at a small flower shop can be approximated using a Poisson distribution that has a mean of four dozen per day. Profit on the roses is $3 per dozen. Leftover are marked down and sold the next day at a loss of $2 per dozen. Assume that all marked down flowers are sold. What is the optimal stocking level?

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Example (solutions)

Cs = $3, Ce = $2 Opportunity cost is P(n)Cs Expected loss for overstocking (1 - P(n)) Ce P(Y n) = Cs/(Cs + Ce) = 3/((3+2) = 0.6 From the table, it is between 3 and 4, round up give you optimal stock of 4 dozen.

Cumulative frequencies for Poisson distribution, mean = 4

Demand (dzn per day) 0 1 2 3 4 5


5

Cumulative frequency 0.018 0.092 0.238 0.434 0.629 0.785

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The Inventory Cycle


Profile of Inventory Level Over Time
Q
Quantity on hand

Usage rate

Reorde r point Time

Receive order

Place order

Receive order

Place order

Receive order

Lead time to Operations Management Introduction


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How to estimate the inventory costs?

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Estimating the inventory costs


Q = quantity to order in each cycle S = fixed cost or set up cost for each order D = demand rate or demand per unit time H = holding cost per unit inventory per unit time c = unit cost of the commodity

TC = total holding cost per unit time


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Estimating the inventory cost

The cost per order = S + cQ The length of order cycle = Q/D unit time

The average inventory level = Q/2 Thus the inventory carrying cost

= (Q/2) H (Q/D) = HQ2/(2D)

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Estimating the inventory cost


The

total cost per order cycle

= S + cQ + HQ2/(2D) Thus the total cost per unit time is dividing the above expression by Q/D, I.e., TC = {S + cQ + HQ2/(2D)} {D/Q}
= DS/Q + cD + HQ/2
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Total Cost

Annual Annual Total cost = carrying + ordering cost cost

TC =

Q H 2

DS Q

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Deriving the EOQ


Using calculus, we take the derivative of the total cost function and set the derivative (slope) equal to zero and solve for Q.
Q OPT = 2DS = H 2(Annual Demand )(Order or Setup Cost ) Annual Holding Cost

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Cost Minimization Goal


The Total-Cost Curve is U-Shaped
Q D TC H S 2 Q

Annual Cost

Ordering Costs Order Quantity (Q)


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QO (optimal order quantity)


Introduction to Operations Management

Minimum Total Cost


The total cost curve reaches its minimum where the carrying and ordering costs are equal.

Q OPT =

2DS = H

2(Annual Demand )(Order or Setup Cost ) Annual Holding Cost

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Total Costs
Cost Adding Purchasing cost doesnt change EOQ TC with PD

TC without PD

PD

EOQ
Introduction to Operations Management

Quantity
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Total Cost with Constant Carrying Costs


TCa
Total Cost

TCb TCc
Decreasing Price

CC a,b,c

OC EOQ
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Quantity

Example (Example 2, p.541)


A local distributor for a national tire company expects to sell approximately 9600 steel-belted radial tires of a certain size and tread design next year. Annual carrying costs are $16 per tire, and ordering costs are $75. This distributor operate 288 days a year.
a. What is the EOQ? b. How many times per year does the store reorder? c. What is the length or an order cycle? d. What is the total ordering and inventory cost?

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Solution (Example 2, p.541)


D = 9600 tires per year, H = $16 per unit per year, S = $75 a. Q0 = {2DS/H} = {2(9600)75/16} = 300 b. Number of orders per year = D/ Q0 = 9600 / 300 = 32 c. The length of one order cycle = 1 / 32 years = 288/32 days = 9 days d. Total ordering and inventory cost = QH/2 + DS/Q = 2400 + 2400 = 4800

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EOQ with quantity discount


This

is a variant of the EOQ model. Quantity discount is another form of economies of scale: pay less for each unit if you order more. The essential trade-off is between economies of scale and carrying cost.

