Inventory control

Lecture 1 (LE)

Copyright ©2013 Pearson Education.

1 1-1
Organization

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Disclaimer
The models and methods discussed are the easier / theoretically
nice ones. In practice things are ALWAYS more complicated!

So please NEVER just apply one of the methods learned blindly.

Thoroughly check the assumptions made in the model.
Adapt the model/method or search for other methods in case
the assumptions are not met. Be critical and use your research
skills.

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Literature
1. Chopra & Meindl, Supply Chain Management
(CH 11/12)
(Search Google for “ TEXTBOOK-SUNIL CHOPRA 5th ed.pdf ”)

2. Chase & Acquilano, Operations management

(14th ed: CH 20 Inventory management)

3. Presentations; Portal

If you ever must manage inventories for real:

• David J. Piasecki , Inventory management explained!
• Tony Wild, Best practice in inventory management
• Max Muller, Essentials of inventory management
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Topics for today

• Intro inventory management

• EOQ
• Derivation
• Robustness / sensitivity
• In practice
• Extension: planned shortages
• Homework

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Inventory management /
Stock control
Stock control encompasses:
• Forecasting (CAS 1.4)
• Lot sizing (wk 1 – 4, 8)
• Calculating safety stock (wk 5 – 6, 7)
• Inventory classification and analysis (wk 9)
• Operational: the actual ordering/replenishment
• Systems: transactional control → inventory accuracy

11-6
Targets are related to
• Customer service
– Measured as stock availability or delivery on time
– Assessment of customer satisfaction – survey results
• Operating costs
– Warehousing and inventory operations costs
– Cost per transaction, movement and purchase
• Inventory investment

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(In)dependent demand

11-8
 For 2000 different
SKU’s!!
Three main decisions:
1. The review interval (how often…)
2. The reorder point (when…)
3. The order quantity / lot size (how much…)
11-9
Importance of order quantity
Most important factor in total inventory investment (= largest
investment of a business)!

Most businesses do a lousy job of determining order quantities

• Use of simple but wrong guidelines
• Mistakes in inputs to calculations and performing the
calculations

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Relevant cost related to order quantity
Order cost includes all costs that are incurred each time an
order is placed

Holding cost is the cost of carrying one unit in inventory for a

specified period of time (cost of investment and storing)

As order quantity (𝑄)

goes up, order cost goes
down and holding cost
goes up

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Ordering in lots results in cycle stock
Remember the difference between inventory on hand (physical)
and inventory position (economic)!

𝑄
Cycle stock 𝐶𝑆 = is the average inventory on hand in a
2
supply chain as a consequence of lot sizes (𝑄). Smaller lot sizes
result in less cycle stock.

What is the ideal lot size 𝑄?

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Lot sizing for a single product (EOQ)
EOQ (economic order quantity) is the order quantity that result in the
lowest overall cost to the company.

Inputs
𝐷 = Annual demand of the product
𝑆 = Fixed cost incurred per order/setup
𝐶 = Cost per unit of product
ℎ = Holding cost per year as a fraction of product cost

Basic assumptions
• Demand is steady at D units per unit time; no demand variability
• Replenishment lead time is fixed Rule of thumbs: demand
• No shortages allowed is regular when variation
• Lot arrives complete coefficient < 1 (after
• Price is fixed outlier correction!)
• Orders can be placed at any time

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Lot sizing decision
Choose 𝑄 to minimize total relevant annual costs (𝑇𝐶), existing of
• Annual ordering/setup cost
𝐷
= number of orders per year ∙ 𝑆 = 𝑆
𝑄
• Annual carrying/holding cost
𝑄
= cycle inventory ∙ ℎ𝐶 = ℎ𝐶
2

𝐷 𝑄
𝑇𝐶(𝑄) = 𝑆+ ℎ𝐶
𝑄 2

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 Lot sizing for a single product

In the minimum the following two conditions must hold:

- The first order derivative 𝑇𝐶 ′ 𝑄∗ = 0 (slope is zero)
- The second order derivative 𝑇𝐶 ′′ 𝑄∗ > 0 (slope is increasing all the time)

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Derivation of optimal lot size 𝑄 ∗

𝐷𝑆 ℎ𝐶
• 𝑇𝐶 ′ 𝑄 = − + =0
𝑄2 2
𝐷𝑆
• 𝑇𝐶 ′′ 𝑄 = >0 → is true for 𝑄 > 0
𝑄3

𝐷𝑆 ℎ𝐶
2
=
𝑄 2
2𝐷𝑆
= ℎ𝐶
𝑄2
2
2𝐷𝑆
𝑄 =
ℎ𝐶
2𝐷𝑆
Optimal 𝑄 (=EOQ): 𝑄 ∗ =
ℎ𝐶

2(𝑂𝑟𝑑𝑒𝑟𝐶𝑜𝑠𝑡)(𝐴𝑛𝑛𝑢𝑎𝑙𝐷𝑒𝑚𝑎𝑛𝑑)
In words: EOQ =
𝐴𝑛𝑛𝑢𝑎𝑙𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔𝐶𝑜𝑠𝑡𝑃𝑒𝑟𝑈𝑛𝑖𝑡

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Lot Sizing for a Single Product (EOQ)
The Economic Order Quantity (EOQ)

∗ 2𝐷𝑆
Optimal lot size Q =
ℎ𝐶

𝐷
Order frequency 𝑛=
𝑄

average inventory 𝑄
Average flow time (in time units) = =
demand per time unit 2𝐷

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Example 1
Demand: 1000 units per month
Order cost per order: $ 4000
Product purchase price: $ 500
Product selling price: $ 600
Holding cost per year as a fraction of unit cost: ℎ = 0.2

Questions
1. What is the optimal lot size?
2. What is the optimal order frequency?
3. Calculate the resulting total annual inventory holding and
ordering cost
4. What is the average flow time for the cycle inventory?

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Calculations
𝐷 = 12000, 𝑆 = 4000, 𝐶 = 500, ℎ = 0.2
1. What is the optimal lot size?

𝑜𝑝𝑡
2 ∙ 12000 ∙ 4000
𝐸𝑂𝑄 = 𝑄 = = 980
0.2 ∙ 500
2. What is the optimal order frequency?
𝐷 12000
= = 12.24
𝑄 980
3. Calculate the resulting total annual order and holding
12000 980
cost: 𝑇𝐶 = ∙ 4000 + ∙ 0.2 ∙ 500
980 2
= 48980 + 49000 = 97980
4. What is the average flow time for the cycle inventory?
𝑄 980
= = 0.041 years (= 0.49 months)
2∙𝐷 2∙12000

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Model in Excel

EOQ model Lot size Order Cost Holding Cost Total cost
980 48990 48990 97980 1

Inputs Value Units Lot size Order Cost Holding Cost Total cost
Demand, D 12000 pieces per year 50 960000 2500 962500
Fixed order cost, S 4000 € per order 100 480000 5000 485000 400000
Cost per unit, C 500 € per piece 150 320000 7500 327500
350000
Holding cost, h 0,2 % per piece per year 200 240000 10000 250000
Days in a year 365 days 250 192000 12500 204500 300000
300 160000 15000 175000 250000
Outputs Value Units 350 137143 17500 154643 200000
EOQ 980 pieces per order 400 120000 20000 140000
150000
Number of orders per year 12,25 450 106667 22500 129167
Cycle inventory (pieces) 490 pieces 500 96000 25000 121000 100000
Cycle inventory (value) 244949 € 550 87273 27500 114773 50000
Cycle inventory (days) 14,90 days 600 80000 30000 110000
0
Annual inventory holding cost 48990 € 650 73846 32500 106346 5
Annual order cost 48990 € 700 68571 35000 103571
Annual material cost 6000000 € 750 64000 37500 101500
Annual total cost 6097980 € 800 60000 40000 100000
850 56471 42500 98971
900 53333 45000 98333
950 50526 47500 98026
1000 48000 50000 98000
1050 45714 52500 98214
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EOQ in practice
• Order cost and carrying cost need to be calculated based on
own business, getting the right cost in the right bucket!
• Use group logic to better maintain the data in the long run.
Differentiate based on value density, risk, and the mode of
transport
• Mistake most often made: exaggeration of order cost,
resulting in too large order quantities

