Managing
INVENTORY
1
Inventory System
• Inventory is the stock of any item or resource used in an
organization and can include: raw materials, finished
products, component parts, supplies, and work-in-process
• An inventory system is the set of policies and controls that
monitor levels of inventory and determines what levels
should be maintained, when stock should be replenished, and
how large orders should be
• Inventory planning of items must address the following two
key questions:
• How much?
• When?
2
Set-up Cost
• Small tap Input Flow
• Medium tap of Materials
• Big tap
Inventory
Shortage Cost Levels
Holding Cost
Demand>Supply
• Small Vessel
• Medium Vessel
• Big Vessel
Output Flow
of Materials Scrap Flow
3
Another Example
2.5 Kgs/7 days 120 Kgs
Ordering Ordering
52 times * Rs 50 per delivery 1 time * Rs 200 per delivery
= Rs 2600 = Rs 200
Holding
Holding 150 KG CONTAINER
5 KG CONTAINER Rs 1000
Rs 250 Maintenance Cost (Rs 200)
Probability of Scrap (Low) Probability of Scrap (High)
120Kgs/Year
??
4
Inventory Costs
• Holding (or carrying) costs
• Costs for storage, handling, insurance, etc
• Setup (or production change) costs
• Costs for arranging specific equipment setups, etc
• Ordering costs
• Costs of someone placing an order, etc
• Shortage costs
• Costs of canceling an order, etc
5
Inventory Management
Having the
At the At the
RIGHT RIGHT RIGHT
STOCK TIME PLACE
(amount)
RECORD KEEPING FLOW OF GOODS
Types of Inventory
Raw Partially Goods in
Material & Completed Finished Replacement
transit
Goods Parts, Tools &
Purchased Goods or Inventories Supplies to warehouse &
Parts WIP customers
6
Types of Inventory
• Cyclic Inventory: Periodic replenishment causes
cyclic inventory
• Seasonal Inventory: Seasonality in demand is
absorbed using inventory
• Pipeline Inventory: Exists due to lead time
• Safety Stock: Used to absorb fluctuations in
demand due to uncertainty
7
Inventory Control Systems
• Continuous system (fixed-
order-quantity)
• constant amount ordered
when inventory declines to
predetermined level
• Periodic system (fixed-time-
period)
• order placed for variable
amount after fixed passage of
time
8
Continuous system (fixed-
order-quantity): EOQ
Model
9
Economic Order Quantity Model (1)
Max = Q
Daily Consumption Rate
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑃𝑒𝑟𝑖𝑜𝑑
Inventory Replenished
Inventory Level
Reorder Point Reorder Point
Cycle 1 Cycle 2 ….Cycle N
Min = 0 Lead Time
Lead Time Time
Holding Cost Ordering Cost
= Average Quantity in storage × Cost of storing a unit = No. of Order × Ordering Cost of Each Order
𝑄 𝐷
Holding Cost = 𝐻 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 10 𝑂
2 𝑄
Economic Order Quantity Model (2)
Annual Ordering Cost ↑ Annual Holding Cost ↑
Annual Holding Cost↓ Annual Ordering Cost↓
Ordering Cost > Holding Cost Holding Cost > Ordering Cost
Annual Total Cost ↑ Annual Total Cost ↑
Annual Cost
𝑄 𝐷
𝐻= 𝑂
2 𝑄
Holding Cost = Ordering Cost
Annual Total Cost ↓
(lowest)
Economic Order Quantity (EOQ)
11
* Constant in Monetary Terms, # Variable in Monetary Terms Order Quantity
EOQ or 𝑸𝒐𝒑𝒕
𝑄 𝐷 2𝐷𝑂
2
𝐻= 𝑂
𝑄 →𝑄 = 𝐻
2
2𝐷𝑂
→𝑄𝑂𝑝𝑡 = 𝐻
12
• HOW MUCH TO ORDER Q*
• WHEN TO ORDER R
• REORDER POINT : THE REORDER POINT IS
THE LEVEL OF INVENTORY AT WHICH A NEW
ORDER SHOULD BE PLACED.
