Operations Management

Seventh Edition
R. Dan Reid & Nada R. Sanders

Chapter 12

Inventory Management

©2020 John Wiley & Sons, Inc. All rights reserved.

Learning Objectives

1. Discuss basic inventory principles.

2. Describe inventory management objectives.
3. Explain the relevant inventory costs.
4. Explain the ABC inventory classification model.
5. Discuss inventory record accuracy.
6. Calculate order quantities.
7. Calculate the appropriate safety stock level.
8. Describe the periodic review approach.

© 2020 John Wiley & Sons, Inc. All rights reserved. 2

 Types of Inventory

• Inventory comes in many shapes/sizes:

o Raw materials — purchased items or extracted materials to be
transformed into components or products
o Components — parts or subassemblies used in final product
o Work-in-process — items in process throughout the plant
o Finished goods — products sold to customers
o Distribution inventory — finished goods in the distribution system

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 Types of Inventory, Figure 12.1

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 How Manufacturers Use Inventory

TABLE 12.1 Function of Inventory

Anticipation inventory Items built in anticipation of future demand. Allows company to

maintain a level production strategy.
Fluctuation inventory Protects against unexpected demand variations. Assures customer
service levels.
Lot-size inventory Results from the actual quantity purchased. Allows for lower unit
costs.
Transportation Items in movement between locations. Inventory moves from
inventory manufacturer to distribution facilities.
Speculative inventory Extra inventory built up or purchased to protect against some future
events. Allows for continuous supply.
MRO inventory Includes maintenance supplies, spare parts, lubricants, cleaning
agents, and daily operating supplies. Facilitates day-to-day operations.

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 Inventory in Service Organizations

• Achieving good inventory control may require the following:

o select, train, and discipline personnel
o maintain tight control over incoming shipments
o maintain tight control over outgoing shipment

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 Inventory Management Objectives

• Three objectives:
o customer service
o cost-efficient operations
o minimum inventory investments

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 Inventory Objectives Summary

TABLE 12.2 Inventory Objectives

Inventory Objectives
Customer service Measured by any of the following:
• Percentage of orders shipped on schedule
• Percentage of line items shipped on schedule
• Percentage of dollar volume shipped on schedule
• Idle time due to component and material shortages
Cost-efficient operations Inventories help achieve cost-effective operations by
• Using buffer stock to assure smooth production flow
• Maintaining a level workforce
• Allowing longer production runs, which spreads the cost of setups
• Taking advantage of quantity discounts
Minimum inventory investment Measured by any of the following:
• Inventory turnover
• Weeks of supply
• Days of supply
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 Customer Service Level Measurements

• Percentage of orders shipped on schedule

o Good measure if orders have similar value (doesn’t capture value of different
orders).
o If one customer represents 50% of your business but only 5% of your orders, 95%
on schedule could represent only 50% of value.
• Percentage of line items shipped on schedule
o Recognizes that not all orders are equal, but doesn’t capture dollar value of orders.
More expensive to measure. Best for finished goods.
o A 90% service level might mean shipping 225 items out of the total 250 line items
totaled from 20 orders scheduled.
• Percentage of dollar volume shipped on schedule
o Recognizes the differences in orders in terms of both line items and dollar value.

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 Example: Inventory Turnover
annual cost of goods sold
Inventory turnover =
average inventory in dollars

If the annual cost of goods sold at the Nadan Company is $5,200,000

and the average inventory in dollars is $1,040,000, what is the
inventory turnover?
Solution

$5,200,000
Inventory turnover = = 5 inventory turns
$1,040,000

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 Example: Weeks of Supply
average inventory on hand in dollars
Weeks of supply =
average weekly usage in dollars

Suppose that the Nadan Company wants to calculate its weeks of supply. From the
previous example, we know that annual cost of goods sold is $5,200,000.
Solution
To determine the weekly cost of goods sold, we divide the annual cost of goods
sold by 52 weeks ($5,200,000 / 52 = $100,000). Given that Nadan maintains an
average inventory of $1,040,000, we calculate the weeks of supply as follows:

$1,040,000
Weeks of supply = = 10.4 weeks of supply
$100,000

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 Example: Hours of Supply
average inventory on hand in dollars
Days of supply =
average daily usage in dollars

average inventory on hand in dollars

Hours of supply =
average hourly usage in dollars

Suppose that the Jenny Company, a specialty gift organization, wants to calculate its days of supply. The annual cost of goods sold
is $1,300,000, the average inventory is $15,600, and the company operates 250 days per year.
Solution
First, we calculate the average daily usage. We divide the annual cost of goods sold by the number of days the company operates
($1,300,000 divided by 250 days equals $5,200). Second, using the formula, we divide the average inventory on hand by the
average daily usage.
$15,600
Days of supply = = 3 days of supply
$650

Suppose the Jenny Company uses a new process that reduces the average inventory held to $3,250. To calculate its current hours
of supply, we first calculate the average hourly usage. Using the data provided and assuming an eight-hour day, we divide the
average daily usage ($5,200) by eight hours. The average hourly usage is $650. Therefore, the hours of supply are

$3,250
Hours of supply = = 5 hours of supply
$650

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 Relevant Inventory Costs

TABLE 12.3 Relevant Inventory Costs

Item cost Price paid per item plus any other direct costs associated with
getting the item to the plant
Holding costs Capital, storage, and risk costs
Ordering costs Fixed, constant dollar amount incurred for each order placed
Shortage costs Loss of customer goodwill, back-order handling, and lost sales

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 Learning Objective 4

Explain the ABC inventory classification model.

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 ABC Inventory Classification

• ABC classification is a method for determining level of control and

frequency of review of inventory items.
• A Pareto analysis (80/20 rule) can be done to segment items into
value categories depending on annual dollar volume (Pareto’s law:
About 20% of the inventory items account for about 80% of the
inventory value).
A Items Typically 20% of the items accounting for 80% of the
inventory value.
B Items Typically an additional 30% of the items accounting for
15% of the inventory value.
C Items Typically the remaining 50% of the items accounting for
only 5% of the inventory value.

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 Example: The AAU Corp.
ABC Problem
ABC Problem ABC Problem Data: Data: Annual
Data: Item Unit $ Value Usage (in units)
• The AAU Corp. is considering 101 12.00 80
102 50.00 10
doing an ABC analysis on its 103 15.00 50
entire inventory but has 104 50.00 40

decided to test the 105 40.00 80

106 75.00 220
technique on a small sample 107 4.00 250
of 15 of its stock-keeping 108 1.50 400

units (SKUs). The annual 109 2.00 250

110 25.00 500
usage and unit cost of each 111 5.00 450
item are shown below. 112 7.50 80
113 3.50 250
114 1.00 1200
115 15.00 300

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 ABC Inventory Analysis Procedure

Step 1: Calculate the annual dollar usage for each item.

Step 2: List the items in descending order based on annual dollar
usage.
Step 3: Calculate the cumulative annual dollar volume.
Step 4: Classify the items into groups.

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 Example: ABC Inventory Analysis: Step 1
ABC Annual ABC Annual ABC Annual Usage ABC Annual Usage
Usage Values: Usage Values: Values: Annual Values: Annual
Item Unit $ Value Usage (in units) Usage ($)

Solution (a): Calculate the 101 12.00 80 960

102 50.00 10 500
annual dollar usage for 103 15.00 50 750

each item. 104 50.00 40 2000

105 40.00 80 3200
106 75.00 220 16,500
107 4.00 250 1000
108 1.50 400 600
109 2.00 250 500
110 25.00 500 12,500
111 5.00 450 2250
112 7.50 80 600
113 3.50 250 875
114 1.00 1200 1200
115 15.00 300 4500
Total $47,935

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 Example: ABC Inventory Analysis: Steps 2–4
ABC Solution: ABC
ABC ABC Solution: ABC Solution: Cumulative Solution:
Solution (b): List the items in Solution:
Item
Annual
Usage ($)
Percentage of
Total Dollars
Percentage of
Total Dollars
Item
Classification
descending order based on annual 106 16,500 34.4 34.4 A

