12

Inventory
Management

PowerPoint presentation to accompany

Heizer and Render
Operations Management, Eleventh Edition
Principles of Operations Management, Ninth Edition

PowerPoint slides by Jeff Heyl

© 2014
© 2014
Pearson
Pearson
Education,
Education,
[Link]. 12 - 1
 Outline
▶ Global Company Profile:
[Link]
▶ The Importance of Inventory
▶ Managing Inventory
▶ Inventory Models
▶ Inventory Models for Independent
Demand

© 2014 Pearson Education, Inc. 12 - 2

 Outline - Continued

▶ Probabilistic Models and

Safety Stock
▶ Single-Period Model
▶ Fixed-Period (P) Systems

© 2014 Pearson Education, Inc. 12 - 3

 Learning Objectives
When you complete this chapter you
should be able to:

1. Conduct an ABC analysis

2. Explain and use cycle counting
3. Explain and use the EOQ model for
independent inventory demand
4. Compute a reorder point and safety
stock

© 2014 Pearson Education, Inc. 12 - 4

 Learning Objectives
When you complete this chapter you
should be able to:

5. Apply the production order quantity

model
6. Explain and use the quantity discount
model
7. Understand service levels and
probabilistic inventory models

© 2014 Pearson Education, Inc. 12 - 5

 Inventory Management at
[Link]

▶ [Link] started as a “virtual”

retailer – no inventory, no warehouses,
no overhead; just computers taking
orders to be filled by others
▶ Growth has forced [Link] to
become a world leader in warehousing
and inventory management

© 2014
© 2014
Pearson
Pearson
Education,
Education,
[Link]. 12 - 6
 Inventory Management at
[Link]
1. Each order is assigned by computer to the
closest distribution center that has the
product(s)
2. A “flow meister” at each distribution center
assigns work crews
3. Lights indicate products that are to be picked
and the light is reset
4. Items are placed in crates on a conveyor, bar
code scanners scan each item 15 times to
virtually eliminate errors
© 2014
© 2014
Pearson
Pearson
Education,
Education,
[Link]. 12 - 7
 Inventory Management at
[Link]
5. Crates arrive at central point where items
are boxed and labeled with new bar code
6. Gift wrapping is done by hand at 30
packages per hour
7. Completed boxes are packed, taped,
weighed and labeled before leaving
warehouse in a truck
8. Order arrives at customer within 1 - 2 days

© 2014
© 2014
Pearson
Pearson
Education,
Education,
[Link]. 12 - 8
 Inventory Management

The objective of inventory

management is to strike a balance
between inventory investment and
customer service

© 2014 Pearson Education, Inc. 12 - 9

 Importance of Inventory
▶ One of the most expensive assets of
many companies representing as
much as 50% of total invested capital
▶ Operations managers must balance
inventory investment and customer
service

© 2014 Pearson Education, Inc. 12 - 10

 Functions of Inventory
1. To provide a selection of goods for
anticipated demand and to separate
the firm from fluctuations in demand
2. To decouple or separate various
parts of the production process
3. To take advantage of quantity
discounts
4. To hedge against inflation

© 2014 Pearson Education, Inc. 12 - 11

 Types of Inventory
▶ Raw material
▶ Purchased but not processed
▶ Work-in-process (WIP)
▶ Undergone some change but not completed
▶ A function of cycle time for a product
▶ Maintenance/repair/operating (MRO)
▶ Necessary to keep machinery and processes
productive
▶ Finished goods
▶ Completed product awaiting shipment
© 2014 Pearson Education, Inc. 12 - 12
 The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

Figure 12.1

© 2014 Pearson Education, Inc. 12 - 13

 Managing Inventory

1. How inventory items can be classified

(ABC analysis)
2. How accurate inventory records can
be maintained

© 2014 Pearson Education, Inc. 12 - 14

 ABC Analysis
▶ Divides inventory into three classes based
on annual dollar volume
▶ Class A - high annual dollar volume
▶ Class B - medium annual dollar volume
▶ Class C - low annual dollar volume
▶ Used to establish policies that focus on the
few critical parts and not the many trivial
ones