• THE REORDER POINT FOR OUR BASIC EOQ
MODEL WITH CONSTANT DEMAND AND A
CONSTANT LEAD TIME TO RECEIVE AN
ORDER IS EQUAL TO THE AMOUNT
DEMANDED DURING THE LEAD TIME,
• R = d. L
• WHERE d = demand rate / period & L = Lead time
Lokesh Vijayvargy, JIM Jaipur 13
EOQ Model (If Supplier Reliability =100%)
Max = EOQ
Daily Consumption Rate
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑃𝑒𝑟𝑖𝑜𝑑
Inventory Replenished
Inventory Level
Reorder Point Reorder Point
Cycle 1 Cycle 2 ….Cycle N
Place Receive Place Receive
Order Order Order Order
Min = 0 Lead Time Lead Time Time
14
• EXAMPLE : IF THE ANNUAL DEMAND OF
AN ITEM IS 10000 UNITS AND THE LEAD
TIME TO RECEIVE AN ORDER IS 10 DAYS,
DETERMINE THE RE-ORDER POINT.
• Solution: R = dL = (10000/365)*10
• WHEN THE INVENTORY LEVEL FALLS TO
274, A NEW ORDER IS PLACED. RE-ORDER
POINT IS NOT RELATED TO OPTIMAL
ORDER QUANTITY OR ANY OF THE
INVENTORY COSTS.
Lokesh Vijayvargy, JIM Jaipur 15
REORDER POINT WITH VARIABLE DEMAND:
Q
INVENTORY LEVEL
R
REORDER
POINT
LT LT
TIME
INVENTORY LEVEL
Q
R
SAFETY
Q STOCK
LT LT
TIME
Lokesh Vijayvargy, JIM Jaipur 16
Safety Stock (If Supplier Reliability < 100%)
Max = EOQ +Safety Stock
Daily Consumption Rate
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑃𝑒𝑟𝑖𝑜𝑑
Inventory Replenished
Inventory Level
Reorder Point Reorder Point
Safety Stock
Place Receive Place Receive
Order Order Order Order
17
Min = 0 Lead Time Lead Time Time
• SAFETY STOCKS: REALISTICALLY,
DEMAND-AND, LEAD TIME ARE
UNCERTAIN. THE INVENTORY LEVEL
MIGHT BE DEPLETED AT A SLOWER OR
FASTER RATE DURING LEAD TIME.
• STOCK OUT: A STOCKOUT IS AN
INVENTORY SHORTAGE.
• SAFETY STOCK: IS A BUFFER ADDED TO
THE INVENTORY ON HAND DURING
LEAD TIME.
Lokesh Vijayvargy, JIM Jaipur 18
Re-Order Point and Safety Stock
Expected
Reorder Point = Demand + Safety Stock
during Lead (Probabilistic)
Time
𝑅 = 𝑑ҧ 𝐿 + z𝜎𝐿
or
𝑅 = 𝑑ҧ 𝐿 + z𝜎𝐿 x 𝐿
(IN SPECIAL CASES STANDARD ERROR)
19
Practice Sum 1
ELECTRONIX STOCKS AND SELLS PC’S. IT COSTS
RS.2500 EACH TIME IT PLACES AN ORDER WITH THE
MANUFACTURER. ANNUAL COST OF CARRYING THE
PC’S IN INVENTORY IS RS.180. THE STORE MANAGER
ESTIMATES THAT THE ANNUAL DEMAND FOR THE PC’S
WILL BE 200 UNITS. DETERMINE THE OPTIMAL ORDER
QUANTITY AND THE TOTAL MINIMUM INVENTORY
COSTS.
Q* =
TC* =
NO. OF ORDERS / YEAR =
ORDER CYCLE TIME =
20
Practice Sum 2 – EOQ
A distributor of large appliances need to determine the order
quantities and reorder points for the various products it carries. The
following data refer to a specific refrigerator in its product line.
▪ Annual Demand = 500 Units
▪ Cost to Place an Order: $100
▪ Holding Cost: 20% of Product Cost per Year
▪ Cost of Refrigerator: $ 500 Each
▪ Standard Deviation of Demand during Lead time: 10 Refrigerators
▪ Lead Time: 7 days
Consider an Even Daily Demand and a 365-day Year.
(a) What is the Economic Order Quantity?
