Inventory Management

Inventory
 Raw materials
 Inventory that will form part of the completed

product, but which has yet to enter the

production process
 Work in process
 Partially completed products which require
additional processing before they become
finished goods
 Finished goods
 Completed products not yet sold (manufacturer)
or merchandise on hand (retailer or wholesaler)
Functions of Inventory
 “Decouple” or separate various parts of the
production process
 To hedge against inflation and upward price
changes-Speculative
 Production smoothing
 Customer service safety stock
Benefits and Costs of Holding
High Levels of Inventory
 Benefits
 More likely to satisfy customer demand

 Lower ordering costs WHERE’S MY

 Costs STUFF?

 Capital tied up

 Storage costs

 Insurance costs
 Inventory Costs

Ordering or Purchase or
Holding Stock-out
Setup Production
Costs Cost
Cost Cost

Total Inventory Cost

 Inventory Costs
 Ordering costs / Setup costs - associated
with costs of placing order and receiving
goods
 Holding costs - associated with holding or
“carrying” inventory over time
 Stock-out costs - associated with shortage
of inventory
 ABC Analysis
 Divides on-hand inventory into 3 classes
 A class, B class, C class
 Basis is usually annual $ volume
$ volume = Annual demand x Unit cost
 Policies based on ABC analysis
 Develop class A suppliers more
 Give tighter physical control of A items
 Forecast A items more carefully
 Classifying Items as ABC

% Annual $ Usage Class % $ Vol. % Items

100 A 80 15
B 15 30
80
C 5 55
60
40
A
B
20 C
0
0 50 100
% of Inventory Items
 Inventory Models
Help answer the
inventory planning
How Much? questions!

When!
 EOQ Model
Annual Cost

Order (Setup) Cost Curve

Order Quantity
Optimal
Order Quantity (Q*)
Inventory Management
Under Certainty

 Economic order quantity model:

 the optimal quantity of inventory ordered that
minimizes the cost of purchasing and holding the
inventory
EOQ Assumptions
 Demand is deterministic
 We know how much will be demanded and when the
demand will occur

 Demand is constant over time

 Given a known level of demand, that demand will be
evenly spread throughout the time period

 Delivery is immediate
 There is no time lag between production and
availability - lead time is zero
EOQ Assumptions (continued)
 Production is instantaneous
 No capacity constraint
 all items are produced simultaneously or;
 the entire order is received at the same time

 Irrespective of the size of the order, the

order costs are assumed as fixed
Economic Order Quantity
 Notation:
 U = demand (in physical units) per period

 F = acquisition costs ($) per order placed

 C = carrying cost ($) per period per unit of

inventory, including opportunity cost

 Q = quantity (in physical units) per order

 P = price ($) per unit of inventory

Economic Order Quantity (cont.)
 Acquisition costs per year :
 F*U/Q

 Average inventory level :

 Q/2

 Carrying costs per year :

 annual carrying cost per unit of inventory
* average inventory
 C* Q/2
Economic Order Quantity (cont.)
 Annual total costs (TC) :
 TC = F*U/Q + C*Q/2

 Acquisition costs will increase as the order

quantity is reduced, but carrying costs will
increase as the order quantity increases
 Economic order quantity:
Q = 2 * F*U / C)
Example
The Acer Co. buys 10,000 units of a certain
raw material each year. The cost of placing
one order is $45 and it costs $4 per year to
carry one unit of inventory.
What is Acer’s EOQ?
Solution

EOQ = [(2*F*U)/C]1/2

= {[2*($45)*(10,000)] /4}1/2

= 475 units
EOQ Model
 Annual ordering cost
 = F(U/Q)= $45(10,000/475)
= $947 per year
 Annual holding cost
 = C(Q/2) = $4(475/2)
= $950 per year
 Total annual cost
= $947 + $950
= $1,897 per year
Limitation of EOQ
 Assumption of constant consumption/ usage of
inventories is of doubtful validity.

 There may be lead time in Replenishment of the

stock.

 Demand may vary.