© 2014 Pearson Education, Inc. 12 - 15

 ABC Analysis
Figure 12.2
Percentage of annual dollar usage

A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100

Percentage of inventory items

© 2014 Pearson Education, Inc. 12 - 16

 ABC Analysis
ABC Calculation
(1) (2) (3) (4) (5) (6) (7)
PERCENT
OF PERCENT
ITEM NUMBER ANNUAL ANNUAL OF ANNUAL
STOCK OF ITEMS VOLUME UNIT DOLLAR DOLLAR
NUMBER STOCKED (UNITS) x COST = VOLUME VOLUME CLASS
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4% B
#12572 600 $ 14.17 $ 8,502 3.7% C
#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $232,057 100.0%

© 2014 Pearson Education, Inc. 12 - 17

 ABC Analysis
▶ Other criteria than annual dollar volume
may be used
▶ High shortage or holding cost
▶ Anticipated engineering changes
▶ Delivery problems
▶ Quality problems

© 2014 Pearson Education, Inc. 12 - 18

 ABC Analysis
▶ Policies employed may include
1. More emphasis on supplier development for
A items
2. Tighter physical inventory control for A items
3. More care in forecasting A items

© 2014 Pearson Education, Inc. 12 - 19

 Case Study
Case Study: Inventory Study Case
▶ Authors: Darya Plinere and Arkady
Borisov

© 2014 Pearson Education, Inc. 12 - 20

 General Comprehension
▶ What were the main inventory
management challenges faced by the
assembling company?
▶ What were the primary factors contributing
to these challenges?
▶ What were the proposed solutions to
address these issues?

© 2014 Pearson Education, Inc. 12 - 21

 Analysis and Evaluation
▶ How did the company's inaccurate demand
forecasting lead to inventory problems?
▶ What are the potential consequences of
excessive safety stock levels?
▶ Why is it important to reduce lead times in
inventory management?
▶ How did the implementation of the proposed
solutions impact the company's performance?

© 2014 Pearson Education, Inc. 12 - 22

Critical Thinking and Application
▶ Can you think of other businesses that might
face similar inventory management challenges?
▶ How could the company have prevented these
problems from occurring in the first place?
▶ What are the potential risks and benefits of
implementing inventory optimization techniques?
▶ Can you suggest additional strategies for
improving inventory management in this
company?

© 2014 Pearson Education, Inc. 12 - 23

 Group Activity
▶ Here are some examples:
▶ Retailers: Grocery stores, department stores, clothing stores
▶ Manufacturers: Automotive companies, electronics manufacturers,
pharmaceutical companies
▶ Restaurants: Fast-food chains, fine dining establishments
▶ Distributors: Wholesalers, supply chain companies
▶ E-commerce: Online retailers like Amazon, eBay
▶ Discuss the following questions:
▶ What are the unique inventory challenges faced by each type of
business?
▶ How do these businesses manage their inventory to meet customer
demand and minimize costs?
▶ What are the potential consequences of inventory mismanagement for
these businesses?
© 2014 Pearson Education, Inc. 12 - 24
 Discussion
▶ What are your personal experiences with inventory
management. This could include:
▶ Managing household supplies
▶ Planning for a vacation or event
▶ Managing inventory for a small business or hobby
▶ Dealing with stockouts or excess inventory
▶ Discussion Questions:
▶ What challenges have you faced when managing inventory?
▶ How have you addressed these challenges?
▶ What lessons have you learned from your experiences?

© 2014 Pearson Education, Inc. 12 - 25

 Record Accuracy
▶ Accurate records are a critical
ingredient in production and
inventory systems
▶ Periodic systems
▶ Perpetual inventory systems

© 2014 Pearson Education, Inc. 12 - 26

 Periodic Systems
Periodic systems involve checking inventory
levels at regular intervals. This method is often
used by small retailers or when vendors manage
the inventory. The downside of this approach is
that you don't have control between checks, so
you often need to carry extra inventory to avoid
running out.
▶ A variation of the periodic system is the two-bin
system. In this system, two containers hold
enough inventory to cover demand. When the
first bin is empty, it's time to reorder.
© 2014 Pearson Education, Inc. 12 - 27
 Perpetual Inventory Systems
Perpetual inventory systems continuously
track inventory by recording both receipts
and withdrawals in real-time. Receipts are
logged when products arrive—often via
automated tools like barcode scanners—and
withdrawals are tracked as items leave the
stockroom or are purchased at a point-of-
sale system.

