Operations Management

Inventory Management

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Importance of Inventory Management

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 Importance of Inventory

• One of the most expensive assets of many companies

representing as much as 50% of total invested capital
• Less inventory lowers costs but increases chances of running out
• More inventory raises costs but always keeps customers happy

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inventory is one of the most expensive assets of many companies, representing as much as 50% of total invested
capital. Operations managers around the globe have long recognized that good inventory management is crucial.
On the one hand, a frm can reduce costs by reducing inventory. On the other hand, production may stop and
customers become dissatisfed when an item is out of stock.

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 Objective of Inventory Management

• The objective of inventory management is to strike a balance

between inventory investment and customer service
• All organizations have some type of inventory planning and
control system.
• An inventory management plan addresses two issues: how much
to order and when to order

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The objective of inventory management is to strike a balance between inventory investment and customer
service. You can never achieve a lowcost strategy without good inventory management.

All organizations have some type of inventory planning and control system. A bank has methods to control its
inventory of cash. A hospital has methods to control blood supplies and pharmaceuticals.

In this chapter, we discuss the functions, types, and management of inventory. We then address two basic
inventory issues: how much to order and when to order.

4
 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

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Inventory can serve several functions that add flexibility to a firm’s operations. The four functions of inventory
are:

1. To provide a selection of goods for anticipated customer demand and to separate the firm from fluctuations
in that demand. Such inventories are typical in retail establishments.
2. To decouple various parts of the production process. For example, if a firm’s supplies fluctuate, extra
inventory may be necessary to decouple the production process from suppliers.
3. To take advantage of quantity discounts, because purchases in larger quantities may reduce the cost of
goods or their delivery
4. To hedge against inflation and upward price changes.

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 • 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
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To accommodate the functions of inventory, firms maintain four types of inventories: (1) raw material inventory,
(2) work-in-process inventory, (3) maintenance/repair/operating supply (MRO) inventory, and (4) fnished-goods
inventory.

Raw material inventory is purchased but not processed.

Work-in-process (WIP) inventory is components or raw material that have undergone some change but are not
completed. WIP exists because of the time it takes for a product to be made

MROs are inventories devoted to maintenance/repair/operating supplies necessary to keep machinery and
processes productive. They exist because the need and timing for maintenance and repair of some equipment are
unknown.

Finished-goods inventory is completed product awaiting shipment. Finished goods inventory is needed because
future customer demands are unknown.

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 The Material Flow Cycle

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Reducing cycle time reduces inventory. Often this task is not difficult: during most of the time a product is “being
made,” it is in fact sitting idle. As Figure 12.1 shows, actual work time, or “run” time, is a small portion of the
material fow time, perhaps as low as 5%.

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Managing Inventory

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 Managing Inventory

1) How inventory items can be classified (ABC

analysis)
2) How accurate inventory records can be
maintained

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Operations managers establish systems for managing inventory. We briefly examine two ingredients of such
systems: (1) how inventory items can be classified (called ABC analysis) and (2) how accurate inventory records
can be maintained.

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 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

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ABC analysis divides on-hand inventory into three classifcations on the basis of annual dollar volume. The idea is
to establish inventory policies that focus resources on the few critical inventory parts and not the many trivial
ones. It is not realistic to monitor inexpensive items with the same intensity as very expensive items.

To determine annual dollar volume for ABC analysis, we measure the annual demand of each inventory item
times the cost per unit.

Class A items are those on which the annual dollar volume is high. Although such items may represent only about
15% of the total inventory items, they represent 70% to 80% of the total dollar usage.

Class B items are those inventory items of medium annual dollar volume. These items may represent about 30%
of inventory items and 15% to 25% of the total value.

Those with low annual dollar volume are Class C, which may represent only 5% of the annual dollar volume but
about 55% of the total inventory items.

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 ABC Analysis

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Graphically, the inventory of many organizations would appear as presented in Figure 12.2

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 ABC Analysis Example

• Silicon Chips, Inc., maker of superfast DRAM chips, wants to

categorize its 10 major inventory items using ABC analysis.
• ABC analysis organizes the items on an annual dollar-volume
basis. Shown below (in columns 1–4) are the 10 items (identified
by stock numbers), their annual demands, and unit costs.
• Annual dollar volume is computed in column 5, along with the
percentage of the total represented by each item in column 6.
Column 7 groups the 10 items into A, B, and C categories.

