Chapter 8

Inventory Management

Concept Notes | Key Formulas | Solved Problems

Operations Management

Topics Covered
# Topic Content

1 Types of Inventory 5 types with examples

2 Functions of Inventory 7 key functions

3 Key Terms & Costs D, S, H, Q, LT, P

4 ABC Classification A / B / C system

5 EOQ Model Formula + Solved Problem

6 EPQ Model Formula + Solved Problem

7 Reorder Point (ROP) With safety stock

8 EOQ with Quantity Discounts All-units discount steps

9 Fixed Order Interval (FOI) Formula + Solved Problem

10 Quick Reference All formulas on one page

 1. Types of Inventory
Inventory refers to any stock of goods or materials held for future use in production, sale, or operations.
The five main types are:

Type Description Analogy

Raw Materials & Basic inputs bought from suppliers; not yet used in
Incoming students
Purchased Parts production.

Work in Progress (WIP) Partially completed goods currently being processed. Current students

Completed products ready for sale (manufacturing) or

Finished Goods Graduating students
merchandise (retail).

Replacement Parts, Tools Items used for maintenance and upkeep of

Campus tools
& Supplies equipment.

Goods-in-Transit Items being shipped to warehouses or customers. Students on leave

2. Functions of Inventory
1. Meet Anticipated Demand: Ensures products are available when customers need them.
2. Smooth Production Requirements: Buffers against seasonal or irregular demand fluctuations.
3. Decouple Components of Production-Distribution: Allows each stage to operate independently
without disruption.
4. Protect Against Stock-outs: Safety stock guards against unexpected demand spikes or supply
delays.
5. Take Advantage of Order Cycles: Ordering in bulk reduces per-unit ordering costs.
6. Hedge Against Price Increases / Quantity Discounts: Buying more now at a lower price saves
money in the long run.
7. Permit Operations: Keeps production lines running smoothly without interruption.

3. Key Inventory Terms & Costs

Symbol Term Definition

D Annual Demand Total units demanded per year.

Q Order Quantity Number of units ordered each time.

S Ordering Cost Fixed cost per order (processing, receiving, etc.).

H Holding Cost Annual cost to store one unit (rent, insurance, spoilage).

P Unit Price Purchase price per unit.

LT Lead Time Time elapsed between placing and receiving an order.

p Production Rate Units produced per year (EPQ model).

- Shortage Cost Cost incurred when demand exceeds available inventory.

 4. ABC Classification System
ABC analysis ranks inventory items by importance (= Unit Price x Annual Usage) so that management
effort is concentrated where it matters most.

Class Importance % of Items % of $ Value Control Level

A Most important — high value 5–15% 70–80% Tight / Very frequent review

B Moderately important 30% 15–25% Moderate review

C Least important — low value 50–60% 5–10% Minimal / Periodic review

Tip: Even though A items are few in number, they account for most of the inventory dollar value — so they deserve
the tightest control.
 5. EOQ Model — Economic Order Quantity
The EOQ model finds the order quantity Q* that minimizes the sum of annual holding cost and annual
ordering cost. It assumes a fixed order size with a variable order interval (Fixed-Q, Variable-T model).

Assumptions:
• Single product.
• Annual demand D is known and constant throughout the year.
• Lead time is constant.
• Each order arrives in one complete delivery (no partial receipts).
• No quantity discounts.

Formulas:
Total Cost: TC = (Q/2) x H + (D/Q) x S

Optimal Order Qty: Q* = sqrt( 2DS / H ) [EOQ]

Minimum Total Cost: TC* = sqrt( 2DSH )

Cycle Inventory = Q* / 2

Reorder Interval: T* = Q* / D

Order Frequency: n* = D / Q*

Notation:
Symbol Meaning

D Annual demand (units/year)

S Ordering (setup) cost per order ($)

H Annual holding cost per unit ($/unit/year)

Q Order quantity (units)

