Inventory Management

JCA Ch. 17
STC Ch. 12

05/24/11 1
 Agenda
 Definition of Inventory System
 Inventory Costs
 Independent vs. Dependent Demand
 Single Period Inventory Model
 Basic Fixed-Order Quantity Models
 Basic Fixed-Time Period Model
 Price Break Model & ABC Classification
 Other Systems and Issues

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 Definition of Inventory System

 Inventory is the stock of any item or resource used in an

organization.

 Types of inventories can be raw materials, finished products,

component parts, supplies, and work-in-process.

 An inventory system is the set of policies and controls that

monitor levels of inventory and determines what levels should be
maintained, when stock should be replenished, and how large
orders should be.

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 Purposes of Inventory

1. To maintain independence of operations.

2. To meet variation in product demand.
3. To allow flexibility in production scheduling.
4. To provide a safeguard for variation in raw material delivery time.
5. To take advantage of economic purchase-order size.

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 Inventory Costs

 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.

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 Independent Vs. Dependent Demand
Independent Demand (Demand not related to other items or
the final end-product)
Dependent Demand
(Derived demand
items for component
parts,
subassemblies,
raw materials, etc.)

E(1

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 Classifying Inventory Models

I. Single-Period Inventory Model

II. Fixed-Order Quantity Models (Perpetual Inventory System)

 Event triggered

III. Fixed-Time Period Models (Periodic System)

 Time triggered

IV. Miscellaneous models (Price Break & ABC Classification)

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 I. Single-Period Inventory Model

Cs Cs = Shortage cost per unit

Service level =
Cs + Ce Ce = Excess cost per unit

Ce Cs

Service level is the probability

that demand will not exceed
the stocking level
Service Level

Quantity

So Stevenson p 587 - 588

Balance point

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 Single Period Model Example
 Demand varied between 300 – 500 liters.
 Ce = $0.20 per unit Stevenson page 588
 Cs = $0.60 per unit
 Service level (SL) = Cs/(Cs+Ce) = .6/(.6+.2)
 Service level = 0.75
Ce Cs
Stock-out risk = 1.00 –
0.75 = 0.25
Service Level = 75%

Quantity

So, the optimal stocking level (So) = 300 + 0.75 (500 – 300)

= 450 liters
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 II. Fixed-Order Quantity Models:
Model Assumptions

 Demand for the product is constant and uniform

throughout the period.

 Lead time (time from ordering to receipt) is constant.

 Price per unit of product is constant.

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 II. Fixed-Order Quantity Models:
Model Assumptions (Cont’d)

 Inventory holding cost is based on average

inventory.

 Ordering or setup costs are constant.

 All demands for the product will be satisfied. (No

back orders are allowed.)

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 Basic Fixed-Order Quantity Model and
Reorder Point Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity
you place your next Q
L = Lead time sized order.
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 Cost Minimization Goal
By adding the item, holding, and ordering costs together, we determine
the total cost curve, which in turn is used to find the Qopt inventory order
point that minimizes total costs.

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT

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Order Quantity (Q) 13
 II.1. Basic Fixed-Order Quantity
(EOQ) Model: Simple Formula

Annual Annual Annual

Total Annual Cost = Purchase + Ordering + Holding
Cost Cost Cost

TC = Total annual cost

D = Demand
D Q C = Cost per unit
TC = DC + S + H Q = Order quantity
Q 2
S = Cost of placing an order
or setup cost
R = Reorder point
L = Lead time
H = Annual holding and storage
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cost per unit of inventory 14
 Deriving the EOQ Formula

Using calculus, we take the first derivative of the total cost function with
respect to Q, and set the derivative (slope) equal to zero, solving for the
optimized (cost minimized) value of Qopt.

2D S 2(A nnual Dem and)(O rder or Setup C ost)

Q O PT = =
H Annual H olding C ost

We also need a
reorder point to tell us
when to place an
order.
_
Reorder point, R = d L
_
d = average daily demand (constant)
L = Lead time (constant)

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 EOQ Example (1) Problem Data

Given the information below, what are the EOQ and

reorder point?