© 2014 Pearson Education, Inc. 12 - 28

 Record Accuracy

▶ Incoming and outgoing

record keeping must be
accurate
▶ Stockrooms should be secure
▶ Necessary to make precise decisions
about ordering, scheduling, and
shipping

© 2014 Pearson Education, Inc. 12 - 29

 Cycle Counting
▶ Items are counted and records updated on
a periodic basis
▶ Often used with ABC analysis
▶ Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records
© 2014 Pearson Education, Inc. 12 - 30
 Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C
items
Policy is to count A items every month (20 working days), B items
every quarter (60 days), and C items every six months (120 days)

CYCLE
ITEM COUNTING NUMBER OF ITEMS
CLASS QUANTITY POLICY COUNTED PER DAY
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day

C 2,750 Every 6 months 2,750/120 = 23/day

77/day

© 2014 Pearson Education, Inc. 12 - 31

Control of Service Inventories
▶ Can be a critical component
of profitability
▶ Losses may come from
shrinkage or pilferage
▶ Applicable techniques include
1. Good personnel selection, training, and
discipline
2. Tight control of incoming shipments
3. Effective control of all goods leaving facility

© 2014 Pearson Education, Inc. 12 - 32

 Inventory Models
▶ Independent demand - the demand for item is
independent of the demand for any other item in
inventory
▶ Dependent demand - the demand for item is
dependent upon the demand for some other item in
the inventory
▶ For example, the demand for refrigerators is
independent of the demand for toaster ovens.
However, the demand for toaster oven components
is dependent on the requirements of toaster ovens.
This chapter focuses on managing inventory where
demand is independent
© 2014 Pearson Education, Inc. 12 - 33
 Inventory Models
▶ Holding costs - the costs of holding or
“carrying” inventory over time
▶ Ordering costs - refers to the expenses
incurred when placing an order for
inventory.
▶ Setup costs - cost to prepare a machine
or process for manufacturing an order
▶ Highly correlated with setup time

© 2014 Pearson Education, Inc. 12 - 34

 Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT OF
CATEGORY INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, scrap, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%

© 2014 Pearson Education, Inc. 12 - 35

 Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENT o n OF
ly p e n
deINVENTORYd in g
CATEGORY
y c o n sid e r a b VALUE
ing c(building a r
osts vrent or depreciation, r e s t r a . (3 - 10%)
tes6%
Hold
Housing costs
t io n, an d in te
operating u s
costs, in e s
taxes,s , lo c a
insurance) m e h ig h tech
th e b th a n 15% , s o
e r a
Materialehandling ll y g r e
costs a t e r
(equipment lease in org costs gr3% er- 3.5%)
eat(1
G n h a v e h old
e m s
nd fashion it
depreciation, power, operating cost)
a
Labor cost (receiving,
than 4 0%. warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%

© 2014 Pearson Education, Inc. 12 - 36

 Inventory Models for
Independent Demand
Need to determine when and
how much to order

1. Basic economic order quantity

(EOQ) model
2. Production order quantity model
3. Quantity discount model

© 2014 Pearson Education, Inc. 12 - 37

 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering)
and holding
6. Stockouts can be completely avoided
© 2014 Pearson Education, Inc. 12 - 38
 Inventory Usage Over Time
Figure 12.3

Total order received

Average
Order Usage rate inventory
quantity = Q on hand
Inventory level

(maximum
Q
inventory
level) 2

Minimum
inventory 0
Time

© 2014 Pearson Education, Inc. 12 - 39

 Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)

Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
© 2014 Pearson Education, Inc. 12 - 40
 Minimizing Costs
▶ By minimizing the sum of setup (or
ordering) and holding costs, total costs are
minimized
▶ Optimal order size Q* will minimize total
cost
▶ A reduction in either cost reduces the total
cost
▶ Optimal order quantity occurs when
holding cost and setup cost are equal
© 2014 Pearson Education, Inc. 12 - 41
 Minimizing Costs D
Annual setup cost = S
Q
Q = Number of pieces per order
Q* = Optimal 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
Annual setup cost = (Number of orders placed per year)
x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
! D$
= # &S
"Q%
© 2014 Pearson Education, Inc. 12 - 42
 Minimizing Costs D
Annual setup cost = S
Q
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal 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
Annual holding cost = (Average inventory level)
x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2
!Q $
= # &H
"2%
© 2014 Pearson Education, Inc. 12 - 43
 Minimizing Costs D
Annual setup cost = S
Q
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal 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

Optimal order quantity is found when annual setup

cost equals annual holding cost
Solving for Q* 2DS = Q 2 H
D !Q $
S = # &H 2DS
Q "2% Q2 =
H
2DS
Q* =
© 2014 Pearson Education, Inc.
H 12 - 44
 Total Annual Cost
Q = Number of pieces per order
Q* = Optimal 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

Total annual cost = Setup cost + Holding cost

Q represent the EOQ

© 2014 Pearson Education, Inc. 12 - 45

 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H

*2(1,000)(10)
Q = = 40,000 = 200 units
0.50

© 2014 Pearson Education, Inc. 12 - 46

 An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Expected Demand D
number of = N = =
orders Order quantity Q*

1,000
N= = 5 orders per year
200

© 2014 Pearson Education, Inc. 12 - 47

 An EOQ Example
Determine optimal time between orders
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected Number of working days per year

time between = T =
orders Expected number of orders

250
T= = 50 days between orders
5

© 2014 Pearson Education, Inc. 12 - 48

 An EOQ Example
Determine the total annual cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S+ H
Q 2
1,000 200
= ($10) + ($.50)
200 2
= (5)($10) + (100)($.50)
= $50 + $50 = $100
© 2014 Pearson Education, Inc. 12 - 49
 The EOQ Model
When including actual cost of material P

Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S + H + PD
Q 2

© 2014 Pearson Education, Inc. 12 - 50

 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 in
the area of the EOQ

© 2014 Pearson Education, Inc. 12 - 51

 An EOQ Example
Determine optimal number of needles
Only to
2%order
less than
D = 1,000 units 1,500 units Q* =the
200total
units
cost of
S = $10 per order N =$125
5 orders/year
when the
H = $.50 per unit per year = 50 days
T order quantity was
200
D Q
TC = S + H
Q 2
1,500 200 1,500 244.9
= ($10) + ($.50) = ($10) + ($.50)
200 2 244.9 2
= $75 + $50 = $125 = 6.125($10) +122.45($.50)
= $61.25 + $61.22 = $122.47

© 2014 Pearson Education, Inc. 12 - 52

 Reorder Points
▶ EOQ answers the “how much” question
▶ The reorder point (ROP) tells “when” to order
▶ Lead time (L) is the time between placing and
receiving an order

Demand Lead time for a new

ROP = per day order in days

ROP = d x L

This equation for ROP assumes that demand during

lead time and lead time itself are constant .

© 2014 Pearson Education, Inc. 12 - 53

 Reorder Points
▶ This equation for ROP assumes that demand
during lead time and lead time itself are
constant . When this is not the case, extra
stock, often called safety stock ( ss ) , should be
added. The reorder point with safety stock then
becomes:

ROP =Expected demand during lead time + Safety stock

© 2014 Pearson Education, Inc. 12 - 54

 Reorder Points
The demand per day, d , is found by dividing
the annual demand, D , by the number of
working days in a year:

d= D
Number of working days in a year

© 2014 Pearson Education, Inc. 12 - 55

 Reorder Point Curve
Figure 12.5

Q*
Resupply takes place as order arrives
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
© 2014 Pearson Education, Inc. 12 - 56
 Reorder Point Example
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days, may take 4

D
d=
Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units

© 2014 Pearson Education, Inc. 12 - 57

 Production Order Quantity Model
1. Used when inventory builds up over a
period of time after an order is placed
2. Used when units are produced and
sold simultaneously Figure 12.6

