Independent –

Demand Inventory

Subject: Operation Management

Lecturer: Ms Ta Thi Bich Thuy

Group 2:
 To Van Phong Vu
 xxxx
 xxxx
 xxxx
Chapter Outline

 Definition
 Purpose of Inventory
 Inventory Cost Structures
 Independent versus Dependent Demand
 Economic Order Quantity
 Continuous Review System
 Periodic Review System
 Using P and Q system in Practice
 Service level and inventory level
 ABC inventory Management
 Reference
 Q&A
 Definition
 Definition in operation’s view: inventory is a stock of materials used to facilitate production or to satisfy
customer demands. It’s include raw materials, work in process and finish goods.
 Others: Inventory as an idle resource of any kind that has potential economic value. This definition consider idle
equipment or workers as inventory.
 Inventory management is among the most important operation management responsibilities
 Inventory management has an impact on all business functions: operation, marketing, accounting and finance
 Inventory stock are located at various points in the production process. Inventory act as a buffer between the
difference demand and supply rates.

Product process

Work in
process
Customer
Raw Finish
Work in
materials goods
process
Inventory
Work in
level
process

Figure 1.2 A water tank

Figure 1.1 A materials-flow process analogy for inventory
Purpose of Inventory

2. Protect again uncertainties:

• Safety stock are maintain in inventory in order to protect against uncertainties in supply, demand and
lead time.
• Safety stock can often be reduced by better coordination of suppliers and customers in supply chain.

5. Allow economic production and purchase

• Economic production: base on produce material in lots thus offer 2 benefits

 Able to spread the set up cost of production machine over a larger number of item
 Permit the use of the same production equipment for different products

• Economic purchase: order in big lots cant take advantages of quantity discounts, ordering cost and
transportation cost

 Cover anticipated changes in demand or supply: to face with expected and foresee changes in demand or
supply such as: raw material price increase, plan market promotion or high sales seasons

 Provide for transit: (or pipeline inventory) consist of materials that is on their way from one point to another
as from vendor to factory, from factory to dealers, retailers, from this store to other warehouse….
Inventory Cost Structure

 Inventory cost structure included the following 4 types of cost:

 Item cost: is the cost of buying or producing the individual inventory items
Item cost = cost per unit x produced quantity
Item cost = cost per unit x bought quantity

Ordering or set up cost:

 Ordering cost: is associated with ordering a batch or lot of items such as cost of typing order,
expediting the order, transportation cost, receiving cost, ….
 Set up cost :include paperwork costs plus cost required to set up the running of production equipments.
This cost often considered as fix cost and can be reduce by changing the way designed and managed
operations
Set up cost = paperwork cost + production equipment running cost
 Carrying ( or holding) cost: The carrying or holding cost is relevant to cost of keeping items in inventory for
a certain period of time
Holding cost = percentage of dollar value x time unit

Ex: 20% annual holding cost

 Carrying cost usually consist of 3 components
 Cost of capital: assigned to inventory as opportunity cost
 Cost of storage: include variable space cost, insurance and taxes. Exclude inventory storage cost
 Cost of obsolescence, deterioration and loss:
 Obsolescence cost: assigned to items have high risk of becoming obsolete: ex fashion clothes,
shoes, bag, mobile...
 Deterioration cost: apply to products that perishable easily over time for example: food, milk, fruit,
blood
 Loss cost: include pilferage and breakage cost when holding items in warehouse
 Stock out cost: is the cost reflect the economic consequences (lost of sale’s profit and future business) of
running out of stock
Independent Vs Dependent Demand
 Independent demand: is demand that is influenced by market need and conditions, out side of operation
controlling.
Ex: finish goods and spare parts inventory for replacement
 Dependent demand: is related to demand of other item and not determine by market
Ex: products built up from spare parts and assemblies
 Different types of demand create different approaches to inventory management

 Independent demand: apply replenishment philosophy

 Dependent demand: use requirements philosophy

Independent demand Dependent demand

Work-in-process, raw materials
Demand Usage

Finish goods, spare parts

Time Time

Figure 1.3 Demand patterns

Economic Order Quantity
 Economic order quantity ( EOQ) developed by F.W Harris in 1915 and expand widely by Mr Wilson, an
consultant
EOQ model base on those consumption:
3) The demand rate is constant, recurring and know
4) The lead time is constant and know
5) No stockouts are allowed
6) Material is ordered or produce in slot or batch and the lot is placed into inventory all at one time
7) Cost structure is used as follows:
 The unit item cost is constant, and no discounts are given for a large order or purchase
 The carrying cost depends linearly on the average inventory level.
8) The item is a single product, there ‘s no interaction with other product

