Chapter 3

Inventory Management
 Introduction to Inventory Management
• Inventory is the stock of any item or resource held to meet future demand
and can include: raw materials, finished products, component parts , and
work-in-process.
• Inventory management is the planning and controlling of
inventories in order to meet the competitive priorities of the
organization.
 Effective inventory management is essential for realizing the full potential of any
value chain.

• Inventory management requires information about expected demands,

amounts on hand and amounts on order for every item stocked at all
locations.
 The appropriate timing and size of the reorder quantities must also be determined.
 Introduction..

• Types of Inventory:
 Cycle Inventory: The portion of total inventory that varies directly with lot
size (Q).
Average cycle inventory = ?
Lot Sizing: The determination of how frequently and in what quantity to
order inventory.
 Safety Stock Inventory: Surplus inventory that a company holds to protect
against uncertainties in demand, lead time and supply changes.
 Anticipation Inventory: is used to absorb uneven rates of demand or supply,
which businesses often face.
 Introduction..…

 Pipeline Inventory: Inventory moving from point to point in the materials flow
system.
DL is the average demand for the item per period
Pipeline inventory = DL = dL
(d) times the number of periods in the item’s lead
time (L).

• Function of Inventory:
1. To “decouple” or separate various parts of the production process, i.e. to
maintain independence of operations.

2. To meet unexpected demand & to provide high levels of customer service.

 Introduction..…

3. To smooth production requirements by meeting seasonal or

cyclical variations in demand.
4. To protect against stock-outs.
5. To provide a safeguard for variation in raw material delivery time.
6. To provide a stock of goods that will provide a “selection” for
customers.
7. To take advantage of economic purchase-order size.
 Introduction..…

• Cost of Inventory:
Holding (or carrying) costs
 Costs for storage, handling, insurance, etc
Setup (or production change) costs
 Costs to prepare a machine or process for manufacturing an
order, eg. arranging specific equipment setups, etc
Ordering costs (costs of replenishing inventory)
 Costs of placing an order and receiving goods
Shortage costs
 Costs incurred when demand exceeds supply.
 Application of Inventory Management

proper management of inventory is important for;

Manufacturing industry

Service industry

Shops

Pharmaceutical shops

Etc.
 Inventory Models

• Inventory Decision Questions

How Much?
When?
 Types of Inventory Models

• Deterministic Inventory Model:

 When demand and lead time for an item are constant.

• Probabilistic Inventory Model:

 When demand and lead time for an item are not constant.
 Independent and Dependent Demand

 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.
 Inventory Models for Independent Demand

Need to determine when and how much to order

 Basic economic order quantity

 Production order quantity

 Quantity discount model

 Deterministic Inventory Model

 Economic Order Quantity Model (EOQ)

Fixed Order Quantity Models.
• Economic Order Quantity Model Assumptions
Demand for the product is known with certainty, is
constant and uniform throughout the period.
Lead time (time from ordering to receipt) is known and
constant.
Price per unit of product is constant (no quantity
discounts).
Inventory holding cost is based on average inventory.
 EOQ cont…

• Ordering or setup costs are constant.

• All demands for the product will be satisfied (no back orders are
allowed).

• No stockouts (shortages) are allowed.

• The order quantity is received all at once. (Instantaneous receipt of

material in a single lot).

The goal is to calculate the order quantitiy that minimizes total cost
 EOQ cont…

• EOQ Model

Inventory Level

Order Average
Quantity Inventory
(Q) (Q/2)

Reorder
Point
(ROP)

Time
Lead Time
 EOQ cont…

• EOQ Cost Model: How Much to Order?

