CHAPTER 7.
0: INVENTORY CONTROL
Content Page
7.1 Introduction 1
7.2 Types of Demand 1
7.3 Types of Inventory 1
7.4 ABC Analysis 2
7.5 Holding, Ordering and Setup Costs 4
7.6 Inventory Models for Independent Demand
7.6.1 Economic Order Quantity model 5
7.6.2 Production Order Quantity model 9
7.6.3 Quantity Discount model 12
7.7 Conclusion 15
7.1 Introduction
Inventory is a stock of items kept by an organization to meet internal or external customer
demand. This chapter review the basic elements of traditional inventory control and discuss several of
the more popular models and techniques for making cost-effective inventory decisions. These
decisions are basically how much to order and when to order to replenish inventory to an optimal level.
Inventory control is a planned approach of determining what to order, when to order and how
much to order and how much to stock that costs associated with buying and storing are optimal
without interrupting production and sales. These questions are answered by the use of inventory
models. The scientific inventory control systems strikes the balance between the loss due to non-
availability of an item and cost of carrying the stock item. Scientific inventory control aims at
maintaining optimum level of stock of goods required by the company at minimum cost to the
company.
Generally, the reasons for keeping inventories are to:
a. Stabilise production
b. Take advantage of price discounts
c. Meet the demand during the replenishment period
d. Prevent loss of orders
e. Keep pace with changing market conditions
7.2 Types of Demand
In general, the demand for items in inventory is either dependent or independent. Dependent
demand items are normally component parts or materials used in the process of producing a final
product. If a motorcycle company plans to produce 2,000 new motorcycles, then it will need 4,000
wheels and tires. The demand for wheels is dependent on the production of motorcycles--the demand
for one item depends on demand for another item. Motorcycles are an example of an independent
demand item. Independent demand items are finished products that are not function of, or dependent
upon, internal production activity.
7.3 Types of Inventory
Most people think of inventory as a final product waiting to be sold to a retail customer.
However, especially in a manufacturing firm, inventory can take on forms besides finished products,
including, raw materials, purchased parts and supplies, labor, WIP parts, component parts, tools,
machinery, and equipment.
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Usually, there are five types of inventory:
a. Raw Material: Materials that are usually purchased but have yet to enter the manufacturing
process
b. Work in process (WIP): Incomplete products or items of products that are no longer
considered raw material but have yet to become finished products.
c. Maintenance, repair and operating materials: Inventories that supplies necessary to keep
machinery and process/operations work.
d. Finished Items: End item/products ready to be sold, but still an asset for the organizations.
e. Miscellaneous inventories: example the office stationeries and other consumable stores.
7.4 ABC Analysis
ABC Analysis is a method for dividing on-hand inventory into three classifications based on
currency volume. ABC analysis is an inventory application of what is known as the Pareto Principle.
The idea is to establish inventory policies that focus resources on the few critical inventory parts and
not the many trivial ones. Typically a company, especially in manufacturing, holds thousands of
independent demand items in inventory but a small percentage is of such a high value to warrant close
inventory control.
In general, about 10% to 20% of all inventory items account for 70% to 80% of the total value
of inventory. These are classified as A, or Class A, items. B items represent approximately 25% to
30% of total inventory units but only about 10% to 20% of total inventory value. C items generally
account for 40% to 60% of all inventory units but represent only 5% to 10% of total value. Table 7.1
shows the percentage of total quantity and total value for each class.
Table 7.1: Percentage of total quantity and total value
Class % of Total Quantity % of Total Value
A 10 – 20 70 – 80
B 25 – 30 10 – 20
C 40 – 60 5 – 10
In ABC analysis each class of inventory requires different levels of inventory control--the
higher the value of the inventory, the tighter the control. Class A items should experience tight
inventory control (because they represent such a large percentage of the total value of inventory); B
and C require more relaxed (perhaps minimal) attention.
7.4.1 Procedure for making ABC analysis
1. Calculate the total inventory value for each item held in inventory by multiplying the number of
units used in a year by its unit price.
2. Rank these items in descending order of their values placing first the item having the highest
total value and so on.
