ِ‫الرحيم‬

َ ّ ‫حم ِن‬ َ ّ ‫ِبس ِم الل َّ ِه‬

ٰ ‫الر‬

Inventory Management

Dr. Mohammed Shamim Uddin Khan

Professor and Ex-Chairman
Department of Finance
University of Chittagong
 OUTLINE
 Concepts on inventory and inventory management
 Inventory Counting Systems
 ABC classification
 Key inventory terms
 How much to order (perpetual system)
 Economic Order Quantity
 Economic Production Quantity

 Price Break Model / Quantity Discount

 When to reorder /Reorder point

 How much to order (periodic system)
 Single Period Model
 INTRODUCTION-1
Inventory is the stock of any kind of resources used in an
organization. Such resources may be classified into
three categories:
(1) physical resources such as raw materials, work-in-
process (semi finished goods), finished goods, spare
parts etc.
(2) human resource such as unused labour, and
(3) financial resource such as working capital, etc.
 INTRODUCTION-2
It is not necessary that an organization have all these
inventory classes. But, whatever may the inventory
items be, they need efficient management as, generally,
a substantial share of its funds is invested in them. An
inventory system is the set of policies and controls that
monitor levels of inventory and determine what levels
should be maintained, when stock should be
replenished, and how large orders should be. The basic
purpose of inventory analysis in manufacturing and
stock keeping services is to specify (a) when items
should be ordered and (b) how large the order should
be.
 INTRODUCTION-3
Different departments within the same organization adopt different
attitudes towards inventory. This is mainly because the particular
functions performed by a department influence the department’s
motivation. For example, the sales department might desire large
stock in reserve to meet virtually every demand that comes.
The production department similarly would ask for large-scale stocks
of materials so that the production system runs uninterrupted.
On the other hand, the finance department would always argue for a
minimum investment in stocks so that the funds could be used
elsewhere for other better purposes.
As early as 1915, an economic-lot-size equation was developed by
F.W Harris that minimized the sum of inventory carrying and
setup costs where the demand was known and constant.
Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
 TYPES OF INVENTORIES-1
1. Cycle inventory: The portion of total inventory that
varies directly with lot size is called cycle inventory.
Determining how frequently to order, and in what
quantity, is called lot sizing.
2. Safety stock (Buffer) inventory: To avoid customer
service problems and the hidden costs of unavailable
components, companies hold safety stock. Safety stock
inventory is surplus inventory that protects against
uncertainties in demand, lead time, and supply changes.
Safety stocks are desirable when suppliers fail to deliver
either the desired quantity on the specified date or items
of acceptable quality, or when manufactured items
require significant amounts of scrap or rework.
 TYPES OF INVENTORIES-2
3. Anticipation inventory: Inventory used to absorb
uneven rates of demand, or supply, which businesses
often face, is referred to as anticipation inventory.
Predictable, seasonal demand patterns lend themselves to
the use of anticipation inventory.
4. Pipeline (Transit) inventory: Inventory moving from
point to point in the materials flow system is called
pipeline inventory. Materials moves from suppliers to a
plant, from one operation to the next in the plant, from
the plant to a distribution centre or customer, and from
the distribution centre to a retailer. Pipeline inventory
consists of orders that have been placed but not yet
received.
 FUNCTIONS OF INVENTORY
1. To meet anticipated demand
2. To smooth production requirements
3. To decouple operations
4. To protect against stock-outs

5. To take advantage of order cycles

6. To help hedge against price increases
7. To permit operations
8. To take advantage of quantity discounts
 
 OBJECTIVES OF INVENTORY CONTROL
 To achieve satisfactory levels of customer service while
keeping inventory costs within reasonable bounds
 Level of customer service
 Costs of ordering and carrying inventory
 COST OF INVENTORY
1. Purchase costs: Purchase price for the items
2. Carrying (Holding) costs: Cost to carry an item in inventory for a
length of time, usually a year
(i) Cost of Capital (interest on capital investment)
(ii) Insurance expenses
(iii) Storage and handling cost
(iv) Obsolescence (spoilage) cost
(v) Miscellaneous costs (theft, damage, tax etc.)
3. Ordering costs: Costs of ordering and receiving inventory
(i) Documentation cost
(ii) Transportation cost
(iii) Receiving cost
(iv) Other cost (cost incurred regardless of quantity)
4. Stock-out cost: Costs when demand exceeds supply
 INVENTORY COUNTING SYSTEMS