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

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 EOQ Example (1) Solution

2DS 2(1,000 )(10)

Q OPT = = = 89.443 units or 90 units
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year
_
Reorder p oint, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In summary, when you only have 20 units left, place the next
order of 90 units.

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 EOQ Example (2) Problem Data

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

Determine the economic order quantity and the

reorder point.

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 EOQ Example (2) Solution

2D S 2(10,000 )(10)
Q O PT = = = 365.148 un its, or 366 u n its
H 1.50

10,000 units / year

d= = 27.397 units / day
365 days / year
_
R = d L = 27.397 units / day (10 days) = 273.97 or 274 units

When in the course of using the inventory you are left

with only 274 units, place the next order of 366 units.

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 II.2. Fixed-Order Quantity Model with
Usage During Production Time

Also known as: Economic Production Quantity (EPQ), or

Gradual Replacement Model

In the previous model, it is assumed that the quantity ordered would be

received in one lot
In many situations, production of an inventory item and usage of that
item take place simultaneously

Characteristics:
- Demand being withdrawn while production is underway
- No stock-outs
- Constant and known demand, lead time and unit cost

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 II.2. Fixed-Order Quantity Model with
Usage During Production Time (Cont’d)
For this case:
Replenishment/production rate (p) > withdrawal/usage rate (u)

TC = (D/Qo)(S) + (Imax/2)(H)

p
Qo = EOQ = (2DS / H) ( --------- )
p-u Stevenson page 569 - 571

p-u
Imax = Qo (--------) Reorder Point (R) = d LT
p

Imax = maximum inventory TC = total cost

u = usage rate Qo = EOQ = Q optimum
p = production rate
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 Problem Example

Product X is a standard item in a firm’s inventory. Final assembly of the

product is performed on an assembly line that is in operation every
day.

One component of product (i.e. component X1) is produced in another

department. This dept, when it produces X1, does so at the rate of
100 units per day. Assume there are 250 working days for a year

u = 40 units/day  D = 40 x 250 = 10 000 units / yr

p = 100 units H = $0.50 per unit
S = $50 C of X1 =$7 each
LT = 7 days

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 Problem Example (Cont’d)

EOQ = ????? R = ??????

EOQ = √ {2(10000)(50) / (0.50)} {100 / (100-40)}

= 1826 units

R = u x LT = 40 (7) = 280 units

Therefore:
An order for 1826 units of component X1 should be placed
when the stock drops to 280 units

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 II.3. Fixed-order Quantity Model with
Demand Variation (Safety Stock)

The danger of this model occurs during the lead time, due to
demand variation

The amount of safety stock depends on the service level

desired

The optimal quantity to be ordered:

EOQ = √ (2DS/H)

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 Quantity
Maximum probable demand
during lead time

Expected demand
during lead time

ROP

Safety stock reduces risk of Safety stock

stockout during lead time LT Time

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 II.3: Fixed-order Quantity Model with
Safety Stock (Cont’d)

The Reorder Point: R = d L + z σ d √LT

Where : Safety stock = z σ d √LT

_ ∑ di
The average daily demand: d = -----------
n
_
∑ ( di – d )2
The std dev of the daily demand: σ d= -------------------
n-1
(Use n - 1 for a sample standard deviation)

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 Problem Example 1

Given information:
D = 1000 units / yr and Q = 200 units
Desired service level = P = 95%
Std dev during lead time = σ L = 25 units
L = 15 days and assumed 250 workdays / year

Question: R = ???????

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 Problem Example 1 (Cont’d)

Solution:
_
d = (1000 / 250) = 4 units / day

P = 95% = 0.95  z = 1.645 (Appendix B – Stevenson p 843)

R = 4(15) + 1.645(25) = 102 units

Therefore: When the stock on hand drops to 102 units, place a

new order of 200 units more

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 Problem Example 2

Daily demand mean = d = 60 units (normally

distributed)
Std dev = σ d = 7 units/day
Lead time = LT = 6 days
Ordering cost = S = $ 10 per order
Holding cost = H= $0.50 per unit/year
Assumed: 365 workdays / year
Desired service level = P = 95%

Questions: EOQ = ???

R = ?????

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 Problem Example 2 (Cont’d)
Solution:
EOQ = √{2(60)(365)(10) / 0.50} = 936 units
P = 95% = 0.95  Z = 1.645 (Appendix B)
Standard deviation during LT = σ d √LT = √6 x (7) = 17.2

R = (60)(6) + 1.645 (17.2)

= 388.29 = 389 units

Therefore: When the inventory drops to 389 units,

order 936 units more

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II.4: Fixed-order Quantity Model with Demand

Variation and Lead Time Variation

The optimal quantity to be ordered:
EOQ = √ (2DS/H)

Reorder Point (R):

Stevenson page 580
R = d LT + Z√ LT σ d
2
+ d 2σ 2
LT

Safety Stock = Z√ LT σ d
2
+ d2 σ 2
LT

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 III. Fixed-Time Period Model with

Safety Stock Formula

q = Average demand + Safety stock – Inventory currently on hand

Amount to order:
Q = d (OI + LT) + Z σ d √ OI + LT - A

Where: OI = order interval

A = amount on hand at reorder time
LT = lead time
σ d = standard deviation of demand

Stevenson page 586

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 Problem Example

Given the information below, how many units should be ordered?

Average daily demand for a product is 20 units.

The review period is 30 days, and lead time is 10 days.
Management has set a policy of satisfying 96 percent
of demand from items in stock. At the beginning of the
review period there are 200 units in inventory. The daily
demand standard deviation is 4 units.

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 Problem Example (Cont’d)

Solution:
Service level = P = 96% (stock-out risk = 4%)
From the Appendix B  Z = 1.75

Q = d (OI + LT) + Z σ d √ OI + LT - A
= 20 (30 + 10) + (1.75)(4) √ (30 + 10) − 200
= 645 units

So, to satisfy 96 percent of the demand, you should

place an order of 645 units at this review period.

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 IV.1. Price-Break Model Formula

Based on the same assumptions as the EOQ model,

the price-break model has a similar Qopt formula:

2DS 2(Annual Demand)(Or der or Setup Cost)

Q OPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since “C” changes for each price-break, the formula above will have
to be used with each price-break cost value.

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 Price-Break Example Problem Data
(Part 1)
A company has a chance to reduce their inventory
ordering costs by placing larger quantity orders using the
price-break order quantity schedule below. What should
their optimal order quantity be if this company purchases
this single inventory item with an e-mail ordering cost of
$4, a carrying cost rate of 2% of the inventory cost of the
item, and an annual demand of 10,000 units?
Order Quantity (units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98

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 Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of “C”.
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not.

Interval from 0 to 2499, the 2DS 2(10,000)( 4)

Qopt value is feasible. Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)( 4)
Qopt value is not feasible. Q OPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)( 4)
Qopt value is not feasible. Q OPT = = = 2,020 units
iC 0.02(0.98)
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 Price-Break Example Solution (Part 3)

Since the feasible solution occurred in the first price-break,

it means that all the other true Qopt values occur at the
beginnings of each price-break interval. Why?

Because the total annual cost function is a

Total “u” shaped function.
annual
costs So the candidates
for the price-breaks
are 1826, 2500,
and 4000 units.

0 1826 2500 4000 Order Quantity

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 Price-Break Example Solution (Part 4)

Next, we plug the true Qopt values into the total cost annual cost function
to determine the total cost under each price-break.
D Q
TC = DC + S + iC
Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000 & more)= $9,949.20
Finally, we select the least costly Qopt , which is this problem occurs in the
4000 & more interval. In summary, our optimal order quantity is 4000
units.
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 IV.2. ABC Classification System

Items kept in inventory are not of equal importance in terms of:

 dollars invested
60
 profit potential % of
$ Value 30 A
 sales or usage volume 0 B
% of 30 C
 stock-out penalties
Use 60

So, identify inventory items based on percentage of total dollar value,

where “A” items are roughly top 15 %, “B” items as next 35 %, and the
lower 65% are the “C” items.

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 Inventory Accuracy and Cycle Counting
Defined

 Inventory accuracy refers to how well the inventory

records agree with physical count.

 Cycle Counting is a physical inventory-taking

technique in which inventory is counted on a
frequent basis rather than once or twice a year.

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