3. Compute the cumulative percentage for the item count and cumulative annual usage value.
4. Classify the items as per the norms for ABC items.
5. The cumulative percentages are represented graphically as in Figure 7.1
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Figure 7.1: Graph from ABC Analysis
Example:
The maintenance department for a manufacturing firm has responsibility for maintaining an inventory
of spare parts for the machinery it services. The parts inventory, unit cost, and annual usage are
shown in table A. The department manager wants to classify the inventory parts according to the ABC
system to determine which stocks of parts should most closely be monitored.
Item Unit Cost (RM) Annual Usage (unit)
A 154.00 500
B 12.50 1000
C 42.86 350
D 0.60 250
E 17.00 1550
F 0.42 1200
G 14.17 600
H 90.00 1000
I 0.60 2000
J 8.50 100
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Solution:
First rank the items according to their total value and also compute each item's percentage of total
value and quantity.
Item Unit Cost (RM) x Annual usage Rank
A 154.00 x 500 = 77 000 2
B 12.50 x 1000 = 12 500 5
C 42.86 x 350 = 15 001 4
D 0.60 x 250 = 150 10
E 17.00 x 1550 = 26 350 3
F 0.42 x 1200 = 504 9
G 14.17 x 600 = 8 502 6
H 90.00 x 1000 = 90 000 1
I 0.60 x 2000 = 1 200 7
J 8.50 x 100 = 850 8
Then, the annual usage value in descending order is written:
Item Annual Cumulative Usage Value Cumulative Class
usage value Annual (%) Usage Value (%)
H 90 000 90 000 38.8 38.8 A
A 77 000 167 000 33.2 72 A
E 26 350 193 350 11.3 83.3 B
C 15 001 208 351 6.4 89.7 B
B 12 500 220 851 5.4 95.1 B
G 8 502 229 353 3.7 98.8 C
I 1 200 230 553 0.5 99.3 C
J 850 231 403 0.4 99.7 C
F 504 231 907 0.2 99.9 C
D 150 232 057 0.1 100 C
Based on simple observation, it appears that the first two items form a group with the highest value,
the next three items form a second group, and the last five items constitute a group. Thus, the ABC
classification for these items is as follows:
Class Items % of total value % of Total Quantity
A H, A 72 17.5
B E, C, B 23 34.0
C G, I, J, F, D 5 48.5
7.5 Holding, Ordering and Setup Costs
There are 3 costs that involved in the inventory analysis:
a. Holding Costs: The cost to keep or carry inventory in stock
b. Ordering Costs: The cost of the ordering process
c. Setup Costs: The cost to prepare a machine or process for production
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7.6 Inventory Models for Independent Demand
The three inventory models are:
a. Economic Order Quantity model (EOQ)
b. Production Order Quantity model (POQ)
c. Quantity Discount model (QD)
Inventory Control – Terminology:
a. Demand: It is number of items required per unit of time. The demand may be either
deterministic or probabilistic in nature.
b. Order cycle: The time period between two successive orders.
c. Lead Time: The length of time between placing an order and receipt of items.
d. Safety stock: It is also called buffer stock or minimum stock.
7.6.1 Economic Order Quantity
The Economic Order Quantity (EOQ) model is a formula for determining the optimal order size
that minimizes the sum of carrying costs and ordering costs. The model formula is derived under a set
of simplifying and restrictive assumptions, as
a. Demand is known, constant and independent
b. Lead time is known and constant
c. The order arrives in one batch at one time
d. Quantity discounts are not possible
e. Only setup and holding cost involved in setting up or placing an order
Figure 7.2: The EOQ Cost Model
Figure 7.2 shows a graph of total costs as a function of the order quantity, Q. The optimal
order size, Q*, will be the quantity that minimizes the total costs. The Q* point occurs at the point
where the ordering cost curve and the holding cost curve intersect, where the total setup/order
costs is equal to the holding cost.
