Inventory Control

Edited and Compiled By

Dr. Chandrashekhar V. Joshi

What is inventory?

You should visualize inventory as stacks of money

sitting on forklifts, on shelves, and in trucks and
planes while in transit.

That’s what inventory is—money. For many

businesses, inventory is the largest asset on the
balance sheet at any given time, even though it is
often not very liquid.

It is a good idea to try to get your inventory down as

far as possible.
 The economic benefit from inventory reduction

The economic benefit from inventory reduction is

evident from the following statistics:

The average cost of inventory in the United States is 30

to 35 percent of its value. For example, if a firm carries
an inventory of $20 million, it costs the firm more than
$6 million per year. These costs are due mainly to
obsolescence, insurance, and opportunity costs. If the
amount of inventory could be reduced to $10 million, for
instance, the firm would save over $3 million, which
goes directly to the bottom line; that is, the savings from
reduced inventory results in increased profit.
 Different types of supply chain inventories

1. The single-period model. This is used when we are making a

one-time purchase of an item. An example might be purchasing
T-shirts to sell at a one-time sporting event.

2. Fixed–order quantity model. This is used when we want to

maintain an item ―in stock,‖ and when we resupply the item, a
certain number of units must be ordered each time. Inventory for
the item is monitored until it gets down to a level where the risk
of stocking out is great enough that we are compelled to order.

3. Fixed–time period model. This is similar to the fixed–order

quantity model, and is used when the item should be in-stock and
ready to use. In this case, the item is ordered at certain intervals
of time, for example, every Friday morning. An example is the
delivery of different types of bread to a grocery store.

4
Supply Chain Inventories—Make-to-Stock Environment
 Definition of Inventory
Inventory is the stock of any item or resource used in an
organization. An inventory system is the set of policies and controls
that monitor levels of inventory and determine what levels should be
maintained, when stock should be replenished, and how large orders
should be.

By convention, manufacturing inventory generally refers to items

that contribute to or become part of a firm’s product output.
Manufacturing inventory is typically classified into raw materials,
finished products, component parts, supplies, and work-in-process. In
distribution, inventory is classified as in-transit, meaning that it is
being moved in the system, and warehouse, which is inventory in a
warehouse or distribution center. Retail sites carry inventory for
immediate sale to customers. In services, inventory generally refers
to the tangible goods to be sold and the supplies necessary to
administer the service.
OBJECTIVES
*Inventory System Defined
*Inventory Costs
*Independent vs. Dependent Demand
*Single-Period Inventory Model
*Multi-Period Inventory Models: Basic Fixed-
Order Quantity Models
*Multi-Period Inventory Models: Basic Fixed-
Time Period Model
*Miscellaneous Systems and Issues
 Inventory System

*Inventory is the stock of any item or

resource used in an organization and can
include: raw materials, finished products,
component parts, supplies, and work-in-
process
*An inventory system is the set of policies
and controls that monitor levels of
inventory and determines what levels
should be maintained, when stock should
be replenished, and how large orders
should be
 PURPOSE OF INVENTROY

1. To maintain independence of operations

2. To meet variation in product demand
3. To allow flexibility in production
scheduling
4. To provide a safeguard for variation in
raw material delivery time
5. To take advantage of economic
purchase-order size
 INVENTORY COSTS

*Holding (or carrying) costs

* Costs for storage, handling, insurance, etc

*Setup (or production change) costs

* Costs for arranging specific equipment setups, etc

*Ordering costs
* Costs of someone placing an order, etc

*Shortage costs
* Costs of canceling an order, etc
 Independent V/s Dependent Demand

Independent Demand (Demand for the final end-

product or demand not related to other items)

Finished
product
Dependent Demand
(Derived demand
items for
component parts,
E(1 subassemblies,
) raw materials, etc)

Component parts
Independent Demand
In independent demand, the demands for various items are unrelated
to each other. For example, a workstation may produce many parts
that are unrelated but that meet some external demand requirement.

Dependent Demand
In dependent demand, the need for any one item is a direct result of
the need for some other item, usually a higher-level item of which it
is part.
 INVENTORY SYSTEMS
*Single-Period Inventory Model

*One time purchasing decision (Example: vendor

selling t-shirts at a football game)
*Seeks to balance the costs of inventory overstock
and under stock

*Multi-Period Inventory Models

*Fixed-Order Quantity Models
* Event triggered (Example: running out of stock)
*Fixed-Time Period Models
* Time triggered (Example: Monthly sales call by sales
representative)
 A Single-Period Inventory Model

This model states that we

should continue to increase
Cu
P
the size of the inventory so
long as the probability of
Co  Cu selling the last unit added is
equal to or greater than the
ratio of: Cu/Co+Cu

Where :
Co  Cost per unit of demand over estimated
Cu  Cost per unit of demand under estimated
P  Probability that the unit will be sold
 A Single-Period Inventory Model Example

*Our college basketball team is playing in a

tournament game this weekend. Based on our past
experience we sell on average 2,400 shirts with a
standard deviation of 350. We make $10 on every
shirt we sell at the game, but lose $5 on every
shirt not sold. How many shirts should we make
for the game?

