Operations Management

Lect. 9 “Inventory Management”

Dr: Aly Hassan Abdelbaky Elbatran

Head of Mechanical Engineering (S_V)

Faculty of Engineering, Arab Academy for Science
and Technology and Maritime Transport, Egypt

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 Types of Inventory
 Inventory comes in many shapes and sizes such as

 Raw materials – purchased items or extracted materials transformed into

components or products

 Components – parts or subassemblies used in final product

 Work-in-process – items in process throughout the plant

 Finished goods – products sold to customers

 Distribution inventory – finished goods in the distribution system

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 Uses of Inventory
 Anticipation or seasonal inventory:- is built in anticipation of

future demand, planned promotional programs, seasonal

fluctuations, plant shutdowns, and vacations.

 Fluctuation Inventory or Safety stock:- is carried as a cushion to

protect against possible demand variation, “just in case” of

unexpected demand.

 Lot-size or cycle stock: results when a company buys or produces

more than is immediately needed. The extra units of lot-size

inventory are carried in inventory and depleted as customers place

orders.

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 Uses of Inventory

 Transportation or Pipeline inventory:- is in transit between the

manufacturing plant and the distribution warehouse.

 Speculative or hedge inventory:- is a buildup to protect against

some future event such as a strike at your supplier, a price increase,

or the scarcity of a product that may or may not happen.

 Maintenance, repair, and operating (MRO) inventories:- includes

maintenance supplies, spare parts, lubricants, cleaning compounds,

and daily operating supplies such as pens, pencils, and note pads.

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 Objectives of Inventory Management
1) Provide desired customer service level:-

 Customer service is a company’s ability to satisfy the needs of its

customers.

 Customer service in inventory management means whether or

not a product is available for the customer when the customer

wants it.

 Customer service is the ability to satisfy customer requirements

 Percentage of orders shipped on schedule:- A customer

service measure appropriate for use when orders have similar

value.

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 Objectives of Inventory Management

 Percentage of line items shipped on schedule:- A customer

service measure appropriate when customer orders vary in number

of line items ordered.

 Percentage of money volume shipped on schedule: recognizes

the differences in orders in terms of both line items and dollar value.

 Idle time due to material and component shortages:- This is an

absolute measure of the manufacturing or service time lost because

material or parts are not available to the workforce

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 Objectives of Inventory Management

2) Provide for cost-efficient operations:

 Buffer stock for smooth production flow

 Maintain a level work force

 Allowing longer production runs & quantity discounts

3) Minimum inventory investments:

 Inventory turnover

 Weeks, days, or hours of supply

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 Customer Service Level Examples
 Percentage of Orders Shipped on Schedule

 Good measure if orders have similar value. Does not capture value.

 If one company represents 50% of your business but only 5% of your

orders, 95% on schedule could represent only 50% of value

 Percentage of Line Items Shipped on Schedule

 Recognizes that not all orders are equal, but does not capture $ value of
orders. More expensive to measure. Ok for finished goods.

 A 90% service level might mean shipping 225 items out of the total 250
line items totaled from 20 orders scheduled

 Percentage Of Dollar Volume Shipped on Schedule

 Recognizes the differences in orders in terms of both line items and $

value

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 Inventory Investment Measures Example
The Coach Motor Home Company has annual cost of goods sold of $10,000,000.
The average inventory value at any point in time is $384,615. Calculate inventory
turnover and weeks/days of supply.

 Inventory Turnover:

annual cost of goods sold $10,000,000

Turnover    26 inventory turns
average inventory value $384,615

 Weeks/Days of Supply:

average inventory on hand in dollars $384,615

Weeks of Supply    2weeks
average weekly usage in dollars $10,000,000/52

$384,615
Days of Supply   10 days
$10,000,000/260

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 Relevant Inventory Costs

Item Cost Includes price paid for the item plus other direct costs associated
with the purchase
Holding Include the variable expenses incurred by the plant related to the
Costs volume of inventory held
e.g. 15-25%

Capital The higher of the cost of capital or the opportunity cost for the
Costs company

Risk Obsolescence, damage, deterioration, theft, insurance and taxes

costs
Storage Included the variable expenses for space, workers, and equipment
costs related to the volume of inventory held

Ordering Fixed, constant dollar amount incurred for each order placed
Cost
Shortage Loss of customer goodwill, back order handling, and lost sales
Costs

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 Determining Order Quantities

Lot-for-lot Order exactly what is needed, You use lot-for-lot when demand
is not constant and you have information about expected
needs.

