Operations Management: Sustainability

and Supply Chain Management

Thirteenth Edition, Global Edition

Chapter 12
Inventory Management

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Outline (1 of 2)
• Global Company Profile: Amazon.com
• The Importance of Inventory
• Managing Inventory
• Inventory Models
• Inventory Models for Independent Demand

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Inventory Management at
Amazon.com (1 of 3)
• Amazon.com started as a “virtual” retailer – no inventory,
no warehouses, no overhead – just computers taking
orders to be filled by others
• Growth has forced Amazon.com to become a world leader
in warehousing and inventory management

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Inventory Management at
Amazon.com (2 of 3)
1. Each order is assigned by computer to one of the
distribution centers
2. A “flow meister” at each distribution center assigns work
crews
3. Robots and technology help workers move merchandise
and pick the correct items
4. Items are placed into crates on a conveyor, bar code
scanners scan each item 15 times to virtually eliminate
errors

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Inventory Management at
Amazon.com (3 of 3)
5. Crates arrive at central point where items are boxed and
labeled with new bar code
6. Order arrives at customer within 1 - 2 days
Amazon expects the customer experience to yield the lowest
price, fastest delivery, and error-free order fulfillment

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Learning Objectives (1 of 2)
When you complete this chapter you should be able to:
12.1 Conduct an ABC analysis
12.2 Explain and use cycle counting
12.3 Explain and use the EOQ model for independent
inventory demand
12.4 Compute a reorder point and explain safety stock

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Learning Objectives (2 of 2)
When you complete this chapter you should be able to:
12.5 Explain and use the quantity discount model

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Inventory Management
The objective of inventory management is to strike a
balance between inventory investment and customer
service

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Importance of Inventory
• One of the most expensive assets of many companies
representing as much as 50% of total invested capital
• Less inventory lowers costs but increases chances of
shortages, which might stop processes or result in
dissatisfied customers
• More inventory raises costs but improves the likelihood of
meeting process and customer demands

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Functions of Inventory
1. To provide a selection of goods for anticipated demand
and to separate the firm from fluctuations in demand
2. To decouple or separate various parts of the production
process
3. To take advantage of quantity discounts
4. To hedge against inflation

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Types of Inventory
• Raw material
– Purchased but not processed
• Work-in-process (WIP)
– Undergone some change but not completed
– A function of flow time for a product
• Maintenance/repair/operating (MRO)
– Necessary to keep machinery and processes
productive
• Finished goods
– Completed product awaiting shipment
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Managing Inventory
1. How inventory items can be classified (ABC analysis)
2. How accurate inventory records can be maintained

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ABC Analysis (1 of 5)
• Divides inventory into three classes based on annual dollar
volume
– Class A - high annual dollar volume
– Class B - medium annual dollar volume
– Class C - low annual dollar volume
• Used to establish policies that focus on the few critical
parts and not the many trivial ones

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ABC Analysis (2 of 5)
Figure 12.2

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ABC Analysis (3 of 5)
ABC Calculation

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ABC Analysis (4 of 5)
• Other criteria than annual dollar volume may be used
– High shortage or holding cost
– Anticipated engineering changes
– Delivery problems
– Quality problems

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ABC Analysis (5 of 5)
• Policies employed may include
1. More emphasis on supplier development for A items
2. Tighter physical inventory control for A items
3. More care in forecasting A items

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Record Accuracy (1 of 2)
• Accurate records are a critical ingredient in production and inventory
systems
– Periodic systems require regular checks of inventory
 Two-bin system
– Perpetual inventory tracks receipts and subtractions on a
continuing basis
 May be semi-automated

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Record Accuracy (2 of 2)
• Incoming and outgoing
record keeping must be
accurate
• Stockrooms should be
secure
• Necessary to make precise
decisions about ordering,
scheduling, and shipping

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Cycle Counting
• Items are counted and records updated on a periodic basis
• Often used with ABC analysis
• Has several advantages
1. Eliminates shutdowns and interruptions
2. Eliminates annual inventory adjustment
3. Trained personnel audit inventory accuracy
4. Allows causes of errors to be identified and corrected
5. Maintains accurate inventory records