 Periodic System
Physical count of items made at periodic
intervals
 Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
 QUANTITY (Q) DETERMINATION MODEL

1. EOQ Model
2. EPQ Model
3. Planned Shortage Model
4. Quantity Discount Model
 ECONOMIC ORDER QUANTITY (EOQ MODEL)

EOQ is the order size that minimizes total annual cost

Assumptions of EOQ
 Annual demand requirements known
 Each order is received in a single delivery
 Demand is even throughout the year
 Lead time does not vary
 There are no quantity discounts
 Only one product is involved
 THE INVENTORY CYCLE

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Average
Cycle
Inventory

Time
Receive Place Receive Place Receive
order order order order order
 FORMULAE ON EOQ

2 DS
Optimal order quantity, Qo 
H

D
Number of reorder times per year =
Qo
Time between orders = Qo
D

Qo D
Total annual variable cost TC  ( ) H  ( ) S
2 Qo
 COST MINIMIZATION GOAL

The Total Inventory Cost Curve is U-Shaped

Q D
TC  H  S
2 Q
Annual Cost

Ordering Costs

Order Quantity (Q)

QO (optimal order quantity)
 MINIMUM TOTAL COST

The total cost curve reaches its minimum

where the carrying and ordering costs are
equal.
QOPT D
H  S
2 QOPT

Length of Order Cycle = QOPT/D

 EXAMPLE -1
Every tire sales at $2 per unit. Forecasted Demand of tire in
next year is 9,600. Annual carrying cost is $16 per tire
and ordering cost is $75. The distributor operates 288
days a year.
Requirements:
a) What is the EOQ?

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
 EXAMPLE 1CONT.
Given that, D = 9,600 tires per year; H =$16 per unit per year
S = $ 75 per order

2 DS 2(9600)75
a )....EOQ  Qopt    300tires
H 16
b) Number of order per year = D/ Qopt = 9600/300 = 32 times
c) Length of Order Cycle = Qopt/ D = 300/9600 = 1/32 of a year or
(1/32)*288 = 9 working day.
d) Total Annual Cost = Ordering cost + Holding cost + Product cost
= ( D/Qopt ) * S + (Qopt / 2)*H + P * D
= 32 * 75 + 150 * 16 + 2 * 9600
= 20904
 ECONOMIC PRODUCTION QUANTITY (EPQ) MODEL

The batch mode of production is widely used in production.

Even in assembly operations, portions of the work are
done in batches. The reason for this is that in certain
instances, the capacity to produce a part exceeds the part’s
usage or demand rate. As long as production continues,
inventory will continue to grow. In such instances it makes
sense to periodically produce such items in bathes or lots.
The assumptions of EPQ model are similar to those of the
EOQ model, except that instead of orders received in a
single delivery, units are received incrementally during
production.
 ASSUMPTIONS OF EPQ MODEL

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. Production rate is constant
6. Lead time does not vary.
7. There are no quantity discounts.
 FORMULAE ON EPQ MODEL

2 DS
1. Optimal production lot size, Qo 
D
(1  ) H
P
Qo
2. Number of production runs per year =
P

Qo
Time between setups = D years.

Total annual variable cost, 1 D DS

TC  (1  )Qo H 
2 P Qo
ECONOMIC PRODUCTION QUANTITY (EPQ)

Run time

Cycle time

 Production done in batches or lots

 Capacity to produce a part exceeds the part’s usage or
demand rate
 Assumptions of EPQ are similar to EOQ except orders
are received incrementally during production
 EXAMPLE - 2
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. Setup
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 setup
(c) Cycle time for the optimal run size
(d) Run time
 EXAMPLE 2 CONT.
Solution: Here D = 48,000 wheels per year, S = $45, H = $1 per
wheel per year, P = 800 X 240 = 192000 wheels per year
(a) Optimal production lot size,
2 DS 2  48000  45
Qo    2400
D 48000
(1  ) H (1  )
P 192000
(b) Total annual minimum cost for carrying and setup

1 D DS
TC  (1  )Qo H 
2 P Qo
1 48000 48000  45
 (1  )2400  1   900  900  $1800
2 192000 2400
 EXAMPLE 2 CONT.
(c) Cycle time for the optimal run size:

Qo 2400
  0.05 per year  0.5  240  12 days
D 48000

(d) Run time (Number of production runs per year):