(b) If a distributor wants 97 percent service probability, what reorder
point R should be used? 21
Case Facts
• Item (Refrigerator) Cost = $500
• Order Cost = $ 100
• Annual Holding Cost = 20% of Item Cost
• Annual Demand (365 days) = 500 units
• Average Demand = 1.37 units per day
• Standard Deviation of weekly demand = 10 units during lead time
• Lead time = 7 days
• Service Probability = 97%
Confidence Level Z- Value
90% 1.28
95% 1.64
96% 1.75
97% 1.88
98% 2.05
99% 2.33 22
Solution (a)
(a) What is the Economic Order Quantity?
Economic Order Quantity
2 𝐷𝑂
𝑄𝑜𝑝𝑡 =
𝐻
2 × 500 𝑢𝑛𝑖𝑡 × $100
𝑄𝑜𝑝𝑡 =
.20 ($500)
𝑸𝒐𝒑𝒕 = 31.62 ≅ 𝟑𝟐 𝒖𝒏𝒊𝒕𝒔
23
Solution (b)
(b) If the distributor wants a 97% service probability, what reorder
point, R should be used?
Expected
Reorder Point = Demand + Safety Stock
during Lead
Time
𝑅 = 𝑑ҧ 𝐿 + z𝜎𝐿
1.37 𝑢𝑛𝑖𝑡𝑠
𝑅= ( × 7 𝑑𝑎𝑦)+ (1.88 × 10 units)
𝑑𝑎𝑦
𝑅 = 28.39 ≅ 𝟐𝟗 𝒖𝒏𝒊𝒕𝒔
24
Economic Order Quantity Model (1)
Supplier Reliability is 100%
MAX = 32 MAX = 32 Reorder point = Demand during Lead
Daily Consumption Rate Time
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑅 = 𝑑ҧ 𝐿
𝑃𝑒𝑟𝑖𝑜𝑑
1.37 Units
Inventory Level
Inventory Replenished
Reorder Point
Reorder Point
Q = 10
Cycle 1 Cycle 2 ….Cycle 16
Min = 0 Lead Time
Lead Time Time
1 Week
25
Economic Order Quantity Model (1)
Supplier Reliability is 97%
Max = 51 MAX = 51
EOQ = 32 EOQ = 32 Reorder point = Demand during Lead
Daily Consumption Rate Time + Safety Stock
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 R = 𝑑ҧ 𝐿 + z𝜎𝐿
𝑃𝑒𝑟𝑖𝑜𝑑
1.37 Units
Inventory Level
Inventory Replenished
Q = 29 Reorder Point
Reorder Point
Cycle 1 Cycle 2 ….Cycle 16
Min = 0 Lead Time
Lead Time Time
1 Week
26
Safety Stock = 19 Units (Initial One –Time)
Practice Sum 3 – EOQ & Discounting
Given the following information, formulate an inventory
management system. The item is demanded 50 weeks a year
Item Cost $ 10.00 Standard deviation of 25 Units per Week
Order Cost $ 250.00 weekly demand
Annual Holding Cost (%) 33% of Item Cost Lead Time 1 Week
Annual Demand 25750 Units Service Probability 95%
Average Demand 515 per week
a) State the order quantity and reorder point.
b) Determine the annual holding and order costs.
c) If a price break of $ 50 per order was offered for purchase
quantities of over 2000, would you take advantage of it? How
much would you save annually? 27
Case Facts
• Item Cost = $10
• Order Cost = $ 250
• Annual Holding Cost = 33% of Item Cost
• Annual Demand (50 weeks) = 25750 units
• Average Demand = 515 units per week
• Standard Deviation of weekly demand = 25 units per week
• Lead time = 1 week
• Service Probability = 95%
Confidence Level Z- Value
90% 1.28
95% 1.64
96% 1.75
97% 1.88
98% 2.05
99% 2.33 28
Solution (a)
(a) State the order quantity and reorder point
Economic Order Quantity
2 𝐷𝑆
𝑄𝑜𝑝𝑡 =
𝐻
2 × 25750 𝑢𝑛𝑖𝑡𝑠 × $ 250
𝑄𝑜𝑝𝑡 =
.33 ($ 10)
𝑸𝒐𝒑𝒕 = 1975.23 ≅ 𝟏𝟗𝟕𝟔 𝒖𝒏𝒊𝒕𝒔
29
Solution (a)
(a) State the order quantity and reorder point
Expected
Reorder Point = Demand + Safety Stock
during Lead
Time
𝑅 = 𝑑ҧ 𝐿 + z𝜎𝐿
515 𝑢𝑛𝑖𝑡𝑠
𝑅= ( × 1 week)+ (1.64 × 25 units)
𝑤𝑒𝑒𝑘
𝑅 = 556 units
30
Solution (b)
(b) Determine the annual holding and order costs
Annual Holding Cost
𝑄
Yearly Holding Cost = H
2
1976
Yearly Holding Cost = × (0.33 × $ 10)
2
Total Cost =
Yearly Holding Cost = $ 3260.4
$3260.4 + $3257.8
Annual Ordering Cost
𝐷 = $6518.2
Yearly Ordering Cost = O
𝑄
25750
Yearly Ordering Cost = × ($ 250)
1976
Yearly Ordering Cost = $ 3257.8 31
Solution (c)
(c) If a price break of $ 50 per order was offered for purchased
quantities above 2000, would you take advantage of it. How much
would you save annually?