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Then, with this fact to develop equations that solve directly Q* using the following variables,
Q = Number of pieces per order
Q* = Optimum number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
The steps to solve Q* are:
1. Develop an expression for setup/ordering cost (Annual setup cost).
2. Develop an expression for holding costs (Annual holding cost).
3. Set setup cost equal to holding costs
4. Solve the equation for the Q*.
1. Annual setup cost:
Annual setup cost = (Number of orders placed per year) x (Setup or order cost per order)
Anual demand
= x (Setup or order cost per order)
Number of units in each order
D D
= X (S ) = S
Q Q
2. Annual Holding Cost
Annual holding cost = (Average inventory level) x (Holding cost per unit per year)
Order quantity
= x (Holding cost per unit per year)
2
Q Q
= X (H ) = H
2 2
3. Optimal order quantity is found when annual setup cost equals annual holding cost,
Annual setup cost = Annual holding cost
D Q
S= H
Q 2
4. Solve Q*
D Q
S= H
Q 2
2 DS = Q 2 H
2 DS
Q2 =
H
2 DS
Q* =
H
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The expected number of orders placed during the year (N) and the expected time between orders (T)
can be determine as follows:
Demand D
Expected number of orders = N = =
Order quantity Q*
Number of working days per year
Expected time between orders = T =
N
The total annual inventory cost is the sum of setup cost and holding cost:
Total annual cost = Setup cost + Holding cost
D Q
TC = S+ H
Q 2
Example:
The annual requirement of an item is 2000 unit. The holding costs amounts RM0.50 per unit per year
and the ordering cost is RM 20 per order. Find
i) Economic Order Quantity
ii) Optimum number of orders per year
iii) Expected time between orders (assume 250 working year)
iv) The total cost
Solution:
i) Economic Order Quantity, Q*
2 DS
Q* =
H
2(2000)(20)
=
0.5
= 400 units
ii) Optimum number of orders per year, N
D 1000
N= = = 5 orders per year
Q 400
iii) Expected time between orders, T = (Number of working days per year)
N
= 250 / 5
= 50 days
iv) The total cost, TC
D Q
TC = S+ H
Q 2
2000 400
= (20) + (0.5)
400 2
= RM 200
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Reorder Point
Simple inventory models assume that:
a. A firm will place an order when the inventory level for that particular item reaches zero.
b. It will receive the ordered items immediately
However, the time between placement and receipt of an order, called lead time, or delivery time,
can be as short as a few hours or as long as months. Thus, the when to order decision is usually
expressed in terms of a reorder point (ROP) – the inventory level at which an order should be placed.
The reorder point (ROP) is given as:
ROP = (Demand per day) (Lead time for a new order in days)
=dxL
where, d = D .
Number of working days in a year
Figure 7.3: The Inventory Order Cycle
Example:
Titanium Assembly, has a demand for 6000 watch per year. The firm operates a 250 day working year.
On average, delivery of an order takes 2 working days. Calculate the Reorder point.
Solution:
d= D . = 6000
Number of working days in a year 250
= 24 units
ROP = d x L = 24 x 2 = 48 units
Thus, when inventory stock drops to 48, an order should be placed. The order will arrive 2 days
later, just as the firm’s stock is depleted.
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7.6.2 Production Order Quantity model
This model is applicable when inventory continuously builds up over a period of time after
placing an order or when the units are manufactured and used at constant rate. The order quantity is
received gradually over time, and the inventory level is depleted at the same time it is being
replenished. This situation is most commonly found when the inventory user is also the producer, as in
a manufacturing operation where a part is produced to use in a larger assembly. This situation also
can occur when orders are delivered gradually over time or when the retailer is also the producer.
Figure 7.4: The Production Order Quantity model
The Production Order Quantity model is shown graphically in Figure 7.4. The inventory level
is gradually replenished as an order is received. In the basic EOQ model, average inventory was half
the maximum inventory level, or Q/2, but in this model variation, the maximum inventory level is not
simply Q; it is an amount somewhat lower than Q, adjusted for the fact the order quantity is depleted
during the order receipt period.
In order to determine the average inventory level, we define the following parameters unique
to this model:
p = daily rate at which the order is received over time, also known as the production rate
d = the daily rate at which inventory is demanded
The demand rate cannot exceed the production rate, since we are still assuming that no
shortages are possible, and, if d = p, there is no order size, since items are used as fast as they are
produced. For this model the production rate must exceed the demand rate, or p > d.
