•

Tata McGraw
 Chapter 17

Inventory Control
 17-3

OBJECTIVES
• Inventory System Defined
• Inventory Costs
• Independent vs. Dependent Demand
• Single-Period Inventory Model
• Multi-Period Inventory Models: Basic
Fixed-Order Quantity Models
• Multi-Period Inventory Models: Basic
Fixed-Time Period Model
• Miscellaneous Systems and Issues
 17-4

Inventory System

• Inventory is the stock of any item or

resource used in an organization and
can include: raw materials, finished
products, component parts, supplies,
and work-in-process
• An inventory system is the set of
policies and controls that monitor levels
of inventory and determines what levels
should be maintained, when stock
should be replenished, and how large
orders should be
 17-5

Purposes of Inventory

1. To maintain independence of
operations
2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size
 17-6

Inventory Costs

• Holding (or carrying) costs

– Costs for storage, handling,
insurance, etc
• Setup (or production change) costs
– Costs for arranging specific
equipment setups, etc
• Ordering costs
– Costs of someone placing an order,
etc
• Shortage costs
– Costs of canceling an order, etc
 17-7

Independent vs. Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Finished
product
Dependent
Demand
(Derived demand
items for
E(1 component
) parts,
subassemblies,
Component parts raw materials,
etc)
 17-8

Inventory Systems

• Single-Period Inventory Model

– One time purchasing decision (Example:
vendor selling t-shirts at a football game)
– Seeks to balance the costs of inventory
overstock and under stock
• Multi-Period Inventory Models
– Fixed-Order Quantity Models
• Event triggered (Example: running out of
stock)
– Fixed-Time Period Models
• Time triggered (Example: Monthly sales
call by sales representative)
 17-9

Single-Period Inventory Model

This
Thismodel
modelstates
statesthat
thatwe
we
CCuu
should
shouldcontinue
the
thesize
continueto
sizeof
ofthe
toincrease
increase
theinventory
inventoryso
P
P so
 long
longasasthe
theprobability
probabilityof
of
CCoo  C
Cuu selling
sellingthe
equal
equalto
thelast
toor
lastunit
unitadded
orgreater
addedisis
greaterthan
thanthe
the
ratio
ratioof:
of:Cu/Co+Cu
Cu/Co+Cu
Where :
Co Cost per unit of demand over estimated
Cu Cost per unit of demand under estimated
P Probability that the unit will be sold
 17-10

Single Period Model Example

• Our college basketball team is playing in a

tournament game this weekend. Based on our
past experience we sell on average 2,400
shirts with a standard deviation of 350. We
make $10 on every shirt we sell at the game,
but lose $5 on every shirt not sold. How many
shirts should we make for the game?
Cu = $10 and Co = $5; P ≤ $10 / ($10 + $5) = .667

Z.667 = .432 (use NORMSDIST(.667) or Appendix E)

therefore we need 2,400 + .432(350) = 2,551 shirts
 17-11

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 1)

• Demand for the product is constant

and uniform throughout the period

• Lead time (time from ordering to

receipt) is constant

• Price per unit of product is constant

 17-12

Multi-Period Models:
Fixed-Order Quantity Model Model Assumptions (Part 2)

• Inventory holding cost is based on

average inventory

• Ordering or setup costs are constant

• All demands for the product will be

satisfied (No back orders are allowed)
 17-13

Basic Fixed-Order Quantity Model and Reorder Point Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
 17-14

Cost Minimization Goal

By
Byadding
addingthe
theitem,
item,holding,
holding,andandordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichin in
turn
turnis
isused
usedtotofind
findthe
theQQopt inventory order point that
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
 17-15

Basic Fixed-Order Quantity (EOQ) Model Formula

TC=Total
TC=Totalannual
annual
cost
cost
Total Annual Annual Annual DD=Demand
=Demand
Annual = Purchase + Ordering + Holding CC=Cost
=Costperperunit
unit
Cost Cost Cost Cost QQ=Order
=Orderquantity
quantity
SS=Cost
=Costofofplacing
placing
an
anorder
orderororsetup
setup
cost
cost
RR=Reorder
=Reorderpointpoint
LL=Lead
=Leadtime
time
D
D Q
Q H=Annual
H=Annualholding
holding
TC
TC == DC
DC ++ SS++ H H and
andstorage
per
storagecost
perunit
unitof
cost
ofinventory
Q
Q 22 inventory
 17-16

