Learning Objectives

When you complete this chapter you

should be able to:

12.1 Conduct an ABC analysis

12.2 Explain and use cycle counting
12.3 Explain and use the EOQ model
for independent inventory demand
12.4 Compute a reorder point and
explain safety stock

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 Learning Objectives
When you complete this chapter you
should be able to:

12.5 Apply the production order quantity

model
12.6 Explain and use the quantity
discount model
12.7 Understand service levels and
probabilistic inventory models

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 Inventory Management

The objective of inventory

management is to strike a balance
between inventory investment and
customer service

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 Importance of Inventory
▶ One of the most expensive assets of many
companies representing as much as 50%
of total invested capital
▶ Less inventory lowers costs but increases
chances of shortages which might stop
processes or result in dissatisfied
customers
▶ More inventory raises costs but improves
the likelihood of meeting process and
customer demands
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 Functions of Inventory
1. To provide a selection of goods for
anticipated demand and to separate
the firm from fluctuations in demand
2. To decouple or separate various
parts of the production process
3. To take advantage of quantity
discounts
4. To hedge against inflation

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 Types of Inventory
▶ Raw material
▶ Purchased but not processed
▶ Work-in-process (WIP)
▶ Undergone some change but not completed
▶ A function of flow time for a product
▶ Maintenance/repair/operating (MRO)
▶ Necessary to keep machinery and processes
productive
▶ Finished goods
▶ Completed product awaiting shipment
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 The Material Flow Cycle

Flow time

95% 5%

Input Wait for Wait to Move Wait in queue Setup Run Output
inspection be moved time for operator time time

Figure 12.1

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 Managing Inventory

1) How inventory items can be classified

(ABC analysis)
2) How accurate inventory records can
be maintained

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 ABC Analysis
▶Divides inventory into three classes based
on annual dollar volume
▶Class A - high annual dollar volume
▶Class B - medium annual dollar volume
▶Class C - low annual dollar volume
▶Used to establish policies that focus on the
few critical parts and not the many trivial
ones

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 Percentage of annual dollar usage ABC Analysis
Figure 12.2
A Items
80 –
70 –
60 –
50 –
40 –
30 –
20 – B Items
10 – C Items
0 – | | | | | | | | | |

10 20 30 40 50 60 70 80 90 100
Percentage of inventory items

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 ABC Analysis
ABC Calculation
(1) (2) (3) (4) (5) (6) (7)

PERCENTAGE PERCENTAGE
ITEM OF NUMBER OF ANNUAL ANNUAL OF ANNUAL
STOCK ITEMS VOLUME UNIT DOLLAR DOLLAR
NUMBER STOCKED (UNITS) x COST = VOLUME VOLUME CLASS
#10286 20% 1,000 $ 90.00 $ 90,000 38.8% A
72%
#11526 500 154.00 77,000 33.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 30% 350 42.86 15,001 6.4% 23% B
#10500 1,000 12.50 12,500 5.4% B
#12572 600 14.17 8,502 3.7% C
#14075 2,000 .60 1,200 .5% C
#01036 50% 100 8.50 850 .4% 5% C
#01307 1,200 .42 504 .2% C
#10572 250 .60 150 .1% C
8,550 $232,057 100.0%

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 ABC Analysis
▶ Other criteria than annual dollar volume
may be used
▶ High shortage or holding cost
▶ Anticipated engineering changes
▶ Delivery problems
▶ Quality problems

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 ABC Analysis
▶Policies employed may include
1. More emphasis on supplier development
for A items
2. Tighter physical inventory control for
A items
3. More care in forecasting A items

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 Record Accuracy
► Accurate records are a
critical ingredient in
production and inventory
systems
► Periodic systems require
regular checks of inventory
► Two-bin system
► Perpetual inventory tracks receipts
and subtractions on a continuing basis
► May be semi-automated
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 Record Accuracy

► Incoming and outgoing

record keeping must be
accurate
► Stockrooms should be
secure
► Necessary to make precise decisions
about ordering, scheduling, and
shipping

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 Cycle Counting
▶Items are counted and records updated on
a periodic basis
▶Often used with ABC analysis
▶Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and
corrected
5. Maintains accurate inventory records
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 Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C
items
Policy is to count A items every month (20 working days), B items
every quarter (60 days), and C items every six months (120 days)

CYCLE
ITEM COUNTING NUMBER OF ITEMS
CLASS QUANTITY POLICY COUNTED PER DAY
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day

C 2,750 Every 6 months 2,750/120 = 23/day

77/day

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Control of Service Inventories
▶Can be a critical component of profitability
▶Losses may come from shrinkage or
pilferage
▶Applicable techniques include
1. Good personnel selection, training, and
discipline
2. Tight control of incoming shipments
3. Effective control of all goods leaving facility

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 Inventory Models
▶Independent demand - the demand for
item is independent of the demand for any
other item in inventory
▶Dependent demand - the demand for
item is dependent upon the demand for
some other item in the inventory

