Operations Management (OPMG)

INVENTORY MANAGEMENT

1. A bakery uses 80 bags of chocolate chips each year. The chocolate chips are purchased
from a supplier for a price of $80 per bag and an ordering cost of $20 per order. Bakery
A’s annual inventory holding cost percentage is 40%. The bakery order chocolate chip
bags 2 times every year. Assuming no variability in demand, what is their total annual
cost of ordering and holding inventory?
A. 800
B. 1360
C. 680
D. 320

Solution: As the bakery places two orders each year, the order quantity per order
should be Q=R/2 = 40. Thus, average inventory is equal to Q/2 = 20. The holding
cost per bag per year = 0.4Ö80 = 32. Thus, total annual cost of ordering and holding
inventory =SÖR/Q+HQ/2 = 20Ö2 + 32Ö20 = 680.

2. As demand increases, the sum of total ordering and holding costs per period when using
the economic order quantity ...... at a rate ......the demand.
A. increases, slower than
B. decreases, slower than.
C. decreases, faster than.
D. increases, equal to.

p
Solution: Substituting the EOQ formula, 2RS/H in the ordering and holding
cost
√ functions, we get the total ordering and holding cost per period as equal to
2RSH , which is increasing with demand. However, when demand doubles, the
√
total cost only increases by a factor of 2
OPMG INVENTORY MANAGEMENT - Page 2 of 8 Term 3

3. Chicagoland Sweets , a commercial baker, uses flour at a constant rate of 4000

pounds every week. Their supplier sells flour in 50-pound bags at a price of $20 per
bag. Chicagoland’s management estimates that they incur a fixed cost of $64 every time
they place an order for flour. Their cost of capital is 25% per year (Assume that 1
year = 50 weeks). Chicagoland determines its order size for flour to minimize its annual
inventory holding and ordering costs.
[3.a] What is the optimal order number of 50-pound bags Chicagoland should order to
minimize annual cost of ordering and holding inventory (i.e., what is the economic
order quantity)?
A. 45
B. 320
C. 2262
D. 4000

Solution: Here we need to find optimal quantity to be ordered or EOQ. We

can solve this either in terms of number of bags directly or number of pounds
and then convert quantity into number of bags. Both will give the same answer.
With given information R= 4000 pounds/week, S= $64 per order and H=
(20/50) × (0.25/50) = $0.002 per week per pound ,(20/50 is the cost of 1
pound, multiplying this by 0.25 given annual holding cost which needs to be
divided
p by 50 top get holding cost per week). Putting all values in the formula,
Q= 2RS/H= (2 × 4000 × 64)/.002 = 16,000 pounds=16,000/50 bags= 320
bags.

[3.b] Chicagoland would like to reduce the average amount of flour inventory it carries
to half without increasing its annual cost. Which of the following will achieve this
objective? (You can assume that the one-time cost of implementing these changes
is negligible).
A. Reduce the fixed cost of placing an order to 16.
B. Reduce the fixed cost of placing an order to 32.
C. Reduce the order size to half without changing anything else.
D. Reduce the order size to fourth without changing anything else.
p
Solution: EOQ is 2RS/H, so if S decreases by 4 times (i.e., reduces from 64
to 16), the EOQ and therefore inventory will reduce by half. Other option which
also reduces inventory to half is choosing the quantity to be half of the EOQ
with fixed cost still being 64. However, this will result in inventory carrying and
ordering cost becoming larger (since we are choosing a non-optimal quantity).
OPMG INVENTORY MANAGEMENT - Page 3 of 8 Term 3

4. Good-Enough-Buy sells laptops in its store, which it purchases from the major computer
manufacturer Orange Inc. Its weekly demand for laptops is normally distributed with
mean of 1000 and standard deviation of 200. Once Good-Enough-Buy places an order,
Orange Inc. takes 1.5 weeks to manufacture it and the trucking company takes 1 week to
deliver it. The senior management at Good-Enough-Buy has mandated a cycle service
level of 99% for the laptops (i.e., in each order cycle Good-Enough-Buy should have
enough inventory to not-stock out with probability 0.99). What should be Good-Enough-
Buy’s reorder point to make sure that it meets the 99% service level requirement?
A. 2500
B. 3236
C. 3665
D. 5736

