INVENTORY

MANAGEMENT

For Operations Management, 9e by

PowerPoint Slides
Krajewski/Ritzman/Malhotra
by Jeff Heyl © 2010 Pearson Education
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Inventory Management

The planning and controlling of inventories to

meet the competitive priorities of the organization.
- Not to reduce cost or to satisfy all demands
- But to have the right amount to achieve the
competitive priorities of the business most efficiently.

Lot Size – The quantity of an inventory item management

either buys from suppliers or manufacturers using internal
process.

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Inventory Trade-off

Inventory – A stock of materials used to satisfy

customer demand or to support the production of
services or goods.
- Inward flows of materials
- Outward flow of services or products

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Pressure for Small Inventories

Inventory Holding Cost – The sum of the cost of capital and the
variable costs of keeping items on hand, such as storage and
handling, taxes, insurance and shrinkage.
Cost of Capital
Storage and Handling Cost
Taxes, Insurance and Shrinkage
- Pilferage
- Obsolescence
- Deterioration ( Spoilage or damage)

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Pressure for Large Inventories

 Customer Service
 Ordering Cost
 Setup Cost
 Labor and Equipment Utilization
 Transportation Cost
 Payments to Suppliers

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Types of Inventory

 Accounting Inventories
- Raw Material (RM)
- Work-in-Process (WIP)
- Finished Goods (FG)
Independent Demand Items – Items for which demand is
influenced by market conditions and is not released to the
inventory decisions for any other item held in stock or
produced.
Dependent Demand Items – Items whose required quantity
varies with the production plans for other item’s held in
the firm’s inventory.

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Safety Stock – Surplus inventory that a company holds to protect
against uncertainties in demand, lead time and supply changes.
- Supplier fails to deliver desired quantity on the specific date or items.
- Safety stock ensures operations are not disrupted rather allowing
subsequent operations to be continued.

Anticipation Inventory – Inventory used to absorb uneven rates

of demand or supply.
- Faces uneven demand
- When suppliers are faces threatened with strike or severe capacity
limitations.

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Pipeline Inventory – Inventory that is created
when an order for an item is issued but not yet
received.
- commit to enough inventory (on hand and
transit) to cover the lead time for the order.
- Longer lead times or higher demands per
week create more pipeline inventory.

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ABC Analysis

Stock-Keeping Unit (SKU) – An individual item or

product that has an identifying code and is held in
inventory somewhere along the supply chain.
ABC Analysis – The process of dividing SKU into
three classes, according to their dollar usage, so
that managers can focus on items that have the
highest dollar value.
20% - 80% dollar usage
30% - 15%
50% - 5%

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 ABC Analysis

 Classifying inventory according to some

measure of importance and allocating control
efforts accordingly

 A-Very Important
 B-Moderate Important
 C- Least Important

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ABC Analysis
Class C
100 — Class B
90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Percentage of SKUs
Figure 12.1 – Typical Chart Using ABC Analysis
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Economic Order Quantity

 The lot size, Q, that minimizes total annual inventory

holding and ordering costs

 Five assumptions
1. Demand rate is constant and known with certainty
2. No constraints are placed on the size of each lot
3. The only two relevant costs are the inventory holding cost and
the fixed cost per lot for ordering or setup
4. Decisions for one item can be made independently of decisions
for other items
5. The lead time is constant and known with certainty

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Calculating EOQ

Receive Inventory depletion

order (demand rate)
On-hand inventory (units)

Average
Q cycle
2 inventory

1 cycle
Time
Figure 12.2 – Cycle-Inventory Levels

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Calculating EOQ

 Annual holding cost

Annual holding cost = (Average cycle inventory)
 (Unit holding cost)

 Annual ordering cost

Annual ordering cost = (Number of orders/Year)
 (Ordering or setup costs)

 Total annual cycle-inventory cost

Total costs = Annual holding cost
+ Annual ordering or setup cost

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Calculating EOQ

Annual cost (dollars)

Total cost

Holding cost

Ordering cost

Lot Size (Q)

