Inventory Planning

&
Control
Inventory: What, Why & How much

Inventory Inventory Planning & Control

Protect against uncertainties: Safety Stock

Allow economic production and purchase : Procurement in lots is beneficial
Anticipation of demand or material price change
Planned market promotion
Businesses with seasonal demand
Transit Inventory : Depends on location of facility and choice of carrier (Pipeline inventory)

Supply , Demand and Lead Time

 Type of Inventory

Process Demand
Purpose Others
stage Type

Raw Materials
WIP Independent Cycle Spares
Finished Goods Dependent Safety Consumable
Seasonal
Pipeline
Independent vs. Dependent Demand

Independent Demand
(demand for item is independent
of demand for any other item)

Dependent Demand
(demand for item is dependent
upon the demand for some
other item)
Independent vs. Dependent Demand

Materials With Materials With

Item
Independent Demand Dependent Demand

Demand
Company Customers Parent Items
Source
Material
Finished Goods WIP & Raw Materials
Type
Method of
Forecast & Booked Calculated
Estimating
Customer Orders
Demand
Planning
EOQ & ROP MRP
Method
Inventory Planning
Independent demand items

• Finished goods and spare parts typically belong to independent demand items in
manufacturing organizations
• Two attributes characterize and distinguish independent demand items:
• Timing of demand: Independent demand items have a continuous demand
• Uncertainty of demand: There is considerable element of uncertainty in the
demand in the case of independent demand items
• Inventory planning of independent demand items must address the following two
key questions:
• How much?
• When?
Inventory Type : Purpose

• Seasonal stocks
– These are accumulated to absorb seasonal fluctuations in supply or demand.

• Cycle stocks
– Due to fixed transportation and handling charges or set up requirements, it is
economical to order or produce large quantities at a time.

• Safety stocks
– These are built as a hedge against uncertainties in supply or demand.

• Pipeline stocks
– Inventories in-transit.
Cyclic, Pipeline and Safety Stocks
A graphical illustration

Cyclic
Quantity Stock

Pipeline inventory

Safety stock
L

Time

Cyclic inventory, pipeline inventory and safety stocks are critically linked to
“how much” and “when” decisions in inventory planning
 Costs associated with inventory

3/18/24 11:49 AM 9
Terms used in Inventory

• Material cost = C (Average price paid per unit purchased is a key cost in the lot-sizing decision )
i

• Fixed ordering cost = C o (Fixed ordering cost includes all costs that do not vary with the size of the order
but are incurred each time an order is placed)

• Holding cost = C H = %*Ci (Holding cost is the cost of carrying one unit in inventory for a specified period
of time i.e. CH/Unit/Year)

• Quantity in a lot or batch size = Q (Quantity is either produced or purchased at a time, EOQ* = Q* )
• Demand per unit time = D (i.e. Demand in one 1 year, d = average demand per week, So, D = d *52 /
year)
Inventory Cost

Holding Costs (CH) Ordering Costs (Co)

• Obsolescence • Supplies
• Insurance • Forms
• Extra staffing • Order processing
• Interest • Clerical support
• Pilferage • etc.
• Damage
• Warehousing Setup Costs (Cs)
• etc. • Clean-up costs
• Re-tooling costs
• Adjustment costs
• etc.
EOQ Model
A graphical representation
Sum of the two costs
Cost of Inventory

Total cost of carrying

Minimum Cost

Total cost of ordering

Economic Level of Inventory

Order Qty.
Fixed Order Quantity Systems: 1.EOQ Model
Fixed Order Quantity Systems: 1.EOQ Model
Demand during the planning period =D
Order quantity =Q
The cost of ordering per order = Co
Inventory carrying cost per unit per unit time = Cc
Q
The average inventory carried by an organisation=
2
æQ ö
The cost associated with carrying inventory = ç * Cc ÷
è2 ø
æD ö
The total ordering cost is given by çç * C o ÷÷
èQ ø
Total cost of the plan =
Total cost of carrying inventory + Total cost of ordering
æQ ö æD ö
TC(Q) = ç * C c ÷ + ç * C o ÷÷
ç
è2 ø èQ ø
Fixed Order Quantity Systems: 1.EOQ Model