Solution: The total lead time for replenishment for Good-Enough-Buy is = 1 +1.5
= 2.5 weeks. Thus, its reorder point should satisfy demand incurred during 2.5 weeks
with probability 0.99. The demand during 2.5 weeks is Normally distributed with
√
mean of = 2.5×1000 = 2500 and standard deviation = 200 × 2.5. The reorder
√
point is thus = 2500 + z.99 ×200 × 2.5 = 3236.

5. Good-Enough-Buy also sells Xanon cameras, which it purchases from camera manufac-
turer Gony. The weekly demand for Xanon cameras is normally distributed with mean
200 and standard deviation 50. Good-Enough-Buy follows a continuous review system
to manage its inventory and has set the reorder point to meet a fixed service level of
90% for the Xanon cameras. Recently Gony announced that due to production glitches,
its lead-time for delivering an order will increase from 1 week to 4 weeks. In order to
keep its service level for Xanon camera at the same level, how should Good-Enough-Buy
adjust its safety inventory (safety stock)?
A. It should double the level of safety inventory
B. It should increase safety inventory four times.
C. It should keep safety inventory at the same level.
D. It should reduce safety inventory by half —

√
Solution: The safety inventory is given by z0.90 × σ × L where σ is the standard
deviation of weekly demand, L is the lead-time (in weeks), and z0.90 is standard normal
fractile corresponding to the service level (i.e., how many standard deviation one has
to be from the mean in order to capture certain probability). As L increases by 4
OPMG INVENTORY MANAGEMENT - Page 4 of 8 Term 3

√
times, keeping service level the same requires increasing the safety inventory by 4
= 2 times

6. Evanston Wine Wholesalers (EWW) is a wine importer. It faces a high fixed cost for
each shipment it brings into the country, so it carefully balances this fixed cost with its
holding costs when placing an order. An Australian winery has approached EWW with
an offer. It would like EWW to order more frequently. It has offered to pay half of
EWW’s fixed cost per order if EWW doubles its order frequency. EWW would have to
order eight times per year instead of four. Should EWW accept this offer?
A. Yes, because it will reduce EWW’s inventory holding costs.
B. Yes, because it will reduce EWW’s fixed costs.
C. No, because it will increase EWW’s inventory holding costs.
D. No, because it will increase EWW’s fixed costs.

Solution: Suppose EWW’s current order quantity is Q. Then, its annual inventory
holding cost is equal to Q/2×H, where H is the holding cost per unit, per year. It’s
annual fixed ordering costs is equal to R/Q×S where R is the annual demand and S
is the fixed ordering cost. If EWW accepts the Australian winery’s offer, then its new
order quantity is equal to Q/2 and its fixed cost per order is equal to S/2. Its annual
inventory holding cost is now equal to (Q/2)/2 ×H, and total fixed ordering cost is
equal to R/(Q/2) ×(S/2) =R/Q ×S. Thus, its inventory holding cost is now lower,
while the fixed order cost per year remains the same. Notice that Q/2 is not the
order quantity
p that minimizes EWW’s total cost. From the EOQ formula, we know
that Q= 2SR/H. Thus, when the fixed p cost per order reduces to S/2, the optimal
√
order quantity for EWW is given by ((2(S/2)R)/H) = Q/ 2. However, because
the offer reduces EWW’s total costs, it is still worthwhile for EWW to accept this
offer.

