MGT2230

Operations and Supply Chain

Management

Inventory Management
Week 7 – Lecture 1 & 2
Dr. Sreejith Balasubramanian
Inventory Management

Inventory
 A stock or store of goods

The objective of inventory management is to strike

a balance between inventory investment and
customer service

12 - 2
Importance of Inventory
 One of the most expensive assets of many companies
representing as much as 50% of total invested capital

A firm can reduce costs by reducing inventory

However, production may stop and customers
become dissatisfied when an item is out of stock.

 Operations managers must

balance inventory
investment and customer
service
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

12 - 4
The Material Flow Cycle

Cycle time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

12 - 5
Types of Inventory
▶ Raw material
▶ Purchased but not processed
▶ Work-in-process (WIP)
▶ 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

12 - 6
Types of Inventory
Types of Inventory
 Maintenance/repair/operations (MRO)
• Necessary to keep machinery and processes
productive
Managing Inventory

1. How inventory items can be classified (ABC

analysis)
2. How accurate inventory records can be maintained

12 - 9
Record Accuracy

 Accurate records are a

critical ingredient in
production and inventory
systems
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

12 - 11
ABC Analysis
1. To determine the annual dollar volume for ABC analysis,
we measure the annual demand of each inventory item
times the cost per unit.
annual dollar volume = annual demand × cost per unit
2. Arrange annual dollar value in descending order.
3. Classify the items
 Class A items may represent only about 15% of the total
inventory items but they represents 70% to 80% of the
annual dollar volume.
 Class B items my represent about 30% of inventory items
and 15% to 25% of the total value.
 Class C items may represent only 5% of the annual dollar
volume, but about 55% of the total inventory items.
12 - 12
ABC Analysis
Percentage of annual dollar usage

A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
|
0 –| | | | | | | |

10 20 30 40 50 60 70 80 90
Percentage of inventory items

12 - 13
ABC Analysis
Ex) Categorize the items on an A-B-C basis.

Annual Percentage
Unit Percentage Item Classification
Item Demand Dollar Sort items of A.D.V
Cost of A.D.V
Value by
1 25 36 900 11.9 percentage 8 52.7 A
2 10 7 70 0.9 of A.D.V. 3 15.8 B
3 24 50 1200 15.8 6 13.2 B
4 15 10 150 2.0 1 11.9 B
5 7 7 49 0.6 4 2.0 C
6 10 100 1000 13.2 10 1.3 C
7 2 21 42 0.6 9 1.1 C
8 10 400 4000 52.7 2 0.9 C
9 80 1 80 1.1 5 0.6 C
10 5 20 100 1.3 7 0.6 C
Total 7591

12 - 14
Inventory Models
▶ 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

12 - 15
Inventory Models

▶ 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
▶ May be highly correlated with setup time

12 - 16
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

12 - 17
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
12 - 18
Basic EOQ Model

Total order received

Average
Order Usage rate inventory
quantity = Q
Inventory level

on hand
(maximum Q
inventory
level) 2

Minimum
inventory 0
Time

12 - 19
Minimizing Costs Optimal order quantity occurs when
holding cost and setup cost are equal
Objective is to minimize total costs

Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
12 - 20
Minimizing Costs

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
Annual setup cost = (Number of orders placed per year)
year x (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order

12 - 21
Minimizing Costs

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
Annual holding cost = (Average inventory level)
H =x Holding or carrying
(Holding cost cost
per unit per per unit per
year)
year
Order quantity
= (Holding cost per unit per year)
2

12 - 22
Minimizing Costs

Q = Number of pieces per order

Q* = Optimal number of pieces per order
(EOQ)
D = Annual demand in units for the
inventory item
S
Optimal = Setup
order or ordering
quantity is cost
foundforwhen
each order
annual
H setup= Holding or carrying
cost equals annual cost per unit
holding per
cost
year
Solving for Q*

12 - 23
Basic EOQ Model
Ex) 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.
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.

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

12 - 24
Basic EOQ Model
Ex) Determine the 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

12 - 25
Basic EOQ Model
Ex) Determine the 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 per year
orders
250
T= = 50 days between orders
5

12 - 26
Basic EOQ Model
Ex) 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

12 - 27
Basic EOQ Model – Handout Q2
Ex) A distributor uses 800 packing crates a month, which it purchases at a
cost of $10 each. The manager has assigned an annual carrying cost of
35 percent of the purchase price per crate. Ordering costs are $28.
Currently the manager orders once a month. How much could the firm
save annually in ordering and carrying costs by using the EOQ?
Qpresent = 800/month, so D = 12×800 = 9600 crates/year.
H = 0.35×$10 = $3.50/crate per year.
S = $28 Can save 364.28
2 DS 2 9600 28 per year
Q EOQ   391.93round to 392
H 3.5 (=1736 – 1371.71)
Q present D 800 9600
TCPresent = H  S  3.5  28 1736
2 Q present 2 800
QEOQ D 392 9600
TCEOQ = H  S  3.5  28 1371.71
2 QEOQ 2 392
12 - 28
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