EOQ cont…
EOQ cont…

EOQ= Q opt. =
EOQ…
EOQ cont…
EOQ cont…
EOQ cont…
EOQ cont…
 EOQ…

• Determine the economic order quantity and the reorder point

given the following…

•Annual Demand = 10,000 units

•Days per year considered in average daily demand =
365
•Cost to place an order = $10
•Holding cost per unit per year = 10% of cost per unit
•Lead time = 10 days
•Cost per unit = $15
EOQ…
 Probabilistic Models and Safety Stock

• Used when demand is not constant or certain

• Use safety stock to achieve a desired service level and avoid stock outs

• ROP = d x L + ss

• Annual stock out costs = the sum of the units short x the probability x the stock out
cost/unit

• x the number of orders per year

Probabilistic Demand
 Production Order Quantity (Economic Lot Size) Model

• Production is done in batches or lots.

• Capacity to produce a part exceeds that part’s usage or demand rate.
• Allows partial receipt of material.
 Other EOQ assumptions apply
• Suited for production environment.
 Material produced, used immediately
 Provides production lot size
• Lower holding cost than EOQ model.
• Answers how much to order and when to order.
Production order quantity model cont…
Production order quantity model cont…
Production order quantity model cont…
Production order quantity model cont…

• Example:
Production order quantity model cont…
• Example cont..
 Quantity Discount Model

• Answers how much to order & when to order.

• Allows quantity discounts.
Price per unit decreases as order quantity increases.
Other EOQ assumptions apply.
• Trade-off is between lower price & increased holding cost.
 Quantity Discount model cont…

• Based on the same assumptions as the EOQ model, the

price-break model has a similar Qopt formula:
Quantity Discount model cont…
 Quantity Discount model cont…

• Examples:
ORDER SIZE PRICE
0 - 99 $10
100 - 199 8 (d1)
200+ 6 (d2)

• For this problem holding cost is given as a constant value, not

as a percentage of price, so the optimal order quantity is the
same for each of the price ranges. ( see the figure)
Quantity Discount model cont…
 Quantity Discount model cont…
• Example:
 Quantity Discount model cont…

• Example:
• A company has a chance to reduce their inventory ordering costs by
placing larger quantity orders using the price-break order quantity schedule
below. What should their optimal order quantity be if this company
purchases this single inventory item with an e-mail ordering cost of $4, a
carrying cost rate of 2% of the inventory cost of the item, and an annual
demand of 10,000 units?

Order Quantity(units) Price/unit($)

0 to 2,499 $1.20
2,500 to 3,999 1.00
4,000 or more .98
 Quantity Discount model cont…

 solution:
Annual Demand (D)= 10,000 units Carrying cost % of total cost (i)= 2%
Cost to place an order (S)= $4 Cost per unit (C) = $1.20, $1.00, $0.98
Quantity Discount model cont…
 Quantity Discount model cont…

• Example 2.

• The maintenance department of a large hospital uses about 816 cases of

liquid cleanser annually. Ordering costs are $12, carrying costs are $4
per case per 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. Determine the optimal order quantity and the total
cost.
 Finite Input Rate Backlogging Allowed

• The basic deterministic single item model with static demand.

Fig. Finite input rate backlogging allowe d

Finite input…

• Optimal order quantity(Q*) for this model is calculated by :

Q*= *

Where,
A= Cost of placing an order
D= Demand rate in units per year
i = Annual inventory carrying cost rate
c = unit variable cost
r = shortage cost per unit per year
P= production rate in units per year
 Infinite Input Rate Backlogging Allowed

• The basic deterministic single item model with static demand.

Fig. Infinite input rate backlogging allowed

Infinite Input
*
Rate…

• Optimal order quantity(Q*) for this model is calculated by:

Q*= *

• Where,
π = shortage cost per unit, independent of period of short

• Reading Assignment:
 Finite and infinite input rates with no backlogs
 2. Stochastic Inventory Model

• Demand and lead time are not constant.

• Answer how much & when to order.

• It assumes that the demand over a period of time is

normally distributed with a mean and a standard deviation.

• It considers only the probability of running out of stock.

 2.1 Single Period Inventory Models

• Single period refers to the situation where the inventory will only
be demanded in one time duration, and cannot be transferred to
the next time duration.