Deriving the EOQ

Using
Using calculus,
calculus, wewe take
take the
the first
first derivative
derivative ofof
the
the total
total cost
cost function
function with
with respect
respect toto Q,
Q, and
and
set
set the
the derivative
derivative (slope)
(slope) equal
equal to to zero,
zero,
solving
solving for
for the
the optimized
optimized (cost
(cost minimized)
minimized)
value
value of
of QQopt
opt

2DS
2DS = 2(Annual
2(Annual DDem
emand)(Order
and)(Order oror Setup
Setup Cost)
Cost)
QQOPT =
OPT = =
HH Annual
Annual Holding
Holding Cost
Cost
__
We
Wealso
alsoneed
needaa RReorder
eorder point,
point, RR == dd LL
reorder
reorderpoint
pointto
to _
tell
tell us
uswhen
whento
to d = average daily demand (constant)
place
placean anorder
order L = Lead time (constant)
 17-17

EOQ Example (1) Problem Data

Given
Giventhe
theinformation
informationbelow,
below, what
whatare
arethe
theEOQ
EOQ and
and
reorder
reorderpoint?
point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
 17-18

EOQ Example (1) Solution

2DS
2DS = 2(1,000
2(1,000 )(10)
)(10) = 89.443 units or 90 units
Q
QOPT =
OPT = H = 2.50 = 89.443 units or 90 units
H 2.50

1,000
1,000 units
units // year
year = 2.74 units / day
dd == = 2.74 units / day
365 days / year
365 days / year

__
Reorder
Reorderpoint,
point, RR == dd LL== 2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18 or
or 20
20 units
units

In
Insummary,
summary,youyouplace
placeananoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have2020units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of9090
units.
units.
 17-19

EOQ Example (2) Problem Data

Determine
Determine thethe economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following…
following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15
 17-20

EOQ Example (2) Solution

2DS
2DS 2(10,000
2(10,000 )(10)
)(10) = 365.148 units, or 366 units
Q
QOPT = =
OPT = H = 1.50 = 365.148 units, or 366 units
H 1.50

10,000
10,000 units
units// year
year = 27.397 units / day
dd == = 27.397 units / day
365 days / year
365 days / year

__
RR == dd LL== 27.397
27.397 units
units//day
day(10
(10 days)
days)== 273.97
273.97 or
or 274
274 units
units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin inthe
thecourse
courseofof
using
usingthe
theinventory
inventoryyou
youare
areleft
leftwith
withonly
only274
274units,
units,
place
placethe
thenext
nextorder
orderofof366
366units.
units.
 17-21

Fixed-Time Period Model with Safety Stock Formula

qq==Average
Averagedemand
demand++Safety
Safetystock
stock––Inventory
Inventorycurrently
currentlyon
onhand
hand

qq==dd(T L)++ZZTT++LL--II
(T++L)

Where
Where::
qq==quantitiy
quantitiyto
tobe
beordered
ordered
TT==the
thenumber
numberof ofdays
daysbetween
betweenreviews
reviews
LL==lead
leadtime
timeinindays
days
dd==forecast
forecast average
averagedaily
dailydemand
demand
zz==the
thenumber
numberof ofstandard
standarddeviations
deviationsfor
foraaspecified
specifiedservice
serviceprobabilit
probabilityy
T + L ==standard
standarddeviation
deviationofofdemand
demandover
overthe
thereview
reviewand
andlead
leadtime
time
T+L
II==current
currentinventory
inventorylevel
level(includes
(includesitems
itemson
onorder)
order)
 17-22

Multi-Period Models: Fixed-Time Period Model:

Determining the Value of sT+L

T+
T+LL

 
22
T+T+LL == i11
ddi
i
i

Since
Sinceeach
eachday
dayisisindependent anddd isisconstant,
independentand constant,
22
T+T+LL == (T + L)
(T + L)dd

• The standard deviation of a sequence

of random events equals the square
root of the sum of the variances
 17-23

Example of the Fixed-Time Period Model

Given
Given the
the information
information below,
below, how
how many
many units
units
should
should be
be ordered?
ordered?
Average daily demand for a product is
20 units. The review period is 30 days,
and lead time is 10 days. Management
has set a policy of satisfying 96 percent
of demand from items in stock. At the
beginning of the review period there are
200 units in inventory. The daily
demand standard deviation is 4 units.
 17-24