Observing Figure 7.4, the time required to receive an order is the order quantity divided by the
rate at which the order is received, or Q/p. For example, if the order size is 100 units and the
production rate, p, is 20 units per day, the order will be received in 5 days. The amount of inventory
that will be depleted or used up during this time period is determined by multiplying by the demand
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rate: (Q/p)d. For example, if it takes 5 days to receive the order and during this time inventory is
depleted at the rate of 2 units per day, then 10 units are used. As a result, the maximum amount of
inventory on hand is the order size minus the amount depleted during the receipt period, computed as
Q
Maximum inventory level = Q − d
p
= Q (1 − d / p )
Since this is the maximum inventory level, the average inventory level is determined by dividing this
amount by 2:
Q
Average inventory level = (1 − d / p)
2
The total carrying cost using this function for average inventory is
Q
Total carrying cost = Hx (1 − d / p )
2
Thus the total annual inventory cost is determined according to the following formula:
D Q
TC = xS + Hx (1 − d / p )
Q 2
Solving this function for the optimal value Q*, set the first derivative equal to zero:
dTC D 1
= − 2 S + H (1 − d / p )
dQ Q 2
2 DS
Q* =
H (1 − d / p )
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Example:
Assume that the GG Outlet Store has its own manufacturing facility in which it produces carpet. The
ordering cost, S = RM150, is the cost of setting up the production process to make carpet. Recall H =
RM0.75 per meter and D = 10,000 meter per year. The manufacturing facility operates the same days
the store is open (311 days) and produces 150 meter of the carpet per day. Determine the optimal
order size, total inventory cost, the length of time to receive an order, the number of orders per year,
and the maximum inventory level.
Solution:
The optimal order size,
Q* = 2DS
H (1-d/p)
Q* = 2 (10000) 150
0.75 (1- 32.2 / 150)
Q* = 2 256.8 meter
The total cost,
TC = D x S + H x Q (1 – d/p)
Q 2
= 10000 (150) + 0.75 (2256.8) (1 – 32.2 / 150)
2256.8 2
= RM 1329
The length of time to receive an order for this type of manufacturing operation is commonly called the
length of the production run
Production run = Q* / p
= 2256.8 / 150
= 15.05 days per order
Number of production runs, N = D /Q
= 10 000 / 2 256.8
= 4.43 runs per year
Finally the maximum inventory level = Q (1 – d/p)
= 1 772 meter
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7.6.3 Quantity Discount model
A quantity discount is a price discount on an item if predetermined numbers of units are
ordered. When items are brought in large quantities, the supplier often given discounts. Example, the
price will be RM10 per item if you purchase 50, RM 8 per item if you purchase 150, or RM5 per item if
you purchase 300 or more. Many manufacturing companies receive price discounts for ordering
materials and supplies in high volume, and retail stores receive price discounts for ordering
merchandise in large quantities. However, if the item is purchased to take advantage of discount, the
inventory carrying costs will increase.
The basic EOQ model can be used to determine the optimal order size with quantity
discounts; however, the application of the model is slightly altered. The total inventory cost function
must now include the purchase price of the item being ordered:
TC = SD + HQ + PD
Q 2
Where
P = per unit price of item
D = annual demand
Purchase price was not considered as part of our basic EOQ formulation earlier because it
had no impact on the optimal order size. In the preceding formula PD is a constant value that would
not alter the basic shape of the total cost curve; that is, the minimum point on the cost curve would still
be at the same location, corresponding to the same value of Q. Thus, the optimal order size is the
same no matter what the purchase price is. However, when a discount price is available, it is
associated with a specific order size, which may be different from the optimal order size, and the
customer must evaluate the trade-off between possibly higher carrying costs with the discount quantity
versus EOQ cost. As a result, the purchase price does affect the order-size decision when a discount
is available.
The EOQ cost model with constant carrying costs for a pricing schedule with two discounts, d1
and d2, is illustrated in Figure 10.5 for the following discounts:
Order Size Price
0-99 RM10
100-199 RM 8 (d1)
200 above RM 6 (d2)
Notice in Figure 7.5 that the optimal order size, Qopt, is the same regardless of the discount
price. Although the total cost curve decreases with each discount in price (i.e., d1 and d2), since
ordering and carrying cost are constant, the optimal order size, Qopt, does not change.
