Chapter 12

Inventory
Management

Learning Objectives
LO1 Discuss the importance of inventory, list major reasons for holding
inventory, and discuss the objectives of inventory management.

LO2 List the main requirements for effective inventory management, and
describe A-B-C classification and perform it.

LO3 Describe the basic economic order quantity model, the economic
production quantity model, the quantity discount model, and the planned
shortage model, and solve typical problems.

LO4 Describe how to determine the reorder point and solve typical problems.

LO5
Describe the fixed-interval model and the coordinated periodic review
model, and solve typical problems.

LO6 Describe the single period model and solve typical problems.

LO7
Briefly discuss the multi-echelon (level or location) inventory
management.
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Chapter Outline
• Introduction to Inventory Management
• Requirements for Effective Inventory Management
• Basic models for inventory ordering and management.
(EOQ, EPQ, A-B-C Analysis etc.)
• Determining the Reorder Point
• Fixed Order Interval Model
• The Single Period Model
• Multi-echelon Inventory Management

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What Is Inventory?
▪ Stock of items kept for use or sale in the future.
▪ Decisions of inventory management.
• How many units to order
• When to order

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Inventory
Independent Demand:
Demand for these items is unknown
and has to be forecasted.
A • Retail items,
• Finished goods,
• Supplies and parts,
B(4) C(2) • Some raw materials

D(2) E(1) D(3) F(2)

Dependent Demand
Manufactured parts

Independent demand is uncertain.

Dependent demand is certain.
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Types of Inventories
Raw materials & purchased parts

Partially completed items called

work in process (WIP)

Finished-goods (or merchandise)

Spare parts, tools, & supplies

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Importance of Inventory
▪ A typical company has approximately half of its current
assets in inventory.
▪ The major source of revenue for retailers and
wholesalers/distributors is the resale of merchandise
(i.e., inventory).
▪ Service companies do not carry as much inventory,
although they do carry inventory of supplies and
equipment.
Supplies/
Assets $ Revenue $
equipment

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Functions of Inventory

To take
To protect
To wait while in advantage of
against stock-
transit quantity
outs
discounts

To smooth To meet
To decouple
production above-average
operations
requirements demand

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Objective of Inventory Management

To achieve satisfactory levels of

customer service while
minimizing inventory costs.

▪ Level of customer service (not understock)

• Fill rate
▪ Costs of ordering and holding inventory (not overstock)
• Inventory turnover
Note: Inadequate management of inventory can result in both
understocking of some items and overstocking of the others.
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Reducing the Need for Inventories

Inventory
Ways to reduce the need for inventory
function

Locate companies in a supply chain close to each other

In-transit Cross-dock or eliminate the DC (ship direct to consumer)

Establish close long-term relationship with suppliers and

Safety customers
Ensure high quality material
Cycle Reduce ordering/setup times
Develop sources of supply & demand that collectively
Seasonal extend seasons
Reduce machine breakdown
Decoupling
Train workers and accept idle time
Anticipation Use forward/futures contracts
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Requirements for Effective Inventory
Management
▪ Safe storage and handling of inventories
▪ Tracking inventory levels,
use of control models. Quantity
▪ Forecasting demand and lead time
▪ Reasonable estimates of: Costs
• Holding costs
• Ordering costs
Control
• Shortage costs
▪ A classification system (A-B-C analysis)

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Safely Storing Inventory

Warehouse Management System (WMS) computer software that
controls the movement and storage of materials within a
warehouse, and processes the associated transactions.

Warehouse/storeroom concerns

Security Safety Obsolescence

It possible to automate both storage and picking operations by

using an automated storage and retrieval system (ASRS)., see
“Sobeys’ High-Tech Distribution Centres” OM in Action. Pg.#435

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 Tracking Inventory Levels and Using
Inventory Control Models
▪ Inventory position Quantity on hand + On order – Back-
ordered.
▪ Fixed-interval/order-up-to level model An inventory control
model that places orders at fixed time intervals to bring the
inventory position up to the order-up-to level.
▪ Perpetual (or continual) tracking keeps track of removals from
and additions to inventory continuously, thus providing
current levels of each item.
▪ Economic order quantity/ reorder point model (EOQ/ ROP)
places a fixed optimal-size order when the inventory position
of an item drops to or below a minimum quantity called the
reorder point.