Order interval

Average inventory
On hand

level =Q/2
Lot size = Q

Time
Figure 1.4 EOQ inventory levels
Economic Order Quantity
 Classic Wilson economic order quantity ( EOQ) With symbols:
D= demand rate (unit per year)
Q= 2SD
iC S= cost per unit order or set up cost (dollars per year)
C= unit cost (dollar per unit)
 The total annual cost of inventory:
i = carrying interest rate ( percent of dollars value per year)
Q= lot size (units)
TC = SD/Q + iCQ/2
TC= total of ordering cost plus carrying cost ( dollars per year)

Total cost per year = ordering cost per year + carrying cost per year
Annual cost TC (UDS/year)

Total cost
(SD/Q + iCQ/2)
Minimum cost

Carrying cost
(iCQ/2)

Ordering cost
(SD/Q)
0
Lot size (Q)
Figure 1.5 Total cost of inventory
Economic Order Quantity
Advantages and disadvantages of EOQ model

Advantages Disadvantages
 The assumptions are reasonably accurate  Assumption of constant demand
 EOQ can be adjust a little to suitable with  No stock out are allowed
reality without greatly affecting the costs (total  Insufficient flexible to use for independent-
cost of inventory) demand inventory management
 Giving the basic concepts of total cost
minimization and economic lot size
Continuous Review System (Q system)
 Stock position (or available stock) = on-hand material + on-order material
 Definition of continuous review system ( called Q system or fixed-order quantity system)
Continually review stock position ( on-hand plus on-order). When the stock position drops to the reorder point R, a
fixed quantity Q is ordered.
In continuous review system, the stock available is monitored continuously, after each transaction. Some
criteria of this method:

 Random demand
 Fixed quantity order at a predetermined order or reorder point
 Order interval will vary depend on the random of demand.

Figure 1.6
Stock on hand

Q A continuous review (Q)

Q Q system
R
R = reorder point
Q = order quantity
L L L
L = lead time
Time
Where:
2 SD
Q= and D = average demand
iC
R= determined by stock out probability
Continuous Review System
 Service level: (3 definitions lead to different reorder points)
 Is the probability that all orders will be filled from stock during the replenishment lead time of one reorder cycle
 Is the percentage of demand filled from stock during a given period of time
 Is the percentage of time the system has stock on hand

 Reorder point: Where

R = reorder point
R=m+s m = average demand over the lead time
s = safety stock
Or
safety stock s = z
R = m + z
z = safety factor
 = standard deviation of demand over the lead time

Figure 1.7
Service-level probability
Probability distribution
Frequency

of demand over lead time

m = mean demand
Stock out probability
R= reorder point
s = safety stock
m R
s
Demand over Lead time
Continuous Review System
Z Services level (%) Stockout (%)
0 50.0 50.0

0.5 69.1 30.9

1.0 84.1 15.9
Table 1.8 1.1 86.4 13.6
Normal Demand 1.2 88.5 11.5
Percentage 1.3 90.3 9.7
1.4 91.9 8.1
1.5 93.3 6.7
1.6 94.5 5.5
1.7 95.5 4.5
1.8 96.4 3.6
1.9 97.1 2.9
2.0 97.7 2.3
2.1 98.2 1.8
2.2 98.6 1.4
2.3 98.9 1.1
2.4 99.2 0.8
2.5 99.4 0.6
2.6 99.5 0.5

2.7 99.6 0.4

2.8 99.7 0.3
2.9 99.8 0.2
3.0 99.9 0.1
Periodic Review System (P system)
 A periodic review system provides another way to handle random demand
 The stock position is reviewed at fixed intervals P and an amount is ordered equal to the target
inventory T minus stock position.
 The amount ordered at each review period will vary depend on actual demand
 The value of P is set by use of the EOQ and the value of T is base on the services level desired
 This method also called: the fixed – order – interval system, period system or P system

T
Figure 1.9 Q1
Q3
A Period review
Q2 Q3
system Q1
Stock on hand

Q2

L L L
P P P
Time
Periodic Review System
2.SD
P = Q/D =
iCD
 Where T = target inventory level
T = m’ + s’ m’ = average demand over P+ L
s’ = safety stock

 ’ = the standard deviation of demand over P

With s’ = z ’ z = safety factor

 The safety stock should be set high enough to assure the desired service level
 By controlling z, we can control the target inventory and the resulting service level provided
 The P equation provides an approximately optimal review interval P, when the demand is highly
uncertain, the approximation may be quite poor and not correct.
 P system always require more safety stock than Q system for the same service level
USING P & Q SYSTEM IN PRACTICE