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 ABC Analysis Example

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The objective of ABC analysis is to try to separate the “important” from the “unimportant.”

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 Record Accuracy

• Accurate records are a critical ingredient in production and

inventory systems
• Periodic systems require regular checks of inventory
• Two-bin system
• Perpetual inventory tracks receipts and subtractions on a
continuing basis
• May be semi-automated

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Record accuracy is a prerequisite to inventory management. Accuracy can be maintained by either periodic or
perpetual systems.

Periodic systems require regular (periodic) checks of inventory to determine quantity on hand. The downside is
lack of control between reviews and the necessity of carrying extra inventory to protect against shortages. A
variation of the periodic system is a two-bin system. In practice, a store manager sets up two containers (each
with adequate inventory to cover demand during the time required to receive another order) and places an order
when the first container is empty.

Alternatively, perpetual inventory tracks both receipts and subtractions from inventory on a continuing basis.
Receipts are usually noted in the receiving department in some semi-automated way, such as via a bar-code
reader.

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 Cycle Counting

• Items are counted and records updated on a periodic basis

• Often used with ABC analysis
• Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records

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Even though an organization may have made substantial efforts to record inventory accurately, these records
must be verifed through a continuing audit. Such audits are known as cycle counting

Cycle counting uses inventory classifcations developed through ABC analysis. With cycle counting procedures,
items are counted, records are verifed, and inaccuracies are periodically documented. The cause of inaccuracies is
then traced and appropriate remedial action taken to ensure integrity of the inventory system. A items will be
counted frequently, perhaps once a month; B items will be counted less frequently, perhaps once a quarter; and C
items will be counted perhaps once every 6 months

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 Cycle Counting Example

5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C

items

Policy is to count A items every month (20 working days), B items

every quarter (60 days), and C items every six months (120 days)

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This daily audit of 77 items is much more efficient and accurate than conducting a massive inventory count once a
year.

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 Knowledge Check

David Alexander has compiled the following table of six items in

inventory at Angelo Products, along with the unit cost and the
annual demand in units, classify the items in an ABC analysis

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 Solution

B item
B item
C item

A item
C item

C item

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 Inventory Models

We now examine a variety of inventory models and the costs associated with them.

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 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

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 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

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Inventory control models assume that demand for an item is either independent of or dependent on the demand
for other items. For example, the demand for refrigerators is independent of the demand for toaster ovens.
However, the demand for toaster oven components is dependent on the requirements of toaster ovens.

This chapter focuses on managing inventory where demand is independent

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 Inventory Models

• Holding costs - the costs of holding or “carrying” inventory

over time
• Ordering cost - the costs of placing an order and receiving
goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
• May be highly correlated with setup time

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Holding costs are the costs associated with holding or storing inventory over time. holding costs also include
obsolescence and costs related to storage, such as insurance, extra staffng, and interest payments

Ordering cost includes costs of supplies, forms, order processing, purchasing, clerical support, and so forth. When
orders are being manufactured, ordering costs also exist, but they are a part of what is called setup costs. Setup
cost is the cost to prepare a machine or process for manufacturing an order. This includes time and labor to clean
and change tools or holders.

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 Holding Costs

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Table 12.1 shows the kinds of costs that need to be evaluated to determine holding costs. Many frms fail to
include all the inventory holding costs. Consequently, inventory holding costs are often understated.

Holding costs vary considerably depending on the business, location, and interest rates. Generally greater than
15%, some high tech and fashion items have holding costs greater than 40%.

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 Holding Cost

• The holding cost is computed as a function of the amount of

inventory on hand.
• It is calculated per unit held in inventory per unit time

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 Ordering/ Setup Cost

The order/setup cost has 2 components: a fixed cost K incurred

independent of the size of the order and a variable cost incurred on
a per unit basis
0 if 𝑥 = 0
𝑂𝐶(𝑥) =
𝐾 + 𝑐𝑥 if 𝑥 > 0

• As mentioned previously Costs included in K typically include

book-keeping costs associated with processing an order, fixed
transportation costs, and order handling costs.