7. Journey Plumbing (JP) sells two types of water heaters: a conventional heater with
a tank, and a tankless heater. Because demand for both types is steady with little
variation, JP holds little or no safety stock and makes its inventory decisions to minimize
its annual holding and ordering costs. The water heaters come from different suppliers
but have similar ordering costs. They also have the same demand rate, but the tankless
water heater costs JP more than the conventional one. Assuming the physical costs in
involved in holding inventory is negligible for either type of heater, which product has
higher annual inventory turns?
A. Conventional heaters.
OPMG INVENTORY MANAGEMENT - Page 5 of 8 Term 3

B. Tankless heaters.
C. Both have equal inventory turns
D. Can’t say based on given information.

Solution: First, note that a higher purchase cost corresponds to a higher per unit
holding cost because of opportunity
p cost of capital.
Next, consider the EOQ formula (2RS/H). If S and R are the same but H is higher
for the tankless water heater, the order quantity must be smaller for the tankless
water heater. Thus, the average inventory is smaller. Since throughput is the same,
Little’s Law says that a smaller inventory translates to a shorter flow time and hence
higher inventory turns.

8. Daily demand for ice creams at the I-Scream parlour is normally distributed with a
mean of 100 tubs and a standard deviation of 40 tubs. The ice cream is supplied by a
wholesaler who charges $2 per tub. Currently, the owner places an order for 2000 tubs
of ice cream each time, when he has 1000 tubs on hand. If the delivery lead time for ice
creams is 5 days, what is the average amount of time spent by a tub of ice cream on the
I-Scream parlour shelf?
A. Less than 1 day because ice cream melts.
B. 10 days
C. 15 days
D. 5 days

Solution: The average daily demand R= 100 tubs. With a order quantity Q= 2000
tubs, the average cycle inventory is equal to Q/2 = 1000 tubs. The re-order point
ROP= 1000 tubs, while the mean demand during the lead time is equal to R×L=
100×5 = 500 tubs. Thus, the safety inventory Is=ROP −R×L=1000-500 = 500
tubs. Thus, the total average inventory of ice cream tubs at the I-Scream parlor is
equal to Q/2 +Is= 1000 + 500 = 1500 tubs. From Little’s Law, the average flow
time is equal to (Q/2 +Is)/R= 1500/100 = 15 days

9. A petrol pump sells 1000 litres of petrol every day. Arranging for one tanker of petrol
delivery costs the petrol pump around INR 4000. The cost of capital for the pump owner
is around 12% per year. Assume the pump pays INR 60 per litre of petrol. What is the
optimal order quantity for the petrol pump? (Assume 360 days per year and that the
tanker is large enough.)
OPMG INVENTORY MANAGEMENT - Page 6 of 8 Term 3

A. 1000 litres
B. 5000 litres
C. 10,000 litres
D. 20,000 litres

Solution: This is a straightforward application of the EOQ formula with R = 1000

per day, S = 4000 and H = (0.12/360) × 60 p = 0.02 INR per litre per day. Substi-
tuting, we get the optimal quantity as Q = 2 × 1000 × 4000/0.02 =20,000.

10. Cream Stone Ice Cream Parlor Daily demand at the Cream-Stone Ice Cream Parlor
follows a Normal distribution with a mean of 100 tubs and a standard deviation of 50
tubs. The ice cream is supplied by a wholesaler who charges $2 per tub and a $90 delivery
fee independent of the order size. The opportunity cost of capital for Cream-Stone is
25% per year. Currently, the owner places an order for 2000 tubs of ice cream each time
she has 600 tubs on hand. Assume 50 weeks in the year.
[10.a] If the delivery lead time is 4 days, what is Cream Stone’s service level?
A. 50%
B. 84.13%
C. 97.72%
D. 99.3%

Solution: The average daily demand R = 100 tubs. With an order quantity
Q = 2000 tubs, the average cycle inventory is equal to Q/2 = 1000 tubs. The
re-order point ROP = 600 tubs, while the mean demand during the lead time is
equal to R×L = 100×4 = 400 tubs. Thus, the safety inventory Is = ROP-R×L
= 600-400
√ =200 tubs. The standard deviation of lead-time demand is equal to
√
σ× L = 50× 4√= 100. Thus, the z value corresponding to the service level is
equal to Is/ (σ× L) = 200/ (100) = 2. Thus, the implied service level is P (Z
≤ 2) = 0.977.