Cu = $10 and Co = $5; P ≤ $10 / ($10 + $5) = .667

Z.667 = .432 from standard normal table

therefore we need 2,400 + .432(350) = 2,551 shirts

Single-period inventory models are useful for a wide variety of service and
manufacturing applications. Consider the following:

1. Overbooking of airline flights. It is common for customers to cancel flight

reservations for a variety of reasons. Here, the cost of underestimating the number of
cancellations is the revenue lost due to an empty seat on a flight. The cost of
overestimating cancellations is the awards, such as free flights or cash payments, that
are given to customers unable to board the flight.

2. Ordering of fashion items. A problem for a retailer selling fashion items is that often
only a single order can be placed for the entire season. This is often caused by long lead
times and the limited life of the merchandise. The cost of underestimating demand is the
lost profit due to sales not made. The cost of overestimating demand is the cost that
results when it is discounted.

3. Any type of one-time order. For example, ordering T-shirts for a sporting event or
printing maps that become obsolete after a certain period of time.
EXAMPLE 1: Hotel Reservations
Multi-period Inventory Systems

There are two general types of multi-period inventory systems: fixed–order quantity
models (also called the economic order quantity, EOQ, and Q-model) and fixed–time
period models (also referred to variously as the periodic system, periodic review system,
fixed–order interval system, and P-model).

Multi-period inventory systems are designed to ensure that an item will be available on
an ongoing basis throughout the year. Usually, the item will be ordered multiple times
throughout the year where the logic in the system dictates the actual quantity ordered and
the timing of the order.

Fixed–order quantity model (Q-model)

An inventory control model where the amount requisitioned is fixed and the actual
ordering is triggered by inventory dropping to a specified level of inventory.

Fixed–time period model (P-model)

An inventory control model that specifies inventory is ordered at the end of a
predetermined time period. The interval of time between orders is fixed and the order
quantity varies.
 Fixed–Order Quantity and Fixed–Time Period Differences

The basic distinction is that fixed–order quantity models are ―event triggered‖ and
fixed–time period models are ―time triggered.‖

That is, a fixed–order quantity model initiates an order when the event of reaching a
specified reorder level occurs. This event may take place at any time, depending on the
demand for the items considered.

In contrast, the fixed–time period model is limited to placing orders at the end of a
predetermined time period; only the passage of time triggers the model.

To use the fixed–order quantity model (which places an order when the remaining
inventory drops to a predetermined order point, R), the inventory remaining must be
continually monitored. Thus, the fixed–order quantity model is a perpetual system,
which requires that every time a withdrawal from inventory or an addition to inventory
is made, records must be updated to reflect whether the reorder point has been reached.
In a fixed–time period model, counting takes place only at the review period.
Fixed–Order Quantity and Fixed–Time Period Differences
Comparison of Fixed–Order Quantity and Fixed–Time Period Reordering Inventory Systems
Fixed–order quantity models attempt to determine the specific point, R, at which an order
will be placed and the size of that order, Q.

The order point, R, is always a specified number of units. An order of size Q is placed when
the inventory available (currently in stock and on order) reaches the point R.

Inventory position is defined as the on-hand plus on-order minus backordered quantities.
The solution to a fixed–order quantity model may stipulate something like this: When the
inventory position drops to 36, place an order for 57 more units.

The simplest models in this category occur when all aspects of the situation are known with
certainty. If the annual demand for a product is 1,000 units, it is precisely 1,000—not 1,000
plus or minus 10 percent. The same is true for setup costs and holding costs. Although the
assumption of complete certainty is rarely valid, it provides a good basis for our coverage
of inventory models.

