MODULE

LESSON 5

INVENTORY MANAGEMENT

OVERVIEW
The section discusses the primer on inventory management. It has considered the
importance of having sufficient stock on hand so as not to delay production or to keep the
customer waiting longer that is acceptable .However, holding cost is a cost . Stocks of
inventory are a major asset in manufacturing an retailing and in the intermediate stages of
distributing and warehousing .This chapter will cover several approaches to inventory
management within the supply chain.

MODULE OBJECTIVES
At the end of the module , the students are expected to:
 Gain understanding of functions of inventory ,
 Learn the types of inventory models and ordering policies,
 Understand the requirements for effective inventory management.

COURSE MATERIALS:

5.0 INVENTORY MANAGEMENT- Introduction

An inventory is a stock or store of goods. Inventories are a vital part of business. Not only
are they necessary for operations, but they also contribute to customer satisfaction. The
major source of revenues for retail and wholesale businesses is the sale of merchandise. In
fact, in terms of dollars, the inventory of goods held for sale is one of the largest assets of a
merchandising business. The different kinds of inventories include the following:
 Raw materials and purchased parts.
 Partially completed goods, called work-in-process (WIP).
 Finished-goods inventories (manufacturing firms) or merchandise (retail stores).
 Tools and supplies.
 Maintenance and repairs (MRO) inventory.
 Goods-in-transit to warehouses, distributors, or customers (pipeline inventory).

 Functions of inventories :
1. To meet anticipated customer demand.
2. To smooth production requirements.
3. To decouple operations.
4. To protect against stockouts.
5. To take advantage of order cycles.
6. To hedge against price increases.
7. To take advantage of quantity discounts.
8. To permit operations.

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 Little’s Law- The average amount of inventory in a system is equal to the product of the
average demand rate and the average time a unit is in the system.
 Inadequate control of inventories can result in both under- and overstocking of items.
 Understocking results in missed deliveries, lost sales, dissatisfied customers, and
production bottlenecks; overstocking unnecessarily ties up funds that might be more
productive elsewhere.

Inventory management has two main concerns:

 One is the level of customer service, that is, to have the right goods, in sufficient
quantities, in the right place, at the right time.
 The other is the costs of ordering and carrying inventories. The overall objective of
inventory management is to achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds.

Performance measures that can be used to judge the effectiveness of inventory

management.:
 The most obvious, of course, is customer satisfaction, which they might measure by
the number and quantity of backorders and/or customer complaints.
 A widely used measure is inventory turnover, which is the ratio of annual cost of goods
sold to average inventory investment. The turnover ratio indicates how many times a
year the inventory is sold. Generally, the higher the ratio, the better, because that implies
more efficient use of inventories. Managers often use inventory turnover to evaluate
inventory management performance; monitoring this metric over time can yield insights
into changes in performance.
 Another useful measure is days of inventory on hand, a number that indicates the
expected number of days of sales that can be supplied from existing inventory. Here, a
balance is desirable; a high number of days might imply excess inventory, while a low
number might imply a risk of running out of stock.

Requirements for effective inventory management:

1. A system to keep track of the inventory on hand and on order. (Inventory Counting
Systems)
 Inventory counting systems can be periodic or perpetual.
 Under a periodic system, a physical count of items in inventory is made at periodic
intervals (e.g., weekly, monthly) in order to decide how much to order of each item.
 Supermarkets, discount stores, and department stores have always been major users of
periodic counting systems.
 A perpetual inventory system (also known as a continual system) keeps track of
removals from inventory continuously, thus monitoring current levels of each item.
Perpetual systems range from very simple to very sophisticated.
 A two-bin system, a very elementary system, uses two containers for inventory, then,
reorders when the first is empty..
 Most have switched to computerized checkout systems using a laser scanning device
that reads a universal product code (UPC), or bar code, printed on an item tag or on
packaging.
 Point-of-sale (POS) systems electronically record actual sales.
 Radio frequency identification (RFID) tags are also used to keep track of inventory in
certain applications.

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2. A reliable forecast of demand that includes an indication of possible forecast error.

