Inventory Management

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 Inventory (Stock)

• Is the goods and materials that a business holds for

the ultimate goals to have a purpose of resale,
production or utilisation---Wikipedia
• Inventory is an accounting term that refers to goods
that are in various stages of being made ready for
sale

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 Types of Inventory
• Raw materials and purchased parts
• Work-in-process (partially completed) products (WIP)
• Finished goods inventory (FGI)
• Rework items
• Tools, machinery, and equipment
• Maintenance, Repair and Operating (MRO)

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 Why having Inventory?

• Uncertainty in customer demand

– Shorter product lifecycles
– More competing products
• Uncertainty in supplies
– Quality/Quantity/Costs/Delivery Times
• Incentives for larger shipments
• Economics of scale
• Quicker response
• Hedge against price increases

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 Inventory Cost
Costs
– Holding (or carrying) costs
• Costs for storage, handling, insurance, tax, maintenance,
Obsolescence etc
• Annual cost: 20%-40%
– Ordering (setup) costs
• Invoices, inspecting goods, moving material in/out
• Costs for arranging specific equipment setups
• A fixed dollar amount per order
– Shortage costs
• Costs of lost sales, loss of goodwill
• Difficult to measure

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 Inventory cost
Example 1: Freight and shipping costs.
Example 2: Cost of losing customer loyalty and
reputation.
Example 3: Managerial & clerical costs of
preparing purchase orders.

Example 4: Costs of inventory spoilage,

breakage, pilferage, scrap, and obsolescence.

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Example 5: Depreciation cost of storage
material-handling equipment.
Example 6: Cost of finding suppliers.
Example 7: Costs associated with
appropriately charging time and materials to
setup the production line.
Example 8: Costs associated with purchase
order processing.
Example 9: Opportunity cost of the money
invested in inventory.
Example 10: Cost of unplanned lost production
or downtime.
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Example 11: Costs associated with filling out the
required papers to setup production line.
Example 12: Cost of moving in-transit goods to
temporary storage.
Example 13: Facility storage costs such as rent,
depreciation, heating, cooling, security, power
and refrigeration.
Example 14: Costs associated with tracking
orders.
Example 15: Inventory services costs such as
labor, insurance, security, and IT.
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Example 16: Costs of moving out the previous
stock of material to setup a machine for a new
order.
Example 17: Costs of customs, duties, and taxes.
Example 18: Cost of electronic data interchange
for acquisition.
Example 19: Costs of emergency shipments
because of stock-outs.
Example 20: Inventory financing costs.

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 Inventory Turns

• Inventory turnover ratio (also known as inventory

turns)
– = Cost of goods sold / Average Inventory
– = Cost of Goods Sold / ((Beginning Inventory + Ending
Inventory) / 2)
• Average Days to Sell Inventory
– = Number of Days a Year / Inventory Turnover Ratio
– = 365 days a year / Inventory Turnover Ratio

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 Inventory Models
• Just-in-time (JIT) Inventory
– replenish inventory only when it is required
• Vendor Managed Inventory (VMI)
– a retailer shares his inventory data with a vendor (sometimes called
supplier) such that the vendor is the decision-maker who determines
the order size for both
– The supplier generates an order and deliver it
• Customer Managed Inventory (CMI)
– customers in the CMI program can upload product flow, stock
information, and on-hand inventory details directly to a web-
integrated system for ordering, invoicing, and more
– The supplier recommends an order and the customer approves it
before delivery
• Consignment Inventory (CI)
– Customers will not pay the supplier until they actually use it
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 ABC System

• A-B-C approach
– A classification system according to some measure of
importance (annual dollar value= Annual demand x Unit cost)

Class % of units % of dollar value

A 5-15 70-80

B 30 15-25

C 50-60 5-10

A Pareto Principle: critical few, trivial many

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 Example: ABC classification
% of % of
Annual Unit Annual annual Units
x = $value stocked
Item Demand cost $value Class

#10286 1000 $90 $90000 38.8% 72% 17.5% A

#11526 500 $154 $77000 33.2% A

#12760 1550 $17 $26350 11.3% B

#10867 350 $42.86 $15001 6.4% 23% 34% B
#10500 1000 $12.50 $12500 5.4% B

#12572 600 $14.17 $8502 3.7% C

#14075 2000 $0.60 $1200 0.5% C
#01036 100 $8.50 $850 0.4% 5% 48.5% C
#01307 1200 $0.42 $504 0.2% C
#10572 250 $0.60 $150 0.1% C

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 Inventory Management Policy
A items B items C items
• High priority • Moderate priority ◼ Low priority
• Tight control with • Moderate control
regular review with regular ◼ Simple
attention control
• Carefully
determined Q, • Order quantities ◼ Large
frequent deliveries, or order points inventories,
continuous review reviewed visual review
• Very accurate and quarterly ◼ Simplified
detailed inventory
records, update • Batch updating of counting,
monthly inventory records annual review

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 Improve Inventory Accuracy

• Make sure your warehouse is organized at all times.

• Have good inventory naming and labeling practices.
• Create and follow documented policies and procedures.
• Utilize cycle counting as a more efficient way to count inventory.
• Only allow certain employees to have access to inventory and
inventory data.
• Transition to using modern technology, such as inventory
management software, to track inventory data.

