INVENTORY MANAGEMENT
Operations Management
Dr. Ron Lembke
Purposes of Inventory
Meet anticipated demand
Demand variability
Supply variability
Decouple production & distribution
permits constant production quantities
Take advantage of quantity discounts
Hedge against price increases
Protect against shortages
2006 13.81 1857 24.0% 446 801 58 1305 9.9
2007
US Inventory, GDP ($B)
14,000
12,000
10,000
8,000
6,000
4,000
2,000
9 84 9 86 9 88 9 90 9 92 9 94 9 96 9 98 0 00 0 02 0 04
1 1 1 1 1 1 1 1 2 2 2
Business Inventories US GDP
US Inventories as % of GDP
25.0%
20.0%
15.0%
% of GDP
10.0%
5.0%
0.0%
9 84 9 86 9 88 9 90 9 2 94 96 9 8 00 0 02 0 4
1 1 1 1 19 19 19 19 20 2 20
Year
Source: CSCMP, Bureau of Economic Analysis
Two Questions
Two main Inventory Questions:
How much to buy?
When is it time to buy?
Also:
Which products to buy?
From whom?
Types of Inventory
Raw Materials
Subcomponents
Work in progress (WIP)
Finished products
Defectives
Returns
Inventory Costs
What costs do we experience because we carry
inventory?
Inventory Costs
Costs associated with inventory:
Cost of the products
Cost of ordering
Cost of hanging onto it
Cost of having too much / disposal
Cost of not having enough (shortage)
Shrinkage Costs
How much is stolen?
2% for discount, dept. stores, hardware, convenience,
sporting goods
3% for toys & hobbies
1.5% for all else
Where does the missing stuff go?
Employees: 44.5%
Shoplifters: 32.7%
Administrative / paperwork error: 17.5%
Vendor fraud: 5.1%
Inventory Holding Costs
Category % of Value
Housing (building) cost 4%
Material handling 3%
Labor cost 3%
Opportunity/investment 9%
Pilferage/scrap/obsolescence 2%
Total Holding Cost 21%
Inventory Models
Fixed order quantity models
How much always same, when changes
Economic order quantity
Production order quantity
Quantity discount
Fixed order period models
How much changes, when always same
Economic Order Quantity
Assumptions
Demand rate is known and constant
No order lead time
Shortages are not allowed
Costs:
S - setup cost per order
H - holding cost per unit time
EOQ
Inventory
Level
Q* Decrease Due to
Optimal Constant Demand
Order
Quantity
Time
EOQ
Inventory
Level
Q* Instantaneous
Optimal Receipt of Optimal
Order Order Quantity
Quantity
Time
EOQ
Inventory
Level
Q*
Reorder
Point
(ROP)
Time
Lead Time
EOQ
Inventory
Level
Q*
Average
Inventory Q/2
Reorder
Point
(ROP)
Time
Lead Time
Total Costs
Average Inventory = Q/2
Annual Holding costs = H * Q/2
# Orders per year = D / Q
Annual Ordering Costs = S * D/Q
Cost of Goods = D * C
Annual Total Costs = Holding + Ordering + CoG
Q D
TC (Q) H * S * C * D
2 Q
How Much to Order?
Annual Cost
Holding Cost
= H * Q/2
Order Quantity
How Much to Order?
Annual Cost
Ordering Cost
= S * D/Q
Holding Cost
= H * Q/2
Order Quantity
How Much to Order?
Total Cost
Annual Cost = Holding + Ordering
Order Quantity
How Much to Order?
Total Cost
Annual Cost = Holding + Ordering
Optimal Q Order Quantity
Optimal Quantity
Q D
Total Costs = H * S * C*D
2 Q
Take derivative H D Set equal
with respect to Q = S* 2 0 to zero
2 Q
Solve for Q:
H DS 2 DS 2 DS
2 Q
2
Q
2 Q H H
Adding Lead Time
Use same order size
2 DS
Q
H
Order before inventory depleted
R = d * L where:
d = average demand rate (per day)
L = lead time (in days)
both in same time period (wks, months, etc.)