When the total cost is minimum, we obtain the most economic order quantity (EOQ). By
taking the first derivative of with respect to Q and equating it to zero we can obtain the
EOQ
Differentiating total cost equation with respect to Q we obtain,
dTC(Q) Cc Co D
= - 2
dQ 2 Q
The second derivative is positive and hence we obtain the minimum cost by equating the
first derivative to zero.
2Co D
Denoting EOQ by Q*, we obtain the expression of Q* as: Q =
*

Cc
D
The optimal number of orders =
Q*
Q*
Time between orders =
D
Issues in using the EOQ Model:
Assumptions
1. The demand is known with certainty
2. Demand is continuous over time
3. There is an instantaneous replenishment of items
4. The items are sourced from an outside supplier
5. Assumptions about order quantity
a) There are no restrictions in the quantity that we can order
b) There are no preferred order quantities for the items
c) No price discount is offered when the order size is large

• Despite this, the EOQ model could be applied with suitable modifications because it is robust
• Assumptions 3, 4 and 5 can be addressed with required modifications
• Relaxing assumption 1 will result in shortages due to difficulty in estimating demand
Fixed Order Quantity Systems:
2. EOQ With Production Lots (EPQ)
Fixed Order Quantity Systems:
2. EOQ With Production Lots (EPQ)
Fixed Order
Quantity Systems:
2. EOQ With
Production Lots
(EPQ)
An EOQ Example

Determine optimal number of needles to order

D = 1,000 units
S = $10 per order
H = $.50 per unit per year
An EOQ Example

Determine optimal number of needles to order

D = 1,000 units
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H

* 2(1,000)(10)
Q = = 40,000 = 200 units
0.50
An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Demand D
Expected number of orders =N= =
Order quantity Q*
An EOQ Example
Determine expected number of orders
D = 1,000 units Q* = 200 units
S = $10 per order
H = $.50 per unit per year

Demand D
Expected number of =N= =
orders Order quantity Q*

1,000
N= = 5 orders per year
200
An EOQ Example

Determine optimal time between orders

D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year

Expected time Number of working days per year

between =T =
orders Expected number of orders

250
T= = 50 days between orders
5
An EOQ Example
An EOQ Example
Determine the total annual cost
D = 1,000 units Q* = 200 units
S = $10 per order N = 5 orders/year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S+ H
Q 2
1,000 200
= ($10) + ($.50)
200 2
= (5)($10) + (100)($.50)
= $50 + $50 = $100
Robustness of EOQ Example
• The EOQ model is robust
• It works even if all parameters and assumptions are not met
• The total cost curve is relatively flat in the area of the EOQ

• Let's compare the EOQ values for two demand levels: 1000 & 1500
• Let's assume the demand to be the same. EOQ=200, but the true order cost
is 15 instead of 10 cost units.
Robustness of EOQ Example
An EOQ Example
Determine optimal number of needles to order
D = 1,000 units 1,500 units Q*1,000 = 200 units
S = $10 per order T = 50 days
H = $.50 per unit per year Q*1,500 = 244.9 units
N= 5 orders/year
Ordering old Q* Ordering new Q*
D Q
TC = S + H
Q 2 1,500 244.9
= ($10) + ($.50)
1,500 200 244.9 2
= ($10) + ($.50)
200 2 = 6.125($10) +122.45($.50)
= $75 + $50 = $125 = $61.25 + $61.22 = $122.47
 a cost of Ci. In general, the unit cost decreases as the quantity ordered incr
C0 Ú C1 Ú Á Ú Cr. For all unit discounts, the average unit cost varies with the qu
All-Unit Quantity Discounts as shown in Figure 11-3. The retailer’s objective is to decide on lot sizes to maxim
equivalently, to minimize the sum of material, order, and holding costs. The solution p
uates the optimal lot size for each price and picks the lot size that minimizes the over
Step 1: Evaluate the optimal lot size for each price Ci,0 … i … r as follows:
2DS
• Pricing schedule has specified quantity break points Qi =
C hCi

q0 , q1, , qr , where q0 = 0

Average Cost per Unit Purchased

• If an order is placed that is at least as large as qi but C0

C1
smaller than qi +1, then each unit has an average unit
C2
cost of Ci
• Unit cost generally decreases as the quantity increases,

i.e., C0 ³ C1 ³  ³ Cr 0 q1 q2 q3 Quantity Purchased

• Objective is to decide on a lot size that will minimize theFIGURE

sum11-3
of Average Unit Cost with All Unit Quantity Discounts

material, order, and holding costs

Quantity Discount Models
• Reduced prices are often available when larger quantities are purchased
• The trade-off is between reduced product cost and increased holding cost

