1

Chapter 11
Inventory
Management
2
Types of Inventories

Raw materials & purchased parts

Incoming students

Work in progress

Current students

Finished-goods inventories
(manufacturing firms) or merchandise (retail
stores)
Graduating students
Replacement parts, tools, & supplies
Goods-in-transit to warehouses or customers
Students on leave
3
Functions of Inventory

To meet anticipated demand

To smooth production requirements

To decouple components of the production-

distribution

To protect against stock-outs

To take advantage of order cycles

To help hedge against price increases or to take

advantage of quantity discounts

To permit operations
4

Inventory level
Low or high

Customer service levels

Can you deliver what customer wants?
Right goods, right place, right time, right quantity

Inventory turnover

Cost of goods sold per year / average inventory investment

Inventory costs, more will come

Costs of ordering & carrying inventories
Decisions: Order size and time
Inventory performance measures
and levers
5
Inventory Counting Systems
A physical count of items in inventory

Periodic/Cycle Counting System:

Physical count of items made at periodic
intervals
How much accuracy is needed?
When should cycle counting be performed?
Who should do it?

Continuous Counting System

System that keeps track of
removals from inventory
continuously, thus monitoring
current levels of each item
6
Inventory Counting Systems (Contd)

Two-Bin System - Two containers of inventory;

reorder when the first is empty

Universal Bar Code - Bar code

printed on a label that has
information about the item
to which it is attached
0
214800 232087768

RFID: Radio frequency identification

7

Lead time: time interval between ordering and

receiving the order, denoted by LT

Holding (carrying) costs: cost to carry an item in

inventory for a length of time, usually a year, denoted
by H

Ordering costs: costs of ordering and receiving

inventory, denoted by S

Shortage costs: costs when demand exceeds supply

Key Inventory Terms
8

A system to keep track of inventory

A reliable forecast of demand

Knowledge of lead times

Reasonable estimates of

Holding costs

Ordering costs

Shortage costs

A classification system
Effective Inventory Management
9
ABC Classification System
Classifying inventory according to some
measure of importance and allocating control
efforts accordingly.
Importance measure= price*annual sales
A
A - very important
B
B - mod. important
C
C - least important
Annual
$ volume
of items
A
A
B
B
C
C
High
Low
Few
Many
Number of Items
10
Inventory Models

Fixed Order Size - Variable Order Interval Models:

1. Economic Order Quantity, EOQ
2. Economic Production Quantity, EPQ
3. EOQ with quantity discounts
All units quantity discount
3.1. Constant holding cost
3.2. Proportional holding cost

4. Reorder point, ROP

Lead time service level

Fill rate

Fixed Order Interval - Variable Order Size Model

5. Fixed Order Interval model, FOI

Single Order Model

6. Newsboy model
11

Assumptions:

Only one product is involved

Annual demand requirements known

Demand is even throughout the year

Lead time does not vary

Each order is received in a single delivery

Infinite production capacity

There are no quantity discounts

1. EOQ Model
12
The Inventory Cycle
Profile of Inventory Level Over Time
Quantity
on hand
Q
Receive
order
Place
order
Receive
order
Place
order
Receive
order
Lead time
Reorder
point
Usage
rate
Time
13
Average inventory held

Length of an inventory cycle

From one order to the next = Q/D

Inventory held over entire inventory cycle

Area under the inventory level = Q (Q/D)

Average inventory held

= Inventory held over a cycle / cycle length
= Q/2
14
Total Cost
Annual
carrying
cost
Annual
ordering
cost
Total cost = +
Q
2
H
D
Q
S
TC =
+
15
Figure 11-4
16
Cost Minimization Goal
Order Quantity
(Q)
The Total-Cost Curve is U-Shaped
Ordering Costs
Q
O
A
n
n
u
a
l