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 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

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we introduce three inventory models that address two important questions: when to order and how much to
order. These independent demand models are:

1. Basic economic order quantity (EOQ) model

2. 2. Production order quantity model
3. 3. Quantity discount model

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 The Economic Order Quantity model

We now examine a variety of inventory models and the costs associated with them.

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 Basic EOQ Model

Model 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

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The economic order quantity (EOQ) model is one of the most commonly used inventory-control techniques. This
technique is relatively easy to use but is based on several assumptions:

1. Demand for an item is known, reasonably constant, and independent of decisions for other items.
2. Lead time—that is, the time between placement and receipt of the order—is known and consistent.
3. Receipt of inventory is instantaneous and complete. In other words, the inventory from an order arrives in
one batch at one time.
4. Quantity discounts are not possible.
5. The only variable costs are the cost of setting up or placing an order (setup or ordering cost) and the cost of
holding or storing inventory over time (holding or carrying cost). These costs were discussed in the previous
section.
6. Stockouts (shortages) can be completely avoided if orders are placed at the right time

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 Basic EOQ Model

• Let Q be the order size

• Whenever the inventory level reaches zero, order Q.
• Now we can determine the optimal value of Q that
minimizes cost per unit time.

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With these assumptions, the graph of inventory usage over time has a sawtooth shape, as in Figure 12.3. In Figure
12.3, Q represents the amount that is ordered. If this amount is 500 dresses, all 500 dresses arrive at one time
(when an order is received). Thus, the inventory level jumps from 0 to 500 dresses. In general, an inventory level
increases from 0 to Q units when an order arrives. Because demand is constant over time, inventory drops at a
uniform rate over time. (Refer to the sloped lines in Figure 12.3.) Each time the inventory is received, the
inventory level again jumps to Q units (represented by the vertical lines). This process continues indefinitely over
time

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 Basic EOQ Model

• T = Q/D.
• The cost per ordering cycle is the sum of holding and ordering cost.
• Let I(t) be the inventory level at time t. The holding cost per cycle is
ℎ𝑄
ℎ𝐼(𝑡)𝑑𝑡 = ℎ × area under inventory level =  .
2𝐷
The ordering cost per cycle is K + cQ.
• Then, the cost per ordering cycle is 𝐶 (𝑄) = 𝐾 + 𝑐𝑄 + ℎ𝑄 /(2𝐷)
• The cost per unit time is
𝐶 (𝑄) 𝐾 + 𝑐𝑄 + ℎ𝑄 /(2𝐷) 𝐷 𝑄
𝐶 (𝑄) = = = 𝐾 + 𝑐𝐷 + ℎ  .
𝑇 𝑄/𝐷 𝑄 2

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 Basic EOQ Model

• The cost per unit time is

( ) /( )
• 𝐶 (𝑄) = = = 𝐾 + 𝑐𝐷 + ℎ  .
/
• Differentiating implies that
( ) ( )
• =− +  , = > 0 
• Therefore, CU(Q) is convex, and the optimal order quantity that
minimizes CU(Q), Q*, is found by setting the first derivative
equal to zero as 𝑄 ∗ =

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 An EOQ Example

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
Determine optimal number of needles to order
D = 1,000 units/year
K = $10 per order
h = $.50 per unit per year
× ×
𝑄∗ = = .
= 40,000 = 200 units

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 An EOQ Example

• Sharp, Inc. has a 250-day working year and wants to find the
number of orders (N) and the expected time between orders (T).
• Expected Number of orders=𝑁 = ∗ = = 5 𝑜𝑟𝑑𝑒𝑟𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

• Cycle Length = T = 𝑦𝑒𝑎𝑟𝑠 = = 50 𝑑𝑎𝑦𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑜𝑟𝑑𝑒𝑟𝑠

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 An EOQ Example

• The cost per unit time is

𝐷 𝑄
𝑇𝐶 = 𝐾 + 𝑐𝐷 + ℎ  
𝑄 2
• Since the term 𝑐𝐷 is constant, it is often omitted when
calculating the total cost per year
• In this example 𝑇𝐶 = 𝐾 + ℎ   = 10 × + .5 × =
100$\year

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 An EOQ Example

• When including actual cost of material c

• Total annual cost = Setup cost + Holding cost + Product cost
• 𝑇𝐶 = 𝐾 + ℎ   + 𝑐𝐷
• Because material cost does not depend on the particular order
policy, we still incur an annual material cost of 𝑐𝐷
• Since 𝑐 = $10, an additional 𝑐𝐷=$10,000 is incurred.