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Tracking Inventory Levels and Using

Inventory Control Models
▪ Two-Bin System
• Two containers of inventory; reorder when the first
is empty
▪ Bar Code
• A unique number assigned to an item or location,
made of a group of vertical bars that are readable
by a scanner
• Universal Product Code (UPC)

0
214800 232087768

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Forecasting Demand and
Lead Times
▪ Purchase lead time
• time interval between ordering and receiving the
order
• it is important to know the manufacturing lead
time, the time it will take for a batch of a
part/product to be manufactured
▪ Point of Sale (POS) system
• Software for electronically recording actual sales at
the time and location of sale

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Estimating Inventory Costs

Ordering or Holding
Setup costs (carrying)
costs

Shortage
costs

Inventory costs
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Inventory Costs
▪ Holding (carrying) costs
• Cost to carry an item in inventory
▪ Ordering costs
• Costs of placing an order (not including purchase
price) receiving it and paying for it
▪ Setup costs
• Time spent preparing equipment for the job by
adjusting machine, changing tools, etc
▪ Shortage costs
• Costs when demand exceeds supply; often
unrealized profit per unit, loss of goodwill
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ABC Classification System

Classifying inventory according to some measure of
importance and allocating control efforts accordingly.
A - very important
B - mod. important
High
C - least important (70-80) A
Annual
$ value B
of items

‘A’ items Low C

(5-10)
should receive Low High
more attention! (15- (50-60)
20)
Percentage of Items
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Example: A-B-C Classification
Annual
Item Annual Dollar % of Total
x Unit Cost =
Number Demand Volume ADV
(ADV)
A
8 1,000 $ 90.00 $ 90,000 38.8%
72%
10 500 154.00 77,000 33.2%
2 1,550 17.00 26,350 11.3% B
5 350 42.86 15,000 6.4% 23%
3 1,000 12.50 12,500 5.4%
1 600 14.17 8,500 3.7%
7 2,000 .60 1,200 .5% C

9 100 8.50 850 .4% 5%

6 1,200 .42 504 .2%
4 250 .60 150 .1%
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Cycle Counting
▪ Regular actual count of the items in inventory on a
cyclic schedule.
▪ Physical inventory Determination of inventory
quantity by actual count.
▪ Cycle counting management. Count

• How much accuracy is needed? Count Count

• Frequency of counting cycle?
• Who should do it? Count Count

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Determining the Economic Order Quantity
and Its Variants
Economic Order Quantity (EOQ): The order size that
minimizes total inventory control cost.

Economic
Basic economic
production quantity
order quantity (EOQ)
(EPQ)

EOQ EOQ
with
quantity
discount
with
planned
shortage
$
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Assumptions of Basic EOQ Model

1. Only one product is involved
2. Annual demand requirements known
3. Demand is even throughout the year
4. Lead time does not vary
5. Each order is received in a single delivery
6. There are no quantity discounts
7. Shortage is not allowed

Table 12-1

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 Inventory Cycles with EOQ
4. Order received after lead time
1. You receive an order (size = (LT) expires, when 0 on hand. The
Q) cycle then repeats.
Q Q Q

Quantity
on hand

Time
2. Quantity LT LT
decreases by
demand rate (d) 3. When quantity reaches
R = Reorder point reorder point quantity (R),
Q = Economic order quantity place another order (size = Q).
LT = Lead time

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EOQ: Minimizing Total Costs

Total cost = Holding + Ordering Costs
Total cost is minimized at Q0 where holding = ordering cost
A
N Total Cost
N
U
A
L Holding
C Costs
O
S
T