dollar usage. 110 12,500 26.1 60.5 A

115 4500 9.4 69.9 B
Solution (c): Calculate the cumulative 105 3200 6.7 76.6 B

annual dollar volume. 111 2250 4.7 81.3 B

104 2000 4.2 85.5 B
Solution (d): Group the items into 114 1200 2.5 88.0 C

classes. 107 1000 2.1 90.1 C

101 960 2.0 92.1 C

Remember that these are not absolute rules 113 875 1.8 93.9 C

for classifying items. Your company wants to 103 750 1.6 95.5 C

group its more valuable items together to 108 600 1.3 96.8 C

make sure that these items get the most 112 600 1.3 98.1 C

control. 102 500 1.0 99.1 C

109 500 1.0 100.1* C
*Total exceeds 100% due to rounding.
Total $47,935

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 Graphical ABC Classification of Materials
• The A items (106 and 110) account
FIGURE 12.2 ABC classification of for 60.5% of the value and 13.3% of
materials the items.
• The B items (115, 105, 111, and
104) account for 25% of the value
and 26.7% of the items.
• The C items make up the last 14.5%
of the value and 60% of the items.
• How might you control each item
classification? Different ordering
rules for each?

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 ABC Inventory: Review Systems

• Continuous review system: Updates inventory balances after each

inventory transaction.
• Periodic review system: Requires regular periodic reviews of the
on-hand quantity to determine the size of the replenishment order.
• Two-bin system: One bin with enough stock to satisfy demand
during replenishment time is kept in the storeroom; the other bin
is placed on the manufacturing floor.

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 Causes of Inventory Inaccuracies

• Inaccurate inventory records can cause:

o lost sales
o disrupted operations
o poor customer service
o lower productivity
o planning errors and expediting

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 Inventory Record Accuracy: Methods

• Two methods for checking record accuracy:

o Periodic counting — physical inventory is taken periodically, usually
annually. Steps include:
• count, verify, collect tickets, reconcile
o Cycle counting — daily counting of pre-specified items provides the
following advantages:
• timely detection and correction of inaccurate records
• elimination of lost production time due to unexpected stockouts
• structured approach using employees trained in cycle counting

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 Determining Order Quantities

• Inventory management and control are managed at the level of the

stock-keeping unit, or SKU, an item at a particular geographic location.

TABLE 12.4 Common Ordering Approaches

Lot-for-lot Order exactly what is needed.
Fixed-order quantity Order a predetermined amount each time an order is
placed.
Min-max system When on-hand inventory falls below a predetermined
minimum level, order a quantity that will take the
inventory back up to its predetermined maximum level.
Order n periods Order enough to satisfy demand for the next n periods.

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 Mathematical Models for Determining Order
Quantity
• Economic order quantity (EOQ)
o An optimizing method used for determining order quantity and
reorder points
o Part of continuous review system, which tracks on-hand inventory
each time a withdrawal is made
• Economic production quantity (EPQ)
o A model that allows for incremental product delivery
• Quantity discount model
o Modifies the EOQ process to consider cases where quantity
discounts are available

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 EOQ Assumptions
• Demand is known and constant —
no safety stock is required.
• Lead time is known and constant.
FIGURE 12.3 The EOQ model
• No quantity discounts are
available.
• Ordering (or setup) costs are
constant.
• All demand is satisfied (no
shortages).
• The order quantity arrives in a
single shipment.

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 Total Annual Inventory Cost with EOQ Model

Total annual cost = annual ordering cost + annual holding costs

D  Q  2DS
TC =  S  +  H  ; and Q =
Q   2  H

FIGURE 12.4 Holding costs equal

ordering costs

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 Economic Production Quantity (EPQ)

• Same assumptions as the EOQ except that inventory arrives in

increments and draws down as it arrives.

FIGURE 12.5 The EPQ model

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 Calculating EPQ

• Calculating EPQ
where  D   IMax 
TC =  S  +  H
Q   2 
TC = total annual cost
D = annual demand  d
IMax = Q 1 − 
Q = quantity to be ordered  p
H = annual holding cost
S = ordering or setup cost 2DS
Q=
where  d
H 1 − 
d = average daily demand rate  p
p = daily production rate
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 EPQ Problem: Ashlee’s Beach Chairs Company

Ashlee’s Beach Chairs Company produces upscale beach chairs. Annual demand for the chairs is estimated at
18,000 units. The frames are made in batches before the final assembly process. Ashlee’s final assembly
department needs frames at a rate of 1,500 per month. Ashlee’s frame department can produce 2,500 frames per
month. The setup cost is $800, and the annual holding cost is $18 per unit. The company operates 20 days per
month. Lead time is 5 days. Determine the optimal order quantity, the total annual costs, and the reorder point.
Before You Begin To determine the optimal EPQ, use the formula

2DS
Q=
 d
H 1 − 
 p
Remember that the demand and production rates used to calculate the ratio must be in the same time frame
(daily, weekly, monthly, quarterly, or annually). To calculate the reorder point, use the formula R = dL. Don’t forget
to transform monthly demand into daily demand to find the reorder point. Reorder points should be found using
the easiest numbers possible. For example, if lead time is given as three weeks, then you should find average
weekly demand and multiply by the three weeks. If lead time is given in months, use average monthly demand.