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 Robustness of EOQ

• 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

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A benefit of the EOQ model is that it is robust. By robust we mean that it gives satisfactory answers even with
substantial variation in its parameters. The total cost of the EOQ changes little in the neighborhood of the
minimum as it can be seen from the graph. The curve is very shallow. This means that variations in setup costs,
holding costs, demand, or even EOQ make relatively modest differences in total cost.

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 Example

• Management in the Sharp, Inc., examples underestimates total

annual demand by 50% (say demand is actually 1,500 needles
rather than 1,000 needles) while using the same Q. How will the
annual inventory cost be impacted?

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 Example

𝐷 = 1,500 units, K = $10 per order, h = $.50 per unit per year
• If Demand is actually 1,500 needles rather than 1,000, but
management uses an order quantity of Q=200(when it should be
Q=244.9 based on D=1,500)
• 𝑇𝐶 = + = 10 × + .5 × = 125
• If the correct Q=244.9 was placed:
.
• 𝑇𝐶 = + = 10 × .
+ .5 × = 122.47
• Only 2% less than the total cost of $125 when the order quantity
was 200
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 Knowledge Check

he Warren W. Fisher Computer Corporation purchases 8,000

transistors each year as components in minicomputers. The unit
cost of each transistor is $10, and the cost of carrying one transistor
in inventory for a year is $3. Ordering cost is $30 per order.
What are (a) the optimal order quantity, (b) the expected number of
orders placed each year, and (c) the expected time between orders?
Assume that Fisher operates on a 200-day working year.

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 Solution

a)𝑄 ∗ = 400
b)N=20 orders
c) Time between orders= 10 working days

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 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
• 𝑅𝑂𝑃 = 𝐷 × 𝐿

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Now that we have decided how much to order, we will look at the second inventory question, when to order.
Simple inventory models assume that receipt of an order is instantaneous. In other words the model assumes it
will receive the ordered items immediately. However, the time between placement and receipt of an order, called
lead time, or delivery time, can be as short as a few hours or as long as months. Thus, the when-to-order decision
is usually expressed in terms of a reorder point (ROP) the inventory level at which an order should be placed

This equation for ROP assumes that demand during lead time and lead time itself are constant

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 Reorder Point

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We order ahead of time in such a way that the actual order is received when the on hand inventory is zero.

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 Reorder Point Example

• 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. The store wants to find the optimal
ordering policy (how much to order and the reorder point).
• 𝑅𝑂𝑃 = 𝐷 × 𝐿 = 8000 × =96

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 Reorder Point Example

• The equation for ROP assumes that demand during lead time
and lead time itself are constant. When this is not the case, extra
stock, often called safety stock (ss), should be added.
• 𝑅𝑂𝑃 = 𝐷 × 𝐿 + 𝑠𝑠
• Referring to the previous example, suppose that the delivery of
an order takes 3 working days, but has been known to take as
long as 4 days.
• 𝑅𝑂𝑃 = 𝐷 × 𝐿 = 8000 × + 8000 × =128

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The safety stock accounts for the uncertainty in lead time

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 Knowledge Check

Annual demand for notebook binders at Meyer’s Stationery Shop is

10,000 units. Brad Meyer operates his business 300 days per year
and finds that deliveries from his supplier generally take 5 working
days. Calculate the reorder point for the notebook binders.

Solution: ROP=167 (round to the nearest integer)

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 Production Order Quantity Model

We now examine a variety of inventory models and the costs associated with them.

