INVENTORY MANAGEMENT

Ch 13 Dr. Ferdous Sarwar

 What is Inventory?
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◻ Inventory
A stock or store of goods
Raw materials, purchased parts, partially finished items
(WIP), and finished goods, as well as spare parts for
machines, tools, and other supplies
◻ Independent demand items (End Items)
demand not related to any other item and primarily
influenced by market conditions
Dependent demand items
◻ demand for an item is influenced by the demand of
another item
30% 90% 6.8%
Current Assets Working Capital Last 5 years

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 US Business Inventories
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◻ According to the US Census Bureau, seasonally

adjusted business inventories stood at
$1.929 trillion in March 2018
 Why do we need inventory?
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◻ Economies of batch production

◻ Unpredictable or unreliable vendors
◻ buffer for imbalanced production lines
◻ buffer for machine downtimes
◻ safety stock against random demands or uncertain lead-times
◻ hedge against poor quality
◻ bi-product from production smoothing
◻ avoid loss of sales or high cost of backorders
◻ fill logistics pipeline – reduce resupply time
◻ display goods to potential customers
 Walmart’s
Supply Chain

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 The need for inventories can be reduced by
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◻ Using standardized parts

◻ Improved forecasting of demand
◻ Using preventive maintenance on equipment and machines
◻ Reducing supplier delivery lead times and delivery reliability
◻ Utilizing reliable suppliers and improving the relationships in the
supply chain
◻ Restructuring the supply chain so that the supplier holds the inventory
◻ Reducing production lead time by using more efficient manufacturing
methods
◻ Developing simpler product designs with fewer parts.
 Types of Inventory
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◻ Raw material
Material needing further processing
Components that go into the product as is
Supplies such as glue, screws, ink, thread
Dependent demand
◻ Work in process (WIP)
Inventory in the production system waiting to be processed or
assembled and may include semi-finished products
Dependent demand
◻ Finished goods
Output of the production process or end items
Demand is usually independent
Finished goods from one manufacturing plant may be raw material for
another
 Conflicting objectives
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 Inventory Metrics
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 Example
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 Inventory Management
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◻ Management has two basic functions concerning

inventory:
1. Establish a system for tracking items in inventory
2. Make decisions about
■ When to order
■ How much to order

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 By initiating a program that utilizes barcodes and scanners, such as this one by Motorola, hospitals can
control inventory supply areas, as well as keep track of all equipment in use across the enterprise.
Stockroom inventory applications track consumable items such as medication and supplies, while check
in/out applications track shared or re-usable items such as X-rays, lab results, diagnostic tools, and other
medical equipment.
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 Requirements for Effective
Inventory Management
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1. A system to keep track of the inventory on hand and on

order.
2. A reliable forecast of demand that includes an indication
of possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs,
ordering costs, and shortage costs.
5. A classification system for inventory items.
 Inventory Counting Systems
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⚫ Periodic System
⚫ Physical count of items in inventory made at periodic
intervals
⚫ Perpetual Inventory System
⚫ System that keeps track of removals from inventory
continuously, thus monitoring current levels of each
item
⚫ An order is placed when inventory drops to a
predetermined minimum level
■ Two-bin system
■ Two containers of inventory; reorder
when the first is empty
■ Universal Product Code (UPC) or Bar-code
■ Point-of-sale (POS) system

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Inventory costs
◻ Purchasing costs
material cost, unit cost Purchase
◻ Ordering costs option
fixed cost of preparing and monitoring order
receiving and handling
◻ Production cost
material and variable manufacturing cost Production
option
◻ Set-up cost
fixed cost to prepare for manufacture
◻ Holding costs
opportunity cost
storage and handling costs
taxes and insurance
pilferage, damage, spoilage, obsolescence, etc.
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◻ Backorder and lost sales costs
 Representative Holding Costs
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Costs proportional to the quantity of inventory held.

Includes:
a) Physical Cost of Space (3%)
b) Taxes and Insurance (2 %)
c) Breakage Spoilage and Deterioration (1%)
d) Opportunity Cost of alternative investment. (10%)
(Total: 16%)

holding costs = 16 % x unit cost

 Classification System
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◻ The A-B-C approach classifies inventory items according to some

measure of importance, usually annual dollar value (i.e., dollar value
per unit multiplied by annual usage rate), and then allocates control
efforts accordingly.
◻ Three classes of items are used: A (very important), B (moderately
important), and C (least important).
 A-B-C Steps
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To solve an A-B-C problem, follow these steps:

1. For each item, multiply annual volume by unit price to
get the annual dollar value.
2. Arrange annual dollar values in descending order.
3. The few (10 to 15 percent) with the highest annual
dollar value are A items. The most (about 50 percent)
with the lowest annual dollar value are C items. Those
in between (about 35 percent) are B items.
 Example: A-B-C
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 Lot Sizing for a Single product (EOQ)
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 Assumptions of EOQ Model
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1. Only one product is involved.

