INVENTORY

MANAGEMENT

1
Chapter Topics

Elements of Inventory Management

Inventory Control Systems
Economic Order Quantity Models
The Basic EOQ Model
The EOQ Model with Non-Instantaneous Receipt
The EOQ Model with Shortages
Quantity Discounts
Reorder Point
Determining Safety Stocks Using Service Levels
Order Quantity for a Periodic Inventory System

2
Elements of Inventory Management
Role of Inventory (1 of 2)
Inventory is a stock of items kept on hand used to meet
customer demand.
A level of inventory is maintained that will meet anticipated
demand.
If demand is not known with certainty, safety (buffer)
stocks are kept on hand.
Additional stocks are sometimes built up to meet seasonal
or cyclical demand.
Large amounts of inventory sometimes purchased to take
advantage of discounts.

3
Elements of Inventory Management
Role of Inventory (2 of 2)
In-process inventories are maintained to provide
independence between operations.
Raw materials inventory kept to avoid delays in case of
supplier problems.
Stock of finished parts kept to meet customer demand in
event of work stoppage.

4
Elements of Inventory Management
Demand
Inventory exists to meet the demand of customers.
Customers can be external (purchasers of products) or
internal (workers using material).
Management needs accurate forecast of demand.
Items that are used internally to produce a final product are
referred to as dependent demand items.
Items that are final products demanded by an external
customer are independent demand items.

5
Elements of Inventory Management
Inventory Costs (1 of 3)
Carrying costs - Costs of holding items in storage.
Vary with level of inventory and sometimes with length
of time held.
Include facility operating costs, record keeping,
interest, etc.
Assigned on a per unit basis per time period, or as
percentage of average inventory value (usually
estimated as 10% to 40%).

6
Elements of Inventory Management
Inventory Costs (2 of 3)
Ordering costs - costs of replenishing stock of inventory.
Expressed as dollar amount per order, independent of
order size.
Vary with the number of orders made.
Include purchase orders, shipping, handling,
inspection, etc.

7
Elements of Inventory Management
Inventory Costs (3 of 3)
Shortage, or stockout costs - Costs associated with
insufficient inventory.
Result in permanent loss of sales and profits for items
not on hand.
Sometimes penalties involved; if customer is internal,
work delays could result.

8
Inventory Control Systems

An inventory control system controls the level of inventory

by determining how much (replenishment level) and when
to order.
Two basic types of systems -continuous (fixed-order
quantity) and periodic (fixed-time).
In a continuous system, an order is placed for the same
constant amount when inventory decreases to a specified
level.
In a periodic system, an order is placed for a variable
amount after a specified period of time.

9
Inventory Control Systems
Continuous Inventory Systems
A continual record of inventory level is maintained.
Whenever inventory decreases to a predetermined level,
the reorder point, an order is placed for a fixed amount to
replenish the stock.
The fixed amount is termed the economic order quantity,
whose magnitude is set at a level that minimizes the total
inventory carrying, ordering, and shortage costs.
Because of continual monitoring, management is always
aware of status of inventory level and critical parts, but
system is relatively expensive to maintain.

Chapter 16 - Inventory Management 10

Inventory Control Systems
Periodic Inventory Systems
Inventory on hand is counted at specific time intervals and
an order placed that brings inventory up to a specified level.
Inventory not monitored between counts and system is
therefore less costly to track and keep account of.
Results in less direct control by management and thus
generally higher levels of inventory to guard against
stockouts.
System requires a new order quantity each time an order is
placed.
Used in smaller retail stores, drugstores, grocery stores and
offices.

Chapter 16 - Inventory Management 11

Economic Order Quantity Models

Economic order quantity, or economic lot size, is the

quantity ordered when inventory decreases to the reorder
point.
Amount is determined using the economic order quantity
(EOQ) model.
Purpose of the EOQ model is to determine the optimal
order size that will minimize total inventory costs.
Three model versions to be discussed:
Basic EOQ model
EOQ model without instantaneous receipt
EOQ model with shortages
Chapter 16 - Inventory Management 12
Economic Order Quantity Models
Basic EOQ Model (1 of 2)
A formula for determining the optimal order size that
minimizes the sum of carrying costs and ordering costs.
Simplifying assumptions and restrictions:
Demand is known with certainty and is relatively
constant over time.
No shortages are allowed.
Lead time for the receipt of orders is constant.
The order quantity is received all at once and
instantaneously.