Characteristics of the Model

• Demand for the product is constant and uniform throughout the period.
• Lead time (time from ordering to receipt) is constant.
• Price per unit of product is constant.
• Inventory holding cost is based on average inventory.
• Ordering or setup costs are constant.
• All demands for the product will be satisfied. (No backorders are allowed.)
 Basic Fixed–Order Quantity Model

The ―sawtooth effect‖ relating Q and R in aboove figure

shows that when the inventory position drops to point R, a
reorder is placed. This order is received at the end of time
period L, which does not vary in this model.
 Multi-Period Models: Fixed-Order Quantity Model
Model Assumptions (Part 1)

* Demand for the product is constant and uniform

throughout the period

* Lead time (time from ordering to receipt) is constant

* Price per unit of product is constant

 Multi-Period Models: Fixed-Order Quantity Model
Model - Assumptions (Part 2)

*Inventory holding cost is based on

average inventory

*Ordering or setup costs are constant

*All demands for the product will be

satisfied (No back orders are allowed)
 Basic Fixed-Order Quantity Model and Reorder Point
Behavior

1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
 Cost Minimization Goal
By adding the item, holding, and ordering costs
together, we determine the total cost curve, which in
turn is used to find the Qopt inventory order point that
minimizes total costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
 Basic Fixed-Order Quantity (EOQ) Model Formula

TC=Total annual
Total Annual Annual Annual cost
Annual = Purchase + Ordering + Holding D =Demand
Cost Cost Cost Cost C =Cost per unit
Q =Order quantity
S =Cost of placing
an order or setup
cost
R =Reorder point
D Q L =Lead time
TC = DC + S + H H=Annual holding
and storage cost
Q 2 per unit of inventory
 Deriving the EOQ

Using calculus, we take the first derivative of the

total cost function with respect to Q, and set the
derivative (slope) equal to zero, solving for the
optimized (cost minimized) value of Qopt

2DS 2(Annual D em and)(Order or Setup Cost)

Q O PT = =
H Annual Holding Cost
_
We also need a R eo rd er p o in t, R = d L
reorder point to
_
tell us when to d = average daily demand (constant)
place an order
L = Lead time (constant)
 EOQ Example (1) Problem Data

Given the information below, what are the EOQ and

reorder point?

Annual Demand = 1,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
 EOQ Example (1) Solution

2D S 2(1,000 )(10)
Q O PT = = = 89.443 units or 90 u n its
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year

_
R eo rd er p o in t, R = d L = 2 .7 4 u n its / d ay (7 d ays) = 1 9 .1 8 o r 2 0 u n its

In summary, you place an optimal order of 90 units. In the

course of using the units to meet demand, when you only
have 20 units left, place the next order of 90 units.
 EOQ Example (2) Problem Data

Determine the economic order quantity and the

reorder point given the following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost per
unit
Lead time = 10 days
Cost per unit = $15
 EOQ Example (2) Solution

2D S 2 (1 0 ,0 0 0 )(1 0 )
Q OPT = = = 3 6 5 .1 4 8 u n its, o r 3 6 6 u n its
H 1 .5 0

10,000 units / year

d= = 27.397 units / day
365 days / year

_
R = d L = 2 7 .3 9 7 u n its / d ay (1 0 d ays) = 2 7 3 .9 7 o r 2 7 4 u n its

Place an order for 366 units. When in the course of

using the inventory you are left with only 274 units,
place the next order of 366 units.
EOQ Example (3) Problem Data

EOQ Example (3) Solution

 Fixed–Order Quantity Model with Safety Stock
A fixed–order quantity system perpetually monitors the inventory level and places a new
order when stock reaches some level, R. The danger of stockout in this model occurs only
during the lead time, between the time an order is placed and the time it is received.

As shown in figure above, an order is placed when the inventory position drops to the reorder
point, R. During this lead time, L, a range of demands is possible. This range is determined
either from an analysis of past demand data or from an estimate (if past data are not
available).

The quantity to be ordered, Q, is calculated in the usual way considering the demand,
shortage cost, ordering cost, holding cost, and so forth. A fixed–order quantity model can be
used to compute Q, such as the simple Qopt model previously discussed. The reorder point is
then set to cover the expected demand during the lead time plus a safety stock determined by
the desired service level. Thus, the key difference between a fixed–order quantity model
where demand is known and one where demand is uncertain is in computing the reorder
point. The order quantity is the same in both cases. The uncertainty element is taken into
account in the safety stock.
 Computation of Reorder Point

The term zσL is the amount of safety stock. Note that if safety stock is
positive, the effect is to place a reorder sooner. That is, R without safety stock
is simply the average demand during the lead time. If lead time usage was
expected to be 20, for example, and safety stock was computed to be 5 units,
then the order would be placed sooner, when 25 units remained. The greater
the safety stock, the sooner the order is placed.
Example on Reorder Point
Example on Order Quantity and Reorder Point
 Fixed Time Period Models
In a fixed–time period system, inventory is counted only at particular times, such as every week or
every month Counting inventory and placing orders periodically are desirable in situations such as
when vendors make routine visits to customers and take orders for their complete line of products, or
when buyers want to combine orders to save transportation costs.