2. Annual demand requirements are known.
3. Demand is spread evenly throughout the year
so that the demand rate is reasonably constant.
4. Lead time is known and constant.
5. Each order is received in a single delivery.
6. There are no quantity discounts.
 The Inventory Cycle
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 Carrying cost, ordering cost, and total
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cost curve
 Costs
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Q=Order Quantity in Units

H=Holding Cost per Unit per Year
D=Demand in Units per Year
S=Ordering Cost per Order
 Deriving EOQ
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◻ Using calculus, we take the derivative of the total cost

function and set the derivative (slope) equal to zero and
solve for Q.
◻ The total cost curve reaches its minimum where the
carrying and ordering costs are equal.

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 Example 1: EOQ
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A local distributor for a national tire company expects to

sell approximately 9,600 steel-belted radial tires of a
certain size and tread design next year. Annual carrying
cost is $16 per tire, and ordering cost is $75. The
distributor operates 288 days a year.
a. What is the EOQ?
b. How many times per year does the store reorder?
c. What is the length of an order cycle?
d. What is the total annual cost if the EOQ quantity is ordered?
 Example 2: EOQ
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 Economic Production Quantity (EPQ)
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Inventory thus builds up at a rate of p - d when production is on, and

inventory is depleted at a rate of d when production is off.
 Assumptions of EPQ Model
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1. Only one item is involved.

2. Annual demand is known.
3. The usage rate is constant.
4. Usage occurs continuously, but production occurs
periodically.
5. The production rate is constant.
6. Lead time does not vary.
7. There are no quantity discounts.
 Production Order Quantity Model
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Q = Number of pieces per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory Holding cost

holding cost = (Average inventory level) x per unit per year

Annual inventory
level = (Maximum inventory level)/2

Maximum Total produced during Total used during

inventory level = the production run – the production run
= pt – dt
 Production Order Quantity Model
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Q = Number of pieces per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum Total produced during Total used during

inventory level = the production run – the production run
= pt – dt
However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
inventory level = p –d =Q 1–
p p p

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p
 Production Order Quantity Model
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Q = Number of pieces per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand
Setup cost =(D/Q)S
Holding cost = 1/2 HQ[1 - (d/p)]

(D/Q)S = 1/2 HQ[1 - (d/p)]

2DS
2
Q =
H[1 - (d/p)]
2DS
Q* =
H[1 - (d/p)]
 Equations
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 Example 3: EPQ
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◻ A toy manufacturer uses 48,000 rubber wheels per year

for its popular dump truck series. The firm makes its own
wheels, which it can produce at a rate of 800 per day. The
toy trucks are assembled uniformly over the entire year.
Carrying cost is $1 per wheel a year. Setup cost for a
production run of wheels is $45. The firm operates 240
days per year.
Determine the
a. Optimal run size.
b. Minimum total annual cost for carrying and setup.
c. Cycle time for the optimal run size.
d. Run time.
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 When to Reorder
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◻ Reorder point
When the quantity on hand of an item drops to this
amount, the item is reordered.
Determinants of the reorder point
1. The rate of demand
2. The lead time
3. The extent of demand and/or lead time variability
4. The degree of stockout risk acceptable to
management
 Reorder Point: Under Certainty
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 Probabilistic Demand
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 Reorder Point: Under Uncertainty
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◻ Demand or lead time uncertainty creates the possibility

that demand will be greater than available supply
◻ To reduce the likelihood of a stockout, it becomes
necessary to carry safety stock
Safety stock
■ Inventory held in excess of expected demand to reduce the risk
of stockout presented by variability in either lead time or
demand rates.
 Risk of stockout=1-Service level

Safety stock reduces risk of The ROP based on a normal

stockout during lead time distribution of lead time demand

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 How Much Safety Stock?
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◻ The amount of safety stock that is appropriate

for a given situation depends upon:
1. The average demand rate and average lead time
2. Demand and lead time variability
3. The desired service level
 Safety Stock Calculation
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Given the demand distribution during Period of Uncertainty (POU)