A Question:
If the EOQ is based on so many horrible
assumptions that are never really true, why is it the
most commonly used ordering policy?
Profit function is very shallow
Even if conditions don’t hold perfectly, profits are
close to optimal
Estimated parameters will not throw you off very far
Quantity Discounts
How does this all change if price changes
depending on order size?
Holding cost as function of cost:
H=I*C
Explicitly consider price:
2DS
Q
I C
Discount Example
D = 10,000 S = $20 I = 20%
Price Quantity EOQ
c = 5.00 Q < 500 633
4.50 501-999 666
3.90 Q >= 1000 716
Discount Pricing
Total Cost
Price 1 Price 2 Price 3
X 633
X 666
X 716
500 1,000 Order Size
Discount Pricing
Total Cost
Price 1 Price 2 Price 3
X 633
X 666
X 716
500 1,000 Order Size
Discount Example
Order 666 at a time:
Hold 666/2 * 4.50 * 0.2= $299.70
Order 10,000/666 * 20 = $300.00
Mat’l 10,000*4.50 = $45,000.00 45,599.70
Order 1,000 at a time:
Hold 1,000/2 * 3.90 * 0.2= $390.00
Order 10,000/1,000 * 20 = $200.00
Mat’l 10,000*3.90 = $39,000.00 39,590.00
Discount Model
1. Compute EOQ for next cheapest price
2. Is EOQ feasible? (is EOQ in range?)
If EOQ is too small, use lowest possible Q to get
price.
3. Compute total cost for this quantity
4. Repeat until EOQ is feasible or too big.
5. Select quantity/price with lowest total cost.
INVENTORY MANAGEMENT
-- RANDOM DEMAND
Random Demand
Don’t know how many we will sell
Sales will differ by period
Average always remains the same
Standard deviation remains constant
Impact of Random Demand
How would our policies change?
How would our order quantity change?
How would our reorder point change?
Mac’s Decision
How many papers to buy?
Average = 90, st dev = 10
Cost = 0.20, Sales Price = 0.50
Salvage = 0.00
Cost of overestimating Demand, CO
CO = 0.20 - 0.00 = 0.20
Cost of Underestimating Demand, CU
CU = 0.50 - 0.20 = 0.30
Optimal Policy
G(x) = Probability demand <= x
Optimal quantity:
Cu
Pr(D Q)
C o Cu
Mac: G(x) = 0.3 / (0.2 + 0.3) = 0.6
From standard normal table, z = 0.253
=Normsinv(0.6) = 0.253
Q* = avg + zs = 90+ 2.53*10 = 90 +2.53 = 93
Optimal Policy
If units are discrete, when in doubt, round up
If u units are on hand, order Q - u units
Model is called “newsboy problem,” newspaper
purchasing decision
By time realize sales are good, no time to order more
By time realize sales are bad, too late, you’re stuck
Similar to the problem of # of Earth Day shirts to
make, lbs. of Valentine’s candy to buy, green beer,
Christmas trees, toys for Christmas, etc., etc.
Random Demand –
Fixed Order Quantity
If we want to satisfy all of the demand 95% of the
time, how many standard deviations above the
mean should the inventory level be?
Probabilistic Models
Safety stock = x m
x
From statistics, z
L
Safety stock & Safety stock = zs
Therefore, z = L
sL
From normal table z.95 = 1.65
Safety stock = zsL= 1.65*10 = 16.5
R = m + Safety Stock
=350+16.5 = 366.5 ≈ 367
Random Example
What should our reorder point be?
demand over the lead time is 50 units,
with standard deviation of 20
want to satisfy all demand 90% of the time
(i.e., 90% chance we do not run out)
To satisfy 90% of the demand, z = 1.28
Safety stock = zσL= 1.28 * 20 = 25.6
R = 50 + 25.6 = 75.6
St Dev Over Lead Time
What if we only know the average daily demand,
and the standard deviation of daily demand?