3. Knowledge of lead times and lead time variability.

Lead time- is the time interval between ordering and receiving the order.

4. Reasonable estimates of inventory holding costs, ordering costs, and shortage costs.
Purchase cost is the amount paid to a vendor or supplier to buy the inventory. It is typically
the largest of all inventory costs.
Holding, or carrying, costs relate to physically having items in storage. Ordering costs are
the costs of ordering and receiving inventory. When a firm produces its own inventory
instead of ordering it from a supplier, machine setup costs are analogous to ordering costs;
that is, they are expressed as a fixed charge per production run, regardless of the size of the
run.
Shortage costs are costs resulting when the demand exceeds the supply of inventory; often
unrealized profit per unit.

5. A Classification system for inventory items using A-B-C Approach/ ABC Analysis
ABC ANALYSIS
 Divides on- hand inventory item into three classification on the basis of annual dollar
volume. ABC analysis is an inventory application of what is known as Pareto principle.
 The Pareto principle states that there are a “ critical few and trivial many”.
 The idea is to establish inventory policies that focus resources on the “few critical “
inventory parts and not the trivial many.
 It is no realistic to monitor inexpensive items with the same intensity as very
expensive items.
 To determine the annual volume for ABC analysis , we measure the annual demand of
each inventory item times the cost per unit .

Class A items are those on which the annual dollar volume is high. Although such items may
represent only about 15% of the total inventory items, they represent 70% to 80% of the total
dollar usage.

Class B items are those inventory items of medium annual dollar volume. These items may
represent that 30% of inventory items and 15% to 25% of the total value sale.

Class C items are those with low annual dollar volume which may represent only 5% of the
annual dollar volume but about 55% of the total inventory items.

Example #1:
Silicon Chips , Inc, maker of super –fast DRAM chips, has organized its 10 inventory items
on an annual dollar –volume basis. Show below are the items ( identified by stock number ), their
annual dollar volume basis. Shown below are the items ( identified by stock number , their annual
demand, unit cost , annual dollar volume , and the percentage of the total represented of the
total represented by each item. In the table below, we show these items grouped into ABC
classifications:.

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 ABC CALCULATION

Item Percent Annual x Unit = Annual Percent class

Stock of volume cost dollar of
Number number (units) volume annual
of items dollar
stocked volume
#10286 1,000 $90.00 $90,000 38.8% A
#11526 500 154.00 77,000 32.2% A
#12760 1,550 17.00 26,350 11.3% B
#10867 350 2.86 15,001 6.4% B
#10500 1.000 12.50 12,500 5.4% B
#12572 600 14.17 8,502 3.7% C
#14075 2,000 0.60 1,200 0.5% C
#01036 100 8.50 850 0.4% C
#01307 1,200 0.42 504 0.2% C
#10572 250 0.60 150 0.1% C
$232,057 100.0%

 Criteria other than annual dollar volume can determine item classification. For instance ,
anticipated engineering changes, delivery problems, quality problems, or high unit cost
,may dictate upgrading items to a higher classification. The advantage of dividing
inventory items into classes allows policies and controls to be established for each class.

Policies that may be based on ABC analysis include the following :

1. Purchasing resources expended on supplier development should be much higher for
individual A items than for C items.
2. A items , as opposed to B and C items , should have tighter physical inventory control:
perhaps they belong in a more secure area, and perhaps the accuracy of inventory records
for A items should be verified more frequently.
3. Forecasting A items may warrant more care than forecasting other items.

 Another application of the A-B-C concept is as a guide to cycle counting, which is a

physical count of items in inventory.

The key questions concerning cycle counting for management are:

1. How much accuracy is needed?
2. When should cycle counting be performed?
3. Who should do it?

Operations Strategy
Inventories often represent a substantial investment. More important, improving
inventory processes can offer significant benefits in terms of cost reduction and customer
satisfaction. Among the areas that have potential are the following:

 Record keeping. It is important to have inventory records that are accurate and up to
date, so that inventory decisions are based on correct information. Estimates of holding,
ordering, and setup costs, as well as demand and lead times, should be reviewed
periodically and updated when necessary.