Newspaper selling is such an example. The newspaper ordered

for today will not be sold tomorrow. Fashion selling is another
example. Spring-summer designs will not sell during the
autumn-winter season.
 Single Period…

• Optimal order quantity for a single-period inventory model :

 The increment analysis addresses the how-much-to-order question by
comparing the cost or loss of ordering one additional unit with the cost or
loss of not ordering one additional unit.
 Co= cost per unit of overestimating demand
This cost represents the loss of ordering one additional unit which
will not sell.
 Cu = cost per unit of underestimating demand
This cost represents the loss of not ordering one additional unit
which could have been sold.
 Single Period…

• Suppose that the probability of the demand of the inventory items

being more than a certain level y is P(D>y), and that the
probability of the demand of the inventory items being less than or
equal to this level y is P(D≤y). Then, the expected loss (EL) will be
either of the following:

• For over estimation: EL(y+1) = Co P(D≤y)

• For underestimation: EL(y) = Cu P(D>y)

 Single Period… cont…

• From the study of Probability, it is known that

P(D>y*) = 1 - P(D≤y*)

P(D≤y*) = Cu /(Cu + Co)

• The above expression provides the general condition for the optimal order
quantity y* in the single-period inventory model. The determination of y*
depends on the probability distribution.
 Single Period…

• Ex: (uniform probability distribution)

• Emma’s Shoe Shop is to order some new design men’s shoes for the next
spring-summer season. The shoes cost £40 per pair and retail £60 per pair. If
there are still shoes not sold by the end of July, they will be put on clearance
sale in August at the price of £30 per pair. It is expected that all the remaining
shoes can be sold during the sale.

• For the size 10D shoes, it is found that the demand can be described by the
uniform probability distribution, shown in Figure below . The demand range
is between 350 and 650 pairs, with average, or expected, demand of 500 pairs
of shoes.
 Single Period…
• Determine the order quantity.
Solution:
 It is essential to work out the overestimating cost Co and the
underestimating cost Cu.
 The cost per pair of overestimating demand is equal to the purchase
cost minus the sale price per pair; that is
Co = £40 - £30 = £10
 The cost per pair of underestimating demand is the difference between
the regular selling price and the and the purchase cost; that is
 Single Period…

Cu = £60 - £40 = £20

Then,

P(D≤y*) = Cu /(Cu + Co) = 20/(20+10) = 2/3

• We can find the optimal order quantity y* by referring to the assumed

probability distribution shown in Figure below and finding the value of
y that will provide P(D≤y*) = 2/3. To do this, we note that in the
uniform distribution the probability is evenly distributed over the entire
range of 350 - 650.
 Single Period…

• Thus, we can satisfy the expression for y* by moving two-

thirds of the way from 350 to 650. That gives

350 + 2/3 (650-350) = 550 pairs

namely, the optimal order quantity of size 10D shoes is 550

pairs.
 2.2 Fixed Order Quantity Model

• It attempts to determine the specific point, R , at which an order will be

placed and the size of that order, Q .

• In the majority of cases, though, demand is not constant but varies from
day to day. Safety stock must therefore be maintained to provide some
level of protection against stock outs.

• Safety stock can be defined as the amount of inventory carried in

addition to the expected demand.
Fixed Order Quantity Model cont…
 Fixed Order Quantity Model cont…

• The quantity to be ordered, Q , is calculated in the usual way

considering the demand, shortage cost, ordering cost, and holding
cost.

• A fixed–order quantity model can be used to compute Q , such as

the simple Q opt model.

• The reorder point is then set to cover the expected demand during
the lead time plus a safety stock determined by the desired service
level.
 Fixed Order Quantity Model cont…

• The reorder point is

R= d L + ZσL
where,
R = Reorder point in units
d = Average daily demand
L = Lead time in days (time between placing an order and receiving
the items)
z = Number of standard deviations for a specified service probability
σL = Standard deviation of usage during lead time
 Fixed Order Quantity Model cont…

• The term ZσL is the amount of safety stock. Note that if safety stock is
positive, the effect is to place a reorder sooner. That is, R without safety
stock is simply the average demand during the lead time.

• If lead time usage was expected to be 20, for example, and safety stock
was computed to be 5 units, then the order would be placed sooner,
when 25 units remained. The greater the safety stock, the sooner the
order is placed.
Fixed Order Quantity Model cont…

• For the daily demand situation, d can be a forecast demand

using any of the models. For example, if a 30-day period
was used to calculate d , then a simple average would be
 Fixed Order Quantity Model cont…

• Consider an economic order quantity case where annual demand

D = 1,000 units, economic order quantity Q = 200 units, the
desired probability of not stocking out P = .95, the standard
deviation of demand during lead time L = 25 units, and lead
time L = 15 days. Determine the reorder point.
• Assume that demand is over a 250-workday year.
Fixed Order Quantity Model cont…
 2.3 Fixed – Time Period Models

• In a fixed–time period system, inventory is counted only at particular

times, such as every

week or every month.

• Counting inventory and placing orders periodically are desirable in

situations such as when vendors make routine visits to customers and
take orders for their complete line of products, or when buyers want to
combine orders to save transportation costs.
 Fixed – Time Period Models cont...

• Fixed–time period models generate order quantities that vary from

period to period, depending on the usage rates. These generally require a
higher level of safety stock than a fixed–order quantity system.

• The fixed–order quantity system assumes continual tracking of

inventory on hand, with an order immediately placed when the reorder
point is reached.

• In contrast, the standard fixed–time period models assume that

inventory is counted only at the time specified for review.
Fixed – Time Period Models cont...

• In a fixed–time period system, reorders are placed at the

time of review ( T ), and the safety stock that must be
reordered is
Safety stock =zσT+L
 Fixed – Time Period Models cont...

• The above figure shows a fixed–time period system with a review

cycle of T and a constant lead time of L. In this case, demand is
randomly distributed about a mean d . The quantity to order, q , is
Fixed – Time Period Models cont...
 Fixed – Time Period Models cont...

• Daily demand for a product is 10 units with a standard deviation of 3 units. The review period is 30

days, and lead time is 14 days. Management has set a policy of satisfying 98 percent of demand from

items in stock. At the beginning of this review period, there are 150 units in inventory. How many units

should be ordered?
 The Newsboy Model

• It is a single period inventory model.

• This model is applied to solve problems related with the daily news paper.

• At the start of each day, a newsboy must decide on the number of papers to
purchase. Daily sales cannot be predicted exactly, and are represented by the
random variable, D.
• The newsboy must carefully consider these costs:
co = unit cost of overage
cu = unit cost of underage

• It can be shown that the optimal number of papers to purchase is the fractal of the
demand distribution given by
P = cu / (cu + co).
 Newsboy cont..

• The classic illustration of this problem involves a newsboy who must purchase a
quantity of newspapers for the day's sale. The purchase cost of the papers is $0.10 and
they are sold to customers for a price of $0.25. Papers unsold at the end of the day are
returned to the publisher for $0.02. The boy does not like to disappoint his customers
(who might turn elsewhere for supply), so he estimates a "good will" cost of $0.15 for
each customer who is not be satisfied if the supply of papers runs out. The boy has
kept a record of sales and shortages, and estimates that the mean demand during the
day is 250 and the standard deviation is 50. A Normal distribution is assumed. How
many papers should he purchase?

This is a single-period problem because today's newspapers will be obsolete tomorrow.

Newsboy cont..
Newsboy cont..

• P = 0.7895
• Z score = 0.8022 ~ 0.805
Q* = μ + Zσ
= 250 + 0.805*50
= 290.2
 ABC Analysis

• Demand volume and value of items vary

• Items kept in inventory are not of equal importance in terms of:
 dollars invested
 profit potential
 sales or usage volume
 stock-out penalties
ABC …

•Classifying inventory according to some measure of importance and

allocating control efforts accordingly.

• A - very important
High
• B - mod. important A
Annual
• C - least important $ value
of items
B

Low
C
Low High
Percentage of Items
ABC …
ABC …
ABC …
ABC …
ABC …
ABC …