Chapter 15: Inventory Systems For

Independent Demand
Definition of Inventory
-Stock of any item or resource used in the
organization.
Inventory System – Set of policies and controls that
monitors levels of inventory, determines what
level should be maintained, when stock should be
replenished, , and how large orders should be.
Manufacturing inventory – Raw materials, finished
products, component parts, supplies, and work in
1
process (WIP)
Basic Purpose of Inventory Analysis
• -To determine (a) when item should be
ordered, and (b) how large the order should be.

2
Purposes of Inventory
• To maintain independence of operations – A
supply of materials at a work center allows that
center flexibility in operations. Independence of
workstations is desirable on assembly lines as
well. The time that it takes to do identical
operations will naturally vary from one unit to
another. Therefore, it is desirable to have a
cushion of several parts within the workstation
so that shorter performance times can
compensate for longer performance times.
3
Purposes of Inventory (Continued)
• To variation in product demand – Demand is not
completely known. Therefore, a safety or buffer
stock must be maintained to absorb variation.

• To allow flexibility in production scheduling – A

stock of inventory relieves the pressure on the
production system to get the goods out. This
causes longer lead times which permit
production planning for smoother flow lower-
cost operation through larger lot-size production.
4
Purposes of Inventory (Continued)
• To provide a safeguard for variation in raw
material delivery time – When material is ordered
from a vendor, delays can occur for a variety of
reasons: a normal variation in shipping time, a
shortage of material at the vendor’s plant causing
backlog, unexpected strike at the vendor’s plant or
at one of the shipping companies etc. Inventory
will play as a safeguard.
• To take advantage of economic purchase-order size
– There are costs to place an order: labor,
communication cost, handling cost, etc. The larger
5
the order, the lower the per-unit cost.
Inventory Costs
• Holding (or carrying cost): costs for storage
facilities, handling, insurance, pilferage,
breakage, obsolescence, depreciation, taxes,
opportunity cost of the capital, etc.

• Set-up (or production change) costs: Costs to

obtain necessary materials, arranging specific
equipments set-up, filling-out the required
papers, appropriately charging time and
materials, moving out the previous stock of
6
material, etc.
Inventory Costs (Continued)
• Ordering costs: Managerial and clerical costs to
prepare the purchase or production order

• Shortage costs: Costs for unfilled demand, lost

customers effect, etc.

7
Inventory Models
- Fixed-order quantity models (economic order quantity
model, Q-model), and Fixed-time period models (periodic
system, periodic review system, fixed-order interval
system, P-model)
- Fixed-order quantity models are “event triggered” and
fixed-time period models are “time triggered”
- A fixed-order quantity model initiates an order when the
event of reaching a specified reorder level occurs. In
contrast, a fixed-time period model initiate an order after a
predetermined time elapses.

8
Fixed-order vs. Fixed-time
• The fixed-time period model has a larger average inventory
because it must also protect against stock out during the
review period, T: the fixed-order quantity model has no
review period.
• The fixed-order quantity model favors more expensive
items because average inventory is lower.
• The fixed-order quantity model is more appropriate for
important items such as critical repair parts because there
is closer monitoring and therefore quicker response to
potential stock out.
• The fixed-order quantity model requires more time to
maintain because every addition or withdrawal is logged.
9
Fixed-Order Quantity Models
- Determine the specific point, R, at which an
order will be placed and the size of that order,
Q.
- R is always a specified number of units. An
order of size Q is placed when the inventory
available (currently available and on order)
reaches the point R.
Inventory position = On-hand + On-order – Back-
ordered
10
Assumptions

• Demand for the product is constant and uniform throughout

the period

• Lead time (time from ordering to receipt) is constant

• Price per unit of product is constant

• Inventory holding cost is based on average inventory

• Ordering or setup costs are constant

• All demands for the product will be satisfied (No back orders
11
are allowed)
 BASIC FIXED-ORDER QUANTITY MODEL AND
REORDER POINT BEHAVIOR
1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
2. Your start using them L L
up over time. 3. When you reach down to a level
Time of inventory of R, you place your
R = Reorder point next Q sized order.
Q = Economic order quantity
L = Lead time
 COST MINIMIZATION GOAL
By
Byadding
addingthe
theitem,
item,holding,
holding,andandordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichin in
turn
turnis
isused
usedtotofind
findthe
theQQopt inventory order point that
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
BASIC FIXED-ORDER QUANTITY TC=Total
TC=Totalannual
annual
cost
(EOQ) MODEL FORMULA cost
DD=Demand
=Demand
Total Annual Annual Annual CC=Cost
=Costperperunit
unit
Annual = Purchase + Ordering + Holding QQ=Order
=Orderquantity
quantity
Cost Cost Cost Cost SS=Cost
=Costofofplacing
placing
an
anorder
orderororsetup
setup
cost
cost
RR=Reorder
=Reorderpoint
point
LL=Lead
=Leadtime
time
H=Annual
H=Annualholding
holding
D Q and
andstorage
storagecost
cost
TC = DC + S + H per
perunit
unitof
ofinventory
inventory

