Presented by :

Amanda R. Arevalo
Rachel Evora
Mariela Faltado
Randy Mendoza

A stock or store of goods

The raw materials, component parts, work-inprocess, or finished products that are held at a
location in the supply chain.
The goods and materials that a business holds for
the ultimate purpose of resale (or repair).
Represents one of the most important assets that
most businesses possess, because the turnover of
inventory represents one of the primary sources of
revenue generation and subsequent earnings for the
company's shareholders/owners.

Inventory can be the most expensive and the

most important asset for an organization

Raw materials inventory purchased

but not processed

WIP (work in progress )

inventory - partially
completed goods or goods
that undergone some
change but not completed

MRO (Maintenance, Repairs, and

operating Supplies) inventory
Replacement parts, tools and supplies
neccessary to keep machinery and
processes productive
Finished-goods inventory
(manufacturing firm) or merchandise
inventory(retail store) completed
products for delivery or shipment
Pipeline inventory - Goods-intransit to warehouses or
customers

Suppliers

Customers

Inventory Storage
Raw
Finished
Materials
Goods
Work in
Process

Fabrication
and
Assembly

Inventory Processing

The supervision of supply,

storage and accessibility of
items in order to ensure an
adequate supply without
excessive oversupply.
Maintaining the inventory
at a desired level. The
desired level keeps on
fluctuating as per the
demandand supply of
goods.

To achieve satisfactory levels

of customer service while
keeping inventory costs
within reasonable bounds
Level of customer
service
Costs of ordering and
carrying inventory

to meet anticipated customer demand (to meet

theanticipation stocks, average demand)
to smooth production requirements (createseasonal
inventoriesto meet seasonal demand)
to decouple operations (eliminate sources of
disruptions)
to protect against stock-outs (holdsafety stocksto
prevent the risk of shortages)
to take advantage of order cycles (buys more
quantities than immediate requirements - cycle
stock, periodic orders, or order cycles)

to hedge against price increases (purchase

large order to hedge future price increase or
implement volume discount)
to permit operations (Little's Law: the average
amount of inventory in a system is equal to
the product of the average demand rate and
the average time a unit is in the system)
to take advantage of quantity discounts
(supplies may give discount on large orders)

There are two basic

decisions that must be
made for every item that
is maintained in inventory.
These decisions have to
do with the timing of
orders for the item and
the size of orders for the
item.

 How much to
order
When to
order

Basic Inventory Decisions

How much ?

When ?

Lot sizing decision

Lot timing decision

Determination of
the quantity to be
ordered

Determination of
the timing for the
orders

Some inventory items can be

classified as independent demand
items, and some can be classified
as dependent demand items.
The manner in which we make
inventory decisions will differ
depending upon whether the item
has independent demand or
dependent demand.

CUSTOMER DEMAND

Independent Demand:
Finished Goods
A

Dependent Demand:
Raw Materials,
Component parts,
Sub-assemblies, etc.

A technique for determining

the best answers to the
how much and when
questions.
Based on the premise that
there is an optimal order
size that will yield the
lowest possible value of the
total inventory cost.

1. Demand for the item is known and constant.

2. Lead time is known and constant. (Lead time is the amount
of time that elapses between when the order is placed and
when it is received.)
3. When an order is received, all the items ordered arrive at
once (instantaneous replenishment).
4. The cost of all units ordered is the same, regardless of the
quantity ordered (no quantity discounts).
5. Ordering costs are known and constant (the cost to place an
order is always the same, regardless of the quantity
ordered).
6. Since there is certainty with respect to the demand rate and
the lead time, orders can be timed to arrive just when we
would have run out. Consequently the model assumes that
there will be no shortages.

There are only two costs that will vary with

changes in the order quantity:
1. the total annual ordering cost
2. the total annual holding cost.
Shortage cost can be ignored because of
assumption No. 6.
Since the cost per unit of all items ordered is
the same, the total annual item cost will be a
constant and will not be affected by the order
quantity.

Inventory levels will fluctuate over time as in the following

graph:

D = annual demand
S = cost per order
H = holding cost per unit per
year
Q = order quantity

Total Annual Ordering Cost =

Annual
Demand
Order
Quantity
D
=x S
Q

Total Annual Ordering Cost = (D/Q) S

x Cost per order

D = annual demand
S = cost per order
H = holding cost per unit per
year
Q = order quantity

Holding cost
Order Quantity
x
Total Annual Holding Cost =
per
2

unit per year

Q
=
2

xH

Total Annual Holding Cost = (Q/2) H

D = annual demand
S = cost per order
H = holding cost per unit per
year
Q = order quantity

Total Annual
Total Inventory Cost =
Ordering Cost
D
=
Q
Total Inventory Cost = (D/Q)S

xS

Total Annual
Holding Cost

(Q/2) H

Q
2

xH

EOQ occurs when :