Ordering Costs

QO Order Quantity (Q)

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Basic Economic Order Quantity (EOQ)

Total Annual Annual

Annual = Holding + Ordering
Cost Cost Cost TC = Total annual cost
Q = Order quantity (units)
H = Annual holding cost
per unit
Q D D = Annual Demand

TC = H + S S = Ordering (or setup)

cost per order
2 Q Q0 = EOQ

2DS 2(Annual Demand) (Order or Setup Cost)

QO = =
H Annual Holding Cost

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EOQ Example
A phone company has annual demand of 10,000. A component has annual
holding cost of $6 per unit, and ordering cost of $75. Calculate EOQ, Total Cost,
number of orders per year and the order cycle time.
H = $6 per unit
S = $75 2DS QH DS
Q o = TC = +
D = 10,000 units H 2 Q
(500)(6) (10,000)(75)
2(10,000) (75) TC = +
Qo = (6)
2 500

Qo = 500 units TC = $1500 + $1500= $3000

Orders per year = D/Qo Length of order cycle = 250

= 10,000/500 days/(D/Qo) = 250/20
= 20 orders/year = 12.5 days
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 EOQ Example
A phone company has annual demand of 15,000. A component has
annual holding cost of $6 per unit, and ordering cost of $75. Calculate
EOQ, Total Cost, number of orders per year and the order cycle time.
H = $6 per unit
2DS QH DS
S = $75 Qo = TC = +
D = 15,000 units H 2 Q
(612)(6) (15,000)(75)
2(15,000) (75) TC = +
Qo = (6)
2 612

TCmin = $1836 + $1838 = $3674

Qo = 612 units
EOQ is 22% Total cost is 22%
more than more than $3000
500
Orders per year = D/Qopt Length of order cycle = 250 days/(D/Qo)
= 15,000/612 = 250/25
= 25 orders/year = 10 days 27
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EOQ Example
A phone company has annual demand of 15,000. A component has
annual holding cost of $6 per unit, and ordering cost of $75.
H = $6 per unit 2DS QH DS
S = $75 Qo = TC = +
D = 15,000 units H 2 Q

2(15,000) (75)
Qo = (6) What if we still use
EOQ of 500?
Qo = 612 units What is total cost?

Total cost is only an (500)(6) (15,000)(75)

extra 2% more if still TC = 2
+ 500
use EOQ of 500
TC = $1500 + $2250 = $3750
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Robust Model
▪ The EOQ model is robust.
▪ It works even if all parameters
and assumptions are not met.
▪ The total cost curve is relatively flat near the EOQ
(especially to the right).

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Economic Production Quantity (EPQ)

If we are producing an item in-house, economic
production quantity (EPQ), determines optimal
production lot size to minimize total annual production
setup and inventory holding cost.
▪ Assumptions of EPQ
• Similar to EOQ
• Except orders are received
incrementally during production

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Economic Production Quantity (EPQ)

Figure 12-6

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Economic Production Quantity (EPQ)

 Annual   Annual 
    I  D
TC =  Holding  +  Setup  =  max  H +   S
 Cost   Cost   2  Q
   
; Run length = ; I max = ( p − d )
Q Q Q
Cycle length =
d p p

2 DS  p 
TC = Total annual cost Q0 =  
Q = Order quantity (units) H  p−d 
H = Annual holding cost
per unit Q0 = Optimal run or order quantity
D = Annual Demand p = Production rate
S = Ordering (or setup) d = Usage or demand rate
cost per order Imax = Maximum inventory level
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 EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per day, 5
days per week, 50 weeks per year. Production is 50,000 per day. The setup cost is
$200 and the annual holding cost rate is $.55 per bag. Calculate the EPQ, the total
cost, the cycle length and optimal production run length.