Annual Holding Cost
𝑄
Total Cost =
Yearly Holding Cost = H
2
Yearly Holding Cost =
2000
× (0.33 × $10) $3300 + $2575
2
Yearly Holding Cost = $ 3300
= $5875
Annual Ordering Cost
𝐷 Total Saving =
Yearly Ordering Cost = O
𝑄
25750
Yearly Ordering Cost =
2000
× ($200) $6518.2 - $5875
Yearly Ordering Cost = $ 2575
= $643.2 32
EOQ with Quantity Discounts
Price per unit decreases as order quantity increases
TC = DO + QH + PD
Q 2
where
P = per unit price of the item
D = annual demand
Lokesh Vijayvargy, JIM Jaipur 33
Quantity Discount: Example
QUANTITY PRICE
O = Rs. 2,500
1 – 49 1,400 H = Rs. 190 per computer
50 - 89 1,100 D = 200
90+ 900
2DO 2(2500)(200)
Qopt = = = 72.5 PCs
H 190
For Q = 72.5 HQopt
DO
TC = + + PD = Rs.233,784
Qopt 2
For Q = 90 HQ
DO
TC = + + PD = Rs. 194,105
Q 2
Lokesh Vijayvargy, JIM Jaipur 34
Practice Sum 4
“Aenroon Batteries” manufactures automotive batteries and require
large quantity of lead metal. The annual demand of lead metal
required for manufacturing batteries is 10000 Kg. The price of lead is
$160 per Kg, the ordering cost is $200 per order and carry cost is 10%
of the unit price (i.e. per Kg) per year. The Lead time is 3 days. The
company operates for 250 days in a year. The standard deviation of
demand during the lead time is 20 units and the company wish to
have a 95% confidence for stock i.e. only in 5% cases stock out is
permitted.
a) Find out Economic Order Quantity, Reorder Point, and
Total Cost of Inventory (including stock value, ordering
and holding cost).
