6 Chapter

Inventory
Management
Text Book:
William J. Stevenson, Operations
Management, 8th ed., McGraw-Hill.
Garrison
Outline
After the end of this lecture, you will be able to:
• Explain what is inventory and its types
• Understand the concept of ABC analysis
• Explain the concepts of holding, ordering and
setup cost
• Develop different types of inventory models
and use them to find out the optimum order
quantity and reorder point

1-2
 Inventory
 One of the most expensive assets
of many companies representing as
much as 50% of total invested
capital
 It refers to the goods or materials
that a business holds for sale,
production, or repair.

© 2006 Prentice Hall, Inc. 12 – 3

 Types of Inventory
 Raw material
 Purchased but not processed
 Work-in-process
 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

© 2006 Prentice Hall, Inc. 12 – 4

 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
© 2006 Prentice Hall, Inc. 12 – 5
 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock 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

© 2006 Prentice Hall, Inc. 12 – 6

 ABC Analysis
Percent of Percent of
Item Number of Annual Annual Annual
Stock Items Volume Unit Dollar Dollar
Number Stocked (units) x Cost = Volume Volume Class
#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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 Percent of annual dollar usage ABC Analysis
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
Percent of inventory items Figure 12.2

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 Holding, Ordering, and
Setup Costs
 Holding costs - the costs of holding
or “carrying” inventory over time
 Ordering costs - the costs of
placing an order and receiving
goods
 Setup costs - cost to prepare a
machine or process for
manufacturing an order
© 2006 Prentice Hall, Inc. 12 – 9
 Independent Versus
Dependent Demand
 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

© 2006 Prentice Hall, Inc. 12 – 10

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

 Basic economic order quantity

 Production order quantity
 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/ordering and
holding
6. Stockouts can be completely avoided
© 2006 Prentice Hall, Inc. 12 – 12
 Inventory Usage Over Time

Usage rate Average

Order inventory
quantity = Q
Inventory level

on hand
(maximum
inventory Q
level) 2

Minimum
inventory

Time

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 Minimizing Costs
Objective is to minimize total costs
Curve for total
cost of holding
and setup

Minimum
total cost
Annual cost

Holding cost
curve

Setup (or order)

cost curve
Optimal Order quantity
Table 11.5 order
© 2006 Prentice Hall, Inc.
quantity 12 – 14
 The EOQ Model
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

© 2006 Prentice Hall, Inc. 12 – 15

 The EOQ Model
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)

x (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2

Q
= ( H)
2

© 2006 Prentice Hall, Inc. 12 – 16

 The EOQ Model
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

Optimal order quantity is found when annual setup cost

equals annual holding cost

D Q
S = H
Q 2
Solving for Q*
2DS = Q2H
Q2 = 2DS/H
Q* = 2DS/H
© 2006 Prentice Hall, Inc. 12 – 17
 An EOQ Example
The Annual Demand of needles in a RMG factory is 1000
units. Each order is associated with $10 cost and the
holding cost is about half dollar per unit per year.
Determine optimal number of needles to order.

D = 1,000 units
S = $10 per order
H = $.50 per unit per year
Q* = 2DS/H

Ans: 200 units

© 2006 Prentice Hall, Inc. 12 – 18

 An EOQ Example
Determine expected number of orders per year
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year
N=(D/Q*)=5

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 An EOQ Example
Determine expected time between orders (or cycle time) if
the factory operates 250 days per year.
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year
T=(total working days/N)=250/5=50 days

© 2006 Prentice Hall, Inc. 12 – 20

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

Total annual cost = Setup cost + Holding cost

D Q*
TC = S + H
Q* 2

© 2006 Prentice Hall, Inc. 12 – 21

 Reorder Points
 EOQ answers the “how much” question
 The reorder point (ROP) tells when to
order
Demand Lead time for a
ROP = per day new order in days

=dxL
D
d = Number of working days in a year

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 Reorder Point Curve
Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
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 Reorder Point Example
The annual demands for DVD in a DVD store is about
8000 DVDs. They order DVDs from a supplier which
takes 3 working days as lead time and number of
working days is 250 days per year for the DVD store.
Calculate the Reorder Point for the DVD store.
Demand = 8,000 DVDs per year
250 working day year
Lead time for orders is 3 working days

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
© 2006 Prentice Hall, Inc. 12 – 24
 Production Order Quantity
Model
 Used when inventory builds up
over a period of time after an
order is placed
 Used when units are produced
and sold simultaneously

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 Production Order Quantity
Model
Part of inventory cycle during
which production (and usage)
is taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time

Figure 12.6

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 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 Holding cost

= (Average inventory level) x
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

© 2006 Prentice Hall, Inc. 12 – 27

 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 –d =Q 1–
p p p

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p

© 2006 Prentice Hall, Inc. 12 – 28

 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
D= Annual demand

Setup cost = (D/Q)S

1
Holding cost = 2 HQ[1 - (d/p)]
1
(D/Q)S = 2 HQ[1 - (d/p)]
2DS
Q =
2
H[1 - (d/p)]

2DS
Q*p =
H[1 - (d/p)]
© 2006 Prentice Hall, Inc. 12 – 29
 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* =
H[1 - (d/p)]

2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283 units

© 2006 Prentice Hall, Inc. 12 – 30

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

When annual data are used the equation becomes

2DS
Q* =
annual demand rate
H 1–
annual production rate

© 2006 Prentice Hall, Inc. 12 – 31

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

Total cost = Setup cost + Holding cost + Product cost

D QH
TC = S+ + PD
Q 2
H=hP ,Where h is percentage of unit cost

© 2006 Prentice Hall, Inc. 12 – 32

 Quantity Discount Models
A company buys cars from a foreign manufacturer.
The annual demand is 5000 cars with an ordering cost
of 49 dollar per order. Holding cost is 20% of unit
price.
A typical quantity discount schedule is below:
Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $?

3 2,000 and over 5 $?

Find out the optimal quantity of order and the

total cost associated with it.

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 Quantity Discount Models
Steps in analyzing a quantity discount
1. For each discount, calculate Q*
2. If Q* for a discount doesn’t qualify,
choose the smallest possible order size
to get the discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
© 2006 Prentice Hall, Inc. 12 – 34
 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

© 2006 Prentice Hall, Inc. 12 – 35

 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
H

2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars order
(.2)(4.75)
© 2006 Prentice Hall, Inc. 12 – 36
 Quantity Discount Example
Calculate Q* for every discount 2DS
Q* =
H
2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars order
(.2)(4.75) 2,000 — adjusted
© 2006 Prentice Hall, Inc. 12 – 37
 Quantity Discount Example
• TC1=(D/Q1*)S+(Q1*/2)H1+M1×D
• TC2=(D/Q2*)S+(Q2*/2)H2+M2×D
• TC3=(D/Q3*)S+(Q3*/2)H3+M3×D

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 Quantity Discount Example
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

Table 12.3

Choose the price and quantity that gives

the lowest total cost
Buy 1,000 units at $4.80 per unit
© 2006 Prentice Hall, Inc. 12 – 39