Introduction to Operations Management


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EOQ with quantity discount

To tackle the problem, there will be a separate (TC) curve for each discount quantity price. The objective is to identify an order quantity that will represent the lowest total cost for the entire set of curves in which the solution is feasible. There are two general cases: The holding cost is constant The holding cost is a percentage of the purchasing price.
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Quantity discount (constant holding cost)


Total

cost per cycle

= setup cost + purchase cost + carrying cost


Setup

cost = S Purchase cost = ciQ, if the order quantity Q is in the range where unit cost is ci. Carrying cost = (Q/2)h(Q/D)
TC

= {S+ciQ+hQ2/(2D)}{D/Q} (annual cost)


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Quantity discount (constant holding cost)


Differentiating, we obtain an optimal order quantity which is independent of the price of the good

2DS Q0 h
The questions is: Is this Q0 a feasible solution to our problem?

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Quantity discount (constant holding cost)


Solution

steps:

1. Compute the EOQ. 2. If the feasible EOQ is on the lowest price curve, then it is the optimal order quantity. 3. If the feasible EOQ is on other curve, find the total cost for this EOQ and the total costs for the break points of all the lower cost curves. Compare these total costs. The point (EOQ point or break point) that yields the lowest total cost is the optimal order quantity.
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Example

The maintenance department of a large hospital uses about 816 cases of liquid cleanser annually. Ordering costs are $12, carrying cost are $4 per case a year, and the new price schedule indicates that orders of less than 50 cases will cost $20 per case, 50 to 79 cases will cost $18 per case, 80 to 99 cases will cost $17 per case, and larger orders will cost $16 per case. Determine the optimal order quantity and the total cost.

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Example (solutions)
1. The common EOQ: = {2(816)(12)/4} = 70

2.

70 falls in the range of 50 to 79, at $18 per case.


TC = DS/Q+ciD+hQ/2

= 816(12)/70 + 18(816) + 4(70)/2 = 14,968 3. Total cost at 80 cases per order TC = 816(12)/80 + 17(816) + 4(80)/2 = 14,154 Total cost at 100 cases per order TC = 816(12)/100 + 16(816) + 4(100)/2 =13,354

The minimum occurs at the break point 100. Thus order 100 cases each time
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Quantity discount (h = rc)

Using the same argument as in the constant holding cost case, Let TCi be the total cost when the unit quantity is ci.
TCi = rciQ/2 + DS/Q + ciD

Therefore EOQ = {2DS/(rci)} In this case, the carrying cost will decrease with the unit price. Thus the EOQ will shift to the right as the unit price decreases.
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Quantity discount (h = rc)


Steps

to identify optimal order quantity

1. Beginning with the lowest price, find the EOQs for each price range until a feasible EOQ is found. 2. If the EOQ for the lowest price is feasible, then it is the Optimal order quantity. 3. Same as step (3) in the constant carrying case.

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Example (p.549)
Surge Electric uses 4000 toggle switches a year. Switches are priced as follows: 1 to 499 at $0.9 each; 500 to 999 at $.85 each; and 1000 or more will be at $0.82 each. It costs approximately $18 to prepare an order and receive it. Carrying cost is 18% of purchased price per unit on an annual basis. Determine the optimal order quantity and the total annual cost.

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Solution
D = 4000 per year; S = 18 ; h = 0.18 {price} Step 1. Find the EOQ for each price, starting with the lowest price EOQ(0.82) = {2(4000)(18)/[(0.18)(0.82)]} = 988
(Not feasible for the price range).

EOQ(0.85)= 970 (feasible for the range 500 to 999) Step 2. Feasible solution is not on the lowest cost curve Step 3. TC(970) = 970(.18)(.85)/2 + 4000(18)/970 + .85(4000) = 3548 TC(1000) = 1000(.18)(.82)/2 + 4000(18)/1000 + .82(4000) = 3426

Thus the minimum total cost is 3426 and the minimum cost order size is 1000 units per order.
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We

have settled the problem of how much to order. The next decision problem is when to order.

