CHAPTER 5

INVENTORY MANAGEMENT
Inventory management is mainly about specifying locations, size and placement of stocked
goods so as to assure that supply chain activities do not run out of goods or supply

DR. NGUYEN HANG GIANG ANH

 LEARNING OBJECTIVES

• Understand the inventory system

• Describe ABC classification
• Describe the inventory models and its underlying assumptions.
• Analyse the replenishment policies
• Describe the continuous review and periodic review systems.

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 MAIN CONTENT
1. Inventory System

2. Inventory Models

3. Replenishment Policies

4. Vendor Managed Inventory

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1. INVENTORY
SYSTEM

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 STOCK VS. INVENTORY
• Stock consists of all the goods and materials that are held by an
organisation → They are formed whenever the organisation’s inputs or outputs
are not used at the time they become available.
• An inventory is a list of items held in stock.
• The main purpose of stocks is to act as a buffer between supply and
demand → Allow operations to continue smoothly and avoid disruptions.
• Recently, Inventory is used for both the list of items and the stock itself,
and the two terms then become interchangeable.

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INVENTORY SYSTEM

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TYPES OF INVENTORY

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 INVENTORY PROFILE
Inventory (Stock) level

Usage rate Avg.

Order inventory
quantity = Q on hand
(max. inventory
level, lot size) Q
2

Min.
inventory

0
Stock Cycle Time

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 PURPOSE OF INVENTORY

Lead
time

Economies
Why
of scales holding Uncertainty
inventory?

Short
product life
cycle
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 ABC INVENTORY CONTROL SYSTEM
• A useful tool to determine which inventories should be counted more
frequently and managed more closely and which others should not.
• ABC analysis is often combined with the 80/20 rule or Pareto analysis.
– This rule suggests that 80 percent of the objective can be achieved by doing 20
percent of the tasks,
– but the remaining 20 percent of the objective will take up 80 percent of the
tasks.
• This system classifies inventory items into groups A, B, and C.

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 ABC INVENTORY CLASSIFICATION
• The A items are given the highest priority, while C items have the lowest
priority and the B items fall somewhere in between.
• The priority is most often determined by annual dollar usage. However,
priority may also be determined by product shelf life, sales volume, whether
the materials are critical components, or some other criteria.
• A summary of the classification is provided

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INVENTORY CLASSIFICATION- ANNUAL DOLLAR USAGE
Annual Annual Percentage of Total
Unit Cost
Item Usage Dollar Annual Dollar
($)
(Units) Usage ($) Usage (%)
1 1.50 5,000 7,500 2.9
2 8.00 1,500 12,000 4.7
3 10.50 10,000 105,000 41.2
4 2.00 6,000 12,000 4.7
5 0.50 7,500 3,750 1.5
6 13.60 6,000 81,600 32.0
7 0.75 5,000 3,750 1.5
8 1.25 4,500 5,625 2.2
9 2.50 7,000 17,500 6.9
10 2.00 3,000 6,000 2.4
Total Annual Dollar Usage: $254,725 100 12
 PARETO CHART
45.0% 120.0%

40.0% A B C 100.0%

Cumulative % Usage
35.0%
Percent Usage

30.0% 80.0%

25.0%
60.0%
20.0%

15.0% 40.0%

10.0%
20.0%
5.0%

0.0% 0.0%
3 6 9 2 4 1 10 8 5 7

Item No.

Percentage of Total Dollar Usage Cumulative Percentage 13

 EXAMPLE
A small store has ten categories of product with the following costs and
annual demands:

Question: Do an ABC analysis of these items. If resources for inventory

control are limited, which items should be given least attention?

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2. INVENTORY
MODELS

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2.1. ECONOMIC ORDER QUANTITY (EOQ) MODEL
• The model is a classic independent demand inventory system that provides
many useful ordering decisions.
• The basic order decision is to determine the optimal order size that
minimizes total annual inventory costs (the sum of the annual order cost
and the annual inventory holding cost).
• In EOQ computations, the term carrying cost is often used in place of
holding cost and setup cost is used in place of order cost.