C
o
s
t
(optimal order quantity)
TC
Q
H
D
Q
S +
2
17
Deriving the EOQ
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.
Q =
2DS
H
=
2(Annual Demand )(Order or Setup Cost )
Annual Holding Cost
OPT
DSH EOQ Q 2 ) cost( Total
18
EOQ example
Demand, D = 12,000 computers per year.
Holding cost, H = 100 per item per year. Fixed cost, S =
$4,000/order.
Find EOQ, Cycle Inventory, Optimal Reorder Interval and
Optimal Ordering Frequency.
EOQ = 979.79, say 980 computers
Cycle inventory = EOQ/2 = 490 units
Optimal Reorder interval, T = 0.0816 year = 0.98 month
Optimal ordering frequency, n=12.24 orders per year.
19
Optimal Quantity is robust
20
Total Costs with Purchasing Cost
Annual
carrying
cost
Purchasing
cost
TC = +
Q
2
H
D
Q
S
TC =
+
+
Annual
ordering
cost
PD +
Note that P is the price.
Note that P is the price.
21
Total Costs with PD
C
o
s
t
EOQ
TC with PD
TC without PD
PD
0
Quantity
Adding Purchasing cost
doesnt change EOQ
22

Production done in batches or lots

Capacity to produce a part exceeds the parts

usage or demand rate

Assumptions of EPQ are similar to EOQ

except orders are received incrementally
during production

This corresponds to producing for an order with

finite production capacity
2. Economic Production Quantity
23

Only one item is involved

Annual demand is known

Usage rate is constant

Usage occurs continually

Production rate p is constant

Lead time does not vary

No quantity discounts
Economic Production Quantity Assumptions
24
Economic Production Quantity
I
n
v
e
n
t
o
r
y

L
e
v
e
l
Usage
Usage
P
r
o
d
u
c
t
i
o
n
&

U
s
a
g
e
P
r
o
d
u
c
t
i
o
n
&

U
s
a
g
e
25
Average inventory held
Q/p
D
p-D
Q/D
Time
Time
(Q/p)(p-D)
(Q/p)(p-D)
Average inventory held=(1/2)(Q/p)(p-D)
Average inventory held=(1/2)(Q/p)(p-D)
Total cost=(1/2)(Q/p)(p-D)H+(D/Q)S
Total cost=(1/2)(Q/p)(p-D)H+(D/Q)S
D p
p
H
DS
Q

2
26
EPQ example
Demand, D = 12,000 computers per year.
p=20,000 per year. Holding cost, H = 100 per
item per year. Fixed cost, S = $4,000/order.
Find EPQ.
EPQ = EOQ*sqrt(p/(p-D))
=979.79*sqrt(20/8)=1549 computers
27
3. All unit quantity discount
Cost/Unit
$3
$2.96
$2.92
Order Quantity
5,000 10,000
Two versions
Two versions
Constant H
Constant H
Proportional H
Proportional H
28
3.1.Total Cost with Constant Carrying Costs
EOQ
Quantity
T
o
t
a
l

C
o
s
t
TC
a
TC
c
TC
b
Decreasing
Price
Annual demand*discount
Annual demand*discount
29
3.1.Total Cost with Constant Carrying Costs
EOQ
Quantity
T
o
t
a
l

C
o
s
t
TC
a
TC
c
TC
b
Decreasing
Price
Annual demand*discount
Annual demand*discount
30
Example Scenario 1
Q*=EOQ
Quantity
T
o
t
a
l

C
o
s
t
a
a
b
b
c
c
Price a > Price b > Price c Price a > Price b > Price c
TC
a
TC
c
TC
b
31
Example Scenario 2
EOQ
Quantity
T
o
t
a
l

C
o
s
t
a
a
b
b
c
c
Price a > Price b > Price c Price a > Price b > Price c
TC
a
TC
c
TC
b
Q*
32
Example Scenario 3
EOQ
Quantity
T
o
t
a
l