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 Cycle Counting
• A continuing reconciliation of inventory with inventory
records
– prevent inventory errors without shutting down the whole facility for a
full count
• Cycle counting vs physical counting
• Method of cycle counting
– ABC analysis: items with higher a value get counted more frequently
than items with a lower value.
– Opportunity-based: conducted when an item undergoes change or has
movement
– Process-based: managers choose which items or areas to count during
each period
– Location-based: counted based only on their physical location within
the warehouse
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 Inventory Decisions

• Uncertain demand makes demand forecast critical

for inventory-related decisions:
– What to order?
– When to order?
– How much to order (batch size)?
• Approach includes a set of techniques
– INVENTORY POLICY!!
 Objectives
◦ Minimize costs
◦ Maximize profit
◦ Service level requirements

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 Inventory Policies
• Variety of techniques
– Certain demand
• Economic order quantity Model (EOQ)
• Production order quantity Model (POQ)
• Discount Model
– Uncertain Demand
• Single Period Model
• Continuous Review Policy: (R, Q) policy
• Periodic Review Policy

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 EOQ Model

Assumptions
• Known and constant demand
• Known and constant lead time
• Instantaneous receipt of material
• No quantity discounts
• Only order (setup) cost and holding cost
• No stockouts
• Planning horizon is long (infinite)

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 The Model
1 year
1 cycle
Q

Daily
Quantity demand (d)
Average inventory on
on hand hand (Q/2)

Q
Reorder point
ROP=d×L
Lead
time L

0 Time
Lead
Ordering time L Q/d Arriving Ordering Arriving

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 EOQ

One cycle: T=Q/d

Maximum
Inventory: Q
Demand
rate: d
Q/2

ROP
Q/d
Minimum
Inventory: 0 Lead Time (L)
Q: order quantity
When to order? ROP=d*L d: daily demand
How much to order? Q*? D: annual demand
Objective? Minimize total inventory cost
=holding cost + setup cost
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 Notation

• D = Demand per year

• d = Demand per day
• S = Setup (order) cost per order
• H = Holding (carrying) cost per unit per year
• L = Lead time in days
• Q=number of pieces per order (order quantity)

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 Costs

Annual ordering cost

= (cost per order)*(number of orders)
S D/Q
Annual holding cost
= (unit holding cost)*(average inventory level)
H/per year Q/2

Annual total cost = annual ordering cost + annual

holding costTC = SD + HQ
Q 2
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 EOQ: Costs

Optimal Order
Quantity Q*

2DS
Optimal Order Quantity: Q* =
H
Reorder Point (ROP)=L*d

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 EOQ Model Equations

Optimal Order Quantity 2* D * S

= Q* =
H
D
Expected Number of Orders =N =
Q
Expected Time Between Orders Working Days / Year
=T =
N
D D = Demand per year
d =
Working Days / Year S = Setup (order) cost per order
H = Holding (carrying) cost
ROP = d ×L d = Demand per day
L = Lead time in days

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 An example
• A medical supply warehouse orders vaccines using the EOQ
model. The annual demand is 10,000 units and is steady over
time, the ordering cost is $50, and the holding cost is 20% of
the unit price per year. The original unit price is $10. The
warehouse operates 100 days a year.
1. What is the holding cost per unit per year?
2. What is the maximum inventory if ordering 1000 units per
order?
3. How many orders per year if ordering 1,000 units per order?
4. What is the economic order quantity?
5. What flaws do you find with the EOQ method?

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 EOQ with Real-World Constraints
• 1. Suppliers only ship in sizes of 100 units. How does this change impact
your decision? What is the inventory cost?
• 2. The warehouse has a limited space of holding 500 units of vaccine. How
does this influence your decision? What is the total inventory cost?
• 3. The vaccine has 6 days of shelf life. Any product not used will be
discarded without any salvage value. What is your order decision and what
is the total inventory cost?
• 4. The vaccine has 10 days of shelf life. Any product not used will be
discarded without any salvage value. What is your order decision and what
is the total inventory cost?
• 5. If the supplier gets a discount of 10% if he orders 1000 units or more,
how much should he order?

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The Normal Distribution

μ: mean of demand
σ: standard deviation
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 One-Period Model
• N(μ, σ2), μ=100 (average demand during the period),
– σ=10 (standard deviation of demand during the period)
• If order 50 units, what is the service level?
• If order 100 units, what is the service level?

Q=50 100 Q*=113 Demand

SS
• How much to order?
– If service level is 90%: Q*= norminv(0.9,100,10)=113
– Safety stock (SS) = 113-100=13 30
 Service Level of One-Period Problem
• Factors to consider
– Price of the product
– Cost of the product
– Salvage value
• Cost of shortage (potential profit-loss due to underestimate)
– Price/unit – cost/unit
• Cost of overage (loss due to overestimate)
– Cost/unit – salvage value/unit
• Service level
• = Cost of shortage/(Cost of shortage+ Cost of overage )

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 Example: McHardee Press
McHardee Press publishes the Fast Food Menu
Book and wishes to determine how many
copies to print. There is a fixed cost of
$5,000 to produce the book and the Fast Foo

incremental profit per copy is

d
en

M
$0.45. Any unsold copies of uB
oo k

the book can be sold at salvage

at a $.55 loss.

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 Fast Fo
Example: McHardee Press o

d
M
en
uB
oo k

Sales for this edition are estimated to be normally

distributed. The most likely sales volume is 12,000
copies and the standard deviation is 5000.
Q1. What is the service level of this product?
Q2. How many copies should be printed at this service level?

Q1: Service level = .45/(.45+.55) = .45

Q2: Find Q * such that 45% of customer demand is met.

Q*= norminv(0.45,12000,5000)=11372

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