Fixed-order Specifies the number of units to order whenever an order is

quantity placed, The advantage of this system is that it is easily
understood; the disadvantage is that it does not minimize
inventory costs.

Min-max Places a replenishment order when the on-hand inventory falls

system below the predetermined minimum level. An order is placed to
bring the inventory back up to the maximum inventory level.

Order n periods Order quantity is determined by total demand for the item for
the next n periods

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 Order Approaches Example

Lot for Lot Example

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 0 0 0 0 0 0 0
Order Placement 40 70 65 60 55 85 75 85

Fixed Order Quantity Example with Order Quantity of 200

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 160 90 25 165 110 25 150 65
Order Placement 200 200 200

Min-Max Example with min.= 50 and max.= 250 units

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 180 110 185 125 70 165 90 165
Order Placement 220 140 180 160

Order n Periods with n = 3 periods

1 2 3 4 5 6 7 8
Requirements 70 70 65 60 55 85 75 85
Projected-on-Hand (30) 135 65 0 140 85 0 85 0
Order Placement 175 200 160

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Mathematical Models for Determining Order Quantity

 Economic Order Quantity (EOQ or Q System)

 An optimizing method used for determining order quantity and

reorder points

 Part of continuous review system which tracks on-hand

inventory each time a withdrawal is made

 Economic Production Quantity (EPQ)

 A model that allows for incremental product delivery

 Quantity Discount Model

 Modifies the EOQ process to consider cases where quantity

discounts are available

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 Economic Order Quantity
EOQ Assumptions:
 Demand is known & constant - no safety stock is required

 Lead time is known & constant

 No quantity discounts are available

 Ordering (or setup) costs are constant

 All demand is satisfied (no shortages)

 The order quantity arrives in a single shipment

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 Inventory Cost with EOQ Model
Total annual cost = annual ordering cost + annual holding costs

D Q 2DS

TCQ   S   H; and Q 
Q  2  H

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 Example:- Cost with EOQ Model
Continuous (Q) Review System Example: A computer company has annual
demand of 10,000. They want to determine EOQ for circuit boards which have an
annual holding cost (H) of $6 per unit, and an ordering cost (S) of $75. They want
to calculate TC and the reorder point (R) if the purchasing lead time is 5 days.
 EOQ (Q)
2DS 2 *10,000 * $75
Q   500 units
H $6

 Reorder Point (R)

10,000
R  Daily Demand x Lead Time  * 5 days  200 units
250 days
 Total Inventory Cost (TC)

 10,000   500 
TC   $75   $6  $1500  $1500  $3000
 500   2 
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 Economic Production Quantity (EPQ)
Same assumptions as the EOQ except: inventory arrives in
increments & is drawn down as it arrives

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 Economic Production Quantity (EPQ)

 Total cost:
 D   I MAX 
TC EPQ   S   H
Q   2 

 Maximum inventory:  d
 d=avg. daily demand rate I MAX  Q 1  
 p=daily production rate  p
 Calculating EPQ

2DS
EPQ 
 d
H
 1  
 p

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 Example: (EPQ)
HP Ltd. Produces its premium plant food in 50# bags. Demand is 100,000 lbs. per
week and they operate 50 wks. each year and HP can produce 250,000 lbs. per
week. The setup cost is $200 and the annual holding cost rate is $0.55 per bag.
Calculate the EPQ. Determine the maximum inventory level. Calculate the total
cost of using the EPQ policy.