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 Variation reduction. Lead time variations and forecast errors are two key factors that
impact inventory management, and variation reduction in these areas can yield
significant improvement in inventory management.
 Lean operation. Lean systems are demand driven, which means that goods are pulled
through the system to match demand instead of being pushed through without a direct
link to demand.
 Supply chain management. Working more closely with suppliers to coordinate
shipments, reduce lead times, and reduce supply chain inventories can reduce the size
and frequency of stockouts while lowering inventory carrying costs.

 INVENTORY ORDERING POLICIES

Inventory ordering policies address the two basic issues of inventory management,
which are HOW MUCH TO ORDER and WHEN TO ORDER. In the following sections, a
number of models are described that are used for these issues. Inventory that is intended to
meet expected demand is known as cycle stock, while inventory that is held to reduce the
probability of experiencing a stockout (i.e., running out of stock) due to demand and/or lead time
variability is known as safety stock.

 HOW MUCH TO ORDER : THE ECONOMIC QUANTITY MODELS (EOQ MODELS )

The question of how much to order is frequently determined by using an economic order quantity
model (EOQ) model. EOQ models identify the optimal order quantity by minimizing the sum of
certain annual costs that vary with order size. These order size models are described here :

 THE BASIC ECONOMIC ORDER QUANTITY MODEL

 THE ECONOMIC PRODUCTION QUANTITY MODEL.
 THE QUANTITY DISCOUNT MODEL

The Basic EOQ model – simplest among the three models . It is used to identify the order
size that will minimize the sum of the annual costs of holding and ordering the inventory.

BASIC ASSUMPTIONS :
1. only one product is involved .
2. Annual demand requirements are known.
3. demand is spread evenly throughout the year so that the demand rate is reasonably
constant.
4. Lead time does not vary.
5. Each order is received in a single delivery.
6. There are no quantity discounts.

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Figure I. The inventory cycle : Profile of inventory level over time.

Q
Q = 350 units
Qty on hand usage rate = 50 units per day

Reorder - - - - - - - - - - - - - - -- - - - - - - - -- - - - - - - - - - -- - - - - --
Point =100 units

0 5 7 12 14 DAY

place order receive order

lead time= 2 days
Given: Order size = 350 ; usage rate = 50 units per day; lead time = 2 days :

Reorder point (ROP) = 100 units ( 2 days supply)

ANNUAL CARRYING COSTS ( C. C.):

Annual carrying cost = Q H where : Q = order quantity in units; H = holding ( carrying )

2
Figure .
A). Carrying costs are linearly related to order size B). Ordering costs are inversely and non-
linearly related to
QH order size
Annual 2 Annual cost
DS
Cost Q

Order quantity order quantity

Where: S= ordering cost
C.) The total cost curve is U-shaped

Annual cost total cost ( TC) = Qx H + D xS

2 Q
CC

OC

Order quantity

Qo ( intersection of OC and CC and where the TC is at the lowest )

ANNUAL ORDERING COST ( O. C. ) = D ( S)

Q
where : D = demand , usually in units per year; S= ordering costs

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 The number of order per year , D/Q decreases as Q increases, annual ordering cost is
inversely related to order size

THE TOTAL ANNUAL COST (TC) FORMULA :

The total annual cost associated with carrying and ordering inventory when Q units are
ordered each time is :

TC = (annual carrying cost + annual ordering cost ) = Q x H + Dx S

2 Q

( Note : D and H must be in the same units , e.g. months , years) . Figure C - reveals that the
total cost curve is u shaped and that it reaches its minimum quantity at the quantity where
carrying and ordering costs are equal.

 Carrying cost is sometimes stated as a percentage of the purchase price of an item rather
than as a dollar amount per unit . However, as long as the percentage is converted into a
dollar amount , the EOQ formula is still appropriate .