Example of the Fixed-Time Period Model: Solution (Part 1)

T+T+LL == (T 22
L) ==
(T++ L) dd 30 1044 == 25.298
30++10
22
25.298

The
The value
value for
for “z”
“z” isis found
found by
by using
using the
the Excel
Excel
NORMSINV
NORMSINV function,function, or or as
as wewe will
will do
do here,
here, using
using
Appendix
Appendix D. D. ByBy adding
adding 0.50.5 to
to all
all the
the values
values in
in
Appendix
Appendix D D and
and finding
finding the
the value
value in in the
the table
table that
that
comes
comes closest
closest to
to the
the service
service probability,
probability, the the “z”
“z”
value
value can
can be
be read
read byby adding
adding thethe column
column heading
heading
label
label to
to the
the row
row label.
label.
So,
So,by
byadding
adding0.5
0.5to
tothe
thevalue
valuefrom
fromAppendix
AppendixDDof of0.4599,
0.4599,
we
wehave
haveaaprobability
probabilityofof0.9599,
0.9599,which
whichisisgiven
givenby
byaazz==1.75
1.75
 17-25

Example of the Fixed-Time Period Model: Solution (Part 2)

qq==dd(T L)++ZZTT++LL --II

(T++L)

qq==20(30
20(30++10)
10)++(1.75)(25.
(1.75)(25.298)
298)--200
200

80044.272
qq==800 44.272--200
200==644.272,
644.272,or
or645
645units
units

So,
So, to
to satisfy
satisfy 96
96 percent
percent of
of the
the demand,
demand,
you
you should
should place
place an
an order
order of
of 645
645 units
units at
at
this
this review
review period
period
 17-26

Price-Break Model Formula

Based on the same assumptions as the EOQ model,

the price-break model has a similar Qopt formula:

2DS 2(Annual Demand)(Order or Setup Cost)

Q OPT = =
iC Annual Holding Cost

i = percentage of unit cost attributed to carrying inventory

C = cost per unit

Since “C” changes for each price-break, the formula

above will have to be used with each price-break cost
value
 17-27

Price-Break Example Problem Data

(Part 1)

AA company
company hashas aa chance
chance toto reduce
reduce their
their inventory
inventory
ordering
ordering costs
costs by
by placing
placing larger
larger quantity
quantity orders
orders using
using
the
the price-break
price-break order
order quantity
quantity schedule
schedule below.
below. What
What
should
should their
their optimal
optimal order
order quantity
quantity be
be ifif this
this company
company
purchases
purchases this
this single
single inventory
inventory item
item with
with an an e-mail
e-mail
ordering
ordering cost
cost of
of $4,
$4, aa carrying
carrying cost
cost rate
rate ofof 2%2% ofof the
the
inventory
inventory cost
cost of
of the
the item,
item, and
and an
an annual
annual demand
demand of of
10,000
10,000 units?
units?
Order Quantity(units) Price/unit($)
0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
 17-28

Price-Break Example Solution (Part 2)

First, plug data into formula for each price-break value of “C”
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DS 2(10,000)(4)

Qopt value is feasible Q OPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)(4)
Qopt value is not feasible Q OPT = = = 2,020 units
iC 0.02(0.98)
 17-29

Price-Break Example Solution (Part 3)

Since
Sincethe
thefeasible
feasiblesolution
solutionoccurred
occurredininthe
thefirst
firstprice-
price-
break,
break, ititmeans
meansthat
thatall
all the
theother
othertrue
trueQQopt values occur
opt values occur
at
atthe
thebeginnings
beginningsof ofeach
eachprice-break
price-breakinterval.
interval. Why?
Why?

