CHAPTER 3 :

INVENTORY CONTROL
MANAGEMENT
(PART 1)

OBJECTIVES:
3.1 Understand inventory control & management
concept.
3.1.1 List objective of inventory control &
management.
3.1.2 Classify types of inventory.
3.2 Understand inventory cost.
3.2.1 Differentiate holding, ordering & setup costs.
3.3 Explain inventory models for independent demand.
3.3.1 Determine economic order quantity model
(EOQ).
3.3.2 Determine production order quantity model
(EPQ).

3.1 Understand inventory control &

management concept.
Definitions :
Inventory - A physical resource that a firm
holds in stock with the intent of selling it or
transforming it into a more valuable state.
Inventory System - A set of policies and
controls that monitors levels of inventory
and determines what levels should be
maintained, when stock should be
replenished, and how large orders should
be.

3.1 Understand inventory control &

management concept.
Inventory Management Questions
What should be the order quantity (Q) ?
When should an order be placed, called a
reorder point (ROP )?
How much safety stock (SS) should be
maintained?

Why?

3.1.1 Objectives of Inventory

Control
1. Maximize the level of customer
service
by avoiding
understocking.
2. Promote efficiency in production
and purchasing by minimizing the
cost of providing an adequate level
of customer service.

3.1.1 Objectives of Inventory

Control
To achieve satisfactory levels of
customer service while keeping
inventory costs within reasonable
bounds.
Level of customer service
Costs of ordering and carrying
inventory

Inventory turnover
is the ratio of average cost of goods sold to
average inventory investment.

Reasons for
Inventories

Improve customer service

Economies of purchasing
Economies of production
Transportation savings
Hedge against future
Unplanned shocks (labor strikes, natural
disasters, surges in demand, etc.)
To maintain independence of supply
chain

3.1.2 Classify types of

inventory.

Raw
Material

3.1.2 Classify types of

inventory.
Different types of Inventory:
Raw Materials
- purchased items received which have not entered the production
process.

Works-in-Process
- raw materials that have entered the manufacturing process & are being
worked on or waiting to be worked on.

Finished Goods
- ready to be sold as completed items.

Distribution inventories
- Finished goods located in the distribution system.

Maintenance, Repair and Operating (MRO)

- items used in production that do not become part of the product.
- include hand tools, spare parts, lubricants & cleaning supplies.

3.2 Understand Inventory

Cost
Holding (or carrying) costs

Costs for storage, handling, insurance, etc.

Setup (or production change) costs
Costs for arranging specific equipment
setups, etc.
Ordering costs
Costs of someone placing an order, etc.
Shortage costs
Costs of canceling an order, etc.

3.2.1 Differentiate Holding, Ordering & Setup

Costs

Holding Cost of Inventory

Opportunity cost of money invested
Cost of handling materialpacking,
moving
Rent and utilities for warehouse
Insurance and taxes

Physical inventory and cycle counting

Inventory shrinkage and obsolescence

3.2.1 Differentiate Holding, Ordering & Setup

Costs
Ordering Cost of Inventory
Are those associated with placing an order either with
the factory or a supplier.
The annual cost of ordering depends upon the number of
orders placed in a year.
This can be reduced by ordering more at one time,
resulting in the placing of fewer orders.
However, this drives up the inventory level & the annual
cost of carrying inventory.

Setup Cost of Inventory

Costs for arranging specific equipment setups, etc.
Every time an order is issued, work centers have to set up to
run the order & tear down the setup at the end of the run.

3.3 Explain inventory models for independent

demand.
What is Independent & Dependent
demand?
Independent Demand

Dependent Demand

C(2)

B(4)

D(2)

E(1)

D(3)

F(2)

Independent demand is uncertain.

Dependent demand is certain.

3.3 Explain inventory models for independent

demand.

What is Independent & Dependent

demand?
Independent demand
finished goods, items that
are ready to be sold.
E.g. a computer
Dependent demand
components of finished
products.
E.g. parts that make up
the computer

How much to order ?

We want to balance the
against the

ordering cost
carrying cost

cost of keeping
goods in inventory

cost of placing
an order

How much to order ?

We can calculate the optimal order quantity
using the Economic Order Quantity, also
known as the.

EOQ

3.3.1 Determine economic order quantity model

Economic Order Quantity Models:

The order size that minimizes total annual

cost.

Assumptions of EOQ Model:

Only one product is involved

The sum
Annual demand requirements known of holding
and setup
Demand is even throughout the year
costs

Lead time does not vary

Each order is received in a single delivery
There are no quantity discounts

The Inventory Cycle

4. The cycle then repeats.

1. You receive an order quantity Q.

Number
of units
on hand

2. Your start using

them up over time.

R = Reorder point
Q = Economic order quantity
L = Lead time

Time

L
3. When you reach down to
a level of inventory of R,
you place your next Q
sized order.

EOQ Cost Model

Reorder Point, R = d . L

No. Of Order,

D - annual demand (d is daily demand)

Q - order quantity
Co
S - cost of placing order or setup cost
H - annual per-unit carrying cost or Holding cost
R - Reorder point
L - Lead time

Cc

EOQ Cost Model

Annual
cost ($)

Qopt =

2DS
H

(is

Total Cost

U-Shaped)

QH
Carrying Cost = 2

Minimum
total cost

DS
Ordering Cost = Q
Optimal order
Qopt

Order Quantity, Q

Minimum Total Cost

The total cost curve reaches its
minimum where the carrying
and ordering costs are equal.
Q
H
2

DS
Q

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

Deriving Qopt
TC =

Co D

CcQ
2

-CoD
Cc
TC
=
+
Q2
Q
2
0=
Qopt =

-C0D
Q2

Cc
2

2CoD
Cc

2(Annual Demand)(Order or Setup Cost)

Annual Holding Cost

EOQ Example (1):

A company that markets a product Z would like to reduce its
inventory cost by determining the optimal number of Z to
obtain per order. The annual demand is 1960 units, the
setup/ordering cost is RM5 per order, and the holding cost per
unit per year is RM1.
(a) Calculate the optimal number of units per order.
(b) If a 260-day working per year, find the number of orders,
N.
(c) Calculate the total inventory costs.

