IE 457 Slides05-SupplyChain-Dr. Ammar Y. Alqahtani

6/10/2020
IE 457:
Supply Chain Management
(Supply Chain Engineering)
Dr. Ammar Y. Alqahtani

Assistant Professor of Industrial Engineering
College of Engineering
King Abdulaziz University
Chapter 12: ©Dr. Ammar Y. Alqahtani Supply Chain Management: Strategy, Planning, & 1
Operation
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Outline
• Inventory Management Overview

• Purpose of Inventory
• Decisions in Inventory
• Costs Associated with Inventory
• Types of Inventory
• Production Line and Buffer Inventory
• ABC Analysis
• Economic Order Quantity
• Economic Manufacturing Quantity
Operation
Inventory Management Overview
• For many manufacturing companies, inventory is one of the

major assets
• In some cases it could be as high as 80% of all the assets
of a company. In such cases, if something goes wrong with
their inventory, they are doomed
• Then there are other companies which carry virtually no
inventory
• Hence, inventory can represent very little to very large
portion of assets of a company
• We are interested in inventory, because it is said that
inventory can make or break a company if proper planning
is not done
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• Inventory is “deadwood” until it is used

• There are many reasons for carrying inventory:
– Companies do not want to disappoint their customers. That is,
whenever the customer demands something, they want to be
able to supply it. If there is insufficient inventory, they might
loose a customer. Every time they loose a customer, they
loose a chance to make a profit (opportunity loss)
– In case of raw material, if we run out of some item it could
hamper production. Even if we were assembling large
products, running out of even a small item like a nut or a bolt
could shut down an assembly line. In fact, there is more to
inventory than just that. We are generally extra careful about
not running out of inexpensive items. Thus we always carry
ample supply of cheap items and monitor closely expensive
items
Operation
– What if we carry too much inventory?

• The item in inventory could become obsolete
• Carrying inventory means that the money invested in it is blocked which
means the company is loosing the opportunity to use that money
somewhere else
• Then there are carrying costs, insurance costs, book-keeping costs,
warehousing costs, etc.
• Thus, too much inventory is bad and too little inventory is
bad.
• We should, therefore, strive to carry just the right amount of
inventory!
• And what is the right amount?
– It is the amount that will minimize the total inventory costs
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Purpose of Inventory
• Inventory is an aid to continuous production. That means,

because of inventory we are able to continue production
• If we were not allowed to carry inventory, there might be
times when we might have to stop production due to some
interruption in delivery of items
Operation
• Inventory helps us to maintain level production. Since

demand is generally not constant, inventory helps us in
absorbing fluctuations in the demand curve. This leads to
stable employment, job security, better labor-management
relationships, etc.
• Inventory provides a hedge against future price increases.
Sometimes, inventory helps reduce costs by storing items
which are anticipated to increase in price due to inflation or
other reasons
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• Inventory is also carried to avoid the danger of strikes and

other possible interruptions
• Sometimes one is forced to carry inventory because one
cannot buy small quantities of certain items because of
packaging or other reasons
• Quantity discounts might be another reason for carrying
inventory
• Of course, inventory is also carried to satisfy customers
with unanticipated demands
Operation
Decisions in Inventory
• The two basic decisions we need to make in any inventory

planning are:
– How much to order? - function of costs
• This depends on many factors, e.g. how much space do we have? Or
how much money do we have? Or how much is the carrying cost? Or how
much is the ordering cost?
– When to order? – function of forecast or scheduled
requirements
• That is, what is the order cycle?
• If these two questions are answered, then a lot of our
inventory problems are solved
• The answers should be economically justified
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Costs Associated with Inventory
• There are three basic types of cost associated with

inventory:
– Ordering and setup costs
• This is the cost associated with placing orders or with setting up the
machine (getting ready) to build inventory
– Carrying costs
• Costs of carrying items in inventory which might include cost of the space
used, interest charges on the money blocked in inventory etc.
– Purchase cost
• Cost of the item itself
Operation
Types of Inventory
• There are several types of inventory. For example:

– Raw stock inventory
– Work-in-process inventory (WIP)
– Final product inventory
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Production Line and Buffer Inventory
Input Stage 1 Stage 2 Stage 3 Output
Buffer 12 Buffer 23
di = downtime percentage for the ith stage

bij = buffer stock between ith and jth stages
Oi = output (in percentage of time) from ith stage
Operation
Input Stage 1 Stage 2 Stage 3 Output
If bij = 0
Buffer 12 Buffer 23
O1 = 1 – d1
O2 = 1 – d1 – d2 + d1d2
O3 = 1 – d1 – d2 – d3 + d1d2 + d1d3 + d2d3 – d1d2d3
If d1 = 5%, d2 = 10%, d3 = 2%,
O1 = 1 – 0.5 = 0.95 95%

O2 = 85.5%
O3 = 83.8%
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If bij = ∞ Input Stage 1