Because
Becausethe
thetotal
total annual
annual cost
costfunction
functionis
is
Total aa“u”
“u”shaped
shapedfunction
function
annual
costs So
Sothe
thecandidates
candidates
for
forthe
theprice-
price-
breaks
breaksare
are1826,
1826,
2500,
2500, and
and4000
4000
units
units
0 1826 2500 4000 Order Quantity
 17-30

Price-Break Example Solution (Part 4)

Next,
Next, we
weplug
plugthe
thetrue
trueQ
Qopt values into the total cost
opt values into the total cost
annual
annual cost
costfunction
functionto
todetermine
determinethethetotal
total cost
costunder
under
each
eachprice-break
price-break
D
D Q
Q iC
TC = DC +
TC = DC + S
S++ iC
Q
Q 2
2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
==$12,043.82
$12,043.82
TC(2500-3999)=
TC(2500-3999)=$10,041
$10,041
TC(4000&more)=
TC(4000&more)=$9,949.20
$9,949.20
Finally,
Finally, we
weselect
selectthe
theleast
leastcostly
costlyQQopt , which is this
opt, which is this
problem
problemoccurs
occursininthe
the4000
4000&&more
moreinterval.
interval. In
In
summary,
summary, ourouroptimal
optimal order
orderquantity
quantityis is4000
4000units
units
 17-31

Miscellaneous Systems:
Optional Replenishment System

Maximum Inventory Level, M

q=M-I

Actual Inventory Level, I

M
I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

 17-32

Miscellaneous Systems:
Bin Systems

Two-Bin System

Order One Bin of

Inventory
Full Empty
One-Bin System

Order Enough to
Refill Bin
Periodic Check
 17-33

ABC Classification System

• Items kept in inventory are not of equal

importance in terms of:
60
– dollars invested % of
$ Value 30 A
– profit potential 0 B
– sales or usage volume % of 30 C
Use 60
– stock-out penalties

So, identify inventory items based on percentage of total

dollar value, where “A” items are roughly top 15 %, “B”
items as next 35 %, and the lower 65% are the “C” items
 17-34

Inventory Accuracy and Cycle Counting

• Inventory accuracy refers to how

well the inventory records agree
with physical count
• Cycle Counting is a physical
inventory-taking technique in
which inventory is counted on a
frequent basis rather than once or
twice a year
 17-35

Question Bowl

Which of the following is a reason why

firms keep a supply of inventory?
a. To maintain independence of
operations
b. To meet variation in product demand
c. To allow flexibility in production
scheduling
d. To take advantage of economic
purchase order size
e. All of the above

Answer: e. All of the above (Also can include to

provide a safeguard for variation in raw material
delivery time.)
 17-36

Question Bowl

An Inventory System should

include policies that are related
to which of the following?
a. How large inventory purchase
orders should be
b. Monitoring levels of inventory
c. Stating when stock should be
replenished
d. All of the above
e. None of the above

Answer: d. All of the above

 17-37

Question Bowl

Which of the following is an

Inventory Cost item that is related
to the managerial and clerical
costs to prepare a purchase or
production order?
a. Holding costs
b. Setup costs
c. Carrying costs
d. Shortage costs Answer: e. None of the
e. None of the above above (Correct answer
is Ordering Costs.)
 17-38

Question Bowl

Which of the following is

considered a Independent
Demand inventory item?
a. Bolts to a automobile
manufacturer
b. Timber to a home builder
c. Windows to a home builder
d. Containers of milk to a grocery
store
e. None of the above

Answer: d. Containers of milk to a grocery store

 17-39

Question Bowl

If you are marketing a more expensive

independent demand inventory
item, which inventory model
should you use?
a. Fixed-time period model
b. Fixed-order quantity model
c. Periodic system
d. Periodic review system
e. P-model

Answer: b. Fixed-order quantity model

 17-40

Question Bowl

If the annual demand for an inventory

item is 5,000 units, the ordering costs
are $100 per order, and the cost of
holding a unit is stock for a year is
$10, which of the following is
approximately the Qopt?
a. 5,000 units
b. $5,000
c. 500 units
d. 316 units Answer: d. 316
e. None of the above units
(Sqrt[(2x1000x10
0)/10=316.2277)
 17-41

Question Bowl

The basic logic behind the ABC

Classification system for inventory
management is which of the
following?
a. Two-bin logic
b. One-bin logic
c. Pareto principle
d. All of the above
e. None of the above
Answer: c. Pareto principle
 17-42

Question Bowl

A physical inventory-taking
technique in which inventory is
counted frequently rather than
once or twice a year is which of
the following?
a. Cycle counting
b. Mathematical programming
c. Pareto principle
d. ABC classification
e. Stockkeeping unit (SKU)

Answer: a. Cycle counting

 17-43

End of Chapter 17