Inventory

Management
12

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 Outline
► The Importance of Inventory
► Managing Inventory
► Inventory Models
► Inventory Models for Independent
Demand

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 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 Explain and use the quantity discount model

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 The objective of inventory
Inventory management is to strike a
balance between inventory
Management investment and customer
service

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 • One of the most expensive
assets of many companies
representing as much as 50% of
total invested capital
Importance of • Lessinventory lowers costs but
Inventory increases chances of running
out
• Moreinventory raises costs but
always keeps customers happy

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 To provide a selection of goods for
anticipated demand and to separate the
firm from fluctuations in demand

To decouple or separate various parts of the

Functions production process

of Inventory To take advantage of quantity discounts

To hedge against inflation

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 Purchased but not
Raw material processed

Undergone some change but

not completed

Types of
Work-in-process (WIP)
A function of cycle time for a
product

Inventory Maintenance/repair/
operating (MRO)
Necessary to keep
machinery and
processes productive

Completed product
Finished goods awaiting shipment

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 Managing Inventory
1) How inventory items can be classified
(ABC analysis)
2) How accurate inventory records can be
maintained

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ABC Divides inventory
into three classes
Used to establish
policies that focus

Analysis based on annual

dollar volume
on the few critical
parts and not the
many trivial ones
Class A - high annual dollar
volume
Class B - medium annual
dollar volume
Class C - low annual dollar
volume

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 ABC Analysis

Percentage of annual dollar usage

Figure 12.2
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

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 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%

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

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 Record Accuracy
► Accurate records are a
critical ingredient in
production and inventory
systems
► Periodic systems require
regular checks of inventory
► Two-bin system
► Perpetual inventory tracks receipts
and subtractions on a continuing
basis
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► May be semi-automated 12 - 13
 Record Accuracy
► Incoming and outgoing
record keeping must be
accurate
► Stockrooms should be secure
► Necessary to make precise
decisions about ordering,
scheduling, and shipping
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 Cycle Counting

Items are counted Often used with Has several

and records ABC analysis advantages
updated on a
Eliminates shutdowns and
periodic basis interruptions
Eliminates annual inventory
adjustment
Trained personnel audit
inventory accuracy
Allows causes of errors to be
identified and corrected
Maintains accurate
inventory records
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 Cycle Counting Example
• 5,000 items in inventory,
500 A items, 1,750 B items,
2,750 C items

• Policyis to count A items

every month (20 working
days), B items every
quarter (60 days), and C
items every six months
(120 days

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 Can be a critical component
of profitability

Control of
Service Losses may come from
shrinkage or pilferage
Inventories
Good personnel
Applicable selection, training, and
discipline
techniques Tight control of incoming
shipments
include Effective control of all
goods leaving facility

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 Independent demand - the
demand for item is
independent of the demand for
Inventory any other item in inventory
Models Dependent demand - the
demand for item is dependent
upon the demand for some
other item in the inventory

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 Holding costs - the costs of holding or
“carrying” inventory over time

Inventory Ordering cost - the costs of placing an

Models
order and receiving goods

Setup cost - cost to

prepare a machine or May be highly
process for correlated with
setup time
manufacturing an
order

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 HOLDIN
G
COSTS

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 HOLDIN
H oldin g c o s t s var y
b
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o
s
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ess
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than
n it ems COSTS
s o m e h ig h t ech a 40%.
15%, o st s g r e at er t h a n
e h o ld in g c
hav

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 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

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 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

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 Inventory Usage Over Time
Figure 12.3

Total order received

Average
Order Usage rate inventory
Inventory level

quantity = on hand
Q Q
(maximum
inventory 2
level)

Minimum
inventory 0
Time

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 Minimizing Costs
Objective is to minimize total Table 12.4(c)
costs Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (order)
cost
Optimal Order quantity
order
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 By minimizing the sum of setup (or
ordering) and holding costs, total
costs are minimized

Optimal order size Q* will minimize

Minimizing total cost

Costs A reduction in either cost reduces

the total cost

Optimal order quantity occurs when

holding cost and setup cost are
equal

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 Minimizing Costs

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

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 Minimizing Costs

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

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 Minimizing Costs
Optimal order quantity is found when
annual setup cost equals annual holding
cost
Annual setup cost = Annual holding cost

OPTIMAL ORDER QUANTITY

Solving for Q*

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 Minimizing Costs
OPTIMAL ORDER
QUANTITY

Expected Demand
number
=N= of =
orders Order quantity

Expected Number of working days per year

time =T =
between Expected number of orders
orders
𝐷 𝑄
TOTAL COST = 𝑇𝐶= (𝑆)+ ( 𝐻 )
𝑄 2

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 EOQ EXAMPLE
Sharp, Inc., a company that markets painless hypordemic needles
to hospitals, would like to reduce its inventory cost by determining
the optimal number of hypodermic needles to obtain per order.
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. The
Sharp, Inc., has a 250-day working year.
Determine:
a) The optimal order quantity
b) The expected number of order each year
c) The expected time between orders?
d) Total annual cost