2(50)(100,000)(200)
2DS EPQ   77,850 Bags
EPQ   100,000 
 d  0.551  
H
1  p 
  250000 
 

 d  
 100 , 000 
I MAX  Q


1  
p

I MAX  77 , 850  1   46 , 710 bags
 250 , 000 

D  I   5,000,000   46,710 
TC EPQ   S    MAX H  TC   200    .55  $25,690
Q   2   77,850   2 

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 Quantity Discount Model
 Same as the EOQ model, except:

 Unit price depends upon the quantity ordered

 The total cost equation becomes:

D  Q 
TC QD   S    H   CD
Q   2 

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 Example 1: Quantity Discount Model
Jeannette’s Steak House currently orders 200 pounds of single-portion filet mignons
at a time (a two-week supply). The annual demand for the filets is 5200 pounds. The
ordering cost is estimated at $50. The annual holding cost is 30 percent of the unit
price. Jeannette pays $7.50 per pound for the steaks. Therefore, the annual holding
cost rate is $2.25 ($7.50 X 0.30). What are the annual total costs?

D  Q 
TC QD   S    H   CD
Q   2 

 5200   200 
TC QD   50$    2.25$   (7.5 X 5200)  40,525$
 200   2 

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 Example 2: Quantity Discount Model
VGHC operates its own laboratory on-site. The lab maintains an inventory of test kits for a
variety of procedures. VGHC uses 780 A1C kits each year. Ordering costs are $15 and holding
costs are $3 per kit per year. The new price list indicates that orders of fewer than 73 kits will
cost $60 per kit, 73 through 144 kits will cost $56 per kit, and orders of more than 144 kits will
cost $53 per kit. Determine the optimal order quantity and the total cost.

2DS 2(780)($15)
EOQ  EOQ$9   88.3 kits ~  89 kits
H $3
This quantity qualifies for a price of $56 per kit. Since it is not the lowest possible price, we calculate the total
cost at this price and compare it to the total cost at any lower price breaks. The total cost when ordering 89 kits is

TC 
780
$15  89 $3  $56780  $43,944.96
89 2
Total cost when ordering 145 kits is

TC 
780
$15  145 $3  $53780  $41,638.19
145 2

Therefore, the VGHC should order 145 kits at a time since it will save $2306.77 each year
($43,944.96 - $41,638.19).

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Example 2: Quantity Discount Model

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 Example 3: Quantity Discount Model
Collin’s Sport store is considering going to a different hat supplier. The present
supplier charges $10 each and requires minimum quantities of 490 hats. The annual
demand is 12,000 hats, the ordering cost is $20, and the inventory carrying cost is
20% of the hat cost, a new supplier is offering hats at $9 in lots of 4000. Who
should he buy from?
 EOQ at lowest price $9. Is it feasible?

2(12,000)(20)
EOQ$9   516 hats
$1.80

 Since the EOQ of 516 is not feasible, calculate the total cost (C) for
each price to make the decision

C$10 
12,000
$20  490 $2  $1012,000  $120,980
490 2
C$9 
12,000
$20  4000
$1.80  $912,000  $101,660
4000 2
 4000 hats at $9 each saves $19,320 annually.

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Safety Stock Level

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 Safety Stock Level

o If demand or lead time is uncertain, safety stock can be added to

improve order-cycle service levels

o R = dL +SS

o Where SS =zσdL, where

o Z is the number of standard deviations and

o σdL is standard deviation of the demand during lead time

o Order-cycle service level

o The probability that demand during lead time will not exceed
on-hand inventory

o A 95% service level (stockout risk of 5%) has a Z=1.645

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Safety Stock Level

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 Example: Safety Stock Level
Suppose that the owner of the cafe, Nick’s, has determined that demand for Juice
during lead time averages 5000 bottles. Nick, the owner, believes the demand during
lead time can be described by a normal distribution with a mean of 5000 bottles and a
standard deviation of 300 bottles. Nick is willing to accept a stockout risk of
approximately 4 percent. Determine the appropriate z value to use. Calculate how
much safety stock Nick should hold. Also determine the reorder point.
To find the appropriate z value associated with the order-cycle service level (1
- 0.04 = 0.9600), you must understand that the table shows only positive z
values. A z value of 0 represents 0.5000. You need to find the z value that is
the difference between the desired service level and a z value of 0 (0.9600 -
0.5000 = 0.4600). Look for the entry closest to 0.4600. If you look at the entry
associated with a z value of 1.75, you should see 0.4599, which is as close to
0.4600 as we can get. Therefore, the appropriate z value is 1.75. To
determine the appropriate amount of safety stock, do the following
calculation:
SS= 1.75 X 300 bottles = 525 bottles of safety stock