C
o
s
t
TC
a
TC
c
TC
b
a
a
b
b
c
c
Price a > Price b > Price c Price a > Price b > Price c
Q*
33
Example Scenario 4
Q*=EOQ
Quantity
T
o
t
a
l

C
o
s
t
TC
a
TC
c
TC
b
a
a
b
b
c
c
Price a > Price b > Price c Price a > Price b > Price c
34
3.1. Finding Q with all units discount with
constant holding cost
Note all the price ranges have the same EOQ
Note all the price ranges have the same EOQ
.
.
Stop if EOQ=Q1 is in the lowest cost range (highest
Stop if EOQ=Q1 is in the lowest cost range (highest
quantity range), otherwise continue towards quantity
quantity range), otherwise continue towards quantity
break points which give lower costs
break points which give lower costs
Quantity
T
o
t
a
l

C
o
s
t
1
1
2
2
H
DS
Q
2
1

35
All-units quantity discounts
Constant holding cost
A popular shoe store sells 8000 pairs per year. The
fixed cost of ordering shoes from the distribution
center is $15 and holding costs are taken as
$12.5 per shoe per year. The per unit purchase
costs from the distribution center is given as
C
3
=60, if 0 < Q < 50
C
2
=55, if 50 <= Q < 150
C
1
=50, if 150 <= Q
where Q is the order size. Determine the optimal
order quantity.
36
Solution
There are three ranges for lot sizes in this problem:
(0, q
2
=50),
(q
2
=50, q
1
=150)
(q
1
=150,infinite).
Holding costs in all there ranges of shoe prices
are given as H=12.5,
EOQ is not feasible in the lowest price range because
138.6 < 150.
The order quantity q
1
=150 is a candidate with cost
TC(150)=8000(50)+8000(15)/150+(12.5)(150)/2
=401,900
Let us go to a higher cost level of (q
2
=50, q
1
=150).
EOQ=138.6 is in the appropriate range, so it is another
candidate with cost
TC(138.6)=8000(55)+8000(15)/138.6+(12.5)(138.6)/2
=441,732
Since TC(150) < TC(132.1), Q=150 is the optimal solution.
Remark: In these computations, we do not need to compute
TC(50), why? Because TC(50) >= TC(132.1).
6 . 138
5 . 12
) 8000 )( 15 ( 2
EOQ
37
3.2. Summary of finding Q with all units discount
with proportional holding cost
Quantity
T
o
t
a
l

C
o
s
t
1
1
1
1
2
H
DS
Q
Note each price range has a different EOQ. Note each price range has a different EOQ.
Stop if Q1=EOQ of the lowest price feasible Stop if Q1=EOQ of the lowest price feasible
Otherwise continue towards higher costs until an EOQ Otherwise continue towards higher costs until an EOQ
becomes feasible. becomes feasible.
In each price range, evaluate the lowest cost In each price range, evaluate the lowest cost
.
.
Lowest cost is either at an EOQ or price break quantity Lowest cost is either at an EOQ or price break quantity
Pick the minimum cost among all evaluated Pick the minimum cost among all evaluated
Example
Example
: Q
: Q
1 1

feasible stop
feasible stop
38
3.2. Finding Q with all units discount with
proportional holding cost
Quantity
T
o
t
a
l

C
o
s
t
1
1
1
1
2
H
DS
Q
2
2
2
H
DS
Q
2
2 Example Example: Q : Q
1 1
infeasible, Q infeasible, Q
2 2

feasible, Break point 1 is feasible, Break point 1 is
selected since TC selected since TC
1 1
< TC < TC
2 2
39
3.2. Finding Q with all units discount with
proportional holding cost
Quantity
T
o
t
a
l