Other firms operate on a fixed time period to facilitate planning their inventory count; for example,
Distributor X calls every two weeks and employees know that all Distributor X’s product must be
counted.

Fixed–time period models generate order quantities that vary from period to period, depending on the
usage rates. These generally require a higher level of safety stock than a fixed–order quantity system.

The fixed–order quantity system assumes continual tracking of inventory on hand, with an order
immediately placed when the reorder point is reached.

In contrast, the standard fixed–time period models assume that inventory is counted only at the time
specified for review. It is possible that some large demand will draw the stock down to zero right after
an order is placed. This condition could go unnoticed until the next review period. Then, the new order,
when placed, still takes time to arrive.

Thus, it is possible to be out of stock throughout the entire review period, T, and order lead time, L.
Safety stock, therefore, must protect against stock outs during the review period itself, as well as during
the lead time from order placement to order receipt.
 Fixed-Time Period Model with Safety Stock Formula

Safety stock can be defined as the amount of inventory

carried in addition to the expected demand.

q = Average demand + Safety stock – Inventory currently on hand

q = d(T + L) + Z  T + L - I

Where :
q = quantitiy to be ordered
T = the number of days between reviews
L = lead time in days
d = forecast average daily demand
z = the number of standard deviations for a specified service probabilit y
 T + L = standard deviation of demand over thereview and lead time
I = current inventorylevel (includes items on order)
 Fixed–Time Period Inventory Model

Example on Quantity to Order

To ensure a 98 percent probability of not stocking out, order 331 units at this review period.
Average Inventory Calculation—Fixed–Order Quantity Model

Average Inventory Calculation—Fixed–Time Period Model

Calculating the Demand

For the daily demand situation, d can be a forecast demand using any of the models on
forecasting. If a 30-day period was used to calculate d, then a simple average would be

where n is the number of days. The standard deviation of the daily demand is

Because σd refers to one day, if lead time extends over several days, we can use the
statistical premise that the standard deviation of a series of independent occurrences is
equal to the square root of the sum of the variances. That is, in general,

For example, suppose we computed the standard deviation of demand to be 10 units per
day. If our lead time to get an order is five days, the standard deviation for the five-day
period, assuming each day can be considered independent, is
Calculating the Demand …

z value associated with a 95 percent probability of not stocking out is 1.64

Inventory Turn Calculation

The inventory turn for an individual item then is

Example: Average Inventory Calculation—Fixed–Order Quantity Model

Example: Average Inventory Calculation—Fixed–Time Period Model

Multi-Period Models: Fixed-Time Period Model:
Determining the Value of T+L

  
T+ L 2
 T+ L = di
i 1

Since each day is independent and  d is constant,

 T+ L = (T + L) d 2

*The standard deviation of a sequence of

random events equals the square root of the
sum of the variances
 Example of the Fixed-Time Period Model

Given the information below, how many units

should be ordered?
Average daily demand for a product is 20
units. The review period is 30 days, and lead
time is 10 days. Management has set a
policy of satisfying 96 percent of demand
from items in stock. At the beginning of the
review period there are 200 units in
inventory. The daily demand standard
deviation is 4 units.
Example of the Fixed-Time Period Model: Solution (Part 1)

 T+ L = (T + L) d 2 =  30 + 10  4  2 = 25.298

The value for ―z‖ is found by using the Excel

NORMSINV function, or as we will do here, using
Appendix D. By adding 0.5 to all the values in
Appendix D and finding the value in the table that
comes closest to the service probability, the ―z‖
value can be read by adding the column heading
label to the row label.

So, by adding 0.5 to the value from Appendix D of 0.4599,

we have a probability of 0.9599, which is given by a z = 1.75
 Example of the Fixed-Time Period Model: Solution (Part 2)

q = d(T + L) + Z  T + L - I

q = 20(30 + 10) + (1.75)(25.298) - 200

q = 800  44.272 - 200 = 644.272, or 645 units

So, to satisfy 96 percent of the demand, you

should place an order of 645 units at this
review period
 Price-Break Model Formula

The price-break model deals with the fact that, generally, the selling price of an item
varies with the order size. This is a discrete or step change rather than a per-unit change

Based on the same assumptions as the EOQ model, the

price-break model has a similar Qopt formula:

2DS 2(Annual Demand)(Order or Setup Cost)

QOPT = =
iC Annual Holding Cost
i = percentage of unit cost attributed to carrying inventory
C = cost per unit

Since “C” changes for each price-break, the formula above

will have to be used with each price-break cost value
Price-Break Example Problem Data - (Part 1)

A company has a chance to reduce their inventory

ordering costs by placing larger quantity orders using
the price-break order quantity schedule below. What
should their optimal order quantity be if this company
purchases this single inventory item with an e-mail
ordering cost of $4, a carrying cost rate of 2% of the
inventory cost of the item, and an annual demand of
10,000 units?