46
 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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In the EOQ model, we assumed that the entire inventory order was received at one time. There are times,
however, when the firm may receive its inventory over a period of time. Such cases require a different model,
one that does not require the instantaneous-receipt assumption. This model is applicable under two situations:
(1) when inventory continuously fows or builds up over a period of time after an order has been placed or (2)
when units are produced and sold simultaneously. Under these circumstances, we take into account daily
production (or inventory-fow) rate and daily demand rate. Figure 12.6 shows inventory levels as a function of
time (and inventory dropping to zero between orders)

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 Production Order Quantity Model

Q(1-D/P)
P-D D
1 1

Q/P Time
T=Q/D

The cost per unit time is 𝐶 𝑄 = + = + 𝑐𝐷 +

1− = + where ℎ = ℎ(1 − )

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At each cycle a total of Q units are produced at a rate of P. As a result the length of the cycle where the inventory
is increasing is Q/P
Since the units are produced and consumed simultaneously, during the first part in the cycle the inventory
increases at a rate of P-D. The maximum inventory occurs at Q/P(P-D)=Q(1-D/P)

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 Production Order Quantity Model

The cost per unit time is 𝐶 𝑄 = + = +

1− = + where ℎ = ℎ(1 − )

2𝐾𝐷
𝑄 ∗=
ℎ(1 − 𝐷/𝑃)

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 Production Order Quantity Example

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.)

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 Production Order Quantity Example

D = 1,000 units/year
P =8 units per day= 2000 units/year
K= $10
h = $0.50 per unit per year

2𝐾𝐷 2 × 10 × 1000
𝑄 ∗= = = 282.8 ≈ 283
𝐷 1000
ℎ 1−𝑃 0.5 1 − 2000

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 Knowledge Check

Leonard Presby, Inc., has an annual demand rate of 1,000 units but
can produce at an average production rate of 2,000 units. Setup
cost is $10; carrying cost is $1. What is the optimal number of units
to be produced each time?
Solution: Q=200 units

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Quantity Discount Models

53
 Quantity Discount Models

• Reduced prices are often available when larger quantities are

purchased
• Trade-off is between reduced product cost and increased
holding cost

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To increase sales, many companies offer quantity discounts to their customers. A quantity discount is simply a
reduced price (P) for an item when it is purchased in larger quantities.

Discount schedules with several discounts for large orders are common. A typical quantity discount schedule
appears in Table 12.2. As can be seen in the table, the normal price of the item is $5. When 1,000 to 1,999 units
are ordered at one time, the price per unit drops to $4.80; when the quantity ordered at one time is 2,000 units or
more, the price is $4.75 per unit. As always, management must decide when and how much to order.

54
 Quantity Discount Models

• Total annual cost = Setup cost + Holding cost + Product cost

• 𝑇𝐶 = + + 𝑐𝐷, 𝑤ℎ𝑒𝑟𝑒 ℎ 𝑄 = 𝐼𝑃(Because unit price
varies, holding cost is expressed as a percent (I) of unit price (P) )
• where Q= Quantity ordered, P= Price per unit
• D= Annual demand in units,I = Holding cost per unit per year
expressed as a percent of price P
• K= Ordering or setup cost per order

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 𝐾𝐷 𝐼𝑃𝑄
𝑇𝐶 = + + 𝑐𝐷
𝑄 2

• 𝑄∗ =
• Note that cD is no longer constant since this term depends on
the quantity purchased

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 1. For each discount, calculate a value for optimal order size Q*,
using the following equation: 𝑄 ∗ =
2. For any discount, if the order quantity is too low to qualify for the
discount, adjust the order quantity upward to the lowest quantity
that will qualify for the discount.
3. Using the preceding total cost equation, compute a total cost for
every Q* determined in Steps 1 and 2.
4. Select the Q* that has the lowest total cost, as computed in Step
3. It will be the quantity that will minimize the total inventory
cost.
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 Quantity Discount Example

Wohl’s Discount Store stocks toy race cars. Recently, the store has been given a
quantity discount schedule for these cars. This quantity schedule was shown in Table
12.2. Thus, the normal cost for the toy race cars is $5.00. For orders between 1,000
and 1,999 units, the unit cost drops to $4.80; for orders of 2,000 or more units, the
unit cost is only $4.75. Furthermore, ordering cost is $49.00 per order, annual demand
is 5,000 race cars, and inventory carrying charge, as a percent of cost, I, is 20%, or .2.
What order quantity will minimize the total inventory cost?
The quantity discount schema is summarized in the following table:

𝑄 < 1000
1000 ≤ 𝑄 < 1999
𝑄 ≥ 2000
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 Quantity Discount Example

Calculate Q* for every discount starting with the lowest price

× ×
𝑄 ∗$ = = 700,feasible
. ×

× ×
𝑄 ∗. $ = . × .
= 714, which is infeasible since in that price
range we should order is between 1000 and 1999- needs to be
adjusted
× ×
𝑄 ∗. $ = = 718, which is infeasible since in that price
. × .
range we should order at least 2000- needs to be adjusted
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 Quantity Discount Example

× ×
𝑄 ∗$ = = 700,
. ×

× ×
𝑄 ∗. $ = . × .
= 1000 − adjusted

× ×
𝑄 ∗. $ = = 2000-adjusted
. × .