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 Solution to EPQ Problem: Ashlee’s Beach Chairs

To determine the total cost, you must calculate the maximum inventory level. To do this you must
first calculate the economic production quantity:

2  18,000  $800
Q= = 2000 units
 1500 
$18  1 −
 2500 

Therefore, IMax is
 1500 
IMax = 2000  1 −
 2500 
= 800 units

and the total annual cost is  18,000   800 

TC =  $800 +  $18
 2000   2 
= $7200 + $7200
= $14,400

Note that the ordering cost equals the annual holding cost. The reorder point is calculated as R = 75 units × 5
days = 375 units. Therefore, the inventory policy is to order a quantity of 2,000 frames when the inventory
reaches 375 units. The total annual cost (excluding item cost) associated with this policy is $14,400.

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 Quantity Discount Model

• Same as the EOQ model, except:

o unit price depends upon the quantity ordered
• The total cost equation becomes:

D  Q 
TC =  S  +  H  + CD
Q   2 

C = unit price
D = annual demand in units

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 Quantity Discount: Holding Costs Given as a
Percentage of the Unit Price
TABLE 12.5 Quantity Discount Procedure
1. Calculate the order quantity using the basic EOQ model and the cheapest price possible.
2. Determine whether the order quantity is feasible. That is, if we order this quantity will the supplier charge us
the price we used to determine our order quantity? If this is a feasible order quantity, you are done.
Otherwise, go to Step 3.
3. If the EOQ quantity found in Step 1 was infeasible, calculate the EOQ for the next higher price.
4. Check again to determine whether this quantity is feasible. If it is not feasible, repeat Step 3. If it is feasible,
move on to Step 5.
5. Calculate the total annual costs associated with your feasible order quantity. You must include ordering,
holding, and material costs.
6. Calculate the total annual costs associated with buying the minimum quantity required to qualify for any prices
that are lower than the price at which the feasible solution was found.
7. Compare the total annual costs of buying these minimum quantities to receive the cheaper price against the
cost of the feasible Q.
8. Recommend whichever order policy has the lowest total annual cost.

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 Example: Quantity Discount

VGHC operates its own laboratory on-site. The lab maintains an inventory of test kits for a
variety of procedures. VGHC uses 780 A1C kits each year. Ordering costs are $15 and
holding costs are $3 per kit per year. The new price list indicates that orders of fewer than
73 kits will cost $60 per kit, 73 through 144 kits will cost $56 per kit, and orders of more
than 144 kits will cost $53 per kit. Determine the optimal order quantity and the total cost.
Before You Begin When you have constant holding costs, you only need to calculate a
single Q value using the basic EOQ formula:
2DS
Q=
H
Check to see what price you must pay per unit if this order quantity is used. If it is the cheapest
possible price, this is your optimal replenishment order quantity. If cheaper prices are available,
calculate the total annual cost if you buy just enough to qualify for the cheaper price. Do this for all
prices cheaper than the price you qualified for with the EOQ. Select the policy that has the lowest
total costs, making sure that material costs were included.

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 Solution to Quantity Discount Example

The first step is to calculate the common Q.

2 × 780 × $15
Q= = 88.3,or 89 kits
$3

This quantity qualifies for a price of $56 per kit. Since it is not the lowest possible price, we calculate
the total cost at this price and compare it to the total cost at any lower price breaks. The total cost
when ordering 89 kits is
 780   89 
TC =  $15  +  $3  + ( $56 × 780 ) = $43,944.96
 89   2 
Total cost when ordering 145 kits is
 780   145 
TC =  $15  +  $3  + ( $53 × 780 ) = $41,638.19
 145   2 
Therefore, the VGHC should order 145 kits at a time since it will save $2,306.77 each year
($43,944.96 − $41,638.19). The total annual cost curves are shown in Figure 12.7.