Read this article carefully if you ever must carry out EOQ
calculations in practice:
https://www.inventoryops.com/economic_order_quantity.htm

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Order cost
Cost associated with “the instance” of an order (and not with
the order “quantity”), related to a single line item on this order.
• Order processing
• Third-party logistic costs
• Receipts processing
• Inbound inspection cost Mainly labor, how to turn into costs?
• Putaway Time studies on a high level
• Accounting
• Manufacturing
• Inbound freight costs?

Create order groups for items with similar order costs (overseas
vs domestically, normal vs certified suppliers, etc.)

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Carrying cost
Cost associated with having “specific quantities” of inventory (so
only costs that vary with inventory quantity)
• Cost of capital (debt or return-on-investment %)
• Inventory insurances
• Taxes (if inventory is taxed)
• Storage costs (exclude process-related warehouse costs,
distinguish between different product groups)
• Risk of damage, theft, spoilage, obsolescence (distinguish
between product groups)
• Labor cost for cycle counting, extra handling

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Other practical issues
• Seasonality and trend
• Clear low and high season → calculate two EOQ’s
• Mild to moderate seasonality → Convert EOQ from units into
time (POQ) (supported by many inventory systems, but tends to
overreact, so compensate for example by using weighted average
of old and new EOQ)
• Use overrides when needed, like fixed maximum order
quantity for perishable items, not EOQ > 1 year of demand or
< half a week of demand
• Case quantities: go with the case quantity if it (or a multiple) is
close to the calculated optimal order quantity (automatically
review as EOQ changes)
• Talk with supplier about MOQ reduction if MOQ >> EOQ

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Inventory reduction?
Don’t just decrease order sizes at random, but work on the
factors that cause you to have inventory:
• Reduce order cost by streamlining ordering process
• Reduce manufacturing setup cost and scrap
• Reduce delivery quantities and lead times with suppliers
• Improve forecast accuracy
• Monitor product life cycles

MANAGE inventory instead of REDUCING it!

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Exercise 1 - Easy
Harley Davidson has its engine assembly plant in Milwaukee and its a
motorcycle assembly plant in Pennsylvania. Engines are transported
between the two plants using trucks. Each truck trip costs $1,000. The
motorcycle plant assembles and sells 300 motorcycles every day of the
year. Each engine costs $500 and Harley incurs a holding cost of 20
percent per year. How many engines should Harley load onto each truck?
What is the average flow time for the cycle inventory of engines at the
motorcycle assembly plant?

Harley has decided to implement Just In Time (JIT) at the motorcycle

b
assembly plant. As part of this initiative, it has reduced the number of
engines loaded on each truck to 100. If each truck trip still costs $1,000,
how does this decision impact annual costs at Harley? What should the
cost of each truck be if a load of 100 engines is to be optimal for Harley?

Answers: 1: 1480, 2.5 days 2: $ 1100 000, $ 4.57

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Robustness of EOQ
Questions
1. What is the impact on 𝑇𝐶 if you choose 𝑄 ′ = 0.8𝑄∗ , or
𝑄′ = 1.2𝑄∗ ? (What is the impact of not choosing exactly
𝑄∗ ?)

2. Would you rather overestimate 𝑄∗ or underestimate 𝑄∗ ?

3. What is the impact on 𝑄 ∗ and on 𝑇𝐶 ∗ if you identify as

order cost 𝑆 ′ = 0.8𝑆, or 𝑆 ′ = 1.2𝑆? (What is the impact
of inaccurate estimation of 𝑆?)

4. How sensitive is 𝑄∗ to a wrong estimate of demand 𝐷:

𝐷′ = 0.8𝐷, or 𝐷′ = 1.2𝐷? (What is the impact of a
wrong forecast of demand?)
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 Calculations question 1
𝑄 ′ = 0.8𝑄 ∗ :
′ 12000 0.8∙980
𝑇𝐶 = 4000 + 0.2 ∙ 500
0.8∙980 2
= 100424 = 1.025 ∙ 𝑇𝐶 ∗

𝑄 ′ = 1.2𝑄 ∗ :
𝑇𝐶 ′ = ⋯ = 1.017 ∙ 𝑇𝐶 ∗

20% deviation from 𝑄 ∗ results only in

about 2% deviation in total cost!