Q 2
DERIVING THE EOQ
Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative ofof the
thetotal
total
cost
cost function
function with
with respect
respect toto Q,
Q, and
and set
set the
thederivative
derivative
(slope)
(slope) equal
equal to
to zero,
zero,solving
solving for
forthe
theoptimized
optimized (cost
(cost
minimized)
minimized) value
valueof of Q
Qopt
opt

2DS 2(Annual Demand)(Order or Setup Cost)

QOPT = =
H Annual Holding Cost
_
We
Wealso
alsoneed
needaa
reorder
reorderpoint
pointto
totell
tellus
us
R eorder p oint, R = d L
when _
whentotoplace
placean
an
order
order d = average daily demand (constant)
L = Lead time (constant)
EOQ EXAMPLE (1) PROBLEM DATA
Given
Giventhe
theinformation
informationbelow,
below,what
whatare
arethe
theEOQ
EOQand
andreorder
reorderpoint?
point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
EOQ EXAMPLE (1) SOLUTION
2DS 2(1,000 )(10)
Q OPT = = = 89.443 units or 90 units
H 2.50

1,000 units / year

d = = 2.74 units / day
365 days / year

_
Reorder point, R = d L = 2.74units / day (7days) = 19.18 or 20 units

In
Insummary,
summary,youyouplace
placeananoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have2020units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of90
90
units.
units.
EOQ EXAMPLE (2) PROBLEM DATA
Determine
Determine thethe economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following…
following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15
EOQ EXAMPLE (2) SOLUTION
2D S 2 (1 0 ,0 0 0 )(1 0 )
Q OPT = = = 3 6 5 .1 4 8 u n its, o r 3 6 6 u n its
H 1 .5 0

10,000 units / year

d= = 27.397 units / day
365 days / year

_
R = d L = 27.397 units / day (10 days) = 273.97 or 274 units

Place
Placeananorder
orderfor
for366
366units.
units. When
Whenininthe
thecourse
courseofofusing
usingthe
the
inventory
inventoryyou
youare
areleft
leftwith
withonly
only274
274units,
units,place
placethe
thenext
nextorder
orderof
of366
366
units.
units.
Fixed-Order Quantity Model With Usage
During Production Time
• The previous model assumed that the quantity ordered
would be received in one lot, but frequently this is not
the case.
• In many situations, production of an inventory item and
usage of that item take place simultaneously (where one
part of a production system acts as supply to another
part).
• Also, companies are beginning to longer-term
arrangements with supplier. Under such contracts, a
single order may cover product or material needs over a
six-month or year period, with the vendor making 20
deliveries weekly or sometimes more frequently.
Fixed-Order Quantity Model With Usage
During Production Time (Continued)
• TC = DC + (D/Q)*S + ((p-d)/2p)*QH
p = Production rate, d = Daily demand rate

After differentiating with respect to Q and setting the

equation to 0,

2 DS p
Qopt = ( * )
H p d

21
Standard Deviation
• Standard deviation, σ, is a measurement of deviation
from mean. In case of demand, it is a measurement of
deviation from average demand.

i1 i
n
( d  d ) 2

σd =standard deviation for daily demand= n

L 2
If lead time is L, then σL = d

22
Establishing Safety Stock Levels
• Up to now, the assumption is that demand is constant and is
precisely known.
• On the contrary, in the majority of the case demand is not
constant but varies from day to day. Hence, safety stock must
be maintained to provide some level of protection against
stock-outs.
Safety stock can be defined as the amount of inventory carried
in addition to the expected demand.
If demand is assumed to follow normal distribution, then the
expected demand is the mean.
If average weekly demand is 100 units and the demand for next
week is expected to be same, then if 120 units is carried in
inventory, then safety stock is (120 – 100) = 20 units.
Service Level
• Service level refers to the number of units demanded
that can be supplied from stock currently on hand.
For example, if annual demand for an item is 1000 units,
a 95% service level means that 950 units can be
supplied immediately from stock and 50 units are
short
The discussion on service levels is based on a statistical
concept known as Expected z or E(z). E(z) is the
expected number of units short during each lead time
(assumption is that demand is normally distributed)
Service Level (Continued)
• For example, assume that the average weekly demand for
an item is 100 units with a standard deviation of 10 units.
If there is 110 units in the inventory at the beginning of
the week, how many items will be short?
• If the demand comes out to be from 111 units to 
the number of units short is 1, 2, 3,……., 
respectively.