Solved Problem — EOQ

Given: D = 12,000 computers/year H = $100/unit/year S = $4,000/order

Step 1 — Q* Q* = sqrt(2 x 12,000 x 4,000 / 100) = sqrt(960,000,000) = 979.8 ~ 980

computers

Step 2 — Cycle Inventory = Q*/2 = 980/2 = 490 units

Step 3 — Reorder Interval T* = 980/12,000 = 0.0817 year ~ 0.98 month ~ 1 month

Step 4 — Order Frequency n* = 12,000/980 = 12.24 orders/year

Step 5 — Minimum TC TC* = sqrt(2 x 12,000 x 4,000 x 100) = sqrt(9,600,000,000) ~
$97,980/year

Key insight: At EOQ, Annual Holding Cost = Annual Ordering Cost. The total-cost curve is U-shaped; deviating from
Q* increases cost, but the curve is flat near the minimum (EOQ is robust).
 6. EPQ Model — Economic Production Quantity
EPQ applies when inventory is replenished gradually during production rather than all at once. The
production rate p must exceed demand rate D.

How it differs from EOQ:

During the production run (length Q/p), inventory builds at rate (p - D). Once production stops, inventory
depletes at rate D until the next run.

Formulas:
Max Inventory = (Q/p)(p - D)

Average Inventory = (1/2)(Q/p)(p - D)

Total Cost = (1/2)(Q/p)(p-D) x H + (D/Q) x S

EPQ = sqrt(2DS/H) x sqrt(p/(p-D)) = EOQ x sqrt(p/(p-D))

Production run length = Q/p

Cycle length = Q/D

Solved Problem — EPQ

Given: D = 12,000/year p = 20,000/year H = $100/unit/year S = $4,000/order

Step 1 — EOQ base EOQ = sqrt(2 x 12,000 x 4,000 / 100) = 979.8

Step 2 — EPQ EPQ = 979.8 x sqrt(20,000 / (20,000 - 12,000)) = 979.8 x sqrt(20,000 /

8,000) = 979.8 x sqrt(2.5) = 979.8 x 1.5811 = 1,549 computers

Step 3 — Max Inventory = (1549/20,000)(20,000 - 12,000) = 0.07745 x 8,000 = 619.6 ~ 620 units

Step 4 — Average = 620/2 = 310 units

Inventory

Step 5 — Total Cost TC = (310)(100) + (12,000/1,549)(4,000) = $31,000 + $30,987 ~

$61,987/year

Step 6 — Production run = Q/p = 1,549/20,000 = 0.0775 year ~ 0.93 month

length

Note: EPQ > EOQ because inventory accumulates gradually, so a larger batch is needed to achieve the same
average stock level.
 7. Reorder Point (ROP)
The ROP is the inventory level at which a new order must be placed so that it arrives just as stock runs out
(or with enough safety stock to cover demand variability during lead time).

Formulas:
Basic ROP (no uncertainty): ROP = d x LT

ROP with Safety Stock: ROP = d x LT + Safety Stock

Safety Stock: SS = z x sigma_dLT

Demand std dev over lead time: sigma_dLT = sigma_d x sqrt(LT)

d = average daily (or weekly) demand

LT = lead time in the same time unit as d

z = z-score for desired service level

sigma_d = std dev of daily demand

Common z-scores:
Service Level z-score

90% 1.28

95% 1.645

99% 2.326

99.9% 3.090

Solved Problem — ROP with Safety Stock

Given: d = 50 units/day LT = 7 days sigma_d = 5 units/day Service Level = 95% (z = 1.645)

Step 1 — sigma_dLT sigma_dLT = 5 x sqrt(7) = 5 x 2.6458 = 13.23 units

Step 2 — Safety Stock SS = 1.645 x 13.23 = 21.76 ~ 22 units

Step 3 — ROP ROP = 50 x 7 + 22 = 350 + 22 = 372 units

Interpretation Place a new order whenever inventory falls to 372 units. This provides a
95% probability that stock will not run out before the order arrives.
 8. EOQ with All-Units Quantity Discounts
When a supplier offers lower prices for larger order quantities, the purchase cost PD must be added to the
total cost.