THE OPTIMAL ORDER QUANTITY ( Qo) OR THE ECONOMIC ORDER QUANTITY (EOQ)
FORMULA :
Qo = √2𝐷𝑆
𝐻

Length of order cycle = Qo

D

Example 1:

A local distributor for a national tire company expects to sell 9,600 steel belted radial
tires of a certain size and tread design nest year . Annual carrying cost is $ 16 per tire, and
ordering cost is $ 75 . The distributor operates 288 days a year.
a. What is the EOQ? (Qo)
b. How many times per year does the store reorder?.
c. What is the length of an order cycle?.
d. What is the total annual cost if the EOQ quantity is ordered?. ( TC)

2𝐷𝑆 2 ( 9600)75
a. Qo = √ =√ = 300 tires
𝐻 16
b. No of orders/ year = D/ Qo = 9,600/300 = 32 times or order
c. Length of order cycle =( 300 tires / 9,600 tires per year) x 288 days = 7 work-days
d. Total cost (TC) = CC+ OC = (Qox H )/2 + (D x S/Qo) = (300 x 16)/2 + (9,600 x 75)/300
= $4,800
Example 2:
ABC manufacturing assembles security monitors . It purchases 3,600 black – and – white
cathode ray tubes a year at $ 65 each. Ordering costs are $31 , and annual carrying cost s are
20% of the purchase price. Compute the optimal quantity and the total annual cost of ordering
and carrying the inventory.

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2𝐷𝑆 2 ( 3600)31
a). Qo = √ =√ = 131 Cathode ray tube
𝐻 13

b). TC = CC + OC = (Qo x H )/2 + (D x S/Qo)= (131)(13)/2 + (3600x 31 )/ 131 = $852 +$ 852 =

TC $1,704

ECONOMIC PRODUCTION QUANTITY (EPQ)

-The batch mode is widely used in production .

Assumptions of the EPQ model

(Similar to EPQ model; except that instead of orders received in a single delivery, units are
received incrementally during production).

1. Only one item is involved.

2. Annual demand is known.
3. The usage rate is constant.
4. Usage occurs continually, but production occurs periodically.
5. The production rate is constant.
6. Lead time does not vary.
7. There are no quantity discounts.

Formulas:

TOTAL COST = (CARRYING COST + SET–UP COST)

TC = CC + SET- UP COST

TC = I max_ . H + D __ S
2 Qo

where:
I max = maximum inventory
H = holding ( carrying) cost per unit
D = demand , usually in units per year
S = ordering cost
Qo = EOQ

 The ECONOMIC RUN QUANTITY (Qo) is :

Qo = 2DS . _p_
H p- u

where:
p = production or delivery rate
u = usage rate

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The cycle time – (the time between orders or between the beginning of runs) for the economic
run size model is a function of run size and usage (demand ) rate .

Cycle time = Qo
u

The run time ( the production phase of the cycle 0 is a function of the run size and the production
rate :
Run time = Qo
p

The Maximum and average inventory levels are :

I max = Qo ( p- u)
p

I average = I max
2

Application Problem #1:

A toy manufacturer uses 48,000 rubber wheels per year for its popular dump truck series.
The firm makes its own wheels , which it can produce at a rate of 800 per day. The toy trucks are
assembled uniformly over the entire year. Carrying cost is $ 1 per wheel a year. Set up cost for a
production run of wheels is $45. the firm operates 240 days per year.
Determine the :
a). Optimal run size.
b). minimum total annual cost for carrying and set up.
C). cycle time for the optimal run size.
D). run time .

Solution:
Given :
D = 48,000 wheels per year ; p = 800 wheels / year
S = $45 ; H= $1 per wheel per year
u = 48,000 wheels per 240 days or 200 wheels per day

a).
Qo = 2DS . _p_ = 2 ( 48,000 (45) . ___800___
H p- u 1 800- 200

Qo= 2,400 wheels

b).
Total cost minimum= carrying cost + Set –up cost
TC = I max_ H + D __ S
2 Qo

TC min = 1,800 x $1 + 48,000 x $45

2 2,400

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TC min= $ 900 + $900 = $1,800

Where :
I max = Qo ( p- u) = 2,400 ( 800 –240)
p 800
I max = 1,800 wheels

Note : The equality of set-up and carrying costs at the EOQ exists.

