Operations Management

LECTURE 3

Prof. dr. Heleen Buldeo Rai

October 25, 2023
CHAPTER 12:
INVENTORY MANAGEMENT
 Refresher: product design processes

Depending on the characteristics of

a production process and its design
strategy, different types of inventory
 Types of inventory
• Raw materials: purchased items or extracted materials that are transformed
into components or products (e.g., gold à jewelry)
• Components: parts or subassemblies used in the final product (e.g.,
transformer à electronic product)
• Work-in-process: unfinished products that are in process
• Finished products: products that are ready to be sold to customers
• Distribution: finished products in the distribution system (e.g., in a warehouse)

• Maintenance, repair and operating inventory: supplies that are used in the
production process without being part of the final product (e.g., tools)

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Types of inventory

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 Inventory purposes

• Anticipation inventory or seasonal inventory: built in anticipation of future

demand, to maintain level production (e.g., promotional programs, seasonal
fluctuations, vacations)
• Fluctuation inventory or safety stock: carried as a buffer against unexpected
demand variations, to assure customer service levels
• Lot-size inventory or cycle stock: results from the actual quantity ordered or
produced, to lower unit costs (e.g., quantity discounts, production minimum)
• Transportation or pipeline inventory: items in movement between locations
• Speculative or hedge inventory: protection against future events (e.g., strikes,
price increase, product scarcity)

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 Inventory management objectives

1. Provide desired customer service level

• Percentage of orders shipped on schedule
• Percentage of line items shipped on schedule
• Percentage of dollar volume shipped on schedule
• Idle time due to material and component shortages

2. Ensure cost-efficient operations

3. Minimize inventory-related investments

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 Inventory management objectives

1. Provide desired customer service level

2. Ensure cost-efficient operations
• Carry work-in-process inventory between workstations, to avoid idle time
• Maintain a level workforce despite seasonal demand, to avoid cost of overtime,
hiring and firing, training, subcontracting, etc.
• Schedule long production runs, to decrease setup cost
• Order large volumes, to receive quantity discounts

3. Minimize inventory-related investments

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 Inventory management objectives

1. Provide desired customer service level

2. Ensure cost-efficient operations
3. Minimize inventory-related investments
Example: the Coach Motor Home Company has an annual cost of goods sold of
$10 000 000. The average inventory value at any point in time is $384 615.
Calculate (a) the inventory turnover and (b) the weeks of supply.

annual cost of goods sold ($) $10 000 000

Turnover = = = 26 inventory turns
average inventory value ($) $384 615

average inventory on hand ($) $384 615

Weeks of supply = = = 2 weeks
average weekly usage ($) $10 000 000 / 52
 Inventory-related costs

• Item costs: direct costs associated with the purchase

I.e., purchase price, transportation, insurance, taxes, handling, (production)
• Holding costs: variable expenses related to the volume of inventory
I.e., capital (interest rate/rate of return), storage, risk
• Ordering costs: fixed costs incurred for each order placed
E.g., administration, handling, (setup)
• Shortage costs: incurred when demand exceeds supply
E.g., back order handling, loss of customer goodwill, lost sales
ABC classification

https://youtu.be/tZxS7uCmIcU
 ABC classification

How to determine the appropriate review frequency for inventory items?

Pareto’s law (20/80): items are segmented based on annual dollar volume
• A items: high dollar volume à continuous review (EOQ model)
• Typically 20% of the items, representing 60-80% of inventory value
• B items: medium dollar volume à periodic review (TI model)
• Typically 30% of the items, representing 25-35% of inventory value
• C items: low dollar volume à less frequent review or two-bin system
• Typically 50% of the items, representing 5-15% of inventory value
ABC classification

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 Determining order quantities

1. Multiple-period models

Fixed order quantity models à continuous review

• Economic order quantity (EOQ)
• Economic production quantity (EPQ)
• Extensions to the EOQ model: quantity discounts, safety stock

Fixed time interval models à periodic review

• Target inventory (TI)

2. Single-period model

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 Economic order quantity (EOQ)

Objective: satisfy demand with minimized sum of order costs and holding costs
à to be determined: when to order and how many items per order?