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Reorder point

In the EOQ model, we assume that the delivery of goods is instantaneous. However, in real life situation, there is a time lag between the time an order is placed and the receiving of the ordered goods. We call this period of time the lead time. Demand is still occurring during the lead time and thus inventory is required to meet customer demand. This is why we need to consider when to order!
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When to reorder
We

can reorder based on:

time, say weekly, monthly, etc quantity of goods on hand

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When to Reorder with EOQ Ordering


Reorder

Point - When the quantity on hand

of an item drops to this amount, the item is reordered


Safety

Stock - Stock that is held in excess

of expected demand due to variable demand rate and/or lead time.


Service

Level - Probability that demand will


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not exceed supply during lead time.

Safety Stock
Quantity

Maximum probable demand during lead time

Expected demand during lead time

ROP
Safety stock
LT
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Time

When to reorder
In

general, we need to consider the following four factors when deciding when to order:
The rate of demand (usually based on a forecast) The length of lead time. The extent of demand and lead time variability. The degree of stock-out risk acceptable to management.
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When to reorder
We

will just cover two simple cases:

The demand rate and lead time are constant Variable demand rate and constant lead time.

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Reorder Point

Service level Risk of a stockout Probability of no stockout Expected demand

ROP
Safety stock

Quantity

z-scale

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ROP - constant demand and lead time


Let d be the demand rate per unit time and LT be the lead time in unit time. The reorder point quantity is given by ROP = expected demand during lead time + safety stock during lead time In this case, safety stock required is 0 Thus ROP = d (LT)

Example: See Example 7 on page 551


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ROP - variable demand rate


The

lead time is constant. In this case, we need extra buffer of safety stock to insure against stock-out risk. Since it cost money to carry safety stocks, a manager must weigh carefully the cost of carrying safety stock against the reduction in stock-out risk (provided by the safety stock)

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ROP - variable demand rate


In

other words, he needs to trade-off the cost of safety stock and the service level. Service level = 1 - stock-out risk ROP = Expected lead time demand + safety stock = d (LT) + z
Where is the standard deviation of the lead time demand = {LT} d

Therefore ROP = d(LT) + z {LT} d


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Example (Problem 4, p.569)


The housekeeping department of a hotel uses approximately 400 washcloths per day. The actual amount tends to vary with the number of guests on any given night. Usage can be approximated by a normal distribution that has a mean of 400 and a standard deviation of 9 washcloths per day. A linen supply company delivers towels and washcloths with a lead time of three days. If the hotel policy is to maintain a stock-out risk of 2 percent, what is the minimum number of washcloths that must be on hand at reorder time, and how much of that amount can be considered safety stock?

Solution: d = 400, LT = 3 days, d = 9 , service level = 1 - risk = 0.98


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Example (solution)
Z = 2.055 (from normal distribution table)

Thus ROP = 400 (3) + 2.055 (3) d = 1200 + 32.03 = 1232 The safety stock is approximately 32 washcloths, providing a service level of 98%.

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Fixed-order-interval model
In

the EOQ/ROP models, fixed quantities of items are ordered at varying time interval. However, many companies ordered at fixed intervals: weekly, biweekly, monthly, etc. They order varying quantity at fixed intervals. We called this class of decision models fixed-orderinterval (FOI) model.
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FOI model
Why

use FOI model?

Is

it optimal?

What

are decision variables in the FOI model?

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FOI model
Assuming

lead time is constant, we need to consider the following factors


the expected demand during the ordering interval and the lead time the safety stock for the ordering interval and lead time the amount of inventory on hand at the time of ordering
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FOI model
Order quantity

Safety stock

Amount on hand (A)


Place order

Time OI LT

Receive order
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FOI model
We

use the following notations OI = Length of order interval A = amount of inventory on hand LT = lead time d = Standard deviation of demand

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FOI model
Amount

to order

= expected demand during protection interval


+ Safety stock for protection interval - amount on hand at time of placing order

= d(OI LT) z d OI LT A

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Example (p.560)
The following information is given for a FOI system. Determine the amount to order. d = 30 units per day, d = 3 units per day, LT = 2 days; OI = 7 days Amount on hand = 71 units, Desired serve level = 99%.

Solution: z = 2.33 for 99% service level.


Amount to order = 30 (7 + 2) + 2.33 (3) (7 + 2) - 71 = 270 + 20.97 - 71 = 220

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