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 Quantity Discount: Cost Curves
FIGURE 12.7 Quantity discount total annual cost with constant holding cost

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 Single-Period Inventory Model

• The single-period model is designed for products that share the

following characteristics:
o Sold at their regular price only during a single time period
o Demand is highly variable but follows a known probability
distribution
o Salvage value is less than its original cost, so money is lost when
these products are sold for their salvage value
• Objective is to balance the gross profit of the sale of a unit with the
cost incurred when a unit is sold after its primary selling period.

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 Example: Single-Period Inventory Model

Rick Jones is chairman of this year’s Walk for Diabetes event. Each year, the organizers of the event typically have
commemorative T-shirts available for purchase by the entrants in the walk. Rick needs to order the shirts well in
advance of the actual event. He must place his order in multiples of 10 (60, 70, 80, etc.). Based on past walks, the
organizers have determined that the probability of selling different quantities of T-shirts in a given year is as
follows:
Demand (shirts) Probability
80 0.20
90 0.25
100 0.30
110 0.15
120 0.10

Rick plans to sell the T-shirts for $20 each. He pays his supplier $8 for each shirt and can sell any unsold shirts for
rags at $2 each. Determine how many T-shirts Rick should order to maximize his expected profits.
Before You Begin In this problem, you need to determine how many T-shirts to order for the event. If you order
too many, you will have leftover shirts with little value. If you don’t order enough, you forgo achieving the profit
associated with each shirt plus creating some customer ill will. The easiest way to approach this decision is to
develop a payoff table to calculate expected profit with each possible order quantity.

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 Single-Period Inventory Model Example: Payoff
Tables
Based on the information provided, develop a payoff table to determine expected profit with each possible order
quantity. Calculate net profit for each combination of order quantity and demand as shown next.
Payoff Payoff Payoff Payoff Payoff
Table Table Table Table Table
Probability of occurrence 0.20 0.25 0.30 0.15 0.10
Customer demand (shirts) 80 90 100 110 120

Number of Shirts Ordered Expected Profit

80 $960 $960 $960 $960 $960 $960
90 $900 $1080 $1080 $1080 $1080 $1044
100 $840 $1020 $1200 $1200 $1200 $1083
110 $780 $960 $1140 $1320 $1320 $1068
120 $720 $900 $1080 $1260 $1440 $1026

The numbers in the payoff table are calculated based on what happened. The three possible outcomes are: (1) the number of shirts ordered equals the
number of shirts demanded, (2) the number of shirts ordered is greater than the number of shirts demanded, and (3) the number of shirts ordered is
less than the number of shirts demanded. To find the payoff when supply equals demand,
Payoff = demand (selling price − unit cost)
In our example, look at what happens when 100 T-shirts are bought and 100 T-shirts are sold.
Payoff = 100 ($20 − $8) = $1200

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 Solution to Single-Period Model Example
When the number of shirts ordered is less than demand, the payoff is calculated as
Payoff = (number of items demanded) × (selling price − item cost) − [(items ordered − items demanded) × (item
cost − item salvage value)]
If 100 T-shirts are ordered and demand is for only 80 shirts, the payoff is
Payoff = 80($20 − $8) − [(100 − 80) × ($8 − $2)] = $840
When the number of shirts ordered is less than demand, the payoff is calculated as
Payoff = number of items ordered × (selling price − item cost)
Returning to the example, determine the payoff when 100 T-shirts are ordered but 120 shirts are demanded.
Payoff = 100 ($20 − $8) = $1,200
After we calculate the payoffs for each combination, we can determine the expected profit for each order
quantity. We do this by multiplying the payoff for an order quantity by the probability for each level of demand.
For example, we calculate the payoff for ordering 100 shirts, $1083, as
($840 × 0.20) + ($1,020 × 0.25) + ($1,200 × 0.30) + ($1,200 × 0.15) + ($1,200 × 0.10)
Once we generate the expected profit for each of the possible order quantities, we select the order quantity with
the highest expected profit. In our case, Rick should order 100 shirts since doing so has an expected profit of
$1,083.
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 Why Companies Don’t Always Use Optimal Order
Quantity
• It is not unusual for companies to order less or more than the EOQ
for several reasons:
o They may not have a known uniform demand.
o Some suppliers have minimum order quantities.
• EOQ provides a benchmark for comparing other policies that will
be more expensive; you should be able to justify the extra expense.