H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days

d = 20,000 bags per day p = 50,000 bags per day

2 DS  p 
Q0 =  
H  p − d 

2(5,000,000)(200)  50G 
Q0 =   = 77,850
.55  50G − 20G 
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EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per day, 5
days per wk, 50 wks per yr. Production is 50,000 per day. Setup cost is $200 and
annual holding cost rate is $.55 per bag. Calculate total cost.

H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days

d = 20,000 bags per day p = 50,000 bags per day

I  D
TC =  max  H +   S I max =
Q
(p − d)
 2  Q p

I max =
77,850
(30000 ) = 46,710 bags
50,000
 46,710   5million 
TC =  (.55) +  200 = $25,690
 2   77,850 
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EPQ Example
Holdit Inc. produces reusable shopping bags. Demand is 20,000 bags per day, 5
days per week, 50 weeks per year. Production is 50,000 per day. The setup
cost is $200 and the annual holding cost rate is $.55 per bag. Calculate cycle
length and optimal production run length.
H = $0.55 per bag S = $200 D = 20,000 bags x 50 wks x 5 days
d = 20,000 bags per day p = 50,000 bags per day

Q Q
Cycle length = ; Run length =
d p

77,850
Cycle length = = every 3.89 days
20,000
77,850
Run length = = 1.56 days per order
50,000
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EOQ with Quantity Discounts

▪ Price reductions are often offered as incentive to buy larger
quantities (the more we buy the less we pay per unit).
▪ Weigh benefits of reduced purchase price against increased
holding cost.

Annual Annual
TC = holding + ordering + Purchasing
cost
cost cost

Q + D S + RD
TC = H
2 Q

R = per unit price of the item

D = annual demand
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 Total Cost with Purchase Cost
Annual Cost
Adding Purchasing cost
doesn’t change EOQ if
there is no quantity discount TC with RD

TC without RD

RD

0 EOQ Quantity
Figure 12-7
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Total Cost with Quantity Discounts

Figure 12-8

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Best Purchase Quantity Procedure
Total cost with quantity
Begin with the
discounts…process.
lowest unit price

Compute the EOQ for each Stop when find a

price range feasible EOQ

Is EOQ for the

lowest unit price feasible?

No: compare total cost at all

Yes: it is the optimal order
break quantities larger than
quantity
feasible EOQ

The quantity that yields the

lowest total cost is optimum
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Example: Quantity Discounts

Below is a quantity discount schedule for an item with
an annual demand of 10,000 units that a company
orders regularly at an ordering cost of $4. The annual
holding cost is 2% of the purchase price per year.
Determine the optimal order quantity.

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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Example: Quantity Discounts
Order Quantity Price/unit($)
D = 10,000 units S = $4 0 to 2,499 $1.20
2,500 to 3,999 1.00
H = .02R R = $1.20, 1.00, 0.98 4,000 or more .98

2DS 2(10,000)(4)
QO = = = 1,826 units
H 0.02(1.20) Interval from 0 to 2499,
the Qo value is feasible
2DS 2(10,000)(4)
QO = = = 2,000 units
H 0.02(1.00) Interval from 2500-3999,
Qo value is NOT feasible
2DS 2(10,000)(4)
QO = = = 2,020 units
H 0.02(0.98) Interval from 4000 & up,
Qo value is NOT feasible

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Quantity Discount Models

1st range 2nd range total cost curve

total cost
curve
Annual cost

EOQ
3rd range total cost curve

EOQs (not feasible)

1st break 2nd break

quantity quantity

0 2500 4000 Quantity

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Example: Quantity Discounts
Q + DS + RD
TC = H
2 Q

TC(0-2499) = (1826/2)(0.02*1.20) + (10000/1826)*4+(10000*1.20)

= $12,043.82

TC(2500-3999)= $10,041

TC(4000&more)= $9,949.20

Therefore the optimal order quantity is 4000 units.