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Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750
C items
Policy is to count A items every month (20 working days), B
items every quarter (60 days), and C items every six months
(120 days)

ITEM CLASS QUANTITY CYCLE COUNTING NUMBER OF ITEMS

POLICY COUNTED PER DAY
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
blank blank blank 77/day

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Control of Service Inventories
• Can be a critical component of profitability
• Losses may come from shrinkage or pilferage
• Applicable techniques include
1. Good personnel selection, training, and discipline
2. Tight control of incoming shipments
3. Effective control of all goods leaving facility

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Inventory Models (1 of 2)
• Independent demand - the demand for item is
independent of the demand for any other item in inventory
• Dependent demand - the demand for item is dependent
upon the demand for some other item in the inventory

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Inventory Models (2 of 2)
• Holding costs - the costs of holding or “carrying” inventory
over time
• Ordering cost - the costs of placing an order and receiving
goods
• Setup cost - cost to prepare a machine or process for
manufacturing an order
– May be highly correlated with setup time

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Holding Costs (1 of 2)
Table 12.1 Determining Inventory Holding Costs

COST (AND RANGE)

CATEGORY AS A PERCENTAGE OF
INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)

Investment costs (borrowing costs, taxes, and 11% (6 - 24%)

insurance on inventory)
Pilferage, space, and obsolescence (much higher 3% (2 - 5%)
in industries undergoing rapid change like tablets
and smart phones)
Overall carrying cost 26%

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Holding Costs (2 of 2)
Table 12.1 Determining Inventory Holding Costs
COST (AND RANGE)
CATEGORY AS A PERCENTAGE OF
INVENTORY VALUE
Housing costs (building rent or depreciation, 6% (3 - 10%)
operating costs, taxes, insurance)
Material handling costs (equipment lease or 3% (1 - 3.5%)
depreciation, power, operating cost)
Labor cost (receiving, warehousing, security) 3% (3 - 5%)

Investment costs (borrowing costs, taxes, and 11% (6 - 24%)

insurance on inventory)
Pilferage, space, and obsolescence (much higher 3% (2 - 5%)
in industries undergoing rapid change like tablets
and smart phones)
Overall carrying cost 26%

Holding costs vary considerably depending on the business, location, and

interest rates. Generally greater than 15%, some high tech and fashion
items have holding costs greater than 40%.
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Inventory Models for Independent
Demand
Need to determine when and how much to order
1. Basic economic order quantity (EOQ) model
2. Quantity discount model

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Basic EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and complete
4. Quantity discounts are not possible
5. Only variable costs are setup (or ordering) and holding
6. Stockouts can be completely avoided

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Inventory Usage Over Time
Figure 12.3

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Minimizing Costs (1 of 7)
Objective is to minimize total costs

Figure 12.4c

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Minimizing Costs (2 of 7)
• By minimizing the sum of setup (or ordering) and holding
costs, total costs are minimized
• Optimal order size Q* will minimize total cost
• A reduction in either cost reduces the total cost
• Optimal order quantity occurs when holding cost and setup
cost are equal

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Minimizing Costs (3 of 7)
The necessary steps are:
1. Develop an expression for setup or ordering cost
2. Develop an expression for holding cost
3. Set setup (order) cost equal to holding cost
4. Solve the equation for the optimal order quantity.

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Minimizing Costs (4 of 7)
Q = Number of units per order

Q* = Optimal number of units per order (EOQ)

D = Annual demand in units for the inventory item

S = Setup or ordering cost for each order

H = Holding or carrying cost per unit per year

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 Minimizing Costs (5 of 7)
Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)

D = Annual demand in units for the inventory

item

S = Setup or ordering cost for each order

H = Holding or carrying cost per unit per year

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Minimizing Costs (6 of 7)
Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)

D = Annual demand in units for the inventory item

S = Setup or ordering cost for each order

H = Holding or carrying cost per unit per year

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Minimizing Costs (7 of 7)
Q = Number of pieces per order