b) If discount of $ 10 per KG of Lead Metal is offered if the
order is placed in quantities of 700 KG or more, then
what should be your decision. 35
Case Facts
• Order Cost = $ 200
• Annual Holding Cost = 10% of Item Cost (per Kg)
• Annual Demand = 10000 Kg
• Days Operating = 250 Days per year
• Average Demand per Day = 10000/250 = 40 Kg per Day
• Lead Time = 3 Days
• Standard Deviation during Lead Time = 20 Units
• Service Level = 95%
• Unit Cost =
Quantity Price
< 700 Kg $ 160 per Kg
> 700 Kg $ 150 per Kg
36
Solution (a)
(a) State the order quantity and reorder point
Economic Order Quantity
2 𝐷𝑆
𝑄𝑜𝑝𝑡 =
𝐻
2 × 10000 𝐾𝑔 × $ 200
𝑄𝑜𝑝𝑡 =
.10 ($ 160)
𝑸𝒐𝒑𝒕 ≅ 𝟓𝟎𝟎 𝒖𝒏𝒊𝒕𝒔
37
Solution (a)
(a) State the reorder point
Expected
Reorder Point = Demand + Safety Stock
during Lead
Time
𝑅 = 𝑑ҧ 𝐿 + z𝜎𝐿
40 𝐾𝐺
𝑅= ( × 3 days)+ (1.64 × 20KG)
𝑑𝑎𝑦
𝑅 = 152.8 KG ≅ 153 KG 38
Solution (a)
(a) State the Total Cost (When EOQ i.e Q = 500)
Annual Annual Annual
Total
Cost = Purchase + Ordering + Holding
Cost Cost Cost
𝐷 𝑄
Total Cost = DC + S + 𝐻
𝑄 2
10000 500
Total Cost = (10000 X 160 ) +
500
X 200 +
2
X 16
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕 𝑬𝑶𝑸=𝟓𝟎𝟎 = $ 1608000
39
Solution (b) – Discounting Model
(a) State the Total Cost (When Q = 700)
Annual Annual Annual
Total
Cost = Purchase + Ordering + Holding
Cost Cost Cost
𝐷 𝑄
Total Cost = DC + S + 𝐻
𝑄 2
10000 700
Total Cost = ( 10000 X 150) +
700
X 200 +
2
X 15
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕 𝑬𝑶𝑸=𝟕𝟎𝟎 = $ 1555357.14
Total Savings = $1608000 - $ 1555357.14
= $52642.86 40
Selective Control of Inventories
Alternative Classification Schemes
• ABC Classification (on the basis of consumption value)
• XYZ Classification (on the basis of unit cost of the item)
• High Unit cost (X Class item)
• Medium Unit cost (Y Class item)
• Low unit cost (Z Class item)
• FSN Classification (on the basis of movement of inventory)
• Fast Moving
• Slow Moving
• Non-moving
• VED Classification (on the basis of criticality of items)
• Vital
• Essential
• Desirable
• On the basis of sources of supply
• Imported
• Indigenous (National Suppliers)
• Indigenous (Local Suppliers) 41
Inventory Control Tool – ABC Analysis
▪ Optimized holding of Inventory
(or Stock) to be used in a Process.
▪ Based on Pareto Law (80:20 Rule).
Materials
▪ In any Large Group, there are
“Significant Few” and
“Insignificant Many”.
A B
Moderate
C
Most Important Least Important
Important
% of Number of 10-15% 20-30% 70%
Inventory Items
% of Value of 70-80% 15-20% 5-10%
Inventory Items
42
Visual Depiction – ABC Analysis (& Salient Features)
100
A B C
Approximate
Accurate Forecast No Forecast
Forecast
% of Value of Inventory Value
70
Junior
Senior Level Middle Level Level
Involvement Involvement Involvement
Strict Degree of Moderate Degree of Relaxed Degree
A Control Control of Control
20
10 B
C
0 10 30 100
43
% of Value of Inventory Items
ABC Classification: Example
Indian Products, Inc., is having a problem trying to control inventory. There is
insufficient time to devote to all its items equally. Here is a sample of some items
stocked, along with the annual usage of each item expressed in dollar volume.
PART UNIT COST ANNUAL USAGE
1 $ 60 90
2 350 40
3 30 130
4 80 60
5 30 100
6 20 180
7 10 170
8 320 50
9 510 60
10 20 120
44
ABC Classification: Example
(cont.)
TOTAL
PART % OFUNIT
TOTAL
COST % OF TOTAL
ANNUAL USAGE
PART VALUE VALUE QUANTITY % CUMMULATIVE
9 1
$30,600 35.9$ 60 6.0 90 6.0
8 2
16,000 18.7350 5.0 40 11.0
2 3
14,000 16.4 30 4.0
A130 15.0
4 80 60
1 5,400 6.3 9.0 24.0
5 30 100
4 4,800
6 5.6 20 6.0 B180 30.0
3 3,900
7 4.6 10 10.0 170 40.0
6 3,600
8 4.2320 % OF TOTAL
18.0 % OF TOTAL
58.0
50QUANTITY
CLASS ITEMS VALUE
5 3,000
9 3.5510 13.0 60 71.0
10 2,400
10
A 9, 8, 2.8
2 20 12.0
71.0 C120 15.0
83.0
7 1,700
B 1, 4, 2.0
3 17.0
16.5 100.0
25.0
C
$85,400 6, 5, 10, 7 12.5 60.0
Example 10.1
45
46