12

Inventory
Management

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives
▪ Define the term inventory and list the major
reasons for holding inventories; and list the main
requirements for effective inventory management.
▪ Discuss the nature and importance of service
inventories
▪ Discuss periodic and perpetual review systems.
▪ Discuss the objectives of inventory management.
▪ Describe the A-B-C approach and explain how it
is useful.
 Learning Objectives
▪ Describe the basic EOQ model and its
assumptions and solve typical problems.
▪ Describe the economic production quantity
model and solve typical problems.
▪ Describe the quantity discount model and
solve typical problems.
▪ Describe reorder point models and solve
typical problems.
▪ Describe situations in which the single-
period model would be appropriate, and
solve typical problems.
 Inventory
Inventory: a stock or store of goods

Different kinds of inventories -

 Raw materials and purchased parts (Clay used in tiles production firms)

 Work in Progress - WIP (Tiles under production)

 Finished good inventories (Ready tiles)

 Replacement parts, tools and supplies (Replacing defective tiles)

 Goods in transit to warehouses or customers - Pipeline inventory

(Tiles for sale)
 Inventory
Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
 Inventory Models
▪ Independent demand – finished goods, items
that are ready to be sold
▪ E.g. a computer
▪ Dependent demand – components of
finished products
▪ E.g. parts that make up the computer
 Types of Inventories
▪ Raw materials & purchased parts
(Clay used in tiles production firms)

▪ Partially completed goods called

work in progress (Tiles under production)
▪ Finished-goods inventories (Ready tiles)
(manufacturing firms or merchandise)
(retail stores)
 Types of Inventories (Cont’d)
▪ Replacement parts, tools, & supplies
(Replacing defective tiles)

▪ Goods-in-transit to warehouses or
customers - Pipeline inventory (Tiles for sale)
 Functions of Inventory
▪ To meet anticipated demand - A customer can
be a person who walks in off the street to buy a new
product (Rangs Showrooms)

▪ To smooth production requirements - Firms

that experience seasonal patterns in demand often build
up inventories during pre-season periods to meet overly
high requirements during seasonal periods (IGLOO and
other ice cream companies)
 Functions of Inventory
▪ To decouple operations - Manufacturing firms
keep buffer stock to tackle any disruption in the operation.
The buffers permit other operations to continue
temporarily while the problem is resolved (Cement
factories)

▪ To protect against stockout - Unexpected

increases in demand increase the risk of shortages.
Delays can occur because of weather condition, delayed
deliveries, quality problem etc. The risk of shortage can
be reduced by holding safety stock.
 Functions of Inventory (Cont’d)
▪ To take advantage of order cycles - To take
advantage of order cycles – To minimize purchasing cost,
firms often buy more than current requirement. They use
this additional quantity for later production. This enables
the firms to buy or produce in economic lot sizes without
trying to match purchases or production with demand
requirements in the short run. This results in order cycle

▪ To help hedge against price increases - When

firms sense any possibility of price increase they purchase
larger than normal amounts to beat the increase. The
ability to store extra goods allow the firms to take the
advantage of discount for larger orders
 Functions of Inventory (Cont’d)

▪ To permit operations - Inventory of raw material,

semi-finished goods and finished goods as well as goods
stored in warehouses allow the operation to continue at
different stages.

▪ To take advantage of quantity discounts -

Suppliers give discount on large orders.
 Objective of Inventory Control
▪ To achieve satisfactory levels of customer
service while keeping inventory costs within
reasonable bounds
▪ Level of customer service
▪ Costs of ordering and carrying inventory

Inventory turnover is the ratio of average

cost of goods sold to average inventory
investment.
Effective Inventory Management
▪ A system to keep track of inventory
▪ A reliable forecast of demand
▪ Knowledge of lead times
▪ Reasonable estimates of
▪ Holding costs
▪ Ordering costs
▪ Shortage costs
▪ A classification system
 Inventory Counting Systems
▪ Periodic System
Physical count of items made at periodic intervals
(e.g. weekly, monthly) to determine how much to
order.
▪ Many small retailers use this approach.
▪ An advantage of this system is that orders for many items occur at
the same time and helps to save ordering and shipping cost.
▪ One of the major disadvantage is the shortages between review
periods.
 Inventory Counting Systems
▪ Perpetual Inventory System
System that keeps track of removals from
inventory continuously, thus monitoring current
levels of each item
▪ An obvious advantage is continuous monitoring of
inventory withdrawals. Also helps to order optimum
quantity.
▪ One disadvantage of this system is added cost of
record keeping.
 Inventory Counting Systems
(Cont’d)
▪ Two-Bin System - Two containers of
inventory; reorder when the first is
empty
▪ Universal Bar Code - Bar code printed
on a label that has information about the
item to which it is attached
Identifies this product
as a grocery item 0