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EOQ with Planned Shortages

▪ Intentionally allowing shortage assumptions:
• All shorted demand is back-ordered
• Back-orders incur shortage costs
• Shortage cost is proportional to waiting time
• All other basic EOQ assumptions

Figure 12-10

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EOQ with Planned Shortages
 Annual   Annual   Annual 
     
TC =  Holding  +  Ordering  +  Back Order 
 Cost   Cost   Cost 
     
 (Q − Qb )2  D  Q2 
TC =   H +   S +  b  B
  2Q 
 2Q  Q  
2 DS  H + B 
Q=  
H  B 
B = back − order cost per unit per year
Qb = quantity back - ordered per order cycle
H = annual holding cost per unit
D = annual demand
S = ordering (or setup) cost per order
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Example: EOQ with Planned Shortage

▪ Annual demand for a refrigerator is 50 units.
▪ Holding cost per unit per year is $200.
▪ Back-order cost per unit per year is estimated to be $500.
▪ Ordering cost from the manufacturer is $10 per order.
▪ Determine order quantity and back-order quantity per order cycle.

D = 50 H = $200 B = $500 S = $10

2 DS  H + B  2(50)(10)  200 + 500 
Q=  =   = 2.65, round to 3 units.
H  B  200  B 
 H   200 
Qb = Q   = 3  = 0.86, round to 1.
H +B  200 + 500 

Allow inventory to drop to zero.

When another unit is demanded, order 3 units.
Example 12-6
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Concept Check
Which of the following is FALSE about EOQ?

A. It determines how many to order.

B. The EOQ always results in the lowest total cost.
C. The model minimizes total cost by balancing carrying
and order costs.
D. The model is robust and works even if all
assumptions are not exact.

© 2018 McGraw-Hill Education Limited. All rights reserved. 47

Concept Check
Which is NOT a difference between EOQ and EPQ?

A. A different formula is used.

B. EPQ is used mainly for producing batches, and EOQ is
for receiving orders.
C. Quantity is received gradually in EPQ.
D. Demand can be variable for EPQ but not for EOQ.

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Concept Check
Which is NOT an assumption of both EOQ and EPQ?

A. Demand is known with certainty

and is constant over time.
B. No shortages are allowed.
C. Order quantity is received all at once.
D. Lead time for the receipt of orders is constant.

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What’s Next?
▪ EOQ models give HOW MANY to order.
▪ Now look at WHEN to order.
• Reorder Point (ROP)
• The inventory position at or
below which the item is reordered

ROP = d  LT

d = Demand rate (units per day or week)

LT = Lead time (in days or weeks)
Note: Demand and lead time must have the same time units.

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Example: ROP
▪ Annual Demand = 1,000 units
▪ Days per year = 365
▪ Lead time = 7 days

1,000 units/year
d= = 2.74 units/day
365 days/year

ROP = d L = 2.74 units/day (7days) = 19.18 or 20 units

When inventory level reaches 20 units, place the next order.

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Fixed Order Quantity/Reorder Point Model

Reorder Point = Expected demand + Safety Stock
(ROP) during lead time

Safety Stock

1. Variability of
2. Service Level
demand and lead time
2a. Lead time
service level

2b. Annual
service level

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When to Reorder with EOQ Ordering
▪ Reorder Point – When inventory position drops to or below this
amount, the item is reordered.
▪ Safety Stock - Stock that is held in excess of expected demand
due to variability of demand and/or lead time.
▪ Service Level – Probability demand will not exceed supply.
• Lead time service level: probability that demand will not
exceed supply during lead time
• Annual service level: percentage of annual demand filled

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Determinants of the Reorder Point

Rate of
Lead time
demand

Demand
Stockout risk
and/or lead
(safety stock)
time variability

ROP = Expected demand

+ Safety stock
during lead time

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Safety Stock
Safety stock reduces
risk of stockout during
lead time.

Figure 12-11
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Reorder Point Using Lead Time Service

Level
The ROP based on a normal distribution of lead time demand.

