AMA International

University

College of administrative
and Financial Science
Midterm Lecture Note
Subject:-
Management Science – 2
ABI-301

INVENTORY MANAGEMENT

Prepared by: Abdulaziz Al-Sa’adi

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INVENTORY MANAGEMENT
Inventory is a stock or store of goods. It includes raw materials or stock incoming suppliers.

What to Inventory?
(A) Raw materials and purchased parts
(B) Partially completed goods
(C) Finished-goods inventories or merchandise
(D) Replacement parts, tools, and suppliers
(E) Goods-in-transit to warehouses or Goods In progress

Types of Demand:
1) Dependent Demand
These are items that are typically subassemblies or component parts that will be
used in the production of a final or finished product. Subassemblies and
component a part is derived from the number of finished units that will be
produced. Example: Demand for wheels for new cars.
2) Independent Demand
These are items that are the finished goods or other end items. These items are
sold or at least shipped out rather than used in making another product.

Functions of Inventory
1. To meet anticipated customer demand. These inventories are referred to as
anticipation stocks because they are held to satisfy planned or expected demand.
2. To smooth production requirements. Firms that experience seasonal patterns in
demand often build up inventories during off-season to meet overly high requirements
during certain seasonal periods. Companies that process fresh fruits and vegetable
deal with seasonal inventories
3. To decouple operations. The buffers permit other operations to continue temporarily
while the problem is resolved. Firms have used buffers of raw materials to insulate
production from disruptions in deliveries from suppliers, and finished goods inventory
to buffer sales operations from manufacturing disruptions.
4. To protect against stock-outs. Delayed deliveries and unexpected increases in demand
increase the risk of shortages. The risk of shortages can be reduced by holding safety
stocks, which are stocks in excess of anticipated demand.
5. To take advantage of order cycles. Inventory storage enables a firm to buy and
produce in economic lot sizes without having to try to match purchases or production
with demand requirements in short run.
6. To hedge against price increase. The ability to store extra goods also allows a firm to
take advantage of price discounts for large orders.
7. To permit operations. Production operations take a certain amount of time means that
there will generally be some work-in-process inventory.

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Midterm Notes
Inadequate control of inventories
Inadequate control of inventories can result into two categories:
1) Under stocking results in missed deliveries, lost sales, dissatisfied customers and
production bottlenecks.
2) Overstocking unnecessarily ties up funds that might be more productive

Two Main Concerns of Inventory Management

First Concern Level of customer service to have the right goods, in sufficient quantities, in
the right place, and at the right time, second Cost of ordering and carrying inventories.

Objectives of Inventory Management

To achieve satisfactory levels of customer service while keeping inventory costs within
reasonable bounds. Specifically Decision maker tries to achieve a balance in stocking and
Fundamental decision must be made related to the timing and size of orders

Requirements for Effective Inventory Management

To be effective, management must have the following:
1. A system to keep track of the inventory on the hand on order.
2. A reliable forecast of demand that includes an indication of possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
5. A classification system for inventory items.

Inventory Counting Systems

1) Periodic System
This is a physical count of items in inventory is made at periodic intervals (e.g. weekly,
monthly) in order to decide how much to order of each item. Major users: Supermarkets,
discounts stores, and department stores.

Advantage
Orders for many items occur at the same time, which can result in economies in processing
and shipping orders

Disadvantages
a) Lack of control between reviews.
b) The need to protect against shortages between review periods by carrying extra stock.
c) The need to make a decision on order quantities at each review

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Midterm Notes
2) Perpetual Inventory System (also known as a continual system)
This keeps track of removals from inventory on a continuous basis, so the system can provide
information on the current level of inventory for each item.

Advantages
1. The control provided by the continuous monitoring of inventory withdrawals.
2. The fixed-order quantity; management can identify an economic order size.

Disadvantage
1. The added cost of record keeping.
Two-bin-system method
Is two containers of inventory; reorder when the first is empty. The advantage of this system
is that there is no need to record each withdrawal from inventory; the disadvantage is that the
reorder card may not be turned in for a variety of reasons.

Tracking System
Universal Product Code (UPC) bar code printed on a label that has information about the
item to which it is attached. Bar coding represents an important development for other sectors
of business besides retailing. In manufacturing, bar codes attached to parts, subassemblies,
and finished goods greatly facilitate counting and monitoring activities.