12 - 29
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

12 - 30
Reorder Point Curve

Q*
Resupply takes place as order arrives
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L

12 - 31
Reorder Points

The above equation assumes that demand during lead

time is constant.
If this is not the case, extra stock called safety stock
(ss) is added:

12 - 32
Reorder Points
Ex) An Apple store has a demand (D) for 8,000 iPods 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 safety stock.
Demand = 8,000 iPods per year
250 working day year
Lead time for orders is 3 working days, may take 4
D
d (demand per day) =
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
= 32 units per day x 4 days = 128 units
12 - 33
 Production Order Quantity Model
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

Part of inventory cycle during which

Inventory level

production (and usage) is taking place

Demand part of cycle with no
production (only usage)
Maximum
inventory

t Time
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 = (Average inventory level) x Holding cost

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
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

Q
Maximum inventory level = (p  d )
p
Maximum inventory level 1Q
Holding cost = (H) = (p - d )H
2 2 p
 Production Order Quantity Model
Inventory level

Part of inventory cycle during which

production (and usage) is taking place

Maximum Demand part of cycle with no

inventory production (only usage)

Q
( p  d)
p
t Time

Run time: Cycle time:

the production phase of the cycle the time between setups
Q of consecutive runs
t Q
p 
d
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
Setup cost = ( D / Q) S
1Q
Holding cost = ( p  d )H
2 p
D 1Q
S ( p  d )H
Q 2 p
2 DS
Q2 
H  1  d p 
2 DS
Q*p 
H  1  d p 
Production Order Quantity Model
Ex) Nathan Manufacturing, Inc., makes and sells specialty hubcaps for the
retail automobile aftermarket. Nathan’s forecast for its wire-wheel hubcap
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 hubcap only as needed, during the 250 days per year
the shop operates.)
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 2(1, 000)(10) 20, 000
Q*p   
H  1  d p  0.50 1  (4 8)  0.50(1 2)

 80, 000 282.8 hubcaps, or 283 hubcaps

Economic Production Quantity (EPQ) – Handout Q1
Ex) The Friendly Sausage Factory (FSF) can produce hot dogs at a rate of
5,000 per day. FSF supplies hot dogs to local restaurants at a steady
rate of 250 per day. The cost to prepare the equipment for producing
hot dogs is $66. Annual holding costs are 45 cents per hot dog. The
factory operates 300 days a year.
a) Find the optimal run size?
p = 5000 hotdogs/day
d = 250 hotdogs/day
D= 250/day × 300 days/yr. = 75,000 hotdogs/year
S = $66
H = $.45/hotdog per year
2 DS 2 75000 66
QP*   4812.27 round to 4812
H  1  d p  .45  1  250 5000 
Economic Production Quantity (EPQ) – Handout Q1
Ex) The Friendly Sausage Factory (FSF) can produce hot dogs at a rate of
5,000 per day. FSF supplies hot dogs to local restaurants at a steady
rate of 250 per day. The cost to prepare the equipment for producing
hot dogs is $66. Annual holding costs are 45 cents per hot dog. The
factory operates 300 days a year.
b) Find the number of runs per year?

D 75000
 15.59 round to 16 runs per year
QP* 4812

c) Find the length (in days) of a run?

QP* 4812
 0.96 days, or approximately 1 day.
p 5000
Quantity Discount Model
▶ Reduced prices are often available when larger quantities
are purchased
▶ Trade-off is between reduced product cost and increased
holding cost

Discount
Quantity Unit Price
number
1 0 to 999 $5.00 Normal price – no discount
2 1,000 to 1,999 $4.80
3 2,000 and over $4.75
 Quantity Discount Model
Total annual cost

Total Cost Carrying Cost  Ordering Cost  Purchasing Cost

Q D
 H  S  PD
2 Q

re Q = Quantity ordered P = Price per unit

D = Annual demand in units H = Holding cost per unit per yea
S = Ordering cost per order

2 DS
Q*p 
IP
Because unit price varies, the holding cost (H) is expressed as a
percent (I) of unit price (P), therefore: H I P
Quantity Discounts Model
Basic EOQ model vs. Quantity discount model
 The total-cost curve with quantity discounts is
composed of a portion of the total-cost curve for each
price
Quantity Discount Model
Steps in analyzing a quantity discount

1. For each discount, calculate Q*

2. If Q* for a discount doesn’t qualify, choose the
lowest possible quantity 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
 Discount
Quantity Unit Price
number
Quantity Discount Model 1 0 to 999 $5.00
2 1,000 to 1,999 $4.80
3 2,000 and over $4.75

Total cost curve for discount 2

Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a and
must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
Quantity Discounts Model
Ex) Wohl’s Discount Store stocks toy race cars. Recently, the store has
been given a quantity discount schedule for these cars. This is shown
in the below table. Furthermore, ordering cost is $49.00 per order,
annual demand is 5,000 race cars, and inventory carrying charge, as a
percentage of cost, I, is 20% or 0.2.
What order quantity will minimize the total inventory cost?