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 ASSUMPTIONS OF THE EOQ MODEL
• The demand is known and constant.
• Order lead time is known and constant.
• Replenishment is instantaneous. The entire order is delivered at one time and
partial shipments are not allowed.
• Price is constant. Quantity or price discounts are not allowed.
• The holding cost is known and constant.
• The order cost is known and constant.
• Stockouts are not allowed. Inventory must be available at all times.

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 OPTIMAL ORDER SIZE (1/2)
The EOQ can be derived from the total cost formula as follows:

Total Cost = Purchase cost + Holding/Carrying cost + Ordering/Setup cost

𝑻𝑪 = 𝑫∗𝑪 + (𝑸/𝟐) ∗ 𝑯 + (𝑫/𝑸) ∗ 𝑺

Total inventory cost (𝑻𝑰𝑪) = (𝑸/𝟐) ∗ 𝑯 + (𝑫/𝑸) ∗ 𝑺

The optimum Q (the EOQ) can be obtained by taking the first derivative of TC with respect to Q and
then setting it equal to zero.

𝒅𝑻𝑪 𝟐𝑫𝑺 𝟐𝑫𝑺

= 𝟎 → 𝑬𝑶𝑸 = 𝑸∗ = =
𝒅𝑸 𝑯 𝒉𝑪

Q: Quantity in a lot or batch size/Order size (units)

D: Demand per unit time
C: Unit cost = average price/unit purchased ($/unit)
S: Cost per order placed or setup cost, ($/order)
H: Holding/Carrying cost = hC ($/unit/year)
h: Holding rate 20
N: Number of orders per time period
OPTIMAL ORDER SIZE (2/2)

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 EXAMPLE
• The store S has observed a stable monthly demand for its line of
mobile phone iPhone of 100 pcs per month. The store incurs a
setup cost of $2,000 every time it places an order for additional
iPhones. The store pays $200 per iPhone. The store’s out-of-pocket
costs of storing an iPhone for a year are about 10% and the
opportunity cost of capital is 15%.
Question: What order size do you recommend for the S store?

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 SOLUTION
• D = 1200 pcs/ year, S = $2,000 / order,
• H = (0.15 + 0.10) 200 = $50 /pcs/ year

➔ Q* = (2 x 1200 x 2000/50)= 309.8

➔ round to Q* = 310
• Total inventory cost:
TIC(Q*) = S  (D/Q*) + H  (Q*/2)
= 2000  (1200/310) + 50  (310/2)
= $7,745 + $7,745
= $15,492 / year
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 2.2. QUANTITY DISCOUNT MODEL
• The quantity discount model is one variation of the EOQ model.
• It relaxes the constant unit price assumption by allowing purchase quantity
discounts → the unit price of an item is allowed to vary with the order size.
• Discounts offerings with quantity constitute motives for ordering higher
quantities and hence, holding larger inventories.
• Therefore, it becomes crucial to find the trade-off between price discount and
cost increase due to keeping larger inventory.

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TOTAL COST CURVE FOR THE QUANTITY
DISCOUNT MODEL

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 QUANTITY DISCOUNT STEPS

1. For each discount price level (P), compute EOQ:

𝟐𝑫𝑺 𝟐𝑫𝑺
𝑬𝑶𝑸 = 𝑸∗ = =
𝑯 𝒉𝑷
2. If EOQ < Minimum for discount, then adjust the quantity to
𝑄 = 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑓𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
3. For each EOQ, compute the total cost:
𝑪 = 𝑫 ∗ 𝑷 + (𝑸/𝟐) ∗ 𝑯 + (𝑫/𝑸) ∗ 𝑺
4. Compare total cost and choose the lowest cost quantity from all levels.

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 EXAMPLE
• The retailer of Heat International is negotiating the air-conditioning units’ respective
purchase cost along with the quantity ordered. Heat International offers the discounts
summarized in the table provided below:

• The total demand for air-conditioning units is 6,500 units/year. Ordering cost is €50
and the annual inventory holding cost is estimated 25% of the unit’s price.
Question: How many air-conditioning units should the retailer order to minimize
its total annual cost?