Demand Forecast and Lead time Information

Managers need to know the extent to which demand and lead time might vary; the greater
the potential variability, the greater the need for additional stock to reduce the risk of a
shortage between deliveries.

Lead time is time interval between ordering and receiving the order.

Inventory Cost (Three Basic Costs )

1. Holding or Carrying Cost is the costs to carry an item in inventory for a length of
time usually a year. Cost includes interest, insurance, taxes, depreciation,
obsolescence, deterioration, spoilage, pilferage, breakage, etc.

2. Ordering Cost is cost of ordering and receiving inventory. These include determining
how much is needed, preparing invoices, inspecting goods upon arrival for quality and
quantity, and moving the goods to temporary storage.

3. Storage Cost is cost resulting when demand exceeds the supply of inventory on hand.
These costs can include the opportunity cost of not making a sale, loss of customer
goodwill, late charges, and similar costs

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Midterm Notes
 Inventory Management Continue….
Classification System
An important aspect of inventory management is that items held in inventory are not of equal
importance in terms of dollars invested, profit potential, sales or usage volume, or stock-out
penalties. Example: A producer of electrical equipment might have electric generators, coils
of wire, and miscellaneous nuts and bolts among the items carried in inventory. It would be
unrealistic to devote equal attention to each of these items.

A-B-C Approach
A-B-C Approach classifies inventory items according to some measure of importance, usually
annual dollar usage, and then allocates control efforts accordingly.

Three Classes of Items Used:

A (very important)
B (moderately important)
C (least important)

The key questions concerning cycle counting for management are:

1. How much accuracy is needed?
2. When should cycle counting be performed?
3. Who should do it?

ECONOMIC ORDER QUANTITY MODELS

Economic Order Quantity (EOQ) is the order size that minimizes total cost. EOQ models
identify the optimal order quantity in terms of minimizing the sum of certain annual costs that
vary with order size.

Three (3) Order Size

1. The economic order quantity model.
2. The economic order quantity model with non instantaneous delivery.
3. The quantity discount model.

Inventory Cycles begins with the receipt of an order of Q units, which are withdrawn at
instant rate over time. When the quantity on the hand is just sufficient to satisfy demand
during lead time, an order for Q units is submitted to the supplier.

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Midterm Notes
 Developing EOQ Mathematical Model
Assumption of the Basic EOQ Model
1. Only one product is involved.
2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year so that the demand rate is
reasonably constant.
4. Lead time does not vary.
5. Each order is received in a single delivery.
6. There are quantity discounts.

Holding Cost(H) or carrying cost

relate to having items in storage. Cost
includes interest, insurance, tax,
depreciation Obsolesce, deterioration,
spoilage, breakage. Warehouse cost
(heat, light, security and rent.

In EOQ Model Holding Cost is

Express in terms of unit, So:
Total holding Cost =
Number of unit x quantity

Ordering Costs are the costs of

ordering and receiving inventory.
They are the cost that varies with the
actual placement of an order such as
shipping cost, preparing invoices,
inspecting goods upon arrivals.

The ordering Cost express as Fixed

dollars per order regardless of
order size.

By merging the two Graphs we can

notice that the minimum Inventory
Cost is at the intersection point.

Total Cost =
Holding Cost + Ordering Cost

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Midterm Notes
 2 D  S
EOQ 
Optimal Quantity = H

Q
Annual Holding Cost = .H
2
D
Annual Carrying Cost = Q .S
Q D
Total annual Inventory Cost= .H + .S
2 Q
Q
Length Of order Cycle = .
D

EXAMPLE OF ORDERING COST FACTORS

 Processing and inspecting incoming inventory
 Developing and sending purchase orders
 Bill paying
 Inventory inquiries
 Utilities, phone bills, and so on, for the purchasing department
 Salaries and wages for the purchasing department employees
 Supplies such as forms and paper for the purchasing department

EXAMPLES OF CARRYING COST FACTORS

 Cost of capital
 Taxes
 Insurance
 Spoilage
 Theft
 Obsolescence
 Supplies such as forms and paper for the warehouse
 Utilities and building costs for the warehouse
 Salaries and wages for warehouse employees

