Inventory Management

A. Introduction
B. Requirements for Effective Inventory
Management
C. Fixed Order Quantity/Reorder Point Model
(FOQRP)
D. FOQRP: Determining the Reorder Point
E. Fixed Order Interval Model
F. The Single Period Model
A. Introduction

Inventory: An idle material or product

A. Introduction
• Basic questions:
– How much to order
– When to order
• Functions of Inventory:
– To meet anticipated demand
– To wait while being transported
– To protect against stock-outs
– To take advantage of economic lot size and quantity discount
– To smooth seasonal production requirements
– To decouple operations
– To hedge against price increases
A. Objectives of Inventory Control

Inventory turnover: Ratio of average cost of goods sold to

average inventory investment
A. Objectives of Inventory Control
• Inadequate control of inventories can result in both under and
overstocking of items
• Under stocking results in:
– Missed deliveries, lost sales, dissatisfied customer,
production stoppage
• Overstocking results in:
– Excessive cost of the inventory
• Objectives of Inventory Control
– Have the right goods, in sufficient quantitative, in the
right place, at the right time
– Have a Low cost of ordering and carrying inventories
B. Requirements for Effective Inventory
Management
1. A system to safely store and use inventory
2. A system to keep track of the inventory, and a
replenishment model
3. Reliable forecasts of demand and knowledge of lead
times
4. Reasonable estimate of inventory holding, ordering, and
shortage costs
5. ABC classification
B2. Inventory Counting and Replenishment
Models
• Periodic System
– Physical count of items
made at periodic intervals
• Perpetual Inventory System
– System that keeps track of
removals from and
additions to inventory
continuously, thus
monitoring current levels
of each item.
B2. Inventory Counting and Replenishment
Models
• Fixed Order Quantity/Reorder Point Model
– An order of a fixed size, usually equal to
the economic order quantity, is placed
when the amount on hand drops below a
minimum quantity called the reorder
point 0
• Two-Bin System
– Two containers of inventory; reorder
when the first is empty 214800 232087768
• Universal Bar Code
– A number assigned to an item or location,
made of a group of vertical bars of
different thickness that are readable by a
scanner
B3. Demand Forecast

• Lead time
– time interval between ordering and receiving
the order
• Point of Sale system
– Software for electronically recording sales
and updating inventory levels at the time and
location of sale
B4. Cost Information
• Holding (carrying) costs
– cost to carry an item in inventory
• Ordering costs
– costs determining order quantity,
preparing purchase orders, and fixed cost
portion of receiving, inspection, and
material handling
• Shortage costs
– costs when demand exceeds supply; often
unrealized profit per unit
B5. ABC Classification

Classifying inventory according to some measure of

importance and allocating control efforts accordingly.

A - very important High

A
Annual
B - mod. Important $ volume
of items
B
C
C - least important Low
Few Many
Number of Items
C. Fixed Order Quantity/Reorder Point Model:
Economic Order Quantity

1. The basic economic order quantity (EOQ)

2. The economic production quantity (EPQ)
3. The EOQ with quantity discount
4. The EOQ with planned shortage
C1. Basic EOQ assumptions

• Only one product is involved

• Annual demand requirements known
• Demand is spread evenly throughout the year so
the demand rate is reasonably constant
• Lead time does not vary
• Each order is received in a single delivery
• There are no quantity discounts
C1. The Inventory Cycle

Profile of Inventory Level Over Time

Q Demand

rate
Quantity
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order

Lead time
 C1. Total Cost

 Annual   Annual 
   
Total Cost =  Carrying  +  Ordering 
 Cost   Cost 
   
Q D
TC = H + S
2 Q
C1. Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q D
TC = H + S
Annual Cost

2 Q

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)
C1. Deriving the optimal order quantity

• 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.
C1. Deriving the optimal order quantity