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

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 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
number of=N= =
orders Order quantity

1,000
N= = 5 orders per year
200

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 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 =T =
between Expected number of orders
orders
250
T= = 50 days between orders
5

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 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

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 The EOQ Model
When including actual cost of material P

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

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 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
P = $0.65
Total annual cost = Setup cost + Holding cost + Product cost
TC =
=
= (5)($10) + (100)($0.50) + ($0.65)(1,000)
= $50 + $50 + $650 = $750

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 Robust Model
▶ The EOQ model is robust
▶ Itworks even if all parameters and assumptions are not
met
▶ The total cost curve is relatively flat in the area of the EOQ

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 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units1,500 unitsQ*1,000 = 200 units
S = $10 per order T = 50 days
H = $.50 per unit per year Q*1,500 = 244.9 units
N= 5 orders/year
Ordering old Q* Ordering new Q*

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 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units1,500 unitsQ*1,000 Only
= 2002%units
less
S = $10 per order Tthan
= 50the total
days
H = $.50 per unit per year Q*1,500cost of $125
= 244.9 units
N= 5 orders/year when the order
quantity was 200
Ordering old Q* Ordering new Q*

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 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 per Lead time for a new
ROP = day order in days
ROP = d x L

d= D
Number of working days in a year

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 Reorder Point Curve
Figure 12.5

Q*

Inventory level (units)

Stock is replenished as order arrives

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
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 Reorder Point Example
Determine the reorder point
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days
No. of working days in year = 250 days
Lead time (L) = 5 days

d= = =4

ROP = d x L = 4 x 5 = 20 units

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 Quantity Discount Models
The normal price of the item is $100. When 120 to 1,499 units are ordered at one
time, the price per units drop to $98; when the quantity ordered at one time is 1,500
units or more, the price is $96 per unit. Suppose that annual demand for the item is
5,200, carrying cost is 28% f the unit cost; and ordering cost are $200. What is the
EOQ? And what is the order quantity is the best?
TABLE 12.2 A Quantity Discount Schedule

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 0 to 119 $ 100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96

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

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

Because unit price varies, holding cost is

expressed as a percent (I) of unit price (P)
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 Quantity Discount Models
Steps in analyzing a quantity discount

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.
2. Calculate the total annual cost for each possible
order quantity determined in Step 1. Select the
quantity that gives the lowest total cost.

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 Quantity Discount Models

1,500 Infeasible – calculate

Q* for next-higher
price

Feasible

Infeasib
le
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 Quantity Discount Example

TC96 = TC98 =
= (3.47)($200) + (750)($26.88) + ($96) = (18.9)($200) + (137.5)($27.44) +
(5,200) ($98)(5,200)
= $693 + $20,160 + $499,200 = = $3,780 + $3,773 + $509,600 =
$520,053 TABLE 12.3 $517,155
Total Cost Computations for Chris Beehner Electronics
ANNUAL ANNUAL ANNUAL
ORDER UNIT ORDERING HOLDING PRODUCT TOTAL ANNUAL
QUANTITY PRICE COST COST COST COST

275 $98 $509,600

$3,780 $3,773 $517,155

1,500 $96 $499,200

$693 $20,160 $520,053
Choose the price and quantity that
gives the lowest total cost
Buy 275 drones at $98 per unit
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 Quantity Discount Models
Figure 12.7
Initial
Price Discount Price 1 Discount Price 2
550,000 –
TC for No
Discount
Annual Total Cost 540,000 –
TC for Discount
1
530,000 –
Not Feasible TC for
520,053 – Discount 2
517,155 –
Feasible
510,000 –

Not Feasible
Possible Order
500,000 – Quantities

120 1,500
Order Quantity
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 Quantity Discount Variations
▶All-units discount is the most popular form
▶Incremental quantity discounts apply only to
those units purchased beyond the price
break quantity
▶Fixed fees may encourage larger purchases
▶Aggregation over items or time
▶Truckload discounts, buy-one-get-one-free
offers, one-time-only sales

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 Exercise 1
The annual demand, ordering cost, and the annual inventory carrying cost rate
for a certain item are D = 600 units, S = $20/order and I = 30% of item price.
Price is established by the following quantity discount schedule. What should
the order quantity be in order to minimize the total annual cost?

Quantity 1 to 49 50 to 249 250 and up

Price $5.00 per unit $4.50 per unit $4.10 per unit

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 Exercise 2
A printing company estimates that it will require 1,000 reams of a certain type of
paper in a given period. The cost of carrying one unit in inventory for that period
is 50 cents. The company buys the paper from a wholesaler in the same town,
sending its own truck to pick up the orders at a fixed cost of $20.00 per trip.
Treating this cost as the order cost,
(a) what is the optimum number of reams to buy at one time?
(b) How many times should lots of this size be bought during this period?
(c) What is the minimum cost (holding and setup) of maintaining inventory on
this item for the period?
(d) Of this total cost, how much is carrying cost and how much is ordering cost?

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