Order Quantity(units) Price/unit($)

0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
 Price-Break Example Solution - (Part 2)

First, plug data into formula for each price-break value of “C”
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98

Next, determine if the computed Qopt values are feasible or not

Interval from 0 to 2499, the 2DS 2(10,000)(4)

Qopt value is feasible QOPT = = = 1,826 units
iC 0.02(1.20)
Interval from 2500-3999, the 2DS 2(10,000)(4)
Qopt value is not feasible QOPT = = = 2,000 units
iC 0.02(1.00)
Interval from 4000 & more, the 2DS 2(10,000)(4)
Qopt value is not feasible QOPT = = = 2,020 units
iC 0.02(0.98)
Price-Break Example Solution - (Part 3)
Since the feasible solution occurred in the first price-
break, it means that all the other true Qopt values occur
at the beginnings of each price-break interval. Why?

Total Because the total annual cost function is

annual a “u” shaped function
costs
So the candidates
for the price-
breaks are 1826,
2500, and 4000
units
0 1826 2500 4000 Order Quantity
Price-Break Example Solution - (Part 4)

Next, we plug the true Qopt values into the total cost
annual cost function to determine the total cost under
each price-break

D Q
TC = DC + S+ iC
Q 2
TC(0-2499)=(10000*1.20)+(10000/1826)*4+(1826/2)(0.02*1.20)
= $12,043.82
TC(2500-3999)= $10,041
TC(4000&more)= $9,949.20

Finally, we select the least costly Qopt, which is this

problem occurs in the 4000 & more interval. In summary,
our optimal order quantity is 4000 units
 Miscellaneous Systems: Optional Replenishment System

Maximum Inventory Level, M

q=M-I

Actual Inventory Level, I

M
I

Q = minimum acceptable order quantity

If q > Q, order q, otherwise do not order any.

 Miscellaneous Systems: Bin Systems

Two-Bin System

Order One Bin of

Inventory
Full Empty
One-Bin System

Order Enough to
Refill Bin
Periodic Check
 ABC Classification System

*Items kept in inventory are not of equal

importance in terms of:
60
* dollars invested % of
$ Value 30 A
* profit potential 0 B
* sales or usage volume % of 30 C
Use 60
* stock-out penalties

So, identify inventory items based on percentage of total

dollar value, where “A” items are roughly top 15 %, “B”
items as next 35 %, and the lower 65% are the “C” items
A. Annual Usage of Inventory by Value

B. ABC Grouping of Inventory Items

 Inventory Accuracy and Cycle Counting

* Inventoryaccuracy refers to how well the inventory

records agree with physical count

* Cycle Counting is a physical inventory-taking

technique in which inventory is counted on a frequent
basis rather than once or twice a year
SOLVED PROBLEM 1
SOLVED PROBLEM 1 …
SOLVED PROBLEM 5 Solution …
Exercise
1. Distinguish between dependent and independent demand in a McDonald’s restaurant, in an integrated
manufacturer of personal copiers, and in a pharmaceutical supply house.
2. Distinguish between in-process inventory, safety stock inventory, and seasonal inventory.
3. Discuss the nature of the costs that affect inventory size. For example:
a. How does shrinkage (stolen stock) contribute to the cost of carrying inventory? How
can this cost be reduced?
b. How does obsolescence contribute to the cost of carrying inventory? How can this
cost be reduced?
4. Under which conditions would a plant manager elect to use a fixed–order quantity model as opposed to a
fixed–time period model? What are the disadvantages of using a fixed–time period ordering system?
5. What two basic questions must be answered by an inventory control decision rule?
6. Discuss the assumptions that are inherent in production setup cost, ordering cost, and carrying costs.
How valid are they?
7. ―The nice thing about inventory models is that you can pull one off the shelf and apply it so long as your
cost estimates are accurate.‖ Comment.
8. Which type of inventory system would you use in the following situations?
a. Supplying your kitchen with fresh food
b. Obtaining a daily newspaper
c. Buying gas for your car
To which of these items do you impute the highest stock-out cost?
9. What is the purpose of classifying items into groups, as the ABC classification does?
10. When cycle counting inventory, why do experts recommend a lower acceptable error tolerance for A
items than B or C items?
Thank You