Expected number of short = 1*P(demand = 111 units) +

2*P(demand = 112 units) + 3*P(demand = 113 units) +
……….+  *P(demand = α )
Service Level
• If z = 1 and standard deviation, σL = 10 units, then
amount of safety stock = z σL = 1*10=10 units
Then, expected number of short is E(z)* σL [E(z) have to
be determined from Exhibit 15.6 for value of z]
Service level = (1 – E(z)* σL /Inventory or Ordered
Amount)*100%
Service Level Example 1
• Consider an economic order quantity case where
annual demand D = 1000 units, economic order
quantity Qopt = 200 units, the desired service level P =
0.95, the standard deviation of demand during lead
time σL = 25 units, and lead time L = 15 days.
Determine the reorder point.
Service Level Example 2
• Daily demand for a certain product is normally
distributed with a mean of 60 and standard deviation
of 7. The source of supply is reliable and maintains a
constant lead time of 6 days. The cost of placing an
order is $10 and annual holding costs are $0.50 per
unit. There are no stock-out costs, and unfilled orders
are filled as soon as the order arrives. Assume sales
occur over the entire year. Find the economic order
quantity and reorder point to satisfy 95% of the
customers from stock on hand.
Fixed Time Period Models
• In a fixed time period system, inventory is counted
only at particular times, such as every week or every
month. Counting inventory and placing orders on a
periodic basis is desirable in situations such as when
vendors make routine visits to customers and take
orders for their complete line of orders.
• Fixed-time period model generate order quantities
that vary from period to period depending on usage
rates. These generally require a higher level of safety
stock than a fixed-order quantity system. It is possible
that some large demand will draw the stock down to 0
right after an order is placed. This condition could go
unnoticed until the next review period.
Fixed-Time Period Model With Specified
Service Level
• In a fixed –time period system, reorders are placed at
the time of review (T), and the safety stock that must
be reordered is
Safety Stock = zσT+L
The quantity to order, q , is
Order quantity = Average demand over the vulnerable
period + Safety Stock – Inventory Currently On Hand
(Plus On Order, If Any)
q = d̄(T+L) + zσT+L – I
E(z) = d̄T(1-P)/ σT+L
EXAMPLE OF THE FIXED-TIME PERIOD MODEL
Given
Giventhe
theinformation
informationbelow,
below,how
howmany
manyunits
unitsshould
shouldbe
be
ordered?
ordered?

Average daily demand for a product is 20 units. The

review period is 30 days, and lead time is 10 days.
Management has set a policy of satisfying 96 percent
of demand from items in stock. At the beginning of
the review period there are 200 units in inventory.
The daily demand standard deviation is 4 units.
EXAMPLE OF THE FIXED-TIME PERIOD
MODEL: SOLUTION (PART 1)
 T+ L = (T + L) d =  30 + 10   4 = 25.298
2 2

E(z)
E(z)==d̄d̄T(1-P)/σ
T(1-P)/σT+L
T+L

== 20*30(1-0.96)/25.298
20*30(1-0.96)/25.298

== 0.949
0.949

IfIfE(z)
E(z)==0.949,
0.949,then
thenzz==-0.84
-0.84

[From
[FromExihibit
Exihibit15.6,
15.6,for
forE(z)
E(z)==1.000,
1.000,zz==-0.90,
-0.90,for
forE(z)
E(z)==0.920,
0.920,zz==-0.80
-0.80

So,
So,for
forE(z)
E(z)==0.949,
0.949,zz==-0.90
-0.90++{(1.000-0.949)/(1.000-0.920)}*{-0.80
{(1.000-0.949)/(1.000-0.920)}*{-0.80–(-0.90)}=-
–(-0.90)}=-
Fixed-Time Period Example (Continued)
The quantity to order = d̄ (T+L)+zσT+L –I
=20(30+10) + (-0.84)*25.298 – 200
=578.75 or 579 units
Background for ABC Inventory Planning
Maintaining inventory through counting, placing orders,
receiving stocks, placing the units in the right place, and
so on takes personnel time and costs money.
When there are limits on these resources, the logical move
is to try to use the available resources to control
inventory in the best way.
In other words, focus on the most important items in
inventory.
Pareto Principle
• In the 19th Century, Villefredo Pareto, in a study of the
distribution of wealth in Milan, found that 20% of the
people controlled 80% of the wealth.
• This logic of the few having the greatest importance
and many having little importance has been
broadened to include many situations and is termed
the Pareto Principle.
Pareto Principle (Continued)
• Pareto principle is true in our everyday lives and is
certainly true in inventory system (where a few items
account for the bulk of investment).
• Any inventory system must specify when an order is to
be placed for an item and how many units to order.
Most inventory control systems involve so many items
that is not practical to model and give thorough
treatment to each item.
• To resolve this, the ABC classification scheme divides
inventory items into three different groupings: high
dollar volume (A), moderate dollar volume (B), and
low dollar volume (C).
ABC Classification
• If the annual usage of items in inventory is listed
according to dollar volume, generally the list shows
that a small number of items account for a large dollar
volume and that a large number of items account for a
small dollar volume.
• The ABC approach divides the list into three groupings
by value: A items constitute roughly the top 15
percent of the items, B items the next 35 percent, and
C items the last 50 percent. A items account for
roughly 70 percent of the dollar volume, B items
account for around 20 percent of the dollar volume,
and C items account for close to 10 percent of the
total dollar volume.
ABC Classification (Continued)
• The values are not exactly fixed. The objective is to
separate the important from unimportant.
• The purpose of classifying items into groups is to
establish the appropriate degree of control over each
item.