Inventory Management

Chapter 2: Independent demand systems

M. Econ Nguyen Hoang Long
An inventory system can be modelled quantitatively based on demand patterns.
Deterministic Models

The order quantity (how much) and reorder point (when) are determined deterministically by
minimizing the total inventory cost that can be expressed as a function of these two
variables. The total inventory cost (T C) is generally composed of the following components:

T C = Tc + To + Ts + D ∗ C
 Inventory Policy

Inventory policy addresses two questions concerning

replenishment of inventory:
• When to order?
• How much to Order?
Reasons for Carrying Inventory

• Protect Against Lead Time Demand

• Maintain Independence of Operations
• Balance Supply and Demand
• Buffer Uncertainty
• Economic Purchase Orders
 Types of Inventory
• Cycle Stock
– inventory for immediate use Pipeline Inventory
– typically produced in batches (production – inventory in transit
cycle) – exists because points of supply and
• Safety Stock demand are not the same
– extra inventory carried for uncertainties in – also called transportation inventory
supply and demand • Maintenance, Repair and Operating
– also called buffer stock Items (MRO)
• Anticipation Inventory – inventories not directly related to produc
– inventory carried in anticipation of events creation
– smooth out the flow of products in supply
chain – also called seasonal or hedge
inventory
 Inventory Costs
• Holding Cost
– costs that vary with the amount of
inventory held
– typically described as a % of inventory
value
– also called carrying cost
• Ordering Cost
– costs involved in placing an order –
sometimes called setup cost
– inversely related to holding cost
• Shortage Cost
– occur when we run out of stock
 Inventory Systems

Inventory systems answer the questions:

when to order and how much to order
There are two categories:
•Fixed-Order Quantity System
– an order of fixed quantity, Q, is placed when
inventory drops to a reorder point, ROP
•Fixed-Time Period System
– inventory is checked in fixed time periods, T, and
the quantity ordered varies
 Economic Order Quantity (EOQ)
The EOQ minimizes the total annual inventory cost
Total Cost = Purchase cost+ Ordering cost + Holding cost
TC = DC + (D/Q)S + (Q/2)H
where:

TC = Total cost
D = Annual demand
C = Unit cost and Q = Order quantity
S = Ordering cost
H = Holding cost
TC = DC + (D/Q)S + (Q/2)H •Notice: DC = Annual purchase cost D/Q = # orders placed
per year
- Annual ordering cost = # orders/yr x cost/order Q/2 = average inventory level
- Annual holding cost = avg. inventory x cost/unit
Economic Order Quantity (EOQ)
The EOQ minimizes the total annual inventory cost
Total Cost = Purchase cost+ Ordering cost + Holding cost

TC = Total cost
D = Annual demand
C = Unit cost and Q = Order
quantity
S = Ordering cost
H = Holding cost
 Economic Order Quantity (EOQ)
EOQ Example Given:
Demand = 1000 items per month Holding Cost = 15% of product cost Ordering Cost =
$300 per order Product Cost = $60 per unit
 Exercise EOQ
[Spring Water] The demand for spring water at the Plano WalMart is 600 litres per
week. The setup cost for placing an order to replenish inventory is $25. The order is
delivered by the supplier which charges WalMart $0.10/liter for the cost of
transportation from the Ozark mountains to Plano. This transportation cost increases
the cost of water to $1.25/liter. The water loses its freshness while stored at the Plano
WalMart. To account for this, the WalMart charges an annual holding cost of $2.6/liter.
Determine how often the WalMart should order for water and what size each order
should be.
From the question, we deduce that K = 25, h = 2.6/52 = 0.05 per week, R = 600 per
week. Note that the transportation cost and the the cost of water are irrelevant for our
analysis. Then the optimal order quantity is Q = r 2KR h = r 2 ∗ 25 ∗ 600 0.05 =
774.6 liters. The WalMart places an order of size 774.6 liters in each order cycle.
Length of such a cycle is Q R = 774.6 600 = 1.29 weeks ≈ 9 days. Every 9 days, the
WalMart should order for 774.6 liters of spring water.
 Fixed-Order Quantity System
A fixed order quantity system is the arrangement in which the inventory level is
continuously monitored, and replenishment stock is ordered in previously-fixed quantities
whenever at-hand stock falls to the established re-order point.
In other words, it is an Inventory Control Systems. An inventory system controls the level
of inventory by determining how much to order (the level of replenishment), and when to
ord
 Fixed-Order Quantity System
Fixed-Order Quantity System
– assumes a constant demand rate of d
– the inventory position, IP, is reduced
by a rate of d
– order placed when the reorder point,
ROP is reached
– when inventory is received, the IP is
increased by the order quantity, Q

– there is a lead time, L, during which we have to wait for the order
– inventory is checked on a continual basis
– Q is computed as the economic order quantity, EOQ
 Reorder Point

There are two main variables to calculate in the Fixed-Order Quantity System:
•Order Quantity (Q) – EOQ is the most Economic Order Quantity
•Reorder Point (ROP)
Assume:
– demand (d), lead time (L), holding cost (H), stock-out cost (S), and unit price (C)
are constant
 Reorder Point (ROP)

Reorder Point (ROP) The ROP provides enough inventory to ensure that demand is
covered during the lead time (L)
ROP = Demand during Lead Time = dL
Given: Lead time = 1 week, d = 250 items/week
ROP = dL = (1) x (250) = 250 items
 order is placed when inventory level = 250 items
 Fixed-Order Size System
System because an order is issued at the time of reaching the Reorder Point. The method
has the following features in the relationship in the demand:
There are no relationships among the demand of each item, and each demand is
independently controlled.
* The demands are continuously made, and their seasonal variation is low. 
* The issue relatively frequently occurs.
* The percentage of consumption is almost fixed, and the demand fluctuates around the
average.
* Slightly many items are stored as inventory.
Thus this method is suitable for independent demand items belonging to B- or C-group,
whose demand is stable, and price is relatively inexpensive.
In the Fixed Size Ordering System, the maximum and minimum of standard inventory
quantity are defined in advance, and the quantity of inventory gradually decreases, and
when the number reaches ROP (Reorder Point, or also just simply OP), an order of EOQ
(Economic Order Quantity) is placed. 
The ROP is set in the following procedure:
(1) determine the actual consumption of each item
(2) determine EOQ
(3) determine the supplier for each item, and then the purchased lead time
(4) determine safety stock considering demand fluctuations, the variation of delivery
date, the lack/loss of stock, and etc.
(5) determine ROP by adding Consumed Amount within Purchased Lead Time to Safety
Stock Quantity
 Fixed-Time Period System
Inventory levels checked in fixed time periods, T – a target inventory level, R, is
restored when order received
– sometimes called Periodic Review System
– quantity ordered varies: Q = R – IP where: Q = order quantity R = target inventory
level IP = inventory position
Compare Inventory Systems
 Independent vs. Dependent Demand

Inventory policy is based on the type of demand

•Independent Demand
– demand for a finished product
•Dependent Demand
– demand for components parts or subassemblies
– order quantities computed with Material Requirements Planning (MRP)
– relationship between independent and dependent demand is shown in a bill of
materials (BOM)
Bill of Materials
 Managing Supply Chain Inventory

In addition to the quantitative models, there are a number of practical

implications to consider:
•ABC Inventory Classification
•Practical Considerations of EOQ
•Measuring Inventory Performance
•Vendor Managed Inventory
 ABC Inventory Classification

ABC system classifies inventory based on its degree of importance Steps:

1. Determine annual usage or sales for each item
2. 2. Determine % of total usage or sales for each item
3. 3. Rank items from highest to lowest %
4. 4. Classify items into groups: A: highest value, B: moderate value, C: least valuable
ABC Inventory Classification
 Practical Considerations of EOQ

• Lumpy Demand
– can use Periodic Order Quantity (POQ) when demand is not uniform
• EOQ Adjustments
– total cost changes little on either side of the EOQ  managers can adjust to
accommodate needs
• Capacity Constraints
– storage capacity and costs should be considered when ordering large quantities
 Measuring Inventory Performance

Common metrics for inventory:

• Units – # units available • Dollars – dollars tied up in inventory
• Weeks of Supply – (avg. on-hand inventory) / (avg. weekly usage)
• Inventory Turns – (cost of good sold) / (avg. inventory value)
 Average Inventory Example

Given a fixed-order quantity model with: Annual Demand (D) = 1,000 units Order
Quantity (Q) = 250 units Safety Stock (SS) = 50 units
• Average Inventory = Q/2 + SS = 250/2 + 50 = 175 units
• Inventory Turn = D/(Q/2 + SS) = 1,000/175 = 5.71 turns per year
 Vendor Managed Inventory (VMI)

VMI arrangements have the vendor responsible for managing the inventory located at
a customer’s facility
The vendor:
– stocks inventory
– places replenishment orders
– arranges the display
– typically owns inventory until purchased
– is required to work closely with customer
 Review

1. Reasons to carry inventory include protecting against lead time demand,

maintaining independence, buffering against uncertainty.
2. 2. Inventory types include: cycle stock, safety stock, anticipation, pipeline, and
MRO. 3.
3. 3 inventory costs: holding, ordering, & shortage.
4. 4. a. Inventory systems answer: when to order and how much to order.
b. Two most common systems are: fixed-order quantity and fixed-time period.
5. Fixed-order quantity systems have a reorder point (ROP). The basic system
utilizes the economic order quantity (EOQ), and when production feeds demand,
it utilizes the economic production quantity (EPQ).
6. In fixed-time period systems the time between orders, T, is constant, and the
order quantity varies. Orders bring the IP to a target level, R.
Independent demand is for a finished product and dependent demand is for
components.
8. ABC classification defines the degree of importance for inventory.
9. The most common ways to measure inventory are in units, dollars, weeks of supply,
and inventory returns.
10.Vendor managed inventory (VMI) is where the vendor is responsible for the
inventory located at a customer’s facility.
Production systems can be classified as Job-shop, Batch, Mass and Continuous
production systems.
 Job-Shop Production
Job-shop production are characterized by manufacturing one or few quantity of products
designed and produced as per the specification of customers within prefixed time and
cost. The distinguishing feature of this is low volume and high variety of products. A job-
shop comprises of general-purpose machines arranged into different departments. Each
job demands unique technological requirements, demands processing on machines in a
certain sequence. Job-shop Production is characterized by:
1. High variety of products and low volume.
2. Use of general-purpose machines and facilities.
3. Highly skilled operators who can take up each job as a challenge because of
uniqueness.
4. Large inventory of materials, tools, parts.
5. Detailed planning is essential for sequencing the requirements of each product,
capacities for each work centre and order priorities.
 Job-Shop Production

Advantages Following are the advantages of Job-shop Production:

1. Because of general purpose machines and facilities variety of products can be
produced.
2. Operators will become more skilled and competent, as each job gives them
learning opportunities.
3. Full potential of operators can be utilized.
4. Opportunity exists for Creative methods and innovative ideas
 Job-Shop Production

Limitations Following are the limitations of Job-shop Production:

1. Higher cost due to frequent set up changes.
2. Higher level of inventory at all levels and hence higher inventory cost.
3. Production planning is complicated.
4. Larger space requirements.
 Batch Production
American Production and Inventory Control Society (APICS) defines Batch Production
as a form of manufacturing in which the job pass through the functional departments in
lots or batches and each lot may have a different routing.
It is characterized by the manufacture of limited number of products produced at regular
intervals and stocked awaiting sales. Batch Production is characterized by
1. Shorter production runs.
2. Plant and machinery are flexible.
3. Plant and machinery set up is used to produce item in a batch and change of set up
is required for processing the next batch.
4. Manufacturing lead-time and cost are lower as compared to job order production.
 Batch Production

Advantages Following are the advantages of Batch Production:

1. Better utilization of plant and machinery.
2. Promotes functional specialization.
3. Cost per unit is lower as compared to job order production.
4. Lower investment in plant and machinery.
5. Flexibility to accommodate and process number of products.
6. Job satisfaction exists for operators.
 Batch Production
Limitations Following are the limitations of Batch Production:
1. Material handling is complex because of irregular and longer flows.
2. Production planning and control is complex.
3. Work in process inventory is higher compared to continuous production.
4. Higher set up costs due to frequent changes in set up.
 Mass Production
Manufacture of discrete parts or assemblies using a continuous process
are called Mass Production.
This production system is justified by very large volume of production.
The machines are arranged in a line or product layout. Product and
process standardization exists and all outputs follow the same path.
Mass Production is characterized by
1. Standardization of product and process sequence.
2. Dedicated special purpose machines having higher production
capacities and output rates.
3. Large volume of products.
4. Shorter cycle time of production.
5. Lower in process inventory.
6. Perfectly balanced production lines.
7. Flow of materials, components and parts is continuous and without any
back tracking.
8. Production planning and control is easy.
 Mass Production
Following are the advantages of Mass Production:
1. Higher rate of production with reduced cycle time.
2. Higher capacity utilization due to line balancing.
3. Less skilled operators are required.
4. Low process inventory.
5. Manufacturing cost per unit is low.

Following are the limitations of Mass Production:

6. Breakdown of one machine will stop an entire production line.
7. Line layout needs major change with the changes in the product design.
8. High investment in production facilities.
9. The cycle time is determined by the slowest operation.
 Continuous Production

Continuous Production facilities are arranged as per the sequence of production

operations from the first operations to the finished product. The items are made to
flow through the sequence of operations through material handling devices such as
conveyors, transfer devices, etc. Continuous Production is characterized by
1. Dedicated plant and equipment with zero flexibility.
2. Material handling is fully automated.
3. Process follows a predetermined sequence of operations.
4. Component materials cannot be readily identified with final product.
5. Planning and scheduling is a routine action.
 Continuous Production
Following are the advantages of Continuous Production:
1. Standardization of product and process sequence.
2. Higher rate of production with reduced cycle time.
3. Higher capacity utilization due to line balancing.
4. Manpower is not required for material handling as it is completely automatic.
5. Person with limited skills can be used on the production line.
6. Unit cost is lower due to high volume of production.

Following are the limitations of Continuous Production:

7. Flexibility to accommodate and process number of products does not exist.
8. Very high investment for setting flow lines.
9. Product differentiation is limited.