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 0 to 119 $100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96
Quantity Discount Models
Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S + IP + PD
Q 2

where Q = Quantity ordered P = Price per unit

D = Annual demand in units I = Holding cost per unit per year
S = Ordering or setup cost per order expressed as a percent of price P

2DS
Q* =
IP

Because unit price varies, holding cost is

expressed as a percent (I) of unit price (P)
Quantity Discount Models
Steps in analyzing a quantity discount

1. Starting with the lowest possible purchase price, calculate Q* until the
first feasible EOQ is found. This is a possible best order quantity, along
with all price-break quantities for all lower prices.
2. Calculate the total annual cost for each possible order quantity
determined in Step 1. Select the quantity that gives the lowest total cost.
Quantity Discount Models

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 0 to 119 $100
Discount price 1 200 to 1,499 $ 98
Discount price 2 1,500 and over $ 96

Let us assume a drone inventory planning problem. Against the Quantity Discount Schedule given
above. The set-up cost is $200/ order, annual demand is 5200 units, and annual inventory carrying
charge as a per cent of cost I, is 28%. What order quantity will minimize the total inventory cost?
Quantity Discount Example

Calculate Q* for every discount *2DS

Q =
starting with the lowest price IP

2(5,200)($200)
Q$96* = = 278 drones/order
(.28)($96)
Infeasible – calculate Q*
for next-higher price

2(5,200)($200)
Q$98* = = 275 drones/order
(.28)($98)
Feasible
Quantity Discount Models
Initial
Price Discount Price 1 Discount Price 2
550,000 –
TC for No Discount
Annual Total Cost 540,000 –
TC for Discount 1
530,000 –
Not Feasible TC for Discount 2
520,053 –
517,155 –
Feasible
510,000 –

Not Feasible
Possible Order
500,000 – Quantities

120 1,500
Order Quantity
Ideal Deterministic Model: Quick Review

Q+S

S
Continuous System: Stochastic Model

• 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.
• Focus must be on demand distribution during the lead time
Reorder Point and Safety Stock
Reorder Point Quantity

• Under deterministic conditions, when both demand and lead

time are constant, the reorder point is set equal to lead time
demand.
• Under probabilistic conditions, when demand and/or lead
time varies, the reorder point often includes safety stock
• Safety stock is the amount by which the reorder point exceeds
the expected (average) lead time demand.
Reorder Points
• EOQ answers the “how much” question
• The reorder point (ROP) tells “when” to order
• Lead time (L) is the time between placing and receiving an order

Demand Lead time for a new

ROP = per day order in days

ROP = d x L

d= D
Number of working days in a year
Reorder Points
Demand = 8,000 iPhones per year
250 working day year
Lead time for orders is 3 working days, may take 4

D
d=
Number of working days in a year

= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
= 32 units per day x 4 days = 128 units
Probabilistic Models and Safety Stock
• Used when demand is not constant or certain
• Use safety stock to achieve a desired service level and avoid
stockouts

ROP = d x L + ss

Annual stockout costs = The sum of the units short for each demand
level x The probability of that demand level x The stockout cost/unit
x The number of orders per year
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

NUMBER OF UNITS PROBABILITY

30 .2
40 .2
ROP à 50 .3
60 .2
70 .1
1.0
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

SAFETY ADDITIONAL TOTAL

STOCK HOLDING COST STOCKOUT COST COST

20 (20)($5) = $100 $0 $100

10 (10)($5) = $ 50 (10)(.1)($40)(6) = $240 $290

0 $ 0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames