Chapter 12

Inventory Management

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Inventory
Inventory
A stock or store of goods

Independent demand items

Items that are ready to be sold or used

12-2

Types of Inventory

Raw materials and purchased parts

Work-in-process
Finished goods inventories or merchandise
Maintenance and repairs (MRO) inventory, tools and
supplies
Goods-in-transit to warehouses or customers (pipeline
inventory)

12-3

Inventory Functions
Inventories serve a number of functions such as:
1.
2.
3.
4.
5.
6.
7.
8.

To meet anticipated customer demand

To smooth production requirements
To decouple operations
To protect against stockouts
To take advantage of order cycles
To hedge against price increases
To permit operations
To take advantage of quantity discounts

12-4

Inventory Management
Management has two basic functions
concerning inventory:
1. Establish a system for tracking items in inventory
2. Make decisions about
When to order
How much to order

12-5

Effective Inventory Management

Requires:
1.
2.
3.
4.

A system keep track of inventory

A reliable forecast of demand
Knowledge of lead time and lead time variability
Reasonable estimates of
holding costs
ordering costs
shortage costs
5. A classification system for inventory items

12-6

Inventory Counting Systems

Periodic System
Physical count of items in inventory made at periodic
intervals

Perpetual Inventory System

System that keeps track of removals from inventory
continuously, thus monitoring current levels of each item
Two-bin system
Two containers of inventory; reorder
when the first is empty

12-7

Inventory Counting Technologies

Universal product code (UPC)
Bar code printed on a label that has information about
the item to which it is attached

Radio frequency identification (RFID) tags

A technology that uses radio waves to identify objects,
such as goods in supply chains

12-8

Demand Forecasts and Lead Time

Forecasts
Inventories are necessary to satisfy customer demands, so it is
important to have a reliable estimates of the amount and timing of
demand

Lead time
Time interval between ordering and receiving the order

Point-of-sale (POS) systems

A system that electronically records actual sales
Such demand information is very useful for enhancing forecasting
and inventory management

12-9

ABC Classification System

A-B-C approach
Classifying inventory according to some measure of importance, and
allocating control efforts accordingly
A items (very important)
10 to 20 percent of the number of items in inventory and about 60 to 70
percent of the annual dollar value
B items (moderately important)
High
C items (least important)
50 to 60 percent of the number
of items in inventory but only
Annual
about 10 to 15 percent of the
$ value
annual dollar value
of items

Low
Few

Number of Items

Many

12-10

Cycle Counting
Cycle counting
A physical count of items in inventory

Cycle counting management

How much accuracy is needed?
A items: 0.2 percent
B items: 1 percent
C items: 5 percent
When should cycle counting be performed?
Who should do it?

12-11

How Much to Order: EOQ Models

The basic economic order quantity model
The economic production quantity model
The quantity discount model

12-12

Basic EOQ Model

The basic EOQ model is used to find a fixed order
quantity that will minimize total annual inventory costs
Assumptions
Only one product is involved
Annual demand requirements are known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single delivery
There are no quantity discounts

12-13

The Inventory Cycle

Profile of Inventory Level Over Time

Usage
rate

Quantity
on hand

Reorder
point

Receive
order

Place
order

Receive
order

Place
order

Receive
order

Time

Lead time

12-14

Total Annual Cost

Total Cost Annual Holding Cost Annual Ordering Cost

Q
H
2

D
S
Q

where
Q Order quantity in units
H Holding (carrying) cost per unit
D Demand, usually in unit per year
S Ordering cost

12-15

Annual Cost

Goal: Total Cost Minimization

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

Ordering Costs

Q* (optimal order quantity)

Order Quantity
(Q)

12-16

Deriving EOQ
Using calculus, we take the derivative of the
total cost function and set the derivative (slope)
equal to zero and solve for Q.
The total cost curve reaches its minimum where
the carrying and ordering costs are equal.

2 DS
2(annual demand)(order cost)
Q

H
annual per unit holding cost
*

12-17

Economic Production Quantity (EPQ)

Assumptions
Only one product is involved
Annual demand requirements are known
Usage rate is constant
Usage occurs continually, but production occurs periodically
The production rate is constant
Lead time does not vary
There are no quantity discounts

12-18

EPQ: Inventory Profile

Q
Q*

Production
and usage

Usage
only

Production
and usage

Usage
only

Production
and usage

Cumulative
production

Imax

Amount
on hand

Time

12-19

EPQ Total Cost

TC Carrying Cost Setup Cost
D
I max
H

Q
2
where
I max Maximum inventory

Q
p u
p
p Production or delivery rate
u Usage rate

12-20

EPQ

2 DS
Q
H
*
p

p
p u

12-21

Quantity Discount Model

Quantity discount
Price reduction offered to customers for placing large
orders
Total Cost Carrying Cost Ordering Cost Purchasing Cost
Q
D
H S PD
2
Q
where
P Unit price

12-22

Quantity Discounts

12-23

Quantity Discounts

12-24

When to Reorder
Reorder point
When the quantity on hand of an item drops to this amount, the
item is reordered.
Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to management

12-25

Reorder Point: Under Certainty

ROP d LT
where
d Demand rate (units per period, per day, per week)
LT Lead time (in same time units as d )

12-26

Reorder Point: Under Uncertainty

Demand or lead time uncertainty creates the possibility
that demand will be greater than available supply
To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
Safety stock
Stock that is held in excess of expected demand due to
variable demand and/or lead time

Expected demand
ROP
Safety Stock
during lead time

12-27

Quantity

Safety Stock

Maximum probable demand

during lead time
Expected demand
during lead time

ROP
Safety stock
LT

Time
12-28

Safety Stock?
As the amount of safety stock carried increases, the risk
of stockout decreases.
This improves customer service level

Service level
The probability that demand will not exceed supply during lead
time
Service level = 100% - Stockout risk

12-29

How Much Safety Stock?

The amount of safety stock that is appropriate
for a given situation depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level

Expected demand
ROP
z dLT
during lead time
where
z Number of standard deviations
dLT The standard deviation of lead time demand
12-30

Reorder Point
The ROP based on a normal
Distribution of lead time demand

Risk of
stockout

Service level

Expected
demand

ROP

Quantity

Safety
stock

z-scale

12-31

Reorder Point: Demand Uncertainty

ROP d z d LT
where
z Number of standard deviations
d Average demand per period (per day, per week)

d The stddev. of demand per period (same time units as d )

LT Lead time (same time units as d )

Note : dLT d LT

12-32

Reorder Point: Lead Time Uncertainty

ROP d LT zd LT
where
z Number of standard deviations
d Demand per period (per day, per week)

LT The stddev. of lead time (same time units as d )

LT Average lead time (same time units as d )

12-33

How Much to Order: FOI

Fixed-order-interval (FOI) model
Orders are placed at fixed time intervals

Reasons for using the FOI model

Suppliers policy may encourage its use
Grouping orders from the same supplier can produce savings in
shipping costs
Some circumstances do not lend themselves to continuously
monitoring inventory position

12-34

Fixed-Quantity vs. Fixed-Interval Ordering

12-35

FOI Model
Amount Target Inventory Inventory Position
to Order
Level
at Time of Order
Q T IP
where
Q Amount to order
T Target inventory level
IP Inventory position at time of order

12-36

FOI Model
T d OI LT z d OI LT
where
OI Order interval (length of time between orders)

*
Q
OI *
Time - frame of interest
D

OI* represents the optimal time between orders.

Time-frame of interest is an appropriate period (e.g.,
days or weeks). This is usually based on the timeframe expressed by the average demand rate, d-bar.
12-37

Single-Period Model
Single-period model
Model for ordering perishables and other items with limited useful
lives
Shortage cost
Generally, the unrealized profit per unit
Cshortage = Cs = Revenue per unit Cost per unit
Excess cost
Different between purchase cost and salvage value of items
left over at the end of the period
Cexcess = Ce = Cost per unit Salvage value per unit

12-38

Single-Period Model
The goal of the single-period model is to identify the
order quantity that will minimize the long-run excess and
shortage costs
Two categories of problem:
Demand can be characterized by a continuous distribution
Demand can be characterized by a discrete distribution

12-39

Stocking Levels
Cs
Service level
C s Ce
where
Cs shortage cost per unit
Ce excess cost per unit
Cs

Ce

Service level
Quantity
So
Balance Point

So =Optimum
Stocking Quantity

12-40