Chapter 16 - Inventory Management 13

Economic Order Quantity Models
Basic EOQ Model (2 of 2)

Figure 16.1
The Inventory Order Cycle

Chapter 16 - Inventory Management 14

Basic EOQ Model
Carrying Cost (1 of 2)
Carrying cost usually expressed on a per unit basis of time,
traditionally one year.
Annual carrying cost equals carrying cost per unit per year
times average inventory level:
Carrying cost per unit per year = Cc
Average inventory = Q/2
Annual carrying cost = CcQ/2.

15
Basic EOQ Model
Ordering Cost
Total annual ordering cost equals cost per order (Co) times
number of orders per year.
Number of orders per year, with known and constant
demand, D, is D/Q, where Q is the order size:
Annual ordering cost = CoD/Q
Only variable is Q, Co and D are constant parameters.
Relative magnitude of the ordering cost is dependent on
order size.

16
Basic EOQ Model
Total Inventory Cost (1 of 2)
Total annual inventory cost is sum of ordering and carrying
cost:

D
TC  Co  Cc Q
Q 2

17
Basic EOQ Model
Total Inventory Cost (2 of 2)

Figure 16.5
The EOQ Cost Model
Chapter 16 - Inventory Management 18
Basic EOQ Model
EOQ and Minimum Total Cost
EOQ occurs where total cost curve is at minimum value
and carrying cost equals ordering cost:

19
Basic EOQ Model
Example (1 of 2)
I-75 Carpet Discount Store, Super Shag carpet sales.
Given following data, determine number of orders to be
made annually and time between orders given store is open
every day except Sunday, Thanksgiving Day, and
Christmas Day.
Model parameters :
Cc  $0.75, Co  $150, D  10,000yd
Optimal order size :

Qopt  2CoD  2(150)(10,000)  2,000 yd

Cc (0.75)
Chapter 16 - Inventory Management 20
Basic EOQ Model
Example (2 of 2)
Total annual inventory cost :

TC min  Co D  Cc Qopt  (150)10,000  (0.75) (2,000)  $1,500

Qopt 2 2,000 2
Number of orders per year :
D  10,000  5
Qopt 2,000

Order cycle time  311 days  311 62.2 store days

D / Qopt 5

Chapter 16 - Inventory Management 21

Basic EOQ Model
EOQ Analysis Over Time (1 of 2)
For any time period unit of analysis, EOQ is the same.
Shag Carpet example on monthly basis:

Model parameters :
Cc  $0.0625 per yd per month
Co  $150 per order
D  833.3 yd per month
Optimal order size :

Qopt  2CoD  2(150)(833.3)  2,000 yd

Cc (0.0625)

Chapter 16 - Inventory Management 22

Basic EOQ Model
EOQ Analysis Over Time (2 of 2)

Total monthly inventory cost :

TC min  Co D  Cc Qopt  (150) (833.3)  (0.0625) (2,000)

Qopt 2 2,000 2
 $125 per month
Total annual inventory cost  ($125)(12)  $1,500

Chapter 16 - Inventory Management 23

EOQ Model
Non-Instantaneous Receipt Description (1 of 2)
In the non-instantaneous receipt model the assumption that
orders are received all at once is relaxed. (Also known as
gradual usage or production lot size model.)
The order quantity is received gradually over time and
inventory is drawn on at the same time it is being
replenished.

Chapter 16 - Inventory Management 24

EOQ Model
Non-Instantaneous Receipt Description (2 of 2)

Figure 16.6
The EOQ Model with Non-Instantaneous Order Receipt

Chapter 16 - Inventory Management 25

Non-Instantaneous Receipt Model
Model Formulation (1 of 2)
p  daily rate at which the order is received over time
d  daily rate at which inventory is demanded

d 

Maximum inventory level  Q 1 p 






Q 
d 
Average inventory level  1 p 

2 

Q 
d 
Total carrying cost  Cc 1 p 

2 

D Q 
d 
Total annual inventory cost  Co  Cc 1 p 

Q 2 

Chapter 16 - Inventory Management 26

Non-Instantaneous Receipt Model
Model Formulation (2 of 2)
Q
Cc 1 p   Co D at lowest point of total cost curve

 d 

2  Q

Optimal order size : Qopt  2CoD

Cc(1 d / p)

Chapter 16 - Inventory Management 27

Non-Instantaneous Receipt Model
Example (1 of 2)
Super Shag carpet manufacturing facility:
Co  $150
Cc  $0.75 per unit
D  10,000 yd per year  10,000/311  32.2 yd per day
p  150 yd per day

Optimal order size : Qopt  2CoD  2(150)(10,000)


d 
Cc1 p 
 

0.751
 32 . 2 


 

