BMM 3633

Industrial Engineering
 CHAPTER 8:
INVENTORY MANAGEMENT
 Define the concept and
Learning importance of inventory
management
Objectives: Distinguish between
Dependent and Independent
Inventory Model
 The Importance of Inventory
Managing Inventory
ABC Analysis
Record Accuracy
Cycle Counting
Control of Service Inventories
Contents: Inventory Models
Independent vs. Dependent
Demand
Holding, Ordering, and Setup Costs
Inventory Models for Independent
Demand
The Basic Economic Order Quantity
(EOQ) Model
Minimizing Costs
Reorder Points
What is Inventory?
Importance of Inventory
Types of Inventory
Types of Inventory
Reasons to Hold Inventory
Purpose of Inventory
Management
An Effective of Inventory
Management Should
An optimum inventory level involves
three types of costs:

Further reading on Heizer

page 463-471
Dangers of Over Investment
Dangers of Under Investment
 Functions of Investment
Management

Track inventory
How much to order (EOQ)
When to order (ROP)
Classification Inventory
 ABC Analysis
Divides inventory into three classes based
on annual dollar volume
Class A - high annual dollar volume
Class B - medium annual dollar volume
Class C - low annual dollar volume

Used to establish policies that focus on the

few critical parts and not the many trivial
ones
 ABC Analysis (cont..)

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A

#12760 1,550 17.00 26,350 11.3% B

#10867 30% 350 42.86 15,001 6.4% 23% B

#10500 1,000 12.50 12,500 5.4% B

 ABC Analysis (cont..)

Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#12572 600 $ 14.17 $ 8,502 3.7% C

#14075 2,000 .60 1,200 .5% C

#01036 50% 100 8.50 850 .4% 5% C

#01307 1,200 .42 504 .2% C

#10572 250 .60 150 .1% C

8,550 $232,057 100.0%

Percent of annual dollar usage
ABC Analysis (cont..)

A Items
80
70
60
50
40
30
20 B Items
10 C Items
0 | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percent of inventory items
 ABC Analysis (cont..)
Other criteria than annual dollar volume
may be used
Anticipated engineering changes
Delivery problems
Quality problems
High unit cost
 ABC Analysis (cont..)

Policies employed may include

More emphasis on supplier development
for A items
Tighter physical inventory control for A
items
More care in forecasting A items
 Record Accuracy
Accurate records are a critical ingredient
in production and inventory systems
Allows organization to focus on what is
needed
Necessary to make precise decisions
about ordering, scheduling, and shipping
Incoming and outgoing record keeping
must be accurate
Stockrooms should be secure
 Cycle Counting
Items are counted and records updated on
a periodic basis
Often used with ABC analysis
to determine cycle
Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records
 Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750
C items
Policy is to count A items every month (20 working days), B
items every quarter (60 days), and C items every six months
(120 days)
Item Number of Items
Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
77/day
 Control of Service Inventories
Can be a critical component
of profitability
Losses may come from
shrinkage or pilferage
Applicable techniques include
1. Good personnel selection, training, and discipline
2. Tight control on incoming shipments
3. Effective control on all goods leaving facility
 Independent Versus
Dependent Demand
Independent demand
the demand for item is independent of
the demand for any other item in
inventory
Dependent demand
the demand for item is dependent upon
the demand for some other item in the
inventory
 Holding, Ordering, and
Setup Costs
Holding costs - the costs of holding or
carrying inventory over time
Ordering costs - the costs of placing an
order and receiving goods
Setup costs - cost to prepare a machine or
process for manufacturing an order
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Holding Costs
Cost (and range)
as a Percent of
Category Inventory Value
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost 3% (3 - 5%)
Investment costs (borrowing costs, taxes, 11% (6 - 24%)
and insurance on inventory)
Pilferage, space, and obsolescence 3% (2 - 5%)
Overall carrying cost 26%
 Inventory Models for
Independent Demand
Need to determine when and how much
to order
1. Basic economic order quantity
2. Production order quantity
3. Quantity discount model
 Basic Economic Order
Quantity (EOQ) Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup and holding
6. Stockouts can be completely avoided
 Basic Economic Order Quantity
(EOQ) Model (cont..)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)
Annual demand Setup or order
=
Number of units in each order cost per order