Determinants of Reorder point quantity (when we have to reorder?)

a) Rate of demand
b) The lead time
c) The extent of demand
d) The degree of stock out risk acceptable to management

ROP (Reorder Point) = Daily Demand X Lead Time

ROP = d x L
Note that Demand is on daily basis

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Midterm Notes
Example

SaveMart needs 1000 coffee makers per year. The cost of each coffee maker is $78.
Ordering cost is $100 per order. Carrying cost is $20 of per unit cost. Lead time is 5
days. SaveMart is open 360 days/yr.
(A) What is EOQ Model?
(B) How many times per year does the store reorder?
(C) What is the length of order cycle?
(D) What is the total annual cost if the EOQ quantity is ordered?

Answer

2 D S 2  1000  100 Q
(A) EOQ    .H = 100 units
H 10 2
D 1000
(B) Number of orders = Q . = . = 10 times
100
Q 100
(C) Cycle Length = .= . = 0.1 per year = 0.1 x 360 days/year = 36 days
D 1000
Q D 100 1000
(D) Total Annual Inventory Cost = .H + .S = .x 20  x100 =2000
2 Q 2 100

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Midterm Notes
 EOQ with Non instantaneous Replenishment (EPQ)

When a firm is both a producer and a user or deliveries are spread over time,
inventories tend to build up gradually instead of instantaneously. If usage production
(or delivery) rates are equal, there will be no inventory buildup since all output will be
used immediately and the issue of lot size doesn’t come up. In the more typical case, the
production or delivery rate exceeds the usage rate. In the production case, production
occurs over only a portion of each cycle because the production rate is greater than the
usage rate, and usage occurs over the entire cycle.
2 DS p
The economic Production Quantity = .
H pu

Total Inventory cost = Carrying cost + setup cost

I max D
TCmin  .H  .S
2 Q
Qp
Cycle Time = time between beginning of range
u
Qp
Run time = production phase of the cycle
p

I max
Average inventory I average 
2
Qp
The maximum inventory level = .( p  u )
p

Where
P is Production or Delivery Rate
U is usage rate

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Midterm Notes
Example
A toy manufacturer uses 48,000 rubber wheels per year for its popular dump truck. The firm
makes its own wheels, which it can produce at a rate of 800 per day. The toy trucks are assembled
uniformly over entire year. Carrying cost is $ 1 per wheel a year. Setup cost of production run of
wheels is $45. The firm operates 240 days per year. Determine the:-
a) Optimal Run Size.
b) Minimum total annual cost for carrying and setup.
c) Cycle time for the optimum run size.
d) Run time.

Answer
D = 48,000 wheels per year
S= $ 45
H= $ 1 per wheel per year
P = 800 wheels per day
U = 48,000 wheel per 240 days or 200 wheels per day
2 DS p 2( 48000) 45 800
a) Qp = . = . =2400 wheels
H pu 1 800  200
I max D
b) TCmin  .H  .S so we first must find Imax
2 Q
Qp 2400
The maximum inventory level = .( p  u ) = .(800  200)  1800 wheel
p 800

I max D 1800 4800

So TCmin  .H  .S = (1)  (45)  1800
2 Q 2 200
Q p 2400
c) Cycle Time =   12 days
u 200
Qp 2400
d) Run time =   3 days
p 800

EOQ with Quantity Discount

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Midterm Notes
Quantity Discounts are price reductions for large orders offered to customers to induce
them to buy in large quantities. If quantity discounts are offered, the customer must weigh the
potential benefits of reduced purchase price and fewer orders that will result from buying in large
quantities against the increase in carrying costs caused by higher average inventories

TC = carrying cost + Ordering cost + Purchasing Cost

Q D
TC = 2 .H  Q .S  PD. Where: P = Unit price

EXAMPLE
The maintenance department of a large hospital uses about 180 cases of liquid cleanser
annually. Ordering costs are $25, carrying costs are $5 per case a year, and the new
schedule indicates that orders of less than 45 cases will cost $2.0 per case, 45 to 69 will
cost $1.7 per case, and more than 70 cases will cost $1.4 per case. Determine the optimal
order quantity and total cost.