 150 


 2,256.8 yd

Chapter 16 - Inventory Management 28

Non-Instantaneous Receipt Model
Example (2 of 2)
D Q 
d 
Total minimum annual inventory cost  Co  Cc 1 p 

Q 2 

 (150) (10,000)  (.075) (2,256 . 8) 

32 . 2 
1   $1,329
 

(2,256.8) 2 
 150 

Production run length  Q

p  2,256.8 15.05 days
150

Number of orders per year (productio n runs)  D

Q

 10,000  4.43 runs

2,256.8
d 

Maximum inventory level  Q 1 p  2,256.81



32 . 2 

  1,772 yd




 150  
Chapter 16 -Inventory Management
  29
EOQ Model with Shortages
Description (1 of 2)
In the EOQ model with shortages, the assumption that
shortages cannot exist is relaxed.
Assumed that unmet demand can be backordered with all
demand eventually satisfied.

Chapter 16 - Inventory Management 30

EOQ Model with Shortages
Description (2 of 2)

Figure 16.7
The EOQ Model with Shortages
Chapter 16 - Inventory Management 31
EOQ Model with Shortages
Model Formulation (1 of 2)

S 2 (Q  S )2
Total shortage costs  Cs Total carrying costs  Cc
2Q 2Q

Total ordering cost  C0 D

Q

S 2 (Q  S )2
Total inventory cost  Cs  Cc  Co D
2Q 2Q Q

2CoD  Cs  Cc 
 
Optimal order quantity  Qopt 
Cc  Cs 

Shortage level  Sopt  Qopt Cc





Cc  Cs 




Chapter 16 - Inventory Management 32

EOQ Model with Shortages
Model Formulation (2 of 2)

Figure 16.8
Cost Model with
Chapter Shortages
16 - Inventory Management 33
EOQ Model with Shortages
Model Formulation (1 of 3)
I-75 Carpet Discount Store allows shortages; shortage cost
Cs, is $2/yard per year.

Co  $150
Cc  $0.75 per yd
Cs  $2 per yd
D  10,000 yd
Optimal order quantity :

Qopt  2CoD  Cs  Cc 
  2(150)(10,000)  2  0.75 
 
      2,345.2 yd
Cc  Cs 
  0.75 
 2 

Chapter 16 - Inventory Management 34

EOQ Model with Shortages
Model Formulation (2 of 3)
Shortage level:

Cc  0.75 
   
Sopt  Qopt 
  2,345.2

  639.6 yd
Cc  Cs 




 2  0.75 
 

Total inventory cost :

S 2 (Q  S )2
TC  Cs  Cc  Co D
2Q 2Q Q

(2)(639 . 6)2 (0.75)(1,705.6)2 (150)(10,000)

  
2(2,345.2) 2(2,345.2) 2,345.2
 $174.44  465.16  639.60  $1,279.20

Chapter 16 - Inventory Management 35

EOQ Model with Shortages
Model Formulation (3 of 3)

Number of orders  D  10,000  4.26 orders per year

Q 2,345.2
Maximum inventory level  Q  S  2,345.2  639.6 1,705.6 yd

Time between orders  t  days per year  311  73.0 days

number of orders 4.26
Time during which inventory is on hand

 t1  Q  S  2,345.2 -639.6  0.171 or 53.2 days

D 10,000
Time during which the re is a shortage

 t 2  S  639.6  0.064 year or 19.9 days

D 10,000 Chapter 16 - Inventory Management 36
Quantity Discounts

Price discounts are often offered if a predetermined number of

units is ordered or when ordering materials in high volume.
Basic EOQ model used with purchase price added:

TC  Co D  Cc Q  PD
Q 2
where: P = per unit price of the item
D = annual demand
Quantity discounts are evaluated under two different
scenarios:
With constant carrying costs
With carrying costs as a percentage of purchase price
Chapter 16 - Inventory Management 37
Quantity Discounts with Constant Carrying Costs
Analysis Approach
Optimal order size is the same regardless of the discount
price.
The total cost with the optimal order size must be compared
with any lower total cost with a discount price to determine
which is the lesser.