Q* = Optimal number of pieces per order (EOQ)

D = Annual demand in units for the inventory

item

S = Setup or ordering cost for each order

H = Holding or carrying cost per unit per year

Optimal order quantity is found when annual setup cost
equals annual holding cost
Solving for Q*

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An EOQ Example (1 of 6)
Determine optimal number of needles to order
D = 1,000 units

S = $10 per order

H = $.50 per unit per year

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An EOQ Example (2 of 6)
Determine expected number of orders

D = 1,000 units Q* = 200 units

S = $10 per order
H = $.50 per unit per year

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An EOQ Example (3 of 6)
Determine optimal time between orders

D = 1,000 units Q* = 200 units

S = $10 per order N = 5 orders/year
H = $.50 per unit per year

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An EOQ Example (4 of 6)
Determine the total annual cost

D = 1,000 units Q* = 200 units

S = $10 per order N = 5 orders/year

H = $.50 per unit per year T = 50 days

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Robust Model
• The EOQ model is robust
• It works even if all parameters and assumptions are not met
• The total cost curve is relatively flat in the area of the E OQ

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An EOQ Example (5 of 6)

Ordering old Q* Ordering new Q*

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An EOQ Example (6 of 6)
Only 2% less than
the total cost of
$125 when the
order quantity was
200

Ordering old Q* Ordering new Q*

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Reorder Points
• EOQ answers the “how much” question
• The reorder point (ROP) tells “when” to order
• Lead time (L) is the time between placing and receiving an
order

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Reorder Point Curve
Figure 12.5

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Reorder Point Example
Demand = 8,000 iPhones per year
250 working day year
Lead time for orders is 3 working days, may take 4

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Production Order Quantity Model
(1 of 5)

1. Used when inventory builds up over a period of time after

an order is placed
2. Used when units are produced and sold simultaneously

Figure 12.6

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Production Order Quantity Model
(2 of 5)

Q = Number of units per order p = Daily production rate

H = Holding cost per unit per year d = Daily demand (usage) rate
t = Length of the production run in days

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Production Order Quantity Model
(3 of 5)
Q = Number of units per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand (usage) rate
t = Length of the production run in days

However, Q = total produced = pt ; thus t = Q/p

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Production Order Quantity Model
(4 of 5)
Q = Number of units per order p = Daily production rate
H = Holding cost per unit per year d = Daily demand (usage) rate
t = Length of the production run in days

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Production Order Quantity Example
D = 1,000 units p = 8 units per day
S = $10 d = 4 units per day
H = $0.50 per unit per year

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Production Order Quantity Model
(5 of 5)

Note:

When annual data are used the equation becomes:

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Quantity Discount Models (1 of 5)
• Reduced prices are often available when larger quantities
are purchased
• Trade-off is between reduced product cost and increased
holding cost

Table 12.2 A Quantity Discount Schedule

PRICE RANGE QUANTITY ORDERED PRICE PER UNIT P

Initial price 0 to 119 $ 100

Discount price 1 120 to 1,499 $ 98

Discount price 2 1,500 and over $ 96

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Quantity Discount Models (2 of 5)

where Q = Quantity ordered P = Price per unit

D = Annual demand in units I = Holding cost per unit per year

S = Ordering or setup cost per order expressed as a percent of price P

Because unit price varies, holding cost is expressed as a

percentage (I) of unit price (P)
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Quantity Discount Models (3 of 5)
Steps in analyzing a quantity discount
1. Starting with the lowest possible purchase price,
calculate Q* until the first feasible EOQ is found. This is
a possible best order quantity, along with all price-break
quantities for all lower prices.
2. Calculate the total annual cost for each possible order
quantity determined in Step 1. Select the quantity that
gives the lowest total cost.

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Quantity Discount Models (5 of 5)
Calculate Q* for every discount
starting with the lowest price

Infeasible – calculate Q*
for next-higher price

Feasible
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Quantity Discount Example
Table 12.3 Total Cost Computations for Chris Beehner
Electronics

Choose the price and quantity that gives the lowest total cost
Buy 275 drones at $98 per unit

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