Assumptions
• The total demand D is known and constant (no safety stock needed)
• All demand needs to be satisfied on time (no backorders possible)
• The lead time L is known and constant
• The fixed ordering cost S is known and constant (independent of the quantity ordered)
• The holding cost is known and proportional to the average inventory level
• No quantity discounts are applicable
• The ordered items are delivered at once

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Economic order quantity (EOQ)
Economic order quantity (EOQ)

Total cost = sum of

ordering costs and
holding costs

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 Economic order quantity (EOQ)

Order size that minimizes TC?

æDö æQö 2DS

TC(Q) = çç ÷÷ * S + ç ÷ * H ® Qopt =
èQø è2ø H

When to place a new order?

R = d*L

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 Economic order quantity (EOQ)

A computer company has an annual demand (D) of 10,000 units. They want to
determine the EOQ for circuit boards which have an annual holding cost (H) of $6 per
unit and an ordering cost (S) of $75. The lead time equals 5 days. The company
operates 250 days per year.
Calculate the economic order quantity (Q), the corresponding total cost (TC) and
the reorder point (R).

2𝐷𝑆 2×10 000×75 10 000

𝐸𝑂𝑄 = = = 500 units per order 𝑅 =𝑑∗𝐿 = ∗ 5 = 200 units
𝐻 6 250

𝑄 𝐷 500 10 000
𝑇𝐶 = 𝐻+ 𝑆= ×6 + ×75 = $3000
2 𝑄 2 500

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 Economic production quantity (EPQ)
Difference compared to EOQ model
• Inventory is gradually replenished and can be used as soon as it arrives
(e.g., internally made items)
2𝐷𝑆
à Higher optimal order quantity Q: 𝑄=
𝑑
𝐻 1−
𝑝

𝑑 𝐷 𝐼!"#
à Lower inventory level and cost: 𝐼!"# = 𝑄 ∗ 1 − 𝑇𝐶 = ∗ 𝑆 + ∗𝐻
𝑝 𝑄 2

• Production rate p must be larger than depletion rate d

• Maximum inventory level 𝐼!"# must be smaller than EPQ

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Economic production quantity (EPQ)
 Quantity discount model

Difference compared to EOQ model

• Vendors allow quantity discounts when large quantities are ordered
à multiple unit price levels (P) depending on the quantity ordered

𝐷 𝑄
𝑇𝐶 = ∗ 𝑆 + ∗ 𝐻 + 𝑷(𝑸) ∗ 𝑫
𝑄 2
 Quantity discount model

Example
A steak house’s annual demand for steaks is 5,200 pounds. The ordering cost is
$50 and the annual holding cost equals 30 percent of the unit price. The price of
the steaks is $7.50 per pound.

However, the supplier offers the following price incentives. For orders of 500
pounds or more, the price per pound is $6.90. For orders of 1,000 pounds or
more, the supplier charges only $6.20 per pound.
Quantity discount model
 Quantity discount model

Procedure
1. Starting from the lowest item price P, check which value of P is the first for
which a feasible EOQ is obtained and compute the TC
2. Also compute the TC for all order quantities Q at price breaks to curves
associated with a lower item price P
3. Select the option involving the lowest TC
 Quantity discount model

Example

2×5200×50
𝑄$%&.() = = 528.74 pounds per order ⇒ Not feasible
0.30 ∗ 6.20

2×5200×50
𝑄$%&.*) = = 501.20 pounds per order ⇒ Feasible
0.30 ∗ 6.90

5200 501
• Option 1: 𝑇𝐶+%,)- = ∗ 50 + ∗ 0.30 ∗ 6.90 + 6.90 ∗ 5200 = $36 918
501 2
5200 1000
• Option 2: 𝑇𝐶+%-))) = ∗ 50 + ∗ 0.30 ∗ 6.20 + 6.20 ∗ 5200 = $𝟑𝟑 𝟒𝟑𝟎
1000 2
 Demand uncertainty