2 DS
Q0 =
H
Q0
Length of order cycle =
D
C2. Economic Production Quantity (EPQ)

• Production done in batches or lots

• Capacity to produce a part exceeds the
part’s usage or demand rate
• Assumptions of EPQ are similar to EOQ
except orders are received incrementally
during production
C2. Economic Production Quantity (EPQ)
  Annual   Annual 
     I max  D
C2. Deriving the TC =  Holding  +  Setup  =   H +   S
optimal run size  Cost   Cost   2  Q
   
Q Q Q
Cycle Time = ; Run Time = ; I max = ( p − d )
d p p
2 DS  p 
Q0 =  
H  p−d 
I max = Maximum Inventory
Q = Run size
S = Setup Cost per Production Run
p = Production rate
d = Demand rate
C3. EOQ with Quantity Discounts

Quantity Discounts: Price reductions for large orders

 Annual   Annual   Annual 

     
TC =  Holding  +  Ordering  +  Purchasing 
 Cost   Cost   Cost 
     
Q D
TC =   H +   S + RD
2 Q
R = Unit Price
C3. Total Costs with RD

Cost Adding Purchasing cost TC with RD

doesn’t change EOQ

TC without RD

RD

0 EOQ Quantity
C3. Total Cost Curve with Quantity Discounts

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
C3. Best Purchase Quantity Procedure

1. Beginning with the lowest unit price, compute

the minimum points for each price range until
you find a feasible minimum point.
2. If the minimum point for the lowest unit price is
feasible, it is the optimal order quantity. If not,
compare the total cost at the minimum price
break quantity for all lower prices with the total
cost of the largest feasible minimum point. The
quantity that yields the lowest total cost is
optimum.
D. Fixed Order Quantity/Reorder Point Model:
Determining the Reorder Point
• Reorder Point (ROP)
– When the quantity on hand of an item drops to this
amount, the item should be 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 not exceed supply
during lead time.
D. Safety Stock

Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock
LT Time
D. Reorder Point

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
D. Amount of Shortage and Service Level

E ( n ) = E ( z )σ dLT
E ( n ) = Expected number of units short per order cycle
E ( z ) = Standardized number of units short obtained fromTable 11 − 3
σ dLT = Standard deviation of lead time demand
D. Amount of Shortage and Service Level

D
E( N ) = E( n)
Q
E ( N ) = Expected number of units short per year

E( N )
SLannual = 1−
D
E ( z )σ dLT
SLannual = 1−
Q
E. Fixed-Order-Interval Model

• Orders are placed at fixed time intervals

• Order quantity for next interval
• Suppliers might encourage fixed intervals
• May require only periodic checks of
inventory levels
E. Fixed-Order-Interval Model

Determining the amount to Order

Q = I max − Amount on hand

 Expected demand 
   Safety 
I max =  during protection  +   =
 interval   Stock 
 
= d ( OI + LT ) + zσ d OI + LT
E. Benefits and Disadvantages
• Benefits
– Items from same supplier may yield
savings in: Ordering, Packing, Shipping
costs
– May be practical when inventories cannot
be closely monitored
• Disadvantages
– Requires a larger safety stock
– Increases carrying cost
– Costs of periodic reviews
F. Single Period Model
• Single period model
– model for ordering of perishables and other
items with limited useful lives
• Shortage cost Cs
– generally the unrealized profits per unit
• Excess cost Ce
– difference between purchase cost and salvage
value of items left over at the end of a period
F. Shortage and Excess Costs

C shortage = Revenue per unit - Cost per unit

C excess = Original per unit - Salvage value per unit

CS
Service Level = SL =
CS + C e
F. Single Period Model
• Continuous stocking levels
– Identifies optimal stocking levels
– Optimal stocking level balances unit
shortage and excess cost
• Discrete stocking levels
– Service levels are discrete rather than
continuous
– Desired service level is equaled or
exceeded
F. Operations Strategy

• Too much inventory

– Tends to hide problems
– Easier to live with problems than to
eliminate them
– Costly to maintain
• Wise strategy
– Reduce lot sizes
– Reduce safety stock