= D (S)
Q Annual setup cost = D S
Q
 Basic Economic Order Quantity
(EOQ) Model (cont..)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)
Order quantity
= (Holding cost per unit per year)
2
Q
=
2
(H) Annual setup cost = D S
Q
Annual holding cost = Q H
2
 Basic Economic Order Quantity
(EOQ) Model (cont..)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Optimal order quantity is found when annual setup
cost equals annual holding cost
D Q
QS = 2H
Annual setup cost = D S
Solving for Q* Q
2DS = Q2H QH
Q2 = 2DS/H Annual holding cost =
2
Q* = 2DS/H
 Example 1
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

Q* = 2DS
H

Q* = 2(1,000)(10) = 40,000 = 200 units

0.50
 Basic Economic Order Quantity
(EOQ) Model (cont..)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
N = Expected number of orders
T = Expected time between orders
TC = Total annual cost
Expected number of orders = (Demand) / (Order quantity)
N= D
Q*
 Basic Economic Order Quantity
(EOQ) Model (cont..)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
N = Expected number of orders
T = Expected time between orders
TC = Total annual cost
Expected time between orders = (Number of working days per year)
(Expected number of orders)

T = Number of working days per year

N
 Basic Economic Order Quantity
(EOQ) Model (cont..)
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
N = Expected number of orders
T = Expected time between orders
TC = Total annual cost
Total annual cost = Setup (order) cost + Holding cost
D Q
TC = S + H
Q 2
 Example 1 (cont..)
Determine the number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand D
number of = N = =
orders Order quantity Q*
1,000
N = = 5 orders per year
200
 Example 1 (cont..)
Determine the expected time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year

Number of working
Expected time days per year
between orders = T =
N
250
T= = 50 days between orders
5
 Example 1 (cont..)
Determine the combined annual ordering and holding costs
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
1,000 200
TC = ($10) + ($.50)
200 2
TC = (5)($10) + (100)($.50) = $50 + $50 = $100
 Robust Model

The EOQ model is robust

It works even if all parameters and
assumptions are not met
The total cost curve is relatively flat in
the area of the EOQ
 Example 2

Management underestimated demand by 50%

D = 1,000 units 1,500 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2
1,500 200
TC = ($10) + ($.50) = $75 + $50 = $125
200 2

Total annual cost increases by only 25%

 Example 2 (cont..)

Actual EOQ for new demand is 244.9 units

D = 1,000 units 1,500 units Q* = 244.9 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

D Q
TC = S + H
Q 2 Only 2% less than
1,500 244.9 the total cost of
TC = ($10) + ($.50) $125 when the
244.9 2
order quantity
TC = $61.24 + $61.24 = $122.48 was 200
 Exercise
The Warren W. Fisher Computer Corporation
purchases 8,000 transistors each year as components
in minicomputers. The unit cost of each transistor is
$10, and the cost of carrying one transistor in
inventory for a year is $3. Ordering cost is $30 per
order. Determine
a) the optimal order quantity
b) the expected number of orders placed each year
c) the expected time between orders
Assume that Fisher operates on a 200-day working
year.
 Reorder Points
EOQ answers the how much question
The reorder point (ROP) tells when to
order
Demand Lead time for a new
ROP = per day order in days
=dxL
D (annual demand)
where; d =
Number of working days in a year
 Reorder Point Curve

Q*
Inventory level (units)

Resupply takes place as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
 Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days

D
d=
Number of working days in a year
= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
 Exercise 1
Annual demand for notebook binder at Meyers
Stationary Shop is 10,000 units. Brad Meyer operates
his business 300 days per year and finds that
deliveries from his supplier generally take 5 working
days. Calculate the reorder point for the notebook
binders.
 Exercise 2
Youre a buyer for SaveMart.
SaveMart needs 1000 coffee makers per year. The cost
of each coffee maker is $78. Ordering cost is $100 per
order. Carrying cost is 40% of per unit cost. Lead time
is 5 days. SaveMart is open 365 days/yr.
What is the optimal order quantity & ROP?
Any Questions???
Thank You
 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time
 Inventory Usage Over Time

Usage rate Average

Order inventory
Inventory level

quantity = Q on hand
(maximum
Q
inventory
level) 2

Minimum
inventory

0
Time
 Minimizing Costs
Objective is to minimize total costs
Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (or order)

cost
Optimal order Order quantity
quantity (Q*)