The reorder point would now be

R = 5000 + 525 = 5525 bottles

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 Periodic Review Systems

 Targeted Inventory level:

TI = d(RP + L) + SS

d = average period demand

RP = review period (days, wks)

L = lead time (days, wks)

SS = zσRP+L

 Replenishment Quantity (Q)=TI- OH (quantity on hand)

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 Periodic Review Systems
An auto parts store calculated the EOQ for Drive Belts at 236 units and wants to
compare the Total Inventory Costs for a Q vs. a P Review System. Annual demand
(D) is 2704, avg. weekly demand is 52, weekly σ is 1.77 belts, and lead time is 3
weeks. The annual TC for the Q system is $229; H=$97, S=$10.

Review Period Q 236


RP  x 52weeks  x52  5wks
D 2704
 Target Inventory for 95% Service Level

TI  d(RP  L)  SS  d(RP  L)  zσRP  L

 
TI  52 units5  3  1.645 1.77 5  3  416  8  424 belts

 Average On-Hand
OHavg= TI-dL=424-(52belts)(3wks) = 268 belts
 Annual Total Cost (P System)

TCp 
52
$10  268 $.97   115  130  $245
5 2
Annual Cost Difference  $245  $229  $16
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 ABC Inventory Classification
 ABC classification is a method for determining level of control
and frequency of review of inventory items

 A Pareto analysis can be done to segment items into value

categories depending on annual dollar volume

 A Items – typically 10%- 20% of the items accounting for 60%-

80% of the inventory value

 B Items – typically an additional 30% of the items accounting for

25%-35% of the inventory value

 C Items – Typically the remaining 50%-60% of the items

accounting for only 5%-15% of the inventory value

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 ABC Inventory Classification
The AAU Corp. is considering doing an ABC analysis on its entire inventory
but has decided to test the technique on a small sample of 15 of its SKU’s.
The annual usage and unit cost of each item is shown below

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ABC Inventory Classification

33
ABC Inventory Classification

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 ABC Inventory Classification
 The A items (106 and 110) account for 60.5% of the value and 13.3% of the items

 The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the items

 The C items make up the last 14.5% of the value and 60% of the items

 How might you control each item classification? Different ordering rules for each?

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 Justifying Smaller Order Quantities

 JIT or “Lean Systems” would recommend reducing order quantities to the

lowest practical levels

 Benefits from reducing Q’s:

 Improved customer responsiveness (inventory = Lead time)

 Reduced Cycle Inventory

 Reduced raw materials and purchased components

 Justifying smaller EOQ’s:

2DS
Q
H
 Reduce Q’s by reducing setup time (S). “Setup reduction” is a well
documented, structured approach to reducing S

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 Inventory Record Accuracy
 Inaccurate inventory records can cause:
 Lost sales
 Disrupted operations
 Poor customer service
 Lower productivity
 Planning errors and expediting

 Two methods are available for checking record accuracy

 Periodic counting - physical inventory is taken periodically, usually
annually
 Cycle counting-daily counting of prespecified items provides the
following advantages:
 Timely detection and correction of inaccurate records
 Elimination of lost production time due to unexpected stock
outs
 Structured approach using employees trained in cycle counting

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Inventory Management Across the Organization

 Inventory management policies affect functional

areas throughout

 Accounting is concerned of the cost implications of

inventory

 Marketing is concerned as stocking decision affect

the level of customer service

 Information Systems is involved to tack and

control inventory records

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THANK YOU

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