2 D S 2  180  25
EOQ    43 unit
H 5
Q D 43 180
Total Cost = .H + .S = . x5  x 25  2 x 43  298.15
2 Q 2 43
If we order 45 unit we may get discount the price will be reduced from $2 to $1.7 and the
total annual cost will be:-
Q D 45 180
Total Annual Cost = .H + .S = .x5  x 25  1.7 x180  518.5
2 Q 2 45
If we order 70 unit we may get further reduction as the price will be reduced from $1.7 to
$1.4 the annual cost in this case would be :-
Q D 70 180
Total Annual Cost = .H + .S = . x5  x 25  1.4 x180  491.3
2 Q 2 70

We can note that at some range from 45 to 70 units annual cost will be appropriate even the EOQ
state other range due to discount effect.
Problem#1

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Midterm Notes
A local distributor for a national tires company expects to sells approximately 9600 steel
belted radial tires of certain size and treated design next year. Annual carrying cost is $16 per
tire and ordering cost is $ 75. The distributor operates 288 days a year.
(A) What is EOQ Model?
(B) How many times per year does the store reorder?
(C) What is the length of order cycle?
(D) What is the total annual cost if the EOQ quantity is ordered?

Problem#2
A large bakery buys flour in 25-pound bags. The bakery uses an average of' 4,860 bags a year.
Preparing an order and receiving a shipment of flour involves a cost of $10 per order. Annual
carrying costs are $75 per bag.
(A) Determine the economic order quantity.
(B) What is the average number of bags on hand?
(C) How many orders per year will there be?
(D) Compute the total cost of ordering and carrying flour.
(E) If ordering costs were to increase by $1 per order, how much that would affect the
minimum total annual cost?

Problem#3

A large law firm uses an average of 40 boxes of copier paper a day. The firm operates 260
days a year. Storage and handling costs for the paper are $30 a year per box, and its costs
approximate $ 60 to order and receive a shipment of paper.
(A) What order size would minimize the sum of annual ordering and carrying costs?
(B) Compute the total annual cost using your order size from part a?
(C) Except for rounding, are annual ordering and carrying costs always equal at EOQ?
(D) The office manager is currently using an order size of 200 boxes. The partners of the
firm expect the office to be managed "in a cost-efficient manner." Would you
recommend that the office manages use the optimal order size instead of 200 boxes?
Justify your answer.

Problem#4
Highland Electric Co. buys coal from Cedar Creek Coal Co. to generate electricity.
CCCC can supply coal at the rate of 3,500 tons per day for $10.50 per ton. HEC uses the
coal at a rate of 800 tons per day and operates 365 days per year. HEC’s annual carrying
cost for coal is $2 per ton, and the ordering cost is $5,000.
a) What is the economical production lot size?
b) What is HEC’s maximum inventory level for coal?
c) What is Cycle time and run time for the optimum run size.

Problem#5

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Midterm Notes
The friendly Sausage factory (FSF) can produce hot dogs at a rate of 5,000 units per day.
FSF supplied hot dogs to local restaurant at a steady state rate of 250 per day. The cost to
prepare equipment for producing hot dog is $66. Annual holding cost is 45 cents per hot
dog. The factory operates 300 days a year. Find
a) The optimal run size.
b) The number of runs per year.
c) The length (in days) of a run.

Problem#6
A chemical firm produces sodium bisulphate in 100-pound bags. Demand for this product
is 20 tons per day. The capacity for producing the product is 50 tons per day. Setup cost
$100 and storage and handling cost are $5 per ton a year. The firm operates 200 days a
year. (Note 1 ton = 2000 pounds)
a) How many bags per run are optimal?
b) What would the average inventory be for this lot size?
c) Determine the approximate length of a production run in days?
d) About how many runs per year would there be?
e) How much could the company save annually if the setup cost reduced to $25 per
run?

Problem#7
A mail order house uses 18,000 boxes a year. Carrying cost are 60 cent of a box cost price and
ordering cost are $96 per order. The following price schedule applied. Determine:-
a) The optimal order quantity?
b) The number of orders per year?

Number of boxes Price per box

1000 to 1900 $ 1.25
2000 to 4999 $ 1.20
5000 to 9999 $ 1.15
10000 or more $1.10

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Midterm Notes