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Figure 7.5: The Quantity Discount model
The graph in Figure 7.5 reflects the composition of the total cost curve resulting from the
discounts kicking in at two successively higher order quantities. The first segment of the total cost
curve (with no discount) is valid only up to 99 units ordered. Beyond that quantity, the total cost curve
(represented by the topmost dashed line) is meaningless because above 100 units there is a discount
(d1). Between 100 and 199 units the total cost drops down to the middle curve. This middle-level cost
curve is valid only up to 199 units because at 200 units there is another, lower discount (d2). So the
total cost curve has two discrete steps, starting with the original total cost curve, dropping down to the
next level cost curve for the first discount, and finally dropping to the third-level cost curve for the final
discount.
Notice that the optimal order size, Qopt, is feasible only for the middle level of the total cost
curve, TC(d1)--it does not coincide with the top level of the cost curve, TC, or the lowest level, TC(d2).
If the optimal EOQ order size had coincided with the lowest level of the total cost curve, it would have
been the optimal order size for the entire discount price schedule. Since it does not coincide with the
lowest level of the total cost curve, the total cost with Qopt must be compared to the lower-level total
cost using Q(d2) to see which results in the minimum total cost.
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Example:
JJ Store stocks toy racecars. Recently, the store has been given a quantity discount as follows:
Order Size Price
1-49 RM14
50-89 RM 11
90 above RM 9
The annual carrying cost for the store for toy racecars is RM 19, the ordering cost is RM 250,
and annual demand for this particular model is estimated to be 200 units. The JJ Store wants to
determine if it should take advantage of this discount or order the basic EOQ order size.
Solution:
First determine the optimal order size and total cost with the basic EOQ model.
Q* = 2 (200) (250)
19
= 72.5 units
Although we will use Qopt = 72.5 in the subsequent computations, realistically the order size would be
73 computers. This order size is eligible for the first discount of $1,100; therefore, this price is used to
compute total cost:
TC = SD + HQ + PD
Q 2
= 250 (200) + 19 (72.5) + 11 (200)
72.5 2
= RM 3578
Since there is a discount for a larger order size than 50 units (i.e., there is a lower cost curve), this total
cost of RM 3578 must be compared with total cost with an order size of 90 and a discounted price of
RM9:
TC = SD + HQ + PD
Q 2
= 250 (200) + 19 (90) + 9 (200)
90 2
= RM 3211
Since this total cost is lower (RM 3211 < RM3578), the maximum discount price should be taken, and
90 units should be ordered. We know that there is no order size larger than 90 that would result in a
lower cost, since the minimum point on this total cost curve has already been determined to be 73.
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7.7 Conclusion
Inventories are important to all types of organisations. Inventories affect everyday operations
because they must be counted, paid for, used in operations, used to satisfy customers, and managed.
Inventory control and managements involve trade-offs among the conflicting objectives of low
inventory investments, good customer service and high resource utilisation. Order quantity decisions
are guided by a trade off between the cost of holding inventories and the combined costs of ordering,
setup, transportation and purchased material. This chapter also covered ABC analysis. ABC analysis
provides managers to focus on the few significant items that account for the bulk of investment in
inventory. Class A items deserve the most attention, with less attention justified for class B and class C
items. 3 types of inventory model introduced in this chapter. The three inventory models are Economic
Order Quantity model (EOQ), Production Order Quantity model (POQ) and Quantity Discount (QD)
model. Each of these models provides a different set of capabilities and opportunities.
References
1. Chase, Jacobs & Aquilano (2006), Operations Management for Competitive Advantage with
th
Global Cases, 11 Edition, McGraw Hill.
th
2. Jay Heizer, Barry Render (2006), Operations Management, 8 Edition, Prentice Hall
3. Stephen N. Chapman (2006), The Fundamentals of Production Planning and Control, Prentice
Hall.
4. Steven Nahmias (2005), Production and Operations Analysis, 5th Edition, McGraw Hill.
5. William J. Stevenson (2005), Operations Management, 8th Edition, McGraw Hill
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