Operations Management: Sustainability

and Supply Chain Management

Thirteenth Edition

Chapter 12
Inventory Management
Outline
• Global Company Profile: [Link]
• The Importance of Inventory
• Managing Inventory
• Inventory Models
• Inventory Models for Independent Demand
Inventory Management at
[Link] (1 of 2)
• [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
Learning Objectives
When you complete this chapter, you should be able to:
12.1 Conduct an ABC analysis
12.2 Explain and use cycle counting
12.3 Explain and use the EOQ model for independent
inventory demand
12.4 Compute a reorder point and explain safety stock
12.5 Apply the production order quantity model
12.6 Explain and use the quantity discount model
Inventory Management
The objective of inventory management is to strike a
balance between inventory investment and customer
service
Importance of Inventory
• One of the most expensive assets of many companies
representing as much as 50% of total invested capital
• Less inventory lowers costs but increases chances of
shortages, which might stop processes or result in
dissatisfied customers
• More inventory raises costs but improves the likelihood of
meeting process and customer demands
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 ‫للتحوط ضد التضخم‬
Types of Inventory
• Raw material
– Purchased but not processed
• Work-in-process (WIP)
– Undergone some change but not completed
– A function of flow time for a product
• Maintenance/repair/operating (MRO)
– Necessary to keep machinery and processes
productive
• Finished goods
– Completed product awaiting shipment
The Material Flow Cycle

Figure 12.1

• Actual work time, or “run” time, is a small portion of the

material flow time, perhaps as low as 5%
• Most of the time that work is in-process (95% of the flow
time) is not productive time.
Managing Inventory

1. How inventory items can be classified (ABC analysis)

2. How accurate inventory records can be maintained
ABC Analysis (1 of 5)
• 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
ABC Analysis (2 of 5)

Figure 12.2 Graphic Representation of ABC Analysis

ABC ANALYSIS FOR A CHIP MANUFACTURER (3 of 5)

Example 1 Silicon Chips, Inc., maker of superfast DRAM chips, wants to

categorize its 10 major inventory items using ABC analysis.
APPROACH ABC analysis organizes the items on an annual dollar-volume
basis. Shown below (in columns 1–4) are the 10 items (identified by stock
numbers), their annual demands, and unit costs.
Solution
ABC Analysis (4 of 5)

• Other criteria than annual dollar volume may be used

– High shortage or holding cost
– Anticipated engineering changes
– Delivery problems
– Quality problems
ABC Analysis (5 of 5)

• 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
Inventory Models (1 of 2)
• 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. (Ch12)
However, the demand for toaster oven components is dependent
on the requirements of toaster ovens. (Ch14)
Inventory Models (2 of 2)
• Holding costs - the costs of holding or “carrying” inventory
over time
• Ordering cost - the costs of placing an order and receiving
goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
– May be highly correlated with setup time
Holding Costs
Table 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
CATEGORY AS A PERCENTAGE
OF 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, space, and obsolescence (much higher 3% (2 - 5%)
in industries undergoing rapid change like tablets
and smart phones)
Overall carrying cost 26%

Holding costs vary considerably depending on the business, location, and

interest rates. Generally greater than 15%, some high tech and fashion
items have holding costs greater than 40%.
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 (POQ) model
3. Quantity discount model
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
Inventory Usage Over Time

Figure 12.3
Minimizing Costs (1 of 6)
Objective is to minimize total costs

Figure 12.4c
Minimizing Costs (2 of 6)

• 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
Minimizing Costs (3 of 6)

The necessary steps are:

1. Develop an expression for setup or ordering cost
2. Develop an expression for holding cost
3. Set setup (order) cost equal to holding cost
4. Solve the equation for the optimal order quantity.
 Minimizing Costs (4 of 6)
Using the following variables, we can determine setup and
holding costs and solve for Q*:
Q = Number of units per order
Q* = Optimal number of units 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 × 𝑆𝑒𝑡𝑢𝑝 𝑜𝑟 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑
= 𝑆𝑒𝑡𝑢𝑝 𝑜𝑟 𝑜𝑟𝑑𝑒𝑟 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑒𝑎𝑐ℎ 𝑜𝑟𝑑𝑒𝑟
D
= S
Q
𝐷
Annual setup cost = 𝑆
𝑄
Minimizing Costs (5 of 6)
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 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑙𝑒𝑣𝑒𝑙 × 𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝑂𝑟𝑑𝑒𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
= 𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
2
Q
= H
2

D
Annual setup cost = S
Q
Q
Annual holding cost = H
2
Minimizing Costs (6 of 6)
Q = Number of pieces per order
D
Q* = Optimal number of pieces per order (EOQ) Annual setup cost = S
Q
D = Annual demand in units for the inventory item Q
Annual holding cost = H
S = Setup or ordering cost for each order 2

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*

 D  Q 2DS = Q2 H
 Q  S =   H
2 2DS
Q2 =
H
2DS
Q∗ = 12-1
H
Example 3 FINDING THE OPTIMAL ORDER SIZE
AT SHARP, INC (1 of 4)

Sharp, Inc., a company that markets painless

hypodermic needles to hospitals, would like to reduce
its inventory cost by determining the optimal number of
hypodermic needles to obtain per order.
APPROACH The annual demand is 1,000 units; the
setup or ordering cost is $10 per order; and the holding
cost per unit per year is $.50.
An EOQ Example (2 of 4)
SOLUTION:

Determine optimal number of needles to order

D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2 DS
Q =
*

H
2(1,000)(10)
Q =
*
= 40,000 = 200 units
0.50
Example 4 COMPUTING NUMBER OF ORDERS AND
TIME BETWEEN ORDERS AT SHARP, INC. (3 of 4)

Sharp, Inc. (in Example 3) has a 250-day working year and wants
to find the number of orders (N) and the expected time between
orders (T ).
APPROACH Using Equations (12-2) and (12-3), Sharp enters the
data given in Example 3.
An EOQ Example (4 of 4)
SOLUTION:

Determine expected number of orders

D = 1,000 units Q* = 200 units

S = $10 per order
H = $.50 per unit per year
Demand D
Expected number of orders = N = =
Order quantity Q *
1,000
N= = 5 orders per year
200
Number of working days per year
Expected time between orders = T =
Expected number of orders
250
T= = 50 days between orders
5
Example 5 COMPUTING COMBINED COST OF
ORDERING AND HOLDING (1 of 2)
Sharp, Inc. (from Examples 3 and 4) wants to determine the
combined annual ordering and holding costs.
APPROACH Apply Equation (12-5), using the data in Example 3.
An EOQ Example (2 of 2)
SOLUTION:

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
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
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

By robust we mean that it gives satisfactory answers even with

substantial variation in its parameters. As we have observed,
determining accurate ordering costs and holding costs for
inventory is often difficult.
The total cost of the EOQ changes little in the neighborhood of
the minimum. The curve is very shallow. This means that
variations in setup costs, holding costs, demand, or even EOQ
make relatively modest differences in total cost.
Example 6 EOQ IS A ROBUST MODEL (1 of 2)
Management in the Sharp, Inc., examples underestimates total
annual demand by 50% (say demand is actually 1,500 needles
rather than 1,000 needles) while using the same Q. How will
the annual inventory cost be impacted?
APPROACH We will solve for annual costs twice. First, we
will apply the wrong EOQ; then we will recompute costs with
the correct EOQ.
 125 − 122.47
An EOQ Example (2 of 2) 125
SOLUTION: Only 2% less than
the total cost of
$125 when the
order quantity was
200

Ordering old Q* Ordering new Q*

D Q 1,500 244.9
TC = S + H = ($10) + ($.50)
Q 2 244.9 2
=
1,500
($10) +
200
($.50) = 6.125($10) + 122.45($.50)
200 2 = $61.25 + $61.22 = $122.47
= $75 + $50 = $125
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
ROP = (Demand per day)(Lead time for a new order in days)
ROP = d × L
𝐷
d= (12-6)
Number of working days in a year

Figure 12.5
Reorder Point Curve
Example 7 COMPUTING REORDER POINTS (ROP) FOR
iPHONES WITH AND WITHOUT SAFETY STOCK

An Apple store has a demand (D) for 8,000 iPhones per year. The
firm operates a 250-day working year.
On average, delivery of an order takes 3 working days, but has
been known to take as long as 4 days. The store wants to
calculate the reorder point without a safety stock and then with a
one-day safety stock.
APPROACH First compute the daily demand and then apply
Equation (12-6) for the ROP.
Then compute the ROP with safety stock.
Reorder Point Example
SOLUTION:

Demand = 8,000 iPhones 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  L
= 32 units per day  3 days = 96 units
= 32 units per day  4 days = 128 units
Production Order Quantity (POQ) Model (1 of 3)
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 Change in Inventory Levels over Time for the Production Model
Production Order Quantity Model (2 of 3)

Q = Number of units 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 Holding cost

1. = (Average inventory level) ×
holding cost per unit per year
2. Annual inventory level = Maximum inventory level /2

Total produced during Total used during

3. Maximum inventory level = −
the production run the production run
= 𝑝𝑡– 𝑑𝑡

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

Q Q 𝑑
(Maximum inventory level) = p −d =𝑄 1−
p 𝑝 𝑝
Maximum inventory level 𝑄 𝑑
4. Holding cost = 2
(𝐻) = 2
1− 𝑝
𝐻
Production Order Quantity Model (3 of 3)
Q = Number of units 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 = 12 HQ1 − (d p )

D 1
S = HQ 1 − (d / p ) 
Q 2
2 DS
Q =
2

H 1 − (d / p ) 
2 DS
Q*p =
H 1 − (d / p )  (12.7)
Example 8 A PRODUCTION ORDER QUANTITY MODEL
Nathan Manufacturing, Inc., makes and sells specialty wheels for
the retail automobile aftermarket. Nathan’s forecast for its wire
wheels is 1,000 units next year, with an average daily demand of
4 units. However, the production process is most efficient at 8
units per day. So the company produces 8 per day but uses only 4
per day. The company wants to solve for the optimum number of
units per order.
(Note: This plant schedules production of this wheel only as
needed, during the 250 days per year the shop operates.)
APPROACH Gather the cost data and apply Equation (12-7):
Annual demand = D = 1,000 units
Setup costs = S = +10
Holding cost = H = +0.50 per unit per year
Daily production rate = p = 8 units daily
Daily demand rate = d = 4 units daily
Production Order Quantity Example
SOLUTION:

D = 1,000 units p = 8 units per day

S = $10 d = 4 units per day
H = $0.50 per unit per year

2 DS
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
Production Order Quantity Model (5 of 5)

Note:
D 1,000
d =4= =
Number of days the plant is in operation 250

When annual data are used the equation becomes:

* 2 DS
Q =
 Annual demand rate 
p

H 1- 
 Annual production rate 
Quantity Discount Models (1 of 5)
• 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

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 1 to 119 $100

Discount price 1 120 to 1,499 $98

Discount price 2 1,500 and over $96
Quantity Discount Models (2 of 5)
Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S + IP + PD (12-9)
Q 2

where Q = Quantity ordered P = Price per unit

D = Annual demand in units I = Holding cost per unit per year
S = Ordering or setup cost per order expressed as a percent of price P

2 DS
Q = *

IP (12-10)

Because unit price varies, holding cost is expressed as a

percentage (I) of unit price (P)
Quantity Discount Models (3 of 5)

Steps in analyzing a quantity discount

STEP 1: Starting with the lowest possible purchase price,
calculate Q* until the first feasible EOQ is found.
This is a possible best order quantity, along with all
price-break quantities for all lower prices.
STEP 2: Calculate the total annual cost for each possible
order quantity determined in STEP 1. Select the
quantity that gives the lowest total cost.
Quantity Discount Models (4 of 5)
Figure 12.7 EOQs and Possible Best Order Quantities for the Quantity
Discount Problem with Three Prices in Table 12.2
Example 9 QUANTITY DISCOUNT MODEL
Chris Beehner Electronics stocks toy remote-control drones.
Recently, the store has been offered a quantity discount schedule
for these drones. This quantity schedule was shown in Table 12.2.
Furthermore, setup cost is $200 per order, annual demand is
5,200 units, and annual inventory carrying charge as a percentage
of cost, I, is 28%. What order quantity will minimize the total
inventory cost?

APPROACH We will follow the two steps just

outlined for the quantity discount model.
Quantity Discount Models (5 of 5)
SOLUTION
Calculate Q* for every discount
starting with the lowest price 2DS
Q =
*

IP

2 ( 5, 200 )( $200 )
Q$96* = = 278 drones / order
(.28)( $96 )
Infeasible – calculate Q*
for next-higher price

2 ( 5, 200 )( $200 )
Q$98* = = 275 drones / order
(.28)( $98) Feasible
Quantity Discount Example
Table 12.3 Total Cost Computations for Chris Beehner
Electronics

Choose the price and quantity that gives the lowest total cost
Buy 275 drones at $98 per unit