Chapter 16 - Inventory Management 38

Quantity Discounts with Constant Carrying Costs
Example (1 of 2)
University bookstore: For following discount schedule
offered by Comptek, should bookstore buy at the discount
terms or order the basic EOQ order size?
Quantity Price
1- 49 $1,400
50 – 89 1,100
90 + 900

Determine optimal order size and total cost:

Co  $2,500 Cc  $190 per unit D  200

Qopt  2CoD  2(2,500)(200)  72.5

Cc 190
Chapter 16 - Inventory Management 39
Quantity Discounts with Constant Carrying Costs
Example (2 of 2)
Compute total cost at eligible discount price ($1,100):
TC min  CoD  Cc Qopt  PD
Qopt 2

 (2,500)(200)  (190) (72.5)  (1,100)(200)  $233,784

(72.5) 2
Compare with total cost of with order size of $90 and price
of $900:
TC  CoD  Cc Q  PD
Q 2

 (2,500)(200)  (190)(90)  (900)(200)  $194,105

(90) 2
Because $194,105 < $233,784, maximum discount price
should be taken and 90 units ordered.
Chapter 16 - Inventory Management 40
Quantity Discounts with Carrying Costs
Percentage of Price Example (1 of 3)
University Bookstore example, but a different optimal order
size for each price discount.
Optimal order size and total cost determined using basic
EOQ model with no quantity discount.
This cost then compared with various discount quantity
order sizes to determine minimum cost order.
This must be compared with EOQ-determined order size for
specific discount price.
Data:
Co = $2,500
D = 200 computers per year
Chapter 16 - Inventory Management 41
Quantity Discounts with Carrying Costs
Percentage of Price Example (2 of 3)
Quantity Price Carrying Cost
0 - 49 $1,400 1,400(.15) = $210
50 - 89 1,100 1,100(.15) = 165
90 + 900 900(.15) = 135
Compute optimum order size for purchase price without
discount and Cc = $210:

Qopt  2CoD  2(2,500)(200)  69

Cc 210
Compute new order size:

Qopt  2(2,500)(200)  77.8

165
Chapter 16 - Inventory Management 42
Quantity Discounts with Carrying Costs
Percentage of Price Example (3 of 3)
Compute minimum total cost:
TC  CoD  Cc Q  PD  (2,500)(200) 165 (77.8)  (1,100)(200)
Q 2 77.8 2
 $232,845
Compare with cost, discount price of $900, order quantity of
90:
TC  (2,500)(200)  (135)(90)  (900)(200)  $191,630
90 2
Optimal order size computed as follows:
Qopt  2(2,500)(200)  86.1
135
Since this order size is less than 90 units , it is not
feasible,thus optimal order size is 90 units.
Chapter 16 - Inventory Management 43
Reorder Point (1 of 4)

The reorder point is the inventory level at which a new

order is placed.
Order must be made while there is enough stock in place to
cover demand during lead time.
Formulation:
R = dL
where d = demand rate per time period
L = lead time
For Carpet Discount store problem:
R = dL = (10,000/311)(10) = 321.54

Chapter 16 - Inventory Management 44

Reorder Point (2 of 4)

Figure 16.9
Reorder Point and Lead Time
Chapter 16 - Inventory Management 45
Reorder Point (3 of 4)

Inventory level might be depleted at slower or faster rate

during lead time.
When demand is uncertain, safety stock is added as a
hedge against stockout.

Figure 16.10
Inventory Model
Chapter with Uncertain
16 - Inventory Demand
Management 46
Reorder Point (4 of 4)

Figure 16.11
Inventory model with safety stock
Chapter 16 - Inventory Management 47
Example Problem Solution
Electronic Village Store (1 of 3)
For data below determine:
Optimal order quantity and total minimum inventory cost.
Assume shortage cost of $600 per unit per year,
compute optimal order quantity and minimum inventory
cost.
Step 1 (part a): Determine the Optimal Order Quantity.
D 1,200 personal computers
Cc  $170
Co  $450

Q  2CoD  2(450)(1,200)  79.7 personal computers

Cc 170
Chapter 16 - Inventory Management 48
Example Problem Solution
Electronic Village Store (2 of 3)
Q D  79.7 

Total cost  Cc  Co 170

1,200 
 
  450 
2 Q 
 2    79.7 
 

 $13,549.91
Step 2 (part b): Compute the EOQ with Shortages.
Cs  $600

Q 2CoD  Cs  Cc 
  2(450)(1200)  600 170 
 
    
Cc  Cs 
  170 
 600 
 90.3 personal computers

Chapter 16 - Inventory Management 49

Example Problem Solution
Electronic Village Store (3 of 3)

S Q

 Cc 

 90 . 3

 170 
  19.9 personal computers

Cc  Cs 






170  600 
 

CsS 2 (Q  S )2 CoD
Total cost   Cc 
2Q 2Q Q

(600 )(19 . 9)2 (90 . 3 19 . 9)2 1,200 

 
 170  450 
2(90.3) 2(90.3)  90.3 
 

 $11,960.98

Chapter 16 - Inventory Management 50

Chapter 16 - Inventory Management 51