Safety Stock = z.dLT

z = Safety factor; number of standard deviations above expected demand
dLT = The standard deviation of demand during lead time
Fig 12-12
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Demand During Lead Time

Figure 12-13
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ROP with Lead Time Service Level

▪ Variable demand during a lead time.
▪ ROP = expected demand during lead time + safety
stock

Example 12-8
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ROP with Lead Time Service Level
Variable demand and constant lead time.

Example 12-9

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ROP with Lead Time Service Level

Both demand and lead time are variable.
ROP = (avg. demand x avg. lead time) + z x st. dev. of demand in
lead time (demand and lead time measures in same time units).

d= standard deviation of demand per day

LT= standard deviation of lead time
dLT = (average lead time x d2)
+ (average daily demand) 2LT2

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Example: ROP with Lead Time Service Level
(demand and LT varies)
Calculate the ROP for a product that has an average demand of 150
units per day and a standard deviation of 16. Lead time averages 5
days, with a standard deviation of 2. The company wants no more
than 5% stockouts.
Service level = 1 – 5% = 95%
From Table 12-3 (p458), z for 95% = 1.65

ROP = (150 units x 5 days) + 1.65dlt

= (150 x 5) + 1.65 (5 days x 162) + (1502 x 12)
= 750 + 1.65 (154) = 1,004 units

Place a new order when inventory level reaches 1004 units.

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ROP Using Annual Service Level

1. Calculate Q (1 − SLannual )
E( z) =
 dLT

2. Use a table to find the z value associated with E(z)

3. Use the z value in the appropriate ROP formula,
ROP = expected demand during lead time + z dLT

SLannual = annual service level

E(z) = standardized expected number of units short during an
order cycle.

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ROP Using Annual Service Level

Example 12-11

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Periodic Review and Can-Order Model

▪ Periodic Review (min-max model)
• Periodically reviewed: RP = review period
• Increase LT by RP
▪ Can-Order Model:
• If at order time, Q on hand < min (ROP),
then order quantity = max – Q on hand
and check if related items below can-order level

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Fixed-Interval/Order-up-to Level Model and
Coordinated Periodic Review Model
▪ Fixed Order Interval/Order up to Level Model
• Orders placed at fixed time intervals
• Determine how much to order to bring inventory level up to
a predetermined point (order up to level)
• Used widely for retail
• Consider expected demand during lead time, safety stock,
and amount on hand
• Demand or lead time can be variable
▪ Different from EOQ/ROP model
• Order size remains fixed from cycle to cycle
• Length of the cycle may vary

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Comparing Inventory Models

EOQ/ROP

Fixed
Interval/
Order up to

Figure 12-14

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Fixed Order Interval: Benefits and
Disadvantages
▪ Benefits
• Grouping items from same supplier
can reduce ordering/shipping costs
• Practical when inventories
cannot be closely monitored

▪ Disadvantages
• Requires a larger safety stock
• Increases carrying cost
• Costs of periodic reviews

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Fixed Order Interval/Order up to Level Model

Determining the Order Interval
Total Annual Inventory Cost:
 D j .OI   1 
TC =    R j .i + ( S + ns) 
 OI 
 2 
Optimal Order Interval:
2 ( S + ns )
*
OI =

i DjRj

OI = order interval (in fraction of a year)

S = fixed ordering cost per purchase order
s = variable ordering cost per SKU included in the order (line item)
(assume s is the same for every SKU)
n = n number of SKUs purchased from the supplier
Rj = unit cost of SKUj , j = 1, …, n
i = annual holding cost rate
Dj = annual demand of SKUj , j = 1, …., n
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34
Fixed Order Interval/Order up to Level Model
Determining the Order up to Level
Q = I max − Amount on hand
 Expected demand 
   Safety 
I max =  during an order interval  +   =
 plus a lead time   Stock 
 
= d (OI + LT ) + z d OI + LT

= Average daily or weekly or monthly demand

OI = Order interval (length of time between orders
LT = Lead time in days or weeks or months
z = Safety factor; # of standard deviations above expected demand
d = Standard deviation of daily or weekly or monthly demand
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Example: Fixed Order Interval Model

Average daily demand for a product is 20 units, with a standard
deviation of 4 units. The order interval is 30 days, and lead time is 10
days. Desired service level is 99%. If there are currently 200 units on
hand, how many should be ordered?