ENMG 605: Operations Management 60

The second step is to adjust upward those values of Q* that are below the allowable discount range.

60
 Quantity Discount Example

𝐾𝐷 𝐼𝑃𝑄
𝑇𝐶 = + + 𝑐𝐷
𝑄 2

ENMG 605: Operations Management 61

compute a total cost for each order quantity. This step is taken with the aid of Table 12.3

61
 Quantity Discount Variations

• All-units discount is the most popular form

• Incremental quantity discounts apply only to those units
purchased beyond the price break quantity

ENMG 605: Operations Management 62

Another Quantity Discount model exists where the discounts are incremental.

62
 Knowledge Check

Whole Nature Foods sells a gluten-free product for which the annual
demand is 5,000 boxes. At the moment, it is paying $6.40 for each
box; carrying cost is 25% of the unit cost; ordering costs are $25. A
new supplier has offered to sell the same item for $6.00 if Whole
Nature Foods buys at least 3,000 boxes per order.
a) What is the cost from If the old supplier is chosen (round to the
nearest integer when calculating Q)?
Solution: Q=295, TC=33632
b) What is the cost from If the new supplier is chosen (round to the
nearest integer when calculating Q)?
Q=3000, TC=32292
ENMG 605: Operations Management 63

63
Probabilistic Models and Safety Stock

64
 Probabilistic Models and Safety Stock

• Used when demand is not constant or certain

• Use safety stock to achieve a desired service level and avoid
stockouts: ROP = d x L + ss
• Annual stockout costs = The sum of the units short for each
demand level × The probability of that demand level × The
stockout cost/unit × The number of orders per year

ENMG 605: Operations Management 65

Another Quantity Discount model exists where the discounts are incremental.

The following inventory models apply when product demand is not known but can be specified by means of a
probability distribution. These types of models are called probabilistic models. Probabilistic models are a real-
world adjustment because demand and lead time won’t always be known and constant.

Uncertain demand raises the possibility of a stockout. One method of reducing stockouts is to hold extra units in
inventory. Safety stock involves adding a number of units as a buffer to the reorder point and ROP=d x L + ss

The amount of safety stock maintained depends on the cost of incurring a stockout and the cost of holding the
extra inventory. Annual stockout cost is computed as follows: Annual stockout costs = The sum of the units
short for each demand level × The probability of that demand level × The stockout cost/unit × The
number of orders per year

65
 Safety Stock Example

David Rivera Optical has determined that its reorder point for eyeglass frames is
50 (d x L) units. Its carrying cost per frame per year is $5, and stockout (or lost
sale) cost is $40 per frame. The store has experienced the following probability
distribution for inventory demand during the lead time (reorder period). The
optimum number of orders per year is six. How much safety stock should David
Rivera keep on hand?

ENMG 605: Operations Management 66

66
 Safety Stock Example

ROP = 50 units Stockout cost = $40 per frame

Orders per year = 6 Carrying cost = $5 per frame per year

A safety stock of 20 frames gives the lowest total cost:

ROP = 50 + 20 = 70 frames

ENMG 605: Operations Management 67

67
 Knowledge Check

Children’s art sets are ordered once each year by Ashok Kumar, Inc., and the reorder
point, without safety stock (dL), is 100 art sets. Inventory carrying cost is $10 per set
per year, and the cost of a stockout is $50 per set per year. Given the following demand
probabilities during the lead time, how much safety stock should be carried?
a) 50
b) 100
c) 150
d) 0

The safety stock that minimizes total incremental cost is 50 sets. The reorder point
then becomes 100 sets + 50 sets, or 150 sets

ENMG 605: Operations Management 68

68
 Probabilistic Demand

ENMG 605: Operations Management 69

When it is difficult or impossible to determine the cost of being out of stock, a manager may decide to follow a
policy of keeping enough safety stock on hand to meet a prescribed customer service level. For instance, Figure
12.8 shows the use of safety stock when demand (for hospital resuscitation kits) is probabilistic. We see that the
safety stock in Figure 12.8 is 16.5 units, and the reorder point is also increased by 16.5.

The manager may want to define the service level as meeting 95% of the demand (or, conversely, having
stockouts only 5% of the time). Assuming that demand during lead time (the reorder period) follows a normal
curve, only the mean and standard deviation are needed to define the inventory requirements for any given
service level.

69
 Probabilistic Demand

• Use prescribed service levels to set safety stock when the cost of
stockouts cannot be determined
• ROP = demand during lead time + ZsdLT
where Z = Number of standard deviations
sdLT = Standard deviation of demand during lead
time
ZsdLT is the safety stock calculated based on the service level
required.

ENMG 605: Operations Management 70

70
 Example

Memphis Regional Hospital stocks a “code blue” resuscitation kit

that has a normally distributed demand during the reorder period.
The mean (average) demand during the reorder period is 350 kits,
and the standard deviation is 10 kits. The hospital administrator
wants to follow a policy that results in stockouts only 5% of the
time.
(a) What is the appropriate value of Z?
(b) How much safety stock should the hospital maintain?
(c) What reorder point should be used?

ENMG 605: Operations Management 71

71
 Example

• The hospital determines how much inventory is needed to meet the demand
95% of the time. The data are as follows:
m = Average demand = 350 kits
sdLT = Standard deviation of demand during lead time = 10 kits
Stockout policy =5% (service level = 95%)
Using the normal pdf table (attached), for an area under the curve of 95%,
the Z = 1.645
Safety stock = ZsdLT = 1.645(10) = 16.5 kits
Reorder point = Expected demand during lead time + Safety stock
= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
ENMG 605: Operations Management 72

72
 Knowledge Check

What safety stock should Ron Satterfield Corporation maintain if

mean sales are 80 during the reorder period, the standard deviation
is 7, and Ron can tolerate stockouts 10% of the time? (round to the
nearest integer)

Safety stock=9

ENMG 605: Operations Management 73

73
 Knowledge Check

The daily demand for 520 flat-screen TVs at Sarah’s Discount

Emporium is normally distributed, with an average of 5 and a
standard deviation of 2 units. The lead time for receiving a
shipment of new TVs is 10 days and is fairly constant. Determine
the reorder point for a 95% service level. (round to the nearest
integer)

ROP=60

ENMG 605: Operations Management 74

74
Other Probabilistic Models

75
 Probabilistic Demand

• When data on demand during lead time is not available, there

are other models available
1. When demand is variable and lead time is constant
2. When lead time is variable and demand is constant
3. When both demand and lead time are variable

ENMG 605: Operations Management 76

Previously, we assumed that both an estimate of expected demand during lead times and its standard deviation
are available. When data on lead time demand are not available, the preceding formulas cannot be applied.
However, three other models are available. We need to determine which model to use for three situations:
1. When demand is variable and lead time is constant
2. When lead time is variable and demand is constant
3. When both demand and lead time are variable

76
 Demand is variable and lead time is constant

ROP = (Average daily demand x Lead time in days) + ZsdLT

where sdLT = sd Lead time
sd = Standard deviation of demand per day

ENMG 605: Operations Management 77

Note that that here we use days, but weeks can also be used

77
 Example

The average daily demand for Lenovo laptop computers at a Circuit

Town store is 15, with a standard deviation of 5 units. The lead time
is constant at 2 days. Find the reorder point if management wants a
90% service level (i.e., risk stockouts only 10% of the time). How
much of this is safety stock

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78
 Example

Average daily demand (normally distributed) = 15

Lead time in days (constant) = 2
Standard deviation of daily demand = 5
Service level = 90%
Z for 90% = 1.28 (from normal pdf table)
ROP = (15 units x 2 days) + ZsdLT
= 30 + 1.28(5)( 2)= 30 + 9.02 = 39.02

Safety stock is about 9 computers

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79
 Lead time is variable, and demand is constant

• ROP = (Daily demand x Average lead time in days) + Z x (Daily

demand) x sLT
• where sLT = Standard deviation of lead time in days

ENMG 605: Operations Management 80

When the demand is constant and only the lead time is variable, then: ROP can be calculated using the following
formula

80
 Example

A store sells about 10 digital cameras a day (almost a constant

quantity). Lead time for camera delivery is normally distributed with
a mean time of 6 days and a standard deviation of 1 day. A 98%
service level is set. Find the ROP.