Qo 2400
  0.0125 per year  0.0125  240  3 days
P 192000
 PLANNED SHORTAGE MODEL:

 A shortage or stock out is a demand that cannot be supplied. In many

situations, shortages are undesirable and should be avoided if at all
possible. However, in other cases it may be desirable – from an
economic point of view – to plan for and allow shortages. In practice,
these types of situations are most commonly found where the value of
the inventory per unit is high and hence the holding cost is high.
 An example of this type of situation is a new car dealer’s inventory.
Often a specific car that a customer wants may not be in stock.
However, if the customer is willing to wait a few weeks the dealer is
usually able to order it.
 The model developed in this section takes into account a type of
shortage known as a backorder. In a backorder situation, we assume
that when a customer places an order and discovers that the supplier is
out of stock, the customer waits until the new shipment arrives, and
then the order is filled.
 FORMULAE ON PLANNED SHORTAGE MODEL

1. Optimal order quantity, Qo 

2 DS H  C
( )
H C

2. Maximum number of backorders, So 

Qo H
H C

3. Number of orders per year = D

Q o

4. Time between orders = Qo years.

D
C
5. Total annual variable cost, . TC  2 DSH .
CH
 EXAMPLE 3
The demand of an item is uniform at a rate of 20 units per
month. The fixed cost is $10 each time a production run is
made. The production cost is $1 per item and the inventory
carrying cost is $0.25 per item per month. If the shortage cost
is $1.25 per item per month, determine how often to make a
production run and what of what size it should be?
Solution:
We are given that D = 20 per month; Holding cost, H = $0.25
Setup cost, S = $10 per production run; Shortage cost, C =
$1.25 2 DS H  C 2( 20)(10) 0.25  1.25
Q  ( ) ( )  44
(a) Optimal order quantity,
o
H C 0.25 1.25

Q o 44
  2 .2
(b) Time between orders = D 20 months
 QUANTITY DISCOUNT MODEL – SOLVING METHOD

When carrying costs are constant:

1.Compute the common minimum point.
2.Only one of the unit prices will have the minimum point in its
feasible rage since the ranges do not overlap. Identify that range.
i. If the feasible minimum point is on the lowest price range,
that is the optimal order quantity.
ii. 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.
iii. Compare the total costs; the quantity (minimum point or
price break) that yields the lowest total cost is the optimal
order quantity.
 QUANTITY DISCOUNT MODEL – SOLVING METHOD

When carrying costs are specified as a percentage

of unit price:
1.Beginning with the lowest unit price, compute the
minimum points for each price range until you find a
feasible minimum point (i.e., until a minimum point falls
in the quantity range for its price).
2.If the minimum point for the lowest unit price is
feasible, it is the optimal order quantity. If the minimum
point is not feasible in the lowest price range, compare
the total cost at the price break for all lower prices with
the total cost of the largest feasible minimum point. The
quantity that yields the lowest total cost is the optimum.
 EXAMPLE- 4
The maintenance department of a large hospital uses about 816
cases of liquid cleanser annually. Ordering costs are $12,
carrying costs are $4 per case per year, and the new price
schedule indicates 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 cost.
Solution: D = 816 cases per year, S = $12, H = $4 /case/ year.

Range Price
1 to 49 $20
50 to 79 18
80 to 99 17
100 or more 16
Optimal economic order quantity
2 DS 2  816  12
Qo    70
H 4
 EXAMPLE – 4 CONT.
The 70 cases can be brought at $18 per case because 70 falls in the
range of 50 to 79 cases. The total cost to purchase 816 cases a year,
at the rate of 70 cases per order will be
TC70 = Carrying cost + Order cost + purchase cost
Q D 70 816
TC70  ( ) H  ( ) S  PD  ( )4  ( )12  18  816  $14,968
2 Qo 2 70

Because lower cost ranges exist, each must be checked against the
minimum cost generated by 70 cases at $18 each. In order to buy at
least $17 per case, at least 80 cases must be purchased. The total
cost at 80 cases will be
Q D 80 816
TC80  ( ) H  ( ) S  PD  ( )4  ( )12  17  816  $14,154
2 Qo 2 80
 EXAMPLE – 4 CONT.

