INVENTORY each item.

When the amount on hand reaches a

predetermined minimum, a fixed quantity, Q, is ordered.
An inventory is a stock or store of goods. Firms typically An obvious advantage of this system is the control
stock hundreds or even thousands of items in inventory, provided by the continuous monitoring of inventory
ranging from small things such as pencils, paper clips, withdrawals. Another advantage is the fixed-order
screws, nuts, and bolts to large items such as machines, quantity; management can determine an optimal order
trucks, construction equipment, and airplanes. quantity. One disadvantage of this approach is the added
cost of record keeping. Moreover, a physical count of
Functions of Inventory inventories must still be performed periodically to
1. To meet anticipated customer demand verify records because of possible errors, pilferage,
2. To smooth production requirements spoilage, and other factors that can reduce the effective
3. To decouple operations amount of inventory. Bank transactions such as customer
4. To reduce risks of stockouts deposits and withdrawals are examples of continuous
5. To take advantage of order cycles recording of inventory changes.
6. To hedge against price increases
7. To permit operations Perpetual systems range from very simple to very
8. To take advantage of quantity discounts sophisticated. A two-bin system, a very elementary
system, uses two containers for inventory. Items are
Objectives of Inventory Management withdrawn from the first bin until its contents are
Management has two basic functions concerning exhausted. It is then time to reorder. The second bin
inventory. One is to establish a system to keep track of contains enough stock to satisfy expected demand until
items in inventory, and the other is to make decisions the order is filled, plus an extra cushion of stock that will
about how much and when to order. To be effective, reduce the chance of a stockout if the order is late or if
management must have the following: usage is greater than expected. The advantage of this
1. A system to keep track of the inventory on hand system is that there is no need to record each withdrawal
and on order. from inventory; the disadvantage is that the reorder card
2. A reliable forecast of demand that includes an may not be turned in for a variety of reasons (e.g.,
indication of possible forecast error. misplaced, the person responsible forgets to turn it in).
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs, Demand Forecasts and Lead-Time Information
ordering costs, and shortage costs. Inventories are used to satisfy demand requirements, so it
5. A classification system for inventory items. is essential to have reliable estimates of the amount and
timing of demand. Similarly, it is essential to know how
Inventory Counting Systems long it will take for orders to be delivered. In addition,
Inventory counting systems can be periodic or perpetual. managers need to know the extent to which demand and
lead time (the time between submitting an order and
Under a periodic system, a physical count of items in receiving it) might vary; the greater the potential
inventory is made at periodic, fixed intervals (e.g., weekly, variability, the greater the need for additional stock to
monthly) in order to decide how much to order for each reduce the risk of a shortage between deliveries. Thus,
item. Many small retailers use this approach: A manager there is a crucial link between forecasting and inventory
periodically checks the shelves and stockroom to management.
determine the quantity on hand. Then the manager
estimates how much will be demanded prior to the next Inventory Costs
delivery period and bases the order quantity on that Four basic costs are associated with inventories:
information. purchase, holding, ordering, and shortage costs.