∞ Stage 2
∞ Stage 3 Output
O1 = 1 – d1
O2 = 1 – d2 Buffer 12 Buffer 23
O3 = 1 – d3
If d1 = 5%, d2 = 10%, d3 = 2%,
O1 = 1 – 0.05 = 0.95 95%
O2 = 90%
O3 = 98%
This is a lot of improvement over the “no buffer” case.
In reality, however, there is a limit on buffer inventory.
Operation
ABC Analysis
• Pareto’s Principle
– In the late 1800s, economist and avid gardener Vilfredo Pareto
established that 80% of the land in Italy was owned by 20% of the
population. The Pareto Principle or the 80:20 rule has proven its
validity in a number of other areas.
• ABC analysis is also built on a similar idea. However, here

we divide the inventory population into three categories,
viz., A, B and C
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ABC Classification
• Category A items include roughly 10-20% of items that

typically account for 70-80% of total dollar value
• Category B items include roughly 30-40% of items that
• Category C items include roughly 40-50% of items that
Operation
Implications of ABC Classification
Degree of Type of Order of Ordering

Control Records Priority Procedure
A items Tight Accurate High to Careful, accurate
and reduce and frequent review
complete inventory of EOQ and OP
B items Normal Good Normal Normal EOQ

analysis
C items Simple Simple Lowest Long term supply

reordered
periodically
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ABC Classification Example
• In an attempt to establish Item No. Annual Investment

an ABC classification, a 1 150
2 1050
firm wants to analyze its 3 950
inventory of 13 items. 4 100
5 1300
6 3000
• Following the usual 7 250
guidelines for ABC 8 22000
breakdown, indicate the 9 300
items which will be 10 40
11 60
classified in each category 12 1100
and find the percentage of 13 500
value for each Total 30800
classification.
Operation
ABC Classification
Number Item Annual Cumulative Value
No. Investment Investment
10 40 40
11 60 100
4 100 200
1 150 350
7 250 600
9 300 900
13 500 1400
3 950 2350
2 1050 3400
12 1100 4500
5 1300 5800
6 3000 8800
8 22000 30800
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ABC Classification
Number Item Annual Cumulative Value
No. Investment Investment
10 40 40
11 60 100
C items 4 100 200
53.8% 1 150 350 4.6%
7 250 600
9 300 900
13 500 1400
3 950 2350
B items 2 1050 3400
38.5% 12 1100 4500 24%
5 1300 5800
6 3000 8800
A items
Chapter 12: ©Dr. Ammar Y. Alqahtani
8 22000 30800
Supply Chain Management: Strategy, Planning, & 21
7.7% Operation 71.4%
Economic Order Quantity (EOQ) Model
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EOQ Model
• Nomenclature
Q = Order quantity
T = Time between orders (cycle time)
D = Demand rate or depletion rate
P = Ordering cost
I = Interest charges/unit of inventory/unit time
W = warehousing cost/unit of inventory/unit time
H = Overall inventory cost factor
C = Cost/item (capital investment cost)
TC = Total cost/unit
Operation
EOQ Model
• Multiple products case
P ( I  W )(T )(Average Inventory)

TC M  C  
Q Q
• Single product case
P ( I )(T )(Average Inventory) (W )(T )(Maximum Inventory)

TC S  C   
Q Q Q
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EOQ Model
• Using the following relationships (see figure)
Q
T
D
Q
Average Inventory 
2
Maximum Inventory  Q
Operation
EOQ Model
P ( I  W )(Q)
TC M  C  
Q 2D
P ( I  2W )(Q)
TC S  C  
Q 2D
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EOQ Model
• In order to minimize the total cost, we differentiate these
total cost equations and put them equal to zeros. After
simplification, we get the following:
2 DP
QM 
I W
2 DP
QS 
I  2W
• Note that, for minimum, the second derivative must be
positive.
Operation
EOQ Model
• Therefore
P
Q
H
I W
HM 
2D
I  2W
HS 
2D
P
TC  C   ( H )(Q)
Q
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EOQ Model Example

• Given the following
D = 800 units/year
P = $70 per order
i = 20% per year
C = $120 per unit
I = $120 * 0.2 = $24 per unit-year
W = $1.80 per unit-month
= $1.80 * 12 = $21.60 per unit-year
Assume the case of one product.
Operation
EOQ Model Example
I  2W 24  2  21.60
HS    0.042
2D 2  800
P 70
Q   41 units
H 0.042
P
TC  C   ( H )(Q)
Q
70
 120   0.042 41
41
 $123.42
Q 41
T   0.05 years
D 800
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Economic Manufactured Quantity (EMQ) Model
QM D
TA
T
Operation
EMQ Model
• Nomenclature
A = Arrival rate
TA = Arrival time (manufacturing time)
• Assumptions
A D
TA  0; A    EOQ Model
ss = startup level (if item produced is not immediately available)
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EMQ Model
• Note that the following relationships hold (see figure):