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Exercise 2 - Medium
Analyze robustness questions 2, 3 and 4 and formulate a
conclusion from your calculations just like it has been done
for question 1.

Answers: 2: overestimation causes less damage than underestimation

3: S’ = 0.8S → TC’ = 1.006 TC*, S’ = 1.2 S → TC’ = 1.004 TC*
4: D’ = 0.8D → TC’ = 1.006 TC*, D’ = 1.2D → TC’ = 1.004 TC*
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EOQ with Q-Sh

planned shortages Sh

• Planned shortages are permitted (backordered demand

units are withdrawn from a replenishment order when it is
delivered).
• Backorder cost: 𝐵 per year per item backordered
• The variables in this model are 𝑄 and 𝑆ℎ , and the relevant
variable costs are annual holding, backorder, and ordering
costs.
• During 𝑡1 there is inventory, during 𝑡2 there is no inventory

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 EOQ with
planned shortages
The average nr of items short
The fraction of time in
which there is shortage

𝑇𝐶 = 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 + 𝑠ℎ𝑜𝑟𝑡𝑎𝑔𝑒 + 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ℎ𝑜𝑙𝑑𝑖𝑛𝑔

𝐷 𝑆ℎ 𝑆ℎ 𝑄−𝑆ℎ 𝑄−𝑆ℎ
=𝑆 + 𝐵 + ℎ𝐶
𝑄 2 Q 2 𝑄
𝜕𝑇𝐶 𝑆𝐷 𝐵𝑆ℎ2
ℎ𝐶 2 𝑄−𝑆ℎ 𝑄− 𝑄−𝑆ℎ 2
= − 2 − 2+ = 0 and
𝜕𝑄 𝑄 2𝑄 2 𝑄2
𝜕𝑇𝐶 2𝐵 2ℎ𝐶 𝑄−𝑆ℎ
= 𝑆 − =0
𝜕𝑆ℎ 2𝑄 ℎ 2𝑄

2𝑆𝐷 𝐵+ℎ𝐶 ℎ𝐶
Results in 𝑄∗ = and 𝑆ℎ∗ = 𝑄∗
ℎ𝐶 𝐵 𝐵+ℎ𝐶

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Exercise 3 - Medium
Higley has a product for which the assumptions of the inventory
model with shortages are valid. Demand for the product is 2000
units per year. The inventory holding cost rate is 20% per year.
The product costs Higley $50 to purchase. The ordering cost is
$25 per order, and it takes 7 days for an order to arrive. The
annual shortage cost is estimated to be $30 per unit per year.
Higley operates 250 days per year.
a) What is the optimal order policy?
b) What are the total annual costs?
c) How many days after receiving an order does Higley run out
of inventory? How long is Higley without inventory per cycle?
d) At what inventory or backorder level should Higley place an
inventory replenishment order?
Answers (unrounded): a) Q = 115.47, Sh = 28.87, b) 866.02 c) 10.82 days after receiving an order
d) At inventory level of 27.11 units 11-36
Exercise 4 - Insight
Zomorrod Sofal Co. is a brick company producing light weight
bricks. An EOQ model is used for the raw material needed to
make the bricks. The company is using a special soil delivered by
trucks. The annual demand of the soil is 2255 trucks and the
purchasing price is €469.5 per truck. The annual carrying cost is
approximately €64 per year for each truckload. The ordering
cost is €27. The company has its own warehouse with capacity
of 18 trucks. There are five warehouses available to rent.

What is the optimal order quantity, which warehouse(s), if any

should be rented, and what are the total cost?
Answer: EOQ = 44 trucks, rent warehouse C, Q = 30 trucks, with TC = 3239.50
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Homework
• Read chapter 11, stop after example 11-2.
• Make the exercises in this slideset

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