INVENTORY MANAGEMENT

PROF ASHIS CHATTERJEE

 MOTIVATION FOR STUDYING
INVENTORY MANAGEMENT
• Economics involved in producing or
purchasing in batches
• Uncertainty in both demand and supply
• Seasonality in demand pattern
• Availability of different Transportation and
Distribution modes
 TYPES OF INVENTORY

• BATCH OR CYCLE STOCK

Manufacturing or purchasing an item at a rate higher than its
consumption rate, to reduce set-up/ordering costs. Involves
trade-off between Inventory and set-up/ordering costs.

• BUFFER OR SAFETY STOCK

Maintaining extra stock over the average requirement to guard
against uncertainty. Involves trade-off between Inventory
Investment and Customer Service level.
 TYPES OF INVENTORY
• ANTICIPATION STOCK
Maintaining extra stock to meet peak season demand.
Involves trade-off between Inventory carrying costs and
costs related to changing production levels.

• TRANSPORTATION STOCK
Goods-in–transit arises because of the necessity of
moving material from one place to another. Movement rate
depends on Inventory carrying and Transportation costs.
 SELECTIVE CONTROL OF
MATERIALS
ABC ANALYSIS
Classification of all consumption items, based on
the “Consumption Value”.
If Annual Demand = D units
Cost per unit =Rs.C
Then, Consumption value = Rs.(DxC). Based on
this, Inventory of a number of items can be
separated into A, B and C classes.
 ABC CLASSIFICATION

• A Items: Those relatively few items that

account for high consumption value (CV),
say,15% of the items accounting for 70%
of the consumption value.
• B items: say,25% of the items, accounting
for 20% of the consumption value.
• C items: Bulk of the items, say,60%, that
account for 10% of the consumption value.
 ABC CLASSIFICATION
EXAMPLE:
Annual Usage/ CV(Rs) Cum.Usage
1. 39400 39400 (39.4%) A
2. 30500 69900 (69.9%) A
3. 10900 80800 (80.8%) B
4. 9800 90600 (90.6%) B
5. 3800 94400 (94.4%) B
6. 2000 96400 (96.4%) C
7. 1800 98200 (98.2%) C
8. 800 99000 (99.0%) C
9. 600 99600 (99.6%) C
10. 400 100000 (100%) C
 INVENTORY CONTROL MODELS
DEMAND

STATIC/ UNIFORM DYNAMIC/ VARIABLE

DETERMINISTIC PROBABILISTIC DETERMINISTIC PROBABILISTIC

PROBLEM P1 PROBLEM P2 PROBLEM P4
PROBLEM P3
 PROBLEM P1: INVENTORY CONTROL
FOR STATIC DETERMINISTIC DEMAND
• Consider the following problem: Demand for a
particular item is uniform and 12,000 units per
year. There is a fixed order placement and
receiving cost of Rs. 120 each time an order is
placed. Each item costs Rs. 10 and the retailer
has a holding cost of 20%. Find the quantity that
the store manager should order in each
replenishment lot.

• Total annual cost = Annual ordering cost + Annual

inv. carrying cost
Annual ordering cost = DA/Q
Annual inv. carrying cost = ½ QIC
 PROBLEM P1: DETERMINING THE EOQ/
BATCH/CYCLE STOCK
Total annual cost = DA/Q + ½ QIC
On differentiating total cost with respect to Q, we
obtain the Economic Order Quantity (EOQ) as:
________
EOQ = √2DA / IC
D = Annual Demand (Units) = 12,000
A = Cost per Order = Rs. 120
I = Inv. carrying factor (Rs/Rs/ yr)= 0.2
C = Cost per unit = Rs 10
Thus, required Order Quantity = 1200 units
 PROBLEM P1: INVENTORY CONTROL
FOR STATIC DETERMINISTIC DEMAND
• P1 allows us to determine the Batch/
Cycle stock.
• It brings out the economics that may exist
in purchasing/producing items in batches.
• The typical tradeoff is between inventory
carrying cost and ordering/setup cost.
• At optimum, the annual inventory carrying
cost is equal to the annual ordering cost.
 PROBLEM P1: AN EXTENSION

• Consider the earlier problem with the only

change that now, the supplier has offered
a discount based on the batch size that is
ordered, say if the order size is between 0
and 799 units, the cost per unit will be
Rs.13 for all units, if the size is between
800 to 1499 units the cost will be Rs.12
and finally cost per unit will be Rs.10 if the
order size is ≥ 1500 units.
 PROBLEM P1: AN EXTENSION,
EOQ WITH DISCOUNTS
Here, purchasing cost is also a relevant cost.
Algorithm:
Step 1: Determine EOQ using the lowest cost per unit
(Rs.10). Check whether this EOQ is feasible i.e.whether
it is above 1500. If feasible : Stop, optimal has been
found. If not feasible go to next step.

Step 2: Calculate the total cost at the breakpoint, i.e., at

1500 units. For example, at Q= 1500 units, total cost =
12000 x 10 (purchase cost) + 8 x 120 (ordering cost) +
½ x 1500 x 0.2 x 10 (inventory carrying cost)
 PROBLEM P1: AN EXTENSION
Step 3: Determine EOQ using the next higher
cost/unit (Rs.12). Check whether this EOQ is
feasible i.e., whether it is between 800 and 1499. If
feasible, find the minimum of total cost at EOQ,
and total cost at Break Point i.e., TC(EOQ) and
TC(1500). Stop,Q corresponding to the min.cost is
optimal. If not feasible go to step 2. Continue till
end.
 PROBLEM P2: INVENTORY CONTROL
FOR STATIC PROBABILISTIC DEMAND

• Mean Rate of Demand not changing with

respect to time.
• With uncertainty coming in, besides the ordering
and inventory carrying costs, one more type of
cost becomes relevant, i.e. the cost of shortage.
• Surrogate for the cost of shortage : service level
(SL); 100% SL implies no stock out, 90% SL
implies probability of stock out = 10%.
 PROBLEM P2: INVENTORY CONTROL
FOR STATIC PROBABILISTIC DEMAND
For P2, Inventory Control implies answering the
following questions:
• How frequently to check the stock status.
• How much to order
• When to place an order.
The policies for answering the first question
can be broadly divided into two categories:
• Continuous Review Policy, also known as
Transaction Reporting System, as the stock
status needs to be checked only if a transaction
occurs.
• Periodic Review Policy: checking the stock status
every T period.
 PROBLEM P2: INVENTORY CONTROL
FOR STATIC PROBABILISTIC DEMAND
• A typical Continuous Review policy may read as
follows: “Go on checking the stock status
continuously, order Q units when the inventory
position drops down to s or below.” Q and s are
respectively the order qty and the reorder level,
the answers to the two major decision variables.
• A typical Periodic Review Policy on the other
hand may read as “ check the stock status every
T months and order so as to bring the inventory
position to S units.” The decision variables in this
case are the review period T and the order up-to
level S.
PROBLEM P2 : AN EXAMPLE
Say, the daily demand of an item is uncertain, and
it can be 1,2 or 3 kg. with all the values being
equally probable. The average demand is not
changing with time. The lead time for procurement
is 2 days. Assume, that (s,Q) policy is used for
Inventory Control, where Q has been found from
Inventory holding and Ordering cost trade-off. The
Manager is interested in finding, when to place the
order so that (a) there is no stock out, (b) Service
Level achieved is 80%.
DETERMINING REORDER LEVEL
(CONT.REVIEW POLICIES)
• Step 1 Find the Probability Distribution of
Demand during the Lead time (L.T),
Demand during LT Prob. Cum.Prob.
2 1/9 1/9
3 2/9 3/9
4 3/9 6/9
5 2/9 8/9
6 1/9 9/9
DETERMINING REORDER LEVEL
(CONT.REVIEW POLICIES)
Interpretation of Cumulative probability : Say,
for demand of 4 during lead time, the cum.prob. is
6/9, i.e, 67%. It implies that during the lead time
there is 67% chance that demand will be ≤ 4 kg.
Thus, if an order is placed with 4Kg. in hand, the
demand will be satisfied for 67% of the time (SL).

Step 2 Find reorder level based on the desired SL.

Thus, 80% SL implies a Reorder Level of 5Kg.
 PROBLEM P2: INVENTORY CONTROL
FOR STATIC PROBABALISTIC DEMAND
• P2 allows us to determine the Buffer/
Safety stock.
• It brings out the economics that may exist
in not allowing shortages.
• The typical tradeoff is between inventory
carrying cost and the shortage cost/
service level.
 PROBLEM P3: INVENTORY CONTROL
FOR DYNAMIC DETERMINISTIC DEMAND
AN EXAMPLE: The forecasted monthly requirement
of a consumption item for the next one year is given below.
(Jan to Dec) 25, 55, 65, 85, 75, 63, 51, 57, 115, 87, 52, 91.
The cost per order is Rs.500 and the inventory carrying
cost calculated based on the quantity left at the end of
every month is given as Rs.10 per unit per month. The
manager has to decide how much to order, and when.
PROBLEM P3: CONCEPT OF DOMINANT
SEQUENCE
PROBLEM STATEMENT: the requirement of an item
in the upcoming two months are 100 and 50 units. The
problem is to find the minimum cost purchase plan. The
relevant costs are, ordering cost, and inventory carrying
cost (ICC). Cost per order is Rs. A and ICC is Rs. H per
unit per month levied on the end inventory.
ANALYSIS: As there is no shortage allowed, the
alternative purchase plans can be written as:
9. Procure 100 in first month and 50 in the second
10. Procure 101 in first month and 49 in the second
11. Procure 102 in first month and 48 in the second

n. Procure 150 in first month and 0 in the second

PROBLEM P3: CONCEPT OF DOMINANT
SEQUENCE cont.,
The costs of the alternative purchasing plans can
be seen as 2A, 2A + H, 2A +2H……A + 50H. As H
is positive, it is sufficient to consider only the first
and the last alternative. Thus, if the requirement
for the two months are D1 and D2 respectively, it is
sufficient to consider the following two sequences/
plans for optimality: 1. D1 + D2 , 0
2. D1 , D2
These are called the dominant sequences.
PROBLEM P3: CONCEPT OF DOMINANT
SEQUENCE cont.,
The number of dominant sequences for a T period
problem = 2 T-1, thus for a 3 period problem with
requirements D1 ,D2 , D3 , The minimum cost plan
will be one among the following four plans:
• D1 + D2 + D3 , 0,0
• D1 + D2 , 0, D3
• D1 , D2 + D3 , 0
• D1 , D2 , D3
 CONCLUDING REMARKS
Approaches to Inventory Management
b) Decisions on Inventory taken without
consideration of Production issues.
c) Simultaneous decisions on Inventory and
Production
Approach (a) has been examined in this
session. Approach (b) will be taken up under
Operations Planning in the next session.