PCOA 009

Management Science
First Semester, SY 2020-2021

Joseph Matthew A. Sierra, CPA

Instructor
MODULE 3

Module 3: Inventory Management

Introduction

• This module is about managing costs associated with inventories

• The module is organized as follows:
o Definition of Inventory
o EOQ Model
o The “How-much-to-order”
o The “When-to-order”
o Safety Stock
o Summary of Formulas
o Assessment
• This module tackles about Economic Order Quantity (EOQ) which aims to minimize the carrying cost
of inventory.
• Topic requires critical thinking and analysis
• Assessment is the application of Economic Order Quantity
Learning Objectives
At the end of this module, the students can:
• Comprehend the dynamics of inventory management’s principles, concepts, and techniques as they relate
to the entire supply chain (customer demand, distribution, and product transformation processes).
• Explain basic concepts of optimization, modelling and linear programming.
• Understand the methods used by organizations to obtain the right quantities of stock or inventory.
• Familiarize themselves with inventory management practices.

Inventory
Inventory refers to idle goods or materials held by an organization for use sometime in the future. Items carried
in inventory include raw materials, purchase parts, components, subassemblies, work-in-process, finished goods,
and supplies. Two primary reasons organizations stock inventory are: (1) to take advantage of economies-of-scale
that exist due to the fixed cost of ordering items, and (2) to buffer against uncertainty in customer demand or
disruptions in supply. Even though inventory serves an important and essential role. The expense associated with
financing and maintaining inventories is a substantial part of the cost of doing business. In large organizations,
the cost associated with inventory can run into the millions of dollars.
In applications involving inventory, managers must answer two important questions.
1. How much should be ordered when the inventory is replenished?
2. When should the inventory be replenished?
Virtually every business uses some sort of inventory management model or system to address the preceding
questions.
Economic Order Quantity (EOQ) Model
The economic order quantity (EOQ) model is applicable when the demand for an item shows a constant, or nearly
constant, rate and when the entire quantity ordered arrives in inventory at one point in time. The constant demand
rate assumption means that the same number of units is taken from inventory each period of tie such as 5 units
every day, 25 units every week, 100 units every four-week period, and so on.
To illustrate the EOQ model, let us consider the situation faced by the R&B Beverage Company. R&B Beverage
is a distributor of beer, wine, and soft drink products. From a main warehouse located in Columbus, Ohio, R&B
supplies nearly 1000 retail stores with beverage products. The beer inventory, which constitutes 40% of the
company’s total inventory, averages approximately 50,000 cases. With an average cost per case of approximately
$8, R&B estimates the value of its beer inventory to be $400,000.
The warehouse manager decided to conduct a detailed study of the inventory costs associated with Bub Beer, the
number-one-selling R&B beer. The purpose of the study is to establish the how-much-to-order and the when-to-
order decision for Bub Beer that will result in the lowest possible cost. The warehouse manager obtained the
following demand data for the past 10 weeks:

Week Demand (cases)

1 2,000
2 2,025
3 1,950
4 2,000
5 2,100
6 2,050
7 2,000
8 1,975
9 1,900
10 2,000
Total cases 20,000

Average cases per week 2,000

In this situation, because demand varies from a low of 1900 to a high of 2100 cases, the assumption of constant
demand of 2000 per week appears to be a reasonable approximation.
The how-much-to-order decision involves selecting an order quantity that draws a compromise between (1)
keeping small inventories and ordering frequently, and (2) keeping large inventories and ordering infrequently.
The first alternative can result in undesirably high ordering costs, while the second alternative can result in
undesirably high inventory holding costs.
Holding costs are the costs associated with maintaining or carrying a given level of inventory; these costs depend
on the size of the inventory. The first holding cost to consider is the cost of financing the inventory investment.
When a firm borrows money, it incurs an interest charge. If the firm uses its own money, it experiences an
opportunity cost associated with not being able to use the money for other investments. In either case, an interest
cost exists for the capital tied up in inventory. This cost of capital is usually expressed as percentage of the
amount invested.
R&B estimates its cost of capital at an annual rate of 18%. A number of other holding costs, such as insurance,
taxes, breakage, pilferage, and warehouse overhead, also depend on the value of the inventory. R&B estimates
theses other costs at an annual rate of approximately 7% of the value of the inventory. Thus, the total holding cost
for the R&B beer inventory is 18% + 7% = 25% of the inventory value, the cost of holding one case of Bub Beer
in inventory for 1 year is 0.25(8) = $2.00.
Ordering cost. This cost, which is considered fixed regardless of the order quantity, covers the preparation of the
voucher; and the processing of the order, including payment, postage, telephone, transportation, invoice
verification, receiving, and so on. For R&B Beverage, the largest portion of the ordering cost involves the salaries
of the purchasers. An analysis of the purchasing process showed that a purchaser spends approximately 45
minutes preparing and processing an order for Bub Beer. With a wage rate and fringe benefit cost for purchasers
of $20 per hour, the labor portion of the ordering cost is $15. Making allowances for paper, postage, telephone,
transportation, and receiving cost at $17, the manager estimates that the ordering cost is $32 per order. That is,
R&B is paying $32 per order regardless of the quantity requested in the order.
The holding cost, ordering cost, and demand information are the three data items that must be known prior to the
use of the EOQ model. After developing these data for the R&B problem. We can look how they are used to
develop a total cost model.
The holding cost can be calculated using the average inventory. That is we can calculate the holding cost by
multiplying the average inventory by the cost of carrying one unit in inventory for the stated period. The period
selected for the model is up to you; it could be one week, one month, one year, or more. However, because the
holding cost for many industries and businesses is expressed as an annual percentage, most inventory models are
developed on an annual cost basis.
INVENTORY FOR BUB BEER
Inventory