C
o
s
t
1
1
Stop if 1 is feasible, otherwise
Stop if 1 is feasible, otherwise
continue towards higher costs until a
continue towards higher costs until a
EOQ becomes feasible.
EOQ becomes feasible.
Evaluate
Evaluate
cost at all alternatives
cost at all alternatives
2
2
40
All-units quantity discounts
Proportional holding cost
A popular shoe store sells 8000 pairs per year. The
fixed cost of ordering shoes from the distribution
center is $15 and holding costs are taken as 25%
of the shoe costs. The per unit purchase costs
from the distribution center is given as
C
3
=60, if 0 < Q < 50
C
2
=55, if 50 <= Q < 150
C
1
=50, if 150 <= Q
where Q is the order size. Determine the optimal
order quantity.
41
Solution
There are three ranges for lot sizes in this problem:
(0, q
2
=50),
(q
2
=50, q
1
=150)
(q
1
=150,infinite).
Holding costs in there ranges of shoe prices
are given as
H
3
=(0.25)60=15,
H
2
=(0.25)55=13.75
H
1
=(0.25)50=12.5.
EOQ
1
is not feasible because 138.6 < 150.
The order quantity q
1
=150 is a candidate with cost
TC(150)=8000(50)+8000(15)/150+(0.25)(50)(150)/2
=401,900
Let us go to a higher cost level of (q
2
=50, q
1
=150).
EOQ
2
=132.1 is in the appropriate range, so it is another candidate with
cost
TC(132.1)=8000(55)+8000(15)/132.1+(0.25)(55)(132.1)/2
=441,800
Since TC(150) < TC(132.1), Q=150 is the optimal solution.
We do not need to compute TC(50) or EOQ
3
, why?
6 . 138
5 . 12
) 8000 )( 15 ( 2
1 . 132
75 . 13
) 8000 )( 15 ( 2
1
2


EOQ
EOQ
42
Types of inventories (stocks) by function
Deterministic demand case

Anticipation stock

For known future demand

Cycle stock

For convenience, some operations are performed occasionally and

stock is used at other times

Why to buy eggs in boxes of 12?

Pipeline stock or Work in Process

Stock in transfer, transformation. Necessary for operations.
Students in the class
Stochastic demand case

Safety stock
Stock against demand variations
43
4. When to Reorder with EOQ Ordering

Reorder Point - When the quantity on hand of

an item drops to this amount, the item is
reordered. We call it ROP.

Safety Stock - Stock that is held in excess of

expected demand due to variable demand rate
and/or lead time. We call it ss.

(lead time) Service Level - Probability that

demand will not exceed supply during lead time.
We call this cycle service level, CSL.
44
Optimal Safety Inventory Levels
Lead Times
time
inventory
Shortage
An inventory cycle
ROP
Q
45
Safety Stock
LT
Time
Expected demand
during lead time
Maximum probable demand
during lead time
ROP
Q
u
a
n
t
i
t
y
Safety stock
46
Inventory and Demand during Lead Time
0
ROP
Demand
During LT
LT
Inventory
DLT: Demand
During LT
0
0
ROP
Inventory=
ROP-DLT
Upside
down
47
Shortage and Demand during Lead Time
ROP
0
Demand
During LT
LT
Shortage
D
L
T
:

D
e
m
a
n
d

D
u
r
i
n
g

L
T
0
0
ROP
Shortage=
DLT-ROP
Upside
down
)} ( , 0 max{ ROP DLT Shortage
48
Cycle Service Level
Cycle service level: percentage of cycles with shortage
ROP] time lead during [Demand inventory] t [Sufficien
inventory sufficient has cycle single a y that Probabilit 0.7
7 . 0
otherwise 1 shortage, has cycle a if 0 Write
10
1 0 1 0 1 1 1 0 1 1
: cycles 10 consider example For

+ + + + + + + + +

CSL
CSL
CSL
49
DLT : Demand during lead time
LT and demand may be uncertain.
2 2 2
2
1
1
) (
time lead during demand the of Variance
) )( ( ) (
time lead during demand the of value Expected
DLT LT D
LT
i
i
LT
i
i
D L D Var
D L D E
+

time lead of Variance

periods of number in time lead Average
demand of Variance
period per demand Average
2
2