214800 232087768

Identifies the Indicates the

manufacturer specific item
 Key Inventory Terms
▪ Lead time: time interval between ordering
and receiving the order
▪ Holding (carrying) costs: cost to carry an
item in inventory for a length of time,
usually a year
▪ Ordering costs: costs of ordering and
receiving inventory
▪ Shortage costs: costs when demand
exceeds supply
 ABC Classification System
Figure 12.1

Classifying inventory according to some

measure of importance and allocating control
Hi
efforts accordingly.
Annu
$ value
A - very important (50-70% money represent 10- of item
20% product/service)
Lo
B - mod. Important (Rest of the item in between A
& C)
C - least important (10-20% money represent 50-
70% product/service)
10 products
 Benefits of ABC Classification System

Area of use Benefit of ABC classification system

Cycle Counting Using ABC classification in cycle counting, A class items will be counted more
Frequency frequently than B or C class items.

Order quantity and safety stock levels are established according to the criticality
Customer Service and cost of each item. Generally this is approached from a dollar accuracy
perspective.

The engineering department may use ABC classification to identify items of high
Engineering
cost or high usage and concentrate their efforts accordingly. There is little point re-
Priorities
engineering products of little value or low usage.

Inventory replenishment systems will vary according to the importance of the

Replenishment inventory items. For example, C class items may be controlled with a simple two-
Systems bin system if they are not particularly bulky. This minimizes the cost of control and
replenishment and does not significantly increase inventory carrying costs.

As A class items form a larger investment in inventory, these items are closely
analyzed to ensure appropriate order quantities and safety stocks are used. A
Investment
class items are always the focus of attempts to improve inventory turns as
Decisions
changes in the way A class items are procured and managed will have the most
significant effect on the overall inventory investment level
 A= 73.25% money, 20% item
C= 10.45% money, 50% item

Annual unit Percentage of total

Item Unit cost ($) Usage in dollar
usage dollar usage
(7500/254725*100)=
PA 01 5,000 1.50 5000*1.5=7,500
2.94% [C]
PA 02 1,500 8.00 12,000 4.71 [B]
PA 03 10,000 10.50 105,000 41.22 [A]
PA 04 6,000 2.00 12,000 4.71 [B]
PA 05 7,500 0.50 3,750 1.47 [C]
PA 06 6,000 13.60 81,600 32.03 [A]
PA 07 5,000 0.75 3,750 1.47 [C]
PA 08 4,500 1.25 5,625 2.21 [C]
PA 09 7,000 2.50 17,500 6.87 [B]
PA 10 3,000 2.00 6,000 2.36 [C]
Total 254,725 100
 ABC Classification

Percentage of total dollar usage

45.0
41.2
40.0

35.0 32.0
30.0

25.0

20.0

15.0

10.0 6.9
4.7 4.7
5.0 2.9 2.4 2.2 1.5 1.5
0.0
PA 03 PA 06 PA 09 PA 02 PA 04 PA 01 PA 10 PA 08 PA 05 PA 07

Class Class C
Class B
A
 ABC Classification

Unit Usage in Percentage of total

Item Usage
Cost($) dollar dollar usage

K34 50 1200

K35 20 400

K36 72 300

M10 160 400

M20 40 600

Z45 60 1600

F14 40 160
 Cycle Counting

▪ A physical count of items in inventory

▪ Cycle counting management
▪ How much accuracy is needed?
▪ When should cycle counting be performed?
▪ Who should do it?
 Economic Order Quantity Models

▪ Economic order quantity (EOQ) model

The order size that minimizes total annual cost

▪ Economic production model

▪ Quantity discount model
 Assumptions of EOQ Model

▪ Only one product is involved

▪ Annual demand requirements known
▪ Demand is even throughout the year
▪ Lead time does not vary
▪ Each order is received in a single
delivery
▪ There are no quantity discounts
 Product requirements=14/Week
Average Inventory= Pro. Req./2=14/2=7
Figure 12.2

Qo=300 Profile of Inventory Level Over Time

Usage
Quantity rate
on hand

Reorder
point

9 Days Time
Receive Place Receive Place Receive
order order order order order
Lead time
Economic Order Quantity (EOQ) Model
▪ Economic Order Quantity (EOQ) Model - A EOQ Model
helps to identify a fixed order size that will minimize the
sum of the annual costs of holding inventory and
ordering inventory.
Q Where,
Annual Holding Cost = H Q = Order quantity in units
2 H = Holding (or carrying) cost per unit
Annual Cost