C.
Cycle time = Qo = 2,400 wheels = 12 days
u 200 wheels per day

*Thus, a run of wheels will be made every 12 days

d). Run time = Qo = 2,400 wheels ___ = 3 days

p 800 wheels per day

* Thus , each run will require three days to complete.

 QUANTITY DISCOUNTS

Quantity discounts- are price reductions for large orders offered to customers to reduce
them to buy in large quantity.

Total cost = carrying + ordering + purchasing

cost cost cost

TC = Q H + D S + PD
2 Q
where : P = unit price ; D = annual usage

Cost TC with PD

TC without PD

0 EOQ Quantity

Figure I. Adding PD does not change the EOQ.

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Example :

Order quantity Price list for different quantities

Price per box
1 to 44 $2.00
45 to 69 $1.70
70 or more $ 1.40

 The procedure for determining the overall EOQ differs slightly, depending on which of these
2 cases is relevant. For carrying costs that are constant, the procedure is as follows :

1. Compute the common minimum point .

2. Only one of the unit prices will have the minimum I its feasible range since the ranges do not
overlap. Identify that range .

a). If the feasible minimum point is on the lowest price range, that is the optimal order
quantity.

b). If the feasible minimum point is in any other range , compute the total cost for the
minimum point and for the price breaks of all lower unit costs. Compare the total costs; the
quantity ( minimum point or price breaks) that yields the lowest total cost is the optimal order
quantity.

Example : ( Quantity discounts)

The maintenance department of a large hospital uses about 816 cases of liquid cleanser
annually. Ordering costs are $12 , carrying costs are 44 per case a year, and the new price
schedule 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 costs.

Given : D = 816 cases per year ; S = $ 12

H = $ 4 per case per year

Range Price
1 to 49 $ 20
50 to 79 18
80 to 99 17
100 or more 16

1). EOQ = 2DS

H

= 2 ( 816) ( 12) = 70 cases

4

2). The 70 case can be bought at $ 18 :

TC (70) = ( Q/2) H + (D/Qo) S + PD

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TC (70) = ( 70/2 ) ( 4) + (816/ 80) (12) + 18 ( 816)= $14,968

TOTAL COST AT LOWER PRICES :

TC ( 80) = ( 80/2) ( 4) + (816/80) ( 12) + 17 ( 816) = $14,154

TC (100) = (100/2) ( 4) + (816/100) ( 12) + 16 ( 816) = $13,354

 Because 100 cases per order yields the lowest total cost , 100 is the overall OPTIMUM
QUANTITY.

 REORDER POINT

 When to reorder with EOQ ordering :

Reorder Point – when the quantity on hand of an item drops to this amount , the item is reordered.

FOUR DETERMINANTS OF THE REORDER POINT QUANTITY :

1. The rate of demand ( usually based on a forecast).
2. The lead time.
3. The extent of demand and /or lead time variability.
4. The degree of stock out risk acceptable to management .

 The REORDER POINT (ROP) if the demand and lead time are both constant :

ROP = d x LT
where : d = demand rate ( units per day or week)
LT = lead time in days or weeks.

Note : demand and lead time have the same time units .

Example : Reorder point (ROP)

Mr Gigolo takes two- a- day vitamins , which are delivered to his home by a route men
seven days after an order is called in. At what point should the man reorder?.
Given : usage = 2 vitamins a day
Lead time = 7 days
Solution:
ROP = usage x lead time
= 2 vitamins per day x 7 days
ROP = 14 Vitamins

 ROP WITH SAFETY STOCK

ROP = ( Expected demand + Safety stock )
during lead time

Service level = 100 percent - stock out risk

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 The amount of safety stock that is appropriate for a given situation depends on the
following :

1.The average demand rate and average lead time

2. Demand and lead time variability .
3. The desired service level.

 ROP MODELS when variability is present :

ROP = (Expected demand + ZσdLT )

during lead time

where:
Zσdlt = safety stock during lead time
Z = number of standard deviations
σdLT = the standard deviation of lead time demand

Example 1:(Reorder point )

Suppose that the manager of a construction supply house determined from historical
records that demand for sand during lead time averages 50 metric tons. In addition, suppose the
manager determined that demand during lead time could be described by a normal distribution
that has a mean of 50 metric tons and a standard deviation of 5 metric tons . Answer the given
questions below, assuming that the manager is willing to accept a stock out risk of no more than
3 percent .