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 Inventory Models
▶Holding costs - the costs of holding or
“carrying” inventory over time
▶Ordering cost - the costs of placing an
order and receiving goods
▶Setup cost - cost to prepare a machine or
process for manufacturing an order
▶May be highly correlated with setup time

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 Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENTAGE
OF INVENTORY
CATEGORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
tablets and smart phones)
Overall carrying cost 26%

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 Holding Costs
TABLE 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
AS A PERCENTAGE
OF INVENTORY
CATEGORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)
Investment costs (borrowing costs, taxes, and 11% (6 - 24%)
insurance on inventory)
Pilferage, space, and obsolescence (much 3% (2 - 5%)
higher in industries undergoing rapid change like
PCs and cell phones)
Overall carrying cost 26%

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 Inventory Models for
Independent Demand
Need to determine when and
how much to order

1. Basic economic order quantity

(EOQ) model
2. Production order quantity model
3. Quantity discount model

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 Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and
complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering)
and holding
6. Stockouts can be completely avoided
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 Inventory Usage Over Time
Figure 12.3

Total order received

Average
Order Usage rate inventory
quantity = Q
Inventory level

on hand
(maximum
Q
inventory
level) 2

Minimum
inventory 0
Time

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 Minimizing Costs
Objective is to minimize total costs
Table 12.4(c)

Total cost of
holding and
setup (order)

Minimum
total cost
Annual cost

Holding cost

Setup (order) cost

Optimal order Order quantity

quantity (Q*)
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 Minimizing Costs
▶By minimizing the sum of setup (or
ordering) and holding costs, total costs are
minimized
▶Optimal order size Q* will minimize total
cost
▶A reduction in either cost reduces the total
cost
▶Optimal order quantity occurs when
holding cost and setup cost are equal
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 Minimizing Costs
The necessary steps are:
1. Develop an expression for setup or
ordering cost
2. Develop an expression for holding cost
3. Set setup (order) cost equal to holding
cost
4. Solve the equation for the optimal order
quantity.

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 Minimizing Costs
Q = Number of units per order
Q* = Optimal number of units per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
× (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
æ Dö
= ç ÷S
èQø
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 Minimizing Costs D
Annual setup cost = S
Q
Q = Number of pieces per order
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual setup cost = (Number of orders placed per year)
× (Setup or order cost per order)

Annual demand Setup or order

=
Number of units in each order cost per order
æ Dö
= ç ÷S
èQø
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 Minimizing Costs D
Annual setup cost = S
Q
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level)
× (Holding cost per unit per year)

Order quantity
= (Holding cost per unit per year)
2
æQö
= ç ÷H
è2ø
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 Minimizing Costs D
Annual setup cost = S
Q
Q
Q = Number of pieces per order Annual holding cost = H
2
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup

cost equals annual holding cost

æ Dö æQ ö Solving for Q* 2DS = Q 2 H

ç ÷S = ç ÷ H 2DS
èQø è2ø Q2 =
H
2DS
Q* =
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 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

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 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

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

1,000
N= = 5 orders per year
200

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 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 Number of working days per year

time between = T =
orders Expected number of orders

250
T= = 50 days between orders
5

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 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
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 The EOQ Model
When including actual cost of material P

Total annual cost = Setup cost + Holding cost + Product cost

D Q
TC = S + H + PD
Q 2

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 Robust Model
▶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

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 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
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 An EOQ Example
Determine optimal number of needles to order
D = 1,000 units 1,500 units Q*1,000
Only=2% 200less
units
than
S = $10 per order the
T =total cost of
50 days
H = $.50 per unit per year $125
Q*1,500 whenunits
= 244.9 the
N= 5 orders/year order quantity was
200
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
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 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

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 Reorder Point Curve
Figure 12.5

Q*
Stock is replenished as order arrives
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
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 Reorder Point Example
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

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

TABLE 12.2 A Quantity Discount Schedule

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 0 to 119 $100
Discount price 1 120 to 1,499 $ 98
Discount price 2 1,500 and over $ 96

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 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 percentage (I) of unit price (P)

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 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.
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 Quantity Discount Models
Figure 12.7
Initial
Price Discount Price 1 Discount Price 2
550,000 –
TC for No Discount
540,000 –
Annual Total Cost

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
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 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

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 Quantity Discount Example

TABLE 12.3 Total Cost Computations for Chris Beehner Electronics

ANNUAL ANNUAL ANNUAL
ORDER UNIT ORDERING HOLDING PRODUCT TOTAL ANNUAL
QUANTITY PRICE COST COST COST COST
275 $98 $3,782 $3,773 $509,600 $517,155
1,500 $96 $693 $20,160 $499,200 $520,053

Choose the price and quantity that gives the

lowest total cost
Buy 275 drones at $98 per unit

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 Quantity Discount Variations
▶ All-units discount is the most popular form
▶ Incremental quantity discounts apply only to
those units purchased beyond the price
break quantity
▶ Fixed fees may encourage larger purchases
▶ Aggregation over items or time
▶ Truckload discounts, buy-one-get-one-free
offers, one-time-only sales

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