Inventory Management

• Inventory Models

• Inventory Control
 “ Sorry we are out of that item”

How often have you heard that during shopping

trips?

Stock of goods is necessary for future use or sale.

In this chapter, I will highlight the kinds of scientific

techniques of which develops mathematical models of
inventory processes.
What is Inventory
 Inventory
Inventory is the stock of any item or resource that has a economic
value and is maintained to fulfill the present and future needs of the
organization.
Manufacturing inventory :Raw material, semi-finished good,
finished goods, spare parts, etc.

Service inventory : refers to the tangible goods to be sold and

supplied necessary to administer the service.

Hospital: No of beds, stock of drugs, specialized personnel etc.

Bank: Cash reserves, tellers etc.
Airline company: Seating capacity, spare part, specialized maintenance
crew etc.

• Unsold goods for sales or raw materials awaiting for manufacture.

Investing large inventories affect an organization's cash flow
and working capital.

Example: Automobile assembly plants and component manufacturers

are knows to carry little inventory and provide good quality finished
goods at the right time.

This will ensure that total inventory cost is minimal.

The basic purpose of inventory analysis is to

• When items should be ordered ?

• How large the order should be ? and
• How much safety stock should be kept?
 Inventory Management
• Inventory Management is the planning and controlling or
methods use to organize, store, replace inventory to meet
supply of goods with cost minimization.

• Too much of inventory – reduces the profitability

• Too little of inventory – creates a shortage in supply chain
and damage customer confidence.

So, Inventory management involves trade-off.

Objectives of Inventory management

• Optimal size of inventory for smooth production and sales

• Maximize profitability
• Minimum investment in inventories
 Purpose of Inventory:
 To meet the product demand.
• Meet unexpected demand
• Smooth seasonal or cyclic demand

 To allow flexibility in production scheduling

Giving Price discount or price increase

 To take advantage of economic purchase order size

 It helps in smooth and effective running of an enterprise.

Irregular supply and demand

Avoiding stock outs (shortages)

Causes of poor inventory control:

I. Overbuying without regard to the forecast or proper

estimate the demand

II. Overproduction

III. Overstocking

IV. Cancellation of orders

 Inventory Costs:
1: Purchase cost: actual price paid for the procurement of items.
Purchase cost = ( price per unit ) x (demand per unit time)

2: Holding (or Carrying cost): Cost carrying (or holding) inventory, i.e
facilities, storage, handling, insurance, breakage, taxes, depreciation etc.

Carrying cost = (Cost of carrying one unit of an item in the inventory

for a given length of time) X (Average number of units
of an item carried in the inventory for given time)
3: Ordering (or set-up cost): cost associated with the cost of placing
orders for procurement items. i.e Quotation, requisition ,order placing,
stationary, mailing, telephone calls, receiving, inspecting and storing etc.

Ordering cost = ( cost per order ) x (number of orders or set-up in the

inventory planning period)
Shortage (or stock out) cost: The shortage of items occurs when
actual demand cannot be fulfilled.

1) The supply of items is awaited by the customers. i.e the items are
back ordered

2) Customer are not ready to wait and there is loss of sale.

Shortage cost = ( Cost of being short one unit in the inventory) x

(Average number of units short in the inventory)
 Factor Affecting Inventory Control

• Demand

• Lead Time

• Order cycle

• Re-order level

• Stock replenishment

• Buffer stocks
 An Inventory Control problem:
The steps to built up a suitable inventory problem:

Step 1: Collect the data regarding the pattern of demand, time horizon,
inventory cost etc.

Step 2: Built up an appropriate relationship so as to develop objective

function of minimizing the total inventory costs subjects to changes in
inventory reorder policy and limits resources (storage, capital etc.).

Step 3: Drive optimal inventory police( Economic order quantity, EOQ) by

appropriate solution procedure so as to balance inventory costs.

Future demand know exactly: Inventory problem is said under certainty

Probability of distribution of future demand ( from the past record) is
know: Inventory problem under risk
Future demand is are unknown : Inventory under uncertainty.
Inventory models for independent demand:

Basic economic order quantity (EOQ) model

The basic economic order quantity model:

Model (I): The Economic Lot size model with constant demand

The economic order quantity (EOQ) is commonly known inventory

control techniques.
 Assumptions:
 Demand is known, continuous and constant over time.

 Lead time, that is, the time between the placement of the
order and the receipt of the order, is known and fixed.

 Receipt of inventory is instantaneous. In other words,

the inventory from an order arrives in one batch, at one time.

 Quantity discounts are not possible

 The only variable costs are an ordering (or setup cost)

and holding or carrying cost).

 There are no stock overages or shortages.

 The optimal order quantity occurred at the point where the
ordering cost curve and the carrying cost curve intersected.