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 SOLUTION (1/2)
• For the lowest price:

2 DS 2  6500  50
EOQ57 = = = 213.57  500 => Invalid => Buy 𝑄 = 500
H 0.25  57

• For the next price:

2 DS 2  6500  50
EOQ58.8 = = = 210.28  300 => Invalid => Buy 𝑄 = 300
H 0.25  58.8

• For the last price:

2 DS 2  6500  50
EOQ 60 = = = 208,16 => Valid => Buy 𝑄 = 208
H 0,25  60
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 SOLUTION (2/2)
• The total cost for EOQ is:
Q D 208 6500
C208 = H + S + PD = 0.25  60 + 50 + 60  6500 = 393,122.5
2 Q 2 208
• The total cost when ordering 300 units:
300 6500
C300 = 0.25  58.8 + 50 + 58.8  6500 = 385,488.3
2 300
• The total cost when ordering 500 units:
500 6500
C500 = 0.25  57 + 50 + 57  6500 = 374,712.5
2 500
=> Since €374,712.5 is the minimum total annual cost → the optimum
ordering quantity is 500 units.

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3. REPLENISHMENT
POLICIES

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 CONTINUOUS AND PERIODIC REVIEW
• Continuous Review: Inventory is continuously monitored and an order fixed
quantity Q is placed when the inventory reaches the Reorder Point (ROP).
• Periodic Review: Inventory is checked at regular/periodic intervals T and an
order is placed to raise total inventory to the Order up to Level (OUL).

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 CONTINUOUS REVIEW SYSTEM
• (s, Q) continuous review policy: This policy orders the same quantity Q
when the inventory reaches the reorder point s. The quantity Q can be
determined by one of the fixed order quantity methods (such as the EOQ).
• (s, S) continuous review policy: When current inventory reaches or falls
below the reorder point s sufficient units are ordered to bring the inventory up
to a predetermined level S.
• For instance, suppose 𝑠 = 10, 𝑆 = 120, and current inventory is 11 units. If the
next demand is 3 units, then on-hand inventory will be reduced to 8 units.
Consequently, an order size of 112 units would be released.

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 PERIODIC REVIEW SYSTEM (1/3)
• (nQ, s, R) periodic review policy: If at the time of inventory review, the
inventory is equal to or less than the reorder point s, the quantity nQ is
ordered to bring the inventory up to the level between s and (s + Q).
• Recall that n= 1, 2, 3, …, and the order size is then some multiple of Q. No
order is placed if the current inventory is higher than the reorder point.

• For example, let 𝑠 = 100 and 𝑄 = 50. If the current inventory is 20 units at
the time of the review, then 2Q quantities (2 x 50 = 100) are ordered to
bring the inventory level up to 120 units.

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 PERIODIC REVIEW SYSTEM (3/3)

• (s, S, R) periodic review policy: If at the time of inventory review, the

physical inventory is equal to or less than the reorder point s, a sufficient
quantity is ordered to bring the inventory level up to the maximum inventory
level S.

• However, if the physical inventory is higher than the reorder point s, no order
is placed. This policy addresses the major deficiency of the (S, R) policy.

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 PERIODIC REVIEW SYSTEM (3/3)
• (S, R) periodic review policy: At each review time, a sufficient quantity is
ordered to bring the inventory up to a predetermined maximum inventory level S.
• This policy places a variable-sized order as long as the inventory is less than the
maximum inventory level S.
• If order cost is high, this is obviously not a preferred system. However, it may
work well if a large variety of items are ordered from the same supplier

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 4. VENDOR
MANAGED
INVENTORY (VMI)

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 VENDOR MANAGED INVENTORY
• If an organisation is trying to reduce the amount of effort it puts into
inventory control, one option is to leave the whole problem to a third party.
• Have another organization look after the stock control → The most
common arrangement of this kind is vendor managed inventory.
• With vendor managed inventory, the wholesaler controls the stocks,
and sends more along when they are needed.
• The benefits: the supplier can co-ordinate stocks over a wider area,
organize transport more efficiently, increase integration in the supply
chain, and give a consistent customer service
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