An advantage of this type of system is that orders for Purchase cost is the amount paid to a vendor or supplier
many items occur at the same time, which can result in to buy the inventory. It is typically the largest of all
economies in processing and shipping orders. There inventory costs.
are also several disadvantages of periodic reviews. One is
a lack of control between reviews. Another is the need Holding, or carrying, costs relate to physically having
to protect against shortages between review periods by items in storage. Costs include interest, insurance, taxes
carrying extra stock. (in some states), depreciation, obsolescence,
deterioration, spoilage, pilferage, breakage, tracking,
A perpetual inventory system (also known as a picking, and warehousing costs (heat, light, rent, workers,
continuous review system) keeps track of removals from equipment, security). They also include opportunity costs
inventory on a continuous basis, so the system can associated with having funds that could be used
provide information on the current level of inventory for
elsewhere tied up in inventory. Note that it is the variable because the unit cost is unaffected by the order size
portion of these costs that is pertinent. unless quantity discounts are a factor. If holding costs are
specified as a percentage of unit cost, then unit cost is
Ordering costs are the costs of ordering and receiving indirectly included in the total cost as a part of holding
inventory. They are the costs that occur with the actual costs.
placement of an order. They include determining how
much is needed, preparing invoices, inspecting goods The basic model involves a number of assumptions. They
upon arrival for quality and quantity, and moving the are listed in Table 13.1.
goods to temporary storage. Ordering costs are generally
expressed as a fixed dollar amount per order, regardless Inventory ordering and usage occur in cycles. Figure 13.2
of order size. illustrates several inventory cycles. A cycle begins with
receipt of an order of Q units, which are withdrawn at a
When a firm produces its own inventory instead of constant rate over time. When the quantity on hand is just
ordering it from a supplier, machine setup costs (e.g., sufficient to satisfy demand during lead time, an order for
preparing equipment for the job by adjusting the machine, Q units is submitted to the supplier. Because it is
changing cutting tools) are analogous to ordering costs; assumed that both the usage rate and the lead time do
that is, they are expressed as a fixed charge per not vary, the order will be received at the precise instant
production run, regardless of the size of the run. that the inventory on hand falls to zero. Thus, orders are
timed to avoid both excess stock and stockouts.
Shortage costs result when demand exceeds the supply
of inventory on hand. These costs can include the
opportunity cost of not making a sale, loss of customer
goodwill, late charges, backorder costs, and similar costs.
Furthermore, if the shortage occurs in an item carried for
internal use (e.g., to supply an assembly line), the cost of
lost production or downtime is considered a shortage cost.

Inventory Ordering Policies

Inventory ordering policies address the two basic issues
of inventory management, which are how much to order
and when to order.

Cycle stock is the amount of inventory needed to meet

expected demand. Many orders produce a low average inventory
Safety stock is the extra inventory carried to reduce the
probability of a stockout due to demand and/ or lead time
variability.
The discussion begins with the issue of how much to
order.

How Much to Order: EOQ Models

Few orders produce a high average inventory
The question of how much to order can be determined by
using an economic order quantity (EOQ) model. EOQ
models identify the optimal order quantity by minimizing
the sum of certain annual costs that vary with order size
and order frequency. Three order size models are
described here:
1. The basic economic order quantity model.
2. The economic production quantity model.
3. The quantity discount model.

Basic Economic Order Quantity (EOQ) Model

The basic EOQ model is the simplest of the three models.
It is used to identify a fixed order size that will minimize
the sum of the annual costs of holding inventory and
ordering inventory. The unit purchase price of items in
inventory is not generally included in the total cost
Carrying Costs are linearly related to order size
Quantity Discounts
Quantity discounts are price reductions for larger orders
offered to customers to induce them to buy in large
quantities. For example, a Chicago surgical supply
company publishes the price list shown:

Formula:
Annual Carrying Cost = (Q/2) x H
Where: Q = Order Quantity (units)
H = Holding (carrying) cost per unit per year

Ordering Costs are inversely and non-linearly related to

order size Notice how the price per box decreases as order quantity
increases. When quantity discounts are available, there
are a number of questions that must be addressed to
decide whether to take advantage of a discount. These
include:
1. Will storage space be available for the additional
items?
2. Will obsolescence or deterioration be an issue?
3. Can we afford to tie up extra funds in inventory?
Formula:
Annual Ordering Cost = (D/Q) x S
If the decision is made to take advantage of a quantity
Where: D = Demand (units per year)
discount, the goal is to select the order quantity that will
S = Ordering cost per order
minimize total cost, where total cost is the sum of carrying
cost, order- ing cost, and purchasing (i.e., product) cost:
Total Cost is U-shaped

Sample Problem:
The maintenance department of a large hospital uses
about 816 cases of liquid cleanser annu- ally. Ordering
costs are $12, carrying costs are $4 per case a year, and
the new price schedule indicates that orders of less than
50 cases will cost $20 per case, 50 to 79 cases will cost
$18 per case, 80 to 99 cases will cost $17 per case, and
larger orders will cost $16 per case. Deter- mine the
Formula: optimal order quantity and the total cost.
TC = Annual Carrying Cost + Annual Ordering Cost
1. Compute the common minimum Q
EOQ Formula 2. Compute for the total cost (including product
cost) for the minimum Q
3. Compute for the total cost (including product
cost) for 80 units
Length of Order Cycle = Q / D 4. Compute for the total cost (including product
cost) for 100 units
Sample Problem:
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?