Graph :

Service
level

Risk of stock out

QUANTITY
Expected demand ROP
Safety stock

0 z – scale

Answer the following questions:

a). What value of z is appropriate?.
b). How much safety stock should be held?.
c). What reorder point should be used ?.

Given :
Expected lead time demand = 50 tons
σdLT = 5 tons
stock out risk = 3 percent

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Solution and Answers :

a). From Appendix Table B, using a service level of 1 –0.03 = 0.9700 , you obtain a value of
Z = +1.88

b). Safety stock (SS)= (Z)( σdLT)= 1.88 ( 5) = 9.40 tons

c).ROP =(expected demand during lead time + S.S.)

= (50 + 9.40 ) = 59.40 tons

Other formulas for ROP:

ROP, when only the demand is variable :

ROP = d x LT + Z LT σd
where :
d = average demand or weekly demand
σd = standad deviation of demand per day or week.
LT = lead time in days or weeks .

ROP ,when only the Lead Time Is Variable :

ROP = d x LT + Z (d) ( σ LT )

Where :
D = daily /weekly demand or lead time
LT = average lead time in days or week
σ LT = standard deviation of lead time in days or week.

ROP , when both the demand and lead time are variable :

σdLT= LT σ2d +d2 σ2LT

ROP = d x LT + Z LT σ2d + d2 σ2LT

Note : Each of these models assumes that demand and lead time are independent.

Example : ( lead time is constant, demand is variable )

A restaurant uses an average of 50 jars of a special sauce each week. Weekly usage of
sauce has a standard deviation of 3 jars. The manager is willing to accept no more than 10 percent
risk of stock out during lead time , which is two weeks . Assume the distribution of usage is normal.

a). Which of the above formulas is appropriate for this situation?. Why?.
b). determine the value of Z.

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TC = 40.25 (30) + 4860(4) = $1207.48

2 40.25
Findings : There was an increased in Total cost of (1207.48 – 1080)= $ 127.48

2. Porkys Sausage Company (PSC) can produce hotdogs at a rate of 5,000 per day. FSC
supplies hotdogs to local stores and restaurants at a steady rate of 250 per day. The cost to
prepare the equipment for producing hotdogs is $22 . Annual holding costs are 15 percent per
hotdog. The factory operates 300 days a year . Find :
a. the optimal run size
b. the number of runs per year .
c. the length ( in days ) of a run

Solution and answers :

Given : 250( 300) = 75,000 hotdogs , P= 5000 hotdogs
U = 250 hotdogs , S= $22 / order , H = $0.15 / hotdog

2𝐷𝑆 𝑝 2 ( 75000) 22 50000

a. Qo = √ . √𝑝−𝑢 = √ √ = 4812.27 hotdogs or 4812
𝐻 0.15 5000−250

b. Number of runs per year = D /QO = 75000/4812.27 = 16 runs /year

c. Length of run = Qo/p = 4812.27 /5000 = 0.96 day

3). ROP for constant demand and variable lead time :

Las Palmas Microtel uses approximately 600 sachet shampoos each day , and this tends to
be fairly constant . Lead time for shampoo delivery is normally distributed with a mean of six
days and a standard deviation of 2 days . A service level of 90 percent is desired ,
a. Find the ROP
b. How many days of supply are on hand at the ROP?

Solution and answers :

Given; d= 600 sachet shampoos per day( constant demand)
SL= 90 % , so z = +1.28( Areas under Normal curve
LT = 6 days ( variable lead time)
LT = 2 days

a. ROP = d x LT + Z (d) ( σ LT ) = 600 (6) + 1.28 (2) (600) = 5,136 shampoo sachets

b. ROP = 5,136 = 8.56 days

d 600

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