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 Justifying Smaller Order Quantities

• JIT or “lean systems” recommend reducing order quantities to the

lowest practical levels.
• Benefits from reducing Q:
o improved customer responsiveness (inventory = lead time)
o reduced cycle inventory
o reduced raw materials and purchased components
• Justifying smaller EPQ’s: 2DS
Q=
H
• EPQ can be reduced by reducing the setup cost (S)

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 Determining Safety Stock and Service Levels

• If demand or lead time is uncertain, safety

FIGURE 12.9 Quantity discount total
stock can be added to improve order-cycle
annual cost with constant holding cost
service levels
R = dL + SS
where SS = zσdL, and z is the number of
standard deviations and σdL is standard
deviation of the demand during lead time.
• Order-cycle service level
o The probability that demand during lead
time will not exceed on-hand inventory.
o For a 95% service level (stockout risk of
5%), z = 1.645.

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 Example: Determining Safety Stock Levels

Suppose that the owner of the campus bar, Nick’s, has determined that demand for beer during lead time
averages 5,000 bottles. Nick, the owner, believes the demand during lead time can be described by a normal
distribution with a mean of 5,000 bottles and a standard deviation of 300 bottles. Nick is willing to accept a
stockout risk of approximately 4 percent. Determine the appropriate z value to use. Calculate how much safety
stock Nick should hold and determine the reorder point.
Before You Begin To determine how much safety stock, should be held, use the formula SS = zσdL . You also need
to use Appendix B to determine the appropriate z value. To determine the reorder point, use the formula R = dL +
SS. Note that safety stock always results in a higher reorder point.
Solution
Go to Appendix B. To find the appropriate z value associated with the order-cycle service level (1 − 0.04 = 0.9600) ,
you must understand that the appendix shows only positive z values. A z value of 0 represents 0.5000. You need to
find the z value that is the difference between the desired service level and a z value of 0 (0.9600 − 0.5000 =
0.4600). Look for the entry closest to 0.4600. If you look at the entry associated with a z value of 1.75, you should
see 0.4599, which is as close to 0.4600 as we can get. Therefore, the appropriate z value is 1.75. To determine the
appropriate amount of safety stock, do the following calculation:
SS = 1.75 × 300 bottles = 525 bottles of safety stock
The reorder point would now be: R = 5,000 + 525 = 5,525 bottles
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 Periodic Review Systems
• Orders are placed at specified, fixed-time intervals (e.g., every Friday)
for an order size (Q) that will bring on-hand inventory (OH) up to the
target inventory (TI), similar to the min-max system.
• Advantages:
o No need for a system to continuously monitor item
o Items ordered from the same supplier can be reviewed on the same day,
saving purchase order costs
• Disadvantages:
o Replenishment quantities (Q) vary
o Order quantities may not qualify for quantity discounts
o On the average, inventory levels will be higher; more stockroom space
needed
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 Periodic Review Systems: Calculations for TI

• Targeted inventory level (TI):

TI = d(RP + L) + SS
Where d = average period demand
RP = review period (days, weeks, etc.)
L = lead time (days, weeks, etc.)
SS = zσRP+L
• Replenishment quantity:
Q = TI – OH

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 Example: Using the Periodic Review System

Gray’s Pharmacy uses a periodic review inventory system. Every Friday, the pharmacist reviews her
inventory and determines the size of the replenishment order. For example, she knows that demand
for 500-mg metformin tablets, a drug for diabetics, is normally distributed with a mean of 6,000
tablets each week with a standard deviation of 500 tablets per week. Lead time is three weeks. The
desired cycle-service level is 95 percent. There are currently no outstanding orders.
a. Calculate the required safety stock.
b. Calculate the target inventory level.
c. If, when she reviews her inventory of metformin, the pharmacist finds that she currently has
19,000 tablets, calculate the appropriate replenishment order quantity.

Before You Begin For this problem, you must determine the target inventory level and make a
decision as to the replenishment quantity to order. To calculate the target inventory, find the
appropriate safety stock level. Use the formula SS = z σ RP+L. Calculate the target inventory as TI = d(RP
+ L + SS). After determining the target inventory, calculate the appropriate order size as Q = TI − OH.