1. Decide your tolerance to stockouts
Probability of Stockout = α
2. Service Level = (1- Probability of Stockout) = (1 - α)
3. Find the z-value
a. using Standard Normal Tables or
b. Using Microsoft Excel NORMINV(1 - α, 0, 1)
4. ROP = mean + z × standard deviation
5. Safety Stock = ROP - mean
 Example 8 (Pg. 571)
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Suppose that the manager of a construction supply house

determined from historical records that demand for sand
during lead time averages 50 tons. In addition, suppose the
manager determined that demand during lead time could
be described by a normal distribution that has a mean of
50 tons and a standard deviation of 5 tons. Answer these
questions, assuming that the manager is willing to accept a
stockout risk of no more than 3 percent:
a. What value of z is appropriate?
b. How much safety stock should be held?
c . What reorder point should be used?
 Solution
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Expected lead time demand = 50 tons

One-sided Z table
σdLT=5 ton
Risk=3%
a. using a service level of 1 − .03 = .9700, value
of z = +1.88
b. Safety stock = zσdLT = 1.88(5) = 9.40 tons.
c. ROP = Expected lead time demand + Safety
stock = 50 + 9.40 = 59.40 tons
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 Reorder Point: Demand Uncertainty
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If only demand is variable,

Note: If only demand is variable, then

 Reorder Point: Demand Uncertainty
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 Demand Rate Lead Time
Constant Constant
Variable Constant
Constant Variable
Variable Variable

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 Quantity Discounts
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◻ If quantity discounts are offered, the buyer must

weigh the potential benefits of reduced purchase
price and fewer orders that will result from
buying in large quantities against the increase in
carrying costs caused by higher average
inventories.
◻ TC=Carrying cost+ Ordering cost+ Purchasing
cost=(Q/2)H+(D/Q)S+PD; where P = Unit price
 Quantity Discount Models
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◻ All-units discount schedule

◻ Incremental quantity discount
◻ Carload discount schedule
 Example 6
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◻ A store stocks toy cars. Recently, the store has

been offered a discount quantity schedule as
shown in the following slide. Furthermore, the
ordering cost is $49 per order, the annual
demand is 5000 race cars, and the inventory
carrying charge as a percentage of cost, I is 20%
or 0.2. What order quantity will minimize the
total cost?
 The quantity discount schedule
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Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

 Steps in Analyzing a Quantity Discount
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1. For each discount, calculate Q*

2. If Q* for a discount doesn’t qualify, choose
the smallest possible order size to get the
discount
3. Compute the total cost for each Q* or
adjusted value from Step 2
4. Select the Q* that gives the lowest total
cost
 Quantity Discount Model
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Total cost curve for discount 2

Total cost
curve for
discount 1
Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a
and must be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
Example 6: Quantity Discount

Calculate Q* for every discount 2DS

Q* =
IP
2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars order
(.2)(4.80)

2(5,000)(49)
Q3* = = 718 cars order
(.2)(4.75)
Quantity Discount

Calculate Q* for every discount 2DS

Q* =
IP
2(5,000)(49)
Q1* = = 700 cars order
(.2)(5.00)

2(5,000)(49)
Q2* = = 714 cars order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars order
(.2)(4.75) 2,000 — adjusted
 Solution (5000/700)*49 0.5*700*0.2*5

Annual Annual Annual

Disco Annual Unit Order
Product Ordering Holding Total
unt # Demand Price Quantity
Cost Cost Cost

1 5000 $5.00 700 $25,000 $350 $350 $25,700

1,00
2 5000 $4.80 $24,000 $245 $480 $24,725
0
2,00 $122.
3 5000 $4.75 $23,750 $950 $24,822.50
0 50

Choose the price and quantity that gives the lowest total
cost
Buy 1,000 units at $4.80 per unit
 How Much to Order: FOI Model
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◻ Fixed-order-interval (FOI) model

Orders are placed at fixed time intervals
◻ Reasons for using the FOI model
Supplier’s policy may encourage its use
Grouping orders from the same supplier can produce
savings in shipping costs
Some circumstances do not lend themselves to
continuously monitoring inventory position
 FOI Model
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 Fixed Interval
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 Measuring Performance
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◻ Service level is not a

convenient KPI
Takes many cycles to
calculate
Only concerned about
lead-time
All or nothing
 Fill Rate Definitions
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◻ Fill rate: The fraction of demand that is satisfied

or “filled” from inventory
 Example
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 Example
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 Fill Rate vs Service Level
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 RFID in Inventory Management
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◻ The RFID (Radio Frequency Identification) chip tags