Figure 12.3 – Graphs of Annual Holding, Ordering, and Total Costs

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Calculating EOQ

 Total annual cycle-inventory and ordering cost

Q D
C= (H) + (S)
2 Q

where
C = total annual cycle-inventory cost
Q = lot size
H = holding cost per unit per year
D = annual demand
S = ordering or setup costs per lot

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The Cost of a Lot-Sizing Policy
Figure 12.4 – Total Annual Cycle-Inventory Cost
Function for the Bird Feeder
Current
cost

3000 –
Total Q D
Annual cost (dollars)

cost = (H) + (S)

2 Q

2000 –
Q
Holding cost = (H)
2

1000 –
D
Ordering cost = (S)
Lowest Q
cost
| | | | | | | |
0–
50 100 150 200 250 300 350 400
Lot Size (Q)
Best Q Current
(EOQ) Q
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Calculating EOQ

 The EOQ formula:

2DS
EOQ =
H

 Time between orders

EOQ
TBOEOQ = (12 months/year)
D

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 Inventory Control Systems

 Continuous review (Q) system

 Reorder point system (ROP) and fixed order
quantity system
 For independent demand items
 Tracks inventory position (IP)
 Includes scheduled receipts (SR), on-hand inventory
(OH), and back orders (BO)

osition = On-hand inventory + Scheduled receipts

– Backorders

IP = OH + SR – BO

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Selecting the Reorder Point
IP IP IP
Order Order Order Order
received received received received
On-hand inventory

Q Q Q

OH OH OH
R
Order Order Order
placed placed placed

L L L Time
TBO TBO TBO

Figure 12.6 – Q System When Demand and Lead Time Are Constant and Certain

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Continuous Review Systems

 Selecting the reorder point with variable demand

and constant lead time

point =Average demand during lead

+ Safety stock
=dL + safety stock

where
d = average demand per week (or day or months)
L = constant lead time in weeks (or days or months)

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Reorder Point

1. Choose an appropriate service-level policy

 Select service level or cycle service level (the desired probability of not
running out of stock in any ordering cycle)
 Protection interval (the period over which safety stock must protect the
user from running out of stock)

2. Determine the demand during lead time probability distribution

3. Determine the safety stock and reorder point levels

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Demand During Lead Time
 Specify mean and standard deviation
 Standard deviation of demand during lead time

σdLT = σd2L = σd L

 Safety stock and reorder point

Safety stock = zσdLT

where
z =number of standard deviations needed to achieve
the cycle-service level
σdLT =stand deviation of demand during lead time

Reorder point = R = dL + safety stock

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Continuous Review Systems

 Two-Bin system
 Visual system
 An empty first bin signals the need to place an order
 Calculating total systems costs
Total cost = Annual cycle inventory holding cost
+ Annual ordering cost
+ Annual safety stock holding cost

Q D
C= (H) + (S) + (H) (Safety stock)
2 Q

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Periodic Review System (P)

 Fixed interval reorder system or periodic

reorder system
 Four of the original EOQ assumptions maintained
 No constraints are placed on lot size
 Holding and ordering costs only
 Independent demand
 Lead times are certain

 Order is placed to bring the inventory position up to the

target inventory level, T, when the predetermined time, P,
has elapsed

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Periodic Review System
 Selecting the time between reviews,
choosing P (length of time between reviews) and T (target
inventory level)
 Selecting T when demand is variable and
lead time is constant
 IP covers demand over a protection interval of
P+L
 The average demand during the protection
interval is d(P + L), or

T = d(P + L) + safety stock for protection interval

Safety stock = zσP + L , where σP + L =  d P  L

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Comparative Advantages

 Primary advantages of P systems

 Convenient

 Orders can be combined

 Only need to know IP when review is made

 Primary advantages of Q systems

 Review frequency may be individualized
 Fixed lot sizes can result in quantity discounts
 Lower safety stocks

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Solved Problem 2
Nelson’s Hardware Store stocks a 19.2 volt cordless drill that is a
popular seller. Annual demand is 5,000 units, the ordering cost is $15,
and the inventory holding cost is $4/unit/year.
a. What is the economic order quantity?
b. What is the total annual cost for this inventory item?
SOLUTION
a. The order quantity is