 P & Q systems are both in wide use for independent demand inventory management.
 The choice between P & Q system should be made on the basis of timing of replenishment,
the type of record keeping system in use, and the cost of the item

In some conditions P system is prefer to used to Q system:

6. The P system should be used when the inventory order must be place or delivered at specified
intervals with regular scheduled
7. The P system should be used when the multiple items are ordered from the same supplier and
delivered in the same shipment ( single order of multiple items)
8. The P system should be used for inexpensive items that are not maintained on perpetual
inventory record ( less record keeping)

Note: In practice there’re a mix system of P & Q inventory rules called hybrid systems, that limited
inventory level within min and max level

min max

Order level Safety level

 Min = reorder point
 Max = target inventory
Compare P & Q system
 Similars:
 Both are systems to handle random demand
 By control z can control service level
 The value of R ( for Q system) and T (P system) is base on service level desired
 Economic order quantity Q is set equal to EOQ (Q system) and time between order P also
set base on EOQ (P system)
 Differences

Q system P system
 Have reorder point  Don’t have a reorder point but target inventory
 Have a economic order quantity Q  Don’t have economic order quantity Q
 Fix order quantities  Various order quantities depend on real demand
 Fix order quantities  Fix order interval ( not order quantity)
• Expensive, single items  Inexpensive, multiple items
• Less safety stock  High safety stock
• High attention to record accuracy  Less record keeping
 R base on fix dropping point of stock position  R is reviewed at fix interval P of stock position
 Require less safety stock for a service level Require more safety stock for the same service level
Inventory order is not regular scheduled (more order) Inventory orders is regular scheduled (less order)
Compare P & Q system

System Advantages Disadvantages

 Advantage of scheduled  Require large safety stock than Q system
P system replenishment  Require higher cost of storage
 Less record keeping

Q system  Require a smaller stock  Require high record keeping and

controlling, accuration.

Note:
 P system used for inexpensive, multiple items, regular schedule of replenishment, high safety
stock, less record keeping
 Q system often used for expensive, single items, less safety stock inventory, high attention to
record accuracy
Service level and Inventory level
 The average inventory formula:
I = Q/2 + z 

 There’s an important trade-off between service level and inventory level, that effect to management
decisions of controlling independent-demand inventory
 High service levels require higher inventory investment ( for a given order quantity (Q) and standard
deviation )
 Services level is a costly decision. A little change in service level can dramatically increase required
inventory level.
 Management should study the service level and investment relationship ( and decide the trade –off)
before setting the service levels desired.
 The relationship between service level and inventory level helps to determine appropriate inventory
turnovers
 Management should seek to continuously reduce Q and  by that reducing the inventory required for
a certain service level

100
Service level (%)

Figure 1.10 Z=2.4

95 Z=1.9 Z=2.1
Z=1.7
Service level versus Z=1.5
Z=1.3
inventory level 90
Z=1.2

85 Z=1.0

150 200 250 300

Average Inventory Level
ABC CONCEPT:
 In 1960 Vilfredo Pareto develop a rule of 80/20 proportion: that a few items ( around 20%) in any
group can contribute the significant proportion (up to 80%) of the entire group.
 ABC analysis also know as Pareto rule or 80-20 rule, this is base on the significant few and the
insignificant many.
 In inventory, a few items (20%) usually take most of inventory value (80% of capital investment)
 The concept should be use to carefully control the significant A items to spend less effort and cost on
the B and C items
 For A class items, we should use continuous review system, and periodic review system for C
items. Take intermediate level of attention and management level to B items.

Item Annual Usage Unit Cost Dollar Usage Percentage of Total

in Unit (USD) (USD) Dollar Usage

1 5,000 1,50 7,500 2,9 %

2 1,500 8,00 12,000 4,7 %
3 10,000 10,50 105,000 41,2%
4 6,000 2,00 12,000 4,7 %
A class = 73,2 %
5 7,500 0,50 3,750 1,5 %
6 6,000 13,60 81,600 32,0 %
7 5,000 0,75 3,750 1,5 %
C class = 10,5 %
8 4,500 1,25 5,625 2,2 %
9 7,000 2,50 17,500 6,9 %
10 3,000 2,00 6,000 2,4 %
Total 254,725 100%
References

 www.apics.org. Finding interested information about inventory control

 www.effectiveinventory.com/articles.html . Read articles and write a short summary of them
 www.cissltd.com. Run online demo of Inventory program
 www.Retailpro.com. Software system for controlling of retail inventories
 Books
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