• If demand during the lead time is uncertain, companies might invest in

safety stock to decrease the probability of shortages:

à Increased reorder point R 2𝐷𝑆

𝑅 = 𝑑 ∗ 𝐿 + 𝑺𝑺 𝑄=
𝐻
à Unaffected reorder quantity Q
𝑄 𝐷
à Increased total cost TC 𝑇𝐶 = + 𝑺𝑺 ∗ 𝐻 + ∗ 𝑆
2 𝑄

• Determine an adequate level of safety stock (SS) based on the order-cycle

service level: the probability that demand during the lead time will not
exceed on-hand inventory
 Demand uncertainty

The use of safety stock changes the reorder point R: the company places a
new order when the remaining stock is 250 units (instead of 200 units), which
creates a buffer to avoid stockouts during the lead time
 Demand uncertainty

The amount of safety stock to hold depends on

the variability of demand and lead time and
the desired order-cycle service level.
 Order-cycle service level approach

• Assumption: demand during the lead time is normally distributed with mean µL
and standard deviation σL

𝑺𝑺 = 𝒛 ∗ 𝛔𝑳

3σL µL = 1000
σL = 20

Safety stock equal to 3σL (z = 3)

reduces the probability of a stockout
to 0.135% [appendix B]
 Example

Assume that the lead time equals 2 days. Daily demand is normally distributed
with a mean of 10 items and a standard deviation of 3 items. Determine the
required safety stock to avoid stockouts with a 95% probability.
µ𝐿 =
𝐿 ∗ 𝑑 = 2 ∗ 10 = 20 items

σ𝐿 =
σ𝑑 ∗ 𝐿 = 3 ∗ 2 = 4.24 items

𝑆𝑆 = 𝑧 ∗ σL = 1.645 ∗ 4.24 = 6.97 items ~ 7 items

à The reorder point R would increase by 7 items

à Inventory costs would increase by 7*H
 Target inventory model

• Periodic review system: the inventory on hand is measured at fixed time

intervals (e.g., once per week) à review period RP
• The order quantity Q is variable and determined based on the difference
between a target inventory level (TI) and the current inventory level on-hand (OH)
• Advantages:
• No need to continuously monitor the inventory level
• Items from the same supplier can be reviewed on the same day to save order costs
• Disadvantages:
• Replenishment quantities vary and may not qualify for quantity discounts
• Higher average inventory levels needed to protect against stockouts
Target inventory model

T = RP
 Target inventory model

• Order quantity: 𝑄 = 𝑇𝐼 − 𝑂𝐻

• Target inventory level based on the expected demand during a review

period and the lead time:

𝑇𝐼 = 𝑑 𝑅𝑃 + 𝐿 + 𝑆𝑆

• Compared to continous review models, a larger safety stock is needed to

protect the company against uncertainty during the review period as well:

𝑆𝑆 = 𝑧 ∗ σ𝑹𝑷+𝐿 σ𝑹𝑷+𝐿 = σ𝑡 ∗ 𝑹𝑷 + 𝐿
 Determining order quantities

1. Multiple-period models

Fixed order quantity models à continuous review

• Economic order quantity (EOQ)
• Economic production quantity (EPQ)
• Extensions to the EOQ model: quantity discounts, safety stock

Fixed time interval models à periodic review

• Target inventory (TI)

2. Single-period model
 Single-period inventory model

Designed for products with the following characteristics:

• Sold at their regular price at a specific occasion or during a short period
(e.g., newspapers, perishable products)
• A discrete demand distribution is known
• The salvage value is less than the purchasing cost à a loss is made on
products that cannot be sold at their regular price

Objective: how many products to stock in order to maximize expected profit?

 Single-period inventory model

Example
T-shirts are purchased in multiples of 10 for a charity event for $8 each. The
selling price is $20 during the event. After the event, the salvage value is just
$2. The probabilities of selling different quantities of T-shirts are:

Probability 0.20 0.25 0.30 0.15 0.10

Demand 80 90 100 110 120

Profit per T-shirt sold: $20 - $8 = $12

Loss per T-shirt that cannot be sold: $8 - $2 = $6
 Single-period inventory model

Prob 0.20 0.25 0.30 0.15 0.10

Demand 80 90 100 110 120
Order Profit
80 $960 $960 $960 $960 $960 $960
90 $900 $1080 $1080 $1080 $1080 $1044
($840*0,2)+($1020*0,25)+
100 $840 $1020 $1200 $1200 $1200 $1083 ($1200*0,3)+($1200*0,15)
+($1200*0,1)= $1083
110 $780 $ 960 $1140 $1320 $1320 $1068
120 $720 $ 900 $1080 $1260 $1440 $1026

110*$12 – 10*$6 = $1260

 Green Inventory Management

How to reduce the CO2 footprint of a

fashion retail logistics operations by
reducing the frequency of store deliveries? Samir Saci, 2023
Green Inventory Management

Samir Saci, 2023

Example from Ikea
 WAREHOUSE MANAGEMENT

Papers on Canvas
• Gu, Goetschalckx, & McGinnis (2007). Research on warehouse operation: A comprehensive review.
European Journal of Operational Research 177, 1-21.
• de Koster, Le-Duc, & Roodbergen (2007). Design and control of warehouse order picking: A literature review.
European Journal of Operational Research 182, 481-501.
Refresher: basic supply chain
 Warehouse function and roles
Warehouse
• Essential component of any supply chain
• Increasingly outsourced to logistic service providers (3PL, 4PL)
• SKU (stock keeping unit) = a specific item at a particular geographical location

Roles of a warehouse
• Commonly used for for storing/buffering products between points of origin and
points of consumption
• Consolidation and product mixing
• Crossdocking
• Value-added services, reverse logistics
 Warehouse function and roles

Buffering allows different parts of the supply chain to operate independently

Objectives:
• Increase operational flexibility
(e.g., impact of seasonal demand,
batch production, uncertainties)
• Reduce customer lead times
 Warehouse function and roles

Consolidation allows product mixing and reduces transportation costs

Warehouse function and roles

Consolidation warehouse: Distribution center:

combines shipments from a number of sources receives large incoming shipments and splits
in the same geographic area into larger, more them up into smaller outgoing shipments to
economical shipping loads demand points in a geographic area
 Warehouse function and roles

Crossdocking allows to consolidate and transfer products directly without

storage/picking, customer is known
 Warehouse function and roles

Value-added logistics allow to to meet specific customer demands, especially

when a postponement strategy is adopted
 Warehouse function and roles

Why are warehouses beneficial to companies?

Some examples:
• Achieving transportation economies (e.g., combined shipments)
• Achieving production economies (e.g., make-to-stock policy)
• Taking advantage of quantity discounts and forward buys
• Meeting changing market conditions and uncertainties (e.g., seasonality, demand fluctuations)
• Overcoming time and space differences between producers and customers
• Providing temporary storage of material to be disposed or recycled (reverse logistics)

Challenges: smaller orders, shorter response times, larger product variety

Warehouse flows and activities

Main warehousing activities

• Receiving
• Storage (transfer and put away)
• Order picking
• Accumulation/sortation
• Crossdocking
• Shipping

Warehouse management
≠
Inventory management
 Warehousing activities

Receiving
• Unloading products from transport carrier (typically truck)
• Updating inventory records
• Inspecting quantity/quality inconsistencies

Storage (transfer and put away)