Total Annual
Ordering Cost

Total Annual
Holding Cost

D/Q)S = (Q/2)H
Simplifying the equation, we have :Q2 = (2DS)/H
This can also be written as :

Q* = 2DS/H

Q* represents the optimal value for Q

This is what we call the EOQ

Given the following data for an inventory scenario

whose characteristics fit the assumptions of the
basic EOQ model:
D = 15,000 units per year
S = $3 per order
H = $1 per unit per year
LT = Replenishment = lead time = 2 days
Operating days per year is assumed to be 300
days

Find the following:

1. Average daily demand
2. EOQ
3. Number of orders placed per year
4. Total annual ordering cost
5. Total annual holding cost
6. Time between orders
7. Reorder point (in units)
8. Average inventory level

1. Average daily demand

15,000 units/yr 300 days/yr = 50 units per day
2. EOQ
EOQ = 2DS/H = (2)(15,000)(3)/(1) = 300
units/order
3. Number of orders placed per year
D/Q = (15,000 units/yr)/(300 units/order) = 50 orders/yr

4. Total annual ordering cost

(D/Q)(S) = [(15,000units/yr)/(300 units/order)]
($3/order)
= $150/yr
5. Total annual holding cost
(Q/2)H = [(300 units/order/2)]($1/unit/yr) = $150/yr
6. Time between orders
(Q/d) = (300 units/order)/(50 units/day) = 6 days/order
or
300days/yr50 orders/yr = 6 days/order

7. Reorder point (in units)

ROP = (daily demand)(Lead time) = (50 units/day)(2
days) = 100 units

8. Average inventory level

Q/2 = 300 units/2 = 150 units

At optimal order quantity (Q*):

Carrying cost = Ordering cost

INPUT VALUES

OUTPUT VALUES

Annual Demand

Economic Order
Quantity (EOQ)

Ordering Cost
Carrying Cost
Lead Time
Demand Per Day

EOQ
Models

Reorder Point (ROP)

After Q* is determined, the second decision is

when to order
Orders must usually be placed before inventory
reaches 0 due to order lead time
Lead time is the time from placing the order until
it is received
The reorder point (ROP) depends on the lead
time (LT)

Given the following data :

D = 1,000 units per year
Lead Time (LT) = 3 business days
Operating days per year is assumed to be250
days
Find the Reorder Point (ROP)

Solution :
Daily Demand (d) =

1,000 units per year

250per
days
Daily demand (d) = 4 units
dayper year
Reorder Point (ROP) = Daily Demand (d) x Lead Time
(LT)
Reorder Point (ROP) = 4 units per day x 3 business
days
Reorder Point (ROP) = 12 units

Economic Production Quantity : Determining How

Much to Produce
The EOQ model assumes inventory arrives
instantaneously
In many cases inventory arrives gradually
The economic production quantity (EPQ)
model assumes inventory is being produced at a
rate of p units per day
There is a setup cost each time production
begins

Parameters
Q* =Optimalproductionquantity(orEPQ)
Cs =Setupcost
D =annualdemand
d =dailydemandrate
p =dailyproductionrate

We will need the average inventory level for

finding carrying cost
Average inventory level is the maximum
Max inventory = Q x (1- d/p)
Ave inventory = Q x (1- d/p)

Total Cost consists of :

Setup cost

= (D/Q) x Cs

Carrying cost

= [ Q x (1- d/p)] x Ch

Production cost

=PxD

As in the EOQ model:

The production cost does not depend on Q
The function is nonlinear

As in the EOQ model, at the optimal quantity

Q* we should have:
Setup cost = Carrying cost
(D/Q*) x Cs = [ Q* x (1- d/p)] x Ch
Rearranging to solve for Q* :

Q* =

Brown Manufacturing produces mini refrigerators

and has 167 business days per year. Other relevant
data are given below :
D = 10,000 units annually
d = 1000 / 167 = ~60 units per day
p = 80 units per day (when producing)
Ch = $0.50 per unit per year
Cs = $100 per setup
P = $5 to produce each unit

The production cycle will last until Q* units

have been produced
Producing at a rate of p units per day means
that it will last (Q*/p) days
For Brown this is:
Q* = 4000 units
p = 80 units per day
4000 / 80 = 50 days

Single-Period Inventory Model

One time purchasing decision (Example:
vendor selling t-shirts at a football game)
Seeks to balance the costs of inventory
overstock and under stock
Multi-Period Inventory Models
Fixed-Order Quantity Models
Event triggered (Example: running out of
stock)
Fixed-Time Period Models
Time triggered (Example: Monthly sales
call by sales representative)

A mathematical model in operations

management and applied economics used to
determine optimal inventory levels.
It is typically characterized by fixed prices and
uncertain demand for a perishable product.
If the inventory level isq, each unit of demand
above qis a lost in potential sales.