To obtain a cost of $16 per case, at least 100 cases per order are
required, and the total cost will be

Q D 100 816
TC100  ( ) H  ( ) S  PD  ( )4  ( )12  16  816  $13,354
2 Qo 2 100

Hence purchasing 100 units is cheaper than other options.

 EXAMPLE - 5

Surge Electric uses 4,000 toggle switches a year.

Switches are priced as follows: 1 to 499, 90 cents
each; 500 to 999, 85 cents each; and 1,000 or more, 80
cents each It costs approximately $30 to prepare an
order and receive it, and carrying costs are 40 percent
of purchase price per unit on an annual basis.
Determine the optimal order quantity and the total
annual cost.
Solution: Here, D = 4,000 switches per year, S = $30,
H = .40P.
 EXAMPLE – 5 CONT.

Find the minimum point for each price, Range Unit Price H
starting with the lowest price, until you 1 to 499 $0.90 $0.36
locate a feasible minimum point.
500 to 999 $0.85 $0.34

1,000 or more $0.80 $0.32

2 DS 2  4000  30
Minimum _ po int 0.80    866 _ switches
H 0.32

2 DS 2  4000  30
Minimum _ po int 0.85    840 _ switches
H 0.34
Because an order size of 866 switches will cost $0.85 each rather
than $0.80 each, 866 is not a feasible minimum point for $0.80 per
switch. Next, try $0.85 per unit. This is feasible; it falls in the $0.85
per switch range of 500 to 999.
 EXAMPLE – 5 CONT.
Now compute the total cost for 840, and compare it to the total
cost of the minimum quantity necessary to obtain a price of $0.80
per switch.

TC840 = carrying cost + ordering cost + purchasing cost

Q D
 H  S  PD
2 Q
840 4,000
 (.34)  (30)  0.85(4000)  $3,686
2 840
1,000 4,000
TC1, 000  (.32)  (30)  0.80(4,000)  $3,480
2 1000

Thus, the minimum-cost order size is 1,000 switches.

 WHEN TO REORDER WITH EOQ ORDERING

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time
 WHEN TO REORDER WITH EOQ ORDERING
• Reorder Point – is the level of inventory at which a new
order is placed
Reorder Point Example
(demand and lead time both constant)

ROP = daily demand x Lead time in days

Demand = 10,000 units/year
Store open 311 days/year
Daily demand = 10,000 / 311 = 32.154 units/day
Lead time = L = 10 days

R = d*L = (32.154)(10) = 321.54 units

 REORDER POINT & SAFETY STOCK

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand
Expected demand
during lead time

Maximum probable demand

Reorder during lead time
point

Time
Safety Stock

ROP = daily demand x Lead time in days + Safety Stocks

 WHEN TO REORDER WITH EOQ ORDERING
(PROBABILISTIC MODELS)

• Safety Stock - Stock that is held in excess of expected demand due

to variable demand rate and/or lead time.
• Service Level - Probability that demand will not exceed supply
during lead time (probability that inventory available during the
lead time will meet the demand)
• Lead time: time interval between ordering and receiving the order
 Answer how much & when to order
 Allow demand and lead time to vary
 Follows normal distribution
 Other EOQ assumptions apply
 Consider service level & safety stock
 Service level = 1 - Probability of stockout
 Higher service level means more safety stock
 More safety stock means higher ROP
SAFETY STOCK AND SERVICE LEVEL

The ROP based on a normal

Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
 Reorder Point for Service Level
Probability of
meeting demand during
lead time = service level

Probability of
a stockout

Safety stock
zd LT

dL R
Expected Demand
d = Demand rate (units per day or week)

d LT = d LT d LT = Standard deviation of Lead time demand

d = Standard deviation of demand per day or week
Z = Number of standard deviations
LT = Lead Time
 EXAMPLE-6

The EOQ is 75 units. Suppose that the average demand is

18 units per week. Average lead time is 14 days with a
standard deviation of 3 days (6 working days in a
week). Determine safety stock and reorder point if
management wants a 90 percent cycle-service level.
Solution: Given that: EOQ =75 units, d = 18/6 = 3 units,
LT = 14 days, σLT = 3 days
Safety Stock: z d LT = 1.28 * 3 * 3 =11.52
Reorder Point: Lead time demand + Safety Stock
 =14*3 + 11.52 = 53.52 or 54 units (approx)
DETERMINANTS OF THE REORDER POINT