2DS 2(5,000)($15)
EOQ = =
H $4
= 37,500 = 193.65 or 194 drills
b. The total annual cost is
Q D 194 5,000
C= (H) + (S) = ($4) + ($15) = $774.60
2 Q 2 194
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Solved Problem 3
A regional distributor purchases discontinued appliances from
various suppliers and then sells them on demand to retailers in
the region. The distributor operates 5 days per week, 52 weeks
per year. Only when it is open for business can orders be
received. Management wants to reevaluate its current inventory
policy, which calls for order quantities of 440 counter-top
mixers. The following data are estimated for the mixer:
Average daily demand (d) = 100 mixers
Standard deviation of daily demand (σd) = 30 mixers
Lead time (L) = 3 days
Holding cost (H) = $9.40/unit/year
Ordering cost (S) = $35/order
Cycle-service level = 92 percent
The distributor uses a continuous review (Q) system

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Solved Problem 3

a. What order quantity Q, and reorder point, R, should be used?

b. What is the total annual cost of the system?
c. If on-hand inventory is 40 units, one open order for 440
mixers is pending, and no backorders exist, should a new
order be placed?

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Solved Problem 3
SOLUTION
a. Annual demand is
D = (5 days/week)(52 weeks/year)(100 mixers/day)
= 26,000 mixers/year

The order quantity is

2DS 2(26,000)($35)
EOQ = =
H $9.40
= 193,167 = 440.02 or 440 mixers

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Solved Problem 3

The standard deviation of the demand during lead time

distribution is
σdLT = σd L = 30 3 = 51.96

A 92 percent cycle-service level corresponds to z = 1.41

Safety stock = zσdLT = 1.41(51.96 mixers) = 73.26 or 73 mixers

Average demand during lead time = dL = 100(3) = 300 mixers

Reorder point (R) = Average demand during lead time + Safety stock
= 300 mixers + 73 mixers = 373 mixers

With a continuous review system, Q = 440 and R = 373

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Solved Problem 3
b. The total annual cost for the Q systems is
Q D
C= (H) + Q (S) + (H)(Safety stock)
2
440 26,000
C= ($9.40) + ($35) + ($9.40)(73) = $4,822.38
2 440

c. Inventory position = On-hand

inventory + Scheduled receipts –
Backorders
IP = OH + SR – BO = 40 + 440 – 0 = 480 mixers

Because IP (480) exceeds R (373), do not place a new order

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Solved Problem 4
Suppose that a periodic review (P) system is used at the
distributor in Solved Problem 3, but otherwise the data are the
same.
a. Calculate the P (in workdays, rounded to the nearest day)
that gives approximately the same number of orders per
year as the EOQ.
b. What is the target inventory level, T? Compare the P system
to the Q system in Solved Problem 3.
c. What is the total annual cost of the P system?
d. It is time to review the item. On-hand inventory is 40 mixers;
receipt of 440 mixers is scheduled, and no backorders exist.
How much should be reordered?

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Solved Problem 4
SOLUTION
a. The time between orders is

EOQ 440
P= (260 days/year) = (260) = 4.4 or 4 days
D 26,000

b. target inventory level, T = d(P + L) + z d P  L

=100(3+4)+1.41*30*√(3+4)= 812
Safety stock = 1.41*30*√(3+4)= 111.91 or about 112 mixers.
The corresponding Q system for the counter-top mixer
requires less safety stock.

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Solved Problem 4
c. The total annual cost of the P system is
dP D
C = 2 (H) + (S) + (H)(Safety stock)
dP
100(4) 26,000
C= ($9.40) + ($35) + ($9.40)(1.41)(79.37)
2 100(4)
= $5,207.80
d. Inventory position is the amount on hand plus scheduled
receipts minus backorders, or
IP = OH + SR – BO = 40 + 440 – 0 = 480 mixers
The order quantity is the target inventory level minus the
inventory position, or
Q = T – IP = 812 mixers – 480 mixers = 332 mixers
An order for 332 mixers should be placed.
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