Q
D
T
Q
A
TA
Therefore Q  DT  ATA
DQ
ss  DTA 
A
Q ss
Hence D 
T TA
T  D
and Q A   Q 
T   A
Operation
EMQ Model
• An item produced is immediately available (no safety

stock):
– Multiple products case
P ( I  W )(Average Inventory)
TCM  C  
Q D
– Single product case

P ( I )(Average Inventory) (W )(Maximum Inventory)
TCS  C   
Q D D
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EMQ Model

QM
D
T  TA
Q
D
T
 T  TA   T 
Therefore QM    Q  1  A Q
 T   T
QM
Average Inventory 
2
 TA  Q  T 
 1    QM  1  A Q
 T  2  T
 D Q T D
 1    A 
 A 2 T A
 D
Maximum Inventory QM  1  Q
Chapter 12: ©Dr. Ammar Y. Alqahtani  ChainAManagement:
Supply  OperationStrategy, Planning, & 35
EMQ Model
• Substituting the above relationships in the total cost

equations, we get

 D
( I  W ) 1  Q
TC M  C  
P  A
Q 2D

 D
( I  2W ) 1  Q
P
TC S  C    A
Q 2D
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EMQ Model
• Taking the derivative of the total cost equations and

putting them equal to zero and solving for Q, we get
2 PD
QM 
 D
(I  W)1 - 
 A

2 PD
QS 
 D
(I  2W)1 - 
 A
Operation
EMQ Model
• An item produced is not immediately available (carry

safety stock):
P ( I  W )(Average Inventory)
TCM  C  
Q D

P ( I )(Average Inventory) (W )(Maximum Inventory)
TCS  C   
Q D D
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EMQ Model
ss
TA
Operation
EMQ Model
Q  ss
Average Inventory   ss
2
Q  ss

2
Maximum Inventory  Q
D
ss  Q 
 A
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EMQ Model
• Substituting the above relationships in the total cost

equations, we get

 D
( I  W ) 1  Q
TC M  C  
P  A
Q 2D

 D
I 1  Q
TC S  C   
P A WQ

Q 2D D
Operation
EMQ Model
• Taking the derivative of the total cost equations and

putting them equal to zero and solving for Q, we get
2 PD
QM 
 D
(I  W)1  
 A

2 PD
QS 
 D
I 1    2W
 A
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Summary of Learning Objectives
• How are the appropriate costs balanced to choose the

optimal amount of cycle inventory in the supply chain?
• What are the effects of quantity discounts on lot size and
cycle inventory?
• What are appropriate discounting schemes for the supply
chain, taking into account cycle inventory?
• What are the effects of trade promotions on lot size and
cycle inventory?
• What are managerial levers that can reduce lot size and
cycle inventory without increasing costs?
Operation
22

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6/10/2020

Dr. Ammar Y. Alqahtani

• Inventory Management Overview

Inventory Management Overview

• For many manufacturing companies, inventory is one of the

Inventory Management Overview

• Inventory is “deadwood” until it is used

Inventory Management Overview

– What if we carry too much inventory?

• Inventory is an aid to continuous production. That means,

• Inventory helps us to maintain level production. Since

• Inventory is also carried to avoid the danger of strikes and

• The two basic decisions we need to make in any inventory

Costs Associated with Inventory

• There are three basic types of cost associated with

• There are several types of inventory. For example:

Production Line and Buffer Inventory

Input Stage 1 Stage 2 Stage 3 Output

di = downtime percentage for the ith stage

Production Line and Buffer Inventory

Input Stage 1 Stage 2 Stage 3 Output

If d1 = 5%, d2 = 10%, d3 = 2%,

O1 = 1 – 0.5 = 0.95 95%

Production Line and Buffer Inventory

If bij = ∞ Input Stage 1

• ABC analysis is also built on a similar idea. However, here

• Category A items include roughly 10-20% of items that

Implications of ABC Classification

Degree of Type of Order of Ordering

B items Normal Good Normal Normal EOQ

C items Simple Simple Lowest Long term supply

ABC Classification Example

• In an attempt to establish Item No. Annual Investment

Economic Order Quantity (EOQ) Model

• Multiple products case

P ( I  W )(T )(Average Inventory)

P ( I )(T )(Average Inventory) (W )(T )(Maximum Inventory)

• Using the following relationships (see figure)

• Multiple products case

EOQ Model Example

EOQ Model Example

Economic Manufactured Quantity (EMQ) Model

ss = startup level (if item produced is not immediately available)

• Note that the following relationships hold (see figure):

• An item produced is immediately available (no safety

– Single product case

• Note that the following relationships hold (see figure):

• Substituting the above relationships in the total cost

– Multiple products case

– Single product case

• Taking the derivative of the total cost equations and

– Multiple products case

– Single product case

• An item produced is not immediately available (carry

– Single product case

• Note that the following relationships hold (see figure):

• Substituting the above relationships in the total cost

– Multiple products case

– Single product case