I max = d (OI + LT ) + z d OI + LT
I max
= 20 (30 + 10) + (2.32) (4) 30 + 10
= 800 + 2.32 (25.298)
= 858.7 or 859 units stock up to level

Amount to order = 859 – 200 = 659 units

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35
Coordinated Periodic Review Model
▪ Determines an order interval (OI) and order up to level for
reviewing every stock keeping unit (SKU)
• Calculate a multiple (mi ) of OI for each SKUi
• Use this to determine the optimal OI for each SKUi
▪ To use:
• Compare on hand inventory of each SKU to its ROP (forecast
demand for next OI + lead time + safety stock)
• If on hand is less: order a quantity that brings the on hand
level to SKU’s order up-to level
• The order up-to level is enough for the next OI + LT

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Single Period Model

▪ Single period model
• Model for ordering of perishables and other items with
limited useful lives
▪ Shortage cost Cs
• Generally the unrealized profits per unit
• Revenue per unit – Cost per unit
▪ Excess cost Ce
• Cost per unit - salvage per unit
for items left over at the end of a period

GOAL = find order quantity (stock level) that minimizes

total excess and shortage costs.

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Single Period Model
▪ Continuous stocking levels
• Identifies optimal stocking levels
• Optimal stocking level balances unit shortage and
excess cost
▪ Discrete stocking levels
• Desired service level is equaled or exceeded
• Compare service level to cumulative probability
of demand

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Optimal Stocking Level

Cs Cs = Shortage cost per unit
Service level (SL) =
Cs + Ce Ce = Excess cost per unit

C Cs
e

Service Level

Quantity

So
Balance point
So = Optimum stocking level (i.e., order quantity
Figure 12-15

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Example: Single Period Model
A cafeteria buys muffins daily. Demand varies Uniformly
between 30 and 50 muffins per day. The cafeteria pays
$.20 per muffin and charges $.80 per muffin. Unsold
muffins are discarded at the end of the day. Find the
optimal stocking level and the stock-out risk for that
quantity.
▪ Cc = Cost per unit – Salvage per unit
= $.20 - $0 = $0.20 per unit
▪ Cs = Revenue per unit- Cost per unit
= $.80 - $.20 = $0.60 per unit
Example 12-15

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Example: Single Period Model

▪ Ce = $0.20 per unit
▪ Cs = $0.60 per unit
▪ Service level = Cs/(Cs+Ce) = .6/(.6+.2)
▪ Service level = .75
C Cs
e
Service Level = 75%
For Uniform
Distribution 30 45 50 Quantity

Optimal = 30 + .75(50-30) = 45 muffins

Stockout risk = 1.00 – 0.75 = 0.25 = 25%
Example 12-15
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38
Example: Single Period Model
A cafeteria buys muffins daily. Demand is approximately
Normal with a mean of 40 and [Link]. of 5 muffins per
day. The cafeteria pays $.20 per muffin and charges $.80
per muffin. Find the optimal stocking level.

If service level is .75

For Normal Distribution From Normal
table, z ≈ .675

Optimal = 40 + 0.675(5) = 43 muffins

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Example: Single Period Model

A company usually carries 2 units of a spare part that costs $500 and has
no salvage value. Part failures can be modeled by a Poisson distribution
with a mean of 2 failures during the useful life of the equipment.
Estimate the range of shortage cost for which stocking 2 units of this
spare part is optimal.
The Poisson table (App. B, Table C) Cs is unknown Ce = $500
provides these values for a mean of 2.0:
Cs
#of Cumulative = .406, so Cs = .406($500 + Cs )
Cs + $500
Failures Probability
0 Optimum stock.135 Cs = $343.17
1 level (rounded.406 Cs
2 up) = 2, then .677 = .677, so Cs = .677($500 + Cs )
Cs + $500
3 SL between .857
C = $1,047.99.
4 .947 The range of shortage cost s
5 .983 is $343.17 to $1,047.99.
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39
Multi-Echelon Control
For warehouse:
▪ Uses total POS data
▪ Plans based on end
customer demand/supply
▪ Lead time = lead time from
supplier to warehouse
(LTW) + lead time of
warehouse to retailer (LTR).
▪ Inventory position = total
inventory in all retailers,
warehouse, and on route
minus backorders to end
customers