D = 5,000 race cars per year

S = $49
H = 0.2×P
Quantity Unit Price
0 to 999 $5.00
1,000 to 1,999 $4.80
2,000 or more $4.75
 Quantity Discounts Model
Ex) D = 5,000 race cars per year
S = $49 * 2 DS
Q 
H = 0.2×P p
IP

Unit
Quantity H
Price

* 2 5000 49
0 to 999 $5.00 0.2×5.00=1 Q 
1 700
1
2 5000 49
1,000 to 1,999 $4.80 0.2×4.80=0.96
*
Q 
2 714 Infeasible!
0.96 1,000 - adjusted
* 2 5000 49
2,000 or more $4.75 0.2×4.75=0.95 Q3  718 Infeasible!
0.95 2,000 - adjusted
 Quantity Discounts Model
Ex) D = 5,000 race cars per year
S = $49 Q D
TC  H  S  PD
H = 0.2×P 2 Q

Unit Order
Quantity Annual Holding Cost
Price Quantity

700
0 to 999 $5.00 700 1 350
2
1000
1,000 to 1,999 $4.80 1000 0.96 480
2
2000
2,000 or more $4.75 2000 0.95 950
2
 Quantity Discounts Model
Ex) D = 5,000 race cars per year
S = $49 Q D
TC  H  S  PD
H = 0.2×P 2 Q

Unit Order
Quantity Annual Ordering Cost
Price Quantity

5000
0 to 999 $5.00 700 49 350
700

5000
1,000 to 1,999 $4.80 1000 49 245
1000

5000
2,000 or more $4.75 2000 49 122.50
2000
 Quantity Discounts Model
Ex) D = 5,000 race cars per year
S = $49 Q D
TC  H  S  PD
H = 0.2×P 2 Q

Unit Order
Quantity Annual Product Cost
Price Quantity

0 to 999 $5.00 700 5 5000 25000

1,000 to 1,999 $4.80 1000 4.80 5000 24000

2,000 or more $4.75 2000 4.75 5000 23750

 Quantity Discounts Model
Ex) D = 5,000 race cars per year
S = $49 Q D
TC  H  S  PD
H = 0.2×P 2 Q

Annual Annual Annual

Unit Order
Quantity Holding Ordering Product Total Cost
Price Quantity
Cost Cost Cost

0 to 999 $5.00 700 $350 $350 $25,000 $25,700

1,000 to
$4.80 1000 $480 $245 $24,000 $24,725
1,999

2,000 or more $4.75 2000 $950 $122.50 $23,750 $24,822.50

Quantity Discounts Model – Handout Q2
Ex) A manufacturer of exercise equipment purchases the pulley section of
the equipment from a supplier who lists these prices: less than 1,000,
$5 each; 1,000 to 3,999, $4.95 each; 4,000 to 5,999, $4.90 each; and
6,000 or more, $4.85 each. Ordering costs are $50, annual carrying
costs per unit are 40 percent of purchase cost, and annual usage is
4,900 pulleys. Determine an order quantity that will minimize total
cost.
D = 4900 units per year
S = $50
H = 0.4×P
Quantity Unit Price H
0 to 999 $5 0.4×5=2
1000 to 3999 4.95 0.4×4.95=1.98
4000 to 5999 4.90 0.4×4.90=1.96
6000 or more 4.85 0.4×4.85=1.94
 Quantity Discounts Model – Handout Q2
Ex) D = 4900 units per year
S = $50
H = 0.4×P

Unit
Quantity H
Price
Feasible!
0 to 999 $5 2

Infeasible!
1000 to 3999 4.95 1.98
1,000 - adjusted

4000 to 5999 4.90 1.96

Infeasible!
4,000 - adjusted
Infeasible!
6000 or more 4.85 1.94
6,000 - adjusted
 Quantity Discounts Model – Handout Q2
Ex) D = 4900 units per year
S = $50
H = 0.4×P
Annual Annual Annual
Unit Order
Quantity H Holding Ordering Product Total Cost
Price Quantity
Cost Cost Cost

0 to 999 $5 2 495 495 495 24500 25490

1000 to 3999 4.95 1.98 1000 990 245 24255 25490

4000 to 5999 4.90 1.96 4000 3920 61 24010 27991

6000 or more 4.85 1.94 6000 5820 41 23765 29626