Managing Inventory

in Supply chain
1. What is inventory and why companies
stock it?

Inventory is an asset owned by the firm for the

purpose of being sold to the customers and make
profit.
2. What are the types of inventory?

Inventories are basically categorized into five

classes:

i. Raw material
ii. Work-in process inventory
iii. Finished goods
iv. Maintenance, repair and utility inventory
v. Pipeline or in-transit inventory
3. What is meant by inventory management?
Holding of different class of inventory at minimum
quantity as per the requirement.

Inventory related costs:

i. Inventory cost
ii. Holding/Carrying cost
iii. Ordering/set up cost
iv. Damage or pilferage cost
v. Exchange rate differentials
 4. Why companies are facing problem in
managing inventory?
If the companys inventory level is too low, it risks
delaying in fulfilling customers order.

If it is too high, it is tying up extra dollars that can be

better used in other areas.
5. What is the solution to the above
problem?

Companies need to maintain an optimal level of

inventory in stock. The optimal level is determined by
EOQ model.
 EOQ Model
Assumptions:
- Demand rate is constant and certain
- Costs applicable: holding cost, ordering cost and material cost
- No constraint on lot sizing
- No uncertainty in lead time

Let,
Q - lot size in units
D - Annual Demand
H - holding cost per unit/year
S - Ordering cost per order
C - Material cost per unit
 EOQ Model: Finding the optimal order quantity

Lets say we decide to order in batches of Q

Inventory position D
Number of periods will be

Q
Average Inventory

Q/2

Time
Period over which demand for Q has occurred

Total Time
 The Inventory Cycle
Profile of Inventory Level Over Time

Q Demand
rate Constant
Demand
Quantity
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 Important Points
1. Reorder point: Level of inventory equals to the
consumption during lead time.
R = (Avg demand) x (Lead time) + Safety stock

2. Lead Time: Time taken to receive the order of

delivery of inventory from the supplier.

3. Safety Stock: The minimum additional inventory to

serve as a buffer to fulfill uncertain demand.
 What is the main insight from EOQ?
Trade-off between holding cost and Ordering cost

Total cost

Annual
Cost Holding cost

Ordering cost

Material
cost

EOQ (Q*) Order Quantity

What is the optimal quantity to order?
Total Cost = Annual material cost + Annual holding Cost + Annual ordering Cost
Annual material Cost = (annual demand) x (cost per unit)
= DxC
Annual holding Cost = (average inventory) x (holding cost)
= (Q/2) x H
Annual ordering Cost = (number of orders) x (cost per order)
= (D/Q) x S

TC = DC + QH/2 + DS/Q

Use calculus: Find the first derivative of TC w.r.to Q and equalize it to zero.

2DS
Finally, EOQ = Q*=
H
 Key Points

1. Total holding and ordering cost are relatively stable around

the economic order quantity.

2. A firm is often served by ordering a convenient lot size

close to the economic order quantity.

3. If the demand increases by a factor of k, the optimal lot

size as well as the number of order placed per year
increases by a factor of k.
 Example-1
Q: A company uses 250 gallons of adhesive per year at a
purchase price of $ 2.5 per gallon. The cost associated
with placing an order is $ 8 and holding cost is 20%
of purchased cost/unit. Calculate the economic order
quantity?
 Example- 2
Q: A company xyz Ltd. has been buying a given items
in a lots 1200 units which is a six month supply. The
cost per unit is Rs. 12, order cost is Rs. 8 per order
and carrying cost is 25 percent. Calculate the savings
per year by buying in economical lot quantities.
 Example- 3
Q: A company requires 250 units of metal bearing
annually at a purchase price of $ 2.5 per unit. The
cost associated in placing an order is $ 8 and with
holding stock is 20% of purchase value. Calculate:
i. Economic order quantity
ii. Ordering cost
iii. Holding cost
iv. Total cost of bearings
 Example-4
Q: A trucking firm has an average demand of 10 new
tires per week and receives delivery from a tire
company in 20 business days (5 days per week) after
placing an order. If the firm maintains a safety stock
of 15 tires, what is the reorder point?
 Example-5
Q: A company purchase 1200 packets of sugar annually
in economic order lots of 100 packets and pays $ 9.85
per packet. If the processing cost for each order are $
10, what are the implied holding cost per annum?
 Example-6
Q: A company ABC ltd requires about 75,000 units of valves per
year and the usage is fairly constant at 6,250 units per month.
The valve cost Rs. 1.50 per unit and the carrying cost is 20%.
The cost to place an order is Rs. 18 and lead time is 45 days.
The safety stock of 3,250 units are desirable. Calculate:
i. Economical order quantity
ii. Frequency of order
iii. Reorder point
 If delivery is not instantaneous, but there is a lead time L:
When to order? How much to order?

Order
Quantity
Q
Inventory

Lead Time
Time
Place Receive
order order
 If demand is known exactly, place an order when
inventory equals demand during lead time.

Order Q: When shall we order?

Quantity A: When inventory = ROP
Q Q: How much shall we order?
A: Q = EOQ
Inventory

Reorder
Point
(ROP)
ROP = Lxd

Lead Time
Time
d: Average demand
L: Lead time in periods Place Receive
order order
 But demand is rarely predictable!

Inventory
Level

Order
Quantity

ROP = ???
Demand???

Place Receive Time

order Lead Time order
 Actual Demand < Expected Demand
Inventory
Level

Order
Quantity
Lead Time Demand

ROP

Inventory at time of receipt

Lead Time Time

Place Receive
order order
 Actual Demand > Expected, we Stock Out
Order
Quantity

Stockout
Point
Inventory

Time

Lead Time Unfilled demand

Place Receive
order order
 If ROP = expected demand, service level is
50%. Inventory left 50% of the time, stock
outs 50% of the time.
Inventory
Level

Order
Quantity
ROP = Expected Demand

Uncertain Demand
Average

Time
 To reduce stockouts we add safety stock
Inventory
Level

Order Quantity
ROP = Q = EOQ
Expected
LT Expected
Demand LT Demand
+Safety
Stock Safety Stock
Lead Time Time

Place Receive
order order
 Decide what Service Level you want to provide
(Service level = probability of NOT stocking out)

Service level Probability

of stock-out

Safety
Stock
 Safety stock =
(safety factor z)(std deviation in LT demand)

Service level Probability

of stock-out

Safety
Stock

Read z from Normal table for a given service level