[10.b] A predictive analytics vendor claims that it can reduce the standard deviation of
daily demand to 25 tubs. If Cream Stone wants to maintain the same service level
and nothing else about the business changes, what is the maximum amount it should
be willing to pay for this service per year?
A. $ 50
B. $ 250
C. $ 1250
OPMG INVENTORY MANAGEMENT - Page 7 of 8 Term 3

D. $ 2500

Solution: As nothing else about the business has changed, the reduction in
demand uncertainty impacts the safety stock held to achieve the 97.72% service
√
level determined in the answer to question 10 a. We know Is = ZSL ×σ× L
As σnew = σ/2, the new safety stock requirement is half of what it was and is
equal to 200/2 = 100 tubs. The inventory holding cost per tub per year is equal
to 0.25×$2 = $0.5. Thus, the benefit of using the predictive analytics is the
inventory cost saving on 100 tubs, i.e., 100×0.5 = $ 50.

11. Rent-a-Suit (RAS) maintains an average inventory of 7500 suits, each of which has an
average useful life of 25 weeks. They donate all old suits to a non-profit, ECHO, which
further distributes them among under privileged youth seeking job opportunities in the
formal sector. ECHO finds it optimal to pick the old suits from RAS’s premises 10 times
per year on average. Assume that the cost of holding one dress in ECHO’s inventory is
INR 300 per year. (Assume that 1 year = 50 weeks.)
[11.a] What must be the fixed cost incurred per pick-up by ECHO?
A. INR 15,000
B. INR 20,000
C. INR 22,500
D. 25,000

Solution: For RAS, I = 7500 and T = 25 weeks. Therefore, the rate at which
old dresses are becoming available is I/T = 7500/25 = 300 per week, using
Little’s law. As ECHO picks up all old suits from RAS, the average rate at
which dresses are being picked up (and needed) by ECHO, R = 300 per week.
We are given that, it is optimal for ECHO to pick up 10 times per year. Thus, the
optimal batch size in which ECHO picks up dresses is R×50/10 = 300×50/10
= 1500. We know the inventory holding p cost per dress per year, H = 300.
Substituting in the EOQ formula, QEOQ = (2 ∗ R ∗ S/H), we get S = 22,500
INR per pick-up.

[11.b] RAS also incurs a holding cost of INR 500 per year on the old dresses. It proposes
to increase the shipment frequency to 20 times per year and share half of ECHO’s
fixed cost per pick up. Which of the following is MOST LIKELY to happen if this
new arrangement was implemented?
A. RAS will reduce its cost, but ECHO would not.
B. ECHO would reduce its cost, but RAS would not.
C. Costs will reduce for both.
OPMG INVENTORY MANAGEMENT - Page 8 of 8 Term 3

D. Costs will increase for both.

Solution: Currently, RAS incurs only holding cost on the old dresses. As
ECHO picks up in batches of 1500 dresses, the average inventory of old dresses
at RAS is also equal to 1500/2 = 750. RAS’s inventory holding cost is therefore
equal to 750×500 = 375,000 INR per year. ECHO’s cost currently is equal to
(R×50/Q) ×S + (Q/2) ×He = 10 ×22500 + 750×300 = 450,000 INR. With
the proposal, Q = R×50/20 = 15000/20 = 750. As RAS shares half the cost
of pick up, RAS’s annual costs are now equal to (R×50)/Q × S/2 + (Q/2) ×
Hr =20×22500/2+750/2×500 = 412,500 INR. On the other hand, ECHO’s cost
becomes 20 ×22500/2 + (750/2) × 300 = 337,500 INR.