LT
D
L
D

50
Reorder Point
ROP
Risk of
a stockout
Service level
Probability of
no stockout
Expected
demand
Safety
stock
0 z
Quantity
z-scale
ROP = E(DLT) + z
ROP = E(DLT) + z

DLT DLT
51
Finding safety stock from cycle service
level CSL
SL) normsinv(C
SL) normsinv(C
variable normal Standard : z ) (
) ) , ( ( ) (
2
DLT
DLT
DLT
DLT
ss D L ROP
D L ROP
D L ROP
z P
ROP D L Normal P ROP DLT P CSL

Note we use normal density for the demand
Note we use normal density for the demand
during lead time
during lead time
The excel function normsinv has default values of 0 and 1 for the mean and
standard deviation. Defaults are used unless these values are specified.
52
Example: Safety inventory vs. Lead time
variability
D = 2,500/day;
D
= 500
L = 7 days; CSL = 0.90
Normsinv(0.9)=1.3, either from table or Excel
If
LT
=0,
DLT
=sqrt(7)*500=1323
ss=1323*normsinv(0.9)=1719.8
ROP=(D)(L)+ss=17500+1719.8
If
LT
=1,
DLT
=sqrt(7*500*500+2500*2500*1)=2828
ss=2828*normsinv(0.9)=3676
ROP=(D)(L)+ss=17500+3676
53
Expected shortage per cycle

First let us study shortage

during the lead time
DLT. of pdf is f where ) ( ) (
)) max( , 0 ( shortage Expected
D

ROP D
D
dD D f ROP D
ROP DLT E

Ex:
4
1
4
1
10)} - (11 max{0,
4
2
10)} - (10 max{0,
4
1
10)} - (9 max{0,
) ( )} (d )} ( max{0, shortage Expected
Shortage? Expected ,
1/4 prob with 11
2/4 prob with 10
1/4 prob with 9
, 10
11
10 d
3
1 i
3 3
2 2
1 1
+ +

'

d D P ROP p ROP d
p d
p d
p d
D ROP
i i
54
Expected shortage per cycle
If we assume that DLT is normal,
3. - 11 Table use ) ( )) , 0 (max( then Let z E ROP DLT E
L D ROP
z
DLT
DLT

2 170 - 172
) 10 ( 10
2
10
6
1
) 12 ( 10
2
12
6
1
10
2 6
1
6
1
) 10 ( shortage Expected
Shortage? Expected ), 12 , 6 ( , 10
2 2
12
10
2
12
10

,
_

,
_

D
D
D
D
D
dD D
Uniform D ROP

Ex:
55
Example: Finding expected shortage per cycle
Suppose that the demand during lead time has
expected value 100 and stdev 30, find the
expected shortage if ROP=120.
z=(120-100)/30=0.66.
E(z)=0.153 from Table 11-3.
Expected shortage = 30*0.153=4.59
56
Fill rate

Fill rate is the percentage of demand filled from

the stock

In a cycle

Fill rate = 1-(Expected shortage during LT) / Q

For normally distributed demand

Q
z E
D
D
Q
z E
DLT
DLT
) (

rate) Fill 1 ( * year per short units of number Expected
) (
1
cycle per Demand
cycle per shortage Expected
1 rate Fill

57
Example: computing the fill rate
Suppose that the demand during lead time has
expected value 100 and stdev 30, find the
expected shortage if ROP=120. Compute the fill
rate if order sizes are 200. Compute the annual
expected shortages if there are 12 order cycles
per year.
Expected shortage per cycle=4.59 from the last
example.
Fill rate = 1-4.59/20=0.7705
Annual expected shortage=12*4.59=55.08.
58
Determinants of the Reorder Point

The rate of demand

The lead time

Demand and/or lead time variability

Stockout risk (safety stock)

59

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

Items from same supplier may yield savings in:

Ordering

Packing

Shipping costs

May be practical when inventories cannot be closely

monitored
5. Fixed-Order-Interval Model
60
A single order must cover the demand until the
next order arrives. Exposure to random
demand during not only lead time but also
before.
Requires higher safety stock than variable order
interval models.
May provide savings in set up / ordering costs.