Total Cost with Purchasing Cost:

TC = (Q/2) x H + (D/Q) x S + P x D

Case A — Constant H: EOQ formula unchanged; check feasibility by bracket.

Case B — Proportional H (H = I x P): EOQ = sqrt( 2DS / (I x P) )

I = inventory holding cost as a fraction of unit price

Step-by-Step Procedure:
1. Start with the lowest price tier.
2. Calculate EOQ using that price (and H = I x P if proportional).
3. Check if the computed EOQ falls within that price bracket.
4. If YES — it is feasible; calculate TC.
5. If NO — use the minimum quantity for that bracket; calculate TC.
6. Repeat for all price tiers.
7. Choose the order quantity with the lowest total TC.

Important: Adding the purchasing cost PD shifts the TC curve down but does NOT change the optimal Q (the
minimum of the variable part stays the same). What changes is which price tier is cheapest overall.
 9. Fixed Order Interval (FOI) Model
In the FOI model, orders are placed at fixed time intervals (e.g., every week), but the order quantity varies
each time to bring inventory up to a target level. This is a Fixed-T, Variable-Q system.

Key difference from EOQ/ROP:

EOQ/ROP monitors inventory continuously and orders a fixed Q when stock hits ROP. FOI checks
inventory only at the review period and orders a variable Q.

Formulas:
Order Quantity: Q = d(OI + LT) + z x sigma_d x sqrt(OI + LT) - I_on_hand

Target Level (T) = d(OI + LT) + SS

Safety Stock: SS = z x sigma_d x sqrt(OI + LT)

OI = Order Interval (fixed review period)

LT = Lead Time

I_on_hand = Current inventory on hand at review time

d = Average demand per period

sigma_d = Std dev of demand per period

Solved Problem — FOI

Given: OI = 30 days LT = 5 days d = 100 units/day sigma_d = 10 units/day Service Level = 90% (z = 1.28)
Current inventory = 500 units

Step 1 — Protection OI + LT = 30 + 5 = 35 days

Period

Step 2 — Expected d x (OI + LT) = 100 x 35 = 3,500 units

Demand

Step 3 — Safety Stock SS = 1.28 x 10 x sqrt(35) = 1.28 x 10 x 5.916 = 75.7 ~ 76 units

Step 4 — Target Level T = 3,500 + 76 = 3,576 units

Step 5 — Order Quantity Q = 3,576 - 500 = 3,076 units

Interpretation Order 3,076 units now. This covers the next 35 days of demand with a
90% service level.
10. Quick Reference — All Formulas
Model / Formula Equation When to Use

Orders received all at once; minimize

EOQ Q* = sqrt(2DS / H)
holding + ordering cost.

Inventory replenished gradually during

EPQ Q* = sqrt(2DS/H) x sqrt(p/(p-D))
production.

Total Cost (EOQ) TC = (Q/2)H + (D/Q)S Annual holding + ordering cost.

Achieved when holding cost = ordering

Min TC at EOQ TC* = sqrt(2DSH)
cost.

ROP (basic) ROP = d x LT No demand uncertainty.

ROP (safety stock) ROP = d x LT + z x sigma_d x sqrt(LT) Covers variability during lead time.

Buffer against demand/supply

Safety Stock SS = z x sigma_dLT
uncertainty.

Q = d(OI+LT) + z x sigma_d x sqrt(OI+LT) -

FOI Order Qty Variable order at fixed time intervals.
I

Add purchase cost when price discounts

TC with Discount TC = (Q/2)H + (D/Q)S + PD
apply.

EPQ (proportional H) EOQ = sqrt(2DS / (IxP)) H is a fraction I of unit price P.

Study Tip: EOQ = EPQ when p is infinite (instant delivery). ROP tells you WHEN to order; EOQ/EPQ tells you HOW
MUCH to order. FOI combines both into a single periodic review.