 EOQ model - the optimal order quantity will occur at a

point where the total setup cost is equal to the total
holding cost.
 Model formulation:

Q = Number of pieces per order

Q* = Optimum number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Inventory Model with constant Demand

and instantaneous Supply
Ordering cost = (Number of orders placed per year) x
(order cost per order)
= (Annual demand / Number of units in each order) x
order cost per order
= (D / Q) S

Holding cost = (Average inventory level) x

(holding cost per unit per year)
= ([L max + L min ]/2 ) x Holding cost per unit per year
= (Q / 2) H

Optimal order quantity is when ordering cost equals to

holding cost.
i.e
(D/Q) S = (Q/2) H
_______
 Q* = √(2DS)/H
The total annual inventory cost is the sum of the Ordering and
holding costs:
Total annual cost = Ordering cost + Holding cost

TC = (D/Q) S + (Q/2) H

Other Formulae:

1)Optimal length of inventory replenishment cycle time (t*)

i.e optimal interval between the successive order:

t* = Q*/D
2)Optimal number of order (N*) to be placed in a given time
period assume (One year)

N* = D / Q*
3) Optimal (minimum) total inventory cost:

TC = (D/Q) S + (Q/2) H
_________
TC* = √(2DSH)
Problem 1:

A manufacturing company purchases 9,000 parts of a

machine for its annual requirements, ordering one month’s
requirement at a time . Each part costs $ 20.The ordering
cost per order is $ 15 and the carrying changes are 15% of
the average inventory per year. You have been asked to
suggest a more economic purchasing police for the company.
What advice would you offer, and how much would it save the
company per year.
Problem 2:

A stockiest has to supply 400 units of a product every Monday to

his customers. He gets the product at Rs 50 per unit from the
manufacturer. The cost of ordering and transportation from the
manufacturer is Rs 75 per order. The cost of carrying inventory is 7.5%
per year of the cost of the product. Find
(a) The economic lot size
(b) The total optimal cost
Problem 3:

A two-wheeler component manufacturing unit uses large

quantities of a component made of steel. Although these are
production items, the demand is continuous and inventory
planning could be done independent of the production plan.
The annual demand of the component is 2,500 boxes. The
company produces the item from a supplier at the rate of
Rs. 750 per box. The company estimates the cost of carrying
inventory to be 18 per cent per unit per annum and the cost
ordering as Rs 1,080 per order. The company works for 250
in a year. How should the company design an inventory control
system for this item? What is the overall cost of the plan?
 Production Order Quantity model :

This model is applicable when inventory continuously flows or builds up

over a period of time after an order has been placed or when units are
produced and sold simultaneously. We take into account the daily
production (or inventory flow) rate and the daily demand rate.

We can determine the annual inventory holding cost for the production
run model:
Assumptions:1) Supply is continuous and constant
2) Production rate per unit time > demand rate
3) Production begins immediately after production set up

Q = Number of pieces per order

H = Holding cost per unit per year
p = Daily production rate
d = Daily demand rate
t = Length of the production run in days
 1) Annual inventory holding cost = (Average inventory level) x
(Holding cost per unit per year)

= (Average inventory level) x H

a) Average inventory level = (Maximum inventory level) /2

b) Maximum inventory level = (Total produced during the

production run)
– (Total consumed during the production run)

= pt – dt
But Q = total produced = pt,

So, t = Q/p.
Therefore,

Maximum inventory level = p(Q/p) – d(Q/p)

= Q – (d / p) Q

= Q (1 – d / p)

 Annual inventory holding cost (or simply holding cost) =

(Maximum inventory level / 2) H = (Q / 2) ( 1 – (d / p) ) H

= (1/2) HQ (1 – (d / p) )
Setup cost = (D / Q) S

Set ordering cost equal to holding cost to obtain EOQ Model (Q*p)

(D / Q) S = (1/2) HQ(1 – (d / p))

Q2 = 2DS / (H (1 – (d / p))
________________
Q*p = √ 2DS / H (1 – (d / p))

Q*p Economic Production Lot Size when inventory is

consumed as it is produced.
Other Formulae:
1)The total Minimum inventory cost:

TC* = (D / Q*) S + (1/2) HQ* (1 – (d / p) )

On substituting the value of Q* we get

_______________
Optimal cost = √ 2DSH (1 – (d / p)

2) Optimal length of each lot size production run:

t*p = Q*/ p
_________________
= 1/p (√ 2DS / (H (1 – (d / p))
3) Optimal production cycle time: t* = Q* /D
_________________
= 1/D (√ 2DS / (H (1 – (d / p))
_______________
= (√ 2 S /DH (1 – (d / p)

4) Optimal number of production runs per year: N* = D/ Q*

_________________
= D/ (√ 2DS / (H (1 – (d / p))
_______________
=(√ DH (1 – (d / p)/2S
Problem 1:

A product is sold at the rate of 50 pieces per day and is manufacturing

at a rate of 250 pieces per day. The set up costs of the machines are $
5000 and the storage costs are found to be $ 0.15 per pieces per day,
with labor charges of $ 20 per pieces , material cost $ 15 and overhead
$ 50 per piece, find the minimum cost batch size if the interest charges
are 8 percent. Compute the optimal number of cycles required in a year
for manufacturing of this product. (Assume 300 working days in a
year.)
 Problem 2:
Beauty Bar Soap is produced on a production line that has an annual
capacity of 60,000 cases. The annual demand is estimated at 26,000
cases, with the demand rate essentially constant throughout the year.
The cleaning, preparation and setup of the production line cost approx.
$135. The manufacturing cost per case is $4.50 and the annual
holding cost is figured at a 24% rate. What is the recommended
production lot size? (250 working days per year)

Answer: EOQ= 3387

Annual TC: $2073
Cycle time: 33 days
Home Assignment :

The economical lot size model with different rates of

demand in different cycle.