Part of inventory cycle during which

Inventory level

production (and usage) is taking place

Demand part of cycle with
no production (only usage)
Maximum
inventory

t Time
© 2014 Pearson Education, Inc. 12 - 58
Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory = (Average inventory level) x Holding cost

holding cost per unit per year

Annual inventory = (Maximum inventory level)/2

level

Maximum = Total produced during – Total used during

inventory level the production run the production run

= pt – dt

© 2014 Pearson Education, Inc. 12 - 59

Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum = Total produced during – Total used during

inventory level the production run the production run

= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level =p p –d p =Q 1– p

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p

© 2014 Pearson Education, Inc. 12 - 60

Production Order Quantity Model
Q = Number of pieces per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Setup cost = (D / Q)S

Holding cost = 21 HQ "#1− d p $% ( )
D
S = 21 HQ "#1− d p $%
( )
Q
2DS
Q2 =
H "#1− d p $%
( )
2DS
Q *p =
H "#1− d p $%
( )
© 2014 Pearson Education, Inc. 12 - 61
 Production Order Quantity
Example
D = 1,000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year

2DS
Q *p =
H "#1− d p $%
( )
2(1,000)(10)
Q *p =
0.50"#1− (4 8)$%

20,000
= = 80,000
0.50(1 2)
= 282.8 hubcaps, or 283 hubcaps

© 2014 Pearson Education, Inc. 12 - 62

Production Order Quantity Model
Note:
D (Demand per year) 1,000
d=4= =
Number of days the plant is in operation 250

When annual data are used the equation becomes

* 2DS
Q =p " Annual demand rate %
H $1− '
# Annual production rate &

© 2014 Pearson Education, Inc. 12 - 63

 Quantity Discount Models
▶ Reduced prices are often available when larger
quantities are purchased
▶ Trade-off is between reduced product cost and
increased holding cost

TABLE 12.2 A Quantity Discount Schedule

DISCOUNT DISCOUNT
NUMBER DISCOUNT QUANTITY DISCOUNT (%) PRICE (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80
3 2,000 and over 5 $4.75

© 2014 Pearson Education, Inc. 12 - 64

 Quantity Discount Models
Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S + H + PD
Q 2
where Q = Quantity ordered P = Price per unit
D = Annual demand in units H = Holding cost per unit per year
S = Ordering or setup cost per order

2DS
Q* =
IP

Because unit price varies, holding cost (H) is

expressed as a percent (I) of unit price (P)

© 2014 Pearson Education, Inc. 12 - 65

 Quantity Discount Example
TABLE 12.3 Total Cost Computations for Wohl’s Discount Store
ANNUAL ANNUAL ANNUAL
DISCOUNT UNIT ORDER PRODUCT ORDERING HOLDING
NUMBER PRICE QUANTITY COST COST COST TOTAL
1 $5.00 700 $25,000 $350 $350 $25,700
2 $4.80 1,000 $24,000 $245 $480 $24,725
3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Choose the price and quantity that gives the

lowest total cost
Buy 1,000 units at $4.80 per unit

© 2014 Pearson Education, Inc. 12 - 70

 Probabilistic Models and
Safety Stock
▶ Used when demand is not constant or certain
▶ Use safety stock to achieve a desired service
level and avoid stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short x

the probability x the stockout cost/unit
x the number of orders per year

© 2014 Pearson Education, Inc. 12 - 71

 Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

NUMBER OF UNITS PROBABILITY

30 .2
40 .2
ROP à 50 .3
60 .2
70 .1
1.0

© 2014 Pearson Education, Inc. 12 - 72

 Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

SAFETY ADDITIONAL TOTAL

STOCK HOLDING COST STOCKOUT COST COST

20 (20)($5) = $100 $0 $100

10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
© 2014 Pearson Education, Inc. 12 - 73
 Probabilistic Demand
Use prescribed service levels to set safety
stock when the cost of stockouts cannot be
determined