Lead time = 4 days,
daily demand = 10,
standard deviation = 5,
What should our reorder point be, if z = 3?
St Dev Over LT
If the average each day is 10, and the lead time is 4
days, then the average demand over the lead time
must be 40.
d * L 10 * 4 40
What is the standard deviation of demand over the
lead time?
Std. Dev. ≠ 5 * 4
St Dev Over Lead Time
Standard deviation of demand =
L Ldays day
45 10
R d * L z L d * L z Ldays day
R = 40 + 3 * 10 = 70
Service Level Criteria
Type I: specify probability that you do not run out
during the lead time
Probability that 100% of customers go home happy
Type II: proportion of demands met from stock
Percentage that go home happy, on average
Fill Rate: easier to observe, is commonly used
G(z)= expected value of shortage, given z. Not
frequently listed in tables
Q
G( z) 1 Fill Rate
L
Two Types of Service
Cycle Demand Stock-Outs
1 180 0 Type I:
2 75 0
8 of 10 periods
3 235 45
4 140 0 80% service
5 180 0
6 200 10 Type II:
7 150 0 1,395 / 1,450 =
8 90 0 96%
9 160 0
10 40 0
Sum 1,450 55
FIXED-TIME PERIOD
MODELS
Fixed-Time Period Model
Every T periods, we look at inventory on hand and
place an order
Lead time still is L.
Order quantity will be different, depending on
demand
Fixed-Time Period Model:
When to Order?
Inventory Level Target maximum
Period Time
Fixed-Time Period Model: :
When to Order?
Inventory Level Target maximum
Period Period Time
Fixed-Time Period Model:
When to Order?
Inventory Level Target maximum
Period Period Time
Fixed-Time Period Model:
When to Order?
Inventory Level Target maximum
Period Period Period Time
Fixed-Time Period Model:
When to Order?
Inventory Level Target maximum
Period Period Period Time
Fixed-Time Period Model:
When to Order?
Inventory Level Target maximum
Period Period Period Time
Fixed Order Period
Standard deviation of demand over T+L =
T L T L
T = Review period length (in days)
σ = std dev per day
Order quantity (12.11) =
q d (T L) z T L I
Inventory Recordkeeping
Two ways to order inventory:
Keep track of how many delivered, sold
Go out and count it every so often
If keeping records, still need to double-check
Annual physical inventory, or
Cycle Counting
Cycle Counting
Physically counting a sample of total inventory
on a regular basis
Used often with ABC classification
A items counted most often (e.g., daily)
Advantages
Eliminates annual shut-down for physical inventory
count
Improves inventory accuracy
Allows causes of errors to be identified
Fixed-Period Model
Answers how much to order
Orders placed at fixed intervals
Inventory brought up to target amount
Amount ordered varies
No continuous inventory count
Possibility of stockout between intervals
Useful when vendors visit routinely
Example: P&G rep. calls every 2 weeks
ABC Analysis
Divides on-hand inventory into 3 classes
A class, B class, C class
Basis is usually annual $ volume
$ volume = Annual demand x Unit cost
Policies based on ABC analysis
Develop class A suppliers more
Give tighter physical control of A items
Forecast A items more carefully
Classifying Items
as ABC
% Annual $ Volume Items %$Vol %Items
100 A 80 15
B 15 30
80
C 5 55
60
40 A
20
B C
0
0 50 100 150
% of Inventory Items
ABC Classification Solution
Stock # Vol. Cost $ Vol. % ABC
206 26,000 $ 36 $936,000 71.1
105 200 600 120,000 9.1
019 2,000 55 110,000 8.4
144 20,000 4 80,000 6.1
207 7,000 10 70,000 5.3
Total 1,316,000 100.0
ABC Classification Solution
Stock # Vol. Cost $ Vol. % ABC
206 26,000 $ 36 $936,000 71.1 A
105 200 600 120,000 9.1 A
019 2,000 55 110,000 8.4 B
144 20,000 4 80,000 6.1 B
207 7,000 10 70,000 5.3 C
Total 1,316,000 100.0