Also known as theNewsvendor

ProblemorNewsboy
Problemby analogy with the
situation faced by a newspaper
vendor who must decide how
many copies of the day's paper
to stock in the face of uncertain
demand and knowing that
unsold copies will be worthless
at the end of the day.

A one-time business decision that occurs in many

different business contexts such as:
Buying seasonal goods (sometimes called style
goods) - A season can be a day, week, year, etc.
For example, most swimsuits can only be purchased
seasonally. If a buyer orders too few swimsuits, the
retailer will have lost sales and dissatisfied
customers. If the buyer orders too many swimsuits,
the retailer will have to sell them at a clearance
price or even throw some away.

Making the last buy or last production run

decision for a product (or component) that
is near the end of its life cycle. - If the
order size is too small, the firm will have
stock outs and disappointed customers. If
the order size is too large, the firm will
only be able to sell the items for their
salvage value.
Setting safety stock levels for an item. - If
the safety stock is too low, stock outs will
occur. If safety stock is too high, the firm
has too much carrying cost. Nearly all
safety stock models are newsvendor
problems with the selling season being
one order cycle or one review period.

Setting target inventory levels A

salesperson carries inventory in the trunk
of a vehicle. The inventory is controlled by
a target inventory level. If the target is too
low, stock outs will occur. If the target is
too high, the salesperson will have too
much carrying cost.
Selecting the right capacity for a facility or
machine If the capacity of a factory or a
machine over the planning horizon is set
too low, stock outs will occur. If capacity is
set too high, the capital costs will be too
high.

Overbooking customers If an airline

overbooks too many passengers, it incurs
the cost of giving away free tickets to
inconvenienced passengers. If the airline
does not overbook enough seats, it incurs
an opportunity cost of lost revenue from
flying with empty seats.

All of these newsvendor problem contexts share

a common mathematical structure with the
following four elements:
A decision variable (Q) The newsvendor
problem is to find the optimal Q for a one-time
decision, where Q is the decision quantity (order
quantity, safety stock level, overbooking level,
etc.). Q* denotes the optimal (best) value for Q.

Uncertain demand (D) Demand is a random

variable defined by the demand distribution and
estimates of the distribution parameters.
Demand may be either discrete (integer) or
continuous.
Unit overage cost (Co) This is the cost of buying
one unit more than the demand during the oneperiod selling season. In the standard retail
context, the overage cost is the unit cost (c) less
the unit salvage value (s), i.e., Co = c s. The
salvage value is the salvage revenue less the
salvage cost required to dispose of the unsold
product.

Unit underage cost (Cu) This is the cost of

buying one unit less than the demand during the
one-period selling season. This is also known as
the stock out (or shortage) cost. In the retail
context, the underage cost is computed as the
lost contribution to profit, which is the unit price
(p) less the unit cost (c), i.e., Cu = p c

The too much/too little problem:

Order too much and inventory is left
over at the end of the season
Order too little and sales are lost.
Given :
Each suit sells for p = $180
Seller charges
c = $110 per suit
Discounted suits sell for v = $90

Co = overage cost (order one too many --- demand

order amount)

<

The cost of ordering one more unit than what

you would have ordered had you known demand
if you have left over inventory the increase in
profit you would have enjoyed had you ordered
one fewer unit.
Co = Cost Salvage value
Co = c v
Co = 110 90
Co = 20

Cu = underage cost (order one too few demand

order amount)

>

The cost of ordering one fewer unit than what you

would have ordered had you known demand
If you had lost sales (i.e., you under ordered), Cu is
the increase in profit you would have enjoyed had
you ordered one more unit.
Cu = Price Cost
Cu = p c
Cu = 180 110
Cu = 70

To maximize expected profit order Q units so that

the expected loss on the Qth unit equals the
expected gain on the Qth unit:

Rearrange terms in the above equation ->

The ratio Cu / (Co + Cu) is called the critical ratio

(CR).

We shall assume demand is distributed as the

normal distribution with mean and standard
deviation .
Find the Q that satisfies the above equality use
NORMSINV(CR) with the critical ratio as the
probability argument.

(Q - ) / = z -

score for the CR so

Q=+z*
Note: where F(Q) = Probability Demand
<= Q

Inputs:
Empirical distribution function table; p = 180;
c = 110; v = 90; Cu = 180-110 = 70; Co = 11090 =20
Find an order quantity
Q such that there is a
77.78% probability that
demand is Q or lower.

Evaluate the critical ratio:

NORMSINV(.7778) = 0.765

Other Inputs: mean = = 3192;

standard deviation = = 1181
Convert into an order quantity
Q=+z*
Q = 3192 + 0.765 * 1181
Q = 4095

Useful when demand is uncertain and is a

continuous variable while the product is perishable.
Theonlyreal

Example :al
The demand is approximately normally
distributed with mean 11.731 and
standard deviation 4.74.
Each copy is purchased for 25 cents and
sold for 75 cents, and he is paid 10 cents
for each unsold copy by his supplier.