 Price per unit may vary with the size of the order.
The EOQ Model with
Quantity Discounts
 Discounts for quantity purchases reduce the
price of inventory and spread acquisition
costs over a larger base.
To Incorporate Discounts
1 Determine optimal quantity in the absence of quantity
discounts.
2 Calculate price paid for that quantity with the discount.
3 For each of the quantity discounts, calculate the price
payable for the quantity closest to the optimal quantity
determined in 1.
4 Calculate the total cost for each combination of price and
quantity.
5 Select the combination that achieves the lowest total cost.
 Example
 Economic Enterprises require 90,000 units of
items annually. Cost per unit is Rs. 3. The cost
per purchase order is Rs. 300. And the inventory
carrying cost is Rs. 6 per unit per year. What
should the firm do if the suppliers offer discounts
as follows:

Order quantity Discount

4500-5999 2%
6000 and above 3%
 Solution
EOQ = 3000 units

Cost per purchase order = Rs. 300

Order Size (units) 3000 4500 6000

Average Inventory (units) 1500 2250 3000
Annual Requirements(units) 90000 90000 90000
Number of Orders 30 20 15
Price per unit 3 2.94 2.91
Cost of purchase 2,70,000 2,64,600 2,61,900
Carrying Cost @ 6/unit 9000 13500 18000
Total Ordering cost 9000 6000 4500

Total Cost 2,88,000 2,84,100 2,84,400

 EOQ Model - When To Order
Inventory Level
Optimal Average
Q Inventory
Order
Quantity (Q*/2)
(Q*)

Reorder
Point O
(ROP)

.75 1 2 3 Time
Lead Time
Order Point
 Decisions:
 quantity to be ordered

 reorder point

 level of inventory at which a new order will be

placed

 With certainty, inventory ordered when inventory

levels equal the demand during lead time

Lead time in days for procurement * Average daily usage

 Inventory Management with
Uncertainty
Inventory
Level

Reorder
Point

Safety Stock
Level

Lead Time Time

Order Point Under Uncertainty

 In reality, the level of demand and the rate at which

the raw materials inventory will be used in
production are not known with certainty

 With uncertainty, an adjustment is necessary

Normal consumption + Safety Stock

 Safety Stock

Stock-out costs Carrying costs

Loss of profit Costs associated with

Loss of customers maintaining inventory
Disrupt the production
schedule

Inversely proportional Directly proportional

to safety stock to safety stock
Determining Safety Stocks
The level of safety stock can be calculated by:
 Where usage rate is variable and the maximum usage rate
can be specified

(Maximum usage rate – Average usage rate) * Lead time

 When both lead time and usage rate vary

Maximum possible usage – Normal usage

= (Maximum daily usage * Maximum Lead Time) – (Average
daily usage * Average lead time)
 Example
 The following information is available relating to the stock-out of
a firm
Stock out (units) Number of months
800 2
600 3
400 5
200 10
0 30
50
The selling price of each unit is Rs 200. The carrying costs are Rs 19
per unit. The stock out costs are Rs 50 per unit.
i) If the firm wishes to never miss a sale, what should be its safety
stock? What is the total cost associated with this level of safety
stock?
ii) What is the optimal safety stock level?
Solution
Stock-out Costs Rs50

Safety stock Stock out Stock-out Prob of Expect Stock- Total Expected
units costs Stock-out out Cost Stock-out costs
800 0 0 0 0 0
600 200 10000 0.04 400 400
400 400 20000 0.04 800
200 10000 0.06 600 1400
200 600 30000 0.04 1200
400 20000 0.06 1200
200 10000 0.1 1000 3400
0 800 40000 0.04 1600
600 30000 0.06 1800
400 20000 0.1 2000
200 10000 0.2 2000 7400
 Carrying Costs Rs19

Safety stock Total Expected Carying cost Total Safety

Stock-out costs Stock Cost
0 7400 0 7400
200 3400 3800 7200
400 1400 7600 9000
600 400 11400 11800
800 0 15200 15200
Inventory Management and the
‘Just-In-Time’ system
 The ‘just-in-time’ system is a way of organizing
the manufacture of goods and is based on the
concept that raw materials, equipment and labor
are each supplied only in amounts required, and at
the times required, to perform the manufacturing
task.
Inventory Management and the
‘Just-In-Time’ system (cont.)

 This synchronization of delivery with demand

reduces inventory levels, lead times and delivery
quantities.
 The aim of the system is to achieve an
improvement in overall efficiency, as well as a
reduction in inventory costs.