ENMG 605: Operations Management 81

81
 Example

Daily demand (constant) = 10

Average lead time = 6 days
Standard deviation of lead time = sLT = 1
Service level = 98%, so Z = 2.055
ROP= (10 units x 6 days) + 2.055(10 units)(1)
= 60 + 20.55 = 80.55
Reorder point is about 81 cameras

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82
 Both demand and lead time are variable

ROP = (Average daily demand x Average lead time) + ZsdLT

where sd = Standard deviation of demand per day

sLT = Standard deviation of lead time in days

sdLT= Average lead time x sd2 + (Average daily demand) sLT

ENMG 605: Operations Management 83

When both the demand and lead time are variable, the formula for reorder point becomes more complex

83
 Example

The Circuit Town store’s most popular item is six-packs of 9-volt

batteries. About 150 packs are sold per day, following a normal
distribution with a standard deviation of 16 packs. Batteries are
ordered from an out-of-state distributor; lead time is normally
distributed with an average of 5 days and a standard deviation of 1
day. To maintain a 95% service level, what ROP is appropriate?

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84
 Example

Average daily demand (normally distributed) = 150

Standard deviation = sd = 16
Average lead time 5 days (normally distributed)
Standard deviation = sLT = 1 day
Service level = 95%, so Z = 1.645
sdLT= 5 daysx 162 + 150=154
𝑅𝑂𝑃 = 150 × 5 + 1.645 × 154 = 1003 𝑝𝑎𝑐𝑘𝑠

ENMG 605: Operations Management 85

85
Single-Period Model

86
 Single-Period Model

• Only one order is placed for a product

• Units have little or no value at the end of the sales period
• This is a typical problem for Christmas trees, seasonal goods,
bakery goods, newspapers, and magazines.
Cs = Cost of shortage = Sales price/unit – Cost/unit
Co = Cost of overage = Cost/unit – Salvage value
• Optimal service level=

ENMG 605: Operations Management 87

A single-period inventory model describes a situation in which one order is placed for a product. At the end of the
sales period, any remaining product has little or no value. This is a typical problem for Christmas trees, seasonal
goods, bakery goods, newspapers, and magazines.

Because the exact demand for such seasonal products is never known, we consider a probability distribution
related to demand. To determine the optimal stocking policy for trees before the season begins, we calculate the
optimal service level

87
 Single-Period Example

Chris Ellis’s newsstand, just outside the Smithsonian subway station

in Washington, DC, usually sells 120 copies of the Washington Post
each day. Chris believes the sale of the Post is normally distributed,
with a standard deviation of 15 papers. He pays 70 cents for each
paper, which sells for $1.25. The Post gives him a 30-cent credit for
each unsold paper. He wants to determine how many papers he
should order each day and the stockout risk for that quantity

ENMG 605: Operations Management 88

88
 Single-Period Example

Average demand = m = 120 papers/day

Standard deviation = s = 15 papers
Cs = cost of shortage = $1.25 – $.70 = $.55
Co = cost of overage = $.70 – $.30 = $.40
. .
Optimal service level= = = = .579 ⇒ 𝑍 = 0.2
. . .

The optimal stocking level= 120 copies + (.20)(s) = 120 + (.20)(15) = 120
+ 3 = 123 papers

The stockout risk = 1 – Service level= 1 – .579 = .422 = 42.2%

ENMG 605: Operations Management 89

89
 Knowledge Check

The owner of a newsstand wants to determine the number of USA

now newspapers that must be ordered at the beginning of each day.
The owner pays ¢30 per copy and sells it for ¢75. Newspapers left
at the end of the day are sold for recycling purposes at a price of ¢5.
Daily demand is assumed to be normally distributed with mean 300
and standard deviation 20. Find the optimal ordering quantity.
(Round to the nearest integer)
S=307

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90