0 0

Length of time holding inventory

Average Inventory Maximum inventory Minimum Inventory

INVENTORY PATTERN FOR THE EOQ INVENTORY MODEL

0 0

Average Inventory Maximum inventory Minimum Inventory

Let
i = Annual holding cost rate
C = Unit cost of the inventory item
𝐶ℎ = Annual cost of holding one unit in inventory
The annual cost of holding one unit in inventory is
𝐶ℎ = iC
The general equation for the annual holding cost for the average inventory of ½ Q units is as follows:
Annual holding cost = (Average inventory) (Annual holding cost per unit)
= ½ Q𝐶ℎ
To complete the total cost model, we must now include the annual ordering cost.
Let D denote the annual demand for the product. For R&B Beverage, D = (52 weeks) (2000 cases per week) =
104,000 cases per year.
Annual ordering cost = (Number of orders per year) (Cost per order)

= (𝐷⁄𝑄 ) 𝐶𝑂

Thus, the total annual cost, denoted TC, can be expressed as follows:
Total annual cost = Annual holding cost + Annual Ordering cost

TC = ½ Q𝐶ℎ + (𝐷⁄𝑄 ) 𝐶𝑂

Using Bub Beer data [𝐶ℎ = iC = (0.25) ($8) = $2, 𝐶𝑂 = $32, and D = 104,000], the total annual cost model is

TC = ½ Q ($2) +( 104,000⁄𝑄) ($32) = Q + 3,328,000⁄𝑄

The How-Much-to-Order Decision
The next step is to find the order quantity Q that will minimize the total annual cost for Bub Beer. Using a trial-
and-error approach, we can compute the total annual cost for several possible order quantities. As a starting point,
let us consider Q = 8,000. The total annual cost for Bub Beer is

TC = Q + 3,328,000⁄𝑄

= 8,000 + 3,328,000⁄8,000 = $8,416

A trial order quantity of 5,000 gives

TC = 5,000 +3,328,000⁄8,000 = $5,666

The minimum total cost order quantity is denoted by an order size of EOQ. By using differential calculus, it can
be shown that the value of EOQ that minimizes the total annual cost given by the formula.
2𝐷𝐶𝑂
EOQ = √
𝐶ℎ

The minimum total annual cost order quantity for Bub Beer is

2(104,000)(32)
EOQ = √ = 1,824 cases
2

The When-to-Order Decision

Now that we know how much to order, we want to address the question of when to order. To answer this question,
we need to introduce the concept of inventory position. The inventory position is defined as the amount of
inventory on hand plus the amount of inventory on order. The When-to-order decision is expressed in terms of a
reorder point – the inventory position at which new order should be placed.
The manufacturer of Bub Beer guarantees a two-day delivery on any order placed by R&B Beverage. Hence,
assuming R&B Beverage operates 250 days per year, the annual demand of 104,000 cases implies a daily demand
of 104,000/250 = 416 cases. Thus, we expect (2days) (416 cases per day) = 832 cases of Bub to be sold during
the two days it takes a new order to reach the R&B warehouse. In inventory terminology, the two-day delivery
period is referred to as the lead time for a new order, and the 832 cases demand anticipated during this period is
referred to as the lead time demand. Thus, R&B should order a new shipment of Bub Beer from the manufacturer
when the inventory reaches 832 cases. For inventory systems using the constant demand rate assumption and a
fixed lead time, the reorder point is the same as the lead time demand. For these systems, the general expression
for the reorder point is as follows:
r = dm
where