FOI compared against variable order interval
models
61
6. How many to order for the winter?
Parkas at L.L. Bean
Demand
D
i

Probabability
p
i

Cumulative Probability of demand
being this size or less, F()
Probability of demand
greater than this size, 1-F()
4 .01 .01 .99
5 .02 .03 .97
6 .04 .07 .93
7 .08 .15 .85
8 .09 .24 .76
9 .11 .35 .65
10 .16 .51 .49
11 .20 .71 .29
12 .11 .82 .18
13 .10 .92 .08
14 .04 .96 .04
15 .02 .98 .02
16 .01 .99 .01
17 .01 1.00 .00

62
Parkas at L.L. Bean

Cost per parka = c = $45

Sale price per parka = p = $100

Discount price per parka = $50

Holding and transportation cost = $10

Salvage value per parka = s = $40

Profit from selling parka = p-c = 100-45 = $55

Underage cost=$55

Cost of overstocking = c-s = 45-40 = $5

Overage cost=$5
63

Single period model: model for ordering of

perishables and other items with limited useful
lives

Shortage cost: generally the unrealized profits per

unit, $55 for L.L.Bean. We call this underage.

Excess cost: difference between purchase cost

and salvage value of items left over at the end of
a period, $5 for L.L.Bean. We call this overage.
6. Single Period Model
64
Parkas at L.L. Bean

Expected demand = 10 (00) parkas

Expected profit from ordering 10 (00) parkas = $499

The underage and overage probabilities after ordering
1100 parkas
P(D>1100):Probability of underage
P(D<1100):Probability of overage
65
Optimal level of product availability
p = sale price; s = outlet or salvage price; c = purchase price
CSL = Probability that demand will be at or below reorder point
At optimal order size,
Expected Marginal Benefit from raising order size =
=P(Demand is above stock)*(Profit from sales)=(1-CSL
*
)(p - c)
Expected Marginal Cost =
=P(Demand is below stock)*(Loss from discounting)=CSL
*
(c - s).
Let C
o
= c-s; C
u
=p-c, then the optimality condition is
(1-CSL
*
)C
u
= CSL
*
C
o
,
CSL
*
= C
u
/ (C
u
+ C
o
)
66
Parkas at L.L. Bean
Additional
100s
Expected
Marginal Benefit
Expected
Marginal Cost
Expected Marginal
Contribution
11
th
5500.49 = 2695 500.51 = 255
2695-255 = 2440
12
th
5500.29 = 1595 500.71 = 355
1595-355 = 1240
13
th
5500.18 = 990 500.82 = 410
990-410 = 580
14
th
5500.08 = 440 500.92 = 460
440-460 = -20
15
th
5500.04 = 220 500.96 = 480
220-480 = -260
16
th
5500.02 = 110 500.98 = 490
110-490 = -380
17
th
5500.01 = 55 500.99 = 495
55-495 = -440
67
Order Quantity for a Single Order
C
o
= Cost of overstocking = $5
C
u
= Cost of understocking = $55
Q
*
= Optimal order size

,
_

+

demand stdev demand mean
C C
C
Q
C C
C
Q Demand P CSL
o u
u
o u
u
_ , _ , norminv
d, distribute normally is demand the If
slide. next the See
917 . 0
5 55
55
) (
*
*
68
Optimal Order Quantity
without Normal Demands
0
0.2
0.4
0.6
0.8
1
1.2
4 6 8
1
0
1
2
1
4
1
6
Cumulative
Probability
Optimal Order Quantity = 13(00)
0.917
69

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 set ups

Reduce safety stock

Aggregate negatively correlated demands

Remember component commonality

Delayed postponement
Operations Strategy