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Distribution Requirements Planning

▪ Distribution requirements planning (DRP).
• determines time-phased replenishment schedules between
manufacturer’s and DCs
• SKU, DRP starts with forecast demand at DCs and works
backward in time, offsetting for replenishment lead times
• DRP requires:
• Forecast of demand at each DC (usually done by the DC
itself).
• Current inventory on hand and on order
• Order quantities/batch sizes and lead times
Inventory optimization A method that determines the location and
optimal level of inventory in the supply chain.

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 Review: Inventory Models
▪ EOQ models used to determine order size.
• Simple model for many types of inventory
• Trade-off between carrying and ordering costs
• Quantity discount model adds purchasing costs and
compares total cost for various order sizes (that is
still a feasible EOQ)
▪ EPQ models used to determine production lot size.
• Used when producing and depleting items at same
time
• Trade-off between carrying and setup costs
• Consider production and usage rate 81
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Review: Inventory Models

▪ ROP (reorder point)
• Determines at what quantity (when) to re-order
• Consider expected demand during lead time and safety stock
• Trade-off cost of carrying safety stock & risk of stockout
▪ Fixed Order Interval Model
• Used when orders placed at fixed time intervals – determine how
much to order
• Used widely for retail
• Consider expected demand during lead time, safety stock, and
amount on hand
• Demand or lead time can be variable
• Need more safety stock, but not continuous monitoring
▪ Single-Period Model
• Determines at what quantity (when) to re-order
• Used when can’t carry goods to next period (e.g.. perishables)
• Trade-off cost of shortages & of excess (wasted) inventory 82
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41
 Chapter Summary
▪ Inventory is any unused material or product, usually stored in a
warehouse.
• Holding costs include storage and opportunity cost of money
tied up in inventory
• Efficient use of inventory measured by inventory turnover
ratio
▪ Inventories serve to meet seasonal demand, decouple
operations, protect against stock-out, and allow economic lot
size or quantity discounts.
▪ Successful inventory management requires safe keeping &
handling, a system to track inventory, accurate information
about demand and lead times, realistic estimates of inventory
costs, and a priority system for classifying the items in inventory
and allocating control efforts (the A-B-C Classification).
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Chapter Summary
▪ EOQ models determine how much to order.
• Types: basic EOQ, economic production quantity,
quantity discounts, and planned shortages models
▪ ROP models determine when to order (inventory
position), even if demand and/or lead time varies.
• Consider service level (probability of not stocking out)
& safety stock
▪ Fixed order interval/order-up-to level and single period
models.
▪ Other models include economic production quantity,
quantity discount and planned shortage models.

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 Chapter Summary
▪ Two types of service level are lead time and annual (fill
rate) service levels
▪ Multi-echelon inventory management is management of
inventory across various organization in a supply chain.
• Methods: multi-echelon control, DRP, inventory
optimization
▪ The formulas presented in this chapter are summarized
in Table 12-5

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Learning Checklist
 Discuss the importance of inventory, list major reasons
for holding inventories.
 Discuss the objectives of inventory management.
 List the main requirements for effective inventory
management.
 Describe the A-B-C approach and perform it.
 Describe Basic Inventory Control Systems.
 Be able to describe and solve problems using:
 EOQ, EPQ, ROP, Quantity discount, planned shortage
 Fixed Order Interval Model, Single Period Model
 Discuss multi-echelon inventory management
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