r = reorder point
d = demand per day
m = lead time for a new order in days
The question of how frequently the order will be placed can now be answered. The period between orders is
referred to as the cycle time. D/Q as the number of orders that will be placed in a year. Thus, D/EOQ =
104,000⁄
1,824 = 57 is the number of orders R&B Beverage will place for Bub Beer each year. If R&B places
57 orders over 250 working days, it will order approximately every 250⁄57 = 4.39 working days.

Safety stock
Safety stock is the quantity of goods that are carried as a protection against possible stockouts. Two cost must
be considered in establishing an optimal safety stock policy:
1. The cost to carry safety stock; and
2. The cost of a stockout.
The cost of carrying safety stock is the same as the cost of carrying working inventory while the stockout costs
usually expressed in terms of the costs of alternative sources of supply, loss of customers or goodwill and shutting
down of operations over the stockout period.
Illustration 1:
A safety stock of 250 has been chosen for Material X. The lead time is 6 days and the annual usage is 25,000
units.
Solution:
25,000
Reorder Point = x 6 + 250 = 932 Units
220
Illustration 2:
Otis company buys ping-pong balls at P25 per dozen from its wholesalers. Otis will sell 35,000 dozen baseball
evenly throughout the year. Otis desires a 12% return on investment (cost of capital) on its inventory investment.
In addition, rent, insurance, taxes, etc. for each dozen of ping-pong ball in inventory is P0.50. the order cost is
P10. Lead time is consistent at two weeks and there are 50 working weeks in a year. The maximum expected
requirement per week is 850 dozens.
Required:
1. Determine the EOQ
2. Determine the Safety Stock
3. Determine the Reorder point
Solution:

2(35,000)(10) 2(35,000)(10)
1. EOQ = √
(𝑃25 𝑥 12%)+0.50
=√ = 447 dozens
𝑃3.50

2. Maximum Lead time usage 850

Less: Average Lead time usage (35,000 ÷ 50) 700
Excess 150
Multiply: Lead time 2
Safety Stock 300
 3. Reorder Point = 700 x 2 + 300 =1700 dozens

Summary of Formulas:

2(𝐷𝑒𝑚𝑎𝑛𝑑 𝑜𝑟 𝑢𝑠𝑎𝑔𝑒)(𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡)

EOQ = √
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡

Reorder Point = Average lead time usage + safety stock

Average lead time usage (lead time demand)
= Lead time x Average usage per unit of time

Safety Stock = (Maximum lead time usage – Normal lead time usage) x Lead time
𝐴𝑛𝑛𝑢𝑎𝑙 𝑢𝑠𝑎𝑔𝑒 𝑜𝑟 𝐷𝑒𝑚𝑎𝑛𝑑
Annual Ordering Cost = x Cost per order
𝐸𝑂𝑄
𝑂𝑟𝑑𝑒𝑟 𝑆𝑖𝑧𝑒
Annual Carrying cost = x Carrying cost per unit
2
Exercises:
PROBLEM 1
Using the EOQ model, Apple Corporation computed economic order quantity for one of the products it sells to
be 4,000 units. Apple Corporation maintains safety stock of 300 units. The quarterly demand for the product is
10,000 units. The order cost is P200 per order. The purchase price of the product is P2.40. The company sells at
a 100% markup. The annual inventory carrying cost is equal to 25% of the average inventory level.
Requirement:
1. How much is the inventory carrying costs?
2. How much is the inventory order cost per year?
PROBLEM 2
Zac Traders, Inc. sells cellphone cases which it buys from a local manufacturer. Zac traders sells 24,000 cases
evenly throughout t he year. The cost of carrying one unit in inventory for one year is P11.52 and the order cost
per order is P38.40.
1. What is the economic order quantity?
2. If Zac would buy in economic order quantities, how much is the total order costs?
3. If Zac would buy in economic order quantities, how much is the inventory carrying costs per year?
4. If the annual demand increases by 44%, the EOQ will increase (decrease) by what percentage?
Reference:

Anderson, D., Sweeney, D., Williams, T., Camm, J., Cochran, J., Fry, M., & Ohlmann, J. (2016). Inventory

Models. In An Introduction to Management Science: Quantitative Approaches to Decision Making (14th

ed., pp. 457–505). Cengage Learning.