 The rate of demand

 The lead time
 Demand and/or lead time variability
 Stock-out risk (safety stock)
 How Much To Order
(Periodic Inventory System)
FIXED-ORDER-INTERVAL MODEL

 Orders are placed at fixed time intervals

 Order quantity for next interval?
 Suppliers might encourage fixed intervals
 May require only periodic checks of
inventory levels
 Risk of stock-out
 FIXED-INTERVAL BENEFITS
 Tight control of inventory items
 Items from same supplier may yield savings
in:
 Ordering
 Packing
 Shipping costs
 May be practical when inventories cannot be
closely monitored
 FIXED-INTERVAL DISADVANTAGES

 Requires a larger safety stock

 Increases carrying cost
 Costs of periodic reviews
EXAMPLE 7 (ROP FOR DEMAND DURING LEAD TIME AND
ITS STANDARD DEVIATION ARE AVAILABLE)
Suppose that the manager of a construction supply house determined from historical
records that demand for sand during lead time averages 50 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 tons and a standard deviation of 5 tons. Answer the
following questions, assuming that the manager is willing to accept a stock out risk of
no more than 3%:
(a) What value of z is appropriate?
(b) How much safety stock should be held?
(c) What reorder point should be used?
Solution:
Here, Expected lead time demand d = 50LT tons,
5
Standard deviation of lead time, tons, Risk = 3%
(a) Service level 97%, the z-value that corresponds to an area under the normal curve to
the left of z for 97% is zabout
 LT 1.88.
(b) Safety stock = = (1.88)(5) = 9.40 tons
(c) Quantity on hand at reorder point =
Expected lead time demand + Safety stock = 50 + 9.40 = 59.4 tons.
 EXAMPLE 8 ROP FOR VARIABLE DEMAND RATE AND
CONSTANT LEAD TIME
The housekeeping department of a motel uses approximately 400 washcloths per
day. The actual number tends vary with the number of guests on any given
night. Usage can be approximated by a normal distribution that has a mean of
400 and a standard deviation of 9 washcloths per day. A linen supply company
delivers towels and washcloths with a lead time of three days. If the motel
policy is to maintain a stock out risk of 2%, what is the minimum number of
washcloths that must be on hand at reorder time, and how much of that amount
can be considered safety stock?
Solution: Here, Demand rate, d = 400 washcloths per day, Lead time, LT = 3 days,
Standard deviation of demand rate = d  9 washcloths per day, Risk = 2% i.e.
service level 98%, the z-value that corresponds to an area under the normal
curve to the left of z for 98% is about 2.055.
Quantity on hand at reorder point,
ROP  dLT  z LT  d  ( 400 )( 3)  ( 2 .055 )( 3 )( 9 )  1200  32 .03  1232 .03
washcloths.
Safety stock is approximately 32 washcloths.
 EXAMPLE 9 (ROP FOR CONSTANT DEMAND RATE AND VARIABLE LEAD TIME

The housekeeping department of a motel uses approximately 600

bars of soap each day, and this tends not to vary by more than a
few bars either way. Lead time for soap delivery is normally
distributed with a mean of six days and a standard deviation of
two days. A service level of 90% is desired. Find the ROP.
Solution:
Here, Demand rate, d = 600 bars per day,
Service level, SL = 90%, so z = 1.28,
Lead time, LT = 6 days,
Standard deviation of lead time,  LT . 2
Quantity on hand at reorder point,
ROP  dLT  zd ( LT )  (600)( 6)  (1.28)( 600)( 2)  5136
bars of soap.
 EXAMPLE 10 (ROP FOR VARIABLE DEMAND RATE
AND VARIABLE LEAD TIME)
The housekeeping department of a motel replaces broken glasses at a rate of 25 per
day. In the past, this quantity has tended to vary normally and have a standard
deviation of 3 glasses per day. Glasses are ordered from a Cleveland supplier.
Lead time is normally distributed with an average of 10 days and a standard
deviation of 2 days. What ROP should be used to achieve a service level of 95%?
Solution:
Here, Demand rate, d = 25 glasses per day, Lead time, LT = 10 days,
Standard deviation of demand rate,  d  3 glasses per day,
Standard deviation of lead time,  LT  2days,

Service level, SL = 95%, so z = 1.65.

Quantity on hand at reorder point
ROP  dLT  LT d2  d 2 LT
2
 (25)(10)  1.65 10(3) 2  (25) 2 (2) 2  334

glasses.