LO 8 © 2020 John Wiley & Sons, Inc. All rights reserved. 47

 Solution to Using the Periodic Review System
Example
a. Go to Appendix B, the area under the standardized normal curve, and look for the z value that equates to 95
percent of the area under the curve. Since the appendix only uses positive z values, and they start at 0.50, we
need to look for a z value that matches the difference between the desired cycle-service level (0.95) and the
starting point of 0.50. So we are looking for a value close to 0.4500. In the appendix we can see that z = 1.64
has a value of 0.4495 while z = 1.65 has a value of 0.4505. By interpolation, a z = 1.645 has a value of exactly
0.4500. Therefore, our desired z value is 1.645.

(
SS = 1.645 σt RP + L )
SS = 1.645 ( 500 1 + 3 ) = 1645 tablets

b. The target inventory level is

TI = 6,000 (1 + 3) + 1,645 = 25,645 units
c. If the current inventory of metformin is 19,000 tablets, the pharmacist should order 6,645 tablets, or
Q = 25, 645 − 19,000 tablets.

LO 8 © 2020 John Wiley & Sons, Inc. All rights reserved. 48

 Inventory Management within OM: How It All Fits
Together
• Inventory management provides the materials and supplies needed to
support actual manufacturing or service operations. Inventory
replenishment policies guide the master production scheduler when
determining which jobs and what quantity should be scheduled
(Supplement D).
• Inventory management policies also affect the layout of the facility. A
policy of small lot sizes and frequent shipments reduces the space
needed to store materials (Chapter 7).
• Longer throughput times reduce an organization’s ability to respond
quickly to changing customer demands (Chapter 4).
• Good inventory management assures continuous supply and minimizes
inventory investment while achieving customer service objectives.
LO 8 © 2020 John Wiley & Sons, Inc. All rights reserved. 49
 Inventory Management across the Organization

• Inventory management policies affect functional areas throughout

the organization.
o Accounting is concerned of the cost implications with inventory.
o Marketing is concerned, as stocking decisions affect the level of
customer service.
o Information systems tracks and controls inventory records.
o Others:
• Purchasing is concerned with workload.
• Manufacturing is concerned with cost efficiency.

LO 8 © 2020 John Wiley & Sons, Inc. All rights reserved. 50

Chapter 12 Highlights (LO 1–2)

• Types of inventory: Raw materials, purchased components, work-

in-process, finished goods, distribution inventory and
maintenance, repair and operating supplies.
o Service organizations, retailers, wholesalers, and food service use
tangible inventory.
• Objectives of inventory management are to provide the desired
level of customer service, to allow cost-efficient operations, and to
minimize inventory investment.
o Inventory investment is measured in inventory turnover and/or level
of supply. Inventory performance is calculated as inventory turnover
or weeks, days, or hours of supply.

© 2020 John Wiley & Sons, Inc. All rights reserved. 51

Chapter 12 Highlights (LO 3–5)

• Relevant inventory costs include item costs, holding costs, and

shortage costs.
• The ABC classification system allows a company to assign the
appropriate level of control and frequency of review of an item
based on its annual dollar volume.
• Cycle counting is a method for maintaining accurate inventory
records and improve record accuracy. Determining what and when
to count are the major decisions.

© 2020 John Wiley & Sons, Inc. All rights reserved. 52

Chapter 12 Highlights (LO 6)

• Lot-for-lot, fixed-order quantity, min-max systems, order n periods,

periodic review systems, EOQ models, quantity discount models,
and single-period models can be used to determine order
quantities.
o Practical considerations can cause a company to not use the optimal
order quantity, such as minimum order requirements.
o Smaller lot sizes give a company flexibility and shorter response
times. The key to reducing order quantities is to reduce ordering or
setup costs.
o Inventory decisions about perishable products can be made using
the single-period inventory model. The expected payoff is calculated
to assist the quantity decision.

© 2020 John Wiley & Sons, Inc. All rights reserved. 53

Chapter 12 Highlights (LO 7–8)

• Calculating the appropriate safety stock policy enables companies

to satisfy their customer service objective at minimum costs. The
desired customer service level determines the appropriate z value.
• Periodic review systems check inventory levels. The ABC
classification system can be used to determine frequency and level
of review.

© 2020 John Wiley & Sons, Inc. All rights reserved. 54

Copyright
©2020 John Wiley & Sons, Inc. All rights reserved.
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© 2020 John Wiley & Sons, Inc. All rights reserved. 55