One obvious solution is approximately 12

copies.
Suppose the vendor purchases a copy that
he doesn't sell. His out-of-pocket expense
is 25 cents 10 cents = 15 cents.
Suppose on the other hand, he is unable to
meet the demand of a customer. In that
case, he loses 75 cents 25 cents = 50
cents profit.

Notation :al

Co = Cost per unit of positive inventory

remaining at the end of the period (known
as the overage cost).

Cu = Cost per unit of unsatisfied demand.

This can be thought of as a cost per unit of
negative ending inventory (known as the
underage cost).

The demand D is a continuous

nonnegative random variable with density
function f (x)
and cumulative
distribution function

F(x).

The decision variable Q is the number of

units to be purchased at the beginning of
the period.

The cost function G(Q) is convex.

Theonlyreal

The optimal solution equation

Determining the optimal policy for function :

Theonlyreal

Example (continuation) :
Normally distributed with mean = 11.73
and standard deviation = 4.74.
Co = 25 10
= 15 cents
The critical ratio is
0.50/0.65

Cu = 75 25
= 50 cents
=
= 0.77.

Purchase enough copies to satisfy all of

the weekly demand with probability 0.77.
The optimal Q* is the 77th percentile of
the demand distribution.

f(x)

Area = 0.77

11.73

Q*

Example (continuation) :

Using the data of the normal distribution

we obtain a standardized value of z =
0.74. The optimal

Q is

Hence, he should purchase 15 copies

every week.

Recall the two general types of multi-period

inventory models :
1. Fixed-order quantity models
Also called the economic order quantity, EOQ,
and Q-model
Event triggered
2. Fixed-time period models
Also called the periodic system, periodic
review system, fixed-order interval system,
and P-model
Time triggered

Key Differences :
To use the fixedorder quantity model, the
inventory remaining must be continually
monitored
In a fixedtime period model, counting takes
place only at the review period
The fixedtime period model
Has a larger average inventory
Favors more expensive items
Is more appropriate for important items
Requires more time to maintain

Fixed-Order Quantity Model

Demand for the product is constant and uniform
throughout the period
Lead time (time from ordering to receipt) is
constant
Price per unit of product is constant
Inventory holding cost is based on average
inventory
Ordering or setup costs are constant
All demands for the product will be satisfied

Recall the Basic Fixed-Order Quantity (EOQ) Model

Recall the Basic Fixed-Order Quantity

Formula
Total
Annual
Annual
Annual
Annual = Purchase +Ordering +Holding
Cost
Cost
Cost
Cost

D
Q
D
Q
TC
TC == DC
DC ++ SS++ H
H
Q
22
Q

Q* = 2DS/H

(EOQ)
TC=Total annual
cost
D =Demand
C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
L =Lead time
H=Annual holding
and storage cost per
unit of inventory

Establishing Safety Stocks

Safety stock is the amount of inventory
carried in addition to the expected
demand
Safety stock can be determined based on
many different criteria
A common approach is to simply keep a
certain number of weeks of supply

Establishing Safety Stocks (cont)

A better approach is to use probability
Assume demand is normally
distributed
Assume we know mean and
standard deviation
To determine probability, we
plot a normal distribution for
expected demand and note
where the amount we have
lies on the curve

Fixed Order Quantity Model

Fixed Order Quantity Model with Safety Stock

Fixed Time Period Model

Fixed Time Period Model with Safety Stock Formula

q = Average demand + Safety stock Inventory
currently on hand

Where : q =
quantity to be ordered
T=
the number of days between reviews
L =lead time in days
d=
forecast average daily demand
z =the number of standard deviations for a specified service
probability
I=
current inventory level, including items on order
T+L = standard deviation of demand over the review & lead
time

Determining the value of T+L

The standard deviation of a sequence of

random events equals the square root of the
sum of the variances

Fixed Time Period Model Sample Problem :

Average daily demand for a product is 20
units. The review period is 30 days, and lead
time is 10 days. Management has set a
policy of satisfying 96 percent of demand
from items in stock. At the beginning of the
review period there are 200 units in
inventory. The daily demand standard
deviation is 4 units.
Given the above information, how many
units should be ordered ?

Solution :

T+
=
T+LL =

22
(T
+
L)

d
(T + L) d ==

22
30

+
10
4
30 + 10 4 == 25.298
25.298

qq==dd(T
(T++L)
L)++ZZTT++LL --II
qq==20(30
20(30++10)
10)++(1.75)(25.
(1.75)(25.298)
298)--200
200
qq==800
80044.272
44.272--200
200==644.272,
644.272,or
or645
645units
units