contain bits of data, such as product serial number.
◻ Scanners will automatically read the information on an
RFID chip into a database, so the companies can keep
track of sales and inventory.
◻ In addition, RFID chips will assist in increasing the speed
of communication on a supply chain. The information
between parties will travel faster, which will improve the
responsiveness of buyers and ordering information on the
supply chain.
 Operations Strategy
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◻ Improving inventory processes can offer significant cost

reduction and customer satisfaction benefits
Areas that may lead to improvement:
■ Record keeping
■ Records and data must be accurate and up-to-date
■ Variation reduction
■ Lead variation
■ Forecast errors
■ Lean operations
■ Supply chain management
 ◻ UPD Manufacturing produces a range of health care appliances for hospital as well as for
home use. The company has experienced a steady demand for its products, which are
highly regarded in the health care field. Recently the company has undertaken a review
of its inventory ordering procedures as part of a larger effort to reduce costs. One of the
company’s products is a blood pressure testing kit. UPD manufactures all of the
components for the kit in-house except for the digital display unit. The display units are
ordered at six-week intervals from the supplier. This ordering system began about five
years ago, because the supplier insisted on it. However, that supplier was bought out by
another supplier about a year ago, and the six-week ordering requirement is no longer in
place. Nonetheless, UPD has continued to use the six-week ordering policy. According to
purchasing manager Tom Chambers, “Unless somebody can give me a reason for
changing, I’m going to stick with what we’ve been doing. I don’t have time to reinvent the
wheel.” Further discussions with Tom revealed a cost of $32 to order and receive a
shipment of display units from the supplier. The company assembles 89 kits a week. Also,
information from Sara James, in Accounting, indicated a weekly carrying cost of $.08 for
each display unit. The supplier has been quite reliable with deliveries; orders are
received five working days after they are faxed to the supplier. Tom indicated that as far
as he was concerned, lead-time variability is virtually nonexistent.
◻ 1.Would using an order interval other than every six weeks reduce costs? If so, what
order interval would be best, and what order size would that involve?
◻ 2. Would you recommend changing to the optimal order interval? Explain.

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 Case: UPD Manufacturing
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Without demand variability, the fixed order interval order quantity

equation reduces to:
Q = d(LT + OI) – Available (because there is no safety stock)
Since Available = d x LT, the fixed order interval order quantity equation Q
further reduces to the following:
Q = d x OI = (89) (6) = 534 units
Therefore, ordering at six-week intervals requires an order quantity of
534 units.
On the other hand, the optimal order quantity is determined by using the
basic EOQ equation.
 Case: UPD Manufacturing
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The weekly total cost based on optimal order quantity EOQ is given below:

The weekly total cost based on six-week fixed order interval (FOI) order
quantity is given below:

Weekly savings of using EOQ rather than 6-week FOI is 26.69 – 21.35 =
$5.34
The annual savings = (52 weeks) ($5.34 /week) = $277.68
The percentage of savings is approximately 25% (5.34 / 21.35). Therefore if FOI approach is
used with other parts or components as well, the total potential loss may be significant.
 Assignment 01
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◻ Demand for the Deskpro computer at Best Buy is

1,000 units per month. Best Buy incurs a fixed
order placement, transportation, and receiving
cost of $4,000 each time an order is placed. Each
computer costs Best Buy $500 and the retailer
has a holding cost of 20 percent. Evaluate the
number of computers that the store manager
should order in each replenishment lot.
 Calculate the following:
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◻ Optimal order size

◻ Cycle inventory
◻ Number of orders per year
◻ Annual ordering and holding cost
◻ Average flow time
 Assignment 02
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◻ The store manager at Best Buy would like to

reduce the optimal lot size from 980 to 200. For
this lot size reduction to be optimal, the store
manager wants to evaluate how much the
ordering cost per lot should be reduced.
 Assignment 03: Multiple Products with Lots Ordered
and Delivered Independently
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◻ Best Buy sells three models of computers, the Litepro, the Medpro, and
the Heavypro. Annual demands for the three products are DL = 12,000
for the Litepro, DM = 1,200 units for the Medpro, and DH = 120 units
for the Heavypro. Each model costs Best Buy $500. A fixed
transportation cost of $4,000 is incurred each time an order is
delivered. For each model ordered and delivered on the same truck, an
additional fixed cost of $1,000 per model is incurred for receiving and
storage. Best Buy incurs a holding cost of 20 percent. Evaluate the lot
sizes that the Best Buy manager should order if lots for each product
are ordered and delivered independently. Also evaluate the annual cost
of such a policy.
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