EOQ Example (2) Problem Data

Determine EOQ and ROP for:
Annual Demand = 1,000 units
Days per year considered in average daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
QQOPT ==
OPT

2DS
2DS =
HH =

2(1,000
2(1,000)(10)
)(10) = 89.443 units or 90 units
= 89.443 units or 90 units
2.50
2.50

1,000
units
//year
1,000
units
year = 2.74 units / day
dd ==
= 2.74 units / day
365
days
/
year
365 days / year
__

Reorder
Reorderpoint,
point, RR==dd LL==2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18or
or 20
20units
units

EOQ Exercise 1 Problem Data

Determine EOQ and ROP for
Annual Demand = 10,000 units
Days per year considered in average daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost per unit
Lead time = 10 days
Cost per unit = $15
2DS
2(10,000
)(10)
2DS
2(10,000
)(10) = 365.148 units, or 366 units
Q
=
=
QOPT
=
= 365.148 units, or 366 units
OPT =
H
1.50
H
1.50

10,000
units
//year
10,000
units
year = 27.397 units / day
dd==
= 27.397 units / day
365
days
/
year
365 days / year
__

R
R ==dd LL==27.397
27.397units
units//day
day(10
(10days)
days)==273.97
273.97or
or 274
274units
units

3.3.2 Determine production order quantity model (

Economic Production Quantity (EPQ)

Production done in batches or lots.
Capacity to produce a part exceeds
the parts usage or demand rate.
Assumptions of EPQ are similar to
EOQ except orders are received
incrementally during production.

Assumptions of EOQ Model:

Only one item is involved.
Annual demand is known.
Usage rate is constant.
Usage occurs continually.
Production rate is constant.
Lead time does not vary.
No quantity discounts.

Economic Production Quantity (EPQ)

Same assumptions as the EOQ except: inventory
arrives in increments & is drawn down as it arrives

EPQ Equations
Total cost:

Maximum inventory:
d=avg. daily demand rate
p=daily production rate

Calculating EPQ

TC EPQ

D I MAX
S
H
Q 2

I MAX

d
Q 1
p

EPQ

2DS
d
1
p

EPQ Problem:
HP Ltd. Produces its premium plant food in 50# bags. Demand is 100,000 lbs.
per week and they operate 50 wks. each year and HP can produce 250,000 lbs.
per week. The setup cost is $200 and the annual holding cost rate is $.55 per
bag. Calculate the EPQ. Determine the maximum inventory level. Calculate the
total cost of using the EPQ policy.
EPQ

2DS
d
1
p

EPQ

I MAX

TC EPQ

D I MAX

S
H
Q 2

TC

d
Q 1
p

2(50)(100,000)(200)
77,850 Bags
100,000

.55 1

250000

100 , 000
MAX 77 , 850 1

250 , 000

46 , 710 bags

5,000,000
46,710
200
.55 $25,690
2

77,850

3.3.3 Evaluate quantity discount mod

Quantity Discount Model

When material is purchased, suppliers often
give a discount on orders over a certain size.
This can be done because larger orders reduce
the suppliers costs; to get larger orders, they
are willing to offer volume discounts.
The buyer must decide whether to accept the
discount, and in doing so, must consider the
relevant costs :
- Purchase cost.
- Ordering cost.
- Carrying cost.

Quantity Discount Model

Same as the EOQ model, except:
Unit price depends upon the quantity
ordered.

The total cost equation becomes:

TC QD

D Q
S
H
Q 2

P : Price/Cost per unit

D : Annual Demand

PD

Quantity Discount Procedure

Calculate the EOQ at the lowest price.
Determine whether the EOQ is feasible
at that price.
Will the vendor sell that quantity at that
price?

If yes, stop if no, continue.

Check the feasibility of EOQ at the next
higher price.
Continue to the next slide ...

QD Procedure

(continued)

Continue until you identify a feasible

EOQ.
Calculate the total costs (including total
item cost) for the feasible EOQ model.
Calculate the total costs of buying at the
minimum quantity required for each of
the cheaper unit prices.
Compare the total cost of each
option & choose the lowest cost
alternative
Any other issues to consider?

Quantity Discount Example:

Collins Sport store is considering going to a different hat supplier. The present
supplier charges $10 each and requires minimum quantities of 490 hats. The
annual demand is 12,000 hats, the ordering cost is $20, and the inventory
carrying cost is 20% of the hat cost, a new supplier is offering hats at $9 in lots
of 4000. Who should he buy from?

EOQ at lowest price $9. Is it feasible?

EOQ$9

2(12,000)(20)
516 hats
$1.80

Since the EOQ of 516 is not feasible (less than 4000), calculate
the total cost (C) for each price to make the decision

12,000
490
$20 $2 $1012,000 $120,980
C$10
490
2
12,000
$20 4000 $1.80 $9 12,000 $101,660
C$9
4000
2
4000 hats at $9 each saves $19,320 annually.

new supplier

Summary of Some Key Points

Re: EOQ Model
How much to order:
Economic Order Quantity Q*
When to order: Reorder Point
Total Cost:
(Item plus Holding plus Ordering)