• Transfer incoming products to storage
• Possibly repackaging (e.g., full pallets to cases or standardized bins)
 Warehousing activities
Order picking
• Most labor-intensive activity in many warehouses
• Obtaining a right amount of the right products for a set of customer orders à
many different strategies
• Customer orders consist of one or more order lines (= SKU in specific
quantity)

Shipping
• Accumulating picked orders into individual customer orders
• Performing value-added services (e.g., pricing, labelling, kitting)
• Packing and stacking customer orders on the right unit load
Warehousing activities
 Operations strategy

Decisions related to operations, but not likely to be changed frequently

Two aspects
• Storage strategy: where to store each SKU?
• Order picking strategy: how to retrieve an SKU when ordered?

Objective: maximize service level subject to available resources (labor,

machines, capital) à typical measures of service level: order delivery time,
order integrity, order accuracy
Storage assignment
 Storage assignment

Forward-reserve allocation
• Large reserve area (bulk stock) and small forward area (pick stock)
• Advantage: picking efficiency through reduced distances
• Disadvantage: frequent replenishment from reserve area
• All SKUs in forward area?
• How many units per SKU in forward area?
 Storage assignment

Storage location assignment policies

• A set of rules which can be used to assign SKUs to storage locations
• Random: assign SKUs randomly to eligible empty locations
• Dedicated: assign SKUs to a fixed location
• Full-turnover storage: assign SKUs generating the highest sales closest to the depot
• Class-based storage: combination of turnover and random strategy

• Family grouping: related SKUs should be stored close to each other

 Storage assignment

Example: class-based storage Apply Pareto’s law to divide

SKUs into three classes (ABC-
classification)

Dedicated storage areas for

each class, but random
assignment within classes

Various strategies to create A,

B and C areas
Order picking systems
Order picking systems

Order picking
methods

Employing Employing
humans machines

Picker-to- Parts-to-
parts picker
Fully
automated
warehouses
zoning,
Technology:
batching
AS/RS,
and routing
robots, AGV
decisions
 Picker-to-parts: zoning

Picking area divided into zones à each order picker assigned to a single zone
• Order pickers travel smaller distances and become familiar with locations
• But: different SKUs of the same order may be in different zones à split orders
should be consolidated before shipping

Consolidation strategies
• Progressive zoning (pick-and-pass)
à Order is picked zone by zone: it goes to the next zone when completed in previous zone
• Synchronized zoning
à Order is picked in parallel: it is merged after picking has been done in all zones
 Picker-to-parts: batching

In the case of small orders (few order lines), single-order picking is inefficient
à order batching reduces travel distances by picking a set of orders in a
single picking tour

Criteria to decide which orders are batched

• Proximity of pick locations (e.g., identical pick locations, distance between pick locations)
• Time windows: order due times must be respected

Sorting needs to be done either during or after picking tour

Picker-to-parts: batching
 Picker-to-parts: routing

Pick list
List of SKUs (and their quantities) to be picked in a single order picking tour
• Assigned to a specific order picker
• Results of zoning and batching decisions

Routing decision
Sequencing the items on the pick list to ensure a short route through the
warehouse for the order picker
 Picker-to-parts: routing

S-shape routing works well in combination with within-aisle storage

Return routing works well in combination with across-aisle storage or diagonal storage
Mid-point routing and largest-gap routing work well in combination with perimeter storage
 Picker-to-parts: technology

Technology to support manual order picking

• Capital investments vs. accuracy and/or productivity improvements
• Examples: scanning, voice picking, pick-to-light, etc.
Picker-to-parts: technology
 Conclusion

Chapter 12: Inventory management

• Types of inventory
• Objectives of inventory
• Multiple-period inventory models with continuous vs. periodic review
• Single-period inventory model

To do
• Read chapter 12 in textbook
• Exercise session related to inventory management
 Conclusion

Warehouse management
• Warehouse function and roles
• Warehousing activities
• Storage assignment and order picking strategies

To do
• Study the slides
• Read both papers on warehousing (Canvas)