ROP =Expected demand during lead time + ZsdLT

where Z = Number of standard deviations

sdLT = Standard deviation of demand during lead
time

© 2014 Pearson Education, Inc. 12 - 75

 Probabilistic Demand

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? kits Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
© 2014 Pearson Education, Inc. 12 - 76
 Probabilistic Example
µ = Average demand = 350 kits
sdLT = Standard deviation of
demand during lead time = 10 kits
Z = 5% stockout policy (service level = 95%)

Using Appendix I, for an area under the curve of

95%, the Z = 1.65
Safety stock = ZsdLT = 1.65(10) = 16.5 kits

Reorder point = Expected demand during lead time +

Safety stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
© 2014 Pearson Education, Inc. 12 - 77
 Probabilistic Example
µ = Average demand = 350 kits
sdLT = Standard deviation of
demand during lead time = 10 kits
Z = 5% stockout policy (service level = 95%)

© 2014 Pearson Education, Inc. 12 - 78

 Other Probabilistic Models
▶ When data on demand during lead time is
not available, there are other models
available
1. When demand is variable and lead time is
constant
2. When lead time is variable and demand is
constant
3. When both demand and lead time are
variable

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 Other Probabilistic Models
Demand is variable and lead time is constant

ROP = (Average daily demand x Lead time in days) + ZsdLT

where sdLT = sd Lead time

sd = standard deviation of demand per day

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 Probabilistic Example
Average daily demand (normally distributed) = 15
Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28
From Appendix I

ROP = (15 units x 2 days) + ZsdLT

= 30 + 1.28(5)( 2)
= 30 + 9.02 = 39.02 ≈ 39

Safety stock is about 9 computers

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 Other Probabilistic Models
Lead time is variable and demand is constant

ROP =(Daily demand x Average lead time in days) +Z x (Daily

demand) x sLT

where sLT = Standard deviation of lead time in days

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 Probabilistic Example
Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time = sLT = 1
Service level = 98%, so Z (from Appendix I) = 2.055

ROP = (10 units x 6 days) + 2.055(10 units)(1)

= 60 + 20.55 = 80.55

Reorder point is about 81 cameras

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 Other Probabilistic Models
Both demand and lead time are variable

ROP = (Average daily demand x Average lead time) + ZsdLT

where sd = Standard deviation of demand per day

sLT = Standard deviation of lead time in days
sdLT = (Average lead time x sd2)
+ (Average daily demand)2s2LT

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 Probabilistic Example
Average daily demand (normally distributed) = 150
Standard deviation = sd = 16
Average lead time 5 days (normally distributed)
Standard deviation = sLT = 1 day
Service level = 95%, so Z = 1.645 (from Appendix I)

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 Single-Period Model
▶ Only one order is placed for a product
▶ Units have little or no value at the end of the
sales period

Cs = Cost of shortage = Sales price/unit – Cost/unit

Co = Cost of overage = Cost/unit – Salvage value (if there is any)

Cs
Service level =
Cs + Co

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 Single-Period Example
Average demand = µ = 120 papers/day
Standard deviation = s = 15 papers
Cs = cost of shortage = $1.25 – $.70 = $.55
Co = cost of overage = $.70 – $.30 = $.40
Cs
Service level =
Cs + Co
.55 Service
= level
.55 + .40 57.9%
.55
= = .579 µ = 120
.95
Optimal stocking level

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 Single-Period Example
From Appendix I, for the area .579, Z @ .20
The optimal stocking level

= 120 copies + (.20)(s)

= 120 + (.20)(15) = 120 + 3 = 123 papers

The stockout risk = 1 – Service level

= 1 – .579 = .421 = 42.1%

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 Fixed-Period (P) Systems
▶ Orders placed at the end of a fixed
period
▶ Inventory counted only at end of period
▶ Order brings inventory up to target level
▶ Only relevant costs are ordering and
holding
▶ Lead times are known and constant
▶ Items are independent of one another

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 Fixed-Period (P) Systems
Figure 12.9
Target quantity (T)

Q4
Q2
On-hand inventory

Q1 P
Q3

Time
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 Fixed-Period Systems
▶ Inventory is only counted at each
review period
▶ May be scheduled at convenient times
▶ Appropriate in routine situations
▶ May result in stockouts between
periods
▶ May require increased safety stock

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