Holding costs
are linearly Q
related to
H
2
order size

Order Quantity (Q)

Economic Order Quantity (EOQ) Model
Where,
D Q = Order quantity in units
Annual Ordering Cost = S D = Demand, in units per year
Q
Annual Cost S = Ordering cost

D
S
Q

Ordering costs
are inversely Order Quantity (Q)
and nonlinearly
related to order
size
 Total Cost

Annual Annual
Total cost = Carrying/Holding + ordering
cost cost
Q + DS
TC = H
2 Q
 Cost Minimization Goal
Figure 12.4C

The Total-Cost Curve is U-Shaped

Q D
TC = H + S
Annual Cost

2 Q

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)
 Deriving the EOQ

Using calculus, we take the derivative of

the total cost function and set the
derivative (slope) equal to zero and solve
for Q.
2DS 2( Annual Demand )(Order or Setup Cost )
Q OPT = =
H Annual Holding Cost
 Minimum Total Cost

The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.

Q = DS
H
2 Q
Economic Production Quantity (EPQ)

▪ Production done in batches or lots

▪ Capacity to produce a part exceeds the
part’s usage or demand rate
▪ Assumptions of EPQ are similar to EOQ
except orders are received
incrementally during production
 Economic Production Quantity
Assumptions
▪ Only one item is involved
▪ Annual demand is known
▪ Usage rate is constant
▪ Usage occurs continually
▪ Production rate is constant
▪ Lead time does not vary
▪ No quantity discounts
 Economic Run Size

2DS p
Q0 =
H p− u
Total Costs with Purchasing Cost

Annual Annual Purchasing

+
TC = carrying + ordering cost
cost cost

Q + DS + PD
TC = H
2 Q
 Total Costs with PD
Figure 12.7

Adding Purchasing cost TC with PD

doesn’t change EOQ

TC without PD
Cost

PD

0 EOQ Quantity
 Total Cost with Constant Carrying Costs
Figure 12.9

TCa
Total Cost

TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
When to Reorder with EOQ Ordering

▪ Reorder Point - When the quantity on

hand of an item drops to this amount,
the item is reordered
▪ Safety Stock - Stock that is held in
excess of expected demand due to
variable demand rate and/or lead time.
▪ Service Level - Probability that demand
will not exceed supply during lead time.
 Determinants of the Reorder Point

▪ The rate of demand

▪ The lead time
▪ Demand and/or lead time variability
▪ Stockout risk (safety stock)
 Safety Stock
Figure 12.12
Quantity

Maximum probable demand

during lead time

Expected demand
during lead time

ROP

Safety stock
Time
Safety stock reduces risk of LT
stockout during lead time
 Reorder Point
Figure 12.13

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
 Fixed-Order-Interval Model

▪ Orders are placed at fixed time intervals

▪ Order quantity for next interval?
▪ Suppliers might encourage fixed
intervals
▪ May require only periodic checks of
inventory levels
▪ Risk of stockout
▪ Fill rate – the percentage of demand
filled by the stock on hand
 Fixed-Interval Benefits

▪ Tight control of inventory items

▪ Items from same supplier may yield
savings in:
▪ Ordering
▪ Packing
▪ Shipping costs
▪ May be practical when inventories
cannot be closely monitored
 Fixed-Interval Disadvantages

▪ Requires a larger safety stock

▪ Increases carrying cost
▪ Costs of periodic reviews
 Single Period Model

▪ Single period model: model for ordering

of perishables and other items with
limited useful lives
▪ Shortage cost: generally the unrealized
profits per unit
▪ Excess cost: difference between
purchase cost and salvage value of
items left over at the end of a period
 Single Period Model
▪ Continuous stocking levels
▪ Identifies optimal stocking levels
▪ Optimal stocking level balances unit
shortage and excess cost

▪ Discrete stocking levels

▪ Service levels are discrete rather than
continuous
▪ Desired service level is equaled or
exceeded
 Optimal Stocking Level

Cs Cs = Shortage cost per unit

Service level =
Cs + Ce Ce = Excess cost per unit

Ce Cs

Service Level

Quantity
So
Balance point
 Example 15
▪ Ce = $0.20 per unit
▪ Cs = $0.60 per unit
▪ Service level = Cs/(Cs+Ce) = .6/(.6+.2)
▪ Service level = .75
Ce Cs

Service Level = 75%

Quantity

Stockout risk = 1.00 – 0.75 = 0.25

 Operations Strategy
▪ Too much inventory
▪ Tends to hide problems
▪ Easier to live with problems than to
eliminate them
▪ Costly to maintain
▪ Wise strategy
▪ Reduce lot sizes
▪ Reduce safety stock